Bucket 3: (Tax Me Never Again):
Similarly to the first bucket, investments made in the area are made with after-tax dollars, and like bucket 2, assets can grow annually without incurring tax liability. Finally, and most critically, funds can be withdrawn in the future with no further tax implications. Clients who can fund this segment of their portfolios can see the most benefit, as municipal bonds, 529 plans, Roth IRAs and specially designed life insurance plans all offer tax-advantaged investing.
To best illustrate the power of creating a diversified portfolio that takes into account the detrimental effect of taxation now and in the future, let’s compare the outcome for two hypothetical clients of identical means and saving capability. The only difference between the two is that the first client relies heavily on qualified plan savings (bucket two) for the future, and invests the rest in traditional non-qualified accounts (bucket one). The second considers asset location, saving the same amount of money over time while intentionally diversifying how that money will be taxed now and in the future.
For simplicity, let’s assume each client needs to supplement retirement income by accessing $100,000 from their overall savings. This is a hypothetical example used for illustrative purposes only, and does not represent the return of any specific investment. Actual rates of return will vary over time, particularly for long-term investments. Tax deferred accounts: Withdrawals of taxable amounts will be subject to ordinary income tax and if made prior to age 59½ may be subject to a 10 percent IRS tax penalty.
Client #1 –Like the majority of Americans, their investments are concentrated in the “tax me always” and “tax me later” buckets. This means that the first $19,000 they take out is taxed at 10 percent (so $1,900 tax liability), the next $58,000 is taxed at 12 percent ($7,000 liability) and the last $23,000 is taxed at 22 percent ($5,000 tax liability). Collectively, their tax liability is $13,900, so of the $100,000 they need annually, they’re only getting $86,100.
Client #2 – By incorporating the “tax me never again” bucket as part of their savings strategy for years, they now have options. The first $19,000 they take out is still taxed at 10 percent (so $1,900 tax liability), and the next $58,000 is still taxed at 12 percent ($7,000 liability). However, they now have the option not to access the final $23,000 from a “tax me never again” account, such as a Roth IRA or specially designed life insurance policy. This means zero additional tax, for a total tax liability of $8,900. Compared to Client 1, they have a total tax savings of $5,000 for that year. Multiply that over a 30-year retirement, and they are able to avoid $150,000 in tax liability.
Intentionally building tax control into portfolio design clearly gives clients options in retirement. For example, if we assume client #2 will avoid paying $150,000 in unnecessary tax over the course of a 30-year retirement, they can choose to retire sooner or retire better, perhaps enjoying an annual trip with grandchildren. Some clients may choose to take less risk as they save for retirement knowing that they can meet their needs easier by avoiding taxation.
Incorporating asset location with asset allocation clearly adds value over a long-term investment experience. Using this tax protection model is one way financial advisors can better serve their clients.
Jeff Magson, CRPC, is an executive vice president and the client experience officer at 1st Global, where he is responsible for national sales and revenue results as well as all product platforms, including those in capital markets, insurance, investment advisory and retirement solutions.