Changes in federal and state tax laws can impact taxes on a household portfolio, but many actions intended to mitigate their impacts are likely to raise rather than lower the household’s taxes over multiple years.
For example, a household might shrink its stock exposure in anticipation of higher corporate tax rates from the Biden administration. But many companies can compensate for higher taxes by reducing their liabilities, effectively paying a much lower tax rate. And the truth is that other investors have already incorporated higher taxes into stock prices.
Moving Tax Liabilities Forward Or Back
In most cases, an investor’s real options are limited to moving investment tax liabilities either forward or back. Contributing to 401(k)s, IRAs, and even investment-only variable annuities (IOVAs) will be effective strategies to limit overall tax exposure, even if tax rates should increase in the future. Why? Almost all households will have a lower income in retirement. A client’s wages in their earning years will be higher than the retirement income they will receive from Social Security, pensions and other payments.
Buy-and-hold is also an effective way to reduce tax exposure, no matter what happens to tax rates. Long-term gains are taxed at a lower rate than short-term gains, but more importantly, a retiree won’t have to contend with non-investment income from wages forcing their long gains to be taxed at 20% (plus a 3.8% Medicare surcharge) instead of a 15% rate.
But asset location is only half the battle. Where do these strategies leave a household in retirement?
Sequencing Still Matters
When in decumulation, a managed sequence of withdrawals from retirement accounts is the primary way to reduce tax exposure. When using software to avoid high tax brackets, the advisor relies on three critical factors to chart a retirement income strategy:
1. Current IRA values for each household member and anticipated asset allocation
2. Expected external sources of income including Social Security, pension and annuity payments
3. Expected tax rates and brackets over the household’s retirement period
In most circumstances, tax rates will be expected to remain the same and brackets will grow with expected inflation. For a married couple, brackets will change based on the shift in status from joint to single filing, after one member survives the other. However, this is an opportunity to substitute in a different set of future rates and brackets. An advisor guided by software will recommend using more of the current year’s available tax brackets than would otherwise be the case. However, this recommendation will not resemble wholesale withdrawals from IRAs, nor associated large Roth conversions.
Greatest Risk? Deviating From A Careful, Multi-Period Sequence Of Smart Actions
Anticipated tax changes can prompt adjustments in recommended actions to reduce investment taxes, but they will rarely justify wholesale actions associated with the use of the highest current tax brackets. Delaying capital gains for extended periods and implementing a sequence of moderate voluntary IRA withdrawals will still dominate other alternatives. In my experience, the greatest risk to minimizing investment taxes over time comes from deviating from a careful, multi-period sequence of smart actions.
Paul Samuelson is chief investment officer and co-founder of LifeYield.
To read more stories , click here