We’re in a fun money marathon series using some running stories and analogies to teach and explore how investors could get more potential mileage from their hard-earned money. We’re walking through seven risks of running your wealth marathon without any support. If you would like to watch the video version of this post, please click here.
Today, we are discussing risk number three of seven: you can run off course with your tax minimization strategy. I fully believe that marathon runners and investors have the same goal. Runners want to be as efficient as possible when going from point A to point B in their marathon, which is a 26.2-mile foot race.
Similarly, investors want to be as efficient as possible in their wealth marathons when going from point A to point B in their lives with their financial goals. Successful marathon runners and investors don’t want to go off course. Runners don’t want to waste precious fuel—the technical term for runners is glycogen stores—the body’s preferred source of energy for marathon races.
Investors don’t want to waste their precious fuel, which is their money and wealth, when they’re going from point A to point B. Investors also want optimal wealth management and tax minimization strategies in their financial plans, just as runners want to do that in a race.
I’ve been helping families manage their wealth for over two decades, but I’m a rookie at marathon running. And speaking of rookie mistakes, I was literally steps away from going off course down at the Kiawah Island Marathon several months ago in Charleston, South Carolina.
Let me share a quick story about this, and then I’ll tie that into the potential consequences investors can face when they go off course with their tax strategy.
I had some issues in the Kiawah Island Marathon that I did not run into at my first marathon last year up at Grandma’s in Duluth.
#1: There were a lot of turns
#2: It was hotter than expected.
#3: I was a little bit out of it race week. I was delirious, and somewhere around the 17-mile mark, the pack I was running with for most of the race started to pull away; they were chasing that sub-three-hour mark. There weren’t as many runners in Kiawah Island as in Grandma’s Marathon that I ran in Duluth, MN, so I didn’t have anybody to follow.
My head was down, and I was utterly clueless about the sign in somebody’s yard with an arrow pointing to the left!) Thank goodness, a race volunteer yelled, “Turn left!” I was steps away from going off course and just running straight. Without that support, I would have run off course. I ended up waving and laughing and yelling thank you.
How bad would it have been to train for hundreds of hours for a marathon and then go off course? Some consequences for me could have been:
#1: I wasted some energy and wasn’t efficient getting from point A to point B.
#2: I could fail to reach my potential goals because I was running longer than I had to, and I could get disqualified for that. So, thank goodness I had some support! Whoever you are, that helped keep me on the race route; thank you!! You helped me potentially qualify for Boston because I ended up just over two minutes below the cutoff. I am grateful for that support.
What does this have to do with running off course with your tax strategy in your wealth marathon?
Well, just like runners can be at risk of running off their optimal course without any support, many investors have their heads down. They’re busy with work, family, kids’ activities, and home projects, or they’re training for a marathon and diving into their Strava stats. They just don’t have the time, energy, expertise, or tools to minimize their tax bill proactively throughout the year.
In today’s post, I can’t list every reason or strategy you should consider for your unique situation. But I’m going to share one of the top ways I believe investors go off course.
How investors go off course
I believe investors go off course and are not efficient because of reactive tax minimization.
Too many investors wait until that tax filing deadline or close to April 15th to talk to their accountant about opportunities or what to do. The problem with that is that many of the tax planning opportunities expired on December 31st of the prior year, so they missed the turn.
Essentially, they’re past the turn for many of those opportunities. And when you miss those opportunities, it could be like a marathon runner who missed a turn. You can waste fuel, you can waste money, you can pay unnecessary taxes, so you’re not as efficient going from point A to point B.
Some opportunities remain between January 1st and the tax filing deadline, like making an IRA or Roth IRA contribution (if you qualify), profit-sharing contributions, or even HSA contributions. However, many tax minimization opportunities that could lower your tax bill this year or in future years expire on December 31st.
For example, if your retirement projections and lifetime tax bill suggest shifting your retirement contributions from a Roth 401(k) to a pretax 401(k), it’s too late to do that after December 31st. Or, if you wanted to max out your plan, it’s too late to do that after December 31st if you didn’t hit the maximum, which could cost you some tax savings.
It’s the same with charitable giving. There are many ways that you can give to charity. Outside of giving cash, you could give appreciated stock. If you meet the requirements, you could open up a donor-advised fund or give from an IRA. But after December 31st, you cannot contribute for the prior year.
If taxpayers miss an opportunity, they’re like marathon runners who’ve gotten off course. They’re not as efficient as they could be.
You could be more efficient if you’re proactive, don’t go off course, and capture opportunities that could benefit you before the end of the year, before that expiration date, instead of waiting until after January 1st to do tax planning.
What are some reasons investors might go off course with their tax strategy?
#1: Like me in the marathon, they had their head down.
#2: They didn’t prioritize tax planning throughout the year.
#3: They didn’t have the tools, the tax planning or the financial planning software, or the expertise to do the work.
So, just how costly is it to go off course with your tax strategy? That’s a difficult question because it depends on your situation and how large an opportunity you could miss if you went off course with your tax strategy. Some missed strategies could cost hundreds of thousands of dollars over a lifetime or even millions!
Let me give you a hypothetical example. Savvy Sue’s financial planning strategy called for $500,000 of Roth conversions in her plan over five years (a Roth conversion is where you pay the tax on a retirement account and move it to a Roth account that can grow tax-free). So Sue’s wealth manager was monitoring her accounts in March of 2020 when COVID impacted the financial markets and the markets went down.
They called Sue and finalized a strategy quickly to convert $100,000 from pretax retirement accounts into her Roth IRA. Sue paid 22% in federal taxes on her Roth, and while it was a big check, she was okay with that because the market was down; she thought it was a good deal, and her financial plan projected her tax rate to be about 10% higher in the future.
Sue looked back and saw that $100,000 had grown to $200,000 when she needed money from her Roth IRA to purchase a cabin with her twin brother, Larry. She was thrilled because the $22,000 in taxes she paid grew to $200,000. As you can see in Sue’s scenario on the screen, she won’t have to pay a dime on that.
Larry, her twin brother, is going in on the cabin with her, 50/50. He also took money out of his Roth to help with this down payment; Larry’s situation was identical to Sue’s.
Let’s compare Sue’s scenario to that of her brother, whom she calls Lazy Larry. They were twins. Their financial pictures were identical: same income, goals, life expectancy, retirement account values, and net worth. But Larry didn’t have a financial plan, a tax minimization strategy, or even a knowledge of Roth conversions.
Larry didn’t have anyone proactively monitoring his accounts for tax minimization opportunities. Sue told Larry, “Hey, you gotta meet with my wealth manager and accountant.” And Larry skipped the appointment because he had an important episode of Ted Lasso to watch. So, instead of doing a Roth conversion, Larry kept that $100,000 in his pretax account.
He didn’t do a conversion. That account was invested the same as Sue’s. It grew to $200,000, and he pulled $200,000 out like his twin sister. The problem is he’s in the 32% tax bracket. He pays 10% more taxes than Sue did, but he doesn’t pay it on the $100,000. He pays it on the $200,000 that the $100,000 grew to. It was never moved to a Roth IRA.
So, Larry is in the 32% bracket and has paid $64,000 in taxes on that initial $100,000, which grew to $200,000.
That’s $42,000 more than Sue during the same time period!
That’s a huge financial cost for Larry for going off course. However, it’s not the end of the story with taxes. When you go off course, there’s even a larger potential cost called opportunity cost. Let me explain. Take a look at that image on the screen.
You can see that with Larry’s $42,000 in unnecessary taxes, if he could have left that money invested in a hypothetical account, let’s say it grows for 40 years and earns 9%, it would have grown to over $362,000. Isn’t that wild?
Let’s recap and then talk about steps you could take to potentially help you from missing a tax minimization turn or an opportunity. But first I have to give you a couple disclaimers.
I am not suggesting you should do a Roth conversion because your plan and tax projections are unique to you. In fact, a Roth conversion might not make sense if you’re projected to be in a lower bracket when you take money out.
I’m also not suggesting that you can earn a 9% rate of return guaranteed. Investments could lose value; they could earn more or less than that.
Runners and investors have similarities
If they go off course, it can cost precious fuel or glycogen stores for runners and money for investors.
Imagine a marathon with no water tables, aid stations, course markers, or volunteers telling you to turn left. It would be a lot easier to go off course without support. Similarly, investors can be at risk of going off course if they don’t proactively practice tax minimization, if they just don’t have the support they need, if they’re too busy, or if they don’t have the tools or the expertise to do that work themselves.
If you’re running a wealth marathon alone and you want some support or a second opinion to see if you might be potentially missing an opportunity, click that button on the screen; you can request an initial consultation.
In my next video, I’ll share what I believe is actually the number one reason investors are inefficient or go off course with retirement planning. But right now, I have a little bonus for you.
Click the button below if you want to take a free tax minimization assessment. It only takes a few minutes, and you might be able to uncover an opportunity or two that could potentially lower your tax bill. Or, click here to read more about One Life’s tax minimization services.