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Strategy for Reducing Tax on Retirement Plan Withdrawals

I've been trying to figure out a way to withdraw funds from retirement accounts without paying tax at income rates. How about this?

To take an example, assume you believe that emerging market stocks will continue their recent declines. You move your retirement plan money into an emerging market ETF such as EEM. You hedge this by investing a taxable account in the same amount in the corresponding inverse (short) ETF (EUM in this case).

If your forecast was correct, you will reduce the value of your retirement account (taxed at income rates) and increase by the same amount the value of your taxable account (taxed at cap gains rates). The combined value of the two accounts is unchanged.

If you believed the target asset class was going to go UP rather than DOWN, you'd make the opposite investment. Buy the inverse fund in your retirement account and buy the bull fund in your taxable account.

Some of the issues I see with this are:

  1. You have a lot of money tied up in the 2 investments, especially if you want to achieve a significant reduction in retirement plan taxes. On the other hand: (a) the zero investment return is enhanced by the tax reduction; and (b) if you're sitting out the recent market volatility in money market funds, you'd be putting your money to good use.

  1. Your future income tax liabilities on the retirement account are replaced by a *near-term* capital gains tax liability (assuming you do not hold these positions for a long time). But paying the tax earlier could be a smart move in view of likely increases in tax rates.

  2. If you bet the wrong way, you'd end up INCREASING your total tax liability. But this is not all bad. The taxable account would throw off near-term capital losses to offset against cap gains and income. And you can probably delay paying the added tax on the retirement plan for many years or even decades.

As an aside, a similar strategy might be used to if you wanted to invest more in your retirement accounts than is possible given current contribution limits. Invest your retirement account in an ETF that you believe is going to experience rapid gains, and invest a taxable account in the same amount of the inverse fund. If you bet correctly, you have made a "contribution" to your retirement plan and gained a near-term capital loss from the taxable account.

Comments?

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Reply to
Pete
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Yes, you've lost the return potential on the total sum invested. While you have $100K long in the IRA and $100K in the inverse fund, you are missing out on the return that $200K will achieve, even in CDs or some other conservative mix.

I notice an increase in the number of schemes to try to save pennies while ignoring the big picture. My best withdrawal advice is to manage your investments so the post tax accounts' gains and interest are subject to the reduced rate and the IRA/401 withdrawals don't bump you to the next bracket. Convert to Roth to 'top off' the bracket you are in. And pass on any schemes, they are nothing but a distraction.

Joe

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Reply to
JoeTaxpayer

An insurance salesman suggested I use my entire retirement savings to buy a variable life insurance plan. Then I would withdraw it while the cash value was low and pay the taxes. Subsequently it would grow in value tax free.

Frank

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Reply to
FranksPlace2

Can you put a VUL inside YOUR retirement account? I know some types of retirement accounts will allow some level of insurance inside but I do believe that there are restrictions. If you can't buy a VUL - or enough VUL - inside the retirement plan you'd have to cash out the retirement account, pay the tax, then buy the VUL - sort of kills the whole thing.

You are going to have to pay some ordinary income tax on what you take out of the retirement account - it is that simple. Paying no tax means either taking no money or taking out that which has declined substantially in value.

Avoiding taxes is easy - simply convert all of your retirement holdings into something that you are certain will go do substantially in value, then when the investment tanks liquidate the account and take out the funds, then use the funds to buy retail investments that will go back up in value - that way you pay the least amount of tax possible and get your investments into something that will throw off capital gains rather than ordinary income. Of course you're taking an extreme risk that you'll be able to recover from such a manuver - I personally wouldn't recommend this.

Depending on the particulars of your situation, you may consider converting your retirement account to a ROTH account, especially while the value of the holdings are low. You'll pay tax on the conversion value, then when the account gains ground and you draw against it in retirmeent - after the later or 5 years or age 59.5 - the money comes out tax free. Assuming of course that the new administration doesn't change the rules on us too much.

A better approach is to focus on being better off AFTER taxes, rather than trying to avoid taxes altogether.

Good luck, Gene E. Utterback, EA, RFC, ABA

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Reply to
Gene E. Utterback, EA, RFC, AB

This isn't regarding your tax scheme (which could instead increase the size of your IRA?), but I see this mentioned about inverse funds often enough that I have to comment on that piece of it...it's important to understand the embedded costs and risks of these retail inverse funds and ETFs. I don't follow either of those ETFs you mentioned, but I'd suggest researching the historical gap between the total return of the long ETF, and the total return of the inverse ETF, factoring in spreads, discounts/premiums to NAV, tracking error, and transaction costs. My guess is that holding a long and a short could bleed out a few percentage points from the position annually, if not substantially more. Research it for each fund though, I may be wrong, the answer may be different.

If an investment scheme relies on something very close to 1:-1 correspondence, you'll need to find a cost-free inverse fund, which is an impossibility. So the costs (of all types) need to be factored in and they may be better than any potential benefit. In fact on days like today when the broad market moves 10% I start pondering how it would be possible to run an inverse fund in that environment, with fund inflows/outflows to boot...it seems plausible that inverse funds and similar strategies are at least a factor in contributing to recent market volatility.

-Tad

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Reply to
Tad Borek

Not an answer to your question, but your mention of using an inverse fund in a retirement account gave me an idea.

Investors are prohibited from borrowing in retirement accounts, but they can use a leveraged ETF to circumvent this. Suppose an investor with $200K in risk capital, $100K in a taxable account and $100K in a Roth IRA, believed that he should be 100% in stocks. Assuming the stock market outperforms cash over his time horizon, I think he could increase after-tax wealth by owning a leveraged ETF with SPX beta of 2 (such as SSO, expense ratio 0.95%) in the Roth account and putting his taxable money in muni bonds, especially at a time when muni yields exceed Treasuries. At retirement he could reduce stock exposure without paying capital gains taxes. I'd have to do some simulations to become confident about this strategy. One question is whether the higher expense ratio on the leveraged ETF outweighs the tax benefit.

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Reply to
beliavsky

I looked into using leveraged funds for 1/3 of my portfolio to try and kick start returns. Most leveraged funds have 2 disadvantages for the strategies mentioned to work over time (2-7 year periods).

1) the leveraged funds are rebalanced daily and track daily performance. 2) the yearly performance of the leveraged fund and the yearly performance of the index are not correlated. For example if S&P 500 returned 7%, a 2X leveraged etf or fund does not return 14%. Highers than 7, but usually less than 14%- actually only a couple percentage points better for significantly more risk (IMO).

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Reply to
jIM

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