Practical Considerations in Tax-Efficient Distribution Planning

1. Are there times when it makes sense to exceed a target EMR?

Elsasser: One of the central challenges that tax-efficient withdrawal planning seeks to alleviate is an excess of IRA money. IRA money in general is inflexible once required minimum distributions begin, is taxed at higher rates than other types of income and impacts the tax clients pay on Social Security and preferential income such as long-term capital gains and qualified dividends. Target EMRs are selected based on a lifetime simulation that makes assumptions about portfolio growth, client longevity, and future tax rates. In the real world, none of these assumptions will be perfect. As a result, an advisor can and should have conversations with clients each year when an additional amount could be withdrawn from an IRA or converted to Roth at an EMR that only slightly exceeds the target EMR. Some circumstances that might cause an advisor to intentionally exceed a target rate, such as a known near-term expense or a market correction.

Pfau: The market correction is an interesting point. To the extent that markets tend to increase over time, a market downturn can represent an opportunity to convert shares to a Roth while they are worth less and generate less taxable income. Of course, it is necessary to have a source for paying the taxes that has not also declined as well, such as cash that the household may have sitting on the sidelines. Growth in a Roth is highly preferred to growth in an IRA. While it is still important to ensure that the client doesn’t step into any of the apparent tax traps, it can make sense to convert dollars that are slightly above a target EMR or to time at least a partial Roth conversion early in the year, without a clear picture of the other incomes that will materialize throughout the year.

2. Are there times when it makes sense to do conversions at a rate higher than the beneficiary’s tax rate?

Pfau: Given a long enough time horizon and reasonably stable tax rates, the Roth will always outpace an IRA (because of the RMD) and a taxable account due to tax drag on capital gains, dividends, and interest. For younger retirees, the time to compound tax free can be well over 30 years. Given those considerations, there are situations in which converting at a tax rate greater than the projected beneficiary tax rate will make sense.

3. When should you intentionally exceed a current Income Related Monthly Adjustment Amount (IRMAA) threshold?

Elsasser: One of the biggest challenges in planning for IRMAA thresholds is that they are unknown at the time you must act because both the threshold and the penalty amount will be determined based on inflation two years after the current tax year. If there is no inflation, the IRMAA thresholds could be the same as they are today. If there is high inflation, there could be substantially more room for withdrawals or conversions than projected. The safest approach for IRMAA thresholds is to operate as though the current year thresholds will remain the same for the following two years. But that approach would frequently create lower conversion amounts than would be possible using an inflation assumption. If you use an inflation assumption, be sure the client understands that it is a projection and it is possible that they will exceed the thresholds two years later.

Pfau: In the EMR method, IRMAA premium surcharges appear as spikes on a tax map because the first dollar that exceeds a threshold causes the entire additional premium to be applied. For example, the first IRMAA threshold (MAGI of $206,001 for those married filing jointly in 2024) creates an effective marginal rate for a couple of 197,040% (additional Part B premiums of $838.80 and Part D of $154.80 per person). When applied to a single dollar over the threshold, it seems that IRMAA thresholds would be prohibitive to conversions. But the EMR on conversion amounts immediately above the IRMAA threshold may drop back to a much lower rate. When that happens, it’s useful to consider the IRMAA premium averaged in with the amounts in each subsequent segment as advisors will often find that accepting the increased premium is worth the deferred impacts of reducing RMDs, reducing tax on Social Security benefits, or avoiding net investment income tax. These can more than offset the cost of paying the additional premium now.

Jarvis: Tax planning often is discussed in terms of quantifiable tax savings, which are great, but not the only source of value when it comes to filling up a tax-free bucket through Roth conversions. The less-often talked about benefit of a tax-free bucket is the flexibility that is created. Unexpected things happen in life and some of those require large sums of money. Those could include needing to replace a roof or paying for large medical bills. On the lighter side, sometimes plans change and a lump sum of money could become necessary for something fun like an RV or an around-the-world trip with family. In either case, having funds in a Roth, a tax-free bucket, creates the flexibility to access savings without worrying about getting killed in taxes along the way.

Since Roth accounts do not have RMDs for the original account holder and are tax free at the time of withdrawal in nearly every case, they create flexibility that cannot be duplicated by pre-tax or taxable accounts.

One concern that is often raised related to converting to a Roth is the impact on Medicare premiums through IRMAA. IRMAA is a consideration in assessing Roth conversions but often not as limiting as people believe. IRMAA changes are also not absolute. Normally there is a two-year lag between income exceeding IRMAA thresholds and Medicare premiums changing. If in that two-year period the taxpayer experiences a “life-changing event” (these include marriage, divorce or annulment, death of a spouse, work stoppage or reduction, a loss of income producing property (not due to sale) a loss of pension income, or an employer settlement payment), they can appeal to allows them to estimate their future income instead of using the higher year in which the event happened (or the year immediately previous to it). This appeal is accomplished through form SSA-44.

4. How do tax-efficient withdrawal plans evolve over time?

Elsasser: Throughout retirement, client account balances, spending needs, and tax rates will change, which will cause the forward expectations for one’s tax burden to change. As a result, advisors should complete an analysis each year to establish a new target tax rate for conversions based on updated information.

Pfau: Though all projections assume some level of tax rate continuity, tax rates have varied significantly over the years. Forward simulations that establish a target tax rate are thus based on the best information that is available at the time. In addition to annual updates to account for changing account balances and spending patterns, advisors should consider the possibility of changes to tax provisions.

5. When should advisors complete Roth conversions?

Elsasser: From a practical perspective, November and December are the key months for finalizing Roth conversions because you can more accurately project the total capital gains, dividends and interest in the non-qualified account at this time, and you will have a firm view of the client’s other income and deductions. Prior to the passage of the Tax Cuts and Jobs Act in 2017, a conversion could be “undone” by recharacterization. Now, a conversion that is completed early in the year could turn out to be an unfixable mistake if the client had surprise income or a larger-than-expected capital gain. When significant market events occur mid-year, consider completing some conversion early, so long as you have a level of certainty that you will have some additional room at the end of the year.

Jarvis: For taxpayers expecting to complete large Roth conversions, it can make sense to have a plan for the year and then execute it in stages depending on the performance of the market throughout the year. Specifically, we are trying to take advantage of inevitable dips in the market without falling victim to trying to "time the market." For example, if a client is planning to convert $100,000 to a Roth during the year, working out ahead of time that if the market falls by a set amount, let's say 10%, then at that time we would convert $50,000 to take advantage of the downswing to pay less in taxes to get the money into the Roth. The rest of the conversion would be saved until later in the year when more of their income is certain. But by converting a portion as the market goes down, we've quantitatively put ourselves ahead and qualitatively we've scratched the itch that every investor has to "do something" when they feel helpless watching their account balance go down.

6. What information should the advisor request from the client?

Elsasser: Tax-efficient distribution planning is very difficult if not impossible without complete information about what is happening in a client’s financial life. To be effective, the advisor needs capital gain and loss information for all accounts, including an estimate of any potential phantom capital gains, a reasonable estimate of all deductions, information on all income sources including pensions, work income, and other incomes, and any withdrawals from accounts. This information is considerably easier to gather for accounts managed by the advisor, so many advisors will provide these services only in situations where they are managing all the client’s accounts. Even in that case, the advisor should have a process to validate that the information is complete and there are no additional accounts or income and get client sign-off that the information is complete before making any recommendations.

7. How should advisors prepare CPAs for the advisor’s process?

Jarvis: Clients typically ask tax professionals for something completely different than financial advisors: “Save me taxes now!” Taxpayers are routinely trained to think of ”winning” at tax time, such as getting a huge refund. That is the expectation clients have of their tax professional. This means that most tax professionals will err on the side of deferring taxes. This also means that they will object (at times aggressively) to anyone who creates tax payments intentionally, including through Roth conversions.

Advisors need to understand this context so that when they are working with clients on income accelerating planning opportunities, like Roth conversions, they are setting clear expectations with the client and opening the lines of communication early with the tax professional. One of the easiest ways to avoid a fight come tax time is to make sure the advisor is helping the client pay any taxes created by the Roth conversion. Whether that is through withholding or an estimated payment, don’t leave it up to the client to remember there will be taxes due with their tax filing.

Roth conversions are not a time for cute analogies. Advisors need to make it crystal clear to their clients that executing a Roth conversion is going to make taxes go up, and that is a good thing! “We are giving the IRS their slice of the pie now so they can’t ask for more later.” Building relationships with tax professionals outside of their filing season is another important step in this process so tax professionals see the advisor as a peer and not an adversary.

8. What information should the advisor request from the CPA?

Jarvis: Always start with data. This means copies of filed tax returns, so the advisor doesn’t have to guess where the client is starting from before the Roth conversion enters the picture. For most taxpayers, their own tax return is like a foreign language. No tax planning happens in a silo, so it’s important to know the moving pieces that might be involved in the decision to convert to a Roth, and reviewing an actual tax return is the best way to ensure the advisor is working with accurate numbers. Clients mean well, but an advisor should never take their word for what was on last year’s tax return. The tax return is a treasure trove of useful information, specifically when Roth conversions are being considered.

The next level up is asking the tax pro for their input on the outcome of a Roth conversion. This is going to be more effective with tax pros an advisor already has a relationship with. Timing is critical (ask during the calendar year and not at filing time). Wording is critical too; don’t ask an open-ended question like “Should this client do a Roth conversion?” Be specific and reinforce the value of a Roth conversion in general: “I am working with a shared client to fill their tax-free bucket and want to make sure we help them get all the related taxes paid. We are considering a $50,000 conversion and based on their most recent tax return are planning to set aside $11,000 for taxes. Anything you think I should be considering on that?”

9. What information should the advisor communicate to the CPA?

Jarvis: Even in situations where an advisor has a strong relationship with their client’s tax pro and is communicating with them throughout the year, one of the best ways to set the client up for success come filing season is to send a year-end tax summary letter (“1099 letter”) to the client in January. Financial advisors have better access to information surrounding investment and retirement accounts than the tax pro. The actual 1099s sent by the account custodians don’t have enough data to ensure the tax return gets filed correctly. In my experience, here are the best practices for preparing and sending an effective 1099 letter:

• The letter should be sent in mid- to late January, after the end of the year but before tax pros are fully into tax-prep mode.

• The letter should be sent to the client but written so they can just give a copy to their tax pro (and the advisor needs to encourage them to do just that).

• The letter should list all accounts the advisor manages and what type of tax reporting forms the client should expect that year. Be sure to use the terminology the custodian will list on the form, i.e. “year-end tax summary” and not simply “1099” so the client knows what to look for.

• Include accounts that closed during the year since they will still kick out 1099s. Review all activity for the year and not just 12/31 balances.

• The letter should list any planning that was done that will not be obvious on the 1099 including Roth conversions, rollovers, qualified charitable distributions, etc.

• Include the date and amount of Roth conversions to help with proper reporting and to help avoid underpayment penalties on large Roth conversions that were completed near the end of the year.

• The letter should make it clear that the advisor is more than happy to answer questions and provide additional information to help the tax-filing process (this is a great way to build relationships with the tax pro).

• Do a test run of gathering and sending the data in December to make sure they and their team are ready to execute in January.

10. How should the advisor validate the tax return reflects what happened?

Jarvis: The biggest piece of reporting that routinely gets missed around Roth conversions is page 2 of form 8606. This is the only place on the tax return that reports to the IRS where the IRA distribution ended up. For clients over the age of 59 1/2, whether the IRA distribution goes into their bank account or is converted to Roth doesn’t impact their tax situation in the year of the conversion (the amount is taxable either way). So the 8606 reporting is glossed over. This is a mistake because it fails to report the Roth basis to the IRS. It’s possible this will never cause an issue, but when the client starts withdrawing those Roth dollars tax free the IRS antennae are going up because “tax-free” is not what the IRS loves to see. Form 8606 allows us to establish the basis as the money goes in and not have to recreate years of account history if the IRS asks questions later.

The advisor should also see the distribution being taxed on line 4 or 5 of page 1 of form 1040. This can take a little bit of digging at times since these lines summarize all activity from IRAs and retirement accounts. It’s possible the Roth conversion will be buried with other transactions. As a best practice, advisors should be getting and reviewing their clients tax returns every single year, regardless of whether a Roth conversion was completed, to stay up to date with their client’s financial and tax situations.

Conclusion

It’s one thing to look at tax-efficient withdrawal patterns in a case study where the rules are rigid, the assumptions are constant and the expectation is that all parties involved are rational, provide perfect information to each other and understand each other precisely. In the real world, decision frameworks frequently act as guidelines that are influenced by emotion, preference, and ability to implement. Ultimately an educated advisor equipped with appropriate knowledge and tools will deliver considerable value to clients through tax-efficient withdrawal planning.

Wade D. Pfau, PhD, CFA, RICP® is a co-founder of the Retirement Income Style Awareness tool, the founder of Retirement Researcher, and a co-host of the Retire with Style podcast. He also serves as a principal and the director of retirement research for McLean Asset Management. He also serves as a research fellow with the Alliance for Lifetime Income and Retirement Income Institute. He is a professor of practice at the American College of Financial Services and past director of the Retirement Income Certified Professional® (RICP®) designation program. Wade’s latest book is Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success.

Joe Elsasser, CFP® is the founder and president of Covisum, a financial planning software company focused on retirement income related decisions and is a founding partner of Adaptive Advice, a Registered Investment Advisor. He co-authored Social Security Essentials: Smart Ways to Help Boost Your Retirement Income and has been a frequent contributor to a variety of industry publications.

Steven A. Jarvis, CPA, MBA, is CEO and head CPA of Retirement Tax Services, a tax firm dedicated to working collaboratively with financial advisors to deliver massive value through tax planning. Steven is an author, speaker, podcast host and in his personal life a self-proclaimed "adventurer." He has worked with thousands of advisors across the country and is a recognized voice on the topic of actionable tax planning. Steven freely shares a content through his weekly tax email newsletter and his daily posts on LinkedIn.

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