Tax-Driven Draw Down Strategies. Presented by Robert S. Keebler, CPA, M.S.T., AEP. 420 South Washington Street Green Bay, WI

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1 Tax-Driven Draw Down Strategies Presented by Robert S. Keebler, CPA, M.S.T., AEP 420 South Washington Street Green Bay, WI Agenda 1. Bracket Management Overview 2. Taxation of IRA Distributions & Social Security 3. Tax Efficient Investing Overview 4. Draw Down Strategies 2

2 Bracket Management 3 Bracket Management Five Dimensional Tax System Ordinary Tax Rates Capital Gains Tax Rates The AMT New Supertax PEP & Pease Limitations New 3.8% Net Investment Income Tax (NIIT) Plus the additional 0.9% Medicare tax on earned income 4

3 Bracket Management 2014 Federal Income Tax Rates and Brackets Rate Based On Taxable Income 20% Capital Gains Rate 0% Capital Gains Rate Single $406, % $457,600+ $406,750 35% $457,600+ $405,100 33% $405,100 28% 25% $36,900 15% $73,800 <$9,075 $186,350 $89,350 10% Married, filing jointly $226,850 $148,850 <$18,150 15% Capital Gains Rate 5 Alternate Minimum Tax How the AMT works. AMT Income Calculation Taxable income (for regular income tax purposes) + Standard deduction (if taken) + Personal/dependency exemptions + Certain exclusion items (e.g. taxes, miscellaneous deductions) + Certain deferral items (e.g. ISO exercise income, depreciation) State income tax refund 3% phase out of itemized deductions (starting in 2013) Certain deferral items (e.g. gain/loss adjustment) Alternative Minimum Taxable Income (AMTI) Less: AMT exemption amount Net AMTI 6

4 Alternate Minimum Tax How the AMT works. AMT Rates 26% 28% Married Filing Separately $0 91,250 $91,251 + All Others $0 182,500 $182,501 + AMT Exemption Exemption Amount Married Filing Jointly $82,100 Married Filing Separately $41,050 All Others $52,800 7 AMT Exemption Phase out Alternate Minimum Tax How the AMT works. Phase out Starts Phase out Ends Married Filing Jointly $156,500 $484,900 Married Filing Separately $ 78,250 $242,450 All Others $117,300 $328,500 For every $1 of income over the threshold the exemption is reduced by $0.25 This increases the marginal rate of taxpayers within the phase out by 25%. Therefore, for a taxpayer within the phase out and the 28% rate applies the marginal rate is 35%! 8

5 Bracket Management Phase Out of Personal Exemptions & Itemized Deductions Phase out of personal exemptions (PEP) and limitations on itemized deductions (Pease) as income rises above the following threshold amounts in 2014: Single taxpayers $254,200 Head of households $279,650 Married filing jointly or surviving spouse $305,050 Married filing separately $152,525 9 Bracket Management Phase Out of Itemized Deductions (Pease) PEP reduces personal exemption by 2% for every $2,500 of income above the threshold amount for most taxpayers Pease cuts itemized deductions by 3% of AGI above the threshold amounts up to a maximum of 80% 10

6 Bracket Management 3.8% NIIT Overview Net Investment Income Includes: Interest Dividends Annuity Distributions Rents Royalties Income derived from passive activity Net capital gain derived from the disposition of property Does NOT Include: Salary, wages, or bonuses Distributions from IRAs or qualified plans Any income taken into account for self employment tax purposes Gain on the sale of an active interest in a partnership or S corporation Items which are otherwise excluded or exempt from income under the income tax law 11 Fly Below the Radar $ 457, % Bracket Ouch! $ 305,050 PEP / Pease Okay $ 250, % NIIT Ideal 12

7 Bracket Management Poor Bracket Management Scenario $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $ Taxable Income and RMD Taxable Income IRA Distributions 39.6% Bracket 35% Bracket 33% Bracket *Taken from a product created by for the AICPA called the Tax Rate Evaluator: A Graphical Calculator for Tax Planning After ATRA (PTX1307M). It is available at or by calling Taxation of IRA Distributions Foundation Concepts IRA distributions are taxable as ordinary income & Roth IRA distributions are generally not taxable If non deductible contributions where made to a traditional IRA, a portion of each IRA distribution will be a return of non taxable basis to the IRA owner to determine the non taxable portion of a distribution, all IRAs and IRA distributions during the year (including outstanding rollovers) must be combined for apportioning basis 14

8 Taxation of IRA Distributions Foundation Concepts Basis Apportionment Formula - Example 15 Taxation of Social Security Benefits % Subject to Income Tax 85% 50% 0% Safe Haven- No Taxation $32,000 (married) $25,000 (single) 50% Zone 85% Zone $44,000 (married) $34,000 (single) Modified Adjusted Gross Income (MAGI) 16

9 Taxation of Social Security Benefits $ Unlimited $34,000 ( Ceiling ) $25,000 ( Floor ) $0 Single If Modified Adjusted Gross Income (MAGI) falls within this range, the taxable benefit is the lesser of: (1) 85% of the excess of MAGI over the ceiling plus $4,500 ($6,000 if married) OR (2) 85% of the Social Security benefits If Modified Adjusted Gross Income (MAGI) falls within this range, the taxable benefit is the lesser of: (1) 50% of the excess of MAGI over the floor OR (2) 50% of the Social Security benefits If Modified Adjusted Gross Income (MAGI) falls within this range, no Social Security benefits are taxable Married Filing Jointly $ Unlimited $44,000 ( Ceiling ) $32,000 ( Floor ) $0 17 Social Security Benefits MAGI = Modified Adjusted Gross Income before SS plus: Tax exempt interest on Series EE U.S. Savings Bonds used to pay tuition Adoption assistance payments Foreign earned income Income from U.S. possessions Income from Puerto Rico Deductions claimed for student loan interest and qualified tuition 18

10 Tax Aware Investing It s not about what you make, but what you keep! 19 Tax Aware Investing KEY TOPICS Tax Structure Determining an effective mix of taxable investments, tax deferred investments and tax free investments 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 20

11 Tax Aware Investing Tax Drag Example Depending on the tax rate, the after tax growth of a $10,000/year investment earning an 8% pre tax yield varies dramatically: Tax Rate After Tax Growth Rate* Final Value 0% 8.0% $2,590,656 10% 7.2% $2,102,199 20% 6.4% $1,712,216 30% 5.6% $1,400,380 40% 4.8% $1,150,637 50% 4.0% $950,255 *After tax growth rate = 8% x (1 tax rate) 21 Tax Aware Investing Ideal Assets for Qualified Plans and IRAs Taxable Bonds REITS High Turnover, Short Term Gain Strategies Nonqualified Dividends High yield Stocks Option Strategies 22

12 Tax Aware Investing Ideal Assets for Taxable Accounts Low Turn Over Gain Strategies Qualified Dividend Long Term Capital Gain Strategies Real estate Investments Oil and Gas Investments I Bonds Tax Exempt Bonds Master Limited Partnership 23 Tax Aware Investing Retirement Assets How are distributions taxed? Basis Tax Free Earnings Loans 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 Contract Life Insurance (4) Modified Endowment Contract Basis First Available Earnings Follow Earnings First N/A Basis Follows 1. All IRAs are combined for the distribution computation 2. All Roth IRAs are combined for the distribution computation 3. Loans available, with interest to the extent of cash surrender 4. Each contract is treated separately for distribution purposes 24

13 100% 401(k) and IRA Strategy $80, (k) IRAs Approach 100% Taxable $80,000 taxed at 25% =$20,000 Tax $60,000 to spend after taxes Tax Aware Investing Retirement Income of $80,000 A Balanced Strategy $80,000 $40,000 $40, (k) /Qualified Plans 100% taxable $40,000 taxed at 15% =$6,000 $74,000 to spend after taxes Cash Value Life Insurance/Roth IRA Tax Free $0,000 taxed at 0% =$0 tax 25 Draw Down Strategies Combing Bracket Management & Tax Aware Investing 26

14 Assessing the Primary Issues Which assets should a client spend first? When should a client do a Roth conversion? Understanding the advantages and disadvantages of taking stock from a qualified plan When and how to draw non qualified annuities When and how to draw deferred compensation When and how to exercise NSOs and ISOs 27 Tax-Sensitive Withdrawal Strategies At Retirement Key Concepts Evaluate rollover of pensions and profit sharing plan Evaluate asset protection issues Manage Net Unrealized Appreciation (NUA) opportunities Monitor the 10% IRC 72(t) penalty Manage basis in both IRAs and qualified plans Manage qualified Roth Distributions Manage MAGI to remain below the threshold amount Reduce net investment income 28

15 Tax-Sensitive Withdrawal Strategies Retirement Years Key Concepts Manage the 10% and 15% tax brackets Generally defer IRA distributions taxed at 25% or greater Draw upon outside assets and deferred compensation first Draw upon traditional IRA assets second Draw upon Roth IRA assets last Review Roth conversions to manage tax brackets Focus on surtax planning Reduce investment income reduce MAGI Reduce MAGI 29 Tax-Sensitive Withdrawal Strategies Later Retirement Years (After Age 70) Key Concepts Manage the 10% and 15% tax brackets Manage Required Minimum Distributions (RMDs) Spend down high basis outside assets 30

16 Tax Sensitive Retirement Perhaps one of the most important decisions a retiree must make is to determine from which retirement assets to withdraw funds to meet everyday living expenses. 31 Tax-Sensitive Retirement Key Decision Factors Size of accounts Size of RMDs relative to cash flow requirement Investment mix / performance Marginal income tax bracket Time horizon Estate planning goals 32

17 Tax-Sensitive Retirement Starting points to evaluate proper withdrawal order Future income at the same or lower tax rate 1) Taxable account 2) Tax-deferred account 3) Tax-free account Future income taxed at higher tax rate 1) Tax-deferred account 2) Taxable account 3) Tax-free account 33 Bracket Management & Example Consider a couple who are semi-retired and both age 60. They will earn about $140,000 this year, but they will require an additional $15,000 from their retirement plans to meet living expenses. The couple has a number of accounts including an IRA with $100,000 and a Roth IRA with $100,000. These accounts earn a return of about 7%. 34

18 Bracket Management & Example (cont) Option 1 Draw down Roth IRA first Option 2 Draw down Traditional IRA first Option 3 Mix Distributions 35 Fill in with Roth to meet Cash Flow Need Target Traditional IRA Distribution Amount Bracket Management & Example(cont) Option 3 mix Earned Income 10% tax bracket 15% tax bracket 25% tax bracket 28% tax bracket 33% tax bracket 35% tax bracket 36

19 Bracket Management & Example (cont) account values after 10 years if future Traditional IRA distributions are taxed at 15% $158,500 $158,000 $157,500 $157,000 $156,500 Roth First Traditional First Mix $156,000 $155,500 $155, Bracket Management & Example (cont) account values after 10 years if future Traditional IRA distributions are taxed at 25% $160,000 $155,000 $150,000 $145,000 $140,000 Roth First Traditional First Mix $135,000 $130,000 $125,000 38

20 Bracket Management & Example 2 Consider a fully retired and both age 62. The couple has a number of accounts including: An IRA with $1,300,000 A brokerage account with $750,000 and a cost basis of $500,000 Their pre-tax rate of return is: 6% (2% yield + 4% growth) 39 Bracket Management & Example 2 (cont.) A Social Security benefit in 2014: $30,000 Annual after-tax cash flow needs of: $144,000 No state income taxes: 0% Itemized deductions: $30,000 40

21 Bracket Management & Example 2 (cont) Option 1 Draw down Traditional IRA First Option 2 Draw down Brokerage Account First Option 3 Mix Distributions withdrawal from IRA up to 10% bracket 41 Tax-Sensitive Retirement Year 5 Year 10 Year 20 Year 30 OPTION 1 Withdraw 100% From Traditional IRA OPTION 2 Withdraw 100% From Brokerage Account OPTION 3 Withdraw From Traditional IRA Up to 10% Tax Bracket 42

22 Bracket Management & Consider the tax consequences to the retiree s heirs & ordering Drawdown of Accounts 43 Bracket Management & Tax consequences to the retiree s heirs: Estimate whether the retiree will be able to leave retirement accounts to their heirs Evaluate drawing down taxable investment assets before IRAs Consider the possibility of a large step-up in basis for taxable assets If client expects to be in the same or lower tax bracket than beneficiaries, consider accelerating taxation and shifting assets to tax-free vehicles (e.g. Roth Conversions) 44

23 Bracket Management & Example 3 Client, age 60 and single, has a $500,000 taxable account and a $500,000 Traditional IRA Client needs $60,000 annually for living expenses Client receives $12,000 of Social Security beginning at age 62 Annual return consists of 3% ordinary income (i.e. interest income) and 4% growth on the value in each account The stock earnings are tax deferred until the time of sale, then taxed as long-term capital gains 25% ordinary income tax rate 15% capital gains tax rate 85% of Social Security benefits are subject to income tax 45 Example 3 (cont.) Bracket Management & Benefit of Withdrawing Funds from a Taxable Account First Balance at a Particular Year $529,519 of additional assets (48% difference) Note: the retiree will be able to leave a large tax benefited account to heirs 46

24 Questions? 47 Required Disclosure Under Circular 230 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. 48

25 Contact Information For information on upcoming seminars and webinars, please visit our website: keeblerandassociates.com/events To be added to our newsletter, please visit keeblerandassociates.com/speaking 49