Journal of Personal Finance Vol 14 issue1

Volume 14 Issue 1 2015 www.journalofpersonalfinance.com

Journal of Personal Finance

Techniques, Strategies and Research for Consumers, Educators and Professional Financial Consultants

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Volume 14, Issue 1

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Journal of Personal Finance

Volume 14, Issue 1 2015 The Official Journal of the International Association of Registered Financial Consultants

Š2015, IARFC. All rights of reproduction in any form reserved.

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Journal of Personal Finance

CONTENTS

Editor’s Notes.........................................................................................................................................................................................8 Which Assets to Leave to Heirs and Related Issues................................................................................................................9 Tom L. Potts, Ph.D., CFP®, Professor of Financial Planning, Baylor University William Reichenstein, Ph.D., CFA, Powers Professor of Investment Management, Baylor University Many retirees have funds in several savings vehicles including taxable accounts, tax-deferred accounts (TDAs) like a traditional IRA, and tax-exempt accounts (TEAs) like a Roth IRA. In this study, we address several questions. For simplicity, we assume the retiree is a widow, but the same considerations apply to a widower and a retired couple. Assume the widow has funds in a tax-deferred account and a tax-exempt account. The first question is: Should she spend the money in the TDA and leave the TEA to her beneficiary child, or vice versa? The second question is: If this widow has multiple children who will inherit the remaining funds and these children have different tax rates, how can she tax-efficiently split the TDAs and TEAs to maximize the after-tax value of these accounts for her children? Third: When should the widow convert funds from the TDA to a TEA? Finally, whether the beneficiary(ies) inherit TDAs or TEAs or some combination of each, the widow should make sure she has taken the steps to ensure that they will be able to stretch distributions from the inherited IRAs over their remaining lifetime(s). Based on the work of Slott (2012), we explain what steps the widow should take now to make sure the IRAs can be stretched. In the next section, we explain how funds in TDAs are best viewed as partnerships with the government. This framework will prove useful when answering these questions.

Mitigating the Impact of Personal Income Taxes on Retirement Savings Distributions......................................17 James S. Welch, Jr., Senior Application Developer for Dynaxys, LLC. When retirement savings include a large tax-deferred account distribution, strategies for sequencing withdrawals from these accounts differ in the amount of money available for annual spending during retirement. The common practice for the scheduling of withdrawals from retirement savings accounts is to first deplete the after-tax account, then the tax-deferred and finally the Roth IRA. This paper quantitatively evaluates optimal plans that maximize spending by sequencing annual withdrawals to minimize the impact of taxes, in order to achieve a targeted final total asset value. I show that the optimal retirement savings withdrawal strategy improves on common practice by increasing the money available for retirement spending by 3% to 30%. Most of the optimal withdrawal plans evaluated in this paper make withdrawals from the tax-deferred account across the entire span of retirement in parallel with withdrawals from first the after-tax account and then the Roth IRA later in retirement.

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Exploring the Antecedents of Financial Behavior for Asians and Non-Hispanic Whites: The Role of Financial Capability and Locus of Control .............................................................................................................................28 John E. Grable, Ph.D., CFP®, Athletic Association Endowed Professor of Family and Consumer Sciences, University of Georgia So-Hyun Joo, Ph.D., Professor, Division of Consumer Studies, Ewha Womans University, South Korea Jooyung Park, Ph.D., Professor in Consumers’ Life Information, College of Human Ecology, Chungnam National University, South Korea Using data collected over a three-year time span (2008 through 2011), this paper examines the association between racial background and financial behavior. This study specifically evaluated differences between Asians and non-Hispanic Whites living in the United States (N = 341). Findings from this research suggest that any racial differences in financial behavior appear to exist only in a two variable correlational sense. Both financial capability and locus of control act as mediators between race and financial behavior. In general, those with high financial capability tend to exhibit better financial behavior. Additionally, individuals who exhibit an internal locus of control perspective also report better financial behavior. Age was also found to be positively associated with better financial behavior. When these factors were controlled for in a multivariate analysis, no meaningful racial differences were noted in this study.

The Greatest Wealth is Health: Relationships between Health and Financial Behaviors ...................................38 Barbara O’Neill, Ph.D., CFP®, CRPC, AFC, CHC, CFEd, CFCS, Extension Specialist in Financial Resource Management, Distinguished Professor, Rutgers Cooperative Extension Financial advisors are encouraged to consider their clients’ health and personal finances holistically. Strengths and challenges in one area of a client’s life often affect the other. Like culture, health status is another “lens” with which to assess clients’ values, goals, plans, personality traits, and lifestyle. This article was written to increase advisors’ understanding of relationships between health and financial practices. When advisors understand a client’s personality traits and projected state of future health, they can provide more comprehensive, targeted advice instead of giving the same advice to clients in different situations. The article begins with a review of recent literature and describes two personality factors found to be associated with positive health and financial behaviors: conscientiousness and time preference. Next, it previews a new online tool to self-assess the frequency of performance of recommended health and financial practices. It concludes with a summary and implications for financial planning practice.

Life and Death Tax Planning for Deferred Annuities ...............................................................................................48 Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, Pinnacle Advisory Group, Columbia, MD The concept of the annuity – a stream of income that will be paid for life – has been around for almost two millennia, and in the US for nearly 200 years now. Annuities became far more popular in the past century or so, though, due to both rising longevity that creates longer retirement periods which need to be funded, and significant tax preferences established in the Internal Revenue Code to incentivize the use of annuities as a vehicle for retirement accumulation (and subsequent decumulation). This article explores the tax implications of deferred annuities in detail.

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CALL FOR PAPERS JOURNAL OF PERSONAL FINANCE (www.JournalofPersonalFinance.com)

OVERVIEW The Journal of Personal Finance is seeking high quality submissions that add to the growing literature in personal finance. The editors are looking for original research that uncovers new insights—research that will have an impact on advice provided to individuals. The Journal of Personal Finance is committed to providing high quality article reviews in a single-reviewer format within 60 days of submission.

Potential topics include: • Household portfolio choice • Retirement planning and income distribution • Individual financial decision-making • Household risk management • Life cycle consumption and asset allocation • Investment research relevant to individual portfolios • Household credit use • Professional financial advice and its regulation • Behavioral factors related to financial decisions • Financial education and literacy Please check the “Submission Guidelines” on the Journal’s website (www.

JournalofPersonalFinance.com) for more details about submitting manuscripts for consideration.

CONTACT Wade Pfau and Joseph Tomlinson, Co-Editors Email: jpfeditor@gmail.com www.JournalofPersonalFinance.com

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JOURNAL OF PERSONAL FINANCE VOLUME 14, ISSUE 1 2015 Co-Editors Wade Pfau, The American College Joseph Tomlinson, Tomlinson Financial Planning, LLC

Editorial Board Benjamin F. Cummings, Ph.D., Saint Joseph’s University Dale L. Domian, Ph.D., CFA, CFP™, York University Michael S. Finke, Ph.D., CFP™, RFC® Texas Tech Joseph W. Goetz, Ph.D., University of Georgia Michael A. Guillemette, Ph.D., University of Missouri Clinton Gudmunson, Ph.D., Iowa State University Sherman Hanna, Ph.D., The Ohio State University George W. Haynes, Ph.D., Montana State University Douglas A. Hershey, Ph.D., Oklahoma State University Karen Eilers Lahey, Ph.D., The University of Akron Douglas Lamdin, Ph.D., University of Maryland Baltimore County Jean M. Lown, Ph.D., Utah State University Angela C. Lyons, Ph.D., University of Illinois Carolyn McClanahan, MD, CFP™, Life Planning Partners Yoko Mimura, Ph.D., California State University, Northridge Robert W. Moreschi, Ph.D., RFC®, Virginia Military Institute Ed Morrow, CLU, ChFC, RFC®, IARFC David Nanigian, Ph.D., The American College Barbara M. O’Neill, Ph.D., CFP™, CRPC, CHC, CFCS, AFCPE, Rutgers Rosilyn Overton, Ph.D., CFP™, RFC®, New Jersey City University Alan Sumutka, CPA, Rider University Jing Jian Xioa, Ph.D., University of Rhode Island Rui Yao, Ph.D., CFP™, University of Missouri Tansel Yilmazer, Ph.D., CFP™, The Ohio State University Yoonkyung Yuh, Ewha Womans University Seoul, Korea Mailing Address:

IARFC Journal of Personal Finance The Financial Planning Building 2507 North Verity Parkway Middletown, OH 45042-0506 Postmaster: Send address changes to IARFC, Journal of Personal Finance, The Financial Planning Building, 2507 North Verity Parkway, Middletown, OH 45042-0506 Permissions: Requests for permission to make copies or to obtain copyright permissions should be directed to the Co-Editors.

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Disclaimer: The Journal of Personal Finance is intended to present timely, accurate, and authoritative information. The editorial staff of the Journal is not engaged in providing investment, legal, accounting, financial, retirement, or other financial planning advice or service. Before implementing any recommendation presented in this Journal readers are encouraged to consult with a competent professional. While the information, data analysis methodology, and author recommendations have been reviewed through a peer evaluation process, some material presented in the Journal may be affected by changes in tax laws, court findings, or future interpretations of rules and regulations. As such, the accuracy and completeness of information, data, and opinions provided in the Journal are in no way guaranteed.

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Journal of Personal Finance

EDITORS’ NOTES

T

his issue begins with an article by Tom Potts and William Reichenstein on which assets to leave to heirs as a function of the tax status of the assets—taxable, tax-deferred, or tax free (Roth IRAs for example). This article extends earlier work by Reichenstein on which types of investments to hold in accounts with differing tax treatment. The authors describe tax-deferred accounts as akin to a partnership with the government, with the taxing authority owning a share of the account equal to the marginal tax rate. This concept can be extremely useful in promoting correct thinking about strategies for tax-deferred accounts and avoiding erroneous thinking, which is all too common.

The second article by James Welch also deals with tax management, and how to optimize the sequence of withdrawals from taxable, tax-deferred, and tax-free accounts. The common practice is to first withdraw funds from taxable accounts before tapping tax-deferred or tax free accounts. But the author demonstrates that this practice may fall short of optimal, and optimization techniques can be utilized that increase the money available for retirement spending by 3% to 30%.

We next turn to a behavioral theme where co-authors John Grable, So-Hyun Joo, and Jooyoug Park compare the financial behavior for Asians and Non-Hispanic Whites. They utilize data collected over the three-year time span 2008 through 2011 in making the comparison. They find that financial capability and locus of control (the degree to which a person feels that they personally control what happens in their life) exert the strongest influence on financial behavior, and when these variables are controlled for, there are no significant racial differences in behavior.

The next article by Barbara O’Neill encourages advisors to take a more holistic approach to planning by developing an understanding of how health status may relate to financial behavior. The study reviews recent literature and describes how two personality factors, conscientiousness and time preference, have been found to be associated with both positive health and positive financial behavior. The article also previews a new online tool to assess health and financial practices.

In the final article, Michael Kites delves into the details of annuity taxation—a subject area where important details are not well understood by many financial advisors. Non-qualified annuities are subject to a unique set of tax laws including “older” grandfathered rules that apply in certain situations and must be navigated to make good annuity decisions on behalf of clients. These considerations apply to both liquidations from contracts during life and consequences after death. Many potential problems can only be fixed while the original annuity owner is alive. Many aspects of annuity taxation rely on nonbinding private letter rulings and the way things are handled may be different for different insurance companies selling and administering the annuities. So it’s important to understand particular insurer’s policies ahead of time. In a larger context, it’s important to balance tax consequences with other non-tax aspects of annuity contracts and to develop a full understanding of the potential impact on the client and potential heirs.

As co-editors, we welcome the submission of research papers that uncover new insights in personal finance and show the potential to have an impact on the financial advice provided to individuals.

©2015, IARFC. All rights of reproduction in any form reserved.

—Wade Pfau —Joe Tomlinson

Volume 14, Issue 1

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Which Assets to Leave to Heirs and Related Issues Tom L. Potts, Ph.D., CFP速, Professor of Finance, Baylor University William Reichenstein, Ph.D., CFA, Powers Professor of Investment Management, Baylor University and principal, Retiree Income, Inc. Many retirees have funds in several savings vehicles including taxable accounts, taxdeferred accounts (TDAs) like a traditional IRA, and tax-exempt accounts (TEAs) like a Roth IRA. In this study, we address several questions. For simplicity, we assume the retiree is a widow, but the same considerations apply to a widower and a retired couple.

Assume the widow has funds in a tax-deferred account and a tax-exempt account. The first question is: Should she spend the money in the TDA and leave the TEA to her beneficiary child, or vice versa? The second question is: If this widow has multiple children who will inherit the remaining funds and these children have different tax rates, how can she tax-efficiently split the TDAs and TEAs to maximize the after-tax value of these accounts for her children? Third: When should the widow convert funds from the TDA to a TEA? Finally, whether the beneficiary(ies) inherit TDAs or TEAs or some combination of each, the widow should make sure she has taken the steps to ensure that they will be able to stretch distributions from the inherited IRAs over their remaining lifetime(s). Based on the work of Slott (2012), we explain what steps the widow should take now to make sure the IRAs can be stretched. In the next section, we explain how funds in TDAs are best viewed as partnerships with the government. This framework will prove useful when answering these questions.

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Tax-Deferred Account Viewed as Partnership In this section, we explain why a TDA is best viewed as a partnership with the government. The government effectively “owns” t of this partnership, where t is the marginal tax rate when the funds are withdrawn in retirement. We begin by examining the after-tax future value of $1 market value in, respectively, a TDA and a TEA. To hold everything else constant, the underlying investment is the same in both the TDA and TEA as is the investment horizon of n years. The underlying asset can be stocks, bonds, or cash and the investment horizon can be any length of time. For now, assume the marginal tax rate in the year of withdrawal will be tn.

The TEA begins with $1 of after-tax funds. It grows at the r percent pretax rate of return for n years. At withdrawal, its market value is (1 + r)n dollars. Assuming the funds are withdrawn after age 59½ and the account has been in existence for at least five years, the withdrawal is tax-free. So, the after-tax value is also (1 + r)n dollars.

The TDA begins with $1 of pretax funds. It grows at the r percent pretax rate of return for n years. At withdrawal, its market value is (1 + r)n dollars. Assuming the marginal tax rate in the year of withdrawal is tn, the after-tax value is (1 + r)n (1 – tn) dollars.

Regardless of the underlying investment or length of investment horizon, the TDA buys (1 – tn) as many goods and services as the same market-value investment in the TEA. Conceptually, the dollar in the TDA today can be separated into (1 – tn) of the investor’s after-tax funds plus tn, which is the government’s share of the current principal. The purchasing power of a dollar in the TDA is the same as the purchasing power of (1 – tn) dollar in a TEA. Thus, a TDA is like a partnership, where the government effectively owns tn of the partnership.

A related point is that, properly viewed, the after-tax value of the TDA grows effectively tax-free, just like funds in a TEA. For a given tax rate at withdrawal, tn, the after-tax value of the TDA grows at the pretax rate of return; that is, it grows effectively tax free. To repeat, a dollar of pretax funds in a TDA can be separated into (1- tn) dollar of the investor’s funds, while the government effectively owns the remaining tn of the TDA. From above, the after-tax value n years hence of the dollar in the TDA is (1 + r)n (1 – tn). The after-tax value of the TDA grows from (1 – tn) to (1 + r)n (1 – tn), that is, it grows at the pretax rate of return.

Industry and academic researchers uniformly agree with this risk and return sharing analogy (e.g., Dammon, Spatt, and Zhang (2004), Horan (2005, 2007a, 2007b), Horvitz and Wilcox (2003), Reichenstein (2001, 2006a, 2006b, 2007a, 2007b, 2008a, 2008b, 2008c), Reichenstein, Horan, and Jennings (2012), Reichenstein and Jennings (2003), and Wilcox, Horvitz, and DiBartolomeo (2006)). In the following sections, we use this framework to address the questions addressed in this study.

Question 1: Should a Parent Leave the TDA or TEA to a Child?

To avoid the constant use of his or her, we assume the retired parent is a widow and the child beneficiary is her son. But the conclusions are the same for a widow, widower, or married couple. For simplicity, assume the market values of the TDA and TEA are $100 each. Initially, we assume the widow will die shortly after the withdrawal and her son will withdraw and pay taxes on inherited funds this year. In a later section, we explain the benefits of allowing the beneficiary to stretch the IRAs over his lifetime. Initially, we assume the remaining funds earn a pretax return of 0%, but this is later relaxed. Withdrawals occur at the beginning of the year.

In Example 1.1, we assume the widow would pay a federal-plus-state marginal tax rate of 40% on TDA withdrawals, while her son would pay 15% on TDA withdrawals. She will spend $60 this year, which requires after-tax funds. In Strategy 1.1A, the widow withdraws $60 from the TEA to meet her spending needs, and her son inherits the rest. He inherits $40 of after-tax funds in the TEA plus $100 of pretax funds in the TDA. After paying taxes this year, his inheritance is worth $125 after taxes, [$40 TEA + $100(1- 0.15) TDA]. In Strategy 1.1B, she withdraws $100 from the TDA to meet her spending needs. Her son inherits the TEA, which is worth $100 after taxes. Clearly, Strategy 1.1A is better.

Someone is going to pay taxes on the TDA withdrawal. This account should be withdrawn by the son because of his lower marginal tax rate. In fact, the son’s $25 advantage in Strategy 1.1A compared to Strategy 1.1B is due to the taxation of the $100 TDA at 15% instead of 40%. Finally, the analogy holds whether or not required minimum distributions apply. If RMDs are required, the widow should compare the marginal tax rate she would pay on additional TDA withdrawals beyond RMDs to the marginal tax rate her beneficiary would pay on those same TDA withdrawals.

Next, let’s reverse the tax rates. Now, the widow would pay a marginal tax rate of 15% on TDA withdrawals, while her son would pay 40% on TDA withdrawals. She will spend $85 this year. In Strategy 1.2A, the widow withdraws $100 from the TDA to meet her spending needs, and her son inherits the $100 in the TEA, which is worth $100 after taxes. In Strategy 1.2B, she withdraws $85 from the TEA and her son inherits the rest. After paying taxes this year, his inheritance is worth $75, [$15 TEA + $100(1- 0.40) TDA]. Strategy 1.2A is better. In fact, the son’s $25 relative advantage in Strategy 1.2A is due to the taxation of the $100 TDA at 15% instead of 40%.

The better strategy in each case may appear obvious. But respected authorities often recommend that parents leave the TEA to their child(ren). For example, in the Wall Street Journal, Coombes (2014) writes, “A general rule is that Roth IRAs are good accounts to leave to loved ones.” In that article, one planner says, “The Roth IRA is pretty much the Cadillac of accounts for [children] to inherit.” The son would be better off inheriting $100 in a Roth TEA than $100 in a TDA, but this ignores the

©2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

spending needs of the parent(s). To return to the partnership principle, the government owns t of the TDA, where t is the marginal tax rate of the withdrawal. The objective is to minimize the embedded tax liability, which requires the lower tax rate party to withdraw funds from the TDA. Since the parent may or may not have the lower tax rate, there is no general rule as to which account to leave to the child.

The same conclusion applies if we assume the underlying investment earns a pretax return of r. In Example 1.1, the son’s ending after-tax value at the end of the year is $125(1+r) in Strategy 1.1A and $100(1+r) in Strategy 1.1B. The equivalent comparison applies in Example 1.2 and in the other examples related to Questions 1 through 3.

Question 2: If multiple children with different tax rates will inherit the funds, how should the widow allocate the remaining accounts?

For this question, assume the widow has two children, one with a marginal tax rate of 40% and the other with a marginal tax rate of 15%. Further assume that the widow wants to leave an equal after-tax amount to each child. How should she allocate the remaining funds?

In Example 2, we assume the children will inherit $100 from a TDA and $100 from a Roth TEA. She wants to leave an equal after-tax amount to each child. Her daughter has the 40% tax rate and her son has a 15% tax rate. In Strategy 2A, the widow leaves the entire $100 in the TDA and $7.50 of the TEA to the son. The after-tax value of the son’s inheritance would be $92.50, [$100(1 – 0.15) + 7.50]. The daughter would inherit the remaining $92.50 in the TEA, which is also worth $92.50 after taxes. In Strategy 2B, the widow leaves half of each account to each child. In this case, the son’s will still inherit $92.50 after taxes, [$50(1 – 0.15) + $50], but the daughter will inherit only $80 after taxes, [$50(1 – 0.40) + $50]. The combined after-tax inheritance is $12.50 more in Strategy 2A than in Strategy 2B. This $12.50 advantage is the tax savings from having the entire $100 (instead of $50) of the TDA taxed at the son’s 15% rate instead of the daughter’s 40% tax rate.

Perhaps the widow wants to leave more after-tax funds to the son, because he is less well off financially. In this case, she might leave the TDA plus $20 of the TEA to her son and the remainder to her daughter. He would inherit $105 after taxes, while the daughter would inherit $80 after taxes. This strategy would leave the daughter with the same after-tax inheritance as she would attain in Strategy 2B, but in this case the son gets the extra $12.50 in tax savings.1

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To return to the partnership principle, the government effectively owns t of the TDA. To leave the funds tax efficiently to children, parents should leave the TDA to child(ren) with lower tax rates.

This requires unequal distributions in terms of market values of accounts. For example, in Strategy 2A, the lower-tax rate son inherits $107.50 across accounts. But this strategy enhances the children’s combined after-tax inheritance – and they buy goods and services with after-tax funds.

Question 3: When does it make sense for a parent to convert funds from a TDA to a TEA? Let us return to the setting where there is a widow and her beneficiary son. As before, we assume the market values of the TDA and TEA are $100 each. We also assume for now that the widow will die shortly after the withdrawal and her son will withdraw and pay taxes on inherited funds this year.

In Example 3.1, the widow has a marginal tax rate of 40%, while the son has a marginal tax rate of 15%. She will spend $60 this year. In Strategy 3.1A, she withdraws $60 from the TEA to meet her spending needs and leaves the rest for her son; that is, she does not convert the TDA to a Roth TEA. After paying taxes this year, the son’s inheritance is worth $125 after taxes, [$40 TEA + $100(1- 0.15) TDA]. In Strategy 3.1B, she withdraws $60 from the TEA, but she also converts the TDA to a Roth TEA. She owes $40 in taxes on the converted TEA. At the end of the year, the son inherits the remaining $40 of after-tax funds from the original TEA plus $60 of funds converted to a TEA for a total of $100 after taxes. Clearly, Strategy 3.1A is better. The son’s inherits $25 more after taxes in Strategy 3.1A, and this is due to the taxation of the TDA at 15% instead of 40%.

Since she has the higher tax rate, she should not convert the TDA to a Roth TEA. To use the partnership principle, the government owns t of the TDA, where t is the marginal tax rate at withdrawal.

The objective is to minimize the embedded tax liability. In this example, the widow should not convert the TDA, so the son will pay taxes on the TDA withdrawal.

In the same Wall Street Journal article, Coombes writes, “Some say if you don’t need the money for living expenses, it may make sense to convert all or part of a traditional retirement account to a Roth simply to benefit your heirs.” Let’s examine when it makes sense for a person who does not need the fund for living expenses to convert a TDA to a TEA. In this example, we assume there are no inheritance taxes and taxes on TDA conversions are paid with funds from this TDA. 1Communicating

the rationale for unequal pretax distributions of the estate among heirs can be difficult and complicated. Different tax rates of heirs is one of several reasons that may call for unequal pretax distributions. Other reasons for unequal distributions may include special needs of one or more heirs and differences in types of assets to be inherited, where one child may inherit real estate or a family business and the other child may inherit financial assets. Equal is not always equitable. Regardless of the reason involved in unequal distributions, it is best to discuss the estate distribution and property division while the parent is alive. This allows the parent to explain the rationale for the estate distribution.

In the example in this study, it should be easy to explain that the objective is to minimize taxes and thus maximize the after-tax value going to the heirs. This requires unequal pretax distributions, but it should be easy to explain that each pretax dollar is smaller than each after-tax dollar.

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As we will show, the conversion of the TDA to a TEA would make sense if the widow has a lower tax rate than the beneficiary son. For example, if the widow would pay 15% on TDA withdrawals or conversions and the son would pay 40% then the widow should both withdraw and convert funds from the TDA. Suppose she will spend $51 this year. In Strategy 3.2A, she withdraws $60 from the TDA and converts the remaining $40 to a Roth TEA. The $60 withdrawal from the TDA would provide her after-tax spending needs of $51. Her son would inherit $134 after taxes, $100 from the original TEA plus the $34 of after-tax funds from the converted TDA after the widow paid $6 in taxes on the $40 conversion amount. In Strategy 3.2B, she withdraws $60 from the TDA to meet her spending needs, but she does not also convert the remaining $40 to a TEA. In this case, her son would inherit $124 after taxes, [$100 + $40(1 – 0.40)]. The son’s $10 advantage in Strategy 3.2A represents the tax savings by having the remaining $40 in the TDA taxed at the widow’s 15% tax rate instead of her son’s 40% tax rate. Someone will pay taxes on the TDA withdrawal. The party with the lower tax rate – in this example the widow – should pay these taxes.

That same article concludes that the conversion decision depends, at least in part, on the length of the investment horizon. Coombes writes, “Withdrawing a lot of money in the years soon after a conversion extends the length of time it takes to reach the breakeven point – or the point at which the hefty upfront tax bill you pay when you convert is outdone by the benefit of your money growing tax-free in the Roth.” She quotes a financial professional who said, “If you aren’t able to leave that [converted] money alone for at least 10 years after you convert it to a Roth, most of the time it’s just not going to work.” We will demonstrate that when taxes on TDA conversions are paid from these funds the length of the investment horizon has nothing to do with the conversion decision. Rather, the conversion decision depends only on the relative sizes of marginal tax rate in the conversion year (if the TDA is converted) versus the marginal tax rate if not converted and withdrawn later in retirement. (Later, we will show that the size of these two marginal tax rates is the key factor even if taxes on TDA withdrawals are paid with funds in a taxable account.)

Let’s compare the after-tax value of this TDA if converted this year and taxes paid at this year’s tax rate, t0, from the converted funds to its after-tax value if not converted and withdrawn after n years at which time taxes are paid at tn. To hold everything else constant, the underlying investment must be the same. Without loss of generality, assume the pretax return is r. The investment horizon, n, can be any length of time. If converted this year, the $100 in the TDA becomes $100(1 – t0) in the TEA. Its after-tax value when withdrawn n years hence is $100(1 – t0)(1+r)n. If retained in the TDA and then withdrawn n years hence, the pretax value at withdrawal is $100(1+r)n and its after-tax value is $100(1+r)n(1 – tn). Comparing the after-tax values clearly shows that the strategy to convert the TDA depends upon the comparison of the tax rate if converted this year, t0, to the tax rate if not converted but withdrawn in n years, tn. Therefore, a taxpayer – whether retired or working – should convert funds from a TDA to

a TEA this year if he has a lower marginal tax rate this year than he expects to have if not converted and withdrawn in retirement.

The length of the investment horizon does not matter. Furthermore, the underlying asset –whether stocks, bonds, or cash –does not matter. The key consideration is the marginal tax rates in the conversion year if funds are converted and withdrawal year in retirement if funds are not converted. Thus, a 20-year-old with a traditional IRA who has a low tax rate – perhaps 0% if a student – should consider converting this traditional IRA to a Roth IRA. He or she can maintain the same investment decision and still plan to withdraw funds for spending in retirement. It is simply a matter of comparing the tax rate in the conversion year to the expected tax rate in retirement.

We now show that if taxes on TDA conversions are paid from funds in a taxable account then the length of the investment horizon can matter. Suppose George has $100 in a TDA and $25 in a taxable account and the marginal tax rates this year and in the withdrawal year in retirement are 25% each. If he converts all TDA funds this year and pays taxes from the taxable account then he has $100 of after-tax funds growing tax free. In contrast, if he retains the funds in the TDA then, using the partnership principle, he effectively has $75 of his funds growing tax free, but the $25 in the taxable account grows at an after-tax rate of return. Thus, potentially there is an advantage to converting the TDA this year even if he would be in a lower tax bracket in retirement. To see how long it would take for the Roth conversion to make sense if he would be in 25% tax bracket in all years before retirement but have his tax rate fall to 15% in retirement, let’s compare the after-tax value of two strategies. In the first, he converts the TDA this year, pays taxes out of the taxable account, and the underlying investment is a bond earning 4% per year. His after-tax ending wealth is $100(1.04)n, that is, the $100 in the TEA grows tax free at 4%. If not converted but withdrawn n years hence when the tax rate is 15%, the after-tax value of the TDA plus taxable account is $100(1.04)n (1 – 0.15) + $25(1.03)n, where 3% is the after-tax return on the bond held in the taxable account since the tax rate was 25% for all years before the withdrawal year. In this example, it would take 53 years before the Roth conversion this year would make sense despite the lower tax rate in retirement.2 In short, for reasonable investment horizons, the key factor remains the relative sizes of the two marginal tax rates.

The same logic applies to parent(s) deciding whether to convert funds from a TDA to a Roth TEA when the funds are intended for the children. Suppose a widow could withdraw additional funds beyond her spending needs each year that would be taxed at 25% rate. Eventually, her son who is living in an income-tax-free state would inherit these funds, which at the margin would be taxed at the 33% federal rate. Obama’s 2015 budget calls for forcing inherited IRAs to be distributed within five years (with some exceptions). Therefore, if this feature is enacted, this son may be in a 15% tax bracket in most years, but since he would be forced to withdraw $1 million in inherited TDAs within five years after his mother’s death then he would be in the 33% federal tax bracket 2The

breakeven period would be even longer if the underlying asset was stock that was taxed at the 15% preferential tax rate.

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Volume 14, Issue 1

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during these five years. In this case, the widow should convert funds beyond her spending needs each year as long as they would be taxed at a lower marginal tax rate than her son would pay. In this example, the widow may be able to convert say $25,000 each year for decades without having the converted funds cause her income to rise above the top of the 25% tax bracket. In this case, the son’s marginal tax rate when he withdraws the funds after his mother’s death may not exceed 25%.3 In the next section, we show how a parent can set up an IRA – whether traditional IRA or Roth IRA – so that the beneficiary can stretch withdrawals over his or her life expectancy.

Stretching the IRA In the prior three sections, we generally assumed the funds would be withdrawn and taxes paid this year by the beneficiary. In this section, we relax this assumption and show the importance of allowing the beneficiary to stretch withdrawals of the inherited TDA or TEA over the beneficiary’s life expectancy. We rely on the work of Ed Slott (2012) to explain the steps a person must take to ensure that a beneficiary (as long as the beneficiary is a person and not, say, the parent’s estate) can stretch distributions over his or her life expectancy.

For simplicity, but without loss of generality, assume the widow has $1 million in her traditional IRA and she wants to leave it to her son. She should name her son the primary beneficiary on the IRA. This makes him a designated beneficiary. As such, he can inherit the IRA and withdraw the funds over his life expectancy. For example, if his mother (the widow) died in 2014 after taking that year’s RMD then in 2015 he would have to take his first RMD. To determine the size of his 2015 RMD let’s assume he turned 40 that year. The life expectancy from the Single Life Expectancy Table (for inherited IRAs) is 43.6.

Thus in 2015, the son’s RMD would be the December 31, 2014 closing balance divided by 43.6. His RMD for 2016 would be the December 31, 2015 closing balance divided by 42.6, one less than the prior year’s life expectancy. His RMD for 2017 would be the December 31, 2016 closing balance divided by 41.6, and so on. In 2058, he would have to withdraw the remaining funds.

In short, by naming a designated beneficiary, the IRA could be withdrawn over a 44 year period. The RMDs are precisely that – required minimum distributions. If the son wanted to withdraw a larger amount in any year then he could. Assuming the TDA’s December 31, 2014 closing balance was $1 million, the son’s RMD would be $22,936, [$1,000,000/43.6]. A series of such withdrawals would not likely cause his marginal tax rate to rise substantially.

3 Coombes (2014b) discusses the implications if inherited IRAs must be withdrawn within five years after inheritance, that is, if there is no stretch IRA. Ed Slott is quoted as saying, “If there’s no stretch IRA, it doesn’t pay for an older person to pay to convert a Roth. Why should someone 60, 70 years old, who’s mainly doing it for their beneficiaries, pay a tax when the deferral rate after they die is limited to five years?” Our example answers his question. In our opinion, Mr. Slott’s advice is best when it comes to stretching an IRA and related themes, but his opinion on investment horizon is demonstrably wrong. The investment horizon is not a critical factor in the conversion decision. Rather, the conversion decision should be based on the comparison between the marginal tax rate in the conversion year and the marginal tax rate if not converted but withdrawn later.

In contrast, suppose the widow named her estate as the beneficiary and the son ultimately was named the beneficiary of the TDA. Since the estate was the first-named beneficiary in the TDA, the son would be a beneficiary, but not a designated beneficiary. Since the estate has no life expectancy, the son would have to withdraw the funds in the first five years, that is, from 2015 through 2019. If he withdraws $200,000 from the TDA in 2015, this additional income would likely cause his marginal tax rate to jump substantially and it may also trigger a higher tax via the Alternative Minimum Tax . Worse yet, if he fails to withdraw anything from 2015 through 2018 then his RMD for 2019 would be the entire TDA balance. Even worse, if he failed to withdraw all funds then he would face 50% penalty tax on the remaining balance since the remaining balance would be the amount by which his distribution failed to match his RMD for that year. In this case, his marginal tax rate would likely jump dramatically. The net result is that the government would get a lot larger chunk of the TDA withdrawals. Using the partnership principle, the government would effectively own a lot larger portion of the TDA, while the son would effectively own a lot smaller portion of this TDA. Let’s return to the widow and her son. But now assume the widow also named a contingent beneficiary, the son’s daughter. In 2015, the son would be 40 and his daughter would be 17. If the son does not need part or all of the $1 million IRA then he could disclaim part or all of it, in which case the daughter would inherit the disclaimed IRA. According to the Single Life Expectancy Table, her life expectancy is 66 years. So, she could enjoy 66 years of tax-deferred growth.

In summary, if the widow does not name a primary beneficiary (or records of her beneficiary choices are not found or the named beneficiary predeceases the widow) then her son would have to withdraw all funds within five years. By naming her son as primary beneficiary, her son could enjoy up to 44 years of tax-deferred growth. If the widow named her son the primary beneficiary and her granddaughter contingent beneficiary then, if the son disclaims the IRA, her granddaughter could enjoy up to 66 years of tax-deferred growth. Finally, suppose the widow had $1 million in a Roth IRA at her death instead of an IRA. In this case, the son or granddaughter would enjoy up to 5, 44, or 66 years of tax-free growth depending upon beneficiary designation in the Roth IRA. The ability to grow funds tax-deferred or tax-free for long periods is, indeed, a valuable option.

There are numerous exceptions to RMD rules affecting tax-deferred accounts including traditional IRAs and other TDAs and tax-exempt accounts like the Roth IRA and Roth 401(k). For an excellent discussion of these rules, we recommend Ed Slott (2012). He is the master of IRAs.

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Conclusion Many retirees have funds in several savings vehicles including tax-deferred accounts (TDA) like a traditional IRA and tax-exempt accounts (TEA) like a Roth IRA. This article addressed several key questions: 1) how funds in TDAs and TEAs should be allocated between a parent and beneficiary child when they are subject to different marginal tax rates, 2) how the parent should bequeath funds in TDAs and TEAs between beneficiaries who are subject to different tax rates, and 3) whether a parent should convert funds from TDA to Roth IRA if these funds are not needed to support the parent’s retirement spending. A key concept is that a TDA is best viewed as a partnership. The government effectively “owns” t of this partnership, where t is the marginal tax rate when the funds are withdrawn. In each case, the objective is to minimize t, to government’s share of the TDA partnership. If required minimum distributions exist then t refers to the marginal tax rate on withdrawals from TDAs or conversions from TDAs beyond the RMD. Someone will pay taxes on withdrawals or conversions from the TDA. These withdrawals or conversions should be saved for the taxpayer with the lower tax rate. For example, if a widow is

subject to a lower marginal tax rate than her beneficiary son then she should withdraw funds from the TDA and save the TEA for her son, and vice versa. Similarly, a parent could bequeath the TDA to the beneficiary with the lower marginal tax rate, while bequeathing the TEA to the beneficiary with the higher tax rate.

Finally, the parent should compare his or her marginal tax rate to the beneficiary’s and convert funds from TDA to Roth IRA as long as the parent’s marginal tax rate is below the beneficiary’s tax rate when he withdraws these inherited funds.

One implication for financial and tax professionals is that they can add value to client accounts by helping them maximize the after-tax value of the combined TDA and TEA accounts. Stated differently, these professionals can add value to client accounts by helping the client minimize the portion of his or her TDAs taken by the government in the form of taxes. Even if financial markets are strongly efficient, professional can still add value to client account by helping them arrange their financial affairs to take advantage of the tax code. A second implication is that clients may need assistance with communication strategies for heirs about asset distributions that seem “unfair” on the surface until tax implications are considered.

Example 1.1: Comparing After-Tax Values of Withdrawals Strategy 1.1A

Person Widow Son

TEA $60 $40

TDA $0 $100(1-.15)

Total $60 $125

1.1B

Widow Son

$0 $100

$100(1-.40) $0

$60 $100

Market values of tax-exempt account (TEA) and tax-deferred account (TDA) are $100 each. Marginal tax rates are 40% for widow and 15% for son.

Example 1.2: Comparing After-Tax Values of Withdrawals Strategy 1.2A

Person Widow Son

TEA $0 $100

TDA $100(1-.15) $0

Total $85 $100

1.2B

Widow Son

$85 $15

$0 $100(1-.40)

$85 $75

Market values of tax-exempt account (TEA) and tax-deferred account (TDA) are $100 each. Marginal tax rates are 15% for widow and 40% for son.

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Example 2: After-Tax Values of Inheritances Strategy 2A

Person Son Daughter

TEA $7.50 $92.50

TDA $100(1-.15) $0

Total $92.50 $92.50

2B

Son Daughter

$50 $50

$50(1-.15) $50(1-.40)

$92.50 $80

Market values of tax-exempt account (TEA) and tax-deferred account (TDA) are $100 each. Marginal tax rates are 15% for son and 40% for daughter.

Example 3.1: After-Tax Values Strategy 3.1A

Person Widow Son

TEA $60 $40

TDA $0 $100(1-.15)

Total $60 $125

3.1B

Widow Son

$60 $40

$100(1-.40) $0

$60 $100*

Market values of tax-exempt account (TEA) and tax-deferred account (TDA) are $100 each. Marginal tax rates are 40% for widow and 15% for son. *In Strategy 3.1B, the son gets $40 after taxes from TEA withdrawal and he inherits $60 of after-tax funds from his mother’s (a.k.a., the widow’s) TDA conversion for a total of $100 after taxes.

Example 3.2: After-Tax Values Strategy 3.2A

Person Widow Son

TEA $0 $100

TDA $100(1-.15) $0

Total $51 $134*

Widow

$0

$60(1-.15)

$51

Son

$100

$40(1-.40)

$124

Market values of tax-exempt account (TEA) and tax-deferred account (TDA) are $100 each. Marginal tax rates are 15% for widow and 40% for son. *The son gets $100 after taxes from TEA withdrawal and $34 inheritance from his mother; his mother (a.k.a., the widow) withdraws $100 from the TDA, which provides $85 after-taxes. She spends $51 and her son inherits $34.

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References Coombes, Andrea. 2014. “The Most Valuable Assets to Leave to Your Heirs, Wall Street Journal, June 3, p. R5.

Coombes, Andrea. 2014b. “Beware Leaving a Roth for Heirs,” Wall Street Journal, September 7, http://online.wsj.com/articles/should-i-leave-aroth-to-my-heirs-1410120116.

Dammon, Robert M., Chester S. Spatt, and Harold H. Zhang. 2004. “Optimal Asset Location and Allocation with Taxable and TaxDeferred Investing.”

Journal of Finance, vol. 59, no. 3 (June): 999–1037.

Horan, Stephen M., 2005, Tax-Advantaged Savings Accounts and Tax-Efficient Wealth Accumulation, Research Foundation of CFA Institute, 2005.

Horan, Stephen M. 2007a. “An Alternative Approach to After-Tax Valuation,” Financial Services Review, vol. 16, no. 3: (Fall) 167-182.

Horan, Stephen M., 2007b, “Applying After-Tax Asset Allocation,” Journal of Wealth Management, 10(2) (Fall): 84–93.

Reichenstein, William. 2007a. “Implications of Principal, Risk, and Returns Sharing Across Savings Vehicles.” Financial Services Review, vol. 16, no. 1 (Spring): 1–17.

Reichenstein, William. 2007b. “Calculating After-tax Asset Allocation is Key to Determining Risk, Returns, and Asset Location,” Journal of Financial Planning, July: 66-77.

Reichenstein, William. 2008a. In the Presence of Taxes: Applications of After-tax Asset Valuations. FPA Press.

Reichenstein, William. 2008b. “One Concept and Some of its Applications,” Journal of Wealth Management, Winter, vol. 11, no. 3: 82-91.

Reichenstein, William. 2008c. “How to Calculate an After-tax Asset Allocation,” Journal of Financial Planning, vol. 21, no. 8, August: 62-69.

Horvitz, Jeffrey E. and Jarrod W. Wilcox. 2003. “Know When to Hold ‘Em and When to Fold ‘Em: The Value of Effective Taxable Investment Management.” Journal of Wealth Management, vol. 6, no. 2 (Fall): 35–59.

Reichenstein, William, Stephen M. Horan , and William W. Jennings. 2012.

“Two Key Concepts for Wealth Management and Beyond,” Financial Analysts Journal, vol. 68, no. 1, January/February: 14-22.

Reichenstein, William. 2001. “Asset Allocation and Asset Location Decisions Revisited.” Journal of Wealth Management, vol. 4, no. 1 (Summer): 16–26.

Reichenstein, William and William W. Jennings. 2003. Integrating Investments and the Tax Code. John Wiley & Sons, Inc. New York, NY.

Reichenstein, William. 2006a. “After-tax Asset Allocation.” Financial Analysts Journal, vol. 62, no. 4 (July/August): 16–26.

Reichenstein, William. 2006b. “Withdrawal Strategies to Make Your Nest Egg Last Longer.” AAII Journal, vol. 28, no. 10, (November): 5-11.

Slott, Ed. 2012. The Retirement Savings Time Bomb … and How to Defuse It, Penguin Books, NY, NY. Wilcox, Jarrod, Jeffrey E. Horvitz, and Dan diBartolomeo. 2006. Investment Management for Private Taxable Investors. Charlottesville, VA: Research Foundation of CFA Institute.

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Volume 14, Issue 1

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Mitigating the Impact of Personal Income Taxes on Retirement Savings Distributions James S. Welch, Jr. James S. Welch, Jr. has been implementing Mathematical Programming Systems since 1964. His particular interests are in matrix description languages, high performance optimizers and pre solving models prior to optimization in order to speed the solution process. Mr. Welch is currently a Senior Application Developer for Dynaxys, LLC. Abstract When retirement savings include a large tax-deferred account distribution strategies for sequencing withdrawals from these accounts differ in the amount of money available for annual spending during retirement. The common practice for the scheduling of withdrawals from retirement savings accounts is to first deplete the after-tax account, then the tax-deferred and finally the Roth IRA. This paper quantitatively evaluates optimal plans that maximize spending by sequencing annual withdrawals to minimize the impact of taxes in order to achieve a targeted final total asset value. We show that the optimal retirement savings withdrawal strategy improves on common practice by increasing the money available for retirement spending by 3% to 30%. Most of the optimal withdrawal plans evaluated in this paper make withdrawals from the tax-deferred account across the entire span of retirement in parallel with withdrawals from first the after-tax account and then the Roth IRA later in retirement.

Keywords: retirement planning, withdrawal strategy, Roth IRA, tax-deferred savings, linear programming, optimal distribution plan, retirement spending.

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Mitigating the Impact of Personal Income Taxes on Retirement Savings Distributions Many retirees have multiple types of retirement savings accounts with different distribution characteristics1. These retirees seek a strategy for the annual withdrawal of funds from their savings in a way that will maximize spending2, not exhaust savings prematurely, and not leave a large surplus.

The answer to a problem depends on how we phrase the question.

In retirement planning the question is usually along the lines of “Given my living expenses when will my savings run out?” The answer comes in the form of which year the savings are exhausted. This idea is extended to the Monte Carlo method which computes the probability of plan failure due to asset volatility.

Professor William F. Sharpe [2013] succinctly defines the problem in his blog: It seems to me that first principles dictate that any rule for spending out of a retirement account should at the very least adhere to the following principle: The amount you spend should depend on 1. How much money you have, and 2. How long you are likely to need it In other words, given my assets, my estimated life expectancy and my desire to spend all my savings, leaving some predefined final total account balance (FTAB) what is the maximum amount of money that I will have to spend each year, after taxes?

This paper addresses retirement planning from the perspective of maximizing spending.

Figure 1 presents an overview of the retirement financial model.

The process is the storing and distribution of funds over the term of retirement (time dynamic) [Hirshfeld 1969]. The boxes inventory money which increases in value each year (circular arrows) according to a rate of return (ROR). The top three boxes are liquid savings accounts from which any amount of money can be withdrawn for spending, taxes or to fund the estate (FTAB).

• Money flows from the Roth IRA to spending or the estate.

• Money flows from the tax-deferred account (IRA)3 to the Roth IRA or the after-tax account, as well as spending, taxes or the estate.

• Money flows from the after-tax account to spending or the estate.

• Illiquid assets can only be sold as a complete entity and the sale proceeds, after taxes are deducted, are transferred to the after-tax account to be distributed later.

• Social Security benefits and pensions are other sources of funds that are not part of savings but contribute to spending, taxes, or the estate.

From the perspective of how they are taxed, these accounts are four entirely different entities.

We omit Social Security benefits and Illiquid Assets from this study because we want to concentrate on the impact of personal income taxes generated by tax-deferred account distributions on spending.

Distribution strategies for sequencing withdrawals from retirement savings accounts differ in the amount of money they produce for spending during retirement because of income taxes on tax-deferred account distributions.

There are two issues in devising a strategy for making annual withdrawals: 1. The order in which accounts are selected for withdrawal affects the amount of money available for spending.

2. The amount to be withdrawn each year affects the FTAB.

1Appendix

Figure 1: Overview of Retirement Planning

A is a glossary providing the narrow definition of terms used in this paper.

2 Spending is the money available for annual personal consumption. We find that real spending is a more useful retirement plan metric than either “age at which the money runs out” or “plan’s nominal ending balance”.

3 We use the term IRA to represent all tax-deferred accounts.

(See Appendix A)

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Volume 14, Issue 1

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Issue 1 – Order of Withdrawal

Discussion

The order of annual withdrawal affects spending because spending is reduced by personal income taxes paid on tax-deferred account withdrawals. Under the Federal progressive income tax a large IRA distribution is taxed at a higher rate than several small distributions made in different years. There are no taxes on distributions from the other accounts.

Regarding optimization, this paper describes how linear programming is used to maximize spending throughout retirement while leaving a specified balance in retirement savings; i.e. no plan failure and no large surplus. The result is an efficient retirement savings withdrawal plan that provides a steady stream of inflation adjusted money over the term of retirement.

The common practice is to withdraw savings from retirement accounts in this order:

Linear Programming (LP) is an operations research tool that has been a successful computer application since the 1950’s [Orchard-Hays 1984]. An LP model is solved by commercial computer software that accepts a model consisting of a set of activities that can be done within constraints on those activities. From the large universe of model solutions the LP optimizer computes one that has some maximum economic value. The objective of an LP model is to optimize an economic value that, in this paper, is the retirement planning value of spending. LP mathematically guarantees that there is no better solution than the one computed [Danzig 1963]. The optimizer reports the economic value of the model and the activities that contribute to the solution.

1. The after-tax account until it is depleted, 2. The IRA until it is depleted, and 3. The Roth IRA account to the end of the plan.

Issue 2 – Amount of Withdrawal The size of annual distributions determines the plan’s final deficit or surplus. Too large of an annual distribution will cause savings to be exhausted before the end of the plan; a great concern to many retirees. A surplus is not of such great concern but an excessive surplus means that the retiree may have practiced unnecessary self-denial while seeking insurance from the deficit threat.

The common practice is to estimate retirement spending through analysis of pre-retirement spending and retirement budget planning. Using this estimate a retirement calculator may be used to determine the plan’s deficit or surplus. A variation of this approach is to utilize a Monte Carlo method calculator to estimate the probability of plan failure, i.e. running out of money before the plan end.

A Unified Approach We compare results from two computer programs that have a unified approach to these two issues:

This paper demonstrates scenarios in which linear programming is used to compute withdrawal plans that increase spending in the range of 3% to 30% as compared to common practice.

A common criticism of simulators and optimizers is that they do not reflect the market volatility of asset values and returns. We argue that active, capital preservation portfolio management can dampen the adverse effects of market volatility so that, when combined with a long planning horizon of 25 years or more the fixed return assumption is valid for planning purposes. Given this assumption, we compare the efficiency of two methods of retirement income planning while ignoring the question of longevity (defined as the chance of exhausting savings before the end of the planning horizon), as is commonly measured with the Monte Carlo method. We assume market volatility and associated risks would impact both methods similarly.

1. A simulator that implements the common practice for Issue 1 (fixed order of withdrawal) and computes maximum savings withdrawal amounts and thus maximum spending (Issue 2).

In this paper we seek to establish the credibility of the two computer programs, measure the differences between the two approaches for various scenarios, and discuss the dynamics of their resultant withdrawal plans.

2. A linear programming optimizer that maximizes spending by computing both the optimal account withdrawal order and the withdrawal amount.

Literature Review

Both programs report a schedule of annual withdrawals; the withdrawal plan.

The fundamental difference between these two programs is that the order of account withdrawal is defined in the simulator whereas the optimizer computes the optimal account withdrawal sequence.

The common practice is based on published, quantitative studies.

Raabe and Toolson [2002] showed that the common practice of withdrawing from retirement savings is more efficient than any other permutation of sequential account distribution strategies.

Their approach recognized the interaction between the IRA and the after-tax account.

Saftner and Fink [2004] compared the results of retirement savings that are exclusively in one of the three accounts. Their results showed that saving in a Roth IRA and an IRA will result in the same plan value (spending plus the FTAB). They showed

Journal of Personal Finance

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that the after-tax account is less efficient than the other two accounts because of the reduced compounding that results from after-tax account income being taxed as it is incurred. Horan [2006] studied the question of whether to withdraw from the IRA or the Roth IRA first. He compared two “naïve” models, 1) Withdraw from the IRA first and the Roth IRA second; 2) vice versa, to his “informed” method. He concluded that withdrawing from both accounts in parallel is the most efficient strategy. He distributed from the IRA until it reached the top of the current tax bracket and then satisfied any remaining spending requirements from the Roth IRA. We know of two published papers describing LP models that compute optimal retirement savings withdrawal plans.

Ragsdale, Seila and Little [1993] demonstrated that their LP optimal withdrawal plan is superior to two heuristic withdrawal methods. Withdrawals are made from two tax-deferred accounts with differing rates of return. Their model fixed the withdrawal rate and maximized generated plan surplus. They computed personal income taxes on withdrawals, met the Required Minimum Distribution (RMD), minimized the Excess Distribution Penalty (no longer a feature in the tax code), and minimized estate taxes.

They modeled two IRAs with different RORs and concluded that distributing the lower performing account first is optimal.

Coopersmith and Sumutka [2011] compared the results of their Tax Efficient (TE) linear programming model to their common rule. Their model computed personal income taxes on tax-deferred withdrawals plus Social Security benefits, satisfied the RMD and minimized estate taxes. TE showed improvement over common practice for situations where

The Experiment Our experiment is to compare the common practice retirement plans to optimized plans. There are three elements of the experiment; the modeling software, the situation being modeled, and the scenarios for obtaining the computational results.

The Software We used two computer programs: 1. The Common Practice Simulator (CPS) is an Excel spreadsheet that we use to simulate the common practice for scheduling account withdrawals and compute maximum withdrawals.

2. The Optimal Retirement Planner (ORP) is the linear programming system that we used to compute the optimal plans for this study.4 CPS is based on a generally recognized heuristic but with its direction reversed, i.e. set the FTAB to zero and maximize withdrawals. ORP maximizes spending for a zero FTAB in a manner that directly compares to CPS. The two programs use the same parameter set and compute to the same objective: maximum spending. The computed plan is measured by spending at age 66 in today’s dollars. Spending for subsequent years is this amount adjusted for inflation; i.e. the anuitization of spending. Both programs model the Federal progressive income tax and the RMD using 2014 IRS tables.

•

he after-tax account ROR is greater than the taxT deferred ROR.

Given a set of parameters both programs’ objective is to compute the maximum spending level that will leave a zero balance in the FTAB.

•

I nitial after-tax account savings are greater than 10 percent of total retirement savings.

The Situation

•

I temized deductions are greater than the standard deduction.

The situation being modeled is a single, 66 year old retiree with $1,000,000 in retirement savings and a planning horizon of 29 years (to age 95). The FTAB is zero, i.e. there will be no estate.

We extend this prior work by: •

Holding the FTAB constant and maximizing spending,

•

Modeling all three accounts and their interaction,

•

Relaxing TE’s restrictions,

•

Implementing IRA to Roth IRA conversions.

•

ssigning a single ROR to all accounts to concentrate A on the effects of taxes on the retirement plan.

All three retirement savings accounts assume the same ROR. The purpose of this study is to demonstrate the impact of personal income taxes on the optimal withdrawal plan without the need to address the confounding impact of different RORs for the three accounts. [Coppersmith and Sumutka 2011].

Annual inflation is assumed to be 2.5%.

4

The CPS spreadsheet is available on request. ORP may be found at www.i-orp.com.

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Computational Results The experiment was to run the two programs with the parameter set described above, for different scenarios, and compare their results.

Rates of Return In the ROR scenarios one million dollars of retirement savings are distributed across all three accounts. The IRA contains $400,000, the Roth IRA $350,000 and the after-tax account $250,000. These proportions were chosen by computing accumulation phase savings for a 30 year old who allocates 1/3 of her annual retirement savings to each of the three accounts. The accumulated asset totals were evaluated at age 66. The initial Roth IRA account balance is lower than the IRA because of income taxes deducted from the Roth IRA contributions. The initial after-tax account balance is even lower due to income taxes deducted from contributions and because the 15% capital gains tax paid on annual investment returns reduces compounding [Saftner and Fink, 2004].

The scenarios compare CPS and ORP spending for a range of RORs. Recall that for the purpose of comparison, RORs are considered average rates and the volatility of the RORs would impact both methods similarly.

ROR selection is one of the important discretionary choices that the retiree has to make. A low ROR indicates a willingness to sacrifice return to achieve low portfolio volatility. A high ROR indicates a desire to achieve greater return by tolerating a higher level of volatility. Since these models are deterministic, not probabilistic, their results are more realistic for low RORs. ROR scenario summary. Table 1 compares spending in today’s dollars, for plans computed by CPS and ORP, using a range of RORs.

Spending - $000 ROR % 0.5 1 2 3 4 5 6 7 8 9 10 15

Efficiency

CPS

ORP

%

22 24 28 33 38 43 49 54 60 66 72 104

25 27 31 35 40 45 51 56 62 68 75 107

13.6 12.5 10.7 6.1 5.3 4.7 4.1 3.7 3.3 3.0 4.2 3.0

Table 1: Comparison of CPS to ORP

Column ROR % contains the rate of return parameter that was varied for the results in Table 1.

The Spending columns show each program’s maximum spending. A year’s withdrawals can come from of any combination of accounts, their sum minus taxes will equal spending for that year.

The Efficiency column quantifies the advantage of the ORP withdrawal plan over CPS. We define efficiency to be the spending difference as a percentage of CPS spending at age 66: Efficiency = (ORP spending – CPS spending)/CPS spending The Efficiency column indicates that as the RORs grow the advantage of optimization over common practice diminishes. As discussed earlier, small RORs indicate less volatile assets and the constant ROR assumption is more credible. Thus ORP spending improvement is more relevant to conservatively invested accounts. ORP’s improved spending partially compensates for reduced returns on lower risk savings.

The 5% ROR plan. This section explores how ORP and CPS determined the spending levels for the 5% ROR scenario.

Withdrawal plan. Withdrawal scheduling is selecting one or more accounts and determining the amount to withdraw each year.

CPS account selection is defined as part of the algorithm. ORP computes the account and the amount for each year’s withdrawal.

Figure 2 shows the distribution plans reported by CPS and ORP for 5% ROR.

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Journal of Personal Finance

Figure 2. Annual Distributions by Account, 5% ROR Scenario Figure 3. Savings Account Balances, 5% ROR Scenario

Panel A of Figure 2 shows CPS withdrawals for each year of the 5% ROR scenario. The after-tax account distributes until age 70, when the RMD forces the first IRA distribution. The IRA makes distributions until it is depleted at age 82 when the Roth IRA takes over. IRA withdrawals overlap withdrawals from the other accounts only at the boundaries. The IRA withdrawals are elevated above the other two lines because of extra money withdrawn to pay taxes.

Panel B is the ORP withdrawal plan. The after-tax account and the IRA make parallel distributions until age 70 when the RMD begins. Then IRA distributions are just large enough to push taxable income to the top of the 0-no tax bracket (See Figure 4). The RMD increases the IRA distributions and reduces the after-tax distributions. After the after-tax account is depleted the IRA and Roth IRA make parallel distributions. IRA distributions are maintained at a level sufficient to hold taxable income at the top of the 10% tax bracket while the Roth IRA satisfies remaining spending requirements Savings account balances. Figure 3 shows the account balances over time under the distribution plans shown in Figure 2.

In Panel A the annual asset balances are falling in tandem as expected for the common practice. In both panels the IRA and Roth

IRA continue to accumulate as the after-tax account declines.

In Panel B after ORP depletes the after-tax account the IRA and the Roth IRA decline in parallel.

Income taxes. Figure 4 shows how real (de-inflated) IRA distributions are allocated across the Federal income tax brackets.5 Each vertical bar represents income subject to taxes. Each bar is segmented into parts according to the tax bracket that the income falls into. For example, in Panel A, the age 72 bar shows income divided into the No Tax, 10% and 15% brackets. The No Tax bracket includes the standard deduction, one personal exemption, and the allowance for being over 65.

Panel A shows the CPS income tax brackets. When there are no IRA distributions there is no income to be taxed. During IRA distributions, CPS taxable income climbs into the 15% tax bracket. Panel B shows ORP income tax brackets. After the after-tax account is depleted IRA distributions fill up the 10% bracket (See Figure 2). This process is being driven by the annualitization of spending and the zero FTAB requirement.

5

Both models were run with 2.5% inflation then the tax reports were “de-inflated”.

Figure 4. Real Income Tax Brackets, 5% ROR ©2015, IARFC. All rights of reproduction in any form reserved.

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CPS is paying all of its taxes early in the plan while ORP spreads taxes across the plan at an overall lower level.

Table 2 shows the total taxes paid in both nominal (Inflated) dollars and real (de-inflated) dollars for the 5% ROR scenario.

System ORP CPS Difference

Taxes - $000 Nominal 33 64 31

Real 21 50 29

It is well to remember at this point that each optimal solution is the best available for the given circumstances.

Account Size

Table 2: Total Taxes Paid, 5% ROR

The differences between the program’s taxes are not consistent with ORP’s $2,000 spending advantage reported in Table 1. Compared to each other the differences are dramatic. But $29,000 spread over a retirement of 29 years leaves $1,000 of spending unaccounted for. We conjecture that the timing of tax payments is as important as the magnitude of tax differences. CPS pays more taxes early in the plan which reduces IRA compounding and thus reduces spending.

Account allocation. An interesting question is “How much do these results depend on the initial allocation of funds in the savings accounts?”

Table 3 summarizes the difference between CPS and ORP for a selection of starting account allocations using a 5% ROR. The first column shows the percentage of the one million in savings allocated to each account. The first row is the 5% ROR scenario from Table 1.

Allocation

The five scenarios with no Roth IRA balance show efficiencies that are significantly larger than the rest of the results. ORP takes full advantage of the strategy of distributing the IRA and after-tax accounts in parallel to the end of the plan as in the 40/00/60 scenario or depleting the after-tax account near the end of the plan as in the 60/00/40 scenario. When there is a Roth IRA balance present then ORP distributes the IRA in parallel with the other two accounts but depleting the after-tax account before beginning Roth IRA distributions, similar to the common practice.

Spending - $000

Efficiency

IRA/ROTH/AT

CPS

ORP

%

40/35/25 00/50/50 30/50/20

43 45 45

45 45 46

4.7 0.0 2.2

50/50/00

44

45

2.3

50/30/20 30/00/70 40/00/60 50/00/50 60/00/40 70/00/30 80/10/10 90/10/00 90/00/10 100/0/00

44 33 33 34 36 38 43 42 42 42

45 43 43 43 43 43 43 42 42 42

2.3 30.3 30.3 26.5 19.4 13.2 0.0 0.0 0.0 0.0

Table 3: A Sampling of Initial Account Balances, 5% ROR

Table 4 summarizes spending and efficiency for retirement accounts of different sizes using the 5% ROR scenario. The first column shows the dollar amount of the total portfolio, distributed across the three accounts in the same proportions as the ROR scenarios.

Beginning

Spending - $000

Balance 1 Million 2 Million 3 Million 4 Million 5 Million

CPS

ORP

43 83 123 163 201

45 89 131 172 214

Efficiency % 4.7 7.2 6.5 5.5 6.5

Table 4: Different Initial Account Balances, 5% ROR ORP’s efficiency is not sensitive to the amount of retirement savings.

IRA to Roth IRA Conversions Discussion From Table 1 Low IRA initial balance provides low levels of taxes to work with.

Parallel IRA and Roth IRA distributions at top of 15% bracket until IRA is depleted at age 86.

Large IRA , Roth IRA, and after-tax balances

No Roth IRA. From age 70 (RMD start) ORP distributes from after-tax and IRA in parallel.

High IRA balances with low after-tax balances means that small parallel distributions have little effect.

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All of the results reported thus far were produced with no IRA to Roth IRA conversions (conversions). The experiments were repeated with conversions allowed.

For every pair of scenarios the total amount of nominal spending increased by less than $1,000. The withdrawal plans differed but the end results were the same.

For example, the results of both of the two 5% ROR, IRA only, scenarios (bottom row of Table 3) show a spending level of $60,000 and a total plan value of $2,629,000. Any improvement due to Roth conversions was lost in rounding error. Hardly worth the extra paper work!

An exception was that the zero Roth IRA scenarios in Table 3 showed a $1,000 spending increase when conversions were allowed.

Figure 5 compares real IRA withdrawals, distributed across the Federal tax brackets, for the two 5% ROR scenarios, one with no Roth conversions, the other with conversions allowed.

Early in the no conversion scenario IRA distributions are at the top of the 0-no tax bracket. The after-tax account supplements the IRA to meet spending requirements.

In the conversions panel IRA withdrawals for conversions are at the top of the 10% bracket while the after-tax account contributes to spending. Late in the plan IRA distributions drop back to the top of the 0-no tax bracket as the Roth IRA supplements spending.

Less total nominal tax was paid ($21,000 over the entire plan) when conversions were permitted then when not ($33,000) even though annual spending was the same. Similar to the Figure 4 discussion we conclude that this is because the reduction in the IRA balance early in retirement meant lower IRA compounding of returns throughout retirement. The compounding loss was offset by the reduction in taxes paid.

Roth conversions may be preferred when factors other than economics are taken into account; e.g. the anticipation of an increase in Federal income tax rates or the desire to leave a substantial estate in a tax free account. Also, the retiree must assess the effect of income on Medicare premiums, given that Roth conversions affect annual incomes in each of the income dependent Medicare premium categories.

Model Validation Before accepting these results we need some assurance that they are valid. We validate our programs by comparing CPS and ORP results for degenerate scenarios and comparing ORP results to other, independent models of similar purpose.

Degenerate Scenarios Our degenerate scenario tests are based on a model with the full $1,000,000 in only one account and with nothing in the other two accounts. Since there is only one active account there is no interaction between accounts and the spending values computed

by CPS and ORP should be the same.

Table 5 compares CPS and ORP spending for the degenerate scenarios.

Active Account After-tax Roth IRA IRA

Spending - $000 CPS ORP 42 42 46 46 42 42

Table 5: Degenerate Scenario Comparisons, 5% ROR

Figure 5: Nominal Tax Brackets for IRA to Roth IRA Conversion Scenarios, 5% ROR Š2015, IARFC. All rights of reproduction in any form reserved.

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Considering how different CPS and ORP are from each other (Excel vs FORTRAN) the computed values for the degenerate scenarios are acceptable.

For the IRA-only scenarios both systems compute personal income tax on withdrawals. The results indicate that the two programs’ income tax calculations are consistent.

Compare ORP to Other Models The second test is to compare ORP’s results to that of other retirement calculators. This is generally not practical because conventional retirement calculators do not include progressive income taxes in their computations. We are aware of four published papers with computational results that can be meaningfully compared to ORP. Table 6 compares ORP results to the results of the four other models. These models are all of the specify-spending-and-compute-the-FTAB variety. We compare ORP to these models by having ORP assume their computed FTAB along with the term of their plan, and compute the optimal spending levels to see if ORP’s ending results compare to the models’ beginning values.

Model CTM TE Reichenstein [2006] Reichenstein [2013]

Term

FTAB

Years 30 25 30 33

$000 1,608 824 0 0

Conclusion We have demonstrated that: •

Linear programming is a credible retirement planning tool.

•

Common practice, as represented by CPS, is an efficient but suboptimal withdrawal strategy.

•

Minimizing taxes is only part of the optimal schedule. When higher taxes are paid early in the plan then spending is reduced by reduced account compounding.

•

Optimization improves on common practice, as represented

by CPS, by 3% to 30%.

•

If there is no IRA then there are no income taxes and optimization follows common practice.

•

Optimization shows a significant advantage over the common practice for scenarios with similar IRA and after-tax account balances but with no Roth IRA.

Spending - $000 Model

ORP

80 60 103 37

78 62 105 34

Table 6: Compare ORP’s Spending to Those of Other Models

CTM is the Comprehensive Tax Model by Sumutka, et al [2012].

CTM assumes a spending rate and computes the maximum FTAB. TE is the “Tax-Efficient Retirement Withdrawal Planning model

by Coppersmith and Sumutka [2011]. TE assumes a spending rate and maximizes the FTAB. Reichenstein assumes a zero FTAB and computes the age at which all savings are depleted.

Of course, we could argue that that our comparison validates these models.

• Partial IRA to Roth IRA conversion decisions may be based on considerations other than plan economics.

Future work may study when to begin Social Security benefits in the context of optimal spending. Another interesting topic is to compare linear, inflation adjusted spending to a scheme that reflects retirees’ actual spending patterns.

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References

Appendix A: Glossary

Coopersmith, Lewis W. and Alan R. Sumutka. (2011). Tax-Efficient Retirement Withdrawal Planning Using a Linear Programming Model. Journal of Financial Planning, September.

After-tax Retirement Savings Account: Contributions to the after-tax account can be from any source that has been taxed.

Taxes are paid annually on asset sales’ profits, dividends and interest. Withdrawals are not taxed. When the IRA withdrawal exceeds spending, say, due to the RMD, the surplus is transferred to the After-tax account. Taxes, at the capital gains rate, are assumed to be paid annually, thereby reducing the account’s ROR. This reduced after-tax ROR is the main reason that both common practice and ORP distributes the after-tax account first.

Dantzig, George B. (1963). Linear Programming and Extensions. Princeton, NJ: Princeton University Press.

Horan, Stephen M. (2006). Optimal Withdrawal Strategies for Retirees with Multiple Savings Accounts. Journal of Financial Planning, November.

Hirshfeld, David S. (1969). Linear Programming Advanced Model Formulation. Management Science Systems Inc. Orchard-Hays, William. (1984). History of Mathematical Programming Systems. Annals of the History of Computing, July.

Raabe, William, and Richard B. Toolson. (2002). Liquidating Retirement Assets in a Tax-efficient Manner. AAII Journal, May. Ragsdale, Cliff T., Andrew F. Seila, and Philip L. Little. (1994). An Optimization Model for Scheduling Withdrawals from Tax-Deferred Retirement Accounts. Financial Services Review, 93-108. Retrieved from www. twenty-first.com/pdf/Ragsdale-An_Opt_Model.pdf Reichenstein, William. (2006). Tax-Efficient Sequencing of Accounts to Tap in Retirement. TIAA-CREF Institute Trends and Issues, October.

Reichenstein, William. (2013). How Social Security and a Tax-Efficient Withdrawal Strategy Extend the Longevity of the Financial Portfolio.

Morningstar. Retrieved from www.socialsecuritysolutions.com/case_coordination.pdf Saftner, Don and Philip R. Fink. (2004). Review Tax Strategies to Ensure That Retirement Years are Golden. Practical Tax Strategies, May. Sumutka, Alan R., Andrew M Sumutka, and Lewis W. Coppersmith. (2012).

Tax-Efficient Retirement Withdrawal Planning Using a Comprehensive Tax Model. Journal of Financial Planning; April, Vol. 25, Issue 4.

After-tax accounts typically include common stock, which often pay dividends that are subject to income tax. We assume that the after-tax account is invested only growth in stocks or mutual funds which pay insignificant dividends relative to the rest of the plan. Also, since the after-tax account is drawn down first there are no dividends later in the plan.

The literature frequently uses the term taxable account for what we call the after-tax account. In our view all accounts are taxable because they are taxed either as money enters the accounts or as it is distributed.

Efficiency: the percentage improvement of one model’s results over another.

Estate: The plan’s FTAB. This is a non-negative number specified as part of a scenario’s assumptions.

Final Total Account Balance (FTAB): The sum of all three savings account at the end of the plan. FTAB is also known as the plan’s estate. The FTAB is a settable parameter. It is set to zero for the scenarios in this paper. Positive values are required for comparing ORP to other systems.

Heuristics: business rules used to recommend a decision. The heuristic of interest here is the common practice for sequencing of accounts for retirement savings withdrawal.

Illiquid Asset: An asset that can only be sold as a single entity.

A home, business or partnership are examples of illiquid assets.

The proceeds of the sale less capital gains taxes on any profits are transferred to the after-tax account in the year of the asset sale.

Optimization: finds the “best available” value of some objective function given a defined domain. For retirement savings distribution the domain is the retiree’s financial situation and choices to be made. The objective function (economic value) is the amount of money available for spending. Optimization is the balancing of asset compounding against minimizing taxes.

©2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

Rate of Return (ROR): The profit on an investment expressed as a percentage of investment’s value.

Required Minimum Distribution (RMD): The RMD is an amount that the IRS requires be withdrawn from the IRA annually beginning at the age of 70½. It is computed as the IRA account balance on December 31 of the previous year divided by a life expectancy value taken from an IRS published table [IRS 2014].

The RMD is recomputed annually with a different life expectancy divisor. RMD withdrawals cannot be converted to the Roth IRA. Roth conversion: the partial distribution of funds from the IRA to the Roth IRA after personal income taxes have been paid.

Roth IRA Retirement Saving Account: Income taxes are paid on the employment income contributions to a Roth IRA but there are no taxes on withdrawals. In addition to employment contributions withdrawals from an IRA may be converted to a Roth IRA after personal income taxes have been paid on the withdrawals. After age 59 ½ withdrawals can be made from the Roth IRA in any amount without penalty.

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Appendix B: ORP Calculations Modeling progressive income taxes in an LP model is straightforward.

ORP maximizes spending. Taxes reduce spending. LP increases spending by reducing taxes. Income subject to income taxes includes all IRA distributions without regard to their use, i.e. spending, Roth Conversions, or transfers to the after-tax account.

The optimal solution will assign income to the zero tax bracket first because it does not affect spending. Taxable income (income beyond the exemptions and deductions) goes into the 10% bracket, the bracket with the next smallest effect on spending. And so on up through the brackets. All brackets, except the 39.6% bracket, have an upper limit on how much money can be assigned to them. We use the 2014 tax tables in all income tax calculations.

ORP and CPS use the same account arithmetic:

Simulator: imitates a heuristic’s behavior over time.

1. Account balances are reported as of the end of the age year after the year’s distribution and compounding.

Spending: the amount of money, after taxes, available for retiree consumption expressed in today’s dollars. Spending is money that leaves the model. ORP balances tax minimization against maximization of asset returns to maximize spending.

2. The account balance as of the beginning of the year is the account balance at the end of the previous year.

Tax-deferred Retirement Savings Accounts (IRA): There are no income taxes on employment earnings contributed to the IRA but all withdrawals are taxed as personal income. This type of account includes IRA, 401k, 403b and a variety of others, all of which are generically equivalent for purposes of this study. The term IRA is used to denote the collection of these accounts since most are converted into an IRA before or at retirement. After age 59 ½ withdrawals can be made from the IRA in any amount without penalty.

Withdrawal Plan: The amount of money withdrawn from each account each year. The plan includes money used for taxes, Roth conversions, spending, and the FTAB.

3. Withdrawals are made at the end of the year after the account has been credited with its annual returns.

4. Contributions and Roth conversions are made at the end of the year.

5. A year’s investment return is at the end of the year. The year’s ending balance is computed as: (1+ROR) * beginning balance – distribution.

This is the previous year’s ending balance increased by the account’s ROR prior to making distributions.

6. Taxes are paid for with account withdrawals and not Social Security payments.

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Journal of Personal Finance

Exploring the Antecedents of Financial Behavior for Asians and Non-Hispanic Whites: The Role of Financial Capability and Locus of Control John E. Grable, Ph.D., CFP®, Athletic Association Endowed Professor of Family and Consumer Sciences, University of Georgia So-Hyun Joo, Ph.D., Professor, Division of Consumer Studies, Ewha Womans University1, South Korea Jooyung Park, Ph.D., Professor in Consumers’ Life Information, College of Human Ecology, Chungnam National University, South Korea Abstract Using data collected over a three-year time span (2008 through 2011), this paper examines the association between racial background and financial behavior. This study specifically evaluated differences between Asians and non-Hispanic Whites living in the United States (N = 341). Findings from this research suggest that any racial differences in financial behavior appear to exist only in a two variable correlational sense. Both financial capability and locus of control act as mediators between race and financial behavior. In general, those with high financial capability tend to exhibit better financial behavior. Additionally, individuals who exhibit an internal locus of control perspective also report better financial behavior. Age was also found to be positively associated with better financial behavior. When these factors were controlled for in a multivariate analysis, no meaningful racial differences were noted in this study.

Key Words: Financial Capability, Locus of Control, Financial Planning, Financial Behavior, Racial Differences 1

Contact: Professor, Ewha Womans University, Seoul, Korea. Email: sohyunjoo@ewha.ac.kr

©2015, IARFC. All rights of reproduction in any form reserved.

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Introduction What are the antecedents of financial behavior? This is a question that has shaped the careers of many economists, as well as researchers interested in personal and household finance topics.

Pursuit of an answer to this question has created a vast body of literature showing that, in many ways, the strongest predictor of financial behavior is a person’s financial capability. For many, this association has led to an acknowledgment that financial knowledge—an indicator of capability—and financial education are key factors that allow “individuals and families to accumulate assets and achieve their financial goals.”1 This quote, from Charles Evans, the CEO and President of the Federal Reserve Bank of Chicago, hints at the notion that financial behavior can be influenced through interventions that improve financial capabilities. Financial capability, as used in this study, refers to ‘possessing the knowledge on financial matters to confidently take effective action that best fulfils an individual’s personal, family and global community goals’ (National Financial Educators Council, n.d.). Although there are a few studies that show otherwise, nearly all reports indicate support for concluding financial capability and financial behavior are positively linked. Individuals who exhibit the best financial behavior almost always possess high levels of financial capability (Fonseca, Mullen, Zamarro, & Zissimopoulos, 2012; Perry & Morris, 2005).

One may conclude that after more than 50 years of study, the answer to what shapes financial behavior—beyond financial capability—would be adequately addressed in the literature. In many respects, this is true. Factors such as income, age, education, race, and certain personality factors are thought to influence the manner in which people evaluate behavioral choices within the financial marketplace. What is most interesting, however, is the growing realization that there may be other issues at play when people conceptualize financial behavioral choices.

Consider reports of racial differences in financial behaviors. The literature is replete with reports that non-Hispanic Whites tend to exhibit better financial behavior than others. It is no surprise then that policy makers, educators, and concerned citizens have increasingly allocated resources, both monetary and human, to facilitate and disseminate broad based financial education, especially to populations typically underserved by financial institutions. Take, for example, the growth of financial literacy centers, clinics, and inner-city asset building programs. The goal of such initiatives is simple; namely, to provide access to free or low cost financial education and information to underrepresented individuals and families as a mechanism to increase financial capability.

Nevertheless, if asked, many financial counselors and educators are quick to acknowledge that sometimes the neediest are the least likely to seek financial education. It is more common for individuals with already high levels of financial capability to be the ones who attend educational meetings. Sometimes these “help-seekers” are looking for behavioral confirmations (Grable & Joo, 1999). That is, they think their behavior is properly 1 Quote available at the Financial Literacy and Economic Summit, 2012, website: http://www.practicalmoneyskills.com/summit2012/

directed, but they want a free or low cost second opinion that supports their current saving and spending activities. Others attend as a social activity—a place to meet people, receive refreshments, and gather handouts. When viewed globally, help-seekers make up, at most, 40% to 45% of the population (Grable & Joo, 1999; 2001).

Rarely do individuals and families pro-actively seek financial counseling, planning, or education on a voluntary basis. It is unusual for the most financially needy to seek help from professional advisers or educators (Grable & Joo, 2001). This might stem from cultural or societal barriers that make help-seeking behavior uncommon. The lack of educational-seeking behavior might also be attributable to low levels of knowledge (Lee, 1997). Another possible explanation may be that some individuals feel that their financial fate is beyond their control, and as such, they do not feel compelled to improve either their level of financial capability or behavior. In other words, some individuals may believe in fate, luck, and fortune to such an extent that they see no need to improve their financial capability as a way to enhance their financial situation. Those with an external locus of control perspective (e.g., believing in luck and fate) might believe that their financial future is already predetermined, and as such, conclude that their ultimate behaviors are unchangeable.

While much of the previous literature has described racial differences in financial behaviors, little research has been devoted to explaining such differences. As discussed later in this paper, it is reasonable to hypothesize that variances in behavior may be associated directly with psychosocial variables and financial capability. It is also possible that indirect effects also explain some differences in behavior. As such, this paper was developed with the following intentions. Tests were first conducted to confirm that financial capability, locus of control, and racial background are associated with financial behavior among Asians and non-Hispanic Whites. In this study, financial capability is most closely aligned with the concept of self-assessed financial knowledge, whereas locus of control refers to the extent to which someone believes they can control life events and outcomes.

Second, evaluations were made to examine the possibility that financial capability and locus of control mediate the association between race and financial behavior. This research advances the literature in two important ways. At a basic level, results add further support to the notion that financial capability and financial behavior are positively associated. At a deeper level, findings indicate that both financial capability and locus of control likely play an important role in explaining the relationship between race and financial behavior.

Review of Literature The Race-Financial Behavior Association A notable variable commonly found to be associated with financial behavior is racial background. The general evidence indicates that there are distinct differences between non-Hispanic

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Whites and others in terms of financial behavior (Lyons, Rachlis, & Scherpf, 2007; Lusardi & Mitchel, 2007; Lusardi, Mitchell, & Curto, 2010). Non-Hispanic Whites tend to exhibit better financial behavior (e.g., management of debt, secured and unsecured loans, and daily money tasks) (FINRA, 2013) compared to other racial groups. Much of the research showing racial differences has tended to focus on African-American populations compared to non-Hispanic White populations. There have been fewer studies that compare non-Hispanic White and Asian populations.

One such study was conducted by Grable, Park, and Joo (2009).

They replicated an earlier study by Perry and Morris (2005) in an effort to address this deficiency in the literature. They found that, similar to other racial comparisons, Asians and non-Hispanic Whites differ in terms of both financial behavior and financial knowledge. Several explanations have been proposed to explain why racial differences should have an impact on financial behavior. The most common framework used to describe dissimilarities relates behavioral outcomes to minority groups in the United States having fewer assets, lower incomes, and less access to financial services (Coleman, 2003; Kim, Chatterjee, & Cho, 2012). This is known as the resource deficit hypothesis. The hypothesis leads to the conclusion that, to some extent, the cultural orientation of minority groups is one that limits the transference of financial capabilities and skills from one generation to another (Gutter, Fox, & Montalto, 1999).

Although the resource deficit explanation is widely articulated, some (e.g., Phares, 1976) have noted that this thinking can lead to research that is stereotypical. For example, while the resource deficit hypothesis may be true for some racial groups, it may not be fully applicable to Asians living either in the United States or away from their country of origin. It is equally plausible that there are cultural preferences that account for differences in financial behavior. Alternatively, it is possible that race is only significant in a two variable correlational sense. If this is true, then other factors may work to mediate the effect of race on financial behavior. This possibility is explained in more detail below. Initially, however, this research proposes the following hypothesis:

H1: Non-Hispanic Whites and Asians will exhibit divergent financial behavior.

The Financial Capability-Behavior Association Perry and Morris (2005) were among the first to document, within a multidimensional model, the role played by a person’s financial capabilities in shaping financial behavior. They found that the propensity to save, control spending, and budget, among a diverse population of Americans, was positively associated with financial capability. Their research supported a similar finding reported by Hilgert, Hogarth, and Beverly (2003). More recently, Robb (2011) found that financial capability is an important factor that influences college students’ credit card practices.

Experiential learning has been shown to be the most effective method for achieving some degree of financial capability for the average person (Hogarth & Hilgert, 2002). This is one reason formal financial education has been touted as a key element in improving financial outcomes. It is important to note, however, that some have questioned the effectiveness of formal education.

Mandell and Klein (2009) found that high school students who had taken a personal financial literacy course did not demonstrate better financial behavior than those who did not take a course.

They used their insights to question the long-term effectiveness of high school financial literacy programs. Although the largest part of the literature suggests a positive association between capabilities and behavior, there is, as Mandell and Klein noted, active debate regarding the true validity of the relationship. This paper adds to the debate by testing the following hypothesis, which is similar to one proposed by Perry and Morris (2005):

H2: Financial capability will be positively associated with better financial behavior.

There is evidence to indicate that financial capability may also serve as a mediating factor when people evaluate and engage in financial behavior (Chan, Burtis, & Bereiter, 1997; Lopez-Cabrales, Perez-Luno, & Cabrera, 2009). Rather than assume that financial behavior is directly associated with racial differences, the existing literature hints at the possibility that financial behavior may really be associated with different levels of financial capability among different racial groups. As such, the following hypothesis was proposed:

H3: Financial capability will mediate differences in financial behavior between nonHispanic Whites and Asians.

The Locus of Control-Financial Behavior Association As discussed in the introduction to this paper, locus of control (LOC) has been shown to be associated with financial behavior. Rotter (1966) defined LOC as a psychosocial construct that captures beliefs about the causes of punishments and rewards experienced by an individual. LOC is typically measured on a continuum, with two extremes. On one end is an internal LOC perspective. Those with internal LOC associate life outcomes with their own skills, abilities, and actions. That is, they assume that outcomes are predictably based on personal efforts, skills, and motivations. External LOC falls on the other end of the continuum. An external LOC perspective is represented by a belief that luck, fate, chance, and the influence of powerful outside influences dictate life outcomes. Those with an external LOC often view the role of skill and motivation in determining behavioral outcomes as less important (Zimmerman, 1995). There is evidence to suggest that LOC is associated with financial behavior.

Davies and Lea (1995) noted in their study that external LOC was related to the accumulation of debt, whereas Perry and Mor-

Š2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

ris (2005) found a negative association between external LOC and a person’s ability to save, budget, and control spending. It is also possible that LOC acts not only as a direct factor influencing financial behavior, but also as a mediating characteristic.

In order to fully appreciate the potential role of LOC in shaping behavioral outcomes, both directly and indirectly, it is useful to understand the theoretical underpinnings of the LOC construct.

According to Phares (1976), the concept of LOC emerged from tests of Social Learning Theory (SLT). SLT was developed as a means to explain how individuals make choice decisions. The theory is premised on six core assumptions: (a) the unit of study is the interaction of a person in his/her meaningful environment; (b) biological determinants of behavior are less important than learned determinants; (c) over time, a person’s personality and behavior stabilize; (d) behavior is determined by both specific and general determinants; (e) behavior is goal-oriented and motivated; and (f) both expectancies and reinforcement play key roles in shaping behavior.

The general consensus among personality researchers is that LOC is most effective in explaining behavior that is somewhat ambiguous in terms of situational cues. This is certainly the case with most forms of financial decision making. That is, rarely are consumers provided with direct instructions for use in solving complex financial questions or when making financial decisions. Phares (1976) reported that researchers and clinicians should expect those with an internal LOC perspective who feel that they have some control over behavioral outcomes to engage in more information and help seeking compared to those with an external LOC. As more information is obtained and integrated into decision-making processes (e.g., past experiences, expectation generalizations, and behavioral reinforcements), it is more likely that those with an internal LOC will be better able to distinguish between optimal and sub-optimal choice alternatives. In other words, an internal LOC perspective should be associated with positive financial behavior. As such, the following hypothesis was tested:

H4: Internal LOC will be positively associated with better financial behavior.

Additionally, it is important to assess whether LOC might also play an indirect role in shaping behavioral choices. Those holding an external LOC orientation, for example, often use this perspective as a mechanism to “protect themselves from anticipated failure or other personal inadequacies” (Phares, 1976, p.

144). This may be a learned response. Some racial groups, for instance, have traditionally had less access to power, economic mobility, and human capital resources than others. Some have argued that this historical background tends to create a world view that is defined by an external LOC perspective. What is most interesting, however, is that holding an external LOC view is not always associated with lower social and/or socioeconomic status. In what has since become a seminal piece, Hsieh, Shybut, and Lotsof (1969) compared LOC profiles of non-Hispanic White American children attending school in Illinois, Asian

31

children born in the United States (i.e., Asian-American) going to school in Chicago, and Asian children enrolled in a Hong Kong school. They found that the non-Hispanic White children were the most internal, whereas the Hong Kong children were the most external. The Asian-American children fell in between.

They attributed these differences primarily to learned cultural differences. Non-Hispanic White Americans tend to hold a social perspective that highly values independent thought and action, whereas Asians have a tendency to be situation-oriented basing decisions on kinship. Further, a status-quo bias appears to be present in most Asian cultures, as does a strong belief in chance, fate, and luck (Grable et al., 2009).

Using SLT as a guide, it is possible then that biological determinants, such as race, may only appear to be directly associated with financial behavior. The direct relationship between race and financial behavior may be mediated by LOC, with those holding an external LOC exhibiting worse financial behavior. This possibility was tested with the following hypothesis:

H5: LOC will mediate differences in financial behavior between non-Hispanic Whites and Asians.

Methods Data for this study were obtained over a multi-year period by combining information from three distinctive financial attitude and behavior surveys. The research team was the same for each of the surveys, which were approved by the principal investigator’s IRB university office. The purpose of each survey was different, and as such, the respondents to each investigation were unique. One survey, for example, was focused on assessing marital and financial attitudes among individuals. Another survey was developed to evaluate resource acquisition behavior among low income households. The third survey was developed to evaluate financial decision making among consumers. The only similarities among the surveys were the questions from which data were obtained for use in this study.

The data represent information obtained from consumers living throughout the United States between 2008 and 2011. Given the research questions underlying this research, the sample was weighted to over-represent non-Hispanic Asian and other non-Hispanic White respondents. It is important to note that while the sample was appropriate for this exploratory study, it was not necessarily representative of the U.S. population. Data were collected using both paper-and-pencil and online survey methods, with both questionnaire types containing the same questions. In total, 1,000 surveys were distributed. In total, 341 non-Hispanic White and non-Hispanic Asian individuals responded to the three surveys. Among those who completed the questionnaires, 69% were female, with a mean and standard deviation age of 38.71 and 13.85 years, respectively. Twenty-nine percent of respondents were non-Hispanic Asian, with the remainder being classified as non-Hispanic White. Although

32

Journal of Personal Finance

limited, respondents were grouped together without regard to their familial country of origin. Among the non-Hispanic Whites, for instance, it is possible that a wide number of cultural backgrounds were represented. Similarly, Asians were categorized as being non-Hispanic and as a group rather than through national differentiation. Given the diverse nature of the surveys, it was not possible to match other respondent demographic data.

Non-Asians and those who were not non-Hispanic Whites were excluded from the study.

The variables of interest in this study were financial capability, financial behavior, and LOC. The measures used to assess these constructs were adopted from Perry and Morris (2005). Financial capability in this study was measured with subjective evaluations on a five-item financial capability measurement. Responses were combined into a summated capability scale. The items were introduced as follows: “How much do you know about the following?” Choice options included: (a) Interest rates, finance charges, and credit terms, (b) Credit ratings and credit files, (c) Managing finances, (d) Investing money, and (e) What is on your credit report. A five-point Likert-type scale was used, with “nothing” coded 1 and “a lot” coded 5. A range from 5 to 25 was possible, with higher scores representing more financial capability. In this study, the mean score was 17.74 (SD = 4.46).The scale’s Cronbach’s alpha was .78.

Financial behavior was measured with five items that were combined into a summated scale. The question was asked as follows: “How do you grade yourself in the following areas?” (a) Controlling my spending, (b) Paying my bills on time, (c) Planning for my financial future, (d) Providing for myself and my family, and (e) Saving money. A five-point Likert-type scale was used, with “poor” scored as 1 and “excellent” scored as 5. A range from 5 to 25 was possible, with higher scores indicative of better behavior. The average score was 18.54 (SD = 3.78). The scale’s reliability, as measured with Cronbach’s alpha, was .87.

LOC, as defined by Perry and Morris (2005), was assessed using seven items measured on a five-point Likert-type scale, with 1= almost never and 5 = almost always. The question was asked as

follows: “How often do you feel?” (a) There is really no way I can solve some of my problems, (b) I am being pushed around in life, (c) There is little I can do to change the important things in my life, (d) I can do anything I set my mind to, (e) What happens to me in the future depends on me, (f) Helpless in dealing with the problems in life, and (g) I have little control over the things that happen to me. Answers to questions (d) and (e) were reverse coded. Scores were summed into a LOC scale, with higher scores representing an external LOC perspective. The average score was 13.07 (SD = 4.49). Using a possible range of 5 to 35, the sample was almost evenly split between internal and external LOC. The scale’s Cronbach’s alpha was .85.

Other variables included in the analyses were coded as follows: respondent sex was coded 1 = male, 0 = female; age was coded in years as reported by respondents; racial background was coded 1 = Non-Hispanic White, 0 = non-Hispanic Asian (i.e., Asian in this study).

Data Analysis Methods Given the specific research questions of interest in this study, the following data analysis tools were used to evaluate the study’s hypotheses: (a) Spearman’s Rho correlations, (b) t-tests, (c) an ordinary least squares (OLS) regression, and (d) Sobel mediation tests. Results from the tests are reported below.

Results

Table 1 shows correlation estimates among the key variables of interest in this study. As expected, financial capability and financial behavior were found to be statistically significantly associated. Having an external LOC perspective was negatively associated with both financial capability and financial behavior.

It was determined that men were more likely to hold an external LOC perspective. Age was found to be positively associated with financial capability and financial behavior, but negatively associated with external LOC. As expected, non-Hispanic Whites held an internal LOC perspective compared to Asians, and they were more knowledgeable and demonstrated better financial behavior.

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Volume 14, Issue 1

FC FB LOC Sex Age Non-Hispanic White Asian

1.00 0.38** -0.24** 0.02 0.18** 0.26** -0.26**

1.00 -0.30** 1.00 -0.02 0.16** 0.23** -0.03 0.19** -0.46** -0.19** 0.45**

1.00 -0.01 -0.35** 0.35**

1.00 -0.07 0.07

1.00 n.a.

Asian

Non-Hispanic White

Age

Sex

Locus of Control (LOC)

Financial Behavior (FB)

Financial Capability (FC)

33

1.00

Note: *p< .05 **p< .01

Table 1: Correlation Coefficients among Key Variables (N = 333) The correlation results reported in Table 1 were useful in describing basic associations between and among variables. As expected, these bivariate results matched, in general, the working assumptions in the literature. Table 2 extends the analysis by comparing non-Hispanic Whites and Asians in terms of financial capability, financial behavior, and LOC. Results indicate that non-Hispanic Whites exhibited better financial behavior than Asians. Non-Hispanic Whites also had a higher level of financial capability than Asians, but they scored lower in external LOC. Variables

Non-Hispanic Whites (N=239)

Financial Behavior Score Financial Capability Score LOC

19.00 (3.74) 18.49 (4.38) 11.77 (3.88)

Asians

t

(N=100) 17.45 (3.66) 15.93 (4.15) 16. 31 (4.27)

3. 50** 4. 97*** -9.41*** *p< .05 **p< .01 ***p< .001

Table 2: Descriptive Statistics of Financial behavior, Financial Capability, and LOC for Non-Hispanic Whites and Asians A regression model was developed to examine the relationships among financial capability, LOC, race, and financial behavior.

The primary purpose behind the use of the regression was to confirm, in a basic multivariate model, that these variables were directly associated with financial behavior. Age and gender were controlled in the model. Although non-Hispanic Whites were found to report better financial behavior in the bivariate analyses, the relationship between these two variables was not statistically significant when controlling for the other variables in the model (Table 3). Based on the regression results, only partial support was noted for Hypothesis 1. Financial capability was found to be positively associated with financial behavior, holding all other factors constant. Given this result, Hypothesis 2 was accepted.

Journal of Personal Finance

34

Variable

Parameter

Standard

t Value

Standardized Estimate

Gender Age Financial Capability LOC Non-Hispanic White Constant

Estimate 0.153 0.043** 0.244*** -0.190*** 0.107 14.877***

Error 0.433 0.014 0.045 0.048 0.499 1.251

0.353 3.098 5.436 -3.992 0.215 11.894

0.433 0.014 0.045 0.048 0.499

Table 3: OLS Regression Results Showing Independent Variable Effects on Financial Behavior

Note: F5, 324 = 17.63*** R2 = .214 *p< .05 **p< .01 ***p< .001

Information regarding Hypothesis 4 is also shown in Table 3.

Internal LOC was found to be associated with better financial behavior. As hypothesized in this study, those with an internal LOC (i.e., low scale scores represent an internal LOC) were found to report better financial behavior. Demonstrating an external LOC perspective was shown to be related to worse financial behavior.

As such, the hypothesis was accepted.

Preacher and Hayesâ&#x20AC;&#x2122;s (2004) criteria for estimating mediation, using B

Preacher and Hayesâ&#x20AC;&#x2122;s (2004) criteria for estimating mediation, using Baron and Kennyâ&#x20AC;&#x2122;s (1986) Sobel test procedures, were Sobel test procedures, were used in this study as described below: used in this study as described below:

(1)(1)

Y = đ?&#x2018;&#x2013;1 +đ?&#x2018;?đ?&#x2018;&#x2039; đ?&#x2018;&#x20AC; = đ?&#x2018;&#x2013;2 +đ?&#x2018;?đ?&#x2018;&#x2039;

(2)

(2)

đ?&#x2018;&#x152; = đ?&#x2018;&#x2013;3 +đ?&#x2018;?â&#x20AC;˛đ?&#x2018;&#x2039;+đ?&#x2018;?đ?&#x2018;&#x20AC; (3)(3) Hypotheses 3 and 5 proposed that financial capability and LOC mediate the association between race and financial behavior. A where: where: mediation model (Figure 1) was developed to test these hypotheses. As shown in Figure 1, X represents race, M is financial Y = outcome variable capability or LOC, and Y is the outcome variable financial Y = outcome variable behavior. The linkage between X and Y is the direct effect of X = independent variable race on financial behavior. The effect of X on Y, through M, is X = independent variable , (3) M must and (4) mustfor significantly Y controlling for X (i.e., bâ&#x2030; M = mediating variable the predict indirectY,effect.

InMorder mediation predict to occur, four criterion must exist concurrently: (1) X must predict M, (2) X must predict M = mediating variable dition to these mediation rules, the (4) predicted coefficient for Xpredict must be i = intercept coefficient Y, (3)four M must predict Y, and M must significantly Y smaller in controlling for X (i.e., b 0). In addition to these four mediation i Results = intercept coefficient n (model) 4 than in condition (model) 2 and Y must not be a cause of M. For the from the mediation tests are shown in Tables 4 rules, the predicted coefficient for X must be smaller in condition and 5. Each mediation criterion has been matched to a model in (model) 4 than conditionusing (model) 2 and Yleast mustsquares not be regression a cause of this test, each path wasinmeasured an ordinary the table. As shown in Table 4, the direct and total effect of race of M. For the purposes of this test, each path was measured using on financial behavior when controlling for LOC was not signifan ordinary least squares regression procedure. e. icant. A post-hoc analysis, as indicated by Hayes and Preacher (2009), was used to estimate the effect size of the indirect effect. c X Y A bootstrap (n = 3,000) estimation procedure (see Hayes, 2012) was employed to calculate confidence intervals for the indirect effect. Based on a 95% confidence interval and the Sobel test M results (sab = 1.023, p < .001), confirmation was obtained for the mediation effect of LOC on financial behavior for race. Addib a tionally, a relatively high effect size was noted (.958). Based on these results, Hypothesis 5 was accepted. That is, LOC was X Y câ&#x20AC;&#x2122; found to mediate the effect of race on financial behavior.

: Hypothesized Mediation EffectMediation of FinancialEffect Capability and LOC on Financial Figure 1: Hypothesized of Financial Capability and LOC on Financial Behavior r

reacher and Hayesâ&#x20AC;&#x2122;s (2004) criteria for estimating mediation, using Baron and Kennyâ&#x20AC;&#x2122;s

obel test procedures, were used in this study as described below:

đ?&#x2018;&#x2039;đ?&#x2018;&#x2039;

+đ?&#x2018;?đ?&#x2018;?ďż˝ (2)

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Volume 14, Issue 1

Model 1 Model 2 Model 3

35

Independent Variables

Dependent Variables

Coefficients

Race (Non-Hispanic Whites) Race (Non-Hispanic Whites) Race (Non-Hispanic Whites)

Financial Behavior LOC Financial Behavior

1.653*** -4.558*** .621

LOC

-.226*** Note: *p< .05 **p< .01 ***p< .001

Table 4: Mediation Test of Financial Behavior as a Function of Race and LOC

A similar mediation test was developed to test Hypothesis 3.

As shown in Table 2, the financial capability of non-Hispanic Whites and Asians was different. It was proposed that differences in financial capability may mediate the effect of race on financial behavior. This proposition was tested using the same procedure described above (Preacher and Hayes, 2004). Table 5 shows the mediated effect of financial capability on race and financial behavior. As presented in the table, the direct effect of race on financial behavior was insignificant when controlling for financial capability. A Sobel test (sab =.781, p < .001) and bootstrapping procedure, similar to the method used with the LOC mediation test, confirmed the significant indirect effect.

Model 1 Model 2 Model 3

Independent Variables

Dependent Variables

Coefficients

Race (Non-Hispanic White) Race (Non-Hispanic White) Race (Non-Hispanic White)

Financial Behavior Financial Capability Financial Behavior

1.588*** 2.574*** .808

Financial Capability

.303***

Table 5: Mediation Test of Financial Behavior as a Function of Financial capability and Race

Discussion

Note: *p< .05 **p< .01 ***p< .001

Hypothesis H1: Non-Hispanic Whites and Asians will exhibit divergent financial behavior.

Results Partially Accepted H2: Financial capability will be positively associated with better financial behavior. Accepted H3: Financial capability will mediate the association between race (Non-Hispanic Accepted

Table 6 summarizes the results from this study.

Each of the hypotheses was supported, with the White and Asian) and financial behavior. exception that Hypothesis 1, which stated that H4: Internal LOC will be positively associated with better financial behavior.

Accepted non-Hispanic Whites and Asians would exhibit H5: LOC will mediate the association between race (Non-Hispanic White Accepted divergent financial behavior. Hypothesis 1 was and Asian) and financial behavior. only partially supported. Behavioral differences were noted in the bivariate analysis; however, the difference was diminished when LOC and Table 6: Summary Results from the Hypothesis Tests financial capability were controlled for in the multivariate analysis. When taken together, these findings are noteworthy. Results confirm several associations commonly The key findings from this study, however, are related to the reported in the literature; namely, individuals with higher levels relationship between race and financial behavior. In a simple of financial capability, regardless of age, gender, or racial backtwo variable bivariate sense, non-Hispanic Whites appear to ground, exhibit better financial behavior. Additionally, LOC apmanage their financial behavior better than Asians. However, all pears to be associated with both financial capability and financial racial differences disappear when LOC and financial capability behavior. Individuals who hold an internal LOC view reported are accounted for in a more robust model. The mediation tests being more capable in relation to their financial situation. They illustrate something even more important. What really appears also engaged in better financial behavior than those with an exto matter, when shaping financial behavior, is LOC and finanternal LOC. Although not tested directly, older respondents were cial capability for Asians and non-Hispanic Whites. Individuals found to exhibit better financial behavior as well.

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Journal of Personal Finance

holding an internal LOC perspective are predicted to report better financial behaviors than others, regardless of their racial background. In addition, those who are financially capable are also predicted to exhibit better financial behavior. Results from this study support a core assumption within SLT; namely, learned perspectives appear to be more important than some biological determinants when people are faced with ambiguous choice dilemmas.

Results from this study suggest that some behavioral differences between Asians and non-Hispanic Whites are likely a result of variations in LOC, rather than being strictly a racial differentiation. Because holding an external LOC is associated with worse financial behavior, it is no surprise that Asians exhibited more problematic behavior. This leads to an important question; namely, can LOC be altered. Regarding the malleability of LOC, the answer to this question, unfortunately, is complicated. As described within SLT, the ability of some individuals to change perceptions, viewpoints, and belief systems tends to diminish with age. If one acknowledges this, but focuses instead on factors that affect controllability perceptions, the evidence clearly suggests that LOC can be altered (see Phares, 1976). In other words, it is possible with effort and guidance, for a person to move along the continuum of control from external to internal.

If it is assumed that both financial capability and LOC can be changed (albeit less dramatically as a person ages), then the question becomes how to bring about change in the most resource effective manner possible. Consider a recent, and widely quoted, review paper by Willis (2008-2009). She concluded that financial education does not increase capabilities, but rather confidence. Willis argued that enhanced levels of confidence likely work against the interests of consumers by tricking those who are confident into making problematic consumer finance choices.

Willis based many of her conclusions on primary research published by Mandell and Klein (2007) who noted that among young people who participated in Jump$tart programs, financial capabilities were not strongly related to financial practices.

Further, and maybe more importantly, Mandell and Klein found that playing a stock market game was highly associated with financial capability scores and financial outcomes. They hypothesized that the stock market game might be more effective, as compared to traditional education interventions, because participants find games to provide intrinsic motivation to learn about personal finance topics. Might there be another explanation as well? It is important to note that neither Willis nor Mandell and Klein were able to control for important psychosocial characteristics when evaluating the effectiveness of financial literacy programming due to limitations in the Jump$tart dataset. We believe that had the study accounted for LOC, as suggested in this study, the modest associations between financial education and behavior might have been different. Specifically, as shown in this study, LOC appears to have both a direct and mediating effect on financial behavior. The stock market game may be perceived by young people as a game with learned patterns and outcomes. These patterns are reinforced with immediate feedback. Although most educators would likely argue that the game

is random and something that encourages risky choices, players may adopt a gamblerâ&#x20AC;&#x2122;s fallacy mentality when playing. That is, the game may provide an illusion of controllability and stability that helps engender an internal LOC perspective, especially when the gameâ&#x20AC;&#x2122;s outcomes are positive. Further, the game may tap into a preference among some with an external LOC for learning scenarios that have inherent aspects of luck, fate, and chance. If a sizable portion of the population shares an external LOC perspective, it is no surprise that education received via a randomized (non-skill based) game would appeal to players and provide a long-lasting knowledge and behavioral impact.

How might results from this study impact financial education?

To begin with, the results indicate that financial capability is positively associated with financial behavioral outcomes.

Also, having an external LOC outlook appears to be negatively related to positive financial behavior. Additionally, the evidence suggests that both of these variables mediate the association between race and financial behavior. If true, then it behooves financial counselors, planners, and educators to incorporate games, assignments, and simulations that might appeal to those with an external LOC into educational programming. Rather than assuming that a well-designed educational program focused on information, handouts, calculators, and traditional tools preferred by those with an internal LOC is appropriate for all audiences, a better alternative may involve assessing the control preferences of each audience or educational needs of a given population.

Additionally, results from this study provide an additional reason to reconsider the role of LOC in personal and household finance research. Researchers and educators who have an interest in helping improve the financial outcomes of consumers should consider designing and testing creative ways to alter consumer perceptions of financial behavior. If the typical consumer today feels that behavioral outcomes associated with financial decisions are somewhat random and beyond their control, then it is unlikely that the consumer will either seek additional information or attempt to improve their behavior. On the other hand, if consumers can be shown ways to develop reasonable goal orientations and methods to reinforce the association between personal decision-making effort in such a way that outcomes are measureable and meaningful, then SLT predicts that behavioral change is possible.

While the results from this study provide an explanatory insight into racial differences in financial behavior, it is important to interpret results within the context of methodological and sample limitations. This paper used a limited dataset. It was not possible, for example, to know whether respondents in the sample were native born, immigrants, or students. Further studies should attempt to segment survey respondents by residency status and regional background. Other important determinants of behavioral intentions and actions were not available in the dataset. While the mediation test results will not be impacted by the inclusion of other variables, a more encompassing regression analysis certainly would be. Future research, therefore, should be conducted to confirm that basic direct associations between and among

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Volume 14, Issue 1

37

racial background, LOC, and financial capability and financial behavior, controlling for other demographic and socioeconomic characteristics, hold true. Additionally, additional research is needed to help clarify whether variables, such as education and income, also mediate the relationship between racial background and financial behavior. Based on this and future studies, it may be possible to move discussions regarding financial behavior away from purely descriptive studies to ones that focus on explaining financial behavior.

References Baron, R. M., & Kenny, D. A. (1986). The moderator-mediator variable distinction in social psychological research: Conceptual, strategic, and statistical considerations. Journal of Personality and Social Psychology, 51, 1173-1182. doi:10.1037/0022-3514.51.6.1173

Hogarth, J. M., Hilgert, M. A. (2002). Financial capability, experience, and learning preferences: Preliminary results from a new survey of financial literacy. Consumer Interests Annual, 48.

Hsieh, T. T., Shybut, J., & Lotsof, E. J. (1969). Internal versus external control and ethnic group membership. Journal of Consulting and Clinical Psychology, 33, 122-124. doi:10.1037/h0027341 Kim, J., Chatterjee, S., & Cho, S. H. (2012). Asset ownership of new Asian immigrants in the United States, Journal of Family and Economic Issues, 33, 215-226. doi:10.1007/s10834-012-9317-0.

Lee, F. (1997). When the going gets tough, do the tough ask for help?

Help-seeking and power motivation in organizations. Organizational Behavior and Human Decision Processes, 72, 336-363. doi:dx.doi. org/10.1006/obhd.1997.2746 Lopez-Cabrales, A., Perez-Luno, A., & Cabrera, R. V. (2009). Knowledge as a mediator between HRM practices and innovative activity. Human Resource Management, 48, 485-503. doi:10.1002/hrm.20295

Chan, C., Burtis, J., & Bereiter, C. (1997). Knowledge building as a mediator of conflict in conceptual change, cognition and instruction. Cognition and Instruction, 15, 1-40. doi:10.1207/s1532690xci1501_1

Lusardi, A., & Mitchell, O. S. (2007). Baby boomer retirement security: The roles of planning, financial literacy, and housing wealth. Journal of Monetary Economics, 54, 205-224. doi:dx.doi.org/10.1016/j.jmoneco.2006.12.001

Coleman, S. (2003). Risk tolerance and investment behavior of Black and Hispanic heads of household. Journal of Financial Counseling and Planning, 14(2), 43-52.

Lusardi, A., Mitchell, O. S., & Curto, V. (2010). Financial literacy among the young. Journal of Consumer Affairs, 44, 358-380. doi:10.1111/ j.1745-6606.2010.01173.x

Davies, E., & Lea, S. E. G. (1995). Student attitudes to student debt. Journal of Economic Psychology, 16, 663-679. doi:dx.doi.org/10.1016/01674870(96)80014-6 FINRA. (2013). Financial capability in the United States: Report of findings from the 2012 National Financial Capability Study. Washington, DC: FINRA Investor Education Foundation.

Fonseca, R., Mullen, K. J., Zamarro, G., & Zissimopoulos, J. (2012). What explains the gender gap in financial literacy? The role of household decision making. Journal of Consumer Affairs, 46, 90-106. doi:10.1111/ j.1745-6606.2011.01221.x Grable, J. E., & Joo, S. (1999). Financial help-seeking behavior: Theory and implications. Journal of Financial Counseling and Planning, 10(1), 14-25.

Grable, J. E., & Joo, S. (2001). A further examination of help-seeking behavior. Journal of Financial Counseling and Planning, 12(1), 55-73.

Grable, J. E., Park, J., & Joo, S. (2009). Explaining Financial Management Behavior for Koreans Living in the United States. Journal of Consumer Affairs, 43, 80-107. doi:10.1111/j.1745-6606.2008.01128.x Gutter, M. S., Fox, J. J., & Montalto, C. P. (1999). Racial differences in investor decision making. Financial Services Review, 8, 149-162. doi:dx. doi.org/10.1016/S1057-0810(99)00040-2 Hayes, A. F. (2012). My macros and code for SPSS and SAS. Available at: http://www.afhayes.com/spss-sas-and-mplus-macros-and-code.html Hayes, A. F., & Preacher, K. J. (2009). Beyond Baron and Kenny: Statistical mediation analysis in the new millennium. Communication Monographs, 76, 408-420. doi:10.1080/03637750903310360 Hilgert, M. A., Hogarth, J. M., & Beverly, S. (2003). Household financial management: The connection between knowledge and behavior. Federal Reserve Bulletin, 89, 309-322.

Lyons, A. C., Rachlis, M., & Scherpf, E. (2007). Whatâ&#x20AC;&#x2122;s in a score?

Differences in consumersâ&#x20AC;&#x2122; credit knowledge using OLS and quantile regressions. Journal of Consumer Affairs,41, 223-249. doi:10.1111/j.17456606.2007.00079.x Mandell, L., & Klein, L. S. (2007). Motivation and financial literacy. Financial Services Review, 16, 105-116.

Mandell, L., & Klein, L. S. (2009). The impact of financial literacy education on subsequent financial behavior. Journal of Financial Counseling and Planning, 20(1),15-24.

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Retrieved from http://www.financialeducatorscouncil.org/financial-capability-definition/ Perry, V. G., & Morris, M. D. (2005). Who is in control? The role of self-perception, knowledge, and income in explaining consumer financial behavior. Journal of Consumer Affairs, 39, 299-313. doi:10.1111/ j.1745-6606.2005.00016.x Phares, E. J. (1976). Locus of Control in Personality. Morristown, NJ: General Learning Press.

Preacher, K. J., & Hayes, A. F. (2004). SPSS and SAS procedures for estimating indirect effects in simple mediation models. Behavior Research Methods, Instruments, & Computers, 36, 717-731.

Robb, C. (2011). Financial capability and credit card behavior among college students. Journal of Family and Economic Issues, 32, 690-698. doi:10.1007/s10834-011-9259-y Willis, L. E. (2008-2009). Against financial literacy education. Iowa Law Review, Vol. 94; U of Penn Law School, Public Law Research Paper No. 08-10; Loyola-LA Legal Studies Paper No., 2008-13. Available at SSRN: http://ssrn.com/abstract=1105384

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The Greatest Wealth is Health: Relationships between Health and Financial Behaviors Barbara O’Neill, Ph.D., CFP®, CRPC, AFC, CHC, CFEd, CFCS, Extension Specialist in Financial Resource Management, Distinguished Professor, Rutgers Cooperative Extension Abstract Financial advisors are encouraged to consider their clients’ health and personal finances holistically. Strengths and challenges in one area of a client’s life often affect the other.

Like culture, health status is another “lens” with which to assess clients’ values, goals, plans, personality traits, and lifestyle. This article was written to increase advisors’ understanding of relationships between health and financial practices. When advisors understand a client’s personality traits and projected state of future health, they can provide more comprehensive, targeted advice instead of giving the same advice to clients in different situations. The article begins with a review of recent literature and describes two personality factors found to be associated with positive health and financial behaviors: conscientiousness and time preference. Next, it previews a new online tool to self-assess the frequency of performance of recommended health and financial practices.

It concludes with a summary and implications for financial planning practice.

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Volume 14, Issue 1

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Introduction More than 2,000 years ago, the ancient Roman poet Virgil was quoted as saying “The greatest wealth is health.” As any financial advisor can attest, accumulated wealth is of little value if someone is unhealthy and unable to enjoy it. In a special edition about health care, Money magazine encouraged readers to maintain their “health capital,” noting “Poor health carries a huge opportunity cost. After all, you can’t save if you can’t earn, and you can’t earn without your health” (Schurenberg, 2007, p.

18). Unfortunately, about 69% of the U.S. population is either overweight or obese (Obesity and Overweight, 2014) and some people sacrifice their health in the pursuit of wealth. They fail to take positive actions on a daily basis such as eating nutritious meals and engaging in physical activity and their health and personal finances suffer accordingly. Poor financial practices, such as overspending, have been found to be associated with physical symptoms of stress (Drentea & Lavrakas, 2000; O’Neill, Sorhaindo, Xiao, & Garman, 2005) and, conversely, poor health practices such as overeating and smoking engender associated financial costs to both individuals and society. The cost of preventable direct health care costs resulting from bad health habits is immense and estimated at $133 billion for smoking (Smoking and Tobacco Use, 2014) and $147 billion for obesity (Causes and Consequences, 2014). Other “issues” such as direct costs associated with alcohol abuse just increase the total further. Poor health also affects individuals and families by draining funds that could otherwise be used for wealth accumulation and financial goal attainment.

Give a multitude of associations between health and personal finances (Hollerich, 2000; O’Neill, 2004; O’Neill, 2005; O’Neill & Ensle, 2013; O’Neill & Ensle, 2014; Sharpe, 2008), financial advisors are encouraged to consider their clients’ health and personal finances holistically (O’Neill, 2005). Strengths and challenges in one area of a client’s life often affect the other.

Like culture, health status is another “lens” with which to assess clients’ values, goals, plans, personality traits, and lifestyle.

Typically, health and personal finances are considered separately by professionals with their own literature and agendas (Vitt, Siegenthaler, Siegenthaler, & Kent, 2002). This article was written to increase financial advisors’ understanding of relationships between health and financial practices. It begins with a review of recent literature and then describes two personality factors found to be associated with performance of positive behaviors: conscientiousness and time preference. Next, the article previews a new online tool for users to self-assess their frequency of performance of recommended health and financial practices.

It concludes with a summary and implications for financial advisors about motivating clients to adopt positive behaviors.

Review of Literature The relationship between health status and economic resources is significant, dynamic, and complex (Sharpe, 2008, p. 50). This literature review of studies of health and wealth associations

published during the past decade extends a previous summary of earlier research compiled by O’Neill (2005) and discusses findings that are instructive for financial advisors. Not all of the study results are what one would expect. For example, a study by the Center for Retirement Research found that the “cost” of better health is the need for greater wealth, which initially sounds counter-intuitive to those expecting unhealthy people to pay more for health care. Although current health care costs of healthy people are often lower than those of their unhealthy counterparts, not to mention having a better quality of life for a longer period of time, the healthier cohort will actually face higher total lifetime health care costs (versus unhealthy persons who often die at younger ages) due to an increased like expectancy resulting in more years of out-of-pocket expenses and an increased likelihood of succumbing to a chronic disease (e.g., diabetes) or needing expensive long-term care at an advanced age (Sun, Webb, and Zhivan 2010).

Another somewhat counterintuitive finding is the impact of recessions on physical health. When the economy gets sick, people get healthier (Colvin, 2009). Rather than experiencing negative health impacts, it has been documented that healthy living habits actually improve during tough economic times as the cost of leisure time decreases. In other words, health maintenance activities like walking, riding a bicycle, sleeping, and preparing food at home are time-intensive. When people work and/or commute fewer hours, they have more time for rest, physical activity, and preparing nutritious meals, which improves their health (Hernandez-Murillo and Martinek 2010). When more people work less, workplace related deaths and commuting auto accidents also decrease. Ruhm (2005) found that a 1% rise in unemployment reduces the total death rate by 0.5 %. Conversely, in a study by the National Business Group on Health (Employees Blame, 2008), employees blamed stress from work, finances, and work/ life balance for lack of a healthy lifestyle. Nearly half (47%) of more than 1,500 workers surveyed said that work demands prevented them from leading a healthier life.

During the past decade, studies have investigated relationships between personal health and financial behaviors and associated personal characteristics. A recent example is a study that found that the decision to contribute to a 401(k) retirement savings plan was associated with whether individuals acted to correct poor physical health indicators (e.g., abnormal blood-test results) that were revealed during an employer-sponsored health examination (Paper Links, 2014; Retirement Planning, 2014; Richtel, 2014).

Employees were given an initial health screening and were told of the results, which were also sent to the worker’s physicians.

The workers were also given information on risky health behaviors and anticipated future health risks. The researchers then followed the workers for two years to see how they attempted to improve their health, and if those changes were tied to financial planning. The 401(k) plan contributors showed improvements in health behaviors about 27% more often than non-contributors despite having few health differences prior to program implementation (Gubler & Pierce, 2014). Similarities in time discounting preferences and a trait called conscientiousness were

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believed to be related to retirement contribution patterns and health improvement behaviors. It should be noted, however, that the relationship between retirement savings and health practices was correlational, not causal.

Moffitt et al. (2011) studied childhood self-control and found that it could predict research subjects’ future physical health, wealth, substance dependence, and criminal offending outcomes.

The researchers’ findings were derived by following a cohort of 1,000 children from birth to age 32. They also studied another cohort of 500 sibling pairs and found that the sibling with lower self-control had poorer outcomes, despite shared family background. A recommendation was made for interventions that address self-control to reduce societal costs, save taxpayers money, and promote prosperity. This study harkens back to the classic “marshmallow experiment studies” of delayed gratification in the late 1960s and early 1970s conducted by psychologist Walter Mischel and colleagues where young children were offered a choice between a small immediate reward or two small rewards if they waited 15 minutes. In follow-up studies with the children, those who waited longer for two rewards had better school performance and overall life outcomes, emphasizing the benefits of delayed gratification (Mischel, Shoda, & Rodriguez, 1989).

Another way that health and finances have increasingly been connected is through workplace programs that integrate both aspects of employees’ lives. These programs may include smoking cessation, weight management, personal finance and health/nutrition classes, and online resources. Human Resources departments of large companies typically contract with specialized companies that provide holistic “workplace wellness” programs for their employees. Examples of these companies are Two Medicine Health and Financial Fitness and Simplicity Health Plans, both of which provide customized workplace wellness programs for employers that incorporate health and financial education.

Simplicity Health Plans has also developed a proprietary Health Index Calculator to forecast for individual employees the financial impact of their poor health habits and the potential savings of improved health habits. Seeing an actual dollar figure resulting from unhealthy personal habits (versus impersonal average national figures) has been found to be a powerful motivator to change behavior (L. Holland, personal communication, July 16, 2014). Sutherland, Christianson, and Leatherman (2008) summarized findings from studies of the use of financial incentives to encourage healthy behaviors, wellness activities, and use of preventive services. They concluded that financial incentives, even relatively small ones, can positively influence individuals’ health-related behaviors. For example, smokers who are paid to quit succeed far more often than those who get no cash reward (Tomsho, 2009; Volpp et al., 2009). Innovative approaches that have also been successful in changing health behaviors include lotteries for prizes if workers achieve health goals and “deposit contracts” where participants can lose their own money if they are unsuccessful (Money May Lure People, 2008; Volpp et al., 2008).

Studies have also explored the effect of health status on earnings.

For example, Kosteas (2012) investigated the economic effects of engaging in regular physical activity and found a positive relationship between regular exercise and labor market earnings.

Engaging in regular exercise (defined as working out at least three hours a week) was found to yield a 6 to 10% wage increase. Study results indicated that moderate exercise resulted in a positive earnings effect and more frequent exercise generated an even larger impact. One possible reason is that fit employees are highly disciplined and more productive, which can lead to career advancement and higher earnings.

On the flip side, studies have found that people who are not in good physical health tend to earn less money than their healthier peers. Conley and Glauber (2007) found that women who were obese earned, on average, 18% less than those who weren’t and also had 25% less household income and a 16% reduction in their probability of marriage. This study supported previous research that found that U.S. women pay an “obesity wage penalty” while men had no economic or marital status effects with the exception of a small wage penalty for obese African-American males. The authors noted that the income difference due to obesity in a White woman’s wages “is equivalent to the difference due to almost two years of education” (p. 272). In addition, negative effects of obesity on earnings persist throughout the life cycle, thereby “widening the gender gap in economic well-being” (p. 273).

Studying this issue from the opposite direction, Kim and Leigh (2010) estimated the effects of wages on obesity and body mass and found that wages were a predictive factor. The findings of this study were consistent with the hypothesis that low wages increase obesity prevalence and body mass. Munster, Ruger, Ochsmann, Letzel and Tische (2009) explored associations between over-indebtedness and obesity with data from a sample of 949 over-indebted German subjects and found a higher risk of obesity for over-indebted individuals compared to the general population. After adjusting for a variety of demographic variables and health factors, they concluded that over-indebtedness was associated with an increased prevalence of overweight and obesity that was not explained by traditional definitions of socioeconomic status such as education and income. In a similar vein, Grafova (2007) examined the relationship between non-collateralized debt or NCD (e.g., credit cards, student loans, medical and legal bills, and family loans) and health behaviors using data from the Panel Study of Income Dynamics. Study results revealed that households whose members tend to lead less healthy lifestyles were more likely to hold NCD, leading to a conclusion that factors such as time preference and self-control may underlie the observed correlation.

Negative income effects are included in estimates of costs to individuals of being overweight and obese in the U.S. Dor, Ferguson, Langwith, and Tan (2010) estimated overall annual costs of being obese as $4,879 for an obese woman and $2,646 for an obese man, Their analysis included non-medical indirect costs such as sick days, lost productivity, lower wages, life insurance

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premiums (i.e., not being able to qualify for preferred rates), and even the need for extra gasoline. The difference between genders was mostly the result of lost wages for obese women.

Obese women lost more income through lost wages than from medical costs. Like Conley and Glauber (2007), Dor et al. found that wages don’t differ for obese men. Their estimated costs for obesity were far more than the cost of merely being overweight which were pegged at $524 for women and $432 for men.

Another interesting area of inquiry has been studies of the relationship between health status and portfolio asset allocations.

Here, results have been mixed. Some studies suggest that health status is an important influence on investor decision-making. For example, Berkowitz and Qiu (2006) concluded that the effect of changes in health status on household financial portfolios is indirect. A health shock significantly reduces household total financial wealth, in turn leading households to restructure the composition of their financial assets. Rosen and Wu (2004) found that health is a significant predictor of both the probability of owning different types of financial assets and the share of financial wealth held in each asset category. Households in poor health are less likely to hold risky financial assets and poor health is associated with a larger share of financial wealth in safe assets. Lin and Sharpe (2007), however, found a lack of relationship between mental and physical health and portfolio change.

In their study, lagged changes in wealth were significantly and negatively associated with the proportion of stocks and bonds subsequently held while lagged changes in health were not, implying that investor reaction to wealth changes was relatively more important.

Personality Factors In conclusions to some of the studies cited above, researchers made reference to personal qualities potentially underlying positive health and financial behaviors. These personality traits affect patterns of thinking and behaving and are relatively stable over time and across various life situations. In this section, two specific personality factors found to be associated with performance of recommended health and financial practices (e.g., losing weight and saving money) are discussed: conscientiousness and time preference. Findings from studies linking these personality factors with personal finance behaviors are also described.

Conscientiousness can be defined as a personality trait characterized by being very careful about doing what you are supposed to do and concerned with doing something correctly. Conscientious people are characterized by being organized, self-disciplined, reliable, and hard-working and conscientiousness can be assessed in research studies using self-report measures, peer reports, and third-party observation. It is considered one of the “big five” personality traits along with openness to experience, extraversion, agreeableness, and neuroticism (Duckworth & Weir, 2011).

Conscientiousness was cited as a possible reason for the Gubler & Pierce (2014) finding of a relationship between retirement savings plan participation and improved health practices following the receipt of results from an employer wellness screening.

If someone is conscientious in one area of life, they may also be in another because they have a tendency to take action to secure their future.

Duckworth and Weir (2011) examined how conscientiousness prospectively predicted responses to the financial crisis of 2008-2009 using Health and Retirement Study (HRS) data. They found that more conscientious people spent less on impulse than others and less frequently bought things that they did not need.

They also earned more money than others and saved more of their income. The researchers concluded that behavioral tendencies predicted the proportion of earnings spent vs. saved.

Letkiewicz and Fox (2014) examined the relationship between financial literacy, conscientiousness, and asset accumulation among young adults. Their findings indicated that both conscientiousness and financial literacy are consistent predictors of asset accumulation. Conscientiousness was measured with two questions on a personality inventory from the National Longitudinal Survey of Youth (NLSY97). A one- standard-deviation increase in conscientiousness was correlated with a 40% increase in net worth, 53% increase in illiquid asset holdings, and 33% increase in liquid asset holdings. The authors recommended that financial education be interpreted more broadly to include interventions to increase conscientiousness and self-control.

Time preference (a.k.a., time discounting and intertemporal choice) refers to the inclination of an individual towards current consumption (expenditures) over future consumption or vice versa. In other words, how likely is someone to delay current spending in anticipation of greater returns in the future? A person who wants to spend their money now and not save it is said to have a high time preference (i.e., a preference for the present than the future) or a high propensity to discount future consumption while a person who values saving in addition to spending has a low time preference. The higher the rate of time preference, the larger the factor by which individuals discount future risks to their health or finances associated with current consumption (e.g., overeating or overspending). A multitude of daily health and financial decisions involve trade-offs between immediate consumption and delayed benefits.

Gubler and Pierce (2014) attributed their findings about the correlation between retirement contribution patterns and health improvements to time preferences, noting “time discounting stems from an underlying psychological trait, which is difficult to change, yet predicts employee behaviors on multiple dimensions” (p. 8). Finke and Huston (2003) explored saving for retirement as a function of time preference using a sample of 6,812 college students. Their results showed strong correlations among decision-making domains that involve time discounting.

In addition, a factor of intertemporal preventive health behaviors was a stronger predictor of the importance of saving for retirement than all other explanatory variables including age, race, parental income, gender, GPA, and college major. On the health side, Komlos, Smith, and Bogin (2004) suggested that linkages exist between obesity and time preference and encouraged more research in this area. Fuchs (1980) explored relationships

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between time preference, health behaviors, and health status and concluded that family background, especially religion, appears to be an important determinant of time preference, which was measured by a series of six questions asking a sample of adults age 25-64 to choose between a sum of money now and a larger sum at a specific point in the future.

Personal Health and Finance Quiz Each year, when people are asked to state their New Year’s resolutions, issues related to improving health (e.g., losing weight) and personal finances (e.g., saving money) rise to the top of the list. To help Americans reach their personal health and financial planning goals, Rutgers Cooperative Extension developed a new online self-assessment tool called the Personal Health and Finance Quiz. The quiz is available online at no charge at http://njaes.rutgers.edu/money/health-finance-quiz/ and is believed to be among the first online surveys available for public use (versus proprietary tools that are used by workplace wellness program providers) to simultaneously query users about their daily health and personal finance practices. Some examples of these behaviors include eating breakfast, getting at least 7 hours of sleep per night, avoiding sugar-sweetened beverages, following a budget, owing less than 20% of monthly take-home pay on consumer debt payments, and maintaining an adequate emergency fund.

The Personal Health and Finance Quiz is part of Small Steps to Health and Wealth™ (SSHW), a national Cooperative Extension program developed to motivate Americans to take action to simultaneously improve their health and personal finances.

SSHW was built around a framework of 25 research-based behavior change strategies. People who complete the quiz indicate one of four frequencies for their performance of ten health behaviors and ten financial behaviors. The responses are Never, Sometimes, Usually, and Always. Upon completion of the quiz, they receive a score for each section of the quiz (i.e., a Health Score and a Finance Score), a Total Score, and links to additional online resources for improved health and financial management.

A high quiz score means that respondents are doing many of the activities that health and financial experts recommend to improve health and build wealth, which increases their likelihood of success.

The Personal Health and Finance Quiz has two additional purposes beyond providing feedback to individual users. The second is to collect research data about the daily health and financial practices of Americans to inform future Cooperative Extension educational programs and the third is to use quiz scores to evaluate the impact of SSHW learning activities. The quiz can be taken as a pre-test before people attend a Cooperative Exten-

sion-sponsored SSHW program and as a post-test several months later to determine if they changed their health and financial practices after learning new information. Initial research analyses about respondents’ health and financial practices and relationships between them are planned for FALL 2015.

About a dozen experts in health and nutrition, personal finance, and evaluation methods provided helpful feedback during development of the Personal Health and Finance Quiz. They helped construct the quiz format and content including specific daily activities that are a “step in the right direction,” even if they are not at the highest level of action recommended by health and personal finance experts. For example, investing $3,650 annually is probably not a sufficient sum for a 55 year old to achieve financial security in later life, as it might be for a 22 year old with three more decades of compound interest. However, investing the equivalent of at least $10 per day is much better than doing nothing, which, unfortunately, is the case for many Americans.

According to the 2014 Retirement Confidence Survey or RCS (Helman, Adams, Copeland, & VanDerhei, 2014), 36% of American workers have less than $1,000 saved for retirement and 60% reported that the total value of their household’s savings and investments, excluding the value of their home and a defined benefit pension, was less than $25,000. Only 11% of 1,501 RCS respondents had saved $250,000 or more.

Quiz data will be used to test relationships between health and financial practices. Relatively few studies of this type have been conducted aside from proprietary workplace wellness research.

Questions that will be explored include the relationship between scores for health and finances (i.e., is it a positive relationship?), scores for individual health and financial behaviors, the relationship between the answer to Question #20 (about personal planning behaviors) and health and financial behavior quiz scores, and demographic differences in health, financial scores and total quiz scores.

Health and personal finance behavior changes start with daily action steps. Financial advisors are encouraged to share the Personal Health and Finance Quiz with their clients as a self-assessment tool and to increase awareness of recommended health and personal finance practices and potential opportunities for self-improvement in both domains of life. The quiz is based on frequently cited recommended activities. The quiz is shown in Table 1, below:

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Table 1 Personal Health and Finance Quiz Want to improve your health and personal finances? It starts with daily health and financial management practices. Take this quiz to assess your current daily activities. Choose the response that best describes how frequently you perform health and financial management practices: 1 = Never 2 = Sometimes 3 = Usually 4 = Always

When you’re done, add up your scores from the 20 questions below. There is a separate score for daily health practices and daily financial practices and a summary at the end of each section. The two separate scores also combine to produce a total quiz score.

Daily Health Behaviors: _____ I eat breakfast before starting my day (e.g., work, school, or other daily activities). _____ I avoid drinking sugar-sweetened beverages (e.g., regular soda and sweetened coffee or tea) _____ I eat 3 ½ to 4 ½ cups of fruits AND vegetables daily. _____ I get at least 7 hours of sleep per night. _____ I eat at least 1-2 high fiber foods each day (e.g., whole wheat bread and pasta, oat bran, beans) _____ I eat and drink fat-free and/or low-fat dairy products. _____ I avoid high-calorie salad dressings, gravies, spreads, and/or sauces. _____ I eat foods that are low in fat and/or saturated fat. _____ I get at least 30 minutes of aerobic and/or muscle-strengthening physical activity at least 5 days per week. _____ I drink at least eight 8-ounce glasses of water and other fluids per day, excluding alcoholic beverages.

Health Score: __________

Score Interpretation 10-16 points

-Your health choices could be better, but don’t despair. It’s never too late to take action to improve your health.

17-24 points

-You are doing a fair job of managing your health practices and have taken some steps in the right direction.

25-32 points

-You are doing a good job and are above average in managing your health.

33-40 points

-You are in excellent shape managing your health. Keep up the good work!

Note: Items that you scored with a 1 or 2 are actions that you should consider taking in the future to improve your health.

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Daily Financial Behaviors: _____ I follow a hand-written or computer-generated spending plan (budget) to guide my spending and savings. _____ I maintain an emergency fund equal to at least three months of basic, essential household expenses. _____ I save the equivalent of at least $1 daily ($365 annually) in loose change in a savings account and/or or jar. _____ I invest the equivalent of at least $10 daily ($3,650 annually) in investment accounts and/or retirement plans. _____ I avoid payday loans, car title loans, pawn shop loans, cash advances, tax refund loans, and other high-cost debt. _____ I owe less than 20% of my monthly net income on monthly consumer debt payments (e.g., credit cards, car loans, student loans, and/or personal loans excluding a mortgage). Example: $3,000 net income x .20 = $600. _____ I eat at least two meals a day prepared at home instead of eating out (excluding traveling). _____ I use advertisements, coupons, promo codes, sales, web sites, and/or discounts to save money on purchases. _____ I live below my means (i.e., spend less than I earn). _____ I make written “to do” lists or specific plans to organize my financial goals, spending, and/or daily activities.

Financial Score: __________ Score Interpretation 10-16 points

- Your financial choices could be better, but don’t despair. It’s never too late to take action to improve your finances.

17-24 points

-You are doing a fair job of managing your personal finances and have taken some steps in the right direction.

25-32 points

-You are doing a good job and are above average in managing your finances.

33-40 points

-You are in excellent shape managing your finances. Keep up the good work!

Note: Items that you scored with a 1 or 2 are actions that you should consider taking in the future to improve your personal finances.

Total (Health + Financial) Score: __________

Summary and Implications Health and wealth are closely knit together in financial planning. Poor health habits almost always wind up costing people money and health care will be many people’s largest expense in retirement (Rozen, 2014). This article described a variety of studies that indicate relationships between health and personal finances. These health and wealth associations include “weight bias” resulting in lower incomes for women, better health habits during recessions, high medical expenses for the treatment of chronic diseases, and higher lifetime health care costs for

healthy individuals with higher than average life expectancies.

Also discussed were two personality traits, conscientiousness and time preference, which have been linked to the performance of recommended health and financial practices. A number of studies have investigated the role of psychological factors as an influence on health and financial behaviors. The Personal Health and Finance Quiz was also introduced as a simple online tool to simultaneously assess respondents’ health and financial wellness behaviors and collect data for future studies of health and wealth relationships.

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Following are implications of health and wealth relationships for financial practitioners: ♦ Include a discussion of health care spending during annual reviews with clients. If this is a routine part of the review process, questions about health status (“Have you recently been hospitalized or had any outpatient surgery?”) won’t seem so out of place. Without being judgmental with clients who are smokers, obese, or have other unhealthy habits, share statistics about the cost of unhealthy habits (e.g., a $7 pack a day of cigarettes) and how healthier lifestyles correlate with lower medical expenses (Rozen, 2014). For example, smokers purchasing life insurance will generally pay higher premiums than non-smokers as will those purchasing health insurance on a government-facilitated exchange under the Affordable Care Act in some states. As is the case with other areas of financial planning, advisors differ on their approach to addressing clients’ health. Rozen described one advisor who recommended avoiding any mention of clients’ personal habits and, instead, using “the vocabulary of financial planning” (e.g., current budget, projected expenses, and retirement income). Another advisor tells clients “What’s the point of planning if you are going to have an early death?” and has seen clients lose weight and stop drinking, perhaps in response to his frankness. ♦ Consider including several questions about basic health issues (e.g., Do you drink? Do you smoke? How often do you exercise? Do any diseases or medical conditions run in your family?) on client prospect questionnaires. The answers provide advisors with useful information that can fuel deep conversations (Rozen, 2014). Responses to the Personal Health and Finance Quiz or a “lifestyle” based life expectancy calculator with questions about personal habits, such as https://www.livingto100.com/, http://www.msrs.state. mn.us/info/Age_Cal.htmls, and http://gosset.wharton.upenn. edu/mortality/perl/CalcForm.html may also be instructive as are results from a client’s workplace wellness program health risk assessment tool, if available. The latter is used by employers to assess the likelihood of workers having certain health conditions in the future based on their lifestyle data and health statistics. As noted in the literature review, discipline in other areas of a client’s life (e.g., regular exercise) may translate to discipline with respect to personal finances. Pullen & Wehner (2007) note that, just like money and property, health is an asset that should be managed wisely. In the absence of adequate health capital, the power of financial capital is greatly diminished. When health is viewed as an asset by financial advisors and discussed with clients from this perspective, it may open discussion of practices that support or undermine it. In addition, when advisors understand a client’s projected state of future health, they can provide more comprehensive, targeted advice instead of giving the same advice (e.g., make retirement asset withdrawals according to the 4% rule) to clients in different situations.

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♦ Realize that changing ingrained personality traits (e.g., increasing conscientiousness) is never easy but people can change their habits for more consistent positive behavior (e.g., saving money and exercising regularly). Two ways that clients can become more conscientious are automating desired behaviors (e.g., retirement savings plan deposits) to eliminate the need for constant self-control and decision-making and using “precommitment devices” such as telling a friend/family member (for accountability) that they will start exercising or will no longer buy lottery tickets or order dessert at a restaurant (Hess, 2013). Better still, have clients create a personal behavior change contract that lists their desired health and financial goals and required actions (see http://njaes.rutgers.edu/sshw/workbook/25_Set_a_ Date_and_Get_Started---Just_Do_It.pdf) Helping clients become more conscientious can produce benefits on many fronts including physical health, mortality, occupational attainment, job performance, and marital stability (Roberts, n.d). ♦ Assess your client’s time preferences. Be aware of their propensity to value future gains (or not) and incorporate this in your planning. Like conscientiousness, time preference is a key determinant of personal behavior. Clients with future-oriented time preferences (i.e., those who value future outcomes relative to immediate ones) should be more likely than others to adopt preventive health and financial measures. Fuchs (1980) assessed health-related time preference with a series of six questions that offered a choice between two cash prizes (e.g., $1,500 now or $4,000 in 5 years and $2,500 now or $4,000 in 3 years). Changing clients’ innate time preferences isn’t easy but they can be shown the benefits of modest decreases in current consumption to free up funds for capital asset accumulation. Online tools like The 1% More Savings Calculator on the New York Times website (http://www.nytimes.com/interactive/2010/03/24/your-money/one-pct-more-calculator.html?_r=0) can be useful. With increased awareness of potential future benefits, clients may become amenable to decreasing current consumption and be less likely to discount future investment growth.

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Hess, B. (2013). Conscientiousness: A trait every one of your future hires should possess-Part 2. Retrieved from http://www.workpuzzle.com/ workpuzzle/2013/07/conscientiousness-a-trait-every-one-of-your-futurehires-should-possess-part-2.html.

Hollerich, A. (2000). The weight and wealth factors. Brass Ring Productions, Ltd. Kim, D. & Leigh, J.P. (2010). Estimating the effects of wages on obesity.

Journal of Occupational and Environmental Medicine, 52(5), 495-500.

Komlos, J., Smith, P.K. & Bogin, B. (2004). Obesity and the rate of time preference: Is there a connection? Journal of Biological Science, 36(2), 209-219.

Kosteas, V.D. (2012). The effect of exercise on earnings: Evidence from the NLSY. Journal of Labor Research, 33, 225-250.

Letkiewicz, J.C. & Fox, J. J. (2014). Conscientiousness, financial literacy, and asset accumulation of young adults. Journal of Consumer Affairs, 48(2), 274-300.

Lin, Y. & Sharpe, D.L. (2007). Effect of health and wealth changes on portfolio allocation of older Americans. In I. Leech (Ed.) Proceedings of the Association for Financial Counseling and Planning Education, 69-76. Retrieved from http://www.afcpe.org/wp-content/uploads/2014/04/2007_afcpe_conference_proceedings_opt.pdf.

Mischel, W., Shoda, Y, & Rodriguez, M.I. (1989). Delay of gratification in children. Science. 244(4907), 933-938.

Moffitt, T.E, Arseneault, L., Belsky, D., Dickson, N, Hancox, R.J., Harrington, H., Houts, R., Poulton, R., Roberts, B.W., Ross, S., Sears, M.R, Thomson, W.M., & Caspi, A. (2011). A gradient of childhood self-control predicts health, wealth, and public safety. Proceedings of the National Academy of Sciences, 108(7), 2693-2698.

Money may lure people to lose weight (2008, December 9). U.S. News & World Report. Retrieved from http://health.usnews.com/health-news/ family-health/brain-and-behavior/articles/2008/12/09/money-may-lurepeople-to-lose-weight.

Munster, E., Ruger, H., Ochsmann, E., Letzel, S. & Tische, A.M. (2009).

Over-indebtedness as a marker of socioeconomic status and its association with obesity: a cross-sectional study. BMC Public Health, 9: 286.

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Obesity and overweight (2014). Atlanta, GA: Centers for Disease Control and Prevention. Retrieved from http://www.cdc.gov/nchs/fastats/obesity-overweight.htm.

O’Neill, B. (2004). Small steps to health and wealth. The Forum for Family and Consumer Issues, 9(3). Retrieved from http://ncsu.edu/ffci/publications/2004/v9-n3-2004-december/fa-1-small-steps.php.

O’Neill, B. (2005). Health and wealth connections: Implications for financial planners. Journal of Personal Finance, 4(2), 27-39.

O’Neill, B. & Ensle, K. (2014). Small steps to health and wealth™: Program update and research insights. The Forum for Family and Consumer Issues, 19(1). Retrieved from http://ncsu.edu/ffci/publications/2014/v19n1-2014-spring/oneil-ensle.php.

O’Neill, B. & Ensle, K. (2013). Small steps to health and wealth (second edition). Ithaca, NY: PALS Publishing.

O’Neill, B., Sorhaindo, B., Xiao, J. J., & Garman, E. T. (2005). Financially distressed consumers: Their financial practices, financial well-being, and health. Financial Counseling and Planning, 16(1), 73-87. Retrieved from http://afcpe.org/assets/pdf/vol1618.pdf.

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Roberts, B.W. (n.d.). Conscientiousness. Urbana-Champaign: University of Illinois. Retrieved from http://faculty.las.illinois.edu/bwroberts/conscientiousness/index.html.

Rosen, H.S. & Wu, S. (2004). Journal of Financial Economics, 72(3), 457484. Retrieved from http://www.sciencedirect.com/science/article/pii/ S0304405X03001788.

Rozen, M. (2014, January 2). Your client chain smokes: Should you speak up? Financial Advisor. Retrieved from http://www.financialadvisoriq. com/c/629754/71304.

Ruhm, C. J. 2005. Healthy living in hard times. Journal of Health Economics, 24(2), 341-363. Retrieved from http://libres.uncg.edu/ir/uncg/f/C_ Ruhm_Healthy_2005.pdf.

Schurenberg, E. (2007, June). Where your health meets your money. Money, 36(6), 18.

Sharpe, D.L. (2008). Health and wealth connections. Journal of Personal Finance, 6(4), 37-56.

Smoking and tobacco use (2014). Atlanta, CA: Centers for Disease Control and Prevention. Retrieved from http://www.cdc.gov/tobacco/ data_statistics/fact_sheets/fast_facts/.

Smoking and tobacco use (2014). Atlanta, CA: Centers for Disease Control and Prevention. Retrieved from http://www.cdc.gov/tobacco/data_statistics/fact_sheets/fast_facts/.

Sun, W., A. Webb, and N. Zhivan (2010). â&#x20AC;&#x153;Does staying healthy reduce your lifetime health care costs?â&#x20AC;? Center for Retirement Research, Number 108. http://crr.bc.edu/wp-content/uploads/2010/05/IB_10-8.pdf.

Sutherland, K., J. B. Christianson, and S. Leatherman (2008, December).

Impact of targeted financial incentives on personal health behavior: A review of literature. Medical Care Research and Review 65: 36S-78S. http://mcr.sagepub.com/content/65/6_suppl/36S.short Tomsho, R. (2009, February 12). More smokers quit if paid, study shows.

The Wall Street Journal, D1, D6.

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Volpp, K.G., Troxel, A.B., Pauly, M.V., Glick, H.A., Puig, A., Asch, D.A., Galvin, R., Zhu, J., Wan, F., DeGuzman, J., Corbett, E., Weiner, J., & Audrain-McGovern, J. (2009). A randomized, controlled trial of financial incentives for smoking cessation. New England Journal of Medicine, 360, 699-709. Retrieved from http://www.nejm.org/doi/ full/10.1056/nejmsa0806819#t=articleTop. Volpp, K.G., John, L.K., Troxel, A.B., Norton, L., Fassbender, J. & Loewenstein, G. (2008). Financial incentive- based approaches for weight loss: A randomized trial. Journal of the American Medical Association. Retrieved from http://jama.jamanetwork.com/article.aspx?articleid=183047.

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Life And Death Tax Planning For Deferred Annuities Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL, Pinnacle Advisory Group, Columbia, MD The concept of the annuity – a stream of income that will be paid for life – has been around for almost two millennia, and in the US for nearly 200 years now. Annuities became far more popular in the past century or so, though, due to both rising longevity that creates longer retirement periods which need to be funded, and significant tax preferences established in the Internal Revenue Code to incentivize the use of annuities as a vehicle for retirement accumulation (and subsequent decumulation). This article explores the tax implications of deferred annuities in detail.

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The concept of the annuity – a stream of income that will be paid for life – has been around for almost two millennia, and in the US for nearly 200 years now. Annuities became far more popular in the past century or so, though, due to both rising longevity that creates longer retirement periods which need to be funded, and significant tax preferences established in the Internal Revenue Code to incentivize the use of annuities as a vehicle for retirement accumulation (and subsequent decumulation).

A unique complication of annuities after death is that, unlike IRAs, it is difficult to stretch post-death annuity distributions through a trust. While the Treasury Regulations allow retirement accounts to “see through” the trust to the underlying beneficiaries, and stretch on their behalf, no such rules have been established for annuities. As a result, planning for annuities may have to trade off between the opportunity to stretch, and the desire to control assets with a trust.

The primary tax preference for deferred annuities still in the accumulation stage is that annual growth on the contract is tax deferred, and does not have to be reported as income until actually withdrawn from the contract. Notably, though, this taxdeferral treatment is only available for annuities that are actually owned by a “natural person” – a living, breathing human being – or in limited circumstances, where a trust owns an annuity “as an agent for a natural person”.

Because many annuity rules are based on private letter rulings, the interpretation of the tax rules may vary from one insurance company to the next. As a result, to plan effectively it’s crucial to understand the rules of the particular annuity contract and annuity company before a death occurs.

When distributions are ultimately taken from an annuity, any gains are taxable as ordinary income, and the tax code requires that any withdrawals from an annuity be treated as “gains first” to the extent of any gain, before any principal is paid out. In addition, gains distributed to an annuity owner prior to age 59 ½ may be subject to a 10% “early withdrawal penalty” unless the distribution is after death or disability of the annuity owner, as part of a series of substantially equal periodic payments, or because the contract is an immediate annuity.

To make effective decisions regarding annuities, including with respect to their taxation, it’s important to understand the key details of the annuity contract itself, including both the type of annuity, and the parties to the contract. The key distinctions in both categories are explained below.

If an annuity is fully surrendered, and the net proceeds received are less than the original cost basis, the loss is deductible and is treated as an ordinary loss (not a capital loss). Unfortunately, though, the loss is claimed as a “miscellaneous itemized deduction subject to the 2%-of-AGI floor” which both limits the benefit of deductibility, and potentially eliminates it entirely for those subject to the Alternative Minimum Tax (AMT).

Because the tax preferences for annuities are intended primarily for retirement accumulation, at the death of an annuity owner, contracts are required to make payments to the beneficiaries, similar to other types of retirement accounts. Notably, though, in the case of an annuity, post-death distributions must begin upon the death of any owner, which can create significant complications in the case of joint ownership of annuity contracts (especially between non-spouses).

A surviving spouse who is the beneficiary of an annuity has the option to continue the contract in his/her own name.

Other natural person beneficiaries have the choice to take distributions out over their life expectancy – though only some annuity companies allow this to be done by taking systematic withdrawals each year, while other companies require that the beneficiary actually annuitize the contract (and give up their liquidity) to stretch payments out over life. For those who are not able to do spousal continuation or take stretch payments over life expectancy, the annuity must be liquidated under the 5-year rule (by the 5th anniversary of the owner’s death).

Understanding Key Annuity Details

Types of Annuities The term “annuity” is actually used to describe a wide range of possible types of annuity contracts, and so when evaluating annuities it’s crucial to narrow the scope and understand which particular type is being analyzed. The three primary ways that annuities can be broken down are: Immediate vs Deferred. An immediate annuity is a contract where a lump sum is paid to receive a set stream of payments, either “for life”, for a certain period of time, or a combination thereof, where the regular payments begin within 1 year of purchase. By contrast, a deferred annuity is a contract that has not yet been converted to a stream of payments. The act of converting a deferred annuity into an immediate annuity is generally called “annuitizing” the contract; to ensure that a deferred annuity is an annuity, all contracts will have some [mandatory] annuity starting date at which the contract must be annuitized (if it was not purchased as an immediate annuity in the first place).

Notably, the label “deferred” annuity is actually a reference not to its tax treatment, but the fact that its annuity starting date at which annuitization must occur is deferred until some point in the future (and in the meantime, the annuity is accumulating growth/return of some sort). Separately, deferred annuities also enjoy tax-deferral treatment, as discussed later, and this treatment is so appealing for some investors that they deliberately seek out contracts that have distant late-age required annuity starting dates, specifically to allow them to maintain the deferred annuity in tax-preferenced deferred status as an accumulation vehicle for a longer period of time.

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Fixed vs Variable. Another important distinction for annuities is between fixed versus variable contracts. Although typically viewed as whether the contract provides a fixed (e.g., bond-like) versus variable (e.g., stock-like) rate of return, technically the fixed/variable distinction is a measure of the value of the annuity units associated with and underlying the contract.

For instance, in a fixed annuity contract, a contribution of $100,000 will typically buy 100,000 annuity units, valued at $1.00 each. Thus, the total value of the contract is 100,000 x $1.00 = $100,000. As the contract generates interest, the returns are used to purchase more annuity units; for instance, $20,000 of interest would buy another 20,000 annuity units (which at a $1.00/unit value are worth $20,000). Throughout, the value of the annuity units remains fixed at $1.00, and the only question is how many annuity units are owned. The fact that the annuity units are fixed at $1.00, and cannot decline in value (or fluctuate at all), is the primary reason why fixed annuities are regulated as insurance products, and not investment securities.

By contrast, in the case of a variable annuity, the value of the units themselves change (up or down) over time. An investor might own 15,000 units of a stock fund valued at $4.00 each, and 20,000 units of a bond fund at $2.00 each, for a total value of 15,000 x $4.00 + 20,000 x $2.00 = $100,000. Similar to the Net Asset Value (NAV) of mutual funds, the value of each annuity unit is ‘arbitrary’ and has no inherent meaning unto itself; it is simply computed based on the value of the underlying assets to determine the total value of the investment position. As with mutual funds, though, returns over time are then generated by the returns in the underlying fund that increases (or decreases) the value of the annuity unit; for instance, if the stock fund was up by 10% to $4.40, the new value of the stock position would be 15,000 x $4.40 = $66,000, and if the bond fund was down by 5%, its new value would be 20,000 x $1.90 = $38,000.

Although this distinction – between fixed annuity units where the number of units accumulate, versus variable annuities where the value of the units grow over time – may seem purely academic (and has no direct impact on taxation), it is important both for regulatory purposes (as noted earlier, the fact that the annuity units are variable is what makes variable annuities regulated as securities), and also in the event the contract is ever annuitized (where annuitized payments are actually calculated based on units and, in the case of variable annuitization, the changing value of the units can lead to changing ongoing annuitized payments).

Non-Qualified vs Qualified. The distinction between nonqualified versus qualified annuities is a reference to the tax status of how they are held. Simply put, “qualified” annuities are contracts that are held inside of tax-qualified retirement plans (e.g., employer retirement plans like 401(k)s, 403(b)s, and profit-sharing plans, or traditional or Roth IRAs), while “nonqualified” annuities are those that were purchased with after-tax dollars (e.g., from a bank or brokerage account).

In the context of the tax code, qualified annuities are subject to the tax laws of the retirement account in which they are held; the fact that it happens to be an annuity inside is generally irrelevant (though special rules do apply to the valuation of annuities in retirement accounts for the purposes of Roth conversions and calculating Required Minimum Distributions). By contrast, nonqualified annuities are taxed under the standalone rules of IRC Section 72.

We will focus specifically on the tax treatment of non-qualified, deferred annuities (regardless of whether they are fixed or variable, as that does not directly impact the tax treatment).

Parties To The Contract In addition to understanding the types of annuities, it’s also vitally important to understand the parties to the contract before making any type of (tax-related or other) annuity decision.

Ultimately, there are four key parties involved in any annuity contract, of which the advisor should always be aware when making a potential decision: Owner. The owner of the contract – also known as the “holder” throughout much of the tax law – is the party that holds legal title to the annuity, and has the rights to make any/all decisions regarding the contract, from whether to change to investment allocation (to the extent allowed), whether to keep or surrender or exchange or take withdrawals from the contract, whether to annuitize or not, and who the beneficiary will be. Except in a few rare circumstances with trusts (discussed later), the owner is also generally the one on those income tax return any gains will be reported (when taxable events occur), and in whose estate the value will be reported for estate tax purposes.

Annuitant. As discussed earlier, there are two primary types of annuities: immediate annuities that have been converted to a stream of income for life (or a period of time); and deferred annuities, which haven’t been annuitized (yet?). In this context, the annuitant has one real purpose: in the event the contract is annuitized, and the payments are to continue “for life”, the annuitant will be the measuring life for those life contingent payments. Notably, beyond this point, though, the annuitant has no legal rights or ownership interest in the contract, now or in the future; the annuitant does not own and control the contract, and is not necessarily the beneficiary (unless separately declared as such). For better or worse, the purpose of that annuitant is simply to be the measuring life if/when the contract is ever annuitized (and in limited cases, to also be the measuring life for certain lifetime income or withdrawal riders under a deferred annuity).

Insurance Company. The insurance company is the entity on the other side of the annuity contract. In the case of a fixed annuity, the funds are actually held in the insurance company’s general account and subject to their credit risk; with a variable annuity, the funds are generally held in the underlying subaccounts and not subject to the credit risk of the insurer,

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though any overarching guarantees (e.g., death benefits, or living benefit riders) are still subject to the credit risk of the insurer.

From the tax perspective, because many tax rules typically applied to annuities are based on non-binding Private Letter Rulings, knowing the insurance company and its policies and procedures can be important, as not all insurance companies will report on or ‘cooperate’ with certain tax-related strategies in the same way.

Beneficiary. The beneficiary of an annuity does not have any formal legal rights to the contract until the owner passes away and the contract properly passes to the beneficiary by operation of the contract (unless established earlier as an irrevocable beneficiary, which is rare). Nonetheless, it is critical to know who the beneficiary is, as the options available for an annuity’s post-death distribution requirements can and will vary depending on the type of beneficiary (spouse, non-spouse individual designated beneficiary, or non-designated beneficiary) as discussed later.

Tax Treatment of Deferred Annuities During Life Annual Tax Deferral As noted earlier, deferred annuities are not actually labeled as “deferred” because they are tax-deferred; instead, the label is a reference to the fact that the annuity starting date at which the contract must be annuitized has been deferred to some point in the future. Historically, this annuity starting date was often aligned to a common retirement age (e.g., age 65), at which time periodic payments for life would begin, similar to other pensions. In turn, to encourage this kind of saving-fora-personal-pension behavior, Congress enacted preferential tax treatment for annuities under IRC Section 72 by providing tax-deferred growth during the deferral/accumulation phase.

Notably, in today’s environment using annuities for tax-deferred accumulation has become so popular that they are rarely annuitized, and instead are often selected for deliberately-late annuity starting dates that will allow the annuity to remain in deferral/accumulation status until a very advanced age.

However, an important caveat to this general rule is that tax deferred growth on a deferred annuity is only allowed in situations where the contract is owned by a natural person (i.e., a living breathing human being).1 If the annuity is not owned by a natural person (e.g., a trust or a business entity), any increases in the value of the annuity each year (i.e., gains) are taxable annually as ordinary income. The “exception to the exception”, though, is that an annuity may still maintain annual tax-deferral of gains, even if it is owned by a non-natural person, if the ownership arrangement is serving “as an agent for a natural person.”

Unfortunately, the tax code and associated regulations do not fully define what constitutes an “agent for a natural person” in the first place. However, a long list of Private Letter Rulings

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over the years have consistently shown that, at least in the case of trusts, the “agent for a natural person” rule applies as long as all the beneficiaries of the trust are natural persons.2 In fact, one Private Letter Ruling appears to have allowed favorable tax treatment for the annuity merely because the income beneficiary was a natural person (though it happens to be the case that the remaindermen were natural persons, too).3 These rulings imply that typical bypass (i.e., credit shelter) trusts, along with revocable living trusts, should easily qualify for favorable treatment, as the beneficiaries are typically all living, breathing human beings.

In the case of other non-natural entities – e.g., business entities – the situation is rather straightforward in the opposite direction: business entities are respected for business purposes, and therefore clearly are not functioning as an agent for a natural person. In the one Private Letter Ruling to consider the issue directly – where an annuity was going to be owned by a (family) limited partnership to implement certain estate planning transfers – the IRS indicated that the nature of the limited partnership as a business entity alone would disqualify the annuity from tax deferral treatment, at which point the PLR was withdrawn (as that would have defeated the remainder of the estate planning strategy).4 Of course, it’s also worth noting that obtaining favorable tax treatment for a partnership-owned deferred annuity would run counter to most typical family limited partnership (FLP) strategies in today’s environment; for the FLP to be respected for discounting purposes, it must clearly be a bona fide business entity separate from the taxpayer, which entirely undermines the case that it is an agent for a natural person for annuity tax deferral purposes (or conversely, successfully showing the partnership is just an agent for a natural person for annuity tax deferral would undermine the credibility of its partnership-related discounts for transfer tax purposes!).

In any event, these rules apply only to non-qualified annuities.

As noted earlier, in the case of qualified annuities, the tax deferral treatment is dictated by the rules of the retirement account that holds the annuity (the IRA, or 401(k), or 403(b), etc.).

Distributions from Annuities Under IRC Section 72, the taxation of withdrawals or payments from annuities are broken into two categories: 1) amounts received as an annuity; and 2) amounts not received as an annuity.

The first category is a reference to amounts that are received as payments from an annuity that has reached its annuity starting date – i.e., an immediate annuity, or a deferred contract that has subsequently been annuitized. Amounts received as an annuity are subject to special so-called “exclusion ratio” rules that allow a portion of each payment to be treated as principal, with the remainder as growth taxed as (ordinary income) gains.5

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The second category – for amounts “not received as an annuity” – addresses the tax treatment of withdrawals from (non-qualified) deferred annuities. In the case of “amounts not received as an annuity” from a deferred annuity contract, the general rule is that gains are taxable first (always as ordinary income) to the extent that there is any gain in the annuity, and only then is any of the principal recovered.6 Example 1. John owns a deferred annuity with a cash value of $105,000, to which he had originally contributed $100,000.

For any distributions that John takes from the contract, the first $5,000 (the amount of embedded gain) will be treated as taxable gains. Any additional withdrawals beyond that first $5,000 will be treated as a return of principal.

Notably, the rules in determining gain for the purposes of gainsfirst partial withdrawals from deferred annuities stipulate that the gain should be determined without regard to surrender charges7; in other words, a contingent surrender charge that hasn’t actually been deducted from the actual cash value is not considered in determining the gain, although in the case of a full surrender of the annuity where surrender charges were actually paid, only the net amount actually received is considered in determining gain.8 Example 2a. Larry owns a deferred annuity with a cash value of $105,000, to which he had contributed $100,000, and the contract still has an $8,000 contingent surrender charge. Thus, the net surrender value (if he walked away now) would be only $97,000, less than his original contribution. If Larry surrenders the entire contract, he will have put in $100,000, and only receive back $97,000, so he will have a $3,000 loss.

Example 2b. Continuing the prior example, if Larry takes a partial withdrawal of $12,000, gain is determined without regard to surrender charges, which means Larry will report taxable income of $5,000 (the embedded gain) and receive a $7,000 return of principal. His cash value will be down to $93,000, his net surrender value will be down to $85,000 (assuming the $8,000 surrender charge still looms), and his cost basis will be down to $93,000 (after adjusting for the return of principal that was paid out). If Larry subsequently takes a full surrender of his contract, he will have an $8,000 loss (proceeds of $87,000 with a cost basis of $95,000).

Notably, in example 2b, Larry would have ultimately had a $5,000 gain and an $8,000 loss, for $3,000 of net loss, which is the same as the $3,000 loss in example 2a as well. However, due to the tax laws pertaining to gains and losses from annuities, with example 2b and the partial surrenders, the gain was recognized now (at the time of surrender), while the loss is only recognized in the future when the contract is fully surrendered; although gains are recognized with a partial surrender, losses are not. When losses are claimed, they are generally an ordinary loss claimed as a miscellaneous itemized deduction subject to the 2%-of-AGI floor (see sidebar).

Deducting Losses On Annuities Losses are not common on most types of fixed annuities, as the guaranteed nature of the annuity principal typically prevents losses (except in the case of an early surrender triggering significant surrender charges). However, in the case of variable annuities, losses can and do occur with market declines.

An annuity loss can only be claimed upon the total surrender of an annuity; a partial surrender, or just bearing an intra-year decline in value, is not deductible.

In the event that a deductible loss does result at the time of surrender, the loss is ordinary income (just as the gain would be) under Revenue Ruling 61-201; accordingly, annuity losses are not capital losses, and cannot be netted against capital gains.

However, while the IRS has affirmed annuity losses as being ordinary losses, there is still some debate about where/ how to claim the loss. Some have suggested that the loss should be claimed as an “other ordinary loss” on the first page of Form 1040 (i.e., as an “above the line” deduction) and the associated Form 4797 for “[Other] Ordinary Gains and Losses [on the Sale of Business Property]”. However, annuities generally are not “business property” and the tax code prescribes that any itemized deductions that don’t have specifically tax code sections to the contrary should all be claimed as a miscellaneous itemized deduction under IRC Section 67(b); accordingly the IRS itself guides in its own Publication 575 that the proper way to claim an annuity loss is as a miscellaneous itemized deduction subject to the 2%-ofAGI floor.

Unfortunately, this is not very favorable treatment, due both to the fact that it requires the taxpayer to itemize deductions in the first place, it limits the deduction to the excess above the 2%-of-AGI threshold, and most significantly the fact that such miscellaneous itemized deductions (thereby including annuity losses) are an adjustment for AMT purposes under IRC Section 67(b)(1)(i). As a result, any taxpayer subject to the AMT will receive no tax benefit for annuity losses, and a significant annuity loss could actually push the taxpayer into the AMT in the first place. Despite the unpopularity of this unfavorable treatment, though, there have been no significant proposals in Congress in recent years to alter the tax treatment for annuity losses, though it is always possible this will be changed in the future.

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Anti-Abuse Aggregation Rule To work around the general gains-first rule for annuity distributions, some annuity owners will purchase multiple annuity contracts for planned liquidations. The idea of the strategy is that with separate contracts, the annuity owner can work through distributions from one contract – income and principal – before moving on to (income/gains from) the next contract.

Example 3a. James is a 55-year-old who plans to put $1,000,000 into an annuity to use for retirement spending when he turns 60.

If 5 years from now the contract is up to $1,250,000, then the first $250,000 that James withdraws will be taxable, before he can spend any of his principal. To avoid this consequence, James instead purchases 10 contracts for $100,000 each, invested in the same manner. Now, with similar total gains, James will have 10 contracts worth $125,000 each, which means he can withdraw $250,000 (by surrendering just two of the 10 contracts) and face gains of only $50,000 (as there would be $200,000 of principal between those two contracts).

To partially block this strategy, the tax code prescribes an “antiabuse aggregation rule” – that all annuities issued during a single calendar year by the same insurance company are treated as one annuity for the purposes of determining gains and the taxable amount of the distribution.9 Example 3b. Given the anti-abuse aggregation rule, if James tries to split his $1,000,000 into 10 contracts, for tax purposes they are still treated as a single contract (with a $1,000,000 cost basis and a $1,250,000 appreciated value), such that the first $250,000 of withdrawals will be taxable, even if it’s the full surrender of two contracts that otherwise just had $25,000 of gains each.

Because the anti-abuse aggregation rule only applies if the annuities are purchased in the same calendar year, and from the same insurance company, the splitting strategy can still be accomplished if the funds are either split over time across multiple calendar years, or amongst multiple insurance companies. Thus, in the above example 3b, James would either have to buy annuities from 10 different insurance companies, or spread his purchases across multiple tax years, to avoid gains aggregation for tax purposes.

Loans from and Gifts of Annuities To prevent “abuse” of the annuity taxation rules, any loans taken from (or collateral pledges of) an annuity are treated as a distribution of that amount from the annuity (with the standard gains-first tax treatment).10 This rule – which differs from the non-taxable loan treatment for life insurance policies – prevents annuity owners from trying to use the cash value while avoiding gains on an annuity by taking loans again the contract; by rendering the taxation of the loan exactly the same as the taxation of simply taking a withdrawal directly, the owner may as well just take a distribution and pay taxes accordingly (and

53 this loans-same-as-distributions tax treatment is why annuity contracts typically do not offer loan provisions in the first place).

Similar, the rules also prevent individuals from trying to shift the tax burden of annuities by transferring ownership. If an annuity is “transferred without adequate consideration” (i.e., partially or fully gifted), the tax law stipulates that any gains will be recognized at the time of the transfer.11 Example 4a. Harold owns an annuity worth $150,000 with an original cost basis of $100,000, and tries to gift it to his son Daniel to avoid the $50,000 gain himself and shift it to be taxed at Daniel’s more favorable tax rates.

However, the actual result will be that the $50,000 gain is recognized immediately by Harold as the transferor, and his son Daniel will simply receive a $150,000 contract with a new $150,000 cost basis. This is the equivalent of Harold having simply surrendered the contract for $150,000, and gifted the $150,000 proceeds to his son, who then reinvests the $150,000 into a new contract.

On the other hand, Harold might still wish to gift an annuity to Daniel, despite the tax consequences, if there were special contractual annuity provisions that were worth keeping (and assuming those guarantees are transferrable under the annuity contract in the first place); the tax rules do not legally prevent the gift of an annuity, but simply remove any income tax benefits of doing so.

Notably, this ‘anti-gifting’ rule also prevents individuals from gifting an annuity to a charity to avoid the income tax consequences. Once again, such a gift would be treated the equivalent of liquidating the contract, and gifting the proceeds.

Example 4b. Continuing the prior example, assume instead that Harold wishes to donate his $150,000 annuity with a $100,000 cost basis to charity to avoid the $50,000 gain. Due to the annuity tax rules, instead such a gift would trigger recognition of the tax gain ($50,000), and would then be followed by a charitable deduction for the full fair market value ($150,000).

Obviously the $150,000 charitable deduction may more than offset the $50,000 gain, but from the tax perspective this is no better than having Harold simply liquidate the $150,000 contract, recognize the $50,000 gain, and gift the $150,000 of cash proceeds.

Grandfathering “Old” Tax Rules The annuity tax laws went through a series of significant changes in the 1980s, especially as a part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA 1982) and the Tax Reform Act of 1986 (TRA 1986). In the case of many new provisions adopted at the time, the new rules applied only to new annuity contracts (or new contributions to existing contracts) that occurred after the rules were implemented; contracts purchased prior to those dates retained their “old” rules.

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Gifting “Old” Annuities For instance, one grandfathering rule under TRA 1986 pertains to the gift of annuities; under prior law, the rule had been that if an annuity was gifted, the gains embedded at the time of transfer were attributable to original owner, but were not recognized until the time that the donee actually surrendered the contract (rather than at the time of transfer). The rule still applies to any annuities that were issued before April 23rd, 1987 (even if gifted long afterwards).12 Example 4c. Continuing the earlier example, if Harold’s $150,000 annuity with a $100,000 cost basis had been purchased prior to 1987, then if the annuity is gifted now (in 2014), Harold will ultimately be required to recognize the $50,000 gain, but the gain will not be reported until the donee he gifts to actually surrenders the contract. If there are additional gains during the intervening time period – for instance, Harold gifts it to his son, and the contract appreciates to $160,000 before it is surrendered – the original gains are taxable to the donor, but the post-gift gains are taxable to the donee (i.e., Harold still reports the $50,000 gain, but his son reports the subsequent $10,000 postgift gain).

“Old” Annuities Purchased By Non-Natural Persons Another grandfathering rule under TRA 1986 pertains to the requirement that annuities be owned by natural persons (or as an agent for a natural person) to receive tax-deferral treatment.

Under the prior rules, this natural person requirement did not exist, and accordingly when it was created, a special “grandfathering” rule was established that allows any annuities that were owned by non-natural persons prior to March 1, 1986, to continue to receive preferential (i.e., tax-deferral) treatment; however, any annuities purchases since this date (or contributions to existing annuities after this date) have been subject to the new natural-person-owner requirement.13 Principal-First Withdrawals From “Old” Annuity Contracts One additional important grandfathering rule dates all the way back to TEFRA 1982, and pertains to the “gains-first” treatment that typically applies to deferred annuities.

Under the pre-TEFRA rules, the tax treatment was the opposite of what it is today – original principal contributions were assumed to be withdrawn first, and gains were received last (similar to how Roth IRA distributions are treated today). When TEFRA was enacted, the rules shifted to their current gainsfirst treatment, but contributions made to any contracts prior to August 13, 1982 retain their pre-TEFRA treatment.14 In the case of contracts that have both pre- and post-TEFRA contributions, withdrawals are assumed to come first from preTEFRA contributions (principal first), then pre- and post-TEFRA

gains, and then finally post-TEFRA contributions; notably, this treatment persists even if the contract was subsequently exchanged for another under IRC Section 1035, which means even a more recent contract could still have pre-TEFRA principal available for tax-free withdrawal if it was funded via exchanges that date back prior to TEFRA.15 Early Withdrawal Penalties Because deferred annuities (like IRAs) are provided tax-deferral benefits to encourage their use for retirement savings, they also (again like IRAs) are potentially subject to “early withdrawal penalties” if gains are withdrawn before age 59 ½ (though certain exceptions apply, beyond just waiting until age 59 ½, as discussed below).16 The early withdrawal penalty is a 10% surtax on any portion of the annuity withdrawal that is included in income, and applies in addition to any other income taxes owed on the withdrawal.17 Notably, though, the early withdrawal for annuities is only applicable to the amount that is otherwise taxable and reported in income; return of principal distributions that are not taxable are not subject to early withdrawal penalties, either (though annuity contract surrender charges may still apply).

Example 5a. Jeremy has an annuity with a $105,000 cash value and a $100,000 cost basis. If Jeremy surrenders the contract and is subject to early withdrawal penalties (prior to age 59 ½ with no other exceptions), he will owe a 10% penalty on just the $5,000 of gain – a $500 penalty – and not the entire $105,000 contract value.

Example 5b. Continuing the prior example, if Jeremy chooses to withdraw only $10,000 from the $105,000 contract, his early withdrawal penalty will still be $500. The reason is that, as discussed earlier, partial withdrawals from annuities are deemed to come from gains first; as a result, Jeremy’s $10,000 withdrawal includes the first/only $5,000 of gain, and the remaining $5,000 is principal. Since there is $5,000 of gain and Jeremy is assumed to be subject to the early withdrawal penalty, the 10% penalty will apply to that $5,000 gain.

Example 5c. Assume instead that Jeremy’s annuity is only worth $95,000 (with the same $100,000 cost basis). If Jeremy takes a partial withdrawal from the annuity, there will be no early withdrawal penalty – regardless of whether has reached age 59 ½ or not – as there cannot be an early withdrawal penalty on the gains included in income if there are no gains associated with the withdrawal in the first place!

Exceptions to Early Withdrawal Penalties In addition to the ‘standard’ rule that the early withdrawal penalty does not apply to distributions from an annuity on/ after the date the owner reaches age 59 ½, a number of other exceptions to avoid the early withdrawal penalty are also

©2015, IARFC. All rights of reproduction in any form reserved.

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available. While these rules are very similar to the exceptions applicable to IRAs, they are not identical, and in fact are listed in a completely different subsection of the tax code (IRC Section 72(t) for IRAs, and IRC Section 72(q) for annuities).

The additional exceptions to the early withdrawal penalty from non-qualified deferred annuities (beyond being past age 59 ½) are for distributions made: - On/after the date of the annuity owner’s death18 (i.e., distributions to beneficiaries after death are never subject to early withdrawal penalties)

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withdrawal penalty exception in the case of annuities does not apply for payments after age 55 and separation from service, nor for payments for medical expenses, health insurance premiums for the unemployed, distributions for college expenses, or the first-time homebuyer exception. In all of those cases, distributions from a non-qualified annuity will still be subject to the early withdrawal penalty (to the extent of gain, and assuming no other exception applies).

Tax Treatment of Deferred Annuities After Death

- To a disabled owner19

Estate Tax Treatment

- As a part of a series of Substantially Equal Periodic Payments20 (the IRS has indicated that taxpayers can use the same rules in calculating SEPPs for annuities as are used to calculate them for IRAs21)

The treatment of a deferred annuity for estate tax purposes is relatively straightforward: the deferred annuity is an asset in the decedent’s estate, and is reported based on its value on the date of death (or the alternate valuation date 6 months later, if appropriate24). Notably, though, the “value” of an annuity for estate tax purposes is not merely its cash value on the date of death, but its value including adjustments to do death itself. In other words, if there is any form of “enhanced death benefit” that increases its value when the annuity owner passes away, this amount should be reported for estate tax purposes as well.

- From an immediate annuity contract22 if it is purchased with a single premium and payments begin within 1 year of purchase This last rule – avoiding the early withdrawal penalty via annuitization – is important to recognize as well, as it only applies in certain very specific circumstances.

Example 6a. Betsy is 50 years old, and purchases an immediate annuity for a 5-year period certain payout. As long as the payments start within 1 year, the payments from the annuity will be exempt from the early withdrawal penalty, even though Betsy is under age 59 ½ (and all the payments will be received prior to age 59 ½!).

Example 6b. Continuing the prior example, if Betsy chooses to purchase her immediate annuity via a 1035 exchange from an existing deferred annuity purchased four years ago, the exception does not apply. The IRS has ruled that in the event of a 1035 exchange, the “purchase date” for the purposes of this rule is the purchase date of the original annuity, not the new one.

As a result, the annuity is still deemed to have been a contract from four years ago, where payments did not begin within 1 year of purchase; more generally, a recent 1035 exchange cannot be used to circumvent the annuitize-within-1-year-of-purchase requirement23.

Example 6c. Continuing the prior example further, if Betsy chooses to purchase her immediate annuity via a 1035 exchange but chooses lifetime payments instead of a 5-year period certain, she will still be exempt from the early withdrawal penalty. In this case, it is not because of the immediate annuity exception – as the purchase date of the original annuity was still more than 1 year ago – but simply because lifetime annuitization will (generally) meet the substantially equal periodic payment requirements anyway, as payments are being made over the life expectancy of the annuity owner!

Notably, many early withdrawal penalty exceptions that apply to IRAs are not on this list of exceptions for annuities; the early

Example 7. Seven years ago, Trevor invested $200,000 into a variable annuity with an enhanced death benefit that was guaranteed to grow at 6%/year. Due to losses in the financial crisis and ongoing fee drag, the growth in Trevor’s annuity has not kept pace with its guaranteed death benefit; 7 years later when he passes away, the cash value is up to only $270,000, but the 6%-compounded death benefit is now just over $300,000.

Accordingly, the proper amount to report on the estate tax return is the $300,000 value that the beneficiaries will actually receive as a death benefit under the terms of the contract, not merely the $270,000 cash value on the date of death.

An important caveat for situations like the one above is that if the accountant preparing Trevor’s estate tax return contacts the annuity company and merely requests the “value” of the annuity on a particular date (when Trevor died), the value may stated as $270,000. To ensure the proper reporting of the annuity’s value on an estate tax return, it is crucial to specifically ask for and confirm the date of death value on that date that includes any adjustments due to death itself!

For estate planning purposes, it’s also important to note that while the annuity is reported in the decedent’s estate for estate tax purposes, annuities generally are not a probate asset (and therefore do not need to be held in a revocable living trust or by other means to avoid probate). As with life insurance, annuities pass by operation of the contract and are payable at death of the owner directly to the stated beneficiary of the annuity, and outside of the probate process (unless the estate itself is named the beneficiary, or becomes the beneficiary by default in the absence of having any other stated beneficiary under the contract).

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Income Tax Treatment After Death The core income tax treatment of withdrawals from annuities after death is the same as it is during life: distributions are taxable as (ordinary income) gains first to the extent of any gains above cost basis, and then principal is returned, with any pre1982 principal coming out first for grandfathered contracts.

The cost basis in the hands of the beneficiary is the same as it was in the hands of the original owner; unlike many other assets, annuities do not receive a step-up in basis at death, though another special “grandfathered” rule does provide step-up in basis for any annuities purchased prior to October 21, 1979 and still held as the original pre-1979 contract25 (given that such deferred annuities would now be in accumulation status for 35+ years, they are relatively uncommon, especially since even a 1035 exchange invalidates this grandfathered step-up-in-basis rule26; nonetheless, some grandfathered annuities eligible for step-up in basis do exist).

Because the embedded gains in an annuity at the death of the owner carry over to the beneficiary (since there is normally no step-up in basis), those embedded gains are treated as Income in Respect of a Decedent (IRD), which in turn means the beneficiary will be eligible for an income tax deduction for any additional estate taxes that were paid due to the embedded gains in the annuity27.

Example 8a. Harriet passes away leaving a $15M+ estate to her daughter Sally that will face a top marginal estate tax rate of 40%. Harriet’s estate includes a $600,000 annuity with a $400,000 cost basis. Given that the last $200,000 of gains effectively increased Harriet’s estate tax liability by 40% x $200,000 = $80,000, Sally will receive an $80,000 income tax deduction for the additional estate taxes triggered by the embedded gain.

Thus, if Sally subsequently liquidated the annuity, she would report $200,000 of income, and an $80,000 IRD deduction

Post-Death Transfers & 1035 Exchanges

beneficiary inherited an annuity from a

The caveat to these new rules allowing

company of questionable credit quality

post-death 1035 exchanges is that because

and wanted to move the funds to a new

the guidance came in the form of a PLR,

Because annuities are IRD assets after

company (but without triggering income

the rules are not binding across all annuity

death, a transfer or change of annuity

taxation).

companies, and there is no obligation for

ownership will trigger immediate recognition of gains under IRC Section 691(a)(2), similar to the consequences of transferring an annuity during the life of the original owner. The actual transfer of ownership due to death itself (from the original decedent owner, to the named beneficiary) is the only change that can be made to the ownership of an annuity that allows a shift in the income

Fortunately, the IRS recently indicated that they will relent a bit in such situations. In PLR 201330016, the IRS declared that a beneficiary of an annuity could still do a 1035 tax-deferred exchange from one annuity contract to another after the death of the original owner (just as the original owner could have done while he/she was alive).

tax consequences of embedded gains

The IRS indicated that to receive

(again, from original decent owner, to the

preferable (i.e., tax-deferred) treatment

beneficiary).

for the exchange, the new annuity needs

Historically, the rules for transfers of annuities after death (without income tax ramifications) were interpreted so strictly, that beneficiaries were not only stuck facing the income tax consequences of the inherited annuity, but couldn’t even change to a new/different annuity contract.

This often created friction, such as when a young beneficiary who inherited a fixed annuity wanted to change to a variable

to contractually obligate the beneficiary to take withdrawals from the contract at least as rapidly as would have occurred under the original contract (in accordance with the annuity post-death distribution rules), and that the annuity needs to be exclusively for the benefit of that beneficiary (i.e., any further change in contract or any ownership would still trigger tax consequences).

annuity companies to honor the request.

Instead, it’s up to the surrendering and receiving annuity companies about whether they will acquiesce to cooperate with a post-death 1035 exchange (if not, the beneficiary may need to obtain their own PLR to force the issue with the annuity company).

As a result, in practice not all beneficiaries who inherit a deferred annuity will be able to 1035 exchange the contract.

Nonetheless, for those who are concerned about the issue and wish to make a postdeath exchange to another contract, the beneficiary should at least contact the annuity company and inquire about the feasibility of either an external 1035 exchange to an annuity at another company, or at least an internal 1035 exchange to another annuity from the same company (e.g., if the sole goal is just to switch from a fixed to a variable annuity).

contract for more growth, or where a ©2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

(which is claimed as a miscellaneous itemized deduction not subject to the 2%-of-AGI floor28). If Sally only takes partial withdrawals from the annuity after death, the $80,000 deduction is generally claimed on a pro-rata basis (e.g., if she withdraws $50,000, or 1/4th of the gains, she will be eligible to claim $20,000 or 1/4th of the IRD deduction29).

The benefit of the IRD deduction, which applies as well to other pre-tax ordinary income assets that do not receive a step-up in basis at death (e.g., pre-tax IRAs), is that it mitigates what would otherwise be double-taxation (paying income taxes on money that was already going to be paid out for estate taxes). Notably, this also means it is not necessary to liquidate an annuity (or other pre-tax assets) before death, to try to avoid the potential for double taxation.

Example 8b. Continuing the example above, if Harriet was concerned about paying income taxes and estate taxes on the same $200,000 gain, she might liquidate the annuity before death. Assuming a 33% tax rate, she would pay $66,667 of income taxes, reducing the net value of the annuity to $533,333.

With a top 40% estate tax rate, the estate tax liability on the $533,333 would be $213,333, and Sally would inherit $320,000.

By contrast, if Harriet simply kept the annuity through death, her total estate tax liability on the $600,000 annuity would be $240,000, but as noted above Harriet would only owe income taxes on $120,000 of the gain (the total $200,000 of gain reduced by the $80,000 IRD deduction), and at a 33% tax rate for Sally the income tax liability would be $40,000. Thus, if Harriet kept the annuity, Sally would inherit $600,000 - $240,000 (estate taxes) - $40,000 (income taxes) = $320,000.

The end result: whether Harriet liquidates the annuity before death or Sally does so after death, Sally inherits the same net $320,000 at the end of the day (and in fact the whole purpose of the IRD deduction is to ensure that these two scenarios come out the same!).

It’s important to note that the IRD deduction is only available for Federal estate taxes triggered by the annuity gain; there is generally no IRD deduction for state estate taxes attributable to pre-tax assets in the estate at death (unless the state explicitly allows it).

On the other hand, because the IRD deduction is an income tax deduction for estate taxes paid on a pre-tax asset, it’s also notable that the IRD deduction is entirely a moot point if the decedent was not subject to Federal estate taxes in the first place!

Required Minimum Distributions From Annuities After Death While the income tax treatment of deferred annuities after death is substantively the same as it is during life, where withdrawals are treated as gains-first (to the extent of any gain, albeit with an adjustment for IRD for wealthy decedents) and are taxed

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as the withdrawals occur, the death of any annuity owner does trigger special rules regarding the timing of those withdrawals: specifically, beneficiaries of inherited annuities are subject to post-death required minimum distribution rules30, similar to those applicable to IRAs and employer retirement plans31.

These post-death distribution requirements apply to annuity beneficiaries after the death of any original owner, regardless of the fact that annuities are not subject to RMDs while the origial annuity owner was alive. And these rules apply at the death of any owner32, which means in the case of a jointly owned annuity, it is actually the first death that triggers the post-death required distribution rules, even though there is a surviving joint owner!

When the death of any owner does occur, the actual post-death distribution requirement will vary depending on the type of the beneficiary. Again, in a manner similar to IRAs, the annuities have different requirements for distributions to beneficiaries depending on whether the beneficiary is a spouse, any other nonspouse individual, or a non-living entity (e.g., the decedent’s estate, or certain types of trusts).

Spousal Continuation In the event that the surviving spouse of the original annuity owner is the beneficiary of the contract (regardless of whether he/she is a joint owner and a beneficiary, or “just” a beneficiary), the spouse may elect to continue the annuity in his/her own name, as though he/she was the original owner.33 In practice, this is similar to the “spousal rollover” rules that apply to retirement accounts, which also allows the beneficiary to continue the original account in the individual’s own name.

Typically, spousal continuation for annuities is accomplished by actually re-registering the annuity in the name of the spouse as the new owner. From that point forward, the contract continues as though he/she owned the contract in the first place for tax purposes (though notwithstanding spousal continuation for tax purposes, the continuity of any annuity contract death benefit or living benefit retirement income guarantees depends on the terms of the annuity itself and may not remain in place beyond the death of the original owner).

An important caveat for the spousal continuation rules to apply is that the surviving spouse must be directly named as the beneficiary of the annuity. A trust for the benefit of the surviving spouse is generally not eligible for spousal continuation. Thus, an annuity left to a bypass trust or QTIP trust for the benefit of a surviving spouse will not be eligible for spousal continuation treatment, and naming even the spouse’s own revocable living trust will generally not apply (though in at least one circumstance, the IRS has allowed in a PLR an annuity that was ‘accidentally’ left to a revocable living trust to ultimately be continued in the name of the surviving spouse, as she had full dominion and control over the trust assets anyway34).

In addition, it’s notable that for a surviving spouse to continue

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Joint Annuity Ownership Between Non-Spouses While the spousal continuation rules allow a non-qualified deferred annuity to be continued in the name of a surviving spouse, the continuation rule is available only for a surviving spouse beneficiary. And because annuities must begin a payout at the death of any (i.e., the first) owner, this means that even in the case of a jointly owned annuity, the surviving (nonspouse) owner cannot continue to keep the annuity after the death of the first owner!

Thus, for instance, an annuity owned by a husband and wife can be continued by the wife after the death of the husband (assuming she is named as the beneficiary), but an annuity owned jointly by two siblings cannot be continued in the name of the second sibling after the death of the first; instead, one of the post-death distribution rules (stretch over life expectancy or the 5-year rule) must apply after the death of the first owner.

Accordingly, advisors should be highly cautious about any situations involving joint ownership of an annuity between non-spouses. In situations where each individual contributes

the contract after the death of the first spouse, he/she must actually be named as the beneficiary. Accordingly, if an annuity is owned jointly between a husband and wife, with a child named as the beneficiary, at the death of the husband (first death of any owner) the annuity will pay out to the named beneficiary (child) and the wife will not be able to continue the contract, even though she is a surviving joint owner! In fact, not only will the wife be disinherited as the contract is paid to the beneficiary, but the wife may even be required to file a gift tax return for the implied gift of her share of half the annuity to the child (while the other half is classified as a bequest from the estate of the husband)!

Fortunately, in some joint ownership situations, annuities will “override” a beneficiary designation and stipulate in the contract itself that a surviving joint owner is automatically deemed to be the primary beneficiary, avoiding this scenario where a surviving owner can be both disinherited, lose the ability to continue the contract (in the case of a spouse; for non-spouse joint owners, see sidebar), and be compelled to file a gift tax return for the half-share that is gifted. However, such deemed beneficiary provisions are not present in all annuity contracts; as a result, if there is truly a desire for a surviving spouse to continue a contract, mere joint ownership is not necessarily sufficient, and the annuity beneficiary designation form should explicitly state that the beneficiary is “surviving joint owner” or simply “surviving spouse.”

half of the value of the contract, joint ownership creates a risk – or in fact, a certainty – that if the annuity is held long enough until someone passes away, the surviving owner will find themselves compelled to withdraw their own money (and the decedent’s share) as a series of post-death distributions!

Conversely, in situations where one individual makes the entire contribution but names a second owner – for instance, where a parent funds the annuity but names the child as joint owner to facilitate access to the contract – an untimely death of the joint owner (the child) could force the remaining owner (the parent) to liquidate their own contract with their own assets, and pay the associated tax consequences!

As a result of these rules, most situations with joint ownership of an annuity between non-spouses will be better served by either simply having a power of attorney for the annuity owner (if the issue is control/access of the annuity), or having joint owners each contribute their own money to their own individual annuity with the other person named as beneficiary, rather than actually following through with joint ownership and its complications.

Stretch Annuities For Non-Spouse Beneficiaries As noted earlier, deferred annuities must begin to pay out to beneficiaries upon the death of any owner. And in situations where the beneficiary is someone besides the spouse, the annuity must pay out; in other words, it cannot be continued in deferred status by the beneficiary, even if that non-spouse beneficiary is a joint owner.

Instead, after the death of the (first) owner, the deferred annuity must begin payments over the life expectancy of the beneficiary, with the first payment occurring within 1 year of the owner’s death.35 (Note: Unlike IRAs, where the first distribution to the beneficiary must begin by December 31st of the year after death, with deferred annuities the first payment must occur precisely within 1 year – i.e., within 365 days of the date of death.)

Notably, while the rules allow for non-spouse beneficiaries to take distributions from an inherited deferred annuity over life expectancy, there has been some uncertainty about how those distributions must be taken. Historically, the interpretation was that payments “over life expectancy” meant annuitizing the contract on behalf of the beneficiary over his/her life expectancy.

For many young beneficiaries this was unappealing, as the payments were sometimes “trivially” small over a long life expectancy; more generally, many beneficiaries chose not to annuitize simply because they wanted to maintain liquidity and have continued access to the annuity (above and beyond small ongoing monthly or annual payments for life) should the

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need arise. In this situation, beneficiaries were forced to choose between receiving payments over life expectancy (but stuck without liquidity), or keeping liquidity and losing the ability to do a lifetime stretch at all.

However, in 2001 this changed with the issuance of an IRS Private Letter Ruling that permitted a beneficiary to take nonannuitized systematic withdrawals from an inherited deferred annuity, effectively using the same process that applies to determining Required Minimum Distributions from inherited retirement accounts.36 And in a surprising follow-up PLR two years later, the IRS granted permission for the taxpayer to claim those systematic withdrawals over life expectancy using the “exclusion ratio” tax treatment, and not the normal “gains-first” treatment that applies to withdrawals from deferred annuities, even though the beneficiary had not annuitized the contract!37 In today’s environment, executing this strategy is often referred to as a “stretch annuity”, similar again to the use of a “stretch IRA”.

The caveat to this “stretch” treatment for an inherited annuity is that, because its “authorization” is from a PLR, there is no requirement for all annuity companies to allow the approach, and as with other PLR-based rules some companies have adopted the rule and others have not. As a result, if obtaining stretch annuity treatment is important/desirable for the annuity owner, it should be verified in advance whether the annuity company will allow it. In addition, it’s important to bear in mind that inherited annuities are only as flexible as the terms of the contract allow, and annuities can be more restrictive than the stretch rules may permit; in other words, even if the annuity company would otherwise allow the stretch, if the specific annuity contract has a requirement to pay out more quickly or be annuitized, the contract itself is still binding on the beneficiary. Nonetheless, in practice a large and increasing number of annuity companies at least permit stretch annuities for beneficiaries, especially for newer contracts that are typically designed to be more flexible and accommodate the strategy.

In the case of multiple beneficiaries, the post-death distribution rules for annuities have generally been interpreted as allowing each beneficiary to annuitize their share of the contract in their own name and use their own life expectancy. However, at this point there has been no explicit requirement that such splitting treatment be permitted in the event that multiples beneficiaries want to take non-qualified systematic withdrawals over their respective life expectancies without annuitizing. Although arguably such an approach appears to fall within the intention of the rules and the general framework of the PLR allowing postdeath systematic withdrawals, and thus “should” be permitted, the lack of any clear and binding rules means some annuity companies will cooperate with beneficiaries who wish to do so, while others will not and may require either the 5-year rule or for multiple beneficiaries to each annuitize to stretch over their individual life expectancy.

59

Notably, in order to elect to stretch payments over the life expectancy of any beneficiary at all, the named beneficiary must be a “designated beneficiary” – i.e., a living, breathing human being who has a life expectancy to stretch over in the first place.38 In the event that the beneficiary is not a designated beneficiary – e.g., the estate, or a trust – then stretch treatment is not available. (See breakout below for further discussion of trusts as annuity beneficiaries.)

The 5-Year Rule In the absence of electing Spousal Continuation or taking an inherited annuity stretch over the life expectancy of a nonspouse beneficiary, the default payment option for deferred annuities after the death of the owner is the “5-year rule” – that the contract must be liquidated by the 5th anniversary of the owner’s deth.39 The 5-year rule may apply because a spousal beneficiary chooses not to do a spousal continuation, or because a nonspouse individual beneficiary fails to begin life expectancy payments within 1 year of the owner’s death, or simply because the beneficiary of the contract is not eligible for any of these options in the first place (e.g., the beneficiary is an estate or a trust). Technically, the 5-year rule is always the default, and beneficiaries must proactively elect spousal continuation or begin life expectancy payments to a designated beneficiary in a timely manner to avoid having the 5-year rule apply.

Notably, while the 5-year rule requires the annuity to be liquidated by the 5th anniversary of the owner’s death, it does not specify the timing of the payments within that 5-year window.

The beneficiary could liquidate immediately after death, wait to withdraw everything at the end of the 5-year deadline, or spread out the payments in any manner desired between those two points, for instance to spread out the tax consequences of the withdrawals. However, given that withdrawals after death still follow the standard “gains-first” tax treatment, spreading out the tax consequences can actually necessitate leaving most of the money in the contract until the end of the 5-year time horizon.

Example 9a. Polly inherits a deferred annuity from her mother, who died on March 30th of 2014; at the time of her mother’s death, the contract was worth $240,000, and had original contributions (i.e., cost basis) of $150,000. If Polly does not elect to take payments over her life expectancy, the contract must be fully liquidated by March 30th of 2019 under the 5-year rule (which actually allows for 6 tax years, including the remainder of the 2014 tax year, 2015, 2016, 2017, 2018, and the permitted withdrawals in the first few months of 2019).

If Polly takes out 1/6th of the contract ($40,000) per year for 5 years, though, she will receive $40,000 of gains-first taxable income in 2014, another $40,000 in 2015, the last $10,000 of gains in 2016 along with $30,000 of principal, and then only principal payments in the remaining 3 years.

Journal of Personal Finance

60

Trusts As Beneficiaries Of (Non-Qualified) Deferred Annuities When a non-qualified deferred annuity

Arguably, there is a case to be made for

the maximum rate that can be used in the

is payable directly to an individual

cross-applying the retirement account “see

calculation, can be cross-applied to non-

beneficiary, the potential to stretch over

through” trust regulations to annuities

qualified annuities as well.

the life expectancy of that designated

as well. The requirements for post-death

Nonetheless, until there are Treasury

beneficiary is explicitly permitted in the

distributions, including the definition of a

Regulations or a ruling directly authorizing

tax code under IRC Section 72(s)(2).

designated beneficiary, and the potential

the cross-application of the retirement

However, the result is far less clear in the

to stretch post-death distributions over

account see-through trust rules to apply

scenario where an annuity is payable not

the life expectancy of that beneficiary,

for annuities, most annuity companies

directly to an individual beneficiary, but to

are virtually identical between IRC

have refused to acquiesce and allow

a trust for his/her benefit instead.

Section 401(a)(9) and IRC Section 72(s)

such a stretch to occur with one of their

In the case of retirement accounts,

(for retirement accounts and annuities,

own annuities, fearing the consequences

Treasury Regulation 1.401(a)(9)-4, Q&A-

respectively). Accordingly, it seems

as the annuity company for failing to

5 explicitly allows an IRA or employer

logical that where the underlying rules

properly administer the annuity post-death

retirement plan to “see through” a trust to

are the same, the Treasury Regulations

distribution rules in compliance with the

its underlying beneficiaries, and as long as

interpreting the application of those rules

tax code. As a result, until the IRS and

the relatively straightforward requirements

should be the same as well. And there is

Treasury take action – or an unfortunate

are met, the trust itself can stretch post-

precedent for this; for instance, the rules

taxpayer who finds themselves in this

death required minimum distributions

allowing substantially equal periodic

circumstance decides to submit a Private

from the retirement account out over the

payment (SEPPs) to avoid an early

Letter Ruling to specifically ask the IRS

life expectancy of the oldest underlying

withdrawal penalty are technically separate

to grant this treatment – the challenge

trust beneficiary. However, these Treasury

for retirement accounts and annuities (IRC

remains that annuity owners who want

Regulations allowing see-through

Section 72(t)(2)(A)(iv) and 72(q)(2)(D),

to bequeath an annuity to a trust for the

treatment for trusts and heir beneficiaries

respectively), but IRS Notice 2004-15

benefit of an individual beneficiary, rather

were written specifically for IRC Section

has explicitly declared that the rules and

than to the beneficiary directly, must

401(a)(9) – which pertains to retirement

regulations for SEPPs from retirement

accept less favorable stretch treatment as

accounts – and not for non-qualified

accounts, including the permitted

a trade-off for the greater control of assets

annuities.

methodologies to calculate SEPPs and

otherwise permitted with the trust.

Example 9b. Continuing the prior example, if Polly actually wishes to spread out the tax consequences, she would actually need to withdraw $15,000/year in 2014, 2015, 2016, 2017, and 2018 (a cumulative $75,000 of gains), and in the final year withdraw $165,000 (including the last $15,000 of gains and all of the $150,000 of principal), producing a highly uneven series of cash flows to create an even distribution of the tax consequences! (Note: If the contract was assumed to have some growth rate, withdrawals may be slightly higher in the earlier years to even out both the $90,000 of embedded gain, plus future growth, but the fundamental principal of uneven cash flows to create an even spread of tax consequences remains the same.)

Conclusion In the end, non-qualified deferred annuities are subject to a unique set of tax laws and preferences – including a number of “older” grandfathered rules that can still apply in certain situations – which must be navigated to make good annuity decisions on behalf of clients, both in how to handle spending and liquidations from contracts during life, and also how to navigate the tax consequences after death. Understanding the rules is especially important for prospective planning situations, including how the annuity contract will be owned and structured, and who the beneficiaries will be, because many potential problems that can arise are only able to be fixed while the original annuity owner is alive, and not after death.

Unfortunately, though, even with prospective planning, many aspects of annuity taxation – especially for beneficiaries – are reliant on non-binding private letter rulings, which means

©2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

61

the choices and their associated tax consequences may truly vary from one insurance company to the next. As a result, if a particular planning strategy – such as a systematic stretch withdrawal after death – is important to the client, it’s crucial to understand how a particular annuity company will handle the situation ahead of time, so changes can be made if necessary.

And of course, beyond the tax planning opportunities that annuities present, it’s vital to understand the actual mechanics of the annuity contract as well, and all of its fine print, as the simple reality is that in the end an annuity is a contract, which means annuity owners and their beneficiaries will – for better or worse – be bound to the terms and conditions of the contract. While in some cases this may be appealing – where the annuity owner purchases an annuity specifically for the guarantees that the contract provides – it’s still important to remember that planning with annuities must balance the tax consequences, the terms of the annuity itself, and the details of what the contract (and insurance company) will or will not allow.

Endnotes 1

IRC Section 72(u) PLRs 9120024, 9204014, 9316018, 9322011, 9639057, 199905015, 199933033, and 200449017.

3 PLR 9752035 4 PLR 199944020 5 IRC Section 72(b) 6 IRC Section 72(e)(2)(B) 7 IRC Section 72(e)(3)(A) 8 IRC Section 72(e)(5)(E) 9 IRC Section 72(e)(11) 10 IRC Section 72(e)(4)(A) 11 IRC Section 72(e)(4)(C) 12 Tax Reform Act of 1986, Section 1826(b)(3)(C) 13 Tax Reform Act of 1986, Section 1135(b) 14 Tax Equity & Fiscal Responsibility Act of 1982, Section 265 15 Revenue Ruling 1985-159 16 IRC Section 72(q)(2) 17 IRC Section 72(q)(1) 18 IRC Section 72(q)(2)(B) 19 IRC Section 72(q)(2)(C) 20 IRC Section 72(q)(2)(D) 21 Revenue Ruling 2002-62 22 IRC Section 72(q)(2)(I) 23 Revenue Ruling 92-95 24 IRC Section 2032 25 Revenue Ruling 79-335 26 PLR 9245035, TAM 9346002 27 IRC Section 691(c) 28 IRC Section 67(b)(7) 29 IRC Section 691(c)(1)(A), Treas. Reg. 1.691(c)-1 30 IRC Section 72(s) 31 IRC Section 401(a)(9) 32 IRC Section 72(s)(1) 33 IRC Section 72(s)(3) 34 PLR 200323012 35 IRC Section 72(s)(2)(C) 36 PLR 200151038 37 PLR 200313016 38 IRC Section 72(s)(4) 39 IRC Section 72(s)(1)(B) 2

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