A mistake we see prospective clients make is not spending enough time tax planning. Their tax planning is usually done after their taxes are filed, if at all. Taxes represent one of the largest drains on a family’s financial assets so managing its effects is important.
“Manage” is a good word for what we do. It connotes controlling what can be controlled and adapting to what cannot be controlled.
Tax rules are plentiful and complex and the number of tax planning twists and turns is vast. It is easy to make mistakes. However, this complexity provides opportunities for the savvy.
A balanced, long term view is also important. In addition to those that do little tax planning, we see others make costly mistakes by over emphasizing tax ramifications at the expense of other factors.
This is particularly true when it comes to investments. Some buy investments touting a tax advantage but they are not likely to be sound investments. Many private deals purporting “write-offs” fall into this category. We also see people engage in transactions to save taxes today without realizing how much they have increased their future taxes. A common example would be when deferred annuity contracts are sold to low-income seniors.
…complexity provides opportunities for the savvy.
We have identified six common tax planning strategies from an investment standpoint we use to benefit our clients. There are several more and each could be a newsletter topic itself, but here are the basics:
Portfolio transition – Tax planning begins immediately when we start working with new clients. Because we work directly and exclusively for clients, our advice is not tied to any particular product. Our financial planning process produces a portfolio design and structure that is tailored to each client’s unique needs. In most cases, we identify changes that should improve the portfolio. Changes can have costs and tax ramifications.
We certainly want to put clients into holdings which are best for them, but we will not just dump existing holdings blindly. We see far too many “advisors” do this primarily because their goal is to get the money out of whatever the client owns and into whatever products the advisor sells. Their compensation is tied to the products. Our goal is to maximize the odds our clients will reach their goals. Period. To do this, we seek to minimize all transition costs to only those which are necessary. In short, after we develop a strategy for our client’s future, we devise an exit strategy from their existing holdings and manage the transition, all of which is done solely in the client’s best interests.
Asset location – Asset allocation is a better known term but asset location is important too. Some investments are less tax efficient than others. For instance, interest on most bonds, dividends paid by real estate investment trusts, many preferred stocks, and many overseas companies are taxed at ordinary income tax rates. Most municipal bonds pay tax-free interest. Stocks which pay no dividends generate no tax liability until sold. If held for more than a year, these gains are taxed at long-term capital gain rates which are lower than ordinary income rates for all taxpayers. To the extent it makes sense within a family’s financial plans, by strategically “locating” highly taxed assets in tax sheltered accounts such as retirement plans or IRAs, total portfolio returns can experience less erosion due to taxes.
Tax-efficient vehicles – Some investment products and approaches are inherently more or less tax-efficient than others based on how they are structured and operated. High turnover strategies, approaches that use leverage, hedge with options or futures contracts, and managers who are free to make large bets or are free to add anything at any time, all tend to produce more taxable income and capital gain distributions than the more prudent, carefully structured long-term vehicles we favor.
Loss harvesting – No one wants losses but all investment assets decline in value from time to time. By turning a paper loss into a realized loss, taxes on gains and up to $3,000 of ordinary income may be offset in any given year. Losses that cannot be used for tax reduction in the year the losses were “harvested” can be carried forward into future years. This is no free lunch. Loss harvesting can cause future gains to be larger if one is not careful. Nonetheless, for high tax bracket clients in particular, opportunistic loss harvesting can lower taxes without disturbing a sound, long term investment plan.
For us, tax planning has no “season.” It is a year-round endeavor.
Lot management – Many people and some advisors don’t understand that their brokerage firms have default settings for tracking tax lots and capital gain accounting. Even fewer understand the implications that go along with those settings. We don’t have to go along with the defaults, but we do have to consciously make alterations before a trade settles to get the maximum advantage.
By exercising some strategic thinking in advance, we can control current taxation, influence future taxation, and take advantage of opportunities. For example, some people find advantage in harvesting gains instead of losses in taxable accounts. If you are charitably inclined, a whole slew of other options are possibilities. For details on the managing of tax lots, see our write up from 2011 and this video on a smart way to make charitable donations.
Managing the impact of cash flows – Leading up to retirement, we save in our accounts. Even if you do not deposit money into your accounts, the accounts experience positive cash flow in the form of interest or dividends. Eventually, you retire or otherwise make withdrawals. Too many people buy investments with deposits, reinvest interest and dividends, and then sell investments to generate cash without much forethought. By intelligently utilizing deposits, interest, dividends, and withdrawals, the tax costs can be minimized and net returns enhanced.
We can also affect taxes by strategically making withdrawals from the type of account or combination of accounts best suited to a client’s situation. The default for many is to first withdraw from taxable accounts, then deferred, then Roth IRAs. This usually lowers taxes today but these savings are often lost via higher taxes in the future, making other methods preferable.
For most citizens, April 15th represents the end of tax season. For us, tax planning has no “season.” It is a year-round endeavor.
News & Notes
Making a real difference: When Charlie Fitzgerald III, CFP® helped found the FPA of Florida, he hoped the organization could make a real difference for the public and the profession. They have certainly done that. 2015 marks the ninth year the group has travelled to Tallahassee to educate regulators and legislators about important financial planning related topics. On their latest trip in March, they helped influence the Florida Board of Education to change the standards for the required high school semester in Economics. Now, half of the course deals specifically with personal financial literacy and personal financial planning. Previously, only about two weeks was focused on financial literacy. This means that our nearly 3 million Florida public high school students will be introduced to and learn about debt management/avoidance, investments, inflation, budgeting, insurance, and taxes. These are important educational building blocks for a sound personal financial future.
Gator to Gator: Charlie recently spoke to students of the Warrington School of Business at his alma mater, the University of Florida. He covered many topics regarding Financial Planning and Wealth Management in the 90 minute session and answered about two dozen questions. “It was a great experience. I have since received several thank you notes from the students and they have invited me back to speak to the UF Wealth Management Association, a student run association which brings in speakers and holds outreach events to fellow students regarding financial planning topics,” said Charlie.
Please remember to call us: When anything significant happens in your life, including changes in your finances, family, or health that could affect your financial plan, please let us know so that we can adapt our planning and portfolio work for you accordingly. Also, if you ever fail to receive a monthly statement for one of the Schwab Institutional or TD Ameritrade Institutional accounts under our management, please let us know so we may assure the respective custodian delivers your statements promptly.
The Team at Moisand Fitzgerald Tamayo, LLC
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Moisand Fitzgerald Tamayo, LLC is an Orlando, Tampa and Melbourne, Florida based fee-only financial planner serving central Florida and clients across the country. Moisand Fitzgerald Tamayo, LLC specializes in providing objective financial planning, retirement planning, and investment management to help clients build, manage, grow, and protect their assets through all phases of one’s life and the many transitions in between. If you have any questions or would like to discuss anything further, please give us a call or send us a note. If you are not a client and wish to receive emails notifying you of new posts – no more than once per month – fill out the subscription information in the sidebar to the right. For more frequent updates, follow us on Facebook, LinkedIn, or Twitter.
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