How to Avoid Putting Multiple Investment Strategies on a Collision Course

Being strategic when selecting investment vehicles to grow your wealth is essential to a successful plan. Without careful planning, decisions made for one investment can have unintended consequences for investments in other arenas. Very soon, tax rules or maturation of long-term projects may end up working at odds with each other resulting in suboptimal portfolios, cash flow issues, higher taxes, and greater investment risk than initially anticipated.

Let’s take a closer look at some common examples where individually sound investment strategies can yield less favorable returns when not given properly combined considerations.

Retirement plans and Social Security come of age

It’s relatively common for people to maximize pre-tax contributions to their retirement plans during working years. Over time, significant balances can build up in these accounts, which eventually require annual minimum distributions once taxpayers reach the age of 70.5. These distributions are then taxable as ordinary income – one of the least preferred ways to receive income.

At the same time, this taxpayer adopted the strategy to defer Social Security until age 70 in an effort to improve cash flow and taxes. Between retirement and age 70, the client lives off their taxable investment account, which generates tax-favored income. For these years, they are in a very low tax bracket, and all is well.

However, when the taxpayer (and the spouse, if close in age) turns 70.5, he faces a double whammy. His tax bracket may jump significantly as both Social Security and required minimum distributions flow to the tax return as ordinary income.

A crystal ball for deferred compensation plans

Another issue we sometimes encounter with clients are elections made years ago for deferred compensation plans. Such plans allow clients to defer income above and beyond regular 401(k) and profit-sharing limits. In exchange for deferring income now, the executive must choose a yearly payout option when she retires. For example, she may choose a 5-year payout, in which case the balance of that year’s contributions gets paid to her yearly according to the selected schedule.

Many people presented such options don’t take time to create a strategy during the open enrollment period. Choosing 5-year payouts year-after-year may seem logical at the time because she assumes she’ll need some cash flow in the early years of retirement.

However, if we fast forward 15 or 20 years when our satisfied executive has elected to retire at age 67, we discover she is facing large payouts of ordinary income for five years. This income becomes compounded by required distributions and Social Security at age 70. Now, this retiree suddenly finds herself in a higher tax bracket than she was while working.

Other ramifications of significantly higher income and cash flow include:

• Medicare premiums are income-tested, so higher-income years result in higher premiums for both spouses.
• Excess cash is either accumulated if the client is not sure where to put funds or potentially invested when the market happens to be at relatively high valuations.
• Capital gains are realized in the years leading up to the high cash flow events, reducing future growth of tax-favored assets.
• Asset allocations for accounts with future required distributions are neglected, leading to higher risk than appropriate when the time comes to make cash withdrawals.

How do you avoid such scenarios? Sketch out future cash flows for your personal assets, just like you would for a capital project at work. We recommend making a list of all accounts and marking a calendar for the next ten years that shows when income may be experienced. Don’t expect to anticipate everything exactly. Still, you should be able to plot items such as the start of required distributions, the termination of a trust, when a business may sell, or the maturation of a real estate deal.

This calendar will help expose where it makes sense to accelerate income recognized, whether through taking IRA distributions before 70.5 or making Roth conversions. In some cases, couples may decide that one spouse should start Social Security earlier than the other. And, if there is a significant income event coming in the next few years, start strategizing now on options such as a tax-deferred exchange or funding a charitable trust.

These are the types of discussions and models we produce for clients each day as part of our comprehensive tax and cash flow planning process. Such planning requires careful consideration of how future cash infusions are structured to create optimal tax plans and wealth growth; plans that work best when you and your advisor have insight into all asset accounts.