These days, a good, comprehensive financial advisor can provide much more than investment management to help clients with their financial future.
A lot of advisors focus on the ascension phase, or the analogy I like to use is climbing Mt. Everest. They focus on risk tolerance and investments while clients are working and contributing toward retirement, which are obviously very important.
But once you get to the summit, in this case retirement, coming down the mountain is totally different. I find when meeting with prospective clients that it is rare that an advisor has laid the tax code on top of their client's retirement situation.
They are missing an opportunity because there is so much we can do that is not going to affect the investment risk of your portfolio.
Have you considered the tax risk of your portfolio? This is what we focus on at my firm, Eagle Ridge Wealth Advisors.
Listen to Episode 50 Here:
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Why Tax Planning?
Focusing on taxes can really help move the needle by saving tens of thousands, hundreds of thousands, and even millions over the course of a 20-, 30-, or 40-year retirement.
I like to say, we focus on the things we can control.
We can’t control what the markets are going to do from one week to the next. And we certainly can’t predict what the markets will do in the short term.
We do believe over the long term they are going to keep up with the rising cost of retirement, which is what we focus on.
But we can also use existing tax laws to help reduce how much our clients will pay in taxes over their lifetime.
Much of the background in this episode comes from an article written by Sheryl Rowling for Morningstar titled: Why Advisors Should Bother With Tax Alpha: A simple way to boost investment performance without adding risk.
Don’t let the “Tax Alpha” part throw you off. It basically means the value added to a client’s financial plan by effectively using tax savings strategies.
Permanent vs. Temporary Tax Savings
When looking at tax savings, there are two types: permanent savings and temporary savings.
Permanent tax savings never have to be paid back. For example, holding on to an investment for over a year will cause the gains to be taxed at the more favorable long-term capital gains rates rather than ordinary income tax rates.
And that difference between the long and short-term gains rates will never have to be paid back.
An example of a temporary tax savings would be contributing to a 401(k). The contributions are made with pre-tax dollars that reduce your taxable income in the current year. But you will be taxed in the future when the money is withdrawn from the account.
One tax savings strategy we provide for our clients is asset location. Asset location means positioning your investments in the best accounts to reduce your taxable income. Vanguard estimates this adds up to .6% per year in client value, if done properly.
Optimizing asset location can provide both permanent and temporary tax savings.
I talked more about the difference between asset allocation and asset location in Episode 43 that I will link in the show notes.
Investors often have up to 3 types of accounts:
- Taxable accounts: which are funded with after tax money, and the income on the investments is taxed in the year it is earned. This income can come from interest, dividends, and (when investments are sold) capital gains.
- Tax deferred accounts, like 401(k)s and traditional IRAs, are funded with pre-tax money, and withdrawals are taxed as ordinary income the year the money is withdrawn from the account in retirement.
- Non-taxable accounts, like Roth IRAs, are funded with after tax money, and the withdrawals and earnings are never taxed in retirement.
If you are investing all 3 types of accounts the same way, you are missing out on potential tax savings!
What Investments Should Go in Which Accounts?
So how do you determine what investments should go in what accounts?
According to Rowling, Appreciating investments, like stock funds, should be placed in a taxable account. These investments are only taxed when sold, and when held for more than a year, they will be taxed at favorable long-term capital gains rates. This results in a permanent tax savings. If those same appreciating investments were held in a tax deferred account, those gains would eventually be taxed at higher ordinary income tax rates when withdrawn.
Income producing investments, like bonds, should be held in a tax deferred account. The interest won’t incur current taxes, and the distributions will be taxed only upon withdrawal, creating a temporary tax savings.
High growth investments should be held in a non-taxable Roth IRA to benefit most from this tax-free account. Plus, Roth IRAs are generally withdrawn last, so they have time to ride out the volatility of high growth investments. This is another example of a permanent tax savings.
A lot of this work is done behind the scenes, so clients may not realize if these benefits are being provided by their advisor.
Roth IRA Conversions
Another tax savings strategy is Roth IRA conversions. I’m not going to go into detail about Roth conversions here because I talked about them in depth in Episode 8, which will be linked in the show notes for this episode.
Roth conversions provide a temporary tax increase in the year of the conversion. Then they provide permanent tax savings because that money and the earnings will never be taxed when withdrawn, either by the account owner or by a beneficiary.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your retirement situation.