CHAPTER 11

The Gift of Preparation

TAX PLANNING

There is an alien in our house. Even though we willingly invited this being into our midst when it was very young, it has become abundantly clear that it does not fully understand the cultural norms of the human realm. For example, when left to its own devices, it will pillage our human food stores even though it subsists on its own specialized alien food. It seeks to re-create the style and substance of our outdoor landscaping by relocating the dirt and mulch of our purposefully designed flower beds onto our sidewalks, and creating new trenches and holes in sections of our yard that were previously flat and covered with grass. And despite our munificent creation of an alien habitat inside of our home, it seeks to live in, and often bring destruction to, our human habitat, furniture, and creature comforts. It’s . . . a dog.

She is, as much as it pains me to say it, our dog, and unless she hears Jack London’s “call of the wild,” she will be for quite some time because she’s still only a puppy. She was a shelter puppy—an adorable, lovable mix between a German Shorthaired Pointer and a Labrador Retriever (at best guess). An especially strong case can be made for the pointer, because as she grew, she became so tall and lanky that her youthful coordination simply couldn’t keep up with her growth. The result was a hysterical few months of physical comedy.

After a February winter storm, she looked like Bambi scrambling to find her footing on the ice-covered snow. If she made it up a flight of stairs, she’d have to be carried down to avoid tumbling over her stilt-like legs. And her tail grew to a point at which it seemed to double her overall length. That tail is a weapon capable of clearing an entire coffee table. And she’s so annoyingly happy that her tail is always in motion. I have, on more than one occasion, seen her lose control of her overjoyed tail, collapsing her entire awkward frame into a heap on the floor.

“Don’t let the tax tail wag the dog.” In college, I heard that quote for the first time from the professor who made the greatest impact on me in those years, Dr. Daniel Singer. He was—and is—that professor who unnerves students because he’s not predictable. One semester, he’d teach a class with three exams and two quizzes in between; the next semester, your entire grade was based on only one presentation. But it was his unpredictability, his passion, and his depth of conviction that drew me to him, and I took as many of his classes as possible. It is now my privilege to teach alongside Dr. Singer as an adjunct faculty member at the university from which I graduated.

Dr. Singer would not claim to have been the first ever to say, “Don’t let the tax tail wag the dog,” but to me, in my junior year of college, it was groundbreaking, and it still is. Too many people, too often, make poor economic decisions because their judgment is clouded by tax concerns. In most financial decisions, tax consequences should be a secondary or tertiary—at best—consideration. Drew Tignanelli, a certified public accountant (CPA) and certified financial planner practitioner with 30 years of experience balancing tax planning within the framework of good financial planning put it to me this way: “First, forget about taxes!”

How could he make such a claim? It’s not because he sees taxes or tax planning as irrelevant or unimportant. He simply recognizes that in the realm of personal financial planning, one should make decisions first based on the wisdom of the investment, insurance, retirement, or estate planning strategy, and then take a look at the tax impact and adjust accordingly.

Tax Myths

In the remainder of this chapter, we will address the most common myths in personal financial planning regarding taxes as well as the tax strategies of which you should be taking advantage.

Myth #1: “I Need a Mortgage for the Tax Deduction”

It is not a myth that most homeowners are able to deduct all or most of the interest they pay on a mortgage. That is true, and the deduction has the impact of reducing our taxable income each year, and that is a good thing. But, it is the pursuit of indebtedness for the primary purpose of having a tax deduction that is financial foolishness.

For example, when you have a mortgage with an interest rate of seven percent, any interest paid will be deductible. If you’re in a 25 percent tax bracket, that means your effective interest rate—after taking the deduction into account—would be 5.25 percent. But you’re still paying 5.25 percent! It’s as if you’re paying the bank one dollar to save 25 cents. Many have made the mistake of purchasing a car with home equity because of the income tax deduction. You may be paying less interest per year, but when you take 15 years to pay the car off, you’d be much better off to take an auto loan with your credit union, or better yet, buy with cash.

Further complicating matters regarding mortgage interest deductions is that your mortgage has an amortization schedule that front-end loads the interest portion of your payment. So when you have just taken out a 30-year mortgage, almost 100 percent of your mortgage payment in the first year will be interest. By the time you have only 10 years left, most of your payment will be going toward principal repayment.

Remember, you don’t get a deduction for your entire mortgage payment; it’s only the interest part of your payment. So if you’re about to retire, you only have 10 years left on your 30-year mortgage, and you’re advised to keep the mortgage because you’ll keep the deduction, recognize you’re not even getting much of a deduction at that point anyway. You would be better served to pay the mortgage off, assuming you have the liquid cash, and be free from the payment in retirement.

The truth: You should never carry a mortgage for the primary purpose of having a tax deduction.

Myth #2: “I Can’t Sell This Stock—I’ll Have to Pay the Capital Gains Tax!”

Cisco, the beloved darling of the technology stock boom of the late 1990s, tells an interesting capital gain story:

Let’s say in October of 1998, you purchased 1,000 shares of Cisco for around $12,000. You bragged over eggnog in December of 1999 how much of a stock-trading genius you were, sitting pretty with a Cisco position worth over $50,000, and your crotchety Uncle Pervis said, “That stock’s way overvalued! You’d be stupid not to sell at least half of that stock now.” You retorted, “That’s crazy! I read in a magazine that ‘it’s different this time,’ and besides, I’d have a huge capital gain tax bill if I sold now.” You called Uncle Pervis to rub it his face in March of 2000 as you were sitting on an $80,000 position, but Uncle Pervis would have the last laugh. By September of 2001, your position was back where you started; down from $80,000 to your original investment of $12,000. You no longer had to worry about capital gains tax because your gain had evaporated.

In this example, you had gained 566 percent or $68,000 on a $12,000 investment. The federal capital gain tax required, had you sold the stock in March of 2000, would have been $13,600. That’s a lot of money, but it’s not nearly as much as the $54,400 of pure, after-tax gains you left on the table by holding the stock even after the economic, valuation, and cyclical factors all pointed toward a red neon SELL sign. Certainly, with the benefit of hindsight, it’s easy to say you should have sold, but it was the tax consequences that made it hard to sell. The best investment decision was to take your gain and pay the tax.

The truth: You should never hold an investment with the avoidance of taxes as the primary determinant.

Myth #3: “I’m Buying This Investment to Lower My Taxes”

In the 1980s, Limited Partnerships were a red hot investment. While they did have a bona fide investment component to them, they were sold largely on their seemingly magical ability to create a tax loss—and accompanying deduction—while the investment somehow made money. A change for the worse regarding tax preference and the incredible illiquidity of these vehicles resulted in painful losses for investors who had been sold shares in Limited Partnerships.

Annuities, also, have been touted by insurance salespeople for many years with the primary pitch that they defer the taxation of gains. As discussed in Chapter 10, many annuities have high expenses, subpar or limited investment choices, and look less attractive from a tax perspective as laws and times change.

Another investment often sold primarily on the basis of tax privilege is municipal bonds. Income from the bonds of a state or local municipality is exempt from federal income tax (and state tax, if you purchase bonds of a municipality in the state in which you live). While carefully purchased municipal bonds can be a wise investment for an individual in a high tax bracket, they make very little sense for individuals in lower brackets.

Let’s assume an investor is faced with a decision to invest in either a highly rated corporate bond yielding 5.5 percent or a highly rated municipal bond yielding four percent. The corporate bond interest will be taxable and the municipal bond interest would be tax free. Which is the best investment? It depends on the prospective owner’s tax rate. If the buyer is in a high income tax bracket, like 35 percent, the four percent tax-free municipal bond gives the buyer an equivalent taxable yield of 6.15 percent. Since that 6.15 percent equivalent taxable yield on the muni is higher than the corporate taxable yield of 5.5 percent, the municipal bond appears to be the wise decision. If, however, the owner of the bond is in a lower tax bracket—let’s say 15 percent—the tax equivalent yield is only 4.7 percent, making the 5.5 percent corporate bond more attractive.

(Incidentally, one must also be wary of interest rate risk and default risk—especially with many state and local municipalities struggling—when considering the appropriateness of including municipal bonds in a portfolio.)

The truth: You should never purchase an investment for the primary reason that it will benefit you from a tax perspective.

Myth #4: “The Bigger the Tax Refund, the Better!”

When winter begins to turn into spring, we all start thinking about taxes—or, at least, we should. It is that time of year when we’d rather be receiving a check than writing one, but we are missing the point. The point isn’t to give Uncle Sam a free loan so that we can feel an imaginary sense of surplus when we receive a refund; nor is the point to be so aggressive in our tax planning that we end up having to write a big check, or paying a penalty for having held on to too much of the U.S. government’s income. Neither should we judge our accountant on his or her performance by how much of a refund we receive.

One of your objectives as an informed taxpayer should be to regulate your withholding exemptions—the amount of tax you pay the government throughout the year—such that you’re not writing or receiving a huge check come tax time. You must also be aware that it is you, not your accountant alone, who is responsible for the accuracy and fidelity of your return. You are signing on the dotted line and the Internal Revenue Service is not a particularly forgiving creditor.

One of the more painful examples I’ve seen is that of an individual who changed tax preparers several years ago. The year of the change, he received a dramatically higher tax refund than he was accustomed to. It wasn’t until I reviewed three years of his tax returns that I realized the accountant had fashioned fraudulent deductions in an effort to boost the refund to win the taxpayer’s loyalty and referrals. The taxpayer, originally referred to the accountant by a family member, was so pleased that he had indeed referred friends and family. Now that he realized the accountant had materialized $15,000 in fraudulent refunds, he’d have to report the news to friends and family, and their lives would be negatively impacted as well.

The truth: The amount of a tax refund has absolutely no bearing on whether or not the taxes were optimally computed. Take full advantage of the tax law and adjust your withholdings so you neither write nor receive a huge check at tax time.

Myth #5: “This Stuff Is Easy; Anyone Can Do It!”

Helpful software tools and low-cost tax preparation services leave the impression that tax planning can be done in a matter of minutes by people who have little or no training. There is a major difference between tax preparation and tax planning. The former can be done by a computer program or tax preparer, but the latter requires the help of a professional CPA working in tandem with you.

Your tax preparation software is only as good as the preparer, and don’t forget that our own Secretary of the Treasury, Tim Geithner, couldn’t get TurboTax to work properly! Even if you think yours is a situation that is easy enough to be handled on your own, you should visit with a CPA every few years to ensure you’re not missing something significant.

The truth: Most people would be best served by having a professional certified public accountant prepare their taxes.

Tax Rules

Now that we have tackled the major tax myths of which you should be wary, we’ll provide some beneficial tax rules to consider implementing in your financial plan.

Rule #1: Take Advantage of a 401k or Other Retirement Plan

The most effective way for most people to minimize taxes is through the use of a retirement plan, such as a 401k, 403b, or Simple IRA. These are corporate retirement plans that allow you to make pretax contributions to an account that will grow tax deferred until you take distributions in retirement. In 2011, an individual can contribute $16,500 to a 401k; if age 50 or over, an additional $5,500 catch-up contribution is allowed. If you make $66,000 per year and contribute $16,000 to your 401k, your taxable income is reduced to $50,000, and you keep the investment. After someone has parted service from a company and reached age 55, distributions can be taken from a 401k without penalty, but the distribution will be treated as taxable income in the year in which it was taken.

Rule #2: Take Advantage of a Roth IRA

A Traditional IRA functions similarly to a 401k or other corporate retirement plan. Contributions up to $5,000, for those with income under $56,000 for a single individual or $90,000 for a married couple, are deductible and thereby reduce taxable income. As in a 401k, the growth in a Traditional IRA will also be tax deferred, but distributions—in this case, after age 59½—are subject to full taxation. For individuals age 50 and over, an additional $1,000 catch-up contribution is allowed.

A Roth IRA, however, is a different animal. With a Roth, you do not receive a tax deduction on the front end, but the money grows and is distributed tax free. You don’t need to get your eyes checked; I did say tax free, and those opportunities are few. The limitations are that you may only contribute $5,000—if 50 or over, $6,000—and make less than $107,000 for an individual or $169,000 as a married couple to be able to contribute the full amount in 2011.

The argument historically has been that if you are young and in a low tax bracket, you should contribute to a Roth; if you’re older and in a high tax bracket, contribute to a Traditional IRA because by the time you take distributions from your Roth IRA, your bracket will likely be lower. But, I suggest that anyone who is eligible to contribute to a Roth should do so. The reason I can be so broad is that almost all of us will have the bulk of our retirement savings in vehicles like a 401k—all of which will be taxed upon distribution. In retirement, if we need income, we’ll be forced to take it from our 401k or Traditional IRA “buckets” and thereby forced to pay tax on it.

It is beneficial for anyone planning for retirement or financial independence to have at least one bucket from which they can take distributions without paying any tax. Oh, and by the way, with Social Security, Medicare, and Medicaid in financial trouble; global, perpetual military activity on the part of the U.S.; trillions (with a “t”) in Great Recession stimulus packages; and over $14.5 trillion (and rising) in national debt, one can make the case that we are seeing the lowest tax rates that we’ll see in our lifetimes. That makes for an even stronger case in support of the Roth.

Rule #3: Create a Liquid Investment Account

A liquid investment account is just a standard individual or joint investment account in which you pay typical taxes. In this account, if you own income-producing bonds, you’ll pay ordinary income tax (which means the interest will be treated as taxable income) on the interest in the year in which it’s paid. If you own stocks, you don’t pay any taxes on the growth until you sell the stocks, and when you do, you’ll pay capital gains tax on the gain (on any stock held over one year), which is currently 15 percent (with very few exceptions). If you lose money on stocks, when you sell them you can take a tax loss. When you do your taxes, tax losses can be set against gains, neutralizing the taxable event. Dividends from stocks are taxed in the year in which they are received at the dividend rate, which is also currently 15 percent—but possibly not for long. Mutual funds, which own stocks and bonds inside of them, pass the taxable impact of capital gains and income on to the mutual fund shareholders.

With all this taxation to manage, why would I suggest you maintain a liquid investment account as a tax strategy? If a portion of your portfolio is focused on investing in stocks, long-term capital gains taxation is preferable to ordinary income tax treatment. If you invest in a stock in your IRA, it will grow tax deferred, and if you sell it in the future and take a distribution from the IRA, you’ll pay ordinary income tax rates, the highest of which is 35 percent in 2011.

If you bought the same stock in a taxable, liquid investment account, your gains would be deferred until you sell the stock in the future. When you sell the stock years later, you will hopefully have a capital gain and, based on today’s rate, you’d pay 15 percent on the gain. If you are in a high tax bracket, the difference between that 35 percent tax in the IRA and 15 percent tax in the liquid investment account is significant. Some even orchestrate a strategy in which they do their fixed income investing inside of their IRA and their growth investing in their taxable account, but remember, too much time focused on a strategy of this nature begins to look like the tax tail wagging the dog. The primary focus in investing should be making wise investment decisions.

Rule #4: Do Long-Term Investing for College in a 529 Plan

The 529 college savings plans offer a tax-privileged way to save for college, but this rule comes with a caveat. From a tax perspective, the 529 functions much like a Roth IRA. Dollars invested in the plan receive no special tax treatment initially, but they grow tax deferred and are distributed—if used for qualifying education expenses—tax free. The caveat is that one’s time horizon must be fairly long to withstand the volatility of the investment vehicles likely to net a meaningful gain. Our next chapter will discuss in greater detail the benefits and drawbacks of 529 education plans.

Rule #5: Utilize a Health Savings Account

You heard us sing the praises of the health savings account (HSA) in Chapter 8, but we need to mention it here again, because the HSA may be the multiuse investment vehicle with the most tax privilege allowed by the IRS. Whether you’re talking about a 401k, a Traditional IRA, or a Roth IRA, the IRS only allows you to get a tax break on one side of the timeline—either your contribution or your distribution is tax privileged, but not both. The HSA, however, allows both the front and the back end tax break. Every dollar contributed to an HSA is a deduction. If your employer contributes, they get the deduction; if you contribute, you get it. The money grows tax deferred, and if you take a distribution to pay for qualified health expenses, the distribution is tax free! That’s the best deal on the street.

Have you heard the joke about the rocket scientist and the accountant? Most of us would imagine it takes a lot more raw intelligence to be a rocket scientist, right? But as the joke goes, the rocket scientists have it easy because their practice is based on immovable scientific fact while accountants are working with a tax code as deep and wide as Lake Michigan, manipulated by thousands of politicians, attorneys, and special interest groups on an annual basis. Okay, so accountants aren’t known for their sense of humor.

It is because of the level of flux and complexity in the tax code—and the reality that there are too many forces at work in taxation outside our control—that we must not pin our investment, insurance, education, retirement, or estate plans on any particular tax structure. These decisions and plans should be made based on their own viability first and the tax impact later. Don’t let the tax tail wag the dog.