New Fiduciary Ruling Creates More Confusion for Investors

new fiduciary law

Last week, the Department of Labor (DOL) issued a new ruling which expands the definition of the term “fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA).

If you’re not familiar with the word fiduciary and how it fits into the world of financial advice, the shorthand definition is that a fiduciary is someone who is required to act in someone else’s best interest.

Although on the surface, it would seem obvious that more consumers receiving more advice that is actually in their best interest would be a good thing, I have some significant concerns with the new ruling.

More Laws, More Confusion

At the top of my list is that I believe the law is likely to create more confusion, not less, among investors who are seeking professional advice. Likewise, I think that many investors will presume that this new fiduciary ruling will put an end to poor or conflicted advice, when in fact that is far from the truth.

Potentially worst of all is that the ruling comes at a time when I see real progress already being made towards educating consumers about the power of things like index funds, low cost investing, and action-oriented financial planning.

Although the DOL may believe that the expanded fiduciary requirements will accelerate this trend, there is little to nothing in the new law that suggests it actually will.

A Commitment to Doing What is Right

To be clear, as a Registered Investment Advisor (RIA), my firm has consistently adhered to a fiduciary standard since the company’s inception. This commitment is defined in the Wealth Engineers Code of Ethics, in each client’s written services agreement, and in the disclosure brochure that is filed with the regulatory authorities and provided to every client.

More importantly, however, putting clients first is simply the right thing to do. I don’t need a fancy word like “fiduciary” to tell me that. I know that my clients have placed great trust in me to provide them with honest advice and to serve as a steward for their finances. That responsibility is something I take very seriously. No law or compliance requirement will change that.

Unfortunately, the new law takes a word that should have a simple and universal meaning and further muddies the water with a series of “ifs, ands, or buts.”

Part-Time Fiduciaries

For example, under the DOL’s new requirements, an advisor who is a registered representative of a broker dealer will now be required to act as a fiduciary when providing advice or recommendations for an investor’s individual retirement account (IRA). So far, so good (at least it would seem).

However, that very same advisor has no fiduciary obligation to that very same client for any of their non-retirement accounts.

This effectively turns thousands of broker-dealer reps into “part-time fiduciaries” who will now split their time between commissioned sales person and fiduciary advisor, often to the same client.

Even worse, the definition of fiduciary in the ruling still allows broker-dealer rep to sell proprietary products and expensive annuities to the client in their IRA. In what world that meets the definition of fiduciary I’m not sure.

My Advisor is a Fiduciary (Except When He’s Not)

Unfortunately, this is just the most recent instance of broker-dealer reps being granted the authority to confuse clients by wearing multiple hats.

The other recent example is broker-dealer reps who are also CFP® Professionals.

While the CFP Board of Standards states affirmatively that “CFP® professionals are held to strict ethical standards to ensure financial planning recommendations are in your best interest,” that doesn’t tell the whole story.

That’s because the CFP Board only requires broker-dealer reps to act in the client’s best interest specifically when delivering financial planning advice. At all other times, a representative has no such obligation.

Confused yet?

Potentially the most frustrating part for a consumer is not knowing when a broker representative is acting in their best interest and when they are not.

Does the advisor sound an alarm and flash some lights to let the client know?

Does the advisor swap their green tie for a red one?

How to Find a Full-Time Fiduciary

Thankfully, what hasn’t changed as a result of the new “fiduciary standard” is that there is still a clear way for consumers to obtain professional advice that puts their interests first all of the time: When selecting a financial professional, choose a fee-only Registered Investment Advisor (RIA).

Even better, ask them to show you in writing that they specifically adhere to a fiduciary standard when delivering investment and financial planning advice.

While nothing can guarantee a successful relationship, working with a fee-only RIA puts you on much firmer ground.

Tax-Efficient Withdrawal Strategies in Retirement

Tax-Efficient Withdrawal Strategies

Comparison of Portfolio Life Under Varying Withdrawal Strategies

Smart-Tax Planning Strategy (35.51 years)
Conventional Wisdom Strategy (33.15 years)
Tax-Inefficient Strategy (30 y)

Source: Tax-Efficient Withdrawal Strategies, Financial Analysts Journal, March/April 2015.[/box]

If you’re approaching or already in retirement, you know that there are many things to consider when it comes to your personal finances and investments. Of course there are the obvious ones: Social Security, required minimum distributions (RMDs), and ensuring that you have the proper asset allocation for your risk profile.

In addition, most investors are aware of the fact that taxes are a critical issue in retirement. Aside from the taxation of Social Security, the biggest issue that most retirees face is withdrawing money from their IRAs, 401ks, and other investment accounts.

Retirement withdrawal strategies can be quite complex. However, as the chart above shows, smart tax planning can add several years to the life of your portfolio. Let’s explore this concept further to understand the implications.

The Conventional Wisdom on Retirement Withdrawals

The conventional wisdom for tax-efficient withdrawals during retirement is to tap your accounts in the following order:

  1. Taxable accounts
  2. Tax-deferred accounts (e.g. traditional IRAs and 401ks)
  3. Tax-exempt accounts (e.g. Roth IRAs and 401ks)

The idea behind this approach is to preserve the funds in Roth accounts for as long as possible in order to allow them to continue to grow tax free. This advice is widely cited by most personal finance and investment publications, as well as the largest mutual fund families and brokerage firms.

A Smarter Approach

However, as I discuss with all of my clients who can benefit from smart tax planning, the conventional wisdom is generally not the best strategy.

Instead of simply following the order outlined above, your focus as an investor should be on minimizing the actual taxes paid. This may sound obvious, but the conventional wisdom effectively ignores the details in favor of a broad brush rule of thumb.

It’s also important to note that the idea of minimizing your total taxes paid starts well before retirement. In fact, an intelligently designed tax minimization strategy applies both to the contributions you make as you build your nest egg and to the withdrawals you make during retirement.

The execution of such a strategy then becomes an ongoing process of optimizing contributions and making tax-efficient withdrawals:

  1. Optimize Contributions: Contributions should be made to tax-deferred (traditional) accounts during years in which you are in a higher tax bracket than you expect to be in during retirement. Conversely, you should make Roth contributions when you are in a lower tax bracket than you expect to be during retirement.
  2. Tax-Efficient Withdrawals: If a client has funds in a taxable account, it is generally advantageous to use this money to pay for living expenses first until the taxable account is exhausted. This is identical to the conventional wisdom. However, the next step is for investors to review their expected taxable income each year. To the extent that the investor is in the 10% or 15% tax bracket, they should strongly consider converting part or all of the funds in their tax-deferred (traditional) accounts to Roth funds. The idea, of course, is to execute conversions until the taxpayer reaches the top of the 15% tax bracket, thereby locking in low rates of taxation on the converted amounts. For some investors, it may also make sense to continue conversions into the 25% or even 28% tax bracket.

The above approach can result in significant tax savings, often to the tune of tens of thousands, or even hundreds of thousands, of dollars. Those savings can improve the investor’s lifestyle and also reduce the risk of the investor running out of money during retirement.

That said, it can be a bit challenging to illustrate the total benefit of tax-efficient withdrawal strategies because of how dynamic they can be. Thankfully, a recently released academic study helps to advance the merits and benefits of smart tax planning in retirement.

New Academic Research Sheds Light on Tax-Efficient Withdrawals

New research from professors Kirsten A. Cook and William Reichenstein, CFA, along with William Meyer, focuses on the impacts of several different retirement withdrawal strategies as it relates to the longevity of an investor’s portfolio.

Their paper, Tax-Efficient Withdrawal Strategies, appeared in the March/April 2015 edition of the Financial Analysts Journal (available for download here) and does a fabulous job illustrating the cumulative benefits of the conversion strategy I outlined above.

Here are a few key highlights from the paper:

  • Investors should think about tax-deferred accounts (such as a traditional IRA) as a limited partnership in which the investor is the general partner and the government is the limited partner. The investor owns a portion of the partnership interest (1 – t) and the government owns the remaining amount (t).
  • An investor receives 100% of the returns from a tax-exempt or a tax-deferred account. However, they typically only receive a portion of the returns from a taxable account (due to taxes on capital gains, dividends, and interest). This is a critically important point and one that I plan to explore in greater detail in a subsequent post. For the purposes of understanding the conclusions of this paper, just know that a fundamental concept of minimizing taxes on retirement account withdrawals is realizing that a Roth account is equally as tax-advantaged as a traditional account. Therefore, the conventional wisdom of simply withdrawing from traditional accounts before Roth accounts isn’t always going to be correct.
  • In order to extend the life of an investment portfolio, the investor’s objective should be to identify opportunities to withdraw funds from tax-deferred (traditional) accounts at particularly low rates. Generally, this means taking withdrawals or executing conversions during years in which the investor is in the 10% or 15% federal tax bracket.
  • The opportunities to make these withdrawals or conversions are often during the years before required minimum distributions begin and in years when the investor has large tax deductions, such as those from high medical expenses.
  • Smart withdrawal strategies can add two to three years to the life of a portfolio compared to the approach advocated by conventional wisdom. What should be even more eye opening for investors is that the worst withdrawal strategy (i.e. the most tax inefficient) can shorten the life of your portfolio by as many as five or six years.

The last bullet is obviously where the rubber meets the road. If you don’t have a clear plan around making withdrawals during retirement, it’s absolutely vital that you sit down to consider your options. Ultimately, you don’t want pay any more taxes than you need to!

State of the Union Tax Reform: Are Your Taxes Going Up?

State of the Union Tax Reform

In his State of the Union address last night, President Obama laid out grand plans for reforming the tax code and eliminating loopholes. Most of this was done in the name of providing relief to the middle class and putting a stop to special interest tax breaks. Politics aside, essentially the president’s budget calls for $320 billion in new taxes primarily targeted at high-income earners and banks.

A call for new taxes should not be overlooked when it comes to financial planning; however, I think there is some important perspective we need to consider in light of the president’s proposals. With that in mind, let’s look at a couple of the reforms the president put on the table which could have the greatest impact on you:

529 Plans

– Under current law (in place since 2001), contributions to a 529 savings plan grow tax-free. As long as the withdrawals are used to pay for qualified college expenses, no taxes are paid on distributions either.

– That’s why 529 plans are probably the single best vehicle for most families to save for their children’s college. In addition to the federal tax benefits noted above, some states (including Colorado) also offer a state income tax deduction on contributions.

– The president’s plan would revert us back to pre-2001 tax law by taxing withdrawals from 529 plans, even if they are used for college expenses.

– This is really an odd proposal since it would have the most significant impact on the very demographic the president said he was focused on helping: the middle class. That said, it’s pretty unlikely that this change would ever make it through Congress. More importantly, the current proposal only calls for changes on future contributions, not money that has already been contributed. Thus, there is no reason to abandon 529 plans at the current moment.

Increase to the Capital Gains Tax Rate

– As part of the ironically named American Taxypayer Relief Act (ATRA) which went into affect on January 1, 2013, the top marginal tax rate for long-term capital gains was raised from 15% to 20%. In addition, a 3.8% “net investment income” surtax also went into effect. The resulting rate amounts to 23.8% for those taxpayers in the 39.6% marginal income tax bracket.

– Obama’s proposed budget would see the top capital gains tax rise from 23.8% to 28%, the highest since 1997. This would amount to a nearly doubling of the highest applicable long-term capital gains under the Obama administration (from 15% to 28%).

– While this change would only impact those taxpayers in the highest tax bracket, it’s important to remember that this group often includes small business owners. That’s because most small businesses are structured as pass-through entities (e.g. limited liability corporations or S-corporations), meaning that the business income flows through to the owner’s return. The owner then pays taxes on that income, even if they reinvest it into the business.

– Similar to the proposed change on 529 plans, the spike in capital gains taxes is also a long-shot to see the light of day with a Republican-controlled Congress. Although future changes are always possible, the same strategies to maximize after-tax returns generally apply in all tax environments. This is a good reminder to focus on what we can control and ignore what we can’t.

Other Proposed Tax Reforms

– Eliminating the Step-Up in Basis: Current tax law provides that inherited assets benefit from a step-up in tax basis to the extent the fair market value of the asset at the time of death is higher than the decedent’s basis. Obama’s State of the Union tax reform proposal would do away with this basis adjustment, meaning an inherited asset would keep the decedent’s original basis (with certain exceptions). The step-up in basis is a significant tax benefit for many Americans and a critical consideration when it comes to investment and financial planning.

– Cap on Retirement Plan Accruals: For many American’s, the most powerful tool to save for retirement is through an IRA and 401k plan. The president’s State of the Union tax reform plan intends to cap the total amount an individual can accrue in such retirement plans at $3.4 million. While this may seem like a lot of money, as we live longer and see fewer benefits from other sources of retirement income, it could have a significant impact on some retirees.

Ultimately, this is likely much ado about nothing, as they say. Although the president delivered a long list of talking points on tax reform, there simply isn’t much bite to the bark since Republicans are unlikely to pass most of the proposals. It’s important to keep a close eye on any changes in legislation, but for now, it’s business as usual.