"If you fail to plan, you're planning to fail!"
- Benjamin Franklin
Over the years, I have talked to hundreds of investors. Far too often I find that investors start with the investments; specifically the greed of investment returns or the fear of investment loss, as opposed to a Financial Plan. Greedy investors frequently take more risk than their financial plan requires; many times that risk is not rewarded when viewed through a Monte Carlo simulation – the probability of not outliving your retirement savings. Fearful investors can be found to not take enough risk to give them a statistically significant probability to meet their long-term cash flows. Both are examples of failing to plan.
Before investors even consider putting their hard earn savings into tit-for-tat investments, they should start with the question of “Why do I need to invest in the first place?”. Well, as the quote above states, “if you fail to plan, you are planning to fail!”. I’m certain you have heard that quote, probably a hundred times. Of course you believe it and live it every day… right? I am sure you have a budget, savings and tax strategy, financial plan, debt strategy, will and estate plan, and have insured properly for life insurance and long-term care. I am also sure your investments are tuned tightly to all these topics… right?! If you are like most investors, you are nearing retirement and are scratching your head as to how you got to today… some money and uncertainty about your financial future.
Today, let’s talk about the financial plan, a comprehensive financial plan; primarily because almost everything else listed above is solved for or evaluated using this tool. Let’s not get this confused with a complimentary plan which is really nothing more than a sales tool. On the surface, it is fine because most clients do need to know if they will outlive their investments. Unfortunately, when clients receive a complimentary plan, often times advisors do not continue to plan for their clients to make sure their financial path is clear or look deeper than the investments and cash-flow projections.
At Kabarec Financial Advisors, Ltd. (KFA), we believe clients should receive a comprehensive financial plan. Below is what we recommend looking for in a comprehensive financial plan:
- Certifications and Fiduciary Standard –You should look for a fee-only, fiduciary with a CFP®, who must put your interests before their own interests.
- Cash-flow analysis with ongoing monitoring – As markets shift, expenses go up for an unforeseen reason or inflation unexpectedly rises. The financial plan is the tool that helps clients understand what Minimum Acceptable Return (MAR) they need and are comfortable to earn in order to meet their long-term financial cash-flows (i.e. retirement, education planning, legacy planning, etc.) while considering variables like budget, savings, investment risk profile, etc. and solving for a range of statistical success through a Monte Carlo simulation. That said, the financial plan should be routinely monitored, including the Monte Carlo simulation, to ensure the client will successfully reach their goals as life happens.
- Financial Manager –Financial planning should also include a financial manager (see below)– the process of routinely evaluating all areas of your financial life with you and your other key advisors (i.e. CPAs, attorneys, insurance agents). This tool helps to ensure that you and your loved ones not only have enough money in retirement, but also have planned appropriately for such things as disposition and taxation of your estate, financial protection in case of an unexpected loss or tax planning so that the IRS doesn’t erode your hard earned nest egg. In addition, the financial manager should include organizing your financial life in one place so that you have the comfort of knowing that your family will be able to find all your important financial documents and have a team of advisors ready to help them when that time arrives.
"You must pay your taxes. But, there's no
law that says you gotta leave a tip."
–Morgan Stanley advertisement
As the relief of tax season fades into the deep corners of our memory, many taxpayers may be sitting back thinking they’re done; they’ve successfully filed their taxes so they can relax and (hopefully) wait for that refund to hit their account. Before you start putting your legs up and planning that summer vacation, remember that if you are not careful you may inadvertently be giving away your hard earned money to the IRS by delaying in planning and preparing for next year’s return.
At Kabarec Financial Advisors, Ltd. (KFA), we are routinely tax planning for our clients to generate tax alpha - the value-add that an advisor provides by implementing “proactive tax strategies that generate tax savings, particularly in a portfolio (where the larger the portfolio, the larger the potential tax benefits).1 As reputable sources like Vanguard, Morningstar and Envestnet point out, strategic tax planning is worth 0.70% to 3%in annual tax alpha, and that estimate does not include the potential benefits of income tax planning, such as tax bracket management - the process of strategically managing your controllable income in conjunction with marginal tax rates to improve overall tax efficiency. We consider the following high level strategies for all of our clients:
Asset Location– Vanguard research shows that asset location can provide clients with up to 0.75% of additional annual return2. Asset location is a tax minimization strategy that locates investments based on two primary factors: an investments tax-efficiency and its expected returns. For example, placing traditionally high growth and high turnover assets, such as emerging markets and sector rotation fund in the tax-free Roth, or sheltering investments that generate high ordinary income, such as taxable bonds in a tax-deferred IRA. A good asset location reference is Chart 1, “the full asset location smile and the asset location priority list” from The Kitces Report, “Advanced Concepts & Strategies in Asset Location”. In addition, asset location is most effective when the strategy is implemented at the “household level” versus at the account level. Therefore, when considering an asset location strategy for your investments look for firms (like KFA) that can diversify your investments at the “household” level.
Source: Michael Kitces, The Kitces Report
Municipal bonds– One of the principal assumptions of an effective asset location strategy is to use taxable bonds in tax-deferred accounts. However, in certain situations where the tax-deferred accounts are not large enough to properly diversify a client’s investments between stocks and bonds, tax-exempt municipal bonds are a good option. In addition, when considering municipal bonds in a taxable account, investors should review their tax bracket to determine if tax-exempt municipal bond yields are comparable to U.S. Treasuries. For example, 10-year AAA municipal are currently at 1.32 relative 10-year U.S. Treasury bonds, and the tax equivalent yield for a 15%, 28% and 35% tax brackets are 2.03, 1.83 and 1.18 relative to 10-year U.S. Treasury bonds. Table 1 shows the comparison of the U.S Treasury Yield Curve to the AAA Municipal Yield Curve.
Tax loss harvesting– Tax loss harvesting is the strategy of selling securities at a loss to offset a capital gains tax liability, without permanently changing the underlying investment/portfolio. Evestnet’s “Capital Sigma: The Return on Advice” shows that a properly tax managed portfolio may be worth 0.60% annually over a buy-and-hold portfolio.3 Investors should be aware that Congress has passed a 30 day “wash sale” to limit potential abuses. The wash sale rule requires that a tax loss can only be claimed by investor’s if the replacement investment is not “sustainably identical”. In addition, investors should note that tax loss harvesting may trigger a future gain, and thus the value of tax loss harvesting is really in the tax deferral of the loss from time originally claimed until the recovered loss is triggered. For example, an investor buys a stock for $10,000 and its value declines to $6,000. The investor can harvest a $4,000 tax loss, but in doing so, the investment will now have a cost basis of $6,000. When the client sells the stock for $10,000 (the original purchase price), the investor’s gain will be $6,000 (so the net gain is $0). 1
Income Tax Planning– The 3rd and 4th quarter of every year, KFA helps clients’ tax plan going into the end of the year. This includes running illustrations to help minimize a client’s tax burden. We use various strategies, including harvesting gains, tax bracket maximization strategies such as Roth conversions or retirement withdrawal ordering optimization, charitable giving and gifting strategies, and the classic tax deferral strategies (e.g. IRA’s). As Michael Kitces points out, “the tax bracket arbitrage opportunity… is often the biggest tax planning opportunity available”, but it is difficult to quantify.1
Kitces, “Evaluating Financial Planning Strategies and Quantifying Their Economic Impact” The Kitces Report, Volume 3, 2015.
Kinniry Jr, Jaconetti, DiJoseph, Zilbering, Bennyhoff, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, September 2016.
Envest PMC’s Quantitative Research Group, “Capital Sigma: The Return of Advice”, 2016.