June 2008 - Posts

• Retirement Withdrawal Strategies

  Overview:  What is the generally accepted order by which an investor should make tax-efficient withdrawals for retirement? With a focus on asset location, this article introduces several points for investors to consider when building their own prudent strategy for making withdrawals from retirement accounts, including situations in which an investor may benefit from deviating from that generally accepted sequence. ---------------------------------------------------------------------------------------------------- A winning investment strategy is about much more than choosing the asset allocation that will provide the greatest chance of achieving one's financial goals. It also involves what is called the asset location decision. Academic literature on asset location commonly suggests that investors should place their highly taxed assets (such as bonds or REITs) in tax-sheltered accounts and their tax-preferenced assets (such as stocks) in taxable accounts. In general, the most tax-efficient equities should be held in taxable accounts whenever possible. Holding them in tax-deferred accounts can result in the following disadvantages: Long-term capital gains are converted into ordinary income (upon withdrawal) The possibility of a step-up in basis for tax purposes is lost For foreign equities, foreign tax credit is lost The potential to perform tax loss harvesting is lost One part of this strategy includes using the most tax-efficient withdrawal sequence to fund retirement. A recent paper by William Reichenstein titled "Tax-Efficient Sequencing of Accounts to Tap in Retirement" provides some answers. For example, Reichenstein posed the question, "Should a retiree withdraw funds from the taxable account then the traditional IRA and then the Roth IRA or would another sequence be preferable?"1 According to Reichenstein, "Returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at positive effective tax rates."2 Reichenstein's paper also said that only part of a traditional IRA's principal is the investor's. The IRS "owns" the remaining portion, so the goal is to minimize the government's share.3 For those able, but not yet required to take distributions from tax-deferred accounts, it is typically most practical to withdraw from taxable accounts first. The withdrawals would be taxed at capital gains rates instead of ordinary income rates. Also, it may be preferable to sell tax-inefficient assets (such as bonds or REITs) held in taxable accounts before selling more tax efficient assets. There are some exceptions to these rules: If the main source of income comes from tax-sheltered accounts, withdrawals should be made from these accounts until taxable income at least reaches the lowest tax bracket. This exception should apply to any year when taxable income is low. For example, an individual with sizeable medical bills due to an extended stay in a nursing home would likely be in a lower tax bracket. Other withdrawal sequences may be preferable if the IRA's beneficiaries will be in a higher tax bracket than its owner. According to the paper, "Retirees who have substantial unrealized gains on taxable assets and will await the step-up in basis at death should withdraw funds from retirement accounts before liquidating the appreciated asset."4 An example would be a terminally ill person. The reason: The effective tax rate on the capital gains will be zero if they await the step-up in basis at death. Delaying withdrawals from an IRA can mean a higher tax bill if the tax rate later rises to higher levels. In addition, if a retiree is in a lower tax bracket but doesn't need to withdraw funds from the IRA to meet spending needs, he or she should consider a conversion to a Roth IRA. Thus, it may not be appropriate to delay withdrawals from traditional IRAs for as long as possible (until age 70½).           Many individuals are also faced with deciding whether to withdraw from a traditional IRA or a Roth IRA. Consider what Reichenstein said about the decision. "Withdrawing funds from the traditional IRA makes sense 1) in years when the retiree is in a low tax bracket and 2) if the retiree's beneficiary will be in a higher tax bracket. ... Withdrawing funds from a Roth IRA instead of a traditional IRA makes sense 1) in years when the retiree is in a high tax bracket and 2) if the retiree's beneficiary - whether an individual or a charity - will be in a lower tax bracket. ... In addition, Roth IRA withdrawals should be preferred if the retiree expects to have large deductible medical expenses later in retirement."5 Finally, he found that sequencing strategies are sensitive to the following: The higher the tax rate, the greater is the advantage from first withdrawing from a taxable account. If capital gains taxes were increased, the advantage would increase. The advantage would also increase if an investor held an actively managed mutual fund that was tax inefficient because of its turnover. The paper stated this "Taxable 1st strategy" has a strong advantage when a portfolio is generally evenly divided between retirement accounts and taxable accounts. In addition, such advantage can increase with an asset's rate of return. Reichenstein's paper suggested it is important to fund retirement spending in the right sequence. Doing so should allow retirees' financial portfolios to last longer than would otherwise be the case. Finally, it is important for investors to consult a tax advisor before implementing any strategy.  1   William Reichenstein, Tax-Efficient Sequencing of Accounts to Tap in Retirement. TIAA-CREF Institute, October 2006. Available at www.tiaa-crefinstitute.org/research/trends/tr100106.html. Accessed April 13, 2007. 2  Ibid. 3  Ibid. 4  Ibid. 5  Ibid. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Jun 27 2008, 12:41 PM by Jim Cornfeld

• Stay Close to Home or Let Your Bond Portfolio Roam? Muni Bond Geographic Diversification

  Overview: Following is a discussion of the benefits of diversifying an individual municipal bond portfolio geographically instead of only purchasing municipal bonds issued within your home state. The main advantage of geographic diversification is that it can reduce over-exposure to risks that might result from local events such as a natural disaster or political changes. Introduction Many investors feel that buying bonds from within their state offers them distinct advantages. The primary advantage would be tax benefits, since many municipal bonds are state and local tax exempt. (They are also almost always federal tax exempt.) However, tax benefits should not preclude consideration of out-of-state issues when building an individual bond portfolio. While it can - and often does - make sense to purchase some bonds within your home state, it is imprudent to build an entire portfolio from them. In fact, even investors who reside in high-tax states (like California with one of the highest state tax rates in the country) can benefit from a diversified bond portfolio. Hometown Connection Could Bring Additional Risk There can be many risks associated with having a portfolio that is not geographically diversified. For example, after Hurricane Katrina, many New Orleans residents might have experienced a "three strikes, you're out" situation. For those who lived and worked in New Orleans and held a significant portion of their fixed income portfolio in bonds issued by the city of New Orleans (or the state of Louisiana), it is likely that they were simultaneously exposed to significant losses in the bond portion of their portfolio, falling real estate prices and uncertainty regarding their employment status. The problem with staying too close to home is that all of the risks incurred in employment, real estate, and other investments are highly correlated. Diversifying Reduces Risk Often, individuals can feel a personal connection to state-specific projects. For example, knowing it is possible to monitor the project's progress in the local newspaper, an investor might deem a local highway improvement bond to be "safer." However, we would argue that investors who fill their portfolio with their local community's bonds incur a greater amount of risk than they may realize. Specifically, geographically diversifying a portfolio can reduce the risks caused by significant changes in a community or state. We will focus on two risks: 1) damage from natural disasters and 2) changes in the political landscape. Damage brought on by extreme weather and natural disasters could reduce the credit rating of a bond, negatively affecting bond holders. In the same way, legislative decisions can have adverse effects on a bond. For example, a decrease in a state's tax rate could also decrease the relative advantages for investors owning that state's bonds. At that time, a resident of that state would receive less of a benefit for owning in-state bonds and might decide to purchase other available bonds (perhaps bonds issued by other states) that would now be more competitive with bonds of their home state. Here's why: The benefit an investor would receive would be lower because of the state's lower tax rate. The yield investors could obtain on another bond from outside of their state - that may be subject to a state tax - would not be disadvantaged as much due to their own state's lower state tax rate. In addition, even taxable investments may now compare more favorably, even though they would be subject to federal and/or state taxes. How to Proceed When seeking geographic diversification and competitive yields, it is possible to find both in the bonds of other states, such as those that don't have state income taxes. However, it is important to remember that each municipal bond portfolio is different and should be customized based on the financial objectives of each investor.  The process of diversifying a portfolio begins with a portfolio analysis, checking the existing bonds' state of issuance and maturities. It is possible that the fixed income portfolio is already naturally geographically diverse and warrants only minor changes. In closing, investors with individual municipal bond portfolios might wish to consider the benefits of geographically diversifying their fixed income portfolio with out-of-state bonds. By carefully selecting specific bonds with the help of an investment advisor who has expertise in building custom bond portfolios, the investor can seek to reduce the risk of the overall fixed income portfolio via geographic diversification, while minimizing adverse tax consequences.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Jun 20 2008, 04:49 PM by Jim Cornfeld