Tag: tax efficiency

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Retirement taxes under Biden or Trump

With the U.S. presidential election less than three weeks away, now is a good time to consider how your retirement taxes may change. In this post, we highlight the differences in Biden Vs. Trump plans for retirees.

The 2020 Presidential Election may change your retirement tax planning.
The 2020 Presidential Election may change your retirement tax planning.
Note:  This post has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Income Taxes in Retirement

Most retirees face some amount of income tax. Social security benefits, pensions, interest on CDs, and bond coupon payments are just a few sources of that can produce retirement income tax. Any voluntary withdrawals from and IRA or 401(k)s, or taking required minimum distributions (RMDs) can also trigger income tax.

The Tax Cut and Jobs Act of 2017 established the current seven income tax brackets, with the lowest at 10% and highest at 37%. Both candidates wish to keep these tax cuts in place, which currently plan to lapse after 2025. But, Biden wishes to alter it so that households making more than $400,000 would pay higher taxes by limiting the value of itemized deductions. He also proposes to increase the top tax rate from 37% to 39.6%. For household making less than $400,000, Biden hopes to increase the standard deduction. Doing so should decrease taxable income and, subsequently, decrease taxes owed.

Capital Gains Taxes in Retirement

Current U.S. tax law states that qualified dividends and long-term capital gains from investments held for more than one year are taxed at a lower rate. Excluding the net investment income tax, the maximum rate is 20%. Trump has suggested lowering this rate to 15%. Biden wishes to tax long-term capital gains at income tax rates for households with over $1,000,000 in taxable income. He also plans to eliminate the step-up in cost basis realized by retirees wishing to pass highly appreciated assets to their heirs.

The SECURE Act and your retirement objectives, by DiLellio and Kinsman (2020), Vol 23, Issue 2, The Graziadio Business Review

What doesn’t appear likely to change

There are several areas of retirement taxation that likely won’t change. For instance, I recently published a peer-reviewed article about the SECURE Act. This law passed with broad bipartisan support, delays the onset of RMDs for younger retirees and changes rules for inherited IRAs.

For now, we encourage you to seek out a retirement calculator, like ours at ETFMathGuy, and we wrote about recently, to see what current U.S. tax law means to your retirement plans. We will update our calculator as tax law for retirement income changes.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Excess Retirement Income Now Included In Our Retirement Income Calculator

We just finished upgrades to our optimal retirement income calculator to include the possibility of having excess retirement income. This situation occurs when Required Minimum Distributions (RMDs) + other non-discretionary sources of retirement income exceed the retiree’s needed income in current and future retirement years. Indeed, this is a good problem to have! It typically occurs when annual retirement income needs are small relative to all the retiree’s income sources. Retirees in this situation have an extremely low risk of outliving their assets.

Click here to launch the Optimal Retirement Income Calculator by ETFMathGuy.

For example, consider a retiree who needs $100,000 of income in their first year of retirement. What should a retiree do if their RMDs are $40,000, pension and social security benefits are $50,000, and interest + dividends in taxable accounts are $20,000, for a total of $110,000? Note: This $10,000 of excess retirement income occurs without taking voluntary withdrawals from any of their accounts. How should a retiree invest this money to maximize tax efficiency?

Retirement Income Sources

As we show on our updated FAQ page, we included many possible sources of retirement income. To help simplify the model, we previously required dividends and interest in taxable accounts to only satisfy immediate retirement income needs. We make a similar assumption of social security and any pension benefits. Put another way, we wouldn’t re-invest these funds for later use in retirement. Thus, the taxable account maintains a single cost basis from investments made prior to retirement.

What about Required Minimum Distributions (RMDs)?

Required Minimum Distributions (RMDs) complicate retirement income planning, and represent non-voluntary account withdrawals. They can also produce the unintended consequence of producing excess retirement income, like in the example above.

Tax Efficient Investing of Excess Retirement Income

We upgraded our model with a simple approach to reinvesting excess retirement income that would never be needed by a retiree. As previously advocated by DiLellio and Ostrov (2020) and DeMuth (2020), zero-dividend equity (e.g. stock) investments offer a solution. For example, the largest zero-dividend ETF is the First Trust Dow Jones Internet Index Fund (ticker: FDN). By reinvesting excess income into an ETF like this one, no gains during retirement would be realized. So, no taxes are due. Then, the total amount in this investment account can be passed to the retiree’s heirs tax-free thanks to a step-up in cost basis, but excluding estate taxes. Below is an image that shows the new black line to track the account holding the excess income that, in this example, starts in year 7.

In this example, excess retirement income starts in year 7, and is reinvested in a zero-dividend ETF for maximum tax efficiency.
In this example, excess retirement income starts in year 7, and is reinvested in a zero-dividend ETF for maximum tax efficiency.

We hope you find this new enhancement helpful in planning for your retirement! Please stay tuned for future enhancements to our web-based calculator, including evaluating the benefits of municipal bond ETFs, Roth conversions, and automating sensitivity analyses.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Retirement income tax

Anyone receiving a regular paycheck is familiar with income tax since it usually appears between the “gross” and “net” income of your pay stubs. In retirement, you will likely have many sources of “retirement income”, and consequently incur “retirement income tax”. In this post, we discuss some typical sources of retirement income tax, and how they interact with one another.

Note:  This post has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Guaranteed Retirement Income

Social Security is one of the most common sources of retirement income. It adjusts for inflation each year, so this benefit rises with the cost of living. Another less common source of guaranteed retirement income is a pension. These guaranteed income sources often give the retiree the choice to decide when benefits begin. They also may allow a deferral of benefits until a later age.

Now, if your total income is sufficiently low, pension and social security income could yield no tax liability. Otherwise, retirees incur tax on this guaranteed income as ordinary income.

Retirement income often is the combination of a number of sources.
Retirement income often is the combination of a number of sources.

Dividends, Interest and Coupon Payments

If you have a savings or taxable brokerage account with stocks, bonds, ETFs, mutual funds or other interest bearing investments, you may receive regular payments. As we discussed in our previous post on taxation, these payments are either taxed as ordinary income or capital gains.

Your “Nest Egg” Accounts

Individual Retirement Accounts (IRAs), 401(k)s, 403(b)s and 457 plans all provide tax-deferred growth. Since we usually fund these accounts with pre-tax money, the IRS taxes qualified distributions as ordinary income. Alternatively, we fund Roth IRAs, Roth 401(k)s and Roth 403(b)s with after-tax money, so we receive qualified distributions tax free. Lastly, if we sell stock or bond ETFs for a gain within a taxable brokerage account that were held for more than one year, taxes incurred are usually at the preferred capital gains rates.

Big Picture

All these sources may sound confusing, and may not apply to all retirees. But, putting these retirement income sources into a conceptual model can help you better understand how they affect a retiree’s annual tax liability. In the model below, we assume that all taxable brokerage accounts have a mix of dividend paying stock and bond ETFs. We show capital gains and qualified dividends above sources of ordinary income, since more ordinary income can push capital gain tax rates to higher brackets.

Retirement Income Sources and Taxation Model by ETFMathGuy’s Optimal Retirement Income Calculator

Using your nest egg efficiently can significantly improve both portfolio longevity and funds bequeathed to your heirs. Based on award winning research, we implemented this model into a free web application. We update the model’s algorithms regularly, so please try out this tool and send us your feedback on features you may want included in the future!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Finding your Optimal Retirement Income

We introduced a new feature to ETFMathGuy.com in 2019 to help current and future retirees plan for the future. We have now upgraded it to find optimal retirement income. Fortunately, the calculator still offers answers to the many commonly posed questions for those nearing or currently in retirement.

  • How long will my portfolio support my discretionary and non-discretionary expenses?
  • How much will my heir or favorite charitable organization receive?
  • What will my future tax liabilities look like?

This calculator models income tax, capital gains taxes and other important elements of U.S. tax law relevant to individuals and couples in retirement. However, this model does not represent tax advice, and is for educational purposes only.

Sequencing Withdrawals for Optimal Retirement Income

In the former version of our calculator, we only applied the so-called “Common Rule“. Using values for a hypothetical 60-year old couple with a 20 year retirement horizon, the figure below shows how the couple can achieve $150,000 of annual after-tax retirement income. Notice how this “married filing jointly” couple has a effective 0% income tax bracket, as labeled on the right of the figure, due to use of the standard deduction. In 2020, this value is $24,800. To re-create these results or create your own, please visit our our interactive retirement calculator.

Common Rule withdrawal sequencing leading to a $1,203,938.01 inheritance. optimal retirement income
Common Rule withdrawal sequencing leading to a $1,203,938.01 inheritance.

While the “Common Rule” is widely adopted by financial planners and major discount brokers like Fidelity and Vanguard, it is known to sub-optimal. Why? This rule typically produces very little tax burden in the earlier years of retirement, unless they are triggered by Required Minimum Distributions (RMDs). Consequently, later retirement years can see very high income tax to maintain retirement income at acceptable levels. This rule also doesn’t take advantage of the step-up in cost basis realized by the retiree’s heirs.

Optimizing Retirement Income Withdrawal Decisions

The latest version of the retirement income calculator can now optimize withdrawal decisions using an “Optimal Rule“. So, using the same values for the calculator as our previous hypothetical couple, their heir’s inheritance increases by 13.7%, or $165,000. If their heir is a qualifying charitable organization, the inheritance increases by  $335,343.94 or 26.1%. We encourage you to try out your own scenarios to see how you can improve your retirement withdrawal decisions.

Optimal Rule withdrawal sequencing leading to a $1,368,938.05 inheritance, a 13.7% increase. optimal retirement income
Optimal Rule withdrawal sequencing leading to a $1,368,938.05 inheritance, a 13.7% increase.

Plans for the Future

We have plenty of other plans for our retirement calculator. For instance, delaying social security, including tax-free municipal bond interest, and assessing the benefits of a Roth conversion are just a few. If you have any thoughts of what you would like to see, please send us your feedback!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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The SECURE act and Your Retirement

On December 20, 2019, the SECURE act (Setting Every Community Up for Retirement Enhancement act) was signed into law. This new law made a number of changes that could effect your plans for retirement. We discuss a few highlights of this new law in this post.

New age for Required Minimum Distributions (RMDs)

The SECURE act recognizes that more individuals are delaying retirement. So, the new law changes the age to take initial RMDs from tax-deferred accounts, like 401(k)s, 403(b)s and traditional IRAs. Previously, initial RMDs were triggered in the year you turned 70 1/2.

Required Minimum Distributions (RMDs) are changing.
Tax laws for retirement are changing. source: Getty Images

The new age under the SECURE act is 72 for individuals who reach 70 1/2 in 2020. Using a handy online age calculator or performing a little mental math, that means anyone born after June 30, 1949 can wait until the year they turn 72 to take RMDs.

How will this new RMD age affect your retirement plan?

In late 2019, we developed a retirement calculator that included income and capital gains tax forecasts. It also included RMDs under the old law. We are happy to announce we have updated our calculator to include this new law. Please check it out! We also added a tool tip for each input in the calculator, to help you better understand how the model works.

We updated our retirement calculator to include the age change of RMDs from 70 1/2/ to 72.

Bad news with the SECURE act

Unfortunately, there is also some bad news for retirees coming from the SECURE act. The so-called “Stretch IRAs” are now not nearly as valuable as they were prior to this law. Previously, IRAs that are passed to nonspouse heirs could be withdrawn over their life time. This feature made inherited IRAs very appealing to younger heirs, who could stretch their payments, limit their income taxes, and stretch pre-tax gains over a longer time. The new law limits this time to 10 years. In a bit of good news, this law does not affect existing inherited accounts.

Conclusions

Tax law will continue to change. We shouldn’t expect congress to continue to keep the taxes status quo. Instead, current and future retirees should consider diversifying their retirement income sources to accommodate possible future changes.

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Retirement Calculator by ETFMathGuy

Seasons greetings to all! We hope this post finds you well. We are happy to introduce a new and evolving feature available to ETFMathGuy subscribers: a new Retirement Calculator!

Retirement Calculator

You may have noticed a new menu option when logging into ETFMathGuy.com labeled “Retirement Calculator”. Please be sure to log-in to our site to access this interactive calculator. If you don’t recall your password, it can be reset here. You also may need to refresh the page containing the calculator.

A new retirement calculator to help you better understand the feasibility of your retirement income.
A new retirement calculator to help you better understand the feasibility of your retirement income.

Another Retirement Calculator?

There are certainly many retirement calculators available online, either free, as part of your brokerage account, or by subscription. I have been using the Fidelity Retirement Income planner for some time, which is free to Fidelity account holders. While there are similarities between our retirement calculator and others, here are a few of the features our retirement income planner includes.

  1. We assume qualified stock dividends and non-qualified bond dividends. Some planning tools tax stock and bond dividends the same. So, we made the assumption that stock and bond investments in a taxable brokerage account hold ETFs like the iShares Core S&P 500 ETF (ticker IVV) and the iShares Core U.S. Aggregate Bond ETF (ticker AGG).
  2. We assume taxable account withdrawals trigger only long-term capital gains taxes. Some planning tools include all taxable account withdrawals as part of ordinary income, which only occurs for capital gains in investments held for less than one year.
  3. We model capital gains taxes and qualified dividends at either the 0%, 15% and 20% rates, with income levels based on taxable income for the current tax year. Some planning tools either exclude taxation of these sources of retirement income, or tax them all at the 15% rate.

Questions or feature requests

We encourage you to try out our new calculator, which also provides more detailed information on how it models retirement income and taxes. We also would love to hear about features you would like to be included in the calculator as its development continues.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Is direct indexing better than buying an ETF?

Direct indexing may be gaining popularity soon, thanks to a continued fee war between several large brokerages. Both Schwab and Ameritrade recently announced commission-free stock trades, in addition to their commission-free ETF trades. This may sound like an appealing alternative, but direct indexing is far from simple.

What is direct indexing?

Direct indexing creates a portfolio that tracks an index through buying individual stocks. So, in the case of the S&P 500, you would invest in common stock from the 500 companies that make up the index. By eliminating the commission for each trade, the cost barrier of buying and selling each stock goes down significantly. However, it still requires many trades. In the case of the S&P 500, there are actually 505 common stock listings for the 500 companies in the index. It turns out that a few companies, like Google, have two share classes. So, one could eliminate the expense ratio of 0.04% currently charged by the iShares Core S&P 500 ETF (ticker: IVV). For a $100,000 portfolio, that is a savings of $40 a year. For portfolios of this size, I would argue that the convenience of trading a single ETF is worth $40 a year.

Tax benefits of direct indexing

When an investor builds a portfolio of common stock with direct indexing, they get more control over its holdings. While ETFs are known to be very tax efficient, tax loss harvesting is not possible at the individual security level. This benefit doesn’t make a difference in retirement accounts that aren’t paying taxes on selling stocks, but can be significant in taxable accounts for high income earners.

Conclusions

I am happy to see commissions for stock trades hitting $0, but I’m not convinced that for most investors, direct indexing makes sense. There is a cost savings, but the additional effort could be significant. And, if your larger investments are in tax-deferred or exempt retirement accounts, there aren’t any tax benefits available anyway. Tax loss harvesting appears to be the most compelling reason to direct index. It is most beneficial to individuals paying the highest marginal tax rates.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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October Portfolios and Third Quarter Market Summary

The October 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker to see the effect of current market conditions on our optimal portfolios. Here, we also summarize the market dynamics in the third quarter.

Third Quarter Market Summary

Today’s issue of the Wall Street Journal had several articles that nicely summarized the latest quarter for ETFs. Today, I discuss two articles. The first deals with investing in precious metals, and the second with preferred stock.

Precious Metals

The first article discusses the opportunity of investing in precious metals in a rate falling environment. The author points out that holding precious metals, like the popular gold ETF (ticker: GLD) or sliver ETF (ticker: SLV) don’t produce a yield like stock and bond ETFs. Then, the article goes on to suggest the “safe haven” aspect of precious metals may be driving their demand. The image below shows that the opportunity for large gains is possible, if investors are willing to accept a high degree of volatility.

Returns of three precious metals in the 3rd quarter, 2019. Source: WSJ, October 1, 2019.
Returns of three precious metals in the 3rd quarter, 2019. Source: WSJ, October 1, 2019.

Preferred stock

The second article discusses a hybrid stock-bond fund that tracks preferred stock. This investment has characteristics of both common stock and bonds, as seen by its performance shown below for a preferred stock ETF (ticker: PGX). Because the riskiness of preferred shared typically falls between stocks and bonds, it is not surprising its returns do too.

Returns of preferred shares ETF vs. stock and bond markets. Source: WSJ, October 1, 2019.
Returns of preferred shares ETF vs. stock and bond markets. Source: WSJ, October 1, 2019.

Conclusions

The financial markets continue to exhibit very dynamic behavior. But, ETFs continue to offer an opportunity to reach parts of the markets in a cost and tax efficient manner. So, we hope this article helps to inform your decision making when selecting ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

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Risks and Opportunities in Fixed-Income ETFs

Fixed-income ETFs (also known as bond ETFs) continue to grow at a rapid pace. Bond ETFs now exist across a wide spectrum of characteristics. Looking for shorter or longer maturity? Or, how about higher yield (aka junk bonds) versus investment grade or Treasury bonds? ETFs even cover the bond markets in both emerging and developed economies worldwide.

At this rate, State Street Global Advisers predicts that assets in bond ETFs could reach $1 trillion by the end of 2019.

What is driving demand?

Like stock-based ETFs, low cost is a big driver. Greater tax efficiency, as we discussed in detail in a post earlier this year, over bond mutual funds helps too. But, the biggest demand could be simply choice.

“Investors really have a lot of choices — more than they’ve had in the past five years. “

Noel Archard, State Street Global Advisors

Liquidity concerns?

Our opinion at ETFMathGuy is that liquidity concerns are minimal. In fact, real-time ETF price availability helps the price discovery process, and should improve liquidity.

“Fixed-income ETFs have been tested more than once over the past 10-11 years, without any major issues. “

Rich Powers, Vanguard

The current focus of fixed-income ETFs

The current focus of fixed-income ETFs is now in portfolio construction. Here at ETFMathGuy, we are helping to lead this initiative by building portfolios to take full advantage of what fixed-income ETFs have to offer. For instance, in the May taxable conservative portfolio for Vanguard, we show a portfolio with a a variety of fixed-income ETFs in it. We also seek to include higher volume alternative ETFs, to mitigate any possible liquidity issues and minimize the bid-ask spread trading costs.

May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy.
May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy

In conclusion, fixed-income ETFs are in important core component of an optimally diversified portfolio. We invite you to browse through the current month optimal portfolios to see the importance of bond ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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ETF Tax Efficiency vs. Mutual Funds

Much has been written about ETF tax efficiency. In this blog post, we summarize what these tax advantages look like to a individual investor who may be considering mutual funds as an alternative.

Let’s start with the basics of capital gains taxes. Short term capital gains are taxed as ordinary income, which for individuals in higher tax brackets, is far from ideal. Below are the tax brackets for married filing jointly in 2018.

The 2018 tax brackets and rates for married couples filing jointly.
Source: CNBC.COM. About half of Americans don’t know what tax bracket they’re now in—here’s how to find out., by Kathleen Elkins

So, let’s suppose you and your spouse made $175,000 in 2018. Then, for every additional $1 of short-term capital gains, you owe 24 cents of income tax. If you are fortunate enough to be earning more, tax rates are even higher. For this reason, higher earners often use municipal bond ETFs in their taxable portfolios.

What produces short-term capital gains?

There are several ways that individual investors produce short-term capital gains with ETFs and mutual funds.

  • Buying an ETF or mutual fund and reselling it for a gain in less than a year.
  • Non-qualified dividends, often produced by fixed income mutual funds and ETFs.
  • Mutual funds that buy and sell assets in their fund to meet their stated objectives or to satisfy investor redemption*.

*This last point is where ETFs carry a significant advantage. The higher the turnover of a mutual fund’s assets, the more often short-term capital gains are passed on to the individual investor.

“If your fund distributes capital gains often, your tax bill may suffer.”

Source: “How Often Do Mutual Funds Pay Capital Gains?”, by
Claire Boyte-White, Investopedia.

But, ETFs have a creation/redemption process that shields these gains from the ETF investor. While some would say it’s a tax dodge, this process has represented a significant ETF tax efficiency for over 20 years. Below is a chart that shows how often these events occurred in comparable index ETFs and index mutual funds.

Examples of ETF tax efficiency, by generating fewer taxable gains than mutual funds.
Source: Bloomberg.

Conclusions

Tax efficiency is an important aspect that individual investors should consider. ETFs generally offer better tax efficiency than comparable mutual funds. While this efficiency is important for all investors, higher wage earners can reap the greatest tax benefits of using ETFs versus mutual funds.