Tom Sedoric

I’m puzzled why there are not more discussions and articles about tax efficiency and investments - particularly when it comes to the issue of tax deferral. There are myriad posts on the importance of expense ratios, performance and management but very little is ever written on the significance of tax minimization as a portfolio is constructed. Taxes are typically our largest lifetime expense (yes, even larger than our kids). I am troubled that journalists don’t educate the public more clearly and with more frequency on such an important topic. Tax planning is far from “sexy” except to an accountant or tax attorney and me. IMCA’s (Investment Management Consultants Association of which I am a member) lead story in their most recent research quarterly was titled “Increased Tax Rates and Investment Strategy”. Like the remarkable underestimation of the potential long-term power of compound interest in creating one’s fortune, there are too few discussions about the potential shortcomings of tax deferral and the significance of tax- efficient investment strategies. 

I’ve beat this drum for a long time. Part of it is due to my personal belief that none of us get something for nothing. Sometimes it is far better to pay the proverbial (tax) piper now rather than later. It was nearly three decades ago, when the transition to 401(k) plans was taking off, that I wrote a column which drew the ire of many of my fellow advisors and my friends in the accounting profession. The abridged version goes like this: beware the myth of tax deferral. My point was to take a hard look at the long-term implications of tax deferral plans and to recognize the potentially serious drawbacks in the future. The future is here for some. There is often confusion about the benefits and mathematics of tax deferral, as well as pretax savings, because sometimes a tax deferred account or investment only defers one from paying potentially more down the road. This may not always be to an investor’s advantage. Sometimes the old fashioned way our parents and grandparents saved and invested makes sense. Owning a tax deferred asset, like the stock of a good company or fund, in a taxable account is often wiser than holding the same fund or company in a tax deferred account like an IRA or 401k. If held in an IRA, that growth company or fund will eventually be taxed as ordinary income. 

Ordinary income tax rates could be twice the level if the stock or fund had been held in a taxable account, sold, and taxed as a long term capital gain. Remember it is not what you make, but what you keep, after taxes and expenses, in investing that matters most.

My “Myth of Deferral” piece was not a popular stance to advocate especially as IRA and 401(k) plans began to fill the void left by the decline in defined-pension plans. Automatic savings can occur if a 401k is in place and can be terrific for the investor taking control of their retirement security and very profitable for mutual fund companies and insurance vendors. I think trends and events over the past three decades have given us a clearer perspective of winners and losers in the tax deferral arrangement. One reality has become quite apparent: people who do not create diversified tax efficiencies and who relied too much on tax-deferred investments in their long-term plans may find themselves hit with much greater tax burdens than they expected or needed to pay in later years. Individual tax rates have been largely declining for three decades while few experts believe tax rates will be lower in the future. The issue of tax efficiencies remains elusive I believe because it sounds dull, dry and formidable; better left to accountants. It is anything but formidable and I believe the matter of tax efficiencies resides in the same category as compound interest. It is considered dull and unexciting when compared to the latest investment scheme. In truth, tax efficiencies should be an integral part of any sound investment plan. 

In theory, if a sleeve of income-earning bonds or high yield bonds is part of an investor’s overall allocation, should these holdings be held in an individual’s taxable or tax deferred account? Why does it matter? What is the cost differential if done improperly? 

Here’s a frequent example of mine when describing this concept to a future client and it has to do with my favorite hypothetical company XYZ. In our theoretical portfolio, Investor A has a $1million investment in company XYZ, with a zero cost basis, held in a tax-deferred IRA savings account. Investor A also has $1million directly invested in company XYZ stock in their personal trust or investment account, also with a zero cost basis. On paper, both assets are worth the same except for the significant difference of future tax liability. And if the client dies with a significant IRA, the tax burden on future generations may even be higher. 

The obligation of the tax-deferred IRA is set at the income tax rate which could currently be over 40%, or higher if ordinary income tax rates increase again. The sales of stock in a taxable account would be subject to a much lower long-term capital gains tax of barely 20 percent for even the highest income investor. Assuming a zero cost basis for this hypothetical example, the IRA investment could have an after-tax value of an estimated $600,000 while the stock investment in a taxable account could be worth as much as $800,000 - a $200,000 difference! Some would call this found money, but in reality it’s a conscious choice to weigh long-term risks and benefits – and naturally unique to every investor. If an investor is blinded or distracted by the allure of tax deferrals, they may miss out on the opportunity to have greater flexibility for future earnings.

The larger issue of financial literacy and tax efficiencies is part of the ABC’s of understanding the fundamentals of long-term planning. Beginning in the late 1980s and 1990s, some began to peek around the curtain and saw a flawed tax deferral magician. 

Forbes Magazine even published an Excel calculator during this time to display the impact of tax on savings and investment. While income tax-rates dropped to their lowest point in several decades, personal savings rates have almost disappeared while inflation moderated. So the hope of paying deferred taxes with inflated dollars proved false. 

I don’t believe that tax deferred plans are inherently unhealthy though the late Sy Syms said “an educated consumer is our best customer” and the same may be true in the realm of tax deferral. Why should one pay more taxes than they need to after all?

 

Steward Partners Global Advisory, LLC and The Sedoric Group maintains a separate professional business relationship with and our registered principals offer securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC. Investment advisory services are offered through Steward Partners Investment Advisory, LLC. This information has been obtained from sources deemed to be reliable but its accuracy and completeness cannot be guaranteed. The views expressed are those of Tom Sedoric – Partner, Executive Managing Director and Wealth Manager and are not necessarily those of Raymond James.