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Many people regard taxes as something that everyone just has to pay. They typically think that tax management and strategies involve taking advantage of some sort of loophole. Sometimes people worry that exercising the strategies could expose them to audit risk. That’s far from the case. An audit is only a risk if you are breaking the tax law—and none of the strategies that we advocate will ever put our clients in the position of breaking laws.

In essence, tax management amounts to finding ways to apply the tax code to specific types of distributions and accounts. The tax code is thick and complex, with a multitude of options that taxpayers can use to maximize their resources. Those options were written into the code with the intent that people would apply them as needed. If they do not take those opportunities, they are at risk of handing over more to the government than they legally need to provide.

A major way that people engage in tax management is by taking advantage of the deferral potential available through 401(k) retirement plans and similar instruments. You get a tax deduction immediately for the money that you contribute, and it grows free of tax for all your working years until such time as you withdraw the money.

However, the IRS remains a permanent partner in your plan. You will be required to begin withdrawing your money when you are age seventy and a half, whether you need it for income or not, and those required minimum distributions will be subjected to the prevailing tax rate in your bracket. If you have saved, say, $1 million and must withdraw $30,000, you will be taxed on it.

How much tax you pay will depend on whether you have anticipated those withdrawals in your tax management strategy. One option, if you are thinking a decade ahead, is to begin a strategy when you are sixty of converting money from your tax-deferred 401(k) plan into a tax-free Roth IRA. You can systematically pay taxes up front on those conversions over the ensuing decade. Gradually, a sizable portion of your portfolio will become tax-free for life.

The proper strategy will depend on your circumstances, of course. Much depends on whether you need the money as retirement income, or whether you would prefer to just leave it be, if you could.

From a tax perspective, there are three types of accounts: tax deferred, tax-free, and taxable. Let’s take a look at each. The most common types of tax-deferred investments are 401(k) and similar plans, IRAs, and annuities in which you are not required to pay taxes on the gains every year. Eventually, when you pull that money out as income, you will have to pay the taxes then. Usually you will be paying at the ordinary income tax rate in your bracket.

Tax-free investments, by contrast, will provide you with distributions that are free of federal tax and sometimes free of state tax as well. Th e most common vehicle for tax-free investing is the Roth IRA, sometimes available as part of a 401(k) plan. Municipal bonds often are federally tax-free, as well. Life insurance also could be considered a tax-free investment, and certain educational accounts provide tax-free benefits.

Taxable investments are those that are subject to taxation in the year in which you realize the income, dividends, and capital gains. Th e most common types are individual equities and mutual funds, ETFs, individual bonds and bond funds, certificates of deposit, savings accounts, and money market accounts. Those have no tax-deferred or tax-free umbrella.

You get no tax deduction on the money that you place in these investments, and you must pay taxes on them annually. Effective financial planning for retirement will ensure that a portion of your assets is in each of those three tax categories. You might think of them as buckets, each for a different purpose. When you are younger, the use of tax-free and tax-deferred investments can provide you with compounding advantages that can significantly boost your portfolio by the time you are ready to retire. For example, in a taxable investment, you might save $3,000 a year for thirty years with 8 percent growth, but after paying taxes in the 28 percent bracket you would only have $173,000. Your money would not even have doubled in three decades. In a tax-free investment, like a Roth IRA, you would have $368,000 free and clear. That’s also how much a tax-deferred investment, Like a 401(k) or IRA, would bring to you, except you would have a permanent partner in Uncle Sam who would eventually want his cut.

When you retire and you need to deliver an income to support your lifestyle, investments in all three buckets will provide you with a combination of assets that you can tap as needed, while making sure that your income remains in the lower brackets. Each bucket has distinct and powerful advantages, as well as some disadvantages. It takes the right balance and an educated management approach to make sure that you are not overpaying in taxes.

Tax-free and tax-deferred compounding can be a powerful tool for accumulating wealth during your working years, but you will need to be making adjustments as you enter retirement.

Many people at that point have most or all of their money in just one bucket, the tax-deferred 401(k) plan. Let’s say you need $100,000 of income during retirement. If your only source is your 401(k), and you withdraw that much, you will be squarely in the 25 percent federal tax bracket if you file your taxes Married Filing Jointly. Th at means you will have spendable income of $75,000, with the balance going to Uncle Sam. However, let’s say you did a little more planning and had money in just two of those three buckets, the tax-deferred one and the tax-free one. If you were to take $50,000 from each of those accounts, you would only be taxed on the $50,000 from the tax-deferred account. That would keep you in the 15 percent federal tax bracket. In other words, you have still withdrawn $100,000, but now you get to keep $92,500. Uncle Sam only gets $7,500, not $25,000.

If you wish to accumulate meaningful dollars for a strategy such as this, it will take you some time to do so. It’s well worth the effort. You will have much more flexibility in designing your retirement income if you have done some sound planning in advance.

Often, when we talk to people about this type of tax saving strategy, they regret that they have not funded a Roth account and wonder whether they have any options. It’s not as if the Roth has been around for ages. It came about as a result of the Taxpayer Relief Act of 1997. Investors have not had decades to take advantage of it. And the Roth 401(k) plans have only been a phenomenon of the last several years. Not everybody has access to a Roth 401(k), and the Roth IRA has income limits, so not everybody can contribute to one.

“I’m too old for a Roth IRA,” people sometimes tell us, or “it doesn’t make sense for me to have a Roth IRA now, because I’m already in retirement.” That is not necessarily the case at all. We can pursue a strategy that amounts to filling up your tax bracket. Let’s say that you are a married couple filing jointly, which means that you will be in the 15 percent federal tax bracket up to the point where you have $75,000 of income. If your taxable income shortly after retirement is only $50,000, that means we have the potential for a $25,000 Roth conversion. You can accomplish that conversion and pay only a 15 percent tax hit. Th e next year you can do it again, converting just enough to keep you within that tax bracket.

The recent federal tax environment has been at historic lows. If we project five or ten years forward, it’s likely (although not certain) that we will be seeing higher tax brackets. This strategy allows you to lock in your tax rate at 15 percent on the money that you are converting to a Roth. This will build up your tax-free assets so that later in retirement you can choose the bucket from which you will make withdrawals as a means of continuing to manage your tax bracket.

Those are just a few of the tax-saving strategies that you might implement, depending upon what you are trying to accomplish and the resources that are available to you. Another strategy, and one that is relatively little-known, involves the “step-up” of cost basis upon death. The cost basis of certain assets will be reset to their current value when left to survivors, meaning the assets no longer will show a gain from their original value, and the survivors will not have to pay a capital gains

In other words, if my mom had $100,000 in a non-qualified investment but she only originally invested $50,000 and she died, there would be a step up in cost basis to the full $100,000 for me.   Therefore, I would only be responsible for tax on any gain over $100,000. If she spent the $100,000 while she was alive then she would be taxed on the difference between the $100,000 and the $50,000 original investment.

Couples sometimes will tell us that they are concerned about leaving a tax burden to their children when they pass away. They don’t so much mind paying some tax on their current income, but they do not want to leave a burden on their estate. The step-up strategy in such cases can be quite useful.  Let’s say a couple owns a significant amount of individual equities that have enjoyed quite a bit of appreciation. Instead of selling them off for income and paying tax on the gain, they could leave those securities to their children, who upon the parents’ passing would get a 100 percent step-up in cost basis. If the couple has $500,000 worth of individual equities with a cost basis of $250,000 and sold those equities while they were alive, the couple would be paying a capital gains tax on the other $250,000 of growth. Their survivors, however, would “step up” that cost basis, so they would owe nothing in capital gains at the time they receive the money. That can be a valuable strategy for families with assets that qualify.

We recently met a couple who had $3 million invested intaxable mutual funds, outside of a tax-deferred retirement plan. Th e account was providing them a valuable opportunity for growth, but it also was putting out income, which they did not need. They were paying about $50,000 a year in taxes on capital gains. Part of that was due to the phenomenon of “phantom tax” that is often seen with mutual funds. Let’s say you purchased XYZ mutual fund in December. Well, that mutual fund has been buying and selling throughout the course of the year, realizing capital gains many times and certainly producing dividends within the portfolio. As part owner of that fund, you are liable at year’s end for the tax that it has incurred during the entire year—even though you have been invested in it for only one month.

If you buy into the mutual fund on December 1 and it drops in value over the next thirty days, you actually could lose money on your investment but still be responsible for the year long gains within that fund. A lot of people do not understand how that works. They cannot conceive of how they could lose money on their investment but still owe tax based on its performance. Mutual funds, from a tax standpoint, can be very inefficient when not part of a tax-deferred portfolio such as a 401(k).

We helped that couple by selling and moving a portion of their money into a low-cost deferred annuity. In the process, we did some “tax harvesting,” in which we off set gains on some investments with the losses on others. In the annuity, the money now had the potential for growth, but the couple no longer had to pay taxes on that growth. That significantly decreased their end-of-the-year tax bill and eliminated the phantom tax on that portion of their money.

In our experience, we have found that the vast majority of all IRAs are liquidated upon the death of the surviving spouse. One reason for that is improper titling, as we pointed out earlier, and another is improper execution of the distribution. Many people are unfamiliar with what are known as stretch provisions, which are available on accounts that are properly titled. All IRAs off er the stretch provision, but only some 401(k)s off er it. It depends upon the policy of the particular plan.

The stretch provision allows the beneficiary of the account to stretch out distributions over his or her lifetime. What happens most of the time, however, is that once the surviving spouse has passed away, the survivors simply liquidate what is left of the account. They take it as a lump sum, and that puts them in the highest tax bracket—meaning they will lose about 45 percent of it to the state and federal governments.

Alternatively, however, survivors could take that distribution slowly over the course of their lifetime. That would keep them, potentially, in a much lower tax bracket while the asset continued to grow throughout those years. Th at stretch provision, however, needs to be set up in advance. If the distribution strategy is not appropriately executed, it simply won’t happen.

In order for this to work, the owner of the account needs to title it and set it up, and the beneficiary needs to execute on it. The beneficiary can take advantage of the full stretch, part of it, or none of it. He or she still can choose to take the lump sum, but at least a far more efficient tax strategy was available.

Unfortunately, young people inheriting a sum of money tend to find some immediate use for it. Perhaps they are facing financial difficulties or want to get out from under a debt or credit card bills, or perhaps they cannot resist the allure of a fancy sports car. Th at, no doubt, is why we have that statistic showing the survivors liquidate the account 90 percent of the time. They either don’t know about the stretch provision, don’t care about it, or have some pressing need for the money.

It’s unfortunate. If stretched over another generation, or even longer, a relatively modest IRA could become a tidy sum. If left untouched for healthy growth, it could turn into a fortune. A couple with two children and two grandchildren, over the course of their life expectancies, could turn a $525,000 IRA into a $4.5 million family legacy. And that’s all by appropriate titling and appropriate distribution on those accounts. So many people work hard to accumulate a nest egg and then do not understand the steps they need to take to properly title their assets. The consequences can be far from what they intended.

Even though you cannot enforce a stretch provision, you have another option. You can set up a trust so that your children do not have the ability to take the lump sum and make those common financial mistakes. If your twenty-four year- old child inherits $500,000 all at once, it’s hard for him or her to take a disciplined approach to managing it. He or she is unlikely to see the long-term value of accepting required minimum distributions each year. That is why some couples want to institute control mechanisms in the distribution of their money.

Through the use of a trust, it’s possible to require the stretch rather than simply recommend it. You must be careful, however, when incorporating a trust as the beneficiary of an IRA. Very specific provisions must be written in the trust to allow the stretch. Most trusts that we review do not have the appropriate language to provide for that. After the IRA is deposited into the trust, the trust ordinarily has five years to liquidate it, and it then has to be taxed. The stretch provision therefore will disappear unless the trust is written appropriately to allow it. Generally, the trust should not be the primary beneficiary of an IRA. It makes sense only in rare
circumstances. In any case, the language to incorporate the stretch provision must be written in a specific manner.

The complexity of the tax code is both an advantage and disadvantage. It can be a disadvantage when the language becomes confusing and complicated. But if you understand the tax code, it can be highly advantageous. If you are willing to plan and work with someone who can help you interpret the details, you can implement strategies that could save you significant money on taxation in retirement.

In this chapter, we have touched on a few of those strategies. There are many others. The ones you choose will depend upon your particular situation and what you are trying to accomplish, and they will depend upon the resources at your disposal.

From a historical perspective, we have been in a low-tax era. In 1964, the highest marginal tax bracket was over 90 percent. As recently as the 1970s, the highest bracket was 70 percent. It seems reasonable to project that the recent low rates likely will be rising closer to the historic norm, particularly considering the levels of government debt that we are facing.

With that in mind, it makes sense to take whatever measures are available now to lock in the lower rates and save on taxes down the road. Such strategies can go far toward improving the probability of an overall successful retirement.

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