Steven M. Lugar, CFP®, is the Managing Director of Beaird Harris Wealth Management, an independent wealth management firm in Dallas. Lugar has more than 25 years’ experience, and for the past several years has been named one of the top wealth managers in the U.S. by Wealth Manager magazine. He spoke to WSJ Financial Adviser about a commonly repeated myth about tax deferral – and why he thinks advisers should offer clients some contrarian advice.
Over the years I’ve frequently heard clients repeat bad advice they’ve been told by other advisers. One of the classic investment myths centers on tax deferral. While tax deferral can be an incredibly powerful force in the effort to build net worth, making investment decisions just to defer taxes can actually result in a worse result for a client over a lifetime.
We often have clients come to us with portfolios of several million dollars, whose prior advisers placed their stock investments in tax-deferred accounts and then purchased municipal bonds in the taxable account. (Most of our clients have a very high marginal rate.)
By all appearances they have a tax-efficient portfolio. At least they think they do. But as every municipal bond investor knows, there’s no magic with tax-exempt income, it’s just that the municipality simply pays in a lower yield than the comparable taxable bonds. So one way to look at it is the investor pays a tax on the front end, by earning a lower yield than the taxable bond of an equivalent maturity and credit quality.
This isn’t a criticism. It’s just an explanation of why we would prefer to buy taxable bonds in the tax-deferred accounts rather than the tax-exempt bonds in the taxable accounts. From a tax perspective they’re equally effective, but it gives us the needed flexibility to move equities from the tax-deferred accounts to the taxable account.
There are several significant negatives associated with holding stocks inside IRAs or annuities. By placing the stocks in tax-deferred accounts, a client is ill-advisedly taking tax-favored capital assets–which right now are taxed at a 15 percent maximum capital gain rate if held long term–and committing to paying the highest marginal rate when they withdraw those funds. Another negative is that investors lose the opportunity to enact tax swaps in their tax-deferred accounts. One of the few silver linings during bear markets is the ability to harvest tax losses by selling the holdings that have suffered the loss and then swapping to comparable holdings.
But again, this opportunity to realize the tax loss is absent within a tax deferred account, including IRAs and annuities. Buying annuities, which commonly carry high recurring expenses, and then buying equity investments inside them is an investing mistake of mammoth proportion, in my opinion.