For advisors, a little tax knowledge can be a dangerous thing. “Most people lose more money trying to reduce taxes than they save in taxes,” says advisor Less Antman, who founded the firm SimplyRich and taught prep courses for CPAs for 27 years.
In an interview with ThinkAdvisor, he warned of the dangers of too much portfolio rebalancing, the limitations of tax-loss harvesting, and the unintended consequences now dogging investors who tried to dodge estate taxes in the ’90s.
Yet, the lure of tax minimization is powerful and often destructive, for middle-class investors through the wealthiest.
Paper Millionaires Turned Paupers
Antman tells the story of a client in the late ’90s who sought his help to minimize taxes on incentive stock options that had amassed enormous built-in gains.
“One of my earliest clients was working for a dot-com company that had given out incentive stock options, they had an enormous built-in gain, and they wanted to figure out the way to minimize taxes.”
Tongue-in-cheek, he suggested holding onto the stock until it crashed and gains disappeared, eliminating the tax problem.
The client took the hint and exercised the options, then immediately sold enough stock to become financially independent for life.
In contrast, many of the client’s colleagues exercised options with a plan to hold the stock for a day and a year in order to convert higher-taxed ordinary income to more lightly taxed long-term capital gains.
The stock collapsed before that day was to arrive for most of the client’s colleagues, and their gains were wiped out.
But that is not all. Antman says that these once paper-rich techies, by exercising their options, became subject to the alternative minimum tax (AMT) on phantom gains for which they received gigantic tax bills at a 28% rate. They could only begin to claw back those payments the following year — with capital losses limited to just $3,000 a year.
To make this more comprehensible, Antman says these tax-minimizing dot-com-ers — on options worth $1 million — would have received a $280,000 AMT bill just for exercising, then after the crash have $1 million worth of capital loss deductions they could use at a rate of $3,000 a year, which has some utility for those living to the age of 340.
“To be fair, several years later Congress passed a limited measure to allow some people to recover old capital losses from the AMT, but they still had to pay the $280,000 on the nonexistent gain and then wait several years for the government to show some mercy.” he says. “And that mercy rule has since expired, so we’re back to tax hell for such people the next time it happens.”
It is common, Antman adds, for particularly smart people to make such mistakes because they research tax-saving strategies and think they understand them without foreseeing the tax traps that lie within. That’s why people with incentive options need a tax-savvy advisor, Antman says, quoting Lord Thomas Dewar of Scottish whisky fame:
“Nothing hurts more than having to pay an income tax, unless it is not having to pay an income tax.”
Muni Bonds, Variable Annuities and Other Potential Tax Traps
Antman’s key tax insight for advisors, though, is to avoid the all-too-common mistake of seeking to minimize taxes rather than maximize after-tax returns.
“There’s a big difference: You can reduce taxes in ways that reduce your income even more,” he says, citing muni bonds as a classic example of reducing a tax bill by accepting lower returns at the outset.
Nobody not in the top tax bracket should even consider them, he says, yet it is common for middle-class investors to park their cash in muni-based money market funds.
Variable annuities are also not all they’re reputed to be, Antman says. They turn all income ordinary, even what would otherwise have been long-term capital gains; lose the stepped-up basis at death that applies to taxable account assets, restrict investment options severely, and typically add fees that far exceed the net benefit of deferring taxation on earnings.
Moreover, deferral is of little value if it is only for a small number of years, so the best case for a variable annuity would presumably be one intended to be held for decades. Yet, money invested for decades belongs in equities, and deferral of equity taxation can be obtained by the use of index mutual funds or ETFs without any of the fees of variable annuities.
“There are lots of ways to cut your taxes that will cut your income even more,” he says.
Antman emphasizes that he does occasionally find a role for an annuity, but it isn’t to save taxes.
“The traditional role of an annuity was to pay a periodic income for life, and was essentially a form of protection against living too long. For those who either have no desire or no ability to consider the needs of heirs or charitable legacies, converting a lump sum into periodic payments for life is a reasonable bet to make with an insurance company.
“Of course, in such cases I will recommend either an inflation-adjusted annuity or an immediate variable annuity that pays for life but varies the payments based on the return of underlying investments, since a fixed annuity doesn’t really protect someone against the impact of long-term inflation. But the one topic that never comes up in a proper discussion of such annuities is taxes.”