Avoid Paying Taxes on Gains
Do you, like many investors, have investment holdings that you’ve retained simply to avoid paying taxes on the gains? Tax avoidance is not a valid reason to hold on to an investment, and many situations should cause you to realize your gains, pay the taxes and feel good about paying the taxes. For example, if a holding is no longer appropriate for your situation if there has been a notable change in the underlying fundamentals of the holding, if the position has been come overvalued versus its peers, if the likelihood of future price movement is to be negative, etc.
Control Your Taxation
Realizing taxes doesn’t mean letting taxes run amuck. There are several opportunities to create a lower and more consistent tax rate throughout your retirement.
The most basic technique starts well before retirement and requires that you structure pre-retirement savings in a fashion that creates an appropriate mix of Qualified (pre-tax) and Non-Qualified (post-tax) savings. While Qualified savings are attractive for deferring current taxation, future distributions from these plans typically offer little tax flexibility and are fully taxed at ordinary income rates.
Accumulating an appropriate mix between Qualified and Non-Qualified dollars will allow you to examine your tax situation each year of retirement and manage distributions in the proportion that is most advantageous for that year’s circumstances. Each year’s decision should involve the counsel of both your accountant and your investment advisor.
Is Your Portfolio Structured To Generate Income?
The concept of simply selling a portfolio holding to meet retirement income needs will likely be fine when investment markets are doing well, but how would it have worked in the downturn of 2008? More specifically, how would you have felt about paying notable capital gains in a year where the markets produced significant losses?
To create a sustainable strategy, it will be important that as much of your planned distributions as possible are based on ongoing income versus portfolio appreciation. A well developed, and well executed, strategy to create a regular income flow via sources like prudently managed individual bonds or the regular dividend payments from income-oriented stocks can provide the required income without having to sell an investment prematurely.
As you prepare for retirement, maximizing portfolio growth should become secondary to a steady and consistent income generation. Unfortunately, very few people transition their investment portfolios towards income generation soon enough, if ever at all. This transition should be carefully planned ten years before retirement with implementation beginning five years before retirement.
Put Your Taxes On A Payment Plan
While it won’t reduce your total amount of taxes due, the end of the calendar year does provide an opportunity to spread the payment of taxes on realized gains over a two-year period. If you sell half of a position in late December and then sell the other half in early January, you can split the tax reporting, and payments, over two years and ease your cash-flow. Additionally, if needed, don’t overlook the ability to take a distribution from the portfolio to pay the taxes – taxes are merely a cost of managing the portfolio.
Note that tax avoidance is not a sound rationale for portfolio management decisions. Over the years, we have regularly encountered situations where the investment loss that was avoided is significantly higher than the taxes were paid at the time of the sale. The alternative is self-correction or circumstances where tax ‘problems’ solve themselves as investment gains turn into losses. Think of it this way — it’s better to get 85% of something versus 100% of nothing.
Bradley R. Newman, CFP®, is the Senior Investment Advisor & Director of Financial Planning for Roof Advisory Group, Inc. Follow him on LinkedIn by clicking here or send Brad your investment questions by clicking here.