Retirement income planning involves much more than just investing your clients’ money and targeting a retirement age. The amount of money your clients have at their disposal is affected by several different factors, including how and when they claim Social Security benefits and the taxes they’re forced to pay on disbursements from various retirement funds.

Poor planning can cause your clients’ retirement to be disrupted by the dreaded “tax torpedo.” Here’s how smarter long-term planning can help them avoid this disaster scenario.

What Is the ‘Tax Torpedo’?

In basic terms, a “tax torpedo” is any tax scenario your client may face in which the marginal tax rate they pay on their income exceeds their statutory tax rate. This can have a significant negative impact on their net income over time because of the higher tax rate they’re forced to pay on their disbursements.

The tax torpedo is usually a result of poor wealth management practices. Tax-efficient retirement planning can help advisors account for multiple scenarios their clients may face in the future. A tax software solution like Tax Clarity can help you and your clients review possible scenarios and the tax implications they may face, which ultimately helps identify strategies you can use to avoid a tax torpedo scenario.

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How to Avoid the Tax Torpedo

Even with uncertain variables to account for over time, financial advisors can create a long-term income distribution plan that shelters their clients’ assets against unnecessary losses caused by poor foresight and easy-to-avoid tax scenarios. Here are four steps your firm can recommend to clients as a means of reducing their tax burden and preserving their wealth:

1. Increase Contributions to Roth IRA Accounts.

For mass-affluent retirees, Roth IRA contributions are an optimal tool to reduce any future tax burden. The tax benefits of these contributions are obvious: By declining any up-front tax benefit and paying taxes on contributions, clients can fund their accounts with after-tax contributions that can later be withdrawn tax-free.

In retirement, these tax-free withdrawals can be taken in any amount without increasing the tax people have to pay on other sources of income, such as Social Security. Combining a Roth IRA with other sources of retirement income is essential for effective tax diversification, and it creates important flexibility that advisors can use to account for many different scenarios their clients may face in the future.

For example, Roth IRA funds are particularly valuable in case someone has a sudden need for cash in the future and they need to make a larger-than-planned withdrawal. With a retirement fund where those withdrawals are taxed, your client’s sudden spike in liquid cash could cost them a pretty penny come tax time. But Roth IRAs offer an emergency valve that can supply income without the consequences of a so-called tax torpedo.

Keep in mind that Roth IRA owners must be at least 59 ½ years of age—and have held the IRA for five years—before they are permitted to make tax-free withdrawals. If your clients are approaching retirement and they haven’t yet set up this retirement account, you may want to prioritize Roth IRA funding to avoid a situation in which they’re liable to pay taxes and a 10 percent penalty on early withdrawals.

2. Pull from Pre-Tax Funds Earlier in Retirement to Reduce Required Minimum Distributions (RMDs).

Post-tax retirement funds provide much-needed flexibility because withdrawals won’t impact your clients’ tax burden. Pre-tax funds need to be managed carefully because they carry significant tax implications—and those implications can be much more significant after 70 years of age.

Some of your clients may be inclined to hold off on withdrawing from pre-tax funds as a means of delaying payment on taxes, but this can create a tax torpedo that strikes once it’s time to take required minimum distributions (RMDs). The tax consequences of delaying these withdrawals are even more significant when factoring in Social Security benefits, which your clients may choose to delay until they hit 70 years of age.

Withdrawing from these pre-tax funds early on—either as soon as retirement starts or as soon as your clients reach 59 ½ years of age—creates flexibility in the following ways:

  • You can schedule withdrawals according to the current tax rates and keep your clients’ withdrawals in the lowest tax bracket possible.
  • You can reduce the overlap between your clients’ taxed retirement withdrawals and their Social Security benefits.
  • By reducing RMDs, you can exert greater control over how clients finance their retirement, ensuring they minimize their tax obligations well into their golden years.

One potential complication to consider with this strategy is the impact these early pre-tax fund withdrawals may have on your clients’ healthcare tax credits. If clients are still paying for private health insurance, the amount they withdraw from these accounts could impact the tax credit they receive for paying their health insurance. Factor this potential cost into any calculation when planning out tax considerations.

3. Consider Delaying Social Security Benefits.

We’ve already touched on the potential implications of stacking Social Security benefits on top of pre-tax retirement fund contributions. As your clients’ taxable income increases, the potential tax they have to pay on Social Security benefits can also increase quickly—in the worst-case scenario, 85 percent of Social Security benefits could be subject to taxation.

This scenario can almost always be avoided through better financial planning. A commonly understood advantage of delaying Social Security benefits is that it increases the monthly benefit amount your clients are entitled to receive. But delaying also gives them more time to withdraw from pre-tax retirement accounts without creating an overlap between the two income sources, which is the easiest way to create a tax torpedo.

The combination of Social Security income with other taxable income could result in clients being subject to a marginal tax rate as high as 49.95 percent. No client will be happy with that result. As an advisor, you should work years in advance to help your clients avoid that scenario.

4. Roll Over Pre-Tax IRAs into Roth IRAs.

When clients have a large amount of money sitting in traditional IRAs, advisors may recommend rolling over those contributions into a Roth IRA. Although this process needs to be carefully managed to optimize rollover amounts relative to tax bracket considerations, rollovers give your clients a way to convert traditional IRA funds into Roth IRA funds while paying a lower tax rate than they could likely expect in retirement.

One option, for example, is to roll over funds during retirement or during a tax year when income is lower than what is typical—and lower than what is expected during many retirement years. Advisors may also recommend “conversion barbelling” as a strategy to maximize the use of marginal tax rates in any given year, optimizing conversions without pushing taxable income for one year into a higher tax bracket.


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Don’t Give Away Your Retirement Nest Egg

Even after your clients have saved up for a well-funded retirement, lax planning for tax-saving opportunities can take a big bite out of those funds and possibly affect their quality of life in their golden years. Take time now to discuss potential tax scenarios with your client, and develop a strategy that minimizes their tax obligations in retirement and maximizes their financial security.

Covisum understands that being a financial advisor is hard, so we make it easier. Our software helps you optimize your clients’ retirement strategies and communicate the value of your advice. Our marketing resources help you attract new clients and our expert customer experience team supports you along the way, helping you continuously show your value to clients. 

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