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Should Your Investment Advisor Understand Tax Laws?

Published in Articles on February 29, 2016

The follow-up question, to be more specific is: Should your investment advisor understand your taxes? Understanding taxes in general is invaluable when deciding which investments to own and how to own them. A general understanding of taxes will help answer questions such as what type of investments you should hold in tax-deferred accounts—IRA/401(k)—and what you should hold in taxable accounts. A number of investment decisions will help increase your after-tax return (net return) when made with a general understanding of income and estate tax law.

But how does the tax law impact your own particular investment decisions? Unfortunately, many investors have actually decreased their net return because they followed some general advice that was not appropriate for their particular circumstances. What you “don’t know you don’t know” can possibly cause the most damage to your net return.

For example, a general rule could be “I should own tax-free bonds so I do not have to pay taxes on the earnings.” When you buy tax-free bonds, you will generally receive a lower return on those bonds because the tax advantage is priced into the bond. Investors are willing to purchase a bond with a lower return because they anticipate a tax savings that will more than offset the reduced bond return. But if you or your advisors “don’t know” your personal circumstances, you may not receive enough, or any, benefit from this tax-free investment. You now own an investment with a lower return but no offsetting tax advantage.

Another general rule regarding income taxes and investing is that you should defer your income and accelerate your deductions. This general rule has the potential to impact many of your investment decisions. Should I have a Roth IRA or a traditional IRA? Should I put more into my company pension plan? Should I sell my investments that have lost money? Should I pay down my mortgage? Should I do a Roth conversion? Should I wait until I am 70½ to start withdrawing from my IRA?

Each of the above questions has a general rule-of-thumb answer. But there is a high likelihood that the best course of action for you will be different than the general rule of thumb. For example, I had an informal conversation with a man who was thrilled to tell me that for the past three years he had paid no taxes. I knew him well enough to know that he was getting close to the time when he would be required to start taking distributions from his IRA. I offered to review his investments and taxes and discovered that he could have withdrawn several thousand dollars from his IRA during those earlier years and still pay no tax. The good news was that he still had a few years before his required distributions kicked in. He is now drawing several thousand dollars out of his IRA at a very low tax rate, compared with what his tax rate will be when he starts his mandatory IRA distributions. He “did not know that he did not know” that by taking distributions out of his IRA now, he would lower his future income taxes.

Every general rule about investing and tax savings needs to be considered with your personal income tax situation in mind. If your personal circumstances are not considered, you will almost certainly reduce your net return. By getting your investing strategies and your income tax strategies coordinated, you will have a greater likelihood of increasing your net return.

The net return you receive from your investments is dependent on many variables, many of which are specific to your circumstances. The benefits that can be gained by coordinating your personal income tax situation with your investing decisions are one component you do have some control over. For this to benefit you, your investment decisions need to be coordinated between your tax and investment advisors.

John D. Parry, CPA, is a financial advisor with Onyx Financial Advisors, LLC, an independent, fee-only, registered investment advisory firm in Idaho Falls, Idaho. He can be reached at (208) 522-6400 or at