In this seemingly-unending era of high uncertainty and little-to-no return on safer investments, you’re searching for anything that can increase your clients’ wealth without incurring more risk and volatility.
But you likely have neglected a strategy that can put a good deal of dough in your clients’ pockets, and is at least as dependable as most stocks, bonds, or mutual funds.
Here’s how paying attention to one important line on your boomer clients’ tax returns can provide big payoffs now, as well as in the future.
The Magic Number
Get a copy of your clients’ most recent income tax returns, and check Line 43 on their 1040 form. (On the 1040A, it’s Line 27, and on the 1040EZ it’s Line 6.)
This is your clients’ taxable income, and it determines the top rate at which your clients’ ordinary income will be taxed.
For the 2012 tax year, that rate can range from 0 percent all the way up to 35 percent. But the most crucial cut-off will likely be the difference between the 15 percent and 25 percent tax brackets.
In 2012 that number at Line 43 on the 1040 is $70,700 for married couples filing jointly, $35,350 for singles, and $47,350 for heads of household.
Obviously it’s going to be difficult to get the taxable income of your higher-earning clients down below the top of the 15 percent bracket.
But it will be feasible for many of your middle-income (and modest-spending) clients, both before and (especially) after they retire.
While They’re Working
There are several ways to reduce your clients’ current income tax bill, including harvesting tax losses, “bunching” itemized deductions, and using annuities to temporarily shelter investment gains and income from taxation.
But the biggest bang for most working clients’ bucks comes when they maximize their contributions to a pre-tax retirement plan at work, such as a 401(k) or 403(b).
In 2012 the maximum contribution to these plans will usually be the lesser of their earnings, or $17,500 ($23,000 if they’re 50 or older this year).
Depending on the income-tax bracket in which the clients land, an additional $10,000 set aside in a pre-tax retirement plan could save the clients at least $2,000 to $3,000 on their income tax bill for the year in question.
That hefty figure doesn’t include any employer-match contributions, or a reduction in future taxes that would otherwise be levied on earnings made if the money hadn’t been deposited in a tax-sheltered plan.
If you’re working with a married couple who has a single breadwinner, and that breadwinner is already maxing out contributions to an at-work retirement plan, don’t forget that you may be able to open a tax-deductible “spousal” IRA for the stay-at-home half of the couple.
Deposits to a spousal IRA are limited by income, though, and spelled out in IRS Publication 590 at www.irs.gov.
Bet the House?
Clients who say they can’t afford to save any more for retirement, but have a good deal of home equity built up may want to look at refinancing a new 30-year mortgage, and using the lower payment and/or any cash-out proceeds to boost their savings into pre-tax retirement plans.
However, an ensuing decline in the investment values within the retirement account can quickly erode even the most significant tax savings, while the mortgage (and payment) will still remain.
Therefore, this strategy should likely be paired with a more-cautious investment allocation.
The loss of a steady paycheck is certainly a concern to most newly-retired clients. But the new-found flexibility in choosing both the source and amount of income can mean a lower effective tax rate on a similar amount of gross income.
Reducing income taxation in retirement requires a strategy that should be implemented as soon as possible, and applied and tweaked at least annually in the future.
The first important phase is after the clients retire, but before they initiate pension and/or Social Security payments.
During this period they should try to convert as much money as possible from IRAs to Roth IRAs, while still remaining below the top of the aforementioned 15 percent federal income tax bracket.
Ideally, the clients will have non-retirement savings set aside to support themselves during this period, so that they convert the maximum amount of IRA money possible, without needing any funds for living expenses.
Once the clients are ready to initiate Social Security and pension payments, any remaining income needed during the year should be taken from the other sources in a prescribed order.
First, they should withdraw money from tax-sheltered IRA accounts—but again, only until they reach the top of the 15 percent tax bracket.
The next source of funds should be savings held outside of retirement accounts, such as savings, stocks, bonds, and mutual fund accounts.
Then the retirees can move on to Roth IRAs to cover any other expenses before the year ends, after which they can start the process all over again.
Some calculating homeowners may even want to establish a home equity line of credit (or HELOC), under the philosophy that paying, say, 5 percent interest on money needed for expenses or emergencies is better than paying 25 percent (or more) in taxes on funds pulled from IRAs.
This tactic is especially useful if the HELOC can be paid off in future years by taking IRA withdrawals that are taxed at a lower rate.
Taking it One Step Further
Even retirees who can survive without taking money from IRAs should still consider moving a portion of the accounts to Roth IRAs, as long as the funds converted are taxed at a rate no higher than the 15 percent federal level.
Any money moved to Roth IRAs will not only avoid taxation in future years, but has no required minimum distribution age, and (assuming the laws remain the same), won’t affect the taxation of Social Security payments when withdrawn.
The conversion can even be recharacterized at a lower amount in the near future if the investments you subsequently choose for the Roth IRA fall in value.
Hopefully, that decline is slightly less certain and sizeable than the tax dollars you save for your clients.