BEST PRACTICES FOR DISTRIBUTION PLANNING IN RETIREMENT LESLEY J. BREY, CFP, CFA, AIF

Transcription

1 BEST PRACTICES FOR DISTRIBUTION PLANNING IN RETIREMENT LESLEY J. BREY, CFP, CFA, AIF >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> White Paper

2 Introduction Ask anyone nearing retirement about their biggest concerns and chances are the most common responses you get will be: 1. Do I have enough money to retire? 2. How do I take money out of my accounts? Historically, financial planning for retirement has focused primarily on the accumulation phase of retirement planning. There are many planning approaches to answering the first question, most of which focus initially on the how-do-you-want-to-live set of goals. Less attention has been given to the period after retirement when individuals must manage both the investment and distribution of their accumulated assets. Recently, however, interest in the distribution phase of retirement has increased as the oldest of the baby boomer generation begins to retire. The focus of this white paper concerns one very important aspect of the second question: how to efficiently create and sustain beneficial retirement income streams for your clients. Broad Issues Impacting Distribution Planning Your top priority as an advisor is to assist your clients in managing their resources so they can make the most of life in retirement and minimize the risk of running out of assets before they run out of life. Let s start with the broad issues that impact planning. Start with Client Priorities and Goals Each client will have specific goals in mind. Every planning process should begin with a conversation between you and your client designed to help identify, clarify, and prioritize your client s financial goals. Use this discussion to define your client s ideal scenario (what would be your client s perfect retirement lifestyle, for example,) and an acceptable scenario (what type of retirement lifestyle would be satisfactory). Although we d all prefer to achieve our ideal retirement lifestyle, it may be necessary for the plan to incorporate elements from the acceptable scenario. Specifically regarding distribution planning in retirement, there are several priorities that will impact your client s plan and the utilization of available resources: Legacy vs. no legacy Whether your client wants to ensure financial security for future generations or aid in the ongoing success of a favorite charitable organization, leaving a legacy will impact the resources to remain in your client s estate and have a bearing on the funds available to live the life they want in retirement. A key question to ask your client is: Do you want your legacy to accomplish something specific (in which case you would probably want to leave a specific amount) or are you simply interested in benefiting a cause? The answer to that question can lead you in the discussion of how to fund this legacy, e.g. savings (a variable amount) or life insurance (a set amount)? Tax deferral short-term vs. long-term Deferring taxes as long as possible is a common investment goal. While much of the growth in taxable and tax-deferred accounts is allowed to compound tax deferred until realized and/or withdrawn, some consideration should be given to the anticipated timing of tax-deferred account withdrawals to manage tax brackets over time. This may mean intentionally filling lower tax brackets earlier in retirement even though it creates higher taxes due. A tax-deferral-under-all-circumstances program may make sense and be the best alternative, but a comparison within a fully integrated plan should be evaluated before implementation. 2

3 Consistent spending vs. flexible spending To a large extent, retirement planning boils down to cash flow. How much money will your client need each year to meet obligations and still maintain the desired standard of living? Cash flow planning should start with consideration of the lifestyle your client plans to lead in retirement and what types of activities your client will pursue. How much of your client s budget, allowing for inflation, needs to be devoted to essentials such as food, health care, and housing expenses? How much does your client want to spend on discretionary items such as travel and entertainment, where there is more flexibility and the ability to cut back if necessary? Adopting a more flexible approach will require you and your client to do a more rigorous analysis to get an accurate sense of your client s retirement needs and how they may change over time. Decide Where and How to Invest As each client approaches retirement, consider consolidating investment accounts to help simplify managing the portfolio and tracking its performance. Consolidation can also make beneficiary planning and management of your client s estate more efficient. Additionally, you ll want to assist your client with his or her portfolio to ensure it is invested for the optimal mix of potential growth and stability based upon your client s priorities and risk tolerance. A well-worn rule of thumb regarding asset allocation is to subtract your age from 100 and allocate that portion to stocks, e.g. a 50-year-old would have 50 percent of her portfolio devoted to stocks; a 70-year-old should only have 30 percent devoted to stocks. However, as people are living longer and are increasingly focused on legacy, you may want to shift the number you use as your starting point to 110 or even higher if you continue to use this rule of thumb at all. Remember, this is simply a starting point. Asset allocation should allow your client to sleep well at night by balancing sometimes conflicting timeframes, volatility tolerance, target income and portfolio growth required to meet life and legacy goals. Generally speaking, here are some guidelines for retirement fund asset allocation: Any money your client needs in the next year should be in cash Any money your client needs in the next five years should be in a non-volatile, fixed-income investment, such as cash, certificates of deposit, or short-/intermediate-term bonds Any money your client won t spend in the next five to ten or more years is a candidate for the stock market Along with asset allocation, you should also consider the type of account in which to place the retirement funds: Taxable accounts Tax-free bonds, buy-and-hold growth stocks Tax-deferred accounts Taxable bonds and bond mutual funds, dividend-producing stocks and income mutual funds, high turnover mutual funds Tax-free accounts All of the potential high appreciation asset classes There are a variety of circumstances that would result in the right account being different for any asset class, so you will need to adjust accordingly for client goals, timeframes, and cash flows. 3

4 Consider Client Volatility and Lifestyle Risk Tolerance The life factor that has the most influence on the mix of asset classes someone should hold is called investment risk tolerance. By taking into account your client s tolerance for risk, or more importantly, tolerance for value volatility or downside fluctuation, you ll be able to build and manage a retirement portfolio suitable to your client s temperament. Because it is not an exact science, most investment managers work with various investor risk categories. Five common categories include: 1. Conservative Unwilling to tolerate noticeable downside market fluctuations, and willing to forego most all significant upside potential, relative to inflation. 2. Moderately Conservative Can tolerate a little more volatility than the Conservative investor in exchange for potential return, but still averse to short-term downside fluctuations. 3. Moderate The most common category for retirement investors. More willing to accept the trade-off between volatility and potential returns, relative to inflation. 4. Moderately Aggressive Willing to take on more downside risk, but expects to participate significantly when the markets rise. 5. Aggressive Usually associated with longer timeframes and higher volatility tolerance. Look at Tax Efficiency A retirement distribution plan would be considered tax efficient if the planned structure results in lower taxes than an alternative plan which also accomplishes the client goals. For most of the accumulation years, we focus on minimizing current income tax. However, during the distribution years, the advisor can add value by looking at potential taxes over time, which may include voluntarily higher income taxes in any given year, especially with the changes in the tax code implemented in 2013, e.g. surtax and higher capital gains rate for higher incomes. Factor In Goal Efficiency In retirement distribution plans, investments tend to be linked to timeframes. In other words, funds earmarked for a goal that s just one to two years away should be safely stowed in a conservative investment such as a money market account or high-quality, short-term bond fund. Knowledge that they have enough funds to cover essential living expenses shelter, food, clothing, health care, etc. for a certain period of time helps clients feel secure in the face of market volatility impacting the balance of their wealth. You might consider developing a goal-targeted plan such as a bucket approach, where retirement funds are split into distinct portfolios according to the timeframe of various financial goals and needs. These needs may include: Desire for spending flexibility Legacy goals, both charitable (tax deductible) and family/heir (often taxable) Sustainable withdrawal needs to meet essential living requirements 4

5 Retirement Income Stream Source Now that we ve considered the primary issues that may impact the development of your client s retirement distribution plan, let s examine some of the more common income sources. Pensions: Know the characteristics Your clients may be among the declining number of workers who expect to receive a pension in retirement. In 2013, only 35 percent of U.S. workers with workplace retirement plans have defined-benefits pensions. 1 Make sure that you ve identified whether your client s pension will increase with inflation. If so, ask about the method used to calculate the increase. If applicable, you should also consider the survivor benefit pre-retirement survivor benefits and post-retirement survivor benefits. Social Security: Inflation adjusted, some survivor benefit Most people expect to collect Social Security benefits in retirement, either based on their own work record or on their spouse s record. While the normal retirement age is currently age (full retirement age), your client is probably eligible to collect Social Security retirement benefits starting at age 62. If your client continues working after full retirement age without claiming Social Security benefits, he or she will receive increased benefits. However, if your client starts to receive Social Security benefits before full retirement age and continues working for pay, some of your client s benefits may be deferred until your client is considered truly retired (no income or full retirement age). You should consult with all of your clients regarding their Social Security benefits and work status to accurately determine and counsel around this retirement income source. Annuities: Infinite configurations Typically, annuities are either single or joint-andsurvivor annuities. A single life annuity provides benefits until death, whereas a jointand-survivor annuity provides benefits through the second-to-die. Insurance companies have modified the features and benefits of annuities significantly over the past few years including: timing of payout (immediate or deferred), investment types (fixed or variable), and liquidity options (with or without withdrawal penalties). You should take the time to identify the specific riders included with your client s annuity to determine suitability and benefits expected throughout retirement. Taxable account withdrawals Within taxable portfolios, your client will probably receive interest, dividends, and capital gains distributions that are taxed each year, regardless of whether they re spent or reinvested. In taxable accounts, you should consider the capital gains impact of funding decisions, but the overarching driver should remain the appropriate investment policy to support long-term client goals. Tax-deferred account withdrawals With the demise of pensions, 401(k), IRA, Keogh, or other retirement accounts represent another source of planned retirement funding. Today, 51 percent of U.S. adults contribute to a retirement plan. 2 You and your client should carefully consider the options available when withdrawing funds from tax-deferred accounts in retirement. The decisions made will affect your client s choices and may have significant tax impacts. Several factors to consider include: Generally, all withdrawals from rolled-over pension funds and tax-deferred plans are subject to taxes at ordinary income tax rates. One exception is the amount set aside from after-tax income. Also, some states do not tax the portion of withdrawals attributable to company contributions. 1 Steering America Toward a More Secure Retirement, Harold Meyerson, The Washington Post, March 6, Sweet Spot: Encourage Employees to Defer Adequate Pay to 401(k)s, Joanne Sammer, Society for Human Resource Management, May 25,

6 Regardless of age, the law requires that the custodian of your client s tax-deferred plan withhold 20 percent of all lump-sum withdrawals for federal income taxes - unless the funds are directly rolled over into an appropriate IRA account. Your client can defer withdrawals from tax-deferred accounts until age 70½. At age 70½, withdrawals must begin based on life expectancy (individual client or joint life expectancy with their spouse). There is a planning opportunity to balance taxable plan withdrawals with spending from taxable funds to ensure lower tax brackets are used up prior to age 70½. Finally, incremental withdrawals, either over a regulatory lifetime (if starting withdrawals prior to 59½) or over five years (if not rolling a lump sum over to an IRA) would spread the income tax impact. Options are dependent upon specific plan documents and thus need to be confirmed with each employer prior to making a distribution election. Tax-free account withdrawals Your client may reap even greater tax advantages with a tax-free retirement, healthcare, or education savings account, such as a Roth IRA, Roth 401(k), health savings account (HSA), or 529 education savings account. As with taxdeferred accounts, your client will owe no tax on current income or capital gains in a tax-free account. In addition, withdrawals are federally tax-free and may be exempt from state and local income tax as well, depending on the type of account provided your client follows the rules for withdrawals. A Distribution Rule of Thumb We ve identified several sources of income that may be available for your clients in retirement, but how should the income sources be used? The traditional theory in regard to managing retirement assets in a tax efficient manner is fairly straightforward: First: Access taxable accounts (e.g., taxable savings accounts, stocks, or a mutual fund held outside of a qualified plan). Second: Access tax-deferred assets including 401(k), IRA, annuity or other qualified retirement plans. Note that any client who is older than 70½ and who has tax-deferred assets is usually required by law to take required minimum distributions annually. Last: Access tax-free accounts such as a Roth IRA or Roth 401(k). The rationale for this distribution sequence is pretty straightforward. Distributions from taxdeferred accounts are treated as ordinary income. Ordinary income tax rates are typically higher than the capital gains tax rates when selling taxable assets. Furthermore, your clients will be paying taxes on the earnings their taxable assets generate, so withdrawing from those accounts first may make sense in most cases. By tapping the lowest-taxed assets first (other than tax-free accounts), tax-deferred accounts continue to grow tax deferred as long as possible. By leaving tax-free accounts to the end you increase the probability that your heirs receive tax-free assets. How You Can Add Value: Adjustments for Client Circumstance and Goals While the traditional distribution planning theory may often be acceptable, a complete retirement plan analysis needs to consider alternatives to traditional theory in light of current economic conditions and the goals of your client. That s because there is no one-size-fits-all solution for funding the retirement paycheck. 6

7 This is an opportunity to demonstrate your value as a financial advisor and show your client that the plan you are recommending is personalized to your client s circumstances and desires. The following are a few examples of topics you should consider when creating your client s plan: Is your client charitable minded or is a charity to be the beneficiary? If your client has significant charitable goals, it may make sense to preserve regular, tax-deferred accounts with the charity as the beneficiary. This may avoid both income tax and estate tax impacts. Is the tax bracket low while drawing from a taxable account? As noted previously, when and from which retirement accounts to withdraw funds can have a significant impact on your client s retirement distribution plan. Additionally, timing regarding your client s current and future tax brackets may also have an impact on distribution planning. The traditional distribution planning theory assumes that your client s tax bracket will be higher during the initial phases of retirement (when tapping taxable accounts) and lower later in retirement. However, if this is not the case, or you and your client believe taxes will increase, it may make sense to consider some alternate strategies. One tactic is to convert some amount of regular IRA assets to a Roth IRA to use up the lower tax brackets in early retirement and gain tax-free investment growth for the client s lifetime. This approach also provides the potential for assets to be left to heirs income tax-free as well. Conversion to Roth IRAs can also be advantageous if your client s distribution plan would necessitate significant required minimum distribution (RMD) at age 70½. With Roth IRAs, there are no RMDs for the owner. Your client can hold the money as long as your client would like. This is also beneficial for your client s legacy goals. If they don t need the money during retirement, it can keep growing. Although your client s beneficiaries will have to take required minimum distributions from the Roth, they won t have to pay income taxes on them under current rules. However, if your client has earmarked his or her IRA to fund a charitable interest, conversion may not be advisable. Charities are already tax-exempt entities, while your client s spouse and/or children are not. Naming a charity as a traditional IRA beneficiary saves on both income and estate taxes; doing it for a Roth IRA may negate opportunities to provide tax-free funds for tax-paying (human) beneficiaries. Are there low basis holdings in a taxable account? If your client has low tax basis holdings in taxable accounts it may be advisable to earmark those funds for lifetime charitable gifts or annual gifts to family members in lower tax brackets: Because charities are tax-exempt entities, allocating low tax basis holdings to meet charitable giving goals during life usually reduces current income tax Gifting low basis shares to family members in lower tax brackets allows them to sell and retain relatively more of the value for personal use What are the impacts of potential tax brackets as your client moves through transitions? The basic distribution planning analysis comes down to predicting future funding requirements, income sources, and income tax rates. Essentially, if your client believes he or she will pay a lower income tax by converting to a Roth IRA today, as opposed to waiting and paying taxes in retirement, then your client should convert. Along with the IRA vs. Roth IRA decision, you will need to work with your client to balance withdrawals from each type of account to use up low brackets each year. 7

8 Using traditional retirement distribution planning theory to maximize tax deferral is sound for many cases. In certain circumstances, adjusting the distribution strategy may yield more efficient plan results for your clients. Depending upon whether the goals of the client are asset longevity or wealth transfer, or some balance between the two, you ll need to consider those needs and which of the various distribution strategies best meet them. Should your client delay social security benefits? Absent the client having significant health issues, you may also consider encouraging them to delay starting Social Security benefit payments. In general, after factoring in inflation adjustments and survivor benefits, delaying the initiation of Social Security benefits results in the highest available annuity payment from the U.S. Government. In fact, if your client started Social Security less than one year ago and before the age of 70, you can suggest that your client buy up Social Security (paying back the benefits received and waiting until age 70 to start). Because every client s retirement priorities and circumstances are different, you can add significant value by providing thoughtful advice and support when determining the optimal distribution plan to unlock tax liabilities and maximize retirement satisfaction. There are many software products on the market today that can aid an advisor with retirement planning. A particularly valuable resource for both retirement and general income tax planning is BNA Income Tax Planner. BNA Income Tax Planner Recognized as a Top 100 Product by Accounting Today and having repeatedly received five-star ratings from CPA Practice Advisor, BNA Income Tax Planner offers the most comprehensive planning features available. Utilizing the powerful tools in BNA Income Tax Planner, accountants and financial planners can efficiently model complex tax scenarios, eliminate surprises, and offer income tax planning and projections that help their clients manage and reduce federal and state individual income tax liability. Along with providing industry leading and up-to-date tax calculation capabilities, BNA Income Tax Planner also helps you: Compare side-by-side what ifs to determine best tax savings using multiple scenarios Create projections for up to 20 planning years Precisely manage the tax ramifications of marriage and divorce, real estate transactions, stock options, and more with drill-down analysis capabilities Effectively manage audits, adjustments, and back-tax engagements with prior-year tax calculations going back to 1987 Save time and reduce errors by importing client data directly from major tax preparation packages including Lacerte, ProSystem fx, UltraTax CS, and GoSystem. BNA Income Tax Planner Web, which includes Federal plus Fifty states, and BNA Income Tax Planner (with optional Fifty States) support calculations for all resident states, NYC, DC, and more than 30 nonresident states. Getting started is straightforward with comprehensive, fully-indexed user and tax reference manuals, online context-sensitive help, and available training classes that enable the average user to perform complex analyses within minutes. 8

9 About Lesley J. Brey Lesley J. Brey founded LJ Brey, Inc. in 1997 to provide personalized, fee-only financial planning and investment management. The company thrives by providing financial clarity and peace of mind for clients and their families. Lesley served on the National Board for the National Association of Personal Financial Advisors (NAPFA) as well as on non-profit and forprofit boards in her community. She is a NAPFA-Registered Financial Advisor and a member of NAPFA, the CFA Institute, The National Association of Tax Professionals (NATP) and the Financial Planning Association (FPA). She is permitted to string some combination of the letters CFP, CFA, AIF, MBA, and PE after her name for professional purposes. About Bloomberg BNA s Software Products Bloomberg BNA offers expert software products for tax and accounting professionals. With category-leading software and top-rated technical support, we are the solution of choice for professional firms and corporations of every size. More than 70,000 customers, including the IRS, depend upon Bloomberg BNA s software products for the highest degree of tax, regulatory, and compliance expertise available in the market. About Bloomberg BNA Bloomberg BNA, a wholly owned subsidiary of Bloomberg, is a leading source of legal, regulatory, and business information for professionals. Its network of more than 2,500 reporters, correspondents, and leading practitioners delivers expert analysis, news, practice tools, and guidance the information that matters most to professionals. Bloomberg BNA s authoritative coverage spans the full range of legal practice areas, including tax & accounting, labor & employment, intellectual property, banking & securities, employee benefits, health care, privacy & data security, human resources, and environment, health & safety. Though intended to provide accurate and authoritative information, this publication is provided with the understanding that it does not constitute tax, legal, accounting, or other professional advice or service. This publication may not be reproduced, stored in a retrieval system, or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of Bloomberg BNA. For more information call , contact your local Bloomberg BNA Representative, or visit South Bell Street, Arlington, VA, BNA Software, a division of Tax Management Inc. All rights reserved. IT002-WH rc 9