3 ways taxes could cause issues for your clients in retirement

Retirement plan savings can create tax issues

Saving for retirement using tax-deferred strategies like defined contribution plans and IRAs can be smart. These plans help reduce a client’s current taxes while they are in the workforce while also taking advantage of any employer match offered. This can help increase savings while delaying taxes.

The balances in defined contribution plans and IRAs have been steadily increasing in recent decades. But taxes will need to be paid when retirees start withdrawing funds to cover their retirement expenses. This presents the potential risk for being taxed at increasing rates.

When appropriate, a financial professional may counsel clients to roll all of their pretax assets into IRAs. This move would consolidate their funds and develop a strategy that meets their current and future income needs.

Although, some clients are in an enviable position – they have other income sources that are more tax efficient. These clients do not need to withdraw from their accounts that are subject to regular income tax right away.

It sounds counter intuitive, but those clients who are well funded for retirement may be more likely to experience tax issues. The IRS has announced a 7% increase in marginal brackets to adjust for inflation, which may help a little but won’t eliminate the tax risk.

Here are three tax issues these clients may encounter.


Deferring plan withdrawals

Common advice suggests to delay withdrawing from retirement accounts as long as possible. This will allow more time for growth and to defer paying income tax on the withdrawals. But for some people, delaying withdrawals until their required age (it is currently age 72 but could be moved to a later age) when their required minimum distributions (RMDs) kick in may actually reduce the amount of money they will have after taxes.

This is because over time, the increasing balances and the percentage increases due to age will require larger RMDs once they come due. This means more money is taxed in the marginal tax bracket or a higher tax bracket. Ultimately, this could mean less after-tax money for the account owner or beneficiaries.


Increased taxes for a surviving spouse

After the death of a spouse, the surviving spouse moves from the married filing jointly (MFJ) to a single filer (SF) status, which impacts their taxes in a big way.

There may be some clients who file as head of household (HoH) or married filing single (MFS), but for brevity, we’ll use MFJ. For example, filing using a single status means compressed income tax brackets, reduced standard deduction, lower premium thresholds for Medicare Part B and Part D, and possible exposure to the 3.8% net investment income tax and the .9% Medicare surcharge.

The death of a spouse also means the loss of one Social Security check. The survivor will need to make up for the loss of that income with a larger withdrawal from their accounts. Not only will they need to make up for the payment, but also, if 85% of the benefit was taxed, they’ll need to gross up to pay for the taxes on the additional 15% withdrawal, then make up for the increased tax with an additional withdrawal. 

These differences can result in clients paying more in taxes after the death of a spouse unless a contingency plan is in place.


No “stretch” for children

The rules for RMDs for beneficiaries of a defined contribution plan or IRA have recently changed. The SECURE Act modified the rules so that beneficiaries are generally required to liquidate the inherited accounts by the end of the 10th calendar year following the owner’s death. Under the old rules, a beneficiary could “stretch” the withdrawals to liquidate the assets over their life. This of course counts as income and can impact taxes. One of the advantages of stretching IRAs was that if the beneficiary was inheriting these taxable distributions during what are their highest earnings years (mid-50s to retirement), they could minimize the impact of taxes during their working years and then increase withdrawals after they retired themselves. While there are exceptions, the majority of beneficiaries will have a much shorter time in which to plan for tax mitigation.

Here are a few potential strategies that could help clients to plan for these tax issues in retirement:

  • Roth IRA conversion – paying taxes now with the expectation they may be higher later (such as when widowed)
  • Withdraw from taxable accounts to “fill up” current tax bracket (i.e., 22%) and invest in capital asset, tax deferred or tax-free investments or products
  • Split beneficiaries – when the first spouse dies, leave a portion to the child (children) for them to stretch, then the larger share to the survivor for the child(ren) to stretch later
  • Annuities and life insurance – life insurance can be used to create a legacy or help to pay taxes on inherited assets, and annuities can offer tax deferral to postpone the immediate effect of taxes.

This content is for general educational purposes only. It is not intended to provide fiduciary, tax, or legal advice and cannot be used to avoid tax penalties; nor is it intended to market, promote, or recommend any tax plan or arrangement. Allianz Life Insurance Company of North America, its affiliates, and their employees and representatives do not give legal or tax advice. Customers are encouraged to consult with their own legal, tax, and financial professionals for specific advice or product recommendations.

Purchasing an annuity within a retirement plan that provides tax deferral under sections of the Internal Revenue Code results in no additional tax benefit. An annuity should be used to fund a qualified plan based upon the annuity’s features other than tax deferral. All annuity features, risks, limitations, and costs should be considered prior to purchasing an annuity within a tax-qualified retirement plan.

Guarantees are backed by the financial strength and claims-paying ability of Allianz Life Insurance Company of North America. Variable annuity guarantees do not apply to the performance of the variable subaccounts, which will fluctuate with market conditions.

Products are issued by Allianz Life Insurance Company of North America. Registered index-linked annuities (RILAs) are distributed by its affiliate, Allianz Life Financial Services, LLC, member FINRA, 5701 Golden Hills Drive, Minneapolis, MN 55416-1297. 800.542.5427 www.allianzlife.com

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