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Tax Management

Mitigating the Tax Tumor®

In my 33 years in this business, while I agree in principal that it’s never a good idea to put all of your eggs into one basket, what amazes me is that most consumers, and apparently most advisors, have neglected to understand the importance of being tax diversified.

You see, the government has basically implemented a very complex tax system when it comes to investing. You have assets that are after-tax-taxable, you have other investments, such as 401(k) and IRA plans that are pre-tax-tax-deferred. The third type of taxation of assets are those that are after-tax-tax-deferred, and finally, you have assets, such as Roth IRAs and Life Insurance proceeds that are after-tax-tax-free.

The problem is that most hard working people are not tax diversified. That’s because they have been taught by wall street to put all of their eggs into the proverbial 401(k) basket…a basket that is full of taxes that you or your heirs are eventually going to have to pay.

I call it the Tax Tumor®, and just like any tumor, you can either deal with it now, or let it grow and get out of hand.

Over the years, the financial world has made a big deal about being “diversified” with your investments. While Tony is the first to agree that not having all of your eggs in one basket is a good way to protect more of your money, the Wall Street narrative is that diversification has potentially hurt both investors and savers alike.

Here’s what Tony has to say about Tax Diversification:

Just the other day, I had a couple come in to meet with me, and were concerned that their investment accounts were not growing. They said they liked their advisor, but never felt like they could keep up with all the paperwork; the advisor assured them that they were “diversified,” and that there was nothing to worry about (even though they weren’t making any money).

So what’s the premise behind diversification? Let’s take a simple example: real estate.

Let’s say you had a bunch of money and wanted to buy real estate as an investment. You could go out to one particular area of town and buy a large office building with all of your money. Or you could take that same amount of money and buy several small office buildings and other commercial buildings in different areas of town.

In the first example of investing in one large office building, you could make a killing on your investment. But what happens if that area of town goes south, or the tenants who occupy the building move out on you? Suddenly, your investment would be at risk.

Now, with the other example of buying different types of properties in different areas of town, you have minimized the possibility of something going wrong with one of the properties in hopes that the other properties would not suffer. On the surface, this makes perfect sense for anyone who is concerned about risk.

So in the area of Wall Street, and with the introduction of mutual funds and the growing popularity of them beginning in the late ‘80s, we saw this concept of diversification take hold. This is particularly true with the 401(k), which sometimes resembles a sushi menu with all the different selections of various types of funds that half of the consumers don’t understand. You’re lead to believe that if you start throwing darts and picking different types of funds, then you’re safe. That’s not always the case.

Maybe the answer isn’t diversification. Maybe, for savers, the answer is: just keep things simple and safe.

Last week, I mentioned clients that wanted me to review their statements and try to make sense of what their advisor called “being diversified.” We uncovered the fact that just because Wall Street has you diversified doesn’t guarantee you won’t lose money, or truly understand how to best use and enjoy it.
In my 32 years in this business, while I agree in principal that it’s never a good idea to put all of your eggs into one basket, what amazes me is that most consumers, and apparently most advisors, have neglected to understand the importance of being tax diversified.

You see, the government has basically implemented a very complex tax system when it comes to investing. You have assets that are after-tax taxable, and you have other investments, such as 401(k) and IRA plans that are pre-tax tax-deferred. The third type of taxation of assets are those that are after-tax-tax-deferred, and finally, you have assets, such as Roth IRAs and Life Insurance proceeds that are after-tax-tax-free.

The problem is that most hard working people are not tax diversified. That’s because they have been taught by Wall Street to put all of their eggs into the proverbial 401(k) basket…a basket that is full of taxes that you or your heirs are eventually going to have to pay.

I call it the Tax Tumor®, and just like any tumor, you can either deal with it now, or let it grow and get out of hand.

Tax Tumor®

For most Americans, the 401(k) is their most valuable asset for retirement. Illustrated in the graph below is a 401(k) worth $300,000. Assuming we lived in a perfect world (no taxes on the 401(k) when we go to take money out), we’d have all the $300,000 to use and enjoy. Unfortunately, we’ve got to deal with our “progressive” tax system that allows the government to take their fair share first (pre-tax really means you’re just postponing the tax).

So there’s the government’s share… bigger than life… as illustrated in the following graph. The question: what are you going to do about it? Here are your only options:

1. Ignore It.

Imagine your doctor discovering a malignant tumor within your body. You could ignore it, but if you do, all the tumor is going to do is grow and get worse. You could do the same with your tax-infested 401(k) or IRA, just pretend the tax tumor doesn’t exist and pray the next President will demand Congress repeal the tax law and give you the 401(k) tax-free (this would be a miracle!).

2. Spend It.

Yes, spend it. The financial world often tells us not to, but if you don’t spend it, Uncle Sam will get his fair share at some point anyway. And at what tax rate? If you’re like most people and believe that taxes will increase, spending it starts sounding better and better. Bigger barns don’t always mean more money in your pocket.

3. Stretch It.

The CPAs and technical folks love this option because they contend that the government is “letting” you defer the taxes. True, but what if tax rates do go up in the future? And what about inflation—if you keep deferring these dollars off into the future, what will they be worth? This idea of deferring the taxes and only taking “minimum distributions” for the rest of your life and that of your heirs, makes you wonder if deferring the enjoyment of the money is all that it’s cracked up to be. This strategy never allows you to eat and enjoy the cow. It’s only promising you a little cream off the top, while the financial world gets to use and enjoy the whole thing.

4. Insure It.

Assuming we can all agree that everyone’s going to die, why in the world would anyone NOT own some amount of tax-free “Whole Life” life insurance? In most cases, this is the only way to guarantee tax-free money to replace the tax that will surely be due at death on the 401(k) plan (unless your beneficiaries stretch it).

Life insurance is the only asset that guarantees a certain amount of cold-hard, tax-free cash when you need it, and not a minute too late when it comes to kicking the bucket. And “tax-free” beats “taxes” every time.

5. Convert It.

This is when you take the taxable cow (your existing IRA) and magically turn it into a tax-free cow. The process is called a Roth Conversion and any retirement specialist that knows anything about 401(k)/IRAs will be able to help you with this. Keep in mind that when and if you do convert a traditional IRA to a Roth IRA, Uncle Sam will want his taxes right then and there. Look before you leap!

In summary, the Tax Tumor® buried in your 401(k) must be dealt with. To get it out will be painful. You can pay Uncle Sam now, or pay him later; he really doesn’t care. The government will one day get their fair share. Your responsibility is to learn your options in order to give you and your family the best chance for keeping as much of your hard-earned money as possible. That’s why it is so important to work with a retirement specialist.

Be sure to talk to your financial advisor about your retirement options. You’ll be glad you did… and will most likely worry less about your retirement as a result.

– The Retirement Pros (Tony Walker, contributing author)
 May 2014