Magazine article The CPA Journal

Best Use of Tax-Deferred Accounts

Magazine article The CPA Journal

Best Use of Tax-Deferred Accounts

Article excerpt

How to Optimize the Wealth Advantage

Tax-deferred accounts often play a central role in accumulating wealth for retirement. For investors who own both personal and tax-deferred assets, implementing a retirement strategy requires the prudent use of both types of accounts. Among the decisions facing investors approaching or already in their retirement years are

* which to use first, tax-deferred or taxable accounts, for spending and wealth transfer,

* how the different accounts should be allocated; and

* how to integrate tax-cfeferred accounts into their overall estate plans.

The best answer to each of these questions for any individual retiree depends on an array of factors unique to his situation.

Holding On to the Deferral Benefit

It's well-known that traditional tax-deferred accounts like LRAs, 401(k) plans, and 403(b) plans are effective savings vehicles. Assets can grow tax-free for decades. But as retirement rolls around and the draw-down period begins, traditional tax-deferred accounts may lose some of their luster. In most cases, withdrawals from these accounts must begin no later than the year in which the investor turns 70 ½, and all withdrawals are generally taxed at ordinary-income rates. (Investors have Ae option of postponing the first distribution until April 1 of the year after which they turn 70 ½.) Those taxes are inevitable; however, investors should not forget that until the funds are fully drawn down, what remains will be earning tax-deferred returns. So even in retirement years, taxdeferred accounts continue to confer a powerful growth advantage.

Exhibit I illustrates just how powerful tax deferral can be, even in the draw-down phase. Assume that one 60-year-old investor has accumulated $2 million in a traditional IRA, while another has the equivalent amount after taxes ($1.2 million) in a taxable account (both allocated 60% stocks/40% bonds). The analysis looks at the advantage of tax deferral through the lens of Monte Carlo modeling, considering the following three different ways the assets could be used:

* As a source of annual spending during the retiree's remaining lifetime (presumed to be 25 years, per current mortality tables);

* As a gift to charity upon the retiree's death (with only the required minimum distributions taken beforehand from the IRA); and

* As a legacy for the retiree's child. In this case, the analysis is extended over the child's lifetime, assuming the IRA's tax benefit is taken advantage of by "stretching" the distributions. (Any funds remaining in the LRA upon the death of the original owner or his offspring are liquidated and subject to income tax.)

In each case, the retiree who holds the funds within a tax-deferred account is able to accumulate far more wealth after all taxes have been paid than the retiree who holds the money in a taxable account. If both spent 3% of their portfolios and the withdrawals grew with inflation, we estimate the median real wealth advantage of tax deferral at almost $1 million over a quarter century. If the funds were not needed for spending but, instead, were left to grow for the benefit of charity, gifting from the LRA would create a $2.5 million advantage. That increment stems from the LRA' s higher tax-advantaged growth rate and its exemption nom income tax when gifted to charity at death. If, instead, funds were left as a family legacy and continued to grow 30 more years into the future, the additional wealth for the child would be an amazing inflation-adjusted $4.7 million - the benefit of tax-deferred growth over a very long time horizon.

A Glitch in the Estate Plan?

Despite this compelling advantage, some worry that letting an ERA continue to grow may be bad estate planning. The perceived problem is that a large LRA may be subject to both income tax and estate tax; indeed, if it's a large enough part of an estate, a substantial portion of the LRA may need to be liquidated just to pay the estate taxes. …

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