Tax planning is often overlooked when it comes to investment management. Tax diversification should be considered along with investment portfolio diversification – and poor planning for either can be detrimental to your wealth as an executive. Brokers oftentimes buy and sell investments within your portfolio without contemplating the tax consequences to you; as long as the investment is “suitable,” brokers feel they have done their due diligence.
Services Apex can provide for Corporate Executives
As a registered investment advisor, Apex is compensated on a fee-only basis – we are paid directly by our clients. We do not buy and sell investments from our own stockpile, like a broker/dealer; we receive no commissions. Simply put, we are a fiduciary who provides investment advice that is in our clients’ best interest – this goes far beyond the “suitable” standard.
Our comprehensive financial planning process helps us identify opportunities for families and corporate executives to help them minimize taxes (both income and estate taxes) while maximizing their income. When working with clients, Apex considers tax diversification as a major factor in investment decisions, as accumulating and distributing wealth in the most efficient manner can save high net worth families and corporate executives millions of dollars over multiple generations.
The basic premise of tax diversification is maintaining exposure to all three types of tax investment accounts: taxable, tax-free and tax-deferred. Reducing taxes and maximizing what is passed onto heirs often involves all three types of accounts, all with different tax consequences. Knowing the different consequences and tax strategies specific to these three types of accounts is of paramount importance when it comes to minimizing your tax bill.
For example consider a corporate executive with a significant amount of company stock in a tax-deferred 401(k) plan. The stock can be transferred from the 401(k) into a taxable account; this is considered a distribution however, taxes are paid at ordinary income rates only on the cost of the stock when purchased (cost basis). Going forward, the advantage is that any appreciation above the original cost basis will be taxed at capital gains rates when the stock is sold instead of at ordinary income rates. Net unrealized appreciation is the difference between the price you initially paid for a stock (its cost basis) and its current market value. Say you can buy company stock in your plan for $20 per share, and you use $2,000 to purchase 100 shares. Five years later, the shares are worth $35 each, for a total value of $3,500: $2,000 of that figure would be your cost basis, and $1,500 would be net unrealized appreciation.
Net Unrealized Appreciation
Why should you care about net unrealized appreciation? When you want to distribute company stock or its cash value out of your 401(k), you will face a choice: Roll it into an IRA, or distribute the company stock into a taxable account and roll the remaining assets into an IRA. The latter option might be more effective, depending on your circumstances, thanks to IRS rules governing net unrealized appreciation of company stock.
When you transfer most types of assets from a 401(k) plan to a taxable account, you pay income tax on their market value. But with company stock, you pay income tax only on the stock’s cost basis—not on the amount it gained since you bought it. (If you are under age 59½, you may also pay a 10% early withdrawal penalty.)
When you sell your shares, you’ll pay long-term capital gains tax on the stocks’ NUA. The maximum federal capital gains tax rate is currently 20%, far lower than the 39.6% top income tax rate, so your potential tax savings may be substantial. Depending on your MAGI (modified adjusted gross income), tax filing status, and net investment income, you may also owe a 3.8% medicare surtax on net investment income. In this case the maximum federal long-term capital gain tax rate becomes 23.8%.
Of course, taxes do not dictate every investment decision we make. On the contrary, we work with clients closely to develop an investment asset allocation strategy as one piece of a long term financial plan that takes into account risk parameters, investment objectives, as well as estate planning and retirement goals. Apex Financial Advisors is experienced in the needs of business owners and corporate executives. Contact us today with any questions you may have.