Page 26 - Investment Advisor March 2022

Cover Story

[A QLAC] can be timed to help with the overall tax planning Security was running out of money.
for your retirement. It all depends on the structure of your The solution was the combination of lowering benefits and
assets. For example, if you have everything in a Roth, you can increasing retirement age, which increased taxes.
have a huge net worth but no taxable income. So this isn’t just
about net worth. The government makes many significant decisions
that affect taxpayers financially but about which
When did the Tax Torpedo first rear its head? they’re often unaware. Agree?
It began when the designers of the tax policy [came out With Social Security, the Supreme Court ruled [in 1960]
with] the major tax reforms of 1983, when they start- that people have no property rights to their Social Security
ed taxing Social Security benefits. This was during the benefits. They’ve been paying into the System their whole
Reagan years. Alan Greenspan was head of the National [working] lifetime but they haven’t any rights to their benefits
Commission on Social Security Reform. It was when Social [which therefore can be reduced or eliminated].

Wade Pfau’s View of the Taxable Retirement World

In a webinar with Jackson, Wade Pfau discussed taxes and retirement. Here’s a
segment where he discussed one example on why tax bracket management is so
important to help pre-retirees and retirees.

[An example of the] logic of tax efficiency is higher income levels, you tend to be taxed at higher rates.
somebody who’s retiring with $2 million. They The tax code is also filled with a number of non-linearities
have a $95,000 spending goal before taxes. And this shows and traps, [including those] related to Social Security and
the value of short-term sacrifice for long-term gain in terms Medicare. Also the preferential income sources are taxed at
of thinking about retirement. So much about retirement long-term capital gains and so forth. In that regard, marginal
planning involves a short-term cost to get a long-term ben- tax rates can end up being higher than we would think by just
efit, whether that’s delaying Social Security, whether that’s looking at the federal tax code.
incorporating an annuity with protected lifetime income, or And there is a number of different types of tax treatment
whether that’s doing some sort of strategic tax planning. in the tax code that we do want to coordinate as part of this
Conventional wisdom is I take Social Security at 62, I fol- process. … Many of the tax rules connect to adjusted gross
low the tax deferred, tax-free distribution strategy. But I’m income rather than the taxable income. So it’s not going to
going to run out of money, in this example, at age 88, versus help to have a below the line tax deduction because what-
if I delay Social Security to 70, and then I take advantage of ever rule we’re talking about is not impacted by the tax
doing strategic Roth conversions quite aggressively before deduction. It’s based on the adjusted gross income before the
Social Security begins. Then I’ll be able to cut back dramati- tax deduction.
cally on the kind of tax bracket management I need to have And of course, itemized deductions only count when
less of my Social Security taxable, avoid Medicare premium they’re higher than the standard deduction. Preferential
increases and so forth. Subsequently I’m able to get that income sources like long-term capital gains and qualified divi-
portfolio to last for 5.6 years longer to age almost 94. dends stack on top of ordinary income and then have differ-
And then even if the portfolio were to deplete, I still have a ent tax rates that apply; a dollar of income can trigger tax on
Social Security benefit at that point that would be 77% larger. Social Security as well a dollar of income can trigger a higher
The logic here is that there can be a short-term cost for a Medicare premium.
long-term efficiency. That wealth, and that example, lags until There is a 3.8% net investment income surtax that [is]
around age 77, but you get so [many more] long-term ben- very non-linear in terms of you having to calculate two
efits subsequently. And age 77 is well before life expectancies different numbers and see which is smallest. And then
for the typical individual working with financial planners. So also there’s required minimum distributions. And those
there’s definitely benefit to be gained from focusing on the can catch individuals off guard after age 72, where they’re
long-term and it has a significant impact. suddenly pushed into a higher tax bracket than they may
have anticipated.
Tax Matters
So why does tax planning matter? It’s a matter of navigating For a complete discussion, refer to Pfau’s book: Retirement
our progressive tax system. We have the situation where at Planning Guidebook.

24 INVESTMENT ADVISOR MARCH 2022 | ThinkAdvisor.com