A Successful And Secure Retirement—Spend-Down Strategies: Part 2

Ed Note: This is part two of a two-part series and is an excerpt from Your Complete Guide To A Successful And Secure Retirement. Part one discussed five of the nine steps to maximize tax-efficient withdrawals for your older clients. Here, the authors discuss steps six through nine.

6. Tax-Wise Charitable Legacy

If you have charitable intentions, the efficient strategy is to leave your tax-deferred accounts to charity and your taxable accounts to family. Traditional IRA accounts left to family will incur income tax as funds are withdrawn. IRA accounts left to charity escape income tax.

Upon review of Stan and Mary’s estate documents, they were both leaving their IRA accounts to other siblings as they have no children. In their trust documents, they have provisions for trust assets to be left to charity. A review by their advisor pointed out that Uncle Sam could actually help them fund their charitable goals by saving income taxes.

Their living trust was revised to leave taxable accounts to family members that would receive a step-up in basis at Stan and Mary’s death, avoiding taxable gains upon sale of the assets. Their IRA beneficiaries were changed to name each other as primary beneficiary with the contingent beneficiaries being charities. They have agreed they will honor each other’s wishes when the first of them passes away. The surviving spouse will make the deceased spouse’s IRA their own and change the primary beneficiaries to be the charities desired by both of them.

7. Tax-Efficient Family Legacy

Rick and Debbie are in their mid-50s. Between the two of them, they have income that puts them in the highest tax bracket. Given the size of their accounts, and their plan to work until age 70, they expect that they will remain in the highest bracket even after retirement.

This year, Rick’s widowed mother, Jean, who is 85, went into assisted living. Although she does not have long-term care insurance, she has sufficient assets to meet her increased expenses. Jean’s income comes from her survivor Social Security benefit of $24,000, her RMD of about $80,000, plus dividends and capital gains from security sales from assets in her taxable account. Jean has been in a 25 percent marginal tax bracket for the last 10 years.

Besides her taxable account and her IRA, Jean also has a variable annuity. It has a current value of about $200,000 and a cost basis of $110,000. Rick has never liked this annuity because of its high expenses. However, he did not want to liquidate it because it would give Jean a large tax liability. In addition, it had a $400,000 death benefit. Finally, Jean and her deceased husband had purchased series EE savings bonds 18 years ago for $10,000. They are now worth over $20,000 and will continue to earn interest for the next 12 years.

As Jean’s sole heir, Rick knows that, while he will inherit the assets in her taxable account without a tax liability, he will have to pay taxes on all the assets in the IRA, and the gains in the annuity and savings bonds. Further, he understands that once he inherited the assets, the taxes would be at his higher tax rate. Rick mentioned this to his financial advisor who set up the following plan that they discussed with Jean, who understood it and agreed:

• Tax Rates: With Jean’s increased medical expenses from assisted living this year, her itemized deductions had increased to the extent that she had no taxable income. The plan called for giving Jean sufficient income from her portfolio to bring her no higher than the top of the 24 percent marginal tax bracket. The financial advisor pointed out that the extra income would mean that Jean would have to pay more for Medicare due to her higher income and estimated that it would be the equivalent of an extra 3 percent tax on the extra taxable income. However, this was more than offset by the fact the family would save about 10 percent from the 37 percent marginal tax rate that Rick and his wife pay.

• Annuity: Because of the death benefit on the annuity, they did not think it wise to liquidate the annuity. Instead, they changed the beneficiary from Rick to his two children, who are in their 20s, just starting out in their careers, and in lower tax brackets. When the two children receive their $200,000 portion of the death benefit, of which $145,000 would be taxable, they would have several options for withdrawing the proceeds in the most tax-efficient manner (such as a lump sum, spread over five years, or systematic withdrawals over life expectancy).

• Savings Bonds: Although Rick thought that Jean should redeem the savings bonds, realize the $10,000 of income, and invest the proceeds into a higher yielding investment, Jean likes having them as a remembrance of her late husband and wants to keep them. Given this, Rick arranged for Jean to report all of the income earned on the bonds to date for her tax return this year. She must continue to report income earned on the savings bonds every year. Consequently, Rick will inherit the bonds with only a minimal tax liability.

• IRA: Each year going forward, Rick will work with his and Jean’s accountant near year end to get a good estimate of what her taxable income will be and how much additional income she can have to bring her to the top of the 24 percent tax bracket. They will then do a Roth conversion in the determined amount. They estimate that they will be able to convert over $100,000 of IRA assets each year to a Roth IRA, saving the family over $10,000 in tax liability and getting tax-free growth in the future.

8. Shifting Future Growth Out Of The Taxable Estate

Joe and Sandy had recently sold their business. The proceeds were large enough that their estate exceeded the amount of assets that could be excluded from taxes. They had two young children and had decided to start a new business. Anticipating the future success of the new business they gifted their interests in the new business to their two children. Since the company was just formed and had no assets, it had no value. Thus, gifting their interests in the new business to an irrevocable trust for their two children did not use up any of their estate tax exemption. In addition, if the venture was successful, all the future growth in value would occur outside of their estate.

9. Gain Harvesting

Jake recently retired from full-time work at age 65. He has decided to wait to claim his Social Security benefit until age 70. Until then, his portfolio, consisting of a $100,000 traditional IRA and $900,000 in a taxable brokerage account with a cost basis of $800,000, will provide the cash needed to meet his spending needs.

In December of his first year of retirement, Jake and his advisor estimate his taxable income to be $10,000. Jake had more than $28,700 remaining in his 12 percent federal income tax bracket. His advisor discussed two alternative strategies. First, he showed Jake that he could convert $28,700 of his traditional IRA dollars to a Roth IRA at the 12 percent ordinary income tax rate. Alternatively, he could choose to “harvest long-term capital gains” within his taxable account of the same amount and lock in the 0 percent federal long-term capital gain rate that applies when taxable income does not exceed $38,700 for single filers (as of 2018 tax brackets).

Jake evaluated the difference between the rates for these two different kinds of income that he has the option to pay now, versus the rate at the next highest bracket for each. In the case of ordinary federal rates (applicable to Roth conversions), the next bracket above 12 percent is 22 percent—a 10 percent difference. In the case of long-term capital gain rates, the next bracket above 0 percent is 15 percent—a 15 percent difference. Favoring the larger difference, Jake chooses to harvest gains within the zero percent federal long-term capital gain bracket. Jake will likely be able to engage in the same strategy for a few years before he runs out of capital gains to harvest. At that point, he will switch to Roth conversions to fill up his 12 percent ordinary income federal bracket in continued pursuit of paying the least amount of total tax over his retirement.

Summary

As you pass through the various phases of the decumulation process, you will be presented with opportunities that, if exploited, can significantly improve the odds of achieving your goals. Efficiently managing your assets during the withdrawal phase requires not only that you take the long-term view (not trying to minimize taxes in any one year, but minimizing them over your lifetime and beyond), but also that the investment management, estate planning, and tax management be fully integrated. Therefore, it requires that someone with expertise in all three areas act as the quarterback on your financial services team.

Larry E. Swedroe is director of research for Buckingham Strategic Wealth and The BAM Alliance. Kevin Grogan is director of investment strategy for Buckingham Strategic Wealth and The BAM Alliance.