RESEARCH FOUNDATION OF CFA INSTITUTE MONOGRAPH. Tax-Advantaged Savings Accounts and Tax-Efficient Wealth Accumulation

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1 Research Foundation of CFA Institute Monograph 69 RESEARCH FOUNDATION OF CFA INSTITUTE MONOGRAPH Tax-Advantaged Savings Accounts and Tax-Efficient Wealth Accumulation Stephen M. Horan, CFA Research Foundation of CFA Institute Monograph (2005) With the aging of the U.S. population, investors have become more aware of the need to save for their retirement. The tax laws in the United States provide a number of tax-advantaged vehicles to save for retirement while at the same time deferring or even exempting investment returns from income taxes. The author discusses the main issues encountered with using such tax-deferred investment accounts to accumulate wealth. He presents a time-value-of-money framework that can be used to illustrate the advantages of the accounts under various tax and investment return scenarios. Because the author uses general tax and finance principles, the framework can be easily adapted to countries other than the United States. There is a saying that one cannot escape death and taxes. Although the prospect of death has always been of concern to investors, taxes on income have been an issue for U.S. investors only since the early 1900s with the passage of the Sixteenth Amendment to the U.S. Constitution, which allowed for the imposition of an income tax. Investors are concerned with wealth accumulation to provide for their well-being until their death (and afterward if an estate is to be left to heirs), but such wealth accumulation depends on the manner in which taxes affect the accumulation and spending of that wealth. Taxadvantaged investments, such as qualified retirement plans and IRAs, have grown over the years and form one avenue of wealth accumulation that investors can use to manage the tax liability associated with Stephen M. Horan, CFA, is at St. Bonaventure University. The summary was prepared by Frank T. Magiera, CFA. For more information about the Research Foundation of CFA Institute, go to /rf/home.html.

2 70 CFA Digest August 2005 such investments. Individuals accumulating wealth for the retirement phase of their lives face a myriad of tax-advantaged choices as well as the option of just investing in taxable accounts. The author explores the issues surrounding the use of tax-deferred accounts (TDAs) for accumulating and spending wealth. He emphasizes retirement vehicles but also addresses tangential issues, including using such accounts for nonretirement purposes. The author begins with a brief history of the tax laws that allowed for the creation of various tax-deferred savings plans. He describes the main features of each savings plan and the tax treatment of its contributions, accumulated earnings, and withdrawals. Depending on the type of plan, contributions can be treated as either taxable as ordinary income or deductible for tax purposes. Accumulated earnings can be deferred from taxes until a later time, exempt from taxes, or subject to taxation as ordinary income, dividends, or capital gains if held in a taxable account. Withdrawals can be taxed as ordinary income, exempt from taxes, or taxed as capital gains if held in a taxable account. Available alternatives can be classified into one of four categories based on tax treatment: plans that are similar to traditional IRAs, plans like the Roth IRA, nondeductible IRAs, and taxable accounts. The author examines the basic issues that should be considered when investors are deciding between a traditional IRA with deductible contributions but taxable withdrawals and a Roth IRA with nondeductible contributions but nontaxable withdrawals. The issues facing the traditional deductible IRA are representative of issues facing all TDAs with such front-loaded tax benefits. Similarly, the Roth IRA serves as a model for all back-loaded TDAs, such as Section 529 education savings plans. Thus, the findings for the traditional and Roth IRAs can be generally applied to their companion plans. The author develops a time-value-of-money framework to calculate future values of retirement assets in different tax environments. Choices between front-loaded and back-loaded vehicles are driven by trade-offs between current tax rates during contribution and earnings periods and those during the withdrawal phase. The primary result is that traditional IRAs become relatively more attractive than Roth IRAs when the investor s withdrawal tax rate declines relative to the contribution tax rate. 2005, CFA Institute

3 Research Foundation of CFA Institute Monograph 71 Some tax-deferred retirement accounts, such as 401(k) plans, allow for employer matching of employee contributions. What should an employee do if given the choice between contributing to a frontloaded, employer-matching 401(k) or a nonmatching, back-loaded Roth IRA? The author shows that employer matching is almost always more valuable than the marginal tax benefits of a Roth IRA. The author also considers the decision to convert a traditional IRA to a Roth IRA. Because investors are required to pay tax on the amount converted, the decision is complicated by the expected life of the converter and the question of the best means to pay the tax liability. Conversion becomes more valuable as the investment horizon increases and when the tax liability is paid by funds taken from a hightax account rather than from a TDA. The author finds that conversion is usually not optimal when taxes are paid from the IRA account unless the investor s tax rate increases by about 11 percent to compensate for the 10 percentage point tax penalty for those who are younger than 59.5 years. An issue that faces investors who earn too much to qualify for deductible IRAs is whether to fund an IRA with nondeductible contributions or to instead fund a taxable investment account. The choice of this and similar decisions (i.e., Roth IRA contribution or taxable investment) depends on the tax structure facing the investments. In other words, is the investor better off having investments in a nondeductible IRA in which the earnings are deferred but eventually taxed as ordinary income, or in a taxable account in which capital gains and dividends are taxed at rates lower than rates for ordinary income? The author s analysis leads to some general rules of thumb: If returns are fully taxed as ordinary income, then the nondeductible IRA is best; if returns consist entirely of deferred capital gains, then the taxable account is best. For taxpayers subject to the alternative minimum tax, however, the nondeductible IRA is attractive. The author focuses on the after-tax value of assets held in tax-advantaged accounts. Depending on the time horizon, investment return, and tax structure, the after-tax future value of a dollar invested in a TDA can be more or less than one dollar. The author considers situations in which the tax structure varies from returns fully taxable to capital gains fully deferred until withdrawn. For traditional IRAs

4 72 CFA Digest August 2005 and partially deductible IRAs, the future after-tax value can be either greater or less than the pretax accumulation. Because Roth IRAs do not incur tax on withdrawals, their after-tax value is always greater than that for traditional IRAs. The author also considers withdrawals taken as annuities over a period of time rather than as a single lump sum. Tax-advantaged accounts, such as IRAs and Section 529 plans for education, were created to encourage savings for some specific purpose. With some exceptions, these plans impose penalties for withdrawals made for purposes other than that for which the account was created. For example, a 10 percent penalty is imposed on IRA withdrawals for investors who are younger than 59.5 years. Even though a penalty is imposed, it still might be advantageous for an investor to fund an IRA for the tax advantages and withdraw the funds early. The author addresses the issue of how long funds must be invested in a retirement account for the tax advantages of the account to outweigh the penalty on early withdrawal. He solves for the breakeven holding period, which is the length of time the funds must be in the TDA to overcome the penalty compared with an investment in a taxable account. The breakeven period is sensitive to the return earned and the tax structure. For example, when significant portions of the return on the taxable investment are in the form of capital gains, the breakeven period tends to increase. Investors can usually choose among many different asset classes and taxable, as well as tax-deferred, accounts. A central issue for wealth accumulation is not only what asset classes to invest in (i.e., the issue of allocation) but also what kind of account in which to place the asset (i.e., the issue of location). The author devotes some effort to addressing these issues. He reviews the literature on the subject and also considers whether asset location affects an investor s overall asset allocation. The author cautions that it is important to use asset allocation proportions that are based on after-tax values and analyze the effect that location has on after-tax proportions because differences between pretax and after-tax asset allocations can be substantial. He considers factors such as tax arbitrage, the effect of borrowing from certain TDA plans, trading activity, liquidity needs and constraints, and future labor income. The author provides intuitive and counterintuitive rules of thumb. 2005, CFA Institute

5 Research Foundation of CFA Institute Monograph 73 The author concludes with guidelines to help financial planning professionals better understand the tax implications of accumulating wealth in tax-advantaged accounts. He notes that measurement of a portfolio s asset allocation exposure on an after-tax basis paints a more accurate picture of an investor s asset allocation. Financial advisors, however, usually ignore this and face the risk of creating portfolios that do not match the return requirements or risk tolerances of their clients. Advisors should provide guidance on asset location as well as asset allocation. The author points out that advisors should be aware that a focus on tax-efficient wealth building also affects the investor s investment constraints. Keywords: Portfolio Management: portfolio construction, rebalancing, and implementation; Private Wealth Management: asset allocation; Private Wealth Management: tax-efficient investing

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