Tax Strategies for the Long Horizon

New taxes and higher rates have dramatically increased the complexity of planning for many taxpayers; however, long-standing techniques for managing income and deductions and taking best advantage of tax-favored vehicles for retirement saving still hold sway.

With the introduction in 2013 of the 3.8% net investment income tax, the 20% capital gains rate, and the 39.6% income tax rate, and the reintroduction of the personal exemption phaseout (PEP) and Pease limitations, America shifted overnight from a two-dimensional federal tax system to a five-dimensional system. Virtually every financial decision now needs to be analyzed through the lens of the regular ­income tax, the alternative minimum tax, the net investment income tax, the new additional brackets for high-income taxpayers, and the PEP and Pease limitations. Going from a two-­dimensional system to a five-dimensional system greatly increases complexity and requires an increase in sophistication in tax analysis methodology, tax strategy, and tax planning software tools.

As Exhibit 1 shows, there are now seven ordinary income tax brackets—10%, 15%, 25%, 28%, 33%, 35%, and 39.6%—and three capital gains tax brackets—0%, 15%, and 20%. Furthermore, combining these tax brackets with the new 3.8% net investment income tax produces even more possible tax brackets; i.e., high-income taxpayers are subject to a 43.4% tax rate on ordinary investment income and a 23.8% tax rate on long-term capital gains. Taking into account the PEP and Pease limitations on income above the applicable threshold amounts effectively increases the tax rates even further.

These changes contribute to a growing realization among investors that it is not what they earn that counts but what they keep after taxes. The prudent investor carefully plans to reduce the drag of taxation on investment performance by analyzing financial decisions with all these changes in mind.

The first step in tax planning is to estimate taxable income over a five- to 15-year horizon. This longer time frame is desirable given the increased progressiveness of the Code. Then, planning to avoid the higher tax brackets and the net investment income tax can begin. Tax planning strategies include:

• Harvesting losses in high-income years;
• Harvesting gains in low-income years;
• Contributing to traditional IRAs in high-income years;
• Contributing to Roth IRAs in low-income years;
• Investing in tax-deferred annuities;
• Creating different types of charitable remainder trusts;
• Creating charitable lead trusts;
• Engaging in installment sales;
• Engaging in life insurance strategies;
• Implementing Roth IRA conversions; and
• Creating family trusts.

While some of these strategies may be complicated, the basic idea is simple—use income smoothing to obtain the maximum benefit of tax rate arbitrage. Basically, income smoothing strategies involve (1) reducing taxable income in high-income years by maximizing deductions and shifting income to lower-income years; and (2) increasing income in low-income years by deferring deductions and increasing taxable income to fill up the lower tax brackets. Put another way, the idea is to "fly below the radar," i.e., to keep taxable income below the 3.8% net investment income tax applicable threshold level, and, if that is not possible, to keep taxable income below the PEP and Pease applicable threshold, and, if that is not possible, to keep taxable income below the 39.6% tax bracket. These thresholds for married-filing-jointly status for 2014 are shown in Exhibit 2.

Many of these income-smoothing strategies create tax deferral, which is also powerful. The longer tax can be deferred, the smaller its present value. Even if the full amount of tax payable cannot be deferred, impressive tax savings can still be achieved by spreading tax over a period rather than paying it all at the beginning of the period.

The types of securities and accounts in the tax-aware investor's portfolio will shift according to the level of the investor's tax burden. As income level increases, the complexity of the strategies will follow. Investors in lower brackets enjoy income from bonds that are underpriced for their tax burden, and capital gains are federally tax-free to the extent of the 15% ordinary-income bracket. Middle-bracket investors who expect their rates to decline will shift income to future years. Taxpayers in the highest brackets will seek statutory tax shelters even if it means accepting a lower return. Exhibit 3 shows the type of income or statutory tax shelter taxpayers should seek, depending on their marginal rate.

In general, only "realization events" trigger taxation. A sale of securities generally is a realization event. However, such a sale within a qualified plan or IRA does not trigger taxation—rather, taxation occurs when certain distributions are taken. To illustrate the value of managing realization events and to calculate the value of deferral, compare a taxable investment account with 10% turnover with a taxable account with 100% turnover in Exhibit 4 using these assumptions:

• Beginning age: 30
• Ending age: 65 (i.e., retirement)
• Annual contribution: $5,000
• Long-term capital gains rate: 15%
• Short-term capital gains rate: 25%
• Annual income/growth rate: 6%

Now, to illustrate the value of the lack of realization events within a qualified plan and to calculate the value of deferral, compare Exhibit 5 showing a taxable investment account with 10% turnover to a Roth IRA account with 100% turnover, both using the same ­assumptions as above.

Clearly, the savings afforded by certain sections of the Code offer significant opportunity for the tax-aware investor. Tax deferral is powerful when growing a portfolio. However, its power is even more impressive when retirees carefully manage distributions from retirement plans.

The first step in managing drawdown years is to make a five- to 15-year tax-bracket projection. This is critical because it establishes a benchmark to weigh options. Knowing the future potential marginal tax rate allows for informed decisions about when to take distributions and when to make Roth conversions. To demonstrate how to estimate a taxpayer's future marginal rate, consider the following example ­illustrated in Exhibit 6.

Assumptions:

• Projection age range: 65—80
• Single
• State tax rate: 0%
• 2014 traditional IRA balance: $3 million
• IRA growth rate: 5%
• 2014 interest income: $50,000
• 2014 Social Security benefits: $25,000
• Real estate rental income: $20,000
• Annual inflation rate: 2%

Compiling and projecting the data reveal that, despite the client's modest investment and Social Security income, required minimum distributions (RMDs) drive the marginal rate up to 33% during retirement. It is clear that accelerating income, by making Roth conversions, for example, will likely be very effective, provided it does not cause the applicable rate to exceed the 33% bracket threshold.

The more relevant question for most, however, is which account to draw annual living expenses from: a traditional IRA, a Roth IRA, or a taxable account. Moreover, some will have the vastly more complicated decision of having to consider life insurance, annuities, deferred compensation, and stock options.

Tremendous value can be added by carefully analyzing the tax implications of the various options. For many clients, the key will be to minimize income exceeding the 15% tax bracket and prevent large fluctuations in income from year to year. Income can be minimized by, for example, delaying distributions from pretax qualified plans and instead selling high-basis capital assets for cash flow. In early retirement years, such strategies can be overwhelmingly effective.

To demonstrate the effectiveness of this distribution management strategy, consider a 60-year-old retiree who requires an additional $7,500 for living expenses. The retiree has the choice of (1) distributing $10,000 from a traditional IRA to meet the shortfall; or (2) selling stock in a taxable brokerage account with a basis equal to its fair market value of $7,500. Keeping the funds in the IRA until age 80, except for RMDs, will result in less taxation than even a taxable equity investment with completely deferred taxation of the growth.

However, an opportunity to give such long-term strategic advice to clients rarely presents itself in comparison with providing tactical advice about managing draws in a particular tax year. Nevertheless, such tactical advice can be equally, if not more, effective. For example, balancing retirement draws from accounts that generate taxable income and those that do not can significantly decrease the amount of wealth consumed annually or allow for greater spending. Consider a retired single taxpayer who has not yet started receiving Social Security and is comfortable drawing $80,000 from savings for living expenses, but is unsure which accounts to draw from. Drawing half that amount from a Roth IRA or cash value of life insurance will reduce taxes significantly, perhaps into a lower marginal bracket.

Equally importantly to manipulating when income is taxed is to consider the drag on investment performance created by taxation. Taxes are often a bigger drag on performance than management fees or commissions, and over time they can dramatically inhibit wealth accumulation.