Paying Taxes For Safety

About a week-and-a-half ago I had an appointment with a very nice couple. They are married, in their middle to late 60s, are very successful, have brought up a very nice family and are recently retired. Let's call them Dan and Ann. Dan and Ann have about $2 million or so in assets and are concerned that they do not have a financial system in place that will support their retirement dreams. After reviewing their current portfolio, I discovered that they do not have any downside risk management, that they are heavily weighted in risky assets, and that they have significant capital gains. I asked Dan why he has not sold some of their stocks and rebalanced their portfolio. Dan replied that he does not want to pay Uncle Sam anything more than he needs to.

Ah, taxes. I hear it all the time, “I pay too much tax,” or “How do I pay the least amount of tax legally?” Tax planning is one of the most critical, yet often overlooked aspects of creating a sound retirement system. I also find it to be one of the most misunderstood. Although a sound retirement system needs to have a balance between tax planning, investment planning, and income planning, paying the least amount of tax should not be the principal goal.

Having a well-balanced, tax-efficient portfolio does not always mean paying the lowest amount of taxes every year. A well-balanced portfolio is one that rebalances the higher risk positions on a periodic basis to ensure that the percentage of a portfolio invested in higher risk assets remains level and consistent as the portfolio develops. In addition, retirees should never place their assets at undue risk in order to save a few tax dollars.

I explained to Dan and Ann that the question they should be asking is whether they should consider paying taxes on a portion of their gains in order to reposition their portfolio to safety. This practice is known in the industry as “rebalancing.” Typically, tax consequences should be considered as only one piece of a larger business decision, in this case, maintaining the relative balance of safe or low-risk assets to higher risk assets in the portfolio. Folks, we should never let the “tax tail wag the dog.”

With that said, let's talk about whether you, AdvancedFolio readers, should consider rebalancing your portfolio. I explained it to Dan and Ann this way. Let's say that you are a fisherman on the bank of a river. You catch 100 fish and you lay them on the river bank. Out of the corner of your eye, you see a very large alligator that has strategically positioned himself at the edge of the water right in front of your catch! You have two options. First, you can throw a few fish back in the water for the alligator to eat, say three of the 100. This will occupy the old gator while you safely gather your catch and head for the hills. Second, you can take your chances that the alligator will either keep his distance or will come to shore and eat maybe 10, 20, 30 or even more of your fish. What would you do?

Dan and Ann began to see my point. Dan said that he thinks it's probably wise to consider throwing a few fish back to keep the gator busy while moving the rest of his catch to safety. He is correct, as capital preservation must be the cornerstone of a sound investment plan.

Let me explain my analogy. If you invested $80,000 and it has grown to $100,000, then you have a $20,000 capital gain. Most taxpayers would pay about $3,000 in taxes if those appreciated assets were sold ($20,000 gain multiplied by a 15 percent capital gains tax rate). The alligator in my example is market risk, the risk that your portfolio will have a significant drop in value. Throwing a few fish back is like paying taxes on the capital gains, which will allow you to retreat to safety and rebalance your portfolio. Again, I think it's prudent to pay $3,000 in taxes in order to move the entire $100,000 to a safer position, or at least to consider doing so. After all, if the market falls, the investor in my example could lose $10,000; $20,000; $30,000 or more in market losses! And remember, I said earlier that Dan and Ann have no downside risk management so a significant loss could prove catastrophic.

Now I remember the day when there were no capital gains tax rates, period. That is, when all gains were taxed at ordinary income tax rates. Therefore, my guidance is this. Capital gains taxes are quite reasonable at the present day. Investors should consider paying these taxes in order to consistently rebalance their portfolios to help minimize downside risk. Some investors may even have no capital gains tax to pay if they sell off appreciated assets.

For example, those who are in a 10 percent or 15 percent ordinary income tax bracket pay zero percent in capital gains taxes. That's right, zero! Other investors may have positions which have lost money or they may have long-term capital loss carryovers which will allow them to offset today's gains with yesterday's losses. (By the way, no, the $3,000 limit does not apply to the offset of capital gains.) This provision in the tax code actually allows taxpayers to deduct an additional $3,000 over and above any offset of gains against past losses. Many stockbrokers fail to think through these very simple tax considerations and therefore their clients are missing the opportunity to sell appreciated stocks in order to rebalance a portfolio with absolutely no tax cost whatsoever.

So, back to the question, should you consider paying taxes on a portion of your gains in order to reposition your portfolio to safety? Yes. All investors should consider liquidating securities with gains in order to consistently rebalance their portfolios according to their risk tolerance. Investors should also, however, evaluate the tax consequences of their actions in order to make informed decisions.

Folks, don't let that pesky alligator come back to bite you. Book your free discovery call and discover how AdvancedFolio can help you keep more of your hard earned money!

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