While there is always considerable grumbling around tax time, this tax season has seemed to cause a particularly high degree of angst and consternation. What was heralded as a tax cut by politicians, turned out for many to be a considerable and surprising tax increase. Among those adversely impacted were high earners living in states with high income and property taxes, due to the SALT (State and Local Tax) deduction cap of $10,000. On top of changing tax policies, 2018 also presented a textbook example for many of having an improper and ill-defined tax strategy in their investment portfolios. For the majority of 2018, the stock market had been very strong, likely leading to the average investor realizing at least some investment gains. The mentality seems is typically: I’ve got a material gain on the year, I can afford to take some chips off the table, and pay the taxes with my profits. Unfortunately, the market proceeded to fall by 20% in the fourth quarter, with most of that loss in December. As the year was drawing to a close, many investors and advisors were faced with an unfortunate combination: negative investment returns coupled with a considerable net realized gain. I recall playing golf in Florida in late December and being paired with a financial advisor from Baltimore. When I asked what he thought about the markets, he grumbled about having to spend a good part of his vacation on the phone with the office selling stocks to book offsetting losses before year-end.
This was an all too common example of letting the tax tail wag the investment dog. Selling losing positions in late 2018, solely for tax reasons, was misguided, and not just because the market has rallied materially from those panic levels. I often remind tax-obsessed clients and prospects that minimizing taxes in their investment portfolios is not the goal, maximizing after-tax returns is. You can see how the desire to minimize tax promotes poor investment decisions. As this tax season has unfolded, and people got a clearer sense of their rising tax liability, there was a knee jerk rush into municipal bonds. This decision, in my estimation, wasn’t based on any analytical analysis of the risk/reward profile of the asset class, or credit analysis of a particular bond issue, but solely on munis’ tax profile.
A better approach is to work with an advisor who proactively and rationally integrates tax sophistication into client financial plans and investment portfolios. This is an ethos that permeates Dolan Partners’ process in working with our clients. Typically the first step is to determine which tax-advantaged accounts are suitable for a client, and then how to maximize the utility of those accounts to fit the client’s needs. Most tax-advantaged accounts have two tax benefits. In some vehicles the contributions are shielded from income tax, this capital can compound over time tax-free, with taxes due only when withdrawals are made. In others, contributions are taxed, the account grows tax-free, and withdrawals are untaxed.
The critical, and often underappreciated, benefit of all tax-advantaged accounts is the tax-free compounding of investment returns over time. The longer the time period you can put between contributions and withdrawals, the more pronounced the benefit is. The best time to open and fund these accounts is today.
Retirement Accounts:
Employer 401k: We determine that the client is maximizing income contributions, optimize the sequencing of those contributions (front end or staggered), maximizing any company match, and determining if there is a any profit sharing program at the company which can increase annual contribution limits. It also makes sense to rollover any 401ks from old jobs into an IRA, as 401k plans tend to have elevated fees and limited investment options.
Roth IRA/Regular IRA: Depending on a client’s circumstances, these non-employer based retirement accounts are a great vehicle for retirement planning and tax strategy.
Health Care:
HSAs: The most tax-advantaged account of all, with a triple tax benefit. Contributions are tax deductible, the money grow tax free, and eligible withdrawals are also untaxed. We study the client’s financial situation and employer benefits to determine if a high deductible health care plan is suitable. For our typical client, it often is. We then encourage clients to maximize HSA contributions, invest those contributions, and, critically, avoid paying current medical expenses from the account. We encourage clients to view HSAs as a retirement health care fund, and we want to take advantage of tax free compounding for as long as possible.
Education:
529s: These plans often make sense for clients with children. Again, starting early is ideal, to maximize the tax benefit. In some cases, contributions are deductible against state taxes. Carefully vetting plan sponsors is important as there is a wide variety in fees and investment options. A final recommendation is to carefully monitor risk exposure as the time horizon for when the funds will be needed shortens.
Once we properly construct a framework of tax-advantaged accounts, we then work to build tax considerations into the construction of investment portfolios. Typically we urge clients to concentrate high return/high volatility risk assets in tax-advantaged accounts, and adopt, when appropriate, a more active investment approach. In taxable accounts, on the other hand, we often recommend a lower risk profile, coupled with an investment approach geared toward long-term, low turnover, capital appreciation. The goal in both types of accounts is the same: maximizing long-term after-tax returns for the client, only the tactics employed are different due to the differing tax characteristics. Once the basics are addressed, we dive deeper into the client’s unique tax profile, and work collaboratively with their tax advisors, to craft customized processes.
The overriding message is that tax planning and tax considerations play an integral part in the Dolan Partners’ process when working with our clients. If death and taxes are unavoidable, you owe it to yourself to work with a financial advisor who proactively builds tax sophistication into clients’ financial plans and investment portfolios.
Learn more at www.dolanpartners.com
Ryan P. Dolan