Broker Check

How Tax Diversified Are You?

| July 17, 2018
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Every good financial advisor worth his or her salt addresses the issues of asset allocation and diversification with their clients. “You can’t be too diversified” has become the mantra of many an advisor in recent years, especially since the 2008 stock market collapse. There’s no question that properly allocated and well-diversified investment portfolios can lower beta (having to do with stock market volatility risk), but there are other risks involved in investing money other than market volatility risk, including longevity risk, inflation risk, tax risk, and interest rate risk. This piece will focus on a risk that many people are not addressing with their overall savings strategy—tax risk.

In essence, from an IRS perspective, there are three places to save your hard-earned money—taxable positions, tax-deferred positions, and tax-free positions. Taxable positions are those savings that create a required reporting of any growth to the position—be it from interest, dividends, short or long-term capital gains, etc.,—on the owner’s current year tax return. For example, in 2016, $1,263 of dividends received in an owned mutual fund would require reporting on line 9a “Ordinary Dividends” (per 1099 report provided by the mutual fund company in this example). So, the “gains” in such accounts create a negative consequence to the tax return. Tax-deferred positions, such as seen with 401(k)s, traditional IRAs, and annuities, do not require any growth inside the account to be reported; however, there likely will be some tax consequence in the future when distributions are taken from these positions. In most cases, tax-deferred positions are funded with either pre-tax contributions, or with contributions that elicit a tax deduction, with the exception being that non-qualified annuities are funded with dollars that have already been taxed, but withdrawals from this type of annuity are more tax-advantaged in that only the growth (which in most cases, except for annuitized payments, will be viewed by the IRS as coming out first) is taxed upon withdrawal. Finally, tax-free positions, such as a Roth IRAs, are funded with dollars that have already been taxed, but from that point on both the growth and future withdrawals occur without taxation incurring, provided IRS guidelines are followed. In essence, then, assuming IRS guidelines are followed, these dollars have the potential to be tax-free forever following the point of contribution, even in the case of passing on these assets to the next generation.

Our experience has been it is very typical for people to approach us to begin some form of retirement planning in their late 50’s to mid 60’s with their assets being very unbalanced from a tax diversification perspective. It’s very typical for us to see about 10% in taxable positions, 90% in tax-deferred positions, and 0% in tax-free. We believe this is the result of many factors of influence, but predominantly from the following: 1) a perceived belief that most people will retire in a lower tax bracket environment than during their working years, 2) a growing fear that they will not accumulate enough savings for retirement coupled with the fact that they too frequently hear “put all the money you can into your qualified retirement accounts”, and 3) because retirement plan contributions are “out of sight, out of mind”, those who lack the self-discipline to save money into places that will not cause a penalty to access use tax-deferred positions to self-impose the discipline they believe they do not possess themselves.  

The reality is most people we help prepare for retirement will not be in a lower tax bracket when they retire (a topic for another blog), and need to have (or already have) the discipline to pay more taxes “now” on their money in order to save some of their money into taxable or tax-free positions. Of course, a key factor in this belief is your answer to the following question: Do you believe moving forward into the future that our tax environment will be better, about the same, or worse than it is today? When posed with this question, most of our clients answer “worse”, and we can’t remember anyone who has answered “better”. We believe the answers we get to this question have way more to do with our country approaching the $20T debt mark than the overall negative connotation that comes with the word “taxes”. The reality is too much restricted availability of cash flow (prior to age 59 ½) is due to poor tax-diversification, and this has been a rarely talked about root cause to the overuse of high-interest credit cards. Another reality is tax-deferred positions are built for retirement “income”, but are very poor vehicles to provide for “periodic distributions” needed to pay for big-ticket expenses in retirement, regardless of your tax-bracket, but especially for those in the 25% tax bracket or above.

Which all leads to a very important question that we believe you should be both able and willing to answer: How tax-diversified are you?

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