Lesson 2, The Uncertainty of Death and Taxes

Well, besides accounting for the possibility of random rates in our retirement income Monte Carlo simulations — which is an important topic in its own right, something I will address in a later lesson — financial advisors should think about adopting tax diversification and hedging strategies.

This might sound academically abstract, but at the very least this implies that there are a number of cherished rules-of-thumb related to retirement that should be re-examined.

For example, it is well documented that many Americans hold fixed-income bonds in their fully taxable accounts while at the same time holding stocks in their tax-deferred accounts. To most specialists, this is quite puzzling and perhaps irrational. After all, if you want to invest in both stocks and bonds, why not place the highly taxed bonds in the tax-deferred account and the lightly taxed stocks in the taxable account?

A steady stream of commentators continues to lament this example of poor financial hygiene. They argue that since the coupons and income from holding bonds are taxed at your marginal tax rate, they should be sheltered and held inside IRA, 401(k) or 403(b) accounts. In contrast, stocks, ETFs and mutual funds which are taxed more favorably, belong in taxable accounts. In fact, financial economists label this the "pecking order" rule of asset location.

And, while there is obviously much merit in the theory, this so-called puzzling behavior might be a good example of where the masses have got it right. If you think in terms of tax uncertainty, people might implicitly be hedging their retirement bets by gambling on a bit of everything.

Remember, capital losses are difficult if not impossible to use (as deductions) inside of a tax-deferred account, but could be netted against future gains outside of the shelter. And, while nobody invests under the anticipation that they will suffer losses, you might want to differentiate between investments with low volatility that are less likely to experience these unwanted losses versus more volatile holdings (e.g., tech stocks) where the option to use those losses is more valuable. Likewise, the uncertainty of tax rates themselves, your own financial situation and your ability to borrow money if needed might create an incentive to keep some bonds un-sheltered.

Here is another example of tax-uncertainty thinking, courtesy of Professor Bill Reichenstein at Baylor University, who is one of the leading scholars on integrating investments and the tax code. At retirement, if you have both tax-deferred accounts and fully taxable accounts, conventional wisdom dictates that you withdraw or spend from your taxable accounts first and let the tax-deferred accounts grow as long as possible. For the most part this makes sense. However, Professor Reichenstein points out that this strategy of waiting and letting shelters grow, might forcibly push you into a higher tax bracket later in retirement. Instead, a retiree might benefit by diversifying withdrawal sources over time.

Obviously, all of these situations are case-specific and there are no one-size-fits-all solutions. My limited point here is that it's worth thinking about managing your future tax risk, not just your current taxes.

In sum — not unlike the conventional rules of investment diversification — the diversification of tax risk implies that you adopt strategies that will benefit under alternative states of nature. Act dynamically. Keep your options open.

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Moshe A. Milevsky , Ph.D., is a finance professor at the Schulich School of Business at York University and is the executive director o the IFID Centre in Toronto, Canada ; see www.ifid.ca