Early each morning, I usually read financial articles and recently came across one by SmartAsset™ entitled How to Avoid Capital Gains Taxes: Helping People Make Smart Financial Decisions.
This article prompted me to write this ONEIDEA.
The basic premise of the article is that “saving for retirement is all about investing and no matter how you go about it, you’re going to end up paying taxes on what you save and earn. Taxes on capital gains can eat up a significant portion of your earnings each year.”
The article goes on to discuss how retirement investing (or savings) can be accomplished in a variety of ways to avoid taxes on capital gains, specifically by:
- Choosing long term growth investments under the premise of a buy and hold strategy (for a year or longer) to pay a lower capital gains tax rate when the investment is sold (presumably) for retirement income purposes. Short term capital gains (on assets held less than a year) are taxed at ordinary income tax rates versus long term capital gains which are taxed at a much lower rate, under our current tax regime. This option involves investing after-tax dollars and paying capital gains taxes along the way. I will call this “tax now – tax later”.
- Choosing to invest in tax deferred arrangements -such as a 401(k) or IRA, thereby avoiding all taxes during the accumulation phase and paying ordinary income taxes on distributions during retirement. This option involves investing pre-tax dollars and paying taxes on invested dollars (basis) AND paying capital gains on distribution. I will call this “no tax now – tax later”. Or, a Roth alternative to a 401(k) or IRA, if available based on your earned income, to avoid taxes on distributions altogether. This option involves investing after-tax dollars and having the ability to take all distributions of both basis and gains tax free during retirement. I will call this “tax now – tax never”.
- Choosing to offset capital gains with capital losses or by tax-loss harvesting. The premise of the offset strategy is that any gains on good investments will be reduced by selling bad investments for a loss, thereby reducing the amount of capital gains taxes owed. I will call this “tax-maybe now – tax-maybe later”.
But what about reinvested dividends in non-qualified accounts? Aren’t they taxed also? Dividends have historically been a meaningful part of the equities market as measured by the S&P 500, averaging around 2% per year, so not an insignificant amount of the total return on equities. Dividends can be taxed as qualified – at the capital gains rate, or non-qualified – at the ordinary income rate.
And what about Qualified Plans, are they not also taxed at death? The Secure Act of 2020 allows 10 years to spread the taxes on inherited qualified money, versus the previous lifetime stretch for beneficiaries that many tax experts had deployed previously to alleviate the tax in inherited qualified plans.
And annuities? Yes, they are taxed also. Accumulated gains are distributed and taxed first as ordinary income, then basis, unless they are annuitized and only then does the annuitant get a portion of each payment distributed tax free, as calculated by an exclusion ratio on each annuity payment. At death, all gains are taxed as “Income in Respect of a Decedent” and subject to the ordinary income tax rate of the beneficiary, although a 5-year stretch may be implemented.
Complex stuff, right? And hence the need for a savvy investment advisor who understands the tax implications of these complexities and can find a balance that will best suit a consumer’s needs during the accumulation phase (the working years), the distribution phase (retirement years) and the transfer phase (at death). Consumers should have an asset “location” (notice that I didn’t say “allocation”) strategy that will:
- Reduce the expense drag of taxes on reinvested capital gains and dividend distributions during the accumulation phase;
- Create both taxable and tax-free income during retirement, including a Social Security Income (SSI) strategy, because to top off all this complexity, if your client earns too much taxable income, 85% of their SSI benefits could be fully taxable; and
- Minimize the tax impact to a consumer’s beneficiaries to maximize the legacy value of the estate.
The SmartAsset™ article states that “according to a 2021 Fidelity study, financial advice can add between 1.5% and 4% to account growth over extended periods”, as seen in the graph below:
I strongly agree with this statement, but the conversation goes well beyond just capital gains taxes, as proposed by SmartAsset™. The complexities of asset “allocation” (the prudent amount of different asset classes) and asset “location” (the prudent amount of different assets such as non-qualified investments, qualified investments, annuities, insurance) should be paramount to the advice provided by a fiduciary financial advisor.
One asset that can be a critical component to a prudent balance of asset location could be cash value life insurance, and it is rarely discussed or implemented by the financial advisor community. Whether the recommendation may be an equity-based insurance solution (variable life), an equity index-based solution (index life), a fixed income solution (universal life) or a guaranteed solution (whole life) is a question of client suitability, advisor preference and what the composition of other client assets may look like.
The tax benefits of cash value life insurance are many, including:
- It behaves as a Roth IRA without the income limitations for contributions – it is a “tax now – tax never” strategy in that contributions are made after tax, but all growth is tax deferred, and all distributions are tax free, so long as the contract meets the definition of a Non-Modified Endowment Contract (Non-MEC).
- In a non-equity-based solution, it can act as a source of funds for retirement income during down or volatile markets, preventing a client from selling equities into losses for consumption purposes, thereby providing time for the equities to rebound in value.
- At the time of death, the “stepped-up” insurance proceeds are completely income tax free to the beneficiaries and can further be sheltered from estate tax inclusion if the client has a meaningful estate, through proper ownership.
- Additional benefits, such as Long-Term Care, can be added to life insurance, further protecting other estate and retirement assets from depletion during end-of-life care situations.
Cash value life insurance can be a very compelling “location” for accumulation, distribution, and transfer assets. However, many investment advisors loath cash value life insurance because it takes away assets under management from their care. Insurance and risk management solutions are critical to the completion of any financial plan and can protect portfolios under an advisor’s care from depletion for other needs and replenish assets for the next generation at death.
Finally, new insurance solutions are available for non-insurance licensed, non-FINRA registered investment advisors that will allow these advisors to construct and manage portfolios and charge their customary fee in their AUM model. These are no-load or low-load solutions that fit the investment advisors fiduciary model.
Contact AgencyONE’s Marketing Department at 301.803.7500 for more information or to discuss a case.