The Advisory Career

Retirement Strategies for Today’s Wealthy

Put tax planning to work all year long

by Laurence Greenberg

Mr. Greenberg is President of Jefferson National, innovator of the industry’s first flat- fee investment-only variable annuity with the largest selection of underlying funds, which was recently named in Barron’s list of Top 50 Annuities for a second consecutive year. For more information, please visit or call 1-866-WHY-FLAT (866-949-3528).

When federal and state taxes are combined, many high net worth and high income clients may be paying tax rates as high as 40 or 50 percent each year. In fact, taxes can be their single biggest investment expense.

With new taxes on high earners recently proposed by Washington, including limits on deductions and hikes on capital gains and estate taxes, many of your clients are likely to be on guard. But there are proactive measures you can take to help clients reduce taxable income, minimize the impact of taxes on investment gains and maximize wealth accumulation. Developing your expertise in tax planning, uncovering new strategies and new products, and putting them to work to build clients’ wealth should be a top priority – not just during tax season, but all year long.

To tax-optimize clients’ portfolios, it’s important to diversify when clients pay taxes – and which taxes they pay. Start by reviewing your clients’ recent tax returns to identify new opportunities, and see where they could make adjustments to align their investing strategies with new tax-planning strategies to add more tax-alpha. Much like the alpha achieved when an investment outperforms its benchmark, tax-alpha is the additional wealth you can generate when optimizing taxes.

Leveraging the Power of Tax Deferral

Every client is unique and has different tax planning needs. But the foundation of every tax-optimized investing strategy starts with tax deferral. By minimizing taxes today and compounding assets tax-deferred, clients can maximize long-term wealth for the future, and pay taxes in retirement – when they are likely to be in a lower tax bracket. Ninety-six percent of RIAs and fee-based advisors say tax deferral is important, and 86 percent expect tax deferral to be more important in the future, according to a survey by Jefferson National. Yet, only 19 percent are aware that tax deferral can generate additional alpha of 100 bps or more – and more than half say their clients have no knowledge about tax deferral outside of qualified plans. That means many clients are paying more taxes than they should – and opportunities to maximize their wealth are being left on the table.

Maxing Out Qualified Plans

The first fundamental step towards a tax-optimized portfolio is maxing out contributions to qualified plans. Start with employer sponsored plans such as 401(k)s and 403(b)s – especially if there is an employer match.

For the self-employed, common tax-deferred qualified plans are Simplified Employee Pension Plans (SEP IRAs), Savings Incentive Match Plan for Employees (SIMPLE IRA) and individual 401(k)s. Once workplace plans are maxed out, clients should make contributions to traditional and Roth IRAs. With a traditional IRA, clients contribute pre-tax dollars. Instead of paying taxes now, they owe taxes when they begin making withdrawals during retirement.

With a Roth IRA, clients use after-tax dollars. They pay taxes now, but can make future withdrawals tax-free starting at the age of 59½. A Roth IRA can be an important tax-free source of income for clients in later years. And many clients will benefit by converting from a Traditional IRA to a Roth IRA. But keep in mind that when having the conversion, the entire value of the IRA is considered to be additional ordinary income.

The resulting “bracket creep” can create an immediate tax burden – a very real disadvantage for some high earners. Many clients can save more on taxes by waiting until they are in retirement to do the conversion, when they will most likely be in a lower bracket. When converting to a Roth, clients have until October to undo the conversion and turn the Roth back into a Traditional IRA. For 2015, the contribution limits for many qualified plans have increased.

Workplace plans such as 401(k)s and 403(b)s now have limits of $18,000, up from $17,500 in 2014. The catch-up contribution limit for participants ages 50 and older is $6,000, up from $5,000. The 2015 contribution limit for traditional IRAs and Roth IRAs is $5,500, with catch-up contribution limit of $1,000. Contributions to workplace plans must be made before December 31 of the current tax year. Contributions to traditional and Roth IRAs can be made until April 15 of the following year.

Low-Cost IOVAs: Maximizing Tax-Alpha

Most high net worth and high income clients can easily max out the low contribution limits of 401(k)s, IRAs and other qualified plans. They often need more tax deferral.

Research has shown that the primary advantage to the variable annuity structure is the power of tax deferral. But many advisors overlook traditional tax-deferred variable annuities, because of high fees, steep commissions and limited fund choices. Just as the power of tax-deferred compounding can grow wealth, the drag of compounding fees can reduce wealth – and the most traditional VAs wipe out any benefit of tax deferral.

When an annuity is low cost, it can boost the power of tax deferral, reduce the risk of wealth depletion and help your client accumulate more. Now a new generation of Investment-Only Variable Annuities (IOVAs) has been designed to feature low costs, no commission and more funds. This new generation of IOVAs has been built to be used as a true tax-advantaged investing platform – instead of a costly and complex insurance product.

Low-cost IOVAs can be used as a “401(k) Extender” to help your clients minimize taxes over the long term and maximize tax-deferred accumulation. And low-cost IOVAs can tax-optimize portfolios in ways that traditional VAs can’t – from asset location, to tax-efficient rebalancing, to funding trusts.

Asset Location: Increase Returns – Without Increasing risk

Asset location involves locating clients’ assets between taxable and tax-deferred vehicles based on tax characteristics. It can generate up to 100 bps to 200 bps of tax alpha or more – without increasing risk.

The first fundamental step towards a tax-optimized portfolio is maxing out contributions to qualified plans

While it’s very situational – depending on factors like the client’s income and potential capital gains – the savings and subsequent wealth created by asset location can be substantial, especially for clients in high tax brackets and clients with a portfolio of $1 million or more.

Start by considering the tax-efficiency of assets. Are they taxed at lower rates for long term capital gains, or at higher rates for short term capital gains and ordinary income? Locate tax-efficient investments such as buy and hold equities, index funds, and tax-exempt municipal bonds in taxable accounts. Locate tax-inefficient investments such as fixed income, REITS, commodities, actively managed strategies and liquid alternatives in tax-deferred vehicles such as qualified plans or IOVAs, to preserve all of the upside without the drag of taxes.

Tax-Efficient Re-Balancing

Re-balancing helps return a portfolio back to its proper allocations, after some assets have increased in value and others declined.

This means selling assets that have gains. And when re-balancing is done in taxable accounts, taxes will be due. But tax implications can be minimized when you divide the total portfolio between taxable accounts and a low-cost IOVA.

When re-balancing means taking gains, it can be done inside the IOVA. Switching among funds won’t generate a tax bill. When re-balancing means taking a loss, take it in taxable accounts and use for tax loss harvesting.

Tax-Loss Harvesting

Taxpayers in higher brackets can harvest losses to offset investment gains and lower their tax liability. Focus on selling losing investments that no longer fit your client’s investing strategy, or use this as an opportunity to rebalance the portfolio. Don’t sell shares to lock in a loss with the intention of buying them back right away. The IRS “wash sale” rule bars investors from claiming the loss if they buy the same or a “substantially identical” investment within 30 days of the sale.

Tax-Optimizing Trusts

More than half of RIAs and fee-based advisors have increased their use of trusts in recent years, according to a recent survey by Jefferson National. Trusts are becoming increasingly important for many estate plans as more than $12 trillion will be inherited by Boomers in The Great Transfer’ of wealth – and an estimated $30 trillion will be transferred from Boomers to their heirs.

While legacy planning has traditionally been the primary factor driving the use of most trusts, advisors say that tax planning is growing in importance. Eighty percent of RIAs and fee-based advisors now cite the importance of using trusts to mitigate the impact of taxes for some of their clients. More than two-thirds (69 percent) of advisors say they plan to increase their use of trusts over the next five years – and 70 percent of them say this increase is because trusts are an effective solution for both tax planning and legacy planning. But tax rates on trust income are high – even at low thresholds–so the benefit of tax deferral may be great.

Trust income in excess of only $12,150 will be taxed at 39.6% – the highest income tax bracket – plus the 3.8 percent net investment income tax. Funding trusts with a low-cost IOVA allows you to build a diversified portfolio, then control when income is generated and when it’s taxed, to help clients generate more wealth and build more wealth for their heirs. Low-cost IOVAs work best with Revocable Trusts, Credit Shelter Trusts, Bypass Trusts, CRUTS, and Special Needs Trusts.

Generational Tax-Planning Tips

Just as smart tax planning can start at any time during the year, it can also start at any age. You can coach clients across multiple generations on tactics to tax-optimize their assets. The upshot: it will help you develop strong relationships with a diverse range of clients to continue growing your practice, whether they are children of your current clients or a younger generation of new investors:

  • Millennials (Age 18 -34)Ensure that they start good habits early, including budgeting, tracking expenses and saving for goals– particularly as they manage big expenses like student loans or moving to a new city. Help them evaluate the pros and cons of renting versus buying their first home. Encourage regular contributions to their employer’s 401(k) program. No amount is too small – and the power of tax deferred accumulation over a lifetime is substantial. As Millennials begin increasing income and greater cash flow, they can consider other tax-deferred retirement vehicles like a Traditional IRA or Roth IRA.
  • Generation X (Age 35 – 50): Encourage Gen X clients to keep track of expenses related to charitable contributions, work, and other business-related activities. These costs can add up – and many can be deducted from taxes each year. Help them evaluate the benefits of investing in additional real estate. As their income increases, regularly increase contributions to 401(k) plans and IRAs. Further optimize savings with additional tax-deferred vehicles such as HSAs and 529 Plans. As they begin to max out qualified plans, many Gen X clients can consider other tax-deferred vehicles – including low-cost IOVAs.
  • Boomers (Age 51 -69): Retirement is imminent for many Baby Boomers. Ensure that they max out 401(k)s, IRA and other qualified retirement plans – including catch-up contributions. Now is the ideal time for them to use a low-cost IOVA as a “401(k) extender.” For older Boomers, legacy planning and wealth transfer may be a priority. Consider IOVA-Funded Trusts to help clients generate more wealth – and build more wealth for their heirs.
  • The Silent Generation (Age 70+): Consider Roth Conversions and diversify income during retirement to minimize “bracket creep,” using Roth and Traditional IRAs, fixed or immediate annuities, and systematic withdrawals from IOVAs. Consider Non-qualified IOVAs, which have no Minimum Distribution Requirements, to provide tax-deferred accumulation beyond age of 70½.

Always the Right Time to Talk Taxes

The 2014 tax season is behind us, but it’s always the right time to talk taxes with clients. And it’s never too early to start planning for next year. By leveraging tax deferral, low-cost Investment-Only VAs, and other tax-advantaged strategies, you can help clients minimize taxes, optimize their portfolio and build more wealth. There’s a direct link between paying less in taxes – and earning higher returns.

The sooner you start talking taxes, the sooner your clients can benefit.