I just got back from my yearly pilgrimage to the Northern California regional conference in San Francisco, which is always one of the best financial planning meetings of the year.

I spoke on "The Seven Keys to the Future" in a breakout session and, to give you an idea of the quality of the meeting, consider that during that same time slot in other rooms they had: Michael Kitces speaking about the next version of "Modern Portfolio Theory"; my former co-worker/analyst Margie Carpenter presenting her research about the risk/return characteristics of emerging market equities and how to change your global allocations based on a combination of each country's percentage of global population, percentage of global GDP, projected overall economic growth and other factors; Ed Jacobson on appreciative financial planning; ActiFi's Spenser Segal (RoadMap) on selecting technology for your practice and Jerry McCoy, who may still be our best technical speaker on planned giving and charitable planning. 

The keynote sessions included Neel Kashkari, who administered the federal government's TARP program, and Michael Lewis, author of Liar's Poker and The Big Short.

I took lots of notes and will write about the meeting in detail in the next issue of my newsletter.  But there were two interesting nuggets that caught my eye:

First, Kent Noard, a former staffer of the IRS, now a tax planner for advisory clients, pointed out that most advisors run their future retirement projections using the client's expected marginal tax bracket.  So if you expect a married couple to be earning over $209,251, indexed for inflation, you plug in 33%; if you expect somewhere between $137,301 to $209,250, you plug in 28%.

Noard flatly said that this is the wrong number to use. 

The right number is the EFFECTIVE tax rate, which takes into account the fact that the first $16,750 is taxed at a 10% rate, and the next $51,249 is taxed at a 15% rate, and so forth; plus all the exemptions and deductible expenses plus the fact that some of each year's total receipts are taxed at (lower) dividend or capital gains rates.

Muni bond payments are not taxed by the federal government at all (unless you're in the AMT) while losses are harvested out of the investment portfolio and many advisory clients have a host of other lines filled out on their tax forms that blunt the bite of the IRS.

The effective tax rate helps you more accurately project the impact of federal taxes on clients' future income. 

How do you calculate this number? 

It's not hard. 

Step one: Take the total income from all sources on the Form 1040, including interest, capital gains and dividends, and add to this number things like federal tax-exempt muni bond income and any other amounts that the client received which are not required to be reported to the IRS.

Step Two: compare that dollar amount to the dollar amount of taxes that were paid in that year. 

Noard went through a quick calculation for one of his clients, and the effective rate came to 22%, even though this person made more than $500,000 in annual income (and, therefore, was in the 35% marginal rate). 

He uses that 22% number (modified based on future projections of lower income in retirement) for goal planning, but he also will show it to clients, which helps them understand the value of his services.

The other nugget came from Bill Reichenstein, who is a fairly well-known professor of investments at Baylor University.  Reichenstein noted that most of us come up with an overall portfolio allocation (in a simplified case: 50% stocks, 50% bonds, although I know all of you are more sophisticated than that) and then you apply it to all of a client's portfolio holdings.


If some of that money is in an IRA or 401(k) plan, and some of it is in a taxable account or Roth, then your allocations are being skewed by the tax obligations.


Take a simple example: suppose a client has $1 million in an IRA and $1 million in a taxable account and you intend for that client to have a 50/50 stock/bond allocation -- and the risk/return profile that this implies. You decide to put the bonds in the IRA so the ordinary income they throw off can grow tax-deferred (this was actually the subject of another part of Reichenstein's presentation) and you put the stocks in the taxable account. 

That's fine, except that the actual value of the IRA is not $1 million. It is, in fact, $1 million minus the taxes that the client would have to pay to get that money out of the portfolio so he/she can spend it. If the client's effective tax rate is (to use a round number) 25%, then $750,000 of that account actually belongs to the client and $250,000 belongs to the government. Your after-tax bond allocation is $750,000, compared with $1 million for your stocks. 

Instead of a 50/50 allocation, you actually have a 57%/43% allocation -- MUCH riskier than you intended.

Reichenstein actually has an online service which explores a lot of these tax-aware issues. But the point I want to make here is that the profession could, with very little effort, be much more precise in its estimates of future tax obligations and portfolio allocations.

And these simple changes could have huge implications in your planning for clients today and in the future.  In fact, you could use the effective tax rate from Noard's presentation in your calculation of the proper after-tax allocations in client portfolios -- the one makes the other more precise.

These are so simple and obvious in retrospect, but it makes me wonder what else we might be missing in our assumptions or our applications based on numbers. 

Can you think of anything?


For more on planning, client service, practice management and marketing, or to join the Inside Information community, contact Bob Veres at Bob@BobVeres.com or go to http://www.bobveres.com/.


Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access