In February, Advisor Zach Ivey participated in the Birmingham Business Journal’s 2015 Tax & Investment Roundtable. Here are highlights and link to the full article.
Q: The stock market has experienced several strong years recently. Should investors be worried in today’s environment?
Ivey: Stock investors should always have an eye towards risk. We’ve been in a bull market for six years, so a lot of people forget about the risks. I like any question that gets people thinking that there are downsides to stocks. Where the markets are currently priced, there certainly is a smaller upside. So you can expect lower future returns, and the downside does get a little bit bigger. But I don’t see anything to be particularly worried about. I think the U.S. economy is fairly healthy. When we look globally, it’s a mixed bag. There are reasons to be hopeful, but investors need to look at how much risk they should be taking and just be aware that equities always pose a risk. All investments pose a risk, but equities in particular. I would also remind people that in the past six years there have been scary headlines all along the way, and we’ve had tremendous returns. So we can’t invest just based on what feels good emotionally.
Q: Are there any major tax or investment regulations to be aware of in 2015?
Ivey: One new rule the IRS came up with, which is fantastic, is for those with after- tax contributions to retirement plans. Now under the new rules, you can roll those after-tax funds directly to a Roth IRA when you separate from service or retire. Most people who have this have after-tax money and their regular pre-tax money. So before it was really murky how the rules were, and different people were doing different things. The IRS came out and cleared it up and said you can roll these over one time when you leave, and take the after-tax money and put it into a Roth and take the pre-tax money and put it in a traditional IRA. It’s really a great benefit, and it also clears up some murkiness that was in the rules before. So if people have the ability to put new money into after-tax, they should potentially talk to their advisor and think about doing it. And if they already have money there – especially if they’re close to retirement or separating from service – they need to think about that new option that they have.
Q: What are some best practices for approaching the current low interest rate environment?
Ivey: One thing we see is people saying that their current income-producing assets aren’t producing enough, so they end up wanting to concentrate more of their portfolios to where everything they have produces income. That creates a portfolio that is very susceptible to downside if interest rates start rising. So it’s important to keep a balance. We can’t overly concentrate our portfolios in income- producing assets. Secondly, the U.S. is the best-looking house on the block right now, but you still have to think globally. The U.S. dollar has appreciated a lot, which has really accounted for the differentials in returns. But there are other places around the world that are engaging in reducing rates, even while we’re worrying about rates going up. So having a global mindset is important. Being 100 percent U.S.-centric is the wrong approach. Even on the bond side, we have to think a little more globally. Lastly, I think there are a lot of products and shiny strategies out there that promise high returns and low risk. Some of these may have some validity. But if you don’t understand them or your advisor can’t fully explain them to you, then just stay clear. Because there are a lot of things out there where you may mitigate interest rate risk, but you’ve opened yourself up to some other risk that you weren’t even aware of, whether it is currency risk or sector risk, etc.
Q: What are the tax consequences of selling my business or passing it down to my family’s next generation?
Ivey: With the estate exemption being so high, I think a lot of people were looking at a transition plan for smaller-sized business, primarily to monetize it so they’d have it for estate purposes. Today that is becoming less of an issue. You should do your personal planning so you know what you need to net. It’s all well and good to position the business and get X value for it, but can you afford to live on that? You need to have your personal financial house in order as you get your business house in order, so you know what you need to have. It may be significantly less than what the business is worth. So then it becomes a decision of are you ready to go, or are you going to wait aroundfor a higher dollar amount that you might not necessarily need? There is a financial answer, and then there is a real-life answer. We only have so many years in our life and we can really use up a lot of that waiting for the best exit, when your personal planning may say that you can go today. That changes how you view that whole transaction. So getting your personal financial house in order to know what you need from the sell or the transfer of the business is the first step. The second step is getting that business ready to be sold, and then thirdly figuring out how to pay the least amount of tax possible.
Q: How should investors address global uncertainty (Russia, Middle East, etc.) in their portfolios?
Ivey: There’s more that can happen than will happen. It’s important to lay a geopolitical history on top of a market history. There have been events galore that can happen every single year. There are always fears, there’s always a bad guy, and yet most of us get up and go to work and try to make more money and make our lives better. Markets are remarkably resilient, but there is headline risk. The higher the stock market valuation gets, the more sensitive we are to geopolitical type risks. From a portfolio construction standpoint, you should be highly diversified, and not have just a U.S. stock and bond portfolio. We still think globally. But you need to really look at what your exposures are – your country, your currency and even your sector exposure. There are certain sectors of the market – like the energy sector recently – that are more susceptible to certain types of risk. If Mr. Putin starts acting nasty, then there are going to be certain sectors that are more affected than others. So being highly diversified is very important. And then lastly, what do we do as things change and develop? John Maynard Keynes used to say, “When the facts change, I change.” We should remain flexible. Not based on headlines or because you feel scared, but if fundamentals start to change, you certainly should be changing your portfolio. It should change how you allocate. Small geopolitical events are going to get the markets riled, but in most cases they don’t require any change in the portfolio, because nothing fundamentally has changed. But if Russia cuts off all oil to Europe, that’s an issue that may be more prolonged than just a week or two of market volatility. So you have to remain nimble and understand where your risks are in the portfolio, and you should rely on a professional investor to help you do that. The do-it-yourself heart surgery kit is not a good idea, and neither is the do-it- yourself portfolio. It’s tough to do because it’s our own money and we’re emotional about it. Having that separation a little bit emotionally by using a professional advisor is more warranted today than it used to be.
Q: What are the impacts of ROTH IRA conversions in income and estate tax planning?
Ivey: I think Roth conversions can play a role in someone’s planning, but the potential benefits are going to be for somebody who is in the same or higher tax bracket in retirement. And really those benefits are a long way off, not only in the retirement time horizon but just to break even. So it’s really important for someone who considers this that they do it in the context of a full financial plan, where they measure the benefits. A lot of people talk about Roth conversions and IRAs, but there is a large subset of the population that would be better off with a traditional tax deduction. Because paying tax today for a benefit that you’ll receive way down the road – with a lot of variables – is a tough thing to get people to do. Sometimes it’s a no-brainer, but it’s talked about a lot more than it’s done.
Q: What are some investment strategies to get the best performance while minimizing tax liability?
Ivey: This tax-location strategy is a great concept. There are certainly parts of the portfolio and types of investments that generate more current income and are less tax-efficient because they have a bunch of activity. So locating those in qualified accounts – IRAs, retirement plans – is a good idea. But we can’t lose the balance. We don’t want all your slow-growing investments in your retirement plan, because they don’t compound. There are tax-efficient investments like ETFs (exchange traded funds) and municipal bonds that are great to locate inside a taxable account. Whereas mutual funds are a less tax-efficient vehicle. So if you’re going to get the same exposure, sometimes using the ETF versus the mutual fund in a taxable account for a high tax bracket investor makes a lot of sense. But the most tax-efficient investment is one that loses money, so we can’t let the tax tale wag the dog. It’s OK to pay a little bit of taxes. We need to make investment decisions that are driven by investment fundamentals, and then think about what we can do to minimize the tax. Lastly, if you have a diversified portfolio, you’re probably going to have losses somewhere during the year. If you don’t have any losses, you’re not diversified. As you have these losses, you should be selling them during the year to help offset gains down the road. Last year was a perfect example. We had U.S. equities and capital gain distributions do very well, but we had losses in bonds and European stocks. If you sold those during the year, then your tax bite was probably pretty low because the losses offset the gains.
Master limited partnerships – MLPs – are very tax efficient if you hold them for a long period of time, but they have seen some volatility. Because for better or for worse, oil and gas flows through those pipes. But overall I think the energy infrastructure in this country will expand, so there are reasons to be hopeful about the MLP space.
Q: What are some key questions that clients should regularly ask their attorneys or financial advisers but often don’t?
Ivey: Many financial advisors are nearing their own retirements and may not have a succession plan in place. So you might want to ask them what their plans are for retirement. The average age of a financial advisor today is in the high 50s. So as a client, you need to know what their plan is. Another great question is, when should we meet next? One of the biggest causes of professional relationships souring or mistakes being made is people not meeting on a regular basis. So setting that next meeting holds both of you accountable. Whenever you end a meeting you should ask when you’re meeting again.
Q: Any final thoughts?
Ivey: The most value that can be provided is that financial-planning piece. Everybody wants to talk about what the next hot stock or sector is going to be, but all that kind of washes out over time. The real decisions – How much should I be saving? How much can I spend? When can I retire? – are of far greater importance than whether we outperformed by 1 percent over last year. Yet those decisions are the things that people don’t want to focus on. It’s important to always back up and look at your plan and the general theme of your portfolio and then have a long enough time horizon to let those things work out, as opposed to trying to pick something that’s going to be hot in 2015.
See the full transcript at Tax & Investments_2015.