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Tax Conscious Investing and Withdrawal Strategies

By WJ Rossi, CFP, ChFC, Partner, Koss Olinger & Company*

Tax strategies can have an enormous impact on future wealth, which is why any financial planning should take a “tax-aware” approach to the management of your assets. Investment accounts usually fall into one of three categories: taxable, tax-deferred and tax-free. Where your funds are invested across the spectrum of these three options and how you take withdrawals can impact the size of your overall nest egg. It is also important to consider whether or not investment profits are going to be taxed as short-term investments, which puts them under the higher ordinary income tax rate, or as long-term investments, which benefit from a rate that ranges from 0% to just over 20%. (The ordinary income tax rate tops out at 39.6%.)

In the simplest terms, you want to minimize your taxes by generating the largest tax bills in tax-deferred account. This enables you keep your investments growing over the years before having to fork over these funds, which could otherwise grow for you, to the government. The bucketing (of assets) approach that we use at Koss Olinger, focuses on locating assets where they can receive the most protection from taxation. An advisor and a client may, for example, have to determine when it is advantageous to do a Roth conversion or take money out of an individual retirement account. Each client tax situation will be different. Generally, a withdrawal plan will take from taxable accounts first, then tax deferred, then tax free last.
Generalizations, however, rarely apply to everyone all the time. For example, if a couple’s tax status Married filing jointly and the couple wants $100,000 income per year – assuming they have all three types of accounts- they may want$25,100 of tax-free money to stay in the 15% bracket (15% bracket goes up to $74,900). Individuals will want to look at their specific situation and coordinate with their investment advisor and tax advisor, as we do for our clients.

While tax location may have the largest impact on the minimization of taxes, selecting tax efficient investments is also important. Low turnover funds, for example, earn a higher “tax-adjusted” return than high turnover funds. (Turnover is a measure of how often an investment fund sells and buys the value it holds in securities.) The average actively managed US-stock fund, for example, has a turnover ratio of 65%1, which means it is selling roughly 60% to 70% of those assets every year. This is bad for two reasons: 1) this implies sizeable gains from sales that will be taxed and 2) it implies that any gains are short-term in nature and, therefore, subject to the higher ordinary income tax rate. An investment, which has an underlying rate of return of 7%, could return as much as 6.17% annually over 20 years after taxation if 30% of assets are subject to short-term capital gains rates, but would earn only 5.06% annually over 20 years after taxation if more than double the number of assets (70% of assets) are subject to short-term capital gains rates. That is more than one percentage point of return every year if a high turnover fund were held.

Yet another way to protect assets on the bond side is to purchase municipal bonds, whose income stream is tax-exempt from Federal income taxes and typically tax-exempt in the state or municipality from which they were issued. While Florida does not tax income, the benefit of avoiding Federal taxes should not be underestimated.

1 Clements, Jonathan, “Cut Your Investment Taxes,” Wall Street Journal, April 19, 2015

*Securities Offered Through ValMark Securities, Inc. Member FINRA/SIPC. ValMark and Koss Olinger are separate entities. Advisory Services offered through Koss-Olinger Consulting, LLC., An SEC Registered Investment Advisor
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