Editor’s note: This is the second in a three-part series about helping your clients plan for and manage the distribution phase of retirement. The first part is here.
While the advisory profession has evolved beyond sales and commissions over the years, there’s room for improvement, especially in tax planning.
Innovations like Holistiplan have made significant strides in helping us to understand tax returns, yet effectively using tax return data to provide comprehensive tax planning remains elusive to many. More work is needed, particularly in planning for retirement distributions among the mass affluent and high-net-worth clients.
We are discussing this issue in a series on clients living longer and how we can better serve them. This article tackles the first part of the problem which is preparing for clients living longer.
Here is the problem. So much of the traditionally available core financial planning software (eMoney and MoneyGuide Pro) is focused on accumulation, and doesn’t thoughtfully consider taxes or strategies for the distribution phase. When it does, the tools are blunt and unsophisticated, possibly even misleading the advisor into thinking that there is process and optimization when there isn’t. I am not only referring to eMoney and MoneyGuide Pro, but also to the plethora of calculators that are available on most of the large custodian websites.
The focus of most, if not all, of these tools is simply on accumulation: Do I have enough to retire? When can I retire? Will I outlive my money?
And while these are important questions, many investors are beyond that point. They know that they have enough. They know how to live within their means. They have already retired. And absent some truly catastrophic event, running out of money is highly unlikely.
What these investors don’t know, however, is how to minimize taxes throughout their retirement. They do not know how to draw down their accounts in a tax smart way. Nor does the accumulation software assist except by recommending very static approaches, such as the “conventional wisdom,” which entails drawing down taxable accounts, then tax-deferred, and then Roth IRA accounts last.
In the alternative, they may recommend the pro rata approach which is similarly flawed. The pro rata approach simply dictates that you draw down your accounts in proportion to the tax treatment of the account. For example, if you have 30% of your money in a taxable account, 20% of your money in a Roth account and 50% of your money in a traditional IRA account, that is the proportion by which you will be spending down your accounts. Quite simply, there is no logic to this approach, despite its attractiveness as a simple formula.
What should advisors be doing? Well, the best answer here is not nothing.
The stakes are high for many clients, potentially hundreds of thousands or millions of dollars of lifetime wealth. In addition, smart tax planning today can protect and create generational wealth so that your clients’ children and grandchildren will either be benefiting or suffering from your decision-making in this area.
We discuss below three key approaches to addressing distribution planning for clients who are focused on tax optimization in retirement.
1. Consider taxes in the withdrawal phase to maximize wealth
It’s crucial to consider taxes in the withdrawal phase, especially for large traditional retirement accounts. Withdrawing substantial amounts (whether due to spending or RMDs or both), can push retirees into higher tax brackets. Effective tax bracket management can be a solution for some clients, especially for those in lower tax brackets with smaller IRAs. However, for clients who are in the process of accumulating a lot of wealth, particularly if that wealth is located in qualified accounts, advisors should invest and locate their assets with the end in mind.
Remember the “widow’s penalty” is a critical concern, particularly for women and couples with a significant age difference. This penalty arises when the surviving spouse has high income and faces reduced deductions, leading to a disproportionately high tax burden. And remember that the widow’s penalty is inescapable for every couple except if both partners die at the exact same time. A highly unlikely event and certainly not something that we would plan for.
Pro tip: For those in the accumulation phase, begin with the end in mind by planning how and when to distribute income in retirement. This helps advisors design an optimal accumulation plan, including key decisions about 401(k) choices, such as paying taxes now (Roth) or deferring them (traditional).
For those in the distribution phase, comparing current and future tax rates will guide the timing and sources of income withdrawals for optimal tax efficiency. The goal is to pay taxes at the lowest possible rate, which may mean paying taxes now instead of later.
2. Consider longevity risk, but be more precise
When planning for retirement, it’s important to consider longevity risk, but estimates should be precise, especially for individuals with chronic health conditions. Estimating a lifespan up to age 95 might overstate the necessary duration of their wealth. These individuals may not need their assets to last that long.
Using online quizzes and tools can provide a more accurate estimate of life expectancy, helping tailor financial plans to a client’s specific needs and ensuring a more realistic approach. However, if the client may live for a longer period of time, then of course you should assume a life expectancy of age 90 or 95 could be helpful.
One calculator we like is the Bluezones Vitality Compass. This tool asks a series of questions about lifestyle, medical history and environment to estimate life expectancy. It is designed for individuals but can be used by both members of a couple to get individual estimates.
Remember that longevity considerations can include many things: health care and caretaking expenses, possible downsizing plans, tax strategies and legacy planning.
Pro tip: Consider using actuarial estimates specific to each client, and then update them regularly as their age and health conditions change.
3. Legacy planning and Roth conversions go hand in hand
Before 2020, beneficiaries of traditional IRAs could manage their tax liabilities by stretching out withdrawals over their life expectancy. If you inherited an IRA before 2020, you still have the option to use this strategy to stretch out withdrawals and associated taxes over your expected lifespan.
However, the SECURE Act changed this for most non-spouse heirs. Now, these heirs no longer have the lifetime withdrawal option. Instead, they must choose between taking a lump sum with immediate taxes due or transferring the funds to an inherited IRA that must be depleted within 10 years of the original owner’s death. As a result, clients with large IRAs need to be thinking about their beneficiaries when doing tax and distribution planning as well. Otherwise, up to 50% of the IRA could end up being paid in taxes—something that nobody wants.
Roth conversions offer intergenerational tax-planning benefits, allowing parents to prepay income taxes for future generations. This strategy supports tax-efficient gifting outside the lifetime exclusion by allowing parents to prepay the taxes and decrease the value of the estate. In addition, the heirs can allow the inherited IRA to grow tax-free for the entire 10-year period, likely doubling in value.
Pro tip: Advisors should consider current versus future tax rates for beneficiaries to decide on initiating Roth conversions, potentially reducing future tax obligations for the heirs and preserving wealth for future generations.
In summary, for many advisors, the focus on accumulation planning only tells half the story. There needs to be an equal focus on distribution planning, particularly for those higher-net-worth clients whose bigger problem may be taxes and legacy planning. Perhaps we should start thinking about accumulation planning not in isolation, but also having the end in mind for a more informed approach?