Investing is a complicated topic that many of your clients do not fully understand. They rely on you and their other advisors to assist them through the process of investing and becoming retirement ready. Taxes in particular are an area that causes significant confusion for clients, not least because they have a tendency to change over time.
Taxes on your clients’ investment accounts can come in several forms. Here, we will discuss some of the most common types, along with strategies to help you better guide your clients over time. I touched on this topic in a recent article, An Investment Expert’s Advice on Income Tax Planning, and I will expand on it here.
Income from your clients’ investments can come in several forms, such as dividends and interest. The best type, especially for your high net worth clients, is tax free. Be aware there are investments that will pay tax-free income but only on a federal level. This is particular important for clients who live in states that have a high income tax bracket.
The majority of your clients’ interest and dividends will be taxed as ordinary income, unless they are a qualified dividend. This will typically be their highest-taxed form of income and is generated from their investments. In these cases, unless the client is in need of this income to live on or they are in low tax bracket, it would make the most sense to try and place these types of assets in a qualified account. This would allow them to own the asset and not pay taxes on the income.
Capital gains are another consideration. This type is broken down into short term, less than 12 months; and long term, longer than 12 months.
Depending on your client’s income, the taxes owed could vary widely. The higher the tax bracket they are in, the larger the difference. Short-term capital gains are taxed as ordinary income and at their normal tax bracket.
However, if the client holds the asset for 12 months and a day, the capital gain becomes long term, providing them with a maximum tax of 20 percent on the federal return, plus the state tax owed. This could amount to a significant difference, and your client will want to make sure they are holding assets, if they can, for the long term in order to maximize their tax position.
If they are looking to purchase an investment with the intention of only holding it on a short-term basis, I would recommend placing this asset in a qualified account and avoiding the capital gain tax altogether.
We all know clients don’t like to take losses, but sometimes it makes sense for them to bite the bullet. I recommend you sit down with them and review their portfolio each November to evaluate their gains and losses for the year. Long- and short-term gains and losses will net out each year, and you can develop a picture of what their capital gains will be.
Based on the review, it may make sense to sell an asset at a loss and negate some of a client’s overall capital gain. At times, I have seen clients who understand they need to do this in order to mitigate their tax liability, but at the same time are still confident the asset will work out long term. In these cases, you can have them double up the position 30-plus days before the end of the year. Then, on day 31, in order to avoid a wash sale, sell the initial lot for the loss. This will provide them with the opportunity to capture the loss and still own the position while participating in the upside potential of the holding.
Planning with your client and their team will elevate you to the level of most trusted provider by your client and build trust with their other advisors. This will ultimately lead to more referrals from both parties, which is a win-win situation for everyone.
This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.
Lawrence Sprung CFP® is the President and Founder of Mitlin Financial, Inc. He entered the financial industry in 1996 and continues to be inspired and energized by the challenge of helping his clients achieve and even surpass their financial goals.
Mitlin Financial, Inc. is an SEC Registered Investment Advisor (RIA) that prides itself on...