Tax-Advantaged Savings Accounts and Tax Efficient Wealth Accumulation FPA Retreat 2006 Scottsdale, AZ May 5, 2006 Stephen M. Horan, Ph.D., CFA St. Bonaventure University Alesco Advisors, LLC Overview Foundational Issues Front-end vs. Back-end TDAs Traditional IRA, 401(k), 403(b), 457, Keogh Roth IRA, Roth 401(k), 529 plans, LSA s Roth IRA Conversions When and how should you convert to a Roth IRA? Early Withdrawal Penalties When is it worth it? Overview Contemporary Issues After-tax Values of TDAs Is a dollar in a TDA the same as a dollar in taxable account? Asset Location Which assets go in which accounts? Withdrawal Location What is the best withdrawal strategy when you have multiple TDAs?
Traditional vs. Roth IRAs What to consider Investor s tax status Contribution tax rate vs. withdrawal tax rate Contribution size relative to contribution limit Investment expected return Investment time horizon Investment tax structure Ordinary income vs. capital gains Deferred vs. realized gains
Traditional vs. Roth IRAs Pretax contributions less than contribution limit A comparable traditional IRA strategy generates tax savings that can be re-invested in the traditional IRA Trad IRA Roth IRA IRA Contribution $1,000 $1,000 Tax Savings (33%) 500 0 Re-invested in traditional IRA Simply compare contribution and withdrawal tax rates Traditional IRAs become relatively more attractive when withdrawal tax rates decline Traditional vs. Roth IRAs Pretax contributions greater than contribution limit A comparable traditional IRA strategy generates tax savings that must be invested in a taxable account Trad IRA Roth IRA IRA Contribution $4,000 $4,000 Tax Savings (33%) 1,320 0 Invested in taxable account Roth IRA becomes relatively more attractive The traditional IRA strategy is disadvantaged by the taxable investment of tax savings
For large contributions and stable tax rates, the Roth IRA accumulates more wealth than the traditional IRA Declining tax rates improve the traditional IRA, especially for lower returns and shorter time horizons
Alternative Minimum Tax (AMT) Exemption phases-outs Increase the effective marginal tax rate favors the traditional IRA Possibly increase effective tax rate on capital gain Effect of TDA contributions on AGI Front-end TDA contributions lower AGI and decrease AMT exposure
Employer Matching for 401(k) Plans 401(k) plans are similar to traditional IRAs Any employer match 401(k) better than traditional IRA Stable or decreasing withdrawal tax rates Any 401(k)-matched investment is superior to Roth IRA. Increasing withdrawal tax rates Almost any 401(k)-matched investment is superior to Roth IRA. Roth IRA Conversion Paying conversion tax from IRA balances Requires an 11.1% increase in withdrawal tax rate for conversion to be worthwhile Paying conversion tax from taxable balances Conversion is worthwhile for investors with constant or increasing withdrawal tax rates Otherwise, withdrawal tax rates need to be greater than those in Figure 2.2
Non-deductible IRAs Always inferior to traditional IRA or Roth IRA Can be superior to a taxable investment when: The investment would be fully taxed as ordinary income Withdrawal tax rate in lower Time horizon is very long (> 25 years) Return is high (< 10%) Nondeductible IRAs are beneficial in only limited situations, especially if the investment is already tax efficient. Early Withdrawal Penalties and Breakeven Time Horizons How long must funds be invested in a TDA to offset an early withdrawal penalty? Breakeven time horizon Depends on: Account type (Traditional vs. Roth IRA) Investment return Contribution vs. withdrawal tax rates Tax structure of the taxable alternative
Breakeven Time Horizon for Roth IRA Early withdrawal penalty applies only to earnings Effectively zero breakeven time horizon for initial contribution Early distributions of earnings are subject to 10% penalty PLUS taxed as ordinary income Double tax contribution and withdrawal Much longer breakeven time horizons
After-tax Value of Tax-Sheltered Assets Taxable equivalent A dollar in a Roth IRA is worth more than a dollar in a taxable account A dollar in a Roth IRA is worth more or less than a dollar in a taxable account After-tax asset allocation
Asset Location The choice of accounts in which investors place various asset classes (e.g., stock vs. bonds) Not asset allocation Asset Location Most investors have similar asset allocations in their different accounts Traditional IRA Taxable Account Bonds $200,000 $200,000 $400,000 40% Stocks $600,000 60% $500,000 $500,000 $1,000,000 The Basic Arbitrage Rule Place highly taxed assets (e.g., fixed-income securities) in tax sheltered accounts Place tax preferred assets (e.g., equity) in taxable accounts Adjust asset allocation with borrowing/lending in the taxable account
Example Suppose an investor has $700,000 in a traditional IRA and in a taxable account and we follow THE RULE. Traditional IRA Taxable Account Bonds $700,000 $0 $700,000 70% Stocks $0 30% $700,000 $1,000,000 Example If the ideal asset allocation is not 70-30, but 40-60, then use margin (i.e., borrow) in the taxable account to buy more equity. Traditional IRA Taxable Account Bonds $700,000 () $400,000 40% Stocks $0 $600,000 $600,000 60% $700,000 $1,000,000 Does the Type of TDA Matter? Is the traditional IRA or the Roth IRA best suited to hold fixed income? Typically, the Roth IRA because the difference in the after-tax values of equity and fixed income is greater for the Roth IRA
Value of Shifting Stock to Bonds in Different TDAs Asset Location and Municipal Bonds Municipal bonds can be used in taxable accounts to achieve fixed income exposure Traditional IRA Taxable Account Bonds $100,000 (Munis) $400,000 40% Stocks $600,000 $0 $600,000 60% $700,000 $1,000,000 Asset Location and Municipal Bonds Disadvantage Using munis for asset location adjustments requires a yield give up, whereas THE RULE does not For high-income investors, this strategy is generally not worthwhile UNLESS the equity is highly tax inefficient (e.g., distributes more than 70% of return as income or short-term gain.) For middle-income taxpayers the threshold is even higher, about 90%
Asset Location and Trading Behavior Active management has a greater tax burden than passive management Passive investors gain more from asset location because the tax differential between equity and fixed income is greater. Nonetheless, gains from passive management (e.g., performance, fees, and taxes) outweigh the gains from optimal asset location. Asset Location and Liquidity Constraints Holding equity, which is more volatile than bonds, in taxable account may trigger an early withdrawal penalty Basic advice still holds Withdrawal Location Withdrawal strategies when both traditional IRAs and Roth IRAs are available? Distribute from traditional IRAs when tax rates are low. Distribute from Roth IRAs when tax rates are high.
Withdrawal Location Progressive Tax Rate Environment Naïve Strategy Deplete traditional IRA first then distribute from Roth IRA Informed Strategy Distribute from traditional IRA up to 15% tax bracket Remainder of distribution requirement from Roth IRA Substantial benefits from optimal withdrawal strategies (e.g., $1,000,000) Conclusions Front-end TDAs for investors with declining tax rates Employer matching rules Convert if tax rates increase Traditional IRAs for non-retirement purposes OK? Locate bonds in TDAs and adjust asset allocation Withdrawal from traditional IRAs through low tax brackets or when tax rates are low