PORTFOLIO MANAGEMENT

Income Taxes

If you are working or earning money, then you are likely paying taxes on the income you receive. A very common approach to reducing your tax bill is to contribute to retirement accounts. In addition to getting a deduction against your income, the money can grow tax-free for years until you take it out in retirement. At that point, many people are in a lower tax bracket and this works out favorably.

Back-door Roth Conversions

In some cases, high earners may wish to use non-deductible contributions and then convert them to Roth accounts. This is known as the backdoor Roth strategy. If they are likely to remain in higher tax brackets - even through retirement - this approach can lock in current tax rates. Moreover, it can allow them to keep their money in the retirement accounts their entire life. That is, Roth accounts can avoid annoying required minimum distributions (RMDs).

Larger Retirement Account Contributions

In addition to the more common retirement accounts like 401Ks and IRAs, there are other types that allow for larger contributions. For example, contributions to SEP IRAs and personalized defined benefit plans can exceed $50,000 and $200,000 per year, respectively.

The bottom line is that one can manage the timing of their income taxes to a large degree. So it is important to use this flexibility to your advantage.

Investment-related Taxes

I use the phrase investment-related taxes to describe taxes related to dividends, interest, rental income, and capital gains. With these in mind, I believe portfolio management decisions are related to and should be considered in conjunction with income tax planning. However, these issues are not the same and require different strategies to manage them. Below I discuss five key strategies to minimize investment-related taxes:

Exchange-traded funds (ETFs)

For portfolios in taxable accounts, I believe ETFs are essential ingredients. Traditional mutual funds regularly make investors pay taxes on capital gains. However, the mechanics of ETFs allow them to rebalance their portfolios without triggering capital gains for their investors.

Tax harvesting

Another key element of tax-efficient portfolio management is tax loss (or gain!) harvesting. This strategy involves the selling of investments that have declined in value to lock in losses. The idea is to replace these with similar investments right away so the portfolio is not meaningfully changed. However, the loss creates a buffer for taking gains elsewhere in the portfolio.

Asset location

Many investors have different types of investment accounts. Some are taxable (e.g., standard brokerage), tax-deferred (e.g., traditional IRA), and tax-free (e.g., Roth). So it can be helpful to place (or locate) one's investments in particular accounts. For example, bond interest is taxable as income rather than capital gains. So it is often advantageous to place bonds in a traditional IRA account. Moreover, IRA money will eventually be taxed as income. Thus, placing slower-growing investments like bonds in an IRA can help minimize the growth eventually taxed as income.  While rules of thumb are useful, mathematical optimization is generally required to get the most out of asset location strategies.

Deferring tax

Bonds and other fixed-income investments are notoriously tax-inefficient. Simple income annuities can reduce or defer many of these taxes for years. These products can produce significant benefits and I have published original research on this topic (optimizing fixed annuity tax deferral). However, please beware of commission-maximizing salesmen who highlight the tax merits of variable and index annuities. The article linked above explains the potential tax issues these products have.

Advanced planning

For investors open to more advanced planning techniques, there are private placement products (e.g., life insurance and variable annuities) that can be structured to reduce taxes. These products have evolved significantly and their prices have become more competitive in recent years. Note: While I conduct due diligence on these products and may recommend them for clients, I am not a broker and cannot transact or receive commissions on these types of products.

Risk Management for Savers

Those who are in their saving and investing phase have different needs. Here are three key areas where the use of insurance as a tool for risk management may be relevant:

• Earnings insurance: When you are working and saving, your future earnings are often your largest asset. Life insurance can help minimize the financial burden on your family in the event of your death. They can also be tailored to decrease coverage over time. This can lower the price and more precisely target the future income at risk.
• Disability: The role of disability insurance is similar to life insurance. Moreover, it can be particularly useful for those whose careers involve a significant amount of physical activity (e.g., doctors and dentists).
• Buy-sell agreements and key-man risk: Businesses with multiple owners often execute agreements to buy each other out under various circumstances (e.g., disability or death). Life insurance can be structured in such a way to seamlessly fund these transactions should the situation arise.

Risk Management for Retirees

For those who are nearing or already in retirement, here are two areas where insurance can be a useful tool for risk management:

• Long-term care: Retirees often get to a point where they can no longer perform everyday activities on their own. Unfortunately, the care they may require can be prohibitively expensive. I can help clients decide between the various solutions to cope with this risk. Purchasing long-term care insurance may not even be necessary. For example, their family may be able to provide the support they need. Moreover, they could also set aside money in reserve or utilize dual-purpose assets (e.g., life insurance). It is important to assess this decision in the broader context of their retirement planning.
• Guaranteed income: Making sure one does not run out of money in retirement is naturally a key consideration. I am an expert at structuring cost- and tax-efficient solutions using income annuities. Please get in touch if you are interested in guaranteed streams of income being a part of your retirement planning.