Tax-lowering ideas for retirement portfolios

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Because the odds of retirement income portfolio survival can be influenced by small changes in distribution rates, reducing clients’ taxes will help increase the probability of long-term success.
Consider the following example: Your client has $2.5 million in retirement assets, takes a 4.5% distribution and is subject to a 25% tax rate. The total distribution is $112,500, and the after-tax amount available to the client is $84,375. If you could reduce the client’s tax rate to 20%, you would need to take only a $105,000 distribution to net $84,000. This would lower the client’s distribution rate to 4.2%.

We know from history that reductions in distribution rates of 0.25% to 0.5% can have a sizable effect on the long-term survivability of an account.

A lower tax rate means lower distributions, which means a higher probability of long-term portfolio survival.

Here are six tax-lowering ideas that can help advisers reduce their clients’ tax rates in retirement:

*Security selection. Last year produced significant mutual fund capital gains distributions. The large distributions created tax liabilities but no actual income or gains for clients to spend. Utilizing more-tax-efficient exchange traded funds or individual equities will likely reduce the client’s tax burden and thus lessen their distribution needs.

*Graduated income tax rates. Under the graduated federal-income-tax rates, certain individual retirement account distributions can be taxed at the lowest income tax brackets. For instance, joint taxpayers fall into the 10% and 15% tax brackets for taxable income up of to $65,100 in 2008. If a retired couple’s standard deduction and personal exemptions could basically offset their taxable Social Security benefits, they have about $65,000 of ordinary income distributions that could be taxed at the 10% and 15% levels. If the client has a sizable IRA, advisers should consider funding the first $65,000 of distributions from the IRA.

*Fixed-income placement. Because all distributions from IRAs are taxed as ordinary income, advisers should consider holding their client’s fixed-income securities in the IRA, especially if they are subject to 10% and 15% income tax rates on the distributions. This allows for continued tax-deferred growth on income that is not distributed, plus the advantage of a lower tax rate on the distributions that are made.

*Minimizing required minimum distributions. Because fixed-income assets are generally slow-growing, allocating the client’s fixed-income holdings to the IRA helps reduce the IRA’s future value, which helps reduce the size of the future RMDs. This is an important issue as the client ages. For instance, between ages 78 and 90, the RMD goes from 5% of the account balance to almost 9%. To the extent possible, positioning assets to slow the growth of the IRA will reduce the client’s future tax liability.

*Equity placement. Because of the current difference in ordinary income tax rates versus dividends and capital gains, advisers should consider holding clients’ equities in their taxable accounts to the extent possible. This preserves the 15% tax rate on dividends and long-term capital gains. If these assets are held in the IRA, the gains are converted to ordinary income once distributed and may be taxed at rates higher than the current dividend and capital gains rates.

*Tax lot management. For taxable-investment accounts, effective tax lot management can help reduce taxes owed on any capital gains sales. As a default, advisers should consider using the “highest cost” method for allocating sales to various tax lots, as long as the assets have been held for at least one year. This allows the client to use the long-term capital gains tax rate of 15% and subject a smaller portion of the distribution to the tax.

For instance, if a client owns a stock with two $10,000 tax lots, one with a 50% gain and one with a 25% gain, and if you are going to sell one lot to fund the client’s $10,000 distribution, it of course makes sense to sell the lot with the 25% gain. At a 15% tax rate, the client’s effective tax rate on that distribution is 3%. (The client sells a $10,000 lot with an $8,000 cost basis. This produces $2,000 of gains at a 15% tax rate. The client owes $300, which is 3% of the distribution amount.)

Charles J. Farrell, J.D., LL.M., is an investment adviser with Northstar Investment Advisors LLC in Denver.

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