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Correct Clients on Gift Taxes, Roth IRAs, ETFs

February 17, 2017

Financial advisors may want to speak to their clients about commonly-held misconceptions regarding taxes and retirement accounts. Consumers are often mistaken about gift taxes, Roth IRAs, ETFs and withdrawals during retirement, according to a recent video report from Morningstar.

For instance, it’s usually not the case that gifts over $14,000 a year to any one individual are subject to the gift tax, according to Christine Benz, director of personal finance at Morningstar. While people do need to file what’s called Form 709 if their gifts exceed that amount, they don’t actually owe any taxes on those gifts if their combined lifetime gifts and the value of their estate upon their death is under $5.49 million as of 2017, she says. That means the gift tax applies only to the very wealthy, according to Benz.

Meanwhile, despite the popularity of Roth individual retirement accounts, which allow for after-tax contributions in return for tax-free withdrawals down the line, they’re not for everyone, she says. People who start saving later in their careers, for example, may want to instead take a deduction on taxes during their contribution, since their post-retirement income tax rate is likely to be lower, according to Benz. But since it’s difficult to predict the difference in tax rates at the time of contribution and at withdrawal, she recommends contributions to both traditional and Roth IRAs.

Investors are also wrongly convinced that all ETFs are tax-efficient investments, according to Benz. Returns on bond product ETFs, for example, are taken as an income distribution and therefore get taxed at the income tax rate, she says. Commodities and precious metals ETFs are likewise less tax-efficient, according to Benz. And even some equity ETFs may have such a high turnover that they stop being tax-efficient, she says.

Finally, advisors may have to discuss their clients’ withdrawal rates. Many investors feel “virtuous” about living only off the income produced by their investment portfolios while leaving the principal alone, Benz says. But what investors take out is still a withdrawal regardless whether it’s from income or from capital withdrawals, she says. The optimal approach is a combination of both, according to Benz.

By Alex Padalka