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IRA bridge could maximize Social Security benefits

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First, the good tax news. 

Clients approaching retirement can delay their future required minimum distributions — and accompanying income taxes — until they’re 73 rather than starting them at 72, as was the rule prior to the Secure 2.0 Act. In 2033, the first RMDs will fall back to 75.

Those changes will help pre-retirees lock in more tax-advantaged investment gains in their individual retirement accounts and build more wealth apart from Social Security.

The bad news is that they face the potential for much higher taxes in the future if they wait that long to begin taking the distributions into their taxable income.

More financial advisors and tax professionals with clients who are eligible for penalty-free IRA withdrawals as young as 59½ years old are considering how the distributions can be a bridge to claiming Social Security benefits later and avoiding so-called stealth expenses, according to four experts who spoke with Financial Planning. The approaching end of the year and the current federal tax brackets mean that it’s an especially timely topic of discussion.

The later the clients claim Social Security, the higher their monthly payments will be in retirement. At the same time, those benefits draw taxes for higher-income households that are also subject to higher Medicare costs. If the clients have built up healthy nest eggs in their traditional IRAs, those assets pose a complex planning opportunity with some built-in risks that can make a major impact on their retirement.

Sarah Brenner, the director of retirement education with Ed Slott and Company
Sarah Brenner is the director of retirement education with Ed Slott and Company.

Ed Slott and Company

“For a lot of people, their IRA is one of their biggest assets, if not their biggest asset,” Sarah Brenner, the director of retirement education with retirement consulting firm Ed Slott and Company, said in an interview. “It makes sense to use this taxable money earlier. It makes sense to use this money as a bridge.”

She and the other experts stressed that the bridge depends on any number of factors that are part of the retirement mix. The strategy also represents a departure from “the old regime,” which held that advisors and their clients should “defer, delay” and “wait until the bitter end” when they were obligated to receive the IRA distributions, according to Heather Schreiber, the founder of advanced planning consulting firm HLS Retirement Consulting.

“Now we’ve had to change our logic about that,” she said. “We have to think about shifting the mindset of people to say, ‘How do we take our assets in a way that’s the most tax-efficient?”

READ MORE: 30 tax questions to answer by the end of the year

The essentials

Advisors and their clients will be looking especially closely at four categories of numbers to figure out whether to use the bridge, with their cash flow needs being the first basic question. 

They’ll need to know the size of their possible RMD — the quotient of their IRA balance divided by life expectancies issued by the IRS. Then they’ll weigh that amount against their Social Security benefit, which is based on their average earnings over as many as 35 years in the workforce and their timing for taking benefits as early as 62, at the full retirement age between 66 and 67, or as late as 70. That’s when there will no longer be an advantage to waiting to claim the benefits.

If those considerations weren’t enough, they’ll need to remember that roughly 40% of Social Security beneficiaries pay federal taxes on the payments they receive and those in some areas must pay state duties on them as well. At the federal level, as much as 85% of the benefits are taxable for individuals with more than $34,000 in “combined income” or joint filers with $44,000. Medicare adds another layer of questions, since any possible Income Related Monthly Adjustment Amounts (IRMAA) with their monthly premiums are tied to income as well.

Each of the permutations could look different through, say, converting the IRA to a Roth to avoid the question of RMDs entirely for the rest of the client’s life while also paying the taxes for the switch. A qualified charitable distribution from an IRA could provide another way around the additional income from the mandatory withdrawal.

Erin Wood, a senior vice president for financial planning and advanced solutions with Omaha, Nebraska-based registered investment advisory firm Carson Group
Erin Wood is a senior vice president for financial planning and advanced solutions with Omaha, Nebraska-based registered investment advisory firm Carson Group.

Carson Group

The stealthiness of the tax and expenses comes from their interaction across income brackets, healthcare costs, RMDs and other areas, according to Erin Wood, a senior vice president for financial planning and advanced solutions with Omaha, Nebraska-based registered investment advisory firm Carson Group.

“All of these things end up being connected together,” she said. “It does surprise people if they’re in a different position than they thought they would be in.”

For some clients, unexpected health problems could put them in that type of bind in which they may need to tap the Social Security benefits right away, according to Valerie Escobar, a senior wealth advisor with Kansas City, Missouri-based advisory practice BMG Advisors. For others, they may wish to keep earning tax-free yield in their IRAs and claim benefits sooner as well, she noted. A third group could opt to use earlier withdrawals as a bridge to wait until 70 for Social Security to get the maximum benefits possible.

Valerie Escobar, a senior wealth advisor with Kansas City, Missouri-based advisory practice BMG Advisors
Valerie Escobar is a senior wealth advisor with Kansas City, Missouri-based advisory practice BMG Advisors.

Valerie Escobar

“I know that if I can wait as long as possible, then 8% growth is going to be credited to me,” Escobar said. “It is a way to offset the risk. You’re putting it on the government and not having to make it on your own investment dollars.”

READ MORE: The post-‘stretch’ home stretch for Roth IRA conversions

Timely questions

In general, the last quarter marks a good time for completing any RMDs or other withdrawals or planning them for next year. The new rules under Secure 2.0 lent another reason for a fresh look at a clients’ options and mandates, according to Brenner.

“Roths are more important than ever,” she said. “They can access that completely tax-free during their retirement.”

The expiration date of many provisions of the Tax Cuts and Jobs Act of 2017 at the end of 2025 tacked on more incentive to convert to a Roth or take distributions under brackets that may revert to their previous, higher rates in 2026, Shreiber noted.

“Do you wait or do you take advantage?” she said. “These years — especially this year and next — are really pivotal opportunity years to consider doing that.”

The current lower rates may act as a “big, big savings opportunity to take advantage of now,” Wood agreed, noting that another shift in IRA guidelines from Secure 2.0 in 2025 and beyond will give clients between the ages of 60 and 63 a chance to make larger so-called catchup contributions to their accounts. Those “can be gold mines for getting extra money saved as well,” but advisors and their clients must find the right balance with their future taxes, she said.

“How much income you have in every given year is the difference between being in a higher tax bracket and a lower tax bracket and what level your Social Security is going to be taxed at as well,” Wood said.

READ MORE: Planning for 2025’s tax brackets and retirement rules

Avoid these mistakes by planning

All of the experts pointed out that clients could get a double whammy from higher taxes and lower benefits by claiming Social Security while still working full- or part-time. The significant hit to benefits offers another rationale for using the bridge strategy to claim later or simply to think through the RMDs far in advance.

“It gives you much more flexibility,” Escobar said. “It allows your model to be able to have more options when you’re planning it all out for your clients.”

Advisors should guide clients through the decision about when to take IRA distributions and claim Social Security by assisting them in avoiding two of the most common mistakes, according to Shreiber. 

The first comes from underestimating how long they’ll live in general and in retirement. The second revolves around the possible negative impact of a “widow’s penalty” in the form of “substantially lower income” for a surviving spouse when there is a significant disparity between their earnings and ages and the older one took Social Security benefits early, she said.

Heather Schreiber, the founder of advanced planning consulting firm HLS Retirement Consulting
Heather Schreiber is the founder of HLS Retirement Consulting.

HLS Retirement Consulting

Talking to clients early and often about the bridge strategy and other tools that may be at their disposal in their retirement can set them up for financial security down the line.

“I tell advisors all over the country that consumers need them — they need them as their advocates on this. They go to Social Security and oftentimes come out more confused than they went,” Shreiber said. “They need help. They really need advocates, and they’re searching for them. So this is an opportunity for advisors to really help their clients by getting more educated about Social Security.”

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Senate unveils plan to fast-track tax cuts, debt limit hike

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Senate Republicans unveiled a budget blueprint designed to fast-track a renewal of President Donald Trump’s tax cuts and an increase to the nation’s borrowing limit, ahead of a planned vote on the resolution later this week. 

The Senate plan will allow for a $4 trillion extension of Trump’s tax cuts and an additional $1.5 trillion in further levy reductions. The House plan called for $4.5 trillion in total cuts.

Republicans say they are assuming that the cost of extending the expiring 2017 Trump tax cuts will cost zero dollars.

The draft is a sign that divisions within the Senate GOP over the size and scope of spending cuts to offset tax reductions are closer to being resolved. 

Lawmakers, however, have yet to face some of the most difficult decisions, including which spending to cut and which tax reductions to prioritize. That will be negotiated in the coming weeks after both chambers approve identical budget resolutions unlocking the process.

The Senate budget plan would also increase the debt ceiling by up to $5 trillion, compared with the $4 trillion hike in the House plan. Senate Republicans say they want to ensure that Congress does not need to vote on the debt ceiling again before the 2026 midterm elections. 

“This budget resolution unlocks the process to permanently extend proven, pro-growth tax policy,” Senate Finance Chairman Mike Crapo, an Idaho Republican, said. 

The blueprint is the latest in a multi-step legislative process for Republicans to pass a renewal of Trump’s tax cuts through Congress. The bill will renew the president’s 2017 reductions set to expire at the end of this year, which include lower rates for households and deductions for privately held businesses. 

Republicans are also hoping to include additional tax measures to the bill, including raising the state and local tax deduction cap and some of Trump’s campaign pledges to eliminate taxes on certain categories of income, including tips and overtime pay.

The plan would allow for the debt ceiling hike to be vote on separately from the rest of the tax and spending package. That gives lawmakers flexibility to move more quickly on the debt ceiling piece if a federal default looms before lawmakers can agree on the tax package.

Political realities

Senate Majority Leader John Thune told reporters on Wednesday, after meeting with Trump at the White House to discuss the tax blueprint, that he’s not sure yet if he has the votes to pass the measure.

Thune in a statement said the budget has been blessed by the top Senate ruleskeeper but Democrats said that it is still vulnerable to being challenged later.

The biggest differences in the Senate budget from the competing House plan are in the directives for spending cuts, a reflection of divisions among lawmakers over reductions to benefit programs, including Medicaid and food stamps. 

The Senate plan pares back a House measure that calls for at least $2 trillion in spending reductions over a decade, a massive reduction that would likely mean curbing popular entitlement programs.

The Senate GOP budget grants significantly more flexibility. It instructs key committees that oversee entitlement programs to come up with at least $4 billion in cuts. Republicans say they expect the final tax package to contain much larger curbs on spending.

The Senate budget would also allow $150 billion in new spending for the military and $175 billion for border and immigration enforcement.

If the minimum spending cuts are achieved along with the maximum tax cuts, the plan would add $5.8 trillion in new deficits over 10 years, according to the Committee for a Responsible Federal Budget.

The Senate is planning a vote on the plan in the coming days. Then it goes to the House for a vote as soon as next week. There, it could face opposition from spending hawks like South Carolina’s Ralph Norman, who are signaling they want more aggressive cuts. 

House Speaker Mike Johnson can likely afford just two or three defections on the budget vote given his slim majority and unified Democratic opposition.

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How asset location decides bond ladder taxes

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Financial advisors and clients worried about stock volatility and inflation can climb bond ladders to safety — but they won’t find any, if those steps lead to a place with higher taxes.

The choice of asset location for bond ladders in a client portfolio can prove so important that some wealthy customers holding them in a taxable brokerage account may wind up losing money in an inflationary period due to the payments to Uncle Sam, according to a new academic study. And those taxes, due to what the author described as the “dead loss” from the so-called original issue discount compared to the value, come with an extra sting if advisors and clients thought the bond ladder had prepared for the rise in inflation.

Bond ladders — whether they are based on Treasury inflation-protected securities like the strategy described in the study or another fixed-income security — provide small but steady returns tied to the regular cadence of maturities in the debt-based products. However, advisors and their clients need to consider where any interest payments, coupon income or principal accretion from the bond ladders could wind up as ordinary income, said Cal Spranger, a fixed income and wealth manager with Seattle-based Badgley + Phelps Wealth Managers.

“Thats going to be the No. 1 concern about, where is the optimal place to hold them,” Spranger said in an interview. “One of our primary objectives for a bond portfolio is to smooth out that volatility. … We’re trying to reduce risk with the bond portfolio, not increase risks.”

READ MORE: Why laddered bond portfolios cover all the bases

The ‘peculiarly bad location’ for a bond ladder

Risk-averse planners, then, could likely predict the conclusion of the working academic paper, which was posted in late February by Edward McQuarrie, a professor emeritus in the Leavey School of Business at Santa Clara University: Tax-deferred retirement accounts such as a 401(k) or a traditional individual retirement account are usually the best location for a Treasury inflation-protected securities ladder. The appreciation attributes available through an after-tax Roth IRA work better for equities than a bond ladder designed for decumulation, and the potential payments to Uncle Sam in brokerage accounts make them an even worse asset location.

“Few planners will be surprised to learn that locating a TIPS ladder in a taxable account leads to phantom income and excess payment of tax, with a consequent reduction in after-tax real spending power,” McQuarrie writes. “Some may be surprised to learn just how baleful that mistake in account location can be, up to and including negative payouts in the early years for high tax brackets and very high rates of inflation. In the worst cases, more is due in tax than the ladder payout provides. And many will be surprised to learn how rapidly the penalty for choosing the wrong asset location increases at higher rates of inflation — precisely the motivation for setting up a TIPS ladder in the first place. Perhaps the most surprising result of all was the discovery that excess tax payments in the early years are never made up. [Original issue discount] causes a dead loss.”

The Roth account may look like a healthy alternative, since the clients wouldn’t owe any further taxes on distributions from them in retirement. But the bond ladder would defeat the whole purpose of that vehicle, McQuarrie writes.

“Planners should recognize that a Roth account is a peculiarly bad location for a bond ladder, whether real or nominal,” he writes. “Ladders are decumulation tools designed to provide a stream of distributions, which the Roth account does not otherwise require. Locating a bond ladder in the Roth thus forfeits what some consider to be one of the most valuable features of the Roth account. If the bond ladder is the only asset in the Roth, then the Roth itself will have been liquidated as the ladder reaches its end.”

READ MORE: How to hedge risk with annuity ladders

RMD advantages

That means that the Treasury inflation-protected securities ladder will add the most value to portfolios in a tax-deferred account (TDA), which McQuarrie acknowledges is not a shocking recommendation to anyone familiar with them. On the other hand, some planners with clients who need to begin required minimum distributions from their traditional IRA may reap further benefits than expected from that location.

“More interesting is the demonstration that the after-tax real income received from a TIPS ladder located in a TDA does not vary with the rate of inflation, in contrast to what happens in a taxable account,” McQuarrie writes. “Also of note was the ability of most TIPS ladders to handle the RMDs due, and, at higher rates of inflation, to shelter other assets from the need to take RMDs.”

The present time of high yields from Treasury inflation-protected securities could represent an ample opportunity to tap into that scenario.

“If TIPS yields are attractive when the ladder is set up, distributions from the ladder will typically satisfy RMDs on the ladder balance throughout the 30 years,” McQuarrie writes. “The higher the inflation experienced, the greater the surplus coverage, allowing other assets in the account to be sheltered in part from RMDs by means of the TIPS ladder payout. However, if TIPS yields are borderline unattractive at ladder set up, and if the ladder proved unnecessary because inflation fell to historically low levels, then there may be a shortfall in RMD coverage in the middle years, requiring either that TIPS bonds be sold prematurely, or that other assets in the TDA be tapped to cover the RMD.”

READ MORE: A primer on the IRA ‘bridge’ to bigger Social Security benefits

The key takeaways on bond ladders

Other caveats to the strategies revolve around any possible state taxes on withdrawals or any number of client circumstances ruling out a universal recommendation. The main message of McQuarrie’s study serves as a warning against putting the ladder in a taxable brokerage account.

“Unsurprisingly, the higher the client’s tax rate, the worse the outcomes from locating a TIPS ladder in taxable when inflation rages,” he writes. “High-bracket taxpayers who accurately foresee a surge in future inflation, and take steps to defend against it, but who make the mistake of locating their TIPS ladder in taxable, can end up paying more in tax to the government than is received from the TIPS ladder during the first year or two.”

For municipal or other types of tax-exempt bonds, though, a taxable account is “the optimal place,” Spranger said. Convertible Treasury or corporate bonds show more similarity with the Treasury inflation-protected securities in that their ideal location is in a tax-deferred account, he noted.

Regardless, bonds act as a crucial core to a client’s portfolio, tamping down on the risk of volatility and sensitivity to interest rates. And the right ladder strategies yield more reliable future rates of returns for clients than a bond ETF or mutual fund, Spranger said.

“We’re strong proponents of using individual bonds, No. 1 so that we can create bond ladders, but, most importantly, for the certainty that individual bonds provide,” he said.

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Why IRS cuts may spare a unit that facilitates mortgages

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Loan applicants and mortgage companies often rely on an Internal Revenue Service that’s dramatically downsizing to help facilitate the lending process, but they may be in luck.

That’s because the division responsible for the main form used to allow consumers to authorize the release of income-tax information to lenders is tied to essential IRS operations.

The Income Verification Express Service could be insulated from what NMN affiliate Accounting Today has described of a series of fluctuating IRS cuts because it’s part of the submission processing unit within wage and investment, a division central to the tax bureau’s purpose.

“It’s unlikely that IVES will be impacted due to association within submission processing,” said Curtis Knuth, president and CEO of NCS, a consumer reporting agency. “Processing tax returns and collecting revenue is the core function and purpose of the IRS.”

Knuth is a member of the IVES participant working group, which is comprised of representatives from companies that facilitate processing of 4506-C forms used to request tax transcripts for mortgages. Those involved represent a range of company sizes and business models.

The IRS has planned to slash thousands of jobs and make billions of dollars of cuts that are still in process, some of which have been successfully challenged in court.

While the current cuts might not be a concern for processing the main form of tax transcript requests this time around, there have been past issues with it in other situations like 2019’s lengthy government shutdown.

President Trump recently signed a continuing funding resolution to avert a shutdown. But it will run out later this year, so the issue could re-emerge if there’s an impasse in Congress at that time. Republicans largely dominate Congress but their lead is thinner in the Senate.

The mortgage industry will likely have an additional option it didn’t have in 2019 if another extended deadlock on the budget emerges and impedes processing of the central tax transcript form.

“It absolutely affected closings, because you couldn’t get the transcripts. You couldn’t get anybody on the phone,” said Phil Crescenzo Jr., vice president of National One Mortgage Corp.’s Southeast division.

There is an automated, free way for consumers to release their transcripts that may still operate when there are issues with the 4506-C process, which has a $4 surcharge. However, the alternative to the 4506-C form is less straightforward and objective as it’s done outside of the mortgage process, requiring a separate logon and actions.

Some of the most recent IRS cuts have targeted technology jobs and could have an impact on systems, so it’s also worth noting that another option lenders have sometimes elected to use is to allow loans temporarily move forward when transcript access is interrupted and verified later. 

There is a risk to waiting for verification or not getting it directly from the IRS, however, as government-related agencies hold mortgage lenders responsible for the accuracy of borrower income information. That risk could increase if loan performance issues become more prevalent.

Currently, tax transcripts primarily come into play for government-related loans made to contract workers, said Crescenzo.

“That’s the only receipt that you have for a self-employed client’s income to know it’s valid,” he said.

The home affordability crunch and rise of gig work like Uber driving has increased interest in these types of mortgages, he said. 

Contract workers can alternatively seek financing from the private non-qualified mortgage market where bank statements could be used to verify self-employment income, but Crescenzo said that has disadvantages related to government-related loans.

“Non QM requires higher downpayments and interest rates than traditional financing,” he said.

In the next couple years, regional demand for loans based on self-employment income could rise given the federal job cuts planned broadly at public agencies, depending on the extent to which court challenges to them go through.

Those potential borrowers will find it difficult to get new mortgages until they can establish more of a track record with their new sources of income, in most cases two years from a tax filing perspective. 

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