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Market Volatility and Taxes – How to Minimize Both to Double Your Returns
As a recovering CFO, I find it particularly fascinating to help people with their financial planning. I recently led a retirement income class here locally, where I had the chance to sit down with one of the students to answer a few questions she had a bit more in depth. It was quickly discovered that our conversation had much more merit to become a formal meeting, so we scheduled a time to visit us at her home where she would feel more comfortable and have access to any documentation she needed. . Our friend, let’s call her Mildred, is a 70-year-old lady who, like most working-class people her age, has all of her assets in IRAs. She has her Social Security and a small pension that she lives on and, like most people who grew up with Depression-era parents, lives quite comfortably within her “fixed income.” Mildred came to our class because one of our goals is to minimize taxes throughout retirement and since she now has required minimum distributions, she wanted to learn everything she could about how to reduce his annual tax bill.
Our conversation was fruitful in that we learned that she was replacing her windows at around $14,000. It was important for her to do this as she plans to give the house to her daughter once she passes away. Mildred doesn’t like owing money, so she called her Certified Financial Planner in Maryland and told him to liquidate enough money for her RMD and a little more so she could pay the windows in cash. So Bob, the financial advisor suggested that she liquidate and distribute about $26,000 from her IRA where they would withhold about 30% for federal and state taxes.
Now, that doesn’t seem to matter, does it? Well, my training as a CFO told me to seek to mitigate the costs of doing business, especially as slippery as taxes. We projected her taxes for next year by completing this deal Mildred would be on the hook for over $11,000. Tax laws have become quite complex, especially when it comes to Social Security income. Any income from IRAs will be counted at 100% when you calculate “provisional income” or how much of your profit will be taxable. So not only does the effective rate increase because you received more income, but more of your Social Security income is taxed. There are three levels, 0%, 50% and 85% and once you reach these thresholds your tax bill increases by 46%. By contributing income to her IRA, she went from an effective tax rate of 14% to a rate above 20%.
My first thought was to split the payment to the windows company using this year’s RMD and then again using next year’s RMD. That would keep her effective tax rate closer to 14% than she would incur anyway. Mildred had two options one is to use her home equity line of credit that she had at 4% and since she itemized the actual cost to her would be closer to 3% per annum and consider that she would pay it off in less than 6 months it would have only cost her about $600 in interest. Her other option, of course, was to use the window company’s interest-free financing that she could pay off in a year. Either way, it would save him $6,000 in taxes.
But our story doesn’t end there…during our conversation we found out that it gives charity quite a bit, around $13,000 a year. So we talked about a tax law called the “Tax Increase Prevention Act” that allows people who are required to distribute income from their qualifying accounts to donate directly to their charity while still being counted as their required minimum distribution. Mildred is required to distribute $11,000 this year, which would be added to her income and an effective tax rate of 14%, or about $1,500 in taxes. Instead, she can transfer $13,000 directly to her charity, satisfy her RMD and bring her entire tax bill. from $5,000 to just over $1,100. In other words, by understanding the tax laws, Mildred is able to increase her “take home pay” from $3,200 to over $3,600. Who couldn’t appreciate a $400 per month raise, especially on a “fixed income”?
Now the final piece of the puzzle, his current portfolio. An allocation composed of 75% equity mutual funds and 25% bond mutual funds. It doesn’t matter how expensive mutual funds are or whether someone in their 60s on a fixed income with minimal assets is so heavily invested in the stock market, let’s talk about distribution. If we follow the RMD schedule, there will be a time each year when Mildred must sell her mutual funds in order to get her distribution. Now, the mindset is to make the whole portfolio earn enough money for her to live off of interest and capital appreciation. That’s great in theory, but if you factor in the embedded fee of around 3%, the market should be doing just fine to stay that way and we all know that markets don’t always go up (except of course the last 6 years, but I digress). Historically speaking there is a 3 year in 10 year bear market and if Mildred lives another 30 years she will have to sell her assets when they drop at least 10 times during her retirement. I’ve been helping individuals and businesses for over 20 years and nothing brings a portfolio to its knees faster than having to withdraw money as assets lose value. A simple math tells us that if I start with $1000 and the market takes $100 and I have to withdraw $100, I have $800 left and if the market recovers what it lost, I now hold $880 what if we did this calculation again? In 4 years it would be $750.
Our student therefore becomes a client when we discover that it would be in her interest to set up and manage two strategies. The first plan is called “Sequence of Returns” where we basically cut Mildred’s wallet into 3 parts; short term (3 years), medium term (5 years) and long term (more than 5 years, built forever). The basic principle of financial planning is that you never distribute assets from a volatile account. By placing 3 years of distribution in a non-volatile account (not losing money), Mildred can be assured that the income will be there if needed. The expected rate of return is something small, around 1-3%, but it is guaranteed and will never lose its principal. Its average allocation would carry a percentage of its assets with 5 years as a minimum but on average around 25% of its assets. This account would contain very minimal volatile assets which should return between 4-7%, we use 6% as a benchmark. The long-term allocation can be committed to the market if necessary or can simply be placed in a guaranteed investment so that there is no loss of capital (why take the risk if you don’t have to?) . In fact, we projected his standard deviation (amount of volatility) to decline from his initial level of 17% to 3.5% for his entire portfolio, while we increased his average rate of return by 3.58 % to more than 10.5%. The second plan was to convert half of his qualified assets (IRA) into tax-free savings investments. By implementing this tax conversion plan, Mildred is able to save at least $30,000 in taxes throughout her retirement and increase her assets by $143,000 at no cost to her.
Good financial planning is about being prudent in your financial decisions and not just “staying the course” when markets crash, rebalancing when things are going too well, or diversifying your portfolio allocation to mitigate risk while capturing the upside potential. It’s about identifying the costs of doing business, the risks associated with a financial decision, and the unknowns that can wipe out any gains, just like a CFO for your household.
If you’d like a hassle-free, private 10-minute conversation about your tax situation or portfolio, email email@example.com and we’ll get to work for you. Take the next step, it’s time.
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