Client Affairs

Challenging Conventional Thinking On Retirement Distribution Planning

Amy Buttell Special Correspondent East Coast 27 April 2011

Challenging Conventional Thinking On Retirement Distribution Planning

Conventional wisdom about retirement distribution planning among financial advisors is actually penalizing their clients, depriving them of the savings they need to avoid outliving their money, argues a leading figure in the industry.

Conventional wisdom about retirement distribution planning among financial advisors is actually penalizing their clients, depriving them of the savings they need to avoid outliving their money, according to Bill Reichenstein, a principal at Retiree, Inc. and a professor of finance and the Pat and Thomas R. Powers Chair in Investment Management at Baylor University in Waco, Texas.

Tax planning is a vital component of retirement distribution planning because it is one factor you, as an advisor, can control. It’s impossible to predict how well a client’s investments will perform, but it’s possible to use the tax code to that client’s advantage to maximize the longevity of that investment portfolio, he adds.

For example, it’s generally accepted that withdrawals should always be made first from taxable accounts rather than traditional IRAs, 401(k)s or 403(b)s. But that’s not always the case, Reichenstein argues, because retirees can maximize their withdrawals based on tax rates, especially when traditional retirement plan withdraws are available to be taxed at an unusually low rate.

“Planners and retirees make mistakes by always defaulting to the taxable account first,” he continues. “In many cases, they can take funds out of the traditional retirement accounts at a low tax rate depending on the individual situation.” That’s because income taxes are graduated so that income is first taxed at 10 percent, which rises to 15 percent, 25 percent, 28 percent and then 33 percent. The income brackets where these tax rates fall into differ depending on a client’s filing status.

So if a client is in a situation where there isn’t much taxable income due to high deductible medical expenses or other itemized deductions or other deductions or credits, that client could very well be better off taking a specific amount of money out of a traditional retirement account than a taxable account. “In many cases it makes sense to take out at least enough from the traditional retirement account to fully use that low tax bracket,” he adds.

In the absence of making use of that low tax bracket, a client will be stuck taking the money out after age 70.5 and likely paying higher tax rates, because that client will have no choice but to take required minimum distributions, Reichenstein says. So by advising clients to wait to draw down their traditional retirement accounts until they have to take distributions at age 70.5 or if they have an unusually low taxable income, you’re potentially leaving money on the table.

Another option is if the client doesn’t need the money from the traditional retirement plan is to roll it over into a Roth IRA, he notes. “If you don’t need to spend that money, you could stick it in a taxable account for the future, or, even better, do a Roth conversion,” he says. “Then it’s growing tax-free for the rest of your client’s life.”

In many cases, the longer a client lives, the higher the chance of bigger out-of-pocket medical expenses, he adds. So while it’s a tough planning problem to figure out, because it may not happen, it can make sense to save some money in a 401(k) plan that could be withdrawn to offset the higher out of pocket medical expenses. “If you think that a client or a client and/or his or her spouse will end up, say, in assisted living and will need to spend a lot of money on medical expenses, it can make sense to save some of the funds in the 401(k) for that eventuality,” he says.

Reichenstein, who has been published extensively on the issue of taxes and their importance in retirement distribution planning, calculated an example under which a retiree employed three different strategies in taking distributions using a taxable account, a Roth IRA and a traditional retirement plan. Under these scenarios, there is a seven-and-a-half year difference between how long the funds last: the difference is between 30 years and 37.5 years.

Here are the results, assuming that the client takes all the money from each account until it’s exhausted, then moves onto the next account in the first two scenarios. A 401(k) account refers to any traditional retirement plan account, including a traditional IRA and a 403(b) account:

·         Strategy 1: 401(k) plan, Roth IRA, taxable account: 30 years

·         Strategy 2: Taxable account, 401(k), Roth IRA: 36.17 years

·         Strategy 3: Withdrawals each year from taxable account, 401(k) and then the Roth IRA: 37.5 years

Because longevity is the biggest wild card in retirement planning, making the maximum use of the tax code to extend the life of a portfolio should be a top priority for all financial advisors, he states. Unfortunately, “most financial planners aren’t trained to help their clients out in this way and most accountants don’t think about it either,” he says.

This is a critical gap in understanding because it’s essentially adding years to client retirement distribution planning without adding any more money to the portfolio or taking any additional investment risk, Reichenstein notes. It may make it easier to figure this out for clients if you think about traditional tax-deferred retirement accounts as a type of trust, where the government owns a certain percentage – future tax payments – and the client owns a certain percentage.

In seeking opportunities to take advantage of times when the client’s taxable income is low to take more funds out of that “trust,” financial advisors can use the tax code to the client’s advantage and extend the overall life of the portfolio. It’s also important to customize a retirement distribution strategy for each client’s specific situation, keeping these principles in mind, Reichenstein believes.


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