Investment Tax Planning
Why We Bark at Taxes
There’s a constant tug of war between gains from investments and losses due to taxes. We see little sense in optimizing investment returns and then giving back what you’ve gained because of poor tax planning. To us that seems like—dare we say it?—the tail wagging the dog.
Investment Tax Planning
We thoroughly integrate tax planning into management of your investments. Here are some of the areas we consider.
For sake of tax efficiency, your investment assets should be placed in the locations that are most tax efficient for your portfolio overall, meaning regular taxable accounts, 401K plans, IRAs, Roth IRAs, trusts, and so on.
Some advisors will apply rules of thumb such as, “Your highest growth assets should be in your Roth account”; “income-producing assets should be in your tax-deferred account”; and so on.
This is well-intended but not very effective. The truly tax-efficient location of your assets depends on your unique circumstances: the amount of your total assets; percentage of assets you have in accounts with different tax statuses; how close to retirement you are; your near-term cash needs; your plans for Roth conversions; your strategy for handling required minimum distributions (RMDs); the cost basis of your taxable assets; and many other factors that are unique to you.
We design your asset-location plan based on your specific circumstances.
One reason Rain Dog emphasizes index funds is that they tend to be tax efficient. Index funds tend to have low portfolio turnover compared to actively managed funds.* With low portfolio turnover, only a small percentage of your gains are taxed each year, and your taxable investments can grow almost as if they were tax-deferred rather than taxable.
*Sources: “Turnover ratios and fund quality,” Investopedia, retrieved 1/24/2024; “US Mutual Fund Turnover and Returns, 1991-2020,” Gene Hochachka, SSRN, December 10, 2021.
We employ tax-loss harvesting strategies when it is tax advantageous to you, all things considered. We believe that the role of tax loss harvesting is often overstated by financial planners, possibly because it can be automated and show a lot of activity in your account. Despite tax-loss harvesting sometimes being overpromised, we believe it is a useful tool in specific circumstances and we use it at those times.
Rebalancing is a valuable investment technique, but taxes can undermine investment performance if rebalancing is not performed with tax consequences in mind. Naive rebalancing can result in short-term capital gains, and too-frequent rebalancing can erode after-tax investment gains. Rebalancing the same way in tax-preferred and taxable accounts is another source of tax inefficiency.
A backdoor Roth conversion can be one your most powerful tax planning tools. We simulate a variety of future tax environments—based on your specific income, assets, and planning horizon—and design a tax-efficient Roth conversion strategy for you.
We do not have a crystal ball that forecasts future tax laws, but we can design a strategy that is flexible and works well with current tax laws as well as adapting to future tax changes.
Some individuals and couples will experience a few years of relatively low employment income as they wind-down full-time employment, or as one partner retires earlier than the other. Those years can provide a valuable tax-management corridor in which to transition your assets to be tax-efficient during retirement. In other words, we can use a tax-efficient process to arrive at a tax-efficient destination.
We hear horror stories of advisors switching clients to new portfolios without considering the tax consequences. Clients can be left with large, unexpected tax bills. At Rain Dog, we fully consider the tax implications and tax-reduction possibilities around such changes.
First, we evaluate whether the benefits of a proposed portfolio change will outweigh the tax consequences. Poor tax planning can wipe out investment gains, and we never want that to happen.
Second, we evaluate the most tax-efficient way to make the desired changes. We evaluate the transition’s timing and the extent to which changes can be made in your tax-preferred accounts without creating tax consequences in your taxable accounts.
Third, if we find that increasing your tax bill in the short term will improve your financial situation over the long term, we will communicate that to you and be sure you agree before we proceed. We don’t want you ever to be surprised by an unexpectedly large tax bill.
Different size estates call for different kinds of tax planning. In addition to the total size of your estate, the specific form in which you leave your assets will affect how much your heirs receive after they pay their taxes. We evaluate that as part of your investment planning. We also consider alternative means of transferring wealth to your heirs, which is especially important for residents of Washington state.
The investment planning tools used by many advisors do not fully consider the effects of taxes on investment growth, or, in some cases, consider taxes at all. Rain Dog’s proprietary Investment Forecasting Model (IFM) thoroughly integrates tax consequences into its investment forecasts.
We believe in paying our fair share of taxes. We just don’t believe in paying more than necessary. Get in touch, and let’s see whether we can take a bite out of your taxes.
