Nerd's Eye View blog

Qualifying A Rental Real Estate Enterprise As A “Business” For The 20% 199A QBI Pass-Through Deduction

February 13, 2019 07:07 am 5 Comments CATEGORY: Taxes

In a classic case of “the gift that keeps on giving,” the new IRC Section 199A included in the sweeping changes to the Internal Revenue Code introduced in the Tax Cuts and Jobs Act enacted by Congress in December 2017 has the potential to help certain business owners significantly reduce their annual tax bill with a 20% deduction against their “qualified” pass-through business income. With the caveat that when it comes to real estate, the new Qualified Business Income (QBI) deduction only applies against business income, and not against “mere” investments in real estate.

In other words, to qualify for the 20% QBI deduction as a rental real estate owner, a taxpayer must establish that they’re engaged in a “qualified trade or business” in the first place. Which, when it comes to rental real estate activity, isn’t always clear (especially since Congress didn’t fully define what constitutes “a business” for the purposes of the new IRC Section 199A in the first place)!

Fortunately for some, at the same time the IRS issues it’s first round of IRC Section 199A Final Regulations, it also released IRS Notice 2019-07, which provides a safe harbor for when a rental real estate enterprise will qualify as a business for purposes of the Section 199A deduction. Specifically, to qualify for the 20% QBI deduction on rental real estate, the taxpayer’s real estate must be directly owned by an individual or eligible pass-through entity (or through a disregarded entity), and their must also be at least 250 hours of total documented “rental services” activity performed in order to qualify.

Notably, though, this 250+ hour requirement carries its own quirks and nuances. Importantly, it’s not an overall requirement, but rather, the 250 hours of “rental services” must be performed for each enterprise, which again, potentially forces the taxpayer to make some important tradeoffs, since treating individual rental properties as separate enterprises has typically offered more flexibility for planning purposes but will now make it harder to qualify each separate property for the QBI deduction. Still, for purposes of counting those 250 hours, the IRS doesn’t require that the services (including such things as advertising, collection of rent, supervision of employees, operation and maintenance, etc.) be performed by the owner themselves, but instead can be performed by an agent, employee, or independent contractor.

Ultimately, individuals who don’t meet those safe harbor requirements still have the opportunity to “prove” that they have such a business (but they will bear the burden of backing up their claim (possibly in court) should the IRS stop in for a visit). Though shifting all rental activities to the lessor – e.g., via a triple-net lease – will unequivocally not qualify for the QBI deduction in the future, as it transitions the real estate purely into a passive investment holding!

Fortunately, for at least some rental real estate business owners, the safe harbor in the IRS Notice 2019-07 provides reasonable clarity about whether their rental enterprise(s) will qualify as a business. But significant complexity remains for some, especially those who own multiple rental real estate properties, and must make decisions that weigh maintaining them as separate enterprises, against the new burdens of ‘proving’ it is a rental real estate business without being able to meet the 250-hours-per-enterprise requirement.

#FASuccess Ep 111: Why The Right Advisory Fee To Charge Is The One That Not All Clients Say “Yes” To, With Jim Stackpool

February 12, 2019 07:03 am 0 Comments CATEGORY: Financial Advisor Success Podcast

Welcome back to the 111th episode of Financial Advisor Success Podcast!

My guest on today's podcast is Jim Stackpool. Jim is the founder of Certainty Advice Group, a practice management consulting firm for financial advisors based in Australia. What's unique about Jim, though, is his particular focus on how to price and demonstrate the value proposition of what he calls non-product-based financial advice, which is increasingly relevant as fiduciary regulation continues to crop up both here in the U.S. and especially in Australia.

In this episode, we talk in depth about how to think about the true value of financial advice. How the expert value of the advisor themselves should be distinct from the products we implement, just as every surgeon uses a scalpel, but the value of the surgeon is not measured in scalpels, why the value of advice is not merely tied to a goals-based conversation but must tie to their real-world complexities, and why in the end we should focus more on the enduring value or what Jim calls the profound value of financial advice that can have material life-changing impacts for clients.

We also talk about how to know whether your advisory services are currently priced appropriately. Why it's actually a problem if you get too many people saying yes to your advisory fee pricing, how even on renewal you should consider raising advisory fees to elevate the business and the work it does with clients, even if you lose a few along the way, and why the AUM model does perhaps have it easier than other pricing models, since fees tend to naturally lift with the growth of the markets, but even under the AUM model, it's still necessary to be reinvesting into your own value proposition of clients or eventually, your fees will naturally drift so high that clients may no longer be willing to pay them.

And be certain to listen to the end, where Jim shares some perspective on the fiduciary regulation changes underway in Australia, where regulators have been even more aggressive in calling out the financial services industry's worst practices in what may culminate in a total breakup of Australia's wirehouse equivalents and a rapid explosion of the Australian independent advisor, akin to the IBD and RIA movements here in the U.S., which raises interesting questions about whether U.S. regulators may also someday become similarly aggressive towards the vertically integrated product distribution model here too.

So whether you're interested in what Australia's sweeping regulatory changes mean for their advice industry, ways in which advisory firms can provide more value to their clients, or how the industry might evolve in the coming decade, then we hope you enjoy this episode of the Financial Advisor Success podcast.

The New 1% Advisory Fee: 1% Of Income, Instead Of 1% Of Assets

February 11, 2019 07:06 am 1 Comment CATEGORY: Practice Management

The AUM model for financial advisors has experienced tremendous growth over the past 20 years, from the rise of the independent RIA to the broker-dealer shift to fee-based accounts. And despite the rise of critics questioning whether the AUM model is the most effective way to align what the client pays with the value being provided, the accelerating momentum of major firms transitioning to the model suggests that not only is the AUM model here to stay… but there may soon be too many financial advisors using the same AUM model to pursue the same relatively-few households who have sufficient liquid assets available to invest and who are actually willing to delegate them to an advisor in the first place. In fact, if the entire advisory community makes the AUM shift all at once, there may be no more than about 23 clients per advisor available!

Yet the reality is that the opportunity in the marketplace for financial advice goes far beyond just those who have at least $100,000 of investable assets available to roll over to an advisor to manage. In part, this is because some advisors are now shifting to an “Assets Under Advisement” (AUA) model that aims to charge clients not just a percentage of their managed portfolio, but a percentage of their entire net worth (on which the financial advisor is providing holistic financial advice), opening up a larger segment of Mass Affluent (and Millionaire) households who have the financial ability to pay for advice, but not the liquidity to access it by rolling over an investment account (e.g., because their assets are tied up in a 401(k) plan where they’re still working!).

However, the even-bigger opportunity to expand financial advice is not just to shift from charging a percentage of assets to a percentage of net worth, but instead to charge a percentage of income instead. Which opens up yet another swath of consumers – commonly known as the “HENRYs” (short for High Earner, Not Rich Yet) – who may not have substantial assets or net worth, but have more than enough income to pay for advice directly out of their income, whether on an hourly, monthly subscription, or annual retainer basis.

And while for high earners, the most straightforward approach may be to simply shift from charging 1% of assets to 1% of income, the reality is that just as AUM fees are typically tiered on a graduated fee schedule – with higher-percentage fees for smaller portfolios and lower fees for sizable accounts – a percentage-of-income fee could be tiered as well. In fact, at a 2%-of-income fee, even median-income households (earning approximately $60,000/year) become economically feasible to service with advice… for which even a 2%-of-income fee can often be recovered by providing good advice on the other 98%, at a cost that is little more than what such individuals would pay in commissions on even a modest IRA rollover into A-share mutual funds or via an insurance purchase. In other words, charging fee-for-service advice isn't just about the HENRYs, but a far wider range of Earners Wanting Advice Now (EWANs) who have the financial wherewithal to pay for it (as a percentage of the income they have, not the assets they don't!).

The key point, though, is simply to understand that, while the AUM model continues to be popular, and has a lot of benefits that make it easy for consumers to pay and highly scalable, it is naturally limited in market size to those who have liquid portfolios available to manage. While the rising shift to alternative fee-for-service models, particularly a percentage-of-income fee, opens up entirely new “blue oceans” of HENRY and EWAN consumers who are not served today by holistic financial advisors!

Weekend Reading for Financial Planners (Feb 9-10)

February 8, 2019 02:53 pm 0 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with the news that state legislators are taking action yet again to fill the fiduciary void left by vacating the DoL fiduciary rule and the SEC's non-fiduciary Best Interest Regulation... this time, from Maryland, which has proposed a new fiduciary rule that would uniformly apply to RIAs, brokers, and insurance agents, and setting off the usual objections from industry product manufacturers that a state patchwork of fiduciary rules will create an unnecessarily high burden of regulatory complexity (albeit while the industry also continues to fight against fiduciary regulation at the Federal level, too!).

Also in the news this week is coverage of the recent TD Ameritrade LINC National conference where CEO Tim Hockey vowed not to compete with the RIAs on its platform (as the issue of RIA custodians with retail divisions competing against their own RIAs becomes an increasingly sensitive issue), a new diversity push at Edward Jones to steer retiring advisors' books of clients to advisors who are women and people of color that some are claiming goes "too far" by paying advisors more to hand off clients to minorities (and less to transition their clients to another white male), the news that within 2 weeks of Bogle's death Vanguard removed its claims of being an "at-cost" and "no-profit" provider (though it's unclear if the firm is really changing its strategy, or simply backing off claims that were causing it legal troubles about whether its pricing was an inappropriate tax dodge), and a look at Fidelity's expansion of its model portfolios as advisors increasingly outsource investment model design and implementation (which asset managers like Fidelity are using as an opportunity to increase their own assets by offering pre-built models that "happen" to predominantly use their own proprietary funds).

From there, we have several articles on advisor technology, from a discussion of whether presentations on advisor technology should be eligible for CFP CE credit, highlights from the T3 advisor technology conference, how the rise of Artificial Intelligence (AI) will likely play out with advisors in the coming years (think less "robots replace advisors" and more "software that combs through data to identify planning opportunities for advisors to discuss with their clients"), and a review of the ongoing technology initiatives at all the major RIA custodians as a veritable "technology arms race" gets underway as platforms compete for advisors' attention.

We wrap up with three interesting articles, all around the theme of the changing landscape of the financial services industry itself: the first looks at the recent Royal Commission report in Australia, a highly critical review of their conflicted financial advisor landscape, and the rather drastic changes that the regulators may now implement to ensure advisors are truly acting in the best interests of their clients and not merely as salespeople for their company's products; the second is a fascinating exploration of the evolution of the financial services industry over the past 130 years, which finds that, despite exponential growth in technology efficiencies, the financial services industry all-in takes the same 1.5% to 2% of assets to facilitate investment now as they did more than a century ago (albeit while providing more value-adds for the same aggregate fee); and the last which looks at research on the true value that clients get from planning for their future finances, and how financial advisors, in particular, appear to provide the most value and best outcomes for at least those planning-oriented clients.

Enjoy the "light" reading!

How The New QBI Deduction-Reduction Ruins The Value Of Pre-Tax Retirement Plans For Small Business Owners

February 6, 2019 07:03 am 5 Comments CATEGORY: Taxes

In December 2017, Congress passed “comprehensive tax reform” via the Tax Cuts and Jobs Act. The law was a once-in-a-generation, massive rewrite of the Tax Code, and gave birth to IRC Section 199A, which allows certain owners of pass-through businesses to receive a deduction for up to 20% of qualified business income.

While the new deduction will be a powerful way for many business owners to reduce their tax liability, it comes at a price… complexity. Many tax experts believe that “new” IRC Section 199A is among the most complicated aspects of the Tax Cuts and Jobs Act. And as evidence to support that claim, individuals can look no further than the IRS’s massive dump of Section 199A guidance on January 18, 2019. That trove of 199A guidance included 247 pages of Final Regulations and discussion, additional Proposed Regulations, IRS Notice 2019-07, and IRS Revenue Procedure 2019-11!

Critically, the introduction of the Section 199A deduction means that business owners must reevaluate their planning from the ground up, as even “obvious” decisions may need to be altered in light of the new rules. Case in point? Going forward, the Section 199A deduction will dramatically reduce the value of a tax-deductible retirement plan contributions.

This new “deduction-reduction problem” with pre-tax retirement contributions arises from the fact that the Section 199A deduction only applies to qualified business income, which is essentially the profits of a company. But when an S corporation makes an employer contribution to an employer-sponsored retirement plan, that contribution, itself, reduces corporate profits. Thus, there is less profit on which the 199A deduction can potentially apply. The sum of these moving parts is that, for some S corporation owners, a contribution to an employer-sponsored retirement plan will effectively result in a partial deduction, but still subject the entire contribution, plus all future earnings, to income tax upon distribution.

Prior to the issuance of the Final Regulations, it was widely assumed that this issue was only applicable to owners of entities taxed as S corporations, since contributions to retirement plans for sole proprietors and partners do not reduce business profits, but rather, are taken as personal above-the-line deductions on new Form Schedule 1 (formerly on the bottom of page 1 of Form 1040). The Final Regulations, however, make clear that sole proprietors and partners must also “back out” these amounts from business profits prior to the application of the 199A deduction. Thus, the “deduction-reduction problem” created by the Section 199A deduction will impact far more small business owners than previously thought.

In general, the primary reason a business owner should make contributions to a tax-deductible retirement plan (as opposed to a Roth-style plan) is that they believe that they are in a higher tax bracket today than they will be when they distribute those funds (along with their earnings) in the future. But when, in effect, you’re only getting a partial deduction for amounts contributed to a plan today, but still have to pay taxes on the “full boat” in the future, it changes the calculus quite a bit! Notably, for business owners who find themselves in this situation, their future tax rate must be even lower for the tax-deductible contribution today to make sense.

But just because a business owner isn’t getting the same bang-for-the-buck on a tax-deductible contribution doesn’t mean that they should throw in the tax-preferred-retirement-savings towel altogether! Instead, 401(k)s with a Roth-style option will simply become more valuable. And for those business owners looking to sock away more for retirement than the $19,000 maximum Roth 401(k) deferral ($25,000 if 50+ by year-end) for 2019, making after-tax contributions to the 401(k) plan (potentially to later convert under the “Mega-Back-Door Roth” strategy) can be an increasingly attractive option as well.

Of course, there is no -one-size-fits-all solution, and there are still plenty of business owners who will continue to benefit from tax-deductible contributions. Such business owners include those in Specified Service Businesses whose income is so high that the QBI deduction is phased out anyway (such as high-income financial advisors, doctors, lawyers, consultants, and accountants), those who believe that their future marginal tax rate will be significantly lower than the marginal tax rate they face today, and business owners who need to reduce their Adjusted Gross Income (AGI) to qualify for other deductions, credits, etc. (as the Section 199A deduction happens “below-the-line” and itself does not reduce AGI).

And of course, it’s important to recognize that tax-favored retirement accounts, in general, should not be abandoned altogether in light of the deduction-reduction impact of Section 199A. While the new deduction-reduction limitation definitely tilts the balance more towards Roth-style retirement accounts, the tax-deferred nature of all retirement accounts cannot be overlooked. Thus, even getting a partial deduction on a contribution today, while paying income tax on the full amount (plus earnings) in the future, will often be preferable than simply investing the same amounts in a taxable account where the entire contribution is implicitly taxed immediately (as an after-tax-dollars account) and then experienced further annual “tax drag” from interest, dividends, and capital gains.

Ultimately though, the most important thing for business owners and their advisors to realize is that the Section 199A deduction’s complexities go far beyond just the calculation of the deduction itself. Rather, there are ripple effects that make it necessary to take a fresh look at every element of a business owner’s overall tax plan, including which type of retirement plans will really provide the maximum benefit in the future!

#FASuccess Ep 110: Adapting The 4-Hour Work Week Into A Highly Profitable 4-Month Work Year Lifestyle Practice, with Micah Shilanski

February 5, 2019 07:15 am 0 Comments CATEGORY: Financial Advisor Success Podcast

Welcome back to the 110th episode of Financial Advisor Success Podcast!

My guest on today's podcast is Micah Shilanski. Micah is a partner with Shilanski & Associates, an independent RIA in Anchorage, Alaska, where Micah personally oversees nearly $130 million of assets under management for almost 160 client households.

What's unique about Micah, though, is that over the past 8 years, he's transitioned from working 70-plus hour work weeks to refining his practice down to the point where he can service all 160 clients while being in the office for only 4 months of the year, an endeavor that he first started simply to get more efficient and better work/life balance, and then had to extend further out of necessity over the past several years to unfortunately support a sick child.

In this episode, we talk about how Micah manages his client workload of meeting processes to be able to sustain 160 clients while being in the office only 4 months of the year. How he boxed together a whopping six or seven client meetings a day for five-week surges in the spring and the fall, the way he handles meeting preparation and client notes in the midst of maintaining such an intensive client meeting schedule, how he sets a communication policy with clients during the onboarding process to set their expectations around his somewhat unusual schedule, and the way Micah overcame his own severe dyslexia to keep rigorous notes into CRM by using a combination of audio dictation tools and video emails to clients.

We also talk about how Micah has managed to not only maintain his practice but grow at 20% a year, despite only being in the office for 4 months, by focusing into a niche of helping federal employees with their retirement benefits. How he created his own niche website, plan-your-federal-retirement.com, to reach prospective clients, the seminar marketing strategy he uses to get even more clients into his niche, why he charges and can get a $500 initial consultation fee even for prospects that find him on the internet, and how by focusing into a niche, he's able to confidently charge above-average fees of $4,000 for an initial plan plus 1.75% of assets under management, because, as Micah emphasizes, there's nothing wrong with charging a premium fee when you genuinely offer specialized and premium service to a niche clientele who simply can't get the same expertise and experience anywhere else.

And be certain to listen to the end, where Micah shares the initial steps that any financial advisor can take to at least start to improve their own personal efficiency in the office, and how despite his time out of the office and the staff support he needs to make that happen, he's ultimately still been able to maintain his target of a nearly 70% EBOC take-home compensation from his $130 million AUM practice.

The Latest In Financial Advisor #FinTech (February 2019)

February 4, 2019 07:07 am 0 Comments CATEGORY: Technology & Advisor FinTech

Welcome to the February 2019 issue of the Latest News in Financial Advisor #FinTech – where we look at the big news, announcements, and underlying trends and developments that are emerging in the world of technology solutions for financial advisors and wealth management!

This month's edition kicks off with the big news that eMoney Advisor founder Edmond Walters is back, with a new financial planning software competitor… but one targeting an entirely different (ultra-high-net-worth) clientele than traditional financial planning tools, such that MoneyGuidePro and Envestnet (owner of FinanceLogix) have actually partnered with Walters’ new Apprise Labs to develop the solution (aptly named “MoneyLogixPro”).

From there, the latest highlights also include a number of interesting advisor technology announcements, including:

RightCapital raises a $3.7M Series A round to scale its competition with MoneyGuidePro, eMoney Advisor, and NaviPlan in the enterprise market
AdvicePay raises a $2M seed extension round by crowdfunding within the advisor community itself to power a new enterprise solution for hybrid broker-dealers offering fee-for-service financial planning
MoneyGuidePro rolls out its own new “downmarket” solution for non-CFPs dubbed MoneyGuideOne, and announces a new, more advanced financial planning software solution to be called MoneyGuideElite
Plaid acquires Quovo to turn its account aggregation services into more actionable APIs that might actually move client assets (or manage them from afar)

Read the analysis about these announcements in this month's column, and a discussion of more trends in advisor technology, including Bridge Financial’s new portfolio performance reporting solution for small-to-mid-sized RIAs, Timeline’s new retirement distribution software to model the impact of dynamic spending rules and dynamic asset allocation on sustainable withdrawal rates, the rollout of two new client survey/feedback tools to better measure client engagement, and a look at how the latest T3 Advisor Technology Survey shows that what advisors state is their most important technology is not what they actually spend the most on (raising the question of whether there’s room for higher-priced CRM and financial planning software, and coming price pressure on portfolio performance reporting tools).

And be certain to read to the end, where we have provided an update to our popular new “Financial Advisor FinTech Solutions Map” as well!

I hope you're continuing to find this new column on financial advisor technology to be helpful! Please share your comments at the end and let me know what you think!

*And for #AdvisorTech companies who want to submit their tech announcements for consideration in future issues, please submit to [email protected]!

Weekend Reading for Financial Planners (Feb 2-3)

February 1, 2019 02:58 pm 0 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with the big industry news that eMoney Advisor founder Edmond Walters is "back", with a new high-end financial planning software to support tax, estate, and legacy planning conversations with ultra-high-net-worth clients... positioned not necessarily to compete with traditional financial planning software, but to go beyond it, as the offering is actually being developed in partnership with MoneyGuidePro and Envestnet's Logix planning software.

Also in the news this week is a great series of profiles on the leading "Women In WealthTech", as ThinkAdvisor highlights the rise of gender diversity in enterprise technology for financial advisors (even as the gender diversity of financial advisors ourselves continues to struggle).

From there, we have several articles on the (re-)emergence of fixed indexed annuities, as DPL Financial Partners facilitates the launch of a new no-commission fixed indexed annuity for the RIA channel, Roger Ibbotson publishes a study suggesting that indexed annuities may be a superior fixed income alternative to traditional bonds in a diversified portfolio, and Michael Edesess suggests that real-world annuity contracts may still be too expensive to beat bonds in practice (and for those who wish to pursue the strategies anyway, could accomplish even more by simply using options strategies themselves instead).

We also have a number of career and practice management articles this week, from tips on the first tasks to outsource to a virtual assistant as a solo financial advisor, more tips on how to make your advisory firm more attractive and compelling when hiring talent in the midst of a severe advisor talent shortage, even more tips on how to manage the overwhelm of meetings, and some fascinating insights from an advisor on what she wishes she learned in practice management sessions about running an advisory firm but instead had to learn "the hard way" instead.

We wrap up with three interesting articles, all around the theme of social media and email overwhelm and how to combat it, including: a recent study that analyzed the effects of taking a 1-month break from Facebook and how it not only created more free time (obviously, from the freed up Facebook time) but also lifted up participants' mood and reduced their political polarization (but also their political knowledge as Facebook is a key source of political news and information); the second explores the effects of taking a month off from email as well (hint: most of your emails are not as important as you think they are!); and the last explores the idea of doing a "digital declutter" and that it's not enough to just try to take a break from social media, and instead we have to rethink the kind of digitally-minimalist lifestyle we really want to live (or not).

Enjoy the "light" reading!

Kitces & Carl Ep 01: How To Value The Value Of Financial Planning

January 31, 2019 12:01 pm 1 Comment CATEGORY: Kitces & Carl Podcast Planning Profession

One of the biggest challenges comprehensive financial planners face today is that “everyone” says they do financial planning. Yet in practice, what they actually do, whether it’s really comprehensive financial planning, or even what constitutes “financial planning” as opposed to just ad hoc financial advice, has no clear and consistent definition within the industry. And if we can’t figure out what the differences are within the industry, then it’s almost impossible for the public to understand the differences between the services offered (including any potential conflicts) by a whole bunch of people who do different stuff (frequently playing by different sets of rules) yet say they all do the same thing! Not to mention trying to help the public understand the value (both financially tangible and intangible) of the financial planning choices available and being offered to them.

To explore this issue, we’re introducing you to a new experimental (but possibly recurring if you like it!) content format we’re simply calling “Kitces & Carl” here at The Nerd’s Eye View, where Michael Kitces and financial advisor communication guru Carl Richards sit down to discuss industry topics from their own unique perspectives. And in this inaugural episode, Michael and Carl talk about the Value of Financial Advice, efforts to quantify that value, and why we may need to move past the asset-based model in order to define and communicate the real value of financial planning to our clients and the public in general.

Fortunately, both Morningstar, Vanguard, and Envestnet have done some research to try and quantify an answer to this very question. Their studies suggest that, even when we ignore any potential excess investment return, the advice that advisors provide around the dollars that they are managing can amount to an additional 1.5-3.0% over what a client would have likely gotten had they “done it themselves”

But, outside of “helping clients avoid big mistakes” by re-allocating their portfolios or talking them off the proverbial “ledge” when volatility ticks up, there’s arguably another aspect to helping clients that transcends the “quantifiable” aspect of the profession. Because most clients don’t have anywhere else they can go and feel safe talking about this topic of money, that is so important yet remains a taboo topic of discussion, and for many carries an enormous amount of baggage. And those hurdles only expand geometrically when it’s a couple that’s sitting across the desk.

In fact, perhaps the greatest problem of trying to explain the value of financial advice, especially while the industry is in the midst of such rapid change, is that we are still tying all our value conversations back to the portfolio-based model... to the extent that, even when trying to quantify the behavioral aspects of planning, industry studies still scale them to a percentage of assets. Even though an increasingly amount of the value of financial planning advice is specifically about the advice that occurs outside of the portfolio!

Alternatively, perhaps instead of trying to put a dollar value on the advice we provide as advisors at all, we might just consider framing it in terms of the real-world outcomes for clients. For instance, what if we as advisors simply said to a couple having stressful arguments about money that, “We help couples have better conversations about money, so they’re not as awkward”? And then let them figure out if it’s valuable enough to them to pay for it? Because, if an advisor can help reduce marital stress and reduce the number of marriages that end out in divorce because of money issues… then clients might consider that a whole lot more valuable that we might have ever imagined anyway!

Ultimately, then, the key point is to recognize that as financial planning continues to expand beyond just building and managing diversified asset allocated portfolios, the key task as an industry is to figure out how we can frame that value beyond the context of “investable assets”. Because if we want to better communicate our value to prospects and clients, especially beyond the portfolio, we must first be willing to fully embrace and acknowledge that value ourselves.

Navigating The Capital Gains Bump Zone: When Ordinary Income Crowds Out Favorable Capital Gains Rates

January 30, 2019 11:07 am 7 Comments CATEGORY: Taxes

While long-term capital gains have had preferential tax rates for most of their history (and receive similar treatment in most developed countries around the world), it’s only in recent years that long-term capital gains have been subject to not just one, but a series of tiered preferential rates, from a 0% rate for those in the lowest tax brackets, to 15% for those in the middle, and 20% for the highest earners (albeit still a “deal” relative to a 37% top tax rate on ordinary income). Plus a 3.8% Medicare surtax that stacks on top of a portion of the 15%, and all of the 20%, long-term capital gains rates.

The significance of this phenomenon is that, similar to ordinary income tax rates, generating “too much” in capital gains can drive the household up into higher capital gains tax rates. And because capital gains income stacks on top of ordinary income, even just increasing ordinary income can effectively crowd out room for preferential long-term capital gains rates.

In fact, the interrelationship between ordinary income and long-term capital gains creates a form of “capital gains bump zone” – where the marginal tax rate on ordinary income can end out being substantially higher than the household’s tax bracket alone, because additional income is both subject to ordinary tax brackets and drives up the taxation of long-term capital gains (or qualified dividends) in the process.

For instance, individuals with as little as “just” $30,000 of income (after deductions) and some capital gains on top who would normally be in the 12% tax bracket may face marginal tax rates as high as 27% due to the capital gains bump zone. And upper-income households eligible for the 35% tax bracket may face a marginal rate of 40% as the top capital gains tax bracket phases in. The effect can be even worse for retirees who also claim Social Security benefits, where the combination of phasing in Social Security benefits, and driving up long-term capital gains to be subject to the 15% rates, can trigger a marginal tax rate of nearly 50%(!) for a household otherwise in the 12% ordinary income tax bracket!

As a result, it’s crucial to consider the coordination of long-term capital gains with ordinary income, and the phase-in of Social Security taxation. For those with negative taxable income, it is generally still appealing to do partial Roth conversions at a marginal tax rate of 0%. But for others in the bottom tax brackets, it may be preferable to harvest 0% long-term capital gains instead (and not do partial Roth conversions that will undo the 0% rate on those capital gains!). While higher-income individuals may prefer to once again do partial Roth conversions in the 22% and 24% brackets, or even the 32% bracket… while avoiding the additional capital gains bump zone that occurs in the 35% bracket.

The bottom line, though, is simply to understand that with 7 ordinary income tax brackets, plus 4 long-term capital gains brackets (with the 3.8% Medicare surtax), tax planning and evaluating marginal tax rates is a function of not just the ordinary income or long-term capital gains rates themselves, but also the interrelationship of the two and the indirect but substantial tax impact of adding more ordinary income when there are already substantial long-term capital gains stacked on top!