Thinking of Retirement in Terms of After-Tax Dollars

Americans struggle all their lives to pay taxes, cursing the IRS while seeking to find their way through the rat's nest of accumulated tax rules to the bright light of deductions and credits.

Americans struggle all their lives to pay taxes, cursing the IRS while seeking to find their way through the rat’s nest of accumulated tax rules to the bright light of deductions and credits.

All the while, many hard-working physicians are saving and investing what little they keep from Uncle Sam’s hungry coffers and planning a retirement in terms of these respective savings totals. Much of their money, of course, lies in tax-deferred accounts, such as individual retirement accounts (IRAs), Keoughs and simple employee pensions (SEPs). And all this time, even many sophisticated investors fail to keep in mind why these amounts are as large as they are: They haven’t yet paid taxes on this income. The problem is that they’re failing to think of their retirement assets in terms of after-tax dollars.

A lot of attention is paid to the advantages of tax deferral. Among these is waiting to pay taxes on income until investors are in a lower bracket when they retire. Some experts say, however, that so much attention is paid to the advantages of tax deferral that people start to view their heretofore untaxed retirement assets as real money that they can spend in Aspen—dollar for dollar.

Not All Yours

Though misguided, this unfortunate approach pervades the structure of retirement planning, including what is perhaps the most critical load-bearing column: asset allocation. Traditional asset allocation plans are typically based on the pretax value of assets. These plans fail to distinguish between the pretax dollars invested and the after-tax dollars that clients actually end up getting their hands on during retirement. Most plans don’t take into account the reality that, before buying goods and services with the assets put aside for retirement, the holders of tax-deferred accounts must first pay taxes on this money.

Published studies by William Reichenstein, a highly regarded finance professor at Baylor University, demonstrate that this traditional approach to retirement planning is like comparing apples with oranges. When clients go to cash in their retirement assets, Reichenstein says, “They find that they don’t have the portfolio they thought they did.”

Consider Reichenstein’s hypothetical couple, who have a highly conservative risk tolerance and a corresponding asset allocation—50% of their portfolio in stocks and 50% in bonds. Let’s assume that the couple’s plan projects assets of $2 million upon retirement: $1 million in an IRA and $1 million in investments that aren’t tax-deferred. Let’s also assume that, like most people, this couple’s IRA is composed primarily of stocks because they were told that it’s best to defer taxes on long-term returns, which traditionally have been higher than those of bond returns.

Couple of Woes

The hitch is that, because these stock-invested IRA assets will be taxed at the long-term capital gains rate of 20% when the couple liquidates during retirement, they will produce only $800,000 when liquidated—not $1 million.

Because of this, the couple’s bond assets are actually over-weighted in the asset allocation. “If they’d realized this, they would have invested more in stocks and less in bonds to achieve an asset allocation that would have been more in line with their risk tolerance,” says Reichenstein. Or, if the couple had held primarily bonds in their IRA and had placed their stocks in actively managed (non-mutual fund) taxable accounts, the bonds would be tax-deferred and the stock wouldn’t. In this case, the effect would be the opposite of the above scenario: The allocation for stocks would have been heavier than the couple had intended.

The oversight of ignoring the post-tax value of assets is typical not only among individual investors, but among professionals as well—though perhaps it’s in their best financial interests to turn a blind eye to the inevitable.

Traditionally, only about 20% of all fund managers beat their benchmark after fees are deducted. And fewer still achieve this goal after taxes are taken into account. Evaluating funds according to their after-tax performance may seem like an obvious move, but it isn’t. “Surprisingly, few advisors actually consider taxes when looking for beneficial mutual funds” for their clients to invest in, says Scott Leonard of Leonard Wealth Management in Redondo Beach, Calif. “If they did, there would be far fewer actively managed funds around.”

Why are advisors so shortsighted? “For the most part, advisors make the exact same mistakes that investors do,” says Leonard. “All they care about is a fund’s rating, and what the total returns are; the funds that they look at are only the ones that make it through the screen for historical total returns, not post-tax returns.”

Advisory Folly

Another reason is that too many advisors have traditionally bought into the cult of stardom that the financial-services industry nurtures about its fund mangers, partly through relentless public relations efforts. “One reason taxes aren’t talked about in this industry is a sense that, ‘This guy’s so good that after-tax results don’t matter,’” says Leonard. And the fund managers certainly don’t have much incentive to factor in tax consequences. Their bonuses are generally based on beating the benchmark. Whether they produce gains for investors net of taxes is rarely the linchpin of their compensation structure.

Also, even when they’re thinking about the problem, advisors don’t like to bring it up with their clients because when clients have a more realistic grip on their total after-tax portfolio, the advisor doesn’t seem to be as valuable. And many advisors charge clients fees representing a percentage of their total assets under management. So the fees would seem proportionately higher to clients who think in post-tax terms.

What should investors do about this advisory shortcoming? One option is to be your own advisor. However, for those with a busy medical practice, attempting to navigate an increasingly perilous landscape in what is now a down market, this can be perilous. The undertaking requires time and energy to monitor and manage investments that most physicians simply don’t have.

So the other option is to evaluate advisors in terms of their post-tax thinking. After all, the goal is to get to the goal line with the most money in your pocket after Uncle Sam takes his cut—not before. A good advisor will help their clients achieve this.

Richard Bierck is a freelance financial writer and editor based in Princeton, NJ.