Market Volatility and Taxes – How to Minimize Both to Double Your Returns

As a prospective CFO, I find it particularly exciting to support people with their financial planning. I recently taught a local retirement income course here, which gave me the opportunity to sit down with one of the students to answer a little more thoroughly some of the questions she had. It quickly became apparent that our conversation had much more value in becoming a formal meeting, so we made an appointment to visit her at home where she would be more comfortable and have access to all the documentation needed. Our friend, let’s call her Mildred, is a 70-year-old lady who, like most workers her age, has all her wealth in IRAs. She has her Social Security and a small pension to live on, and like most people who grew up with Depression-era parents, she lives fairly comfortably within the confines of her “fixed income.” Mildred came to our class because one of our focus areas is minimizing taxes during retirement, and now that she has the minimum payouts required, she wanted to learn all about how to reduce her annual income tax bill.

Our conversation was fruitful in that we learned that she would be replacing her windows for approximately $14,000. That was important to her because she plans to give the house to her daughter once she’s over. Mildred doesn’t like to owe money, so she called her certified financial planner in Maryland and told him to liquidate enough money for her RMD and a little more so she can pay cash for the windows. So Bob, the financial advisor, suggested that they liquidate and distribute about $26,000 from their IRA, where they would withhold about 30% for taxes to the federal and state governments.

Now that sounds like it’s no big deal, right? Well, my CFO training told me to try to mitigate the cost of doing business, especially as high as taxes. We projected her taxes for the next year, if Mildred completed this transaction she would be on the hook for over $11,000. Tax laws have become quite complex, especially when it comes to Social Security income. Any income from IRAs is counted at 100% when you calculate “provisional income,” or how much of your benefit becomes taxable. So not only does the effective tax rate go up because you received more income, but more of your Social Security income is taxed as well. There are three levels, 0%, 50% and 85%, and once you hit these thresholds your tax bill will increase by 46%. By distributing income from her IRA, she went from an effective tax rate of 14% to over 20%.

My first thought was to split the payment to the window company with this year’s RMD and then again with next year’s RMD. That would keep her effective tax rate closer to the 14% she would incur anyway. Mildred had two choices, one was to use her home equity line of credit at 4% and since she was listing the effective cost to her would be closer to 3% annually and she would pay it back in less than 6 months if she only had about $600 cost in interest. Her other option, of course, was to use the window company’s interest-free financing, which she could pay off in a year. Either way, it would save her $6,000 in taxes.

But our story doesn’t end there… during our conversation we discovered that it gives quite a bit to charity, around $13,000 a year. So we were talking about a tax law called the “Tax Increase Prevention Act” that allows people who need to distribute income from their qualifying accounts to donate directly to their charity while counting as their minimum required distribution. Mildred has $11,000 to pay out in addition to her income this year, at an effective tax rate of 14%, which equates to about $1,500 in taxes. Instead, she can wire $13,000 directly to her nonprofit, satisfy her RMD, and file her entire tax bill from $5,000 to just over $1,100. In other words, by understanding tax laws, Mildred is able to increase her take home pay from $3,200 to over $3,600. Who couldn’t be happy about a $400 monthly increase, especially on a “fixed income”?

Now the last piece of the puzzle, her current portfolio. An allocation that is 75% equity funds and 25% bond funds. No matter how expensive mutual funds are, or the fact that someone in their 70’s with a steady income and minimal assets gets so heavily invested in the stock market, let’s talk about distribution. If we stick to the RMD schedule, at some point each year Mildred will have to sell her mutual funds to receive her distribution. Now the mindset is that the entire portfolio makes enough money where it can live on the interest and capital appreciation. In theory that’s great, but when you factor in the embedded fees of around 3% the market would have to do very well to stay at that rate and we all know markets don’t always go up (except for the last 6 years of course but I digress). Historically there is a bear market 3 years out of 10 and if Mildred lives another 30 years she will have to sell her fortune at least 10 times during her retirement as it dwindles. I’ve been helping people and businesses for over 20 years and nothing brings a portfolio to its knees like having to take out money while assets are falling in value. Simple math tells us if I start with $1,000 and the market takes $100 and I have to withdraw $100 I’m left with $800 and if the market recoups its losses I’m now holding $880 if we still do this math would do once? In 4 years it would be $750.

Thus, our student becomes a client when we determine that it would be in her best interest to implement and manage two strategies. The first plan is called “Sequence of Returns” where we essentially divide Mildred’s portfolio into 3 parts; short-term (3 years), medium-term (5 years) and long-term (more than 5 years, built to last). The fundamental tenet of financial planning is that you never allocate assets from a volatile account. By placing 3 years of distributions in a non-volatile (no loss of money) account, Mildred can rest assured that the income will be there when needed. The expected return is a bit small, around 1 – 3%, but it is guaranteed and will never lose its capital. Your middle allocation would carry a percentage of your wealth with 5 years as a minimum, but on average around 25% of your wealth. This account would contain very minimal volatile assets that should return between 4% and 7%, we use 6% as a benchmark. The long-term allocation can be made in the market when needed, or simply invested in a guaranteed investment so there is no loss of capital (why take the risk when you don’t have to?). In fact, we have predicted that their standard deviation (volatility) will decrease from originally 17% to 3.5% for their overall portfolio, while increasing their average return from 3.58% to over 10.5%. The second plan was to convert half of their qualifying wealth (IRAs) into tax-free savings investments. By implementing this tax conversion plan, Mildred is poised to save at least $30,000 in taxes during her retirement and increase her wealth by $143,000 at no cost to her.

Good financial planning is about being prudent with your financial decisions, not just “staying the course” when markets are down, rebalancing when things are getting too good, or diversifying your portfolio allocation to reduce risk and at the same time exploit upside potential. It’s about identifying the costs of doing business, the risks associated with financial decisions, and the unknowns that can wipe out any gains, just like a CFO would for your household.

If you would like a 10-minute, hassle-free private conversation about your tax situation or portfolio, email and we’ll get to work for you. Take the next step, it’s time.