You may have heard the saying "old age is not for sissies." Well, neither are taxes when it comes to figuring out how an extra dollar of retirement income can boost taxable income by three times that amount.
"Taxes are a critical piece in retirement planning, yet most financial advisers avoid discussing the topic for several reasons," writes Joe Elsasser, founder of Covisum, a training and software company that helps advisers create retirement income plans through smart Social Security claiming strategies and tax-efficient withdrawals.
"Many financial advisers know taxes have a significant impact on their clients, but due to uncertainty surrounding the scope of their duty to clients and the possibility of compliance issues for addressing taxes, they ignore or gloss over the topic of taxes," Mr. Elsasser wrote in a recent whitepaper, "The Elephant and the Snowball: How Advisors Can and Should Talk Taxes with Clients."
He predicted that if, and when, the Department of Labor's fiduciary rule is implemented, it will create an environment in which ignorance of the tax implications of retirement advice will no longer be tolerated.
"Interactions of various tax provisions can increase a client's overall tax liability and, in turn, diminish the sustainability of their retirement income," Mr. Elsasser wrote. "In retirement, it is not uncommon to see one extra dollar that's harvested from the wrong account at the wrong time snowball into $3.60 of income subject to tax."
He offered an example of a married couple with $40,000 of Social Security benefits and $15,000 of IRA withdrawals who would pay no federal income tax in 2016. That is due to partial exclusion of Social Security income rendering only $1,500 of benefits subject to tax for total taxable income of $16,500 ($15,000 IRA withdrawals + $1,500 in Social Security benefits).
Using the standard deduction of $12,600, plus an additional $2,500 if both spouses are 65 or older, and personal exemptions worth $4,050 each brings the total deductions to $23,200. That exceeds the total taxable income of $16,500 by $6,700 ($23,200 – $16,500) so no tax is owed.
Many advisers might consider taking an extra $6,700 out of the IRA. Conceptually, a negative $6,700 would mean a client could add $6,700 of taxable income without paying tax, right? Wrong!
An additional IRA withdrawal of $6,700 would increase the amount of Social Security benefits subject to tax and increase taxable IRA withdrawals boosting total taxable income to $26,550. That means the additional IRA withdrawal of $6,700 created additional taxable income of $10,050 ($26,550-$16,500). The result is a net taxable income of $3,350 rather than zero.
If a married couple over age 65 had only long-term capital gains and qualified dividends on their return with no other income in 2016, they could take over $98,000 of capital gains and qualified dividends and pay zero federal income tax. That's because capital gains or qualified dividends that occur while the client's adjusted gross income is under the 25% bracket receive a 0% tax rate. But when a client has capital gains and is collecting Social Security benefits, it means that a portion of Social Security becomes taxable. The amount that is taxed can vary from 50% to 85%.
"The combination of Social Security with ordinary income, such as IRA withdrawals and capital gains, can create a 'snowball' effect where the resulting tax on one additional dollar of income recognized is far greater than what is expected," Mr. Elsasser explained.
William Meyer, founder of Social Security Solutions, a competing software and training company, calls this phenomenon the "tax torpedo," a reference to the sharp spike and subsequent decline in a retiree's marginal tax rate on Social Security benefits as their income increases.
As much as 85% of a client's Social Security benefits can be taxed depending on total income and marital status. For some couples, this tax torpedo can effectively lower Social Security benefits by almost 30%, Mr. Meyer said. But there are ways to limit its impact.
"By delaying their Social Security benefits and living off an IRA in the early years, the higher benefit they will receive later will reduce the amount of taxable income they'll need to withdraw from their IRAs in those later years," he explained. "These smaller withdrawals will reduce taxes owned on their Social Security benefits." Based on his firm's research, this strategy is best suited for clients with retirement savings between $200,000 and $600,000, he said.
Bottom line: Advisers who equip themselves with tools that consider a client's overall financial situation, including the tax implication of various strategies, are in a better position to demonstrate the added value their advice brings to their clients' portfolios. That's an effective way to show they are acting in their clients' best interests.
(Questions about new Social Security rules? Find the answers in my new ebook.)
Mary Beth Franklin is a contributing editor to InvestmentNews and a certified financial planner.