Taxes Are An Assumption Too! How taxes are handled…

1. Phillip Knotts, Director of Training WEALTHCARE CAPITAL MANAGEMENT May 10th, 2004 Taxes Are An Assumption Too!How taxes are handled…

2. The process of creating financial advice involves many factors… • Including: • The impact of including investment risk in our projections • How the math works • The new set of premises around which we have created the Wealthcare process • Concentration risk to the portfolio • Tax and allocation efficiency risk • Converting goals and resources into cash flows • Capital Market Assumptions – modeling what we intend • Implementation Risk – implementing what we modelled • Today we will cover everyone’s favorite topic… TAXES!

3. When applying these factors to financial advising…there are things that we “know” and things we must “assume” • For example: • We “know” portfolios will not produce the same return each year • We “know” that the timing of deposits/withdrawals and returns impact results • We “know” people would prefer to avoid risk if possible • We “know” people are more comfortable having some level of certainty • We “know” investors would prefer to save as little as possible, spend as much as possible, be financially independent as soon as possible, take as little risk as possible, etc. • The things we “know” result in new premises for a new advisory process • But there are also things we have to “assume” Like the nature of what might be expected from Capital Markets And, the impact of taxation….

4. What do we “KNOW” about taxes? • We “know”: • Currenttax rates that will be applied this tax year • Tax rates in the future will be different • We don’t know for sure whenthey will change • Or what future rates or rules will be • All we know is that the future of taxes is uncertain • We also know people prefer to avoid them • And therefore will tactically and strategically avoid or defer taxes when possible • The greatest impact of tax efficiency is at the upper end of the potential results • Having little material impact at the lower end where we measure confidence • We also know whatever we project will be wrong because of uncertainty

5. What do we know about UNCERTAINTY? • There is a wide range of potential results • Results based on the average are far different than confident results • Being TOO AGGRESSIVE in assumptions (i.e. zero volatility, median result) will set us (and clients) up for disappointment • Being TOO CONSERVATIVE compromises the only life the client has • ALSO, with the UNCERTAINTY of results • And the resulting wide range of potential outcomes • At reasonably high confidence levels • What might appear to be material and precise assuming PRECISE (identical) returns • BECOMES IMMATERIAL WITH LITTLE PRECISION

6. So, in dealing with taxes, what should we ASSUME? • Behavior and preference of investors: • Avoid taxes • Defer taxes • Maintain lifestyle (don’t alter lifestyle to fund taxes) • Uncertainty of markets: • Each simulation (or trial) will have completely different tax impact • This is much different than if we assume the same return each year • Let’s look at an example

7. For example, let’s look at a simple projection of IRA distributions and the impact of Required Minimum Distributions • 70 Year Old, $1 million in IRA assets with no cost basis, balanced allocation- flat $80,366 after tax annual spending need: Notice How CERTAIN Taxes Look And Returns Appear

8. For example, let’s look at a simple projection of IRA distributions and the impact of Required Minimum Distributions • 70 Year Old, $1 million in IRA assets with no cost basis, balanced allocation- flat $80,366 after tax annual spending need: They May Be Forced Into “Excess Distributions” in Later Years

9. For example, let’s look at a simple projection of IRA distributions and the impact of Required Minimum Distributions • 70 Year Old, $1 million in IRA assets with no cost basis, balanced allocation- flat $80,366 after tax annual spending need: But, the returns are unpredictable… And so are the taxes

10. For example, let’s look at a simple projection of IRA distributions and the impact of Required Minimum Distributions • 70 Year Old, $1 million in IRA assets with no cost basis, balanced allocation- flat $80,366 after tax annual spending need: Or the taxes could be similar… with unpredictable returns… But the ending value could change

11. For example, let’s look at a simple projection of IRA distributions and the impact of Required Minimum Distributions • 70 Year Old, $1 million in IRA assets with no cost basis, balanced allocation- flat $80,366 after tax annual spending need: Or things could completely fall apart… Saved on taxes! But pretty deep in debt!

12. Of course, each of these widely different results were based on the SAME tax assumption… • CURRENT TAX RATES & RULES*! • But remember where the impact had… • IMPACT! • When returns were really GREAT…Top 5% result, 13.54% Return - $8.1 Million • Or when the timing of results HURT…75%-tile, 9.68% Return – Broke @ 87 • But Taxes were about the same… • Assuming 10.05% with no volatility - $1 million ending value • Or, FORTUNATE timing of a terrible 6.7% return - $338,000 ending value • Because results are unpredictable, and rates are unpredictable, and rules are unpredictable…false precision here can be a folly. • Let’s revisit our 70 year old with $1 Million in their IRA, and compare results between: • Florida – 0% Income Taxes, Virginia – 5.75%, & California 9.30% • *Marginal rates are updated based on Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Dividends and long term capital gains are taxed based on post sunset rules.

13. Comparison of 9.3% Spread in State Income Taxes • Considering how uncertain the rates and rules are… • The differences still are not very material… • Even at the upper tail…. • At the assumed return the difference appeared more material • Florida: $1,350,000 • CA: $820,000 • Until we understood the range of possible outcomes

14. Comparison of 9.3% Spread in State Income Taxes • Of course, the comfort factor is too low with the higher withdrawal rate… But, with a $57,000 withdrawal, the results look like this Very Little Difference in Comfort

15. So…does that mean we are haphazard in our tax assumptions? • No… • Based on the premises of what might be material • The preference for investors to avoid/defer taxes • The fact that there are 1000 different scenarios to model • And the premise that investors will not compromise their goals to avoid taxes • We have pretty detailed assumptions • But, they have been designed around coping with multiple (1000 different) outcomes • Which means that we may have to change the things we focus on compared to when we were dealing with ONE outcome (fixed return assumptions)

16. For example, in our required minimum distribution example, with fixed returns, we assumed the investor would end up with about $1 million at age 93, forcing some excess distributions at age 91. • But in reality, we discovered they may be forced into distributions in excess of their need starting at age 75, and ending up with $8.1 Million ($3.8 million of which is in a taxable account) • Or, they could very well have run out of money (1 in 4 chance) before age 87Traditionally, when we looked at only one result (fixed return), we might attempt to manage things like avoiding required minimum distributions by: • Stopping tax advantaged contributions • Or increasing withdrawal amounts (to fund a gifting program for example) • While these “actions” appeared to make sense when these steps APPEARED to have CERTAIN benefit (i.e. when returns were “certain”)…Uncertainty of the results changes our perspective because these actions may: • Lower confidence to unsatisfactory levels

17. So…What are the assumptions? • There are two “main” tax environments during an investor’s lifetime: Pre-retirement: When one or both are working for substantial income (marginal tax rates MAY BE high…may not though, depending on scenario) Post-retirement: When earned income is not substantial • The difference between these two is a judgment call • Controlled by “client” retirement age • Pre-retirement rates estimated on household earned income • Post-retirement rates estimated on RETIREMENT SPENDING NEED (will explain more later)

18. So…What are the assumptions? • The system assumes: Marginal rates for yield and short-term capital gains Long-term capital gains rates for long-term gains Effective tax rates on distributions in tax-deferred accounts in post-retirement Marginal tax rates on distributions in tax-deferred accounts in pre-retirement State tax rates based on the same pre & post retirement rules Federal deductibility of state income taxes Cost basis of positions in taxable accounts (100% turnover, 50% taxed long-term) Non-taxable distributions from tax-deferred accounts for after-tax contributions Effective tax rates for pensions, SSI and other sources of retirement income Realized losses carried forward to off-set future gains Bias toward continuing deferral Unless RMD applies • While these are “global” assumptions… Each trial will model completely different results

19. Let’s compare how these assumptions apply to the first five years of two different trials • 59 Year old considering retirement, $400,000 in taxable investments, $1,000,000 in tax deferred, $100,000 withdrawal for first 10 years of retirement (includes travel budget), SSI starting at age 67, retirement need declining to $60,000 at age 70: • Trial # 288 Big Difference in Ending Value Taxes First 3 Years: $17,819 First 5 Years: $39,102 Trial # 842 And in the “timing” of returns Taxes First 3 Years: $39,269 First 5 Years: $42,314

20. Just two years later the results of these two trials look about the same…They have depleted their taxable assets and have $1.8 million in their IRAs • 59 Year old considering retirement, $400,000 in taxable investments, $1,000,000 in tax deferred, $100,000 withdrawal for first 10 years of retirement (includes travel budget), SSI starting at age 67, retirement need declining to $60,000 at age 70: • Trial # 288 Trial # 842 Total taxes paid over 7 year differing by $4,449- albeit “timed” differently

21. The next seven years things change a lot… • 59 Year old considering retirement, $400,000 in taxable investments, $1,000,000 in tax deferred, $100,000 withdrawal for first 10 years of retirement (includes travel budget), SSI starting at age 67, retirement need declining to $60,000 at age 70: • Trial # 288 This portfolio forced major RMD… and had DOUBLE the value Trial # 842

22. And by the end of the plan, things are really different… And… look at the difference in Taxes… Maybe these aren’t “perfect” but, compared to $20,092 a year??? • 59 Year old considering retirement, $400,000 in taxable investments, $1,000,000 in tax deferred, $100,000 withdrawal for first 10 years of retirement (includes travel budget), SSI starting at age 67, retirement need declining to $60,000 at age 70: • Trial # 288 Ending Results: 16th %-tile Trial # 842 Ending Results: 72nd %-tile

23. Did you notice how the “Net Cash Flow” changed over time? • 59 Year old considering retirement, $400,000 in taxable investments, $1,000,000 in tax deferred, $100,000 withdrawal for first 10 years of retirement (includes travel budget), SSI starting at age 67, retirement need declining to $60,000 at age 70: • Trial # 288 It started with their $100,000 “Need” Then declined when the client received SSI Then declined again when spouse received SSI Then declined again when travel stopped Then INCREASED when client died and spouse only received survivor SSI

24. So, while looking at any one scenario we may make different decisions… • Imagine how difficult it would be to input those tax decisions ONE THOUSAND TIMES • Much more difficult than profiling the client! • Therefore, unless we want to set different tax rules for EACH TRIAL • We need to apply some simplifying assumptions • Remembering: • Rates and rules in the future are uncertain • What used to look material using certain (fixed) returns, is immaterial in the context of the vast uncertainty of investment returns • No matter how precise we get, we will be wrong • We are modeling a thousand different tax scenarios

25. Things like the order in which goals are paid from specific assets, that APPEARED to make a big difference assuming CERTAIN returns • Are going to be different in every trial based on the rules within the engine: • Goals are assumed to be paid for with a bias toward continuing tax deferral • Investment Income (bond yield & dividends) • Planned Taxable Savings/ or other sources of retirement income • Taxable Realized Gains (based on turnover) • Taxable Gains Forced To Be Realized (needed to meet goal) • Tax Deferred Accounts (plus ordinary income tax needed to meet net amount and net of after tax contributions) • Tax Exempt Accounts (Roth) • Loan (in debt) • Unless there was a required minimum distribution …the after tax amount will be used before any withdrawals happen to accounts.

26. Since these rules are applied to each trial • The things we model are different than traditional fixed return analysis • For example, say that a single cash flow (buy a retirement home for $200,000 10 years into retirement) with traditional analysis was assumed to come from some taxable portfolios • In our analysis, there will be: • Trials where the taxable assets were depleted so the money had to come from tax-deferred assets requiring a “gross up” to pay deferred taxes • Trials where there was forced RMD that provided a portion of the capital • Trials where prior results were so strong, that there was enough investment yield to fund the purchase • Trials that depleted the taxable assets the year this occurred • Trials where there wasn’t any money left to fund the purchase • When returns are assumed to be certain, we can “tell” the tool where to get the money • When we understand that there is uncertainty, we need to make a simplifying assumption • Or enter one thousand choices

27. What about the rules for “pre” & “post” retirement? • In general, it makes sense to apply marginal rates to investment returns while the client still has significant earnings…agreed? • But, why base the effective and marginal rates on Retirement Income Need if they are retired? • First…we have to base it on something • Next…it does represent what will be needed on a regular, recurring basis • Next…most people have some tax deferred assets • Therefore, some trials will have forced RMD • Next…if there is an offsetting “retirement income source” it will probably be taxable (pension, SSI, deferred comp) so investment returns in excess of need will still be taxed at marginal rates • Next…it is rare that sources of retirement income will be in excess of need • Let’s see how this works….

28. One year, post retirement tax assumptions: • $57,000 “need” with offsetting source • Therefore no turnover needed to fund cash need • With 0% turnover assumption Taxes equal 25% marginal rate on investment yield

29. One year, post retirement tax assumptions: These scenarios all assumed no turnover • $57,000 “need” with offsetting source- Only yield taxed Without offsetting “source” some gains were forced to be realized, increasing taxes (in this case assuming $1 million cost basis) With a cost basis of zero, gains were paid on the entire amount needed to fund withdrawal

30. But, we assume some turnover: • Results with 100% turnover and all gains short-term: Results with 100% turnover and all gains long-term: Difference = $16,945 Long Term Rate: 20% Ordinary Income Rate: 25% Difference is 5% spread on appreciation Both paid $6,905 on yield (25%) All gains long-term had $67,779 (20%) in capital gains, plus $6,905 = $74,685 All short-term had $84,724 (25%) in capital gains, plus $6,905= $91,630

31. In any year, we will be under & overestimating taxes • Probably not as far off though as when we assumed identical returns each year • For years with really high returns, marginal rate will not be marginal enough • Likewise, in years where “needs” are met from taxable assets, we will be overestimating the taxes (marginal tax rates on investments though first dollars would really be taxed at effective rates) • But, these tend to off-set one another • The thing to be careful of is: • Over-estimating taxes due to: • All/most assets in taxable accounts when: • Non-lifelong needs (i.e. travel budget) is included in retirement income need • With relatively little, or no, sources of retirement income • AND • Under-estimating taxes due to: • Most/all assets in tax deferred accounts with • Lifelong needs modeled separately from retirement income need • And relatively high sources of retirement income • Like household income in pre-retirement, the retirement income need merely sets the post-retirement tax assumptions

32. To correct for these: • Over-estimating taxes due to: • All/most assets in taxable accounts when: • Non-lifelong needs (i.e. travel budget) is included in retirement income need • With relatively little, or no, sources of retirement income • Don’t include non-life long needs in retirement income need • Under-estimating taxes due to: • Most/all assets in tax deferred accounts with • Lifelong needs modeled separately from retirement income need • And relatively high sources of retirement income • Include lifelong needs in retirement income need

33. The resulting tax assumptions from differing “needs” can be HUGE… • Same pre-retirement household income of $100,000 • Different retirement income need had HUGE impact in post-retirement rates But the results of both of these fall WAY out of realistic ranges & hopefully we won’t be designing plans with these odds

34. In fact, with realistic “comfort zone” retirement income needs, the difference in rates is fairly small (less than the 9.3% state tax spread)

35. In summary… • Taxes are pretty complicated • With one thousand different trials, we are covering a wide gamut of scenarios • And, while there are not tools to randomly model the uncertainty of taxes • The treatment of taxes in the system probably mimics this uncertainty well • And within the context of the range of potential results is accurate • Also: • We are being far more realistic than the assumptions made with fixed returns • But we have to be careful to “check our premises” when comparing the two • Because what used to be important, material, and something to manage • Is exposed as a similar misrepresentation to the fixed returns we projected