As clients move from the accumulation to the distribution phase of retirement planning, an effective tax strategy can minimize taxes and maximize savings. These savings can serve as a primary source of cash flow during retirement.
Tax professionals who are intent on creating a comprehensive tax plan for client portfolios can follow a four-step process that may help preserve and extend the life of a limited pool of retirement assets.
- Tax diversification: Many advisors already set up buckets of assets to withdraw funds from to meet the cash flow and minimum retirement distribution needs of clients. They are also well aware of the benefits of investment diversification. But an often overlooked consideration is tax diversification. Tax laws are always changing, and it’s impossible to know what they’ll be like when clients retire or throughout their retirement years. Diversifying investments in different types of accounts can diversify tax risk and create more flexibility to optimally select the most tax efficient method of liquidating assets. Most clients save for retirement using a mix of tax-deferred, tax-free and taxable accounts. Withdrawing assets from those accounts in a tax-savvy way can minimize tax liabilities and maximize savings. For example, distributions from 401(k) and traditional IRAs are taxed at ordinary income rates, while capital gains rates on taxable accounts can be lower. Although contributions to Roth IRAs are taxed, withdrawals are not taxed, so mixing and matching withdrawals and varying strategies year to year can have benefits.
- Asset allocation: As retirement approaches, asset allocations may need adjustment to account for the fact that income isn’t coming into the portfolio any more. Risk tolerances may change as clients approach or enter retirement; it’s a stage of life when risk aversion tends to rise. That being said, it still may make sense for some investors to allocate to riskier assets such as equities, both due to their potential for growth and because retirement may last 30 years or more. In such cases, investors should educate themselves about the risks involved in this strategy or discusses them with their financial advisor.
- Asset location: There are two aspects to asset location in retirement. The first is where to place assets based on how they are taxed; the second is how taxes impact the value of retirement assets in various types of accounts. In the first case, it makes sense to place investments with both high distribution rates and high tax rates on those distributions in tax-deferred or tax-free vehicles such as 401(k)s and traditional and Roth IRAs. Conversely, it makes sense to place investments with relatively low taxable distributions into taxable accounts. In the second case, advisors should consider how taxes will ultimately impact the value of assets and adjust their overall asset allocations accordingly.
- Strategic rebalancing: An intentional rebalancing strategy takes some thought – particularly when keeping the above three variables in mind. Because of the contribution limits and structures of retirement accounts, it’s not always possible to optimally allocate, locate or rebalance specific asset classes. That being said, a disciplined, systematic rebalancing strategy can pay off by limiting risk, preserving returns and minimizing taxes.
In an investing universe where markets are increasingly volatile and expenses are rising, minimizing taxes is an area where advisors can make a positive value add contribution. More information on investment strategies and portfolio construction is available here.
Traditional IRA - An individual retirement account (IRA) that allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred.
Roth IRA - A Roth Individual Retirement Account (ROTH IRA) is a retirement plan in which contributions are not tax deductible and qualified distributions are tax-free, provided the account has been open a minimum of five years.
Tax-deferred - investment accounts on which applicable taxes are paid at a future date
Tax-free accounts - accounts that are exempt from tax
Taxable accounts - accounts that are subject to taxes
401(k) - A qualified plan established by an employer to which eligible employees may make salary contributions on a post-tax and/or pretax basis.
Natixis Global Asset Management does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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