ELITE ADVISOR BEST PRACTICES

Withdrawal Strategies: An Overview

How wealth advisors provide significant value toclients who are preparing to fund their retirement lifestyles in a tax-efficient way

By Ernest Clark

Key Takeaways:

  • Retirees’ portfolios may last longer if they incur the least amount of income tax possible over their retirement period.
  • Retirees may reduce their retirement income tax expense by avoiding income-tax-bracket creeping and investing their portfolios in an income-tax-efficient way.
  • Wealth advisors add value to the process by selecting the appropriate amount and assets to liquidate to fund the retiree’s lifestyle.


Clients have spent their working lives focused on growing their portfolios to achieve the highest amount of after-income-tax return for the amount of risk taken. As members of the Baby Boomer generation near the end of the asset accumulation phase of their lives, they are beginning to focus on the portfolio withdrawal stage. They will be focused on funding the cost of their lifestyles with the lowest possible income tax expense over their lifetimes. These retirees will expect you, their wealth advisor, to have expertise in withdrawal strategies and to communicate with their tax expert to achieve this goal. Wealth advisors providing this service will maintain their clients and attract new clients who are at the withdrawal stageand seeking the service.

Withdrawal Goals

The retiree’s goal is for the financial portfolio to last as long as possible while incurring the least amount of income taxes over retirement years.

The retiree’s lifestyle will be funded with the cash from taxable income that must be recognized during the taxable year, regardless of portfolio withdrawal planning. These non-portfolio sources of taxable income include defined-benefit-plan benefits, employee deferred income, rental income, business income and required minimum distributions from tax-deferred accounts. The wealth advisor, along with the retiree’s tax expert, should bring significant value to the client by determining the source of funding of the remaining lifestyle cost by incurring the lowest effective income tax rate.

Long-Term Opportunity

Taxpayers are normally concerned about the amount of income taxes they pay in the current year. Without client education followed by appropriate planning, your client may pay no income tax for several years and then pay income taxes at higher brackets. To achieve the lowest dollar income tax expense over the entire retirement period, the retiree should avoid tax-bracket creeping caused by our progressive income tax system. The wealth advisor, working with the client’s income tax expert, should recommend an annual target taxable income to avoid bracket creeping. The experts should engage in year-end income tax planning to determine if the client will achieve this taxable income goal and to make the financial transactions, if necessary, to either increase projected income or increase deductions.

Types of Income Taxpayers

The wealth advisor and income tax expert should establish aneffective, long-term income-tax-rate goal to avoid income tax bracket creeping. The following list of income taxpayer types may assist in setting the goal:

  • Low-income taxpayersare:
    • Generally in the lowest income tax brackets, such as 10to 15 percent
    • Generally eligible for various income tax credits
    • Not subject to tax on Social Security
  • Low-to-middle income taxpayers are:
    • Generally in the middle income tax brackets, such as 15 or 25 percent to 28 percent
    • Generally eligible for certain favorable income tax attributes, such as a zero percent tax rate rather than a 15 percent rate on capital gains and qualified dividends
  • Middle-to-high income taxpayers are:
    • Generally in the upper end of the middle income tax brackets, such as 28 to 33 percent
    • Subject to alternative minimum tax (AMT) and other phase-outs
  • High-income taxpayers are:
    • Generally in the highest marginal income tax bracket, 35 percent
    • Subject to several phase-outs and surtaxes such as AMT

Under the Health Care and Education Reconciliation Act of 2010, starting in years beginning after December 31, 2012, taxpayers will be subject to a 3.8 percent tax on net investment income in excess of modified adjusted gross income (including investment income) of $250,000 for married filing jointly.

Tax “Buckets”

Retirees own assets in accounts that determine the tax treatment of the assets and their income due to the tax bucket. The wealth advisor should select assets to liquidate to fund the required lifestyle while preventing bracket creeping by understanding the tax consequences of the portfolio’s tax buckets.

  • Taxable accounts
    • Taxable interest—Income tax at highest tax marginal rate.
    • Tax exempt—Not taxable but security was purchased to yield income at an after-tax rate.
    • Dividends—Taxed at long-term capital gain rate.
    • Sale of asset held over one year—Deferred until sale, return of basis not taxable, gain taxable at long-term capital gain rate.
    • Sale of asset held under one year—Deferred until sale, return of basis not taxable, gain taxable at ordinary income tax rate.
    • Heirs receive stepped-up basis at death and avoid capital gain on growth.
  • Tax-deferred accounts
    • Contributions were tax-deductible.
    • Grows income-tax deferred.
    • 100 percent ordinary income at withdrawal.
    • 10 percent penalty for withdrawal before age 59 ½ and required minimum annual distribution at age 70 ½.
    • Heirs subject to required minimum distribution at their ordinary income rates.
  • Tax-free accounts (Roth IRAs)
    • Tax-free growth.
    • Tax-free distributions.
    • No required minimum annual distribution at age 70 ½.
    • Heirs receive tax-free distributions.
Conclusion

This article discussed the value that wealth manager scan provide by assisting their retired clients in managing their long-term income tax expenses and avoiding bracket creeping. In my next article, we will discuss additional value you can bring through asset placement and other withdrawal strategies.


About the Author

Ernest Clark, CPA/PFS, is a principal and the director of wealth management of BAM Advisor Services, LLC, a comprehensive service provider for independent Registered Investment Advisor firms across the country.