The Intersection of Taxes and Financial Wellness
This blog is being published in March, the thick of tax season. But, it’s always, as a practical matter, tax season. Unless you’re way off the grid, and probably even then, some sort of tax will be assessed to or collected from you today. If you’ve been successful or plan to be, taxes either have already come or will come to call. The difference between a family that understands that taxes are the biggest issue of their financial life and one that simply accepts whatever the forms say can be an order of magnitude.
Tax planning is not merely a seasonal activity. It’s a journey, not a destination. The most successful investors and wealth managers take a strategic approach to taxes, aiming to defer, delay, convert, offset, and even eliminate tax liabilities. Being smart about taxes spans virtually every element of financial planning, from allocating assets to disposing of highly appreciated assets to the legacy you intend to leave behind.
When combined with sound budgeting and disciplined retirement planning, strategic tax planning can produce real lifestyle security no matter how long you or your spouse will live. Your longevity and how healthy (and lucky) you are are huge variables. Memory care facilities today cost between $60,000 and $90,000 per year, although some are much higher. The typical American will spend one-half of all their lifetime healthcare expenses in the last five years of their life and one-quarter in just the last year.
Investopedia estimates that over a 16.8-year retirement, total living expenses could amount to approximately $1.56 million for residents of New York City. That assumes that the person retires at 64 and only lives to 80.8 years old. If they made it to 90, that number would be well over $2 million. Even in a low-cost, rural area, that number will be very close to $1 million for the 81-year-old and more for those who live longer.
That New York number is based on just under $93,000 per year in living expenses. There are many people who’d suggest that $8,000 per month won’t go very far in the Big Apple. Living a long life with many years retired has become a very expensive thing, and can be crippling if you need care for a debilitating disease.
According to Charles Schwab’s 2024 Modern Wealth Survey, Americans believe that a net worth of $2.5 million is required to be considered wealthy. As you can see from the numbers above, without advanced planning and smart tax strategies, just being “wealthy” may not be enough to ensure an uninterrupted lifestyle, let alone to leave a meaningful legacy.
It’s What You Keep
Any responsible financial planner will tell you that job one is lifetime lifestyle security; the client simply cannot outlive their money. Because of variables like longevity and healthcare, the total cost of a retired life can vary hugely. But there is another consequential variable, and it can make the difference between running out of money before you die and leaving a meaningful inheritance: how fast your nest egg compounds.
That same responsible planner from above would tell you that the range of average annual growth assumption of your portfolio will be somewhere between 4% per year and 10% per year. The difference will come down to an expected return on bonds, which will earn about 4% per year, and stocks, which have returned about 10% per year for the last 100 years.
That planner is not going to predict a return much above 10% because they know that you would need to speculate to make returns higher than that. Speculation is nearly impossible to predict reliably. You can get lucky with stocks; some decades have returned above 15% on an average annual basis, but some decades have been well below 10%. For planning purposes, there’s way too much risk in day trading, or short selling, or using margin, and way too big a likelihood that you’d lose money with those strategies.
How you blend bonds and stocks together will give you your gross compounding number. Just doing the math, half in bonds and half in stocks should have an expected annual return of 7%. Considering the way statistics and mean variance work, the more years you keep that blend, the more likely it is to be near that 7% number, but much will depend upon when you start your retirement. Things get a lot more complicated when we think through what is likely to happen to your gross return.
A One, Two, Three Punch
First, you can expect to pay something to have your money managed. If you use low-cost ETFs, you will reap nearly all of the return of the indexes you own. Mutual funds, which are generally much more expensive than ETFs, will cut deeper into your return. Some active managers charge as much as 2% or 2.5% to manage a stock portfolio. These portfolio custody, trading, and management fees can cut that 10% gross return by up to 25%.
Second, it’s reasonable to assume some price inflation on the goods you’ll need to buy in retirement. The CPI has been higher than its 30-year average for the last several years, but the Fed targets a 2% annual inflation rate, so it’s a fair input variable. If we cut the expected return on stocks and bonds by just 2%, the real return (after inflation) on bonds is cut in half and on stocks by 20%. After portfolio management costs and inflation, what had been a 10% return on stocks has become somewhere between 5.5% and about 7.5%.
Third, and perhaps most significantly, you will owe capital gains tax and ordinary income taxes on the money in your non-qualified accounts as you earn it, and on withdrawals from your IRA and other qualified retirement accounts as you take them. Losses will offset gains, but we assume your account will grow, so there will be net gains. This is going to put a big hit on your gross return, probably somewhere between 20% and 50%. Suddenly, that 10% return on stocks starts to look hardly worth the effort.
Let’s look at the math: your stocks earn a gross return of 10%, but management fees take 2%, so you’re down to 8%. Taxes eat, say, another 2.5%, so now you’re at 5.5%. Finally, inflation takes 2%, so what you keep is 3.5%. This scenario is not only a common occurrence; it’s virtually typical.
If you’re wondering about things like the economy, interest rates, or geopolitical events, you can stop wondering, at least as far as financial planning is concerned. Those things are all baked into the average 10% return assumption. The last 100 years in the U.S. have seen just about everything, and that’s been the approximate average annual return.
The good news here is that the variables you need to worry about come down to just four: what it costs to manage your money, how efficiently it’s managed from a tax standpoint, how well diversified it is, and how much risk you’re willing and able to take. All of those things can be controlled, which means you can have a real and potentially very meaningful impact on what your net return will be, and that may be what matters most.
A very good portfolio manager can employ a number of techniques to help you keep more of what you earn. They can use location strategies to build tax efficiency into your portfolio, such as putting bonds and dividend-paying stocks into your tax-sheltered IRA or tax-free Roth account. In addition, they can use a low-turnover trading strategy and combine it with loss harvesting, greatly reducing your tax bill.
Vanguard has estimated that an effective advisor can actually have a negative cost for you. If your advisor charges you 1% per year to manage your money but saves you 2% or 3% in tax efficiency, they have left you much better off than you’d have been on your own. It’s likely they will have the tools, the discipline, and the technology to manage your money much more efficiently than you can.
In the example above, your taxes could be much, much lower. Low fees and effective tax management can make the difference between that 3.5% return we calculated above and a 7% return. That may not seem like much at first glance, but in the world of money management, it’s a world of difference. One million dollars compounding at 3.5% for 20 years will grow to $1,989,789, but if it compounds at 7%, it will become $3,869,684, creating almost three times as much growth.
Tax-Efficient Investing Tips
Investing wisely is prudent, but investing with tax efficiency is critically important. Every dollar saved on taxes is a dollar that can be reinvested to accelerate wealth accumulation. Consider the following tax-efficient investing strategies, but as you do, be honest about whether or not you’ll be able to do them on your own. An advisor who has the right skills and tools can make a world of difference:
Long-Term Investing. Capital gains from long-term investments are typically taxed at lower rates compared to short-term gains. By holding investments for longer periods, you can benefit from these reduced tax rates by diligently selling investments that have declined in value to offset gains from other investments. This strategy even works with stocks you believe in, when they’ve temporarily lost value. Tax-loss harvesting can reduce your overall taxable income and is an effective way to manage your portfolio’s tax efficiency.
Dividend Strategies. Dividend-paying stocks or funds can provide a steady income stream, giving you the benefit of both stocks and bonds. However, be mindful of how dividends are taxed. Favoring qualified dividends, which are subject to lower tax rates, can improve the after-tax yield of your investments.
Asset Location. Strategically placing investments in taxable versus tax-advantaged accounts can have a significant impact on your tax liability. For example, holding high-growth investments in tax-deferred accounts while keeping income-generating assets in taxable accounts can help balance overall tax exposure.
By prioritizing tax efficiency in your investment strategy, you enhance the potential for compounded growth over time. This approach not only optimizes your returns but also provides a resilient foundation for your financial future.
Final Thoughts
Fiscal fitness demands a holistic approach that combines thoughtful planning, intelligent asset allocation, clarity about your risk tolerance, tax-efficient portfolio structure and management, and careful advisor selection. By integrating smart tax moves into every aspect of your financial plan, you can create a structure that reduces your tax liabilities and thereby maximizes your long-term wealth.
We encourage you to review your current financial strategies and consider how you can incorporate these smart tax moves into your planning. Consulting with financial and tax professionals can also provide personalized insights tailored to your unique situation, but it could be life-changing if you find and work with an advisor who understands the importance of tax-efficient portfolio management.
