TAX-EFFICIENT DRAWDOWNS IN RETIREMENT

TAX-EFFICIENT DRAWDOWNS IN RETIREMENT CFA Society Houston Stephen M. Horan, Ph.D., CFA, CIPM Managing Director, Credentialing

TAX-EFFICIENT DRAWDOWNS IN RETIREMENT Agenda Conclusions 1. Conventional wisdom 2. The economics of various taxable structures 3. Implications for pre-retirement asset allocation and asset location 4. Using available tax structures in retirement 1. Taxes reduce investment risk for taxable accounts (but not TDAs and Roths) 2. Asset allocation and asset location are solved by the same process 3. Withdrawal order between taxpreferred account structures is irrelevant is a flat tax and static tasx regime 4. Large opportunities for tax efficient withdrawals in a progressive tax system

CONVENTIONAL WISDOM Spend from your taxable account first.... Next, consider withdrawing money from your tax-deferred accounts.... Finally, withdraw money from tax-free accounts. - Vanguard (2013)

ECONOMICS OF TAX STRUCTURES 1. TDAs are like a limited partnership with the government 2. Investors bear all risk and return on after-tax funds in TDAs 3. Investors share risk and return with the government in taxable accounts

A TAX-DEFERRED ACCOUNT (TDA): LIMITED PARTNERSHIP WITH TWO PARTNERS Investor Limited Partner (1-t n ) Principal Corpus Incremental Return Government General Partner t n Principal Corpus Incremental Return

TAX-DEFERRED ACCOUNTS (TDA): THE INVESTOR BEARS ALL RISK AND RETURN ON AFTER-TAX FUNDS

TAXABLE ACCOUNTS: TAXES REDUCE INVESTMENT RISK Consider a $100,000 investment with the following potential outcomes Outcome Prob. Pretax Accumulation Pretax Return After-Tax Market Value After- Tax Returns Good 1/3 $125,000 25% $115,000 15% Average 1/3 110,000 10% 106,000 6% Bad 1/3 95,000 5% 97,000 3% Exp. Value $110,000 10% $106,000 6% Std. Dev. (σ) 15% 9% Note: Investment returns are assumed to be taxed at a rate of 40 percent in the year they are earned.

TAXABLE ACCOUNTS: WHAT IS YOUR TAX RATE? Investor Type Expression Future Accumulation Accrual Equivalent Return Accrual Equivalent Tax Rate Exempt Investor $1,000(1.08) 20 $4,661 8.0% 0.0% Passive Investor $1,000[(1.08) 20 (1 0.2) + 0.2] $3,929 7.1% 11.5% Active Investor $1,000[1 + 0.08(1 0.2)] 20 $3,458 6.4% 20.0% Trader $1,000[1 + 0.08(1 0.4)] 20 $2,554 4.8% 40.0%

TAXABLE ACCOUNTS: AN EXAMPLE Value of a Taxable Account Over Time 400 373 350 323 300 r TE = [(1+r*) n (1-T*) + T* - (1-B)t cg ] 1/n -1 = 6.0% 250 Value 200 r* = r(1 - p d t d - p oi t oi - p cg t cg ) = 6.8% k = r f + (1 - p d t d - p oi t oi - p cg t cg )β(r m - r f ) = 7.3% 150 Pretax Value = 100 After-Tax Value = 80 50 Value of a taxable account over time assuming an 8% return. The pretax return is 8%. The proportion of return taxed each 0year as ordinary income, dividends, and capital gains is 25%, 25%, and 0%, respectively. The tax rates on each of these 0 forms of return are 5 assumed to be 30%, 10 30%, and 25%, respectively. 15 The original 20cost basis is assumed to be 60% of the initial pretax market value. The Year risk-free rate is 3%, the beta is one, and the market risk premium is 5%. 10

IMPLICATIONS IN PRE-RETIREMENT 1. After-tax asset allocation is what matters 2. After-tax portfolio optimization is different 3. Use multiple tax structures in the accumulation phase to provide options in drawdown

MEASURING AFTER-TAX ASSET ALLOCATION: A SIMPLE EXAMPLE Account Type Asset Class Pretax Market Value Pretax Weights After-Tax Market Value After-Tax Weights 401(k) Stock $1,500,000 75% $900,000 64.3% Roth IRA Bonds 500,000 25% 500,000 35.7% Total Portfolio $2,000,000 100% $1,400,000 100% Note: Withdrawals at the end of the investment horizon are assumed to be taxed at a rate of 40 percent.

AFTER-TAX PORTFOLIO OPTIMIZATION Each asset-account combination is a unique after-tax asset After-Tax Returns Different assets Different accounts/entities - Trusts - Tax-deferred accounts (e.g., Traditional IRA, 401(k), PPVA, RRSP) - Tax-exempt accounts (e.g., Roth IRA, Roth 401(k), 529 plans, PPLI TFSA) - Taxable accounts After-Tax Volatility After-Tax Covariance Matrix Portfolio Constraints Funds available in a particular taxable entity

PORTFOLIO OPTIMIZATION: A SIMPLE EXAMPLE (PRE-TAX) Equity Cash Return 8% 3% Std. Dev. 20% 0% Optimal Weight 31% 69% 14

PORTFOLIO OPTIMIZATION: A SIMPLE EXAMPLE (AFTER-TAX) Taxable TDA Equity Bonds Equity Bonds Pretax Return 8% 3% 8% 3% Effective Ann. Tax Rate 20% 40% 15% 15% Effective After-Tax Return 6.4% 1.8% 6.8% 2.6% Pretax Std. Dev. 20.0% 0.0% 20.0% 0.0% After-tax Std. Dev. 16.0% 0.0% 17.0% 0.0% Weight 40.0% 0.0% 0.0% 60.0% Account Constraints 40.0% 60.0%

IMPLICATIONS FOR DRAWDOWN 1. Use tax brackets strategically 2. Use of conversion and re-characterization option strategically 3. Use volatility strategically 16

DRAWDOWN SEQUENCE: TAX-DEFERRED ACCOUNT (TDA) VS. TAX-EXEMPT ACCOUNT (TEA) Simple Drawdown Strategies Naïve Strategies 1. Drawdown TDA until depleted 2. Drawdown TEA until depleted Informed Strategy 1. Drawdown TDA to fill up low tax brackets Flat Tax Structure Withdrawal sequence is irrelevant 17

PROGRESSIVE MARGINAL TAX RATES ADJUSTED FOR EXEMPTIONS Exemptions, Deductions, Tax Rates, and Tax Brackets for a Married Couple Filing Jointly in 2015 Marginal Tax Rate Exemptions, Deductions, AGI Tax Brackets Income from Income to 0% $20,600 $0 $20,600 10% $18,450 $20,600 $39,050 15% $74,900 $39,050 $95,500 25% $151,200 $95,500 $171,800 28% $230,450 $171,800 $251,050 33% $411,500 $251,050 $432,100 35% $464,850 $432,100 $485,450 39.6% > $464,850 $485,450 greater * Taxpayers over the age of 65 are entitled to an additional standard deduction of $1,000 per spouse. ** Personal exemptions begin to phase out at AGI of $309,900 and are eliminated at AGI above $380,750. 18

PROGRESSIVE TAX RATE ENVIRONMENT: BASE CASE ASSUMPTIONS $1,000,000 in traditional IRA $720,000 in Roth IRA (TDA) Inflation- Adjusted Spending 25-year time horizon 8% return Terminal tax rate is 28%

PROGRESSIVE TAX RATES Traditional then Roth is the better of the two naïve withdrawal strategies Informed strategies offer substantial improvement 10% 15% 25%

PROGRESSIVE TAX RATES Traditional then Roth is the better of the two naïve withdrawal strategies - These incremental accumulations are in relation to the Traditional then Roth strategy Informed strategies offer substantial improvement 10% 15% 25%

WEALTHIER INVESTORS Low and High tax brackets are relative terms TDA $2 million TEA $1.44 million TDA $4 million TEA $2.88 million Fill up to 25% tax bracket Corresponds to $171,800 income ($151,200 AGI) Fill up to 28% tax bracket Corresponds to $251,050 income ($230,450 AGI)

ROTH IRA CONVERSION STRATEGIES Fill low tax brackets with Roth IRA Conversions Spread Roth conversions over multiple tax years Delay Social Security benefits? Converting Depreciated Assets Use valuation discounts (e.g., liquidity or control) Option to Re-characterize Conversions Convert risky assets Convert EARLY and OFTEN Roth IRA straddle

OPTION TO RE-CHARACTERIZE CONVERSION Convert Early Options are more valuable as their time to expiration increases (i.e., time value) Recharacterization election must be made before filing return - April 15 up to 15½ months - October 15 up to 21½ months (with extension) Convert Often Options are more valuable as the volatility of the underlying asset increases Introduce non-systematic risk into individual converted Roth IRAs Use uncorrelated (perhaps negatively correlated) assets in separate conversions Re-characterize (and perhaps reconvert) those that decrease in value. - Keep those that don t.

MULTIPLE ROTH IRA CONVERSIONS Single Roth IRA Conversion 0 1 Google 100,000 50,000 BP 100,000 150,000 Total 200,000 200,000 Conversion Tax 80,000 (40% tax rate) Multiple Roth IRA Conversion 0 1 Google Roth IRA #1 100,000 50,000 Re characterize and re convert BP Roth IRA #2 100,000 150,000 Pay original conversion tax Total 200,000 200,000 Conversion Tax 60,000 (40% tax rate)

ASSUMPTIONS: COOK, MEYER, AND REICHENSTEIN (2015, FAJ) Spending: $81,400 after-tax (~5%) each year for single individual ~$1.7 million (TDA = $916,505; TEA = $234,928; Taxable = $549,601) Inflation rate = growth in tax brackets 2013 federal tax brackets Personal exemption + standard deduction ( 65)= $11,500 Top of 15% bracket = $36,350 Thus, she can WD $47,750 from TDA each year with these WDs taxed at 15% or less WDs occur at beginning of year Bonds earn 4% interest Stocks earn -12.6%, 5%, and 22.6% returns for 4% geometric avg return Copyright Retiree Inc. All rights reserved. 26

DRAWDOWN SEQUENCE: TAXABLE ACCOUNTS, TDA, AND TEA Longevity Strategy Phase 1 Phase 2 Phase 3 (years) #1 TEA TDA Taxable 30 Naïve #2 Taxable TDA TEA 33.2 TDA Fill low tax bracket #1 Taxable Supplement TEA Supplement 34.4 Informed #2 Taxable TDA conversion Fill low tax bracket Taxable TDA Fill low tax bracket TEA TEA Supplement TDA Fill low tax bracket 35.5 #3 1 st TDA conversion Fill low bracket 2 nd TDA conversion Fill low bracket Re characterize the lower valued conversion TEA 36.2 27

ROTH IRA STRADDLE Hypothetical Index Current value = 100 Roth IRA #1 $50,000 Long Call, Strike = 50 Roth IRA #2 $50,000 Long Put, Strike = 150 160 140 120 100 80 60 40 20 0 0 25 50 75 100 125 150 175 200 160 140 120 100 80 60 40 20 0 0 25 50 75 100 125 150 175 200 Call Value at Exp Put Value at Exp Call Value at Exp Put Value at Exp Pretax Value

200 ROTH IRA STRADDLE AFTER-TAX RESULT 150 100 50 0 0 25 50 75 100 125 150 175 200 Index Value (S) < 50 50 100 100 150 > 150 Roth IRA Call Recharacterize Recharacterize & Reconvert Roth IRA Put Recharacterize & Reconvert Recharacterize Call Coversion Tax 0 40% (S 50) 40% (50) 40% (50) Put Coversion Tax 40% (50) 40% (50) 40% (150 S) 0 Total Conversion Tax 40% (50) 40% (S) 40% (200 S) 40% (50) Tax w/o Recharacterization 40% (100) 40% (100) 40% (100) 40% (100) Recharacterization Tax Savings 40% (50) 40% (100 S) 40% (S 100) 40% (50)

VOLATILITY ERODES WEALTH ESPECIALLY IN THE DRAWDOWN PHASE 130.0 120.0 110.0 100.0 90.0 1X Long 2X Long 80.0 70.0 60.0 1 2 3 4 5 6 7 8 9 10 11

RETURN VOLATILITY: AN EXAMPLE Initial Portfolio of $100 with 10% average return Greater volatility leads to lower future accumulations, all else equal Year 0 1 2 3 Return (15% volatility) 25% 10% -5% Portfolio 100 125 138 131 Return (25% volatility) 35% 10% -15% Portfolio 100 135 149 126 Difference 5

RETURN SEQUENCE WITHOUT WITHDRAWALS: AN EXAMPLE Positive returns followed by negative and vice versa Year 0 1 2 3 Sequence of returns does NOT affect future accumulations in the absence of withdrawals Withdrawal 0 0 0 Return 25% 10% -5% Portfolio 100 125 138 131 Withdrawal 0 0 0 Return -5% 10% 25% Portfolio 100 95 105 131 Difference 0

RETURN SEQUENCE WITH WITHDRAWALS: AN EXAMPLE 10% withdrawal with different return sequences and 15% volatility Year 0 1 2 3 Sequence of returns DOES affect future accumulations in the presence of withdrawals Withdrawal 10 10 10 Return 25% 10% -5% Portfolio 100 115 117 101 Withdrawal 10 10 10 Return -5% 10% 25% Portfolio 100 85 84 94 Difference 6

RETURN SEQUENCE WITH WITHDRAWALS AND GREATER VOLATILITY: AN EXAMPLE 10% withdrawal with different return sequences and 25% volatility Year 0 1 2 3 Withdrawal 10 10 10 Greater volatility exacerbates the impact of return sequence. Return 35% 10% -15% Portfolio 100 125 128 98 Withdrawal 10 10 10 Return -15% 10% 35% Portfolio 100 75 73 88 Difference 11

WHY MIGHT MARGINAL TAX RATE DIFFER FROM TAX BRACKETS? 1. Taxation of Social Security benefits 2. Increase in Medicare Part B and Part D premiums 3. Pease and PEPs: Elimination of itemized deductions and personal exemption phase out 4. Increase in preferential capital gain tax rate 5. Net investment income tax (a.k.a., Medicare surtax)

SOCIAL SECURITY TAX TORPEDO 30% With $25,000 SS Benefit, Standard Exemptions and Deductions, and No Other Income 25% Marginal Tax Rate 20% 15% 10% 5% 0% 0 20,000 40,000 60,000 80,000 100,000 Taxable Retirement Account Distributions Stated Marginal Tax Rate Effective Marginal Tax Rate

SOCIAL SECURITY TAX TORPEDO 30% With $25,000 SS Benefit, Standard Exemptions and Deductions, and $20,000 Other Income 25% Marginal Tax Rate 20% 15% 10% 5% 0% 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 Taxable Retirement Account Distributions Stated Marginal Tax Rate Effective Marginal Tax Rate

INSIGHT FROM HIGH MEDICAL EXPENSES Ideally, save some funds in TDA to satisfy non-trivial probability of having high medical bills, especially late in life. In such years, marginal tax rate should be low, potentially zero.

TAX EFFICIENT DRAWDOWN CONCLUSIONS Withdrawals from Taxable Accounts Generally, tap taxable accounts first, if possible, for either withdrawals or IRA conversions Fill low tax brackets with taxable distributions Use taxable accounts withdrawals to enable TDA conversions (and recharacterizations) strategically Withdrawal Sequence among IRAs Irrelevant if constant, flat tax Tap Roth IRAs when tax rates are high Fill up low tax bracket with taxable distributions (withdrawals or conversions) Be aware of the Social Security Tax torpedo for mass affluent retirees Accumulation Implications Maintain flexibility Diversify account structures

REFERENCES Brunel, Jean, 2002, Integrated Wealth Management, Institutional Investor Books. Cook, Kristin, William Meyer, and William Reichenstein (2015). Tax-Efficient Withdrawal Strategies." Financial Analysts Journal, Vol. 71, No. 2 (March/April): 16-29. Evensky, Harold, Stephen M. Horan, and Thomas R. Robinson, 2011, The New Wealth Management: The Financial Adviser s Guide to Managing and Investing Client Assets, Wiley & Sons. Horan, Stephen M. (2005). Tax-Advantaged Savings Accounts and Tax-Efficient Wealth Accumulation. Charlottesville, VA: Research Foundation of CFA Institute. Horan, Stephen M. (2006a). "Optimal Withdrawal Strategies for Retirees with Multiple Savings Accounts."Journal of Financial Planning, Vol. 19, No. 11 (November): 62-75. Horan, Stephen M. (2006b). "Withdrawal Location and Progressive Tax Rates." Financial Analysts Journal, Vol. 62, No. 6 (November/December): 77-87. Horan, Stephen M., 2008, Private Wealth: Wealth Management in Practice, Wiley & Sons. Horan, Stephen M., and Ashraf Al Zaman (2008). "Tax-Adjusted Portfolio Optimization and Asset Location: Extensions and Synthesis." Journal of Wealth Management, Vol. 11, No. 3 (Winter): 56-73. Meyer, William, and William Reichenstein (2013a). "Adding Longevity through Tax-Efficient Withdrawal Strategies." Journal of Wealth Management, Vol. 16, No. 1 (Summer): 57-64. Reichenstein, William, Stephen M. Horan, and William W. Jennings (2012). "Two Key Concepts for Wealth Management and Beyond." Financial Analysts Journal, Vol. 68, No. 1 (January/February): 14-22. Wilcox, Jarrod, Jeffrey Horvitz, Dan DiBartelomeo, 2006, Investment Management for Taxable Private Investors, Research Foundation of CFA Institute, Charlottesville, VA.

QUESTIONS? 42