Managing income level risks for retired clients
By monitoring where your clients fall on the scale of incremental income level risks, you can help them reduce their taxes by carefully choosing the sources used to meet their cash-flow needs.
You are adept at managing your clients’ tax planning during their work years, but you also need to be attuned to tax planning opportunities after they retire. During retirement, clients can exceed several thresholds that may cause their tax liabilities to increase.
By monitoring where your clients fall on the scale of incremental income level risks, you can help them reduce their taxes by carefully choosing the sources used to meet their cash-flow needs.
Start by pinpointing the cash-flow level of your retiree and identifying the thresholds that may apply to him or her. For example, if your client is married with an annual cash-flow need of $180,000, by reducing the cash flow or changing the source of the cash flow, you may be able to lower the taxable income below the $170,000 Medicare premium means test level and potentially avoid the start of the 28% marginal tax rate bracket at $153,100.
(More: The appeal and pitfalls of holding unconventional assets in retirement accounts)
Similarly, for a single person with a cash-flow need of $220,000 annually, your goal might be to avoid the 3.8% net investment income tax ($200,000) and the maximum Medicare Part B premium level ($214,000).
Here are several strategies for changing the source of your retired clients’ cash-flow needs to reduce their taxable income.
The “three buckets” approach. You can encourage your retirees to have three sources of income available to meet their cash-flow needs.
The three buckets are: a mostly already-taxed investment account; a tax-deferred, qualified retirement account; and a nontaxable account, which might include Roth IRAs, a reverse mortgage line of credit or life insurance.
There usually is not much you can do about your retirees’ cash-flow needs, but it may be possible to draw the cash flows from the three buckets in a way that avoids exceeding the target threshold, thereby reducing the tax liability.
RMD control and Roth conversions before 70½. Required minimum distributions for clients in their 80s average approximately 7% of their qualified assets. These high distributions often push clients above the thresholds causing higher lifetime tax. Doing Roth conversions for clients in their 60s can reduce these high RMDs later in life. Be sure to compare the marginal tax rates to check that you are actually lowering their taxes.
A reverse mortgage line of credit. Nontaxable cash flow from a reverse mortgage not only reduces tax liability, it postpones the use of qualified retirement dollars, allowing those assets to grow for use later in retirement.
Asset allocation strategies. Holding fixed-income assets in qualified accounts and equities in nonqualified accounts is one strategy to reduce taxes. Investing in tax-efficient mutual funds and ETFs is another.
Timely tax-loss harvesting. If your client is pushed above a threshold because of an unanticipated capital gain, you can offset the gain by recognizing potential capital losses in the client’s portfolio.
Charitable donations. You can concentrate several years of charitable donations in a donor-advised fund in one year, and distribute your pledged amounts to the target charities in subsequent years. Also, your clients with IRAs can avoid the tax on their RMDs by making qualified charitable distributions directly to their favorite charities. Neither the IRA distribution nor the charitable donation is reported on your client’s tax return (up to $100,000).
(More: DOL fiduciary rule pushing broker-dealer assets to fee-based accounts, away from commissions)
Annuities. Your clients can decrease their taxable investment income and obtain a guaranteed stream of income by using a portion of their taxable portfolio to purchase an annuity. Immediate or deferred annuity distributions will be partially taxable. Alternatively, a qualified longevity annuity contract can be purchased inside a qualified retirement plan, reducing current RMDs and guaranteeing a future stream of income.
Life insurance. If your client is insurable and has adequate resources for retirement, you might consider the purchase of a cash value life insurance policy to lower portfolio income below the next income tax threshold.
| Risk | Single income thresholds | Married filing jointly income thresholds |
|---|---|---|
| The Social Security “tax torpedo” increases the marginal income tax rate as the percentage of Social Security benefits subject to income tax increases from 0% to 85%. | Two thresholds: $25,000 and $34,000 of modified adjusted gross income | Two thresholds: $32,000 and $44,000 of modifiedadjusted gross income |
| Transition from 15% to 25% marginal income tax bracket, and moving from a 0% to 15% tax rate on qualified dividends and long-term capital gains. | $37,950 of taxable income | $75,900 of taxable income |
| Medicare Part B premium — the higher your income, the higher your monthly premium. The difference could be more than $300 per month. | Four thresholds: $85,000, $107,000, $160,000 and $214,000 of modified adjusted gross income | Four thresholds: $170,000, $214,000, $320,000 and $428,000 of modified adjusted gross income |
| Start of the 28% marginal tax rate bracket and the marriage penalty. | $91,900 of taxable income | $153,100 of taxable income |
| 3.8% surtax level on net investment income. | $200,000 of adjusted gross income | $250,000 of adjusted gross income |
| Personal exemption(s) deduction phase out (2% for each $2,500 in excess of the threshold). | $261,500 of adjusted gross income | $313,800 of adjusted gross income |
| Itemized deductions phase out. | $287,650 of adjusted gross income | $313,800 of adjusted gross income |
| Hitting the maximum 39.6% marginal tax rate bracket, resulting in the 20% capital gain rate for qualified dividends and long-term capital gains. | $418,401 of taxable income | $470,701 of taxable income |
After a period of time, your client will have access to the cash reserves of the policy, providing another nontaxable source of cash flow, and your client’s family will receive nontaxable insurance proceeds when the client dies.
Implementing strategies to lower your clients’ income taxes during retirement increases your clients’ spendable cash flow and adds years to how long their retirement assets will last.
Randy Gardner, a certified public accountant, certified financial planner and attorney, is head of financial and fiduciary education at Horace Mann, an insurance and financial services company.
Learn more about reprints and licensing for this article.
