The bottom line: Financial professionals should re-evaluate each of their favorite tax-deferred strategies in light of a changing environment. Some strategies will remain attractive and perhaps become relatively more effective. In others, any benefits created by tax-deferred may be more than offset by rising tax rates, extra costs, higher risks or other negative impacts. This column will help you separate the winners and losers.

How Tax-deferral Works Best

On a basic level, tax-deferral works best when four conditions are met:

1. A buy-and-hold investment earns an attractive rate of return over a period of time.
2. Income tax rates remain stable or decline over time.
3. Tax-deferral does not impose additional costs, risks or other drawbacks.
4. Earnings eventually can be withdrawn and taxed at attractive rates.

The first three points are somewhat intuitive, but the fourth is not ? and ignoring it can lead to tax-inefficient strategies. For example, suppose your client, Bob, wants to invest a $100,000 inheritance in the stock market over the next 10 years. He in evaluating two alternatives: 1) a tax-deferred variable annuity; and 2) a buy-and-hold position in a single stock that pays no dividends. Let's assume that both earn an annualized return of 7% (net of expenses) and income tax rates don't change over ten years. We'll also assume that Bob pays combined federal/state income taxes at a 35% rate on ordinary income. The table below summarizes hypothetical results.

The annuity is not the more tax-efficient choice. This is because Bob can buy-and-hold a single stock, defer taxes for 10 years, and then pay tax on the growth at long-term capital gains rates. Under current law, that creates a "tax rate arbitrage" of 20% compared to ordinary income tax rates (35% – 15%). If Bob should die during the 10-year holding period, the tax rate arbitrage would be even greater. His heirs would owe ordinary income tax on the inherited VA gains, while they would receive a stepped-up basis on the stock and could pay no income tax at all.

Of course, a variable annuity offers investment diversification, while the single stock does not, and in the past this has been a compelling advantage for VAs. However, with the growth of exchange-traded funds (ETFs), the balance has shifted. It is now possible to purchase an ETF that behaves like a single stock for tax purposes – i.e., long-term capital gain treatment on appreciation and stepped-up basis at death – and also delivers broad market diversification.

But all this assumes current tax law. Effective tax planning strategies must also consider the future, and the tax rate arbitrage advantage of the ETF (in the example above) could grow even greater for affluent Americans over the next decade, due to a rising tax storm.

The Coming Tax Storm

It is probable, perhaps inevitable, that high-income Americans will not again in their lifetimes see ordinary income tax rates as low as those of the present. The reasons are many and complex, and here is a quick summary.

• A spiraling federal deficit – The federal budget projected deficits of $1.8 trillion in fiscal year 2009 (ending 9/30/09) and $1.3 trillion for 2010, and that was before the recession produced sharp declines in federal tax deposits. For June of 2009, federal tax deposits were 18.5% lower than in the same month of 2008.
• Out-of-control entitlements – Even the current federal debt of $11.4 trillion (more than $37,000 per person) pales in comparison with an estimated $58 trillion in unfunded liabilities for government entitlement programs – Social Security, Medicare and Medicaid. To see a running toll of federal debts and liabilities in real time, look here:

  www.usdebtclock.org

• Deteriorating state/local finances – A recent report by the Center on Budget and Policy Priorities projected combined state budget gaps of $350 billion from the present through the end of fiscal year 2011. According to the report: "Unlike the federal government, the vast majority of states are governed under rules that prohibit them from running a deficit or borrowing to cover their operating expenses. As a result, states have three primary actions they can take during a fiscal crisis: draw down available reserves, cut spending, and raise taxes." Massachusetts, California, and New Jersey have raised personal tax rates recently, and other large states such as Pennsylvania and New York are considering it.
• Hidden taxes on the affluent – The tax impact on affluent Americans doesn't end with published tax brackets. An assortment of hidden taxes is increasing the burden, including the phase-out of itemized deductions and personal exemptions, income-tiered taxation of Social Security benefits, income-relating of Medicare Part B premiums, income limits on tax credits for higher education, and the phase-out limits for receiving various federal tax credits. Proposals have been floated in Washington to "income-relate" (means-test) Social Security benefits and the tax-deductible portion of health insurance premiums and mortgage interest. All of these measures potentially could increase the effective marginal income tax rates of the highly affluent.
• Scheduled tax increases – In its budget proposal, the Obama Administration has committed to letting the "Bush tax cuts" expire on schedule at the end of 2010. This will cause the top two tax brackets to increase from the current 33% and 35% to 36% and 39.6%, respectively. The federal rate on long-term capital gains would increase from 15% to 20%.

When the full impact of the tax storm hits, it is reasonable to expect that high-income Americans could face top effective marginal rate 10-15% higher than under current law. While the rate on capital gains may also increase, there are compelling arguments for keeping capital gains rates modest during a time when America must promote capital formation to rebuild the economy.

The dilemma that high-income taxpayers face on ordinary income is that they are being "nickeled-and-dimed" with myriad tax increases that nobody (including their own CPAs) can anticipate or plan for. In the future, the advantage of capital gains over ordinary income may be two-fold: 1) a wider tax rate arbitrage gap; and 2) simpler and more predictable tax planning.

The Tax-deferral Breakeven Table

Financial professionals have used many tools and techniques to help clients evaluate the benefits of tax-deferral. Yet, here is one tool that you probably have never seen before, and it is intuitively useful.

An example demonstrates its application. Suppose your client has a choice between a currently taxable investment and a tax-deferred investment, both earning the same rate of return. Let's assume the client pays a marginal combined income tax rate of 30%, and the tax-deferred investment will be liquidated at the end of a given period, with all income taxes payable at 30% at that point. The question is ? how much would the client's top marginal tax rate have to increase in the future to wipe out the benefit of tax-deferral?

Example: Assume that initial investments of $10,000 earn a 7% rate of return over a period of 15 years. The tax-deferred investment hypothetically would grow to $27,590 and the taxable investment to $20,494. After paying tax on the tax-deferred account @ 30%, the tax-deferred account would be worth $1,819 more ("the value of tax-deferral"). But if the investor's marginal tax rate increases by 10.3%% when the tax-deferred account is liquidated (to 40.3%), then the two accounts would break even (produce the same after-tax benefit), and the value of tax-deferral would go to zero.

Note: The table should be used as a guide, not for detailed tax planning analysis. Breakeven rates would be different for marginal tax rates other than 30%. The table assumes a tax rate increase all at once, at the time accounts are liquidated, and doesn't measure gradual tax increases over time.

The table shows that tax-deferral has the best chance of overcoming any future tax rate increases when investment returns are high and the deferral period is long. Historically, over the past 40 years, an all-stock portfolio has returned about 9% annualized and a mixed stock-bond portfolio about 7%. However, many market analysts believe long-term trend returns on both stocks and bonds will be lower in the future, due to slower U.S. economic growth and soaring federal debts. If mixed stock-bond portfolios average about a 5% annual return over the next 10-15 years, even a fairly modest increase in tax rates could erase most of the benefit of tax-deferral.

Tax-deferred Strategies That Are Losing Momentum

In an era of rising personal income tax burdens and lower long-term trend returns on investments, some formerly popular tax-deferral strategies may be less attractive. They include:

Variable annuities (VAs) – The VA industry is currently in turmoil as life insurance companies struggle to hedge the risks of guaranteed death benefits and living benefit riders in more volatile markets. Many carriers are imposing investment restrictions that have made it difficult for financial advisors to implement aggressive investment strategies. Carriers also are increasing the cost of enhanced death benefits and living benefit riders.

These developments will make it harder for VAs to earn attractive returns after costs, thus diluting the value of tax-deferral. Most VA investors want some equity exposure, and 100% of the gains they earn in stock portfolios eventually will be taxed as ordinary income, rather than as long-term capital gains. VA investors (or their heirs) ultimately will pay the price of any future increases in top marginal tax rates, as well as any increases in the arbitrage gap between ordinary income and capital gains.

Non-qualified deferred compensation (NQDC) – During this recession, many corporate executives are regretting past decisions to participate in NQDC. Specifically, they are questioning whether it was smart to trade the benefit of tax-deferred compensation for the drawback of being an unsecured creditor of their own employer. NQDC merely defers the receipt of ordinary income, and ultimately it taxes any build-up in the account as ordinary income. Some executives could achieve better tax results, and avoid the risks of being unsecured creditors, by taking current income, paying taxes, and investing in securities capable of producing long-term capital gains. Other types of executive benefits, such as executive bonus plans, also appear relatively more attractive in the current climate.

For more on the risks of NQDC, see: How to Fill Gaps in the NQDC Story

Minimum distribution IRA strategies – Some retired people have tried to maximum tax-deferral on Traditional IRAs by taking only the minimum required distributions annually after age 70 1/2 . But in today's environment, more retirees are reducing investment risk exposure and potential returns. According to the Tax-deferral Breakeven Table, that makes it less likely they will benefit from continued tax-deferral, given even a modest future increase in marginal income tax rates during their lifetimes. Tax-deferral also could make them more vulnerable to additional income-relating of Social Security or Medicare benefits.

Some retirees would be better off accelerating Traditional IRA distributions, paying income tax at current rates, and reinvesting the money in solutions that can arbitrage lower tax rates in the future, such as life insurance or ETFs. Accelerating distributions also can simplify post-death transfers and help to reduce federal estate taxes and settlement costs.

All three solutions identified above merely defer taxes into the future and then subject gains to ordinary income tax rates. They also impose drawbacks such as extra fees and surrender charges in VAs, unsecured creditor risk in NQDC, and minimum distribution requirements and estate tax impact in Traditional IRAs.

Relatively Attractive Tax-deferral Strategies

Other tax-deferral strategies will continue to be attractive because they: 1) allow income taxes to be paid today, at what may one day seem to be bargain rates; and/or 2) offer opportunities to arbitrage ordinary income into capital gains or tax-exempt income.

529 college savings plans – These savings programs can have fairly long time frames when set up for young children, and they allow tax-exempt distributions for qualified educational expenses. Therefore, investors can enjoy long-term tax-deferral without worrying that income tax rates will increase in the future. Currently, withdrawals from these plans are not included in any IRS phase-out limits or income-relating (means-testing) formulas. There are no credible tax proposals under consideration that would diminish the tax benefits of 529 plans.

Roth IRA conversions – Roth IRAs allow investors to make tax-exempt distributions after a five-year holding period and upon attaining age 59 1/2 , or upon death, disability or first home purchase. Retired people who have access to a Roth IRA for income will have the flexibility to take withdrawals that don't push them above phase-out or income-relating thresholds. For more on planning such flexibility, see: The Value of Flexible Untaxable Retirement Income

Financial advisors now have a unique window of opportunity to offer affluent clients Roth conversions from Traditional IRAs or qualified retirement plans. The $100,000 modified adjusted gross income limit that currently applies to conversions is scheduled to permanently disappear on the first day of 2010, and a favorable tax reporting treatment applies to conversions made at any time in 2010.

Tax loss harvesting with ETFs – ETFs allow investors to buy-and-hold diversified portfolios of indexed funds with low current income tax impact, long-term tax-deferral, and long-term capital gains treatment (or stepped-up basis) when positions eventually are sold or transferred. Most leading ETFs have made minimal or no taxable distributions in recent years. In any given year, ETF shares that decline in value create tax-loss harvesting opportunities, which can offset any realized gain or taxable distributions.

Precious metals – The world's original money – gold and silver, coins or bullion – remains an attractive way to defer income tax long-term and ultimately pay capital gains. At a time when many of the world's leading currencies, including the dollar, are under devaluation pressure, gold and silver represent a globally accepted hard currency with the potential to hold value. Since precious metals' performance is somewhat volatile from year to year and individual tax lots can be tracked and sold, precious metals can work well in tax-loss harvesting strategies.

Life insurance cash values – The inside tax-deferred build-up of life insurance has been threatened in Congress at times in the past, but there has been little talk of changing it recently. In addition to growing on a tax-deferred basis, cash value can be accessed tax-free through loans and also help to build a death benefit that eventually is paid to beneficiaries income tax-free.

In summary, tax-deferral is far from dead as an attractive concept. But as new tax storms brew, financial advisors should re-evaluate which tax-deferred strategies will give their clients the greatest combination of flexibility, cost-efficiency and tax-savings.

The ability to merely postpone taxes – and then face future taxes at ordinary income rates – is no longer very attractive, unless clients can earn high rates of return over long horizons. On the other hand, strategies that allow tax-deferred earnings plus tax-free income, stepped-up basis or capital gains treatment may be more valuable than ever.