As 2023 came to a close, financial advisors were actively engaged in end-of-year Roth conversions, strategically shifting funds from qualified, tax-deferred accounts to take advantage of lower tax rates. While this practice is common, there’s an even more substantial opportunity that many advisors may be overlooking. Instead of solely focusing on year-end Roth conversions when a retiree’s tax situation is apparent, advisors can significantly enhance their approach by incorporating tax-targeted distributions from tax-deferred accounts for retirement income throughout the year.
To fully grasp this opportunity, advisors should consider how retirees’ income is being sourced throughout the year. Typically, advisors follow the conventional wisdom of withdrawing from a household’s taxable accounts, followed by tax-deferred accounts, and finally, from Roth accounts. This method often results in taxable capital gains when withdrawing from taxable accounts and delaying ordinary taxable income from tax-deferred accounts until required minimum distributions (RMDs) begin.
In years where clients expect to be in a lower tax rate, it may make more sense to withdraw funds from tax-deferred accounts before RMD age, capitalizing on those lower advantageous tax rates for ordinary income and deferring realizing gains. However, advisors often shy away from this approach due to its perceived complexity.
The intricacy arises from the interplay between ordinary taxable income from tax-deferred distributions and capital gains from taxable accounts. This combination can impact the taxation of Social Security, as well as the tax rate for both ordinary income and capital gains. Additionally, the taxation of a household’s other income sources such as pensions, rental income, or part-time work in retirement needs to be considered. Attempting to optimize tax-efficient distributions across a household’s various accounts using a worksheet can be challenging, inefficient, and prone to error.
Empowering your advisors with robust retirement income software that simplifies these complex calculations can lead to more confident and valuable client interactions. Advisors need retirement income distribution software that surpasses traditional financial planning tools and can also seamlessly integrate with a firm’s portfolio management system. The potential value of tax-optimal retirement income distributions for clients is substantial.
To dive deeper into the mechanics of retirement income distributions, a recent white paper published by our firm, Income Discovery, details how adopting tax-targeted distributions throughout the year, not just at year-end, goes beyond traditional financial planning strategies. The paper covers the following capabilities essential for retirement income platforms:
- Optimization and Dynamic Withdrawal Order: employing detailed tax-targeted withdrawal strategies for intelligent, long-term tax management over short-term tax minimization or only Roth conversions.
- Targeting an Incremental Effective Tax Rate: tax targeting for withdrawals from qualified, tax-deferred accounts throughout the year must consider the effective marginal rate, which includes the effect on Social Security and capital gains taxation.
- Capital Gains Management: the system should minimize realized gains when the full tax picture is unknown while making withdrawals throughout the year and harvesting losses when opportunities arise. At the end of the year, tax-free gains can be harvested, if available.
- Multi-Account Disbursals: withdrawals intelligently spread across multiple accounts using the guidelines above to manage the household’s taxes versus the industry standard of following a static order or fixed proportional withdrawal.
A compelling case study within the white paper shows these strategies in action. Anne and Ben, a hypothetical retiring couple, significantly reduced their retirement plan's risk (by increasing success probability from 50% to 98%) and taking their projected after-tax legacy from zero to $1.4 million by leveraging optimized strategies that include dynamic tax-targeted distributions, rather than just Roth conversions.
The interplay of tax-targeted distributions, dynamic withdrawal orders, and capital gains management can seem daunting. Yet, with the support of advanced retirement income software, these intricate calculations become accessible and scalable, delivering substantial value to your clients. This value addition is akin to generating an additional portfolio return of 275 basis points for the household—commonly referred to as the advisor’s gamma.
Explore these strategies in more depth and study the methodology behind them in our white paper, which provides a comprehensive look into the impact of tax-targeted income distributions. By embracing this approach, advisors can foster stronger trust with clients, showcase the tangible value they provide and foster revenue growth through increased adoption of advisory services.
Manish Malhotra is the Founder and CEO of Income Discovery, an intelligent, simplified, and scalable platform that can deliver a personalized, tax-optimal paycheck to clients in retirement.