When a client brings in new assets to invest, you probably start by weighing the virtues of bonds versus stocks, mutual funds versus ETFs and global markets versus the good old U.S. of A.

But before you throw down an eight-pound leather-bound portfolio allocation recommendation in front of your client, you may first want to consider which investment vehicles he should use, and if you are even going to keep the money at all.

Yes, you read that right. Redirecting the check elsewhere might be the best thing for the client, even if it means you don't get paid. The key factors that will affect this decision are:

  • What return the alternatives are likely to provide.

  • The predictability of that return.

  • Any tax benefits offered by the alternatives.

Here are the questions you and your client should consider before you put any of his “new money” to work:

  1. Is the client missing the “match?”

    If your client's employer sponsors an at-work retirement plan, like a 401(k), and offers to match employee contributions up to a certain percentage, it's usually best for your client to contribute enough money to the retirement plan to at least get that matching amount.

    The return on extra dollars sent to the plan, and matched by the employer, can range from 25 cents on every dollar to even a one-for-one match (up to a certain percentage of salary).

    Keep in mind that although the matching contributions might hit the account by the end of the year, there is usually a vesting schedule for employer contributions that has to expire before all of the matching money belongs to your client. So the attractiveness of this option might be reduced if the client doesn't think he will be on the job long enough to get all of the matching contributions credited to his account.

  2. Is he maxing out his retirement deposits?

    Probably not, according to figures from the Center for Retirement Research. Their calculations showed that only about half of workers making more than $100,000 per year were putting as much as possible into at-work retirement plans.

    That shortfall is bound to hurt the retirement security of workers when they reach their Golden Years. But if your client isn't making the most of his contributions, it may also cost him today. That's because depending on the combined state and federal tax bracket in which he lands, a dollar put into a pre-tax plan could immediately save him anywhere from 10 to 40 cents or more on this year's tax bill.

    Plus, money going into the plan will defer taxation on any future gains made on the deposit until the money is ultimately pulled out in retirement.

    A salient question, though, is, “How likely is it that the tax rate paid on withdrawals from a retirement account will be lower than the rates at the time of deferral?”

    It's probable. A recent study from the Survey of Consumer Finances found that although 41 percent of taxpayers were in the top four tax brackets before retirement (at least 28 percent at the federal level for the year studied), only 18 percent were still in those brackets once they ditched the world of work.

  3. Is there any debt incurring non-deductible interest?

    Here is where all optimism you have about both “the markets” in general, and your specific investment expertise in particular, runs smack dab into the harsh reality of debt that is guaranteed to incur interest until it gets paid — and offers no tax advantages.

    Unless you can promise an after-tax rate of return that will both outpace the fixed rate charged on the outstanding balances, and occur at least as long as it takes to pay off the debt, you have to swallow your pride, and recommend the client zero out the accounts before making any other investments.

    Paying off balances from credit cards charging double-digit interest rates is a no-brainer. But even the high single-digit rates charged on auto, consumer and student loans might be difficult for you to outperform.

  4. Does the client qualify for a Roth IRA?

    There's no upfront benefit to making a deposit into a Roth IRA. But in the coming years, prospective earnings on the deposit will grow unfettered by taxation. After age 59 1/2, earnings that have been in the account for at least five years come out tax-free.

    The contributions, on the other hand, are a little more liquid. They can be taken back out at any time — for any reason — with no taxes or penalties whatsoever.

    Don't forget that although the 2007 deposit limits for a Roth IRA are the lesser of the client's earned income or $4,000 ($5,000 for those over 50), married clients can also open a spousal Roth IRA for a non-income earning wife or husband. (Hopefully you learned long ago not to refer to a stay-at-home spouse as “non-working.”)

  5. Are all college expenses covered?

    If there will be big, as-of-yet-unfunded tuition bills down the road, then your client (and his children or grandchildren) may be better served if you put the money into a 529 college savings plan.

    Like the Roth IRA, deposits to a 529 account are unlikely to provide any immediate tax reduction. That is, unless the client can take advantage of certain plans' state income tax deductions for resident depositors.

    But, also like the Roth IRA, taxation on earnings in a 529 account is avoided while the money remains in the account. And if the withdrawals from a 529 go toward qualified higher education expenses, taxes can be avoided completely.

  6. Does he have a mortgage on which he is deducting the interest?

    To calculate what after-tax return you would have to earn for the client to turn the money over to you, take the current mortgage interest rate, and multiply it by the rate at which his income would otherwise be taxed.

For instance, let's say a client has 30 years left on a 6 percent mortgage, itemizes and is in the 35 percent tax bracket. The benchmark you need to beat is a measly after-tax return rate of 3.9 percent (6 percent × [1 - 0.35]). Just buy a AAA-rated 4 percent tax-free bond maturing in 2037 and forget about it, right?

Not so fast. In the future, the client may lose the mortgage interest deduction, either because of legislative changes or variations in his personal tax situation. This will raise your standard back up to 6 percent after tax.

That number still may be obtainable. But in years in which your confidence in exceeding that rate of return is low, you may want to recommend that the client peel some assets out of the portfolio to pay down the mortgage instead.

You can test various hypothetical “mortgage versus investment” scenarios with a free (albeit rudimentary) calculator available at http://hughchou.org/calc/payoff_v_borrow.cgi.

Achieving A Greater Reward

At first, you may cringe a little inside as you direct clients' money away from your oversight, and back toward a company retirement plan or paying off high-interest debt.

And the fees you're likely to earn from opening a Roth IRA or 529 account likely won't even cover the cost of the coffee the client drinks while he's filling out the paperwork.

But by asking these questions first, you may find more ways to save them money on taxes and interest. Best of all, it's a good way to ensure that deliveries of “new money” keep coming in.

RUNGS ON THE TAX LADDER

Since you're probably not a CPA, you (thankfully) aren't charged with providing tax advice to your clients. But you should at least be aware of the potential tax savings these steps might provide. Here are the income ceilings and corresponding tax rates for 2007, courtesy of the IRS.

Filing Status Tax Bracket Single Married (Jointly) Married (Separately) Head of Household
10% $7,825 $15,650 $7,825 $11,200
15 31,850 63,700 31,850 42,650
25 77,100 128,500 64,250 110,100
28 160,850 195,850 97,925 178,350
33 349,700 349,750 174,850 349,700
35 no limit no limit no limit no limit
Source: IRS

CHEAT SHEET

A quick reference list to help you decide where to put your clients' new cash assets.

  1. Is the client eligible for an employer matching contribution?

    Put aside at least enough to get the match.

  2. Is he maxing out his contribution to his at-work retirement plan?

    For 2007 the limit is the lesser of his earnings, or $15,500 ($20,500 for workers over 50).

  3. Does he have high-interest debt outstanding?

    Pay that off before investing.

  4. Is he eligible to make a contribution to a Roth IRA?

    Eligibility begins to phase out at $156,000 of modified,. adjusted gross income for those married filing jointly, and $99,000 for single filers.

  5. Is college likely?

    Contribution limits for 529 plans under normal circumstances are $12,000 per depositor, per beneficiary, per year.

  6. Does he have a mortgage outstanding?

    If it's a low fixed rate on which the interest is tax-deductible, it may be better to pay it off as slowly as possible.

Writer's BIO: Kevin McKinley CFP is a Vice President-Private Wealth Management at Robert W. Baird & Co., and the author of the book Make Your Kid a Millionaire (Simon & Schuster). You can reach him at kmckinley@rwbaird.com