The Tax Distinction

Although many retirement plan recordkeepers, and the advisers who work with them, offer a fairly broad and deep level of financial education, this is not normative, says Don Calcagni, chief investment officer (CIO) with Mercer Advisors in Denver.

When it comes to the subject of taxes, “many retirement plan advisers, when advising participants, will typically stick to ‘what you can and cannot do and how the various vehicles work’—for example, when you’d want to fund a Roth 401(k) versus making pretax deferrals to a 401(k),” Calcagni says. “Advisers should not tell [all] participants to diversify across two different tax buckets, because that’s a bit of a value judgment without having done an in-depth financial plan and tax review for each individual plan participant. In my view, that would be tantamount to giving personalized tax advice.”

At Mercer Advisors, Calcagni says, participants are educated on their options: “‘Here are two different components of your plan; here’s how they work; here’s where it may be a good idea to consider funding one versus the othdeer.’ We’re at least giving them some insight into what context makes sense when the options are compared. And unless the participant has engaged us directly for financial planning or tax advisory services, that’s where it stops. Many plan advisers will direct people to have that conversation with their CPA [Certified Public Accountant]. But advisers are raising awareness of the issue, and if participants act on [the issue], it’s a completely different matter.”

Colleen Carcone, director of Wealth Planning Strategies for TIAA in Boston, agrees. “For specific advice, plan participants should work with tax or general counsel.” But there are concepts about which participants can be educated, Carcone says. “We do seminars that plan sponsors can promote to employees. Topics include when to take Social Security and how to recreate income, which includes information about taxation,” she says.

According to Jim Pendergast, senior vice president of lending company altLINE, a division of The Southern Bank Co., in Birmingham, Alabama, participants ideally should be made to understand the two main types of tax-advantaged plans: tax deferred and tax exempt. They could be explained as simply as: “‘A tax-deferred account means you pay income taxes on the money you withdraw from an account when you actually withdraw it, not when you put it in. This is how vehicles such as traditional IRAs [individual retirement accounts] and most DC [defined contribution] plans work, making them extremely popular retirement accounts for Americans and businesses,’” he says.

“Tax exempt is the opposite side of the coin,” Pendergast would continue. “‘Here, any contributions you make into the account in the first place are after-tax income. So, you don’t pay taxes when you withdraw from the account, and any earnings or growth in that account remain tax-free as well, versus other accounts where you must pay capital gains taxes. Any account in which employees are invested in company stock incurs capital gains taxes. You will pay taxes on the difference in the value of the stock between the time of purchase and of sale. The most common tax-exempt account type is a Roth.’” This explains the concepts without giving advice, he says.

Several advisers share such information in a PowerPoint, short video on their website or in some other electronic medium.

A further source of retirement income to discuss with participants is Social Security. What to make clear about this tax-deferred government benefit will depend somewhat on the employee audience. “[Lower-paid] employees won’t pay taxes on Social Security if it’s their only source of income during retirement and if it’s too low to be taxed,” says Ben Reynolds, CEO and founder of Sure Dividend in Houston. “If an employee has a pension also, he may have to pay taxes on Social Security income if it totals $25,000 or more. This limit is different for those who are married.”

Plan Sponsor Council of America (PSCA) research finds that the concept of retirement planning is growing in importance with plan sponsors, surpassing interest in increasing plan participation, according to Aaron Moore, senior vice president, head of client engagement for retirement plan services at Lincoln Financial Group in Philadelphia.

“For the most part, we see plan sponsors offering educational seminars about taxes like they do for Social Security, providing tax information but not tax advice. The content can be made available in print,” Moore says. “We encourage participants to seek the advice of a tax professional.”

Savings Decisions

Before making any other savings decisions, the first thing participants should think about is maxing out the employer match, Moore says.

Then, to decide how to allocate savings among different types of accounts—Roth, a health savings account (HSA), options outside of the employer plan—participants need to consider where their income will come from in retirement—Social Security, an employer-sponsored defined contribution (DC) or defined benefit (DB) plan, or other assets—and what their tax rate is now compared with what it could be in the future.

But correctly predicting whether one’s tax rate will be higher or lower in retirement is difficult, Moore observes, and this can be pointed out: “Generally, the younger you are, the more your earning power will increase over your career, so, if you’re closer to the beginning of your career, it’s more likely your tax rate in retirement will be higher.” For those reasons, some people will “choose to allocate between pretax and Roth as there’s no predictability, and they might want flexibility in retirement,” he says.

Establishing a Distribution Strategy

When setting a course for how to take distributions, participants should know to factor in sources of income beyond their employer-sponsored plan, Carcone says, and also which ones will be taxed—e.g., some parts of after-tax, not-Roth accounts, stock sales that reveal capital gains and interest earned in bank accounts, for which the retiree will pay income tax. “Participants should look at all income sources so they can coordinate a tax strategy.”

It can be noted that, when a person retires, being able to withdraw from a tax-free source of money keeps him out of a higher tax bracket, Moore says. And “it also helps savings last because the retiree isn’t giving up so much in taxes.”

When helping participants develop a distribution strategy, it is key to remind them that managing tax liability is “a year-by-year thing,” Moore says. “It’s variable over the course of retirement. Expenses may be greater at the beginning of retirement, or later. How will taxes change when the retiree starts getting Social Security or has to take RMDs [required minimum distributions]? Retirees will have to adapt their strategies to their unique needs,” he says.

“While advisers can provide education, participants should be encouraged to work with qualified tax professionals,” Carcone reiterates. It’s a complex area where advisers and sponsors could get into inadvertent trouble. They need to make the right education available.”

Art by Lily Padula