On Retirement

How to best minimize taxes during retirement

Combine tax-efficient withdrawals and Social Security claiming strategies to improve retirement outcomes

Feb 5, 2015 @ 1:00 pm

By Mary Beth Franklin

Maximizing Social Security benefits through appropriate claiming strategies is just the first step in improving your clients' retirement success. The second, more complicated step is to minimize their taxes by locating assets in the proper type of accounts and tapping those assets in the optimum order.

The combination of higher Social Security benefits and lower marginal tax rates results in more spendable retirement income in the long run and can extend the life of your clients' portfolio, reducing the chance they will run out of money.

Conventional wisdom dictates that retirees tap their taxable accounts first, followed by tax-deferred retirement accounts, and finally tax-exempt Roth individual retirement accounts. But this withdrawal hierarchy could unintentionally increase a client's overall tax burden, including boosting the portion of Social Security benefits subject to income taxes and triggering higher Medicare premiums when income rises above certain thresholds.

(More: Two new Social Security books to add to your go-to list)

Consider a retiree who is not yet age 70, and therefore is not subject to required minimum distributions from his IRA or other retirement accounts. A large percentage of withdrawals from taxable accounts may represent a return of principal, which is not taxed, or long-term capital gains and qualified dividends, which are treated more favorably than ordinary income.

This retiree could easily be in the 15% federal income tax bracket and consequently could pay no tax on long-term gains and dividends. In 2015, a single retiree claiming one personal exemption ($4,000), the standard deduction ($6,300) plus the additional standard deduction for individuals who are age 65 and older ($1,550) could have up to $49,300 of income and still be in the 15% bracket. A married couple could have twice that amount of income — $98,000 — and remain in the 15% bracket. But once RMDs begin, they could be catapulted into the 25% bracket.

It may be more tax efficient early in retirement to withdraw funds from his tax-deferred account first to take full advantage of the 15% tax bracket, and only then tap his taxable account if he needs additional income. In future years, after the taxable account is exhausted, the retiree can take tax-deferred income first for up to the top of the 15% bracket and then withdraw any additional funds from a tax-exempt Roth account.

By tapping tax-deferred retirement accounts early, it will reduce the size of RMDs in later years, boosting an adviser's ability to manage the client's taxable income. It can also provide an income cushion enabling a retiree to delay claiming Social Security.

Advisers should also look beyond asset allocation and pay attention to the location of their clients' assets. Bonds and other interest-bearing assets, which are taxed as ordinary income, are best suited for tax-deferred retirement accounts. Investments such as stocks and mutual funds that produce long-term gains and qualified dividends are better held in a taxable brokerage account to take advantage of favorable capital gains tax rates.

(More: Obama's capital gains tax plan: What it boils down to for you and your clients)

Of course, keeping up with ever-changing tax rules and rates and how they apply to various pots of clients' money can be a challenge. But software can take the headache out of figuring out which account to tap when.

Imagine if you could show your clients a simple bar chart that clearly displays their beginning portfolio balance, plus the cumulative value of maximizing their lifetime Social Security benefits and the projected value of tax-efficient management of their assets. Then you could distill that 1-2-3 strategy into a single number — which represents their additional assets thanks to your savvy advice. Put another way, advisers could use that single number — which could easily total six digits — to dramatically quantify the value of their advice.

That function is now available for free to advisers who use SSanalyzer.com, a Social Security claiming software program. Just click the “coordinate” tab to see how it integrates a client's spending needs, savings and income.

SSAnalyzer Chief Executive William Meyer, a pioneer in Social Security research, has demonstrated that tapping retirement assets early as a way of deferring Social Security benefits until they are worth more later can extend the life of a portfolio by an additional two to 10 years.

It may not be as simple as 1-2-3, but technology can put these powerful tools and concepts within the reach of any adviser willing to take the next step to coordinate their clients' retirement income planning.

Best practices in drawdown strategies and new technology available to create tax-efficient retirement income plans are two of the topics on the agenda for this year's InvestmentNews Retirement Income Summit in Chicago on May 3-4.

I'll be there again to discuss how Social Security claiming strategies are essential to building your retirement income business. Mr. Meyer will be a panelist discussing how technology can help advisers maximize their clients' Social Security benefits, optimize their drawdown strategies and minimize their tax bite.

(Questions about Social Security? Find the answers in my ebook.)

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