Tax Alpha. Robert S. Keebler, CPA, M.S.T., AEP. Keebler & Associates, LLP 420 South Washington Street Green Bay, WI

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Tax Alpha

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Presented by

Robert S. Keebler, CPA, M.S.T., AEP

Keebler & Associates, LLP 420 South Washington Street

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Agenda

1. Five Dimensional Tax System

• Ordinary Income Rates

• Capital Gains Rates

• AMT

• PEP & Pease Limitations

• NIIT

2. Tax-Aware Investing

• Overview

• Tax Asset Classes

• Statutory Tax Shelters

• Tax Diversification

• “Asset Location”

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• Ordinary Tax Rates

• Capital Gains Tax Rates

• The AMT

• PEP & Pease Limitations

• New 3.8% Net Investment Income Tax (NIIT)

– Plus the additional 0.9% Medicare tax on earned income

Bracket Management

Five Dimensional Tax System

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Bracket Management

2014 Federal Income Tax Rates and Brackets

25%

15%

10%

39.6%

35%

28%

33%

Rates Based On Taxable Income

Single Married, filing jointly

$406,750+ $457,600+

$457,600+

$406,750

$405,100 $405,100

<$9,075

$186,350

$89,350

$226,850

$148,850

$36,900 $73,800

<$18,150 0% Capital

Gains Rate

15%

LT

Capital Gains Rate 20% LT Capital

Gains Rate

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• Phaseout of personal exemptions (PEP) and

limitations on itemized deductions (Pease) as income rises above the following threshold amounts--

• Amounts will be indexed for inflation

• Above certain AGI amounts, personal exemptions

Single taxpayers $254,200

Head of households $279,650

Married filing jointly or surviving spouse $305,050

Married filing separately $152,525

Bracket Management

2014 Phaseout of Personal Exemptions

& Itemized Deductions

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• PEP reduces personal exemption by

– 2% for every $2,500 of income above the threshold amount for most taxpayers

• Pease cuts itemized deductions by

– 3% of AGI above the threshold amounts up to a maximum of 80%

Bracket Management

Phase-Out of Itemized Deductions (Pease)

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Alternate Minimum Tax

How the AMT works.

How AMT is calculated

Taxable income (for regular income tax purposes) + Standard deduction (if taken)

+ Personal/dependency exemptions

+ Certain “exclusion” items (e.g. taxes, miscellaneous deductions) + Certain “deferral” items (e.g. ISO exercise income, depreciation) - State income tax refund

- 3% phase-out of itemized deductions (starting in 2013) - Certain “deferral” items (e.g. gain/loss adjustment) Alternative Minimum Taxable Income (AMTI)

Less: AMT exemption amount Net AMTI

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Alternate Minimum Tax

How the AMT works.

AMT Rates

AMT Exemption

26% 28%

Married Filing Separately $0 – 91,250 $91,251 + All Others $0 – 182,500 $182,501 +

Exemption Amount Married Filing Jointly $82,100

Married Filing Separately $41,050

All Others $52,800

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Alternate Minimum Tax

How the AMT works.

AMT Exemption Phase-out

• For every $1 of income over the threshold the exemption is reduced by $0.25

• This increases the marginal rate of taxpayers within the phase-out by 25%.

• Therefore, for a taxpayer within the phaseout and the 28% rate applies the marginal rate is 35% !

Phaseout Starts Phaseout Ends

Married Filing Jointly $156,500 $484,900

Married Filing Separately $ 78,250 $242,450

All Others $117,300 $328,500

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Bracket Management

The Net Investment Income Tax

Application to individuals

The NIIT is equal to:

1. “Net investment Income”

OR

2. The excess (if any) of –

- “Modified Adjusted Gross Income (MAGI)

- “Threshold amount”

3.8% X

the lesser of

1. Net Investment Income OR

2. The excess (if any) of—

- “Modified Adjusted Gross Income (MAGI) over the “Threshold Amount”

See IRC Section 1411(a)(1) and Reg. Section 1.1411-2(b)(1)

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Bracket Management

3.8% NIIT Overview – Net Investment Income

Does NOT Include:

• Salary, wages, or bonuses

• Distributions from IRAs or qualified plans

• Any income taken into account for self- employment tax purposes

• Gain on the sale of an active interest in a partnership or S corporation (generally)

• Items which are otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt

bonds, capital gain excluded under IRC 121, and veterans benefits

Includes:

• Interest

• Dividends

• Non-qualified annuity distributions (taxable portion)

• Rents

• Royalties

• Income derived from passive activity

• Net gain derived from the disposition of property (capital gains)

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Bracket Management

Assets by Bracket

39.6%

35%

33%

28%

25%

15%

10%

Tax-Free

• Roth IRAs

• Life Insurance

• Tax-Exempt Interest Income Tax-Deferred

• IRAs, 401(k)s, 403(b)s

• Non-qualified Deferred Annuities

Taxable

• Interest Income

• Capital Gains

• Qualified Dividends

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“Fly below the radar”

Bracket Management

Summary

$305,050 PEP/Pease

$250,000 3.8% NIIT

$457,600

39.6% Income Tax Rate

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• Married Filing Jointly Taxpayer

• 5 Year Projection

• In 2013:

– $150,000 Wages/Nonqualified Deferred Comp.

– $50,000 Long-Term Capital Gains – $20,000 Itemized Deductions

– $5,000,000 IRA

• In 2015:

– IRA RMDs Begin

• Other Assumptions: 2% inflation rate, 8% IRA growth rate

Bracket Management

Example

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Bracket Management

Poor Bracket Management Scenario

$- $100,000 $200,000 $300,000 $400,000 $500,000 $600,000 $700,000 $800,000 $900,000

Taxable Income and RMD Married/filing jointly

Taxable Income IRA Distributions 39.6% Bracket 35% Bracket 33% Bracket

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Bracket Management

Poor Bracket Management Scenario

$- $100,000.00 $200,000.00 $300,000.00 $400,000.00 $500,000.00 $600,000.00 $700,000.00

Taxable Income per Bracket

10.00% 15.00% 25.00% 28.00% 33.00% 35.00% 39.60%

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Bracket Management

Poor Bracket Management Scenario

$- $5,000 $10,000 $15,000 $20,000 $25,000 $30,000

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028

Itemized Deductions

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Tax Aware Investing

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Tax Aware Investing

Overview

• Taxes are the biggest drag on investment performance

• It is not what you earn that counts, but what you keep after taxes

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Tax Aware Investing

KEY TOPICS

• Tax Structure – Determining the “optimum” mix of taxable investments, tax-deferred investments and tax-free

investments (i.e. Where should retirement savings be invested?)

• Tax-Sensitive Asset Allocation – Understanding the impact that income taxation has on asset allocation and

diversification

• Asset Location – Identifying which assets to place in certain investment vehicles

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Tax Aware Investing

Example

• Example: Depending on the tax rate, the

accumulation of investing $10,000/year for 40 years at a 8% pretax rate of return will differ dramatically:

Tax Rate After-Tax Growth Rate* Final Value

0% 8.0% $2,590,656

10% 7.2% $2,102,199

20% 6.4% $1,712,216

30% 5.6% $1,400,380

40% 4.8% $1,150,637

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Tax Aware Investing

Strategy

• Strategies for tax-aware investing:

– Increasing investment in tax-favored assets – Deferring gain recognition

– Changing portfolio construction – After-tax asset allocation

– Tax-sensitive asset location

– Managing income, gains, losses and tax brackets from year-to-year

– Managing capital asset holding periods

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Interest Income - Taxable

Capital Gain Income

-Preferential Rate -Deferral until

sale

Roth IRA and Insurance

- Tax Free Growth/

Benefits Real Estate

and Oil & Gas

- Tax Preferences Pension

and IRA Income

- Tax Deferred

 Money market

 Corporate bonds

 US Treasury bonds

Attributes

 Annual income tax on interest

 Taxed at highest marginal rates

 Equity Securities

Attributes

 Deferral until sale

 Reduced capital gains rate

 Step-up basis at death

Real Estate

 Depreciation tax shield

 1031 exchanges

 Deferral on growth until sale

Oil & Gas

 Large up front IDC deductions

 Depletion allowances

 Pension plans

 Profit sharing plans

 Annuities Attributes

 Growth during lifetime

 RMD for IRA and qualified plans

 No step-up Dividend

Income

Tax Exempt Interest

 Equity securities

Attributes

 Qualified dividends at LTCG rate

 Return of capital dividend

 Capital gain dividends

 Bonds issued by State and local Governmental entities

Attributes

 Federal tax exempt

 State tax exempt

Roth IRA

 Tax-free growth during lifetime

 No 70½ RMD

 Tax-free distributions out to beneficiaries life expectancy

Life Insurance

 Tax-deferred growth

 Tax-exempt

Tax Aware Investing

Tax Asset Classes

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Tax Aware Investing

Income Taxation Basics of Retirement Investments

Three Main Types of Retirement Investment Accounts

• Taxable investment accounts – income generated within the account (i.e.

interest, dividends, capital gains, etc.) are taxed each year to the account owner

• Tax-deferred investment accounts (e.g. traditional IRAs, traditional qualified retirement plans, non-qualified annuities, deferred compensation) – income generated within the account is not taxed until distributions are taken from the account

• Tax-free investment accounts (e.g. Roth IRAs, life insurance) – income

generated within the account is never taxed when distributions are made (provided certain qualifications are met)

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Tax Aware Investing

Income Taxation Basics of Retirement Investments

Common Assets in a Client’s Portfolio

• IRA Accounts

• Roth IRA Accounts

• ERISA Plans

• Tax-Deferred Annuities

• Life Insurance

• Stocks, Bonds, Warrants, Options

• Employer NSOs and ISOs

• Employer Deferred Compensation

• Real Estate

• Oil & Gas

• U.S. Savings Bonds

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Tax Aware Investing

Investment Incentives in the Tax Code

• Qualified dividends

• Long-term capital gains

• Qualified retirement accounts (e.g. 401(k) plan)

• Roth IRAs/Roth 401(k) plans

• Real estate depreciation

• Oil & gas

• Life insurance

• Non-qualified annuities

• Master Limited Partnerships (MLPs)

• Index options

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Tax Aware Investing

Deductible IRAs, Pension Plan Incentives and Deferred Compensation

• Defined Contribution Plans

• Defined Benefit Plans

• Deductible contributions

• Roth IRA conversions

• Tax deferred growth

• Taxable withdrawals

• Net Unrealized Appreciation (NUA)

• Lump-sum averaging

• Aggregation of accounts

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Tax Aware Investing

Roth IRA and Roth 401(K) Incentives

• Non-deductible contributions

• Tax-free growth

• Non-taxable withdrawals for “qualified distributions”

• Five-year rule & Age 59 ½ Rule

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Tax Aware Investing

Qualified Dividend Incentives

• Taxation of Interest Income - Ordinary Income

• Taxation of Traditional Dividends- Ordinary Income

• Taxation of “Qualified Dividends” – Capital

Gains Rate of 15%

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Tax Aware Investing

Capital Gains Incentives

• Gains Deferred until Property is Sold

• Short-term Gains are Taxed at Ordinary Rates

• Long-term Gains are Taxed at Lower Tax Rates

• Step-up in Basis at Death

• Gifts to Charity or a Charitable Trust that do not Trigger Tax

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Tax Aware Investing

Real Estate Incentives

• Interest Deductions

• Depreciation Tax Shield

• 1031 Tax-free Exchanges

• Step-up in Basis at Death

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Tax Aware Investing

Life Insurance Incentives

• Tax-Deferred Growth

• Tax-Free Death Benefit

• Tax-Free Basis Distributions First

• Tax-Free Loans

• All Contracts are Treated Separately

• Modified Endowment Restrictions

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Tax Aware Investing

Nonqualified Annuity Incentives

• Tax-deferred Growth

• Pro-rate Basis Distributions if Annuitized

• All Contracts are Treated Separately

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Tax Aware Investing

Incentives for Master Limited Partnerships

• Cash Distributions are often Tax-free

• Depreciation Tax-shield

• Reduction in Basis

• Step-up in Basis at Depth

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Tax Aware Investing

Blending Tax and Finance

• Asset “Allocation”

• Tax Incentives

• Asset “Location”

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Tax Aware Investing

Common Problems Blending Tax and Finance

• Large IRAs and Qualified Plans

• Minimal IRAs and Qualified Plans

• High Turnover Investments

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Tax Aware Investing

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%

$- $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000

Total Investment Balance

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Tax Aware Investing

Breakeven Rates of Active Equity Investment vs. Passive Equity Investment

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%

Passive Equity Investment Turnover %

Active Equity Investment Turnover %

ASSUMPTIONS

Capital Gains Tax Rate 15%

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Tax Aware Investing

Breakeven Rates of Active Equity Investment vs. Passive Equity Investment

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%

Passive Equity Investment Turnover %

Active Equity Investment Turnover %

ASSUMPTIONS

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Tax Aware Investing

Comparison of “Real” Capital Gains Rates (Present Value)

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%

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%

YEAR

COST OF CAPITAL

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Tax Aware Investing

Observations- What have We learned?

• Life Insurance is on 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

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Tax Aware Investing

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

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Client accesses $150,000 from her 401(k)

Client accesses $75,000 from her 401(k) and $65,000 from her cash value life

insurance policy and/or Roth IRA

Without Tax Diversification

The full $150,000 is taxable at an average tax rate of 30% or $45,000

Only the $65,000 from her 401(k) is taxable, and it’s taxed at the lower average

tax rate of 15% or $11,250

Leaving client $105,000 to spend in retirement

Leaving client $138,750 to spend in retirement

With Tax Diversification

Tax Aware Investing

The Benefits of Tax Diversification

Retirement Income of $150,000

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Tax Aware Investing

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)

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Tax Aware Investing

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

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Tax Aware Investing

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

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Tax Aware Investing

Tax Aspects of Location of Equities

• 15% Long-Term Rate

• No Gain Realized until Property is Sold

• Step-up in Basis at Death

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Tax Aware Investing

Ideal Assets for Qualified Plans and IRAs

• Taxable Bonds

• REITS

• High Turnover, Short-Term Gain Strategies

• Nonqualified Dividends

• High yield Stocks

• Option Strategies

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Tax Aware Investing

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

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CONCLUSION

QUESTIONS?

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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.