Taxes play an important role at every stage of life and are a crucial aspect of financial plans for advisors to discuss with clients. Clients should regularly monitor how taxes will affect assets over the course of their financial plans and prepare for multiple outcomes. Advisors can help clients take steps earlier in life to mitigate their tax obligations and maximize savings for retirement.
Clients can build flexibility into their plans and may choose in some situations to pay taxes during the accumulation phase or defer until the savings are accessed during retirement. Income tax brackets and variable factors such as inflation, health conditions and cost of living are important considerations to keep in mind during retirement planning.
Plan for the three stages of retirement
A retiree’s activity level during retirement generally follows three stages, each of which directly impacts the amount of income they will require and their ability to pay associated income taxes. A client in the active stage of retirement may be someone who has just retired and spends money to indulge in experiences or possessions. Help clients maximize access to disposable funds and reduce tax obligation during this high-spend stage. The second phase of retirement is passive, in which clients lead a more conservative lifestyle and only pay for necessary expenses. They may even find themselves saving during this stage if their pension income is higher than their spending.The third stage of retirement is undefined and dependent of the individual’s health status, which may increase their income need. Advisors can help clients navigate and prepare for unexpected health issues and the unknown length of retirement within this challenging stage. You can work with your clients to evaluate assets on an ongoing basis and align tax obligations and needs based on their stage of retirement.
Strategies for tax optimization
Dependent on a client’s ability to qualify for insurance products or access tax-advantaged savings vehicles, there are a few strategies to help alleviate challenges pre and post-retirement. Evaluate the plan of each client to determine the combination of strategies that will produce a more optimal outcome.
Before retirement
Many clients do not understand what tax bracket they are currently in, much less can predict where they will fall after retirement. For example, clients who invested into their own business may fall in a higher tax bracket after retirement. They will be taxed at a higher rate, so advisors should help these clients minimize the tax obligation during retirement. On the other hand, salaried employees who are in a higher bracket before retirement should work with an advisor to secure tax savings while they are employed. Clients can build these goals into comprehensive financial plans. Advisors should review these goals on an annual basis to make any necessary adjustments and hold clients accountable for their financial plans.
Clients must also look at their whole portfolio to facilitate the use of any tax savings. Motivate clients to use tax refunds wisely to eliminate or minimize other payments and debt they may carry into retirement. One technique is for clients to take whatever tax savings they receive and direct them against a mortgage or other debts. This strategy enables the client to simultaneously save for retirement and reduce debt.
A line of credit secured by the home should be recommended prior to retirement if a client does not have one. The line of credit can carry a zero balance until clients need to use it. If during retirement they need to make a large purchase, accessing funds from their portfolios that will trigger taxes could take them into a higher income tax bracket. Using the line of credit, they can withdraw the funds over a two-year period. The tax that they save by not triggering all the taxes in one year will more than compensate paying any interest due on the line of credit.
After retirement
Help clients understand that their tax bracket will change – particularly for business owners whose taxable income may be higher during retirement because they are no longer investing in their businesses and are now taking an income from it. Clients’ combined income sources and savings distributions may move them into a higher bracket, with increased tax obligation.
Clients can leverage certain life insurance products to help prepare for life after retirement. Cash value buildup that grows tax-free while invested in the policy can be used to supplement income if needed. For instance, if the economy is in a downturn and clients need to access fundsthey can borrow against a life insurance policy. The loan can be paid down once the equity markets stabilize. If they do use this strategy, the clients need to be made aware of possible tax implications if the loan is not paid by year end. If the cash value is not needed during retirement, the money grows tax free and it passes on to the named beneficiary tax-free.
Charitable giving is another option that can reduce tax on the estate. Clients can direct retirement funds and life insurance proceeds that will not be needed to a favorite charity. This is an ideal way for clients to leave a legacy and offset taxes.
Geographic considerations
Clients can also take advantage of the various investment options unique to their country or region. For instance, Canadians are able to invest up to a specified amount of money in Tax-Free Savings Accounts (TFSA) and shelter resulting growth from taxable income. Money taken out of the account by clients or left to beneficiaries is not taxed, and the added “income” will not impact their marginal tax brackets. Clients with access to similar accounts should maximize contributions to reduce taxable income and increase savings overall.
Canadian clients can also use the housing market to redirect taxable income. Because proceeds from primary residence sales are not taxed, some home owners consider selling their home when market values increase. Although at first glance it may provide cash on hand to invest, new investments may come with associated tax implications. If clients do not need immediate access to the money, it may be better to stay in the house and let the value increase with the market. If clients truly want to downsize, they should seek guidance from an advisor for investment alternatives that will minimize tax obligations.
Educate clients about the status of their financial plan and help them monitor goals on an ongoing basis. When you meet with your clients, always discuss tax implications associated with an actions or plans and refer them to their tax accountant where necessary.
Taxes should not cross clients’ minds only once a year during tax season. Review retirement plans that take into account all their goals to make sure clients can enjoy a high-quality life after retirement and are not burdened by tax obligations that could have been avoided.
Aurora Tancock, CFP, FLMI, MDRT
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