P a g e 1 UB Tax Institute November 14, 2016 8:30 10 a.m. Session A Tax-Efficient Retirement & Social Security Planning Strategies Tax-Efficient Retirement Planning Strategies Timothy J. Domino CPA, CFP : Common Retirement Planning Misconceptions: o #1 Spending in retirement decreases On average, spending drops modestly (14%) immediately after retirement 53% report a drop in spending at retirement 35% report a negligible drop in spending at retirement 12% report an increase in spending at retirement o #2 Employment will cease during retirement years 20% of Americans age 65 or older are now working Highest percentage since the early 60 s, before Medicare enacted o #3 Retirees only support themselves during retirement years 22% of adult Americans financially support a parent or adult child $12,000 per year of support on average o #4 Your income tax liability will be lower during retirement Depends on a variety of factors, including timing, statutory tax rates and deductions, and sources of income Can be managed Tax-Efficient Retirement Planning Process: o (1) Building a tax diversified portfolio of retirement assets o (2) Deploying those assets to meet spending and portfolio preservation goals in a tax-efficient manner Minimizing taxability of investment income and in the generation of spendable income, to the extent possible, over time Drivers of Personal Income Tax Liability During Retirement Years: o Spending needs dictate the amount of income to be recognized o Recognized income comprised of forced and optional sources of income Forced sources of income include defined benefit pension distributions, required minimum distributions from retirement accounts and social security payments
P a g e 2 Optional sources of income include withdrawals from tax-deferred retirement accounts (IRAs, 401(K)s), tax-free retirement accounts (ROTH IRAs) and brokerage accounts funded with after tax dollars o Taxable income derived from forced and optional income sources, in conjunction with the tax rates, deductions and exemptions in effect for the year Keys to Tax-Efficient Retirement Planning: o Achieving Tax Asset Diversification understanding the income tax attributes of an individual s current retirement investment portfolio and evaluating opportunities to modify those attributes o Performing Tax Bracket Management understanding the income tax impact of an individual s combination of forced and optional income sources and evaluating opportunities to reduce their effective tax rate on that income over time o Requires (1) realistic future spending assumptions and; (2) performing various income tax projections to evaluate various combinations of forced and optional income, as well as to identify and quantify opportunities to modify the tax attributes of retirement assets Tax Asset Diversification: o Objective is to achieve a portfolio consisting of groups of retirement assets with different tax attributes o Obstacles to achieving tax asset diversification Tax-deferred account eligibility or savings limits Tax policy uncertainty Tax-deferral temptation Limited savings discipline in non-tax-deferred accounts Tax Asset Diversification Tax-Free Accounts: o Tax Attributes a group of assets consisting primarily of after-tax contributions whose contributions, capital appreciation and income can be withdrawn tax-free during traditional retirement years o Examples include Roth IRAs, Roth 401(k)s and Health Savings Accounts ( HSAs ) utilized as retirement savings vehicle o Diversification opportunities to build a group of Tax-Free Assets: Direct Roth IRA contributions Roth conversions and backdoor Roth IRA contributions After-tax 40(k) contribution rollover segregation HSA utilization deferral and medical expense aggregation
P a g e 3 Tax Asset Diversification Tax-Deferred Accounts: o Tax Attributes a group of assets consisting primarily of pre-tax contributions whose contributions, capital appreciation and income can be withdrawn as ordinary taxable income during traditional retirement years o Examples include 401(k)s, traditional IRAs and Qualified Retirement Plans o Diversification opportunities to build a group of Tax-Deferred Assets: Salary deferrals up to annual limits for pre and post-tax contributions Lump sum pension distribution rollover Tax Asset Diversification Taxable Accounts: o Tax Attributes a group of assets consisting primarily of after-tax contributions whose contributions can be withdrawn tax free, capital appreciation can be withdrawn at capital gains tax rates and whose income is taxed as it is realized at either capital gains or ordinary income tax rates, depending on character and can subsequentially be withdrawn tax-free o Examples include brokerage and savings accounts o Diversification opportunities to build a group of Taxable Account Assets: Systematic savings Minimizing tax drag, or reduction in after-tax assets, through appropriate selection of investments (i.e., municipal bonds) and tactical location of investments between taxable and tax-free/tax-deferred accounts, in accordance of overall investment policy Enhancing after-tax value of assets with capital appreciation through basis enhancing capital gain harvesting during optimal interim periods, and by offsetting capital gains using capital losses harvested during interim opportunities Tax Bracket Management: o Objective is to subject retirement income, both forced and optional, to the lowest tax rates possible to reduce tax drag on after-tax retirement spending cash flow and retirement portfolio assets o Obstacles to managing tax bracket Identifying and acting upon tax minimization opportunities both before and during retirement, and even considering consequences after death for heirs Balancing power of compounding returns in tax-free or tax-deferred environments with present value of deferred taxes and future tax rates and policies Constraints of current retirement portfolio tax asset diversification Awareness of current income tax rate brackets, as well as the applicable thresholds for Medicare surtaxes and exemption and deduction phase-outs
P a g e 4 Tax Bracket Management Retirement Portfolio Withdrawal Strategies: o Traditionally advisors recommended liquidating taxable accounts first, then taxdeferred accounts and finally tax-free accounts, in the effort to maximize the impact of tax-deferred/tax-free compounding o Modern withdrawal strategies still give some preference to maximizing taxdeferred/tax-free compounding, but retirees must also consider opportunities to minimize taxation on income over time by combining distributions from different groups of assets with different tax attributes Tax Bracket Management Planning Strategies Tax-Deferred Accounts: o Quantify Required Minimum Distributions and understand impact on future marginal and effective tax rates. Consider taking distributions sooner than required beginning date (or performing partial Roth conversions) if distributions/conversions are going to be taxed at substantially lower income tax rates o Perform Roth conversions during income anomaly years prior to retirement or required beginning date Income anomaly years include income gap years, where an individual retires relatively early but does not begin receiving the bulk of their forced income until years later. In many instances this causes the individual s income and marginal tax rates to drop substantially, giving them the opportunity to recognize optional sources of income or change the tax attributes of a portion of their assets, at a substantially lower income tax rate than they would experience after the income gap years Income anomaly years also include years in which the individual may still be working but has abnormally large itemized deductions or has a net operating loss, which can both absorb the recognition of additional optional sources of income or change the tax attributes of a portion of their assets, at a substantially lower income tax rate than they would experience after the income anomaly year or years o Consider delaying beginning Social Security benefits (thus increasing your future benefit amount) and substituting the income with withdrawals from your taxable or tax-deferred accounts. This can have the effect of increasing your future Social Security benefits, having withdrawals taxed at a slightly lower tax rate, and possibly reduce the taxability of future Social Security benefits and tax-deferred account withdrawals o Consider taking earlier than anticipated or partial distributions from tax-deferred accounts to take advantage of state income tax incentives on qualified retirement income (i.e., $20,000 per person New York state exclusion) o Delay Required Minimum Distributions by rolling qualified accounts into postemployment 401(k)s
P a g e 5 o Considering performing Roth conversions for estate planning tax burn when balances are unlikely to ever be utilized beyond RMD s and won t be designated for charitable purposes Tax Bracket Management Planning Strategies Taxable Accounts: o Reduce tax drag on taxable account portfolio by utilizing tax-free municipal bonds, when appropriate o In conjunction with overall asset allocation investment policy, consider deploying asset location strategies to minimize the tax drag on taxable account portfolios. Basic asset location strategies would include locating heavy income (i.e., interest and dividends) producing investments inside tax-deferred or tax-free accounts, and locating growth oriented investments inside taxable accounts. o Harvest capital losses to offset future capital gains during liquidation and withdrawal phase or to minimize tax drag of mutual fund capital gain distributions. Avoid wash sale rules and retain market exposure by remaining invested in highly correlated investments o Harvest capital gains when in 0% or 15% capital gain rate brackets. There are no wash gain rules! This will increase basis in the investments and help minimize taxation during liquidation and withdrawal phase o Consider avoiding recognition of substantial capital gains when step-up in basis is imminent. Tax Bracket Management Planning Strategies Tax-Free Accounts: o Income tax nirvana - planning strategies focus heavily in getting retirement assets into this group o Consider utilizing withdrawals from tax-free investment accounts to supplement spending during positive income anomaly years Tax Bracket Management Maximizing Deductions & Exemptions in Retirement Years: o Qualifying relative dependency exemptions o Medical expense itemized deduction for ageing parents being supported o Maximizing tax related itemized deductions by considering the state and local sales tax deduction and considering timing of payment of state income tax liabilities o Understand that itemized deductions previously excluded because taxpayer was under thresholds or in AMT may now be beneficial again during reduced income retirement years o Ensure maximum income tax benefit of charitable donations by front-loading contributions to a donor-advised fund or utilizing Qualified Charitable Distributions from IRAs