Many people automatically reinvest income from investments and retirement accounts, when it would make more sense to direct that money to living expenses or use it for gifts to family or charity.
The place to start, advisers say, is with a master plan that encompasses cash flow, living expenses and any giving goals. There are variables that shift as people age, such as sources of income. When IRA account holders reach 70 1/2, they must begin taking required minimum distributions, which can amount to a lot money if the account is large.
The distributions are subject to federal and state taxes, as are dividends and interest earned on savings. "Clients that are already paying taxes on such amounts should consider using it as part of their cash flow," said Laura M. Sundquist, a financial planner and accountant at Sage Financial Design Inc. in Simsbury, Conn.
When that income is reinvested, any dividends and gains from those investments face new taxes. Ms. Sundquist is often surprised to see that retirees fail to consider this and put the money back into the markets, often through automatic dividend reinvestment plans.
The "one piece of homework" she gives clients, said Ms. Sundquist, is to figure out how much they need to live on a monthly basis. Once she has that figured, she calculates how much to draw from various sources, such as dividends, interest, retirement accounts, and Social Security, and takes taxes into account.
Weighing taxes is more important than ever. Changes in federal tax rates this year raised the top rate on dividends to 20% from 15%. Interest and retirement account income is taxed as ordinary income, with a new top rate of 39.6%.
Thomas H. Zimmerman, a financial planner in Evanston, Ill., who manages about $190 million, said his firm is "all about doing the master plan first." He updates clients' comprehensive plans every year, mapping out cash flow in the fourth quarter.
Though most of his clients are worth between $3 million and $5 million, many of them still rely partly on required minimum distributions to cover their cost of living, according to Mr. Zimmerman. Whatever is left over of a distribution, they may invest.
One client, the retired CEO of a smaller publicly traded company, uses $50,000 of a distribution to fund a family limited partnership that buys foreclosed homes and refurbishes them to rent out. The man's children are investors in the partnership, which he enjoys using to teach them about business.
Advisers with retired clients who are charitably inclined say the most tax-efficient use of a required minimum distribution is often to roll part or all of it over directly to a favorite cause. The law now allows a direct rollover up to $100,000.
This works especially well when a charitable contribution brings a taxpayer's adjusted gross income below $200,000--$250,000 for couples--so that the new 3.8% surtax on investment income won't apply, according to Larry Maddox, president of Horizon Advisors, a Houston firm with $205 million under management.
When giving goals are more centered around family, it's tax-efficient to give interest, dividends or retirement account distributions. A person can give unlimited tax-free gifts of up to $14,000 this year to separate individuals.
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