AssetBuilder Inc, - Registered Invesment Advisor - Simple Investing Smart Future
in
Opml Feed
RSS Feed

Registered Investment Advisor

Scott Burns' Articles -- Recent and Archived

It's Important to Know Your Tax Bracket

Q. We have three variable annuities that have matured. We have been advised to consolidate (total of $325,000) to one variable annuity. First, how can we get out of these annuities with minimum tax consequence? If we have to start a new annuity, should we consider Fidelity or Vanguard for lowest cost? We are retired, in our-mid 70s, with zero debt, own our home and a net worth about $1.3 million. --- B.T., from Dallas, TX

A. What you do with your contracts depends on three things: your tax bracket, your other sources of income, and how your other financial assets are invested. One way to extract the most money with the least tax consequences is to take money from the contract with the smallest accumulated tax liability. Stop taking money when the added taxable income takes you out of the 15 percent tax bracket and into the 25 percent tax bracket. With luck, you could liberate the original investment at no cost and pay only 15 percent on the accumulated earnings.

For 2007 you can have $63,700 of taxable income on a joint return and still be in the 15 percent tax bracket. Since you also have personal exemptions and the standard deduction, this means your total income can be at least $83,300 before you are in the 25 percent tax bracket. More if you itemize your deductions for large charitable contributions, etc. So take enough out to get to the edge of the 25 percent bracket. There is nothing to prevent you from doing this next year as well.

Once you have exhausted the 15 percent money, consider converting a portion of the annuity money into a life annuity. In your mid-70s some amount of this should provide you with a large cash income as well as spreading the tax liability on the accumulated earnings over your single or joint life expectancy.

Finally, make a 1035 exchange to the Vanguard annuity, where your total cost will be about 60 basis points (that's 0.6 percentage points), and you can build a diversified portfolio with the low-cost funds available in the Vanguard product.

Q. I've read most of your comments regarding Life Cycle Funds and the Thrift Savings Plan and agree wholeheartedly with all of them.

Both my wife and I are 29 years old and have fully funded Roth IRAs in accordance with your Six Ways portfolio. I've been in the military for almost 7 years and plan on at least another 13. With that in mind, what kind of asset allocation would you recommend holding among the various funds available in the TSP for additional retirement money? ---C.T., by email

A. With two inflation-adjusted pensions that will replace a significant portion of your wages when you retire, you have substantially more capacity for market risk than most people. Let me explain why.

Fewer and fewer workers have defined-benefit pension plans. So they won't have a guaranteed lifetime income. Instead, they will have to replace a larger proportion of their wage earnings with income from their tax-deferred savings plans and taxable savings. The more income they have to replace that way, the more cautious they must be with the money--- so they need more in fixed-income and less in equities.

Your position is different. Less of your retirement income will need to come from tax-deferred savings. So you can take more risk. This will be particularly true if you own a house and manage to retire free of mortgage debt.

Rather than using one of the lifecycle funds, which changes its asset allocation year by year, I suggest a mixture of G fund (government securities), C fund (large common stocks), S fund (small common stocks) and I fund (international common stocks). An equal mixture of these four would be 75 percent equities and 25 percent fixed-income. ------------------------------------------------------------------------------------------------

Personal finance writer Scott Burns is syndicated by Universal Press. His twice weekly column appears in newspapers from Boston to Seattle. He is the Chief Investment Strategist for AssetBuilder, Inc. Readers can register at www.scottburns.com. Questions/comments can be posted directly. They can also be sent, without registration, to scott@scottburns.com. Questions of general interest will be answered in future columns and on this blog.

Click on the "Archive" navigation to see other columns. All comments are welcomed and appreciated.
Published May 02 2007, 06:00 PM by scottb
Filed under: ,

Comments

 

ABModerator03 said:

Mr. Burns -

I'm afraid you are in error with regard to the L- (Life Cycle) Funds within the TSP. To quote from the TSP site (http://www.tsp.gov/rates/fundsheet-lfunds.pdf): "The L Funds are rebalanced to their target allocations each business day. The investment mix of each fund adjusts quarterly to more conservative investments as the fund's time horizon shortens."

To my way of thinking, this level of automated activity on an investor's behalf easily surpasses even the most diligently obsessive person's typical commitment to monitoring their assets. As such, much like your oft-discussed "couch potato" variations, it follows what I call the "Ron Popeil" model of investing -- "Just set it, and forget it." In an actuarial sense, maybe this isn't such a bad approach for the great bulk of investors.

Bill McGarvey

From Scott Burns:

I think it's more like a difference of opinion than an error. While the fastidious automation of asset allocation offered by lifecycle funds is very appealing for the reasons you mentioned, the bigger question is whether the funds are starting, and ending, with an appropriate level of risk for the particular investor. The cookie cutter approach simply doesn't apply when you add in things like expected pension funds, relative size of social security income, whether you will be debt-free or have debt service in retirement, etc.
May 3, 2007 7:38 AM
 

ABModerator03 said:

Relpy to "Its important...bracket".

A point I want to make sure to correct because so many Variable annuity salespeople slyly use the terminology to switch annuities to generate commissions.

A Variable Annuity does NOT "mature".... The back end surrender charges fall off. You can stay in an existing annuity if it still accomplishes your goals.

I agree with Scott that many times it makes sense to go into a lower cost VA, BUT the reason is NOT because the Annuity "matures".

From Scott Burns:

Right. Variable annuities don't "mature." They just work down their early redemption charges. Note that "mature" was in the readers' letter, not my answer.
May 3, 2007 10:21 AM
 

ABModerator03 said:

I am 72 yrs.and have a fully funded pension, which plus SS nets 41K. My wife has 10K SS and 500K in conservative investments. I have 250K and all in equities. I prefer not to be locked into annuities and desire the growth potential of equities. Neither do I want to be locked into a lifestyle fund which makes all my decisions for me. Once a year I should be able to pay a bit of attention to my investment balance. The security of the pension makes it all possible.
May 3, 2007 1:59 PM
 

ABModerator03 said:

I agree with your opinion regarding "cookie cutter" approaches. My opening point, though, is that you claimed, "Rather than using one of the lifecycle funds, which changes its asset allocation year by year,..." On the contrary, as the citation suggests, the L-funds are re-balanced both daily and quarterly, not on a yearly basis. From Scott Burns: The phrase "year by year" was not meant literally. It was meant to indicate that the asset allocation changed over time.
May 3, 2007 2:01 PM
 

ABModerator03 said:

Mr. Burns I am 43, work for the USPS and also invest in the TSP. I would like to retire by age 60. Should I leave my investment in the L-2030 fund or move them to the 4 way split you mentioned above? If I do the 4 way split, how often should the funds to be reallocated so that each fund has 25%?
May 3, 2007 6:51 PM
 

ABModerator03 said:

Regarding the question about consolidating three VAs

1. Neither fixed nor variable annuities "mature" as stated in the question and as is correctly pointed out in the response by jfsully.

2. I think the question being asked (unless we just don't have the complete question) is how to move from one annuity to another, as has been recommended, so as to minimize the income-tax impact. The simplest thing to do is to do a 1035 tax-free exchange. This standard procedure will transfer the owner's cost basis, if any, to the new annuity without any tax consequence. If his broker is suggesting anything else, the gentleman who owns the VAs should find another broker who is familiar with this process.

3. The larger question is "What is the justification for making the move in the first place?" In other words, is the (lateral) move justifiable as a suitable recommendation? Or is it just being done to gin up commissions (as I suspect in this case).

How is the recommendation to pass muster with the broker's compliance department as a suitable recommendation? What is the broker telling his compliance department? At the customer's age, what new features or benefits will he gain to justify the move? What is the death benefit that might be lost? Are there optional benefits, living benefits or death benefits, that justify the move. Why is this move taking place?

Arguably, the investments within each variable annuity are commodities. There is little difference between the investment options from one VA to another. So, that is not a good enough reason to make a lateral move like this.

And each VA offers the same income-tax deferral, so that isn't it. Why recommend a lateral move?

This is why "Suitability" is no longer an adequate standard for making investment recommendations and why investors are moving to a fiduciary standard by hiring an investment advisor.

From Scott Burns:

Those are all good questions--- and point to the amount of churn in VA assets, as agents look to shift clients from one VA to another.

In most cases the "commodity" argument holds water--- if the VA alternative is being presented by a salesperson, odds are it will (1) have a high insurance expense and (2) offer relatively high cost managed sub-accounts. The best case for a 1035 exchange is a move to a low cost VA contract such as the Vanguard variable annuity. If that move is made, the client can save about 160 basis points a year in costs over the managed/marketed alternative.

Unfortunately, most people don't know about the low cost alternative and they are unlikely to hear about it from the VA sales force.
May 3, 2007 7:09 PM
 

ABModerator03 said:

It's difficult to do tax planning, especially if you try to retrieve it from the IRS. You say your gross income can be at least 83,300 and still be in the 15% bracket. Isn't that 81,200? Won't the std deduction be 10,700 and the personal exemption be 6,800 for two people (joint return)?

From Scott Burns:

The top of the 15 percent tax bracket is $63,700. The standard deduction is $10,700. Two personal exemptions adds another $6,800. Those figures total the $81,200 you mention. But they don't include the $1,050 deduction allowed for each party in a joint account who is blind or elderly.

You qualify as elderly at age 65. When you add that $2,100, a retiree can have $83,300 of income before entering the 25 percent tax bracket.
May 4, 2007 12:49 PM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
Copyright © 2007 - 2008, AssetBuilder Inc - DFA Advisor. All Rights Reserved. View our Terms & Disclaimers.