The following is in response to Bob Veres’ article, The Profession's Faulty Assumptions: A Top Ten List, which appeared last week:
Dear Editor,
Thanks to Bob Veres for his perspicacious comments that reflect my experience. As a practitioner, teacher and author, I routinely express the same concern with the use of assumptions. One of my favorite quotes is from an advisor who said: “The Roth IRA conversion is a no-brainer.” My response was that he obviously hadn’t used his brain to consider all the variables involved in the analysis.
Jim Knaus
Global Wealth Advisors LLC
Troy, MI
Dear Editor,
Mr. Veres discusses a tax-aware strategy for withdrawing from an IRA. It is unclear to me how this is accomplished. For example, if a person needs $90,000 per year to live on and assuming all IRA distributions are pre-tax, then the overall tax rate is what matters, not an artificial “ the first 15% comes from the IRA, etc.” That is money is fungible and I don’t get how you lower the effective tax rate.
Can you help clarify this?
Thanks,
Steve Gelfand
Merrill Lynch
San Francisco, CA
Bob Veres responds:
I may not have been as clear as I might have been in the explanation. The point, though, is that instead of living on the taxable portfolio before the IRA distributions become mandatory, the client takes preliminary IRA distributions (even though he doesn't have to) to fill up the first few tax brackets. The rest of his income will come from the taxable portfolio, which has already been taxed.
Otherwise, if he takes all of that $90,000 out of the taxable portfolio, you end up wasting those lower brackets. Meanwhile, you build up the IRA to the point where the mandatory distributions are taxed at higher marginal rates. The overall effect is to get money out of the IRA at something well below the highest marginal rate – before the mandatory distributions kick in – and then the mandatory distributions are lower, the taxable portfolio still has something left, and those future tax rates are controlled as well.
Bill Reichenstein explains all this much more elegantly than I do. He has the great advantage of knowing all of this intimately. But I think these issues are central to adding value for clients who are in retirement.
Dear Editor,
I run an SFO. We are decent investors, having outperformed the S&P 500 on a compound annual growth rate by several hundred basis points per year. I have kept careful records since I started in 1997, when we began selling our low-cost basis holdings of an S&P 100 company. We had consulted with highly competent estate planning lawyers and CPAs to estimate the trade-offs between holding and selling and had decided selling and reinvesting in new assets over time was the best option for us.
When I recently added together all my investment income since 1997 (interest and dividends plus realized and unrealized gains and losses) and all income and capital gains taxes (federal, state, and local) I was shocked to discover that taxes paid were fully 40% of the total investment income. That means our effective, not marginal, tax rate for the last 15 years has been 40%. Some might ask how that is possible in the era of the "Bush tax cuts."
There are several reasons that I have identified:
- We received a large inheritance in recent years, which has boosted our income, realized gains, and tax bill.
- The capital gains taxes paid on realized sales of low-cost basis long-term holdings are relatively high compared to the tax portion paid out on high-cost basis long-term property.
- The realized and unrealized losses associated with two severe bear markets wiped out years of gains.
A majority of the inheritance was received prior to the 2008 bear market, so we lost a larger absolute number of dollars even though we succeeded in limiting total portfolio losses to only 20%.
It is very easy to underestimate taxes as a percent of income. Accurately forecasting the tax circumstances is often more difficult than we can imagine.
Anonymous
Bob Veres responds:
I certainly agree that it's possible to underestimate tax rates as well as overestimate them, so I concede, up-front, your main point. But looking at your circumstances, it's hard to see where the 40% rate came from, with so many capital gains (even on low-basis holdings) at a maximum of 20% and all those realized losses. A one-time blip from the inheritance at Bush-era rates would have forced you deep into the 35% rate for that year.
But I'm not a CPA. Maybe another reader can see the way 40% came out of your fact pattern.
The following is in response to Joe Tomlinson’s article, How Safe are Annuities?, which appeared on August 14:
Dear Editor,
Can Tomlinson comment on variable annuities (VAs) in particular?
I am a very big advocate of VAs with living benefits/withdrawal benefits as a part of my clients’ retirement income.
My current preferred vendor is Jackson National. They allow my client to be 100% invested in equities.
There are no silver bullets, so I want to make sure there are no risks or costs that I am missing here:
- High current costs (about 300bps to own an index fund + M&E + living benefit rider)
- Rider expenses that can be raised over the life of client contract prior to income phase (this is capped at 150bps)
- The insurance company could fail
I recognize that some may consider 300bp in fees to be high, but I believe the income insurance is worth the cost.
Trey Haydon
Investment Management Consultant
Portfolio Manager
Raymond James | Morgan Keegan
Joe Tomlinson responds:
I'm not personally a big fan of VAs because of the high fees, but I have the luxury of mostly being a pundit/writer and not having to generate business to make money. So I recognize others may need to look at things differently.
Jackson National is rated AA by S&P and A1 by Moodys. Most of the respectable life companies fall in the A or AA category so there are no alarm bells there. You might want to check the prospectus to see what flexibility they have to raise M&Es or investment management fees or introduce other expense charges – in other words, anything the prospectus would allow them to get away with if they got in financial trouble.
You can access the Georgia guarantee association site via www.NOLHGA.com (upper right). Here's what they say about variable annuities in their FAQ section:
Are variable annuities covered by the guaranty association?
Generally speaking, a variable annuity contract with general account guarantees will be eligible for guaranty association coverage, subject to applicable limits and exclusions on coverage. However, specific questions regarding coverage will be determined by the applicable guaranty association based on the terms of the contract, other relevant facts, and the guaranty association law in effect at the time of liquidation.
This is quite standard language that probably comes from the national association. The "specific question" disclaimer that they put in is the same you will likely get if you call them. There have been, fortunately, few significant failures and the guaranty associations wait for an insurer to fail and then determine how they will cover things.
Georgia has a somewhat unusual provision in that they cover $100,000 of annuity cash value or $300,000 for annuities in payout. I'm not a lawyer, but my reading would be, if a VA insurer got in trouble and there were VAs with living benefits that had exhausted their account value, the Georgia guaranty association would need to cover up to $300,000 of future withdrawal payments. You could try posing this hypothetical case with a phone call to the Georgia guaranty association to see whether they are willing to give you a definitive answer.
I'm not aware of any cases of failures of companies with living benefit VAs, so I don't know of any precedent to go on.
The following is in response to Beverly Flaxington’s column, Dealing with Gossip in a Small Firm, which appeared last week:
Dear Editor,
As a facilitator, I see this within groups and get caught up in it myself. Let’s say you have a problem with someone (based on what they said or what you thought they said) What do we typically do when this occurs? We go share it with someone else – a peer, a boss, everyone except the person who really needs to hear it!
Teammates frequently even take it straight to their manager. Think of the impact and fallout of doing things this way – first of all, the person you are taking it to can do nothing but listen to you bellyache. What are you expecting them to do? If they do something, then they have broken your trust! If you allow them (or push them) to respond to the information for you, you are going to lose respect and your relationship with that individual.
Teams that are ready to fix this dynamic have to honestly sit down, look each other in the eye and say “we all have our gripes with each other for good reason, but why don’t we agree to start doing things in the right way in the right spirit? After all, if you tell me what your issue is or what you don’t like that I did, haven’t you actually done something positive regarding our relationship and the team overall?”
But we tend to take confrontation and disagreement as world-shattering stuff instead of recognizing the good that is to be gained. If we can manage to handle such situations in a respectful, tactful and non-confrontational way, it will drastically improve the way a team operates.
Often, after I have worked with a team for some period, I begin to see myself as one of the team. Eventually someone will take issue with how I am performing or maybe an opinion that I express. Instead of taking issue with me, the person shuts down, creating a barrier to further learning or communicating on that person’s part. Later, the person may take it to someone that wasn’t even there! It tears down relationships, discourages communication, kills trust and makes life miserable for all around the issue. Not to mention all the wasted time that these kind of things end up taking, because we took it through a cycle of the wrong people.
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