Strategic Wealth Partners was acquired by Kovitz Investment Group Partners, LLC ("Kovitz"), a registered investment adviser with the SEC on May 1, 2024. Strategic Wealth Partners is now a division of Kovitz and its registered investment adviser. Materials created prior to this date were created by Strategic Wealth Partners and are accurate as of the time of publishing.

When You Have Significant Assets In Tax-Deferred Accounts

Many high-net worth and ultra-high net worth individuals have accumulated significant pre-tax assets in tax-deferred accounts such as IRAs and 401(k)s.  While these types of accounts offer the benefit of tax-deferred growth, they also come with unique considerations when it comes to wealth management.

There are countless articles that address the basics of IRAs, 401(k)s, and other types of tax-advantaged accounts – this article is geared specifically towards those individuals who have already amassed high six-figure or seven-figure balances in pre-tax retirement accounts. For that reason, I will skip over the basics, except to mention that since pre-tax IRAs and 401(k)s are funded with (you guessed it) pre-tax dollars, distributions are taxed as ordinary income. This is important to remember throughout the article.

Consider John, a 59-year old business owner who has consistently “maxed” out his retirement accounts throughout his working career. He currently has the following pre-tax retirement account balances:

  • Traditional IRA (from an old job) – $100,00
  • Current 401(k) – $1,900,000

Additionally, his wife Jane has an investment account titled in the name of her revocable Trust worth $5 million, for a total combined investment portfolio of $7 million.

As part of the Secure Act 2.0, the age at which one is forced to start taking Required Minimum Distributions (“RMDs”) from pre-tax retirement accounts increased to 73 this year and increases again to 75 in 2033. At 59 years old, if John retires today without contributing another penny to a retirement account, and his existing retirement accounts grow an average of 6% per year for the next 16 years, he’ll have close to $5 million in pre-tax assets by age 75.

Assuming no significant changes to the law, he’d be required to withdraw roughly $200,000 at that time, and potentially more in later years…all taxed as ordinary income.  So much for being in a low tax bracket during retirement!

If John & Jane are like many of our clients, they may find themselves in the enviable position of not needing their tax-deferred accounts to support their lifestyle. The more tax-favorable Trust account, along with Social Security and potentially other sources of passive income, could cover their needs.

While every client situation is different, below are some areas of wealth management that we would review with John and Jane

Investments

Some investments, such as an S&P 500 index fund, can be very tax-efficient. Aside from dividends, most of the growth in these types of funds comes from appreciation, which can be deferred for a long time…potentially forever.

Other investments are not always so tax-efficient. Most of our clients’ portfolios have at least some allocation to “alternative investments,” whose goal (broadly speaking) is to generate better returns than the bond market, less risk (measured by volatility) than the stock market, and relatively low sensitivity to both stocks and bonds. (For more information, see this article by our co-founder Dave Copeland.) 

While not always the case, one of the drawbacks of certain alternative investments is that to achieve these goals, they may employ strategies that aren’t always tax-efficient. They may produce a lot of current income in the form of yield or short-term capital gains, or they may employ hedging techniques that can prohibit a permanent deferral of gains.  Often these strategies invest in private markets, which can mean that in addition to producing current income, they may offer more limited liquidity than traditional investments. 

For these reasons, to the extent that John and Jane wish to invest in alternative investments, we would likely try to hold these investments in tax-deferred accounts, where dividends, income, and realized capital gains do not increase current taxes, and where the limited liquidity is less of a concern.

While IRAs typically offer a wide array of investment options, 401(k)s are usually limited to a very small menu of investment options. If John and Jane wanted to allocate a meaningful portion of their portfolio to alternatives, it might be advisable for John to rollover a portion of his 401(k) to his IRA, where the investment options expand significantly. Although he is still working, most 401(k) plans allow for something called an “in-service rollover” at age 59.5.

A potentially better option would be to shift to a “self-directed” 401(k), which many plans offer and which can accommodate a much broader array of investment options. Self-directed 401(k) accounts usually offer the same (or similar) investment flexibility as IRAs.

In John’s case, by doing either an in-service rollover or a self-directed 401(k), he could invest within a tax-deferred account in certain strategies that might otherwise only have been available to him through Jane’s revocable Trust, where they’d potentially create investment-related taxable income.

If you have a lot of money in a 401(k) plan and are not satisfied with the investment options available, you may want to consider an in-service rollover or a self-directed 401(k) option.

Roth Conversions

If John retires at age 59, he and Jane might find themselves in a much lower tax bracket than during their working years. Social security hasn’t yet begun, nor have RMDs. It’s possible that the only income they have would be portfolio income from the Trust.

During this period between John’s retirement and age 75 (when his RMDs begin…yours may begin sooner), he could consider converting a portion of his pre-tax assets to a Roth IRA each year. Roth IRAs can grow tax-free and be withdrawn by John and Jane, or by their heirs, tax-free.

The amount of the Roth conversion is taxable during the year of conversion, but care can be taken to only convert an amount that keeps overall taxable income within a certain tax bracket. This requires coordination between John and Jane, their advisor, and their accountant. When done properly, Roth conversions can add significant tax value by accelerating taxes into an “artificially low” income year to avoid paying taxes at a higher rate later.

Charity

If John and Jane do not need the projected $200,000 of taxable income from John’s retirement accounts to support their lifestyle, and are already inclined to give to charity, a great way to give would be to take advantage of a Qualified Charitable Distribution (“QCD”).  A QCD is a type of donation that can be made from John’s IRA directly to a qualified charity. This can help reduce taxes for John & Jane because the QCD amount counts as a distribution from John’s IRA (i.e. it satisfies a portion of his RMD) but is not included in their taxable income.

Note that QCDs are limited to $100,000 per year, and QCDs can only be made from IRAs, not 401(k)s. As such, it may be advisable for John to roll his 401(k) to an IRA to ensure that there is always enough in the IRA to make annual QCDs.

Estate Planning

If John and Jane are like many of our clients, it is extremely likely that they will leave behind sizeable retirement account balances to their heirs, who will then have to take their own RMDs over a more compressed period of time.

If, in their estate plan, John and Jane wish to leave behind a certain amount to charity, it may make sense to name these charities (or a Donor-Advised Fund) as a partial beneficiary of John’s retirement accounts, as opposed to naming charities in a Trust or a will. Unlike heirs, charities won’t pay income taxes on distributions from retirement accounts, and for that reason it can be more tax-efficient to use retirement accounts for charitable bequests at death, while leaving more “non-retirement” assets to heirs. 

Conclusion

Having significant assets in tax-deferred accounts really expands the possibilities of financial planning and overall wealth management. Furthermore, laws surrounding tax-deferred accounts are constantly changing, often with unclear guidance that leaves account holders guessing what to do.

If you are looking to speak with an advisor who understands the nuances of tax-deferred accounts and will take the time to understand the unique details of your situation, we invite you to connect with our team. 


Disclosure:

    This article contains general information that is not suitable for everyone. The information contained herein should not be constructed as personalized investment advice. Reading or utilizing this information does not create an advisory relationship. An advisory relationship can be established only after the following two events have been completed (1) our thorough review with you of all the relevant facts pertaining to a potential engagement; and (2) the execution of a Client Advisory Agreement. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

      Strategic Wealth Partners (‘SWP’) is an SEC registered investment advisor with its principal place of business in the State of Illinois. The brochure is limited to the dissemination of general information pertaining to its investment advisory services, views on the market, and investment philosophy. Any subsequent, direct communication by SWP with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of SWP, please contact SWP or refer to the Investment Advisor Public Disclosure website (http://www.adviserinfo.sec.gov).

      For additional information about SWP, including fees and services, send for our disclosure brochure as set forth on Form ADV from SWP using the contact information herein. Please read the disclosure brochure carefully before you invest or send money (http://www.stratwealth.com/legal).

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