Countering Low Yield & Volatility

A new approach to tax planning with IOVAs

by Laurence Greenberg

Mr. Greenberg is President of Jefferson National, innovator of the industry’s first flat- fee investment-only variable annuity with the largest selection of underlying funds, which was recently named in Barron’s list of Top 50 Annuities for a second consecutive year. For more information, please visit or call 1-866-WHY-FLAT (866-949-3528).

In spite of challenges posed by low yields and ongoing volatility, advisors helped clients generate substantial gains in 2014. But they face another hurdle as April 15 approaches.

Analysts expect this year to be one of the worst on record for capital gains distributions. And that could mean a huge tax bill for your clients. Taxes can be the single biggest investment expense a client will face, especially the high net worth.

Tax rates can be as high as 40 percent or even 50 percent, when Federal and State taxes are combined. And, advisors and their clients are still feeling the pain of the 2013 tax hikes. Many households are paying more – and high earners have been hit hardest, with increases to income taxes, capital gains taxes and other changes.

Glenn Frank, Director of Investment Tax Strategy at Lexington Wealth Management and President of Frank Advising observes, “For many advisors and clients, taxes will be the next big thing. The taxes on investors’ portfolios have been hiked up across the board. And right now, tax laws are looking about as permanent as they get.”

In 2013, the top bracket increased to 39.6 percent from 35 percent for income taxes and short-term capital gains. The top tax rate for long-term capital gains and dividends increased to 20 percent from 15 percent. For the 2014 tax year, the top rate of 39.6 percent applies to individuals with income over $406,750 and married couples filing jointly with income over $457,600. The Health Care Surtax of 3.8 percent on net investment income kicked in for singles with income of $200,000 and married couples with income over $250,000.

Taxes on the wealthiest estates, worth upwards of $5 million, increased to 40 percent from 35 percent. There was also a phase-out of personal exemptions (PEP). For the 2014 tax year, PEP begins for individuals with income of $254,200 and married couples with income of $305,050. State taxes are also taking a bigger bite. In November 2012, California passed Proposition 30, creating a top income tax rate of 13.3 percent for individuals with annual income of more than $1 million. This exceeds Hawaii’s top rate of 11 percent and Oregon’s top rate of 9.9 percent.

In May 2013, Minnesota passed an Omnibus Tax Bill, increasing the top income tax rate to 9.85 percent. Other high tax states include Iowa (8.98%), New Jersey (8.97%), Vermont (8.95%), Washington D.C. (8.95%), and New York (8.83%). Depending on the state, these high tax rates often apply not only to income, but to capital gains as well.

Tax Deferral is Key

To cut taxes paid on income and investment gains, it’s important to help clients achieve “tax diversification,” which means controlling tax rates and the types of taxes paid with the end goal of maximizing the impact of tax efficiency.

This “Tax-Alpha” is much like the alpha achieved when an investment outperforms its benchmark. In effect, tax-alpha is the additional wealth you can generate when implementing a tax-optimized strategy. And tax deferral is key to generating tax-alpha. With tax deferral, clients keep more of what they earn by deferring taxes during peak earning years, when they are taxed at a higher rate.

They accumulate substantially more over time through tax-deferred compounded growth. And when withdrawing income in retirement years, they are likely to be in a lower bracket and pay less in taxes. Advisors’ focus on the power of tax deferral is increasing. According to a study by Jefferson National last spring, 96 percent of advisors consider tax deferral important and 94 percent said clients agree.

Yet, more than half of advisors said clients have no knowledge about tax deferral beyond traditional 401(k)s and IRAs, and less than 20 percent of advisors were aware that tax deferral can add 100 bps or more of alpha to an investment. This means many high net worth clients are missing opportunities to maximize wealth through tax-deferred vehicles. In a time of high taxes, increasing your awareness of tax deferral, and understanding the techniques for using it, is critical

IOVAs: Built for Tax-Advantaged Investing

The first step in any tax-optimized strategy is investing in tax-deferred qualified plans. The IRS recently announced cost-of-living adjustments, raising 2015 tax year contribution limits for 401(k)s, 403(b)s and 457(b)s. Pre-tax contributions will increase from $17,500 for the 2014 tax year to $18,000 in the 2015 tax year. The catch-up contribution for clients 50 or older will increase from $5,500 to $6,000.

These increases are incremental, but can help clients reduce taxable income now, while accelerating savings for their future. For additional COLA adjustments affecting other retirement plan items, see the latest IRS information release. Yet, for the high net worth, who can easily max out the contribution limits of qualified plans, there have been few other options for efficient tax-advantaged investing.

But now there is a new category of Investment-Only Variable Annuities (IOVAs). With low fees, or even flat-fees, no commissions, and no surrender charges, low-cost Investment-Only VAs are designed to maximize the power of tax deferral. With an expanded lineup of underlying funds, including liquid alternatives using strategies like those favored by hedge funds, low-cost IOVAs are built for use as a tax-advantage investing platform, instead of as a costly and complex insurance product.

In effect, tax-alpha is the additional wealth you can generate when implementing a tax-optimized strategy. And tax deferral is key to generating tax-alpha.

Once a client has maxed out qualified plans, there are several effective strategies for using a low-cost IOVA with a broad lineup of funds to tax-optimize your clients’ portfolios.

Asset Location

Asset location involves locating clients’ assets between taxable and tax-deferred vehicles based on tax characteristics. Research shows that asset location helps increase returns by 100 bps or more – without increasing risk. “While it’s very situational – depending on factors like the client’s income and potential capital gains – the savings and subsequent wealth created by asset location can be substantial, especially for clients in high tax brackets and clients with a portfolio of $1 million or more,” says Frank.

Start by considering the tax-efficiency of assets. Are they taxed at lower rates for long term capital gains, or at higher rates for short term capital gains and ordinary income? Locate tax-efficient investments such as buy and hold equities, index funds, ETFs, and tax-exempt municipal bonds in taxable accounts. Locate tax-inefficient investments such as fixed income, REITS, commodities, actively managed strategies and liquid alternatives in IOVAs, to preserve all of the upside without the drag of taxes.

Tax-Efficient Re-Balancing

Re-balancing helps return a portfolio back to its proper allocations, after some assets have increased in value and others declined. This means selling assets that have gains. And when re-balancing is done in taxable accounts, taxes will be due.

But tax implications can be minimized by dividing the total portfolio between taxable accounts and a low-cost IOVA. When re-balancing means taking gains, it can be done inside the IOVA. Switching among funds won’t generate a tax bill. When re-balancing means taking a loss, take it in taxable accounts and use for tax loss harvesting. As Franks says, “Re-balancing should be based on your overall portfolio. For best tax results, take losses in your taxable account and gains within your VA.”

Creating a Personal Pension

Pension Defined benefits plans and pensions continue disappearing. But wealthy clients can use low-cost IOVAs to create their own personal pension.

One of the biggest challenges is how to draw retirement income so that clients don’t unintentionally creep into a higher tax bracket. It’s important to plan an income withdrawal strategy with taxes in mind and have a range of sources with different tax treatments. Diversify more strategically, using Roth and Traditional IRAs, fixed or immediate annuities, and systematic withdrawals from the IOVA.

Non-qualified IOVAs are especially attractive because they have no minimum distribution requirements, offering tax-deferred accumulation beyond the age of 70½.

Preserving a Windfall

Many high net worth clients are likely to be entrepreneurs. When it’s time to sell a business, IOVAs are an effective tool to help optimize that windfall. If a client sells a business valued at $5 million, for example, they might pay $1.5 million in taxes, and with the remaining $3.5 million, build a fully-diversified tax-optimized portfolio by locating the most tax-inefficient assets in a low-cost IOVA, where they can grow tax-deferred.

If the client has no immediate need for liquidity, an IOVA can often be one of the most efficient solutions for the entire sum.

 Legacy Planning and Wealth Transfer

Trust income in excess of $11,950 is taxed at 39.6 percent – the highest income tax bracket – plus the 3.8 percent net investment income tax.

By funding a trust with a low-cost IOVA, you can build a diversified portfolio, then minimize, delay or even eliminate the current tax, to maintain more wealth. Trusts that work well with IOVAs include Credit Shelter Trusts or Bypass Trusts, to save more for future generations; Net Income with Makeup Charitable Remainder Unitrusts (NIMCRUT), to reduce taxation of highly appreciated assets; Revocable Trusts to shelter income for clients in high brackets; and Special Needs Trusts. Another solution for wealth transfer includes using a non-qualified stretch with an IOVA to generate a lifetime income stream for heirs.

Employing IOVAs for legacy planning can help create more wealth for the next generation of family members – and the next generation of clients for your firm.

Right Time for IOVAs

With tax season approaching and more potential hikes in the headlines, tax-planning should be a top priority. Along with providing low cost, more choice and more flexibility, Investment-Only VAs can be used in ways that traditional VAs cannot.

They’re a powerful tool for asset location, tax-efficient re-balancing, creating a personal pension, preserving a windfall and legacy planning. Built as a platform to provide more investing solutions, IOVAs offer new ways to meet your clients’ needs – and deepen client relationships. It’s no surprise sales have doubled in two years, to nearly $5 billion as of Q3 2014 compared to $2.4 billion at year-end 2012, according to Morningstar.

There’s a very direct relationship between paying less in taxes each year – and earning higher returns. Now is the right time to take a new approach to tax planning with innovative IOVAs. ♦