Spread the Wealth: Strategies for Efficient Use of Your Savings

by Danielle Woods, daniellewoods@propel-fa.com

Many of us cannot choose when we retire.  Some of us just like to work and others must work for financial reasons.  Whether we choose to retire, or the choice is made for us due to layoffs or health issues, there will likely come a time when we must live off our savings.  

COVID notwithstanding, the United States has experienced an extended period of economic prosperity following the Great Recession of 2008-2009. That prosperity becomes evident when you look at the market value of your retirement savings. For many of us, that retirement savings is predominantly held in a 401(k) and/or traditional IRA. Those are pre-tax savings accounts, meaning all distributions will be taxed at regular income tax rates upon withdrawal.

Many CPAs and future retirees make the troubling assumption that income tax rates will be much lower when a person is retired than when working. After more than 20 years working with folks and their finances, I can tell you that is not true for many people. Couple that with constant tax changes, and the need for proactive planning becomes monumental to thriving in your retirement years.

Accumulation and Retention Phases

Obviously, we each have a different perspective on our finances depending on what phase of life we are living. Twenty-five-year-old’s with their first full-time jobs are in a very different place than experienced workers who are retiring after 40 years of service.

1. Accumulation Phase. The Accumulation Phase lasts for about four decades of your life: from your 20’s through your 50’s. During this period, we are saving money in a variety of ways; but the most common is our employer’s traditional 401(k) plan. The employer matches our contributions, and we enjoy tax savings on whatever we contributed. We can also buy and sell assets in that account without fear of tax consequences on those transactions. Over the years, that account grows and becomes worth far more than what we and our employer contributed to it.

At Propel, we work with our clients to diversify account types to provide flexibility and tax-efficiency down the road. That includes pre-tax savings (401k/IRA), Roth IRAs, and taxable brokerage accounts. It is essential that we keep up with the differing account types in order to maximize tax and investment efficiency and flexibility. {Please see my February 2021 blogpost, Traditional Retirement Savings: Why Tax-Deferred Accounts like 401(k)s May Be the Wrong Choice for Some Taxpayers — Propel Financial Advisors, for more detail about account types and consequences.}

2. Transition Phase.  As we approach our 60’s, our Accumulation Phase may be in Transition. Our focus may have shifted to retaining what we have, making sure we have enough to last, and reducing our tax liability when distributions are needed. To make that happen, we need a strategy to help us during our Distribution Phase.

3. Distribution Phase.  During the Distribution Phase, we are completely reliant on all the savings and strategies we have employed all along.  We may no longer be able to support ourselves with earned income. At this point, if done properly, our plan has provided us with multiple sources of income. Those sources all have different rules and tax laws that apply to them, and it is essential that we understand how those impact us and our needs.

Now that we have all of the different types of accounts and a financial plan that confirms we can pay for our retirement, it’s time to determine which source will provide for our needs. After all, 401k savings is taxed very differently than Roth or taxable savings. So, what’s the answer? It depends.

We may find that every year is completely different from the last, and we must be nimble and active with our plan. To quote Ferris Bueller, “Life moves pretty fast.” That is becoming more and more true in the world of personal finance. There has been a tax law change every year for the past 4 years, and 2022 promises to bring more. We, as Americans, are changing jobs and retirement dates faster than our hairstyles.

As an advisor, I must review a client’s situation regularly to determine the best course of action. I might recommend that the client hold off on filing for Social Security or even take it early. I might suggest the client start spending down his IRA before he even needs it to help spread out the taxes or because a future year’s tax rates will be higher.  

It is a puzzle with moving parts that will continue to change. The best way to deal with it is to be flexible and to communicate!

The Legacy Phase – The Next Possible Step

Sadly, the savings rate in the United States is dismally low for future retirees. According to a Ramsey Solutions article from 9/27/21, Americans in their 60s have an average retirement account balance of $182,100.  Considering how much our lives cost now, while we are working, it’s clear that won’t last long.

But the average is somewhere in the middle, which means some of us will have an excess. Whatever is not spent during our lives will be spent after we are gone. Thus, our accumulated savings has now entered the Legacy Phase.

When properly planned, we actually have a lot of control over what happens to our assets upon our deaths.  

Legal Options:

1. Last Will and Testament:  This document tells the Court how we want our assets handed out when we pass away.  A letter written to family or loved ones IS NOT a will and will not stand up in Court.

2. Beneficiary Designations: Many accounts such as life insurance, brokerage accounts, bank checking and savings accounts, retirement accounts (IRAs, 401(k)s, Roth IRAs) allow us to designate who we want to inherit our accounts when we pass.  It’s very simple, and if done properly, will not have to be reviewed by a Court.

3. Donor-Advised Fund/Charitable Trust:  These accounts allow you to distribute assets to charitable entities outside of a will.

4. Irrevocable and Living Trusts:  These documents have different rules, but both allow us to remove our assets from the review of the Courts when done properly.

Tax Planning:

It is important to keep in mind that the various account types (IRA/401(k), Roth IRAs, Brokerage accounts, Bank Savings/Checking, Life Insurance policies) have different tax consequences both while we are alive and after we have passed on.

If we spend our IRA or 401(k) accounts while we are alive, we will pay taxes on the distributions as if it was earned income.  If we leave an IRA or a 401(k) plan account to a spouse when we pass, they can treat the account as their own and are not required to take distributions until the age of 72. They will also pay taxes as if it is earned income (at regular income tax rates).  

When an IRA passes to a non-spouse, the beneficiaries will be required to withdraw and pay taxes on all funds within 10 years. This is a drastic change in the law that went into effect on 1/1/2020 thanks to The Secure Act.  Important Information About Retirement Accounts - SECURE ACT — Propel Financial Advisors

**Keep in mind that increased income will impact the taxation of Social Security benefits and the cost of some medical premiums.**

Roth IRA beneficiaries have it easier.  While withdrawals are required, they are not taxed and will not impact income-based medical premiums.  

Taxable investments such as brokerage accounts, savings accounts, and checking accounts can pass rather easily to a beneficiary with little to no tax consequences on the recipients.  If a brokerage account includes assets such as stocks, the beneficiary enjoys a “step-up” in the basis.  

For example:  

Mr. Rogers bought 100 shares of ABC stock for $5,000 in 1960.  In 2003, the stock was worth $50,000.  He considered selling the stock when he got sick, but he would have to pay capital gains on $45,000. He chose to leave the stock to his friend Daniel in his will and passes away later that year.

Because Daniel inherited the stock, he enjoys a step-up in the cost basis. (Cost basis is the term for the original purchase price. The taxable amount, or “gain”, is determined by subtracting the basis from the amount you sell it for.) Instead of having tax basis of only $5,000 as it would have been for Mr. Rogers, his basis is now the value of the stock on the date of Mr. Rogers’ death - $50,000.  Daniel sells the stock for $50,000 and owes no tax.

Wrapping it Up

There are a lot of tools available to create a plan, but all plans must be flexible to address life and statutory changes.  At Propel, we specialize in this kind of planning; and we encourage our clients to be proactive. Diversifying accounts and assets as well as communicating life changes to our advisors will save stress, time, and money.