How to Avoid Tax Traps in Retirement Income Planning: Wade Pfau

Tax-deferred accounts have many well-appreciated features, Pfau says, starting with the fact that contributions are (mostly) deductible, while future withdrawals will be taxed as ordinary income and could (potentially) be in a lower tax bracket.

There are drawbacks, however, and these include RMDs starting at age 73 or 75, as well as early withdrawal penalties of 10% or more.

A third big category is Roth accounts, Pfau explains, and these have their own appeal. While contributions are not tax deductible, qualified withdrawals are not taxed, which provides flexibility to generate retirement spending without tax.

Choosing Between Account Types

Pfau says advisors and their clients should put more thought into how they make decisions about asset location well in advance of the retirement period.

Generally, he says, the guiding principle in such decisions should not be to delay taxes as long as possible, as is often (and mistakenly) suggested. Rather, the key is to prioritize the payment of taxes at lower rates, and that can often mean paying taxes earlier than is strictly necessary.

Very broadly speaking, this means favoring tax-deferred accounts when current tax rates are high and favoring tax-exempt accounts when current tax rates are low — but there is a lot of nuance to consider based on the individual client's savings journey and anticipated needs in retirement.

The same concept applies to Roth conversions, Pfau says: "Do them when there are low current tax rates, and if there have been market losses that will make conversions even more efficient." The best outcomes from conversions, Pfau adds, come when the client can pay the taxes due with a ready source of cash — not directly from the assets being converted.

"The real lesson here is that it's not always about deferring taxes as long as possible," Pfau emphasizes. "The key is to be efficient and smart about when you are going to be paying taxes. You are trying to get the right level of income in a given year to get that smoothing effect over time, so that you don't push yourself into a really high bracket in one year only to see income fall dramatically in the next."

According to Pfau, advisors may have to work hard to help their clients see that making a short-term sacrifice can result in better long-term outcomes, but the effort is well worth it when it comes to portfolio longevity.

Techniques to Efficiently Generate Income

In Pfau's experience, the complexity of the tax framework and the many different approaches to saving and spending that clients can take also presents opportunity for savvy advisors.

In some cases, he notes, it could make sense to encourage clients to spend less from taxable accounts and more from tax-deferred accounts to cover a spending goal in a way that increases taxable income toward the desired level. This can be useful in years when sources of working or investment income are low and the client wants to "fill up" their low-tax income bucket.

In other circumstances, clients should favor covering their spending goal from taxable accounts, but then increase taxable income by doing Roth conversions with assets from the tax-deferred account. Or, clients could see a benefit from generating taxable long-term capital gains by selling and then immediately re-purchasing assets in taxable accounts — especially when they are still in the 0% tax bracket for preferential income sources.

Though it may seem counterintuitive, Pfau says, there are further reasons to frontload taxes in some circumstances.

One such reason are "public policy unknowns" and the effort to managing the risk of future tax increases. Another is the tax implications that arise after the death of a spouse, because taxes can easily increase as one becomes a single filer again after many years spent in a higher marginal tax bracket.

Pictured: Wade Pfau