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The Tax-Smart Portfolio: Helping to Keep More of What you Earn

Tax strategies can have a surprisingly large potential impact on lifetime wealth accumulation. A look at some of the techniques that could help you keep more money growing. 

Every investor is looking for an edge that helps them boost their overall wealth. But one strategy that some investors don’t pay enough attention to is tax efficient investing. The reason?  Even small reductions in tax costs can have enormous consequences for wealth accumulation.

In an example drawn from a Morgan Stanley report, an improvement of 0.6% per year in aftertax returns resulted in a remaining wealth difference of 75% after 30 years of distributions.1 No small improvement.

“People are often surprised to learn just how much of their long-term investment returns go to taxes, and how much of a difference that can make in terms of whether or not they will meet their financial goals," said Lisa Shalett, Morgan Stanley Wealth Management Head of Investment and Portfolio Strategies.

Faced with a shortfall between lifestyle plans and wealth accumulation, some investors consider options like delaying retirement or taking on more investment risk in an attempt to boost returns. But a key strategy for boosting long-term returns—which may not necessarily add risk—is being smart about tax efficiency.

Utilizing a Variety of Strategies

The benefits of tax-deferral vehicles such as 401(k)s and Individual Retirement Accounts are well known, and naturally a tax strategy should start by utilizing those vehicles. For many people, the simple strategy of deferring taxes as long as possible can be effective, because it allows your investment earnings to compound without the headwind of a front-end tax payment. Depositing earnings in a tax-deferred 401(k) or IRA, with the possible addition of a tax-exempt Roth IRA, is a typical option.

Another option is to put aside money for specific categories of spending like education and health care using tax-deferred accounts such as 529 Education or Health Care Savings Accounts.

But there are also lesser-known strategies that can also meaningfully add to your long-term wealth.  

Some Lesser-Known Strategies

Compared to a 401(k), the annual additional returns generated by the lesser-known strategies may seem small. But just as the power of compounded interest can help small early-career contributions balloon over the decades, small losses due to taxes can snowball over a lifetime.

For example, higher income investors who can max out their tax-deferred retirement accounts can add additional strategies, such as investing in tax-exempt municipal bonds, and utilizing “tax managed” investment products that hold gains and “harvest” losses to create tax losses. As with qualified retirement accounts, tax managed investment strategies work by deferring tax costs into the future.

For high net worth investors, insurance and annuities products can also be effective in helping to reduce the impact of taxes on lifetime wealth. These include:

  • Investment-Only Variable Annuities (IOVA). Investors who have hit the contribution or income caps for pre-tax retirement accounts such as 401(k)s and IRAs can direct post-tax savings to an IOVA, where investment gains are not taxed until they’re withdrawn. This relatively new vehicle is designed for wealth accumulation, coming without the more costly features of other variable annuities, such as guaranteed withdrawal benefits, but with a broader menu of investment options. Its impact on wealth generation is greatest for investors with a long time horizon.
  • Universal Life Insurance. Another avenue for individuals who have maxed out their qualified retirement accounts, these policies combine potential wealth accumulation with protection for family in the event of the investor's death. For a set term, the policy buyer pays premiums, the majority of which, after fees and the cost of insurance, are invested in the markets. After the initial term, the cash balance grows tax-free. Subject to certain restrictions, the cash value of a universal life policy can be accessed tax free, initially through withdrawal of principal and subsequently by loans against its death benefit.

For most people, one or more of these products and account types can help them improve their tax efficiency. Their full potential to provide a boost to aftertax returns, though, can only be unlocked when they are set up as building blocks in a more complex, integrated tax strategy.

For example, when you have a mix of accounts and products with different tax treatments you can increase the impact of the tax advantaged accounts through “tax-efficient asset location,” where investments are sourced per account according to their growth potential and relative tax efficiency. 

A Smart Withdrawal Strategy

A retirement income plan is another way in which the different components of a tax strategy can complement one another by sequencing withdrawals in a tax efficient way. A simple withdrawal sequence might involve withdrawing from taxable accounts first and tax advantaged accounts last, but, according to Daniel Hunt, Morgan Stanley Wealth Management Senior Asset Allocation Strategist, even-more complex withdrawal sequencing strategies can have a significantly greater impact on lifetime spending power. For example, distributing savings that don’t register as taxable income, like withdrawals from a universal life insurance policy, while converting portions of tax-deferred savings into a Roth IRA can “smooth your reported income, so you pay lower average rates, while continuing to shelter your investments from tax.

"Overall, how these different approaches are combined can make a significant difference when it comes to building wealth over the long term. “Each of them can be helpful in and of themselves, but in concert they can provide much more significant compounded benefits that can really move the needle. If you have an advisor who's willing to sit with you and put together a comprehensive strategy where the pieces work together, that can make all the difference," Hunt said.

1 By using the strategy of withdrawal sequencing, the value-added is approximately 0.6% of equivalent aftertax return. Note that these annual returns would compound to very large numbers over the long investment horizons of many financial goals. In the case of withdrawal sequencing, the difference in returns in the case study is equivalent to nearly a 75% difference in final wealth accumulation. This strategy would be recommended for investors who (1) Have adequate savings relative to spending needs (2) Have a high marginal tax rate and (3) Have sources of low-tax distributions with which to smooth income. Investment liquidations to support retirement spending sequenced in order to increase tax efficiency. Withdrawals from taxable account come first to extend tax deferred/ tax-exempt growth of other investments. Income smoothing and partial Roth conversion conducted to lower effective tax rates and minimize spikes in taxable income driven by required minimum distributions. Illustrated value-added based on top marginal federal tax rates for 20 years pre-retirement, and a 5% initial withdrawal rate for 30 years in retirement. Overall portfolio strategy based on a 60% equity/40% fixed income allocation assuming an efficient tax allocation across accounts.

Model Calculation Assumptions: The analyses in this article are based, in part, on a Monte Carlo simulation, which involves repeated sampling of asset class returns from a known distribution.

IMPORTANT: The projections or other information generated by this Monte Carlo simulation analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time.

The analysis for this projection on wealth difference from withdrawal sequence is based on the improvement of withdrawal capability following tax efficient withdrawal sequence among multiple account types in a 10,000-iteration Monte Carlo simulation. Retirement income starts after 20 years’ asset accumulation. The withdrawal amount is calibrated to be 5% of portfolio value minus unrealized tax liability in each iteration, adjusted for the cost of living for 30 years. During the asset accumulation period, investors stay in 39.6% federal tax bracket, with a 5.2% state tax and 3.8% a Medicare tax. During retirement phase, investors’ federal tax bracket is determined by the withdrawal amount together with $20,000 inflation-adjusted Social Security payment each year, subject to additional 5.2% state tax. Tax brackets are based on 2016 married filed jointly status and assumed to grow with inflation rate. Asset growth rates are based on Global Investment Committee forecasted capital markets assumptions as of March 2016, with the first seven years assuming strategic assumptions and subsequent 13 years assuming secular assumptions. Inflation rate is assumed to be 2.3% per year. Portfolios are rebalanced each year across multiple account types to maintain overall asset allocation close to 60% equities and 40% fixed income as much as possible after yearly spending amount being withdrawn. The reason for choosing a 60% equity/40% equity/bond allocation is because it’s a common allocation in balanced portfolios as well as in multiasset funds. If a different balanced allocation is selected, results would be different than those suggested. Unrealized tax liabilities are subtracted from portfolio ending values to calculate internal rate of return. Probability of success is defined as having at least $1 in any of the account types at the end of 50 years simulation. Partial years of withdrawal are recorded if combined portfolio value at any year is not enough to support expected retirement spending at any year.

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