Divider
Divider


Alan Haft
 

$91,463 for Free

Depending on how your clients play their cards, they just might hit the jackpot.

October 18, 2010
by Alan Haft

Your clients can win it playing bingo, betting the horses or any number of other things. But for purposes of this article, the money I’m talking about is by getting it with a little tax efficiency.

Higher taxes are a near certainty on the horizon. But as ugly as higher taxes will be, most people aren’t aware that it’s actually a lot worse than they think.

After all, does paying a dollar in tax really just cost a dollar? At first glance, it might seem that way, but upon closer math, it’s really not. Paying one dollar in tax will wind up costing a lot more than what first meets the eye.

Here’s an example:

Let’s suppose I have $100,000 in an after-tax account such as a CD (or some other investment that throws off ordinary income tax). In addition, let’s suppose:

  • I earn an average of five percent per year,
  • I’m in a combined 40 percent tax bracket,
  • I re-invest the earnings I receive, and
  • I pay the taxes owed each year from an account outside the CD.

Running the math, at the end of a 20-year period, you might think my account value should be around $265,330, which at first glance doesn’t seem all that bad.

Very nice.

Or is it? First off, we have to account for the taxes I paid on the earnings along the way and remember, as the account grows larger, so does my tax bill. As such, at the end of the period, when deducting the taxes I paid from another source along the way, the adjusted account value can be construed as really being worth only $199,198.

But the story doesn’t end there. Each time your client reaches into their savings to pay the tax, that money is leaving their money universe forever.

Suppose I reach into my savings to pay $500 dollars in taxes for a particular year. Did I really lose $500 to the Internal Revenue Service (IRS)? Yes, but I really lost more than that as well. In this case, I’ve lost the opportunity to invest that money, didn’t I? Sure I did, so not only did I lose that money to the IRS, but I also lost the opportunity to invest and grow it.

This is obviously what Opportunity Cost is all about and it’s also the reason why paying one dollar in taxes really costs us more than that mere dollar alone.

So, with that in mind, we really need to adjust the math above. Assuming the earnings on the money paid to the IRS would have earned the same as my CD did, when deducting the Opportunity Cost of money paid to the IRS and the earnings it would have otherwise received, a more precise account value at the end of the term leaves us with around $164,252, not $265,330.

Solutions

Unfortunately, most people are not aware of the true dollars lost due to tax inefficiency. These days, when many people are struggling to save anything for retirement, understanding how to improve the efficiency of investing would give most people a greater chance of achieving retirement success.

In fact, I find most people would be far more likely to succeed in accumulating more dollars not by saving more (few can nor do they want to) and/or trying to find investments that could deliver higher returns (which brings more risk), but instead to focus on how to invest with tax efficiency on their minds and this is what my “free” $91,463 is all about.

So, how can one get more efficient with their investments? The answer comes down to a few possibilities, two of which I’ll discuss here: Flatten the Tax or Reduce It.

Flatten the Tax

In this method, your client doesn’t re-invest earnings received on the account. Instead, your client pays the tax on the earnings received, then on an annual basis transfers earnings over to a tax deferred account along the way. In this case, the original account balance and taxes owed remains flat and the tax deferred account builds over time.

Running the math, the CD account would then appear as follows:

  • End-of-term account balance: $265,330
  • Cumulative taxes paid: ($38,095)
  • Opportunity Cost on taxes paid: ($24,888)
  • Net account value: $202,347

Not bad. By “moving” the earnings into a tax deferred account, your client would have paid less tax and increased their account amount as well. By focusing on the efficiency of your client’s investments, they would have added more money into their pocket without having to save more or hope for higher returns.

Tax practitioners should note, however, that for their clients to use this option or the Reduce the Tax option (discussed below), they will have to be able to put the earnings — or earnings and principle amounts — into a tax-deferred account. That said, they may not be able to do this because of the various limitations on contributions to tax-deferred accounts.

Alternately, your clients may also choose to put the earnings or earnings and principle into tax-free investments (e.g. municipal bonds) or taxable long-term growth investments (such as non-dividend paying growth stocks and real estate as well).

Finally, remind your clients that should they decide to put their money into tax-free investments, they may not earn the same return as with a taxable investment because of the taxes that are factored into the returns offered by tax-free investments. Also, should your clients put their money into taxable long-term growth property, note that it will be tied up and unavailable for use.

Reduce the Tax

While flattening the tax can certainly improve the efficiency of my investment, Reducing the Tax often provides the best results of all.

In this method, your client doesn’t re-invest the earnings received on the account nor do they flatten the tax by moving earnings into a tax deferredaccount. Here, they take both the earnings and principal out of the account each year and move them into a tax-deferred account.

If your client did this over a five-year period (as an example), the equation would appear as follows:

  • End-of-term account balance: $265,330
  • Cumulative taxes paid: ($3,995)
  • Opportunity Cost on taxes paid: ($5,620)
  • Net account value: $255,715

With this method, your clients would now see an increased net amount by $91,463, which is where I essentially get my “free” money due to efficiencies of my investing.

Summary

The following chart will be helpful to summarize the hypothetical outcome, for example only, of the three methods described above:

  INCREASING TAX
(re-invest earnings, the way most people do it)
FLATTEN TAX
(move earnings to tax deferred account)
REDUCE TAX
(move both earnings and principal to tax deferred account)
End Balance 265,330
Cumulative taxes paid 66,132 38,095 3,995
Opportunity Cost on Taxes Paid 34,946 24,888 5,620
Balance Minus Taxes and Opportunity Cost 164,252 202,347 255,715
Advantage over Increasing Tax - 38,095 91,463
Deferred taxes remaining 0 28,037 62,137

The Deferred Tax

If your client re-invested the earnings (in the Reduce Tax method with principal as well) into something vehicles such as non-dividend paying growth stocks or real estate and didn’t cash it out, their heirs could potentially receive the account tax-free due to the step-up in cost basis.

Furthermore, your client may also move the earnings and principal into municipal bonds or choose to move earnings and/or principal into a modified life insurance policy in which monies can be potentially borrowed out tax-free as well.

Conclusion

There’re many possibilities regarding how to structure your client’s accounts to achieve the highest amount of efficiency. And by doing so, you too might just end up discovering a “free” $91,463 dollars as well.

Want to see the math supporting this article? E-mail me.

Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller, You Can Never Be Too Rich and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical and for example only.

* For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage services as well as commissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.