When it comes to talking about taxes, sometimes all you need is the right story

As we begin 2022, there is a lot of noise in the marketplace: midterm elections, omicron and everything in between.

One topic that seems to have been put on the back burner but shouldn’t be is the topic of taxes. According to the U.S. Debt Clock, the United States has about $29 trillion in debt as of the end of 2021. I know a trillion here or a trillion there may not seem like a lot, but just remember if you wanted to count to a trillion and you started today it would take you 32,000 years. Yes, 32,000 years. The big question will be, how do we pay all that back? Our government could stop spending, but let’s be honest. I want to be a professional golfer. Neither are going to happen.

One of my associates, Frank Pape, referenced this quote by Russell Long: “Don’t tax you, don’t tax me, tax the man behind the tree.” The reason I love this quote is because it encapsulates how everyone feels about taxes. They should be paid, but not by us. Unfortunately the man behind the tree is the end client.

When we go back to the Value of an Advisor study, we remember that one of the biggest sources of value an advisor provides their clients is through helping mitigate the impact of taxes on their portfolios. Not long ago I wrote about the top five questions advisors should be asking every client. On that list is, How much do you consider taxes when it comes to your investments? The problem is that sometimes advisors have a hard time explaining how taxes affect portfolios, and clients have a hard time seeing the effect of taxes on their portfolios. As we prepare to go into tax season, I thought it would be useful for advisors to be equipped with numerous stories or examples about how to talk about taxes to clients.

Let’s begin with some examples of everyday things that are analogous to what taxes represent in a client portfolio.

The bag of chips

My personal favorite illustration of after-tax returns is a bag of chips. You might be asking, what do chips have to do with taxes? Have you ever bought a big bag of chips and been disappointed by how many chips were actually in the bag? Think of the air in the bag as a tax on your bag of chips.

TV commercials

Another example is how long a television show is. If I were to ask you how long an episode of Grey’s Anatomy is you would say one hour, but you would be wrong. It is about 40 minutes plus commercials. Commercials are the taxes of a television show.

Discount airlines

Let’s say you want to go away for spring break, and you book a flight on a discount airline because the price looks good. After you buy the ticket, you notice you must pay extra for a seat, luggage and possibly the bathroom. All of the extras can be considered the equivalent to taxes.

Tax Freedom Day

Then there is Tax Freedom Day. If you have never heard of that day, read on. According to thereisadayforthat.com:

Tax Freedom Day was conceived in the 1940s to help people understand how much of their money all levels of American government take in taxes by asking a simple question. If the average worker sent his entire paycheck to the government starting on Jan. 1, how many days would he have to work before he got to keep any of his own money? The day his wages become his own is Tax Freedom Day, which is calculated every year by the Tax Foundation. Tax Freedom Day typically falls in April.

This year it will fall on April 18. So after April 18 we are done working for the government. That means almost four months of our income is paid in taxes.

Termites

You can also just describe taxes like termites. A colony of termites is estimated to be able to eat a pound of wood a day. As a homeowner you never see the termites, you just see the effects. Taxes erode your returns like termites erode your house.

If you have clients who are a little more technically inclined, you can always just break it down to cost. One of my associates, Sean Ryan, came up with a great term called the government expense ratio. What is that? That is the actual percentage your mutual fund is losing to taxes. It is also called slippage. Everyone wants to talk about the expense ratio of a fund, but they are forgetting there are two costs to a taxable fund: the expense ratio and the government expense ratio.

Another good illustration of what taxes can do to your return is to just look at gross pay compared to net pay, or the difference between your paystub and take-home pay, as my associate Rob Kuharic would say. You don’t spend your gross pay, you spend your take home pay.

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Source: Carl Richards. https://behaviorgap.com/

Once you get a client to finally understand the effects of taxes, they might ask what an advisor can do about it and that is where the Handyman story from my associate Martin Roche comes in.

Advisor: Tim, I know you are a homeowner. Do you like being a homeowner?

Tim: Yes, but I hate being one when the heater or furnace goes out, because they are expensive and they always break when I am not expecting them to.

Advisor: I agree, that is why I have a handyman come in once a month to do ongoing maintenance on my house to make sure I don’t get that surprise big bill one day. What if I were to hire someone to try to do the same thing in your taxable account? They would conduct tax-loss harvesting throughout the year to hopefully avoid a big bill at the end of the year.

Tim: I would love that.

The chart below shows the effect of keeping that money in the account versus paying it out to the government. You don’t need to save a lot to make a big difference.

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This is a hypothetical illustration and not meant to represent an actual investment strategy. *Represents 2020 tax due of investor with a $500,000 portfolio, 7% capital gains distribution, and assumed tax rate of 30% (66% of tax = long-term capital gains at 23.8%, 34% of tax =short-term capital gains at 40.8%)

If you are wondering when would be a good time to talk to clients about taxes, it is now. There are a couple of reasons for that. Clients will be receiving their Form 1099’s soon. We have an investor-friendly document outlining ways for you to diagnose what clients can be doing to help reduce the impact of investment taxes. As you can see below, the average capital gain from mutual funds was pretty big this year.

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Source: Morningstar. U.S. Stocks: Russell 3000® Index. U.S. equity funds: Morningstar broad category ‘US Equity’ which includes mutual funds and ETFs (and multiple share classes). For years 2001 through 2020 % = calendar year cap gain distribution ÷ year-end NAV (net asset value), 2021 % = total cap gain distribution ÷ respective pre-distribution NAV. For years 2001 through 2013, used oldest share class. 2014 forward includes all share classes. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Since the year is just getting started, it’s a great time to set up a call with your client’s CPA to go over some ideas for 2022. We can also help you come up with ideas. If you are worried about where to start, please request our After-Tax Wealth Handbook.

So be that handyman or just be a really good advisor and help your clients understand the effect taxes can have on their accounts, and then show them strategies to lessen the blow.

As Mark Twain said: ”The difference between the taxman and the taxidermist is the taxidermist leaves the skin.”