Download Implications for Asset Allocation, Location, and

Taxes Exist! Implications for Asset
Allocation, Location, and Withdrawal
Strategies
S
a eg es in Retirement
e e e
Thornburg Asset Management
September 19, 2011
William Reichenstein,, PhD,, CFA
Powers Professor of Investments Baylor
University
Principal, Retiree, Inc. and Social
Security Solutions, Inc.
1
Presentation based on
William Reichenstein,
In the Presence of Taxes:
Applications of After-tax
Asset Valuations,
FPA Press,
Press September 2008.
2008
2
1
Outline:
1 Key Concept: $1 of pre
1.
pre-tax
tax funds in 401(k) is like (1
(1tn) dollar of after-tax funds in Roth IRA, where tn is
the tax rate in retirement
2. Choice of savings vehicles
3. Implications for calculating asset allocation
4. Effective tax rates on bonds and stocks held in Roth,
401(k), and taxable account
5 Implications
5.
I
li ti
ffor assett location
l
ti
6. Implications for withdrawal strategies in retirement
7. Roth conversions in withdrawal strategies
3
1. Key Concept
1.
{
{
$1 of pre-tax funds in 401(k) is like
(1- tn) dollar of after-tax funds in
Roth IRA, where tn is the tax rate in
retirement.
--Henceforth,
tax-deferred account
(TDA)
(
) represents
p
401(k),
( ), 403(b),
( ),
traditional IRA, Keogh, etc.
--Henceforth, Roth represents Roth IRA,
Roth 401(k) and Roth 403(b).
4
2
Comparing After-tax Future Values Of
$1 of pretax funds in TDA to $1 of aftertax funds in Roth
{
{
{
{
Assume today’s $1 market value earns
pre tax return of r per year for n years.
pre-tax
years
Funds will be withdrawn n years hence
when the individual will have a 28%
marginal tax rate, i.e., tn = 28%
Tax-deferred account:$1(1+r)n (1-0.28)
Roth: $1(1+r)n
If invested in the same asset, the after
aftertax value of the tax-deferred account
will be worth (1-tn) or 72% of the Roth’s
after-tax value.
5
Examples
{
{
$0.72 in a Roth has the same
purchasing power as $1 in a TDA.
If the cumulative pre-tax return before
withdrawal is 100% then the Roth will
double and buy $1.44 of goods and
services, while the TDA will be worth
$2 before
befo e taxes
t e but
b t $1.44
$1 44 after
fte taxes.
t e
They have the same purchasing
power.
6
3
Conclusion and Concepts
{
{
{
Conclusion: $1 of pre-tax funds
in tax-deferred account is like
(1-tn) of after-tax funds in Roth.
It is useful to conceptually separate
each pre-tax $1 in tax-deferred account
into (1-tn) of the investor’s after-tax
funds plus tn, where tn is the
government’s share of the current
principal
principal.
A tax-deferred account is like a
partnership with the government
being a silent partner that “owns” tn
of this partnership.
7
2. Choice of Savings Vehicles
-Should your client save in a 401(k) or
Roth 401(k) or, similarly, in a traditional
IRA or Roth IRA?
8
4
What if marginal tax rates are the
same today and in retirement?
Original
Investment
Ending
Wealth
401(k) $1,000 pretax
$ 280 tax saved
$ 720 after tax
$2,000 pretax
$ 560 taxes
$1,440
,
after tax
Roth
$ 720 after tax
401(k)
$1,440 after tax
9
What if marginal tax rates are lower in
retirement? t = 35%, tn = 28%
Original
Investment
Ending
Wealth
401(k) $1,000 pretax
$2,000 pretax
$ 350 tax saved $ 560 taxes
$ 650 after tax $1,440 after tax
Roth
IRA
$ 650 after tax
$1,300 after tax
10
5
Lessons
{
{
If you expect a lower marginal tax rate
in retirement then save in the TDA, and
vice versa.
If you expect the same marginal tax
rate today and in retirement then there
may be a slight preference for the Roth.
--Why? 1
1. Tax diversification
diversification. 2
2. $16
$16,000
000 saving
in a Roth is larger than $16,000 saving in a
TDA 3. Roth distributions do not affect taxation
of Social Security or Medicare Part B premiums.
11
Lessons continued
{
{
{
Slide 10: Your client invests $1,000 in a
401(k) in a year when she is in a 35% tax
bracket. If she expects to be in 28% tax
bracket in retirement, when calculating her
current asset allocation, how large should
she view this $1,000 pretax balance?
Answer: As $720 after taxes because it has
the purchasing power of $720 in a Roth.
Lesson: Convert today’s balances in TDAs to
after-tax dollars by multiplying by (1-tn).
Today’s marginal tax rate is irrelevant when
calculating the current asset allocation.
12
6
3. Implications for
3
calculation of asset
allocation
13
What is Peggy’s Asset Allocation?
Market Value Asset
$500,000
$500,000
Savings Vehicle
Bonds Tax-def Acct
Stocks Roth
Assume she will have a 28% marginal tax
rate in retirement.
retirement
14
7
What is her Asset Allocation?
{
{
{
According to the after-tax approach, it
contains $360
$360,000
000 or $500
$500,000
000 (1(1 .28)
28) after
taxes in bonds and $500,000 after taxes in
stocks for a 42% bonds and 58% stocks
after-tax asset allocation.
According to the traditional approach, it is
50% bonds and 50% stocks.
Th traditional
The
t diti
l approach
h exaggerates
t th
the
allocation to the dominant asset held in
401(k).
15
But Peggy does not know tn!
{
{
Since the traditional approach
pp
ignores taxes, it implicitly assumes
tn will be zero.
It is better to estimate tn and
calculate an asset allocation that is
approximately
pp
y right
g than to assume
tn is zero.
16
8
4. Effective tax rates on
4
bonds and stocks held in
Roth, TDA, and taxable
account
17
After-tax Future Values of Bonds and
Stocks Held in Roth, Tax-deferred
Account, and Taxable Account
Beginning investment value: $1 market value
Bonds
Roth
(1+r)n
Tax-def Account
(1+r)n (1-.28)
Taxable Account
(1+r(1-.28))n
Day Trader:
Stocks
(1+r)n
(1+r)n (1-.28)
(1+r(1-.28))n
Active Investor: (1+r(1-.15))n
Passive Investor: (1+r)n(1-.15)+.15
Exempt Investor: (1+r)n
r=pre-tax return, n = investment horizon in years
Assume t = tn = 28% and long-term capital gain tax rate, tc = 15%.
For simplicity assume all stock returns are capital gains.
18
9
Principal, Risk and Returns
Sharing for Tax-deferred Accounts
{
For someone who will be in the 28%
tax bracket in retirement, the aftertax value of a dollar of pre-tax
funds in a tax-deferred account
grows from $0.72 today to
$0.72(1+r)n in n years. The
investor effectively “owns” (1tn) of principal, but the after-tax
value grows tax exempt.
19
Effective tax rates on bonds and stocks held
in Roth, TDA, and taxable account
Beginning investment value: $1 market value
Bonds
Stocks
Roth
0%
0%
Tax-def Account
0%
0%
Taxable Account
28%
Day Trader:
28%
Active Investor: 15%
Passive Investor:< 15%
Exempt Investor:
0%
r=pre-tax return, n = investment horizon in years
Assume t = tn = 28% and long-term capital gain tax rate, tc = 15%.
For simplicity assume all stock returns are capital gains.
20
10
Government bears some risk as
well as taking some return
•Assume stocks’ pretax returns are -8%, 8%, and
24% iin a th
three-year period.
i d Th
The pretax
t expected
t d
return is 8% and standard deviation is 16%.
•For an active investor, the after-tax returns are
about -6.8%, 6.8%, and 20.4%. The after-tax
expected return is 6.8% and standard deviation is
13.6%.
•Conclusion: The government bears some of the
risk and takes some of the return on assets held in
taxable accounts.
21
5. Implications
p
for asset location
Conclusion: Bonds should be held in
retirement accounts (i.e., tax-deferred
accounts and Roths) and stocks in taxable
accounts, while maintaining the target asset
allocation?
22
11
Logic of Asset Location
Active stock mgmt style
Asset Location
1.
2.
Effective Tax Rates
Stocks in taxable
accounts
Bonds in tax-def
accounts and
Roths
15% tax rate
Bonds in taxable
accounts
Stocks in tax-def
accounts and
Roths
28% tax rate
0%
0%
23
Concept
{
{
It is better to let the government
g
take 15% of stocks’ returns and risk
than 28% of bonds’ returns and
risk.
So, locate stocks in taxable
accounts and bonds in retirement
accounts including tax-deferred
accounts and Roths.
24
12
Spread
{
{
{
For this active investor, the spread
between effective tax rates on interest
income and stock returns is (28% 15%).
For wealthy client who will await the
step-up in basis at death, this spread
may
y be (40%
(
- 0%).
)
Asset location should be most
important to high net worth clients
who will passively manage stocks.
25
Why not put highest returning
asset in Roth?
{
{
Answer: Investors care about risk
and return. This argument just
looks at return.
In a mean-variance optimization,
you can always find a portfolio will a
better risk-return tradeoff by
y
holding stocks instead of bonds in
taxable accounts, while attaining
target asset allocation.
26
13
Target Asset Allocations
Asset Allocation
Bonds ret acct
Stocks ret acct
Bonds tax acct
Stocks tax acct
Total
{
{
{
After-Tax Values
30% Stocks 50% Stocks
70% Stocks
$500,000
$500,000
$300,000
$0
$0
$200,000
$200,000
$0
$0
$300,000
$500,000
$500,000
$1,000,000 $1,000,000 $1,000,000
Assume $1 million after-tax portfolio, 50% in retirement
accounts and 50% in taxable accounts.
accounts
Bonds and stocks should not be held in both retirement and
taxable accounts …
… except liquidity reserves must be held in taxable account.
27
Generalized Advice on Asset
Location
{
{
Place bonds
bonds, REITs,
REITs and other
assets with returns subject to
ordinary income tax rate in taxdeferred accounts and Roths.
Place stocks, especially passively
held stocks
stocks, in taxable accounts
accounts.
28
14
6. Implications for
6
withdrawal strategies in
retirement
29
Rule of Thumb
{
{
Recall that the effective tax rate on
funds held in Roths and tax-deferred
accounts is 0%, while effective tax rates
on assets held in taxable accounts are
generally positive.
Rule of Thumb: Withdraw funds
from taxable accounts before
retirement accounts.
30
15
Exceptions to Rule of Thumb
{
{
Key idea: The government
effectively owns tn of principal in
tax-deferred accounts, where tn is
the tax rate at withdrawal. Look for
situations when tn is low!
Before RMDs begin after 70.5, your client’s
taxable income may be low. If so, consider
withdrawing funds from tax-deferred
accounts (or convert funds from traditional
IRA to Roth IRA) to use low tax brackets.
31
Exceptions to Rule of Thumb
{
{
{
If your client’s tax bracket will rise after
2012 then withdraw funds from TDAs to
top of “low” tax bracket the next two
years.
When tax rate is low—perhaps due to
large contribution or deductible medical
expenses—withdraw funds from taxdeferred accounts.
accounts
If your client is terminally ill, don’t realize
capital gains even if this means dipping
into tax-deferred accounts or Roths.
32
16
Withdrawal Strategy from Tax-deferred
Account and Roth—no Bequest Motive
After withdrawals from taxable accounts,
should you withdraw from TDA or Roth
next?
{
{
Objective: maximize portfolio’s
longevity
Withdraw funds from tax-deferred
account to top of “low”
low tax bracket
and then withdraw additional funds
from Roth.
33
Summary of “Importance of
Withdrawal Strategy”
Table 1. Summary of Portfolio Longevities with Three Withdrawal Strategies
Withd l St t
Withdrawal Strategy L it f Fi i l P tf li
Longevity of Financial Portfolio
Strategy 1: 401(k) then Roth IRA then taxable 30 years
account Strategy 2: Taxable account then 401(k) then 36.17 years
Roth IRA Strategy 3: Withdrawals each year from 37.5 years
taxable account and 401(k) and then Roth IRA
taxable account and 401(k) and then Roth IRA and 401(k) 34
17
Withdrawal Strategy from Tax-deferred
Account and Roth—Bequest Motive
After withdrawals from taxable accounts,
should you withdraw from TDA or Roth
next?
{ Objective: maximize after-tax value of
accounts for retiree and beneficiary
{ Retiree’s tax rate is higher than her child
beneficiary’s tax rate. She should withdraw
funds from Roth and save TDA for child.
child
{ If retiree’s tax rate is lower than her child’s,
she should withdraw funds from TDA and
save Roth for child.
35
Non-Qualified Tax-Def Annuities
{
{
{
{
What is it? Invest after-tax $$, grow
t
tax
def,
d f returns
t
taxed
t
d as ord.
d income
i
Asset location preference: bonds
With some exceptions, most have high
costs and thus low returns
Withdrawal recommendation: withdraw
maximum amount each year that is
not subject to surrender penalty
(unless embedded options are deep in
money)
36
18
Mike & Jen, Age 62 with $1,500,000 of assets
They began retirement in January 2010. They are wondering how
long their financial portfolio may last if they spend $107
$107,800
800
after taxes in 2010 and an inflation-adjusted equivalent amount
each year thereafter while both spouses are alive, but 75% of
that amount after the death of the first spouse at 78. They begin
Social Security benefits at age 66 getting $2,500 and $1,500
each month in today’s dollars. They have $1,000,000 in 401(k)s
and $500,000 in regular taxable accounts.
gy 1: Withdraw funds from the 401(k)s
( ) first and then the
Strategy
taxable accounts.
Strategy 2: Each year, withdraw funds tax efficiently from their
401(k)s and taxable accounts in a fashion that is designed to
increase the longevity of their portfolio, and use a partial Roth
conversion when appropriate.
37
In Strategy 1, the portfolio runs out of money at the end of 2039.
In Strategy 2, the portfolio runs out of money in 2047.
By withdrawing funds tax efficiently, they were able to extend the portfolio’s
longevity by more than seven years.
See retireeinc.com then Learning Library then Case Studies.
38
19
Cyrus Age 62 with $3,000,000 of
Financial Assets
He plans to retire from work this year. He
has $3,000,000
$3 000 000 in financial assets including
$1,900,000 in a 401(k),$100,000 in Roth
IRA, $100,000 in a non-qualified annuity,
and $900,000 in regular taxable accounts.
He wants to know how long his financial
portfolio may last if he spends $131,000
after taxes in the first year and an
inflation-adjusted equivalent amount each
year thereafter.
39
Three Withdrawal
Strategies
{
{
{
{
Strategy 1: He begins Social Security at age 62 and
withdraws funds tax inefficiently.
Strategy 2: He begins Social Security at age 70 and
withdraws funds tax inefficiently.
Strategy 3: He begins Social Security at age 70 and
withdraws funds in a tax-efficient manner from his
financial portfolio. Each year, he will withdraw funds
from his 401(k), Roth IRA, non-qualified annuity and
taxable accounts in a fashion that is designed to increase
the longevity of his portfolio.
portfolio
We assume he maintains a 50% stocks-50% bonds after-tax
asset allocation with stocks earning 7% per year and bonds
earning 3%. Primary Insurance Amount is $2,000. See
www.retireeinc.com then Learning Library then Case Studies
for more details.
40
20
In Strategy 1, his portfolio runs out of money at the end of 2037.
In Strategy 2, his portfolio runs out of money near the end of 2038.
In Strategy 3, it runs out of money part way through 2043. The taxefficient withdrawal strategy added more than four years
to his portfolio's longevity.
41
7. Roth conversions in
7
withdrawal strategies
42
21
Roth Conversions
{
{
Objective:
j
Convert funds from TDA
to Roth if it will be taxed at “low”
tax rate. Convert funds to raise
taxable income to the top of a “low”
tax bracket.
With Roth conversions,, it is seldom
a matter of converting all or none
43
Roth Conversions Continued
{
{
{
Suggestion: Convert more than
sufficient funds in a year to fully use top
of “low” tax bracket.
Next year recharacterize whatever is
necessary to take income to top of “low”
tax bracket.
For example,
p
y
you might
g convert
$50,000 in 2011 and in 2012
recharacterized $12,213 to take your
client’s 2011 taxable income to top of
“low” bracket.
44
22
Key Concepts
{
{
{
{
{
Taxes exist and they matter!
A tax-deferred
tax deferred account is like a
partnership with the government being a
silent partner that “owns” tn of the
partnership’s principal.
For asset allocation: Pretax dollars in TDAs
are smaller than after-tax dollars in Roths.
Eff
Effective
i
tax rate for
f TDA is
i 0%.
0%
For asset location: hold stocks in taxable
accounts and bonds in retirement
accounts, while maintaining target asset
allocation.
45
Key Ideas for Withdrawal
Strategies
{
{
{
Rule of Thumb: Withdraw funds from
t
taxable
bl accounts
t b
before
f
retirement
ti
t
accounts like TDAs and Roths.
Exceptions: Look for opportunities to
withdraw funds from TDAs when tax
rate will be unusually low.
Th
These
may occur b
before
f
RMDs
RMD begin,
b i
before tax rate hike, when medical
costs are high, and when
contributions are high.
46
23
Key Ideas for Withdrawal
Strategies
{
{
{
Concerning
g withdrawals from TDA
and Roth, try to minimize average
tax rate on the TDA withdrawals.
Withdraw from TDA (or convert to
Roth) up to top of low bracket.
If beneficiary is in lower tax
bracket, save the TDA for him and
have retiree use the Roth, and vice
versa.
47
24