Tax Diversification?

Q: Why should anybody listen to C/Suite? A: Because we have walked 10,000 miles in our clients’ shoes.

Through multiple decades of serving Senior Leader families, we have mastered an appreciation for the entire arc of the executive experience from Director to C/Suite and from early career to officers in retirement for over 20 years. Perspective delivers wisdom that supersedes knowledge.

Today’s perspective turns to a simple but powerful topic: Tax Diversification within the context of retirement.

The number one question which arises as an officer approaches retirement, regardless of net worth, is:

  • Where is my income coming from the moment my paycheck stops?

Here is the slightly more refined question:

  • What is the most tax-effective way of structuring the income I need in retirement?

The answer to the less enlightened question:

If you retire at age 55, you’ll live off cash from option exercises each year for about 5-8 years and invest the excess. Next, we’ll work around pre-scheduled deferred comp distributions (again, ordinary income subject to market risk) and sell enough bonds or stock until you hit age 72. At age 72, you must take required minimum distributions (ordinary income subject to market risk), so finally, we will supplement the required minimum distributions with enough other portfolio income to satisfy your spending needs. While accurate, the answer seems too fuzzy for most clients.  Only clarity brings peace of mind, so a more clarified perspective is in order.

The answer to the more enlightened question:

The second question is really about stewardship because the question recognizes that tax is a drag on the portfolio.  Since all our clients know they have sufficient resources to get through retirement, inevitably, a third question replaces the second: “Look, we’ve been under corporate business stress for decades. In retirement, we don’t want to be under stock market stress worrying about how a substantial market downdraft like the years between 2000 and 2014 might impact our plans.” So this is now a qualitative discussion about risk elimination when facing the unknown.

How do you prepare for the unknowns of tax and market risks?

The starting point is to recognize the wisdom of Socrates that “The only true wisdom is in knowing that you do not know!” Nobody knows how the markets will perform through your retirement. Nobody knows precisely the tax environment throughout your retirement, so one prepares for the worst while hoping for the best! Our suggested solution is to craft predetermined, independent streams of income that are taxed differently. Lifting portfolio yield to the point of providing 100% of your retirement income need removes the fear of having to sell assets into a declining market. Increasing yield reduces portfolio stress. December of 1999, in hindsight, was a disastrous retirement date; unless you had an advisor whose focus had been to help you design multiple sources of differently taxed income streams. Having many choices allows for calling audibles during retirement that provide required income in the most tax-effective manner regardless of market risks. That’s a mouth full, so it might be wise to read that a few times.

Again, how does one plan for the unknown?

Clients and their advisors are so busy worrying about market volatility that many clients have long forgotten about tax volatility or tax risk. Many clients and advisors lose sight that tax deferral is NOT tax avoidance; it is merely a deferral of tax. This mistake in thinking leads a client to maximization of 401K and deferred compensation. The result is that many new clients retire with 70+% of their investment portfolio held in tax-deferred instruments, 5% in tax-free instruments, and 25% owned in taxable accounts. Imagine the tax inefficiency of centering a significant portion of retirement income around the withdrawal of ordinary income from tax-qualified sources, especially into the teeth of rising marginal tax rates! The 70%/5%/25% tax allocation we see so often is the inverse of what would have been optimal tax allocation over the past couple of decades with the benefit of hindsight. With enormous deficits piling up, it seems plausible that most clients retiring today will face much higher marginal tax rates rather than the lower rates their advisors might have been suggesting. Ouch! We don’t know this with certainty, but there is a more nuanced point to consider.

OK, then get to the point!

Think about the three tax buckets: 1) Tax-Deferred 2) Tax-Free 3) Taxable. Don’t put all your eggs into the same tax bucket! For example, (if you can help it) don’t retire with a 70% allocation to tax-deferred, a 5% tax-free allocation, and a 25% allocation to Taxable. Instead, strive for an equitable mix in each bucket closer to 33%. It is easier to meet the demands of unforeseen change by structuring a balanced blend across the tax buckets. The objective may be to create the most tax-effective cash flow across the arc of your retirement experience; however, if 70-90% of available capital resides tax-deferred, there are limited options to manage tax.

A parting thought:

One last thought, if you are going to over-allocate to one of the three buckets above, we suggest you over-allocate to the second, Tax-Free bucket, and recognize that there are many ways aside from Roth or Roth 401K to fill that bucket! Those alternate investment opportunities are beyond the scope of this blog, so we suggest you seek us or other competent advisory assistance to help you fill that Tax-Free bucket!

Stoddard Barnhill

Phillip Barnhill

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The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.

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Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client’s individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for related questions.

This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.

About the Authors

Phil Barnhill, CLU

Private Wealth Advisor
Director of Risk Management

Stoddard Barnhill, CFP®

Private Wealth Advisor

For nearly 25 years Phil has worked exclusively with senior leaders of public and large private companies. Over the past six years Stoddard has been carefully mentored in this niche market, leading to a highly-specialized practice knowledge within the team. This focus on corporate executives and their family dynamics comes with significant insights into executive compensation, stock concentration, equity monetization, and the full life-cycle of a career in the C-Suite.

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