The Profession's Faulty Assumptions: A Top Ten List

Bob Veres

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One of the few great additions to our English language is the phrase "garbage-in, garbage out," a shorthand way of saying that our fancy computer systems are only as accurate as the data they are given to work with.  In the financial planning profession, we have to make a lot of assumptions about the world in order to run spreadsheet models, retirement projections, retirement sufficiency analyses and generally determine how much a client should save and invest for the future.

But I have come to believe that many of the industry-standard inputs into our models are (how can I say this delicately?) garbage. 

Here are my top ten garbage inputs, with, where possible, an explanation of how we might possibly improve on them.

  1. Benefits of a Roth Conversion.  Theoretically, any analysis of a Roth conversion should hinge on the tax rate in the future vs. the client's current tax rate.  If the two are equal, then the math says that the conversion is a revenue-neutral transaction; you are exchanging current tax payments for exactly the same future tax savings.

    Of course, there are other issues to consider--and they tend to weigh on the side of the conversion.  Income from the Roth allows you to reduce taxable income such that you might avoid taxation of Social Security benefits and the new 3.8% Medicare tax on unearned income.  Beyond that, Roth accounts can grow tax-deferred without having to pay out required minimum distributions. 

    So where's the garbage?  Baylor University professor Bill Reichenstein points out that a tax-aware retirement income strategy can dramatically lower the actual rate at which IRA distributions are taxed. 

    "Suppose you have a simple case where the client has two portfolios, one is taxable, the other is an IRA," he suggests.  "A lot of articles say that the optimal strategy is to deplete the taxable account and let the IRA grow as long as possible.  But the most tax-aware strategy is to fill up that first 15% bracket with an IRA distribution, and then use money from the taxable portfolio for the rest of the client's income."  You can be more aggressive and fill up to the 25% rate--and here's what you get:

    $16,000 at a 10% rate = $1,600 in taxes
    $51,199 at a 15% rate = $7,680 in taxes
    $69,800 at a 25% rate = $17,287 in taxes

    The IRA is depleted by $137,000 and pays an aggregate 19.5% tax rate.  Let's say you do this for five years before the client starts taking mandatory distributions.  The mandatory distributions are reduced accordingly, and there is still money in the taxable account.  You can still use those mandatory distributions to fill up the client's lower brackets--meaning it is plausible that the actual IRA tax rate will be, by the end of the client's life, somewhere in the low 20s, rather than 35% or whatever tax hike rate the advisor predicted in the original analysis. 

    Meanwhile, the conversion today is adding to the client's taxable income, which means the money is taxed at the client's highest marginal tax rate--probably 35% for most clients.

    If you project 35% vs., say, 23% future tax rates, even if you add in all the other benefits of a Roth, do the numbers favor a big conversion?  My guess is that for most clients, a closer look at the numbers will lead you to make small opportunistic conversions when the tax bite can be offset by losses in the portfolio.

  1. Expected future tax rates.  I know that most of you are assuming that taxes will go up in the future, especially for your wealthier clients, and I can't disagree.  Today's default software options assume that Uncle Sam will take 35% of client income, plus another X% bite by the state, and now, looking at the expiring tax rates at the end of the year and noticing that our national deficit hasn't gone away, you may override the default and project 40% plus something higher than X in your retirement worksheets.  If you're feeling conservative, those numbers may be higher.

    Where's the garbage in that?  Kent Noard, a former staffer at the IRS, now with KLN Financial Group in San Jose, CA, says flatly that the marginal rate is not an appropriate estimate of actual future tax payments.  Instead, he uses the effective tax rate, which takes into account the fact that the first $16,750 is taxed at a 10% rate, and the next $51,249 is taxed at a 15% rate, and so forth.  Beyond that, clients have all the exemptions and deductible expenses, some portion of their total receipts are taxed at (lower) dividend or capital gains rates, muni bond payments are not taxed by the federal government at all (unless you're in the AMT), losses are harvested out of the investment portfolio, and many advisory clients have a host of other lines filled out on their tax forms that blunt Uncle Sam's fingers in your client's wallet. 

    When you take all this into account, the marginal tax rate looks like a very sloppy estimate indeed.

    How do you calculate the effective tax rate?  It's not hard.  Step one: Take the total income from all sources on the Form 1040, including interest, capital gains and dividends, and add to this number things like federal tax-exempt muni bond income and any other amounts that the client received which are not required to be reported to the IRS.

    Step Two: compare that dollar amount to the dollar amount of taxes that were paid in that year. 

    Noard offers a quick calculation for one of his clients, where the effective rate comes to 22%, even though this person brought in more than $500,000 in annual income (and, therefore, was in the 35% marginal rate).  He uses that 22% number (modified based on future projections of lower income in retirement) for goal planning, but he also will show it to clients, which helps them understand the value of his services.