Retirement Distribution Tax Planning

“Please consult your tax advisor.” This is the standard disclaimer brokerage firms give whenever a client requests a withdrawal from their retirement account. It’s their way of washing their hands of the situation. Brokerage firms focus on investments, not taxes.

Brokerage firms often have thousands of clients. Getting to know every one of their client’s specific tax situations would be difficult at best. That’s why they put the responsibility for understanding tax consequences back on the investor. That sounds good in theory, but the reality is that many retirees fail to consider the impact a retirement distribution will have until it’s too late. To build a tax efficient distribution strategy, you need to have a plan in place as soon as possible.

Tax Planning Mistakes

While a brokerage firm can’t be expected to know every client’s tax situation, your financial advisor most definitely should know. And that’s why I’m writing this article today. I recently prepared the taxes for an elderly client who’s ‘advisor’ didn’t bother learning about his client’s tax situation. She needed money, and her financial advisor simply cut her a check without thinking. 

The result was a $7,000 tax bill this year. Normally, she paid quarterly estimated taxes and, at worst, sent a few hundred in to cover any shortfall. What happened to cause the huge jump in taxes? Her problem started when she needed to withdraw over $10,000 to cover unforeseen medical expenses. The advisor took it out of her traditional IRA. That was a costly mistake.

When you take a distribution from a traditional IRA, the money is being taxed for the first time.  That income is taxed at your ordinary income rate. By itself, a $10,000 withdrawal might not have much impact on retirees in lower tax brackets. My client thought withholding 10% of the distribution was enough to cover the extra tax burden. But because her financial advisor didn’t have a proper distribution strategy in place, the income caused her Social Security payments to become taxable for the first time. That added to the amount owed to the IRS.

Taxes on Social Security

Suddenly seeing thousands more due at tax time can be a shock. For years, this client had collected Social Security. She made sure to take out the required minimum distributions (RMD) from her IRA and Thrift Savings Plan. She also collected a government pension from the Office of Personnel Management. The client also had savings in a Roth IRA, a trust account, and access to a fixed annuity. Until this year, she hadn’t thought to set up a withdrawal strategy that prevented her Social Security benefits from becoming taxable.

To do that, you need to understand the tax treatment of the funds available during retirement. For most, Social Security makes up the foundation of retirement income. One of the benefits of Social Security payments is that they are often federally tax-free. However, if a retiree has ‘substantial income’, up to 85% of the benefits can bec.

So what counts as ‘substantial income’? According to the IRS, an individual tax filer making between $25,000 and $34,000 may have to pay income tax on up to 50% of their Social Security benefits. If the filer earns more than $34,000, 85% of the benefit may be taxable. For joint filers, income between $32,000 and $44,000 can have half of the amount taxed. Above $44,000, up to 85% may be taxable.

The IRS considers income wages, self-employment, interest, dividends or ‘money from ‘other’ sources. Capital gains, the amount of growth on the sale of an investment, is counted towards adjusted gross income (AGI). Money coming from a qualified retirement account can also be considered income, depending on the tax structure of the account.

For my client, her tax problem came from the fact that her retirement distribution caused her Social Security payment to be taxed at the 85% rate. The additional income pushed her top marginal income bracket higher as well. Before this, her benefits hadn’t been taxed. A simple tax planning strategy could have avoided the increased expense.  

Creating a Tax Advantaged Retirement Strategy

As I’ve already said, one should start a tax strategy as early as possible. Creating a tax efficient distribution strategy can begin well before retirement. This is done by saving in both pre and post-tax retirement accounts in addition to taxable brokerage accounts. The most common way for people to save in these investment accounts is through their employer sponsored plans. These plans include 401k, 401(b)7, 457, 401a and others, depending on what kind of employer you have.

Pre-tax retirement accounts have been around longer than post-tax accounts. Traditional IRAs and 401k plans are the most commonly used pre-tax retirement accounts. A pre-tax account is not taxed at the time of the contribution. Making the contribution allows you to deduct the amount from current income, which helps lower the tax burden that year. The investments can grow tax free until withdrawn from the account.  

A pre-tax contribution shifts the tax burden from the year the contribution is made to when it’s distributed. That can help reduce a saver’s overall tax expense because the tax rate is often higher while a person is working than when they start drawing on the money in retirement. However, since this income is being taxed for the first time, it’s considered income that can cause Social Security benefits to become taxable.

This is where post-tax and taxable brokerage accounts can help. Post-tax savings accounts include Roth IRAs and Roth 401ks. The money contributed to one of these accounts is taxed in the year the contribution is made, yet the funds can grow tax free and there are no taxes owed at retirement. There are conditions to qualify for Roth contributions and to be eligible for tax free treatment.

Having both pre and post-tax accounts available allows one to coordinate the tax treatment of income needed during retirement. Retirees can balance withdrawals from their brokerage, traditional, and Roth accounts in a way that limits the taxability of Social Security while keeping their income in a lower tax bracket. While you need to fulfill the annual RMD, there’s no need to take a distribution from your pre-tax account beyond that. Ideally, the tax-free distributions from a Roth account would take care of the remainder of a retiree’s needs. 

A Financial Advisor’s Role

Most retirees can implement a simple tax planning strategy on their own. Understanding what is considered income and when that income can cause Social Security to become taxable is building one. It’s not incredibly difficult to coordinate when the only investment accounts you own are a traditional and Roth IRA. As with anything, more moving parts means more complexity.

Consolidating accounts spread across multiple brokerage firms is one way to reduce complexity. A big reason for doing so is to better understand what funds need to be withdrawn to satisfy the RMD rules. Financial advisors often encourage clients to do so for this reason, but a good advisor should be able to manage your tax situations even if funds are held at multiple institutions. 

Hiring a financial advisor may be a good idea if you do have multiple accounts. It also becomes beneficial when taxable brokerage accounts are being used in retirement. Capital gains, while taxed differently, are considered part of AGI. Offsetting capital gains and losses is an important part of a tax strategy both before and during retirement. A financial advisor isn’t essential for this, but having one certainly makes it easier to manage the process.

Your tax situation should always be considered by your financial advisor. Unfortunately, many financial professionals primarily focus on investments. For the client I was working with, her financial advisor held an Accredited Asset Management Specialist (AAMS) designation. He should have been aware of the outside accounts and her tax situation. Unfortunately, he wasn’t.

Studies have shown that working with a financial advisor is more beneficial than going at it alone. Part of your financial strategy needs to be finding someone who understands the tax consequences of your distributions. When interviewing a prospective advisor, ask who will manage your tax strategy. If they tell you to consult with a tax advisor, you might want to keep looking around.

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