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What You Need to Know

  • Tax issues cut across all aspects of the saving, spending and investing process, such that consideration of tax matters can significantly boost overall outcomes.
  • Given the constant fluctuations in tax laws and regulations, tax planning is best done on a shorter time frame.
  • While the tax laws may change frequently, the most common questions about tax mitigation do not.

As shown by the recent kerfuffle over the death of the stretch IRA, the IRS’ controversial interpretation of the rules around its death, and the penalty relief extended late last week to IRA beneficiaries who have not complied with that interpretation, tax planning strategies are ever-changing.

But that doesn’t mean there are no constants when it comes to advisors’ role in tax planning.

“There is no such thing as a permanent tax law,” says Timothy Steffen, director of tax planning at Baird Private Wealth Management, the U.S.-based financial planning arm of the multinational independent investment bank and financial services company Baird.

As a certified public accountant and director of tax planning for Baird, Steffen is responsible for researching, writing and speaking on important tax issues that affect the firm’s diverse set of clients. His work covers topics related to retirement planning, executive compensation, business ownership, legislative changes and overall best practices.

During a recent interview with ThinkAdvisor, Steffen offered a number of tips and suggestions for his colleagues in the financial planning industry, with the hope of inspiring them to consider the tantamount importance of tax issues in the planning process.

As Steffen emphasizes, the financial advisor will never replace a client’s trusted accountants or tax attorneys, but advisors must understand that tax issues cut across all aspects of the saving, spending and investing process, such that close collaboration on tax matters can significantly boost overall outcomes.

Here are four of Steffen’s top tax considerations.

1. Change in Tax Laws Is Constant, but Best Practices Are Fixed

Steffen says the first key lesson to understand about tax issues is that they are always changing, with the result being that tax planning is, generally speaking, best done over a shorter time frame compared with the long-term nature of the typical client’s overall financial plan.

“There is no such thing as a permanent tax law,” he says. “Change is just such a constant in this field.”

As an example, Steffen points to the evolution in tax rates seen in the past five years, thanks mostly to the passage of the Tax Cuts and Jobs Act of 2017. That law substantially changed key rules for deductions, depreciation, expensing, tax credits and other tax items that affect all sorts of businesses and individuals.

At this stage, Steffen says, the TCJA-based changes are relatively well appreciated by clients and advisors. However, the cuts are set to expire in 2025, barring further congressional action.

“At this point, it's basically impossible to guess what is going to happen to tax rates beyond 2025, and that means we have to just focus on what we know today and plan accordingly,” Steffen explains.

Steffen says it is rational, from a historical perspective, to assume that tax rates are likelier to go up in the future than down, but by how much and when is anyone’s guess. “What we can say confidently is that we are experiencing relatively low tax rates right now from a historical point of view, and that is true both for ordinary income and for capital gains,” Steffen points out. “We can also be confident that the rates will continue to ebb and flow over time. It tends to be cyclical.”

(Image: Shutterstock)

2. Tax Issues Present Emotional Hurdles for Clients

For a variety of complicated and interrelated reasons, tax changes have a unique impact on people, Steffen says.

“Clients simply react differently to learning about new tax liabilities than they do to many other challenges,” he says. “I think this is largely because people find it harder to see the tangible impact of their paying taxes.”

Tax issues can also call to mind clients’ deeply held political views, adding another layer of complexity to the puzzle. For their part, advisors can do a lot to help their clients keep taxation issues in perspective.

As a case in point, Steffen points to the fact that many clients in certain regions of the country felt a sense of dread or panic when they learned that there would be a new, substantially lower cap instituted at the federal level on state and local tax (SALT) deductions as part of the Tax Cuts and Jobs Act.

Steffen notes that many clients with this concern overlooked the fact that, in their particular situation, the overall reduction in tax levels would more than make up for the loss of the specific SALT deduction.

(Image: Adobe Stock)

3. Loss of Stretch IRAs Is a Genuine Planning Challenge for HNW Clients

Though the policy change happened nearly three years ago, Steffen says, the elimination of the stretch IRA continues to be an important point of focus when factoring taxes into clients’ financial plans.

“The big thing a lot of tax-conscious advisors are focusing on right now is what is going on with the new 10-year window for distributing inherited IRAs,” Steffen notes. “Under the current framework, most beneficiaries, not including spouses, have to distribute the value of the IRA within 10 years.”

In many cases, Steffen says, this new framework will mean that clients face a bigger tax burden.

“You have to be prepared to have that tough conversation because, in most cases, the client and their heirs are going to pay more taxes because of this,” Steffen says. “You can’t avoid that basic fact, but you can take steps to mitigate that loss, depending on the client’s unique situation.”

Steffen says one key challenge is that it has been unclear whether a client must start taking distributions in the first year after the original IRA owner’s death, or if it would be possible to backload the distributions in the 10-year window.

The confusion surrounds those beneficiaries who inherited an IRA in 2020 or later and were subject to the 10-year rule, where the entire inherited IRA balance would have to be withdrawn by the end of the 10th year after death.

In regulations proposed earlier this year, the IRS says that if these beneficiaries inherited from someone that was already taking required minimum distributions, then not only are they subject to the 10-year rule, but they will also be required to take RMDs for years one through nine after death.

Steffen says the required distributions in years one through nine may disadvantage those IRA inheritors who are near their own retirement, as it would make sense for many of these people to back-load the distributions until they stop generating their own income.

Under the proposed regulations, it appears this backloading won’t be possible in cases where the IRA owner had already initiated RMDs, but a newly published IRS notice provides helpful relief by establishing that the normal 50% penalty for missed RMDs will not apply to such beneficiaries for 2021 and 2022. The IRS says it will finalize these regulations soon.

(Image: Shutterstock)

4. The Most Common Tax Questions are Evergreen

While the tax laws may change frequently, Steffen says, the most common questions about tax mitigation do not.

In his experience, far and away the most common questions pertain to the possible utility of a Roth conversion and determining the appropriate size and timing of such a conversion.

“A lot of clients come to the table having done some basic research,” Steffen says. “Maybe they understand a Roth conversion is potentially good for them in the long run, but they need help to create a tactical, actionable conversion plan.”

Steffen says he has to spend a lot of time convincing clients that creating a multi-year strategy for a Roth conversion might be the best idea.

“Many people tell me they would rather just pay the taxes today, up front, and get it over with in one go, even though that is often not the optimal approach from a tax mitigation perspective,” Steffen notes.

Steffen says every client situation is unique, but there are a few pillars to lean on when contemplating a Roth conversion. For example, a common starting point is to begin by converting dollars the client doesn’t think they are actually going to need to spend in their lifetime.

“If you do a Roth conversion, it is best to let the money stay in the Roth as long as possible, because you are basically front loading a tax bill that you didn’t have to pay today,” he explains.

Another important tip is that, if a client is going to make a Roth conversion, they should already have liquid assets available outside of the IRA to pay the excess income taxes. It generally makes little sense to use money from within the IRA to pay the excess taxes.

(Image: Shutterstock)


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