December Tax-Efficient Investing Through Asset Location. John Wyckoff, CPA/PFS, CFP

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1 John Wyckoff, CPA/PFS, CFP

2 Your investment priorities are likely to evolve over time, but one goal will remain constant: to maximize your investment returns. Not all returns are created equal, however. To keep more of the money your investments earn, you may want to consider how and when the returns will be taxed. Taxes can take a big bite out of investment returns but there are ways to lessen their impact. And unlike market volatility, tax management is an aspect of investing that you can control. John Wyckoff, CPA/PFS, CFP john.wyckoff@standard.com About John Wyckoff John is a Certified Financial Planner professional with 15 years in personal financial planning and investment advice and 35 years as a Certified Public Accountant. He has extensive education and experience in income taxes, personal financial planning and private wealth management. John graduated from University of California, Berkeley, with a bachelor s degree in sociology and a Master of Business Administration. He also received a Master of Taxation from Portland State University. What Is Asset Location? As you and your advisor build your investment portfolio, you ll use a variety of strategies to help protect your assets from market volatility and increase returns. For example: Asset allocation how your portfolio is allocated among stocks, bonds and cash helps determine your portfolio s level of risk. Diversification allocating your assets among a variety of investment types, such as large-cap equities, emerging market funds, different types of fixed-income funds and alternative investments can help you weather different economic conditions, delivering a measure of growth and stability. Periodic rebalancing can help you maintain your desired asset allocation and level of risk. Investment selection, such as choosing investments with low management expenses and fees, is yet another strategy. Asset location is another smart strategy to consider (not to be confused with asset allocation). It is not a substitute for any of the above, but it is essential for helping maximize after-tax returns. Asset location is a form of tax management. It refers to the placement of your assets into specific types of accounts depending on how they are taxed. Investment accounts can be taxable, tax-deferred or tax-free. By strategically placing investments in a particular type of account, you can potentially decrease the taxes you ll owe this year, in retirement and throughout your lifetime. Take a look at each type of account: Tax-deferred investment accounts, including common retirement savings vehicles such as 401(k)s and Individual Retirement Accounts (IRAs), not only allow you to defer taxes on investment earnings but also provide current tax savings. Generally, the money you deposit into these accounts is not taxed when you earn it, and it can grow without incurring taxes on interest, dividends or capital gains along the way. Once you begin withdrawing from the account, however, you owe income tax on the amount withdrawn in the year of the withdrawal. Tax-deferred accounts also come with strict withdrawal rules, including required minimum distributions (RMDs) that force you to begin withdrawing funds starting at age 70 ½. With taxable investment accounts, you pay taxes on any earnings each year. The funds you invest into these accounts factor into your adjusted gross income and are taxed accordingly. The upside is that under current law, the tax rates on net longterm capital gains are lower than the rates that apply to ordinary income. Tax-free investment accounts incur no tax on current income or capital gains as long as you follow the rules for withdrawals. These include Roth IRA and Roth 401(k) accounts, as well as Coverdell education savings accounts. However, there is no tax deduction for a contribution to a tax-free account.

3 Accounts Contributions Tax Deductible? Earning Taxed Annually? Withdrawals Taxed? RMDs at Age 70 ½? Tax-deferred Yes No Yes Yes Taxable No Yes Yes No Tax-free No No No No Generally, tax-deferred accounts are considered the best place to hold your investments. But once you ve maxed out your contributions to those accounts, and assuming you have or will have additional accounts, you need to decide which investments to hold in your tax-deferred account versus a tax-free account or taxable account. After you ve paid due consideration to the fundamental rules of investing allocate your assets, rebalance periodically, diversify your portfolio and seek investments that hold down costs then it may be time to consider asset location. After you ve paid due consideration to the fundamental rules of investing allocate your assets, rebalance periodically, diversify your portfolio and seek investments that hold down costs then it may be time to consider asset location. But this strategy is not for every investor. It s most effective for those who hold both taxable and taxdeferred accounts and are currently in a high tax bracket but expect to be in a lower tax bracket in retirement. In addition, because an asset location strategy takes time to work, it is generally better for those who expect to be invested for at least 10 years. And remember, it may work differently for different investors. : A Lifelong Process Two guiding rules will help you keep more of what you earn during your working years and assure a comfortable retirement: 1. Avoid high marginal tax rates 2. Optimize income and sources of cash flow in retirement Let s look more closely at how these principles apply. Managing Your Tax Rate As you progress through life, your income typically rises as you receive raises and bonuses, inheritances, sales of property and so on. As that happens, your marginal tax rate that is, the tax paid on any additional dollar of income also increases. Unless you do something to avoid high marginal tax rates, you will pay more in income taxes. The first strategy for holding down your marginal tax rate during your working years is to invest for retirement in a tax-deferred account. If your employer offers a 401(k), contribute the maximum allowed. That contribution will reduce your current income subject to taxes, and your account can grow and earn interest and dividends all taxfree until the money is withdrawn. You will eventually pay taxes on the money when you start drawing down the account in retirement, but at that time, presumably, you will be in a lower tax bracket. If your employer does not offer a 401(k), you can fund an IRA to achieve similar tax benefits. After making the maximum contributions allowable to your tax-deferred accounts, it s time to consider asset location deciding what types of investments to hold in which type of account. Remember that you will pay taxes on dividends, interest and capital gains in your taxable accounts, so by minimizing your tax liability in these accounts, you will maximize after-tax returns. You may also choose to invest in Roth IRA or Roth 401(k) accounts, which are treated differently in the tax code than regular IRAs and 401(k) accounts. With the Roth products, your annual contributions are made with after-tax money, but withdrawals are tax-free. Locating Assets for Tax Efficiency During your working years, it is most efficient to hold interest-yielding investments (such as bond mutual funds, real estate funds and commodities funds) in your tax-deferred accounts and hold growth assets (such as stocks and stock mutual funds) in taxable accounts and tax-free Roth IRAs and Roth 401(k)s.

4 This strategy takes advantage of the fact that different asset classes are taxed differently. In general, most bonds are considered tax-inefficient, because the interest income is usually taxable at ordinary income rates. (U.S. savings bonds and tax-free municipal bonds are exceptions.) By contrast, stocks are quite tax-efficient, with longterm realized gains taxed at a rate as low as 15 percent (depending on the investor s tax bracket). Stock mutual funds also can be tax-efficient, although those with higher turnover which generally comes with higher expense ratios may not be. This chart illustrates the asset location strategy. Tax Treatment of Expected Returns Tax-Deferred (401(k) & IRAs) Taxable Tax-Free (Roth 401(k) & IRAs) Growth Assets U.S. stock mutual funds Int l & emerging markets Taxed at long-term capital gains stock mutual funds Real estate mutual funds Taxed at ordinary income rates Commodities mutual funds Stability Assets U.S. bond mutual funds Taxed at ordinary income rates Int l bond mutual funds Preservation Assets Short-term bond mutual funds Taxed at ordinary income rates Cash Key: Optimal Appropriate Avoid Of course, what is appropriate from a tax perspective varies for any individual or household. You should consult a tax professional for specific tax advice and an investment professional to help you sort out the details for your own portfolio. Investing (and Spending) in Retirement The benefits of asset location become clearest in retirement. During those years, your asset location strategy can help ensure a steady stream of income for a comfortable lifestyle and preserve your assets to help them last at least as long as you do. Two strategies work hand-in-hand to help you achieve this goal: 1. Delay Social Security benefits as long as possible 2. Manage withdrawals from tax-deferred accounts to optimize retirement cash Strategy 1: Delaying Social Security Benefits Deciding when to claim Social Security benefits is a critical decision for every individual. You ll need to consider many factors: for instance, your health status, life expectancy, income needs and whether or not you plan to work. Many people start drawing Social

5 Security benefits as soon as they are eligible at age 62. It may seem an attractive option at the time, but doing so could cause you to miss out on higher potential benefits in the future, as well as an important tax-minimization strategy. Converting your traditional IRA to a Roth IRA makes sense if you have enough after-tax income to cover the conversion taxes, and if the income would be taxed at a lower rate in the year of conversion rather than the year you wish to withdraw funds. Your monthly Social Security benefit is based on a formula that includes your lifetime earnings and other variables. The calculation of your monthly benefit at full retirement age (66 for those born from 1943 to 1954, rising to 67 for those born in 1960 and later) is called your primary insurance amount (PIA). If you take Social Security any time before your full retirement age, you will receive a percentage of the PIA, ranging from 75 percent if you start at age 62 up to 93.3 percent if you start at age 65. The lower rate will prevail for the rest of your life. Despite the reduced benefit amount, most people choose to receive Social Security benefits before full retirement age. In fact, 72 percent of current income recipients are receiving reduced benefits. Another option one that might be more advantageous is to delay taking Social Security for a few years after you hit your full retirement age. This will increase your monthly withdrawal by 8 percent per year, up to age 70, after which point it does not change. To maximize Social Security income, the primary wage earner in your household the one who has earned the most over his or her lifetime should postpone benefits until age 70 if possible, and any secondary wage earner should delay until full retirement age. This is a good strategy for maximizing survivor benefits, too. In fact, delaying Social Security benefits is likely to increase total lifetime benefits for couples who are aged 65 or older, considering that at least one spouse has a 45 percent probability of living to age 90. Social Security choices, including when to take benefits and how to coordinate spousal benefits, can be highly complex. Work with your advisor to calculate what s best for your situation. Strategy 2: Managing Tax-Deferred Withdrawals and Social Security By age 70 ½, you must start withdrawing from your tax-deferred retirement accounts also known as taking RMDs. If you delay Social Security benefits until age 70, you can reduce your taxable income in the period before you must take your taxable RMDs. This gives you time to take advantage of potential Roth conversions of your IRAs. When you convert a traditional IRA to a Roth IRA, you will owe taxes on the full amount converted in the year(s) of the conversion, but you will be able to withdraw from the account tax-free in later years. Converting your IRA makes sense if you have enough after-tax income to cover these taxes, and if the income would be taxed at a lower rate in the year of conversion rather than the year you wish to withdraw funds. Remember, converting to a Roth IRA means that your account will no longer be subject to RMDs, and you ll be able to draw down the converted assets without further taxation. Building up Roth IRA balances before age 70 ½ provides a pool of tax-free assets that can be used to supplement pension income, IRA distributions and Social Security benefits. While many people decide to take distributions from tax-deferred accounts as late as possible, it is worth considering the alternative. That s because Social Security is subject to what is sometimes called a stealth tax. Social Security benefits are tax-free up to a point, but they are subject to tax if they increase your income above a certain level. Currently, if a single person has an income of $25,000 before Social Security, then 50 percent of any Social Security benefits are taxed as ordinary income until the person s income reaches $34,000. Beyond that, 85 percent of Social Security income is taxed. For a married couple filing jointly, the threshold is between $32,000 and $44,000. This means that if you can stay within those thresholds, you will pay lower taxes than if you exceed them. Some people believe themselves to be in a lower tax bracket than they actually are only to discover that they hadn t factored in their Social Security income. Someone in the 15 percent tax bracket, for example, might end up paying taxes at a 25 percent rate when Social Security benefits are included.

6 To keep from triggering higher taxes, you must minimize your adjusted gross income when taking Social Security benefits. If you need retirement income in the meantime, consider tapping your IRAs for living expenses. Although the IRA distributions are taxable, you may currently be in a low tax bracket and can pay taxes on them at a lower rate than you would if you waited. By converting to a Roth IRA and taking traditional IRA distributions early on, you can reduce the IRA balances that are subject to RMDs at age 70 ½. At that time, you will have lower IRA income and your Social Security income may be taxed at a lower rate. Following this strategy in a thoughtful and diligent manner can keep you from paying higher taxes in retirement and help you preserve your assets throughout your lifetime. Develop a Tax-Efficient Approach Any investor must evaluate and balance current taxable income and tax burden with future taxable income and tax burden. Your individual situation and goals should be your guide. Understanding the tax implications of your investment accounts both at the time you contribute and when you withdraw is important. Going further and developing a strategy to invest certain assets in the most efficient account types can be helpful to particular investors. And all investors need to carefully consider the tax impact of Social Security benefits and RMDs. Let us help you evaluate whether asset location is right for your portfolio. A financial advisor can help you navigate the myriad possibilities to ensure that you choose an optimal strategy that allows you to keep more of your investment returns so that you can enjoy the retirement lifestyle you want.

7 About StanCorp Investment Advisers Helping you achieve lifelong financial well-being is the primary focus of StanCorp Investment Advisers, Inc. We have a fiduciary duty to act in your best interest and adhere to a prudent, unbiased approach to managing your money. Our asset management process starts with learning about you and your goals. Your advisor will recommend a portfolio structure that invests your assets according to your specific time frame. We go beyond your portfolio to take a comprehensive look at all aspects of your financial life and provide guidance to set you on a path to financial well-being StanCorp Investment Advisers, Inc. All rights reserved.