Do You Trust Your Spouse? A Question About Taxes
By: Philip "Flip" O'Toole
How did Andy Dufresne become the most trusted inmate at Shawshank State Prison?
He gave great tax advice.
“And that’s how it came to pass, that on the second-to-last day on the job, the convict crew that tarred the plate factory roof in the spring of ’49 wound up sitting in a row at ten o’clock in the morning drinking icy-cold bohemian-style beer, courtesy of the hardest screw that ever walked a turn at Shawshank State Prison.”
-Red (Morgan Freeman), The Shawshank Redemption
SHAWSHANK PRISON – AN OHIO AND NATIONAL TREASURE
For those of you in Northeast Ohio, perhaps you have seen the “Welcome Shawshank Fans” billboard along I-71 near the Ohio State Reformatory in Mansfield, 80 miles south of downtown Cleveland. In the summer of 1993, the movie “The Shawshank Redemption” starring Tim Robbins and Morgan Freeman was filmed almost exclusively at this location. The Ohio State Reformatory is now home to the Shawshank Museum where, according to the “Destination Mansfield” website, you can “immerse yourself in props, set pieces, costumes and other treasures involved in the making of the Oscar-nominated film”. I encourage you to take the trip down to Mansfield. You will not be disappointed.
For those unfamiliar with the film, the story is of “hot-shot banker” Andy Dufresne (played by Tim Robbins) falsely accused and imprisoned for murder. I will not spoil the ending for you, but the storyline follows Andy and his close pal Red (played by Morgan Freeman) as they navigate maximum security prison life during the middle part of the 20th Century. One of the turning points of the film is a scene about halfway through when Andy and some of his best inmate buddies are recruited to tar the roof of the license plate factory.
As the inmates work in the hot sun, Chief Hedley, the meanest prison guard at Shawshank, is sharing a story with the other prison guards about a $35,000 inheritance he is about to receive from his late brother. He is upset that the government is about to take out a large chunk of his inheritance in taxes. Andy, leaning on his experience as a banker, overhears this conversation and approaches Chief Hedley with the attention-getting question “Do you trust your wife?” Andy proceeds to hastily lay out a tax-planning strategy as Hedley threatens to toss Andy off the roof for daring to approach him with such a question. Andy quickly explains that a legal tax-planning strategy would allow Hedley to avoid taxes entirely by gifting the entirety of the $35,000 inheritance to his wife as “the IRS allows a one-time only gift to your spouse for up to $60,000 tax-free” (per the movie script).
From this point forward, Andy is held in higher esteem by Hedley and the rest of the prison staff who immediately pivot and put Andy to work in the prison library where he can more easily work on their tax returns each year. Prison Warden Norton then recruits Andy for a more nefarious and lucrative job for which you will need to watch the movie for more detail. The moral of the story? Tax planning is a powerful tool.
NOTHING BUT NET - WHAT DOES SHAWSHANK HAVE TO DO WITH MY TAX RETURN?
One of the challenges we face from time to time in the world of Private Wealth Management is the perception that a Financial Advisor’s primary job is to outperform an arbitrary benchmark chosen by either the client or the media. What would they like us to outperform what you ask? That lies in the eye of the beholder. Here are some questions we sometimes hear from prospective clients:
• Can you “do better” than my 401k?
• Can you outperform the S&P 500?
• Can you outperform my brother-in-law? (my personal favorite)
The number of benchmarks some people wish to outperform is seemingly endless!
However, if we are all being intellectually honest with each other, then we must agree that outperformance is largely out of our control. We try to be as diligent as possible in our research to marry our clients with the most appropriate, best-constructed portfolios, but the reality is the gross returns going forward of any given security, fund, asset class or benchmark over the next block of time is both unknowable and uncontrollable. But if I could be so bold, that is not the point. We DO NOT BELIEVE the primary job of the prudent financial advisor is to outperform arbitrary benchmarks.
We DO BELIEVE however that the job of the prudent financial advisor is to work closely with families providing them with all the empirical data necessary to make the best financial decisions that can help them maximize their family’s NET worth from generation to generation. What does NET worth mean? For the families we counsel, NET is about how much wealth is kept in the family and how much is consumed by fees, taxes and inflation. At the end of the day, the NET number is the only one that matters.
For example, if a client earned 5% on the cash in their bank account in 2023, they were probably ecstatic considering the very low interest rate environment we were stuck in from 2008-2023. However, if the client was in a 37% tax bracket and inflation was 3.4% in 2023 (per the bureau of labor statistics), the NET return on their gross 5% return from their bank account after taxes and inflation was a negative -0.1%. While the gross value of their bank account increased nominally by 5%, the real purchasing power of that account was less after taxes and inflation.
If you are currently evaluating your financial advisor year-to-year based on his/her ability to consistently outperform an arbitrary benchmark (like the S&P 500), my guess is you are most likely disappointed. If instead you measure the value of your prudent financial advisor based on how well they work with you to maximize your family’s NET worth AFTER fees, taxes and inflation from generation to generation and their ability to effectively communicate that message, then I would argue you believe that hiring your financial advisor was some of the best money you have ever spent.
THREE DIFFERENT TAX PLANNING CONVERSATIONS WE HAD WITH CLIENTS THIS WEEK ALONE
At TOJ, we are not CPA’s, nor do we play CPA’s on TV. We do not process tax returns, nor do we desire to process tax returns. However, we are well-versed on the IRS tax code as it applies to planning and investments, and we strive to be accretive to the relationships our clients have with their current tax professionals. My partner Ray has an accounting background and started his career in Corporate Accounting, and I have read more about the Tax Code than I care to remember. The point is we understand how important managing taxes is to overall wealth management and therefore it is at the core of everything we do at TOJ Private Wealth. Here are just three conversations we had with clients this week about their current and/or future tax challenges.
- How many of your retirement dollars are Tax-deferred vs Tax-free?
Paraphrasing Ed Slott, a revered and go-to industry expert, who recently said on a podcast that Traditional IRA’s “are not individual accounts as the name suggests. They are joint accounts between you and the US Government, and the Government decides how much they get and how much you keep.” What a mind-blowing way to articulate the tax reality of traditional qualified accounts like 401k plans and Traditional IRA’s. In other words, as our dollars in these type of pre-tax defined contribution accounts (aka Traditional) grow over time bringing smiles to all our faces, so grows our lifetime income tax liability on those same dollars which we must inevitably withdraw and pay income taxes. We can begin withdrawing penalty-free (not tax-free) as early as age 59 ½, but are mandated by the IRS to withdraw and pay ordinary income taxes no later than age 73 in 2024, via the “Required Minimum Distribution” provision of the IRS Tax Code.
To take it a step further, the taxes owed on those dollars arguably can grow at a higher rate than the overall account balances themselves. What do I mean? The growth rate on the tax liability depends upon what congress chooses to do with the tax code in the future and whether the overall growth of the account bumps us into a higher tax bracket down the road (with tax brackets being progressive and all).
Oftentimes the strategy of transferring tax-deferred dollars (Traditional) into tax-free accounts (Roth) is oversimplified with the term “Roth Conversion”, as in “call us, we do Roth Conversions”, as if one pushes a button that magically maximizes the Roth Conversion strategy in the most efficient way at the most opportune time. Yes, it is true that anybody can do a Roth Conversion. But there is a difference between utilizing a Roth Conversion and properly managing a Roth Conversion both this year and in future years. It is the same difference between a 20-handicapper utilizing a set of golf clubs and Scottie Scheffler, the #1 golfer in the world, managing a set of golf clubs. Both can show up and play Sleepy Hollow Golf Course on any given Friday, but I promise the results will be drastically different. Efficiently moving money from tax-deferred accounts to tax-free accounts requires a detailed understanding of the client and their total financial picture.
As a reminder, Roth IRA’s can be powerful as they enable you to withdraw your dollars tax-free while also removing the Required Minimum Distribution provision from the equation. Additionally, the strategy allows families to pass these accounts to their heirs tax-free. For some, the tax savings achieved by strategically moving dollars from tax-deferred to tax-free accounts can be an order of magnitude over a lifetime.
Ask yourselves: have we truly done a thorough dive into what strategy and tactics are most efficient for our unique, personal circumstances?
2. What is your capital gains tax exposure now and/or projected in the future on your concentrated stock position(s), your business(es), and/or your direct real estate holding(s)?
In addition to ordinary income tax, many of our clients face significant capital gains tax exposure either now or in the future. For most, this exposure is in the form of a concentrated employer stock position, a privately held business or direct real estate holdings. While there is no Roth account that allows these assets to be sold capital gains tax-free, there are strategies for reducing a client’s capital gains tax exposure that can be employed now and well into the future. One of those strategies is tax-loss harvesting in non-qualified accounts. The tax code does allow investors to offset their capital gains taxes by recognizing losses that can then be used to reduce their capital gains tax. Furthermore, if the losses are not needed all at once, they can be carried forward and used on future tax returns into perpetuity.
For our wealthiest clients who have significant future capital gains tax exposure, we began utilizing Direct Indexing strategies with some of their non-qualified dollars. I will not bore you with all the details, but share briefly the objectives of Direct Indexing:
•Core Equity Exposure designed to deliver benchmark-like performance (ie the S&P 500).
•Year-round tax management is designed to recognize capital losses helping investors keep more of what they earn throughout their lifetime.
•Build greater wealth over time by more efficiently managing your capital gains tax exposure.
Ask yourselves: Do we know our current Capital Gains Tax exposure? What will it project to be in 5 years or 10 years? Are there tax management strategies available to us today that could help us offset some of those capital gains taxes now or in the future?
3.What is Net Unrealized Appreciation (NUA) and do you own company stock in your 401k?
Some publicly traded corporations offer company stock as an option to their employees in their 401k plans. Some of those stocks have performed extremely well over the past 20-30 years. As a result, some of our clients have a large amount of their net worth tied up in that company’s stock.
If one of our client’s goals is to diversify that concentrated position, they could easily do so either within their 401k or outside if they chose the IRA rollover option. All they would have to do is sell some or all the stock and use the proceeds to invest in a more diversified portfolio. Both are reasonable strategies for achieving the goal of increased diversification and both would be non-taxable events in the short-term. However, as we discussed above, the IRS would eventually collect their fair share of those dollars in the form of income tax when those funds are withdrawn from their respective accounts. What if dug a little deeper?
There is a little-known provision in the tax code called Net Unrealized Appreciation (NUA). NUA is a tax strategy available to you if you participate in an employer-sponsored retirement plan (ie 401k) that contains securities issued by your employer (ie company stock). NUA allows you to move the stock out of your 401k into a taxable account after paying ordinary income tax on the cost basis in the year you do the transfer. You could continue to own the stock, or you could continue with your strategy to diversify the position. Instead of paying income tax on the withdrawals from the 401k, you would instead owe capital gains tax on the sale of stock in the year of the sale. In essence, you are trading your income tax rate with your capital gains rate. And as the tax code is currently written, the capital gains tax rate for most of our clients is lower than their income tax rate. I would encourage you to read through the hypothetical illustration of NUA on Fidelity’s website for a better understanding of how the strategy can benefit you.
In many cases, the cost basis on the stock for people who have been at their company for years, if not decades, is extremely low. For example, we had a client this week who participated in his company 401k for many years purchasing company stock when the price was very low. As a result, his cost basis is only $17,000 on $400,000 worth of company stock. If he chose to employ the NUA tax strategy, he would owe ordinary income tax on the $17,000 this calendar year, however, he will pay capital gains tax rates on all future distributions instead of ordinary income tax rates.
Ask yourselves: Do we have a concentrated stock position in our 401k plan and has it been explained to us how NUA may impact our family’s wealth in this generation and the next?
NOTHING BUT NET – ANDY DUFRESNE AND THE VALUE OF TAX PLANNING
As Morgan Freeman told us in The Shawshank Redemption, Andy Dufresne in the spring of ’49 was able to curry the favor of Captain Hadley, the hardest screw to ever walk the floors of Shawshank State Prison by simply sharing a tax planning strategy that would allow Hadley to receive his inheritance from his brother tax-free. From that point forward, Andy was held in high regard by both the prison guards and warden.
The point is that great tax advice is powerful. We understand that focusing on relative gross performance is exactly that, gross. Our job is to provide our clients with the empirical data required to make the best financial decisions possible across the spectrum of their financial lives, including taxes. Our collective mission is to maximize our clients NET worth after fees, taxes and inflation from generation to generation.
FIVE QUESTIONS TO PONDER TODAY IN PREPARATION FOR NEXT YEAR’S TAX RETURN
Now that you understand how we feel about the difference between Gross and Net when it comes to the wealth of our clients, perhaps it would be prudent to take a moment to discuss the following five questions with your loved ones.
- Are we focusing on arbitrary outperformance metrics or are we instead relentlessly and perpetually implementing and executing strategies that will truly impact our family’s NET worth at a generational level?
2. How many of our current retirement dollars are tax-deferred vs tax-free and can we improve upon our situation in the most efficient manner?
3. What is the current and future impact of capital gains taxes on our large non-qualified accounts, concentrated stock position(s), privately held business(es) and/or direct real estate holding(s)?
4. Are we or somebody we love eligible to take advantage of the Net Unrealized Appreciation provision in the tax code that applies to company stock owned in our 401kplans?
5. Have we taken our family to The Shawshank Museum in Mansfield yet and, if not, what are we waiting for?