Tax-Efficient Investing: Comparing The Results (Part 2 of Tax-Efficient Investing Webinar Series)

Tax Aware Investing
-It’s the after Tax Return that Counts!
Advisors4Advisors
Presented by:

Robert S. Keebler, CPA, MST, AEP (Distinguished)
Stephen J. Bigge CPA, CSEP
Peter J. Melcher JD, LL.M, MBA
Keebler & Associates, LLP
420 S. Washington St.
Green Bay, WI 54301
Phone: (920) 593-1701
Robert.Keebler@keeblerandassociates.com
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.

Tax-Deferred Annuity/Life Insurance
Key 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%

© 2011 Keebler & Associates, LLP
Al Rights Reserved. 2

Scenarios
1. Tax-Deferred Annuity vs. Taxable Investment Account
(Bond Portfolio)
(Stock Portfolio w/100% Turnover)
4. Life Insurance vs. Taxable Investment Account
(Bond Portfolio)


Tax-Deferred Annuity vs. Taxable
Investment Account (Bond Portfolio)
Total Investment Balance
$350,000
COMMENT: Tax-deferred
$300,000
growth over time allows for
$250,000
more wealth to accumulate.

$200,000

$150,000

$100,000

$50,000

$-
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

Tax-Deferred Annuity Taxable Investment Account


Investment Account (Stock Portfolio
w/100% Turnover)
$350,000
COMMENT: Tax-deferred growth over time
$300,000
allows for more wealth to accumulate.
$250,000
However, without any income tax deduction and
lower capital gains tax rates, the tax-deferred
$200,000 annuity barely breaks even with a taxable
investment.
$150,000

$100,000

$50,000

$-
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

Tax-Deferred Annuity Taxable Investment Account


Investment Account (Stock Portfolio
w/10% Turnover)
$400,000
COMMENT: Even with tax-deferred
$350,000
growth, the taxable investment is
$300,000 better over time because of the
$250,000
lower capital gains tax rates.

$200,000

$150,000

$100,000

$50,000

$-
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

Taxable Investment Account Tax-Deferred Annuity


Life Insurance vs. Taxable Investment
Account (Bond Portfolio)*
$450,000

$400,000
COMMENT: Tax-free growth
over time allows for more
$350,000
wealth to accumulate.
$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

$-
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

Life Insurance Taxable Investment Account

* Assumes only the cash value of the life insurance policy


Account (Stock Portfolio w/100%
Turnover)*
$450,000

$400,000
COMMENT: Tax-free growth over
time allows for more wealth to
$350,000
accumulate, even with lower
$300,000 capital gains tax rates.
$250,000

$200,000

$150,000

$100,000

$50,000

$-
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




Account (Stock Portfolio w/10%
Turnover)*
$450,000

$400,000
COMMENT: Tax-free growth over
time allows for more wealth to
$350,000
accumulate, even with lower capital
$300,000 gains tax rates and low turnover.
$250,000

$200,000

$150,000

$100,000

$50,000

$-
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




Tax-Deferred Annuity/Life Insurance
Observations (What Have We Learned?)
• Bonds (or other ordinary income producing assets) should be
held in a tax-deferred annuity or life insurance
• Low turnover equity investments should be held in a taxable
investment account
• Life insurance is much better than taxable investment accounts
with ordinary income producing assets) because of the tax-free
nature of the income


Comparison of Passive Stock Investment
vs. Active Equity Investment
ASSUMPTIONS
Initial Investment $100,000
Growth Rate 8.8% (i.e. S&P 500 compounded annual growth rate (CAGR) since 1988)
Turnover Rate (Passive Investment) 10%
Turnover Rate (Active Investment) 100%
Capital Gains Tax Rate 15%

$1,400,000

$1,200,000

$1,000,000

$800,000

$600,000

$400,000

$200,000

$-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Passive Equity Investment Active Equity Investment


Breakeven Rates of Active Equity
Investment vs. Passive Equity Investment
Passive Equity Investment Turnover %
Active Equity Investment Turnover %

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
10% 8.93%
20% 9.07% 8.94%
30% 9.21% 9.08% 8.94%
40% 9.36% 9.22% 9.08% 8.84%
50% 9.51% 9.37% 9.23% 8.98% 8.94%
60% 9.67% 9.53% 9.38% 9.13% 9.09% 8.95%
70% 9.83% 9.68% 9.54% 9.28% 9.24% 9.09% 8.95%
80% 10.00% 9.85% 9.70% 9.44% 9.40% 9.25% 9.10% 8.95%
90% 10.17% 10.02% 9.87% 9.61% 9.56% 9.41% 9.26% 9.11% 8.95%
100% 10.35% 10.20% 10.04% 9.77% 9.73% 9.58% 9.42% 9.27% 9.11% 8.96%
ASSUMPTIONS


Breakeven Rates of Active Equity
Investment vs. Passive Equity Investment
Passive Equity Investment Turnover %
Active Equity Investment Turnover %

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
10% 9.12%
20% 9.46% 9.13%
30% 9.83% 9.49% 9.14%
40% 10.23% 9.87% 9.52% 9.16%
50% 10.67% 10.29% 9.92% 9.55% 9.17%
60% 11.14% 10.75% 10.36% 9.97% 9.58% 9.19%
70% 11.66% 11.25% 10.84% 10.43% 10.02% 9.62% 9.21%
80% 12.22% 11.79% 11.37% 10.94% 10.51% 10.08% 9.66% 9.23%
90% 12.85% 12.40% 11.95% 11.50% 11.05% 10.60% 10.15% 9.70% 9.25%
100% 13.54% 13.06% 12.59% 12.12% 11.64% 11.17% 10.70% 10.22% 9.75% 9.27%
ASSUMPTIONS


Comparison of “Real” Capital Gains
Rates (Present Value)
COST OF CAPITAL
2% 4% 6% 8% 10%
0 15.00% 15.00% 15.00% 15.00% 15.00%
5 13.59% 12.33% 11.21% 10.21% 9.31%
YEAR

10 12.31% 10.13% 8.38% 6.95% 5.78%
15 11.15% 8.33% 6.26% 4.73% 3.59%
20 10.09% 6.85% 4.68% 3.22% 2.23%
25 9.14% 5.63% 3.49% 2.19% 1.38%
30 8.28% 4.62% 2.61% 1.49% 0.86%


Tax Aware Investing Observations-
What have We learned?
• Life Insurance is an Extremely Efficient “Tax Asset
Class” for Bond Type Investments
• Tax-deferred Annuities are more Efficient then
Bond Type Investments
• Passive Low-turnover Investments provide a
Higher After-tax Return on Investment than more
Active Strategies generating Short-term or Long-
term Capital Gains
• The Real Capital Gains Rate on a Present Value
Basis is Substantially less than the 15% Statutory
Rate

Understanding the Tax-Law
• Deductions upon Funding
• Recovery of Basis
• Taxation upon Withdrawal


Understanding the Tax-Law
• IRAs and Pensions
• Nondeductible IRAs
• Roth IRAs
• Capital Gains Incentives
• Tax Deferred Annuities
• Life Insurance
• Real Estate


IRAs and Pensions
• Deductible Contributions
• Taxable Withdrawals


Nondeductible IRAs
• Nondeductible Contribution
• Taxable Withdrawals (except for basis)


Roth IRAs
• Nondeductible Contributions
• Tax-free withdrawals
• No RMD at age 70 ½
• Roth 401(k) – RMDs at 70 ½


Capital Gains Incentives
• Lower Rates
• Deferral on Passive Investments
– “Buy and Hold” strategies


Tax-Deferred Annuities
• Tax-Free Growth
• Taxable Distributions
• Strategy is based on Deferral


Life Insurance Strategies
• Tax-Free withdraw of Basis
• Borrowing on a Tax-Free Basis
• Extremely effective for High Income Taxpayers
• Tax Free Death Benefit


Preparing for Retirement
• Common Questions:
– How much Capital do I need?
– How much Capital will I have?
– How much do I need to save?
• For “Outside Capital”, the common questions
are:
– Where do I invest my Capital?
– How will the earnings be impacted by income
taxes?


Tax-Aware Retirement Planning
• The optimal retirement plan would include:
– Contributions that are tax deductible
– Accumulations that are tax free
– Distributions that are tax-free
• Such a plan does not exist, but you can have
any two of these tax benefits
• A balanced approach is required to avoid high
tax brackets during retirement


Your Retirement Savings Tax Options
• Tax Treatment
– Contributions: Tax deductible, After tax
– Accumulation: Tax deferred, Tax deferred
– Distributions: Taxable, Tax free
• Financial Vehicles
– Traditional IRA, Roth IRA
– 401 (k) or pension plans, tax-free municipal bonds
– Profit sharing plans, cash value life insurance
– Keogh


Is Tax Deferral Always the Best
Strategy?
• Under the new tax law, the tax leverage
benefits of deferring may not always exist
• Lower tax rates and narrower
tax brackets may require
balanced strategy
• Too much Deferral creates the
“Disproportionate IRA” problem



Tax Rate – Distribution Year
Tax Rate – Contribution Year

10% 15% 25% 28% 33% 35%
10%
15%
25%
28%
33%
35%


Total Retirement Funds @ Death (i.e. Age 84)

15% Tax Rate @ 25% Tax Rate @ 35% Tax Rate @ 45% Tax Rate @
Distribution Distribution Distribution Distribution
$ % $ % $ % $ %
15% Tax Rate @ Contribution $ - 0.00% $ 131,649 10.74% $ 263,298 22.13% $ 394,947 34.25%
25% Tax Rate @ Contribution $ (131,649) -10.43% $ - 0.00% $ 131,649 11.07% $ 263,298 22.83%
35% Tax Rate @ Contribution $ (263,298) -20.86% $ (131,649) -10.74% $ - 0.00% $ 131,649 11.42%
45% Tax Rate @ Contribution $ (394,947) -31.29% $ (263,298) -21.48% $ (131,649) -11.07% $ - 0.00%
Assumptions
Current age of IRA owner: 35
Age of IRA @ retirement: 65
Annual IRA contribution (Age 35 – 49): $5,000
Annual IRA contribution (Age 50 – 65): $6,000
Pre-tax growth rate (IRA): 6%
After- tax growth rate: 5%
% of after-tax IRA distributions reinvested: 100%


The Benefits of Tax Diversification
Retirement Income of $150,000

Without Tax Diversification With Tax Diversification

Client accesses $75,000 from her 401(k)
Client accesses $150,000 from her 401(k) and $65,000 from her cash value life
insurance policy and/or Roth IRA

Only the $65,000 from her 401(k) is
The full $150,000 is taxable at an average
taxable, and it’s taxed at the lower average
tax rate of 30% or $45,000
tax rate of 15% or $11,250

Leaving client $105,000 to spend in Leaving client $138,750 to spend in
retirement retirement


Retirement Income of $80,000
100% 401(k) and
IRA Strategy A Balanced Strategy

$80,000 $80,000
$40,000 $40,000
401(k) /Qualified Cash Value Life
401(k) IRAs Approach
Plans Insurance/Roth
100% Taxable IRA
100% taxable
$80,000 taxed at Tax Free
$40,000 taxed at
25% $0,000 taxed at
15%
0%
=$20,000 Tax =$6,000 =$0 tax
$60,000 to spend $74,000 to spend
after taxes after taxes

Understanding Tax Adjusted Asset
Allocation
• Currently Most Asset Allocation Models Use
Standard Pre-tax Return and Standard Risk
Assumptions
• Income Tax “Drag” should be Taken into
Account
• Income Tax Rates vary by Taxpayer
• Capital Gains are Taxed at Different Rates
• Conflicts with the Current Practice(s)

Beyond Asset Allocation
Understanding “Asset Location”
• Concept:
– Begin with “Tax-adjusted” asset allocation
– Once you know the proper asset allocation, then you
need to select “Asset Location”
– Asset Location is driven by:
• Tax benefits associated with the proper location of equities
and fixed income
– General Rule: Fixed income should be held in
Retirement Accounts, Annuities or Life Insurance
– General Rule: Equities should be held in taxable
accounts


Tax Aspects of Fixed Income
Investments
• In general, fixed income assets produce:
– Ordinary income
– Taxed on an annual basis
– Heavy annual “Tax Drag”
• Exceptions:
– Bonds in Tax-deferred accounts
– I bonds
– Tax-exempt Bonds


Tax Aspects of Location of Equities
• 15% Long-Term Rate
• No Gain Realized until Property is Sold
• Step-up in Basis at Death


Ideal Assets for Qualified Plans and
IRAs
• Taxable Bonds
• REITS
• High Turnover, Short-Term Gain Strategies
• Nonqualified Dividends
• High yield Stocks
• Option Strategies


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


Tax-Sensitive Withdrawal Strategies
• Consider the tax structure of the account as you allocate assets
– Income producing assets in traditional IRA
– Capital gains assets (especially those you intend to hold for a long
period) in a taxable account
– Roth IRA Rapid Growth

The illustration is NOT Bonds Stock
intended to be a
recommendation, but to IRA
$250,000 $250,000 $500,000
provoke thought. As you
know, asset allocation should
be determined according to Taxable Account
risk tolerance and time $250,000 $250,000 $500,000
horizon. Tax sensitivity would
be considered secondarily.


Tax-Sensitive Account
•
Allocation
Orange = position the investor would be at under the original 50% stock / 50% bond
investment mix
• Blue = additional $63,890 of additional growth the investor would achieve by placing 100% bonds
in IRA
• Assumptions: Bonds and the stock both generate a 7% return on a pre-tax basis. The stock earnings
are deferred until the time of sale, then taxed as long-term capital gains. The amount of any tax
savings from a deductible IRA contribution is invested in a taxable investment account earning the
same yield as the IRA. The values shown for the IRA include the value of the taxable investment
account. The client is in the 25% ordinary income tax bracket (15%* for capital gains purposes)
Integrating Account Tax Structure with Asset Allocation
(100% Bonds in IRA vs. 50/50 Mix of Stock and Bonds in IRA)
2,800,000

Option A - 100% Bonds in IRA
Option B - 50/50 Mix in IRA
2,550,000 $63,890 of
additional assets
(2.6% increase)
2,300,000
* The 15% long-term capital
gain rate is only effective
2,050,000
under current law through
2010. It is not certain that the
Congress will extend the
15% rate.
1,800,000
10 11 12 13 14 15


•
Effect of Capital Gains Incentives
Example:
– $100,000 beginning cash to invest and 28% tax bracket (15% long-term capital gains
bracket)
– Options:
• Corporate bonds (6% annual interest)
• Municipal bonds** (4.5% annual interest)
• Stocks (1% annual non-qualified dividends, 5% growth
[100% asset turnover])
After-Tax Balance of a Taxable Account (Invested in Stock, Municipal Bonds and Corporate Bonds)
$400,000
Stock (50% Turnover) Stock (100% Turnover) $65,732 of
$300,000 additional assets
Municipal Bonds Corporate Bonds (23% difference)
$200,000

$100,000

$-
1 3 5 7 9 11 13 15 17 19 21 23 25
Year
•The 15% long-term capital gain rate is only effective under current law through 2012. It is not certain that the Congress will extend the 15% rate.
•**Municipal bounds may not be suitable for a person in this low of a tax bracket.


Assets for Roth Accounts
• High Turnover Equity Strategies
• Small Cap Growth and Value Strategies
• Option Strategies
• Certain Hedge Funds


CIRCULAR 230 DISCLOSURE
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.

©2011 Keebler & Associates, LLP
All Rights Reserved. 42

Tax-Efficient Investing: Comparing The Results (Part 2 of Tax-Efficient Investing Webinar Series)

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Tax-Efficient Investing: Comparing The Results (Part 2 of Tax-Efficient Investing Webinar Series)