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How to Avoid Tax Traps in Retirement Income Planning: Wade Pfau

By John Manganaro

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What You Need to Know

  • The complex and progressive nature of the U.S. tax system makes the potential for costly mistakes all too real.
  • New income planning solutions are emerging to help advisors, but nothing replaces a solid personal foundation in basic rules.
  • Most important is the ability to question common rules of thumb and conventional wisdom that can shortchange clients.

The development of tax-efficient strategies for retirement saving and spending is one of the hottest areas of research and solutions development in the wealth management industry.

While much progress has been made in helping advisors and their clients understand the dynamics at play in solving the “decumulation challenge,” the sheer complexity of the matter means mistakes remain all too easy.

In fact, according to Wade Pfau, the well-known retirement income researcher and co-founder of the Retirement Income Style Awareness program, common mistakes made by advisors and their clients can result in the payment of tens of thousands of dollars in excess lifetime taxes, potentially robbing otherwise diligent savers of years of portfolio longevity.

Pfau made this case during a webinar hosted this week by Jackson National, during which he spoke in detail about the tax framework that retirement savers must navigate. During the presentation, Pfau also highlighted some common pitfalls and spotlighted some key strategies and planning concepts that can help advisors and their clients achieve tax efficiency and peace of mind.

According to Pfau, advisors owe it to their clients to stay current on changing tax laws and the best practices being implemented across the wealth management space.

Fortunately, new income planning solutions are emerging to help advisors, but nothing replaces a solid personal foundation in basic rules. Most important, Pfau says, is the ability to question common rules of thumb and rethink conventional wisdom that can shortchange clients.

Why Tax Efficiency Is Hard

As Pfau points out, the U.S. tax code is progressive, meaning taxes are assessed at increasingly higher rates on increasingly higher incomes. Given that the clients of wealth managers tend to be in the mass affluent and high-net-worth segments, much of their income will be subject to tax.

“What makes this kind of planning tricky is that different portions of a given client’s income are going to be taxed at different rates, and that can result in a complex picture,” Pfau explains. “In a lot of ways, the tax code is filled with what I call ‘non-linearities’ and traps, because of the complex interplay of different marginal tax rates.”

There is also the fact that preferential income sources, such as long-term capital gains and qualified dividends, end up “stacking” on top of other income and have different tax rates, Pfau explains.

“So, in the end it can be a pretty complex effort to tease out exactly what tax bracket a client will land in, and then to understand what other taxes they may be subject to,” Pfau says. “The stakes are high, because even a single dollar of additional income can trigger taxes on Social Security benefits and result in higher Medicare premiums.”

According to Pfau, other factors to be aware of are the fact that poorly structured income can trigger the loss of Affordable Care Act health insurance subsidies, and the arrival of required minimum distributions can easily push someone into a higher tax bracket if a proper plan isn’t in place.

Key Account Facts

Pfau says one of the more powerful levers advisors and their clients can pull when it comes to achieving tax efficiency is addressing asset location — though he also warns that “asset allocation is always more important than asset location alone.”

Many clients, he argues, will benefit from having assets spread across taxable, tax-deferred and tax-exempt accounts.

While taxable accounts will see clients owe ongoing taxes on interest and dividends, their qualified dividends and realized long-term capital gains taxes will be assessed at lower rates. Other benefits include the fact that a taxable account’s cost basis can be spent tax-free, and the cost basis receives a step up at death — thereby avoiding capital gains tax.

Also important, Pfau says, is the ability for distributions from taxable accounts to be structured to registered either capital gains or losses. A savvy investor will aim to use both techniques during their savings journey, depending on the prevailing market conditions.

Tax-deferred accounts have many well-appreciated features, Pfau says, starting with the fact that contributions are (mostly) deductible, while future withdrawals will be taxed as ordinary income and could (potentially) be in a lower tax bracket.

There are drawbacks, however, and these include RMDs starting at age 73 or 75, as well as early withdrawal penalties of 10% or more.

A third big category is Roth accounts, Pfau explains, and these have their own appeal. While contributions are not tax deductible, qualified withdrawals are not taxed, which provides flexibility to generate retirement spending without tax.

Choosing Between Account Types

Pfau says advisors and their clients should put more thought into how they make decisions about asset location well in advance of the retirement period.

Generally, he says, the guiding principle in such decisions should not be to delay taxes as long as possible, as is often (and mistakenly) suggested. Rather, the key is to prioritize the payment of taxes at lower rates, and that can often mean paying taxes earlier than is strictly necessary.

Very broadly speaking, this means favoring tax-deferred accounts when current tax rates are high and favoring tax-exempt accounts when current tax rates are low — but there is a lot of nuance to consider based on the individual client’s savings journey and anticipated needs in retirement.

The same concept applies to Roth conversions, Pfau says: “Do them when there are low current tax rates, and if there have been market losses that will make conversions even more efficient.” The best outcomes from conversions, Pfau adds, come when the client can pay the taxes due with a ready source of cash — not directly from the assets being converted.

“The real lesson here is that it’s not always about deferring taxes as long as possible,” Pfau emphasizes. “The key is to be efficient and smart about when you are going to be paying taxes. You are trying to get the right level of income in a given year to get that smoothing effect over time, so that you don’t push yourself into a really high bracket in one year only to see income fall dramatically in the next.”

According to Pfau, advisors may have to work hard to help their clients see that making a short-term sacrifice can result in better long-term outcomes, but the effort is well worth it when it comes to portfolio longevity.

Techniques to Efficiently Generate Income

In Pfau’s experience, the complexity of the tax framework and the many different approaches to saving and spending that clients can take also presents opportunity for savvy advisors.

In some cases, he notes, it could make sense to encourage clients to spend less from taxable accounts and more from tax-deferred accounts to cover a spending goal in a way that increases taxable income toward the desired level. This can be useful in years when sources of working or investment income are low and the client wants to “fill up” their low-tax income bucket.

In other circumstances, clients should favor covering their spending goal from taxable accounts, but then increase taxable income by doing Roth conversions with assets from the tax-deferred account. Or, clients could see a benefit from generating taxable long-term capital gains by selling and then immediately re-purchasing assets in taxable accounts — especially when they are still in the 0% tax bracket for preferential income sources.

Though it may seem counterintuitive, Pfau says, there are further reasons to frontload taxes in some circumstances.

One such reason are “public policy unknowns” and the effort to managing the risk of future tax increases. Another is the tax implications that arise after the death of a spouse, because taxes can easily increase as one becomes a single filer again after many years spent in a higher marginal tax bracket.

Pictured: Wade Pfau

John Manganaro

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