Financial Tax Planning is one of the many benefits of a financial advisor.
Taxes are an inevitable part of being successful. If you feel like you are paying too much in taxes, you have a good problem. The people that don’t have tax issues typically don’t have much income. Having said that, there is no reason to pay more than your fair share of taxes and there are ways that a financial advisor can help you minimize the amount of tax you pay.
A financial advisor can also help you to assess the risk/reward of maintaining an investment or selling it and paying the tax bill.
1. Tax Diversification - Just like there are benefits to investing in a diversified manner, there are benefits to having tax diversification. By investing in a diversified way you won’t make a killing if one asset class takes off, but you also won’t get killed if one drops precipitously. A similar approach to tax diversification is prudent. There are three broad categories of financial accounts from the taxation standpoint. These are:
i. Tax-free – Roth IRA or Roth 401(k) accounts
ii. Tax-deferred – traditional IRA, 401(k) and 403(b) accounts
iii. Taxable – typical brokerage or bank accounts
By maintaining some of your investments in each of the three tax “buckets” you have the flexibility to determine how to meet your cash flow needs during retirement in the most tax-efficient manner.
Tax-free accounts are referred to as Roth accounts. There are Roth IRAs and some employer-sponsored plans (e.g. 401(k) or 403(b) plans have a Roth option within the plan. The name is based on Senator William Roth, the sponsor of the 1997 legislation that created them. The premise of the Roth is that you put money into the account that you have already paid taxes on.
The money is invested and over time it grows and when you start to withdraw the funds your investment and the growth of the investment can be withdrawn tax-free assuming you have met the rules that allow tax-free withdrawals. These rules are not onerous and are in place to provide incentives for people to invest these funds for long-term goals, not utilize them for short-term needs.
Tax-deferred accounts are most commonly known as traditional IRAs, 401(k) or 403(b) accounts. The odd numbering/naming convention for these accounts relates to the section of the tax-code that allowed their creation and dictates the rules around their usage. Most often these accounts are funded with pre-tax money, i.e. earnings that you have not yet paid taxes on. These pre-tax earnings are deposited in an account and invested and the principal and gains are allowed to grow without any tax expense until the funds are withdrawn.
Similar to the Roth accounts, there are rules that must be followed with these accounts to keep their tax-deferred status, but these rules are relatively easy for an individual investor to comply with. When the funds in a tax-deferred account are withdrawn, taxes must be paid.
Since the original principal that funded these accounts was salary or earned income, these withdrawals are taxed at Ordinary Income rates. Tax rates on Ordinary Income are generally higher than tax rates on Capital Gains which will be explained in more detail when we discuss taxable accounts. While the benefits of tax-free growth in a Roth account are very compelling, the benefits of tax-deferred growth over longer periods of time can be quite compelling too.
Taxable accounts are comparatively simple and there are no tax rules governing when and how you can tap these funds. The downside to taxable accounts is that all income and gains that are generated create a tax expense that is due and payable immediately. Some of these gains may be taxed at a reduced rate if they meet the criteria to be designated as Long-Term Capital Gains. Long-term capital gains rates range from a low of 0% to a high of 23.8%, which is significantly lower than Ordinary Income tax rates that range from a low of 0% to a high of 39.6%.
Your ordinary income tax rate could also vary considerably over your lifetime as your earnings increase and decrease over time. Some retirees find their ordinary tax rates decline considerably from the highest levels achieved in their peak-earnings years.
By maintaining a mix of taxable, tax-deferred and tax-free assets your financial advisor can work with you to meet cash flow in the most tax-efficient manner and better adapt to the tax changes that come out of Washington at a frustratingly frequent rate.
2. Asset Location – Refers to the process of placing certain investments into taxable, tax-deferred or tax-free accounts due to the timing and tax-treatment of income on that investment. All investments generate taxable events and those events may be taxed at different tax rates depending on the nature of the income and the account it is generated in. Municipal bonds generate interest income that is free of Federal, and possibly state, income tax if owned in a taxable account. If the municipal bond is owned in a tax-deferred account (e.g. IRA) that same interest income will be taxed at ordinary income rates when withdrawn from the account.
Interest income on corporate bonds is normally taxed at ordinary income tax rates and the timing of the cash flow and tax impact is driven by the bonds themselves, not by the investor. If owned in a taxable account they are taxed at ordinary tax rates when cash is received. If that same income is received in a tax-deferred account (e.g. IRA) it will be taxed at the same ordinary tax rates, but not until it is withdrawn, possible many years later.
Long-term capital gains and qualified dividends are taxed at rates that vary from 0% to 23.8% and those taxes are incurred when you sell at a gain or receive dividends in a taxable account. If those same investments are held in a tax-deferred account the tax bill isn’t due immediately, but you will pay ordinary income tax when you withdraw the money from the tax-deferred account.
Your financial advisor should know the nature of the gains that are anticipated and how those gains will be taxed and place investments in the best tax “location”. Investments that are most likely to generate long-term capital gains should be held in taxable accounts where they can benefit from the lower tax rates applied to those gains. Comparatively, bond investments that are likely to generate ordinary income are better suited to be housed in tax-deferred accounts.
This doesn’t lower the tax rate per se, but by allowing the tax hit to be delayed, potentially for years, the impact of that tax is minimized. Add in the possibility of lower ordinary tax-rates in retirement and this strategy looks even more appealing.
3. Tax Loss Harvesting/Gain Recognition – Many of the taxable events in an investor’s life are out of their control, but there are events the investor can control. Investments can be valued throughout your holding period and they generate unrealized gains and losses. Taxes are generally not due on the gains, nor are losses deductible until you have sold the investment to convert those unrealized gains and losses into realized events for tax purposes.
The investor cannot determine when the bonds or stocks they own will pay interest or dividend income or when a mutual fund will make a capital gains distribution, but the investor controls when an investment is sold and that determines when a gain or loss is recognized. An advisor that is sensitive to taxes, but not focused on taxes in isolation, can help you time these events so that you can manage your overall tax expense.
How this works in practice differs by client and situation, but here is an example: A new client comes to us with an existing portfolio that is inappropriate for their current risk and objectives, but the portfolio has a few positions that have large unrealized gains as they’ve been held for a long time. While it may be tempting to maintain these investments to delay a tax expense, the long term risk of having inappropriate investments exceeds the tax benefits of not doing anything. Selling the positions and recognizing all the gains in one tax year may push the client into a higher tax bracket, but if we stagger the sales and recognize some in December and some in January, we have put the same taxable gain into their income, but spread over two tax years. This reduces the likelihood of this gain pushing the client into the higher tax bracket.
Tax loss harvesting is a similar tax-timing activity, but it relates to the recognition of losses to minimize taxable income. Inevitably in a well-diversified portfolio there are asset classes that are top performers and bottom performers. If those bottom performers are in a loss position they can be sold to recognize a loss. Depending on the client situation that loss can be used to reduce the tax expense related to other capital gains or used to reduce other taxable income. By delaying the recognition of gains we delay the tax payment and lower its economic costs by using future dollars to pay it, conversely by recognizing losses today, we generate a tax benefit with immediate value.
4. Low-turnover Investing – Selling an investment is the trigger that creates a taxable event, therefore it is prudent to adopt a strategy that doesn’t generate a lot of trading or turnover. By deferring gains for as long as possible, an investor can reap real economic value. Short-term investment strategies or frequent trading eliminate the benefit of tax deferral and destroys rather than creates value for the investor. An advisor can help you harness that value by doing the following:
a. Adopting a good long-term investment strategy
b. Having a deliberate process of when to change investments
c. Rebalancing back to strategy periodically
d. Using low-turnover mutual funds and ETFs in the portfolio
An advisor that is implementing all of these efforts to keep turnover low will lessen the tax impact of a successful investment strategy and increase the after-tax returns that you need to meet your goals and objectives.
5. Estate Tax Planning – There is too much complexity in estate tax planning to fit within a paragraph or two, but we can highlight some of the key ways that an advisor can help minimize the tax expense of your estate for you and your heirs.
An advisor will consider the estate tax as well as the income tax impacts of different strategies. Prior to our current, rather generous, Federal estate tax regime, it often made sense to transfer vacation homes and other real property into a trust when an estate was valued at more than $1 million. The benefit of the trust was to reduce the assets subject to estate tax rates approximating 50% and the cost was that the lifetime gain on the asset was subject to capital gains taxes at rates that were below the estate tax rates.
In today’s estate tax regime, where estates less than $10.5 million are not subject to Federal estate tax, the capital gains tax expense is likely to exceed the estate tax benefit. An advisor can work with you to understand your estate planning wishes, your concerns about your family’s long term financial health and help you minimize the total tax impact that executing your estate plan would entail.
What does all of this mean for you? If you are working with a financial advisor that looks at your situation in a comprehensive manner, is sensitive to taxes and works to explain how all of this comes together for your financial plan, you are in good hands. If the advice you receive is related to the product or investment you are purchasing, focuses exclusively on taxes or doesn’t take into account the specific things that make your entire situation unique, you may want to consider finding a CERTIFIED FINANCIAL PLANNER™ that works in this manner.
The five things highlighted above are an ongoing part of how we manage our client’s financial lives and most clients are unaware of the depth and breadth of our efforts to ensure we do what’s best for them at all times. This discussion is for general financial planning purposes and any planned actions should be reviewed with competent tax or legal advisors before execution.