How to Flatten or Reduce Taxes on a Taxable Account

When you have money compounding in a taxable account, three possible scenarios unfold.

• First, you can roll the earnings back into the account to increase your account.  As your account earnings increase your tax liability increases, as well.
• Second, you can create a level or flat tax liability by re-positioning the earnings to a more tax favored account.
• Third, you can reduce your tax liability by re-positioning earnings and principal over a period of time.

This issue examines the process and results so you can determine the best course for your situation.

For illustration purposes, assume you have $300,000 in a taxable account, you’re in the 30% tax bracket and plan to be in the 25% tax bracket in the future as you consider tax deferred options.

Click Figure 1 for a short video that shows that $300,000 compounding at 5% over the next 20 years would become $795,989.

Figure 1. Compound Interest

When you compound interest in a taxable investment, your account grows dramatically. Click the video in Figure 2 to see the account and earnings increase and the taxes grow right along with them.

You can see the taxes due on the earnings each year in the video, paying in accordance with the 30% income tax bracket for the profile in the example.  At the end of 20 years, the account would have grown to $795,989, but the cumulative taxes paid would be $148,797.  After accounting for the payment of the taxes, your net financial position would increase $647,193.

Figure 2. Compound Interest and increasing taxes

It’s important to understand that people rarely pay for taxes along the way from the account that’s increasing.  They pay for taxes by reaching into their lifestyle.  In year 20, the tax bill due on the earnings would equal $11,371, which may or may not be easy to pay out of lifestyle.

What are your options?

An Immediate Pay Down alternative would involve moving all the money at once to a tax favored account where the money could grow tax deferred.  This option is the quickest method to reduce current income taxes.  However, doing so may result in restrictions, penalties or charges on access to the money, and there are few types of accounts into which you could immediately move such a large amount of money to grow tax deferred.

Click Figure 3 for a video that shows moving all the money into a tax deferred account earning the same rate of return.  The money grows tax deferred in this account until you need it in the future.  In this example, we assume a future, lower 25% income tax bracket, so the taxes deferred would be $123,997.

Figure 3. Immediate Paydown Option

The ‘Flat Tax’ option leaves the principal in the account, re-directs the earnings to a more tax-favored environment and keeps the tax paid at a flat amoung.  To be sure you have the $300,000 account balance in place at the end of the 20 years, you can take $14,286 at the beginning of each year and the balance in the account will grow back to $300,000 by the beginning of the next year so you can take the $14,286 again.  After 20 years, your net total between the two accounts is up, $710,275, and your cumulative taxes are down, $85,714.  Click Figure 4 for a video showing the year-by-year breakdown.

Figure 4. Preserve Account 1. Reposition Earnings and Flatten Taxes

In the ‘Reducing Tax’ option, the goal is to re-position the entire account along with earnings into a more tax-favored environment over a designated period of time and reduce taxes along the way.  To be consistent, we’ll look at a 20 year period.  As the principal declines each year to zero, the amount of earnings on the account and taxes paid on those earnings decline proportionately.  The taxes paid out of pocket go down, which means lifestyle can go up.

Click Figure 5 to show the annual withdrawal of principal and interest from the original account (Account 1).  This amount is reinvested in a tax favored account (Account 2.) The balances of both accounts are shown.

To deplete the account by the end of 20 years, you may withdraw $22,926 at the beginning of each year and re-position this amount into the tax favored Account.2.  At the end of 20 years, the entire $300,000 has been re-positioned into a tax favored account and has grown (using the same 5% rate for the sake of consistency) to $795,989.  Cumulative taxes paid along the way have decreased to $47,559.  Your net financial position has improved by $748,431.  You have more money compounding in a tax favored account and you’ve significantly reduced your tax liability.

Figure 5. Transfer Principal & Earnings to Tax Favored Account and Reduce Tax

If you could realize those savings over 20 years, what if you re-positioned the money from Account 1 to Account 2 at a faster pace?  Click Figure 6 to show moving the money over a 10 year period.  To re-position Account 1 over 10 years, you can withdraw $37,001 at the beginning of each year and move it to a tax favored Account 2.

Notice that after 10 years, the cumulative taxes paid total $21,004 and your account compounds to the same $795, 989 at the end of 20 years.  However, your net financial position after 20 years has improved to $774,985 because of the lower taxes you paid over the ten years.

Figure 6. Transfer Principal and Interest to Tax Favored Account Over 10 Yrs and Reduce Taxes
So, you’ve had to pay less from your lifestyle to cover the taxes due.  That’s improves your current lifestyle.  You’ve also improved your net financial position at the end of the same 20 year time period, which will improve your future lifestyle.

The ‘Hidden Cost’ that’s too often overlooked—

You must remember that for every dollar you paid toward taxes, you not only lost that dollar, you lose what that dollar could have earned for you, as well.  This is called Opportunity Cost.  Opportunity Cost is a frequently ignored loss, or ‘Wealth Transfer,’ that occurs unnecessarily, unintentionally and unknowingly due to how we handle the cash flowing through our lives and where we put that money to work.

Click Figure 7 to examine a summary of these three options for paying taxes on money taken from a taxable account and include an examination of the Opportunity Costs in each case.  This Summary shows how you can dramatically reduce the taxes paid through the years, which also correspondingly reduces the Opportunity Costs on those dollars.

Figure 7. Summary of Options with Opportunity Costs

In the ‘Flat Tax’ and ‘Reducing Tax’ columns, you have the option to move those funds to an account where your money can grow tax deferred and you can access the money tax free.  If you choose that option, you would have the ability to completely eliminate the taxes in the last line that would otherwise be paid as deferred taxes.

The objective of this letter is to present strategies to ‘flatten’ and ‘reduce’ the tax liability when you move funds from a taxable account to a more tax favored account where you can access your money in the future tax deferred or, preferably, tax free.  This is an objective for many people today who believe tax rates may be higher in the future, are uncertain in which tax bracket they will find themselves in the future or what deductions might still be available.

In addition to reducing current tax liabilities using the ‘Flat Tax’ and ‘Reducing Tax’ options we discussed, you can significantly reduce future income tax liabilities and create the additional benefit of increased liquidity, use and control over your money.

To learn whether any of the strategies presented above might be suitable for your situation and how to effectively reposition money from a taxable account to a more tax favored account, call for a no obligation consultation.  But don’t delay.  If income tax rates do creep up in the future, the opportunity cost or procrastination will creep up, as well.

To Your Prosperity,

Scott

Scott Scholz

Independent Registered Financial Consultant

425-829-4110     www.ScottScholz.com   scott@scottscholz.com

PS  Financial success is achieved by following the Right Principles, which stand the test of time, not following the current ‘right predictions’ that are subject to change from day to day.  “The Fiscal Fitness Letter” presents the ‘Right Principles’ for financial success and challenges misleading conventional paradigms about money and achieving financial independence.  If the principles presented here make sense to you, please share them with those you care about.   Add their name to The Fiscal Fitness Letter mailing list.

“There are two choices in life: to accept conditions as they exist or to accept responsibility for changing them.” – Denis Waitly

Debtor vs. Saver vs. Wealth Creator & the Private Reserve System.

What is the best way to make those major capital purchases that occur during your lifetime, such as automobiles, major appliances, weddings, education or even homes?

Most people believe the same thing I was told when I was young:  Save money until you have enough and you can afford to buy what you want.  Don’t spend money you don’t have.  Don’t borrow money.  Don’t pay interest.

The only accepted exception to this would be using a mortgage to purchase a home.   But conventional wisdom states you should pay off that mortgage as fast as possible.  Does that match what you believe to be the right or the most efficient way to use your money?

The fact is you finance everything you buy.  Either you pay interest when you borrow, or you give up interest you could have earned when you pay cash.  You must consider the costs associated with these purchases, especially the Opportunity Costs.  It’s not just what you pay… it’s ‘How’ you pay for it.

Let’s assume you want to buy a new car and the one you want costs $30,000.  If you live according to the teaching above, you work hard to save up enough money so you can buy the car.  How many cars will you buy over your lifetime?  Your auto acquisition process through life might look like this picture of the Saver’s Cycle in Figure 1:

Figure 1. Saver’s Cycle.

You save enough, purchase the car and deplete the savings and start saving again for the next purchase.

On the other hand, some people find themselves in need of a new vehicle but they don’t have the money saved for the purchase.  They must borrow the money and then work to pay it off.  They might fall into an acquisition process like the Debtor’s Cycle, see Figure 2.

Figure 2.  Debtor’s Cycle.

The Debtor borrows the money and works to get back to zero.  Interestingly, the Saver ends up in the same place.  The Saver saves and then spends his way back to zero.   Check Figures 1 and 2 again and note the Zero line.  Indeed, The Debtor loses money that he pays in interest to the lender.  That’s a primary reason for the widespread conventional wisdom to avoid borrowing.  But, if you make the $30,000 cash purchase, you also lose money.  In fact, you potentially lose even more money than The Debtor.  Let’s look closely at the costs and then look at a third way to make these types of purchases.

Let’s say you’re ‘The Saver,’ you already have $30,000 and you’re ready to buy your car. (By the way, it works just as well for $10,000 cars or $80,000 cars.)  The question: “Is the smartest way to buy the car to a) pay $30,000 cash for the car or to b) keep control of the cash in a safe place earning a rate of return and borrow $30,000 from the dealer and pay interest on a loan?”

Assume the terms for borrowing from the dealer are 6% and the $30,000 is amortized over 5 years.  You’d pay $580 per month for the car, a total of $4799 interest over the 5 years and have the car loan paid off.  See the upper half of Figure 3.

Let’s also say you took the $30,000 cash you were going to use to pay for the car and instead put it in a safe place and earned 6% (the same as the cost of the loan) over the next 5 years.

What would your $30,000 become in five years compounding at 6%?  Your $30,000 would earn $10,466 in interest and grow to $40,466 by the time you have the car paid off.  See the lower half of Figure 3.

Figure 3. Amortizing at 6%, Compounding at 6%.

By NOT paying $30,000 cash for the car, you allowed your money to earn $10,466 in 5 years.  Meanwhile, you paid $4799 in interest over those 5 years, netting $5,667.  If you borrow rather than pay cash, you’re actually $5,667 financially better off after 5 years!

Another perspective is that by paying cash, your Lost Opportunity Cost on your money is $5,667 and you actually would lose more money by paying cash for the car than by borrowing and simply paying the $4,799 in interest.

What if the loan only cost 4% and you earned 7%?  Reason tells you The Lost Opportunity Cost would be even greater, doesn’t it?   You’re right:

Let’s revisit the question, ”How many cars will you buy during your lifetime and what would paying cash actually cost you in lost opportunity costs over your lifetime?”  Imagine this cycle recurring  5 times if you bought 5 cars over your lifetime.  That’s almost a $44,500 unnecessary “Wealth Transfer” to lost opportunity costs that’s due to ‘How’ you pay for your car (if you pay 4% and earn 7%, as in the example above.) Is paying cash the most efficient use of your money?

There’s a more efficient way.  Rather than being a Debtor or a Saver, what if you try the “Wealth Creator’s Cycle?“  In this case, rather than save and then spend your money on the car and lose control of your cash, you accumulate and collateralize your money and retain control of your cash.  You allow your money to continue to compound, build greater wealth, increasing your collateral capacity.  See Figure 4.

Figure 4.  Wealth Creator’s Cycle.

You might begin your own Private Reserve Account once you save some amount of money – $5000 or $10,000, in our example, $30,000, that you collateralize and repay repeatedly.  You never allow your money to be ‘consumed’ by the purchase of the car.  That enables the $30,000 to continue compounding for you throughout your life, increasing your collateral capacity and putting you in a stronger financial position in the future.

Which is the most efficient way to optimize the performance of your money for you as you make major capital purchase – including your home?  Debtor?  Saver?  Or Wealth Creator?

If you’re in wealth-building mode and want to optimize the performance of cash flow and assets, the answer should be clear.  Math is emotion-less and it doesn’t lie.  The difference over 10 year or 30 years can be incredibly life changing.  See Figure 4.

Building your own ‘Private Reserve Account’ and using the ‘Wealth Creator Cycle’ for capital purchases and other projects during your lifetime will help avoid unnecessary ‘wealth transfers’ due to lost opportunity costs and place you in a much stronger financial position.  You can apply the same strategy to areas other than capital purchases, as well, e.g., paying for children’s/grandchildren’s college expenses, starting a business, investment capital, paying for your home, etc.

If you’d like to learn how to increase your collateral capacity, build a Private Reserve account and how you can make it work for your projects, call for a no obligation consultation.  But don’t delay.  As we discussed last time, the one thing you can never recapture is time.

To Your Prosperity,

Scott, January 2012

Scott Scholz

Independent Registered Financial Consultant

425-829-4110     www.ScottScholz.com   scott@scottscholz.com

PS  Financial success is achieved by following the right principles, not following the current ‘right predictions’ which change from day to day.  “The Fiscal Fitness Letter” presents the ‘Right Principles’ for financial success and challenges misleading conventional paradigms about money and achieving financial independence.  If the principles presented here make sense to you, please share them with those you care about.   Add their name to The Fiscal Fitness Letter mailing list above.

“Your mind is like a parachute. It’s only functional when open.” – Tolleson

It’s About Time.

Once while being questioned about the need to take action, President John F. Kennedy responded with this:  “The great French Marshall Lyautey once asked his gardener to plant a tree.  The gardener objected that the tree was slow growing and would not reach maturity for 100 years.  The Marshall replied, ‘In that case, there is no time to lose; plant it this afternoon!’”

This missive, indeed, will be about the power of Time and Compounding Interest working together.  Time is both your most powerful ally and formidable adversary.  Indeed, that applies to more than just our finances.  Time is the one thing you never get back in life.  You can regain your health, your money, old relationships…  But not time.  There’s no time to lose!

One of the big shortcomings in our culture is that we don’t do a better job of educating, especially our kids, about money – How it works and how to make it work for you.  We learn how to spend it, easily enough.  But not how to conserve and nurture it for the future for a time when we won’t have to work so hard for it.  Those who understand this don’t have to wait until age 60 or 65 to retire, if that’s their goal, or to engage and enjoy life on an entirely different level.

If you have children, for example explore this example with them and ask them, “Who will end up with the most money at the end?” and which they would rather be?  The example isn’t only for children:

Saver #1 is a hard worker who understands the value of time and the importance of saving.  He gets a job at age 16.  Each year, he saves $2,000 – roughly 250 hours of work at minimum wage, 6 weeks of full-time work in the summer or 25 weeks of part-time work (10 hours per week) during the school year.  Either way, it’s not an unrealistic amount of money for an enterprising 16 year old to earn, while still having plenty of money for current spending.

Saving $2,000 per year becomes a habit, and Saver #1 does it every year.  Even after he begins his career in his mid-20s, he continues to set aside $2,000 per year.  He invests these savings conservatively to earn 8% and in an account where the earning are not taxed as they accrue.  He never saves more than $2,000 per year.  He has plenty of money to spend on things he needs and wants, but he always remembers to “pay himself first.”

By the time he’s 40 years old, he’s contributed $48,000 to his savings program.  At that point, he calculates that if he continues to earn as he has, he’ll have plenty to live on when he’s 65.  So, at age 40, Saver #1 stops saving money.  He’s now free to spend all the money he makes for the rest of his life.

Saver #2 doesn’t learn to save when he’s young and doesn’t even get a job until after college.  By that time, he’s so busy buying things – cars, vacations, dinners at nice restaurants, clothes, houses, etc., he never can “afford” to save a dime.

He wakes up at age 40 and realizes he doesn’t have anything in the way of a retirement fund or liquid savings at all.  So, frantically, he begins to save, and he does a great job.  He saves $10,000 per year, every year, to make up for lost time.  He knows he’s got to play “catch-up.”  Like Saver #1, he invests conservatively, because he can’t afford to lose money or time, and earns 8% a year.  By the time he turns 65, Saver #2 has contributed $250,000 towards his savings program.

Guess who has more money at age 65?  Is it Saver #1, who never contributed more than $2,000 per year and whose savings totaled $48,000 in his lifetime?  Or is it Saver #2, who had to save five times as much per year and saved $250,000?

At age 65, Saver #1 has more than $1 million in his account.  Saver #2’s account has about $800,000.  You might ask your child, which Saver would you rather be?  And, would it be easier to save $2000/year or $10,000/year?

Now, assume both Savers want an $80,000 per year ‘quality of life in today’s dollars’ and see how long this money will last.  How long will their money provide for Saver #1 and Saver #2?  If inflation averages what it’s been for their 65 year lives, inflation will be 3.96%.  (That’s not a prediction.  I’d be happy to put your own numbers into the calculator for a test.)  Let’s also assume a 15% income tax bracket.  (I’m not predicting future tax rates will be that low, either.)

   Saver #1 can enjoy an $80,000 per year quality of life (adjusted for inflation and taxes) until age 88. (assuming he also receives $2000 per month in Social Security benefits from age 67).  After age 88, he’ll have only Social Security benefits to live on.

Saver #2 will enjoy an $80,000 per year quality of life (adjusted for inflation and taxes and including the same Social Security benefits) until age 80.  Then, his savings are consumed and he’ll have to survive on only Social Security benefits, or get another job.

Most teenagers should be able to understand the assumptions in these examples.  If you need to simplify, you might omit the details about the income tax bracket and inflation.  It’s the principle you want them to grasp.

If your child says, “Gee, that’s a no-brainer.  I’d obviously prefer to be Saver #1.” you can congratulate him or her (and yourself) and get him to start a savings habit immediately.  A top priority for earned money every month is to ‘pay yourself first.’  Start early.  Take advantage of time and the power of compounding interest and enjoy financially security earlier in life.

Unfortunately, in my years of practice, I’ve encountered too few people who’ve implemented this simple practice of Saver #1 above.  The vast majority are Saver #2.  They’ve put themselves into a spot, stressed and afraid.  It doesn’t matter why.  The best time to change and start saving is now.  There’s no time to lose!

In case you question the assertion that the vast majority of people around you are Saver #2, allow me to share this:

In December, 2010, Wells Fargo bank released a study saying the average American has saved less than 7% of their desired retirement nest egg, and respondents aged 50-59 have saved an average of only $29,000 for retirement.

The study goes on to say more than a third of respondents believe they’ll have to work during retirement in order to afford the things they want or just to make ends meet.  The report claims there is another third living in a dream world.

This supports an earlier study by the Bureau of Labor & Statistics and the IRS, which concluded that only 1% are financially independent, 4% are financially secure and the remainder require some form of financial support from external sources.  We should note this includes Social Security, which was not intended to supply all of one’s financial needs.

Laurie Nordquist, Director of Wells Fargo Institutional Retirement Trust states, “Too many American have their heads in the sand in the face of obvious savings deficits.  Barring a miracle, a winning lottery ticket or a big inheritance, they’re going to be forced to dramatically cut back their lifestyles after retirement.”

Although that may be the unfortunate truth for many, it needn’t be the case for all.

So where can you start?  Or, where could your child start?

Start as early as possible to take advantage of Time and Compound Interest to create financial success and security.  Consider “The Smartest Savings Plan for Our Times,” as a wealth building cornerstone suitable for any saver.  You can acquire a copy, free, via my website, HERE.  There’s no time to lose.

Naturally, for assistance or guidance designing the best plan for financial success, I remain at your service.

To Your Prosperity,

Scott

Scott Scholz

Independent Registered Financial Consultant

425-829-4110     www.ScottScholz.com   scott@scottscholz.com

PS  Financial success is achieved by following the right principles, not following the current ‘right predictions’ which change from day to day.  “The Fiscal Fitness Letter” presents the ‘Right Principles’ for financial success and challenges misleading conventional paradigms about money and achieving financial independence.  If the principles presented here make sense to you, please share them with those you care about.  Add their name to The Fiscal Fitness Letter mailing list.