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Helping Your Client’s Plan for an Optimal Retirement by Preparing for the Impact of Taxes

Two subjects that are widely covered when discussing the accumulation phase in retirement are:

  • Portfolio diversification within your retirement plan
  • The importance of saving early and often

Once people enter the distribution phase in retirement, guaranteed lifetime income, risk management, and managing lifestyle habits become the more popular discussions. If there is one thing I emphasize to all retirees, it’s that retirement is not about your assets; it’s all about income and I would argue guaranteed lifetime income is just that! One key part of retirement planning that is often forgotten, whether it is in the accumulation or distribution phase, is understanding the taxation of your accounts and policies. Since we are in tax season, this is a very pertinent conversation to have with your clients.

When entering retirement, conventional wisdom would tell your clients to tap into their taxable retirement accounts first, followed by tax-deferred accounts. Although this may work for most people, make sure that your clients have an understanding of the required minimum distributions (RMDs) that they will be forced to take at age 70½. If the retirement accounts are too large, there is a possibility they may get “punished” and placed in a higher tax bracket. RMDs are an oddity, as the IRS requires you to withdraw the bulk of your money in your 90’s. If you are 70½-years-old, when are the best years of your life going to be? It is highly likely that the first 10 years are going to be your best during your 70’s, not as likely in your 90’s.

Real-World Solutions

What are some real-world solutions that can be applied simply to help solve this tax issue? Let’s look at different ways retirement accounts are taxed that will help guide your clients in the right direction.

Annuities and Taxes

In “Paychecks and Playchecks: Retirement Solutions for Life,” I highlight a strategy called RMD Maximization. This is a strategy that can help your clients optimize and maximize the amount of income in the Required Minimum Distribution phase. You simply transfer the traditional individual retirement accounts (IRA) or 401(k) into a lifetime income annuity. Since the annuity is set up as an IRA, no taxable event occurs during the transfer. And since the lifetime income annuity pays for the rest of your life, it also satisfies the RMD requirement. In fact, anyone of any age can do this.

Did you know that a 30-year-old could move their IRA or 401(k) into a lifetime income annuity, start receiving a check the next month, and there would be NO 10% penalty. Why? Because the lifetime income annuity satisfies IRS Distribution Code 72(t): Substantially Equal Payments for Life.1

Now, I am not recommending 30-year-olds do this, I said that to be provocative. However, you do run into cases of people in their 50’s who want to retire and you need to know that they can do this. Many advisors also don’t realize that you can have a joint life payout on an individual retirement account. But, it is possible! This is a great strategy for many couples. They can each have a joint life payout on their lifetime income annuities.

By converting some of their retirement assets into an annuity, your clients will see that the lifetime income payout will be higher than the RMD, every single year. But, if the payout on an annuity is higher, won’t your clients pay more in taxes? Well, if they were to use the government method and take out the RMD, they’re going to pay taxes out of their own money. But, if they use the lifetime income annuity, they will pay taxes out of the extra money that they weren’t getting before. In this instance, it is not the taxes that really matter. It is where you can get the most amount of income for your client’s life as well as their spouse’s life after taxes!

IRAs, Pensions, and 401(k)s

These investment vehicles are great for the journey through the accumulation phase, but prepare to feel the swift kick once you begin drawing from these accounts. Withdrawals from IRAs and 401(k)s are taxed as ordinary income. Distributions are non-taxable only on amounts made as after-tax contributions.

Roth IRAs

Since Roth contributions are made as after-tax contributions, they can be withdrawn tax-free in retirement and can be passed tax-free to subsequent generations as well. If you convert a traditional IRA into a Roth IRA, taxes are due because of the conversion, but the withdrawals in retirement will be tax-free.

Life Insurance

Many people don’t realize that life insurance can provide tax-free income in retirement. Life insurance gives your clients the license to spend their money. Since the death benefit of the policy can be left to their family, this allows them to spend their own retirement money freely. Life insurance policies can also be 1035 exchanged into lifetime income annuities that provide guaranteed, tax advantaged, and lifetime income. Building up a portfolio of permanent life insurance policies gives you many powerful options in retirement.

Social Security and Taxes

With the recent changes in November 2015, understanding your clients’ Social Security benefits is more important than ever. What can surprise many people is that a portion of their benefit is susceptible to taxation. For the majority of Americans, it is necessary for them to work in retirement and earn wages. Before your clients begin working full-time, it’s important to note a few things:

  • If an individual is under his or her full retirement age for the entire calendar year, then $1 in Social Security benefits will be deducted for every $2 that is earned above the income of $15,720.
  • If an individual reaches his or her full retirement age during the calendar year, then $1 in Social Security benefits will be deducted from every $3 that is earned above the annual limit of $41,880.
  • There is no earnings limit that exists beginning with the month in which an individual reaches his or her full retirement age.

In addition to the Social Security earnings test, people are also subject to taxation of other provisional income. Provisional income would be considered half of your Social Security benefit plus all other taxable income, which would include dividends, realized interest, capital gains, and municipal bond interest. Many seniors don’t understand that every penny of tax-free bond interest counts towards the taxation of social security benefits. The amount will be dependent on how much the person earns as well as their tax filing status. With the changes made in 2015, understanding the effects your clients’ earnings can have on their benefit can absolutely make an impact on their overall retirement plan.

Optimal Way to Retire

Retirement is all about taking the key risks off the table. Taxes are one risk that with proper education and homework, can be minimized dramatically. Life insurance and lifetime income annuities are great products for your clients to decrease their risk of overpaying Uncle Sam and can provide guaranteed lifetime income for the entirety of their retirement. While tax season is in full swing, connect with your clients by discussing their retirement taxation plan and you will be amazed at where the conversation will go.

2 Social Security Administration

Tom Hegna Tom Hegna, CLU, ChFC, CASL, is an author, speaker and economist and host of a popular public television show. As a former Fortune 100 senior executive, Tom has dedicated his entire career to helping retirees obtain a “happily ever after” retirement. He has been featured on FoxBusiness, American College Wealth Channel Magazine, Round the Table, Advisor Today and GAMA Magazine. Tom is also a retired U.S. Army Reserves Lieutenant Colonel. He currently lives in Arizona with his wife and children.

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