Sometimes following financial advice, while technically correct, could turn out to be a costly mistake. It is important to note that a correct choice and the best choice are not always the same thing. The following are the three most egregious examples I saw this tax season where people took factually correct information that in reality was financial terrible advice.
Earning Less to Pay Less?
An excerpt from a client’s email to me:
Clients typically do not request lower returns, so I gave my client a call. She explained that she owed money on her previous year’s taxes. When she asked her tax preparer how she could pay less taxes this year, this is what she was advised: “Have your financial guy earn less on your investments or move it to the bank.”
While her tax preparer’s advice isn’t technically wrong, it is terrible advice. It is true that she would likely pay less in taxes if her investments grew at a lower percentage. The long-term capital gains rate for many investors is 15% but you get to keep the other 85 cents of every dollar of growth in your portfolio. And with a tax-efficient portfolio or strategies like tax harvesting, you can defer taxes or lower them further.
This client’s portfolio increased about $150,000 in 2017. The result was $50,000 in realized gain and a capital gain tax bill of about $7,500 for the year. That may seem like a lot of taxes until you realize that it she still has approximately $142,500 more than she had at the beginning of the year. I don’t know too many people who would complain about an extra $142,500 after taxes.
If that same client invested her money at a bank, at an interest rate of 1.5%, she would have earned $11,250. (1.5% of her beginning account balance of $750,000). Because bank interest is taxed as regular income, she would have owed $2,812.50 of taxes on this interest.
Assuming a 25% federal tax bracket, her tax bill was reduced by 62% for this money. That may seem great until you realize she netted 94% less money. She would have earned a net amount of $8,437.50 at the bank, which is $134,062.50 less than what she earned in her actual tax-efficient investment account. Sometimes paying more taxes can be a good thing.
Saving more for Retirement is not Always a good thing
An engineer, let’s call him Bob, contacted me for help because he put too much money into his Roth IRA.
Bob did his research and decided a Roth IRA was the best retirement account for his situation. Also, he realized he was behind on his accumulation of wealth for retirement. The Roth IRA is a very popular retirement account, and the average American is not on track to replace their income in retirement.
In order to try and catch up, Bob put in a whopping $200,000 into his Roth IRA at the end of 2016. This caused him two big problems. First, you can only put $5,500 into a Roth IRA each year, and if you can save $200,000 in a single year, you likely are not eligible to contribute to a Roth IRA.
Unaware of his over contribution, Bob was loving his Roth IRA. He was trading heavily and riding the wave of the stock market from late 2016 until today. He had done quite well and this account had ballooned to more than $300,000. As far as Bob knew, things were great until he got a notice from the IRS inquiring about his excess contributions to his Roth IRA.
The IRS will eventually figure out if you put too much money into a retirement account and the penalties are large for over contributing. There is a six-percent fee for ineligible contributions that is paid using form 5329 when filing your taxes. If the mistake is not corrected, the fee will be applied to each tax year the money is in the account.