Paul Winkler: Hey there, welcome to “The Investor Coaching Show.” I am Paul Winkler, talking money and investing. That’s what we talk about around here.
Paul Winkler.com is the website. And that’s where the podcast ends up if you happen to pick it up there or right here on the radio.
Investment Workshops
So one of the things that I would talk about is some interesting conversations that took place during the course of this week. So let’s say that you’re looking for some financial advice and you’re looking for some guidance.
And we talk about from time to time the workshops that are held around town where somebody sets up a workshop typically to try to sell investment products. But they’ll typically have some education. For example, something on social security, maybe a little bit on Medicare, or something on taxes and the effect of taxes.
That’s how investment advisors are often trained to sell stuff. Get out there, teach workshops, people come, they feel, they get to know you a little bit, and they go, “Oh, this is a nice person.”
And typically if you get into the financial industry, you’re normally a fairly nice person and you like people and you get along with people. But what happens so often is that products are being sold and being pushed at these various events — not necessarily on-site because they’ll tell you you’re under no obligation, you won’t be sold anything on site or anything like that, but you’ll have a follow-up meeting.
And then that’s where the sales process starts. That’s something I’ve objected to somewhat often.
One of the guys in the office in here was telling me about this big, big investment firm, a major firm. And a person goes to work there. They get a Series 7, they get a Series 65. Series 7 allows you to sell stocks and bonds and options and those types of things.
And then you get Series 65, and you’re dealing with a lot of the CYA type of stuff, really, that’s where it gets down to. One person actually called it that this week and I laughed and said, “Yeah, that’s kind of how I see it too.”
We had Series 63 when I was coming up and they were called the Blue Sky Laws and you were learning about things that you can do, things you can say, things you can’t say, and so on and so forth. But that was it. It was literally “Get out there and sell” after that.
I worked for a huge, huge investment firm that shall remain nameless. And your job was to get out there and sell the stuff that they wanted you to be putting out there like annuities and different life insurance things, mutual funds, you managed contracts, and those types of things.
Well, I was just one of those people who was so frustrated ’cause I was so analytical. I would look at these things and go, “I can’t recommend this stuff to people.” And I had people around me who were recommending it, and they didn’t have a problem with it. Because they never really thought too deeply about what they were recommending is what it got down to.
So these tax workshops and things like that, typically what they’re doing is teaching a few things.
A lot of times where I find that there are problems is they’re making presumptions about the future when they’re teaching these things.
And I’ll talk a little bit more about that in just a second — the presumptions about the future.
Tax Risks of Financial Planning
I was reading the brochure for a huge mutual fund company on their financial planning practices. You have a brochure that you disclose about what you do to the investing public, an ADV form, and you disclose what you do, what the risks are, what the conflicts of interest are, and those types of things. I’ve talked about that a little bit in the past, some of the things that I tell people to look out for.
Watch out when they’re talking about how they’re doing fundamental analysis.
When they’re doing fundamental analysis, what you’re looking at there is you’re looking at the companies and the fundamentals and determining whether this is a good company to invest in. Well, the problem is, what drives stock prices more than anything? News. The fundamentals of a company can be unbelievably great all up to the point where the news comes out and it comes crashing down and they didn’t do you any good whatsoever.
Yet that’s what they’re using as their criteria for choosing investments. And to the public, it sounds like a good idea.
Don’t you want to study a company before you invest in it? And the reality of it is that you look at the effort, and literally a prudent investor rule — which is written to help people constitute what is prudent investing of an investment portfolio — tells you that all your efforts in doing that typically promise little to no payoff to a negative payoff when you take into account all the transaction costs and the expenses of doing it.
And so that’s the law telling you that this is probably not the greatest idea, but you can do it. Doesn’t mean that you can’t do it.
But anyway, back to the disclosure. In the disclosure, they’re saying that in financial planning, the risks have risks.
And I was taken aback. I was like, “Oh, look at this. They’re actually admitting that some of these financial planning practices have risks.”
I used to have a buddy of mine who does what I do in a different part of the country, and he would go as far as to say that financial planners are the problem more than the solution. And I got a kick out of that because yeah, a lot of times financial planning has been used to sell products and things that people shouldn’t really be doing.
And it sounds sophisticated. You get this 80 to 90-page financial plan of all the things you ought to do, and “Oh, by the way, we sell all those things.” It’s kind of the way it worked out.
But they were talking about in their brochure, the risks, the tax risks of financial planning. And I want to talk about that because I think it’s super important. I think a lot of people are going out to these workshops and they’re signing up and going, “Yeah, this makes sense,” but they’re not thinking about the possible risks.
Investing on a Pre-Tax Basis
Okay, so let’s talk about the different types of tax advantages you might get with investments. Number one, when I invest in something — let’s say I invest in a 401k at work or I invest in an IRA — I might do this on a pre-tax basis.
So that would be one tax advantage so to speak: I put money in, and I don’t pay taxes on the income right now because I don’t need the income till down the road. So if I’m in, let’s just use a 24% tax bracket, and I’ve got $10,000 and I put that money away, I’ll save $2,400 in taxes versus if I had taken it in income. Because what happens is I pay taxes on the last dollars that I earn at different rates.
If I’m super, super low income, because of standard deductions, I may have no taxes. If you don’t make any more than let’s say $5,000 in a year, you won’t have federal income taxes. Then you go up to a 10% tax bracket, depending on whether you are married or single when these breaking points happen when you go from zero to 10. It just depends on that.
And then 12, then 22 and 24 and so on, up to 37 as we speak. So when I put the money in, I don’t pay taxes on it. That is a deduction, so to speak.
I can deduct it against my taxes. I don’t have to pay anything on it.
Then what happens is I don’t have to pay taxes on the accumulation. So let’s say I have a return on those investments, instead of declaring it as income right now, the gain in the investment, I can defer it to some point in the future when I’m actually pulling the money out.
And that can have some huge benefits. So that’s tax deferral, tax deductibility, tax deferral.
Future Taxes
Then you have the other aspect, which could be tax-free. Now that, you’re looking at it, and you might not get a deduction like a Roth. You don’t get a deduction for a contribution into a Roth 401k or a Roth IRA.
You take after-tax dollars, that 10,000 minus the 2,400, and then that 7,600 that’s left, you put that into the Roth IRA. So you pay the taxes now, the money’s gone. It’s at the government now, but I get to keep it.
I don’t have to pay taxes on it when I’m accumulating, but I also don’t have to pay taxes when I pull the money back out as we speak right now. The way Roth IRAs are actually taxed, I don’t have to pay taxes on it.
Now it can be a great benefit. Let’s say I’m in a very low bracket right now, but I’m likely to be a higher one in the future, that’s where that works the best because of the differential between my current tax rate.
Let’s say I’m only in a 10% or I’m zero even. Let’s say I have super, super low income, and then in the future I’ll be in a higher bracket because of inheritances, because I’ve accumulated a lot of money, because of whatever, I can actually benefit greatly from the Roth IRA many times in that case because I’m going to be likely in a higher bracket in the future.
Now, that’s why I said in many cases and likely in all those, as I call them, weasel words, this is one of the risks of financial planning. You are presuming on the future as to what the tax code is going to look like. You’re presuming that in the future with my Roth example, that you will be in a higher tax rate in the future.
Our tax system may completely change. You don’t know that.
You may find that in the future we do away with income taxes, 30 years down the road or whatever, and we go completely to a consumption tax, where you’re only taxed on the goods that you buy.
And it may be sold that, “Hey, look, we got a lot of people that come into this country. They’re not necessarily on the radar and therefore we don’t get taxes returns from them.”
Or there are a lot of people that are evading taxes. They’re taking cash for maybe doing home repair projects for you. And therefore to get them on the grid or get them paying something into the system, we need to do a national sales tax. That would be an example of something like that.
So when we look at that, we go, Well, is there a possibility that that would be the tax system? Could it be an amalgamation of the two? Could we have a little bit of an income tax in the future plus a consumption tax?
Assuming Tax Rates Will Be Higher
A lot of times I’ve seen at these workshops, and I remember one of the things I was trained to do, and I was almost really queasy about this and just going, I can’t do this, but there were a lot of my compadres in the investing industry that had no problem doing it because it helped them sell life insurance.
But what they would do is they’d go, “Hey, look, we got this thing. It’s kind of like a Roth IRA. It’s a life insurance policy. You put money in.”
“You don’t have to pay taxes on the gains. Then you take loans out against the death benefit later on. It’s tax-free, and it doesn’t affect your social security. You can even pay for your kid’s college education.
“It isn’t even on the radar screen as far as college aid, tuition assistance and all that garbage. And what we can do is we can set this thing, this Roth type of an investment vehicle up for you. And by the way, it’s something that the rich do.”
They would teach that. And I would be like, “Really? People have fallen for that?” I was like, “Oh my goodness, this is insane that this is what people are being told to do.”
And it is. So what happens is that we’re assuming, number one, in some of these workshops, that tax rates will be higher. And what they’ll say is “Hey, look, the government is in a huge bit of trouble.”
And that is that they’ve got the debt up to the ceiling and they’re just in all kinds of financial problems and what they’re going to do in the future is they’re going to raise taxes so high, it’s going to be nosebleed. And then when you pull your money out of your IRAs, then you’re going to be paying a ton of taxes on that.
Well, again, it’s presuming in the future that there isn’t something else going on here. And that something else going on could be other ways of collecting taxes on people. So that’s number one, that I would agree with that brochure by this big mutual fund company, that there can be risks of financial planning.
Now, this is why when we look at diversification in investment vehicles, not just putting all your eggs in large U.S. stocks or small U.S. stocks or value companies or international or U.S. or bonds or cash or anything like that.
We diversify from a tax standpoint.
So that would be something you think about. Well, one of the things that we look at is, well, can we look at other parts of our tax system and do we have something else that we can diversify into as far as a tax standpoint goes?
What I’m going to do is I’m going to take a quick break and I’m going to come back and I’m going to talk more about that because there are some things on the table from a tax proposal standpoint that could be really weird when it comes to diversification and it’s a good example of how things can change. So I want to talk about that and I’ll get into that next right after this.
Tax Laws Can Change
Okay, so some of the workshops that you see, you’ll get this flyer in the mail or brochure saying, “Hey, come out. We’re going to be talking about taxes. We’re going to be talking about social security. We’re going to be talking about whatever.”
One of the things that I saw in a recent brochure was by a big mutual fund company saying that there are risks of financial planning. I was like, “Bravo.” They had, in their disclosure, their risks.
One of the risks that you find is that you’re presuming upon the future so often in financial planning discussions.
And I’m going to talk about that in a lot of different ways in just a second and some of the other ways that we find this. But one of the ways we just talked about is how people are looking at going pre-tax or post-tax, Roth IRA or traditional IRA, and you got to recognize that tax laws can change and so sometimes we have to look at ways to protect ourselves, and that way could be tax diversification, having a little bit of money in pre-tax, and having a little bit of money in post-tax.
Now, there’s another way that we can do this and that is to go into the different structure of capital gains. So let’s say if I have an investment portfolio and it is a non-qualified portfolio. In other words, I just own, let’s say stocks or something like that.
Now, real estate can be this to some extent because you can have a capital gains structure there as well. But I’m just going to stick with stocks and fixed income and investments and those types of things, just for explanation purposes here.
Now with the capital gains tax rate, for example, you might be as high as a 37% tax rate for capital gains or for regular income purposes. Excuse me. Now, capital gains would be much lower.
Now you have some surtaxes. But you have in general for people in a 10 or 12% tax rate, it’s a 0% rate is what it is for capital gains and then you can go to 15% and some people 20% and you might have small surtaxes on top, not huge surtaxes.
But there are small surtaxes on top of that that I won’t get into because it just gets too complicated and a lot of you aren’t going to be subject to it. A lot of people aren’t subject to them.
What Are Capital Gains?
But anyway, let’s say that we look at capital gains. Well, what are they? Well, let’s say that I have a capital asset. I buy a stock, let’s say, and that stock, I pay $10 for it and let’s say that I don’t have any dividends or anything like that and I hold it for more than a year and I sell it for $15.
Well, I’ll have a $5 capital gain, right? And then I have to pay taxes on that.
If I’m in a 0% tax bracket because I’m in 10 or 12% marginal rate because my income is low, the rate may be 0 or it might be 15 or the 20 that I was talking about. Now, if we look at what is going on right now in the political world, there has been talk about changing the capital gains structure because only rich people pay this and I’m going, “No, A lot of people pay capital gains taxes.”
If you look at just regular people, many of them have to pay and think about it. When I’m trying to sell a piece of real estate or a house or something like that, look at the rate that is covered or the amount of gain that is actually covered where I don’t have to pay taxes.
It’s been stagnant for a long, long time, $250,000 and 500,000 for married couples, and you look at that. It hasn’t changed. Well, what’s going on there?
More and more people are being subject to taxes because of the increase in the value of their real estate.
Really, if you think about, it is a way for the government to benefit from inflation, another way of looking at that. You look at, for example, taxation on social security. You have thresholds.
You take your provisional income, your income, plus half your social security and you’ll have thresholds like 32,000, 44,000 for married people, and if those two things, provisional income plus half of your social security, exceed those numbers, you can now have social security taxation. You have to pay taxes on your social security.
Paying Taxes on Inflation
Well, originally social security wasn’t taxed. So now what we have are those thresholds. But those thresholds were set up a long time ago, one of them in the 1980s, and then in the 1990s, we had the second set of thresholds set up.
So now people are paying taxes on social security. They never dreamt they would have been paying taxes on it.
Why? Because they never changed the thresholds, the 32,000 and the 44,000.
Back when they were set up, 44,000 was a huge amount of income that a lot of people just never dreamt that they would get to and you go, “Are you kidding me?” No. Think about it.
Let’s just go back to the ‘70s. I always like to use that because it’s so stark. If you made around $10,000, you were doing just great.
That was all you needed for an annual income. Yes, annual. I’m not talking monthly. I’m talking annual income.
All you needed was that, and now we look at that and go, “Yeah, forget that, trying to live off of that amount of money,” and that’s inflation. And the other thing that happens with capital gains is that taxation on capital gains that people are talking about, and increasing it, especially when we look at, for example, taxing gains as we go.
That’s what people have been talking about is politicians going, “Hey, how about if we go and make you pay taxes as you go because there are rich people that are getting by without taxes?” And you go, “Well, wait a minute. What are the components of capital gains?”
The components of capital gains are you have an asset that you buy and then it goes up in value and you pay taxes on the difference when you sell it, right? What is part of the reason that it went up in value? I would submit that it’s inflation.
You look at a house, for example, and in the 1970s, you buy a house for $30,000, right? Now it’s $300,000 or $400,000. Well, you’ll have a house that would have sold for a much, much lower amount back in the ’70s being worth a whole lot more now just due to nothing else other than inflation.
So I’m going to be paying taxes on inflation? Does that seem fair? Does that make sense? And I would submit it’s kind of yuck.
Capital Appreciation
Now, another aspect of things is capital appreciation would be using your brain power to increase the value of something, and so you might have that aspect of the increase in value of an asset because you have an entrepreneur that has done something to make a company more valuable or you own an asset and there are entrepreneurs or people that work for the company that increase the value of it.
And you might look at that and go, “Well, maybe we ought to pay taxes on some of that.” But the reality of it is how do you track that kind of stuff?
How do you figure out if you’re paying taxes as you go?
What if you go and pay taxes on the gain on something and then you decide to sell it and just before you sell it, it drops in value, and you paid all these taxes over these years, and now you got to go and you sell it at a loss, let’s say? I mean, to make it even worse, now you’ve been paying taxes on gains all these years and then you sell the doggone thing at a loss.
Is the government going to go send you a check and send you a check with the time value of money built into it as well? In other words, you paid $10,000 in taxes and you did that years ago, years and years ago, $10,000, and now it takes $50,000 to buy what $10,000 used to buy. Hope you’re following me.
Then all of a sudden, it increases in value to $50,000. But you lose money on it and you’re going, “Well, do you just give me back my $10,000, government, or do I get the time value of money because now that 10,000, if I hadn’t paid it to you, would have been worth 50 someplace?”
You see the complexity of this? It’s like, Oh my gosh. This is insane.
And you think about the record keeping to try to keep up with the gains every year, especially if you own, let’s say, a non-publicly traded company and all of a sudden you’ve got to get a valuation every year to determine what your tax is on this thing. That’s just insanity.
When You Can’t Afford the Taxes on Your Assets
The other thing is this. You’re getting these gains and this investment vehicle that you’ve got or this asset that you own and you’re probably paying taxes as you go. So you’re paying taxes as you go and you’re going, “Well, I don’t have the money to pay the taxes on this asset.”
A lot of entrepreneurs, most of their assets are in their businesses. They don’t have a lot of liquid assets outside of that.
So what do I have to do? Do I have to sell shares in my company just to pay the taxes? Do I have to sell it to private equity who comes in and screws up the company?
I’ve had so many business owners — oh my goodness — they wring their hands because they’ve seen it and I’ve seen it where somebody sells out their company when they retire and a private equity firm comes in and they rearrange everything to make the company more profitable just so they can make more money. But they mess up the business.
And I’ve seen it where the staff, the long-running staff of a company, the owner sells. Private equity comes in.
They screw up the company and the staff that made the company so valuable, they did all of the work and they had all the relationships with clients, and they bolt. They’re out of there. So it’s just mind-boggling that you could force somebody to do something like this.
Now, another thing that happens is this. I’m going to save it for after a break. But there is another aspect of the capital gains. There are few of them, matter of fact, that I’m going to talk about right after this and again, we’re presuming of on the future if these changes take place.
But this is something that you need to be just aware of because too often what happens is people get into this mode where they just get really excited about a certain tax advantage and then they get themselves overly concentrated with their money in one way of handling it from a tax standpoint. Then later on, when the tax laws change, that’s when they get caught and they lose a bunch of money or they run into some serious trouble and they can’t retire just because they’re in such a bad situation from a tax standpoint because they expected life to be one way and it didn’t turn out that way.
PART 2
Paul Winkler: All right. I’m back here on “The Investor Coaching Show.” I’m Paul Winkler. Paulwinkler.com is the website.
Working Tax Differences Against Each Other
So we’re just talking a little bit about taxes here. You’ve got different types of taxation on investments, tax deferral, tax-free, tax-deductible, all those types of things, I talked about that. Capital gains taxes as well — I talked a little bit about that.
And when we have a capital asset, like a house or a business or maybe stock or something like that, or investment vehicles that are taxed in that particular manner, there can be an advantage, so to speak, depending on what the tax law is. When you’re dealing with these things, where you have the regular federal income tax rates, 10, 12, 22, 24, and all the way up to 37, and you look at the capital gains rates, it’s 0, 10, 15, and then 20 are the three tax rates there plus you can have some surtaxes.
Here is the situation. You look at that and go, “Well, there are big differences between these things. Can I work these against each other?”
And the answer is, yeah, you can. Sometimes you can do that.
Now the other thing about non-qualified assets is they don’t have the limitations on what you can invest in it as well, and that can be helpful. So there are a lot of reasons that we might use these two things against each other, but there are people saying that the rich aren’t paying their fair share.
“We got to tax them more. We got to make them pay taxes on these capital assets.”
And the reality of it is that a lot of regular old people have capital assets they pay taxes on. I gave the example of a house where a lot of people are now having to pay taxes on gains on their homes when they sell them.
Even though you have the exemption, the exemption hasn’t changed in a long, long time.
And it’s inadequate for a lot of people to cover them from the taxes on just the sale of their personal residence.
Capital Improvements
Now if we look at another issue, and let’s say that you have this personal residence and then you do some capital improvements to it. Let’s say that I buy something for $100,000, and forget the exemptions — I just want to get this concept to you, okay?
Let’s say I buy something for $100,000, and I have a capital improvement of $50,000 that I make on it. And the point that I sell it is $400,000. Now if I don’t pay attention to this stuff and keep track of it, I could have a $300,000 capital gain, right?
Because I bought it for a hundred and I’m just keeping this super, super simple, and then it’s $400,000 when I sell it. Now that $300,000, I could have a tax on that amount of money.
Like I said, forget the exemptions now; I want you to get this concept. I do a capital improvement and I put $50,000 into the property that I can now add to the basis, and let’s say I did it many, many years ago.
So I’ve got $100,000 that I paid for the place, $50,000 that I put in as an improvement, and then in the future it’s $400,000. Now I’ve cut my gain back from 300,000 back to 250,000.
Here’s the thing: I’ve never heard anybody talk about this, but I think that this is something to think about. Well, you got to think about it and just go “Uh,” more than anything.
But when I actually put that capital improvement of $50,000, money had a different value at that point in time. You got the time value of money inflation, that $50,000 that may have been put in decades ago, it might be $300,000 right now.
But they don’t let you increase the value of that improvement.
So I can’t say that I put $100,000 into it, I put 50 in it, but in today’s dollars that 50 is worth $200,000. So my real basis should be a hundred, which I paid for, and the current value of that improvement, $50,000. Now it takes 200,000 to buy what 50 used to buy.
So I take the 100 plus 200, my base is $300,000, and then I sell it for 400. I’ve got $100,000 gain. Just don’t let you do that. So you just go, “Oh, my goodness.”
Protecting Yourself With Tax Diversification
In a lot of ways the tax code is set up to really benefit the federal government. And like I said, with capital gains in general and the idea of increasing taxes on them, a lot of your capital gains are a result of inflation. And that’s even the case with your qualified plans too, if you think about it.
A lot of your increase in the value of your money in your 401(k) is due to just inflation. Because if we look at the S&P 500, for example, what’s the rate of return of the S&P 500 from 1926? Still now, a lot of you are screaming at your radio going, “It’s 10%.”
But after inflation, it’s seven. So 3% of that return went by the wayside and it was just due to inflation. But when I pull the asset out in the future and pay taxes on it, let’s say on a pre-tax type of an investment vehicle, when I pull the money out, what do I pay taxes on?
All of it. Not just the part that increased in value by 7%. I pull out the money and it’s a tax on all of it. And you think about that, whoa, that’s kind of problematic.
Now, what are some of the things that we do now? And when we talk about protecting ourselves, I talk about making sure that I have tax diversification.
I have lots of different things out there to protect myself based on what the tax law may change to, what it might morph into. Well, what are some things we do now?
I’m always looking at what’s the current tax code and just doing everything I possibly can.
It’s a big part of our job, really keeping up on this stuff. And it’s daunting. I’m not going to mince words. It’s daunting to keep up on all of this stuff, the tax laws and how they keep changing, and it’s just frustrating.
As time goes on, I think about the average client that gets older, and maybe they had some handle on it in their youth, but now they’re looking around thinking, I don’t even know what to do. And that’s why we have the CE.
We do the continuing education. We’re constantly keeping them on this stuff.
Rebalancing Your Portfolio
But back to this, let’s say we look at what we can do now. Well, one of the things when we’re managing a non-qualified portfolio, when we’re managing it and then we’re looking over this portfolio, one of the things we’re looking at is how to rebalance it to keep it more tax efficient.
And one of the ways to do that is let’s say I have two assets. I have large U.S. stocks, and I have small U.S. stocks in the portfolio. Well, when you’re managing a portfolio, let’s say that I want to have 10% of my money in one area and 10% in the other area. And all of a sudden one area does really well, and it’s taking up 15% of my portfolio.
It’s done really, really well comparatively, the other area hasn’t done as well. It’s only taking up, let’s say 5%. Just to keep it really simple.
They’re supposed to be both taking up 10. Well, one of the things that you might do is sell off the five overage. One is at 15, it’s supposed to be at 10, sell the 5% overage and buy the other one that’s at five and it should be at 10. And then bring them back into balance.
So we hear that referred to as rebalancing. A lot of investment companies actually misuse that word. They are actually talking about tactical asset allocation.
That is not what I’m talking about. Again, the level of education is problematic in this industry.
But anyway, we look at that and we say, “Okay, well, we could do that.” What’s a better way?
Is there a better way to do it? Yeah, you can do it based on cash flows.
So if I own an asset in concert with other people, when the one asset doesn’t do as well, there’s new money flowing in and there’s money flowing out. I can put the new money flowing in to the asset that is underrepresented, thus bringing it back closer to the 10%.
How Are You Managing the Portfolio?
If money has to flow out — for some reason, somebody’s in retirement, they own the same thing, the investment portfolio like you do — we can send the money out of the overrepresented asset category, the one that’s at 15, it’s only supposed to be a 10. And thereby what ends up happening there is we have a situation where you can much better control the taxation on the investment portfolio. The other thing you can do is make sure the management fees come out of dividends and things like that which are currently taxable.
Another thing that you can do is make sure that you have the deviation from a target when you do have to rebalance the traditional way that the expected benefit outweighs the costs. And then another thing that you can do is this: The Hong Kong management philosophy. How are you managing the portfolio?
Are you engaging in tactical asset allocation? Are you engaging in fundamental analysis?
Those things that I just talked about a little bit earlier. I cannot remember seriously the last time that somebody brought an investment portfolio in for me to analyze where that wasn’t in the company’s ADV that was managing the money or the mutual fund company’s prospectus on how they were managing the money. It is such a common practice.
And I thought 25 years ago, almost 25 years when I started this show, that that would be gone by the wayside. People wouldn’t do that anymore. But no, it’s as strong as ever.
But let me just give you the short version that that can be terribly tax inefficient to manage money that way. And I’ll talk about that in just a second as to why that’s so terribly tax inefficient and can be so problematic. Why do people still do it? I’ll talk about that next too.
The Unpredictability of Taxes
So I’ve been spending the last hour talking about taxes, different types of advantages you can get, tax deferral, tax-free, some of the capital gains proposals and the problems with that. The problem with financial planning sometimes is that you’re presuming upon the future, and you’re trying to predict what’s going to happen next.
And especially when it comes to taxes, that can be terribly, terribly unpredictable. I’ve been doing this for well over 30 years, and the number of tax law changes that have taken place over that period of time is daunting. I mean, daunting.
Estate taxes. Remember the exemption? You could pass only $600,000 worth of assets.
I think it was even lower than that when I got in. I forgot what it was when I got into the industry, because I wasn’t doing much estate planning work back then, but it was like a pittance. You could just about pass nothing.
Capital gains tax rates were so, so different from what they are now.
Federal income tax rates, good grief. The standard deduction, I will never forget the standard deduction, which is how much income you can earn and pay no taxes on, now for a couple it’s around 30,000. It was 5,700 back then.
You just think about it and go, “What? Really?” It was only 5,700 when I got my first financial planning designation. Funny how that changes as times change.
But one of the things that, when we look at the management of an investment portfolio we see so often is tactical asset allocation, fundamental analysis of portfolios. Technical analysis is another thing. You’ll have that as a term that’s thrown about in the ADVs.
And like I said, I can’t remember the last time I met with somebody, and I meet with a lot of people, that I didn’t see that as being in the fine print of the investment manager that they were working with or the fund company that they were working with. It is such a common and ubiquitous practice that I would be shocked if I saw that it wasn’t in there.
Fundamental Analysis
But the problem with that is the tax issues that can come about as a result of managing money that way. Why?
Well, because when I am engaging in fundamental analysis, I’m looking at the companies and I’m going, “Which company is better than another? Which company do I should be investing? What are the fundamentals of this company versus that company over there?”
And when we see people like John Stossel throwing darts at stock tables and beating the professionals, we see that that doesn’t make a whole lot of sense. We see monkeys throwing darts, and we see that there are some that are really funny.
Some of the studies, I’m going to leave it there. I’m just, I’m not going there. Some of the studies have been absolutely hilarious where they make fun of this practice.
But here’s the problem with it: If I buy this company, and I sell this other company over here because I think that this company is going to do better than that one, and if I’ve held the stock I’m selling for less than a year, I could end up with taxes up to 37% or higher if I’m in a state with a tax, so I can have a whole lot of money in gains go to the government. Bam. Gone.
Now, if, let’s say I do this on a regular basis, and you see this in mutual funds, you see this trading that takes place, I could end up with lots of taxation as I go. And what ends up happening is that can really dilute the return of the portfolio significantly because I’m paying taxes as I go in the portfolio.
Now, the other thing is, if I’m doing this with asset classes, now you’ll see index funds do this, for example, index funds will be reconstituted. And what’s reconstitution?
Well, they’re changing the stocks in the index, and they have to sell a boatload of stocks, and then they have to buy a boatload in their place.
And they’re not thinking about the tax consequences. If you’re dealing with a fund manager, they might want to hang onto it because when you reconstitute it, this might be something you do once a year with an index.
So you do this trade, and all of a sudden, you could have, in some cases, you could have these shorter term capital gains taxes and higher tax rates on the portfolio because of trades that take place inside the portfolio. Versus, it might be that the fund manager, if they’re paying any attention, are going to hold onto the stock for just a little bit longer so that the taxation will be at long-term capital gains rates, which are much, much lower.
So we look at that and we go, “Whoa, wait a minute. I didn’t even think about that.”
Tactical Asset Allocation
If we’re engaging in this tactical asset allocation, we’re moving money around from one asset category to another. For example, I think, Well, I think what’s going to happen with the election is this. And if this happens, then this market segment’s going to probably do better than this one.
And then I may trigger taxes in that way. So there are a lot of things when we look at this, the cash flows, and the way of managing the portfolio, that can have a significant tax impact.
Then you have annuities, which can be a huge issue because they’re last in, first out.
In other words, I put a $100,000 in. And let’s say that I make $50,000, and then I pull the money out.
Well, if it’s a regular non-qualified annuity, that $50,000 is what comes out first. So I have to pay taxes on that. I don’t get my basis back or what I put in until last.
Now, if I annuitize, which almost nobody does because they don’t like to lose control over the money, and that’s something I’ve talked about many times before, but if I do that, I can maybe spread the tax out.
But almost nobody ever does that because of the loss of control over the money. And they don’t like that. Who can blame them?
But then you look at it as an inherited asset. Annuities as an inherited asset can be a huge problem from a tax standpoint, but the commissions are so high, they’re recommended routinely at these workshops. Go figure, conflicts of interest.
PaulWinkler.com is the website. You can set up something if you want to go see any of the folks at our offices around town, we have 11 of them, one probably right near you.
You can set up a 15-minute phone call if you want to just talk to somebody or just go, “No, this makes sense to me. I’m just going.” Just do that. We’d love to see you.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
