Thanks to the second-longest bull market on record, the S&P and other indexes are roaring, performance is strong and account values are rising. But if there is one downside to the market’s all-time highs, it’s the tax bill clients will pay.
With the latest tax overhaul and political uncertainty, it is key advisors keep taxes — and their impact on clients — top of mind.
Taxes can be the single biggest investment expense a client will face — as much as 40% or even 50% of their earnings every single year, when federal and state taxes are combined. For 2017, the highest federal income tax rate is 39.6% on ordinary income, and up to 23.8% on dividends and long-term capital gains when the 3.8% health care surtax on investment income is included.
In recent years, many households have been paying more — and high earners have been hit hardest.
Knowing how to navigate the tax landscape, and demonstrating your expertise, is a competitive differentiator for your firm and one of the most meaningful services you can provide for your clients.
It’s not too late to take measures that can help reduce the taxes your clients will owe on income and investment gains. With year-end deadlines fast approaching, these tips will help clients control not only how much they pay in taxes — but also when they pay taxes:
Just defer it. Helping clients diversify between different tax rates and different types of taxes, as well as diversify between taxable investments and tax-deferred vehicles, is the first step to controlling how much your clients pay — and when those taxes are paid.
With tax deferral, clients keep more of what they earn by deferring taxes during peak earning years, when they are taxed at a higher rate. They accumulate substantially more. Saving thousands of dollars in taxes each year can grow into hundreds of thousands of dollars through tax-deferred compounding over a time horizon of 20 years or more. And when clients withdraw income in retirement, they are likely to be in a lower bracket and pay less.
Advisors and clients alike recognize the power of tax deferral to help achieve tax diversification, effectively manage the timing of taxes and ultimately generate more wealth. As our own surveys have shown, 96% of RIAs and fee-based advisors say tax deferral is important, and 94% report that their clients agree.
Max it out. The next step in tax-smart investing is maxing-out tax-deferred vehicles. Start with qualified plans like 401(k)s to take advantage of any employer match. And ensure clients over 50 make catch-up contributions. There is still (a little) time to act — contributions to workplace retirement plans can be made until December 31, 2017.
Next max-out traditional IRAs and Roth IRAs. To make an IRA contribution for the 2017 tax-year, the deadline is April 15, 2018. Many advisors wait until this April deadline to evaluate the client’s tax return and determine the best way to invest. With a Traditional IRA (assuming the client is not covered by a workplace retirement plan and/or does not exceed applicable income limitations), clients pay no taxes now — and instead wait to pay taxes later when making future withdrawals during retirement. With a Roth IRA they pay taxes now — but make future withdrawals tax-free and penalty-free as long as they are at least 59½. Clients can also make non-deductible contributions to Traditional IRAs. While the non-deductible contributions do not have the benefit of immediate deduction, they do grow tax deferred, similar to an Investment-Only Variable Annuity.
After maxing out qualified plans, consider low-cost IOVAs. IOVAs are designed to maximize the power of tax deferral, while they minimize taxes over the long term, with lower costs, and a broad choice of underlying funds for the optimal tax-advantaged investment strategies. Some IOVAs are re-engineered to meet the unique needs of RIAs and fee-based advisors, with no asset based M&E, no commission and no surrender fees.
Location is everything. Not all investments have the same tax impact. Some are more tax-efficient than others. Asset location is a proven strategy to help increase returns—without increasing risk—by locating assets between taxable and tax-deferred vehicles based on their tax efficiency.
In crafting asset allocation strategies, start by considering the tax-efficiency of assets. Are they taxed at lower rates for long term capital gains, or at higher rates for short term capital gains and ordinary income?
Locate tax-efficient investments such as index funds, tax-exempt municipal bonds and buy and hold equities or ETFs in taxable accounts. Locate tax-inefficient investments such as fixed income, REITS, commodities, liquid alternatives and actively managed strategies in tax-deferred vehicles such as qualified plans or low-cost IOVAs, to preserve all of the upside without the drag of taxes. The savings and subsequent wealth created by asset location can be substantial, especially for clients in high tax brackets.
Planning can be very different for clients based on their state of residence. Certain states have no personal income tax, including Wyoming, Washington, Texas, South Dakota, Nevada, Florida and Alaska. But costs can add up quickly for clients in the top 10 highest income tax states, including California (13.3%), Oregon (9.9%), Minnesota (9.85%), Iowa (8.98%), New Jersey (8.97%), Vermont (8.95%), District of Columbia (8.95%), New York (8.82%), Hawaii (8.25%), and Wisconsin (7.65%).
In high-tax states, clients, advisors and lawmakers alike are concerned about the loss of the state tax deduction in 2018. The impact could be significant. Some may consider accelerating deductions into 2017. But this could have unintended consequences, leading to the payment of the alternative minimum tax for some clients. Clearly, the complexity and uncertainty for these clients has increased in a year where ongoing gridlock has caused lawmakers to hit roadblocks along the road to tax reform. Now that the tax overhaul is a reality, it is important for you to formulate a game plan to assist your clients in maximizing the potential benefits provided and avoid any potential pitfalls along the way.
Taxes may be one of the biggest investment expenses that your clients face. But these three tips help you put clients first. Just defer it, max-it out, and use asset location to increase returns without increasing risk. Make every basis point of performance count, create more value for your clients, and in a bull market where competition for clients runs high, you can win by not losing.