The investment returns of the past 15 years have been disappointing, at least by historical standards. Through year-end 2015, the S&P 500 Index only grew at an annualized rate of 5.00%. That’s less than half of the 10.71% average return for rolling fifteen-year periods going back to 1926. Especially in these lower-return environments, we want to minimize the amount of investment profits lost to the income tax bite.
The tax law actually incents savings for retirement by providing tax deferral which changes the timing of when taxes are due. Deferral is a big deal. Even though it has been around for more than three decades, we find that not everyone is taking full advantage of the planning opportunities.
As a reminder of how deferral works, think back to the shock of seeing how much of your first paycheck was lost to withholding taxes. As an example, at a 25% tax rate, you must earn $13,333 of gross income in order to have $10,000 remaining. But with the special tax deferral rules, if you save within certain qualified investment programs like a 401(k) or IRA, you can actually invest the full $13,333 immediately.
Deferral also provides an exception to the normal tax rule that each year you must pay tax on your realized investment profits. But, deferral means the tax liability has been delayed, not avoided. So, every dollar, when it is ultimately taken out of a retirement plan, triggers income tax.
The Tax Partnership. Commentators suggest viewing this pending tax liability like a partnership between you and the government. In effect, the government “owns” a portion of your retirement plan equal to the amount of that looming tax bite. You own the rest. Each year, together you and the government earn investment profits (or losses) on the combined balance. The ultimate split of assets between you and the government is not determined until you actually make distributions from the plan, and, for the most part, you have a fair amount of latitude in the timing of these withdrawals.
Congress intended for retirement funds to be used later in life, so they established rules about taking distributions too early or too late. If you choose to take funds too early (before age 59½), you will generally be assessed a 10% penalty. Also, in order to prevent people from holding retirement assets too long, the IRS has created tables based on life expectancy estimates that require participants in a qualified plan make at least certain required minimum distributions starting at age 70½. But important opportunities live inside these rules.
Remember the US tax code is progressive meaning your tax rate, and thus the government’s share of your retirement partnership, depends on your income level at the time you take money out of your qualified plan. In 2016, a married couple with taxable income up to roughly $75,000 will pay tax at a rate of 15%. If that income increases to $152,000, they jump into the 25% tax bracket. At $232,000 of income, the tax rate goes to 33%.
Imagine a married couple who have accumulated $1,000,000 in a 401(k) plan. If the couple decided to withdraw the balance over five years, the more than $200,000 of annual distributions could easily push the couple into that 33% tax bracket, meaning up to one-third of the plan would be lost to taxes. If, instead, the couple stretched their withdrawals over 20 years, the $50,000 annual payouts could quite possibly keep the couple in the 15% bracket. Simply delaying withdrawals drastically cuts the government’s “share” of the partnership, sometimes by more than half.
For some folks the choice of when to take retirement distributions is determined more by economic necessity than tax planning. But many people do have a fair amount of discretion over when they need to withdraw funds. So, why not time the distributions to minimize the tax bite?
Two Big Planning Opportunities. Many people who retire in their early- to mid-sixties experience a lull in their taxable income. They no longer earn a paycheck, and often they are not yet receiving Social Security. In this first phase of retirement, not paying much, if any, income tax feels great. For years they have heard of the benefits of deferring or delaying taxes as long as possible which, in general, is good, but here, there may actually be an opportunity to pay taxes earlier but at a lower rate.
If you have a sizeable retirement plan, once required minimum distributions kick in you will likely get bumped up to a higher tax bracket. What if, during the low income years (likely before age 70½), you make limited withdrawals from your retirement plan, say, just enough to keep you within the 15% or even 25% bracket. You could always reinvest these funds or even consider converting them to a Roth IRA. In either case you will trigger some tax, but remember it is all about the partnership allocation. If assets can be withdrawn at those lower tax rates, it may well be beneficial in the end to trigger low rate tax now versus waiting to pay higher rate tax later.
The chart below illustrates the potential wealth gain of being smarter about when to take distributions. The blue area shows the standard approach of taking only required minimum distributions starting at age 70½. The green area shows the additional wealth solely from taking distributions earlier at those lower tax rates. Over time this strategy can make a significant impact.
Because every person’s financial situation is unique we believe the only way to identify and quantify this potential enhancement to your wealth is to take the time to run these projections. Our analysis depends on understanding you and your tax situation throughout retirement. Done well, we can help you make your money work harder in order to accomplish your goals and dreams.
A similar tax planning opportunity occurs at your death. The rules here get a little complicated, but essentially the decisions are based around spreading out or stretching the withdrawals for as long as possible to avoid paying tax at the higher rates. In “tax-speak” we are looking to stretch what is known as the “Applicable Distribution Period,” meaning the life expectancy factor used by the IRS in computing its Required Minimum Distribution.
We all know the tax tail should not wag the dog, and priority one is getting retirement assets transferred to the right heirs. But, to the extent income taxes impact decisions, it is important to understand that getting retirement funds to different beneficiaries in different ways has different tax consequences.
As an example, many people mistakenly think it makes perfect sense to leave your retirement plans to your estate which will then distribute the funds as directed by your will. However, under the tax code, when plan assets are left to an estate or “non-individual,” the plan assets must be paid out over just five years which can easily mean paying tax in higher brackets.
If, instead, an individual is named (or a trust that qualifies as a “see-through trust” under the code) the deferral period will be based on the beneficiary’s life expectancy. So, assume Herman dies owning a retirement plan he wants to pass to his son, Eddie. He can get the funds to Eddie by leaving the plan proceeds to his estate and then have his will direct his estate be distributed to Eddie. Alternatively, he could specifically name Eddie (or a qualifying trust for Eddie) as the beneficiary of his retirement assets. Either way, Eddie gets the money, but by avoiding payment to the estate, Eddie gains a big opportunity. Instead of the five year payout period, Eddie can now stretch withdrawals over the next 35 years, likely meaning lower tax brackets which translates to a bigger inheritance net of income tax. Wealth-wise, that could make a tremendous difference as illustrated below.
Here the blue area of the chart shows the projected account balances from taking distributions from an inherited IRA over five years. After paying tax on the distributions, we assume the net proceeds are invested in a similar fashion as the IRA. The green area shows the power of tax deferral – here distributions are spread over a 35-year life expectancy resulting in less tax and more wealth.
Herman may want to instead leave assets to his wife, Lilly. Here again, rather than name his estate, Herman should specifically name Lilly as his beneficiary. This gives her other opportunities besides avoiding that five-year payout rule. Lilly can choose to “rollover” the retirement plan essentially treating it as if it has always been hers. Going forward, required minimum distributions will not start until her age 70½ and then they will be made based on her life expectancy. If she is younger and anticipates needing funds before age 59½, rather than rollover the plan, she can treat the IRA as inherited, giving her the added benefit of access to the funds without paying the 10% penalty for early withdrawals.
At Foster Group, we created our Standard of Care to make sure we are systematically addressing planning opportunities like this for all our clients. In certain situations, the rules can get complicated. Our goal is to talk through your various options to verify your retirement assets are working for you in the best manner possible.
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