In Marvin Gaye’s cool jam, “Trouble Man”, he sings, “There are only three things for sure, taxes, death, and trouble, oh this I know.” Financial advisors help us avoid taxes, and life insurance policies protect our families’ finances from unexpected death, but how do we prepare for trouble? I start every financial plan with the Safety Net because it is the foundation upon which the rest of the plan is built, and it is also the foundation upon which we can confidently stand and take wealth-building risks in other parts of our portfolio. Let’s explore the appropriate size of the Safety Net and its potential components.
The general rule of thumb measures the size of a proper emergency fund as six to twelve months’ worth of expenses. For example, if your mortgage payment, car payment, utilities groceries, and miscellaneous spending add up to $10,000/month, your emergency fund should have somewhere between $60,000 and $120,000. Like all personal finance, determining the size of an emergency fund is a combination of mathematical formulas and personal reflection.
Risk-averse people may want twelve months or more whereas a risk seeker may only want six months. Investors should also consider how reliable and consistent their sources of income are. For example, a salesperson with little or no base salary and inconsistent commissions should opt for a much larger emergency fund. A federal employee with a steady paycheck and future pension may opt for a lower emergency fund.
Let’s assume you work with your financial advisor and together you determine that your emergency fund should be 10 months, or $100,000. That does not mean that you let $100,000 sit in your checking account earning zero interest. In fact, I recommend only keeping two, or three months at most, worth of expenses in a checking account to smooth out the variability in month-to-month spending. We would use the remaining $70,0000 to $80,000 to buy safe and easily accessible assets, such as short-term US treasuries and CDs, which, at the time of this writing yield over 5%.
Having sufficient safe, liquid assets in your Safety Net will cover unexpected expenses and losses of income when trouble inevitably comes. It will also give you the necessary cushion so you do not have to dip into your long-term investments, which will almost certainly be down when you face trouble personally. Now is a great time to get your Safety Net in order, and you may feel like Marvin Gaye at the end of the song, “Don't care what the weather. Don't care 'bout no trouble, got me together, I feel the kind of protection that's all around me.”
Tune in next month when we explore another component of the Safety Net, a HELOC!
Last month we discussed the importance of asset location. For assets located in taxable brokerage accounts, focusing on after-tax total return, rather than simply total return, can add significant value to your net worth over time. Let’s explore the short- and long-term capital gains rates, qualified dividends, and tax-loss harvesting.
Unlike traditional IRAs, where the saver pays taxes on withdrawals and can trade within the account without tax implications, trades within a taxable brokerage trigger capital gains or losses. For example, if you buy 100 shares of a stock trading at $10 per share, and sell it for $20 per share, you would trigger a capital gain of $1,000. If you held the stock for one year or less, the IRS would tax the $1000 gain at your ordinary income rate. If you held the stock for one year or more, you would pay the far more favorable long-term capital gains rate of 0%, 15%, or 20%, depending on your income level for the year. Unless you have an extremely compelling reason to sell a stock within a year after buying it, try to hold out until day 365.
Not all dividends are created equal. The IRS taxes ordinary dividends (the default for all dividends) at the ordinary income rate. However, if a common stock or mutual fund is held for at least 60 days, and the dividend is paid by an American or qualifying foreign company and is not listed as unqualified by the IRS, then the dividend is “qualified” and taxed at the favorable long term capital gains rate. Make sure your taxable investments pay qualified dividends.
Buy and hold is a fine strategy, but you can add significant value to your after-tax total return by employing a tax loss harvesting strategy in your taxable account. Imagine you bought $50,000 of an SP500 ETF in December 2021. In 2022, you were down about 20% and your investment was only worth $40,000. Rather than just waiting for the market to recover, you could have sold your SP500 ETF, realized the $10,000 loss, and bought something similar like a large-cap mutual fund (but not so similar that you create a wash sale, and kill the strategy) so that when the market recovers, you also participate in the upside.
By harvesting the $10,000 loss, you create a tax asset, which can be used to offset gains in other parts of your portfolio. If you have no other triggered gains, which you wouldn’t if your advisor manages your assets in a tax-aware way, you can deduct up to $3,000 against your income. The remaining $7,000 would carry forward to the next tax year to offset gains or deduct $3,000 against income, and so on. Over time, the $10,000 tax asset is worth $10,000 multiplied by your marginal tax rate, for as much as $3,700 of real dollars in your pocket come April.
Holding investments for at least one year, making sure your portfolio pays you qualified dividends, and harvesting tax losses can all help you save money on taxes and keep more of what you earn. Remember, though, that if you wait for tax season to think about these strategies, you’re too late! Now is the best time to reach out to a financial advisor to optimize your tax strategy.
Tune in next month when we’ll evaluate the relationship between financial planning and investment management!
In Charles Dickens’s timeless classic, A Christmas Carol, two gentlemen approach Ebenezer Scrooge in his office and say:
“At this festive season of the year, Mr. Scrooge, it is more than usually desirable that we should make some slight provision for the Poor and destitute, who suffer greatly at the present time.”
Indeed, many of us reflect on our blessings during the holiday season, setting aside some time or money for those less fortunate. At the risk of pouring cold water on the warm and fuzzy feelings we feel after helping someone in need, we must remember one thing. Taking a moment to plan and strategize our charitable giving can create significant savings come that other—Far more dreaded season—Tax season. For those unfamiliar with tax-efficient giving, we will introduce the concepts of itemized deductions, cash versus appreciated securities, and Donor-advised Funds. ‘Tis the season!
For filers to enjoy the tax benefits of charitable giving in 2022, they must itemize their deductions and not take the standard deduction. That means the sum of all itemized deductions, including charitable donations, must be more than $25,900 for married couples filing jointly and more than $12,950 for single filers. For those whose itemized deductions total something very close to the standard deduction, it may make sense to “bundle” 2022 and 2023’s donations in 2022. Imagine a single person who donates $1,000 per year to charity and whose other itemized deductions (excluding charitable donations) total $12,000. By not bundling, she would itemize $13,000 in deductions in 2022 and then take the standard deduction of $13,850 in 2023. By bundling her ’22 and ’23 donations in 2022, she would have $14,000 in deductions in 2022 and still take the standard deduction of $13,580 in 2023, thus maximizing the tax savings of her charitable donations.
Before cutting a check to your favorite charity, look to your brokerage account first for appreciated securities. Do you have stocks or mutual funds you’ve held for more than a year that have appreciated significantly? Donate the stock or mutual fund instead of cash! If you give a $10,000 check to a charity, you’ll get a $10,000 deduction. However, if you donate $10,000 worth of stock that you only paid $5,000 for, you’ll not only get the $10,000 deduction, but you’ll also avoid paying capital gains. In this case, that could be up to an additional $1,000 in tax savings (based on a top capital gains rate of 20% for $5000).
Sometimes, our charitable inclinations do not perfectly align with our optimal tax strategy. Fear not—A Donor Advised Fund can help bridge the timing gap. For example, you may want to donate $5,000 per year for the next five years to charity but do not yet know which charitable organizations most closely reflect your core values. You may also own highly appreciated company stock and wish to diversify your investment portfolio. Rather than sell your company stock and trigger a capital gains tax, donate $25,000 ($5,000 times five years) of that stock to a Donor Advised Fund. You will avoid the capital gains tax, reduce your investment exposure to the company, and receive a $25,000 upfront tax deduction. You then instruct the Donor Advised Fund to make $5,000 donations each year for the next five years to the charities of your choice.
We’ve only scratched the surface of tax-efficient giving, but hopefully, some of these examples have given you a glimpse of what’s possible. Talk to a financial advisor before employing any of the strategies discussed above, as nuance and specifics of the tax code (and the giving strategies) are beyond the scope of this article, and there may be better options for your unique situation. Tune in next month to see who can benefit the most from financial planning in 2023!