The following is adapted from Wayne Titus’s new book, The Entrepreneur’s Guide to Financial Well-Being. The book is available at Amazon.com.
A 21st century financial adviser creates a vision for the future that accommodates the short-term and long-term view for entrepreneurs. Unfortunately, many advisers still think only about the short term and how much they can profit from clients.
Here’s an example. A client named Raj, a tool-and-die manufacturer with a midsized company in Detroit, came to me to have his tax return prepared. He had a financial adviser already. When Raj and his wife, Rena, returned to my office to discuss and sign their return, I reluctantly had to inform them they owed $130,000 in federal income tax.
Needless to say, the couple was unhappily surprised. I explained that Raj’s adviser had been extremely active in managing his portfolio, buying and selling tech stocks like Facebook, Apple, and Google (and making a lot of money in commissions).
On the surface it looked to Raj like he was having significant gains in his portfolio, but in reality, the taxes were killing him. All his capital gains were short term, meaning they were taxed as ordinary income because he had held them less than a year.
If Raj had held them longer, he would have been taxed at lower rate. Also, other short-term investments didn’t stay in Raj’s portfolio long enough to be treated as qualified dividend income, which also caused the dividends to be taxed at a higher rate.
Raj’s adviser had not implemented an allocation strategy to increase tax efficiency. Such a strategy ensures you pay less tax because of how you allocate across different account types. Raj’s adviser had done what many advisers do, which is have clients hold exactly the same allocation in an IRA as they hold in a taxable account.
That’s inefficient, but advisers go that route because it takes them out of harm’s way legally; they won’t be held responsible for making tax decisions for their clients.
There’s a more efficient way, and that’s to understand the nature of the investment, how the income from it is taxed, and where best to put that income.
If Raj’s broker had been trading stocks within his IRA or his Roth IRA, Raj would not have been immediately hit so hard. Meanwhile, Raj’s corporate bonds from companies Ford and Delphi were in a taxable account; they should have been placed inside his traditional IRA to shelter them from being taxed as ordinary income.
Yet Raj’s municipal bonds were in that IRA, an illogical place as well, since they are exempt from federal tax and don’t need sheltering.
Raj’s allocation made little sense. Every client’s situation and tax bracket are different, of course, yet the main point an adviser should be discussing with you is not returns, but returns aftertaxes. Different investments carry different tax implications.
Again, a 21st century financial adviser looks at every aspect of your financial picture.
Look for a Strategic Adviser
Active managers and advisers who constantly buy and sell stocks or mutual funds, like Raj’s adviser did, are often seen as master builders who have all the answers. That’s an old-school method, as is the more passive strategy of buy and hold. Today’s world requires something different: strategicmanagement. I firmly believe that, overall, a client’s financial picture should be highly engineered and strategically managed.
We gather information from the client and put it through our process, which informs a long-term strategy, including the development and implementation of an allocation.
We then look for mutual fund managers whose funds will implement the strategy.
The goal is to find low-cost institutional funds that have low turnover and high tax efficiency, and maintain their asset class. You don’t need to buy individual stocks; you’re better off diversifying your risk with mutual funds.
I use the analogy of LEGO toys to explain the strategy. When you rip open the LEGO box and dump the bricks out onto the table, the instructions fall out, too. If you snap the pieces together in a particular way, it delivers the model pictured.
Now imagine that those LEGO pieces represent individual mutual funds. If you snap together a financial portfolio model, but a year from now every individual manager changes the size, color, and shape of their blocks, will your model look anything like it did when you snapped it together? No. Each block represents how we are trying to expose the portfolio to that asset class. We look for managers who are consistent so that we can snap together an efficient, effective strategy.
Having a strategy doesn’t mean the details of your “model” never change, because they can and often do. Imagine that each block in your model is made of a sponge material, and notice how it reacts to humidity changes that represent the ups and downs of the stock market. Depending upon the humidity of the marketplace, the LEGO model (your portfolio) shrinks or grows. One sponge will have more moisture in it than the other, and little cracks and spaces will appear between the bricks.
When that happens, the moisture is squeezed out of one block and put it into another. That shift suggests we need to rebalance your portfolio, which means buying or selling assets to maintain your allocation strategy. With rebalancing, we adjust the model, not to change size or shape, but to refit the pieces together, maintaining diversification across 12,000 to 15,000 underlying company stocks worldwide.
The strategy is tax efficient and effective while balancing asset class exposure. That’s true diversification. Let’s take Raj’s example and apply this approach. If he had gone through a process like ours, he would’ve been diversified across more asset classes.
We would have set things up differently to minimize tax implications and improve tax efficiency over the long term. Raj held mostly large US companies in the S&P 500; we would have traded only when his portfolio needed rebalancing.
In addition, we would have allocated his holdings across his account types differently: joint accounts would go under the taxable category; the IRA and 401(k) accounts under tax deferred; and the Roth IRA accounts under nontaxable. Such a strategy considers the income generated by the underlying holdings. It strategically moves both capital gain and municipal bond assets to taxable accounts. It moves ordinary income assets to his retirement accounts. His allocation would shift over time, but without the daily trading and resulting tax impacts that he experienced with his financial adviser.