Market Glitches and Tax Efficient Retirement

As we have been thinking through and putting the finishing edits on our periodic thought piece, the news of the NASDAQ market exchange’s halt in trading for 3 hours starting at 12:14 pm yesterday was unfolding. The industry, and NASDAQ in particular, has been grappling with the vulnerabilities of an increasingly digital world, and the incident is another black eye for the NASDAQ market, which you may recall botched the initial public offering of Facebook (ironically one of the companies that has ostensibly benefitted so handsomely from society’s digital migration). The failure took place in NASDAQ’s system for reporting quotes and trades and, in fact, the market maker also fell short on its electronic reporting (market feed) that lets firms know trading has come to a stop. We were watching this closely as it unfolded and below are our takeaways so far:

1. This incident will likely bolster the Securities and Exchange Commission’s case for more oversight and a step-up in automated trading rules that have been proposed. It could lead to fines and sanctions imposed on exchanges for future incidents. We don’t think that more oversight is necessarily positive, but we believe more transparency and accountability should be a positive step and may mitigate the likelihood of more such incidents.
2. The incident is another lesson in the importance of diversification in clients’ portfolios, as investors want to make sure that the impact of global events such as this one will have a varying impact on portfolios (there will be winners and losers), and we maintain that trying to predict that will require a crystal ball. We continue to believe that disciplined re-balancing of an agreed upon strategic asset allocation is a more sound strategy than trying to predict the winners and losers of a near random incident such as this one.
3. The popular press, which always seems to want to explain matters that really should not be analyzed hastily, has once again shed a little more of its credibility. This morning The Wall Street Journal attributed the "root cause" to "complexity" in its electronic headline. We think it's best to take more time to examine the issue, and we are happy to discuss what we learn from more reliable sources.

We will continue to monitor the situation, and hope that you will, in the meantime, find the time to examine our perspective on a tax-efficient retirement, an issue that we believe will have much more of lasting impact on your portfolio than yesterday’s technology glitch:

The whole idea of tax planning during retirement is a relatively new one in many financial planning circles. It’s likely you've heard the conventional “cookie cutter” strategy from magazines and online web commentators: when you retire, take money out of your taxable accounts first, which allows the money in your conventional IRA and Roth IRA to compound on a tax-free basis for the longest possible time. When the taxable account finally runs out, start taking money out of your conventional IRA, which will cause you to pay ordinary income taxes, and let the money compound in the Roth IRA. If there's any money left over, the Roth IRA is the best vehicle to pass investment assets onto heirs, since the money won't be taxed when it is taken in distributions that can be deferred over their lifetime.

The conventional wisdom, alas, is much better in theory than in actual practice. If you take all your income out of taxable accounts, you might end up in a 10% (less than $8,925 in taxable income) or 15% (less than $36,250) marginal tax bracket. What's wrong with that? Retirees who have a significant amount of money in their IRA--and who are growing that pool of assets during the first decade of retirement--will have to start taking mandatory distributions at age 70 1/2, even if they don't need the income. Those distributions could push them into significantly higher tax brackets. And, the tax brackets in the future might possibly be higher than they are today. Raise your hand if you think tax rates are going to go down in the next 10-15 years.

Another problem is that retirees who are working with a financial advisor will have very different investments inside and outside their IRA accounts. Depleting the taxable account first means, for them, selling their stocks first, leaving them with a portfolio comprised mainly of real estate investment trusts, bond funds and commodities futures funds during their later years--which basically means they will fail to get the full benefits of diversification and rebalancing.

Gradually letting some of the air out of the IRA in the years before mandatory distributions come due may be a more tax-efficient strategy. That might mean taking out enough IRA money to offset your standard deduction and personal exemption and fill up the 15% tax bracket, meanwhile taking the rest of your living expenses from the taxable account.

Paying at a 15% rate today could mean not paying at a 28% or 33%--or higher, depending on the whims of Congress--rate in the future. Alternatively, for people who don't need the income, you could make a partial conversion of assets from the IRA account to a Roth IRA--just enough to offset the various deductions and fill up that 15% bracket. We partner with our clients’ CPA firms semi-annually to make sure we re-visit whether this strategy makes sense.

You pay taxes on some of those converted assets at 15% today in order to avoid any future taxation on them down the road. Since Roth IRAs don't have any mandatory distributions for the original owner, you're free to take the money out tax-free or not as you desire in the later retirement years--or leave that money to your heirs.

Looking at the retiree's total tax picture might also use your lower tax bracket to sell some stocks that have significant appreciation, taking the capital gains at a 10% rate, and avoiding a 20% or 23.8% (if the Medicare tax is applicable) tax rate if the asset were sold when mandatory distributions are pushing you into the upper brackets.

Ultimately, we are talking about tax optimization. When one can pay taxes at a lower rate today than they would have to pay in the future, or when they can pay at a low rate today and avoid all future taxation on those assets altogether, we believe this can be profoundly impactful on an investor’s financial freedom.

Every situation is different, every year is different for every situation, and many investors are beginning to realize that planning for a tax-efficient retirement is more complicated. However, careful planning will help those who take the time to ensure they are getting the most value out of their retirement assets. This is why we work so closely with our clients on tax-related matters.