Avoiding Financial Strategy Collision Course
Implementing a financial strategy that maximizes wealth and defers taxes effectively for as long as possible is a goal for many. However, suppose you aren’t careful or select the wrong deferral strategy for your unique situation. In that case, you may end up with tax consequences concentrated in a small number of years – undoing much of the benefit of deferring in the first place. To avoid such a tax burden, plan appropriately and implement informed strategies supported by a wealth manager.
Potential Strategy Collisions
There are three main areas where your strategy may be set on a “collision course.” In most cases, the collision can be avoided through careful planning and the support of a professional like a wealth manager.
1. Desire to Reduce Taxes During Working Years
For many, the belief is the time during their working years represents the highest tax bracket they’ll be in. At this time, a common tendency is to put as much into tax-deferred accounts as possible (for example, a 401(k) and a nonqualified deferred compensation plan), which allows you to avoid taxes while funding these accounts. However, once retirement age arrives, additional income such as Social Security or a pension often hit at the same time as your required distributions from the 401(k) or deferred compensation plan. As a result, you may end up with a lot of ordinary income in this 5-10-year period, pushing yourself into the highest tax bracket. This can also lead to a situation of underfunded taxable accounts and overfunded non-taxable accounts (or retirement overfunding).
To avoid this pitfall, conduct detailed income tax projections for multiple years that include the predetermined payout planning of your retirement account and other strategies such as Roth conversions. In situations like this, a wealth manager can assist by creating these year-by-year projections, and then advise on whether it makes sense to stretch out payment options for deferred compensation plans. Part of the consideration will include balancing the company’s liability to you and ensuring you’re comfortable with the company’s creditworthiness. Deferred compensation is an easy way to lower tax consequences during working years, but it can also be a risky one. You also shouldn’t be afraid of recognizing income from traditional IRAs or your 401(k), in the event we see higher tax rates in the future. In some cases, it makes sense to use them.
2. Capital Gains Avoidance Attempts
Another potential area for strategy “collision” is concentrated stock positions. At times, to avoid taxes, people won’t regularly rebalance or sell their stock positions over the years. As a result, they end up with large capital gains – especially if, or when, they have a retirement or liquidity need to access the money. At that point, there is no option but to realize the capital gains and you end up pushing yourself into the highest capital gains tax bracket.
Instead, investors should have a balanced and diversified portfolio managed by a professional. The professional will conduct regular rebalancing to ensure you avoid ending up with disproportionate capital gains. This moves asset allocation slowly over time in a way appropriate to your retirement needs instead of switching over the day you retire. Having an awareness that you can target those capital gains for lower tax bracket years is important.
3. Assortment of Illiquid Assets
Investing in assets gained from disparate investment recommendations is another area for “collision,” especially when they are illiquid. Some people continually invest in deals that are pitched to them by friends or family or jump from one real estate project into the next (using a 1031 exchange, for example). The result is an extensive portfolio consisting of illiquid assets. When it’s time to make a large purchase, or as retirement living expense needs arise, asset repositioning may be required. Having invested in illiquid assets is problematic because deals may not pay out in the near term, and the option to finance may not exist in retirement (without income to show the bank). You may also need to pay taxes on the realized gain. This issue is compounded when you have overfunded retirement accounts.
To avoid this situation, plan payout schedules for illiquid investments. A wealth manager can help coordinate with other potential income channels and tax strategies to ensure that when the taxes are due, assets are available to pay them. Concerning real estate, a wealth manager might look at the overall allocation and advise to pay taxes in some years, rolling some assets out of an illiquid bucket to make them available for use going forward. In brief, as deals disburse and liquidities are achieved, it’s important to consider future needs and cash flow rather than “blindly” putting assets back into the next deal.
Enlisting Guidance to Avoid a Collision Course
A wealth manager can help strategize and ensure you don’t wind up on one of the damaging “collision courses” described above. At Richard P. Slaughter Associates, we have the tools and resources to help our clients plan far into the future, even 20+ years down the road. We capitalize on our institutional knowledge about our clients’ unique situations and risk tolerances (which often shift over time), as well as their finances, to look at the entire picture. We then put this into a single system and make projections that hold up over the long term and within the context of other life and finance-related events.
The longevity of the relationships we maintain with our clients allows us to fully understand how allocations need to change over time so we may find opportunities for asset realignment at appropriate moments in the future. We can also coordinate with other service providers, such as a CPA, to ensure all strategies align.