Blog Archives - PFwise.com

Should I Invest in My Home State 529 Plan?

12/30/2013

Q. My home state offers tax incentive to invest in the state's 529 plan, but its expense ratio is quite high. Should I invest in my home state 529 plan?

A. There is a simple rule of thumb to determine if you should invest in your home state 529 plan or not -

E < T/N + 0.17% ?

E - your home state 529 expense ratio
T - the percentage of your contribution you will get back in state tax benefits
N - the number of years you will need the 529 money
0.17% - is the cheap New York State 529 plan's expense ratio

If your E is less than T/N+0.17%, invest in your home state 529 plan. Otherwise, go with NY State 529 plan.

Example
If you put $5,000 into your home state 529 plan, you will get 5% state income tax deduction, which is $250. Your child will be in college 10 years from now. T/N = 0.5%. If your home state 529 plan's expense ratio is less than 0.67%, invest in your home state 529 plan this year.

Repeat the above calculation each year.

Key Considerations of Tax Arbitrage Transactions

12/23/2013

In our previous blogs, we introduced what is tax arbitrage, how to use Roth conversion and Capital harvesting to conduct tax arbitrage. In order to effectively harvest income to take advantage of potential tax arbitrage opportunities, the first key is to recognize that the income itself must be recognized by the end of the year, which means the Roth conversion or the gains-harvesting trade must be done by December 31st.

Roth Conversion Recharacterization
Beyond just executing the transaction, though, the reality is that because these strategies are very sensitive to getting tax rates right, and making sure to take enough income to fill a currently-favorable tax bracket but not rise into the next one, effective implementation also requires doing a tax projection for the current year just to determine where those tax thresholds are, given income and deductions for the year. Fortunately, the recharacterization opportunity for Roth conversions gives a little more flexibility, though; it's always an option to just deliberately convert more than enough, and simply recharacterize the exact amount that turned out to be "too much" early next year once all the final numbers are in for the tax return. With harvesting gains, though, estimating the appropriate amount based on a tax projection is the best that can be done (the more accurate the estimates of income and deductions, the more precise the gains harvesting can be).

Consider More Than Tax Brackets
In addition, it's important to bear in mind that income creation strategies can impact more than just the obvious tax brackets themselves. Going forward, creating income may make ultra-low income individuals eligible for premium assistance tax credits, though "too much" income can also render them ineligible, resulting in a potentially significant loss of tax credits and an indirect increase in the marginal tax rate as a result of phasing out the credits.

Similarly, for many retired people, additional income can trigger the taxation of Social Security benefits, or higher Medicare Part B and Part D income-related premium adjustments; while neither of these makes it unequivocally "wrong" to create income, both represent situations that boost the marginal tax rate higher than "just" what tax brackets alone imply, yet must be accounted for when considering the value of harvesting gains or doing Roth conversions.

For others, state taxation may be a factor; if there is a planned move (in the coming years, or perhaps at the retirement transition), the difference in state tax rates should be considered, and may either make Roth conversions and gains harvesting much more appealing (if the future state would have a higher tax rate) or less appealing (if the future state will have a lower tax rate).

And of course, if the individual doesn't expect to use the IRA or appreciated investments at all, and they're likely held until death, it's important to consider the likely tax bracket of the beneficiaries (if lower, they may prefer to inherit a traditional IRA and not a Roth!) and the available step-up in basis at death (which essentially represents a "free" gains harvesting tax event).

Harvest Capital Gains or Losses

12/19/2013

The Changing Capital Gain Tax Structure
For the past several decades, there have only been two capital gains tax rates - an ultra-low rate (10%, then 5%, now 0%) for those the bottom ordinary income tax bracket(s), and a single top rate (20%, now 15%) for all other capital gains income. Thus, regardless of whether someone had $50,000, or $250,000, or $500,000 of capital gains, once past the bottom bracket(s) all capital gains were subject to the same flat top rate.

In 2013, though, this is no longer true. The introduction of a new top 20% capital gains tax bracket (on top of the existing 0% and 15% rates), along with the introduction of the new 3.8% Medicare surtax, effectively creates four long-term capital gains tax brackets: 0%, 15%, 18.8%, and 23.8%, with progressively higher rates as income rises. The significance of these new rules is not merely that capital gains may be subject to a new higher top tax rate; the presence of this new four tax bracket structure for capital gains rates dramatically changes the economic value and potential "risks" of tax deferral.

Push Capital Gains Into the Future?
The problem is that in the context of capital gains, systematically deferring gains and harvesting losses can create a larger and larger looming capital gain, and with today's four-bracket structure a larger future gain can actually result in less wealth. While in the past the tax rate might have been the same for a $50,000 and $500,000 capital gain (at least for those beyond eligibility for 0% rates), now it can be the difference between paying 15% tax rates and 23.8% instead. Pushing gains into the future that trigger the 3.8% Medicare surtax, and possibly the new top capital gains rate as well, can overwhelm the value of tax deferral itself.

Harvesting Capital Gains Now?
Accordingly, those who are eligible for favorable long-term capital gains tax rates should consider harvesting gains in order to "lock in" tax rates at today's rates, if they are favorable. The good news is that harvesting gains is much easier than harvesting losses. While claiming losses requires managing around the so-called "wash sale" rules that prevent the purchase of a substantially similar security within 30 days before/after the sale that produced a loss, there is no such rule for harvesting capital gains; Congress does not have a rule that states "you owe us taxes, but since you bought the investment again, you don't have to send us the money." To the contrary, selling an investment and buying it back must trigger income recognition and a potential tax event; except that with today's capital gains rates, that can actually be an effective tax arbitration strategy, even if it simply means selling investment positions that are up and buying them back immediately!

Similar to harvesting Roth conversions, though, the key again is not to harvest such large gains that the current tax bracket is bumped into the upper levels. Instead, the goal is to harvest just enough to fill the lower tax brackets, stop before reaching the upper brackets, and then wait to repeat the process again next year! In addition, it's also important to note that those who are harvesting capital gains should not harvest losses as well; just as harvesting gains creates wealth by capturing gains at lower rates, it's also advantageous to defer losses to the future when rates will be higher (assuming, of course, that the individual projects that their tax rates will be higher in the future than they are now in the first place).

Roth vs Traditional IRA: The Four Factors That Determine Which Is Best

12/18/2013

To Roth or not to Roth? While the appeal for lifetime tax-free growth from a Roth may be appealing, the reality is that the Roth is not always the winning choice, and there are many myths and misunderstands about Roth accounts that make it difficult to know which is best.

There are four (and only four!) fundamental factors that determine whether a Roth will or not will be more effective than a traditional pre-tax retirement account. Some factors are always in favor of the Roth account, but others can work against the Roth account; in fact, blindly choosing a Roth and ignoring the relevant factors can actually lead to wealth destruction! By knowing the four factors and avoiding the Roth myths, though, you can be assured of making an effective wealth-building decision.

Current Vs Future Tax Rates
By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates. Current tax rates means the marginal tax rate that will be paid today (or the marginal tax rate on the deduction that would be received) by contributing or using a pre-tax retirement account versus contribution or converting to a Roth account. Future tax rates means whatever tax rate would apply to the funds in the retirement account when withdrawn in the future - ostensibly in retirement, or possibly even by the next generation if the retirement account is not expected to be depleted during the lifetime of the owner.

The principle of this equation is remarkably straightforward - the greatest wealth is created by paying taxes when the rates are lowest. If rates are low today and higher in the future - e.g., for the young worker, or someone in between jobs - go with the Roth and pay taxes at today's low rates. If rates will be lower in the future - e.g., for someone whose taxable income will drop in retirement, or where the retirement account may be spent by the next generation at their lower personal tax rates - the traditional retirement account is the winner. Getting the tax rate equation wrong can result in a significant destruction of client wealth, by unnecessarily paying taxes at high rates!

Impact of RMDs
One important distinction about Roth IRAs (although not Roth 401(k) accounts) is that they are not subject to required minimum distributions (RMDs) during the lifetime of the account owner, while traditional IRAs are. The net result is a slight benefit in favor of the Roth IRA, for the simple reason that it allows more dollars to stay inside their tax-preferenced wrapper. This is an outright benefit for Roths, compared to the traditional IRA that slowly self-liquidates from RMDs, forcing money into taxable accounts where their future growth will be slowed by ongoing tax drag.

Notably, though, this benefit applies only as long as the IRA owner is alive! After death of the owner, all retirement accounts have required minimum distributions for beneficiaries, and the exact same rules apply whether it's an inherited IRA or an inherited Roth IRA (the RMD is the same, even though the tax treatment of the RMD amount may be different). Accordingly, the benefit of avoiding lifetime RMDs applies only as long as the IRA owner is alive, and likewise applies only if the IRA owner actually lives past age 70 1/2 when RMDs begin! Otherwise, the avoiding-RMDs benefit is actually a moot point.

Contribution Limits and the Embedded Tax Liability
Another factor that favors the Roth IRA is the interaction between the IRA contribution limits and the future tax liability of a pre-tax account.

For example, imagine you are in the 28% tax bracket. If you have $1,000 in an IRA, the reality is that you actually have $720 in the IRA for yourself, and $280 in the IRA that's "on hold" for the IRS and the Federal government in the form of future taxes. If the IRA doubles to $2,000, then your share grows to $1,440 and the IRS's share grows to $560; the IRS still has 28% of the account earmarked.

In general, this isn't necessarily a "problem" as the benefit is still grow on the IRS' share before they have to be paid (that's the benefit of tax-deductible contributions); the goal is simply to pay the IRS its share whenever the tax rate is lowest, as noted earlier.

However, if you wish to make a maximum $5,000 contribution, now it's a problem. Because you can't make a full $5,000 contribution; in practice, you make a $3,600 contribution for yourself and a $1,400 contribution on behalf of the IRS. On the other hand, if you make a Roth contribution, the entire $5,000 amount is held for yourself, because the IRS' share is paid with outside investment dollars. So as long as you intend to contribute the limit, it's better (all else being equal) to contribute to a Roth and pay the taxes with outside dollars, than contribute to a traditional where the IRS' share crowds out some of the contribution limit, while tax-inefficient dollars are still growing on the side. Notably, the same effect applies for a Roth conversion where the tax liability is paid with outside dollars; just pretend that the current balance of the traditional IRA is effectively the "contribution limit" to a Roth.

State Estate Taxes
The final factor that can favor a Roth IRA is estate taxes, for the simple reason that it's bad news to pay estate taxes on a retirement account when part of it isn't even yours in the first place - it's earmarked for Uncle Sam!

For example, you have $1,000,000 traditional IRA and a $1,000,000 investment account has to report $2,000,000 on your estate tax return (combined with any other assets); however, if you convert the account has a $1,000,000 Roth IRA and only a $650,000 investment account (assuming a 35% tax rate on the conversion), for a total estate value of $1,650,000. At a 35% estate tax rate, making $350,000 of value "disappear" can result in $122,500 of estate tax savings!

The caveat is that such conversion strategies don't necessarily help for Federal estate taxes, because of the Income in Respect of a Decedent (IRD) deduction, which allows beneficiaries to deduct any estate taxes attributable to the IRA from the income they must report when they take withdrawals from the IRA. The net result is that whether the IRA is converted before death (reducing estate taxes due by paying the income taxes) or is passed on as a pre-tax IRA (reducing the income taxes due by paying the estate taxes), the heirs end out with the same amount of money.

However, that's only for Federal estate taxes. Most states that have a state-level estate tax do not have a state IRD deduction. As a result, if you are exposed to state estate taxes, you will find that the Roth allows you to leave more money for the next generation, at least to the extent of the 6% to 16% estate tax rate applicable in most states who have such a tax. Of course, you should be cautious not to push up your tax rate too far with a big conversion that the adverse income tax impact outweights the state estate tax savings!

The Bottom Line
In the end, avoiding lifetime RMDs, state estate taxes, and paying IRA tax liabilities with outside dollars are all benefits of using a Roth IRA over a traditional IRA. However, the reality is that the driving force on wealth creation - or destruction - is still a comparison of current versus future tax rates. As a result, even with all the other factors working favorably, a Roth can actually still be a wealth destroyer if future tax rates were going to be much lower for that individual when the funds are withdrawn (either by yourself in retirement, or by your heirs in the next generation).

So while the Roth IRA may be favorable in many situations, it's hardly automatic in all of them! It's important to evaluate the details of your situation, and look at each of the four factors, to determine whether and to what extent each will have an impact, and make a decision accordingly.

How Much Cash To Hold In My Investment Portfolio

12/15/2013

Q. I heard that I need to reserve 6 months cash as emergency fund, isn't that too much? How much cash should I hold in my overall investment portfolio?

A. Unless you are super wealthy, chances are, you don't have 6 month's cash as emergency fund. That's based on many surveys conducted by the likes of U.S. Trust, BlackRock, UBS, and American Express.

But do you have large chunk of cash sitting in your investment portfolio, as you are a skittish investor? If you do, don't blame yourself, if you ever experienced the following drops, it's understandable to carry lots of cash:

Technology/dotcom stock drops of 80% (2000-2002)
Housing drops of 35% (2005-2009)
Banking stock drops of 75% (2007-2009)
Equity market drops of 57% (2007-2009)
Commodities drops of 50% (2011-2013)

Why not to put cash in fixed income? Actually that interest rate situation probably exacerbated the problem - concerned about rising interest rates in the future, investors are liquidating bonds.

So, how much cash to hold in your investment portfolio?

Warren Buffet once described cash as "a call option that can't be priced, relative to the ability of cash to buy assets".

But few investors have the discipline of Warren Buffet, when market crashes, you will end up in more cash rather than exercising that call option.

When can you do, as an ordinary investor?

My advice, carry 5% or so of your investment portfolio as cash, and deploy the rest to a mix of equities and laddered bonds (with 3-7 year durations and hold to maturity).

Roth or Traditional IRA - Which is Better

12/14/2013

To Roth or not to Roth?

While the appeal for lifetime tax-free growth from a Roth may be appealing, the reality is that the Roth is not always the winning choice, and there are many myths and misunderstands about Roth accounts that make it difficult to know which is best. The reality is that there are four (and only four!) fundamental factors that determine whether a Roth will or not will be more effective than a traditional pre-tax retirement account. Some factors are always in favor of the Roth account, but others can work against the Roth account; in fact, blindly choosing a Roth and ignoring the relevant factors can actually lead to wealth destruction! By knowing the four factors and avoiding the Roth myths, you can be assured of making an effective wealth-building decision.

The Four Factors
There are only four factors that impact the wealth outcome when choosing between a Roth or traditional retirement account. They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes. Some of these factors solely benefit the Roth, but others can benefit the pre-tax account; failing to evaluate the situation properly can turn a Roth decision from a wealth creator into a long-term wealth destroyer!

Current Vs Future Tax Rates
By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates. Current tax rates means the marginal tax rate that will be paid today (or the marginal tax rate on the deduction that would be received) by contributing or using a pre-tax retirement account versus contribution or converting to a Roth account. Future tax rates means whatever tax rate would apply to the funds in the retirement account when withdrawn in the future - ostensibly in retirement, or possibly even by the next generation if the retirement account is not expected to be depleted during the lifetime of the owner.

The principle of this equation is remarkably straightforward - the greatest wealth is created by paying taxes when the rates are lowest. If rates are low today and higher in the future - e.g., for the young worker, or someone in between jobs - go with the Roth and pay taxes at today's low rates. If rates will be lower in the future - e.g., for someone whose taxable income will drop in retirement, or where the retirement account may be spent by the next generation at their lower personal tax rates - the traditional retirement account is the winner. Getting the tax rate equation wrong can result in a significant destruction of client wealth, by unnecessarily paying taxes at high rates!

Impact of RMDs
One important distinction about Roth IRAs (although not Roth 401(k) accounts) is that they are not subject to required minimum distributions (RMDs) during the lifetime of the account owner, while traditional IRAs are. The net result is a slight benefit in favor of the Roth IRA, for the simple reason that it allows more dollars to stay inside their tax-preferenced wrapper. This is an outright benefit for Roths, compared to the traditional IRA that slowly self-liquidates from RMDs, forcing money into taxable accounts where their future growth will be slowed by ongoing tax drag.

Notably, though, this benefit applies only as long as the IRA owner is alive! After death of the owner, all retirement accounts have required minimum distributions for beneficiaries, and the exact same rules apply whether it's an inherited IRA or an inherited Roth IRA (the RMD is the same, even though the tax treatment of the RMD amount may be different). Accordingly, the benefit of avoiding lifetime RMDs applies only as long as the IRA owner is alive, and likewise applies only if the IRA owner actually lives past age 70 1/2 when RMDs begin! Otherwise, the avoiding-RMDs benefit is actually a moot point.

Contribution Limits and the Embedded Tax Liability
Another factor that favors the Roth IRA is the interaction between the IRA contribution limits and the future tax liability of a pre-tax account.

For example, imagine a you are in the 28% tax bracket. If you have $1,000 in an IRA, the reality is that you actually have $720 in the IRA for yourself, and $280 in the IRA that's "on hold" for the IRS and the Federal government in the form of future taxes. If the IRA doubles to $2,000, then your share grows to $1,440 and the IRS's share grows to $560; the IRS still has 28% of the account earmarked.

In general, this isn't necessarily a "problem" as the benefit is still grow on the IRS' share before they have to be paid (that's the benefit of tax-deductible contributions); the goal is simply to pay the IRS its share whenever the tax rate is lowest, as noted earlier.

However, if you wish to make a maximum $5,000 contribution, now it's a problem. Because you can't make a full $5,000 contribution; in practice, you make a $3,600 contribution for yourself and a $1,400 contribution on behalf of the IRS. On the other hand, if you make a Roth contribution, the entire $5,000 amount is held for yourself, because the IRS' share is paid with outside investment dollars. So as long as you intend to contribute the limit, it's better (all else being equal) to contribute to a Roth and pay the taxes with outside dollars, than contribute to a traditional where the IRS' share crowds out some of the contribution limit, while tax-inefficient dollars are still growing on the side. Notably, the same effect applies for a Roth conversion where the tax liability is paid with outside dollars; just pretend that the current balance of the traditional IRA is effectively the "contribution limit" to a Roth.

State Estate Taxes
The final factor that can favor a Roth IRA is estate taxes, for the simple reason that it's bad news to pay estate taxes on a retirement account when part of it isn't even yours in the first place - it's earmarked for Uncle Sam!

For example, someone with a $1,000,000 traditional IRA and a $1,000,000 investment account has to report $2,000,000 on his/her estate tax return (combined with any other assets); however, he or she who converts the account has a $1,000,000 Roth IRA and only a $650,000 investment account (assuming a 35% tax rate on the conversion), for a total estate value of $1,650,000. At a 35% estate tax rate, making $350,000 of value "disappear" can result in $122,500 of estate tax savings!

The caveat is that such conversion strategies don't necessarily help for Federal estate taxes, because of the Income in Respect of a Decedent (IRD) deduction, which allows beneficiaries to deduct any estate taxes attributable to the IRA from the income they must report when they take withdrawals from the IRA. The net result is that whether the IRA is converted before death (reducing estate taxes due by paying the income taxes) or is passed on as a pre-tax IRA (reducing the income taxes due by paying the estate taxes), the heirs end out with the same amount of money.

However, that's only for Federal estate taxes. Most states that have a state-level estate tax do not have a state IRD deduction. As a result, people who are exposed to state estate taxes will find that the Roth allows them to leave more money for the next generation, at least to the extent of the 6% to 16% estate tax rate applicable in most states who have such a tax. Of course, people should be cautious not to push up their tax rate so far with a big conversion that the adverse income tax impact outweights the state estate tax savings!

The Bottom Line
In the end, avoiding lifetime RMDs, state estate taxes, and paying IRA tax liabilities with outside dollars are all benefits of using a Roth IRA over a traditional IRA. However, the reality is that the driving force on wealth creation - or destruction - is still a comparison of current versus future tax rates. As a result, even with all the other factors working favorably, a Roth can actually still be a wealth destroyer if future tax rates were going to be much lower for that individual client when the funds are withdrawn (either by the client in retirement, or by heirs in the next generation).

So while the Roth IRA may be favorable in many situations, it's hardly automatic in all of them! It's important to evaluate the details of your situation, and look at each of the four factors, to determine whether and to what extent each will have an impact, and make a decision accordingly.

What is Tax Arbitrage Through Roth Conversion

12/14/2013

In our last blog, we introduce the concept of tax arbitrage. Retirement accounts are one of the few vehicles that simultaneously allow individuals the potential for tax deferral, and the opportunity to control the timing of when income occurs, creating a perfect opportunity for wealth creation through tax bracket arbitrage. And the primary means of doing so: the Roth conversion.

Roth Conversion Requirements
Since 2010, Roth conversions have been available to anyone with an IRA, without any income limitations. The only requirement is that any taxable amounts from the IRA must be reported in income at the time of conversion; yet in point of fact, being able to recognize the income for tax purposes is the whole point of the strategy in the first place. And unlike just withdrawing the money to attempt to recognize it at favorable tax rates, a Roth conversion allows the individual to report the income and still enjoy tax-free growth in the future.

Roth Conversion Conditions
Notably, though, a Roth conversion is not always a winning proposition. If the individual could have simply withdrawn (or converted) the money in the future at a lower tax rate, more wealth is preserved by not doing a Roth conversion (although there are some other minor benefits to Roth conversions, like avoiding RMDs while alive, changes in tax brackets are by far the most dominating of the four factors that impact Roth conversions). As a result, optimal Roth conversion planning requires making tactical decisions about when to time the recognition of income. In addition, the reality is that a large Roth conversion itself can create enough income to drive up a taxpayer's current rates; as a result, optimal Roth conversion planning often involves an ongoing series of partial Roth conversions, rather than a single large tax event.

Roth Conversion Timing Strategies
Given that the general goal of Roth conversions is to execute them when is income (and tax brackets/marginal tax rates) are lower, general timing strategies for Roth conversions include:

Years between retirement (end of employment income) and when required minimum distributions must begin
Years with a job layoff or otherwise temporarily depressed income
Years where business income (for business owners or the self-employed) is low
Earlier years of working career before income/earnings have ramped up (though in this circumstance, many just contribute to a Roth account in the first place, rather than converting an existing pre-tax retirement account)

Roth Conversion Key Caveat
The caveat, though, is that if this year is a low-income year, the Roth conversion must be executed by the end of the year. Although taxpayers have as late as their tax filing deadline, plus extensions, to recharacterize a Roth conversion, the original conversion itself must be completed by December 31st to be eligible!

In our next blog post, we will discuss another tax arbitrage tactic - harvesting capital gain (or loss).

What Is Tax Arbitrage

12/13/2013

The Fundamental of Tax Deferral
The fundamental benefit of tax deferral is rather straightforward - if taxes have to be paid someday, the longer that day can be deferred into the future, the more time that the taxpayer can have those dollars working on his/her behalf instead. For instance, if an investment purchased for $100,000 has appreciated to $150,000, then at a 15% long-term capital gains tax rate, the owner will someday owe a $7,500 tax bill (a 15% liability on the $50,000 gain); however, to the extent this $7,500 can remain invested, rather than being sent to Uncle Sam, the investor enjoys compounding growth on $150,000 instead of only $142,500. With an 8% growth rate, the investor can generate an extra 8% x $7,500 = $600 of growth each year; compounded over time, this can accumulate to a non-trivial amount of additional wealth, created solely by taking advantage of tax deferral and the "time value of money."

If Tax Rate Will be Lower In the Future
Of course, a key caveat of this benefit is that it assumes the tax rate remains the same throughout. If the reality is that the tax rate is lower in the future, the wealth creation can be even greater; for instance, if the $50,000 gain is deferred to a time period where the taxpayer has no other income and is partially or fully eligible for the 0% long-term capital gains tax rate, then the $7,500 tax bill isn't just deferred for $600/year of economic value; some or all of that $7,500 tax liability may be permanently avoided. Similarly, if the individual might have been subject to a 23.8% long-term capital gains rate this year - due to the top 20% capital gains rate, plus the 3.8% Medicare surtax - and would only be subject to a 15% tax rate in the future, the value of tax deferral is not only compounding growth on Uncle Sam's share, but the fact that the tax bill in the future may be outright smaller than it is today if the tax rate is going to drop.

If Tax Rate Will be Higher In the Future
However, the caveat is that in some situations, the future tax rate is not equal, nor lower, but higher; in such circumstances, the higher tax rate in the future can undermine some or all of the economic value of tax deferral in the first place. For instance, if the taxpayer's rate was 15% now, but 23.8% next year, the liability of that $50,000 gain is about to go from $7,500 to $11,900! In such a scenario, merely generating $600 of tax deferral value means the investor actually ends out with less money by deferring taxes. The optimal strategy would have actually been to recognize the gain now, and to go ahead and pay the $7,500 tax liability today, rather than push the income into the future at a higher rate!

The Reality of Future Tax Rate
And unfortunately, the reality is that the potential for higher tax rates in the future is a reality that many people face. In part, this is due to the simple fact that tax brackets themselves increase as income rises; accordingly, the larger an IRA grows, the greater the risk that it will have to be liquidated in the higher tax brackets in the future, as eventually huge Required Minimum Distributions (RMDs) actually force the taxpayer into the upper brackets. Similarly, in a world where there are now effectively four capital gains tax brackets, the same problem applies for capital gains as well; if investors do too good of a job harvesting losses and deferring gains, when it actually comes time to liquidate and sell the investment, the tax bracket may be driven so high that there is actually less money as a result of deferring the tax bill!

The Optimal Tax Planning
Accordingly, "optimal" tax planning is less about just deferring and deferring and deferring taxes, and more about trying to time the income to the year when the tax rates will be lowest. Sometimes that means pushing the income out to the future, but in other circumstances the best way to save on taxes may be to choose to pay them now, at current rates, rather than paying at higher rates in the future. In essence, this creates an opportunity for "tax bracket arbitrage" - a form of free wealth creation by making well-timed decisions about when to recognize income for tax purposes.

In our next blog, we will discuss the tax arbitrage through Roth conversions.

Life Insurance and Annuity

12/8/2013

When you are young, you need life insurance in case you died too soon.

When you plan your retirement, you need annuity in case you lived too long.

Which IRA is Right for You?

12/4/2013

Etrade has a nice Easy IRA Selector, check it out if you own a small business so you can decide which IRA is right for you.

What is the Annuity Puzzle?

12/2/2013

What Do Annuity Buyers Want? - In this cover story to Research Magazine, financial planning professor Michael Finke looks at why annuities seem to be "theoretically" and academically optimal for retirement, yet so few buy them.

This "annuity puzzle" has challenged economists for years, given that annuities are so effective at smoothing income with little risk of outliving it, yet Finke concludes that ultimately the real problem is that most people aren't economists; they have more complex and nuanced goals, and irrational biases, not typically captured in standard economic models.

Yet notably, for the inflation-adjusted annuity that everyone has by default - their Social Security payments - people exhibit the opposite irrational extreme; when asked what lump sum would be necessary to give up $500/month in Social Security payments in 2008, the average respondent in the Health and Retirement Study responded $250,000 - equivalent to an assumed longevity of 130 years with a 0% discount rate. Our unwillingness to sell something for a fair price once we own it is known as the endowment effect, which explains the overvaluing of Social Security payments and our unwillingness to convert them to a lump sum, but Finke notes that the endowment effect is also likely what causes us to overvalue our liquid retirement sums and become unwilling to convert them to an annuity.

Accordingly, Finke suggests that one of the best ways to consider addressing the issue is by "reframing" their retirement assets as income instead of wealth; for instance, the Department of Labor is considering an approach where retirement plan sponsors would illustrate retirement assets based on the income they would buy rather than just their future lump sum value (especially since most people have no idea how to translate one to the other intuitively).

Another challenge is dealing with loss aversion - even if it's unlikely, we fear the losses associated with dying shortly after purchasing an annuitized stream of income; Finke notes that while economically obtaining a cash refund guarantee is less optimal, in that it reduces income, if it helps to manage the loss aversion fear, this "imperfect alternative" may still be a better course of action.

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