One of the most important decisions retirees must make is which retirement account will take care of the distributions and the timing of those distributions. Options could include tax-advantaged accounts such as a 401 (k) or traditional IRA, tax-free roth accounts, annuities and taxable investment accounts. Additionally, the client may have social security or a pension payment.
Making the right decisions from a tax planning perspective can save clients a lot of money and help maximize their withdrawable retirement cash flow. This is one area of retirement planning where financial advisors can add real value for their clients. (for more information, see: how advisors can manage evolving retirement .)
Taxable investment accounts generally include brokerage accounts that hold stocks, bonds, mutual funds, and other investment instruments. Gains on investments in these accounts are taxed at preferred long-term capital gains rates as long as they are held for at least one year and one day. There is a range of capital gains for 2015, but the most common is 15% with a 20% rate for high income investors. In addition, there is a 3. 8% medicare surcharge that kicks in for those with adjusted gross income of $200, 000 or more ($250, 000 for married filing jointly).
Tax-deferred, tax-free accounts
Tax-deferred accounts typically include traditional iras and retirement accounts such as 401 (k) or 403 (b). Distributions are fully taxable in the year of ordinary income. These accounts are subject to the minimum distributions at age 70 ½ years. Payments from an annuity are generally partially taxable and partially tax-free. The portion relating to the original premiums is not subject to income tax if the contract is annuitized. (for more information, see: tips for transitioning your client from earning to drawdown .)
Tax-exempt accounts include roth iras and 401 (k) s, as well as loans from certain cash value life insurance policies.
Monthly pension payments are generally fully taxable, although certain state pensions are exempt from state income taxes. Social security contributions are taxable, but there are many rules. (for more information, see: how you can help clients with social security .)
Planning is important
Financial advisors need to consider both the long-term and short-term view of their client's retirement situation. Help you determine which accounts to tap and in what order. Longer term planning will include a macro look at where your client is in retirement and what they are doing. These include issues such as whether they work during retirement and the potential size of their required minimum distributions once they reach age 70. Have reached the age of 65.
For example, if the client is working during retirement, his or her income will be a factor in determining when to apply for social security. For 2015, earnings above $15, 720 will face a reduction in benefits of $1 for every $2 of earnings above that amount for those who have not yet reached their full retirement age, which is generally 66 (67 if born in 1960 or later). This combined with the increased benefit level for waiting could be a good reason to advise these clients to wait until they take their benefits. (for more information, see: the risk of offering social security advice .)
Required minimum distributions
For someone with an IRA balance of $1 million at the end of 2014 RMD) for 2015 would be over $36, 000. This is fully taxable ordinary income and is added on top of any other taxable income of the client. Customers with larger retirement plans will have higher required minimum distributions and the amounts will be larger with age, all things being equal. Many clients may not need this income and would welcome a reduction in the tax sting they create.
There are several planning options. Depending on the client's tax bracket in the years prior to the start of rmds, it may make sense to use these tax-deferred accounts at least to the point where the client's current tax bracket is fully utilized. This has the added benefit of reducing the value of these accounts and results in a lower RMD calculation down the road. (to read about this, see: how advisors can address longevity risk .)
For clients working past age 70 ½, it may not be necessary to take an RMD from 401(k). With your employer if you own less than 5% of the company and the plan allows this exemption. One planning option is to roll old 401 (k) balances into this plan, if it is allowed to shield this money from rmds for a few years as well. This planning option may need to take place a few years before reaching the age of 70 ½ years.
A roth conversion may also be a good strategy for some clients. If the client's taxable income is relatively low, they may consider doing the conversion of some or all of their traditional IRA to a roth. They would owe income tax on the amount converted, but they would not owe income tax on distributions in the future as long as certain conditions are met. In addition, there are no rmds on a roth IRA in addition to some estate planning opportunities. Your financial advisor really needs to enter the numbers here to see if that makes sense. (for more information, see: estate planning tips for older and outdated clients .)
Things can change in the life of a retired client, giving you reasons to change your distribution strategy. Even for a year. An example might be if the client suffers an illness or other medical or dental situation that causes the medical expenses to exceed 7.5% of adjusted gross income for the year. Expenses above this level are deductible, and if the deduction is significant enough, the client might consider taking distributions from a traditional IRA or 401(k) account against a tax-free roth account or selling appreciated taxable securities taxed at preferred capital gains rates.
Customers who may still be years away from retirement should consider funding a health savings account (HSA) if they have access to one. This can be done through a high deductible medical policy through an employer or one that you open for yourself. The contributions are used to reduce current taxes, and the money can be withdrawn tax-free in retirement to cover the cost of health care, including insurance. Of course, the client must be able to fund medical expenses from other sources while working to implement this strategy. (for more information, see: IRS sets 2016 HSA deduction limits.)