Tax Alpha. Robert S. Keebler, CPA, M.S.T., AEP. Keebler & Associates, LLP 420 South Washington Street Green Bay, WI

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1 Tax Alpha Presented by Robert S. Keebler, CPA, M.S.T., AEP Keebler & Associates, LLP 420 South Washington Street Green Bay, WI 54301

2 Agenda 1. Five Dimensional Tax System Ordinary Income Rates Capital Gains Rates AMT PEP & Pease Limitations NIIT 2. Tax-Aware Investing Overview Tax Asset Classes Statutory Tax Shelters Tax Diversification Asset Location 2

3 Ordinary Tax Rates Capital Gains Tax Rates The AMT Bracket Management Five Dimensional Tax System PEP & Pease Limitations New 3.8% Net Investment Income Tax (NIIT) Plus the additional 0.9% Medicare tax on earned income 3

4 Bracket Management 2014 Federal Income Tax Rates and Brackets Rates Based On Taxable Income 20% LT Capital Gains Rate Single Married, filing jointly $406, % $457,600+ $406,750 35% $457,600+ $405,100 33% $405,100 $186,350 28% $226,850 $89,350 25% $148,850 15% LT Capital Gains Rate $36,900 0% Capital 15% $73,800 <$9,075 Gains Rate 10% <$18,150 4

5 Bracket Management 2014 Phaseout of Personal Exemptions & Itemized Deductions Phaseout of personal exemptions (PEP) and limitations on itemized deductions (Pease) as income rises above the following threshold amounts-- Single taxpayers $254,200 Head of households $279,650 Married filing jointly or surviving spouse $305,050 Married filing separately $152,525 Amounts will be indexed for inflation Above certain AGI amounts, personal exemptions are completely phased out. 5

6 Bracket Management Phase-Out of Itemized Deductions (Pease) PEP reduces personal exemption by 2% for every $2,500 of income above the threshold amount for most taxpayers Pease cuts itemized deductions by 3% of AGI above the threshold amounts up to a maximum of 80% 6

7 How AMT is calculated Alternate Minimum Tax How the AMT works. Taxable income (for regular income tax purposes) + Standard deduction (if taken) + Personal/dependency exemptions + Certain exclusion items (e.g. taxes, miscellaneous deductions) + Certain deferral items (e.g. ISO exercise income, depreciation) - State income tax refund - 3% phase-out of itemized deductions (starting in 2013) - Certain deferral items (e.g. gain/loss adjustment) Alternative Minimum Taxable Income (AMTI) Less: AMT exemption amount Net AMTI 7

8 Alternate Minimum Tax How the AMT works. AMT Rates 26% 28% Married Filing Separately $0 91,250 $91,251 + All Others $0 182,500 $182,501 + AMT Exemption Exemption Amount Married Filing Jointly $82,100 Married Filing Separately $41,050 All Others $52,800 8

9 AMT Exemption Phase-out Alternate Minimum Tax How the AMT works. Phaseout Starts Phaseout Ends Married Filing Jointly $156,500 $484,900 Married Filing Separately $ 78,250 $242,450 All Others $117,300 $328,500 For every $1 of income over the threshold the exemption is reduced by $0.25 This increases the marginal rate of taxpayers within the phase-out by 25%. Therefore, for a taxpayer within the phaseout and the 28% rate applies the marginal rate is 35%! 9

10 Bracket Management The Net Investment Income Tax Application to individuals The NIIT is equal to: 3.8% X the lesser of 1. Net investment Investment Income OR OR 2. The excess (if any) of 2. The excess (if any) of - Modified Adjusted Gross Income (MAGI) - Threshold amount - Modified Adjusted Gross Income (MAGI) over the Threshold Amount See IRC Section 1411(a)(1) and Reg. Section (b)(1) 10

11 Bracket Management 3.8% NIIT Overview Net Investment Income Includes: Interest Dividends Non-qualified annuity distributions (taxable portion) Rents Royalties Income derived from passive activity Net gain derived from the disposition of property (capital gains) Does NOT Include: Salary, wages, or bonuses Distributions from IRAs or qualified plans Any income taken into account for selfemployment tax purposes Gain on the sale of an active interest in a partnership or S corporation (generally) Items which are otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt bonds, capital gain excluded under IRC 121, and veterans benefits 11

12 Bracket Management Assets by Bracket 39.6% 35% 33% 28% 25% 15% 10% Tax-Free Roth IRAs Life Insurance Tax-Exempt Interest Income Tax-Deferred IRAs, 401(k)s, 403(b)s Non-qualified Deferred Annuities Taxable Interest Income Capital Gains Qualified Dividends 12

13 Bracket Management Summary Fly below the radar $457, % Income Tax Rate $305,050 PEP/Pease $250, % NIIT 13

14 Married Filing Jointly Taxpayer 5 Year Projection In 2013: $150,000 Wages/Nonqualified Deferred Comp. $50,000 Long-Term Capital Gains $20,000 Itemized Deductions $5,000,000 IRA In 2015: IRA RMDs Begin Bracket Management Example Other Assumptions: 2% inflation rate, 8% IRA growth rate 14

15 Bracket Management Poor Bracket Management Scenario $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $- Taxable Income and RMD Married/filing jointly Taxable Income IRA Distributions 39.6% Bracket 35% Bracket 33% Bracket 15

16 Bracket Management Poor Bracket Management Scenario Taxable Income per Bracket $700, $600, $500, $400, $300, $200, $100, $ % 15.00% 25.00% 28.00% 33.00% 35.00% 39.60% 16

17 Bracket Management Poor Bracket Management Scenario $30,000 Itemized Deductions $25,000 $20,000 $15,000 $10,000 $5,000 $ Total Itemized Deductions Net Itemized Deductions 17

18 18 18

19 Overview Taxes are the biggest drag on investment performance It is not what you earn that counts, but what you keep after taxes 19 19

20 KEY TOPICS Tax Structure Determining the optimum mix of taxable investments, tax-deferred investments and tax-free investments (i.e. Where should retirement savings be invested?) Tax-Sensitive Asset Allocation Understanding the impact that income taxation has on asset allocation and diversification Asset Location Identifying which assets to place in certain investment vehicles 20 20

21 Example Example: Depending on the tax rate, the accumulation of investing $10,000/year for 40 years at a 8% pretax rate of return will differ dramatically: Tax Rate After-Tax Growth Rate* Final Value 0% 8.0% $2,590,656 10% 7.2% $2,102,199 20% 6.4% $1,712,216 30% 5.6% $1,400,380 40% 4.8% $1,150,637 50% 4.0% $950,255 *After-tax growth rate = 8% x (1-tax rate) 21 21

22 Strategy Strategies for tax-aware investing: Increasing investment in tax-favored assets Deferring gain recognition Changing portfolio construction After-tax asset allocation Tax-sensitive asset location Managing income, gains, losses and tax brackets from year-to-year Managing capital asset holding periods 22 22

23 Tax Asset Classes Interest Income - Taxable Dividend Income Capital Gain Income -Preferential Rate -Deferral until sale Tax Exempt Interest Pension and IRA Income - Tax Deferred Real Estate and Oil & Gas - Tax Preferences Roth IRA and Insurance - Tax Free Growth/ Benefits Money market Corporate bonds US Treasury bonds Attributes Annual income tax on interest Taxed at highest marginal rates Equity securities Attributes Qualified dividends at LTCG rate Return of capital dividend Capital gain dividends Equity Securities Attributes Deferral until sale Reduced capital gains rate Step-up basis at death Bonds issued by State and local Governmental entities Attributes Federal tax exempt State tax exempt Pension plans Profit sharing plans Annuities Attributes Growth during lifetime RMD for IRA and qualified plans No step-up Real Estate Depreciation tax shield 1031 exchanges Deferral on growth until sale Oil & Gas Large up front IDC deductions Depletion allowances Roth IRA Tax-free growth during lifetime No 70½ RMD Tax-free distributions out to beneficiaries life expectancy Life Insurance Tax-deferred growth Tax-exempt payout at death 23 23

24 Income Taxation Basics of Retirement Investments Three Main Types of Retirement Investment Accounts Taxable investment accounts income generated within the account (i.e. interest, dividends, capital gains, etc.) are taxed each year to the account owner Tax-deferred investment accounts (e.g. traditional IRAs, traditional qualified retirement plans, non-qualified annuities, deferred compensation) income generated within the account is not taxed until distributions are taken from the account Tax-free investment accounts (e.g. Roth IRAs, life insurance) income generated within the account is never taxed when distributions are made (provided certain qualifications are met) 24 24

25 Income Taxation Basics of Retirement Investments Common Assets in a Client s Portfolio IRA Accounts Roth IRA Accounts ERISA Plans Tax-Deferred Annuities Life Insurance Stocks, Bonds, Warrants, Options Employer NSOs and ISOs Employer Deferred Compensation Real Estate Oil & Gas U.S. Savings Bonds 25 25

26 Investment Incentives in the Tax Code Qualified dividends Long-term capital gains Qualified retirement accounts (e.g. 401(k) plan) Roth IRAs/Roth 401(k) plans Real estate depreciation Oil & gas Life insurance Non-qualified annuities Master Limited Partnerships (MLPs) Index options 26 26

27 Deductible IRAs, Pension Plan Incentives and Deferred Compensation Defined Contribution Plans Defined Benefit Plans Deductible contributions Roth IRA conversions Tax deferred growth Taxable withdrawals Net Unrealized Appreciation (NUA) Lump-sum averaging Aggregation of accounts 27 27

28 Roth IRA and Roth 401(K) Incentives Non-deductible contributions Tax-free growth Non-taxable withdrawals for qualified distributions Five-year rule & Age 59 ½ Rule 28 28

29 Qualified Dividend Incentives Taxation of Interest Income - Ordinary Income Taxation of Traditional Dividends- Ordinary Income Taxation of Qualified Dividends Capital Gains Rate of 15% 29 29

30 Capital Gains Incentives Gains Deferred until Property is Sold Short-term Gains are Taxed at Ordinary Rates Long-term Gains are Taxed at Lower Tax Rates Step-up in Basis at Death Gifts to Charity or a Charitable Trust that do not Trigger Tax 30 30

31 Interest Deductions Tax Aware Investing Real Estate Incentives Depreciation Tax Shield 1031 Tax-free Exchanges Step-up in Basis at Death 31 31

32 Tax-Deferred Growth Tax Aware Investing Life Insurance Incentives Tax-Free Death Benefit Tax-Free Basis Distributions First Tax-Free Loans All Contracts are Treated Separately Modified Endowment Restrictions 32 32

33 Nonqualified Annuity Incentives Tax-deferred Growth Pro-rate Basis Distributions if Annuitized All Contracts are Treated Separately 33 33

34 Incentives for Master Limited Partnerships Cash Distributions are often Tax-free Depreciation Tax-shield Reduction in Basis Step-up in Basis at Depth 34 34

35 Asset Allocation Tax Incentives Asset Location Tax Aware Investing Blending Tax and Finance 35 35

36 Common Problems Blending Tax and Finance Large IRAs and Qualified Plans Minimal IRAs and Qualified Plans High Turnover Investments 36 36

37 Comparison of Passive Stock Investment vs. Active Equity Investment ASSUMPTIONS Initial Investment $100,000 Growth Rate 8.8% (i.e. S&P 500 compounded annual growth rate (CAGR) since 1988) Turnover Rate (Passive Investment) 10% Turnover Rate (Active Investment) 100% Capital Gains Tax Rate 15% $1,400,000 Total Investment Balance $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $ Passive Equity Investment Active Equity Investment 37 37

38 Active Equity Investment Turnover % Tax Aware Investing Breakeven Rates of Active Equity Investment vs. Passive Equity Investment Passive Equity Investment Turnover % 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 10% 8.93% 20% 9.07% 8.94% 30% 9.21% 9.08% 8.94% 40% 9.36% 9.22% 9.08% 8.84% 50% 9.51% 9.37% 9.23% 8.98% 8.94% 60% 9.67% 9.53% 9.38% 9.13% 9.09% 8.95% 70% 9.83% 9.68% 9.54% 9.28% 9.24% 9.09% 8.95% 80% 10.00% 9.85% 9.70% 9.44% 9.40% 9.25% 9.10% 8.95% 90% 10.17% 10.02% 9.87% 9.61% 9.56% 9.41% 9.26% 9.11% 8.95% 100% 10.35% 10.20% 10.04% 9.77% 9.73% 9.58% 9.42% 9.27% 9.11% 8.96% ASSUMPTIONS Growth Rate 8.8% (i.e. S&P 500 compounded annual growth rate (CAGR) since 1988) Capital Gains Tax Rate 15% 38 38

39 Active Equity Investment Turnover % Tax Aware Investing Breakeven Rates of Active Equity Investment vs. Passive Equity Investment Passive Equity Investment Turnover % 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 10% 9.12% 20% 9.46% 9.13% 30% 9.83% 9.49% 9.14% 40% 10.23% 9.87% 9.52% 9.16% 50% 10.67% 10.29% 9.92% 9.55% 9.17% 60% 11.14% 10.75% 10.36% 9.97% 9.58% 9.19% 70% 11.66% 11.25% 10.84% 10.43% 10.02% 9.62% 9.21% 80% 12.22% 11.79% 11.37% 10.94% 10.51% 10.08% 9.66% 9.23% 90% 12.85% 12.40% 11.95% 11.50% 11.05% 10.60% 10.15% 9.70% 9.25% 100% 13.54% 13.06% 12.59% 12.12% 11.64% 11.17% 10.70% 10.22% 9.75% 9.27% ASSUMPTIONS Growth Rate 8.8% (i.e. S&P 500 compounded annual growth rate (CAGR) since 1988) Capital Gains Tax Rate 35% 39 39

40 Comparison of Real Capital Gains Rates (Present Value) YEAR COST OF CAPITAL 2% 4% 6% 8% 10% % 15.00% 15.00% 15.00% 15.00% % 12.33% 11.21% 10.21% 9.31% % 10.13% 8.38% 6.95% 5.78% % 8.33% 6.26% 4.73% 3.59% % 6.85% 4.68% 3.22% 2.23% % 5.63% 3.49% 2.19% 1.38% % 4.62% 2.61% 1.49% 0.86% 40 40

41 Observations- What have We learned? Life Insurance is on Extremely Efficient Tax Asset Class for Bond Type Investments Tax-deferred Annuities are more Efficient then Bond Type Investments Passive Low-turnover Investments provide a Higher After-tax Return on Investment than more Active Strategies generating Short-term or Long-term Capital Gains The Real Capital Gains Rate on a Present Value Basis is Substantially less than the 15% Statutory Rate 41 41

42 Is Tax Deferral Always the Best Strategy? Under the new tax law, the tax leverage benefits of deferring may not always exist Lower tax rates and narrower tax brackets may require balanced strategy Too much Deferral creates the Disproportionate IRA problem 42 42

43 The Benefits of Tax Diversification Retirement Income of $150,000 Without Tax Diversification With Tax Diversification Client accesses $150,000 from her 401(k) Client accesses $75,000 from her 401(k) and $65,000 from her cash value life insurance policy and/or Roth IRA The full $150,000 is taxable at an average tax rate of 30% or $45,000 Only the $65,000 from her 401(k) is taxable, and it s taxed at the lower average tax rate of 15% or $11,250 Leaving client $105,000 to spend in retirement Leaving client $138,750 to spend in retirement 43 43

44 Understanding Tax Adjusted Asset Allocation Currently Most Asset Allocation Models Use Standard Pre-tax Return and Standard Risk Assumptions Income Tax Drag should be Taken into Account Income Tax Rates vary by Taxpayer Capital Gains are Taxed at Different Rates Conflicts with the Current Practice(s) 44 44

45 Beyond Asset Allocation: Understanding Asset Location Concept: Begin with Tax-adjusted asset allocation Once you know the proper asset allocation, then you need to select Asset Location Asset Location is driven by: Tax benefits associated with the proper location of equities and fixed income General Rule: Fixed income should be held in Retirement Accounts, Annuities or Life Insurance General Rule: Equities should be held in taxable accounts 45 45

46 Tax Aspects of Fixed Income Investments In general, fixed income assets produce: Ordinary income Taxed on an annual basis Heavy annual Tax Drag Exceptions: Bonds in Tax-deferred accounts I bonds Tax-exempt Bonds 46 46

47 Tax Aspects of Location of Equities 15% Long-Term Rate No Gain Realized until Property is Sold Step-up in Basis at Death 47 47

48 Ideal Assets for Qualified Plans and IRAs Taxable Bonds REITS High Turnover, Short-Term Gain Strategies Nonqualified Dividends High yield Stocks Option Strategies 48 48

49 Ideal Assets for Taxable Accounts Low Turn-Over Gain Strategies Qualified Dividend Long-Term Capital Gain Strategies Real estate Investments Oil and Gas Investments I Bonds Tax-Exempt Bonds Master Limited Partnership 49 49

50 CONCLUSION QUESTIONS? 50

51 To comment on this presentation or to be added to our mailing list please visit: keeblerandassociates.com/speaking To find more upcoming events please visit: Keeblerandassociates.com/events 51

52 Circular 230 Disclosure Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party. For discussion purposes only. This work is intended to provide general information about the tax and other laws applicable to retirement benefits. The author, his firm or anyone forwarding or reproducing this work shall have neither liability nor responsibility to any person or entity with respect to any loss or damage caused, or alleged to be caused, directly or indirectly by the information contained in this work. This work does not represent tax, accounting, or legal advice. The individual taxpayer is advised to and should rely on their own advisors. 52

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