Changes in federal and state tax laws can affect the taxes on a household portfolio. However, many measures to mitigate their impact are likely to raise rather than lower taxes on the budget over several years.
For example, a household could reduce its equity exposure in anticipation of higher corporate tax rates from the Biden administration. However, many companies can offset higher taxes by reducing their liabilities and effectively paying a much lower tax rate. And the truth is, other investors have already included higher taxes in stock prices.
Move tax liabilities forward or backward
In most cases, an investor’s real options are limited to shifting investment tax liabilities forward or backward. Contributing to 401 (k) s, IRAs, and even investment-only variable annuities (IOVAs) will be an effective strategy for limiting overall tax exposure, even if tax rates should rise in the future. Why? Almost all households will have lower incomes in retirement. A client’s wages in their earning years are higher than the retirement income they receive from social security, pensions, and other payments.
Buy-and-hold is also an effective way to reduce tax exposure, regardless of what happens to tax rates. Long-term gains are taxed at a lower tax rate than short-term gains. More importantly, however, a retiree does not struggle with uninvested income from wages that force their long-term profits to be taxed at a 20% (plus 3.8% Medicare surcharge) instead of a 15% rate.
However, locating assets is only half the battle. Where do these strategies leave a retired household?
Sequencing is still important
With 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 determine a retirement income strategy:
1. Current IRA values for each household member and expected asset allocation
2. Expected external sources of income, including social security, retirement and pension payments
3. Expected tax rates and classes over the retirement period of the household
In most cases, tax rates are expected to stay the same and the brackets to grow with expected inflation. For a married couple, the parentheses change based on the status change from joint to one-time filing after one member survives the other. However, this is an opportunity to substitute another set of future sentences and parentheses. A software-led advisor will recommend using more of the current year’s available tax brackets than you would otherwise. However, this recommendation is not similar to wholesale withdrawals from IRAs, nor associated large Roth conversions.
Biggest Risk? Deviation from a careful, multi-periodic sequence of intelligent actions
Anticipated tax changes may result in adjustments to the recommended measures to lower investment taxes, but rarely justify wholesale measures related to the use of the highest current tax brackets. Delaying capital gains over long periods of time and implementing a series of moderate voluntary IRA withdrawals will continue to dominate other alternatives. In my experience, the greatest risk to minimizing investment taxes over time is deviating from a careful, multi-period sequence of intelligent actions.
Paul Samuelson is the chief investment officer and co-founder of LifeYield.
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