In a Rising Tax-Rate Environment, Deferral Can Help Manage The 1099

June 9, 2021

 

Under several proposed bills, some taxpayers could see higher ordinary income and capital gains rates, and a higher tax bill. For some clients, tax deferral can help control the 1099 and leave more dollars for reinvestment.

 

Tax drag can affect the rate at which invested assets grow. Investors may have federal taxes on earned and unearned income, as well as the potential for additional taxes, such as the net investment income tax and alternative minimum tax. Add state taxes, and effective tax rates of 30%+ can be a reality. (Note: Effective Tax Rate = Taxes Paid ÷ Adjusted Gross Income.)

Deferral can allow clients to time and control the recognition of gains, which, in turn, can help reduce or smooth out tax costs.

 

Examples of clients who might benefit from deferral:

  • Higher income now, less income in retirement. In their peak earning years, some couples are high-income earners now, but expect to need less income in retirement. For this group, tax deferral can reduce tax drag during the peak earning years. Distributions of ordinary income in retirement can be managed. If qualified accounts are already maxed out, a deferred annuity may be another option to consider. (Remember that Roth accounts can produce tax-free distributions for this group.)

  • Retirees looking for tax management. Many retirees want to invest but are reluctant to add to their 1099s. For this group, additional tax deferral from a tax-deferred annuity may help avoid current taxation of any growth of your asset. (For those with a desire for growth and concerns about the market, some tax-deferred variable annuities offer principal or income protection for an additional cost.)

 

Some common sources of deferral:

  • Employer-sponsored retirement plans. Many clients are familiar with the deferral offered by employer-sponsored plans, such as 401(k)s, 403(b)s, 457(b)s, SEP-IRAs, and Simple IRAs. These plans offer clients tax-deferred growth. For those with large qualified accounts and/or other significant resources, there can be one downside: The IRS requires annual required minimum distributions (RMDs) after the account owner reaches age 72. That can mean unneeded additional ordinary income is distributed at an inopportune time.

  • Roth accounts. Designated Roth accounts in 401(k) plans, Roth 403(b)s, Roth 457(b)s, and Roth IRAs also offer tax-deferred growth, as well as tax-free distributions (assuming the accounts qualify under the Internal Revenue Code (IRC)). While the other accounts require RMDs, Roth IRAs offer the additional benefit of no RMDs for account owners.

  • Tax-deferred annuities. For some clients, tax-deferred annuities offer an additional way to delay taxes on invested assets. While qualified accounts typically should be funded first, some clients will benefit from this option. (Remember that access to tax-deferred annuities, like qualified accounts, is limited before age 59½.)
     

Except for qualifying Roth accounts, remember that the distributions from the above accounts are considered ordinary income and taxed at those rates, which are usually higher than capital gains rates.

This may be an opportune time to check your clients’ 1099s and determine if deferral may be appropriate. With the potential for rising tax rates in today’s environment, deferral may help manage tax drag and help more clients reach their goals.


 

This material is educational and intended for an audience with financial services knowledge.


 

For more information on retirement-planning strategies, please contact the Retirement Strategies Group at (800) 722-2333, or email us at RSG@PacificLife.com

 


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