Archives for March 2015

Your marginal tax rate (and, in many cases, how you expect your marginal tax rate to change over time) is a critical factor in tax planning decisions.

One thing that married couples often fail to consider in their planning is that, in the majority of cases, after one spouse dies, the widow/widower’s marginal tax rate will be greater than the marginal tax rate that the couple faced in the years immediately prior to the first spouse’s death.

Unfortunately, there is of course no way to know when widowhood will start or how long it will last. I’ve found it challenging to even determine how long widowhood lasts on average. I’ve seen figures from 8 years to 15 years quoted by reputable sources. Regardless, even 8 years is a considerable length of time and merits inclusion in tax planning.

Why Does Marginal Tax Rate Increase When One Spouse Dies?

After one spouse dies, the surviving spouse (starting in the following year, when they would have to begin filing as single) is left with smaller tax brackets. The 10% and 15% tax brackets are exactly half the size for single people that they are for married couples filing jointly. And the standard deduction and personal exemption of the surviving spouse are half of the amounts that the couple used to receive.

As far as income, there is typically a reduction when one spouse dies, but that reduction is typically insufficient to counteract the smaller exemption, standard deduction, and tax brackets. Social Security, for instance, does fall when one spouse dies, but the reduction is usually less than 50% (because if the spouse with the higher retirement benefit dies, the surviving spouse can claim a widow/widower benefit that’s equal to the deceased spouse’s retirement benefit). And investment-related income doesn’t typically decline at all when one spouse dies.

How Does This Affect Tax Planning?

This foreseeable increase in marginal tax rate after the death of one spouse is important because it affects decisions in which you have to compare your current marginal tax rate to the marginal tax rate you expect to have in the future. Specifically:

• It is a minor point in favor of making Roth contributions (as opposed to tax-deferred contributions) during working years,
• It is a significant point in favor of prioritizing retirement spending from tax-deferred accounts (as opposed to Roth accounts) while both spouses are still alive, and
• It is a significant point in favor of doing Roth conversions while both spouses are still alive.

A reader writes in, asking:

“Regarding Roth conversions, is it worth it to convert, putting yourself in pretty high tax brackets if you have a lot to convert? Second is it worthwhile to do some converting when the result would likely still leave you with heavy RMD’s and 85% of SS taxed, nullifying some of the better reasons to convert?”

In the simplest situation — in which a person has only tax-deferred and Roth accounts — it usually only makes sense to do a Roth conversion if your marginal tax rate on the conversion is lower than you expect your marginal tax rate to be at every point in the future. (Otherwise, you could wait until the point at which you do have the lower tax rate and do the conversion then.)

Even with this simple situation, however, there are three additional points to keep in mind.

First, at least in theory, this analysis should be done dollar-by-dollar, because converting isn’t an all-or-nothing question. For example, if you have $500,000 in a traditional IRA, it may make sense to convert some of it. But after you’ve already converted a certain amount this year, you reach a point where your marginal tax rate on additional conversions is higher (e.g., because you’re in a higher tax bracket or because you reach a point where additional income would reduce/eliminate your eligibility for a certain tax break), so the math changes for additional conversions.

Second, you must include any applicable penalty when figuring the marginal tax rate on the conversion. For example, if you have $100,000 in a traditional IRA and you move $85,000 to a Roth IRA and $15,000 to your checking account in order to use it to pay the tax on the conversion, that $15,000 would count as a distribution and could be subject to the 10% penalty if you’re under age 59.5.

Third, as we’ve discussed here on several occasions, your marginal tax rate is not necessarily the same as your tax bracket. (It’s super common, for instance, for retirees to have a higher marginal tax rate than the tax bracket they’re in, due to the way in which Social Security is taxed.)

What if You Have Taxable Accounts As Well?

With taxable accounts in the mix as well, the analysis becomes much more complicated. In short, having money in taxable accounts typically makes Roth conversions more appealing, because you can use that taxable account money to pay the tax on the conversion, rather than having to siphon off some of the IRA assets to pay the tax.

As a result, if you have non-retirement-account assets with which you could pay the tax, Roth conversions typically make sense even if you expect to have only the same marginal tax rate in the future as you have right now. In fact, they can even make sense in some cases in which you currently have a higher marginal tax rate than you expect to have in the future — because the advantage that comes from tax-sheltering more of your assets may outweigh the disadvantage of paying a (relatively) high tax rate on the conversion.

In cases in which your tax rate on the conversion would be higher than the marginal tax rate you expect to face in the future, some of the factors to consider when deciding whether to convert or not would include:

• How much higher is your current marginal tax rate than the marginal tax rate you expect to face in the future? (The greater the difference, the more appealing it becomes to wait rather than do a conversion now.)
• How long do you expect the assets be in the Roth account? That is, how long before you expect to spend the money? (The longer, the greater the savings from a conversion due to not having to pay tax on further growth.)
• What rate of return would you expect for the assets in question? (The higher, the greater the savings from a conversion.)
• Do you have sufficient cash on hand in taxable accounts to pay the tax (or, alternatively, assets in taxable accounts that have cost basis equal to or greater than their current market value)? If you would have to liquidate taxable holdings — and pay capital gains taxes in doing so — in order to raise cash to pay the tax on the conversion, that’s a point against the conversion.
• How likely do you think it is that you’ll be leaving these assets to heirs? (In many cases, it’s actually tax-efficient to leave taxable assets to heirs, because the heirs would get a step-up in cost basis.)

As you can see, this isn’t a question to which you can calculate a definitive answer, because many of the factors are unknowable. As a result, you may find that it makes sense to take a middle-of-the-road sort of approach, in which you do relatively modest conversions each year (perhaps converting until you reach the top of your current tax bracket) and sometimes converting more in years in which your income (and therefore marginal tax rate) is lower or the market is down (thereby reducing the cost of a conversion).

A reader writes in, asking:

“Now that tax season is beginning to wind down, I was wondering if you might weigh in on the pros and cons of Tax-managed balanced funds and how they might serve a place in a retirement portfolio for a typical investor? I wasn’t able to understand a lot about the advantages of Vanguard’s VTMFX for example.”

If we compare the Vanguard Tax-Managed Balanced Fund to the Vanguard Balanced Index Fund, the tax-managed fund is supposed to be more tax-efficient for two reasons: it uses municipal bonds rather than taxable bonds and it skews the stock portfolio toward holdings with low dividend yields.

The first point potentially improves tax efficiency because muni bonds are exempt from federal income tax. However, it’s critical to remember that, depending on your marginal tax rate, muni bonds may not be the best choice. Muni bonds offer lower yields than taxable bonds with a similar level of risk, so it only makes sense to use muni bonds when the tax savings outweigh the lower yield. (Said differently, it only makes sense to hold muni bonds if they have a higher yield than the after-tax yield on taxable bonds of a similar risk level.)

Skewing the stock holdings toward low-dividend stocks potentially improves tax efficiency because, if a greater portion of a stock’s total return is made up of capital appreciation rather than dividends, the investor has a greater ability to defer taxation. (That is, dividends are taxed right away, whereas capital appreciation isn’t taxed until shares are sold.)

If, however, you’re in the 15% tax bracket or below, it’s possible that skewing toward low-dividend stocks actually reduces tax-efficiency. In that income range, both qualified dividends and long-term capital gains are taxed at a 0% rate. As a result, you’d prefer that a greater portion of the total return show up on your tax return now as tax-free dividends than show up later as long-term capital gains — because later you may not be in the range where LTCGs are tax-free, or tax law may have changed to eliminate the 0% rate.

When Does It Make Sense to Use a Tax-Managed Balanced Fund?

Personally, I would be reluctant to use an all-in-one fund (even a tax-managed one) in a taxable account. While a tax-managed balanced fund is likely to be more tax-efficient than a normal all-in-one fund, it is still going to be less tax-efficient than a DIY allocation, for two reasons.

First, it allows for fewer opportunities for tax-loss harvesting. With an all-in-one fund, you can only tax-loss harvest if the whole fund goes down. In contrast, with a DIY allocation, there will be many occasions on which the overall portfolio is up, yet there’s an opportunity to tax-loss harvest because one particular piece of the portfolio is down.

Second, an all-in-one fund (even a tax-managed one) gets in the way of an asset location strategy. (Under an asset location strategy, you tax-shelter your least tax-efficient assets by holding them in retirement accounts. And it is only your more tax-efficient assets that you hold in a taxable account — to the extent possible, anyway.) For many investors, rather than holding a tax-managed balanced fund, it makes sense to hold only taxable bonds (in order to get their higher yields) and simply keep them in retirement accounts — and hold only stocks (which are naturally tax-efficient, due to the low tax rates on qualified dividends and long-term capital gains) in taxable accounts.

That said, while I have a low tolerance for hassle, I’m sure there are investors who have an even lower tolerance for hassle. For them, a tax-managed balanced fund could make a lot of sense. In other words, if an investor wouldn’t be bothering to tax-loss harvest or pay attention to asset location in the first place, a tax-managed balanced fund might be just as tax-efficient as a DIY allocation.