More On Tax Planningfrom The Advisor's Professional Library
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
A recent Jefferson National Life Insurance white paper on portfolio management says that tax efficiency will emerge as a "significant new imperative" as taxes rise and markets remain volatile and that financial advisors can mitigate clients' risk by investing in a new category of low-cost variable annuity.
Titled "The Tax-Efficient Frontier," the paper written by Jefferson Chief Operating Officer David Lau asserts that certain asset classes benefit considerably from tax deferral while others don't. By adding the principle of asset location on top of asset allocation, Lau claims, advisors investing in a new category of variable annuity can help clients earn higher returns without taking on any additional risk and increase after-tax returns by as much as 100 basis points.
The white paper states that locating asset classes in the right vehicle, whether tax-deferred or taxable, can increase internal rate of return without increasing risk. Because U.S. tax rates have been so low in recent years, achieving a "tax-efficient frontier" has not been a priority for many advisors, according to Lau. But, he adds, this is likely to change now that the Bush tax cuts are ready to sunset and tax rates are moving back up.
"Now," Lau writes, "there is a new category of low-cost no-load variable annuities that can be used as wrap products, allowing clients to invest more tax-deferred. An analysis suggests the use of these VAs can increase an investor's long-term wealth by approximately 100 basis points per year without increasing risk."
Variable annuities have become more popular in recent years because they allow holders either to take a lump sum upon retirement or to create a steady income stream that can last for years or until death. But these annuities also have drawn criticism because of the stiff penalties charged--of 5% or more--if investors want to withdraw money earlier than scheduled. A January 16, 2006, online Wall Street Journal report on the issue points to the efforts of companies like Jefferson National Life Insurance to overcome this negative image by selling variable annuities with lower costs.
In the paper's key points, Lau says that to optimize the tax-efficient frontier, affluent investors may need access to more tax deferral than allowed by the low contribution limits of 401(k) plans or IRAs. However, he says, the only real alternative--the variability annuity--presents numerous challenges, starting with "fee bloat," which typically destroys the benefits of tax deferral.
To demonstrate different tax effects, Lau and his group of analysts studied the long-term performance through June 30, 2008, of four prominent funds with distinct asset classes, two from Vanguard and one each from PIMCO and Janus. To perform this analysis, the group did primary research on the tax characteristics of traditional mutual funds, using data from the University of Chicago's Center for Research in Security Prices as well as Ibbotson Associates. The white paper expands upon primary research and a proprietary analytical model that Jefferson National developed in 2008 with Ira Weiss, Ph.D., of the University of Chicago.
Dallas-based Jefferson National Life Insurance Company, with GAAP assets of $2.1 billion, was founded in 1937.
Prior to joining Jefferson National, Lau was principal and co-founder of The Oysterhouse Group, LLC, a management consulting firm. He also served as senior vice president of operations at E*Trade Bank and senior vice president of marketing at it its predecessor, TeleBank. He holds a bachelor's degree in economics from the College of William & Mary.
"Every financial advisor is familiar with the efficient frontier as a way to define the optimal balance of risk and reward for their clients," said Laurence Greenberg, president of Jefferson National, in a release. "As our research shows, by tax-deferring assets such as bonds, which generate ordinary income, or actively managed funds, which produce short-term capital gains, advisors can create the 'tax-efficient frontier' to help their clients earn higher returns and build considerably more long-term wealth."
Read a story about the polarized attitude toward annuities from the archives of InvestmentAdvisor.com.