How Many Piece Puzzle Can A 3 Year Old Do Market Volatility and Taxes – How to Minimize Both to Double Your Returns

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Market Volatility and Taxes – How to Minimize Both to Double Your Returns

As a recovering CFO, I find helping people with their financial planning especially fascinating. 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 in a little more detail. It was quickly discovered that our conversation had much more merit in becoming a formal meeting, so we scheduled a time for us to visit at her home, where she would feel more at ease and have access to any documentation she might need. 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. 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 the confines of her “fixed income”. Mildred came to our class because one of our emphases is to minimize taxes during retirement and since she now has Required Minimum Distributions, she wanted to learn everything she could about how to lower her annual income tax bill.

Our conversation was fruitful as we learned that she was replacing her windows at about $14,000. This was important for her to do because she plans to give her daughter the house after she passes away. Mildred doesn’t like to owe money so she called her Certified Financial Planner out in Maryland and told him to liquidate enough money for her RMD and a little extra 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 taxes to the federal and state governments.

Now that sounds like it doesn’t matter, right? Well, my CFO training told me to look at mitigating the costs of doing business, especially something 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. The tax laws have become quite complex especially when it comes to Social Security Income. Any income coming from IRAs will be counted 100% when calculating the “Provisional Income” or how much of your profit will be taxable. So not only does the effective tax 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 when you reach those thresholds, your tax bill increases at a 46% clip. By pouring income from her IRA, she went from a 14% effective tax rate to one that was more than 20%.

My first thought was to split the payment to the window company using this year’s RMD and then again using next year’s RMD. This would keep her effective tax rate closer to 14%, which she would have been in anyway. Mildred had two options, one is to use her home equity line of credit that she had at 4% and as she listed, the effective cost to her would be closer to 3% annually and consider that she will pay it off in less than 6 months . it would have only cost her about $600 in interest. Her other option was, of course, to use the window company’s interest-free financing, which she could pay off in a year. Either way, this would save her $6,000 in taxes.

But our story doesn’t end there… during our conversation we discovered that this gives charity quite a lot, about $13,000 every year. So we talked about a tax law called the “Tax Increment Prevention Act,” which allows people who need to distribute income from their qualified accounts to donate directly to their charity as long as they count toward their Required Minimum Distribution. Mildred is required to distribute $11,000 this year that would be added to her income and at a 14% effective tax rate that is about $1,500 in taxes, instead she can transfer $13,000 directly to her charitable organization, satisfy her RMD and bring in her entire tax bill. from $5,000 down to just over $1,100. In other words, by understanding the tax laws, Mildred can increase her “take-home pay” from $3,200 to more than $3,600. Who couldn’t appreciate a $400 monthly raise, especially on a “fixed income”?

Now, the last piece of the puzzle, her current portfolio. An allocation consisting of 75% equity mutual funds and 25% bond mutual funds. No matter how expensive mutual funds or the fact that someone in their 70s on a fixed income with minimal assets is allocated so heavily into the stock market, let’s talk about distribution. If we go with the RMD schedule, there will be a time each year that Mildred will have to sell her mutual funds to receive her distribution. Now, the mindset is to have the entire portfolio making enough money where she can live off the interest and capital appreciation. That’s great in theory, but when you factor in the embedded fees of about 3%, the market would have to do very well to hold that direction and we all know the markets don’t always go up (except of course the last 6 years, but I digress ). 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 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 the assets are down. Simple math tells us if I start with $1,000 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 hold $880 and if we did that math again? After 4 years it would be $750.

So our student becomes a client when we discover that it would be in her best interest to implement and manage two strategies. The first plan is called “Sequence of Returns” where basically we cut Mildred’s portfolio into 3 parts; short term (3 years), medium term (5 years) and long term (longer than 5 years, built to last forever). The basic financial planning fundamental is that you never distribute assets from a volatile account. By putting 3 years of distribution into a non-volatile (doesn’t lose money) account, Mildred can be assured that the income will be there if needed. The expected return is something small, about 1 – 3%, but it is guaranteed and will never lose its principal. Her average allocation would carry a percentage of her assets with 5 years as her minimum but on average around 25% of her assets. This account would carry very minimal volatile assets that should yield between 4 and 7%, we use 6% as a reference. The long-term allocation can be involved in 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 her standard deviation (amount of volatility) to decrease from where it was originally at 17% down to 3.5% for her overall portfolio as we increased her average rate of return from 3.58% to over 10.5%. The second plan was to convert half of her qualified assets (IRA) 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 about “staying the course” when markets go south, rebalancing when things get too good or diversifying your portfolio to mitigate risk while capturing upside potential. It’s about identifying the costs of doing business, the risks associated with financial decisions and the unknowns that can wipe out all gains as well as CFO for your household.

If you would like a 10 minute, free private conversation about your tax situation or portfolio, send an email to [email protected] and we will get to work for you. Take the next step, it’s time.

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