The Investor Taxation Lifecycle

We are not CPAs nor are we tax preparers, but a great deal of our time is spent working with clients and their professionals honing a financial plan that is tax efficient.  We advise our clients to hire a CPA with whom we can work together to manage their financial plans.  The financial plan and corresponding tax plan address today’s tax picture while also anticipating the likely tax picture in the future.


The biggest misconception of many investors (and tax preparers for that matter) is the belief that lowering today’s tax bill should be the only priority.  In our experience, everyone should have a plan that takes into consideration the entire tax lifecycle.  By doing so, we have made a significant impact on the taxes owed over a client’s lifetime.  Oftentimes, and usually preceding a curious look, the first request we make of a prospective client is their most recent tax return.  The tax return tells us so much about the individual or couple and we often base our initial priorities on what it reveals.



If not managed properly, taxes can present a severe headwind for net investment appreciation and income.  The difficulty is that each investor is presented with a rather unique tax structure that requires an ability to step back and anticipate how decisions today could have a positive or negative impact in the future.  It is important to understand the four primary asset types and how they are taxed over your lifetime.  After each asset type, there is a quick example of how we have creatively planned around this asset type.


Traditional Pre-tax Retirement Assets


When most people refer to retirement accounts, this asset type is what they are referencing.   Most often, these assets are held in 401(k)s, 403(b)s, or IRAs and have been funded through payroll contributions (or annual personal contributions) over time.  We group these account types because many of the rules are similar for each.

Contributions to these account types have (in almost all cases) allowed the investor to deduct from his or her income.  As well, these assets grow tax-free and eventually are distributed after some attained age (typically 59 ½).  This account type is also subject to Required Minimum Distributions beginning at age 72.  The amount of the RMD accelerates over the remainder of your lifetime.  The most important planning attribute of this asset type is that all distributions are taxable at ordinary income tax rates.  I am always surprised when investors are surprised that their large 401(k) balance also comes with a rather large tax bill as it is distributed.


  • Planning Idea:  We often advocate for people to convert some or all of this type of account to Roth (and pay taxes on that conversion from another source) when the expected RMD is more than what they will need in retirement income.  Roth IRAs do not currently require RMDs.  Although RMDs in your early 70s are lower, the required percentage to distribute grows over time and could even push you into a higher tax bracket.  We have noticed a recent phenomenon where very responsible savers are being rewarded with large RMDs and accompanying large tax bills.


Roth Retirement Assets:


Roth IRAs and Roth 401(k)s are becoming more and more prevalent each year.  Opposite that of their Traditional brethren above, no deduction is granted for contributions made to these accounts.  However, Roth accounts grow tax-free and, most importantly, are distributed tax-free after some attained age, typically 59 ½, and after a five-year holding period.

The “old school” way of thinking on this account type usually advocated the use of Roth accounts for those in lower-income tax brackets in their earning years.  Roth 401(k)s, unlike Roth IRA(s), are subject to RMDs but they are tax-free and can be easily mitigated under current tax law.  In a future chapter, we will touch on the many benefits of Roth accounts but know these have become a very common recommendation even for those in the highest tax brackets.


  • Planning Idea:  As you can see, we are fans of Roth accounts.  We most often view Roth dollars as the last dollars you should spend and plan around them accordingly.  These dollars are fantastic for estate transfer because you can pass on much of the benefit of this account type to survivors through Inherited Roth IRAs.  They also offer a great place for your most aggressive, long-term, appreciating investments and a tax-free source if there is a large liquidity need.  Finally, Roth dollars provide a hedge against future tax increases as the purchasing power would not be affected by an increase in future tax rates.


Non-Qualified Investment Assets


If a client can fully maximize the use of Qualified retirement accounts (Pre-tax or Roth), our typical next recommendation is to fund non-qualified accounts.  Just like a bank account, you might have in your name or jointly with your spouse, these are accounts where tax has to be paid each year on any RECOGNIZED gains and income.  I stress the word RECOGNIZED because it is our job to help our clients strategically take gains (or even losses) in any given year when it is most optimal.  The biggest misunderstanding of this account type is that they are not tax efficient.

With Federal long-term capital gains and qualified dividend tax rates between 15 and 20%, most of our clients pay the lowest tax bills (versus distributions from IRAs and 401ks) on these accounts each year, even when taking monthly or annual income/distributions.  This asset type also currently receives a step-up at death, meaning your heirs will not be responsible for unrecognized gains during your lifetime.


  • Planning Idea: Because we can affect the tax implications of non-qualified assets, each year we can initiate transactions for the best long-term benefit of the client.  As well, we can use the tax issues created by these assets to defray the use of other assets.  As an example, we can use appreciated securities to fund gifting plans for clients.  By giving appreciated securities, clients receive the full deduction at the asset market value but do not have to pay taxes on the gains in the asset.


Tax-Deferred Assets/Insurance with Cash Value


As I mentioned in the opening paragraph, many people unwisely focus solely on this year’s tax bill.   One method of investment to defer current year taxes on gains or income is to invest through an insurance policy or contract (annuity).  This can be a great decision in certain cases as it might allow them to avoid paying at the highest bracket if significant other income is anticipated.  The important thing to remember is that most tax-deferred accounts tax earnings first.  Whereas in a non-qualified account, we can strategically sell from the most tax-efficient asset to create cash for distribution.

In an annuity, any gain above the original investment is considered the first amount distributed and taxable at ordinary income tax rates.  This is a perfectly fine approach if you understand the implications and when to recognize income from these account types.  Cash-value life insurance works similarly although whole life policies allow situations for tax-free basis withdrawal or tax-free loan against the policy in certain situations.  The most important thing to remember about any insurance or annuity contract is you need to know the tax implications now, in the future, and what options you have at your disposal today to optimize the dollars in these contracts.


  • Planning Idea:  If you are out of a surrender period on your life or annuity contract, you should always know if the contract you are in is the best contract for your current self.  Oftentimes, these contracts are purchased years if not decades before, and a client’s needs have changed dramatically.  Working within the tax laws allowing for tax-free exchanges, we have recommended numerous strategies to optimize these dollars.  Examples include but are not limited to exchanging an old life policy for a new one that requires no further premium, exchanging life policies for annuity contracts with guaranteed income features, or even cashing out a policy or contract that no longer suits the client.


The clients we see with the most flexibility in retirement and income planning have exposure to most, if not all, of these asset types.  As a planner, this provides us the greatest amount of flexibility; in any given tax year or after any given tax rule change, we can modify the client’s plan.  We continually anticipate potential tax rule changes and hone tax plans to adapt to a moving target.  With this approach, we encourage our clients to review their taxes with us each year to make certain there isn’t a better way.  Tax filing season starts after December 31st; it is important to understand that tax planning happens well in advance of the year-end as there is little that can be done (for last year) once the calendar turns.


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