How to win the retirement tax game

By Dave DeWitte
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As they look forward to the day when they can finally kick back and use that retirement nest egg, many Iowans assume that their annual tax liability will finally ease.

That kind of thinking can have nettlesome consequences, however, because there are so many ways taxes can nibble away at retirement income; the combined effect of all of them can be a painful bite.

At Northwestern Mutual in Cedar Rapids, Wealth Management Advisor Mitch Peyton encounters otherwise well-educated and informed savers who forget that Social Security income is taxable, or that they could have to take required minimum distributions (RMDs) from traditional Individual Retirement Accounts at age 70.5, which could bump them to a higher tax bracket.

Life can also produce some unintended tax surprises. A common one is when one spouse in a couple that has been filing joint tax returns dies, leaving the surviving spouse to file as a single taxpayer with roughly the equivalent amount of income.

Business owners or farmers may also tend to forget about some of the tax advantages they lose when they get out of the business, from company vehicles taxed as businesses expenses to write-offs for the part of their home used as an office.

“Usually, the business owner has had a lot of different income streams in the business,” Mr. Peyton said. “The tax code is usually favorable to their income stream when they’re in business, but after they retire, they lose that flexibility.”

If owners are planning to fund their retirement through the sale of their farm or business, they may also encounter a thick layer of tax consequences that could dampen their retirement outlook.

Many owners decide to sell their business as the first step to retirement, often holding onto the building or other real estate to provide them with an ongoing revenue stream, Mr. Peyton said. Later on, when the timing is advantageous, they intend to sell the real estate.

“They’ve kind of created two pensions,” he explained.

While two “pensions” may be great, the tax consequences can make a big difference in how great it is. Selling a business or real estate outright can produce a significant taxable event. The business sale may be taxed as income, and the real estate sale may result in a sizable capital gain.

“A lot of times, a business owner will walk into his CPA’s office and say, ‘I’ve just sold my business,’” said Clinton Brady, a financial advisor at Northwestern Mutual. “At that point, there’s not much the CPA can say except, ‘congratulations.’”

Northwestern Mutual urges clients and non-clients alike to take a proactive approach, meeting with an advisor or preferably a team with tax and investment expertise to figure out the best exit strategy well in advance.

“We feel there’s serious value in having their business succession plan talking to their retirement plan,” Mr. Peyton said.

One tax strategy is to arrange an installment sale of the real estate so that it generates income for the retiring owner over a period of time, lowering the tax consequences, Mr. Brady said.

Another strategy may be to allocate more of the price to the real estate and less to the business itself, taking advantage of the fact that the corporate gains tax rate is lower than the income tax rate.

Building a retirement and succession plan that work together can be particularly important for farmers who want to pass the operation onto an heir. That heir may expect to inherit the farm through their parents’ estate, Mr. Peyton said, but if one parent’s health begins to fail and additional income is needed to pay for long-term care, they could be forced to sell off much of their property, with significant capital gains tax consequences to pay for it.

Long-term care insurance or other strategies could avoid the shocking disappointment, Mr. Peyton said, but only if the saver has planned in advance.

The percentage of business owners who don’t plan effectively for succession and retirement is somewhat surprising, according to Mr. Brady, but there are good reasons for that. Many business owners are preoccupied with the multitude of issues that go with overseeing their enterprise on a daily basis.

Unlike a regular wage-earner who may be able to calculate how much income they can draw from a defined contribution or traditional retirement account, the business owner is often concerned mainly about the valuation their business will receive when it’s time to sell it, and not about how to minimize tax consequences or turn it into an income stream through an annuity or other strategy.

It’s also difficult for business owners and other savers to prepare for the many outcomes they could see in retirement. It’s now common for at least one member of a married couple to live into their early 90s, Mr. Brady said.

“You could be looking at, essentially, a 30-year vacation,” he said.

Think in buckets

Premier Investments of Iowa CEO Jeffrey Johnston has been advising clients planning for retirement for about 30 years. He says a common rule of thumb is the “4 percent rule,” where  the retiree should be able to withdraw 4 percent of their nest egg every year to use for retirement income, but he’s evolved to a formula similar to the required minimum distribution tables for IRAs, thereby taking inflation into account.

“Basically at 65, instead of 4 percent, someone would take out 3.1 percent [of assets],” he said. The percentage increases with age.

Mr. Johnston has long utilized a retirement savings approach called the “bucket method” that helps to ensure assets will not be exhausted, and perhaps, more importantly, increases the saver’s peace of mind during periods of market turbulence.

Assets are divided into four buckets: liquid assets for immediate needs, income assets for intermediate needs over the next three to five years, growth assets for long-term needs and legacy assets that may never be spent, and may be passed on to heirs or philanthropic causes.

Tax strategy is particularly important in the legacy bucket – a pool of investments that can include financial products such as variable single premium life insurance policies, variable annuities and second-to-die life insurance policies for couples.

Before buying specialized products such as those offered by large financial companies, Mr. Johnston strongly advises the saver to understand the exact problem they are intended to address and how they address it.

Bucket investing can be particularly comforting at times like the present, Mr. Johnston said, because the record economic expansion has grown long in the tooth, and many investors fear a recession will reduce the value of stocks and other cycle-sensitive investments in their portfolio.

Investments in stocks and equity-based mutual funds, for instance, could decline sharply in a recession, however they would be allocated to the growth bucket, which is reserved for assets that would not be needed for 48 months or more.

“If we have a high-stress person who can’t sleep when the [growth] bucket drops, we need to adjust our bucket allocations in consideration of that,” Mr. Johnston said.

Although there are general guidelines on how much of a saver’s assets should be placed in each bucket, Mr. Johnston said the percentages depend on individual circumstances, and the saver’s financial plan, including the bucket allocations, should be reviewed periodically and adjusted if necessary. A saver in their early 50s, for instance, might have 85 percent of their assets allocated to the riskier growth bucket, whereas at the normal retirement age of 65, a 40 percent growth allocation would be more appropriate.

Products like annuities, which provide a steady stream of retirement income, also address a psychological need of retirees.

“We want to make sure we have a check in the mailbox equal to the bills in the mailbox,” said Mr. Brady.

Research has shown that retirees “have no problem spending the mailbox money,” he said, “but they have a hard time liquidating assets to pay bills.”

Catching up

While such strategies as minimizing tax and investment management fees can help with the goal of making sure savings cover all your retirement needs, not everyone approaches retirement with the savings they would like.

Savers can control three variables that make a big difference in how long their savings will last: Working longer, boosting their retirement contributions in their final years of employment, and adjusting their post-retirement spending and lifestyle.

Contributing more to a retirement plan often isn’t so difficult in the saver’s waning years of employment because they have already managed many of life’s big financial hurdles, such as paying off the car, their children’s college expenses and maybe even their home.

Many approach the retirement years with high aspirations for international travel and plan to spend more time at their vacation condo or timeshare. As the saver approaches retirement, Mr. Peyton says it’s a good time to evaluate how realistic those plans are. If they are not, the options could include scaling back their bucket list, or something increasingly common – taking a part-time job after retirement to ensure that those dreams can still be realized.

Most important, in Mr. Johnston’s view, is building a financial plan and keeping it up to date.

“At the absolute end of the day, you have to have a financial plan,” he said. “If you don’t have a financial plan it won’t come together. No coach ever goes into a game, takes old plays that haven’t been updated to the new defenses or new rules, and expects to win.”   CBJ