The Importance of Properly Owning Your Investments

Today, let’s continue talking about the complexities of taxes. Taxes are the greatest expense you’ll face in your lifetime. Now, taxes won’t bankrupt you; paying taxes usually means you're still making money, but our goal is to reduce, mitigate, or eliminate taxes whenever possible. Always pay your fair share, but never a dollar more.

In the last article, I talked about Required Minimum Distributions (RMDs) and the importance of timing those distributions through a strategy called a Roth conversion or moving your money from forever taxed to never-again taxed. The key is to get ahead of the curve. Don’t wait until age 73 creeps up on you and you’re suddenly forced to withdraw from your IRA at unknown tax rates. Take advantage of today's known and historically low tax rates. 

The next area of complexity is how you own your investments. This aspect includes not only how you take distributions but also what’s going on behind the scenes in how you own them. The tax system that governs non-IRA investments, like stocks, bonds, and mutual funds, is based on capital gains. This means you’ve invested capital in a company or another form of investment, and that capital has appreciated. If you invest $1 and it turns into $2, you have a capital gain of $1.

The IRS makes a clear distinction between long-term capital gains and short-term capital gains:

·      Long-term capital gains: appreciation on stocks held for more than a year.

·      Short-term capital gains: appreciation on stocks held for less than a year.

Why is this distinction important?

Short-term capital gains are taxed at ordinary income rates, which are typically higher than they are for long-term gains in your portfolio.

How can we avoid taxes on short-term gains?

Tax and investment concerns are often in conflict. For example, if you want to move assets around in your portfolio or withdraw money to spend, you may incur a short-term gain and pay ordinary income tax on it. The only way to avoid gains altogether is to leave your money alone indefinitely. Consequently, your portfolio may drift out of balance. For instance, if you had one stock and one bond, and the stock grew faster than the bond, the stock would make up a larger percentage of your portfolio and increase your risk in many cases. This is why it’s important to regularly rebalance your investments.

Fortunately, we can help you develop a tax-efficient portfolio to help you manage your investments better. At Lord and Richards, we specialize in mitigating taxes in your life, especially in your portfolio. This is why we recommend sitting down with us for a tax clarity visit, which is included in your Retirement Freedom Plan™. 

When you think of capital gains, you probably think of the desirable 15% tax bracket, which is the rate for most long-term gains. This rate is a government incentive for you to hold onto your investments longer and keep them in America. However, as your various income sources compound, you may find yourself in the 20% tax bracket. Additionally, there’s a 3.8% net investment income tax, bringing your total to 23.8%—the highest long-term capital gains rate. Compare that to the highest short-term capital gains rate, which is 37% plus the 3.8% net investment income tax. This pushes your tax rate over 40%, almost double the long-term tax rate! We want you to get ahead of this now and start developing a plan.

Each person's situation is different. Sometimes you'll need to withdraw money, and other times you may be able to avoid it. Now, remember that if you have a Roth IRA and have been converting assets into the “never-again taxed” category, you don’t have to worry about that money—it’s tax-free. Maximizing your tax-free investments will help you immensely. However, no matter how hard you try, you’re likely to end up with some ordinary money that will fall into the capital gains system.

Are the people with whom you’re investing watching your back?

You may be tempted to hold onto your investments, not worry about diversification and rebalancing, and leave it to grow on its own. I’ve met people who have one stock, like Coca-Cola, and have passed it down from generation to generation. Lack of diversification increases your risk substantially. You're betting your life that the management of that company will always act in the best interest of the shareholders, which may not always happen.

What about stock that is being managed for you by someone else? At Lord and Richards, we avoid mutual funds to the best of our ability, due to the internal costs and inefficiencies, but we’ll use them as an example. Let's say you have a mutual fund with an Apple stock that was purchased back in 1985. You didn't buy the mutual fund until 2014, and you held it through 2015. In the middle of 2015, the fund manager decided that Apple wasn't a good investment and sold the entire thing. Any gain recognized must be passed through the mutual fund to the current owners, even if they didn't participate in the gain. While this seems unfair, this is the reality of throwing your lot in with everybody else. You participate in gains that you may never have benefited from. Let's get ahead of this and start designing portfolios that don't leave you vulnerable to the whims of fund managers and markets. 

Our team recently put together a detailed investment report for a client. Their former advisor had composed a portfolio containing 32 mutual funds, 21 ETFs, and a variety of stocks and bonds. The average fund in their portfolio owned over 1,600 securities, and their portfolio contained over 93,677 stocks and bonds! There are only 3,600 listed equities in the United States. How did they end up with over 93,000? They owned the same companies multiple times within their portfolio. In this client’s case, they owned Microsoft in 15 different funds.

Unfortunately, this kind of portfolio is quite common and creates inefficiencies and unnecessary turnover, which in turn creates excessive taxes. This issue is caused by a lack of proper management. The portfolio I just shared with you had a turnover rate of 87%, which means 87% of the holdings incurred involuntary gains.

It's important that we have a conversation around how you own your investments and whether you're incurring unnecessary fees and taxes due to turnover and duplication in your portfolio. Let's sit down for a Retirement Freedom Review™ at no cost to you. This will give you peace of mind and get you on the road to mitigating taxes. It simply starts with a phone call.

Investment Advisory Services offered through Lord and Richards Wealth Management, LLC, a Registered Investment Adviser.