Sunday, March 23, 2014

Equity Investment Strategies:  Taxes, Tax Efficiency, and After‐Tax Returns  

Mill Creek Capital Advisors write: Higher tax rates are starting to attract investors’ attention. Rate increases have  increased the taxes payable on dividend income and on short‐term and long‐term realized  capital gains.  With few or no “tax loss carry‐forwards” to shelter future gains against taxes,  many investors are now wondering whether they should change their approach to equity investing.   

The accumulation of large potentially taxable capital gains is a “high quality” problem about 
which to be concerned, particularly since such gains have so closely followed sharp capital 
losses created during the stock market decline of late‐2007 to early‐2009.  However, not all 
investment strategies within an asset class produce the same pattern of tax liabilities.  Equity 
index funds and ETFs, for example, are generally more tax‐efficient than actively managed 
equity portfolio strategies on an annual basis.  Tax loss harvesting strategies can also help 
investors manage their investment‐related taxes by offsetting gains produced elsewhere.  
But both of these strategies still expose investors to potentially large tax bills when they are later liquidated. 

This report explores the relative tax efficiency of index funds and ETFs while also debunking a  belief that this characteristic makes such strategies inherently far superior to actively managed equity strategies.  It also analyzes how different investment strategies could affect investors’ future tax bills, and offers conclusions on how investors can best structure equity portfolios to manage their yearly and cumulative tax liabilities.  We recommend that investors consult their tax advisors for advice on how the conclusions we draw herein apply to their particular  situations.   Click here to read and or download Mill Creek Capital Advisors Report: Equity Investment Strategies:  Taxes, Tax Efficiency, and After‐Tax Returns. (read or download here).
Posted on 11:54 AM | Categories:

Filing taxes married or separately, and legal liability for a spouse's past filings

Karin Price Mueller/NJ.com - The Star-Ledger writes:  Question. My wife and I were married five years ago. It’s her first marriage and my second. We are in our 50s and we have kept our finances separate. This included tax filings, maintaining two homes (one in her name and one in mine) and we have protected each other’s assets via a prenuptial agreement. We have always filed Married Filing Separately. Does this protect our separate assets in the event that either party had made mistakes or oversights in their previous IRS filings? And if we file this year as Married Filing Jointly, would either of us now be liable for any back taxes or penalties for prior filings that we filed separately?
— Ron

Answer . It’s very smart of you to ask first, rather than do it and potentially deal with a mess later.

You actually have two fundamental questions: The first has to do with income taxes and the second has to do with assets.

When you file separate returns, each taxpayer is responsible for the accuracy and payment of tax related to their own return, said Clare Wherley, a certified financial planner and certified public accountant with Lassus Wherley in New Providence.

"On a joint return, both spouses are responsible for the accuracy and the payment of tax," she said. "If either spouse is unwilling to assume legal and financial responsibility for the other spouse’s tax obligations on a joint return, he or she should file separately."
A newly married spouse is not liable for the other spouse’s past tax obligations, or filings before the marriage, Wherley said.
But there is one catch.

"A refund on a joint return or an assessment on a past — pre-marriage — return could affect the ‘innocent spouse," she said. "In the case of a refund on a joint return, it could be diverted to satisfy a prior year obligation of the not-so-innocent spouse."

If this happens, she said, the innocent spouse can file for injured spouse relief.
You mentioned that you and your spouse keep your assets separate. Wherley said that’s a smart strategy because if the IRS decides to seize assets to satisfy a prior (non-innocent spouse) tax obligation, it can access joint assets.

Bottom line: If you suspect prior years’ tax obligations exist, you would be wise to file separately.
It would also be smart to ask a tax preparer if you have any concerns about your particular situation.

You can visit NJ.com here, you can follow the author Karin Price Mueller on Twitter Here.

Posted on 11:19 AM | Categories:

For those legally married but filing taxes alone, another HealthCare.gov hurdle looms

Amy Goldstein for the Washington Post writes: In May 2012, when the Internal Revenue Service proposed its rules for Americans to get government subsidies for health insurance, officials acknowledged that a legal quirk needed to be fixed: The Affordable Care Act was written in a way that inadvertently denied such help to some people who live apart from spouses who abuse them, are in prison or are on the cusp of a divorce.
The problem is that the law’s authors, in creating tax credits to help pay for health plans bought through the new insurance marketplaces, had overlooked the fact that some married people file their tax returns separately.
The IRS said in the preamble to those 2012 rules that it would correct the mistake, yet in the nearly two years since then, the Treasury Department has not made the change. And battered spouses have become the leading edge of a small army of people — legally married but filing taxes on their own — stepping up pressure in an effort to get an equal chance at affordable health plans.
As the first open-enrollment period for the new federal and state insurance marketplaces approaches its March 31 deadline, Treasury is preparing to take steps early this week to allow married survivors of domestic abuse to claim subsidies for health plans, no matter how they file their taxes, according to a department official who spoke on condition of anonymity because the decision is not yet public. Others who are married but filing separately won’t get relief for now. [snip]   The article continues at the Washington Post, click here to continue reading.
Posted on 11:18 AM | Categories:

Should we take advantage of after tax 401k?

Over at Bogleheads we came across the following discussion: 

Should we take advantage of after tax 401k?Postby Jfet » Fri Mar 21, 2014 8:32 pm

We have a goal of retiring in the near future but I recently found out about after tax 401k contributions.

The plan actually says: "The after-tax (non-Roth) annual deferral limit has been increased to $20,000 (previously it was capped at 7%). This limit is above and beyond the pre-tax/Roth limit of $17,500. In addition to being able to save $20,000 per year on an after-tax basis, you may also elect a Roth-in-Plan
conversion, which allows you to convert certain Plan balances (including after-tax) to Roth within the Plan, providing potential long-term tax benefits."

Does this mean the company actually will handle a sort of $20,000 back door Roth 401K conversion for you each year?

If we already have a >$500,000 401K balance, would this still make sense? We will be going from a top tax bracket to a near zero bracket in a few years so I hesitate to pay any extra tax now, but if it is truly like the backdoor Roth...
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Re: Should we take advantage of after tax 401k?Postby Alan S. » Fri Mar 21, 2014 9:01 pm

The quoted paragraph conspicuously avoids mention of an option to distribute these funds out of the plan as a rollover to your Roth IRA. But even if you do not have that option, an in plan Roth rollover (aka conversion) is preferable to after tax savings. In your high current bracket with much lower brackets in the near future, you should max out your pre tax 401k contributions (17,500 plus any catch up) before making additional contributions. But if you can afford to make the additional contributions after maxing out the pre tax option, go ahead and make the after tax contributions and do in plan Roth rollovers with some frequency to avoid any earnings buildup in the after tax account before the rollover.
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Re: Should we take advantage of after tax 401k?Postby placeholder » Fri Mar 21, 2014 9:16 pm

If the choices in the plan are very good then an in plan conversion is about as good as a rollover to a Roth IRA but if not then really look into the latter.
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Re: Should we take advantage of after tax 401k?Postby Jfet » Sat Mar 22, 2014 8:10 am

Thanks, I will look into it closer. I just didn't want the situation where the money gets taxed twice (going in and coming out).

We do have the cashflow to make the extra contribution but I am a little bit concerned with having too much in tax deferred and not enough in taxable (yes I know about 72T but unsure if we are going to do that). I will have to do some projections.
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Re: Should we take advantage of after tax 401k?Postby killjoy2012 » Sat Mar 22, 2014 8:23 am

My company also allows after tax contributions, and I was assured, upon separation from the company, that all of those contributions + gains could be directly rolled into a Roth IRA. I could also do partials while still working there, but the vesting/holding rules made it sound like it was more trouble than it would be worth. There was no mention of rolling it into a Roth 401k though... the money had to essentially be move out of the 401k program, either by separating from the company, or limited in-service extractions.
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Re: Should we take advantage of after tax 401k?Postby island » Sat Mar 22, 2014 11:02 am

Jfet wrote:Thanks, I will look into it closer. I just didn't want the situation where the money gets taxed twice (going in and coming out).

We do have the cashflow to make the extra contribution but I am a little bit concerned with having too much in tax deferred and not enough in taxable (yes I know about 72T but unsure if we are going to do that). I will have to do some projections.

I've also thought about doing after tax contributions to my 401K and how the taxation works.
I imagine withdrawal being more complicated due to needing to separate what was already taxed from what wasn't?
Would I be creating a tax bomb when time for RMDs?
Plus at withdrawal the gains would not be taxed at a favorable rate so am I better off to put that $ in a tax efficient fund in a taxable account?
I don't have answers to those questions yet, so for now I've gone with a taxable account and some ibonds.
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Re: Should we take advantage of after tax 401k?Postby trees » Sat Mar 22, 2014 11:53 am

If you have the in-plan conversion available (which it sounds like you do), its absolutely worth it. At this point it's not a choice between tax deferred or not, but simple whether you want gains on your post tax money to be taxed in the future (taxable) or not (after tax-tax w/ conversion to Roth). It doesn't result in any additional taxation now, as long as you do the conversion immediately before growth happens.
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Re: Should we take advantage of after tax 401k?Postby trees » Sat Mar 22, 2014 11:59 am

island wrote:I've also thought about doing after tax contributions to my 401K and how the taxation works.
I imagine withdrawal being more complicated due to needing to separate what was already taxed from what wasn't?
Would I be creating a tax bomb when time for RMDs?
Plus at withdrawal the gains would not be taxed at a favorable rate so am I better off to put that $ in a tax efficient fund in a taxable account?
I don't have answers to those questions yet, so for now I've gone with a taxable account and some ibonds.

If you stop at after tax contribution s, it's rarely worth it. However, if you do the in-plan conversion mentioned by the OP, you end up with a normal Roth 401k - there is no additional taxation, and when you leave the company this can be rolled to a Roth IRA with no RMD.
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Re: Should we take advantage of after tax 401k?Postby retiredjg » Sun Mar 23, 2014 10:47 am

Jfet wrote:We do have the cashflow to make the extra contribution but I am a little bit concerned with having too much in tax deferred and not enough in taxable (yes I know about 72T but unsure if we are going to do that). I will have to do some projections.

But this money would not be going into a tax-deferred account. It would be going into an after tax account, then rolled to either Roth IRA or Roth 401k.

If it goes directly to Roth IRA, there is no need for 72t that I can see.

If, instead, the money got rolled to Roth 401k (in plan conversion), I don't know what happens. I know that it can be rolled to Roth IRA, but I'm not sure what happens to the 5 year rules which I believe are associated with Roth 401k.
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Re: Should we take advantage of after tax 401k?Postby retiredjg » Sun Mar 23, 2014 10:50 am

Are you aware that if you retire in or after the year in which you reach 55, your 401k money is available for distribution without jumping through the 72t hoops? It must be left in the 401k to do this - you lose that ability if the money gets rolled to a Rollover IRA.
Posted on 11:18 AM | Categories:

Question about 401k vs Roth IRA

Over at Bogleheads we came across the following discussion: 

Question about 401k vs Roth IRAPostby carofe » Thu Mar 20, 2014 8:32 pm

Hi,
My company matches 33% up to 18% of contribution ( I know, it sounds weird but it is real)
I would like to contribute 12% total to my retirement but putting everything into the 401k is not what I would like to do since I expect higher taxes when I retire.

If I put all in 401k, it would be only 9% contribution (+3% matching = 12%) pretax.
but if I decide to put something in a Roth IRA I can do something like:
6% pretax contribution (+2% matching = 8%)
4% post tax contribution to Roth IRA (to meet the 12%)
It is a total of 10% out of my salary.

Definitely I would be saving 1% if I put everything in my 401k but I would be paying higher taxes in the future.

Is it worth having the Roth IRA in this case? What would you recommend?

Thanks for you help
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Re: Question about 401k vs Roth IRAPostby kerplunk » Thu Mar 20, 2014 9:28 pm

Definitely contribute the 18% to your 401(k) if you can. It's free money.

40% US LC // 40% US SC // 10% Int LC // 10% Int SC
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Re: Question about 401k vs Roth IRAPostby joe8d » Thu Mar 20, 2014 9:36 pm

kerplunk wrote:Definitely contribute the 18% to your 401(k) if you can. It's free money.



:thumbsup
!8% contribution (TD) + 6% Company match. The company match will pay for taxes upon withdrawal up to the 25% Bracket. You will get a tax break on your 18% + no tax on any future gains on your portion up to the 25% bracket upon withdrawal
Last edited by joe8d on Thu Mar 20, 2014 9:53 pm, edited 3 times in total.
All the Best, | JoeUser avatar
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Re: Question about 401k vs Roth IRAPostby Johm221122 » Thu Mar 20, 2014 9:40 pm

I had a dollar per dollar match years ago and said to myself I don't want to put all my money in 401, now I look back and think I'm a big dummy :oops: 
John
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Re: Question about 401k vs Roth IRAPostby retiredjg » Thu Mar 20, 2014 10:53 pm

carofe wrote:...but putting everything into the 401k is not what I would like to do since I expect higher taxes when I retire.

This would be unusual. Are you willing to share why you think this?

You may be confusing wealth with high tax rate. They do not necessarily go together.

Either way, I would not pass up any free money - get your entire match.
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Re: Question about 401k vs Roth IRAPostby carofe » Thu Mar 20, 2014 11:33 pm

Thank you all for your advice! I'm expecting higher taxes because I expect to be in the 25% bracket soon and also because of the way the US government is going...

Regards
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Re: Question about 401k vs Roth IRAPostby rkhusky » Fri Mar 21, 2014 8:11 am

If you are in the 15% tax bracket now and you have horrible choices in your 401K (active funds with ER of 1-2%), it might make sense to forgo some of the free money.
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Re: Question about 401k vs Roth IRAPostby jimb_fromATL » Fri Mar 21, 2014 9:34 am

carofe wrote:Thank you all for your advice! I'm expecting higher taxes because I expect to be in the 25% bracket soon and also because of the way the US government is going...

Regards


You may be overlooking that in addition to getting the free extra pay for contributing the first 18%, another of the tax advantages for maxing the 401(k) is that you get to defer taxes on dividends, too. In an after-tax account, you'll have to pay taxes on the dividends every year. Thus you have less to invest for the next year. So your equivalent rate of return each year is less.

Chances are that the long-term capital gains tax rate will be less on your earnings in the after-tax account, but the earnings from the money you didn't pay in taxes in the deferred account will probably more than offset it. There's certainly no way that you can beat the free money of the company match.

It also sounds like you're falling into the trap that even a lot of book and website writers, speakers, and talk show hosts fall into, in thinking that your marginal or top tax bracket is the percentage that you pay on all of your income. Actually, we have standard deductions, personal exemptions, and graduated steps in lower tax brackets that all go up with inflation. You pay no tax on anything until you exceed the deduction and exemption(s), and then pay a lower percentage on all of your income now (or withdrawals in retirement) in the lower brackets.

In Georgia where I live, and presumably some other states, you'd get to defer paying state income tax and invest that money to earn compound interest for your entire life in the 401(k) and pay little or no state income tax on your retirement withdrawals. The same would apply if you can defer tax in the state where you work but move to GA or some other state where you wouldn't pay income tax after retirement.

Also bear in mind that you don't pay FICA tax on retirement income like pensions, social security, and withdrawals from retirement plans. Depending on your total retirement income you may pay no tax on social security, or pay tax on some percentage of it. But you'll never pay tax on more than on 85% of SS ... as the laws now stand.

So ...you usually won't have to withdraw nearly as much at retirement to have the same amount left to spend. That may reduce your top (marginal) bracket and your average tax percentage.

A good rule of thumb is to contribute up to the maximum company match, then --if your income allows it-- invested money in a Roth IRA too. Since a Roth IRA is not subject to the Required Minimum Withdrawals, you may may be able to balance withdrawals from the tax-deferred/taxable accounts and the Roth in retirement to keep your top bracket lower if you're near a step to the next higher marginal rate.

Here's an example to illustrate the difference between marginal bracket and the actual percentage of taxes you pay:

Note that you'd actually be increasing your income (hopefully) and retirement contributions over the years. So this is effectively in terms of today's dollars:

For 2014 a married couple with total income of $120,000 contributing 14.58% ($17,500) to 401(k)s and taking the standard deduction of $12,400 and personal exemptions of $7900 for 2 has an AGI of $102,500 and a taxable income of $82,200. They'd pay $12,263 federal income tax. They would have $8,400 of ther income taxes in their top bracket of 25%, but their federal income tax before any credits is only 10.22% of their wages.

Notice that the average of all the income tax is way less than their top bracket. That means there could be very substantial percentage increases in all of the brackets across the board before you'd pay nearly as much tax on your retirement income as you get to defer in your highest brackets while you're working.

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Re: Question about 401k vs Roth IRAPostby retiredjg » Fri Mar 21, 2014 10:00 am

You are probably mistaken in your concern that you will pay higher taxes in the distant future. Very few people do, for a couple of reasons.

First, your "income" will probably drop when you retire and not all of your income will necessarily be taxable. Second, as already mentioned, in our tax system you have some income that is not taxed, some is taxed at 10%, some at 15%, some at 25%, etc. So even if you end up in something like the 25% tax bracket in retirement, not all of the money is taxed at that rate.

I'm not sure what "33% up to 18% of contribution" means, but if you are not getting all the match that is available, you are not only throwing away the free money, you are throwing away the income from the free money. That could be a lot.

Roth IRA is a great and wonderful thing and I suggest it highly....after you contribute enough to get all the match from your employer.

A good potential choice for you, while in the 15% bracket, would be to use Roth 401k if you have that available. Once you hit the 25% bracket, I'd switch back to traditional 401k. Or you might be in a position to use traditional enough to pull you into the 15% bracket, then use Roth for the rest.
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Posted on 11:18 AM | Categories: