Tax Alpha®: What Sophisticated Counselors & Advisors Need to Know—Part 2 of 2

By Robert S. Keebler, CPA, MST, AEP (Distinguished), CGMA

In the world of finance, “Alpha” is often referred to as the value a money manager generates by exceeding a particular benchmark. In the world of financial planning, Tax Alpha® is best defined as the value financial advisors add by reducing the tax burden on portfolio income – “After all, it is what you keep not what you earn that counts.” A thorough knowledge of the intersection between tax and finance will allow an advisor to substantially reduce a client’s overall tax burden. The heart of Tax Alpha® for most clients is bracket management, IRA and other deferral strategies, DrawDown strategies, and “asset location.”

Recap and Introduction

In the first article of this two article series we discussed the complexity of planning in a five dimensional tax system and the significant tax burden imposed on investments. We also covered some specific strategies such as appropriate investments for a given marginal rate, the value of deferral, and the tax benefit of a well-considered DrawDown strategy.

However, taxes are often a bigger drag on performance than management fees or commissions and over time can dramatically inhibit wealth accumulation. Therefore, considering how investments are organized and managed from a “tax-drag” perspective is also critical.

Active v. Passive Management

Commonly discussed by financial industry commentators is the higher return of an actively managed fund is often offset by higher management fees. However, less commonly discussed is the additional after tax return on investment required by a high turnover fund to outperform a low turnover fund.

The tax code works against the high turnover fund in two ways. The first is the greater annual loss of a portion of the return to taxation. The second is that any fund with a turnover of greater than 50% will, at least in part, lose the preferred rate on long term capital gains because the holding period requirement cannot be met.

Therefore, for a high turnover fund to provide an equal return to a low turnover fund the pre-tax return of the high turnover fund must be substantially greater. Consider the following table which compares the after-tax rate of return required to equal to an untaxed fund with an 8.8% rate of return.

NOTE: The chart assumes: (1) a marginal ordinary income tax rate of 35%, (2) a marginal capital gains tax rate of 15%, and (3) the fund manager does not sell securities yet to reach the holding period requirement to receive preferred treatment except to meet the turnover requirement.

Retirement Account Asset Location

In addition to managing the selection of funds within a taxable account, a prudent investor will also consider the tax treatment of different investment vehicles. This is critical because an advantage is realized by locating an investment with certain tax characteristic in an account which best shelters that type of income. This pairing can be extremely effective.

An IRA or 401k account is often well paired with the ordinary income producing assets which the prudent investor believes important to their asset allocation. Such assets could for example include a bond or a high turnover stock portfolio or strategy involving selling option contracts. Over time the impact of deferring the taxation of the income taxed at the ordinary rates is significant. Consider the following chart which compares the account balance of a typical retirement saver over time:

NOTE: Current Age: 30; Retirement Age: 65; Annual Savings (age 30-49): $5,000; Annual Savings (age 50-65): $6,000; Ordinary Income Tax Rate: 25%; Long-Term Capital Gains Rate: 15%; Annual Growth Rate/Yield: 6%

However, note that locating a stock portfolio with a 10% turnover in a pre-tax account adds much less value because long term capital gains are already granted a “statutory tax shelter” by the Code:

The benefit, or rather loss thereof, is even more profound when the IRA does not receive part of its preferential tax treatment. Consider the value of the same individual investing in bonds through a non-deductible IRA compared to holding the bonds in a taxable account.

Now compare a low turnover equity strategy held in a non-deductible IRA compared to that strategy in held in a taxable account:

Note that, incredibly, the tax benefit of preferred capital gains treatment actually allows the taxable account to outperform the same investment in a non-deductible IRA. The reason for this is two-fold:

A non-deductible IRA does not receive the upfront benefit of a reduction of taxable income and distributions which exceed basis are taxable;
Growth is subject to ordinary income rates when distributed from the IRA whereas the taxable account growth is subject to preferential capital gains rates. However, its important note it may be difficult in practice to find investments with a sufficient lower turnover to take advantage of the preferred capital gains rate and deferral with a comparable return to other opportunities.

Life Insurance Asset Location

Qualified retirement accounts are, however, not the only place within the tax code for an investor find shelter from tax-drag. Another excellent vehicle which certain investors can utilize to decrease their after-tax wealth accumulation is life insurance. Consider the wealth accumulation the investor from the previous examples can expect by buying a $1,000,000 whole life insurance policy instead of investing in bonds through a taxable account:

NOTE: Current Age: 30; Last Premium Due Age: 65; Annual Premium/Savings (age 30-49): $5,000; Annual Premium/Savings (age 50-65): $6,000; Ordinary Income Tax Rate: 25%; Long-Term Capital Gains Rate: 15%; Annual Growth Rate/Yield: 6%

While each option produces a comparable result as the investor matures, note that even with the high tax drag of a bond portfolio, the insurance benefit is often less than the value of the bond portfolio before the investor’s life expectancy. This effect is clearer when life insurance is compared to an investment with less “tax drag” such as a low turnover equity fund:

Nevertheless, life insurance is a tax-efficient means of wealth creation for investors with a high marginal income tax rate who wish to invest in income producing assets. Consider the same investor comparing a bond portfolio to an insurance policy, except their marginal ordinary income tax rate is the maximum federal rate of 43.4%:

Non-Qualified Tax Deferred Annuity vs. Asset Location

Qualified pre-tax retirement accounts provide income tax deductions, tax deferral, and the ability to shift income to lower tax years. Non-qualified tax deferred annuities, like non-deductible IRAs, provide two out of three of these benefits without contribution limits: tax deferral and income shifting.

Consider an investor subject to a 25% marginal ordinary income tax rate both during working and retirement years that is considering either investing $50,000 in a bond portfolio or purchasing an annuity with those funds:

NOTE: Current Age: 50; Annuity Start Age: 65; Annuity Term: 15 years; Initial Investment: $50,000 ; Ordinary Income Tax Rate: 25%; Annual Growth Rate/Yield: 6%

Note that the annuity’s advantage is merely due to tax-deferral. However, if the investor can also use a tax deferred annuity to shift investment income to from higher to lower marginal rate years the strategy can be substantially more effective:

NOTE: Current Age: 50; Annuity Start Age: 65; Annuity Term: 15 years; Initial Investment: $50,000 ; Ordinary Income Tax Rate Age 50-65: 43.4%; Ordinary Income Tax Rate Age 66-80:25%; Annual Growth Rate/Yield: 6%

However, it is important to note this strategy is substantially less effective when the investor’s alternative investment option to the annuity takes advantage of a “statutory tax shelter,” such as a low turnover equity portfolio:

NOTE: Current Age: 50; Annuity Start Age: 65; Annuity Term: 15 years; Initial Investment: $50,000 ; Capital Gains Tax Rate Age 50-65: 23.8%; Capital Gains Tax Rate Age 65-80: 15%; Ordinary Income Tax Rate Age 66-80:25%; Annual Growth Rate/Yield: 6%

Conclusion

Many opportunities exist for the tax aware investor to substantially increase their wealth accumulation over time. However, none of these strategies are suitable for every investor. Advisors can help clients become tax aware investors by integrating financial goals with tax planning and identifying opportunity. Investors with a long time horizon can especially benefit from “asset location” strategies which reduce “tax-drag.”

RELATED EDUCATION & PRODUCTS

Below is a list of a number of educational programs and products that relate to this topic that you might be interested in:

ABOUT THE AUTHOR

Robert S. Keebler, CPA, MST, AEP (Distinguished), CGMA is a partner with Keebler & Associates, LLP and is a 2007 recipient of the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels. He has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States and one of the Top 40 Tax Advisors to Know During a Recession. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and in estate, gift and income tax examinations and appeals.

In the past 20 years, he has received over 150 favorable private letter rulings including several key rulings of “first impression.” Mr. Keebler is nationally recognized as an expert in estate and retirement planning and works collaboratively with other experts on academic reviews and papers, and client matters. Mr. Keebler is the author of over 75 articles and columns and editor, author, or co-author of many books and treatises on wealth transfer and taxation, including the Warren, Gorham & Lamont of RIA treatise Esperti, Peterson and Keebler/Irrevocable Trusts: Analysis with Forms.

He is a frequent speaker for legal, accounting, insurance and financial planning groups throughout the United States at seminars and conferences on advanced IRA distribution strategies, estate planning and trust administration topics including the AICPA’s Advanced Estate Planning, Personal Financial Planning Conference and Tax Strategies for the High Income Individual Conference.

To contact Mr. Keebler, call his office at 920-593-1701 or by e-mail at robert. keebler@keeblerandassociates.com.

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