Maximizing your retirement wealth

By David B. Synder, JD, CLU, December 3, 2018

For nearly all dermatologists, getting to retirement on their financial terms — whatever they may be — is their number one financial goal. This is not surprising, as it is the goal of most physicians in all specialties. In this article, I will address one long-term strategy that is under-appreciated in retirement planning, along with a few other tactics that can be helpful in this endeavor.

Tax diversification as a long-term strategy: Because we don’t know what future taxes will look like

Most dermatologists have heard of the term financial term diversification. Typically, they know it only as applied in investing and asset allocation, where one should diversify the asset classes in one’s portfolio because this can reduce risk without sacrificing long-term returns. Certainly, this is a fundamental rule of investing.

Here, however, I am referring to tax diversification, which means building wealth in multiple buckets’ that will be taxed differently in retirement (at least under current rules). These three buckets are:

1. Assets subject to ordinary income tax rates upon distribution in retirement (typically, qualified retirement plans like 401(k)s and profit-sharing plans where one gets a deduction for the contribution)

2. Assets subject to capital gains tax rates when they are sold to generate retirement cash (typically, securities in a brokerage account, non-home real estate, and other business interests)

3. Assets not subject to tax upon distribution (such as Roth IRAs and, if managed properly, cash value life insurance).

The illustration below may help you to envision the value of having differently taxed buckets to draw on when you reach retirement.

When planning for retirement, we believe it is essential to diversify your wealth to tax rate exposure. Because the retirement/distribution of wealth phase may last for many years, or even multiple decades, being diversified across such tax buckets puts you in a position of strength and gives you options of where to draw income depending on the tax rates then in effect. For example, dermatologists who are too reliant on their qualified retirement plan in retirement may be in for a difficult time if ordinary income tax rates rise significantly once they retire. Given the history of our federal income taxes (not to mention state income taxes), one cannot ignore the risk that rates may be higher in retirementperhaps significantly higher.

Other tactics for savvy tax planning

The key concept here is that any dollar saved in taxes today may become $2, $3, $4, or more in retirement, depending on your time horizon and portfolio returns. This is one reason why being smart with taxes on investments makes sense not only on the macro level, as discussed above, but also through implementation of the following tactics as one builds wealth for retirement.

1. Consider owning municipal bonds in taxable accounts: Most municipal bonds are exempt from federal taxation. Certain issues may also be exempt from state and local taxes. If you are in the highest federal tax bracket, you may be paying tax on investment income at a 2018 rate of 40.8%. Under these circumstances, a municipal bond yielding 3% will provide a superior after-tax return in comparison to a corporate bond yielding as high as 5% in an individual or joint registration, a pass-through LLC, or in many trust accounts. Therefore, it is important in many circumstances to make certain your long-term plan utilizes the advantages of owning certain municipal bonds in taxable accounts.

2. Be cognizant of holding periods: Long-term capital gains rates are much more favorable than short-term rates. Holding a security for a period of 12 months presents an opportunity to save nearly 20% on the taxation of your appreciated position. For example, an initial investment of $50,000 which grows to $100,000, represents a $50,000 unrealized gain. If an investor in the highest tax bracket simply delays liquidation of the position (assuming the security price does not change), the tax savings in this scenario would be $8,500. Although an awareness of the holding period of a security would appear to be a basic principal of investing, many mutual funds and managed accounts are not designed for tax sensitivity. High-income investors should be aware that the average client of most advisors is not in the highest federal tax bracket. Therefore, it is generally advantageous to seek the advice of a financial professional who is aware of holding periods and has experience executing an appropriate exit strategy.

3. Proactively realize losses to offset gains: One benefit of diversifying across asset classes is that if the portfolio is structured properly, the securities typically will not move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, it creates a tax-planning opportunity. Domestic equities have experienced a consistent upward trend from the depths of the financial crisis in March 2009. However, international stocks, commodities, and multiple fixed income investments have experienced down years. Astute advisors were presented with the opportunity to save clients thousands of dollars in taxes by performing strategic tax swaps prior to year-end. It is important to understand the rules relating to wash sales when executing such tactics. The laws are confusing, and if a mistake is made your loss could be disallowed. Make certain your advisor is well-versed in utilizing tax offsets.

4. Think twice about gifting cash: This is not to discourage your charitable intentions. Quite the opposite is true. However, a successful investor can occasionally find themselves in a precarious position. You may have allocated 5% of your portfolio to a growth stock with significant upside. Several years have passed, the security has experienced explosive growth, and it now represents 15% of your investable assets. Suddenly your portfolio has a concentrated position with significant gains, and the level of risk is no longer consistent with your long-term objectives. The sound practice of rebalancing your portfolio then becomes very costly, because liquidation of the stock could create a taxable event that may negatively impact your net return.
   
   By planning ahead, you may be able to gift a portion of the appreciated security to a charitable organization able to accept this type of donation. The value of your gift can be replaced with the cash you originally intended to donate to the charitable organization and, in this scenario, your cash will create a new cost basis. The charity can liquidate the stock without paying tax, and you have removed a future tax liability from your portfolio. Implementing the aforementioned gifting strategy offers the potential to save thousands of dollars in taxes over the life of your portfolio.

5. Understand your mutual fund’s tax cost ratio: The technical detail behind a mutual fund’s tax cost ratio is beyond the scope of this article. Our intent is to simply bring this topic to your attention. Tax cost ratio represents the percentage of an investor’s assets that are lost to taxes. Mutual funds avoid double taxation, provided they pay at least 90% of net investment income and realized capital gains to shareholders at the end of the calendar year. But, all mutual funds are not created equally, and proper research will allow you to identify funds that are tax efficient.
   
   A well-managed mutual fund will add diversification to a portfolio while creating the opportunity to outperform asset classes with inefficient markets. You do need to be aware of funds with excessive turnover. An understanding of when a fund pays its capital gains distributions is a critical component of successful investing. A poorly timed fund purchase can result in acquiring another investor’s tax liability. It is not unusual for an investor to experience a negative return in a calendar year, and yet find himself on the receiving end of a capital gains distribution. Understanding the tax cost ratios of the funds that make up portions of your investment plan will enable you to take advantage of the many benefits of owning mutual funds.

When it comes to investing for retirement, dermatologists should do everything they can to be diversified tax-wise for the long term, as well as being tax-efficient tactically along the way. This article laid out a few ideas on how to do so. The author welcomes your questions. 

Disclosure:

OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site www.adviserinfo.sec.gov.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.

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