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Tax-Efficient Investing: Top Strategies | Morgan Stanley

1 Source: “Global Investment Committee Special Report: Tax Efficiency: Getting to What You Need By Keeping More of What You Earn,” Morgan Stanley Wealth Management, Mar 3, 2022

2 By using the strategy of withdrawal sequencing, the value-added is approximately 0.5% of equivalent after-tax return. Note that these annual returns would compound to very large numbers over the long investment horizons of many financial goals. In the case of withdrawal sequencing, the difference in returns in the case study is equivalent to nearly a 50% difference in final wealth accumulation. This strategy would be recommended for investors who (1) Have adequate savings relative to spending needs (2) Have a high marginal tax rate and (3) Have sources of low-tax distributions with which to smooth income. Investment liquidations to support retirement spending sequenced in order to increase tax efficiency. Withdrawals from taxable accounts come first to extend tax deferred/ tax-exempt growth of other investments. Income smoothing and partial Roth conversion conducted to lower effective tax rates and minimize spikes in taxable income driven by required minimum distributions. Illustrated value-added based on top marginal federal tax rates for 20 years pre-retirement, and a 5% initial withdrawal rate for 30 years in retirement. Overall portfolio strategy based on a 60% equity/40% fixed income allocation assuming an efficient tax allocation across accounts.

Model Calculation Assumptions: The analyses in this article are based, in part, on a Monte Carlo simulation, which involves repeated sampling of asset class returns from a known distribution.

IMPORTANT: The projections or other information generated by this Monte Carlo simulation analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Results may vary with each use and over time.

The analysis for this projection on wealth difference from withdrawal sequence is based on the improvement of withdrawal capability following tax efficient withdrawal sequence among multiple account types in a 10,000-iteration Monte Carlo simulation. Retirement income starts after 20 years’ asset accumulation. The withdrawal amount is calibrated to be 4.5% of portfolio value minus unrealized tax liability in each iteration, adjusted for the cost of living for 30 years. During the asset accumulation period, investors stay in 37% federal tax bracket, with a 5.2% state tax and 3.8% a Medicare tax. During retirement phase, investors’ federal tax bracket is determined by the withdrawal amount together with $20,000 inflation-adjusted Social Security payment each year, subject to additional 5.2% state tax. Tax brackets are based on 2021 married filing jointly status and assumed to grow with inflation rate. Asset growth rates are based on Global Investment Committee forecasted capital markets assumptions as of March 2021, with the first seven years assuming strategic assumptions and subsequent 13 years assuming secular assumptions. Inflation rate is assumed to be 1.75% per year. Portfolios are rebalanced each year across multiple account types to maintain overall asset allocation close to 60% equities and 40% fixed income as much as possible after yearly spending amount being withdrawn. The reason for choosing a 60% equity/40% equity/bond allocation is because it’s a common allocation in balanced portfolios as well as in multi-asset funds. If a different balanced allocation is selected, results would be different than those suggested. Unrealized tax liabilities are subtracted from portfolio ending values to calculate internal rate of return. Probability of success is defined as having at least $1 in any of the account types at the end of 50 years simulation. Partial years of withdrawal are recorded if combined portfolio value at any year is not enough to support expected retirement spending at any year.

3 To leverage the tax deferral benefits of index / variable universal life insurance, in early years the policy buyer can pay maximum annual premiums allowed up to the IRS MEC limit until the policy is fully funded. A modified endowment contract (MEC) is a designation given to cash value life insurance contracts whose funding exceeds federal tax law limits.  If an insurance policy is considered an MEC, it loses the tax benefits it would otherwise have of withdrawals and loans made from the policy. The taxation of withdrawals and loans under an MEC is similar to that of non-qualified annuity withdrawals.

4 We assume here that the policy would be funded in a way that won’t trigger MEC status, such that loans taken from the policy would not be subject to income tax.

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This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this material may not be appropriate for all investors. Morgan Stanley Wealth Management (“Morgan Stanley”) recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

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Investors should consider many factors before deciding which 529 plan is appropriate. Some of these factors include: the Plan’s investment options and the historical investment performance of these options, the Plan’s flexibility and features, the reputation and expertise of the Plan’s investment manager, Plan contribution limits and the federal and state tax benefits associated with an investment in the Plan. Some states, for example, offer favorable tax treatment and other benefits to their residents only if they invest in the state’s own Qualified Tuition Program. Investors should determine their home state’s tax treatment of 529 plans when considering whether to choose an in-state or out-of-state plan. Investors should consult with their tax or legal advisor before investing in any 529 Plan or contact their state tax division for more information. Morgan Stanley Smith Barney LLC does not provide tax and/or legal advice. Investors should review a Program Disclosure Statement, which contains more information on investment options, risk factors, fees and expenses and possible tax consequences.

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Diversification does not assure a profit or protect against loss in declining financial markets.

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Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made. NOTE: High-yield bonds are subject to additional risks, such as increased risk of default and greater volatility, because of the lower credit quality of the issues.

Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one’s state of residence and, if applicable, local tax-exemption applies if securities are issued within one’s city of residence. However, this can vary from jurisdiction to jurisdiction. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability.

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Variable annuities are long-term investments designed for retirement purposes and may be subject to market fluctuations, investment risk and possible loss of principal.

All guarantees are based on the claims-paying ability of the issuing insurance company.

Taxable distributions (and certain deemed distributions) from a variable annuity are subject to ordinary income tax and, if taken prior to age 59½, may be subject to an additional 10% federal income tax. Early surrender charges may also apply. Withdrawals will reduce the death benefit and cash surrender value.

If you are investing in a variable annuity through a tax-advantage retirement plan such as an IRA, you will get no additional tax advantage from the variable annuity. Under these circumstances, you should only consider buying a variable annuity because of its other features, such as lifetime income payments and death benefit protection.

Tax deferral may not be available if the variable annuity is owned by a “non-natural person” such as a corporation or certain types of trusts.

Insurance policies are subject to underwriting and certain requirements. Insurance policies contain exclusions, limitations, reductions in benefits, and terms for keeping them in force.

Any withdrawal or unpaid policy loan balance and interest will reduce your life insurance policy’s death benefit and cash value and may cause the policy to lapse. If the life insurance policy lapses, you may incur tax consequences. Interest on loans will be billed annually. If you do not pay the amount due, it will be added to the amount of the loan and next year’s interest will be based on this new loan amount. You may make policy loan repayments at any time.

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