Kurt Wunderlich, CFA, CFP®, 3/26/2020
As a kid, if you get $20 from your parents the world opens up and the possibilities seem just endless. Candy bars, apps, the latest “it” thing and so much more can be yours. You pull out your spend, save and give jars and plop that crisp bill right into the spend container.
As an adult, financial life is a bit more complex. You have to create and implement a comprehensive, values-based financial plan that balances short-term and long-term goals. You have to discern, order and fund the various priorities competing for your next dollar. And you have to deal with a lot of things that are simply outside your control. Given the very real demands of a mature financial life, as well as widespread uncertainty today about a great many things, it might be helpful or comforting to bring a little simplicity back to the way we think about money. Consider that, at the end of the day, there are really only four things you can do with your hard-earned money: spend it, save it, donate it to charity, or give it to the government. In basic terms, our approach is designed to maximize what you can put into the first three buckets and minimize what you pay to the last bucket through careful and tax-conscious strategic planning. What are these strategies, you ask? Well, let’s examine some of them.
Asset placement (or asset location) is the sequel to asset allocation. It is strategically placing your investments across your various types of accounts to minimize taxes over your lifetime. Ideally, stocks would be invested in taxable accounts, like a trust, individual, or joint account. Stock gains have a lower tax rate than ordinary income when the stock is held for more than one year. You also control when you realize taxes by controlling when you sell. Lastly, when far down the road you pass away and transfer assets to your heirs, an asset’s cost basis is increased to fair market value, helping to mitigate tax consequences when it is sold in the future. Taxes generally are the biggest “fee” in any portfolio; optimizing asset placement allows you to reduce that cost.
Roth Versus Pre-Tax Savings
While it can be a complex topic with lots of moving parts to consider, at its most essential level the choice to save in a Roth IRA or 401(k) versus a traditional IRA or 401(k) is based on tax rates now versus later. While this decision can only be made in the context of your personal circumstances, it is important to recognize that diversifying your type-of-account buckets can give you more options in retirement. For instance, saving to your work retirement plan using pre-tax dollars, then contributing to a Roth IRA, may allow you to hedge which route will be more beneficial in the future.
Buy and Hold
Again, taxes are generally the biggest cost in a portfolio. Continual changes to your portfolio, perhaps in reaction to headline news, can generate a large tax bill, reducing your account value. Investing your money based on a personalized, comprehensive strategy can help harness the emotions around current or market events and encourage you to follow the plan that puts the greatest odds of success in your favor. We suggest selling for only two reasons: to reduce risk or fund your lifestyle in retirement. The amount of risk in your portfolio is based on what you can tolerate in tumultuous times or how much you need to take to achieve your long-term goals.
Strategic giving allows you to both make a difference in your community and improve your tax situation. For example, donating stocks that have grown in value permits you to eliminate future capital gains taxes while giving money to charity or a good cause. Qualified charities do not have to pay taxes, so only market value is important to them. Another option is to stack your donations. Making what normally might be two or three years’ worth of gifts in a single year could mean itemizing your taxes rather than taking the standard deduction, thereby providing support to a worthy cause while also enhancing the tax benefit.
Creating estate documents that reflect your values and wishes is important. Updating beneficiaries and funding trusts is an important step, as skipping it can channel money to unintended parties or increase the tax consequences. Coordinating with your attorney and wealth advisor is critical to ensuring your estate documents effectively and appropriately provide for your loved ones in the way you desire.
Building up your assets is less about what you earn and more about what sticks to you. These strategies help your dollars stick where it’s most important to you and focus on minimizing the amount of your money you owe in taxes. Adopting a few of them as part of an overarching, comprehensive plan can have a major impact on your ability to achieve financial independence.
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