Taxes and Transitions

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1 Taxes and Transitions THE NEW FRONTIER FOR RETIREMENT PLANNING Wealthy individuals have been hit with their first major tax increase in more than 20 years, with tax hikes on ordinary income, dividends and capital gains. The current tax environment has put a strain on wealth building, creating more challenges for retirement planning at a time when many investors particularly baby boomers are not saving nearly enough for tomorrow. Navigating this ever-shifting tax environment requires innovative approaches to help optimize deferred-savings vehicles and take advantage of forward-thinking wealth and investment strategies. Retirement planning will require heightened vigilance to ensure tax-smart saving decisions, given that the tax environment is likely to become more challenging as time goes on. Tough New Tax Laws and a Retirement Savings Crunch Most investment and retirement professionals agree that Americans are woefully unprepared for their retirement years. According to a study by the Employee Benefit Research Institute (EBRI) 1, Americans are facing a $4.5 trillion retirement savings shortfall. The study found that only 57% of Americans are saving for retirement at all, and even many wealthy individuals are dramatically underestimating their future cash needs. Legislation that took effect in 2013 makes wealthy taxpayers efforts to save for retirement even more challenging by increasing their tax burden. Additional surtaxes and reduced benefits are also chipping away at after-tax income, leaving some taxpayers in a higher tax bracket than they would otherwise have expected. First, the American Taxpayer Relief Act (ATRA) increased the top tax rate from 35% to 39.6% for ordinary income, including both regular wages and interest from corporate bonds. ATRA also raised the top tax rate for long-term capital gains and qualified dividends from 15% to 20%. In 2014, these top rates apply to those taxpayers with taxable income greater than $406,750 (single filers) or $457,600 (married, filing jointly). The amounts are adjusted annually for inflation. Furthermore, healthcare legislation enacted in 2010 created an additional tax burden on higher income taxpayers. Effective in 2013, the Affordable Care Act increased the Medicare payroll tax to 2.35% from 1.45%, and imposed a new 3.8% surtax on net investment income (NII). These changes impact many different types of investment income, including interest, dividends, annuities, royalties, rents, passive-activity income and capital gains.

2 Unlike ATRA, the Medicare payroll tax and the NII surtax apply to taxpayers with adjusted gross income (AGI) greater than $200,000 (single filers) or $250,000 (married, filing jointly). 2 AGI does not take into account certain deductions such as charitable gifts, mortgage interest and property taxes that would otherwise reduce taxable income. The NII surtax is calculated based on AGI, while income tax brackets are pegged to taxable income. This mismatch means people in lower tax brackets could be subject to the NII surtax if they take more deductions and have a higher AGI. Moreover, unlike the tax brackets under ATRA, the AGI threshold is not indexed for inflation. Effectively, the combination of ATRA and the healthcare legislation increased the tax rate on long-term capital gains and qualified dividend income by close to 59% for high net worth taxpayers. While many tax changes already have been implemented, more are likely to come. The legislative horizon is already dotted with contentious suggestions that will have a dramatic impact on investing and retirement planning for years to come. Retirement Planning Strategies for Today s Landscape Regardless of the legislative changes out of Washington and the inevitability of more tax increases to come, any sound retirement plan should start with an honest assessment of your long-term objectives and spending needs. Objective-driven investing is a sound approach to align investors life goals with their investment strategies. It starts by identifying how much money you need to maintain your lifestyle, and how much you wish to transfer to future generations or philanthropic causes. As outlined in Exhibit 1, investors can identify both lifestyle and wealth transfer goals and then incorporate investment strategies expressly designed to achieve each goal as part of a diversified portfolio. A thorough evaluation of retirement plans is equally important to ensure you are optimizing tax-deferred accounts, including employee 401(k) and 403(b) plans, traditional and Roth IRA accounts. For instance, in this rising tax environment, retirement investors should consider maximizing retirement Exhibit 1 Objective-Driven Investing: A Sound Start to Retirement Planning Wealth Preservation Seek principal protection, stability, liquidity and consistent income generation. Income Generation Seek high levels of current income, modest principal growth and inflation protection. Wealth Accumulation Seek capital growth/growth of principal. Multi-Generational Transfer Seek growth of principal for current and subsequent generations. Legacy Funding Seeks to sustain portfolio assets and income across generations in perpetuity. Lifestyle Wealth Transfer Source: BNY Mellon Wealth Management 2

3 contributions during high-income years as a means of accumulating assets on a tax-deferred basis. Retirement plans offer an excellent means to minimize taxable income. Exhibit 2 outlines some common plan types, savings limits for 2014 and key benefits. Traditional IRAs vs. Roth IRAs While distributions from qualified retirement plans and IRAs are not subject to the NII surtax, they are taxed as ordinary income, which may be subject to a rate as high as 39.6%. In addition, distributions from qualified retirement plans and IRAs are included in the taxpayer s AGI calculation, which also may subject the taxpayer to the NII surtax on a larger portion of investment income. In this respect, a Roth IRA has a distinct advantage under current law, since qualified distributions from Roth IRAs are tax-free and do not increase the taxpayer s AGI. Furthermore, unlike traditional IRAs, non-inherited Roth IRAs as well as Roth IRAs inherited by spouses have no required minimum distributions (RMDs). Thus, they can continue to grow tax-free even after a taxpayer reaches the age of 70½, the age at which traditional IRA holders must take RMDs. RMDs are always important to keep in mind for planning purposes, regardless of a person s age. For example, an investor at 70½ years old with a $3 million traditional IRA would need to take an RMD of more than $110,000, plus Social Security of approximately $45,000. This income, together with any investment income, is likely to push that investor into a higher tax bracket. At age 80 the impact is even greater, with an RMD of $160,000, because the older a person gets, the greater the required annual withdrawals. Those investors who are diligently saving will need to think ahead so they can properly manage their tax-deferred accounts when they reach their 70s and 80s. Revisiting the Roth 401(k) ATRA introduced new provisions allowing for more flexibility in Roth accounts, which not only grow tax-free, but also may be withdrawn tax-free provided certain requirements are satisfied. Individuals may convert a traditional 401(k) or 403(b) plan to a Roth 401(k) under certain conditions: if one is offered by their employer, and if conversions are allowed. Previously, most conversions were only allowed for those who met the distribution requirements of their employer s plan. Typically, a distribution was allowed in any of the following situations: If they left that employer, reached age 59½, or upon their death or disability. Anyone planning to convert to a Roth should be careful about doing so with a lump sum as it may bump them into a higher tax bracket. While a Roth may not be the answer for every investor, it does offer some potential benefits for tax planning and wealth accumulation. It may be especially attractive for taxpayers who are currently in a lower income tax bracket but expect to be subject to a higher rate in the future. Note that since ordinary income tax will be due on the entire amount of pre-tax Exhibit Savings Limits Are Your Maximizing Your Savings? Plan Type 2014 Savings Limit Key Benefits 401(k), 403(b) and 457 plans $17,500 (additional $5,500 for those over 50) Potential employer match; tax-deferred savings Traditional and Roth IRAs* $5,500 (additional $1,000 for those over 50) Tax-deferred savings; exempt from NII surtax Roth 401(k) $17,500 (additional $5,500 for those over 50) Pay taxes now vs. later when your tax bracket may be lower Defined benefit plans Limits are based on future forecasted payouts Good vehicle for sole proprietors to accumulate pre-tax funds quickly *Income limits for a Roth IRA are AGI of less than $129,000 (single filers) or $191,000 (married, filing jointly). Contributions are phased out for AGIs between $114,000-$129,000 (single filers) or $181,000-$191,000 (married, filing jointly). 3

4 rollover, it is important to have sufficient assets outside the Roth to cover this tax liability. Taxpayers contemplating such a conversion should consult with their tax advisors to determine if it makes sense, how much to convert and when is the best time to do so. While tax-deferred saving is critical in today s environment, it also is important to maintain a balance between tax-deferred and taxable accounts. Overweighting the tax-deferred bucket could result in higher taxes during retirement, as taxes become due on large distributions from the tax-deferred accounts. This can be particularly problematic after reaching age 70½, when RMDs are required for all but Roth accounts. Asset location, discussed in the next section, outlines some key methods to optimize tax-deferred and taxable accounts. Asset Location: Employing the Optimal Account for Each Investment Asset location involves the distribution of assets and asset classes within different types of accounts and entities to optimize an investor s overall after-tax results. Given the changing tax landscape, retirement investors can best maximize their portfolios growth potential by considering factors such as tax efficiency and time horizon when deciding where to place assets among differing account types. While asset location decisions can be complex, simply put, the goal is to place investments most likely to incur higher taxes (i.e., those with higher capital gains potential) in investment accounts that afford tax-deferred protection. Exhibit 3 offers a barbell guide to locating assets in the most appropriate accounts for the maximization of after-tax wealth. While an investor s unique financial situation must be considered, Exhibit 3 provides general rules of thumb and a starting point for dividing asset classes among accounts after determining an overall asset allocation strategy. Short-term and corporate bonds (including high yield bonds), which have the highest yield but are subject to ordinary income tax, receive the most benefit from deferred taxes when placed in a tax-deferred account. Assets such as REITs, hedge funds and actively-managed equities have the potential for high returns but also frequently make significant taxable distributions. Thus, these asset types are less tax-efficient and also should be considered as appropriate assets for taxdeferred accounts. Meanwhile, tax-efficient assets, such as large cap equities purchased to hold for the medium to long term, often are better placed in a taxable account. Likewise, it may make sense to place stocks that pay little or no dividends in taxable accounts, as their return is derived primarily from capital appreciation and taxes are deferred until the owner realizes the gains. One asset class that always should be placed in a taxable account is municipal bonds; there is no reason to position them in a tax-deferred account. Exhibit 3 Identifying the Optimal Location for Retirement Assets Tax-Deferred Accounts Taxable fixed income: Corporate bonds, highyield bonds, short-term bonds Taxable Accounts Tax-efficient equities: Large cap tax-efficient stocks Tax-Deferred Accounts Tax-inefficient equities: Dividend-paying stocks, actively-traded equities, small caps, emerging markets equities, REITs, hedge funds Source: BNY Mellon Wealth Management 4

5 Additional Strategies to Consider: Life Insurance Another option for retirement planning may be the use of cash value life insurance that exceeds the amount traditionally purchased for mortality protection. Loans taken from such policies are not usually subject to income tax, thus providing a tax-efficient source of funds. However, this only makes sense if the projected tax savings exceed the insurance costs. Conclusion: The Time to Start is Now Many people are not prepared for retirement, and the task of saving has become increasingly complicated. Saving for tomorrow should be a lifelong endeavor in which investors continually review their plans and their future income needs. Investors should reset their expectations and think realistically and carefully about what the future holds. They should keep their focus on optimizing their savings during their working years, with an eye toward tax-efficient strategies. While retirement planning today is nothing like that of the previous generation, the old adage to save early, save often, remains a sound approach. At BNY Mellon Wealth Management, we work with pension plans, mutual funds, institutions, advisors and individuals to understand the complex and evolving needs of investors who are planning for tomorrow against a rising tide of challenges and changes. As a global company with expertise, resources and vision, we re also thinking about the solutions from all sides. To learn more about retirement solutions from BNY Mellon Wealth Management, please visit bnymellonwealthmanagement.com. 1 Preparing for Retirement in America, 2013 Retirement Confidence Survey, Employee Benefit Research Institute. 2 For simplicity purposes, all references to Modified Adjusted Gross Income (MAGI) have been changed to Adjusted Gross Income (AGI). MAGI for the purposes of ATRA and the healthcare legislation is adjusted gross income, less the foreign income exclusion, applying to U.S. workers overseas. This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. Pursuant to IRS Circular 230, we inform you that any tax information contained in this communication is not intended as tax advice and is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein The Bank of New York Mellon Corporation. All rights reserved. 5 Rev. 6/2014 [368]