As people plan for retirement, they rarely take into consideration the tax implications. What taxpayers may not realize is that the amount of retirement income that goes toward taxes can considerably lower the funds available to sustain the type of life they imagined for themselves. This is where offering your assistance as a Certified Tax Planner can be invaluable. By helping taxpayers create a tax plan, those retirement funds can be stretched much farther than they would otherwise. You can also help taxpayers stay abreast of the latest changes to tax law, especially those that directly impact retirement funds. For instance, the Inflation Reduction Act introduced new retirement plan contribution limits and rules for required minimum distributions (RMDs). Taxpayers will need expert help understanding how this factors into their personal retirement plan.
In order to formulate a tax-efficient retirement plan, you first need to know how the taxpayer intends to generate cash for their retirement. If their approach involves continual sales and transactions, that can drive up their investment costs and increase the amount of work needed to accurately calculate taxes.
Taxpayers can choose between three basic cash-generating strategies: an invest for income, capital gains top-up, or blended strategy.
Invest for Income. With this approach, taxpayers invest in anything that generates income, from traditional options like bonds and stock dividends or newer options like estate investment trusts and master limited partnerships. The goal is to receive income directly and live off of these earnings during retirement. You will need to ask the taxpayer about their target income: how much money do you need to sustain yourself through a year of retirement?
A potential downside to this approach is that taxpayers tend to be less aware of the tax consequences of their investments. Since they receive cash directly and don’t have to liquidate any accounts, it’s easier to reach the end of the year having given very little thought to what their tax bill might look like the following year. This is where you can help make informed projections so that taxpayers can set aside a sufficient amount of money to cover any taxes due.
Capital Gains Top-Up. With this strategy, taxpayers adopt a more balanced portfolio since they are trying to generate income through a combination of dividends, interest, and capital gains. Whereas with investing for income they would receive cash directly, with capital gains top-up the income is immediately reinvested back into the brokerage account. This approach focuses more on accumulating capital throughout the year. Then the taxpayer can convert to cash later when they actually need to spend it.
The liability of this strategy is that when the taxpayer needs cash, they may have to sell off certain investments—which will result in a capital gain. Since the amount received will depend on market performance, they won’t know how much that capital gain will be in advance.
Fully-Invested Total Return. This last strategy combines elements of the first two. The taxpayer will likely have a combination of interest, dividends, and capital gains that are reinvested into their accounts and produce growth over time. When cash is needed, they will have to take whatever step is required by that investment, such as selling an asset.
This option can take a lot of time to manage because the taxpayer is making sales frequently to cover expenses throughout the year. If they need cash right away, they may not have a lot of flexibility in what they are selling, so they may simply have to accept the capital gains taxes attached to that sale.
When choosing an approach to generating cash, advise the taxpayer to take in consideration the costs associated with risk and labor intensity. Investing for income will be the lowest cost, while a blended strategy will be the most expensive, since the taxpayer is continually selling things to generate cash. If they use the blended strategy, they should also be conscious of their transaction costs and look for ways to pay less in this area.
For more in-depth training on tax planning for retirement income, sign up to become a Certified Tax Planner today.
