Clear Direction for Your Retirement:

Capital Gains- The Tricky Tax Trap with Risky Implications

Working with a firm that’s been in existence for over 30 years and being a part of that existence for better than 15 years has allowed me to see many interesting things in terms of investor behavior. Bull markets, Bear markets and everything in between play upon the investors primary drivers of fear and greed in strange ways, partly because the financial industry-at-large typically markets to the investor from one of these emotions depending on market conditions. 

One thing to keep in mind is that any financial decision should be based within the context of a well thought out and coordinated financial plan (involving tax, estate, investing, income and insurance planning) and not simply prod-uct sales. This helps reduce the risk of making emotional decisions rather than logical ones. 

One area that can become myopic if not approached properly is that of long-term tax implications within a plan. By myopic, I mean that while taxes are a very important con-sideration in long-term planning, they aren’t the only consideration and the tax tail should never wag the financial planning dog. 

Tax concerns can come in various shades such as over-funded tax-deferred accounts (e.g. IRA’s) coupled with an imbalance of tax-free (e.g. Roth) and/or after-tax funds (which is where tax-efficiency in retirement is most easily achieved). Simply said, most have

too much money in tax-deferred accounts and very little if any in Roth and after-tax savings. However, while having a tax balanced approach (IRA vs Roth/ After-tax) is great, it’s not the only tax trap we see.

Another common tax issue we see is in after-tax accounts that have tremendous capital gains built up inside them (taxed in the year sold, even if not distributed). For instance, someone may have funded their account with $100,000 (called the “cost basis” of

the account) fifteen years ago and now the investment growth balance of that investment is hovering around $300,000. That means there is a $200,000 capital gain implication in the account should they need money or want to reposition the funds and sell any position(s). If the positions have been held more than twelve months they will have long-term capital gain rate implications (15% or more depending on total income) and if the positions have been held less than twelve months, the capital gain is taxed at ordinary income tax rates. These taxes are in addition to any dividend or interest income they may receive. In after-tax invest-ment accounts this creates two primary issues, both driven emotionally by fear and greed.

First, the account holder is typically fearful about ever selling positions (regardless of market conditions) or taking distributions (over and above dividends and interest) due to the tax implications. They also may have concerns about paying taxes now while their heirs would get a step-up in basis if they die and pay no tax. While these decisions can certainly be situation specific and for most, saving taxes sounds great intuitively, it can create very serious problems in terms of risk-management during retirement when risk should be dialed back in some fashion. We see this quite often and it creates a difficult situation with clients where account holdings may have to be unwound over a period of years to help them reduce their risk exposure while seeking to reduce their tax hit.  

Second, the account holder typically and mistakenly believes (from a place of greed) that just because markets have always come back to go higher historically, they will come back this time as well. This relates to point one in the sense that they are afraid to sell and reduce risk (due to tax implications) and thus convince themselves that everything will be okay once they’ve rode out the storm. The problem with this thinking is that no

one knows the future and that is a really big gamble. Saving 15% worth of taxation while 50% of your wealth is destroyed in a bear market due to poor risk management is not

a good trade.

So, what are the key points to ponder? 

1. After-tax accounts can pose just as big a risk as overfunded IRA’s from a tax perspective.
2. Your planning goals should drive decisions and taxes are but one of many consider
3. Be careful trading risk for tax savings.
4. A good financial planner should evaluate and coordinate all five areas of your financial life (tax, income, estate, investing, insurance) and manage your mix of investment account(s) (IRA’s, Roth’s, after-tax) accordingly.

I  hope this is helpful to your retirement journey. Call us, come see us or visit us at www.woottonfinancial.com, we’d love the opportunity to help address your questions and concerns and provide you Clear Direction for Your Retirement®.

Investment Advisory services offered through Game Plan Advisors, Inc., a registered investment advisor. Insurance services offered through Wootton Financial Group, Inc. Game Plan Advisors, Inc. and Wootton Financial Group, Inc. are affiliated through common ownership. Neither Game Plan Advisors, Inc nor Wootton Financial Group, Inc. offer legal or tax advice. Please consult the appro-priate professional regarding your individual circumstance. Not associated with or endorsed by the Social Security Administration or any other government agency.

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