Don't Let the Tax Tail Wag the Dog

Making prudent and effective financial decisions can be difficult enough without letting tax considerations hijack your primary objectives. While tax efficiency matters, and all else being equal it's important to consider tax impact when assessing a decision, I never want to see people making suboptimal choices because they were hyper-focused on minimizing their tax bill above all else.

Some thought experiments:

• If you earn W-2 or 1099 pay, there's a high likelihood you pay taxes on your income. Would you give up your income and choose to make no money this year if I told you that you could reduce your tax bill close to $0 by doing so? Or do you, in the big picture, prefer having an income and accept that taxes are part of that picture?
• If I told you (purely hypothetically, of course) that I could similarly reduce your tax bill, but in order to take the deal you'd have to flip a coin, and if the coin landed "tails" then the majority of your wealth would disappear - would you take that deal?

For some reason, when the question isn't phrased in such obvious terms, many people lose this frame of reference. It is, in fact, better to make money than to lose it, even though that might come with a higher tax bill. Also, there is a limit to how much risk is acceptable purely to avoid a tax consequence (again, a tax consequence that derives from successfully making money).

There are some situations in which we tend to see tax impact and tax minimization jump straight to the front of the line in clients' minds, when really it should just be one of many considerations.

These situations come in a few common shapes:

• Waiting to sell something until the characterization changes from short-term to long-term, to save percentage points on the tax rate.
• Avoiding changing a risk-inappropriate portfolio, because selling out of gains to purchase a more appropriate portfolio would involve taxes.
• Making tax-first decisions about where to locate assets, such as in trusts or qualified retirement accounts, when real goals may call for more liquidity, access, and flexibility.
• Avoiding making critical business decisions until a tax-minimizing strategy reveals itself.
• Avoiding income producing strategies when income and/or diversification would be appropriate or necessary, out of fear of generating taxable income.

These scenarios illustrate a crucial principle: Tax considerations should inform your financial strategy, not drive it.

Here's how to maintain perspective:

1. Start with your goals
   What are you truly trying to achieve? Building retirement security? Creating a legacy? Having liquidity for opportunities? Let these primary objectives guide your major decisions.

2. Consider the full picture
   Tax implications are just one factor among many - including risk management, return potential, liquidity needs, and time horizon. Weigh all these elements together rather than optimizing for taxes in isolation.

3. Focus on after-tax returns
   What matters is how much money you keep after all costs and taxes. Sometimes paying taxes is the price of admission to superior after-tax results through better investments or risk management.

4. Watch for false economies
   Tax deferral isn't always optimal. For instance, maxing out retirement accounts could leave you cash-poor during your peak earning years when you need capital for other opportunities.

5. Be strategic, not reactive
   Plan proactively for tax efficiency through asset location, tax-loss harvesting, and charitable giving strategies, and only when each of those is a proper fit. But don't let last-minute tax moves derail sound long-term strategy.

You can still pay attention to taxes:

The tax code creates both opportunities and pitfalls. The key is to harness tax advantages in service of your broader financial goals - not to let tax mitigation become your primary goal. Keep taxes in their proper place as one important consideration among many.

It's important to understand tax consequences and available mitigation strategies. It's ideal to know the trade-offs and make them knowingly. There can be ways to manage risk on a concentrated position, for example, without simply taking all of the capital gains and calling it day, and there can be ways to transition one portfolio strategy to another without blanket selling and purchasing. Trusts can be, and often are, used successfully for tax management purposes. Some vehicles are far more tax efficient than others.

But sometimes it's not the best decision for you to do the thing that results in the least taxes. Tax minimization often involves complexity, tax-efficient vehicles and account types typically come with their own significant restrictions, and avoiding income-generation or capital gains can often come with a risk tradeoff.

After all, paying some taxes is, to a degree, the sign of a successful financial life. It means you're earning, growing, and realizing gains. While nobody enjoys writing checks to the IRS, making poor financial decisions just to minimize taxes is the definition of penny-wise and pound-foolish.

Let your life goals and sound financial principles be the proverbial "dog" who takes ownership of wagging its tail. Tax planning can come along for the walk, but it shouldn't be holding the leash.

2025-7683174.1 Exp 02/27