5 Tax-Smart Steps to Help Build Wealth

Footnotes:

¹ For full methodology, see end notes.

End notes:

This publication is not provided as part of an investment advisory service offered by Morgan Stanley, the funds discussed in this publication are not currently available to be implemented as part of an investment advisory service and this publication should not be regarded as a recommendation of any Morgan Stanley investment advisory service. Any returns displayed are gross figures and as such, do not take into account fees and other expenses, including advisory fees, the deduction of which, when compounded over a period of years, would decrease returns. Information regarding Morgan Stanley standard advisory fees is available in the Form ADV Part 2, at www.morganstanley.com/adv.

This report is based on tax law in effect at the time of its publication. Subsequent changes in tax law may have an impact on the strategies outlined.

Given the impact of individual circumstances on the assessment of federal gift and estate tax, such as the amount of lifetime exemption used and size of overall estate, we exclude estate taxes from scenarios below that are focused on wealth transfer after the investor passes away.

Methodology for added return estimates

Tax-rate assumption: Unless otherwise stated, the tax rates assumed throughout the report are as follows: a 37% federal tax bracket, 3.8% net investment income tax rate (Medicare surtax) and 5.2% state tax rate.

Capital Market Assumptions: Unless otherwise stated, asset return assumptions are based on the Global Investment Committee’s (GIC’s) capital market assumptions (published March 2024). Return scenarios are simulated using Monte Carlo analysis, with the GIC’s strategic assumptions used for the first seven years and secular assumptions used afterward. For additional detail, please see the 2024 “Annual Update of GIC Capital Market Assumptions.”

Simulation: Unless otherwise stated, estimates for each strategy are modeled using 10,000 simulations of different market scenarios, using Monte Carlo analysis and the GIC’s capital market assumptions. We report median internal rate of return (IRR) improvement as estimates of value-add in Exhibit 1 and provide estimates for a range of outcomes based on the 32nd percentile and 68th percentile IRR improvement (unless otherwise specified).

Tax-Advantaged Account: Our estimate for value-add is modeled as follows: Assume an investor could invest assets in either a taxable account or a common government-sponsored tax-advantaged retirement account. We compare the performance across both account types, measuring the post-liquidation values after 40 years of simulated growth. Both account types hold the same asset allocation of 50% equities, 20% fixed income and 30% alternatives. We calculate IRR for the tax-advantaged account by measuring the after-tax equivalent amount of the initial contribution and the post-liquidation value in order to calculate annualized gain. The IRR of the taxable account is measured similarly, though the initial investment is sized as an equivalent after-tax dollar amount assuming 100% cost basis.

Municipal Bonds: Our estimate for value-add is based on the historical average spread between the after-tax equivalent yield of 10-year US Treasury bonds and 10-year municipal bonds, measured between Jan. 5, 2001 and Sept. 9, 2024.

Direct Indexing/Tax-Loss Harvesting: Our simulation follows the method described in the June 2024 report, “Direct Indexing: Opportunities for Customization and Potential Tax Alpha.” Our estimate for value-add is calculated as the post-liquidation IRR for a direct indexing strategy, assuming fees of 30 basis points per year. Our simulation runs 100 trials, with 10,000 iterations in each trial, in order to calculate the average IRR benefit across the 100 trials. We then compare this IRR to a baseline that is invested in a passively managed ETF, modeled as having zero fees and expenses. The simulation horizon used is five years.

Exchange Funds: Our estimate assumes that an investor owns a concentrated position that has a cost basis equal to 10% of its current market value and seeks to diversify into broad market exposure using an exchange fund. We calculate value-add as the difference in IRR between a scenario in which the investor exchanges their current concentrated position for shares in an exchange fund and a scenario in which they liquidate their concentrated position and invest the after-tax proceeds into 100% passive US equity exposure. In both cases, return assumptions follow the GIC’s 2024 capital market assumptions and assume 0% turnover. The simulation horizon is 20 years. We assume that the exchange fund is held for seven years, that its underlying holdings are composed of 80% passive US equity and 20% private real estate exposure and that it charges an annual account fee of 0.92% of assets under management during the seven years. After seven years, the investor’s shares in the exchange fund are redeemed in exchange for a basket of diversified US equity shares, which the investor holds for an additional 13 years.

Tax-Aware Long-Short Strategies: Our estimates source assumptions for the pace and magnitude of realized net capital loss possible in this strategy from “Beyond Direct Indexing: Dynamic Direct Long-Short Investing” (cited below), following the authors’ analysis of a “relaxed-constraint” method and the 150%/50% long/short leverage approach. Our calculations assume an investment horizon of ten years and rely on the GIC’s secular capital market assumptions for US equities. We conservatively assume that there is no additional investment alpha provided by the manager of the long-short strategy, and thus our estimates represent only the tax alpha added. Total expenses are assumed to be 1%. We calculate value-add by measuring the cumulative realized net capital loss and assume that funds grow tax-deferred. After 10 years, assets are liquidated and taxes paid. The estimated range shown in Exhibit 1 relies on the 90th percentile and 10th percentile of cumulative net capital loss, sourced from the report, in the same calculation described above.

Investment-Only Variable Annuity: Our estimate for value-add assumes that an equivalent amount of after-tax funds ($1 million) is invested in either an IOVA (bought in a nonqualified account) or a taxable account. Both strategies are invested in a 100% active equity portfolio with an annual turnover rate of 100% and are held for 40 years. Based on prevailing prices, we assume that the IOVA charges 0.95% of assets under management annually. After 40 years, we assume that gains in the IOVA are taxed as ordinary income in order to calculate post-liquidation value. We then calculate the IRR for each strategy and use the difference to represent the added return potential of an IOVA.

Indexed and Variable Universal Life Insurance: Our estimates for value-add assume an equal amount of assets ($400,000) is used to either buy life insurance, contributed as premiums over a period of 10 years, or invested in a taxable account. The taxable account is assumed to be invested in investment grade bonds to compare with Index Universal Life insurance (IUL) and invested in equities to compare with variable universal life insurance (VUL). We calculate IRR based on each insurance policies’ tax-free death benefits and compare these IRRs to the IRR achieved using the taxable portfolio’s ending value, assuming a cost basis step-up (equal to pre-liquidated value) upon the account holder’s death at age 85.

Life insurance quotes assume the policyholder is a 45-year-old male non-tobacco user. Premiums are paid for both insurance policy types in a size of $40,000 per year for 10 years. These premiums are subject to a premium-based administrative charge and a sales charge that sum to 10% and 4.75% for IUL and VUL policies, respectively, plus a transaction charge of 9.5% and 3.7%, respectively, calculated against the remaining premium amount. During the first 10 years, both policies offer an initial death benefit of $619,564. After 10 years, the death benefit option in both life insurance contracts is switched from an increasing amount to a level amount, subject to the minimum required death benefit defined in US Code §7702.

We assume that both IUL and VUL policies also charge a policy expense of $144 per year. The monthly cost of insurance rate varies by age, ranging from 0.00767% at age 46 to 0.01902% at age 85 and is sourced from the Prudential CPII Specimen Contract document (as of September 2024) to represent current prices available. For the IUL policy, we assume the subaccount credit rate is linked to the price performance of the MSCI All County World Index and subject to a floor rate of 0% and a cap at 10.25% per year.

Private Placement Variable Annuity: Our estimates of value-add assume that an equal amount of assets ($1 million) is invested in either a private placement variable annuity (PPVA) or a taxable account and assume that 100% of funds are invested in alternatives, modeled as broad hedge funds, within each structure. IRRs are based on the liquidated values for both the PPVA and the taxable account, after a simulated holding period of 40 years. Representative of current prices, we assume that the PPVA charges a 1% sales load. Separate account charges are applied every year, including an account maintenance charge and an asset-based distribution charge. Current account maintenance charge is modeled as follows: 0.30% for assets below $20 million, 0.25% for assets between $20 million and $40 million, and 0.20% for assets of $40 million or more. The current asset-based distribution charge is modeled as follows: 0.05% for assets below $25 million and 0.00% for $25 million or more.

Private Placement Life Insurance: Our estimates of value-add assume that an equal amount of assets ($3 million) is invested in either private placement life insurance (PPLI) or a taxable account, assuming 100% of funds are invested in alternatives, modeled as broad hedge funds, within each structure. We assume the investor begins at age 50 and dies at age 90, for a 40-year investment horizon in both scenarios. IRRs for PPLI are based on the amount distributed, income tax-free, after the policyholder’s death and are compared to the IRR of the taxable portfolio, measured using its ending value after the same period of time and assuming a step-up in cost basis (equal to pre-liquidation value) upon death of the account holder.

We model the PPLI premium as $1,000,000 per year for three years, with an initial death benefit of $12,527,000. Sales load, deferred acquisition charge and state premium tax are each charged on the premium. Sales load charge is 1.75% for a premium below $2.5 million and 1.25% for a premium from $2.5 million to $5 million. Deferred acquisition charge is 0.7%, and state premium tax is 2.0%. Cost of insurance (COI) charge is based on client’s age and health as well as net value at risk. Separate account charges are applied every year, including an account maintenance charge and an asset-based distribution charge. Current account maintenance charge is 0.20% for years 1-10, 0.15% for years 11-20 and 0.1% for years 21 and beyond. Current asset-based distribution charge is 0.3% for assets below $25 million, 0.2% for assets from $25 million to $50 million and 0.15% for $50 million or more.

Asset Location: Our estimates assume that the investor holds assets across multiple account types and structures, including both taxable and tax-deferred accounts, as well as (in the asset-location scenario) an investment-only variable annuity, with a time horizon of 20 years. We assume that the investor maintains an aggregate asset allocation of 60% equities and 40% fixed income in both scenarios, but the location of each underlying asset is varied across the baseline and asset-location scenarios.

Our baseline scenario follows a pro-rata asset allocation for both account types. This asset allocation includes 15% investment grade fixed income, 20% municipal bonds, 5% high yield bonds, 30% passive equities, 25% active equities and 5% REITs. In the asset location scenario, each account’s allocations vary. The taxable account holds 40% municipal bonds and 60% passive equity; the tax-deferred account holds 30% investment grade fixed income, 10% high yield bonds, 50% active equities and 10% REITs.

Turnover rates generally follow 2024 GIC assumptions, though we assume a turnover of 10% for low-turnover equity managers and 100% for high-turnover equity managers. During the asset accumulation period, investors stay in the 37% federal tax bracket, with a 5.2% state tax and a 3.8% net investment income tax. At the end of the investment horizon, portfolio values are evaluated using their after tax-equivalent amount, assuming that the investors are in the 24% federal tax bracket and subject to a 5.2% state tax. Investment-only variable annuity fee is assumed to be 0.95% per year.

Intelligent Withdrawals and Income Smoothing: Our estimates for value-add assume that an investor holds a 60% equity, 40% fixed income portfolio across multiple account types, including taxable and tax-deferred accounts, as well as an investment-only variable annuity, and that the order and magnitude of withdrawals across these accounts is varied by the investor.

We allow for 20 years of asset growth in each scenario, with $1.5 million of assets distributed across accounts as in the “asset location” example described above. We do not model additional contributions during this accumulation period. After these 20 years, withdrawals begin in order to provide retirement income. We calculate the annual withdrawal amount as equal to 4% of the aggregate portfolio’s pre-tax value at retirement, plus an annual adjustment for the cost of living (following inflation). We assume that withdrawals continue for 30 years.

In the baseline scenario, we assume that withdrawals occur systematically, with withdrawals sized pro-rata from each account based on the assets held in each account. In the “intelligent withdrawal” scenario, we assume that withdrawals are taken from the taxable account first, then from the tax-deferred retirement account and IOVA in pro-rata amounts, and from the Roth last.

The “income smoothing” scenario is designed to be similar to the intelligent withdrawal scenario, but in this case, we convert funds from the tax-deferred retirement account to a Roth account. The amount converted is determined such that, when combined with other sources of realized income each year, the upper threshold for the 12% tax bracket is reached.

During the wealth accumulation period of all scenarios, we assume that the investor remains in the 37% federal tax bracket and is subject to a 5.2% state tax and 3.8% net investment income tax. During the subsequent retirement phase, we calculate the investor’s federal tax bracket based on the withdrawal amount (and account type), alongside a yearly Social Security payment—of $40,000 in the first year of retirement and adjusted for inflation afterward (Social Security subject to the 5.2% state tax and federal income tax).

Income tax brackets are based on the 2024 rates for a taxpayer that claims “married, filed jointly” status, and the tax brackets are assumed to grow with inflation.

Inflation rate is assumed to be 2.36% per year, per the GIC’s 2024 capital market assumptions.

Portfolios are rebalanced each year within each account type, after the yearly spending amount is withdrawn.

Unrealized tax liabilities are subtracted from portfolio ending values to calculate IRR.

Added Return and Wealth Accumulation Estimates for Hypothetical Investor

We use Monte Carlo analysis to simulate 10,000 capital market scenarios in order to estimate the value-add from using tax-efficient investing techniques. These simulations produce a range of investment outcomes that inform our estimates for each category of technique: enrolling in tax-advantaged accounts, leveraging tax efficient strategies for taxable assets and applying portfolio-level tax strategies. These exhibits show the median outcome of these simulations, assuming a holding period of 20 years.

In the baseline scenario, we assume the investor has $10,000,000 in taxable assets and a target asset allocation of 20% investment grade fixed income, 30% passively managed equities, 20% actively managed equities and 30% alternatives (modeled as broad hedge funds). $1 million of the taxable assets to be invested is assumed to be a concentrated stock position that has significantly appreciated from cost basis and assumed to be 10% of its market value. We assume that the investor seeks to exit this concentrated position and diversify it into broad, passively managed equity exposure. In this baseline scenario, we model a liquidation of this position, incurring capital gains taxes, in order to reallocate the remaining after-tax proceeds into passively managed equities.

The next sequential modeling step modifies the previous scenario to estimate the potential impact of using tax-advantaged accounts. Here, we assume that the investor has accumulated $500,000 of their initial assets in a Roth account and $926,000 in a traditional retirement account (equivalent to $500,000 on an after-tax basis), with the remaining $9,000,000 in a taxable account. All three account types follow the same asset allocation as in the baseline scenario. Similarly, we assume that the $1,000,000 concentrated position in a single stock is liquidated at the beginning of the simulation and invested in passively managed equities, realizing capital gains and paying the associated taxes at that point.

The next modeling step applies tax-efficient strategies to the $9,000,000 held in taxable accounts. Here, we assume that the investor replaces their taxable fixed income holdings with municipal bonds that are exempt from federal and state taxes as well as the net investment income tax. We also assume that they deposit the concentrated $1,000,000 position in a single stock into an exchange fund, in return receiving proportional exposure to the exchange fund’s performance, which we model as 80% passively managed, broad US equity exposure and 20% private real estate exposure. The remaining $2,000,000 of exposure sought in passively managed equities is achieved using direct indexing vehicles for the first five years of the horizon, followed by a buy-and-hold strategy with minimum turnover after that. We also assume that the investor allocates $1,000,000 to an investment-only variable annuity (assuming a pro-rata underlying asset allocation); and for alternatives exposure, $3,000,000 to a private placement variable annuity. The fees for both vehicles are assumed to be the same as those used in the modeling of Exhibit 1. The underlying exposure of the PPVA is modeled to be 100% invested in alternatives (modeled as broad hedge fund exposure). All other accounts and the IOVA are assumed to have the same pro-rata allocation of 28.6% municipal bonds, 42.8% passive equities and 28.6% active equities.

Our final step models portfolio-level tax strategies, in this case “asset location” (intelligent withdrawals and income smoothing are not applicable to accumulation-focused strategies). To implement this technique, we modify the underlying holdings of the different account types such that the Roth account, traditional retirement account and IOVA each hold 100% of their funds in actively managed equities, while the taxable account is assumed to hold 40% of funds in municipal bonds and the remaining 60% in passively managed equities.

As in the previous exhibits, asset growth rates are based on the GIC’s 2024 capital market assumptions. We follow the strategic assumptions for the first seven years of the horizon and in the remaining years follow the secular assumptions. Turnover rates generally follow GIC 2024 assumptions, though we assume a turnover rate of 10% for low-turnover equity managers and 100% for high-turnover equity managers.

During the asset accumulation period of the simulations, we assume that the investor remains in the 37% federal tax bracket, with a 5.2% state tax and a 3.8% net investment income tax. At the end of the investment horizon, portfolio values are represented as their after-tax equivalent amounts, and we assume that the investor is in the 24% federal tax bracket, with a 5.2% state tax and 3.8% net investment income tax.

Citations

Liberman, Joseph and Krasner, Stanley and Sosner, Nathan and Maia de Freitas, Pedro Paulo, Beyond Direct Indexing: Dynamic Direct Long-Short Investing (May 3, 2023). The Journal of Beta Investment Strategies, Direct Indexing Special Issue 2023, 14 (3): 10-41; DOI: 10.3905/jbis.2023.1.045, Available at SSRN: https://ssrn.com/abstract=4437402 or http://dx.doi.org/10.2139/ssrn.4437402

Disclosures

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Also, municipal bonds acquired in the secondary market at a discount may be subject to the market discount tax provisions, and therefore could give rise to taxable income.  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. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability.

Insurance does not pertain to market values which will fluctuate over the life of the bonds; it covers only the timely payment of interest and principal.  Credit quality varies depending on the specific issuer and insurer.

Variable Annuities

Variable annuities are sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable annuity contract and the underlying investments, which should be considered carefully before investing. Prospectuses for both the variable annuity contract and the underlying investments are available from your Financial Advisor. Please read the prospectus carefully before you invest.

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, including optional benefits, are based on the financial strength and claims-paying ability of the issuing insurance company and do not apply to the underlying investment options.

Optional riders may not be able to be purchased in combination and are available at an additional cost. Some optional riders must be elected at time of purchase. Optional riders may be subject to specific limitations, restrictions, holding periods, costs, and expenses as specified by the insurance company in the annuity contract.

If you are investing in a variable annuity through a tax-advantaged 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 benefits protection.

Taxable distributions (and certain deemed distributions) are subject to ordinary income tax and, if taken prior to age 59 ½, may be subject to a 10% federal income tax penalty. Early withdrawals will reduce the death benefit and cash surrender value.

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Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Environmental, Social and Governance (“ESG”) investments in a portfolio may experience performance that is lower or higher than a portfolio not employing such practices.  Portfolios with ESG restrictions and strategies as well as ESG investments may not be able to take advantage of the same opportunities or market trends as portfolios where ESG criteria is not applied. There are inconsistent ESG definitions and criteria within the industry, as well as multiple ESG ratings providers that provide ESG ratings of the same subject companies and/or securities that vary among the providers.  Certain issuers of investments may have differing and inconsistent views concerning ESG criteria where the ESG claims made in offering documents or other literature may overstate ESG impact. ESG designations are as of the date of this material, and no assurance is provided that the underlying assets have maintained or will maintain and such designation or any stated ESG compliance. As a result, it is difficult to compare ESG investment products or to evaluate an ESG investment product in comparison to one that does not focus on ESG. Investors should also independently consider whether the ESG investment product meets their own ESG objectives or criteria. There is no assurance that an ESG investing strategy or techniques employed will be successful. Past performance is not a guarantee or a dependable measure of future results.

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