The twilight of clients' working years are the most crucial when it comes to softening the tax blow of required minimum distributions.
Clients in their 60s, particularly those with hefty amounts in their individual retirement accounts and 401(k)s, know they will be on the hook for RMDs from those accounts once they turn 70.5.
Unfortunately, those withdrawals can bring a host of tax problems with them. They inflate clients' adjusted gross income, and the amount pulled from the account is also taxable. A higher AGI can subject clients to a phaseout of personal exemptions and itemized deductions
if their AGI is over $250,000 for singles and $300,000 for married couples filing jointly.
This is where “pre-retirement” planning comes into the picture, notes Lyle K. Benson Jr., a certified public accountant and founder of L.K. Benson & Co. “Clients in their sixties may be in a lower bracket with a large IRA,” he noted. “They need to avoid ending up in a higher bracket at 70.5.”
How much a client expects to face in taxes from RMDs comes down to two factors: the amount of taxable dollars being pulled from the retirement account, and how much overall income is taxable, according to Jeffrey Levine, an IRA technical consultant with Ed Slott and Co.
“You're minimizing one or the other,” he said. “You can have fewer taxable distributions coming out because you pulled the money out earlier, and you can reduce other income.”
In order to mitigate the ill effects of higher income, Mr. Benson uses incremental Roth conversions of those large qualified accounts in the years leading up to age 70.5. Bear in mind that Roth IRAs don't call for withdrawals
until after the owner dies. Effectively, income that is tax-inefficient is being replaced with tax-efficient dollars.
Meanwhile, advisers can control the flow of taxable income by considering Social Security claiming strategies. At most, up to 85% of a client's Social Security benefits are subject to federal income taxes — meaning that
15% of that income is tax-free.
“If you have a dollar of income coming from an IRA and a dollar coming from Social Security, you have more spendable income from Social Security,” Mr. Levine said. “That's often overlooked; advisers don't take it into consideration.”
Another tactic worth considering is discussing a client's ability to stay on at the workplace as an employee, even if that individual is coming in a day or two a month as a consultant. If the client's ownership stake in the business providing the retirement plan is less than 5%, then that individual can stay on at the workplace and hold off on RMDs until he retires.
“If you still work, even if infrequently, as long as you are an employee of that company and you're still working, then that's good enough,” said Mr. Levine. “It's an out-there strategy.”
