"Strategies for Maximizing After-Tax Wealth Creation"
Strategies for Maximizing After-Tax Wealth Creation NAPFA National 2007 May 4, 2007 Cheryl R. Holland, CFP® 1 Tax-Deferred Savings Non-deductible IRAs and Roth IRAs Roth 401(k)s/403(b)s Children Partnerships/LLC/Sole Proprietorships Subchapter S/C Corporation Roth Conversions 2010 Annual opportunities Funding IRAs at the first of the year 2 Tax Deferred Savings Non-Deductible IRAs $150,000 Value of Taxable Account (Ordinary Income Only) Value of Taxable Account (Capital Gain Only) Value of Tax-Deferred Account $125,000 $100,000 End Value After Taxes $75,000 $50,000 $25,000 $0 1 year 10 years 20 years 30 years Assumptions: 9% return, 18% capital gains rate, 40.26% ordinary income tax rate 3 Tax Deferred Savings Funding IRAs and 401(k)s at the first of the year $450,000.00 $400,000.00 $350,000.00 Payment at End of Period Payment at Beginning of Period $300,000.00 $250,000.00 Final Value $200,000.00 $150,000.00 $100,000.00 $50,000.00 $0.00 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 Years Invested $4000 invested annually at 7% growth rate 4 Tax-Deferred Savings Funding 529 Future plans State income tax deduction Harvesting losses Health Savings Accounts Tax Relief and Health Care Act 2007 1035 Exchange Life insurance to an annuity Annuity to annuity and withdraw 5 Capturing efficiencies in delivering tax planning advice – Knowledge Management Automate processes Income tax letters Requesting returns Reviewing returns Charitable gift of appreciated securities Leverage technology Paperless exchange of returns OCR returns Extract key data points to CRM Create checklists Income Tax Return Review Income Tax Planning meeting 6 Sample Income Tax Letter February 1, 2007 Mr. and Mrs. John Client 1000 Devine Street Irmo, SC 29063-9238 Dear John and Jane: The purpose of this letter is to assist you with gathering information for the preparation of your 2006 income tax returns. 1099s The purpose of this letter is to assist you with gathering information for the preparation of your 2006 income tax returns. According to our records, you will receive 1099s from Charles Schwab and Company, Inc with a projected mailing date of January 31st. If you do not have this information in hand shortly after this mailing date, please contact us. We will assist you in locating any missing forms. 1099-R You may receive a 1099-R related to the rollover of the 401(k) account. We are enclosing documentation to provide to your CPA reflecting the deposit of this rollover amount in your IRA Rollover account. SURRENDER OF LIFE INSURANCE POLICY Jane surrendered a life insurance policy with New York Life in 2006. The taxable gain on this policy should be on the 1099 from New York Life. If not, we can assist you in documenting this information. INDIVIDUAL RETIREMENT ACCOUNT CONTRIBUTIONS You each made a $4,000 non-deductible contribution to an IRA for the 2006 tax year. Please be aware that Form 8606 needs to be filed for these nondeductible contributions. John made a $4,000 contribution to a Roth IRA for the 2006 tax year. Jane made a $4,000 contribution to a Roth IRA for the 2006 tax year. As you are aware there are income limitations on the ability to fund a Roth IRA. If your adjusted gross income is too high, you will begin to lose the ability to fund this Roth IRA. If this occurs, let us know so we may take corrective action and reclassify this contribution. CHARITABLE GIFT OF APPRECIATED SECURITIES You made a gift of 150 shares of Pfizer for which we do not have the cost basis to Central Carolina Community Foundation. The value of the gift for income tax purposes will be on the statement provided by the charitable organization. Please provide this information to Kris when completing his tax organizer. 7 Sample Tax Letter – Page 2 MEDICAL EXPENSES Please be aware that the amounts you pay for your long-term care insurance are deductible as a medical expense on your Schedule A within certain constraints. The premiums paid for the year should be provided to your CPA. TRUST DISTRIBUTIONS Because you are the beneficiary of a Generation Skipping/Credit Shelter/…. Trust, we have enclosed a distributions report for tax-year and a Portfolio Statement as of the end of the tax-year. If we have omitted any items that may be needed for preparation of this return, please have your CPA call me and we will be happy to provide the needed data. REALIZED GAINS/LOSSES We have enclosed a printout of your taxable sales for the year that provides cost basis and acquisition information. You will note there are a number of investments with an acquisition date of January 1, 1985. We do have the cost basis for these purchases but not exact acquisition dates for all blocks. Thus, January 1, 1985, is just a placeholder and is accurate for income tax reporting purposes. GIFT TAX RETURN During the 2006 tax year you made annual exclusion gifts to family members. We have provided this information to David Sojourner so that he may determine whether to file a gift tax return. SOUTH CAROLINA 529 PLAN During the year, you contributed $5,000 to the South Carolina 529 Plan. This contribution will reduce your taxable income on the South Carolina return and therefore your South Carolina tax liability. You should have a statement from the Future Scholar program reflecting your contributions for 2006 which you will need to include in your tax preparation package for your CPA. MARGIN INTEREST We are enclosing a report documenting the margin interest paid on your taxable accounts in 2006. 8 Sample Tax Letter – Page 3 MONEY MARKET INTEREST—PORTION ATTRIBUTABLE TO U.S. SECURITIES OR SOUTH CAROLINA MUNICIPAL BONDS The money market managers will not be able to provide this information until late February. Once we have received the information, we will post it on the Abacus Planning Group website, www.abacusplanninggroup.com. If you will navigate to Strategic Partners and select Certified Public Accountants, you will be able to retrieve this information for all Charles Schwab and Company and Vanguard Group money markets and bond funds. REQUEST FOR FEDERAL AND STATE RETURN We hope this information is helpful. Please let us know if we can provide you or any additional information in preparing your income taxes. When your income taxes are completed, please make sure we receive a copy for our files. Sincerely yours, Cheryl R. Holland cc: CPA 9 Managing the Tax Drag on Portfolios Mutual fund selection issues Exchange Traded Funds Asset location decisions Marginal Tax Bracket and Investment Decisions Money Market Fund Selection Tax Loss Harvesting Calculating and reviewing the tax drag on a portfolio as a benchmark 10 Managing the Tax Drag on Portfolios Mutual Fund Selection Issues Fund Name Turnover Ratio Potential Cap Gains Exposure U.S. Large Capitalization Funds DFA US Large Co 2% 12% Amer Funds Amcap A 16% 19% Fidelity Contrafund 64% 29% SPDR Trust Series 1 2% 0% Fidelity Magellan 6% 39% International Large Capitalization Funds DFA Large Cap Intl 1% 16% Fidelity Overseas 79% 12% Artisan International Inv 55% 14% Harbor Intl Instl 12% 41% U. S. Small Capitalization Funds DFA U.S. Micro Cap 27% 33% Royce Microcap 44% 28% Schwab Small-Cap Eq Inv 118% 5% Absolute Return Funds Calamos Gr & Inc A 65% 17% Gateway Fund 71% 9% 11 Managing the Tax Drag on Portfolios Asset Allocation Decisions Accum ulated Wealth Over 30 Years Strategy 1: Bonds in IRA IRA, $1,512,680 Taxable, $3,598,385 Ending Wealth = $5,111,064 IRA Taxable Ending Wealth = Strategy 2: Stocks in IRA IRA, $3,521,930 Taxable, $1,403,397 $4,925,326 $0 $1,000,000 $2,000,000 $3,000,000 $4,000,000 $5,000,000 $6,000,000 Ordinary tax rate: 30%; Capital gains rate: 15%; Stocks pre-tax return: 8%; Bonds pre-tax return: 5%; Number of years: 30; Amount in IRA: $500,000; Amount in taxable: $500,000 Source: Gobind Daryanani, Ph.D., CFP®, and Chris Cordaro, CFP® 12 Managing the Tax Drag on Portfolios Asset Allocation Decisions End-Wealth Differences for Baseline Case IRA Factor Taxable Factor Difference Real Estate [Public] 10.33 8.21 2.11 U.S. Large Stocks - Active 11.97 9.99 1.98 Commodities 5.29 4.45 0.83 U.S. Small Stocks - Active 14.24 13.51 0.73 Absolute Return 5.33 4.62 0.71 High-Yield Bonds 3.16 3.08 0.08 Emerging Markets 16.01 16.06 -0.05 International Large Stock 7.41 7.63 -0.22 Short-Term Bonds 1.26 1.59 -0.33 U.S. Large Stocks - Tax Efficient 6.8 8.6 -1.8 Source: Gobind Daryanani, Ph.D., CFP®, and Chris Cordaro, CFP® 13 Managing the Tax Drag on Portfolios Mutual Fund Tax Efficiency Tax Efficient Vanguard Limited Term Tax-Exempt Taxable Accounts DFA US Large Company DFA Large-Cap Value Artisan International DFA International Large-Cap Gateway Harbor International DFA Emerging Markets DFA International Small-Cap DFA Two-Year Global Bond DFA Microcap Royce Microcap Calamos Growth and Income Merger PIMCO Foreign Bond DFA Real Estate Securities PIMCO Total Return PIMCO Diversified Income Cohen and Steers International Realty Tax Inefficient PIMCO Commodity Real Return Tax-Deffered Accounts 14 Managing the Tax Drag on Portfolios Asset Location Decisions Diff-Located $5,485,881 Stocks-In $5,208,722 Bonds-In $5,035,322 Pro-Rata $5,118,229 $4,800,000 $5,000,000 $5,200,000 $5,400,000 $5,600,000 Comparison of Location Strategies for Baseline Case Straight-Line Analyses with Annual Rebalancing Start AT End Return Pro-Rata $1,000,000 $5,118,229 5.59% Bonds-In $1,000,000 $5,035,322 5.54% Stocks-In $1,000,000 $5,208,722 5.66% Diff-Located $1,000,000 $5,485,881 5.84% Source: Gobind Daryanani, Ph.D., CFP®, and Chris Cordaro, CFP® 15 Managing the Tax Drag on Portfolios Marginal Tax Bracket and Investment Decisions 0.075 0.07 0.065 0.06 0.055 Yield 0.05 0.045 0.04 Vanguard Intermediate Tax Exempt Vanguard Intermediate Bond 0.035 Tax Equivalent Yield of Vanguard T/E @ 25% MTB 0.03 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Year 16 Managing the Tax Drag on Portfolios Money Market Fund Selection 5.0% 4.5% Vanguard Prime Money Mrkt Vanguard U.S. Treasury Money Mrkt 4.0% Vanguard U.S. Treasury Money Mrkt Tax Equivalent yield @ 7% State Tax Bracket 3.5% Vanguard Tax Exempt Money Market Vanguard Tax Exempt Money Market Tax Equivalent 3.0% yield @ 35% Marginal Tax Bracket Yield 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- 04 04 04 04 04 04 04 04 04 04 04 04 05 05 05 05 05 05 05 05 05 05 05 05 Month 17 Money Market Rates 4/3/2007 4/10/2007 Schwab Value Advantage (SWVXX) 4.92% 4.92% Schwab Advisor Cash Reserves (SWQXX) 4.71% 4.70% Schwab Advisor Cash Reserves – Premier (SWZXX) 4.78% 4.77% Schwab U.S. Treasury (SWUXX) 4.48% 4.49% SC tax equivalent yield (assumes 7% SC income tax) 4.82% 4.83% 18 Managing the Tax Drag on Portfolios Calculating and Reviewing tax drag as a benchmark 2000 2001 2002 2003 2004 2005 2006 12/31 Balance 1,782,484.63 1,793,206.00 1,613,031.51 2,174,410.81 2,506,263.98 2,774,222 3,162,105.12 Reduction $ 8,912.00 4,487.28 2873.22 1,509.20 8,103.60 9,154.93 30,040.00 Reduction % 0.50% 0.25% 0.18% 0.07% 0.32% 0.33% 0.95% ((Taxable interest plus non-qualifying dividends plus short term capital gains x MTB) + (Ordinary qualifying dividends + net long term capital gains/loss x 18%)) ÷ 12/31 balance = portfolio tax drag. 19 Nickels and Dimes Income with Respect to the Decedent for IRAs and annuities Capitalizing investment advisor fees UBTI for IRAs and CRUTs Deductibility of hedge fund fees Investment Interest deduction Charitable gift of appreciated assets or from IRA Net Unrealized Appreciation 20 Nickels and Dimes Capitalizing Investment Advisor Fees Mr. and Mrs. Client SECTION 266 CAPITALIZATION OF CARRYING COSTS 2004 Tax Return Blue items require input. All others are calculated formulas (please do not input here). Please input the Financial Planning Fees as a negative number. Total Current Year Fee $ 15,000.00 Financial Planning Fee (3,000.00) 100% deductible on Schedule A as miscellaneous deductions vs. capitalized in Schedule D. Asset Management Fee $ 12,000.00 Allocated across accounts - partial deductible against taxable accounts/partial nondeductible against tax deferred accounts ACCOUNT ACCOUNT GROSS ACCOUNT PRIOR YEAR CURRENT YEAR TOTAL TURNOVER DEDUCTIBLE REMAINING BALANCE PROCEEDS BALANCE COST ALLOCATED FEES RATIO PORTION (1) 2005 12/31/2003 TOTAL 12/31/2004 CAP Must put in account type as TD or TA for formulas to calculate properly Tax Deferred Accounts: SC 401 (k) TD 138,495 @@ 153,315 0 @@ 901 901 0 0 901 SC 457 TD 49,356 @@ 54,365 0 @@ 319 319 0 0 319 TIAA-CREF TD 103,163 @@ 106,239 0 @@ 624 624 0 0 624 Schwab Deductible IRA TD 100,597 @@ 111,736 0 @@ 657 657 0 0 657 Schwab Simple IRA TD 22,928 @@ 35,642 0 @@ 209 209 0 0 209 T. D. Waterhouse Roth IRA TD 7,180 @@ 6,683 0 @@ 39 39 0 0 39 Schwab Deductible IRA TD 44,078 @@ 49,968 0 @@ 294 294 0 0 294 Schwab Simple IRA TD 22,849 @@ 44,614 0 @@ 262 262 0 0 262 T. D. Waterhouse Roth IRA TD 7,048 @@ 6,552 0 @@ 38 38 0 0 38 Annuity TD 75,340 @@ 81,773 0 @@ 480 480 0 0 480 Taxable Accounts: MAP, LP 2001 TA 50,000 50,000 0 294 294 0 0 294 Schwab One TA 164,120 98,967 211,919 0 1,245 1,245 0.46700429 581 664 Schwab Brokerage TA 424,414 493,579 0 2,900 2,900 0 0 2,900 Schwab Brokerage TA 74,410 30,764 86,135 0 506 506 0.357161292 181 325 Schwab CRUT TA 104,077 102,572 0 603 603 0 0 603 Schwab One TA 184,846 153,651 0 903 903 0 0 903 T.D. Waterhouse TA 277,317 293,606 0 1,725 1,725 0 0 1,725 South Financial Group TA 17,552 0 0 0 0 0 0 0 Total 1,867,771 0 2,042,348 0 12,000 12,000 762 11,238 Value Advantage 0 Value Advantage 0 129,731 '@@ - No allocation of fees to tax-deferred assets or real estate assets which pay a separate fee so no reason to input gross proceeds for these accounts. (1) To be input as a separate line item on Schedule D as cost basis with zero sales proceeds. It may also be added with othe r sales. 21 Concentrated Positions Goal – Diversifying a portfolio – Providing a temporary hedge against a price decline – Monetizing the position to provide liquidity for other needs Separate Account Workout, e.g. Parametric Charitable Remainder Unitrusts/Foundations Exchange Funds Equity Collars and Protective Puts Gift to charity Limit Orders 22 Concentrated Positions INVESTOR OBJECTIVES Hedge Management Provide Downside Upside Position of Tax Liquidity Diversification Risk Potential Exit Speed Liability Immediate Greater Greater Proceeds Greater After Lesser Greater Lesser Gains Sale Proceeds are are available for sale, portfolio is Position is Position is are immediately immediately reinvestment no longer immediately immediately recognized available impacted exited exited Separate Moderate Moderate Greater Position Greater Price Greater Moderate Exit Account Proceeds Proceeds from sales may be appreciation is Position is Strategy is available as sales are reinvested in temporarily possible during gradually planned to Workout are executed uncorrelated hedged during workout period exited balance potential according to plan securities workout period if unhedged gain/loss and tax consequences Equity Moderate C lient Moderate Loan Greater Moderate Lesser Moderate Under RISK MANAGEMENT STRATEGIES Collar may borrow up to proceeds may be Price Downside risk is Position may straddle rules, 50% of the reinvested appreciation is limited to the put be disposed of gains on the put position for limited to the strike price for the the collar are realized and reinvestment, call strike price the duration fo is unwound deductions may 100% for other the contract for the duration be limited purposes of the contract Protective Moderate Still Lesser Greater Greater Moderate Moderate Gains Put Options have the ability to Diversification can Provides investor Unlimited C an sell at are realized sell position only be achieved by with downside minus cost of any point on upon disposition above the strike borrowing cash protection. the option. the upside but of the position at price but must against the hedged downside will expiration pay for put position and expire at option. revinvesting in strike price. other securities. Exchange Lesser A seven- Greater C lient Moderate Moderate Greater At Greater The Fund year commitment receives share of Market exposure Market redemption exchange of period is required diversified portfolio to a diversified exposure to a client receives shares is tax- portfolio diversified a diversified free portfolio portfolio Charitable Moderate Greater Asset is Moderate Moderate Greater Greater Remainder Provides income sold and proceeds Income stream Income stream Immediate Generates an stream based on are reinvested in is affected by is affected by dispositon of immediate tax- Trust the term of the diversified portfolio value of the value of the position deduction and trust diversified diversified the assets are portfolio portfolio excluded from the donor's estate for estate- Source: Schwab Institutional tax purposes 23 Prudent Investor Act (3) A trustee shall consider in investing and managing trust assets those circumstances of the following as are relevant to the trust or its beneficiaries: (a) general economic conditions; (b) the possible effect of inflation or deflation; (c) the expected tax consequences of investment decisions or strategies; (d) the role that each investment or course of action plays within the overall trust portfolio, including financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property; (e) the expected total return from income and the appreciation of capital; (f) other resources of the beneficiaries; (g) needs for liquidity, regularity of income, and preservation or appreciation of capital; and (h) an asset's special relationship or special value to the purposes of the trust or to one or more of the beneficiaries. 24 “Don’t let the tax tail wag the dog” 25 Bibliography FPA Journal – Asset Location: A Generic Framework for Maximizing After-Tax Wealth. Daryanani, Gobind, Ph.D., and Chris Cordaro. www.fpanet.org. Morningstar, Inc. Morningstar Principia – Advanced Analytics. www.morningstar.com Schwab Institutional. Market Knowledge Tools - “Investment Strategies to Reduce the Risk of Concentrated Positions.” www.savingforcollege.com. 529 website. Investing with a Tax-Efficient Eye. Robert Gordon. CFA Institute Conference Proceedings. www.cfapubs.org. Ed Slott’s IRA Advisor. 1-800-663-1340. 26 Bibliography www.foundationsource.com Gardner, Randy. “Recent Developments Help Avoid the Double Tax on IRD Property.” Journal of Financial Planning. February 2007. www.fpanet.org. Reiner, Eric L. “A Sly Deduction.” Wealth Manager. March 2007. www.wealthmanagermag.com Slott, Ed. “NUA No-No’s.” Financial Planning. July 2006. www.Financial-Planning.com Strobel, Caroline and Paul Steer. “Proper Planning can Minimize the Impact in Respect of a Decedent.” The Tax Advisor,Vol. 26, No. 5, May 1995, pp.297-304 Swift, Marie. “A Round of Transitions.” Wealth Manager. February 2007. www.wealthmanager.com 27