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Investment decisions MUST consider tax consequences

Are taxes a financial topic? Seriously - think about this for a minute. Are taxes a financial topic? You must be thinking: “Don’t ask stupid questions. Yes, of course taxes are most certainly a financial topic.” Ok, then riddle me this. Why is it that so many “financial advisors” avoid taxes with phrases like, “I’m no tax expert. Be sure to consult your accountant.”

If taxes are a financial topic and your financial advisor doesn’t know tax, he/she missed out on half their education.

Let me see that tax return!

Financial advisors should be asking for your tax return every year. If your advisor doesn’t you should question how they are making decisions in your best interest with only part of your financial picture in mind. Most decisions financial advisors make impact both today’s tax bill as well as tomorrows. In fact, it’s hard to think of a single financial decision that doesn’t have a tax Component. Consider these common concerns:

  • How much should I contribute to my retirement plan?
  • Should I contribute to a traditional or ROTH plan?
  • Which account should I take money from first?
  • I’m still working, should I start social security now or later?
Each one of these answers has an impact on tax. A well informed decision simply cannot be made without considering the tax impact.

Yea, my portfolio is tax efficient. I have municipal bonds.

Often, when pressed for “tax efficiency”, a financial advisor will advise municipal bond based investments. Most advisors read the “label” on these sorts of investments, saw the words “tax advantaged” or “tax free”, got all excited, and proclaimed victory against Uncle Sam. This and a basic understanding of ROTH accounts are commonly an advisor's only solution to winning the tax game. Is this enough? Hardly!

Sometimes tax-free municipal bonds are a great fit. However, picking some generic mutual bond fund is only doing half the job. Those funds may produce tax free income on your federal tax return. What about the state? Municipal bonds are taxable to the state you live in if they are issued in another state. A generic fund may be a half solution providing little to no state benefit.

Furthermore, don’t make the mistake of overlooking the 0% long term capital gains rate. This rate is only available to taxpayers in lower brackets. Trading one tax-free investment for another tax-free investment won’t get you ahead.

Well, what then?

Infusing a tax strategy into any financial strategy is not for the faint of heart. Taxes are complicated. Engineering future tax strategy takes more skill than simply a cursory knowledge of tax deductions. Why? Accountants are schooled to document history. You take your tax documents each spring and say “tell me what I owe for last year.” Many fantastic tax preparers struggle with the infinite what-if possibilities of designing a forward looking tax plan.

Some strategies to consider are:

  1. Don’t make investments that cause tax at ordinary rates in a taxable account (one that causes tax impact every year). Instead, move those to a tax advantaged account and invest in items that produce dividends taxable at lower capital gain rates.
  2. Don’t waste low income years or the few retirement years. Use those years to pay a smaller controlled amount of tax while moving money to tax-free accounts.
  3. Be sure charitable giving is done in a way that produces a meaningful tax advantage.
  4. Use the 0% long-term capital gain bracket to your advantage.
  5. Give to charity directly from your IRA if your are over 70 ½.
  6. Don’t use ROTH accounts if you expect your tax bracket to be less in the future.

While taxable income can be harder to control during working years, retirement years have infinite options. Don’t miss out on those “golden years.”

Are you the financial coordinator?

A common way to approach the complications of handling money is to have separate advisors. One to talk about investments and another to talk about tax. This is done, well, because that's how it’s always been done. Some cite the benefits in a “multitude of counselors.” That approach has merit, but also a single point of failure. If those advisors don’t communicate regularly, the burden of coordination and overall strategy falls to YOU! If you’re capable, willing, and know that’s your role - great. If not, mistakes will be made and opportunities will be missed.

Most people don’t fully understand the level of coordination necessary between tax and financial strategies until it’s too late. Virtually every decision you make in your financial planning has a tax impact. Each time a financial strategy is considered it must be followed by, “what’s the tax impact of this choice?”

Investment Advisor AND Tax Advisor

Imagine sitting with a financial advisor who is proposing a strategy. It sounds great and you’re about ready to sign-up, but remember the advisor has never seen your tax return or even asked about taxes. Wisely, you remember to ask, “What’s the tax impact of this strategy.” The response is, “I’m not a tax expert. I advise you to ask your accountant about that.” What are you to do now? Can you fully relay the details and timing of the strategy to your accountant? What about answering questions or evaluating feedback?

Reality is that coordination of multiple advisors is exhausting and nerve racking. Few are able to serve as the financial coordinator effectively. Some lack know-how, some lack time, others just don’t want to do the job. Regardless, it’s a critical job that can’t be ignored or overlooked.

To have a truly comprehensive financial plan, it must include a tax strategy integrated at the deepest levels. If your financial advisor doesn’t sit down and talk with your tax advisor regularly to make sure no opportunities are missed and no mistakes are made - mistakes will be made and opportunities will be missed. If your financial advisor and your tax advisor are the same people, coordination and creation of a plan for your financial success is more easily accomplished.

Notice: This generic information is not intended to be taken as tax, legal, benefits, financial, or HR advice. Since rules and regulations change over time and can vary (by industry, entity type, and locale), consult your accountant, lawyer, and/or HR expert for specific guidance.
Scott Patterson

Scott Patterson


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