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Picking The Right Tax Class Bucket – From A Dublin CPA

Picking The Right Tax Class Bucket – From A Dublin CPA

Ignoring Tax Class Diversification
Means Setting Up Future Tax Bombs For Your Clients

Warren Buffett is widely regarded as one of the most successful investors in the world. Here are a few Quotes from the “Oracle of Omaha” on diversification:

“Diversification is a protection against ignorance.”

“Risk can be greatly reduced by concentrating on only a few holdings.”

Based on these quotes, it is obvious Buffett is not a big fan of diversification. But most of us and our clients are not Warren Buffett.

Every time we turn on the financial channels or attend an investment seminar someone is promoting diversification. This notion has been part of mainstream financial planning for a long time. There is a widespread belief in the truth of statements such as “studies show that asset mix determines 93.6 percent of the return of a portfolio.” This concept has become a financial mantra and has become second nature. For now let’s just assume diversification is critical for the long term health of a portfolio.

Tax Diversification Buckets

As CPAs and Personal Financial Specialists (PFSs), are we truly serving our clients best interest by only emphasizing the funding of retirement plans for today’s “tax write-off”, instead of considering the concept of tax class diversification during the tax and financial process with our clients?

Are we telling our clients the whole story? Are we really helping them prepare for their financial future? Over the last 13 years, I have personally designed and established over 80 qualified pension plans, mostly defined benefit (DB) plans. However, in the last five years I have been seriously considering the financial and tax logic of encouraging my clients to only focus their resources on tax deductions by funding qualified plans exclusively. It is a lot easier to convince a client to fund a DB plan to generate tax write-offs, rather than having the client pay income taxes now to create a tax-free income stream in the future and eliminating the typical restrictions of qualified plans.

One of our professional responsibilities is to educate our clients on the long-term risk of tax-deferred vehicles and the resulting tax bomb in the future. Helping our clients overcome the need for instant gratification to minimize their current income taxes is a must. Instant gratification is mainly concentrating on the immediate result and not thinking about the outcome in the future or what its effect is later in life.

Another way to look at it, instant gratification is the habit of always wanting to enjoy now and not having the patience to wait for future benefits. Anything that gives us temporary happiness or excitement, but is actually not a good thing for your life, can be put in this category.

“We care a lot more about today than about the future,” explains Harvard economics professor David Laibson. “Humans, like a lot of other animals, place full weight on what happens right now and half weight on what happens even a few days away.”

That’s because we react emotionally to immediate gratification and think logically about future rewards. And emotion often trumps logic.

That said, why do we seem to neglect the idea of diversifying from a tax-class perspective? If we diversify our asset classes so that losses do not negatively impact our financial pictures as much, then doesn’t it make sense to use the same logic for tax classes?

In 2016, the national outstanding debt is $19.8 trillion. It is more than likely income tax rates will increase in the coming years and we may experience significant changes in the U.S. tax code, as increasing tax revenues will be a way that our government tries to lower this debt. Therefore, tax class diversification is a must.

Two Tax Class Buckets Identified By A Dublin CPA

Understanding Both

When I first introduce this concept to my clients I simply refer to tax classes as “future income buckets” – a taxable income bucket and a tax free income bucket. I often asked my clients “when you access your money in the future, which bucket would you rather access the tax-free bucket or the taxable bucket?” Obviously, most of my clients always answer the tax free bucket.

When we access our money, there are only two categories from which we can pull money. The first one is the taxable category, which includes tax deferred, tax qualified plans and various types of annuities to name just a few. There will be taxes due as we take distributions out of this category. The second category is tax-free income, when qualified distributions are taken. The Roth IRA is a well-known financial vehicle in this bucket – but this has it’s limits.

We’ve recommended using the built in value of whole life insurance as a time tested option for our clients.

This program has become very popular with my clients.

Benefits:

  • Safety
  • Valuable tax benefits
  • Asset protection
  • Income-Tax-free death benefit
  • Professional money management

Like a venerable Swiss Army Knife, it is a robust and versatile solution – one used by the Clintons.

A Tool in Clinton’s Toolbox

Remember that diversification is only part of the story. In order to truly prepare and maximize your clients’ future income stream, current and possible future income taxes must be taken into consideration.

Be sure to talk to your clients about the full diversification process to provide them with the flexibility to choose between the different income “buckets” and meet your professional responsibilities.

Palma Financial Services, Inc. has been serving the tax and financial planning needs of businesses and individual clients throughout the East Bay and beyond for over two decades. As a Dublin CPA firm, we have built relationships and financial plans which preserve our clients’ wealth – current and future – with full legal compliance and tax law comprehension.

Contact us to to set up the right tax bucket allocation today! Our solutions and recommendations are backed with the experience of Miguel A. Palma — a Certified Public Accountant (CPA) and Personal Financial Specialist (PFS).

Contact Palma Financial Services, Inc.

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