Clients’ tax obligations should always be top of mind, especially when retirement is imminent.
As they approach retirement, clients’ portfolios can be weighted incorrectly because of inadequate attention paid to tax obligations, which can hurt returns.
Financial advisors can help by reallocating and restructuring clients’ portfolios to be more tax-efficient.
Clients will then realize more gains from their investments, according to tax professionals.
“Advisors’ advice on clients’ taxes is especially important the closer they get to retirement,” says Greg Hammer, chief executive and president of Hammer Financial Group in Schererville, Ind. “But a lot of advisors don’t take advantage of the opportunity clients have to reduce their tax liabilities.”
For pre-retiree as well as retiree clients, Hammer recommends that advisors use tax-efficient models to minimize the taxes from capital gains and dividends being generated from the portfolio. Also consider using investments that generate either qualified dividends or tax-free dividends instead of ordinary dividends.
Qualified dividends can have preferential treatment, Hammer says.
Advisors should also consider restructuring the portfolio using tax-deferred investments.
This strategy is especially valuable if the taxable proportion of Social Security income can be reduced, Hammer says.
Conversely, if clients aren’t paying taxes, “they should take advantage of the [IRS] windows of standard deductions and exemptions and consider [individual retirement account] withdrawals that can be instituted causing little or no taxable ramifications,” Hammer says.
For example, clients who aren’t using all standard deductions and exemptions could withdraw from their taxable accounts without creating additional taxes, which would allow them to increase their cost basis in the portfolio, Hammer says.
“Minimizing taxes for retirement purposes can be as simple as the order the investments are used. The long-term income projects always look better if you keep taxes tax-deferred as long as possible,” says Richard S. Babjak, president of World Equity Group in Arlington Heights, Ill.
“A client may want to spend all non-qualified money first to keep tax-deferred money growing tax-deferred as long as possible even if depleting principle on the non-qualified portion of the portfolio,” he says.
By contrast to Hammer, who advocates putting pre-retiree and retiree clients into tax-efficient investments, Craig J. Ferrantino, founder and principal of Craig James Financial Services LLC in Melville, N.Y., makes a case for tax-free bonds as part of an overall retirement asset re-allocation strategy.
“I want to move my clients from the taxable world to the tax deferred world and then, if possible, to the tax-free world,” he says. “Tax-free bonds can break the cycle of taxation in an overall strategy when choosing investments.”
Besides the tax-free income that clients gain from tax-free bonds, Ferrantino, like Hammer, encourages clients when suitable to invest in Roth IRAs to eliminate future taxation on capital gains, dividends and interest.
“A client should never buy any investments solely for tax purposes,” Babjak says.
“The tax advantages may be just be one component of the investment, and the investment still needs to be a sound investment,” he says. “Sometimes paying taxes is just the price of success.”
Bruce W. Fraser, a New York financial writer, is a contributor to Financial Advisor and On Wall Street magazines.
This is part of a 30-day series on retirement planning strategies.