Tax season is in full swing, and it can bring some uneasy thoughts. “How much will I get back?” “How much will I owe?” “Am I forgetting anything?” “What can I expect next year?”
In a recent team meeting, one of our firm’s partners shared a question from a client that’s often not heard, “Why is my tax bill so low?!”
This client had been taking significant IRA distributions since the beginning of retirement as they had settled into a routine of travel and other retirement leisure. Of course, IRA distributions are generally going to be taxed as income, and the client became accustomed to paying a steady tax bill each year. In recent years, their travel slowed and their expenses correspondingly decreased, but their regular withdrawals had not.
During a meeting with us last year reviewing their financial plan, this client shared their updated spending with us. As our team reviewed the numbers, it was clear that they were taking far more than they needed even after accounting for required minimum distributions (RMDs) from their IRAs.
With less travel spending and a bloated checking account balance, our team updated the client’s plan and made the simple recommendation of reducing distributions to align with their current expenses. Specifically, reducing the excess withdrawals (above RMDs) from the IRAs lowered the client’s taxable income.
As the client filed their tax return, they were pleasantly surprised to find their tax bill is far lower: $20,000 lower!
This seeming simple tweak just illustrates the power of having a system, structure, discipline, and support in managing your wealth, and this example is just the tip of the iceberg. Life happens, and circumstances change. When is the last time you reviewed your situation to ensure your financial plan is still serving your needs?
The role of tax strategies in trading and managing investment portfolios
Certain tax strategies can add a meaningful boost to portfolio performance because taxes are an explicit cost to any portfolio and, therefore, a detractor from performance. Although tax situations are unique to each individual, any strategy that limits or delays the tax bill and retains more after-tax return for investors will face little argument.
“Avoidance of taxes is not a criminal offense. Any attempt to reduce, avoid, minimize, or alleviate taxes by legitimate means is permissible. The distinction between evasion and avoidance is fine yet definite. One who avoids tax does not conceal or misrepresent. He shapes events to reduce or eliminate tax liability and upon the happening of the events, makes a complete disclosure. Evasion, on the other hand, involves deceit, subterfuge, camouflage, concealment, some attempt to color or obscure events, or making things seem other than what they are.”— Internal Revenue Manual Code 220.127.116.11.2.1 (05-15-2008) 26 USC §7201 – Avoidance Distinguished from Evasion
Assuming all investors pay taxes either now or later, the chart below illustrates the benefit of delaying taxes. We assume a portfolio of 60% stocks, 40% bonds that is rebalanced every year. The solid line depicts the growth of the 100% taxable portfolio, while the dotted line shows portfolio growth in a 100% tax-deferred portfolio. Of course, the taxman arrives eventually, so we show the hit (a worst-case all-at-once tax consequence) to the tax-deferred line when withdrawing at ordinary income tax rates.