Tax Strategies: It’s All in the Details
In my experience, there are two types of people when it comes to income taxes. The first is the client who wants to avoid or significantly reduce taxes, by whatever means necessary. The other client sees taxes as a necessary evil and appreciates attempts to reduce taxes, but not at the expense of an overall strategy.
Take Roth conversions as an example. More than a few clients are asking for our opinions on whether it makes sense to pay taxes now on a portion or all their retirement assets in exchange for future tax-free growth. Some advisors will say that it is hardly ever a good strategy to pre-pay any taxes. Others point to the significant long-term tax savings and growth on converted assets, as they are not required to be withdrawn like more traditional retirement assets. Both responses can be correct, but it depends on the client and their individual circumstances.
In a recent client analysis, I noted that Roth conversion strategies improved lifetime portfolio values and lowered overall taxes but ultimately recommended against the strategy. The reason was that these Roth conversions reduced taxable assets, resulting in the need to take earlier distributions from retirement assets, which also increased taxes, and ended with a later-in-life breakeven point. But for other clients, our recommendation may be to do the conversions because we are intentionally re-allocating resources for the next generation.
Another client wanted strategies to reduce taxes on a combination of low earned income and higher investment income. We ran a scenario in which the earned income was partially offset by maximum pre-tax contributions to a retirement plan. Once again, while total portfolio assets were higher with the additional retirement plan contributions, lower taxes during the years of contributions were more than offset by higher taxes later as a direct result of greater retirement account balances and higher required minimum distributions.
An alternate strategy applied to the same client was a charitable gift, again with similar parameters in terms of the contribution level and time frame as the pre-tax contribution to a retirement plan. In this scenario, total taxes paid over the course of the projection were lower, but so were portfolio balances. In the end, the question becomes whether the desire for lower taxes is sufficient reason to give away assets? Certainly, if there is strong charitable intent, this strategy makes sense. Otherwise, it seems like paying taxes is the price of keeping a certain level of assets.
My advice to anyone looking to reduce taxes is to consider the sources of taxable income and how any tactic to effectively reduce this income for tax purposes impacts cash flow and/or asset levels. We love running scenarios and evaluating the best course of action for our clients, considering their unique situations.
Meet Kristan L. Anderson, CEBS®, CFP®
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This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.