Episode 28: Tax Planning Strategies for Turbulent Times Part 2

In Part 2 of this three-part series, Brett shares best practices for tax efficient investing.

In our last episode, we introduced some of the tools of the tax planning trade. And these included tax-sheltered accounts for saving towards retirement, healthcare and education, as well as some tax efficient tools for charitable giving, emergency spending, and estate planning.

But it’s one thing to have the tools. It’s quite another to make the best use of them. In other words, your tax planning techniques matter at least as much as the tools themselves. Because they’re also much more enduring, especially if you can combine them into a unified strategy across your varied financial interests. Tax breaks are going to come and go and are way beyond our control. But with a tailored, tax-wise strategy in place, it’s much easier to adjust as needed, rather than having to start all over again whenever something seems to change.

Effective Tax Planning Reduces Your Lifetime Tax Bill

So, let’s talk about tax planning. In the big picture, it’s not unlike a piece of artwork. Your best tax planning efforts include meticulous attention to the details, as well as to how each action contributes to your bigger picture. We view effective tax planning as a way to reduce your lifetime tax bill or beyond, especially if you’re preparing for a tax efficient wealth transfer to your heirs, let’s say through the sale of a business.

Because in short, tax planning is best considered an ongoing campaign. It’s going to be staged on multiple fronts. And it makes the best use of the tools described in our previous episode. But for us, it begins with your investment techniques, which we’re going to cover in today’s episode.

Tax Efficient Investing

We like to lead with tax-wise investing. Because one of the most powerful ways to ward off excess taxes is to be tax-wise about your investing every step of the way. And yet few business owners take full advantage of the many opportunities available at every level. These levels include how you manage your investments, how you select individual holdings, and how you buy or sell those holdings along the way.

So, as you manage your investments, are you doing all you can to build, manage and spend down your taxable and tax-sheltered accounts for maximum lifetime tax efficiency? When you’re building your wealth, are you maxing out all of your contributions to the appropriate tax-sheltered accounts?

The more money you hold in various tax-sheltered structures, the more flexibility you’ll have to delete or at least defer taxes otherwise inherent when we’re building capital wealth. When you’re managing your investments, are you being deliberate about your asset location? Dividing your various assets among your taxable versus tax sheltered accounts for overall tax efficiency? Ideally, you use your tax-sheltered accounts to hold your least tax efficient holdings while locating your most tax efficient holdings in your taxable accounts.

And when it comes time to spend your wealth, have you planned how to tap your taxable tax deferred and tax-free accounts? There’s no universal answer to that question, by the way. Because cash flow planning calls for a deep understanding of the particular accounts you have and the assets you’ve got, the particular rules involved in deploying each, and your particular spending goals. All that while keeping a close eye on any changes that may alter your plans.

Choosing Your Investments

As you select your individual holdings, are you being deliberate about selecting tax efficient vehicles? Even when different funds share identical investment objectives, some may be considerably better than others at managing their underlying holdings. You also want to seek out fund managers with solid tax management practices. And what I mean by practices are first and foremost, are they patient investing?

Many fund managers will try to beat the market by actively picking individual stocks or timing their market exposures. We suggest using managers who instead patiently participate in their target market’s long-term expected growth. This not only makes overall sense, but it’s also typically more tax efficient as it involves less potentially taxable actions.

You may also want tax-managed investing. Because for your taxable accounts, some fund managers offer funds that are deliberately tilted toward tax friendly trading techniques, such as avoiding short-term capital gains and more aggressively realizing capital losses to offset gains. As you buy or sell your holdings like the fund managers you choose, are you also being patient and deliberate in your trading? Do you avoid excessive trading and short-term capital gains, which are currently taxed at higher rates?

Are You Guided by a Personalized Investment Plan?

How about this? Are you guided by a personalized investment plan? The bottom line is the fewer trades required to stick to your investment plan, the better off you’ll likely be when it comes time for taxes. Having an investment plan also facilitates your advisor’s ability to identify and make best use of tax loss and tax gain harvesting opportunities when they’re appropriate.

Tax loss harvesting typically involves three things. One, you sell all or part of a position in your portfolio when it’s worth less than you paid for it. Then, you reinvest the proceeds in a similar, not substantially identical position. And three, you can optionally return the proceeds to the original position after at least 31 days have passed to avoid the IRS wash sale rule. You can then use any realized capital losses to offset current or future capital gains without significantly altering your portfolio mix.

Proper Tax Planning Gives You More Control

It’s worth noting tax loss harvesting typically lowers a harvested holding’s cost basis. So contrary to popular belief, you’re usually just postponing rather than eliminating taxable gains entirely. So why even bother?

Well, more time gives you more control over when, how, or even if you’ll realize those gains. For example, you can wait until tax rates are more favorable or reduce embedded gains over time through gifting, charitable, or estate planning tactics.

Tax gain harvesting involves selling appreciative holdings to deliberately generate taxable income. So why would you do that? Remember, your goal is to minimize lifetime taxes paid. So especially once you’re tapping your portfolio in retirement, you may intentionally generate taxable income in years when your tax rates are more favorable. And then you’d preserve your tax favored income for years when your rates are going to be higher. Basically, you’re sacrificing a tax return battle, hoping to win the tax planning war.

Managing for tax efficient investing is just one way we help business owners reduce their lifetime taxes. We also then help integrate all of what we talked about today into their broad financial interests. And we’ll cover that in our next episode.