Creating and maintaining an investment portfolio that provides the best risk/return profile is the obsession of many investors. More return with less risk is obviously the goal. The stakes are high, which is why professionals and academics alike get into heated debates about competing models. A model that produces return results superior to others by mere fractions of a percentage point without more risk is considered a resounding success. That’s all good for investors, but sometimes it just isn’t the most important issue.
In the real world (as opposed to a deliberately simplified financial model), the tax drag caused by investing decisions can have a much greater effect on the investor’s after-tax investment return. After-tax return is the money left over after taxes are paid that can actually be spent, and different types of investment accounts offer different tax treatments for different assets. For instance, a capital gain earned in the stock market may face twice the tax drag in a traditional IRA (where distributions are taxed at the investor’s marginal income tax rate) when compared to a taxable account (where long-term capital gains receive a preferential rate). Deliberately choosing the best type of account to hold a particular investment is often called an asset “location” strategy. All too often investment managers ignore the practical realities involved in maximizing the after-tax investment return through an asset location strategy..
When an investment manager can create a higher after-tax return for investors by minimizing tax drag, that’s referred to as “tax alpha” (where alpha means more return without more risk). A Roth IRA is the holy grail of investment accounts if the goal is to increase tax alpha. If handled properly, earnings in a Roth IRA never face any taxes. In the years since 1998, when the Roth IRA was launched, Congress has steadily liberalized the constraints that prevent many affluent investors from making Roth IRAs a large percentage of their portfolio.
This steady change in the tax rules has meant that investment managers can create more tax alpha for their clients if they are aware of all the techniques at their disposal. Sometimes this requires close coordination with a client’s tax advisor, but these generally aren’t considered risky maneuvers and a good tax advisor usually gets pretty excited to see that their client is working with an investment manager who isn’t making the tax bill even higher than it should be.
The most basic technique for increasing the amount of assets in a Roth IRA is for the investor to make Roth IRA contributions each year. The investor, or their spouse, must have compensation for the year, so investors in retirement are usually out of luck. In 2017 the contribution limit is up to $5500, with folks 50 and over able to add an additional $1000 as a “catch-up” contribution.
But if you make more income than the limit, or don’t file your taxes the right way, you can’t make a Roth IRA contribution. In 2017, single filers begin phasing out of the full contribution limit at $118,000 in income (actually Modified Adjusted Gross Income for Roth IRA Purposes http://www.irs.gov/publications/p590/ch02.html#en_US_2013_publink1000230985 ), losing all ability to contribute after $133,000. The phase-out range for married filing jointly is $186,000 – $196,000. That leaves in a lot of people, but excludes those who are in the higher earning categories.
The biggest change to help affluent investors was when the income limits for Roth “conversions” went away. When Roth IRAs were first introduced, Congress wanted to make sure that folks at higher income levels couldn’t benefit from this new type of IRA, so income limits were added. But a few years ago, lawmakers looking to plug budget gaps realized that a conversion to a Roth IRA requires the investor to pay taxes on the balance of the assets (minus any taxed contributions known as “basis”). Investors rushing to convert IRAs to Roth IRAs have paid a lot of taxes in the short run in hopes of a long-term tax benefit.
History offers a cautionary tale, however, because in 1998 and 1999 many folks within the income limit for conversion converted IRAs full of technology stocks. Just a few years later it was common to hear about someone who converted a $100,000 IRA to a Roth, paid $35,000 in taxes, but now was staring at a brokerage statement for their Roth IRA showing an account value of something like $20,000. They paid more in taxes (from other accounts) than their new Roth IRA was eventually worth! Thus began a wave or “re-characterizations” to reverse the conversion, but for many investors it was too late to meet the deadlines to make that happen. But if assets are diversified and managed prudently, then for many investors it can make sense to convert an IRA to a Roth IRA.
One big administrative trap remains, however, and I’ve seen it catch investors, investment advisors, and even CPAs who didn’t understand the rules. It’s simple: the IRS considers all of your IRAs be just one IRA. By that I mean that if one IRA is full of post-tax contributions, you can’t just convert that one IRA to a Roth IRA to minimize your tax burden.
Here is an example:
Some naïve tax filers will try to convert IRA #1 to a Roth IRA, thinking that they will only pay tax on the $10K in earnings. The $20K converts tax-free, right? Wrong! The IRS says that the tax filer has only one IRA, worth $100K,with $20K in basis that isn’t taxed upon distribution or conversion. Any contribution is a pro-rata mix of the total of all IRA assets. So a $30K conversion pulls $6K from basis and $24K from other sources that are taxable. When the tax filers tries to only pay taxes on $10K instead of $24K, then penalties likely result. The IRS usually takes a few years to figure out the error and by then it can be too late to avoid some serious problems or a “recharacterization” to reverse the conversion.
When considering whether or not to convert an IRA to a Roth IRA, it’s important to decide if the intention is to eventually convert all of the IRA. The future benefit of tax-free returns is impossible to estimate with certainty, whereas the bill for converting is pretty easy to calculate. But there is one extra technique available once all of the IRA is converted, and that is the so-called “back door Roth IRA”.
Once there is no IRA balance due to a conversion, investors can make a contribution to their regular IRA each year and then immediately convert it to a Roth. Investors that don’t qualify to make a straightforward Roth IRA contribution are often also the ones who can only make non-deductible IRA contributions. The eligibility rules combine an income test and a participation test in your employer’s retirement plan (http://www.irs.gov/Retirement-Plans/IRA-Deduction-Limits).
So the basic flow of funds and paperwork is this:
First, cash from your bank account goes into your IRA as a non-deductible contribution. This requires that you file Form 8606 to document that there is basis. It results in the IRA custodian sending you and the IRA a Form 5498 to document that you made a contribution (but beware, you probably won’t get this until June of the next year).
Then the cash in the IRA gets moved into the Roth as a conversion. This needs to be documented on your Form 1099 when you file for that tax year. The conversion from the IRA results in your custodian sending you a Form 1099-R to show that the funds left the IRA (you will get this in January of the next year). And it also results in your custodian sending you yet another Form 5498, but this time from the Roth IRA that received the funds (and yes, it won’t come until June of the next year).
At the end of this you essentially put cash from your bank account into your Roth IRA, but beware of the paper trail. The June time frame to get some of the forms causes many filers to make mistakes. But it stems from the fact that custodians wait until after April 15 of the following year to begin producing tax forms to document any money that was put into an IRA. This delays the forms for conversions, even though that deadline was December 31. But contributions and conversions use Form 5498 so the custodians ship them all out at the same time.
To summarize: if you can make Roth IRA contributions, do it. Reducing tax drag is probably a no-brainer decision. And if you can’t make Roth IRA contributions, but are willing to pay a bit of taxes to convert your IRA to a Roth, then terrific for you because it might work out in the end. The variables are many and the future is unknown, so it’s a risk. But if that conversion also allows you to begin a process of making annual backdoor Roth contributions that you otherwise couldn’t do then it likely tilts the odds in your favor.
At BIP Wealth we always encourage our clients to get the best tax advice they can find from a qualified tax advisor. We don’t give tax advice per se, and when we have an idea that could increase your tax alpha we like to coordinate with you and your tax advisor. And sometimes the benefits you reap are even more significant than the investment returns.
This communication contains general investing information that is not suitable for everyone and is subject to change without notice. Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass. The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security. Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors. Indices are not available for direct investment.
It’s one thing to have a vision for your wealth. But, in our complex financial landscape, where things can change in a heartbeat, it’s just as important to have a plan in place that takes a comprehensive approach. This is where the concept of holistic financial planning comes into play. Beyond taking a traditional view of finances—one that focuses solely on single aspects like investments, savings, or retirement—holistic planning has a more human approach and embraces a person’s lifestyle, priorities, and goals. It weaves together every financial thread of their life—from tax planning to investments to insurance needs—ultimately aligning each aspect with their unique financial circumstances. Because of this, holistic planning can not only enhance financial decision-making but can also help to foster peace of mind in the long term, knowing that every part of your financial life is working in harmony to potentially achieve long-term goals.
So, why might holistic wealth management be important to your success? In this blog, we’ll break down the top five reasons to implement a holistic financial strategy in navigating toward a secure, prosperous financial future.
For many, financial planning means more than just short-term stock returns. Perhaps you’re hoping to buy your dream home or car. Maybe you want to fund your child’s college education. You may even want to start a small business. Whatever the case may be, holistic planning can help you align with those goals in a more efficient way.
Now, what happens if your goals change? As you get older or the financial markets evolve, can holistic planning adapt to your new situation? Yes. Holistic wealth management from a firm like BIP Wealth can provide clients with a plan that is prescribed to be resilient to sudden changes such as dips in the stock market or higher taxes. Through these personalized plans, clients have the opportunity to establish a more resilient portfolio and lifestyle that can adapt to their evolving needs.
As life and the financial markets change with time, so should your wealth planning. A key value of holistic planning is its versatility, allowing both advisors and clients to make constant changes to target specific goals if needed. This flexibility is especially important for analyzing the global markets. The below graphic takes a look at the percentage of annual returns across a number of the world’s key markets, solidifying the need for a broadly diversified portfolio that can adapt to changing conditions.Source: Dimensional
Through a holistic financial plan, you may be able to achieve higher or more consistent returns as you focus on diversifying your portfolio to be more flexible. A study from Dimensional, a financial investment firm, found that from 1990-2020, investors looking to yield higher returns from global equities as well as global intermediate government and credit bonds would have performed better with holistic planning in most instances.
While thinking about your dream retirement or financial future can be an exciting time, it is also important to keep in mind the many risks that are associated with investing. Say you have a large chunk of your money invested in a single stock. At any given moment, that stock’s value could plummet, taking your hard-earned capital with it. That’s why a core element of a holistic planning philosophy should hold a somewhat pessimistic projection of the future. By actively thinking about how to properly react to inevitable market fluctuations, tax increases, or unexpected life shifts such as job loss, relocation, or injury, you can potentially limit your overall risk and set your portfolio up for a more robust future.
While it can be tempting to pursue high-risk, high-reward investments with quick payouts, holistic planning takes into account several other factors, especially when focusing on a sustainable, long-term gain, including one’s desire for a comfortable retirement or generational wealth transfer. Think of this like sitting in rush hour traffic, for example. You may quickly switch to a lane that is going faster only to find yourself at a standstill soon after. Although you might have temporarily moved ahead of some cars, they may end up beating you in the long run.
Holistic wealth management can include comprehensive plans that are built around passive income sources that drive a client’s retirement years or figure out the best way for them to enjoy their current lifestyle without having to continue their working days. By considering a client’s complete financial situation, holistic wealth management may help them accomplish more than just simple returns. Over the course of years, this system may help turn that dream retirement into an actual reality.
Finally, a component of a comprehensive holistic plan may aim to manage, control, and reduce your tax liabilities wherever possible. This is very important for estate planning and generational wealth transfers, as figuring out areas to reduce your tax burden can make a major difference over the years.
Our holistic planning formula blends Nobel Prize-winning empirical research with savvy integrations of alternative investments. Through our carefully-personalized plans, we’ve helped our clients unlock financial opportunities in both private and public markets that have historically been reserved for the ultra-wealthy.
At BIP Wealth, you’ll have access to a team of experts who will be with you and your family at every step of your financial journey. If you’re looking for a unique approach to holistic wealth planning, you can browse our offerings—from private equities, private credit offerings, public market investment plans, and covered call strategies.
What is holistic wealth planning?
Holistic wealth planning does not focus solely on singular investments, instead determining a person’s current financial situation, lifestyle, and ultimate goals to create a long-term plan for retirement, estate planning, investments, and more.
Why is holistic planning important?
From potentially limiting financial risk to better aligning with personal goals, holistic planning is important for those who are looking for more than just short-term investment returns.
