Tax-Sensitive Withdrawal Strategies: Managing Capital Gains, Dividends, and Brackets

Tax Aware Investing
-It’s the after Tax Return that Counts!
Advisors4Advisors
Part IV
Presented by:

Robert S. Keebler, CPA, MST, AEP (Distinguished)
Stephen J. Bigge CPA, CSEP
Peter J. Melcher JD, LL.M, MBA
Keebler & Associates, LLP
420 S. Washington St.
Green Bay, WI 54301
Phone: (920) 593-1701
Robert.Keebler@keeblerandassociates.com
Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained
in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties
under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you
would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us.

Tax-Sensitive Withdrawal
Strategies

© 2011 Keebler & Associates, LLP
Al Rights Reserved. 2 2

Tax-Sensitive Withdrawal Strategies
• Managing capital gains and dividends
– Short-term capital gains
• Held 1 year or less
– Long-term capital gains
• Held more than 1 year
– Taxpayers in the 10 & 15% tax bracket
• 0% rate (2011-2012)
• 5% rate (2013)
– Taxpayers in a tax bracket greater than 15%
• 15% rate (through 2012)
– Qualifying dividends (through 2012)
• 15% for tax payers in tax brackets greater than 15%
• 5% for tax payers in the 10% or 15% tax bracket

Al Rights Reserved. 3

• Manage taxation of Social Security benefits
• Manage income tax brackets
• Select high-basis securities to sell first
• Aggressively harvest outside portfolio losses
• Defer Roth IRA distributions
• Implement Roth conversions
• Tax efficient use of annuities
• Manage charitable gifts
• 3.8% Medicare “surtax”


Assessing the Primary Issues
• Which assets should a client spend first?
• When should a client do a Roth conversion?
• Understanding the advantages and disadvantages of taking
stock from a qualified plan
• When and how to draw non-qualified annuities
• When and how to draw deferred compensation
• When and how to draw low basis securities
• When and how to exercise NSOs and ISOs



Interest Capital Gain Tax Exempt Pension Real Estate,
Dividend and Oil & Gas Roth IRA and
Income Income Interest
Income IRA Income Insurance

- Taxable -Preferential Rate - Tax
Preferences - Tax Free
-Deferral until
- Tax Deferred Growth/
sale
Benefits

• Money • Equity • Equity • Bonds issued by • Pension plans Real Estate Roth IRA
market securities Securities State and local • Profit sharing • Depreciation • Tax-free
• Corporate Governmental plans tax shield growth during
bonds Attributes Attributes entities • Annuities • 1031 lifetime
• US Treasury • Qualified • Deferral exchanges • No 70½ RMD
bonds dividends at until sale Attributes Attributes • Deferral on • Tax-free
LTCG rate • Reduced • Federal tax • Growth during growth until distributions
Attributes • Return of capital gains exempt lifetime sale out to
• Annual capital rate • State tax exempt • RMD for IRA beneficiaries
income tax dividend • Step-up and qualified Oil & Gas life expectancy
on interest • Capital gain basis at plans • Large up
• Taxed at dividends death • No step-up front IDC Life Insurance
highest deductions • Tax-deferred
marginal • Depletion growth
rates allowances • Tax-exempt
payout at
death


Top Planning Ideas

1.Fill-up the 10% or 15% bracket
2.Roth conversions by asset class and Roth conversions to
manage tax brackets
3.Spend from the outside portfolio first once you have “filled up”
the 15% bracket
4.Bonds should generally be positioned in one’s IRA because of
the annual tax burden
5.Life insurance can be a very valuable supplement to existing
pensions


Early Accumulation Years (Ages 25-45)
Key Tax Concepts
• Maximize qualified retirement savings
• Maximize IRA accounts
• Position some funding in Roth IRAs or Roth 401(k)
• Review whole life or universal life insurance
• Deferral via annuities
• Low-risk Oil & Gas transactions
• Low-risk Real Estate transactions
• Focus on low turnover strategies


Core Accumulation Years (Ages 46 - Retirement)
Key Concepts
• Continue to apply key concepts form early years
• Aggressively manage taxation of wage earnings
– Retirement plans
– Deferred compensation
• Aggressively manage taxation of investments


At Retirement - Key Concepts

• Evaluate rollover of pensions and profit sharing plan
• Evaluate asset protection issues
• Manage Net Unrealized Appreciation (NUA) opportunities
• Monitor the 10% IRC §72(t) penalty
• Manage basis in both IRAs and qualified plans
• Manage qualified Roth Distributions


Early Retirement Years (Retirement to Age 70)
Key Concepts
• Manage the 10% and 15% tax brackets
• Generally defer IRA distributions taxed at 25% or greater
• Draw upon “outside” assets and deferred compensation first
• Draw upon traditional IRA assets second
• Draw upon Roth IRA assets last
• Review Roth conversions to manage tax brackets


Later Retirement Years (After Age 70)
Key Concepts

• Manage the 10% and 15% tax brackets
• Take all Required Minimum Distributions (RMDs)
• Spend down high basis outside assets
• Draw additional funds from IRA to manage tax brackets
• Update estate planning


• Consider the tax structure of the account as you allocate assets
– Income producing assets in traditional IRA
– Capital gains assets (especially those you intend to hold for a long
period) in a taxable account
– Roth IRA Rapid Growth

The illustration is NOT Bonds Stock
intended to be a
recommendation, but to IRA
$250,000 $250,000 $500,000
provoke thought. As you
know, asset allocation should
be determined according to Taxable Account
risk tolerance and time $250,000 $250,000 $500,000
horizon. Tax sensitivity would
be considered secondarily.


Tax-Sensitive Account
•
Allocation
Orange = position the investor would be at under the original 50% stock / 50% bond
investment mix
• Blue = additional $63,890 of additional growth the investor would achieve by placing 100% bonds
in IRA
• Assumptions: Bonds and the stock both generate a 7% return on a pre-tax basis. The stock earnings
are deferred until the time of sale, then taxed as long-term capital gains. The amount of any tax
savings from a deductible IRA contribution is invested in a taxable investment account earning the
same yield as the IRA. The values shown for the IRA include the value of the taxable investment
account. The client is in the 25% ordinary income tax bracket (15%* for capital gains purposes)

Integrating Account Tax Structure with Asset Allocation
(100% Bonds in IRA vs. 50/50 Mix of Stock and Bonds in IRA)
2,800,000

Option A - 100% Bonds in IRA
Option B - 50/50 Mix in IRA
2,550,000
$63,890 of
additional assets
(2.6% increase)
2,300,000 * The 15% long-term capital
gain rate is only effective
under current law through
2,050,000 2010. It is not certain that the
Congress will extend the
15% rate.
1,800,000
10 11 12 13 14 15


•
Effect of Capital Gains Incentives
Example:
– $100,000 beginning cash to invest and 28% tax bracket (15% long-term capital gains
bracket)
– Options:
• Corporate bonds (6% annual interest)
• Municipal bonds** (4.5% annual interest)
• Stocks (1% annual non-qualified dividends, 5% growth
[100% asset turnover])
After-Tax Balance of a Taxable Account (Invested in Stock, Municipal Bonds and Corporate Bonds)
$400,000
Stock (50% Turnover) Stock (100% Turnover) $65,732 of
$300,000 additional assets
Municipal Bonds Corporate Bonds (23% difference)
$200,000

$100,000

$-
1 3 5 7 9 11 13 15 17 19 21 23 25
Year
•The 15% long-term capital gain rate is only effective under current law through 2012. It is not certain that the Congress will extend the 15% rate.
•**Municipal bounds may not be suitable for a person in this low of a tax bracket.


Tax-Sensitive Distribution Strategies

• Importance of a solid distribution strategy
• Four key issues to consider when structuring a
distribution portfolio:
– Which retirement investment vehicles
(tax-sensitive account allocation) to include in
the distribution portfolio
– The order in which plan assets should be withdrawn
– Loss harvesting and the specific identification method
– Tactical income tax planning with defined benefit
plans, tax-deferred annuities, Net Unrealized
Appreciation, and Roth conversions


• Timing is Everything – which tax-sensitive account should
be used first
• Best result comes from withdrawing funds in a manner
that produces the most favorable overall income tax
consequences. (Be sure to consider heirs’ income
tax brackets)
• Some general (simplistic) concepts to consider – remember
every client is different
– Utilize taxable accounts first
– Sell high basis assets first
– Utilize IRA to manage tax brackets
– Defer Roth IRA distributions
– Carefully implement Roth conversions



• Principle #1: Determining which tax-favored
account to withdraw from first
– Deals with the timing of withdrawals between tax-
deferred assets (e.g. Traditional IRAs) and tax-free
assets (e.g., Roth IRA)
– Theory: If a retiree makes equal, after-tax withdrawals
from tax-deferred and tax-exempt accounts, the order
of the withdrawals between the two accounts will not
affect the longevity of the withdrawal period of the
two accounts
– Assumptions: The assets in each account must both
be growing tax-deferred at the same rate of return
and the income tax rate must remain flat over the
period of the analysis


• Principle #1 - Example 1:
Traditional Roth IRA
Assumes a 6% return IRA First First
Initial balance - Traditional IRA $100,000 $100,000
Initial balance - Roth IRA $100,000 $100,000
Federal income tax rate - Traditional IRA 28.00% 28.00%
Annual after-tax cash flow needed $15,000 $15,000
Annual pre-tax withdrawal $20,833 $15,000
Period until exhaustion - Initial asset 5.8 8.8
Period until exhaustion - Remaining asset 14.2 11.2
Maximum withdrawal period (years) 20 20

• No matter which account tax structure is depleted first, the maximum withdrawal period for both
account tax structures is the same
• Assumes a 6% annual beginning of period return; a simple 28% tax rate; and distributions are
sufficient to cover any RMDs.

This is a hypothetical example for illustrative purposes only.



100% Traditional
IRA First 50/50 Mix
Initial balance - Traditional IRA $100,000 $100,000
Initial balance - Roth IRA $100,000 $100,000
Annual after-tax cash flow needed $15,000 $15,000
Annual pre-tax withdrawal – Traditional IRA (15% tax rate) $8,824 $8,824
Annual pre-tax withdrawal – Traditional IRA (28% tax rate) $10,417 -
Annual pre-tax withdrawal – Roth IRA - $7,500
Annual pre-tax withdrawal (First 6 years comparison) $19,241 $16,324
Period until exhaustion – initial asset 6.4 19.6
Period until exhaustion - Remaining asset 14.9 3.6
Maximum withdrawal period (years) 21.3 23.3
• By spreading out distributions over taxable & nontaxable accounts you may be able to keep your client
in the marginal income bracket.
• Assumes a 6% annual beginning of period return; a simplified hypothetical marginal tax rate of 15% on
the first $8,824 of income and 28% thereafter to achieve the 50/50 after-tax distribution mix; no other
taxable income; and distributions are sufficient to cover any RMDs.
(This is a hypothetical example for illustrative purposes only.)



• Principle #2: Things to consider when determining whether to
withdraw from tax-favored versus taxable accounts
– May be advisable to spend down taxable investment
assets first followed by tax-deferred investment assets.
But, consider the issue of large step-up in basis potential
for elderly clients.
– If client expects to be in the same or lower tax bracket
than beneficiaries, consider client bearing a portion of the
tax at their lower rate.


• Principle #2 – Example: Client, age 60 and single, has a $500,000 taxable account and a
$500,000 Traditional IRA
– Needs $60,000 annually for living expenses
– Receives $12,000 of Social Security beginning at age 62
• Assumptions: Annual return consists of 3% ordinary income (i.e. interest income) and 4% growth on the
value in each account. The stock earnings are tax deferred until the time of sale, then taxed as long-term
capital gains. Basis on the sale is determined as a percentage of the total account value. Required
Minimum Distribution (RMD) begins at age 70½, regardless of the intended distribution ordering. If the
RMD and the income from the taxable account exceed the living expenses for a year, the excess is
reinvested in the taxable account. 25% ordinary income tax rate, 15% capital gains tax rate, 85% of Social
Security benefits are subject to income tax

Benefit of Withdrawing Funds from a Taxable Account First
Balance at a Particular Year
Withdraw From Taxable Investment Account First
$1,633,578
Withdraw From Traditional IRA First
$529,519 of
$1,316,362
additional assets
$1,084,493 $1,104,059
$984,410 $1,005,256 (48% difference)

Age 65 75 85

Tax-Sensitive Distribution Strategies In Theory

• Other considerations: future tax rates
• Some general (simplistic) distribution
order to consider
– Remember every client is different Tax Roth
Deferred 401(k)
– Taxable investments Accounts
– Traditional IRAs and
qualified retirement plans
– Roth IRAs and Roth 401(k)s Investment
Accounts

Discuss with tax advisor prior to having elderly clients sell assets that
could have received a step-up in basis


2011 Tax Brackets
Married
Qualified Married Filing Head of
Single Widow(er) Filing Jointly Separately Household

10% Tax Rate $8,500 $17,000 $17,000 Stock $8,500 IRA $12,150

15% Tax Rate $34,500 $69,000 $69,000 $34,500 $46,250

25% Tax Rate $83,600 $139,350 $139,350 $69,675 $119,400

28% Tax Rate $174,400 $212,300 $212,300 $106,150 $193,350

33% Tax Rate $379,150 $379,150 $379,150 $189,575 $379,150

35% Tax Rate > $379,150 > $379,150 > $379,150 > $189,575 > $379,150

Source: Internal Revenue Service

Tax-Sensitive Distribution Decision Matrix
• Spend-down strategy should be structured in a way so as to maximize economic
returns while minimizing income taxes
• Factors to consider
– Investment returns within each account tax structure
– Current and projected future income tax rates
– Taxability of Social Security
– Required Minimum Distributions
– Long-term strategic goals
• Decision matrix:

Future income at the Future income taxed at
same or lower tax rate higher tax rate

1) Taxable account 1) Tax-deferred account
2) Tax-deferred account 2) Taxable account
3) Tax-free account 3) Tax-free account


Loss Harvesting and the
Specific Identification Method
• Loss harvesting, especially in volatile markets, will often have
a meaningful impact on the effective capital gains tax rate
• The truly sophisticated financial advisor will also integrate the
benefits of the specific identification method when selecting
which particular mutual funds (provided average cost has
previously not been used on the account) or securities to sell


Tactical Income Tax Planning

• Defined Benefit Plans
– Distributions from a defined benefit plan will almost
always generate ordinary income in the year received
– There is a greater need for tactical tax-sensitive asset
allocation planning when defined benefit plans are part of
the retirement distribution equation


• Non-Qualified Tax-Deferred Annuities
– Provides a client with the right to receive annual
(or more frequent) payments over his life or for a
guaranteed number of years
– Unless a tax-deferred annuity is annuitized, the taxpayer
is generally deemed to withdraw ordinary income first
and then tax-free basis. This income tax consequence
may be mitigated
– One might purchase these investments in different tax
years and then annuitize them over a period
of years


• Employer securities in a qualified plan (Net Unrealized Appreciation)
– Difference between Fair Market Value at distribution and basis is Net
Unrealized Appreciation (NUA)
– NUA is currently taxed at long-term capital gain tax rates
(currently 5% / 15%)
– Example:
• Fair Market Value of stock $ 750,000
• Employer basis $ 150,000
• Net Unrealized Appreciation (NUA) $ 600,000
• Amount taxable as ordinary income
if stock is distributed and not sold $ 150,000
Distribution must qualify as a lump sum distribution employer stock be a “qualified
employer security”
10% penalty may apply on the basis based on individual’s age



• Qualified Plan Rollovers
– When rolling funds from a qualified plan to an IRA one has
a choice of rolling over or not rolling over after-tax funds
(i.e., basis)
– Strong consideration should be given to not rolling over
after-tax funds and utilizing these proceeds to fund a Roth
conversion or spend on a tax-free basis


Other Planning
Considerations


Net Unrealized Appreciation (NUA)
• Under the tax law, if an employee has employer
securities in his/her qualified retirement plan, he/she
may be able convert a portion of the total distribution
from the plan from ordinary income into capital gain
income
• In order to achieve this favorable tax treatment, the
distribution from the qualified retirement plan must
be made pursuant to a “lump-sum distribution”
• To qualify as a “lump-sum distribution” the distribution must
be made pursuant to a “triggering event”


“Triggering Events”

• On account of employee’s death
• After the employee attains age 59½
• On account of employee’s “separation from service”
• After the employee has become disabled (within the
meaning of section 72(m)(7))

CAUTION: If prior year distributions have been made after one triggering event, the
taxpayer must wait until another triggering event to qualify for lump sum distribution
“within one taxable year” rule.


Taxation of Lump-Sum Distribution

Fair Market Value (FMV) of stock $750,000
Employer basis $150,000
Net Unrealized Appreciation (NUA) $600,000
Amount taxed at rollout $150,000


Taxation of Lump-Sum Distribution

• Ordinary income recognized on cost basis
• If taxpayer is under age 55 at the time of distribution, the taxpayer
must also pay the 10% early withdrawal tax on the cost basis
• Difference between FMV at rollout and cost basis is Net
Unrealized Appreciation (NUA)
• NUA is not taxed at the time of distribution, but rather at a later
time when the stock is sold
• NUA is taxed at long-term capital gain tax rates (0%/15%)
• Ten-year averaging and 20% capital gain
• Only available to those individuals born before 1/2/1936
• 20% capital gain only applies to pre-1974 contributions


Taxation of Post-Distribution Gain

• Holding period one year or less from time of distribution
= short-term capital gain
• Holding period greater than one year from time of
distribution = long-term capital gain


Taxation of NUA at Death

• NUA does not receive a step-up in basis
• However, subsequent gain above NUA should receive a step-up
in basis

• If an estate or trust contains NUA stock, a fractional
funding clause must be used
• Otherwise, the NUA will be subject to immediate taxation


Compensatory Stock Options:
NQSOs and ISOs


Compensatory Stock Options
Two Types of Options

• Non-Qualified Stock Options (NQSOs)

• Incentive Stock Options (ISOs)


Non-Qualified Stock Options (NQSOs)

• Any stock option that does not qualify for special
tax treatment under IRC 422
• May be transferable
• No specific holding period requirements
• Employer receives an income tax deduction for
the difference between the strike price and the
fair market value of the securities on the date of
exercise


“Cashless Exercise”

• The exchange of previously acquired stock (not subject to
any holding period requirement) for the funding price of
new shares is a tax-free exchange.
• The basis and holding period of the old stock are carried
over (i.e. “tacked”) to the same number of shares acquired
in the exchange.
• The basis in the excess shares is equal to the income
recognized on the transaction (the fair market value), and
the holding period begins with the date of exercise.


Tax Consequences
• Ordinary income is recognized on the difference between the
strike price and the fair market value of the stock on the
exercise date.
• FICA and Medicare are applicable to the ordinary income.
• The subsequent appreciation will be subject to capital gain. The
holding period will determine whether the gain will be long-
term or short-term.
• The holding period for purposes of determining the correct
capital gain rate begins with the exercise date.
• The basis of the stock is the exercise price plus the amount of
income recognized upon the exercise of the option.


Tax Consequences

$100

FMV at sale

FMV at exercise
Short or long-
term capital gain
Compensation
income
$0
Strike price

Incentive Stock Options (ISOs)
Requirements

• The stock option plan is in writing
• The plan specifies the number of shares that can be purchased under
the plan, as well as the eligible employees
• The FMV of the stock with respect to which the options are exercisable
for the first time does not exceed $100,000 during any calendar year
• The options must be exercised within ten years after they are granted
• The options are exercisable only by the employee during his or her life
• The options are transferable only upon the death of the employee


Requirements
• The employee must be employed by the issuing corporation at
all times from the option grant date until three months after
the date of exercise
• The stock acquired under the option must be held for at least
two years after the time it is granted and one year after the
time it is exercised
• If an option is granted to a 10% or greater shareholder, the
exercise price must be at least 110% of the FMV of the stock
subject to the option
• The employer’s shareholders must approve the plan within
twelve months before or after the employer’s board of
directors adopts the plan
• The option is granted within ten years of the plan’s adoption
by the board of directors or, if earlier, the date it is approved
by the shareholders

Al Rights Reserved.
45

“Cashless” Exercise

• Stock acquired from a means other than a previous ISO or stock
acquired from a previous ISO that is held for the required
period of time can be used for a stock swap.
• The exercise of an ISO with a stock swap will not trigger
ordinary income (but could trigger AMT).
• The basis and holding period for the shares surrendered tack to
the same number of share acquired in the swap. However, the
holding period of the old shares does not tack for purposes of
the special holding requirements of the ISO stock.


“Disqualifying Disposition”

If the stock acquired by the exercise of an ISO is
disposed of before one year has lapsed from the
exercise date or two years from the issue date, the sale
will be subject to the following recapture rules:
• Ordinary income is recognized on the difference between
the exercise price and the fair market value at the time of
exercise.
• FICA and Medicare withholding will not apply
• In addition there will be short or long term capital gain on
the difference between the fair market value at the time of
exercise and the selling price.

Al Rights Reserved.
47

Tax Consequences

$100

FMV at sale

FMV at exercise AMT Regular
capital
gain capital
gain (short or
long-term)
AMT adjustment

$0
Strike price

Al Rights Reserved.
48

Exercise Considerations

• Opinion of experts
• Historical returns
• Fundamental analysis--look at data about
company, ratios, statistics, etc.
• Security market line
• Importance of expert investment counsel to your client
• Important for setting inputs for option exercise model

Al Rights Reserved.
49

Early Exercise Considerations

• Forfeit time value of option
• Differential tax consequences favor early exercises)
• Dividends on underlying stock
• Cash flow situation
• Price change expectations for underlying stock Need for
diversification--concentrated portfolio
• Better investment is available--exercise, sell and reinvest
• Possible future change in tax rates
• Employer stock ownership requirements


CIRCULAR 230 DISCLOSURE
Pursuant to the rules of professional conduct set forth in Circular 230, as
promulgated by the United States Department of the Treasury, nothing contained in
this communication was intended or written to be used by any taxpayer for the
purpose of avoiding penalties that may be imposed on the taxpayer by the Internal
Revenue Service, and it cannot be used by any taxpayer for such purpose. No
one, without our express prior written permission, may use or refer to any tax
advice in this communication in promoting, marketing, or recommending a
partnership or other entity, investment plan or arrangement to any other party.

For discussion purposes only. This work is intended to provide general information
about the tax and other laws applicable to retirement benefits. The author, his firm
or anyone forwarding or reproducing this work shall have neither liability nor
responsibility to any person or entity with respect to any loss or damage caused, or
alleged to be caused, directly or indirectly by the information contained in this work.
This work does not represent tax, accounting, or legal advice. The individual
taxpayer is advised to and should rely on their own advisors.

©2011 Keebler & Associates, LLP
All Rights Reserved. 52

Tax-Sensitive Withdrawal Strategies: Managing Capital Gains, Dividends, and Brackets

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