The Value of Tax Alpha

Financial Planning Dentist

In today’s fiercely competitive investment management landscape, financial advisors are encountering challenges from various fronts, including fellow advisors, brokers/dealers, insurance agents, robo-advisors, and self-directed investors. In this environment, where promising excess returns over market performance is unrealistic in the long term, advisors are exploring alternative avenues to enhance their clients’ investment outcomes.

While offering other services like financial planning and consultations is undoubtedly valuable, they often don’t directly contribute to improving the investment bottom line over a year. So, how can advisors truly augment investment performance without escalating risk? The answer lies in tax optimization, commonly known as “tax alpha.”

Tax alpha involves integrating tax-saving strategies into investment management, providing clients with both permanent and temporary tax savings. These strategies can significantly benefit clients and set advisors apart in the competitive landscape.

Permanent Tax Savings Strategies

Permanent tax savings are those that don’t necessitate repayment to the tax authorities. One such strategy is avoiding short-term capital gains, where assets held for less than a year incur higher tax rates. Investors can substantially reduce tax liabilities by deferring sales to qualify for long-term treatment.

Location optimization is another powerful strategy, offering both permanent and temporary tax benefits. It involves placing investments in the most tax-efficient accounts and aligning investment types with account types to minimize current and future taxes. For instance, holding tax-inefficient investments in tax-deferred accounts and appreciating assets in taxable accounts can lead to significant tax savings.

Temporary Tax-Savings Strategies

Temporary tax savings strategies, although postponing tax obligations, can still be valuable. Tax-loss harvesting, for instance, involves selling investments at a loss to offset gains, thereby reducing current tax liabilities. Additionally, choosing high-cost lots when selling assets and avoiding year-end capital gains distributions are effective strategies for temporarily lowering taxes.

Implementation of Strategies

Advisors can implement tax-saving strategies manually, automatically, or by delegating to specialized software or asset management programs. Automated solutions can ensure comprehensive implementation of tax strategies, minimizing the risk of overlooking tax-saving opportunities.

Communicating with Clients

Advisors must educate clients about the benefits of tax-saving strategies and quantify the tax savings provided. By explaining concepts like location optimization through various channels and providing personalized reports showcasing tax savings, advisors can reinforce the value they bring to their client’s financial well-being.

Conscious Buying of Individual Bonds

In the pursuit of tax optimization, the selection of bonds plays a crucial role. Certain types of bonds offer distinct tax advantages, making them suitable for inclusion in investment portfolios. Here are some considerations for buying the right kinds of bonds for tax reasons:

1. Tax-Exempt Municipal Bonds: Municipal bonds issued by state and local governments typically offer interest income exempt from federal taxes and sometimes from state taxes as well, especially if the investor resides in the issuing state. These bonds are particularly beneficial for investors in higher tax brackets, as they provide a tax-efficient source of income.

2. Treasury Inflation-Protected Securities (TIPS): TIPS are U.S. Treasury securities designed to protect against inflation by adjusting their principal value based on changes in the Consumer Price Index (CPI). While the interest income from TIPS is subject to federal taxes, the inflation adjustment on the principal is taxable only when the securities are sold or mature. For investors seeking protection against inflation with minimal tax implications, TIPS can be a suitable option.

3. Zero Coupon Bonds: These bonds pay no coupon to investors annually, so there is nothing to tax year in and year out. The entire yield of this bond type is paid out in the form of capital gains – which is far lower than the income tax rate for many investors. While the lack of an income is unappealing for many, the tax strategy is sound for those who are looking for yield with lower taxation.

4. Taxable Bonds in Tax-Advantaged Accounts: Taxable bonds, such as corporate bonds or Treasury bonds, are generally more tax-efficient when held within tax-advantaged accounts like IRAs or 401(k)s. Since the interest income from taxable bonds is taxed at ordinary income rates, sheltering them within tax-deferred accounts can help mitigate tax liabilities, allowing for greater compounding of returns over time.

In an era where investment services are increasingly commoditized, differentiation is vital for advisors to retain and attract clients. While financial planning remains essential, creating tax alpha can significantly enhance the value proposition for clients. By incorporating tax-saving strategies into investment management, advisors can deliver tangible benefits that positively impact clients’ investment outcomes.

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Kevin Taylor

Your Money, Your Freedom: The 4-Point Fun Guide to Decoding Your Employment Dependency!

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This quirky analogy is precisely what delving into your investment asset performance feels like. It’s an exercise in evaluating whether your hard-earned money is actively working towards your dreams and lifestyle needs or if it’s just taking up space on the sofa, idly passing time. It’s high time those potatoes were given a meaningful job! If your employment dependency is on the higher side, meaning a significant chunk of your lifestyle relies on your job income, the pressure on these couch potatoes—your investments and savings—is somewhat alleviated. They can afford to be a bit more relaxed because your job is doing the heavy lifting. However, if that dependency figure is alarmingly low, indicating that you’re leaning heavily on your investments to fund your day-to-day life, then it’s a wake-up call for your sedentary spuds. This scenario demands that your investments shed their couch potato persona and shift into high gear. 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The beauty of this metric is that the lower your dependency on your employment income, the more freedom you have to enjoy life’s pleasures without the ominous cloud of the next payday looming over you. It’s about achieving that delicate balance where your financial stability is not rocked by the absence of a paycheck, allowing you to lead a life filled with joy, security, and prosperity. Moreover, the concept of employment dependency doesn’t just offer a snapshot of your current financial resilience; it’s also a crystal ball into your future, especially your retirement years. By putting your lifestyle through a “stress test” using the Employment Dependency metric, you gain invaluable insights into how your days of leisure and retirement could look. Will you be sipping margaritas on a beach, or will you be pinching pennies? This metric illuminates the path to ensuring your retirement paycheck—funded by pensions, savings, and investments—can support your dream lifestyle. It’s about preparing today for the tomorrow you desire, making sure that when work becomes an option rather than a necessity, your lifestyle continues unabated. This dual focus on present joy and future security is what makes understanding and optimizing your employment dependency so crucial. 3. What If… The Game Life, with its unpredictable twists and turns, often throws us into scenarios we never saw coming. Imagine one day you’re on top of the world, with a hefty bonus check in hand, ready to splurge or invest. The next day, the tide turns, and those freelance projects that were your bread and butter suddenly dry up. Here’s where playing the “What If” game with your Employment Dependency metric becomes your secret superpower, allowing you to navigate through life’s uncertainties with grace and poise. Think of it as your personal financial forecasting tool, crafting an umbrella sturdy enough to shield you from any storm that life decides to brew. This approach not only tests your financial resilience in times of stress but also empowers you to remain comfortable and secure, no matter the financial weather outside. It’s about preparing for the worst while hoping for the best, ensuring that whatever life tosses your way, you’re ready to catch it with a smile. But let’s push the envelope further. What if your Employment Dependency metric could do more than just safeguard your current lifestyle? What if it could open the door to possibilities you’ve only dreamed of? Imagine living on a cruise ship, traveling the world without a care, or dedicating your days to volunteering for causes close to your heart. By understanding and adjusting your employment dependency, you start to sketch the blueprint of your life’s next chapter. It’s not just about surviving; it’s about thriving in ways you’ve only imagined. This foresight enables you to allocate your finances not just for survival or comfort, but for the fulfillment of your deepest desires and dreams. Asking “What might it require today to get there?” transforms your financial planning from a mere exercise in numbers to a strategic map leading to your ideal future. It’s about realizing that with the right planning and insight, your financial decisions today are the seeds of the lifestyle you aspire to live tomorrow. 4. Your Financial Safety Net Finding yourself high on the employment dependency scale can feel akin

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Do I need life insurance?

Most likely yes.  Your financial and family situation will be the deciding factor. If you’re single, have a large amount of savings, and no dependents then life insurance may not be for you. The reason being, unless your savings cannot pay for your debt(s) and that debt would be a burden on the person (most likely family) that takes it on then you don’t need life insurance.  Life insurance is typically purchased if you’re the primary provider for your dependents and spouse. For example, if you own a home with a mortgage and your significant other make 80% of your family’s income, how would you pay your mortgage if they were to unexpectedly pass? If you have kids, how would you support your family? When people are young their debt is usually very high with student loans, car payments, mortgages, kids, etc so one major event or death would be devastating to a primary provider’s family.  For assessing life insurance needs, InSight looks at this math: Mortgage payoff + spending coverage – adjusted net worth = Life Insurance Need  The 30-year number enables us to be very conservative with our estimate and that is always adjustable. The 3.3% withdrawal rate is a safe estimate that the primary provider’s family can safely (withdraw a consistent amount without dipping into principal) for life.  Now the difference between permanent and term, how long you need the coverage, what riders you choose, etc will be up to your plan and goals and will need to be reviewed with a Financial Planner and Insurance Agent.  If you found this helpful please share it and/or leave a comment!

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How much should you keep in the bank in relation to your investments?

Great question! So there are a couple of ways to think about this but I will give you what I believe are two simple strategies. One emergency fund + Investments OR The Three Bucket Strategy:  First the Emergency + Investment Account method: First Establish the Emergency Fund How much? 3-12 months of non-discretionary cash for your emergency fund. Three months if you’re single and highly employable and 12 months if you’re older (50+) with dependents and you’re the primary provider. For everyone else, six months is a great place to be. Put this cash or in money market accounts that are liquid (you can access immediately).  What type of account(s) should I use? Savings Account or checking account Then develop Investment Account(s) Once you have your emergency fund taken care of this is where you can invest the rest. Read Saving Automation 101 & Investing 101   OR try the Three Bucket Strategy: First Bucket: 3-12 months of non-discretionary cash for your emergency fund. Type of account: Savings Account or checking account 3 months if you’re single and highly employable and 12 months if you’re older (50+) with dependents and you’re the primary provider. If you’re in between 6 months is a great place to be. Put this cash in money market accounts that are fully liquid (you can access immediately).  Second Bucket: 1-3 years of individual bonds and maybe some equity. Brokerage account  This is money that is used to generate income to replenish your first bucket, provide a safety net, and is supposed to be less volatile than investing in the general market. If your cash is used up in bucket one you take some of the money from this bucket and shift it over into bucket one to replenish that amount. For conservative investors, this is a great place to buy bonds with different maturities to build what is called a bond ladder (1-year bond, 2-year bond, 3-year bond). For aggressive investors, you may use a balanced approach of a total stock market ETF and a total bond market ETF (a balanced fund).  Third Bucket: 3 years + of equities This is your long term money. Money that you don’t plan to touch or use for anything other than to let it grow and compound. This should be invested into equities. Reinvesting your dividends and letting time run and the effect of compounding work for you.  If you found this helpful please share it and/or leave a comment! 

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