One of the most important concepts in investing is diversification. When you are appropriately diversified, your portfolio is spread amongst multiple sectors of the market so losses in one area can be mitigated by gains in another. This is referred to as market diversification.
One area of diversification that we focus on in our planning is tax diversification. During retirement, your largest bill won’t be food, or housing, or even health care (that’s your second largest). Without wise planning, your largest bill (by far) will be taxes.
We have all been told throughout our lives, “Invest in your IRA! Save on taxes!”. What they don’t tell you is that in retirement EVERY DOLLAR will be taxed in full. How much you pay in taxes during retirement, when you are on a fixed income, is largely out of your control. Retirement is the time when you need flexibility and control over how much tax you pay, so you can live the lifestyle you want to live.
We believe in diversifying your portfolio to include all kinds of tax situations – tax-deferred, tax-free, and taxable (also known as non-qualified). That way, when you retire, you’ll have some control over how much tax you pay.
We consider our clients’ current and future potential tax situations, and work with their tax advisors to make sure we are putting the best plan in place. The earlier you start planning, the easier it is to be tax diversified – contact our office to get started!
If you have investments in the stock or bond market, chances are you are using mutual funds to appropriately diversify yourself. That’s a very wise and important choice. But do you know what you actually own? Do you know what is going on inside of those funds?
Every one of those funds has an expense ratio. It is expressed as a percent of the value of the fund. (If you are wondering what your expense ratios are, you can go to finance.yahoo.com and enter the ticker symbol.) These expense ratios reflect the expenses inherent in the fund that the SEC requires the fund to disclose to you. But there are a variety of expenses and inefficiencies that they are NOT required to disclose. These include transaction fees, commissions, soft dollar accounts, trade desk conflicts, over-diversification, and others.
If you own these funds in a non-IRA account, taxes can become a major issue. If a fund manager is doing a lot of active trading, that turnover could generate short-term or long-term capital gains for you, even if you have owned the fund for years. Those capital gains are passed on to you in the form of a 1099 each Spring, and must be filed with your taxes, increasing your bill to the IRS. But capital losses, which could mitigate those taxes, are not passed on to you. They are retained by the fund to help with their own taxes.
All of these things have a significant drag on the performance of the fund. Forbes Magazine estimated in 2011 that costs, taxes, and inefficiencies contribute an additional 2.5% – 3% annually, on top of the expense ratio. This can result in a 50% lower return over just 10 years.
At Rocky Mountain Financial Designs, we are dedicated to cost-efficient, tax-efficient investing. Our investment firm, Townsquare Capital, is revolutionizing the industry using a system known as Separately Managed Accounts (SMA). These strategies cut out the middleman (the mutual fund) with all its fees and inefficiencies. By doing so, we can potentially increase your performance by 2% – 3% without changing the amount of risk you are taking.
You used to need millions of dollars to participate in an SMA. But with the advent of technology, Townsquare has negotiated with the top SMA managers in the country to bring their minimums down. We can now get you into a well-diversified SMA plan with about $250,000 in investable assets.
If you’d like, we can do an audit of your current portfolio. We will “pop the hood” on your mutual funds and tell you what exactly you own, what the fees are, where the inefficiencies are, and whether an SMA plan would be advantageous to you. Schedule an initial consultation, or contact us for more information.
The US Congress doesn’t always make good decisions. But in 1997, they passed a law creating a powerful tool for retirement. It was named for the principal sponsor of the bill, Senator William Roth of Delaware. Thus the Roth IRA was born.
Here’s how it works: you make contributions with after-tax money. Your account grows tax-free. Then in retirement, all your distributions, both principal and growth, come back to you tax-free.
But since Congress didn’t want to give up too much of that tax revenue, they put restrictions on use of the Roth. First, you can only contribute $6000 (2019) to the account each year ($7000 if you’re over 50). That is simply not enough to retire on, especially considering inflation.
Second, if you make too much money you cannot contribute. If you are making between $193,000 and $203,000 (married filing jointly) your contribution limit is reduced. Over $203,000 and you cannot contribute at all.
Third, you don’t have access to all the money in the account. You can pull out your contributions, since the IRS has already taxed you on it. But if you try to withdraw the growth before you are 50 ½ you will pay a 10% penalty.
There is another way. A strategy exists that we have dubbed the “Super Roth” strategy. It works the same as a Roth, in that you contribute after-tax dollars. It grows tax-free and comes back to you tax-free. There are NO contribution limits, NO income limits, and you can access about 80% of the value with no penalties.
This strategy is not for everyone. It is a little more expensive to maintain than a regular account. But having a tax-free asset is a critical part of a solid retirement plan. (To compare its value to a tax-deferred account, just add your tax bracket to the total value.) Check out our explanation of tax-diversification below or let us know if you would like to learn more.