How to help your clients understand tax equivalent returns

By Jeff Reed

Kestler Financial Group


Maybe Phil Mickelson had it right. The more I consider his comments on taxes that I wrote about earlier this year, the more I think he has a point. In fact, in California, the tax situation may be the worst in the country (Hawaii currently holds that claim with a higher top rate and lower annual income than any other state).

The real dollars

What I think gets lost in translation, however, is just how much money we’re talking about when it comes to taxes. Most of us understand the percentages, but what about the real dollars? What if we think about it this way: How much more money does a California resident have to earn to have an income equivalent to a state without income tax (Florida, Texas or Nevada)?

That is a much more important question, with a more painful answer. Consider a California resident earns $250,000, with an effective tax rate of 9.21 percent:



How much more would this taxpayer need to make to have an income equivalent to their neighbor in Nevada, who keeps all of the $250,000 in this example?

The answer is $275,000 — an increase of over 10 percent. That’s the tough thing about percentages: The percentage increase you need to see to make up a shortfall is always greater than the percentage decrease.

It’s the same with market losses, and the vast majority of our clients simply do not understand the math. They just understand the pain of the loss or writing the check for the tax bill.

Tax diversification in retirement

In the discussion of Phil’s situation, I focused most of the attention on current taxation, with only a small reference to the need for tax diversification in retirement. In retirement, this idea of having to take an additional 10 percent in income to achieve the same purchasing power is enormously important. Frankly, it can be the difference between outliving your assets and being comfortable in retirement.
Of course, not everyone dreams of relocating to a more tax-friendly state in retirement, and that means finding another way to address the problem.

Tax-free income

One alternative is to create sources of tax-free income and avoid not only the state level taxes, but the federal, as well. In this analysis, we’ll once again focus our attention on the real dollars. This time, however, the focus is on how much less income is required when that income is not subject to income tax.

So, if I have a retirement income goal of $250,000 per year, and none of it is subject to tax, I need to take $250,000 for the year. Using the same state tax rates as the example above (9.21 percent), plus the corresponding federal rate of 23.76 percent (yielding a combined rate of 32.97 percent in this example), the taxable equivalent of a tax-free $250,000 income is $375,000! An increase of 50 percent!

While this is admittedly a simplified calculation versus the actual taxes due, the real increase will be a big number and certainly more meaningful than a percentage.

To most clients, percentages are vague, theoretical measures. But dollars are tangible.

They interact with them every day, and probably even have some in their wallet. They represent our clients’ reality, and our clients’ reality is hugely suggestive of using life insurance to create a tax-free source of income in retirement.

Tying it all together

This brings me to the real point of today’s discussion: Breaking down the technical topics we discuss every day into terms, analogies and stories for our clients will always result in greater levels of understanding. Greater understanding means more engaged clients. These engaged clients have higher levels of trust, and will give you more of their business and refer more of their friends and colleagues. That leads to a happy producer with a profitable practice.