Managing Tax-Efficient Withdrawal Strategies for Retirement

Retirement income decisions on the sequencing of withdrawals interact with each other, income tax provisions and the client’s financial goals. What appears to be a sound decision could produce unintended costs unless the advisor considers the interaction of retirement income sufficiency, income taxes and potential estate taxes.

A white paper by Carlo Cordasco, senior national director of the Nationwide Retirement Institute, “Withdrawal Sequencing Strategies That Could Enhance Tax Efficiency,” examines these interactions. 

Cordasco describes the problem: “What does an IRA withdrawal do to the taxability of a capital gain? What does the presence of capital gains do to the taxation of Social Security benefits? And how is the client’s effective tax rate impacted when he or she has all of the above? The first two questions are examples of product- and account-level tax considerations; the third points to the importance of a deeper awareness of interactions.”

Cordasco presents a series of scenarios using a building block approach to illustrate how advisors should consider tax interactions.

For instance, the first scenario starts with the income tax calculation for a retired couple who have incurred a capital gain, which in this first example is taxed at the available 0% rate. He then complicates the situation by adding a $10,000 IRA withdrawal to the same capital gain. The additional IRA income results in $10,000 of the capital gains being shifted into the 15% bracket for a tax liability of $1,500. 

Other scenarios take the same approach. Cordasco calculates the income taxes from a client receiving both Social Security and IRA withdrawals. This requires a calculation of the couple’s provisional income and the taxability of their Social Security income. In the second part of the illustration, he adds an additional $10,000 IRA withdrawal and shows its tax cost. While an advisor will recognize the tax interactions involved, clients probably won’t understand the total costs until the advisor explains them. 

Besides considering income tax minimization, Cordasco also discusses how different sequencing strategies affect other goals that retirees often have:

• Portfolio longevity: Extending the life of their retirement portfolio.
• Sustainable income: Maintaining their standard of living in retirement.
• After-tax estate value: Preserving savings to pass on to heirs.

An essential requirement to providing clients with comprehensive analyses is having software that recognizes the tax interactions and presents the results in a format clients can understand.

Financial professionals may want to consider software that allows them to factor in several key variables, Cordasco suggests: “One argument in favor of tax diversification-related asset location is that it allows retirees the flexibility to respond to a changing tax environment over the course of their retirement. Software that allows for different assumptions regarding future tax rates can be helpful. 

“Also, software that allows financial professionals to identify potential income tax issues for beneficiaries can provide opportunities to incorporate those beneficiaries into the planning process, which can lead to building a generational practice.”

Other key considerations Cordasco mentions include understanding how to incorporate individual issues, qualified and nonqualified investments, insurance-based products, health savings accounts, etc., into the program to optimize the combination of minimizing taxes and maximizing income over time. For example, loading both Roth and non-Roth 401(k)/IRA investments and selecting the proper tax impacts on future tax withdrawals is valuable. 

“Another example is cash value life insurance,” he adds. “Many of the leading planning software programs allow the user to show the cash value as an asset and source of income, which of course comes with its own unique taxable/non-taxable considerations.

‘’Once the assets are captured and properly ‘located’ or classified for tax purposes, the financial professional is in position to begin the income sequencing needs analysis across the complete portfolio. Of course, the right strategy will depend upon the client’s unique needs and tax advice must come from a tax professional.”

As a practical example, he cites managing modified adjusted gross income, or MAGI, which among other considerations affects Medicare Part B premiums, which in turn can impact Social Security benefits. As MAGI increases, Medicare Part B premiums, which are predicated upon a sliding scale, can increase as well. This in turn may reduce the client’s Social Security benefit because Medicare Part B premiums are paid for from the client’s Social Security benefit. 

“With an eye on managing MAGI, the financial professional who is monitoring their clients’ income needs and potential taxation levels can tap into the planning software to identify which of their income sources may provide income not included in the MAGI calculation,” he explains. “This provides the FP with the opportunity to meet the income need, reducing both the client’s Medicare Part B premium and income-related taxes.”