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Taxes Exist! Implications for Asset Allocation, Location, and Withdrawal Strategies in Retirement S a eg es e e e

Thornburg Asset Management September 19, 2011

William Reichenstein, PhD, CFA

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, ,Powers Professor of Investments Baylor UniversityPrincipal, Retiree, Inc. and Social Security Solutions, Inc.

Presentation based on

William Reichenstein,William Reichenstein,

In the Presence of Taxes: Applications of After-tax Asset Valuations,

FPA Press September 2008

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FPA Press, September 2008.

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Outline:

1 Key Concept: $1 of pre-tax funds in 401(k) is like (1-1. Key Concept: $1 of pre tax funds in 401(k) is like (1tn) dollar of after-tax funds in Roth IRA, where tn is the tax rate in retirement

2. Choice of savings vehicles3. Implications for calculating asset allocation4. Effective tax rates on bonds and stocks held in Roth,

401(k), and taxable account5 I li ti f t l ti

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5. Implications for asset location6. Implications for withdrawal strategies in retirement7. Roth conversions in withdrawal strategies

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 401(k), 403(b),

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( ) p ( ), ( ),traditional IRA, Keogh, etc. --Henceforth, Roth represents Roth IRA, Roth 401(k) and Roth 403(b).

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Comparing After-tax Future Values Of $1 of pretax funds in TDA to $1 of after-tax funds in Roth

Assume today’s $1 market value earns pre tax return of r per year for n years pre-tax return of r per year for n 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 Funds will be withdrawn n years hence when the individual will have a 28% marginal tax rate, i.e., tn = 28%Tax-deferred account:$1(1+r)n (1-0.28) Roth: $1(1+r)n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-

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If invested in the same asset, the aftertax value of the tax-deferred account will be worth (1-tn) or 72% of the Roth’s after-tax value.

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 befo e t e b t $1 44 fte t e

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$2 before taxes but $1.44 after taxes. They have the same purchasing power.

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Conclusion and ConceptsConclusion: $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

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principal. A tax-deferred account is like a partnership with the government being a silent partner that “owns” tnof this partnership.

2. Choice of Savings Vehicles2. 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?

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What if marginal tax rates are the same today and in retirement?

Original Investment

Ending WealthInvestment Wealth

401(k) $1,000 pretax$ 280 tax saved$ 720 after tax

$2,000 pretax$ 560 taxes$1,440 after tax

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Roth401(k) $ 720 after tax $1,440 after tax

What if marginal tax rates are lower in retirement? t = 35%, tn = 28%

Original Investment

Ending WealthInvestment Wealth

401(k) $1,000 pretax$ 350 tax saved$ 650 after tax

$2,000 pretax$ 560 taxes$1,440 after tax

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RothIRA $ 650 after tax $1,300 after tax

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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 Tax diversification 2 $16 000 saving --Why? 1. Tax diversification. 2. $16,000 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.

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Lessons continued Slide 10: Your client invests $1,000 in a 401(k) in a year when she is in a 35% tax 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. 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.

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3 Implications for 3. Implications for calculation of asset allocation

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What is Peggy’s Asset Allocation?

Market Value Asset Savings Vehicle

$500,000 Bonds Tax-def Acct$500,000 Stocks Roth

Assume she will have a 28% marginal tax rate in retirement

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rate in retirement.

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What is her Asset Allocation? According to the after-tax approach, it contains $360 000 or $500 000 (1- 28) after contains $360,000 or $500,000 (1 .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 t diti l h t th

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The traditional approach exaggerates the allocation to the dominant asset held in 401(k).

But Peggy does not know tn!

Since the traditional approach ppignores taxes, it implicitly assumes tn will be zero. It is better to estimate tn and calculate an asset allocation that is approximately right than to assume

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pp y gtn is zero.

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4 Effective tax rates on 4. Effective tax rates on bonds and stocks held in Roth, TDA, and taxable account

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After-tax Future Values of Bonds and Stocks Held in Roth, Tax-deferred Account, and Taxable Account

Beginning investment value: $1 market valueBeginning investment value: $1 market valueBonds Stocks

Roth (1+r)n (1+r)n

Tax-def Account (1+r)n (1-.28) (1+r)n (1-.28)Taxable Account (1+r(1-.28))n Day Trader: (1+r(1-.28))n

Active Investor: (1+r(1-.15))n

Passive Investor: (1+r)n(1-.15)+.15Exempt Investor: (1+r)n

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r=pre-tax return, n = investment horizon in yearsAssume t = tn = 28% and long-term capital gain tax rate, tc = 15%. For simplicity assume all stock returns are capital gains.

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Principal, Risk and Returns Sharing for Tax-deferred Accounts

For someone who will be in the 28% tax bracket in retirement, the after-tax 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

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investor effectively “owns” (1-tn) of principal, but the after-taxvalue grows tax exempt.

Effective tax rates on bonds and stocks held in Roth, TDA, and taxable account

Beginning investment value: $1 market valueBonds Stocks

Roth 0% 0%Tax-def Account 0% 0% Taxable Account 28% Day Trader: 28%

Active Investor: 15%Passive Investor:< 15%Exempt Investor: 0%

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r=pre-tax return, n = investment horizon in yearsAssume t = tn = 28% and long-term capital gain tax rate, tc = 15%. For simplicity assume all stock returns are capital gains.

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Government bears some risk as well as taking some return

•Assume stocks’ pretax returns are -8%, 8%, and 24% i th i d Th t t d24% in a three-year period. The pretax expected 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

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•Conclusion: The government bears some of the risk and takes some of the return on assets held in taxable accounts.

5. Implications for asset locationp

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?

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Logic of Asset Location

Active stock mgmt style

Asset Location Effective Tax Rates

1. Stocks in taxable accountsBonds in tax-def accounts and Roths

15% tax rate

0%

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2. Bonds in taxable accountsStocks in tax-def accounts and Roths

28% tax rate

0%

Concept

It is better to let the government gtake 15% of stocks’ returns and risk than 28% of bonds’ returns and risk. So, locate stocks in taxable accounts and bonds in retirement

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accounts including tax-deferred accounts and Roths.

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SpreadFor this active investor, the spread between effective tax rates on interest 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 be (40% - 0%).

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y ( )Asset location should be most important to high net worth clients who will passively manage stocks.

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 yholding stocks instead of bonds in taxable accounts, while attaining target asset allocation.

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Target Asset Allocations

After-Tax Values Asset Allocation 30% Stocks 50% Stocks 70% StocksAsset Allocation 30% Stocks 50% Stocks 70% StocksBonds ret acct $500,000 $500,000 $300,000Stocks ret acct $0 $0 $200,000Bonds tax acct $200,000 $0 $0Stocks tax acct $300,000 $500,000 $500,000Total $1,000,000 $1,000,000 $1,000,000

Assume $1 million after-tax portfolio, 50% in retirement accounts and 50% in taxable accounts

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accounts and 50% in taxable accounts.Bonds and stocks should not be held in both retirement and taxable accounts …… except liquidity reserves must be held in taxable account.

Generalized Advice on Asset Location

Place bonds REITs and other Place bonds, REITs, and other assets with returns subject to ordinary income tax rate in tax-deferred accounts and Roths. Place stocks, especially passively held stocks in taxable accounts

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held stocks, in taxable accounts.

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6 Implications for 6. Implications for withdrawal strategies in retirement

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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

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from taxable accounts before retirement accounts.

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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

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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.

Exceptions to Rule of ThumbIf 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 tax-deferred accounts

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deferred accounts. If your client is terminally ill, don’t realize capital gains even if this means dipping into tax-deferred accounts or Roths.

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Withdrawal Strategy from Tax-deferred Account and Roth—no Bequest Motive

After withdrawals from taxable accounts, should you withdraw from TDA or Roth should you withdraw from TDA or Roth next?

Objective: maximize portfolio’s longevityWithdraw funds from tax-deferred account to top of “low” tax bracket

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account to top of low tax bracket and then withdraw additional funds from Roth.

Summary of “Importance of Withdrawal Strategy”Table 1. Summary of Portfolio Longevities with Three Withdrawal Strategies

Withd l St t L it f Fi i l P tf liWithdrawal Strategy  Longevity of Financial PortfolioStrategy 1: 401(k) then Roth IRA then taxable account 

30 years

Strategy 2: Taxable account then 401(k) then Roth IRA 

36.17 years

Strategy 3: Withdrawals each year from taxable account and 401(k) and then Roth IRA

37.5 years

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taxable account and 401(k) and then Roth IRA and 401(k) 

 

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Withdrawal Strategy from Tax-deferred Account and Roth—Bequest Motive

After withdrawals from taxable accounts, should you withdraw from TDA or Roth should you withdraw from TDA or Roth next?Objective: maximize after-tax value of accounts for retiree and beneficiaryRetiree’s tax rate is higher than her child beneficiary’s tax rate. She should withdraw funds from Roth and save TDA for child

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funds from Roth and save TDA for child.If retiree’s tax rate is lower than her child’s, she should withdraw funds from TDA and save Roth for child.

Non-Qualified Tax-Def Annuities

What is it? Invest after-tax $$, grow t d f t t d d itax def, returns taxed as ord. incomeAsset 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)

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Mike & Jen, Age 62 with $1,500,000 of assetsThey began retirement in January 2010. They are wondering how long their financial portfolio may last if they spend $107 800 long their financial portfolio may last if they spend $107,800 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.

Strategy 1: Withdraw funds from the 401(k)s first and then the

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gy ( )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.

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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.

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Cyrus Age 62 with $3,000,000 of Financial Assets

He plans to retire from work this year. He has $3 000 000 in financial assets including has $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 after taxes in the first year and an inflation-adjusted equivalent amount each year thereafter.

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Three WithdrawalStrategies

Strategy 1: He begins Social Security at age 62 and withdraws funds tax inefficiently.Strategy 2: He begins Social Security at age 70 and 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 portfoliothe longevity of his 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.

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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 tax-

efficient withdrawal strategy added more than four years to his portfolio's longevity.

7 Roth conversions in 7. Roth conversions in withdrawal strategies

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Roth Conversions

Objective: Convert funds from TDA jto 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

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Roth Conversions Continued Suggestion: Convert more than sufficient funds in a year to fully use top 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, you might convert p y g$50,000 in 2011 and in 2012 recharacterized $12,213 to take your client’s 2011 taxable income to top of “low” bracket.

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Key Concepts Taxes exist and they matter!A tax deferred account is like a A 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 i f TDA i 0% Effective tax rate for TDA is 0%. For asset location: hold stocks in taxable accounts and bonds in retirement accounts, while maintaining target asset allocation.

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Key Ideas for Withdrawal Strategies

Rule of Thumb: Withdraw funds from t bl t b f ti t taxable accounts before retirement accounts like TDAs and Roths. Exceptions: Look for opportunities to withdraw funds from TDAs when tax rate will be unusually low. Th b f RMD b i These may occur before RMDs begin, before tax rate hike, when medical costs are high, and when contributions are high.

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Key Ideas for Withdrawal Strategies

Concerning withdrawals from TDA gand 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 If beneficiary is in lower tax bracket, save the TDA for him and have retiree use the Roth, and vice versa.

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