Protecting Clients’ Retirement Income From Taxation

In the next few decades, the federal government will have to deliver trillions of dollars in promised Social Security and Medicare benefits. With reserves depleting, the only realistic way for the government to honor these commitments is to raise taxes.

Some experts believe taxes must double to keep these programs solvent. This poses a problem for the average American investor who has accumulated most of their retirement savings in tax-deferred accounts. To shield clients from a potential tax tsunami, advisors must diversify clients’ assets to include tax-free sources of income.   

Tax Trap

From a tax perspective, investments fall into three buckets. The first is the “taxable bucket,” covering any account that generates a Form 1099. These accounts are highly taxable but tend to be very liquid and work well as emergency funds. Generally, the taxable bucket should hold between three and six months’ worth of basic living expenses. 

The second bucket consists of “tax-deferred” accounts, which includes traditional IRAs, 401(k)s, 403(b)s, simplified employee pensions, SIMPLE IRAs, etc. While the rules governing these accounts differ, they all share two features: contributions are tax-deductible and distributions are taxed as ordinary income.

This setup works well if an investor believes they will be in a lower tax bracket in retirement. But given the looming insolvency of our nation’s entitlement programs, this may not necessarily be the case.

Deferred, Not Diminished

The problem with tax-deferred accounts doesn’t stop there. At retirement, your clients have likely lost all the deductions they enjoyed during their working years. For example, if your client’s house is paid off, they’ve lost their mortgage interest deduction. If their children have flown the coop, there’s no child tax credit. Furthermore, during retirement they’re no longer making tax-deductible contributions to retirement plans. Finally, instead of donating money to charities, most retirees donate their time.

By retirement, the only deduction most clients have left is the standard deduction: $25,100 if filing jointly, $12,550 if filing single. So, if a client retired today on $120,000 of gross income, their taxable income would be $94,900. That puts their marginal tax bracket at 22%! Throw in another 6% for state income taxes, and that totals 28% on the margin. That’s a lot higher than most people think! 

To compound matters, the tax-deferred bucket in retirement can feel a bit like being stuck between a rock and a hard place. What’s the rock? The rock is when clients don’t take enough money out. At age 72, an IRS-required minimum distribution comes into effect. If clients don’t take it, they pay an excise tax of 50%. What’s the hard place? Withdrawing too much money. This could force a client into a higher tax bracket and cause them to lose a portion of their Social Security to taxation. 

Social Security taxation is tied to what the IRS calls “provisional income.” What counts as provisional income? Any income reported on a 1099, any distributions from a tax-deferred account, and half of your client’s Social Security benefits. If provisional income is greater than $34,000 as a single filer, or $44,000 as a married filer, then up to 85% of your client’s Social Security benefits can become taxable at their highest marginal tax rate. In short, darned if you don’t take out enough money, and darned if you take out too much.

Securing Retirement Safety

Finally, we consider the tax-free bucket. To be truly tax-free, investment accounts must satisfy two tests. First, withdrawals cannot trigger federal, state or capital gains taxes. Second, withdrawals cannot count as provisional income. There are a few truly tax-free alternatives that clients can use in shielding their retirement savings from the impact of higher taxes.

One true tax-free investment account is the Roth IRA. Once contributions are made, they grow tax-deferred and, after age 59 1/2, both principal and earnings can be distributed tax-free. Furthermore, distributions do not cause Social Security taxation.

Another tax-free investment that comes with more limitations is a health savings account. Contributions grow tax-deferred and can be used to pay for qualifying medical expenses tax-free. Other tax-free withdrawals can be made when clients reimburse themselves for qualifying medical expenses paid for out of pocket.

Permanent life insurance can also be a way to build wealth in the tax-free bucket. Contributions to permanent life insurance policy cash values grow tax-deferred, and policy loans can be taken out tax-free without having to be paid back while the policyowner is alive. There are no contribution limits, no income limitations, and in some cases, clients can access death benefits prior to death to pay for long-term care.

To shore up weaknesses in Social Security and Medicare, the government may soon be forced to raise taxes on virtually all Americans. With careful planning, however, advisors can help clients protect their investment accounts and maximize their after-tax retirement income.

David C. McKnight, a four-year MDRT member, is the president of Power of Zero and the author of best-selling books The Power of Zero and Tax-Free Income for Life. He may be contacted at david.mcknight@innfeedback.com.