Market Volatility and Taxes: How to Minimize Both to Double Your Returns

As a CFO in recovery, I find it especially fascinating to help people with their financial planning. I recently held a retirement income class here locally where I had the opportunity to sit down with one of the students to answer some questions that I had a little more in-depth. It was quickly discovered that our conversation had much more merit to become a formal meeting, so we scheduled an hour to visit her at her home, where she would feel more comfortable and have access to any documentation she might need. Our friend, let’s call her Mildred, is a 70-year-old lady who, like most of the working class her age, has all her assets in IRA accounts. He has his social security and a small pension to live on and, like most people who grew up with parents from the time of the depression, he lives quite comfortably within the limits of his ‘fixed income’. Mildred came to our class because one of our emphasis is on minimizing taxes during retirement and since she now has Minimum Required Distributions, she wanted to learn everything she could about how to lower her annual income tax bill.

Our conversation was fruitful because we learned that he was replacing his windows for approximately $ 14,000. This was important to her because she plans to give the house to her daughter after she passes away. Mildred doesn’t like to owe money, so she called her certified financial planner in Maryland and told him to clear enough money for her RMD and a little more so she could pay the windows in cash. So Bob, the financial advisor, suggested that he liquidate and distribute about $ 26,000 from his IRA, where they would withhold about 30% for federal and state taxes.

That sounds like no big deal, right? Well, my training as a CFO told me to look to mitigate the costs of doing business, especially as slippery as taxes. We project your taxes for next year by completing this transaction, Mildred would be on the hook for over $ 11,000. Tax laws have gotten quite complex, especially when it comes to Social Security income. Any income from an IRA will be counted at 100% when you calculate “provisional income” or the amount of your benefit that will be taxable. Therefore, not only does the effective rate increase because you received more income, but more of your income is taxed from Social Security. There are three tiers, 0%, 50%, and 85% and once you reach those thresholds, your tax bill increases to 46%. By spilling income from your IRA, you went from an effective tax rate of 14% to one that was over 20%.

My first thought was to split the payment to the window company using this year’s RMD and then again using next year’s RMD. This would keep your effective tax rate closer to the 14% that you would incur anyway. Mildred had two options, one is to use the home equity line of credit that she had at 4% and, given that she detailed, the effective cost for her would be closer to 3% per year and consider that she would pay it off in less than 6 months. It would only have cost you about $ 600 in interest. His other option was, of course, to use interest-free financing from the window company that he could pay off in a year. Either way, this would save you $ 6,000 in taxes.

But our story doesn’t end there … during our conversation we discovered that he donates quite a bit to charity, around $ 13,000 a year. So we’re talking about a tax law called the “Tax Rise Prevention Act” that allows individuals who must distribute the proceeds from their qualifying accounts to donate directly to their charity while they count as their Minimum Required Distribution. Mildred is due to distribute $ 11,000 this year that would be added to her income and to a 14% effective tax rate which is about $ 1,500 in taxes, instead she can transfer $ 13,000 directly to her charity, satisfy her RMD and bring her bill full tax from $ 5,000 to just over $ 1,100. In other words, by understanding the tax laws, Mildred can increase her ‘take home pay’ from $ 3,200 to more than $ 3,600. Who couldn’t appreciate an increase of $ 400 per month, especially on a “fixed income”?

Now for the last piece of the puzzle, your current portfolio. An allocation comprised of 75% stock mutual funds and 25% bond mutual funds. No matter how expensive mutual funds are or the fact that someone in their 70s with a fixed income and minimal assets is so heavily assigned to the stock market, let’s talk distribution. If we agree to RMD’s schedule, there will be a time each year when Mildred will have to sell her mutual funds to get her distribution. Now the mindset is that the entire portfolio makes enough money to be able to live off interest and capital appreciation. That’s great in theory, but when the built-in rates of about 3% are taken into account the market would have to do very well to stay on track and we all know that markets don’t always go up (except of course the last 6 years, but I digress). Historically speaking, there is a bear market 3 out of 10 years and if Mildred lives another 30 years, she will have to sell her assets when they are in decline at least 10 times during her retirement. I’ve been helping people and businesses for over 20 years and nothing brings a portfolio to its knees faster than having to withdraw money while assets are losing value. Simple math tells us that if I start with $ 1,000 and the market takes $ 100 and I have to withdraw $ 100, I have $ 800 left and if the market recovers what it lost, now I have $ 880 and if we did that math again? In 4 years it would be $ 750.

So our student becomes a client when we discover that the best thing for her would be to implement and manage two strategies. The first plan is called “Sequence of Returns”, where we essentially divide Mildred’s portfolio into 3 parts; short term (3 years), medium term (5 years) and long term (more than 5 years, built forever). The basic rationale for financial planning is never to distribute assets from a volatile account. By putting 3 years of distribution into a non-volatile account (she doesn’t lose money), Mildred can be sure that the income will be there if needed. The expected rate of return is somewhat small, around 1-3%, but it is guaranteed and you will never lose your principal. Your median allowance would carry a percentage of your assets with at least 5 years, but on average around 25% of your assets. This account would have minimum volatile assets that should accumulate between 4 and 7%, we use 6% as a reference. The long-term allocation can be made in the market if necessary or it can simply be placed in a guaranteed investment so there is no loss of capital (why take the risk if it is not necessary?). In fact, we project that your standard deviation (amount of volatility) will decrease from where it originally was at 17% to 3.5% for your overall portfolio, while we increased your average rate of return from 3.58% to more than 10.5%. The second plan was to convert half of your qualifying assets (IRAs) into tax-free savings investments. By implementing this tax conversion plan, Mildred is ready to save at least $ 30,000 in taxes during retirement and increase her assets by $ 143,000 at no cost to her.

Good financial planning is about being prudent with your financial decisions and not just “staying the course” when markets go south, rebalancing when things get too good, or diversifying your portfolio allocation to mitigate risk. while capturing upside potential. It’s about identifying the costs of doing business, the risks associated with financial decisions, and the unknowns that can wipe out all profits just like a CFO for your home.

For a no-nonsense, 10-minute private conversation about your tax situation or portfolio, please email [email protected] and we’ll get to work for you. Take the next step, it’s time.