Financial & Estate Planning

Practical Finance: Rules of Thumb to Forget. Number Two….

PRACTICAL FINANCE

RULES of THUMB to FORGET. NUMBER TWO….

This one seems to hit the personal finance columns and blogs with regularity when December rolls around. We are referring to those pieces with year-end tax advice that almost always mention the advantage of taking steps to defer taxes to future years. There are typically a number of reasons cited. You may be in a lower tax bracket in future years. Actual tax rates may be lower in future years. Postponing tax allows you to earn interest on the government’s share of the money. You can pay the future taxes with cheaper (inflated) dollars.

These supposed benefits of deferring taxes have become one of those almost sacred rules of thumb. In fact, a few of our CPAs on the L&W team recall that “Defer, Defer, Defer!” became almost a mantra when we were taking our income tax courses in college.

One thing has become crystal clear to our team after almost 50 years of helping families with their wealth management needs. There are important exceptions to every rule, and this “rule” of deferring tax is certainly one of those that should not be accepted without question. The simple fact is that deferring taxes is not always the best plan. A couple of pretty common fact patterns that we encounter with clients can help illustrate this point.

  • Postponing recognition of capital gains on investments is one application of this rule of thumb. Our Chief Investment Officer, Ryan Patterson, CFA, CFP, commented at a recent Investment Committee meeting, “What most people forget is that under our very ‘non-simple’ tax system, long-term capital gains have their own graduated rate schedule, with rates ranging from 0% to 23.8%, depending on amount. Deferring gain recognition typically has marginal impact on portfolio returns, and may result in taxes at higher rates later. Care and planning are required in timing decisions.”
  • Accumulating excessive balances in tax-deferred retirement accounts will likely dictate distributions of ordinary income when Required Minimum Distribution rules take effect at age 70-1/2. The result of excessive tax-deferred build-up may be unbalanced Net Worth Statements where all accessible assets are in accounts that trigger taxable income when accessed. Added to Social Security and other income, this income can hit marginal tax brackets higher than those applicable during the working years. Heidi Davis, CPA/PFS, CFP, former chair of our Wealth Planning Committee, adds, “… often, these required distributions can push retired investors into high-income premium categories for their Medicare coverage.”
  • Deferral of excessive money into tax-deferred accounts also means a sacrifice in flexibility. Access to these monies before age 59-1/2 is generally punitive. Also, these assets cannot be pledged as collateral in financing transactions.

These three examples by no means exhaust the subject. There are others we could discuss with more time. But once again, these three are a reminder not to lean too heavily on rules of thumb such as “Defer, Defer, Defer!” The better approach is to be thoughtful about decisions like this and seek help from a qualified advisor, one functioning under the fiduciary business model, who is obligated to act in your best interest and provide non-conflicted advice.