Prior to passage of the SECURE Act, I posted suggestions for drawdown strategies for the wealthy. A lot has happened in the eighteen months since that post, and strategies for all prospective retirees have changed. The pandemic upended the economy, we have both a new President and a new Congress, and life expectancies have changed. My most recent post addresses 2021 drawdown strategies for low-income retirees, but high-net-worth retirees should be reexamining their approaches as well.
The wealthy are likely to have enough money to retire on comfortably. That is not the concern here. The issue is how to maximize the efficiency of retirement drawdowns so as to fulfill other financial planning goals, such as leaving more to charity or increasing the legacy left to heirs. To maximize efficiencies, the prospective retiree should pay attention to market conditions and changing tax law.
The economy has obviously shifted as a result of the pandemic and the subsequent government response. A common concern for many financial analysts is that we’re in an environment where the economy is struggling while the stock market is flourishing. This raises the threat of sequence of return risk, particularly for high-net-worth individuals who have a significant portion of their wealth invested in the stock market. One only needs to look back to the Great Recession to see situations where individuals who had just retired suffered as much as a 40 percent loss in their retirement capital because of the plunge in equity prices. Since retirees are decumulating their retirement capital rather than accumulating an investment portfolio, an early hit to the value of that capital can have permanent consequences.
A companion economic issue is the appearance of inflation for the first time in many years. A bout of inflation shortly after retiring threatens a permanent loss of buying power for the retiree – and because that buying power is not easy to regain, inflation represents a deep financial risk.
The twin threats of sequence of return risk and a spike in inflation mean that both the makeup of the retirement portfolio and the order of decumulation of that portfolio are crucial for meeting planning goals. That means a “set it and forget it” strategy is likely to disappoint the high-net-worth retiree.
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When, Not If, Taxes Change
Although the common retirement planning mantra is to work with the tax situation that exists today – not possible changes that might happen in the future – these are not common times. Both federal and state taxes are likely to change, with the net outcome being an increase in taxes for high income and high-net-worth individuals. These increases, however, probably won’t be a simple across-the-board boost in marginal tax rates. The changes will likely be more nuanced, and offer the opportunity to blunt some of the effect of these increases by careful ordering of how and when retirement income is taken.
In terms of federal income tax, a delay in effective dates for any tax increase could be the driving consideration. Many of the income tax advantages from the Tax Cuts and Jobs Act are set to expire beginning in 2026. The makeup of the current Congress and Administration would suggest that, at a minimum, these tax advantages will be allowed to sunset. It is also possible taxes may be changed before the sunset, but it is unlikely that the changes would be retroactive to the beginning of this year. With the prospect of future income tax increases, the present value of paying income taxes today may be superior to the normal strategy of saving through tax deferral. The advantage of a pay-them-now versus a pay-them-later approach may present itself in numerous ways.
It’s a no-brainer that the current 37 percent top marginal tax rate is lower than the proposed return to Obama-era taxes at 39 ½ percent. In the retirement planning realm, this becomes a very real consideration because recently there have been more, not less, opportunities to defer income. But should you defer when tax rates are going up?
With the SECURE Act, required minimum distributions (RMDs) have been pushed out from age 70 ½ to age 72. Last November the IRS increased the RMD life expectancy table for most retirees, such that the required distribution each year will be less than what would be required currently. This translates to the ability to further defer taxes on IRAs and 401(k)s into the future. However, income taxes on these tax-deferred accounts cannot be avoided forever. So a case can be made for paying low taxes on IRAs and 401(k) balances now rather than enjoying tax deferral and paying tax at a higher rate in the future.
The tax advantage of paying tax now may also show itself in the form of avoiding future changes in tax thresholds. Examples include income limits for Medicare Part B premiums and the non-indexed Net Investment Income (NII), or the baked-in sunsetting of the qualified business income deduction for pass-through business owners in 2026. In other words, it’s not just about the marginal tax rate going up, but also other taxes taking a bigger bite in the future. An example of a payroll tax where this may appear is the proposed additional FICA tax that would be applied to wage earners with incomes exceeding $400,000. Putting this all together for the prospective retiree, recognition of gains, losses and tax timing becomes crucial.
Further complicating the tax mix is the fate of estate and gift taxes. The estate and gift tax rate of 40 percent remains higher than even the proposed top income tax rate, but currently these transfer taxes apply to only a small subset of the high-net-worth demographic. However, the exemption level that shelters estates from the estate tax will automatically sunset from the current sky-high $11.7 million level to approximately half as much beginning in 2026. Further, there is a Democratic push to advance that date and lower the exemption even further to $3.5 million, with an accompanying increase in the applicable tax rate. This means that far more high-net-worth taxpayers will need to consider whether it makes sense to trade paying more in income taxes in order to avoid paying high gift and estate taxes.
Strategies To Implement
We are dealing with a mind-bending slurry of tax considerations for well-healed retirees. There can be no one right approach to take since no one knows where the economy and taxes are taking us. Perhaps the best strategy for the high-net-worth taxpayer is to get good advice from multiple sources. Some strategies will be product focused (for example, investments and annuities) and therefore in the financial advisor’s realm; some will be CPA-generated income tax-based considerations; and some will be estate and gift tax planning techniques coming from estate lawyers. The prospective retiree should gather the planning team together and develop a coordinated, and dynamic approach to adapting to the changing situation. Start with a tax-smart approach for today and agree on a means for monitoring and modifying the plan as tax and economic changes unfurl.
What are some possible approaches to consider for now? Below are five examples of the myriad planning opportunities to contemplate.
1. As stated above, save taxes by paying taxes. It may be better to pay income taxes now at 37 percent than to have thresholds be lowered and rates increased in the future. Specifically, take IRA distributions as an early drawdown source for funding retirement income needs.
2. Lower overall taxes by converting IRAs to Roth IRAs. The systematic Roth conversion technique helps spread out income taxes over several years. This approach is even more powerful currently because tax rates are likely to increase. Further, because the stretch IRA approach no longer applies for most beneficiaries of inherited IRAs, Roths are an after-tax way to avoid this trap.
3. Delay filing for Social Security until age 70. Even though there is concern about funding levels for this popular benefit, it is one of the few inflation-adjusted lifetime benefits available today. Even high-income retirees need income sources that retain purchasing power.
4. Consider making gifts rather than bequests. During this current period where estate tax exemptions are high, many affluent taxpayers have been holding back on gifting in order to gain a step-up in tax basis at death. Now that the estate tax is likely to apply to these same affluent individuals, it may be wiser to transfer some wealth currently in order to avoid high estate taxes. This is going to vary considerable among individuals, and will require careful tax modeling.
5. Take a fresh look at income generating irrevocable transfers, whether to heirs or to charities. For example, the Grantor Retained Annuity Trust (GRAT) is an ideal means to secure some retirement income while transferring appreciation out of the estate. GRATs are an especially potent weapon while interest rates remain low and Congress has yet to curtail their usage. If the ultimate beneficiary of the estate is, instead, a charity, the taxpayer should consider either a Charitable Remainder Annuity Trust (CRAT) or a Gift Annuity. In both cases, the grantor receives current income, income tax advantages, and removal of the asset from the estate.
Opposite Day occurred back on January 25, and April Fools’ Day just passed, but there are still plenty of opportunities to go a different direction than the norm. Specifically, high-net-worth individuals should eschew common knowledge, avoid rules of thumb, and approach their retirements with a different plan. The economy is in flux, and taxes are likely to change. These new 2021 approaches may just provide the net advantage that high-net-worth individuals are seeking.