Morgan Stanley
  • Wealth Management
  • May 27, 2022

The Tax-Smart Portfolio: Helping to Keep More of What You Earn

Tax strategies can have a surprisingly large potential impact on lifetime wealth accumulation. A look at some of the techniques that could help you keep more money growing.

 

 

Every investor is looking for an edge that helps them boost their overall wealth. But one strategy that some investors don’t pay enough attention to is tax efficient investing. The reason? Even small reductions in tax costs can have enormous consequences for wealth accumulation

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In an example drawn from a Morgan Stanley report,1 an improvement of 0.5% per year in after-tax returns resulted in a difference of 50% in final wealth after 30 years of retirement income distributions.2 No small improvement.

“People are often surprised to learn just how much of their long-term investment returns go to taxes, and how much of a difference that can make in terms of whether or not they will meet their financial goals," said Lisa Shalett, Morgan Stanley Wealth Management Chief Investment Officer.

Faced with a shortfall between lifestyle plans and wealth accumulation, some investors consider options like delaying retirement or taking on more investment risk in an attempt to boost returns. But a key strategy for boosting long-term returns—which may not necessarily add risk—is being smart about tax efficiency.

Utilizing a Variety of Strategies

The benefits of tax-deferral vehicles such as 401(k)s and individual retirement accounts (IRAs) are well known, and naturally a tax strategy should start by utilizing those vehicles. For many people, the simple strategy of making pre-tax contributions to a 401(k) account or tax-deductible contributions to an IRA and deferring taxes as long as possible can be effective, because it allows your investment earnings to compound without the headwind of a front-end tax payment.

Another option is to put aside money for specific categories of spending like education and health care using tax-deferred accounts such as 529 plans or Health Savings Accounts (HSAs).

But there are also lesser-known strategies that can also meaningfully add to your long-term wealth. 

Compared to a 401(k), the annual additional returns generated by the lesser-known strategies may seem small. But just as the power of compounded interest can help small early-career contributions balloon over the decades, small losses due to taxes can snowball over a lifetime.

For example, higher income investors who can max out their tax- deferred qualified retirement accounts can add additional strategies, such as investing in tax-exempt municipal bonds. They can also use “tax managed” investment products that hold gains and “harvest” any losses that are incurred during the tax year or carried over from a prior tax return; these tax losses can also be used to offset capital gains for tax purposes. As with qualified retirement accounts, tax managed investment strategies work by deferring tax costs into the future. 

For high net worth investors, insurance and annuities products can also be effective in helping to reduce the impact of taxes on lifetime wealth. These include:

  • Investment-Only Variable Annuities (IOVA). Investors who have hit the contribution or income caps for qualified retirement accounts such as 401(k)s and IRAs can direct post-tax savings to a non-qualified IOVA, where investment gains are not taxed until they’re withdrawn and assets are not subjected to required minimum distributions (RMDs). This relatively new vehicle is designed for wealth accumulation, coming without the more costly features of other variable annuities, such as guaranteed withdrawal benefits, but with a broader menu of investment options. Its impact on wealth generation is greatest for investors with a long time horizon.
  •  Index / Variable Universal Life Insurance. Another avenue for individuals who have maxed out their qualified retirement accounts, these policies combine potential wealth accumulation with protection for family in the event of the investor’s death. Under certain circumstances,3 the policy buyer pays premiums in early years, the majority of which, after fees and the cost of insurance, are invested in the markets or linked to the performance of a stock market index, and the cash balance potentially grows tax-deferred. Subject to certain restrictions, the cash value of an index / variable universal life policy can be accessed tax free, initially through withdrawal of principal and subsequently by loans against its death benefit.

While each of these products can help improve tax efficiency in isolation, their full potential to boost after-tax returns can only be unlocked when they are set up as building blocks in a more complex, integrated tax strategy. 

For example, when you have a mix of accounts and products with different tax treatments you can increase the impact of the tax advantaged accounts through “tax-efficient asset location,” which locates the investments contained within an overall strategy into different account types according to their growth potential and relative tax efficiency. 

A retirement income plan is another way in which the different components of a tax strategy can complement one another, by sequencing the order of asset sales in a tax efficient way. A simple withdrawal sequence might involve withdrawing from taxable accounts first and tax-advantaged accounts last, but, according to Daniel Hunt, Morgan Stanley Wealth Management Senior Investment Strategist, even-more complex withdrawal sequencing strategies can have a significantly greater impact on lifetime spending power. For example, distributing savings that don’t register as taxable income, like certain municipal bond coupon payments, or taking loans4 from an index / variable universal life insurance policy, while converting portions of tax-deferred savings into a Roth IRA can “smooth” your reported income, so you pay lower average rates, while continuing to shelter your investments from tax.

"Overall, how these different approaches are combined can make a significant difference when it comes to building wealth over the long term. Each of them can be helpful in and of themselves, but in concert they can provide much more significant compounded benefits that can really move the needle. If you have a Financial Advisor who’s willing to sit with you and your tax advisor and put together a comprehensive strategy where the pieces work together, that can make all the difference," Hunt said.

As part of Morgan Stanley’s Total Tax 365, your Financial Advisor or Private Wealth Advisor has access to some of the tax-management solutions.

In addition, if you have complex tax planning needs, your Financial Advisor can connect you to experienced tax planning professionals at leading U.S.-based providers across the country to help you optimize your tax strategy.

If you haven’t taken a look at how tax-efficient investing can help lower your tax burden and increase long-term wealth, talk with your Financial Advisor or Private Wealth Advisor and ask for a copy of the whitepaper, Tax Efficiency: Getting to What You Need by Keeping More of What You Earn. 

Find a Financial Advisor, Branch and Private Wealth Advisor near you. 

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1 Source: “Global Investment Committee Special Report: Tax Efficiency: Getting to What You Need By Keeping More of What You Earn," Morgan Stanley Wealth Management, Mar 3, 2022

2 By using the strategy of withdrawal sequencing, the value-added is approximately 0.5% of equivalent after-tax return. Note that these annual returns would compound to very large numbers over the long investment horizons of many financial goals. In the case of withdrawal sequencing, the difference in returns in the case study is equivalent to nearly a 50% difference in final wealth accumulation. This strategy would be recommended for investors who (1) Have adequate savings relative to spending needs (2) Have a high marginal tax rate and (3) Have sources of low-tax distributions with which to smooth income. Investment liquidations to support retirement spending sequenced in order to increase tax efficiency. Withdrawals from taxable accounts come first to extend tax deferred/ tax-exempt growth of other investments. Income smoothing and partial Roth conversion conducted to lower effective tax rates and minimize spikes in taxable income driven by required minimum distributions. Illustrated value-added based on top marginal federal tax rates for 20 years pre-retirement, and a 5% initial withdrawal rate for 30 years in retirement. Overall portfolio strategy based on a 60% equity/40% fixed income allocation assuming an efficient tax allocation across accounts.

Model Calculation Assumptions: The analyses in this article are based, in part, on a Monte Carlo simulation, which involves repeated sampling of asset class returns from a known distribution.

IMPORTANT: The projections or other information generated by this Monte Carlo simulation analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time.

The analysis for this projection on wealth difference from withdrawal sequence is based on the improvement of withdrawal capability following tax efficient withdrawal sequence among multiple account types in a 10,000-iteration Monte Carlo simulation. Retirement income starts after 20 years’ asset accumulation. The withdrawal amount is calibrated to be 4.5% of portfolio value minus unrealized tax liability in each iteration, adjusted for the cost of living for 30 years. During the asset accumulation period, investors stay in 37% federal tax bracket, with a 5.2% state tax and 3.8% a Medicare tax. During retirement phase, investors’ federal tax bracket is determined by the withdrawal amount together with $20,000 inflation-adjusted Social Security payment each year, subject to additional 5.2% state tax. Tax brackets are based on 2021 married filing jointly status and assumed to grow with inflation rate. Asset growth rates are based on Global Investment Committee forecasted capital markets assumptions as of March 2021, with the first seven years assuming strategic assumptions and subsequent 13 years assuming secular assumptions. Inflation rate is assumed to be 1.75% per year. Portfolios are rebalanced each year across multiple account types to maintain overall asset allocation close to 60% equities and 40% fixed income as much as possible after yearly spending amount being withdrawn. The reason for choosing a 60% equity/40% equity/bond allocation is because it’s a common allocation in balanced portfolios as well as in multi-asset funds. If a different balanced allocation is selected, results would be different than those suggested. Unrealized tax liabilities are subtracted from portfolio ending values to calculate internal rate of return. Probability of success is defined as having at least $1 in any of the account types at the end of 50 years simulation. Partial years of withdrawal are recorded if combined portfolio value at any year is not enough to support expected retirement spending at any year.

3 To leverage the tax deferral benefits of index / variable universal life insurance, in early years the policy buyer can pay maximum annual premiums allowed up to the IRS MEC limit until the policy is fully funded. A modified endowment contract (MEC) is a designation given to cash value life insurance contracts whose funding exceeds federal tax law limits.  If an insurance policy is considered an MEC, it loses the tax benefits it would otherwise have of withdrawals and loans made from the policy. The taxation of withdrawals and loans under an MEC is similar to that of non-qualified annuity withdrawals.

4 We assume here that the policy would be funded in a way that won’t trigger MEC status, such that loans taken from the policy would not be subject to income tax.

Disclosures

This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this material may not be appropriate for all investors. Morgan Stanley Wealth Management (“Morgan Stanley”) recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

When Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors (collectively, “Morgan Stanley”) provide “investment advice” regarding a retirement or welfare benefit plan account, an individual retirement account or a Coverdell education savings account (“Retirement Account”), Morgan Stanley is a “fiduciary” as those terms are defined under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and/or the Internal Revenue Code of 1986 (the “Code”), as applicable. When Morgan Stanley provides investment education, takes orders on an unsolicited basis or otherwise does not provide “investment advice”, Morgan Stanley will not be considered a “fiduciary” under ERISA and/or the Code. For more information regarding Morgan Stanley’s role with respect to a Retirement Account, please visit  www.morganstanley.com/disclosures/dol. Tax laws are complex and subject to change. Morgan Stanley does not provide tax or legal advice. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account.

Investors should consider many factors before deciding which 529 plan is appropriate. Some of these factors include: the Plan’s investment options and the historical investment performance of these options, the Plan’s flexibility and features, the reputation and expertise of the Plan’s investment manager, Plan contribution limits and the federal and state tax benefits associated with an investment in the Plan. Some states, for example, offer favorable tax treatment and other benefits to their residents only if they invest in the state’s own Qualified Tuition Program. Investors should determine their home state’s tax treatment of 529 plans when considering whether to choose an in-state or out-of-state plan. Investors should consult with their tax or legal advisor before investing in any 529 Plan or contact their state tax division for more information. Morgan Stanley Smith Barney LLC does not provide tax and/or legal advice. Investors should review a Program Disclosure Statement, which contains more information on investment options, risk factors, fees and expenses and possible tax consequences.

Individuals should consult their personal tax advisor or attorney for matters involving taxation and tax planning and their attorney for matters involving personal trusts and estate planning.

Diversification does not assure a profit or protect against loss in declining financial markets.

Companies paying dividends can reduce or cut payouts at any time.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. NOTE: High-yield bonds are subject to additional risks, such as increased risk of default and greater volatility, because of the lower credit quality of the issues.

Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, if applicable, local tax-exemption applies if securities are issued within one’s city of residence. However, this can vary from jurisdiction to jurisdiction. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability.

Insurance and annuity products are offered in conjunction with Morgan Stanley Smith Barney LLC’s licensed insurance agency affiliates.

Variable products are sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable product contract and the underlying investments, which should be considered carefully before investing. Prospectuses for both the variable product contract and the underlying investments are available from your Financial Advisor. Please read the prospectus carefully before investing.

Variable annuities are long-term investments designed for retirement purposes and may be subject to market fluctuations, investment risk and possible loss of principal.

All guarantees are based on the claims-paying ability of the issuing insurance company.

Taxable distributions (and certain deemed distributions) from a variable annuity are subject to ordinary income tax and, if taken prior to age 59½, may be subject to an additional 10% federal income tax. Early surrender charges may also apply. Withdrawals will reduce the death benefit and cash surrender value.

If you are investing in a variable annuity through a tax-advantage retirement plan such as an IRA, you will get no additional tax advantage from the variable annuity. Under these circumstances, you should only consider buying a variable annuity because of its other features, such as lifetime income payments and death benefit protection.

Tax deferral may not be available if the variable annuity is owned by a "non-natural person" such as a corporation or certain types of trusts.

Insurance policies are subject to underwriting and certain requirements. Insurance policies contain exclusions, limitations, reductions in benefits, and terms for keeping them in force.

Any withdrawal or unpaid policy loan balance and interest will reduce your life insurance policy's death benefit and cash value and may cause the policy to lapse. If the life insurance policy lapses, you may incur tax consequences. Interest on loans will be billed annually. If you do not pay the amount due, it will be added to the amount of the loan and next year's interest will be based on this new loan amount. You may make policy loan repayments at any time.

Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States.

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