There has been a lot of news lately about the Biden administration’s economic plans, particularly the proposed tax increases that will be needed to offset at least a portion of the additional spending. Even without the additional spending programs working their way through Congress, it’s likely that some level of tax increases would have been necessary to address the rapidly growing national debt. The sheer size of the spending proposals, however, has opened discussions on some sizable tax increases, with potentially huge consequences for individual investors.
There is much speculation about which of the changes will make it through Congress, and when they might become effective. Tax advisors are so deep in the minutiae of tax brackets, deductions and exemptions that they may miss a key takeaway from these and other tax proposals. Like many other aspects of life, the one reliable constant with tax law is that it will change. Smart investors don’t just react to these changes as they occur, but they put themselves in a position to absorb these changes more effectively over time.
Let’s take a few examples of tax law changes that are relevant for investors. Since the implementation of the federal income tax in 1913, the top marginal tax rate for individuals has ranged from 7% to 94%. Since 1954, the top tax rate on long-term capital gains has been as high as 40% and as low as 15%. And the estate tax exemption, which determines what portion of a taxpayer’s estate can be excluded from the estate tax calculation, was only $675,000 as recently as 2001, while today it stands at $11.7 million. Clearly, over the past 100 years or so, changes in tax law have been quite numerous, and quite significant. What’s less appreciated is that, these days, a typical investor might spend 65 – 70 years managing a portfolio, from the time they start a career all the way through retirement. Tax attorneys are nice if you can afford them, but there are some fundamental tools that will help you stay ahead of the tax curve over such a long-time horizon.
Build tax flexibility into your portfolio. Not every investment account is treated the same for tax purposes. Contributions to “qualified” accounts like 401(k) plans and traditional IRAs provide a tax deduction when the contributions are made, but distributions from those accounts in retirement are fully taxable. Contributions to a Roth IRA or a 529 college savings plan are not deductible, but distributions from those accounts can be taken tax-free.* Lastly, earnings in a brokerage account are taxable, but when those investments are sold, only the gains are taxed, and they are taxed at more favorable capital gains tax rates if they were held for more than one year. Accumulating assets in each of these tax “buckets” (tax-deferred, tax-free and taxable) can provide opportunities to reduce taxes over the entire investment life cycle and can help make the portfolio more resilient to the inevitable changes in the tax code.
Make tax planning part of a comprehensive financial plan. Income taxes are impossible to ignore, but they are just one of many factors that impact your overall financial health. A comprehensive financial plan can help put income taxes in their proper context. Socking the maximum amount into your 401(k) every year can save on the tax bill, but that 401(k) won’t help you much if you want to change careers and have to pay taxes and a 10% penalty to access those funds if necessary. Likewise, a good financial planner can model the potential effects of tax law changes to determine their impact and identify ways to offset that impact with higher savings rates or a later retirement date if necessary. Without such a plan, the impacts may not be fully known until much later, when the ability to adapt is more limited.
Find a financial advisor with tax expertise. Building and managing a tax-efficient investment portfolio can significantly increase the growth and longevity of that portfolio. Unfortunately, many tax preparers don’t focus enough on investing issues, and many financial advisors simply don’t have the necessary tax expertise to do this well. When selecting a financial advisor, look for one who is also a CPA or a Certified Financial Planner (CFP) such as we have at Fullen Financial. These advisors tend to focus more on comprehensive financial planning and the effective management of income taxes as part of that plan.
We will hear much more about President Biden’s tax proposals in the weeks and months ahead, but changes to the tax code certainly will not end there. Investors will adapt to the new rules as they always do, and those with a comprehensive, strategic approach are likely to fare better in the long run.
*Distributions from a 529 college savings plan are tax-free if used for qualified educational expenses.
About the Author: Kevin Fix, CPA / PFS is a fee-only fiduciary Senior Financial Advisor at Fullen Financial Group. He has worked for more than 25 years in accounting and finance, with much of his career spent in public accounting and company financial management. He has extensive experience managing finances and investments for individuals, small business owners and large corporations. Kevin earned his CPA license in 1992 and became an independent Registered Investment Advisor in 2011.
Kevin earned Bachelor’s degrees in Accounting and International Studies from Miami University, and a Master’s degree in Business Administration from the University of Chicago Booth School of Business. He is a member of the American Institute of CPAs and their Personal Financial Planning practice section. Kevin lives in Upper Arlington with his wife, Amy, and their three children, and is an active member of the business community.
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