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Tax Efficient Investing and Distribution Strategies

Remember taking a personal accounting class in high school or early college? You probably have some vague memories of the professor explaining the difference between a 401(K) account and a Roth IRA, or maybe manipulating spreadsheets to learn basic budgeting. You may also recall a short section on tax efficiency.


Chapter 1


It’s a concept that ultimately has the power to make or break your retirement, yet it’s a topic that many know very little—if anything at all—about. You might have learned about it briefly in school, from a publication like Forbes, or in a book you read one weekend that a friend shared with you. What we’re suggesting here is that you likely haven’t spent much time thinking about tax-efficient investing as a significant piece of your financial or retirement plan. Taxes are our greatest lifetime expense yet many find themselves “setting and forgetting” their savings strategy for the rest of their life, despite the need to evaluate one’s investment strategy on an annual basis.

Tax-efficient investing is not a static strategy. It must evolve as your financial situation changes and as tax policy continues to be morphed by Congress and the IRS. This is where a skilled professional, and financial planner, can help you. Rather than needing to juggle all of these changes yourself, a talented financial planner can consult with one’s tax professional to understand important changes to tax policy. Good tax professionals can see the client implications of tax policy changes and work proactively to protect your unique interests, your saving strategy, and eventually your distribution plans for retirement income.

Through tax-efficient investing, which is a balance of pre-, post-, and tax-free investments, you can potentially maximize your ability to draw from your nest egg when you ultimately enter retirement. It’s not just a worthwhile strategy—it can be essential to your success in retirement.


Chapter 2

The Evolution of Tax Policy

Nothing is certain but death and taxes—a phrase attributed to a letter written by Benjamin Franklin in 1789 still holds true over 230 years later. Taxes have, in many ways, shaped this country. The Civil War resulted in Congress passing The Revenue Act of 1861, which levied a tax on incomes more than $800. It was the first income tax in the United States, and although rescinded in 1871, it paved the way for our federal government to develop our modern tax system – for good or ill.

In 1913, the federal government introduced the 16th Amendment to allow income taxes to be reintroduced. Quickly after this, our government established an income tax for citizens earning over $3,000 annually. This new tax only affected 1% of the population at the time. Fast forward to WWII and Roosevelt’s New Deal, which ratcheted up taxes to fund the effort to boost the economy. By 1936, the highest tax rate was 76%—a figure that’s difficult for most of us to wrap our heads around today.

The incredibly high tax rates of this time were not destined to go away any time soon. The highest tax rate was over 80% well into 1950. Rather than reeling in these astronomical rates, Congress instead started rolling out deductions for specific circumstances. Then, in 1981, Reagan’s Economic Recovery Tax Act lowered all the individual tax brackets by 25%, and then again, in 1986, top rates were reduced from 50 to 28%.

The late nineties saw the introduction of negative income tax, a hidden spending program that gave tax credits to people who paid no taxes. Essentially, this program was intended to guarantee a basic income to people below the threshold for tax liability without needing to rely on the welfare system.

Of course, the last twenty-odd years are what we’re all most familiar with. Income tax is currently split into seven brackets, with rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%. Federal capital gains taxes are currently at 0%, 15%, or 20% - or possibly 23%, depending on the asset in question. Worth noting, too, is the recent decline in tax revenue—the 2017 Tax Act cut corporate tax rates from 35% to 21%. That, paired with increased federal spending, has accelerated our national debt to over $30 trillion. Not to mention the costs of benefit and social spending programs like public pensions, Social Security, and Medicaid, which are expected to expand enormously as Baby Boomers leave the workforce and enter retirement.

Taxes are a very different beast than they were a hundred years ago—or even fifty years ago. And they’re likely to continue to evolve and change in the coming years, especially considering our national debt.

Who’s going to pay for it? We are.

Despite this, we often see folks extrapolating current conditions into the future—tax rates are historically low, and people expect them to remain that way forever. Some are even basing their investment strategy on today’s tax policy, blissfully ignorant to the inevitable changes that loom on the horizon.

The danger of optimism bias is its power over our decision-making. It’s the teenage adage, “I’m invincible!” feeling as you race down the highway going twenty over the limit. Optimism bias convinces us that everything will be alright, despite the flashing lights all around. In finance, it placates us into thinking that today’s markets and tax policy will remain the same forever. This is just not the case. In fact, many tax brackets are expected to condense in the coming years, and people may find themselves in a higher tax bracket than expected.

One thing, however, that will hold true is that taxes are life’s greatest expense.

This is where tax-efficient investing comes into play. By having a balanced, tax-efficient investment strategy, savvy savers can increase their net rate of return despite inevitable changes to tax policy.


Chapter 3

Issues with Tax-Deferred Investments

All too often, new clients come to us with the bulk of their investments in a 401(k) account. They began building up this investment account in their twenties when they entered their career and let it build for years without taking a step back to analyze their strategy. While there’s nothing wrong with tax-deferred accounts like a traditional 401(k) or a traditional IRA, trouble arises when they’re the only accounts in a person's retirement savings strategy.

These accounts require people to pay taxes on withdrawals at the time of the withdrawal. Right now, someone who wants to live on $50,000 each year in retirement would need to draw $67,000 to $68,000 from tax-deferred accounts to pay for taxes. And this is likely to change in the future as tax policy evolves, either for better or worse – and probably for worse. For anyone unaware of the reality of tax deferral, it’s a harsh realization that their investments aren’t worth nearly as much as they perceive them to be from their retirement account statements.

The 401(k) is a necessary piece of the puzzle. But it must be paired with those post- and tax-free investments to create tax efficiency for the future. The reality is that the 401(k) was created almost accidentally in 1978 when Congress altered the tax code with the Revenue Act of the time. Early proponents of 401(k) plans had no idea what was to come—that the 401(k) would largely replace “safe” pension plans and expose more and more workers to the rise and fall of the stock market. That, coupled with a widespread lack of financial literacy about tax-deferred investments, leads us to where we are today. Too few people practice tax-efficient investing.

You’re far from alone if you’ve been placing all your eggs in one basket in preparation for retirement. On the bright side, it’s never too late to improve your retirement savings strategy and implement tax-efficient investing. You deserve a successful retirement, and we can help you achieve it. Building wealth is the first step, but a competent fiduciary can help you retain that tax efficient wealth well into retirement. As Tom Sedoric wrote, “Remember it is not what you make, but what you keep, after taxes and expenses, in investing that matters most.”

Steward Partners Investment Solutions, LLC (“Steward Partners”), its affiliates and Steward Partners Wealth Managers do not provide tax or legal advice. You should consult with your tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.

When Steward Partners Investment Solutions LLC, its affiliates and Steward Partners Wealth Managers provide “investment advice” regarding a retirement or welfare benefit plan account, an individual retirement account or a Coverdell education savings account. Steward Partners is a “fiduciary” as those terms are defined under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and/or the Internal Revenue Code of 1986 (the “Code”), as applicable. When Steward Partners provides investment education, takes orders on an unsolicited basis or otherwise does not provide “investment advice”, Steward Partners will not be considered a “fiduciary” under ERISA and/or the Code. Tax laws are complex and subject to change. Steward Partners does not provide tax or legal advice. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account.

Securities and investment advisory services offered through Steward Partners Investment Solutions, LLC, registered broker/dealer, member FINRA/SIPC, and SEC registered investment adviser. Investment Advisory Services may also be offered through Steward Partners Investment Advisory, LLC, an SEC registered investment adviser. Steward Partners Investment Solutions, LLC, Steward Partners Investment Advisory, LLC, and Steward Partners Global Advisory, LLC are affiliates and separately operated. The Sedoric Group is a team at Steward Partners.

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