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The Taxes 2-Step

by smeneshi - Dec 28, 2015

With 2015 winding down and winter now beginning, it’s hard to believe another season is quickly sneaking up on us. Whereas Christmastime is known to be the season of cheer, April 15 puts a cap on what I call the season of fear: Tax Time. The discussion around the issue of taxes, and how to pay the least amount, tends to start around this time of the year as we gather with friends and family during holiday get-togethers. This makes perfect sense since December is a time that many investors – both retail and institutional – take part in tax-loss harvesting. Tax-loss harvesting is a tax-reduction strategy whereby an investor typically sells stock, bond, and mutual fund positions that have fallen in value to lock in losses that will help to offset the taxes that will be owed on positions that were sold for a profit earlier in the year. During the handful of trading days that remain in 2015, it’s logical to assume we will see tax-related selling given the sharp stock market corrections during the summer and to a lesser degree, earlier this month. Even though you can’t eliminate the taxes owed on your gains, tax-loss harvesting is a tried and true way to help reduce your tax bill.

As for ordinary income taxes, what can be done to offset the taxes that have to be paid due to distributions from deferred compensation accounts such as 457, 401(k), 403b, and Traditional IRAs? Unfortunately, very little. Outside of a few exceptions and excluding after-tax contributions, every dollar that you pull from tax-deferred accounts will be taxed at ordinary income tax rates. Even after death when your deferred compensation accounts are passed onto surviving family members, they will still have to pay income taxes on any amount withdrawn from their newly inherited accounts. How much in taxes will you or your beneficiaries have to pay?   In general, if you have $600,000 in a pre-tax deferred compensation account, depending on your tax bracket, about a quarter of that money has to be paid to Uncle Sam.  In other words, about 25% of your pre-tax savings don’t even belong to you!  The reasoning makes sense of course; the Treasury Department did you a big favor by giving you a tax break up front during your working years, and when it’s time to make a withdrawal, they need their favor repaid.  It’s kind like when Don Corleone called in a favor from Bonasera – the mortician he granted a favor to during the opening scene of the Godfather.



The good news is if you or your beneficiaries have to pay a hefty load of income taxes on retirement plan distributions, it doesn’t mean that your estate needs to feel the pinch. In fact, an informed investor can leverage the earnings generated by his or her investments to ensure that every single penny that has to be paid to their partner (the IRS) will be returned to the family completely tax-free.

If you’re wondering exactly how this simple and effective strategy works, below is a real-life example of how one of our clients will preserve about $150,000 in family wealth:

I recently sat down with two of our clients (a married couple) during our quarterly review. The purpose of our reviews is to keep our clients updated on the performance of their portfolio, discuss national and international events that could impact their retirement, assess life’s many and unpredictable risks, and to ask about any existing or developing issues that could potentially affect their financial security. Taxes, and how to pay less of them, is also a topic that is regularly discussed with our clients during account reviews. When I pointed out to the couple how much of their net worth they can expect to lose to the IRS, they were understandably upset. In this particular case, both the husband and wife will be getting a pension and Social Security benefits. When they both retire in a few years, their combined income will be around $200,000. That’s obviously the good news. The bad news is because their income is so high, any distribution they make from their deferred compensation accounts will be taxed at a clip of about 30% In other words, almost 1/3 of their retirement savings don’t even belong to them!

So how did my clients, like so many Americans, wind up in such a quagmire? Well, the conventional wisdom for Baby Boomers was to save a part of their paycheck into pre-tax retirement accounts such as 401(k), 457, and 403b plans when tax rates were high and then withdraw those savings during their retirement years when tax rates would presumably be lower. The only problem, as many Baby Boomers are now finding out, is their tax rate in retirement may in fact be higher than what it was during the years they were working and saving into retirement accounts. In the case of my clients, it’s their retirement income that will keep them in a higher tax bracket, and any retirement plan distributions more than about $10,000 will push them into the next highest bracket. Their high income, along with the fact they don’t itemize deductions any longer (which is the case for a lot of retired Baby Boomers), means they’ll be waving goodbye to about 1/3 of their net worth (not including their home).

Since there was simply nothing we could advise that our clients do to avoid paying taxes, we suggested replacing the IRS’s share (about $150,000) of their hard-earned dollars.  The way this simple and effective (yet hugely underutilized) estate planning strategy works is through the use of life insurance, ideally paid for by earnings generated by retirement assets. In the case of our clients, we calculated that if they pay life insurance premiums until the age of 95, they would have paid a total of roughly $150,000.  They or their beneficiaries would also have paid about $200,000 in income taxes due to distributions from their retirement accounts. However, because of the way we structured their policies, the life insurance company will pay their estate $350,000 completely tax-free upon their death. In other words, our clients’ estate is completely preserved.

When it comes to pre-tax retirement plan savings, the bottom line is about a quarter of the total of your account value does not belong to you.  At the distribution of those savings, either you or your beneficiaries will have to pay income taxes.  This doesn’t mean, however, that your estate needs to be reduced.  Using the simple life insurance strategy outlined above is an effective way to make sure that your legacy is passed on intact so that a lifetime of savings can benefit future generations.


** Disclaimer*** Before engaging in tax strategies, be sure to consult with an experienced and competent tax accountant.  Estate preservation strategies should be carefully planned and considered.

Securities and advisory services offered through Ausdal Financial Partners, Inc.  Member FINRA/SIPC 5187 Utica Ridge Road Davenport, IA 52807    563-326-2064  Public Retirement Planners, LLC and Ausdal Financial Partners, Inc. are separately owned and operated.



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