Most wealth management clients don’t think ahead when it comes to the tax impact of their income strategies. They tend to think about taxes only on a year-to-year basis, and many lack the financial expertise to understand the complex implications of effective marginal tax rates, among other complicated issues related to income distribution.
As a financial advisor, you have an opportunity to educate clients on the often-overlooked impact of tax-efficient retirement strategies. Yet many advisors are leery of talking taxes too much with their clients, given industry practice related to tax advice.
Focus on Tax Efficiency, Not Tax Advice
This apprehension to cross the line between discussing wealth management strategies and discussing the tax implications of those strategies can result in advisors failing to give clients the insights they need to maximize tax efficiency in the long run.
But when advisors fail to account for the tax impact of these practices, they can end up setting their clients up for costly problems down the road. The impact of these inefficiencies can cost thousands or tens of thousands of dollars over a period of several years, taking a large bite out of the client’s retirement fund.
Advisors should be careful not to offer their clients tax advice. However, they can incorporate wealth management strategies and tools that account for this tax impact and give clients the information they need to minimize their long-term tax obligations.
Here’s a look at common inefficiencies that may cost your clients money—and guidance on how to implement a more efficient, strategic approach.
Common Examples of Tax Inefficiencies in Retirement Planning
Tax inefficiencies can be a drain on the sustainability of your clients’ long-term income—and some of these tax impacts may be hidden from view without a focus on long-term retirement planning that limits the likely tax burden your clients will face.
These tax inefficiencies can take several forms, including the following:
Excessive Withdrawals from One Account as a Short-Term Tax Savings Move
Large withdrawals from a tax-free retirement fund, for example, can result in a tax bomb in the future when clients are forced to withdraw heavily from taxed retirement accounts within a single tax year.
Early Withdrawals from Roth Accounts
Roth accounts offer attractive tax-free withdrawals. However, wealth management strategies should plan withdrawals from these accounts in combination with withdrawals from taxed accounts as a means of reducing the clients’ effective marginal tax rate paid over time.
Withdrawals That Increase Your Social Security Taxation
Mismanaged taxable withdrawals, when combined with Social Security benefits, can lead to a sharp spike in the tax rate paid on your Social Security benefits—commonly known as a “tax torpedo.” This scenario can be very costly, resulting in effective marginal rates on a portion of the clients’ income of up to 49.95 percent for someone who is otherwise in the 12 percent tax bracket.
Once required minimum distributions (RMDs) kick in, your clients will be forced to make withdrawals from retirement accounts, which are generally taxed as ordinary income.By accounting for this future tax impact in the present, advisors can develop a tax-efficient strategy that reduces the potential burden of taxes on these withdrawals.
A Failure to Use Tax Loss Harvesting to Offset Investment Gains
Tax loss harvesting is a crucial wealth management tool to leverage losses as a means of reducing taxation. Advisors should leverage tax loss harvesting to keep more money in their clients’ accounts.
A Failure to Account for a Number of Different Tax Scenarios
When it comes to taxes, the future is never certain. Scenario planning can help clients understand the potential tax impact of various wealth management strategies—but a failure to understand these scenarios can paint your clients into a corner.
The Importance of Tax-Efficient Retirement Strategies for Your Clients
Although advisors should be careful not to offer guidance that could be construed as tax advice, they have plenty of latitude in using wealth planning tools and models to build a tax-efficient strategy for their clients.
Understanding and accounting for this tax impact is important for the following reasons:
Tax implications may affect when and how your clients choose to claim Social Security benefits.
Depending on the amount of tax they’re liable to face, for example, clients may prefer to delay Social Security benefits for longer, increasing their overall benefit while withdrawing from taxed retirement funds in the meantime. By doing so, they can save post-tax withdrawals to combine with Social Security.
Clients can better understand and plan for the effective marginal tax rates they may face.
When a tax-efficient retirement strategy is developed, it gives clients time and insight to prepare for the taxation they’re expecting in the future. Knowing they have this time can assist them in their conversations with tax advisors providing explicit tax planning guidance.
Tax implications can affect which accounts clients want to withdraw from in any given tax year.
Tax laws and circumstances are liable to change at any time. When clients understand the tax impact of their withdrawals, they can make fully informed decisions with the tax implications in mind.
A discussion about the tax impact on retirement can be a tool to recommend Roth conversions other wealth management practices that reduce tax burdens over time.
Although financial advisors can’t offer tax advice, they can offer and execute financial services that potentially reduce tax burden for their clients.
Ultimately, a tax-efficient retirement strategy that accounts for different scenarios helps clients protect more of their retirement savings.
As a financial advisor, your primary focus is on growing wealth for your clients. If you’re serious about maximizing the income for your clients, tax-efficient strategies are required.
The Value of Tax Mapping as an Educational Tool
Tools like Tax Clarity can help you educate your clients on the tax implications of various retirement wealth management strategies while also providing your firm with the tools you need to make smarter decisions optimized around tax implications.
With the Tax Map tool offered by Tax Clarity, you can achieve the following:
- Generate tax maps for clients based on anticipated income, and identify the year-to-year tax management practices that optimize your taxation.
- Understand the effective marginal tax rate and use this calculation to optimize income withdrawals without moving up into a higher tax bracket.
- Identify opportunities to perform a Roth conversion, and in what amounts, to avoid tax surprises.
As an advisor, you have a unique opportunity to build a retirement strategy that accounts for this potential tax impact—and your clients are expecting you to help them create a retirement strategy that is built for the long haul.
Strategic Guidance to Preserve Your Clients’ Wealth
Efficient management of the tax impact on retirement wealth strategy has real-life consequences for your clients, affecting not only their available income in retirement, but also when they’re able to retire based on the amount they have saved and the net amount they will be able to spend post-tax in retirement.
Every year, advisors should encourage clients to look at the year ahead when considering tax implications on retirement strategies. Additionally, advisors should consider looking at the potential tax landscape years into the future to help navigate retirement decisions.