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Welcome to personal finance for
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long-term investors, where we believe
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Benjamin Franklin's advice that an
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investment in knowledge pays the best
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interest both in finances and in your
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life. Every episode teaches you personal
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finance and long-term investing in
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simple terms. Now, here's your host,
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Jesse Kramer. Hello and welcome to
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episode 111 of Personal Finance for
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Long-Term Investors. My name is Jesse
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Kramer. By day, I work for a fiduciary
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wealth management firm helping clients
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all over the country. For more details,
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go to bestinterest.blog/work.
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A link is in the show notes. And by
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night, I write a blog called The Best
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Interest and I podcast here on personal
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finance for long-term investors. I help
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busy professionals and retirees avoid
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costly mistakes and grow their wealth.
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And I do so by simplifying complex ideas
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about personal finance from investing to
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taxes to retirement and beyond. And this
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is an interesting slightly out of order
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bonus episode meant to serve as a
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companion episode, if you will, and now
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a companion to what? The same day that
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this episode is published, episode 555
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of Choose FI is being published,
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featuring just a really interesting
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conversation between Brad Barrett, the
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host of Choose FI, and myself. I really
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recommend that if you haven't listened
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to that, if you're hearing my episode
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here first, that you go over and listen
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to episode 555 of Choose FI. Brad and I,
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we talk about the pitfalls that occur
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when people, whether it's people in the
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FI movement, just DIY financial planners
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in general, yeah, do-it-yourselfers,
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when they attempt to overoptimize their
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financial plans. And to put it simply,
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to put it bluntly, we only get so many
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optimization points, if you will, that
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we get to use in our financial plan or
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just in our lives in general. And in
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your plan, if you want to say optimize
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for simplicity, well, then you probably
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can't also tax loss harvest and create a
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Roth conversion ladder. Those aren't
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quite simple enough. If you want to
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optimize for being able to sleep well at
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night, well then you probably won't be
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able to own 100% stocks. Not that you'd
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necessarily want to always in the first
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place. And the idea is if you're going
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to optimize for sleep, you're probably
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going to have to sacrifice some
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long-term returns. And then there are
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two of my favorite financial planning
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metaphors, the the puzzle pieces and the
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spiderweb metaphors. If you try to solve
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a puzzle without all the pieces, you're
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going to fail. And if you try to
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optimize your financial plan without
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understanding all of your unique pieces,
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you'll also fail. And like a spiderweb,
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sometimes the intricate kind of
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interconnectedness of a financial plan
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can surprise us. We tug on one thing
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over here, hoping to optimize it, but we
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end up pulling apart or weakening the
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web over there unexpectedly. So that's
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the idea of the choose FI episode. And
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we do dive into some specific examples
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of planning gone wrong, I suppose. But
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just in general, we we spend a good
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amount of time maybe more on the
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philosophical side of why it's important
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to yes, we want to optimize, we want to
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improve, we want our financial plans to
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be hardy and foolproof, we want them to
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be sustainable, we want them to provide
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us with good returns, but
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overoptimizing, this is something I've
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talked about here a few times before,
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just that overoptimizing can lead to
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problems. So, make sure you go over to
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Choosi, check out episode 555. And if
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you happen to be listening right now
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coming from ChooseFi, well, welcome. I
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think you'll find that this podcast,
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personal finance for long-term
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investors, it's a I think you'll find it
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to be an excellent way to add detailed
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and nuanced financial planning ideas
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into your personal quiver. So, give this
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episode a listen. Listen to a few more
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episodes if you'd like. The AMA
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episodes, I'll say, are probably my most
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popular episodes. So, you can go back
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and listen to my Ask Me Anything AMA
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episodes. And if you like it, hit that
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subscribe button. So before the meat of
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this bonus episode, we always do a quick
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review of the week. And this one comes
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from Skip from Omaha. Omaha, the home of
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Warren Buffett. Go back to episode 110.
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We talked all about Warren Buffett. Skip
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says, "I love the detail. I started
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listening a few months ago after hearing
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Jesse on stacking Benjamins. Jesse's
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style is wonderful and amazingly
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detailed and informative discussion on a
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level that's just right. with his
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thoughts on topics that appear again and
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again in personal finance. Jesse often
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touches on angles and nuance that I had
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not previously considered. I'm quickly
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becoming a regular listener. Well, Skip,
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thank you so much for the kind words.
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Shoot me an email and I'll send you a
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super soft podcast t-shirt as a thank
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you for that wonderful rating and
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review. So, with that, let's begin the
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companion content to ChooseFi episode
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555. One thing that Brad and I talk
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about in that episode, we have a little
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sidebar, maybe five or so minutes. We
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talk about this thing called the middle
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class trap. Now, some of you listening,
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especially if you're a maybe a diehard
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on the Choose FI Facebook page or if
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you've just been listening to a lot of
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financial podcasts recently, you'll know
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exactly what the middle class trap is.
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But for those of you who have never
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heard of that word before or that term,
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the middle class trap, it refers to the
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situation where someone is on the
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borderline of financial independence. If
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you look at their net worth, but that a
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lot of their net worth is quote unquote
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trapped inside of real estate, home
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equity, or it's trapped inside qualified
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retirement accounts, you know, 401ks,
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IRA, things that they can't touch until
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they're 59. So, if you just look at that
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one number alone, just one number on
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paper, net worth, you might look at a
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person and say, "Oh, they're probably
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financially independent. I mean, look at
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how much money they have." But in
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reality, this person feels a little bit
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trapped by the nature of their worth in
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that they can't really tap into their
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home equity in order to retire and live
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off that as a income stream. And they're
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worried they can't really tap into their
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retirement accounts before age 59 unless
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they suffer some sort of penalty or tax
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or whatever it may be. So, anyway,
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that's the middle class trap. And
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there's an interesting episode of the
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Bigger Pockets Money podcast. It was
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episode 651 651 published on June 20th
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where Mindy and Scott, the hosts of
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Bigger Pockets, they had Brad Barrett of
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Choose FI go on to their podcast and
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they had a pretty lively debate about
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the middle class trap. Then Brad and I
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discussed it together on Choose FI and
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then that brings me here to today. So I
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guess one part of the conversation is
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how exactly do we define financial
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independence? Do we look at someone's
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net worth? Do we only look at someone's
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investable assets? What about a primary
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home? And my two cents is, well, it's
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not quite either. At least that's not
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the way I think about financial
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independence. Instead, the way I think
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about it is we need cash inflows in your
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life to offset cash outflows forever,
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right, throughout retirement in a
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healthy way. And so, if an investment
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portfolio is the only source of those
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cash inflows, then yes, it's appropriate
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to use a safe withdrawal rate like the
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4% rule. And okay, that is up for
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debate, the 4% rule. Maybe it's 4.5 or
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4.7 or 5.0. That's fine. Maybe we're
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uber conservative and we think our safe
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withdrawal rate is only 3.3% or
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something like that. A little bit of a
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personal choice there. I certainly have
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my thoughts and we can dive into that on
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a different podcast episode. So, we take
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our safe withdrawal rate. We understand
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what our annual spending is. We take the
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inverse of our safe withdrawal rate. So,
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for the 4% rule, the inverse of that
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would be 25, right? 100% divided by 4%
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is 25. So we take our annual spending,
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we multiply it by 25, and that needs to
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be the size of your investment
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portfolio. That's your FI number, as you
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will. So it's not net worth, it's the
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size of an investment portfolio. But if
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you have rental income, which is a big
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part of the Bigger Pockets philosophy,
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right, is owning real estate rental
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income. If you have rental income, if
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you have other passive income,
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eventually you'll have social security,
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right? You're retiring early right now.
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Maybe you don't have social security
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right now, but eventually you will.
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Well, all of that stuff is going to
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reduce your cash inflow requirements.
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It's going to mean that you don't need
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to have as big a portfolio as you
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otherwise would because you have these
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other sources of cash inflow that don't
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need to be coming from your portfolio.
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And thus, that should fundamentally
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reduce the amount of investable assets
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that you need to retire. And one other
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important side note here, whether it's
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social security or rental income or the
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sale of a property or whatever it may
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be, both your inflows and your outflows
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in retirement, just like in the rest of
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life, they're going to be lumpy. They're
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going to eb and flow over time. They're
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going to change over time. The 4% rule
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assumes a constant withdrawal every year
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adjusting for inflation. And we know
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that's just not how the world works. I
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saw a metaphor recently. Someone said
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it's like flying a plane and and when
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you get the pilot to uh the cruising
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altitude, you you handcuff the pilot's
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hands to the wheel and you say you can't
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change from here. And it's like, well, I
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guess on cruising altitude, I don't even
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know if that's a great metaphor because
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cruising altitude uh implies that we're
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doing the same thing for, you know, the
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rest of the flight until we land. And
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even then, like retirement is just much
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more uh volatile than that. The way that
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someone's spending can change
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year-over-year. I mean, I've seen it
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firsthand at work. People's spending can
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change by quite a bit, by full
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percentage points or more on an annual
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basis, by five or six figures on an
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annual basis. So, if you're interested,
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I wrote a white paper that you can
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download for free. It's at the homepage
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of bestinterest.blog. And I get into
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some details there just about this. The
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white paper is all about building your
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retirement paycheck. And I think that's
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a really helpful frame of mind to
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approach safe withdrawal rates and
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certain percentage rules and what it
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really means to be FI. At the end of the
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day, we have to understand that whether
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we're retiring in total from a full-time
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job, whether we have side income,
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whether we have a pension or social
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security or whatever it may be, we have
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to think about the fact that we're
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replacing income somehow. And all these
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different pieces, maybe some of it is
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coming from an investment portfolio. All
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these different pieces are going to
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cobble themselves together to provide us
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with a retirement paycheck. And yes,
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that retirement paycheck can and should
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needs to change over time. But anyway,
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this white paper is all about, I think,
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a good framework of how to think about
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and build your own retirement paycheck.
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Anyway, back to the middle class trap.
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Another part of the middle class trap is
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this idea that, oh, I can't touch my IAS
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early. I can't touch my 401k before I'm
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59 and a half. Those kind of things. But
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if you've spent enough time around the
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DIYer circle, and may maybe you haven't,
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I'm here to tell you that there are some
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really good ways to access your
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retirement accounts, your qualified
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accounts before you turn age 59 and a
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half. And I'm going to go over three of
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them right now. The first one is called
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the rule of 72T. It's also called
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substantially equal periodic payments,
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SEP, SEP. It's a special IRS provision
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that allows early withdrawals. A good
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thing, right? early withdrawals from a
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retirement account like an IRA before
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age 59 and a half and without the usual
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10% penalty. Sounds great. Now, to
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qualify, you must take equal payments.
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Again, it was substantially equal
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periodic payments. So, you have to sign
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yourself up for equal payments. There's
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a few different ways, three different
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ways in fact, that the IRS approves to
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find your equal payments. I won't get
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into those details right now, but there
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are three different calculations, if you
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will, to determine your equal payments
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that you get to withdraw from your
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retirement accounts. And you need to do
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so for one of two options, whichever one
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is longer, for at least 5 years or until
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age 59 and a half. Okay? So, if you're
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45 years old right now and you're
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listening to this, you could set up
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substantially equal periodic payments.
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You're 45 years old, you need to
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continue those until you're 59 and a
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half. So, you're signing yourself up for
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14 and a half years ostensibly of equal
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periodic payments coming from your
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accounts. It's designed for people who
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need early access to retirement funds
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used quite often by people in the FIRE
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movement, early retirees. But the thing
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to be careful of is once you get
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started, it's rigid. If you modify or
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you stop payments early, the IRS will
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retroactively, yes, retroactively, apply
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the 10% early withdrawal penalty to all
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your prior withdrawals. Plus, they will
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charge you interest. Okay? So, you don't
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want to mess this up. You want to get it
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right. It is a useful tool, but it's got
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some sharp edges to it. A SE plan should
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be designed pretty carefully. Ideally,
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you you'd want to work with a CFP just
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to make sure that you get all the the
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nuts and bolts and details correct. And
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the last thing I'll say on the SE is
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just just for reference because some of
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you might be curious. Depending on the
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calculation method you use, there are
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three of them. One's called the RMD,
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required minimum distribution method.
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One's called fixed amortization and the
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other one is fixed annuitization. And
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you can look those up or we can talk
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about them on another episode. But
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depending on which one you use and a
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little bit depending on the the length
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of time that your SE will be going for,
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it has to go for at least 5 years. It
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might go longer if you're younger than
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age 54. you can expect that something
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like 3 to 6% of your account balance
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will be available to you on an annual
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basis. So again, just for reference,
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somewhere in that 3 to 6% range is is a
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good estimate. Next, I want to talk
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about the rule of 55. The rule of 55
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allows you to withdraw money
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penalty-free. Excellent. From your 401k
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or 403b. Notice I didn't say from your
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IAS. from your 401k or your 403b if you
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leave your job in or after the year you
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turn 55 or for certain public safety
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workers it's actually age 50 but we're
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going to go with age 55 for now just for
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simplicity sake. So it applies only this
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rule applies only to the retirement plan
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at the job you just left. This rule does
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not apply to old 401ks. This rule does
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not apply to old IAS or existing IAS
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unless unless you choose to roll those
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old plans or those old accounts into
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your current retirement account first.
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In other words, any money that this rule
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of 55 applies to has to exist inside
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your current employer 401k or 403b. then
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you are allowed to take penalty-free
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withdrawals from that 401k or 43b before
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your age 59 and a half as long as you're
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in or after the the year you turn 55. So
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it really all it does is right it moves
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up that 59 1/2 year old age to age 55.
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It's that simple. The withdrawals are
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still taxed as income as they would have
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been anyway if you waited till age 59.
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You just avoid the the 10% penalty. So
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again, this rule is designed to help
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people who retire early or are laid off.
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they need access to their retirement
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funds without getting penalized. You
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don't need to set up any sort of fixed
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payment schedule like you do with a 72T
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or uh substantially equal periodic
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payments. You just get to take what you
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need whenever you need it with rule of
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55. And again, the important catch is
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this only works with employer sponsored
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plans, not with IAS. So if you roll your
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401k into an IRA right after leaving
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your job, you lose the ability to
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execute the rule of 55. So use
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carefully. Again, as long as you have
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your ducks in a row, it's a flexible
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way, a great way to tap into retirement
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savings a few years early without Uncle
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Sam slapping your wrist. The last one I
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want to talk about really quick, the
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Roth conversion ladder. This might be
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out of the three, rule of 55 or 72t,
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this might be the one that people are
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most familiar with, but still it's not
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an everyday topic that people talk
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about. The Roth conversion ladder is a
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strategy to access our retirement funds
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again before age 59 and a half without
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penalties. Excellent. And it's done so
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by slowly converting a traditional IRA
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or a traditional 401k funds into a Roth
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IRA over time. So how it works, each
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year you convert a chunk of your pre-tax
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retirement money into a Roth IRA. So
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each year you're doing a Roth
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conversion. That conversion is taxed as
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income the year you do it. We know that.
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But then after 5 years, there's this
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5-year rule that we've talked about here
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on the podcast before. After 5 years,
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you can withdraw the converted amount
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penalty and taxfree, even if you're
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under age 59 and a half. So, by
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repeating this annually each year,
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you're just thinking 5 years ahead, you
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essentially create this quote unquote
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ladder. Each year's conversion becomes
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available 5 years later. And this method
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helps tons of early retirees bridge the
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gap, as it were, between their
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retirement age and then age 59 and a
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half when their traditional withdrawals
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would be penalty-free anyway. But two
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key rules apply here and we want to make
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sure we get them right. So each
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conversion starts its own unique 5-year
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clock. We need to be aware of that fact.
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And then the earnings on conversions,
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the earnings cannot be withdrawn taxfree
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until you're 59 and a half. And you need
00:15:51
to have had your Roth IRA for at least 5
00:15:53
years. So again, the converted amount,
00:15:55
the amount of capital, the amount of
00:15:57
principal that we convert in the Roth
00:15:59
conversion that is available penalty and
00:16:02
taxfree after 5 years. But any earnings
00:16:04
that we earn on those conversions in the
00:16:07
intermediate intervening 5 years, the
00:16:09
earnings cannot be withdrawn until we're
00:16:11
59 and a half. So, a lot of nuance there
00:16:14
and a lot of things we need to make sure
00:16:15
we get right. A Roth conversion ladder
00:16:17
allows early access as we said in a
00:16:19
taxefficient and in a penalty-free way,
00:16:21
but yes, it requires planning ahead. It
00:16:23
requires keeping good records to work
00:16:25
well. Going back to the idea of
00:16:27
simplicity, things like a Roth
00:16:29
conversion ladder, things like the rule
00:16:30
of 72T, not necessarily simple. You
00:16:33
know, if you want to use them in order
00:16:34
to optimize your retirement plan, by all
00:16:37
means, do so. I think it's a great thing
00:16:39
to do. But just realize that, yeah,
00:16:41
you're taking on some complexity into
00:16:42
your life. That's okay. Especially if it
00:16:44
means you get to save some money along
00:16:46
the way. Now, back to the the middle
00:16:48
class trap. Mindy and Scott from Bigger
00:16:50
Pockets and Brad from Choose FI. They
00:16:52
also discussed their reluctance and I I
00:16:54
should be specific here. Mainly Scott
00:16:57
discussed his reluctance to sell stocks
00:17:00
and really to sell any assets in
00:17:02
retirement in order to fund his
00:17:04
lifestyle. And Brad pushed back on that
00:17:06
pretty hard in episode 555 of Choose FI.
00:17:09
Brad and I kind of like both threw up
00:17:10
our hands and like what is going on? How
00:17:12
can you not how can you not plan to sell
00:17:14
stocks in order to fund your retirement?
00:17:17
And I want to kind of maybe talk about
00:17:19
both sides of this question here. My own
00:17:21
opinions first, but then also I'm happy
00:17:24
to play devil's advocate a little bit.
00:17:25
You know, when I think about my clients
00:17:27
in retirement, I mean, they're
00:17:28
absolutely selling their assets to fund
00:17:30
their retirement lifestyle. Like, of
00:17:31
course they are to some extent. Just why
00:17:33
wouldn't they be? Why would you save and
00:17:35
invest for decades to retire on time or
00:17:38
to retire early or to retire to this
00:17:40
wonderful retirement life, but then not
00:17:42
sell stocks to help that cause? You
00:17:44
know, we talk here, I share with you
00:17:46
guys there are two drivers to stock
00:17:48
returns. There's the dividends and then
00:17:50
there's capital appreciation. And to
00:17:52
intentionally not to intentionally never
00:17:55
sell your stocks, you're cutting off one
00:17:57
of those major payoffs. You're cutting
00:17:59
off the bigger one. In fact, I mean,
00:18:01
capital appreciation is traditionally
00:18:03
much bigger than than dividend payouts.
00:18:06
It just doesn't make sense to me at
00:18:07
least to to plan to hold on to your
00:18:09
stocks forever. And I should pause and
00:18:12
and maybe here's where the devil's
00:18:13
advocate portion comes in because yes,
00:18:14
it's hard to turn from a saver to a
00:18:17
spender. We know that like
00:18:18
psychologically speaking, if you've been
00:18:20
saving for 40 years and all of a sudden
00:18:22
you have to start spending what you've
00:18:24
been saving, that's hard to do. You hear
00:18:27
apocryphal stories, you hear anecdotes,
00:18:29
you you see studies, and it's common for
00:18:32
retirees to have a hard time to switch
00:18:34
from saver to spender. And I suppose
00:18:36
that means that if you're not spending
00:18:37
much, if you're feeling that reluctance
00:18:39
to spend, you might not feel the need to
00:18:42
sell any of your stocks to support your
00:18:43
lifestyle. Like, why? I'm not spending
00:18:45
any money. Why would I sell my stocks?
00:18:46
But to me though, that's a not a
00:18:49
connection to owning stocks per se.
00:18:51
Instead, it's just a reluctance to spend
00:18:53
money. I mean, maybe we're talking about
00:18:54
the same thing, but to me, and I
00:18:56
encourage for you to consider that money
00:18:58
is fungeible. That's a big takeaway.
00:19:00
Money is fungeible. A dollar is a dollar
00:19:03
is a dollar. So, if you're comfortable
00:19:04
spending $10,000 a month from your bank
00:19:06
account, you know, via the income that
00:19:08
you receive from your 9 toive job, you
00:19:10
should feel equally comfortable spending
00:19:12
money that comes in via social security.
00:19:14
You should feel equally comfortable
00:19:16
spending money that comes from the sale
00:19:17
of stocks. You should feel equally
00:19:19
comfortable spending money whether it
00:19:21
comes from a Roth account, a traditional
00:19:23
account, a taxable account, right? Money
00:19:24
is fungeable. And yes, of course, there
00:19:26
are tax considerations, you know, Roth
00:19:29
traditional taxable account. I I'm not
00:19:31
saying to ignore the tax considerations.
00:19:33
There are portfolio allocation questions
00:19:35
and I'm not saying to ignore those.
00:19:36
That's the kind of stuff we dive into
00:19:38
here all the time. It's important stuff.
00:19:40
But once we've talked about those
00:19:42
planning topics and once we've designed
00:19:44
some sort of optimization into our
00:19:46
financial plan, there's no reason why
00:19:49
$100 coming from stocks is more or less
00:19:52
valuable than $100 in cash, more or less
00:19:55
precious than $100 in cash. It's all
00:19:58
fungeable, right? You could take that
00:19:59
cash in your bank and literally buy
00:20:01
stocks with it today. You could convert
00:20:03
that money from one asset type to the
00:20:06
other type with a snap of your fingers.
00:20:08
It's the same thing. It's fungeible. And
00:20:10
this is the equivalent of saying that
00:20:12
ice is better than water or vice versa.
00:20:14
Right? It's the same thing. It's just at
00:20:16
a slightly different energy state. $100
00:20:18
in cash is the same as $100 in stocks,
00:20:21
just at a different energy state. Now,
00:20:24
if you have the psychological crutch
00:20:25
that's preventing you from parting ways
00:20:27
with a particular stock or fund because
00:20:29
you've held it for a long time, well, I
00:20:32
understand it, but it's just one of the
00:20:33
many mental money problems that exists.
00:20:36
And we all know of these mental sticking
00:20:38
points that can cause major damage to a
00:20:40
financial plan. It could be timing the
00:20:42
market. It could be habitual spending.
00:20:44
Yes, it could be an emotional affinity
00:20:46
for holding on to a certain specific
00:20:48
asset even when it doesn't make sense to
00:20:50
do so. It's just another reason to
00:20:52
consider seeking neutral third-party
00:20:54
outside opinions to to help you make
00:20:56
sure that you're truly making the right
00:20:58
decisions optimizing your long-term
00:21:00
financial plan. Here's a quick ad and
00:21:02
then we'll get back to the show. Did you
00:21:04
know my written blog, The Best Interest,
00:21:07
was nominated for 2022 personal finance
00:21:10
blog of the year and it's been
00:21:11
highlighted in the Wall Street Journal,
00:21:13
Yahoo Finance, and on CNBC. I love
00:21:16
writing, especially when that writing is
00:21:17
to share financial education. And I
00:21:20
usually write one or two articles per
00:21:22
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00:21:24
bestinterest.blog.
00:21:26
Again, the web address is
00:21:28
bestinterest.blog.
00:21:30
Check it out. Okay. Now, I want to pivot
00:21:32
into the second big topic that Brad and
00:21:34
I discuss on ChooseFi episode 555. I
00:21:37
want to dive into some of the specific
00:21:38
areas of overoptimization that I see in
00:21:41
do-it-yourself and financial
00:21:43
independence circles. So, if you've
00:21:45
already listened to episode 555, some of
00:21:47
what I'm about to say will be a little
00:21:48
bit of a repeat, but you know, we didn't
00:21:50
necessarily get into all the detail that
00:21:52
that I have prepped. So, I'm just going
00:21:54
to share with you some of my prep. If
00:21:56
you have any questions, you can reach
00:21:57
out to me at jessebinest.blog.
00:21:59
So, first, tax loss harvesting. Brad and
00:22:02
I did get into this one a little bit.
00:22:03
Tax loss harvesting is the, you know,
00:22:05
strategic practice where investors sell
00:22:07
assets at a capital loss to offset other
00:22:10
capital's gains. It minimizes their
00:22:12
overall tax burden at the end of the
00:22:13
year and is commonly employed to try to
00:22:16
optimize investment portfolios and
00:22:18
enhance after tax returns. But tax loss
00:22:21
harvesting has its limitations and I
00:22:23
think done well and done usually
00:22:26
sparingly. It can certainly be additive,
00:22:28
but if it's done too much, if it's quote
00:22:30
unquote overoptimized, that might be the
00:22:32
wrong word, just overdone. Usually the
00:22:35
last few uh squeezes, nothing comes out.
00:22:38
There's no juice. In the Choose FI
00:22:40
episode, we talked about the wash sale
00:22:41
rule, but I'll share it with you here
00:22:42
again. You know, there's a big
00:22:44
limitation in tax loss harvesting that
00:22:46
it's just a trip wire, maybe more so
00:22:47
than a limitation. When you sell an
00:22:49
asset at a loss, there's a 30-day look
00:22:52
back and a 30-day look forward that
00:22:55
bookends the sale of that asset. If
00:22:57
during that 61-day period, right, 30
00:23:00
days backward, 30 days forward, plus the
00:23:01
the day of the sale itself, if during
00:23:04
those 61 days, you bought a
00:23:06
substantially identical asset in any
00:23:08
account and in any of your spouse's
00:23:10
accounts, assuming you filed jointly
00:23:12
with your spouse, then your capital loss
00:23:15
doesn't count. It's considered a wash
00:23:17
sale. And the wash sale rule prevents,
00:23:19
you know, manipulating a stock portfolio
00:23:21
to accelerate the recognition of tax
00:23:23
losses or defer the recognition of tax
00:23:25
gains. So there's a reason why the wash
00:23:27
rule is in there. But again, it's a trip
00:23:30
wire and and something we Brad and I
00:23:32
talked about is, you know, even if 25
00:23:34
days ago in a totally different account,
00:23:36
a retirement account, let's say you had
00:23:38
a substantially uh equivalent asset,
00:23:41
maybe it was a very similar index fund.
00:23:43
They're both total market index funds or
00:23:45
both S&P 500 index funds or something
00:23:47
like that. And if 25 days ago in a
00:23:49
totally different account that fund had
00:23:52
a dividend automatically reinvested to
00:23:54
buy a minuscule share of whatever it
00:23:56
was, well, that's within the 30-day look
00:24:00
back period. That is a substantially
00:24:02
equivalent asset. And therefore, you
00:24:05
probably aren't even aware of it, but
00:24:06
that fact that that trade happened 25
00:24:08
days ago nullifies the tax loss that
00:24:11
you're trying to realize today. So, just
00:24:12
something to be careful there. Now,
00:24:14
there are some times when tax loss
00:24:15
harvesting is definitely worth it. It's
00:24:17
worth it to offset a liquidation event.
00:24:20
It's worth it to offset income. Usually,
00:24:23
it's definitely worth it to offset
00:24:24
diversifying from an overconentration in
00:24:26
your portfolio. You know, if you're a
00:24:28
equity employee and you've got a million
00:24:30
dollars tied up in Amazon RSUs and
00:24:33
options because that's where you work,
00:24:36
well, you want to diversify from that
00:24:38
overconentration anyway. So, you might
00:24:40
as well use some losses in your
00:24:42
portfolio to offset any gains from
00:24:44
diversifying out of Amazon. If you
00:24:46
inherited a cabin in the woods from your
00:24:48
grandpa when he died and you just want
00:24:50
to sell it anyway, but maybe it's worth
00:24:52
something. It's worth more than the
00:24:54
basis you inherited it at and you'd owe
00:24:55
capital gains on that. Well, guess what?
00:24:57
You're going to sell the house anyway as
00:24:59
part of your overall financial plan. You
00:25:02
might as well offset those gains using
00:25:04
some losses. So, this is where tax loss
00:25:05
harvesting can be helpful. Offsetting
00:25:07
income is a great one because income tax
00:25:09
brackets, at least as of now, income tax
00:25:11
brackets are much higher than capital
00:25:13
gains brackets. So, if you can use a
00:25:16
capital loss to offset income, that's a
00:25:18
wonderful thing. The one reminder on
00:25:20
that front, though, is there's a really
00:25:21
specific order of operations when it
00:25:23
comes to how losses can offset gains.
00:25:26
Short-term losses first, they have to
00:25:28
offset short-term gains, and long-term
00:25:30
losses have to offset long-term gains.
00:25:32
So, you think of it as a short bucket
00:25:34
and a long bucket. Then if you still
00:25:37
have net losses in either bucket, they
00:25:39
can offset the net gains from the other
00:25:41
bucket. So in other words, no matter
00:25:42
what, capital losses will always offset
00:25:45
capital gains first, short to short,
00:25:47
long to long, and then if there needs to
00:25:49
be a crossover, there's a crossover.
00:25:51
Then if you still have remaining capital
00:25:53
losses, then you can offset up to $3,000
00:25:56
in income, which is a great thing, but
00:25:58
only $3,000 per year. But then if you
00:26:01
still have capital losses remaining,
00:26:03
they carry forward to the next year. The
00:26:05
problem as I see it though is that most
00:26:07
of the time people use tax loss
00:26:09
harvesting in what I would consider a
00:26:11
neutral to bad way. And what they do is
00:26:13
they simply want to zero out the gains
00:26:15
inside of their portfolio. The most
00:26:17
common reason I see people using it.
00:26:19
They have unrealized losses on their
00:26:21
books and they just feel this need to
00:26:23
use them. So they think they might as
00:26:25
well realize gains inside their
00:26:26
portfolio, use their losses to negate
00:26:29
the gains and therefore negate some sort
00:26:31
of taxes that they might owe this year.
00:26:33
and then they reinvest all the proceeds
00:26:35
from these sales. At best, this is a
00:26:38
neutral use of tax loss harvesting and
00:26:40
it's just a little bit of a waste of
00:26:41
time and the math explains why. So,
00:26:43
first, by reinvesting all the proceeds
00:26:45
of their transactions and by looking for
00:26:48
not substantially identical but close to
00:26:51
equivalent investment types. The famous
00:26:53
example you hear is someone will say,
00:26:54
"Well, I I sold my S&P 500 index fund at
00:26:58
a loss and I bought a total market index
00:27:00
fund as a replacement." because a total
00:27:02
market index fund is something like 80%
00:27:04
the same as an S&P 500 index fund. So
00:27:07
they're not identical, but they're
00:27:09
really close. And that's the way that
00:27:11
people often approach tax loss
00:27:12
harvesting. And so I hope you'll agree
00:27:14
with me when I say that the overall
00:27:16
portfolio construction isn't changing.
00:27:19
There's no fundamental investing
00:27:20
benefit, right? It's not like we're
00:27:22
diversifying away from a concentrated
00:27:24
stock position. It's not like we're
00:27:26
selling grandpa's old cabin in the
00:27:28
woods. All we're doing is kind of
00:27:29
trading one ticker symbol for another
00:27:31
and those two underlying securities are
00:27:34
really close to being functionally the
00:27:36
same. There's no sort of factor of well
00:27:38
I ought to be doing this anyway to clean
00:27:40
up my portfolio like in the early
00:27:42
example. All we're doing is selling one
00:27:45
similar asset for buying another similar
00:27:48
asset and then hoping that the losses
00:27:49
and the gains offset each other in some
00:27:51
beneficial way. But then we have to ask,
00:27:53
well, is there truly a tax benefit? And
00:27:56
this is where the rubber meets the road.
00:27:57
We'll see if I can explain this. Well, I
00:27:59
would argue that there's no net tax
00:28:01
benefit because the the dollars that we
00:28:03
sell that realize capital gains and then
00:28:06
get reinvested, those dollars have an
00:28:09
increase in cost basis. We're selling an
00:28:11
asset to realize capital gains and then
00:28:13
we're buying some other asset over here.
00:28:15
So on those dollars involved in that
00:28:17
transaction, they just got an increase
00:28:19
in cost basis. While the assets with
00:28:21
losses, they get a decrease in cost
00:28:23
basis in equal magnitude. Right? that
00:28:26
the assets with losses, we bought them
00:28:28
at $100 per share, so now we sell them,
00:28:30
we realize a loss, and we buy back at
00:28:32
$80 a share. So that's a decrease in
00:28:34
cost basis. The fact that those two
00:28:37
changes in cost basis zero out to each
00:28:39
other, that's why the losses negate the
00:28:41
gains, the zeroing out, and it leads to
00:28:44
a zero overall net change in the cost
00:28:46
basis of the portfolio. And that means
00:28:48
that any capital gains that you quote
00:28:49
unquote saved this year or any taxes
00:28:51
that you saved this year, you're simply
00:28:54
kicking the can down the road to a
00:28:56
future year. So now, if you think that
00:28:58
you'll pay a lower tax rate in that
00:29:00
future year, I follow what you're
00:29:02
saying. And yeah, technically that is
00:29:04
worthwhile. That's a reasonable use of
00:29:06
tax loss harvesting. It's the the tax
00:29:08
arbitrage benefit that we've discussed
00:29:09
here on the podcast many times before.
00:29:12
But in most of the real life examples
00:29:14
that I've encountered, there's no real
00:29:16
tax arbitrage going on. It's just
00:29:18
postponing the inevitable tax bill for
00:29:22
no real net benefit. Now, postponing
00:29:25
that inevitable tax bill, it might be a
00:29:27
good thing in a couple cases. I mean,
00:29:29
the question should come up, you know,
00:29:30
would you rather pay $1,000 in capital
00:29:32
gains taxes today or kick that can down
00:29:34
the road and pay $1,000 in 10 years? The
00:29:37
answer is pretty easy. I'd rather pay
00:29:38
that in 10 years. And the benefit of tax
00:29:41
loss harvesting in this way, right? This
00:29:43
neutral benefit of tax loss harvesting
00:29:45
is simply tax deferral. It's kicking the
00:29:47
can down the road. I mean, technically
00:29:49
it's good, right? The time value of
00:29:51
money suggests I would rather pay that
00:29:53
tax bill in 10 years, but the juice is
00:29:56
only worth the squeeze at large dollar
00:29:58
amounts for long periods of time. If you
00:30:01
can defer $100,000 in capital gains
00:30:04
taxes for 10 years, yeah, go ahead and
00:30:07
use tax loss harvesting. But if you're
00:30:09
deferring like 500 bucks for a year, the
00:30:12
juice just isn't worth the squeeze. Here
00:30:14
are a couple other scenarios. Again,
00:30:15
this is for, you know, I suppose this is
00:30:17
an advanced planning technique, but it's
00:30:19
just something to be aware of cuz there
00:30:21
are some other downsides, too. One that
00:30:23
comes up, maybe not too often, but more
00:30:25
often if you're from the FI community,
00:30:27
and so if you're coming over here from
00:30:28
Choose Fi, this might apply to you.
00:30:30
Well, first off, we already talked about
00:30:31
a little bit of this. If you want to use
00:30:33
your capital losses to offset regular
00:30:35
taxable income, you can only do that if
00:30:37
you've already offset all of your
00:30:39
capital gains. And now, what happens if
00:30:41
you've done your diligent FI retirement
00:30:44
planning and you've intentionally put
00:30:46
yourself in the 0% capital gains tax
00:30:49
bracket? If you've done that, if you've
00:30:52
put yourself in the 0% capital gains tax
00:30:54
bracket, you want to realize capital
00:30:56
gains and then you want to quote unquote
00:30:59
pay 0% tax. like you you want those
00:31:02
gains to show up on your tax return and
00:31:05
and you want them to sit there and be
00:31:07
part of the 0% tax bracket. But if you
00:31:10
have capital losses, even if you don't
00:31:12
want them to, those capital losses will
00:31:14
negate your gains. And the gains that
00:31:17
you would have paid 0% on anyway kind of
00:31:20
just get wiped clean by the losses and
00:31:22
you pay 0% on them. So your losses, what
00:31:26
did they do for you? They took something
00:31:27
that you would have paid zero dollars of
00:31:29
tax on anyway and it turned it into
00:31:31
something that you pay 0 of tax on. Your
00:31:34
losses weren't actually used for any
00:31:36
real benefit, but those losses are used
00:31:38
up. They disappear. You don't actually
00:31:40
get to save money with your capital
00:31:42
losses. So again, without careful tax
00:31:45
planning, your losses might be wasted.
00:31:47
And it's just one of those areas of
00:31:48
financial planning where I see people
00:31:50
sometimes overoptimize to their own
00:31:52
detriment. Another detail, death ends
00:31:55
the conversation. If a taxpayer dies
00:31:57
with unused tax losses, their
00:31:59
opportunity to use those losses will
00:32:00
disappear forever. So, a question of
00:32:02
mortality, a question of health, a
00:32:04
question of age, should be thoughtfully
00:32:07
considered as part of a long-term tax
00:32:09
plan. Tax loss harvesting, just like all
00:32:11
tax planning tactics, should never be
00:32:13
considered in a vacuum alone. Right?
00:32:14
There are simply too many complicating
00:32:16
factors involved, too many puzzle
00:32:17
pieces. The spiderweb is too
00:32:19
intertwined. It's a tool. Taxless
00:32:21
harvesting is a tool. And like all
00:32:23
tools, it can be used as as part of a
00:32:25
healthy long-term tax plan, but it's
00:32:27
certainly not the only thing to
00:32:28
consider. Next, I want to talk about
00:32:30
asset location. And again, we talked
00:32:31
about in episode 555. Asset location can
00:32:35
be a pretty powerful arrow in your
00:32:36
financial planning quiver or it can be a
00:32:38
total waste of time. The two
00:32:40
fundamentals that set the table for the
00:32:41
asset location discussion. The first one
00:32:43
is that many investments, most
00:32:45
investments provide some sort of cash
00:32:47
back to the investor as an annual return
00:32:49
on investment. So stocks provide
00:32:51
dividend yield. Bonds usually pay
00:32:53
income. Mutual funds and ETFs can
00:32:56
trigger a yearly realized capital gains
00:32:58
for their investors even if the investor
00:33:00
didn't actually sell off their shares of
00:33:02
the mutual fund or ETF. That's just the
00:33:03
way that those rappers are taxed. So
00:33:06
that's the first fact. Cash comes back
00:33:08
to the investors. The second fact is
00:33:10
that those dividends, the bond income,
00:33:12
the realized gains, they're all subject
00:33:14
to taxes, annual taxes, unless the
00:33:16
assets are held in a qualified tax
00:33:18
advantage account like a 401k or an IRA.
00:33:21
So when they're held inside of a taxable
00:33:23
investment account, then the investor
00:33:25
suffers that annual taxation described
00:33:27
above described before. So those two
00:33:30
facts raise an interesting question. Can
00:33:32
we intentionally place the quote unquote
00:33:34
high tax investments into our tax
00:33:37
sheltered tax advantaged accounts and
00:33:40
then put the lower tax investments into
00:33:42
our taxable accounts. And if we do this
00:33:44
right, in theory at least, we should be
00:33:46
able to lower our annual tax bill. We're
00:33:49
not sacrificing any sort of investment
00:33:50
returns or investment rewards. All we're
00:33:53
doing is lowering our annual tax bill,
00:33:55
leaving more assets inside of our
00:33:57
portfolio to compound, creating some
00:34:00
sort of positive long-term advantage.
00:34:02
We're minimizing the so-called tax drag
00:34:04
in order to maximize our total after tax
00:34:07
returns. This is the idea of asset
00:34:09
location. Now, a discerning investor
00:34:12
might ask, why not completely avoid
00:34:14
investments that shed off too much
00:34:15
taxable income in the first place? Like,
00:34:17
wouldn't that just be an easier path?
00:34:18
Why why own any bond, right? If bonds
00:34:21
are tax inefficient, which they are, why
00:34:24
should we own a single bond in our
00:34:25
portfolio? The short response, maybe the
00:34:27
canned response, is that we don't want
00:34:29
to let the tax tail wag the investing
00:34:31
dog. So, in other words, tax
00:34:33
considerations shouldn't dictate
00:34:35
investment decisions at the expense of
00:34:37
sound investment strategy. Yes,
00:34:39
minimizing taxes is important, but it
00:34:41
really is a secondary goal behind risk
00:34:43
tolerance, time horizon,
00:34:45
diversification, and overall portfolio
00:34:48
objectives. I can say from some
00:34:50
experience that asset location isn't the
00:34:52
only place where investors let the tax
00:34:54
tail whack their investing dog. Some
00:34:57
people avoid uh necessary portfolio
00:34:59
rebalancing for fear of capital gains.
00:35:01
They hold on to currently bad
00:35:04
investments in order to defer some sort
00:35:06
of capital gains. They stay overweight
00:35:08
in their own company stock in RSUs, in
00:35:10
stock options, etc. to avoid taxes and
00:35:13
capital gains. So, a lot of times people
00:35:15
permit the fear of taxes to cause them
00:35:17
to do pretty dumb stuff inside of their
00:35:19
portfolio. And ideally, that's something
00:35:21
we don't want to do. Smart investors,
00:35:23
yes, they optimize for taxes. It is
00:35:25
important, but they don't let tax
00:35:26
concerns override sound investing
00:35:29
principles. The basics of asset location
00:35:32
are pretty straightforward. So, bonds
00:35:33
tend to be tax inefficient, right? Bond
00:35:35
returns come from annual interest, which
00:35:37
cannot be deferred into future years.
00:35:39
can't defer the interest and it's taxed
00:35:41
at usually at ordinary income tax rates.
00:35:43
So if a bond has a 4% annual return,
00:35:46
taxes federal and state can quickly
00:35:48
reduce that to a 3% or lower after tax
00:35:51
return. I won't get into details here.
00:35:53
Different types of bonds can be taxed
00:35:55
differently at the federal or the state
00:35:56
level. A municipal bond, a treasury
00:35:58
bond, etc., etc. Stocks though are
00:36:00
typically much more tax efficient,
00:36:02
though dividend yields can vary. It's
00:36:04
common for a large diversified mutual
00:36:06
fund or ETF, maybe like VTI, you know,
00:36:09
Vanguard's total stock market ETF, to
00:36:11
have a dividend yield in the 1 to 2%
00:36:13
range. Most of those dividends are taxed
00:36:15
at capital gains rates, not at income
00:36:17
tax rates. Capital gains rates are
00:36:19
better. Asset location theory is pretty
00:36:21
simple. If your portfolio needs bonds,
00:36:24
keep them in a qualified account.
00:36:25
Shelter them from taxes. Nullify the tax
00:36:28
inefficiency of bonds. Then fill up the
00:36:31
rest of your accounts, including your
00:36:32
taxable account with stocks. If you're
00:36:35
going to hold assets in a taxable
00:36:36
account, if you've filled up all your
00:36:37
qualified accounts and now your money
00:36:39
has nowhere to go but taxable accounts,
00:36:41
you might as well hold the more tax
00:36:43
efficient assets in the taxable account.
00:36:45
You can use the same thought process. If
00:36:47
you own other assets, real estate
00:36:48
investment trusts are famously extremely
00:36:51
inefficient. High yield corporate bonds,
00:36:54
very tax inefficient. lower yield money
00:36:57
market cash short-term bond funds are
00:37:00
somewhat more on the efficient side.
00:37:02
Again, it does depend on the interest
00:37:04
rates for what it's worth. The big
00:37:05
question is, well, does this actually
00:37:08
work? Like, how beneficial is asset
00:37:10
location over the long haul? And a
00:37:12
really nice 2022 study from Vanguard
00:37:15
clearly shows that asset location does
00:37:17
provide a measurable benefit to
00:37:19
investors. But the bigger question,
00:37:20
which we'll answer in a couple minutes,
00:37:22
is how and why particular investors
00:37:25
receive much more benefit than others.
00:37:27
And we'll also discuss when and why
00:37:29
asset location strategies can go too
00:37:31
far, becoming an actual detriment to
00:37:33
other aspects of a financial plan. So
00:37:35
for most investors, optimal asset
00:37:38
location will yield an annual
00:37:40
performance improvement of.1% to 2% per
00:37:44
year when averaged over their portfolio
00:37:46
timeline. So, if you'd rather think in
00:37:48
basis points, that's 10 basis points,
00:37:50
right? 10 hundredths of 1%. 10 basis
00:37:54
points to 20 basis points per year over
00:37:57
the lifetime of their portfolio. A fair
00:38:00
question, especially if you're the the
00:38:01
engineering type out there, is like,
00:38:02
well, 10 or 20 basis points better
00:38:04
compared to what? So, the baseline in
00:38:06
the Vanguard study was an equal
00:38:08
allocation portfolio that assumed that
00:38:10
all accounts, traditional, Roth, and
00:38:12
taxable, had identical allocations. It
00:38:15
was a 60/40 mix. 60% stocks, 40% bonds
00:38:18
in all three accounts. From that
00:38:20
baseline, they compared various asset
00:38:22
location strategies. So, who does asset
00:38:25
location help the most and why does it
00:38:26
help them the most? Well, there are
00:38:28
really three main reasons why asset
00:38:30
locations might help you. First off,
00:38:32
more balanced and conservative investors
00:38:34
see a larger benefit from asset location
00:38:37
because their portfolios have
00:38:38
significant bonds in them. And asset
00:38:41
location works better with tax
00:38:43
inefficient assets like bonds. Uh the
00:38:45
second cohort are people with higher
00:38:47
income. They're in higher tax brackets.
00:38:49
They see a larger benefit of asset
00:38:51
location too. High earners have higher
00:38:53
marginal tax rates up to 37% on bond
00:38:56
interest up to 24% on capital gains when
00:38:59
you include the NI tax. So a high
00:39:01
earnner simply has more taxes to save
00:39:03
than a low earner. And it's just all the
00:39:05
more reason for an high earnner to
00:39:07
consider asset location strategies. And
00:39:09
last, people who will bequeath or leave
00:39:12
to their heirs a more significant
00:39:14
portion of their taxable accounts will
00:39:15
see a larger benefit from asset
00:39:18
location. So owning stocks in your
00:39:20
taxable account is efficient, but it can
00:39:22
become quite costly due to capital gains
00:39:24
taxes if you need to sell those stocks.
00:39:26
But if an investor plans to bequef those
00:39:29
stocks at their death, they'll achieve a
00:39:31
step up in basis cost basis. They will
00:39:34
avoid the entire capital gains tax that
00:39:36
they otherwise would have owed if they
00:39:38
sold their stocks during life. So, as
00:39:40
I've written before, that's a little bit
00:39:42
of a controversial aspect of current tax
00:39:44
law. It's like a get out of jail free
00:39:45
card for capital gains taxes. But
00:39:47
nevertheless, if a large portion of
00:39:49
one's assets are will be bequeafd, asset
00:39:52
location can become even more valuable.
00:39:54
For those type of investors, they could
00:39:56
see asset location yield an annual
00:39:58
performance improvement of up to.3 or
00:40:00
point4% per year, 30 or 40 basis points
00:40:03
per year. But are there downsides? And
00:40:05
the short answer is yes. There are some
00:40:07
downsides to asset location if it's
00:40:09
overoptimized. The first one is uh
00:40:11
liquidity, accessibility, and timeline
00:40:13
issues. One of the significant downsides
00:40:16
of an optimized of a perfectly optimized
00:40:18
asset location strategy is that your
00:40:20
accounts will assuredly no longer match
00:40:22
the timelines in your financial plan. So
00:40:25
for example, because of the time
00:40:26
flexibility of a taxable brokerage
00:40:28
account, I believe it should be
00:40:30
generally more conservatively positioned
00:40:32
than qualified accounts. So that means
00:40:35
based on investing principles alone, a
00:40:37
taxable account should probably have
00:40:39
some more bonds in it than a qualified
00:40:41
account. Similarly, most people view
00:40:43
their Roth accounts as the last assets
00:40:45
they'll ever touch. And when you look at
00:40:46
a proper retirement withdrawal strategy,
00:40:49
which I have a detailed, I think it's
00:40:51
like a 4,000word article all about the
00:40:53
the proper order of operations for
00:40:55
retirement withdrawals. We can throw
00:40:57
that link in the show notes. When you
00:40:59
see a proper retirement withdrawal
00:41:01
strategy, the rule of thumb usually is
00:41:02
that Roth is last. and and many people
00:41:05
in fact see Roth accounts as kind of the
00:41:07
crown jewel of their inheritance that
00:41:08
they'll leave to their kids because
00:41:09
they're not going to burden their kids
00:41:11
with any sort of taxes uh if they leave
00:41:12
them a Roth account. And so in many
00:41:15
cases Roth accounts have the longest
00:41:17
timeline in someone's financial plan.
00:41:19
Therefore, Roths should be the most
00:41:21
aggressively positioned all stocks. But
00:41:24
asset location strategies typically
00:41:26
conflict with those ideas. An asset
00:41:28
location strategy would have no bonds in
00:41:30
a taxable account. Instead, those bonds
00:41:32
would reside in qualified accounts,
00:41:34
including potentially a Roth account.
00:41:36
Also, depending on an investor's age, an
00:41:38
optimized asset location strategy can
00:41:40
quickly be self-defeating, especially in
00:41:42
turbulent markets. By sheltering bonds
00:41:45
in a qualified account, we're also
00:41:46
making them illquid until retirement
00:41:48
age, barring some special planning
00:41:50
techniques that we've talked about
00:41:51
earlier on this episode. So, as such, a
00:41:53
turbulent market could force us to sell
00:41:55
stocks out of our taxable account at a
00:41:57
time when we'd honestly rather not do
00:41:59
that. Asset location strategies can also
00:42:01
cause rebalancing problems similar to
00:42:03
the ones I just stated. An optimized
00:42:05
asset location will likely lead to
00:42:07
issues when rebalancing your portfolio
00:42:09
because you can no longer rebalance
00:42:11
within a single account. Every single
00:42:13
time you rebalance, you're going to have
00:42:15
to think about selling assets out of one
00:42:17
account. And then if we need to say sell
00:42:20
uh something out of our taxable account
00:42:22
in order to fund our current lifestyle,
00:42:24
well asset location would probably
00:42:25
dictate that that taxable account is
00:42:27
chalk full of stocks. So now we're
00:42:29
selling stocks for a short-term need
00:42:31
when we'd probably usually we'd be
00:42:33
rather be selling bonds to fund a
00:42:35
short-term need and no we're selling
00:42:37
stocks. Well that means we have to go
00:42:38
into a qualified account now and
00:42:41
rebalance between an equivalent amount
00:42:42
of bonds and stocks so that our overall
00:42:45
asset allocation isn't really changing
00:42:48
even though the specific location of
00:42:50
those assets is changing. The point is
00:42:52
it's just a little bit more complex than
00:42:54
it needs to be in my opinion. A few more
00:42:56
potential issues with asset location
00:42:58
changes in tax law. Now, typically I
00:43:00
make tax planning decisions based on the
00:43:02
knowledge we have today. I'm not in the
00:43:04
game of predicting future tax law, but
00:43:06
some people would argue with me. And the
00:43:07
most common argument is that income
00:43:09
taxes will almost assuredly increase in
00:43:12
coming years. I mean, time only time
00:43:14
will tell. Changes in tax rates though,
00:43:16
capital gains treatment, new legislation
00:43:18
could radically alter the effectiveness
00:43:20
of an asset location strategy. It's
00:43:22
happened before. It'll undoubtedly
00:43:24
happen again. and we just don't know
00:43:25
when. I mean, what if the the step up in
00:43:27
basis upon death is written out of law?
00:43:30
What if the capital gains bracket are
00:43:32
dramatically increased, potentially even
00:43:34
increased above income tax rates? Those
00:43:36
type of changes would make today's, you
00:43:38
know, bestlaid asset location simply
00:43:40
obsolete. There are other unforeseen
00:43:43
externalities too. of the things that
00:43:44
come to mind is Medicare Irma sir
00:43:47
charges, how traditional tax deferred
00:43:49
accounts often lead to higher taxable
00:43:51
income, extra social security taxability
00:43:54
and taxation or just the phase out of
00:43:56
certain types of deductions. The whole
00:43:57
idea, the whole point is if you
00:43:59
overindex on asset location, you might
00:44:01
overlook other consequences within your
00:44:03
financial plan. And then last, I mean,
00:44:06
legacy and estate planning is a big part
00:44:08
of of overall financial planning. And
00:44:10
it's always good to ask, well, what
00:44:11
happens if and when I die? And as far as
00:44:14
asset location is concerned, my main
00:44:16
concerns are well, what happens to your
00:44:18
taxable investment accounts when you die
00:44:20
and what happens to your traditional
00:44:22
investment accounts when you die. In
00:44:24
general, as we've already talked about,
00:44:25
your taxable accounts will be left to
00:44:27
your heirs at a stepped up cost basis,
00:44:29
nullifying any unrealized capital gains
00:44:31
in those accounts. Your traditional
00:44:33
accounts, if you leave them to a spouse,
00:44:34
they essentially inherit them as is. But
00:44:37
if you leave them to anyone else, kids,
00:44:39
grandkids, something like that, they'll
00:44:40
be converted into inherited IAS for your
00:44:43
beneficiaries, subject to specific
00:44:45
withdrawal rules like the 10-year rule
00:44:47
and the accompanying income taxes. Those
00:44:50
different tax treatments really do
00:44:51
matter, and optimizing for tax
00:44:54
efficiency during your lifetime might
00:44:56
not necessarily result in the best
00:44:58
estate planning outcomes and the best
00:45:01
tax outcomes for your heirs and for your
00:45:03
beneficiaries. So, I'm definitely a fan
00:45:05
of asset location. After all, 10 basis
00:45:08
points, 20 basis points, 30 basis points
00:45:10
a year can really add up over an
00:45:12
investing lifetime. That really can lead
00:45:14
to some compound benefits. But I'm also
00:45:16
a big proponent of maintaining proper
00:45:18
investing principles, looking at the
00:45:20
bigger picture. And I think if we focus
00:45:21
too intently on just asset location,
00:45:24
it'll cause more harmful side effects
00:45:26
than positive main effects. Here's a
00:45:28
quick ad and then we'll get back to the
00:45:30
show. Serious question. Why do
00:45:33
podcasters constantly ask for ratings
00:45:35
and reviews? Yes, they do help highlight
00:45:37
our shows to new listeners. They help
00:45:39
strangers find us on Apple Podcast and
00:45:41
Spotify. It's totally true and a good
00:45:43
reason to ask for ratings and reviews.
00:45:45
But I have something more important, at
00:45:47
least more important to me. I want to
00:45:50
know if you like this stuff. I want to
00:45:52
know if you like my podcast episodes, my
00:45:54
monologues, my guests, the information I
00:45:56
share with you and the stories I tell. I
00:45:58
want to improve and make your listening
00:46:00
more enjoyable in the process. So yeah,
00:46:02
I would love to read your reviews. And
00:46:04
sure, if you throw a rating in there,
00:46:06
too, that's great. If you like what I'm
00:46:08
doing, please share it with me. It's
00:46:10
such a great feeling to read your
00:46:12
feedback. I'd love to read your review
00:46:14
or see a rating on Apple Podcast or
00:46:17
Spotify. Thank you. Two more quick
00:46:19
topics. Well, one quick one, one that
00:46:21
might take a few minutes. The quick one
00:46:22
is Roth conversions. I talk about Roth
00:46:24
conversions a lot. It's a pretty common
00:46:26
topic to talk about. And I think because
00:46:28
it's a common topic to talk about, some
00:46:30
kind of maybe more casual DIY retirees,
00:46:33
they hear it and they think to
00:46:34
themselves, "Oh, I should be doing that.
00:46:36
I've heard it talked about a lot. I
00:46:38
should be doing it myself. Let me just
00:46:39
go do it." And the way I respond to that
00:46:42
is like, "Well, it only makes sense for
00:46:43
certain people, right? Roth conversions
00:46:45
are a tax arbitrage strategy. We hope to
00:46:48
intentionally realize taxes this year
00:46:51
because we believe based on, you know,
00:46:53
projections of future cash flow. We
00:46:55
believe that to not do that, we would
00:46:57
suffer higher tax rates in a future
00:46:59
year. Paying lower tax rates this year
00:47:01
to avoid higher tax rates in a future
00:47:03
year. That's tax arbitrage. And that's
00:47:05
the reason why we'd want to do Roth
00:47:07
conversions. But sometimes I just hear
00:47:08
people say like, "No, no, I I'm just
00:47:10
doing it because I I need more Roth
00:47:12
dollars." Or like, "No, no, I've just
00:47:13
heard it's a good thing to do and
00:47:14
therefore I'm going to do it." And even
00:47:16
if they are going to suffer a higher tax
00:47:19
rate this year instead of simply waiting
00:47:21
for a future year when they might just
00:47:23
be able to pull money out of a
00:47:24
traditional IRA at a lower tax rate. No,
00:47:27
no, they just want to do a Roth
00:47:29
conversion and pay more tax for no
00:47:31
reason. I even had a a CPA come to me
00:47:34
and and we were talking about a client
00:47:35
that we, you know, I work with them on
00:47:36
the wealth management side, he works
00:47:38
with them on the tax side, and he was
00:47:40
saying, "This person should do a Roth
00:47:42
conversion." And we brought in our
00:47:43
planning team just to kind of say like,
00:47:45
well, why do you think that? And his
00:47:46
rationale was, well, I'd rather her pay
00:47:50
24 cents on the dollar this year on a
00:47:52
small amount and then let it grow rather
00:47:55
than paying waiting 5 years or 10 years
00:47:58
and paying 22 or 12 cents on the dollar.
00:48:01
Those are the federal tax brackets in in
00:48:03
a future year. And it just doesn't make
00:48:05
sense if you understand the way that
00:48:07
taxes or especially, you know, federal
00:48:09
taxes and and kind of Roth conversions
00:48:11
and those kind of things, the way that
00:48:12
they interact with federal tax brackets.
00:48:16
All we need to do is look at marginal
00:48:18
tax rates today and future and that's
00:48:21
it. There's this whole acorn and oak
00:48:23
tree metaphor that I've gone into before
00:48:24
on on here on the podcast. The metaphor
00:48:26
is a terrible metaphor. It doesn't make
00:48:27
any sense. Would you rather pay, you
00:48:30
know, would you rather shut off 20% of
00:48:31
an acorn or 20% of an oak tree? The
00:48:34
logic is that the acorn is smaller.
00:48:36
People forget the fact that, well, if
00:48:38
you shed off 20% of an acorn and then
00:48:40
you plant it in the ground, the oak tree
00:48:42
that grows up will end up being 20 20%
00:48:44
smaller anyway cuz you're starting with
00:48:45
20% less money. The whole point is,
00:48:48
probably bel.
00:48:50
Roth conversions aren't an inherent good
00:48:52
in and of themselves. They only make
00:48:54
sense for specific people in specific
00:48:56
scenarios if there's a tax arbitrage
00:48:58
that they can take advantage of. The
00:49:00
last punching bag today, which
00:49:02
thankfully I don't see too much in the
00:49:03
FI community, but if you spend time
00:49:05
trying to learn about personal finance
00:49:07
online, you will hear people talking
00:49:09
about dividend investing, dividend
00:49:11
investing as if it's this magic panacea,
00:49:13
and instead I want to make dividend
00:49:14
investing a bit of today's punching bag.
00:49:16
As we already talked about today, the
00:49:17
fundamental value proposition of stock
00:49:19
investing is twofold. We hope that a
00:49:22
company's capital value increases. We
00:49:24
want them to invent valuable
00:49:25
intellectual property and buy land and
00:49:27
build factories and earn more cash. And
00:49:29
all of this growth comes from them
00:49:31
investing money. They invest their own
00:49:33
earnings wisely back into their own
00:49:35
business so that we can then as owners
00:49:38
of stocks of owners of the business
00:49:40
eventually sell our stock for a capital
00:49:42
gain. And second, we hope that a
00:49:44
company's earnings increase over time
00:49:45
and that some of those earnings will
00:49:47
flow back to us as part owners as stock
00:49:49
owners of the company. And those
00:49:51
payments to shareholders, to stock
00:49:52
owners, those payments are called
00:49:54
dividends. The dividends we receive
00:49:56
today, tomorrow, and every day in the
00:49:57
future, they add up to the net present
00:50:00
value of the company. Or at least that's
00:50:01
the way Warren Buffett would think about
00:50:02
it. So both the capital value, capital
00:50:05
gains, and dividends are a function of a
00:50:07
company's earnings. So all investors
00:50:09
total returns are a function of
00:50:11
earnings. This is a vital point, and
00:50:13
we'll return to this point in a little
00:50:14
bit. All investors total returns are a
00:50:18
simply a function of a company's
00:50:19
earnings. That's the vital point. So
00:50:21
dividend investing is this kind of
00:50:23
branch of stock investing where
00:50:25
investors use a company's dividend
00:50:27
payments as a primary factor as to
00:50:29
whether they should buy the stock or
00:50:30
not. And so by collecting a portfolio of
00:50:33
dividend high dividend paying stocks,
00:50:36
these investors are ensuring that they
00:50:38
will receive a a strong dividend cash
00:50:40
flow on a regular basis. And it's a fair
00:50:43
question to ask. Well, aren't all stocks
00:50:45
dividend stocks? I guess I don't
00:50:46
understand the difference. If a stock
00:50:47
gets money to me, the investor, through
00:50:49
capital gains or dividends? Well, what
00:50:51
makes a stock truly a dividend stock?
00:50:53
And well, yes, that's mostly true, not
00:50:55
quite 100% true. So, famously, Amazon's
00:50:57
never paid a dividend. It's still a
00:50:59
growing company. Growing companies
00:51:00
rarely pay out dividends. Instead, they
00:51:02
reinvest their earnings into their own
00:51:04
company in pursuit of more further
00:51:06
growth. So for that reason, Amazon would
00:51:09
not be an attractive stock to a dividend
00:51:11
investor, even though it's a terrific
00:51:13
company that's provided great returns to
00:51:15
its investors over the last 25 years.
00:51:17
Bergkshire Hathway, Warren Buffett's
00:51:19
company, has never paid a dividend
00:51:20
either. Buffett strongly believes that
00:51:22
for every dollar retained by Bergkshire,
00:51:24
at least $1 of market value should be
00:51:26
created for the owners. And when Buffett
00:51:29
reinvests $1 into his own company, they
00:51:31
find really smart ways of turning that
00:51:33
dollar into more than $1 of capital
00:51:36
gains for the stock owners. But most
00:51:38
companies will at some point pay a
00:51:40
dividend. They'll have, you know,
00:51:42
limited internal opportunities for
00:51:43
growth. And the best option at that
00:51:46
point for shareholders is for the
00:51:47
company to raise a dividend. And then
00:51:49
the company will become a potential
00:51:51
target for dividend investors. And my
00:51:54
thesis against dividend investing is
00:51:56
pretty simple. It's not that dividend
00:51:57
investing is bad. It's just that it's
00:51:59
overhyped. It's overhyped because too
00:52:01
many internet gurus are sharing bad
00:52:03
information. Right? Remember the term
00:52:05
guru is popular because the word
00:52:06
charlatan is hard to spell. Dividend
00:52:09
investing promoters, they're just chalk
00:52:10
full of bad logic. So, let me explain
00:52:12
the purported benefits of dividend
00:52:14
investing and then I'll explain why
00:52:16
those so-called benefits are simply
00:52:18
misplaced. So, the first piece of bad
00:52:20
logic is people say, "Well, I get paid a
00:52:23
dividend and I still own the stock."
00:52:26
They're loing a a free lunch that they
00:52:28
get from dividend payments. They're
00:52:29
getting quarterly cash payment and they
00:52:31
still own the underlying stock. I mean,
00:52:33
what a deal. Well, first, as we've
00:52:35
covered, this is really how all stocks
00:52:37
work. It's not special. It's kind of
00:52:39
like saying, "Well, my boss gave me a
00:52:40
paycheck and I'm still employed." Okay,
00:52:44
that's how jobs work. Welcome to planet
00:52:46
Earth. So, I mean, dividend investors
00:52:47
believe that their dividend payments are
00:52:49
quote unquote something for nothing
00:52:51
since they still own their full share of
00:52:53
stock. It's just a false premise. So,
00:52:55
let's say I'm the CEO of Best Buy and
00:52:58
the stock is trading at $100 per share
00:53:00
and I choose to pay my investors a
00:53:02
dividend of $2 per share. As soon as I
00:53:05
pay that dividend, the stock price
00:53:07
immediately drops to $98. My share
00:53:10
holders now have a $98 share plus $2 in
00:53:14
cash. Why does the price drop? Because
00:53:17
the market is smart enough to realize
00:53:18
that my CEO wallet at Best Buy is now $2
00:53:21
lighter. I mean, seriously, it really is
00:53:23
that simple. $2 per share just
00:53:26
disappeared off the company's balance
00:53:27
sheet and the market, of course they
00:53:30
are, is smart enough to realize that
00:53:31
fact. So now the stock price should be
00:53:33
$2 less. The shareholders got their
00:53:35
dividend at the cost of capital growth.
00:53:39
Without the dividend, the stock price
00:53:40
would still be $100. Remember our vital
00:53:43
point that we talked about just a couple
00:53:44
minutes ago. All investors total returns
00:53:48
are a function of earnings. If you use
00:53:50
earnings to pay a dividend, you will
00:53:52
have fewer earnings to fund capital
00:53:55
growth. The pie is finite and it's a
00:53:57
function of earnings. Dividends do not
00:54:00
create money out of thin air. You can't
00:54:02
have your cake or your pie and eat it
00:54:04
too. There is no free lunch. Now, the
00:54:07
second piece of bad logic from dividend
00:54:08
investors is when they say, "Well, I
00:54:10
don't keep the dividend, though. I
00:54:12
reinvest it." Well, reinvesting your
00:54:14
dividends is a terrific idea for any
00:54:16
long-term investor. It's an essential
00:54:18
gear in the compound interest engine,
00:54:20
but it's not a special feature for
00:54:21
dividend investing. Once again, the math
00:54:23
explains why. In the example above,
00:54:26
forgoing taxes for now, I won't talk
00:54:28
about taxes for now, but just going back
00:54:29
to the example above. If you took your
00:54:32
$2 dividend from Best Buy and you
00:54:34
reinvest it, you now go back to owning
00:54:36
$100 worth of the company. It's just as
00:54:39
if Best Buy didn't pay that dividend in
00:54:41
the first place. It's the same math. But
00:54:44
the the dividend investor, they might
00:54:45
say, "Well, but I own more shares now. I
00:54:47
own my one share and then I use my $2 to
00:54:50
buy a fraction more share." And and
00:54:52
we'll get to that. We'll get to that
00:54:53
point because I have an argument against
00:54:55
that, too. When a company does not pay a
00:54:57
dividend, they reinvest their earnings
00:54:59
on your behalf. Reinvesting your
00:55:01
dividends is mathematically equivalent
00:55:03
to the company retaining its own
00:55:04
dividends and reinvesting them on your
00:55:06
behalf. It's the same exact result for
00:55:08
the investor. Again, not counting taxes
00:55:10
for now. And that's why the but ivory
00:55:12
invest argument isn't really a
00:55:14
differentiating argument for dividend
00:55:16
investors. The third piece of bad logic
00:55:18
is when a dividend investor says, "Well,
00:55:20
dividend stocks produce a unique cash
00:55:22
flow for me." As we've covered,
00:55:24
dividends are a type of regular cash
00:55:25
flow paid out to investors. But is that
00:55:28
cash flow a unique feature that
00:55:30
non-ividend stocks simply cannot
00:55:32
replicate? And the answer is no. It's
00:55:34
not unique. Once again, there's nothing
00:55:36
special about dividend stocks here
00:55:38
because rather than accepting a $2
00:55:39
dividend from Best Buy, imagine a
00:55:41
parallel universe where shareholders
00:55:43
say, "Well, no, don't pay me the
00:55:44
dividend, Best Buy. Keep the stock at
00:55:46
$100 instead. And if I need cash, I'll
00:55:49
just sell $2 worth of the stock." That
00:55:52
investor could sell 2% of their shares.
00:55:54
They would have $98 in Best Buy left
00:55:56
over and $2 in cash. It's the same exact
00:55:59
math. The only difference would be the
00:56:01
taxation. Dividends and capital gains
00:56:03
are mostly taxed the same. Depends on
00:56:06
the type of dividend, but in the
00:56:08
situations where they are taxed
00:56:10
differently, dividend taxes are worse
00:56:12
than capital gains taxes. It's yet
00:56:14
another strike against dividend
00:56:16
investing. Now, quick sidebar. Someone
00:56:18
might say, "Well, Jesse, in that example
00:56:20
you just outlined, you're diluting your
00:56:21
shares, right? Dividend investors would
00:56:23
argue that my solution is bad because it
00:56:25
dilutes my ownership. I had to sell 2%
00:56:28
of my shares whereas they the dividend
00:56:30
investors don't have to sell any shares
00:56:32
and now therefore I must own less of the
00:56:35
company. It's just another example
00:56:36
though unfortunately of mathematical
00:56:38
semantics. There's a Google sheet in
00:56:40
this article. So this article will be in
00:56:41
the show notes and I have a link to a
00:56:42
Google sheet that you can go explore
00:56:44
yourself that explains why after 30
00:56:46
years where I show one quote unquote
00:56:48
dividend investor and I show another
00:56:50
person who's kind of following my just
00:56:52
sell your shares point of view, the two
00:56:54
investors end up in the same exact spot.
00:56:56
A dividend investor will end up with
00:56:57
more shares of a lower value stock plus
00:57:00
a pile of dividend cash. And my
00:57:02
suggestion results in fewer shares of a
00:57:05
higher value stock plus an identical
00:57:08
pile of capital gains cash. The final
00:57:10
dollar values, you know, the number of
00:57:12
shares times the the share price are
00:57:14
identical. It's kind of like saying
00:57:16
what's more valuable, a $100 bill or 100
00:57:20
$1 bills. Dividend investors claim that
00:57:22
they'd rather have the bigger pile of $1
00:57:25
bills. Let's just let that sink in. Bad
00:57:27
logic number four is when a dividend
00:57:29
investor says, "Well, wait. I own my
00:57:30
dividend stocks inside of a taxefficient
00:57:32
account." Okay. Well, owning dividend
00:57:34
stocks in a tax efficient account is a
00:57:36
terrific thing. It really is. It's just
00:57:38
as terrific as owning any other stocks
00:57:40
inside of a taxefficient account. This
00:57:42
argument highlights the benefits of
00:57:44
taxefficient accounts. It doesn't
00:57:46
highlight any special benefits of
00:57:48
dividend stocks. The fifth piece of bad
00:57:50
logic is when they say, "Well, I'll
00:57:51
never sell and that income will just
00:57:53
keep on rolling in." This argument is
00:57:55
that their dividends will continue
00:57:56
forever. This just fountain of cash that
00:57:59
never runs out. But companies are free
00:58:01
to change their dividends at their own
00:58:02
discretion and they will do so when
00:58:04
times are bad. Future dividends are
00:58:06
anything but promised. Not to mention,
00:58:09
we can choose to never sell our
00:58:11
non-ividend stocks and create the same
00:58:13
exact cash flow as I described in the
00:58:15
third example of bad logic. And then the
00:58:17
sixth example here of bad logic is when
00:58:20
they say, "Well, look how high the
00:58:21
dividend is. It must be a great
00:58:23
company." As I alluded to, there are
00:58:24
some great companies, Amazon and
00:58:26
Bergkshire, that have zero dividends,
00:58:27
and there are some terrible companies
00:58:29
that use their death rattle to raise
00:58:32
huge dividends, begging some suckers to
00:58:34
come in and invest in their shares.
00:58:36
There's no correlation between the
00:58:37
soundness of an investment and the
00:58:39
presence or size of their dividend
00:58:41
payments. So again, I'm not saying that
00:58:43
dividend stocks are bad. I'm just saying
00:58:45
that they're not special. And dividend
00:58:47
investing as a practice is built upon
00:58:49
the foundation that dividend stocks are
00:58:51
special. If you build your philosophy on
00:58:53
a false premise, you just get a bad
00:58:55
philosophy. As my, you know, I grew up
00:58:57
in the country and as my rural brethren
00:58:59
would say, you plant corn, you get corn.
00:59:01
I own hundreds of dividend stocks within
00:59:04
my diversified portfolio. Index funds
00:59:06
are chock full of dividend stocks. But
00:59:08
neither I nor those index funds hold
00:59:11
those stocks strictly because of the
00:59:13
dividends. We hold them because the
00:59:15
companies they represent will grow over
00:59:16
the next few decades. It's that simple.
00:59:18
Dividend stocks are fine, but there's no
00:59:20
free lunch. Thanks for tuning in to this
00:59:22
episode of Personal Finance for
00:59:24
Long-Term Investors. If you have a
00:59:26
question for Jesse to answer on a future
00:59:28
episode, send him an email over at its
00:59:31
blog, The Best Interest. His email
00:59:33
address is [email protected].
00:59:36
Again, that's jessevestinterest.blog.
00:59:40
Did you enjoy the show? Subscribe, rate,
00:59:42
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00:59:44
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00:59:46
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00:59:49
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00:59:50
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00:59:53
for Long-Term Investors. Personal
00:59:55
Finance for Long-Term Investors is a
00:59:57
personal podcast meant for education and
00:59:59
entertainment. It should not be taken as
01:00:01
financial advice and it's not
01:00:03
prescriptive of your financial
01:00:04
situation.
