Tax-Efficient Investing: Top Strategies | Morgan Stanley
1 Source: “Global Investment Committee Special Report: Tax Efficiency: Getting to What You Need By Keeping More of What You Earn,” Morgan Stanley Wealth Management, Mar 3, 2022
2 By using the strategy of withdrawal sequencing, the value-added is approximately 0.5% of equivalent after-tax return. Note that these annual returns would compound to very large numbers over the long investment horizons of many financial goals. In the case of withdrawal sequencing, the difference in returns in the case study is equivalent to nearly a 50% difference in final wealth accumulation. This strategy would be recommended for investors who (1) Have adequate savings relative to spending needs (2) Have a high marginal tax rate and (3) Have sources of low-tax distributions with which to smooth income. Investment liquidations to support retirement spending sequenced in order to increase tax efficiency. Withdrawals from taxable accounts come first to extend tax deferred/ tax-exempt growth of other investments. Income smoothing and partial Roth conversion conducted to lower effective tax rates and minimize spikes in taxable income driven by required minimum distributions. Illustrated value-added based on top marginal federal tax rates for 20 years pre-retirement, and a 5% initial withdrawal rate for 30 years in retirement. Overall portfolio strategy based on a 60% equity/40% fixed income allocation assuming an efficient tax allocation across accounts.
Model Calculation Assumptions: The analyses in this article are based, in part, on a Monte Carlo simulation, which involves repeated sampling of asset class returns from a known distribution.
IMPORTANT: The projections or other information generated by this Monte Carlo simulation analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time.
The analysis for this projection on wealth difference from withdrawal sequence is based on the improvement of withdrawal capability following tax efficient withdrawal sequence among multiple account types in a 10,000-iteration Monte Carlo simulation. Retirement income starts after 20 years’ asset accumulation. The withdrawal amount is calibrated to be 4.5% of portfolio value minus unrealized tax liability in each iteration, adjusted for the cost of living for 30 years. During the asset accumulation period, investors stay in 37% federal tax bracket, with a 5.2% state tax and 3.8% a Medicare tax. During retirement phase, investors’ federal tax bracket is determined by the withdrawal amount together with $20,000 inflation-adjusted Social Security payment each year, subject to additional 5.2% state tax. Tax brackets are based on 2021 married filing jointly status and assumed to grow with inflation rate. Asset growth rates are based on Global Investment Committee forecasted capital markets assumptions as of March 2021, with the first seven years assuming strategic assumptions and subsequent 13 years assuming secular assumptions. Inflation rate is assumed to be 1.75% per year. Portfolios are rebalanced each year across multiple account types to maintain overall asset allocation close to 60% equities and 40% fixed income as much as possible after yearly spending amount being withdrawn. The reason for choosing a 60% equity/40% equity/bond allocation is because it’s a common allocation in balanced portfolios as well as in multi-asset funds. If a different balanced allocation is selected, results would be different than those suggested. Unrealized tax liabilities are subtracted from portfolio ending values to calculate internal rate of return. Probability of success is defined as having at least $1 in any of the account types at the end of 50 years simulation. Partial years of withdrawal are recorded if combined portfolio value at any year is not enough to support expected retirement spending at any year.
3 To leverage the tax deferral benefits of index / variable universal life insurance, in early years the policy buyer can pay maximum annual premiums allowed up to the IRS MEC limit until the policy is fully funded. A modified endowment contract (MEC) is a designation given to cash value life insurance contracts whose funding exceeds federal tax law limits. If an insurance policy is considered an MEC, it loses the tax benefits it would otherwise have of withdrawals and loans made from the policy. The taxation of withdrawals and loans under an MEC is similar to that of non-qualified annuity withdrawals.
4 We assume here that the policy would be funded in a way that won’t trigger MEC status, such that loans taken from the policy would not be subject to income tax.
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