introduction to tax-efficient investing (part 1)

Tax-Aware Investing--It’s The After-Tax Return That Counts!

Part 1 of 4

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us.

Presented by:

Robert S. Keebler, CPA, MST, AEP (Distinguished)Keebler & Associates, LLP

420 S. Washington St.Green Bay, WI 54301

Phone: (920) [email protected]

Tax-Efficient Investing Webinar Series

Tax Aware Investing KEY TOPICS• Tax Structure – Determining the “optimum” mix of taxable

investments, tax-deferred investments and tax-free investments (i.e. Where should retirement savings be invested?)

• Tax-Sensitive Asset Allocation – Understanding the impact that income taxation has on asset allocation and diversification

• Asset Location – Identifying which assets to place in certain investment vehicles

• Retirement Distribution Strategies to Last a Lifetime – Integrating tax structure, tax-sensitive allocation and asset location to ensure that retirement funds will last a lifetime

SM Tax Asset Classes is a service mark of Robert S. Keebler, CPA, MST, AEP and Keebler & Associates, LLP

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Tax StructureDetermining the “Optimum” Mix of Investment

Vehicles/Structures


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Roth IRA• Tax-free

growth during lifetime

• No 70½ RMD• Tax-free

distributions out to beneficiaries life expectancy

Life Insurance• Tax-deferred

growth• Tax-exempt

payout at death

Interest Income

- Taxable

Capital Gain Income

- Preferential Rate

- Deferral until sale

Roth IRA and

Insurance

- Tax Free Growth/ Benefits

Real Estate, Oil & Gas and

Tax Exempt Bonds

- Tax Preferences

Pension and

IRA Income

- Tax Deferred

• Money market

• Corporate bonds

• US Treasury bonds

Attributes• Annual

income tax on interest

• Taxed at highest marginal rates

• Equity Securities

Attributes• Deferral

until sale• Reduced

capital gains rate

• Step-up basis at death

Real Estate• Depreciation

tax shield• 1031

exchanges• Deferral on

growth until sale

Oil & Gas• Large up

front IDC deductions

• Depletion allowances

• Pension plans• Profit sharing

plans• Annuities

Attributes• Growth during

lifetime• RMD for IRA

and qualified plans

• No step-up

TAX ASSET CLASSESSM

Dividend Income

Tax Exempt Interest

• Equity securities

Attributes• Qualified

dividends at LTCG rate

• Return of capital dividend

• Capital gain dividends

• Bonds issued by State and local Governmental entities

Attributes• Federal tax

exempt• State tax exempt

© 2011 Prepared by Robert S. Keebler, CPA, MST, AEP (Distinguished) Keebler & Associates, LLPAll Rights [email protected]

Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party.

For discussion purposes only. This work is intended to provide general information about the tax and other laws applicable to retirement benefits. The author, his firm or anyone forwarding or reproducing this work shall have neither liability nor responsibility to any person or entity with respect to any loss or damage caused, or alleged to be caused, directly or indirectly by the information contained in this work. This work does not represent tax, accounting, or legal advice. The individual taxpayer is advised to and should rely on their own advisors.


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© 2011 Keebler & Associates, LLPAl Rights Reserved.

Income Taxation Basics of Retirement InvestmentsThree Main Types of Retirement Investment Accounts

• Taxable investment accounts – income generated within the account (i.e. interest, dividends, capital gains, etc.) are taxed each year to the account owner

• Tax-deferred investment accounts (e.g. traditional IRAs, traditional qualified retirement plans, non-qualified annuities, deferred compensation) – income generated within the account is not taxed until distributions are taken from the account

• Tax-free investment accounts (e.g. Roth IRAs, life insurance) – income generated within the account is never taxed when distributions are made (provided certain qualifications are met)

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Income Taxation Basics of Retirement InvestmentsCommon Assets in a Client’s Portfolio

• IRA Accounts• Roth IRA Accounts• ERISA Plans• Tax-Deferred Annuities• Life Insurance• Stocks, Bonds, Warrants, Options• Employer NSOs and ISOs• Employer Deferred Compensation• Real Estate• Oil & Gas• U.S. Savings Bonds

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• 2011 Ordinary Income Rates

• Capital Gain– 0% rate if you are in the 10% or 15% bracket– 15% rate if you are in the 25%, 28%, 33% or 35% bracket


SingleQualified

Widow(er)Married

Filing Jointly

Married Filing

SeparatelyHead of

Household

10% Tax Rate $8,500 $17,000 $17,000 $8,500 $12,150

15% Tax Rate $34,500 $69,000 $69,000 $34,500 $46,250

25% Tax Rate $83,600 $139,350 $139,350 $69,675 $119,400

28% Tax Rate $174,400 $212,300 $212,300 $106,150 $193,350

33% Tax Rate $379,150 $379,150 $379,150 $189,575 $379,150

35% Tax Rate > $379,150 > $379,150 > $379,150 > $189,575 > $379,150

Income Taxation Basics of Retirement Investments

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2011 & 20122013 & Beyond1

10% 15%

15% 15%

25% 28%

28% 31%

33% 36%

35% 39.6%

2011 & 20122013&

Beyond*

0% 10% / 8%15% 20% / 18%

Ordinary IncomeLong-TermCapital Gains

*NOTE: In general, the 8% and 18% capital gains rates only apply to long-term capital gains on property that has been held more than five years at the time of sale.

For the 18% rate, the property must be purchased after December 31, 2000.



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Beginning with the 2013 tax year, a new 3.8% Medicare “surtax” on net investment income will apply to all taxpayers whose income exceeds a certain “threshold amount”. This new “surtax” will, in essence, raise the marginal income tax rate for affected taxpayers.

• Thus, a taxpayer in the 39.6% tax bracket (i.e. the highest marginal income tax rate in 2013) would have a federal marginal rate of 43.4%!


Income Taxation Basics of Retirement InvestmentsNew 3.8% Medicare “Surtax”

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New 3.8% Medicare “Surtax”

Tax Rate in 2011 & 2012

Tax Rate in 2013

Tax Rate in 2013+

(w/surtax)10% 15% 15%15% 15% 15%25% 28% 28%28% 31% 34.8%33% 36% 39.8%35% 39.6% 43.4%

NOTE: The chart above assumes that the 3.8% Medicare surtax would not begin to apply until a person’s taxable income reaches the 31% tax bracket (based on certain net investment income and itemized deduction assumptions). However, there are times, though unlikely, when the 3.8% could apply to a person in a lower tax bracket (i.e. 15%, 28%) or may not apply to a person in higher tax brackets (31%, 36%, 39.6%).



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APPLICATION TO INDIVIDUALS – the new Medicare surtax is equal to 3.8% times the lesser of the following:

1. “Net investment income”, OR

2. The excess (if any) of –

a. “Modified adjusted gross income” (“MAGI”) for such taxable year, over the

b. “Threshold amount”



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Three critical terms are associated with the 3.8% Medicare surtax:

• “Net investment income”• “Threshold amount”• “Modified adjusted gross income” (“MAGI”)



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• “Net investment income” is defined as interest, dividends, annuities, rents, royalties, income derived from a passive activity, and net capital gain derived from the disposition of property (other than property held in an active trade or business), reduced by deductions properly allocable to such income.

• Specifically, this does not include the following:

1. Income derived from an active trade or business;

2. Distributions from IRAs or their qualified plans;

3. Any income taken into account for self-employment tax purposes;

4. Gain on the sale of an active interest in a partnership or S corporation; or

5. Items which are otherwise excluded or exempt from income under income tax law, such as interest from tax-exempt bonds, capital gain excluded on the sale of a principal residence under IRC §121, and veteran’s benefits.



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“Threshold amount” is the key factor in determining the “lesser of” formula for purposes of calculating the surtax.

Threshold amounts• Single taxpayers - $200,000• Married, filing jointly taxpayers - $250,000• Estates/trusts - $11,350 (i.e. top income tax bracket in 2011)



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Investment Incentives in the Tax Code• Qualified dividends • Long-term capital gains • Qualified retirement accounts (e.g. 401(k) plan) • Roth IRAs/Roth 401(k) plans • Real estate depreciation • Oil & gas• Life insurance• Non-qualified annuities• Master Limited Partnerships (MLPs)• Index options

© 2011 Keebler & Associates, LLPAl Rights Reserved. 15

Deductible IRAs, Pension Plan Incentives and Deferred Compensation

• Deductible contributions• Tax deferred growth• Taxable withdrawals • Net Unrealized Appreciation (NUA)• Lump-sum averaging • Aggregation of accounts• Roth IRA conversions


Roth IRA and Roth 401(K) Incentives

• Non-deductible contributions• Tax-free growth• Non-taxable withdrawals for “qualified

distributions” • Five-year rule & Age 59 ½ Rule


Qualified Dividend Incentives

• Taxation of Interest Income - Ordinary Income• Taxation of Traditional Dividends- Ordinary

Income• Taxation of “Qualified Dividends” – Capital

Gains Rate of 15%


Capital Gains Incentives

• Gains Deferred until Property is Sold• Short-term Gains are Taxed at Ordinary Rates• Long-term Gains are Taxed at Lower Tax Rates• Step-up in Basis at Death• Gifts to Charity or a Charitable Trust that do

not Trigger Tax


Real Estate Incentives

• Interest Deductions• Depreciation Tax Shield• 1031 Tax-free Exchanges• Step-up in Basis at Death


Oil and Gas Incentives

• Intangible drilling costs (IDCs) provide a large immediate income tax deduction (up to 85% of the initial investment)• Losses, if any, created as a result of IDCs will be

ordinary (thus lowering a taxpayer’s AGI)• Must be a general partner in the first year• Possible AMT add-back issues if IDCs exceed 40% of

AMTI• Depletion and other depreciation (including

Section 179 expensing) provide for additional deductions during the term of the investment

• Additional tax credits may be available for certain oil & gas ventures

• AMT Issues

© 2011 Keebler & Associates, LLPAll Rights Reserved. 21

Life Insurance Incentives

• Tax-Deferred Growth• Tax-Free Death Benefit• Tax-Free Basis Distributions First• Tax-Free Loans• All Contracts are Treated Separately• Modified Endowment Restrictions


Nonqualified Annuity Incentives

• Tax-deferred Growth• Pro-rate Basis Distributions if Annuitized • All Contracts are Treated Separately


Retirement AssetsHow are Distributions Taxed?

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© Robert S. Keebler, CPA, MST, AEPKeebler & Associates, LLPAll Rights Reserved

Basis Tax-Free Loans

Earnings

IRA(1) Pro rata Method N/A Pro rata Method

ERISA Plan Pro rata Method N/A Pro rata Method

Roth IRA(2) Basis First N/A Earnings Follow

Non-qualified Annuity Basis Follows N/A Earnings First

Life Insurance(3)

Non-Modified Endowment ContractBasis First Available Earnings Follow

Life Insurance(4)

Modified Endowment ContractEarnings First N/A Basis Follows

1. All IRAs are combined for the distribution computation2. All Roth IRAs are combined for the distribution computation3. Loans available, with interest to the extent of cash surrender4. Each contract is treated separately for distribution purposes

Attributes Non-qualified Annuity MEC

During LifeCash value growth Income tax deferred Same

Lifetime distributions Taxable as income to the extent of growth, followed by recovery of

basis

Same

10% penalty on distribution before age 59 ½

10% penalty on taxable amount unless an exception applies

Same

Exceptions to 10% penalty Taxpayer’s age 59 ½ or disability, owner’s death, series of

substantially equal periodic payments

Same without death

Gifts of contract during life Donor pays income tax on any gain in the contract

No income tax to donor or donee

At Death

Death proceeds Amount in excess of basis in the contract is taxed as ordinary income

to the beneficiary

Generally, 100% free from income tax to the beneficiary

Annuities and Modified Endowment ContractsTax Attributes

25© 2011 Keebler & Associates, LLPAl Rights Reserved.

Incentives for Master Limited Partnerships

• Cash Distributions are often Tax-free• Depreciation Tax-shield• Reduction in Basis• Step-up in Basis at Depth


Incentives for Listed Index Options

• 60% Long-term Capital Gain• 40% Short-term Capital Gain• Effective Tax Rate of 23%

– ((15% X 60%) + (35% X 40%))• “Marked to Market” Taxation at Year End


Blending Tax and Finance

• Asset “Allocation”• Tax Incentives• Asset “Location”


Common Problems Blending Tax and Finance

• Large IRAs and Qualified Plans• Minimal IRAs and Qualified Plans• High Turnover Investments


The Mathematics of WealthCreation


Traditional IRA/Roth IRAKey Assumptions


• Beginning Age: 30• Ending Age: 65 (i.e. retirement)• Annual Contribution (Age 30 – 49): $5,000• Annual Contribution (Age 50 – 65): $6,000• Ordinary Income Tax Rate (@ contribution): 25%• Ordinary Income Tax Rate (@ distribution): 25%• Long-Term Capital Gains Tax Rate: 15%• Annual Income/Growth Rate: 6%

Scenarios


1. Deductible Traditional IRA vs. Taxable Investment Account(Bond Portfolio)

2. Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/100% Turnover)

3. Deductible Traditional IRA vs. Taxable Investment Account(Stock Portfolio w/10% Turnover)

4. Non-Deductible Traditional IRA vs. Taxable Investment Account (Bond Portfolio)

5. Non-Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/100% Turnover)

Scenarios


6. Non-Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/10% Turnover)7. Roth IRA vs. Taxable Investment Account

(Bond Portfolio)8. Roth IRA vs. Taxable Investment Account

(Stock Portfolio w/100% Turnover)9. Roth IRA vs. Taxable Investment Account

(Stock Portfolio w/10% Turnover)10. Deductible Traditional IRA vs. Roth IRA11. Non-Deductible Traditional IRA vs. Roth IRA

Deductible Traditional IRA vs. Taxable Investment Account (Bond Portfolio)


30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000 Total Investment Balance

Deductible Traditional IRA Taxable Investment Account

COMMENT: Tax-deferred growth over time allows for more wealth to accumulate.

Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/100% Turnover)


30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000



COMMENT: Tax-deferred growth over time allows for more wealth to accumulate, even with lower capital gains tax rates

Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/10% Turnover)


30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000



COMMENT: Tax-deferred growth over time allows for more wealth to accumulate. However, with low turnover and lower capital gains tax rates, the taxable investment stays pretty close.


Non-Deductible Traditional IRA vs. Taxable Investment Account (Bond Portfolio)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000


Non-Deductible Traditional IRA Taxable Investment Account

COMMENT: Tax-deferred growth over time allows for more wealth to accumulate. However, without any income tax deduction, the traditional IRA is not as favorable.


Non-Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/100% Turnover)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000


Taxable Investment Account Non-Deductible Traditional IRA

COMMENT: Tax-deferred growth over time allows for more wealth to accumulate. However, without any income tax deduction and lower capital gains tax rates, the IRA barely breaks even with a taxable investment.


Non-Deductible Traditional IRA vs. Taxable Investment Account (Stock Portfolio w/10% Turnover)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000


Taxable Investment Account Non-Deductible Traditional IRA

COMMENT: Even with tax-deferred growth, the taxable investment is better over time because of the lower capital gains tax rates.


Roth IRA vs. Taxable Investment Account (Bond Portfolio)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000


Roth IRA Taxable Investment Account

COMMENT: Tax-free growth over time allows for more wealth to accumulate.


Roth IRA vs. Taxable Investment Account (Stock Portfolio w/100% Turnover)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000



COMMENT: Tax-free growth over time allows for more wealth to accumulate, even with lower capital gains tax rates.


Roth IRA vs. Taxable Investment Account (Stock Portfolio w/10% Turnover)

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000



COMMENT: Tax-free growth over time allows for more wealth to accumulate, though low turnover and lower capital gains tax rates even-up the two investments.


Deductible Traditional IRA vs. Roth IRA

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000


Roth IRA Deductible Traditional IRA

COMMENT: Assuming tax rates are the same in the contribution years as in the withdrawal years, a deductible traditional IRA and Roth IRA will come out to be roughly the same. The only slight difference is due to the after-tax rate of return in the “side fund”.


Non-Deductible Traditional IRA vs. Roth IRA

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 $-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000


Roth IRA Non-Deductible Traditional IRA

COMMENT: Assuming tax rates are the same in the contribution years as in the withdrawal years, a Roth IRA will come out ahead because there is no reinvestment opportunity with a non-deductible traditional IRA.

Traditional IRA/Roth IRAObservations (What Have We Learned?)


• Bonds (or other ordinary income producing assets) should be placed in IRAs (traditional/Roth) instead of taxable investment accounts

• Lower turnover equity investments (i.e. long-term capital gain assets) should be positioned in taxable investment accounts

• Roth IRAs are slightly better than deductible traditional IRAs and taxable investment accounts with low turnover equity investments

• Roth IRAs are much better than non-deductible traditional IRAs and taxable investment accounts with ordinary income producing assets)

Tax-Deferred Annuity/Life InsuranceKey Assumptions


• Beginning Age: 30• Ending Age: 65 (i.e. retirement)• Initial Investment: $50,000• Ordinary Income Tax Rate: 25%• Long-Term Capital Gains Tax Rate: 15%• Annual Income/Growth Rate: 6%• Annual Yield Rate (Tax-Deferred Annuity): 6%• Annual Yield Rate (Life Insurance): 6%

introduction to tax-efficient investing (part 1)

Economy & Finance

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taxable investment accounts

deductible traditional ira

income taxation basics

net investment income

taxable investment account

deductible traditional iras