If you’re a tax professional or financial adviser, you know many of your clients are focused on saving for their golden years but generally treat what to do once they’re in retirement as an afterthought. This is problematic because of the many tax traps that can arise once a person has retired, and it’s why I’ve long counseled investors, tax professionals, and financial advisers to plan for them before retirement.
The most common retirement tax traps that I have seen investors encounter fall into two buckets:
- Using deferral of tax liability as the sole planning goal; and
- Failing to recognize (and mitigate ahead of time) the innate tax inefficiencies associated with passing down retirement assets after death.
Too often, investors think about the tax burdens attributable to their retirement accounts as something inevitable and inflexible—for example, what the corresponding tax damage will be when they’re forced to withdraw from their retirement as a required minimum distribution (RMD) this year or what portion of their retirement assets will be left for their family and how it will be depleted by taxes. Meanwhile, they forget that some early strategic planning with respect to timing and amount of distributions, Roth conversions, and beneficiaries can make a big difference in their (and their loved ones’) tax bills.
Tax Trap 1
For tax professionals and financial advisers: if deferral is your client’s North Star, and assuming they have plenty of non-qualified assets to fund their lifestyle, their defaults could be delaying distributions until the age of 72, limiting distributions to RMDs, and avoiding income acceleration transactions like Roth conversions.
This may be the optimal plan for some investors, but generally, there’s a lot of nuance that’s lost if they’re only thinking about deferring retirement income tax liability as long as possible. In certain cases, it may make sense for your clients to consider actually accelerating income tax liability through early (pre-RMD age) and excess (over RMD) distributions, as well as Roth conversions. This type of planning is all about “income smoothing,” or managing a client’s income levels over a period of years to avoid slipping into higher tax brackets, fully leveraging their deductions and minimizing their overall tax bill over that same period.
For example, consider an investor in their early 60s who doesn’t need to access their retirement account to pay living expenses. Should they be taking distributions from a retirement account even if not required to take RMDs? It depends; the person’s instinct might be to avoid taking distributions until reaching the mandatory RMD age of 72, with the goal of deferring tax liability for as long as possible. However, what if the person actually expects to be in a higher income tax bracket in their 70s because they expect to inherit income-producing property, or because they simply believe tax rates are likely to increase over the next decade? It may make sense to start taking distributions now, which would lower RMDs in the future and could smooth out income tax liability during retirement years.
Deferral should not be the only consideration when evaluating the timing and numbr of distributions from a client’s retirement account. Need, age, income levels, and tax brackets—both now and in the future—should all be part of the discussion.
Distributions are not the only tool for income smoothing in the retirement context. Tax professionals and financial advisers can also inform clients that:
- Strategic Roth conversions are a great way to increase taxable income in years when a client has more deductions or is looking to “fill up” their tax bracket; and
- Making qualified charitable distributions (QCDs) is an easy way to decrease taxable income (by offsetting RMDs) in years when a client is looking to avoid bracket creep or keep their tax bill lower for liquidity reasons.
Tax Trap 2
Millions of investors will have retirement assets remaining upon their passing. This may seem like a good problem to have, except retirement assets are notoriously tax-inefficient (and tax-uncertain) to pass down. There’s likely substantial future tax liability awaiting children and grandchildren with traditional retirement accounts (versus a Roth account), and it’s nearly impossible to predict the extent of such liability. The SECURE Act and the new 10-year rule for inherited IRAs has only compounded this issue.
Because of these innate tax inefficiencies, a client’s instinct to hold on to retirement assets until death (with the goal of preserving as much as possible for future generations) can be a real tax trap. It may sound great to pass down a $2 million inherited IRA to a client’s family, but there’s a big question mark regarding how much of that $2 million they actually see.
The taxes associated with that inheritance would depend on the client’s date of death, their beneficiaries’ income and tax brackets, future tax rates, and the estate tax exemption, to name a few. While there’s no magic solution, there are ways to minimize the uncertainty around the retirement portion of a client’s legacy.
Some potential planning strategies that tax professionals and financial advisers can discuss with clients include:
- Using retirement assets as the source for charitable giving, both during life through QCDs and at death through beneficiary designations;
- Completely using qualified asset before non-qualified assets to pay for a client’s living expenses;
- “Diversifying” away from a client’s retirement accounts by taking one or several large distributions (in excess of RMDs); and
- Considering one or several Roth conversions.
If you’re a tax professional or financial adviser working with a client preparing to retire, these are sensitive topics to discuss as part of financial and tax planning. It is never easy, but having those tough talks to avoid retirement tax traps is vital.
It also can help to prevent easily avoidable and often overlooked tax traps, such as not reviewing and updating beneficiary designations for a client’s retirement accounts or a client’s inaction because of the unknown or uncertainty around taxes and planning in retirement. Both can have huge tax consequences for a person’s estate or the loved ones to whom they had hoped to pass on their assets.
Start small—there’s no need to address a person’s legacy and what they will leave behind in one fell swoop. In one meeting, ask about setting up beneficiaries in a client’s will. In another, raise the question of what QCDs a client may want to make before retirement and in retirement. Tax professionals and financial advisers can tackle these—as well as questions around how a client wants to pass down retirement assets or take distributions—bit by bit.
The bottom line is that while many people picture retirement as a finish line at the end of a good, long race, it’s not a single moment in time. It’s usually many decades long, and a lot can happen with a client’s finances and tax liabilities during that time. Starting small, early, and often with conversations about how clients can pass on retirement assets, when to start taking distributions, and more can help to avoid retirement tax traps.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Leslie Geller is a former attorney who is currently a wealth strategist at Capital Group. Geller works with financial advisers with high-net-worth clients providing support on all matters related to taxation, wealth transfer, and family governance.
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