- Older or ill investors might consider deferring capital gains until they pass, thereby saving heirs significant amounts in taxes otherwise due.
- Stay healthy or be generous: Health-care and charitable expenses can shave your tax bill.
- Employ "tax location optimization" strategies.
Financial advisors can deploy a variety of strategies to decrease the toll that taxes can take on retiree clients' portfolios. The following are three areas of focus.
Income: Sources and timing of income can affect tax liability.
Retirees with large taxable investment accounts should utilize qualified dividends, long-term capital gains and tax-free municipal bond income, said James A. Daniel, certified financial planner and owner of The Advisory Firm.
"For the stock side of the portfolio, the dividend income should focus on dividend paying stocks," he said. "Either in the zero percent tax bracket, if taxable income falls below the 25 percent marginal rate, or 15 percent, if taxable income falls below the 39.6 percent marginal rate."
For taxable gains, Daniel continued, "if the account owner limits any gains taken to those they have held longer than 12 months, the long-term capital gains tax is identical to the dividend rates above."
Finally, Daniel advises investors use tax-free municipal bonds to balance their stock allocations with bonds in a taxable portfolio bonds.
Deferring capital gains can protect inheritances, according to Kevin Reardon, CFP and president of Shakespeare Wealth Management.
Upon death, every person receives a "step up" in basis, thereby eliminating capital gains on appreciated assets, he said.
"When someone passes away, the cost basis of an asset is raised to the market value at the time of death," Reardon said. "For older or sickly clients, it may make sense to defer taking capital gains until they pass.
"In a recent client situation, we saved [some clients] over $100,000 in taxes for the heirs by not selling appreciated securities."
Expenditures: Paying health-care expenses and making charitable contributions can offer beneficial tax strategies.
Those who have non-qualified annuities can use them to pay long-term care premiums, Reardon said. "Although withdrawals from annuities are taxable income, you can direct assets out of your non-qualified annuities to pay for long term care premiums and these 'transfers' aren't taxable."
Kevin Brosious, CFP, certified public accountant and president of Wealth Management, recommends that people with high-deductible health-care plans fully fund their health savings account, up to the annual limit of $6,750 per family. "The health savings account is a super IRA," he said. "It allows the participant to contribute pretax into the plan and if the money is eventually used for medical expenses, the withdrawals are not taxed."
Qualified charitable distributions are useful tools for reducing a client's tax bill, said Steven Elwell, CFP and partner and vice president at Level Financial Advisors. This strategy, under certain circumstances, allows them to donate their required minimum distributions directly to charity.
"This reduces the amount of adjusted gross income shown on your tax return, which in turn may allow you to stay below certain income limits affecting Medicare premiums," he said.
Asset location: Tax location optimization is a strategy whereby people with individual retirement accounts, Roth IRAs and non-retirement brokerage accounts are conscious of which account they house each type of investment while still achieving their overall portfolio target mix, Elwell said.
"An example would be a target mix of 50 percent stocks and 50 percent bonds," he said. "We could buy the bonds, which pay ordinary dividends, within the IRA, and buy the stocks, which pay qualified dividends and long-term capital gains, within the Roth IRA and non-retirement accounts."
The key is that, in general, stocks grow faster than bonds, Elwell said, so that, in theory, the Roth and non-retirement accounts grow more quickly. Therefore, the investments with the largest gains are being earned tax-free inside a Roth and receiving qualified dividend and long term capital gain treatment inside the non-retirement accounts. The regular IRA is growing more slowly, so the taxable RMDs will be smaller.
Because recent retirees often defer Social Security benefits until age 70 and RMDs begin at age 70½, many wealthy couples have a "doughnut hole" in their taxable income between ages 66 and 70, said Louis Kokernak, CFP and principal of Haven Financial Advisors. This opens the door to moderate size Roth conversions between those ages.
"Most of my clients have accumulated significant assets in taxable accounts that can fund expenses in the early years of retirement," Kokernak said. "These joint taxable accounts could generate a lot of cash with minimal tax liability by selling securities with a high-cost basis and then opening Roth accounts."
This could result in significant tax savings over time, he said. For example, a married couple filing jointly pays tax at a 15 percent rate on income up to $76,000, which jumps to 25 percent at the next level.
"Why not pay some taxes in early retirement, while the couple's tax burden is relatively low?" Kokernak asked. "In effect, they are redistributing assets from their traditional IRAs and 401(k) plans early to take advantage of their lower tax liability in early retirement."
— By Deborah Nason, special to CNBC.com