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Market Volatility and Taxes – How to Minimize Both to Double Your Returns
As a recovering CFO, I find it especially fascinating to help people with their financial planning. I recently did a retirement income class here locally where I had the opportunity to sit down with one of the students to answer some questions she had a little more in depth. It quickly became clear that our conversation had much more merit to turn into a formal meeting, so we scheduled a time to visit her 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 her assets in IRAs. He has his Social Security and a small pension to live off of, and like most people who grew up with Depression-era parents, he lives very comfortably within the confines of his “fixed income.” Mildred came to our class because one of our emphases is minimizing taxes in retirement, and since she now has required minimum distributions, she wanted to learn all she could about how to lower her annual income tax bill.
Our conversation was fruitful as we learned that he was replacing the windows for about $14,000. This was important to her because she plans to give the house to her daughter after she dies. Mildred doesn’t like to owe money, so she called her Certified Financial Planner in Maryland and told her to put away enough money for her RMD and a little extra so she could pay the windows in cash. So Bob, the financial advisor, suggested that he liquidate and distribute about $26,000 from his IRA where they would withhold 30% for federal and state taxes.
Now that doesn’t seem like a big deal, does it? Well, my CFO training told me to try to mitigate the costs of doing business, especially one as slippery as taxes. We projected her taxes for next year by completing this transaction 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 100% when you calculate your “provisional income” or how much of your benefit will be taxable. So not only does your effective rate go up 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 pouring income from his IRA, he went from an effective tax rate of 14% to one that exceeded 20%.
My first thought was to split the payment to the window company using this year’s RMD and then again with next year’s RMD. This would keep his effective tax rate closer to the 14% he would incur anyway. Mildred had two options, one is to use her home equity line of credit that she had at 4% and as she detailed, the effective cost to her would be closer to 3% per year and consider paying it off in less than 6 months it would have only cost him about $600 in interest. His other option was, of course, to use interest-free financing from the window company that he could pay off in a year. Either way, this would save you $6,000 in taxes.
But our story doesn’t end there… during our conversation we found out that this gives quite a bit to charity, about $13,000 a year. So we talked about a tax law called the “Tax Hinge Prevention Act” that allows people who are required to distribute income from their qualified accounts to donate directly to their charity while they are accounted for as its mandatory minimum distribution. Mildred must distribute $11,000 this year, which would be added to her income and at an effective tax rate of 14% that is about $1,500 in taxes, instead she can transfer $13,000 directly to her charity, satisfy the your RMD and bring your entire tax bill. from $5,000 to just over $1,100. In other words, by understanding the tax laws, Mildred can increase her “take home” from $3,200 to more than $3,600. Who wouldn’t appreciate a $400 a month raise, especially on a “fixed income”?
Now, the final piece of the puzzle, your current portfolio. An allocation made up of 75% equity mutual funds and 25% bond mutual funds. It doesn’t matter how expensive mutual funds are or the fact that someone in their 70s on fixed income with minimal assets is so heavily allocated to the stock market, we’re talking distribution. If we follow the RMD schedule, there will be a time each year when Mildred will have to sell her mutual funds to get her distribution. Now, the mindset is that the entire portfolio earns enough money to live off the interest and capital appreciation. This is great in theory, but when you factor in the embedded fees of about 3%, the market would have to do very well to stay that way and we all know that markets don’t always go up (except of course the ‘last 6 years, but I’m rambling). Historically speaking, there is a bear market 3 out of every 10 years and if Mildred lives another 30 years, she will have to sell her assets when they are in decline at least 10 times during her retirement. I’ve been helping people and businesses for over 20 years and nothing brings a portfolio to its knees faster than having to cash out while assets are declining in value. Simple math tells us that if I start with $1000 and the market takes 100 and I have to withdraw 100 I’m left with 800 and if the market recovers what it lost I now have 880 and if we do that math again? In 4 years it would be $750.
Thus, our student becomes a client when we discover that it would be in her best interest to implement and manage two strategies. The first shot is called “Sequence of Returns” where we essentially split Mildred’s portfolio into 3 parts; short term (3 years), medium term (5 years) and long term (more than 5 years, built to last). The basic fundamental of financial planning is that you never distribute assets from a volatile account. By placing 3 years of distribution in a non-volatile (not losing money) account, Mildred can be sure that the income will be there if needed. The expected rate of return is a bit small, between 1-3%, but it is guaranteed and you will never lose your principal. Your average allocation would carry a percentage of your assets with at least 5 years, but on average around 25% of your assets. This account would carry very minimal volatile assets that should collect between 4 and 7%, let’s use 6% as a reference. The long-term allocation can be traded in the market if necessary or simply placed in a guaranteed investment so that there is no loss of capital (why risk it if you don’t have to?). In fact, we projected that their standard deviation (amount of volatility) will decrease from where it was originally at 17% to 3.5% for their overall portfolio, while we increased their average rate of return from 3.58% to more than 10.5%. The second plan was to convert half of his qualified assets (IRAs) into tax-free savings investments. By implementing this tax conversion plan, Mildred is in line to save at least $30,000 in taxes during her retirement and increase her assets by $143,000 at no cost to her.
Good financial planning is about being prudent with your financial decisions and not just “staying the course” when markets go south, rebalancing when things get too good, or diversifying your portfolio allocation to mitigate the risk and capture the upside potential. It’s about identifying the costs of doing business, the risks associated with financial decisions, and the unknowns that can wipe out any gains as a CFO for your home.
If you’d like a hassle-free, 10-minute private conversation about your tax situation or portfolio, email [email protected] and we’ll get to work for you. Take the next step, it’s time.
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