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welcome to the best interest podcast
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where we believe Benjamin Franklin's
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advice that an investment in knowledge
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pays the best interest both in finances
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and in your life every episode teaches
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you personal finance and investing in
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simple terms now here's your host Jesse
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Kramer hello and welcome to the best
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interest podcast my name is Jesse Kramer
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this is episode 99 of the podcast it's
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an AMA and ask me anything episode where
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you send in your personal finance your
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financial planning your investment
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questions and I provide some detailed
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intricate hopefully interesting and
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educational answers and today we have
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five great questions to work through but
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first as always we have a review of the
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week this review comes from J Beetle 3
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and Jay said episode 96 is required
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listening I listen to a lot of personal
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finance content and episode 96 is the
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best explanation of why index long-term
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investing is the most effective path to
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wealth I love this podcast is reasonable
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and measured tone and explanations well
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J Beetle thank you very much I'm glad
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episode 96 resonated with you and
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listeners I do think episode 96 is good
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I think it's very helpful and I
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encourage you all to listen to it if you
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haven't listened to it yet and J Beetle
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shoot me an email Jesse at best. blog
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and we'll get you hooked up with a nice
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soft best interest interest t-shirt and
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speaking of the email address Jesse
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bestin interest. blog listeners that's
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how you can send in your questions for
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episodes like this the ask me anything
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episodes but before we get to the first
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question we have a second short fun
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announcement episode 100 is right around
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the corner and we will be announcing a
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small branding change in episode 100 so
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while I have affection for the Triple
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meaning of the best interest as a name
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the simple fact is that not everybody
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out there who hears those words the best
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interest immediately thinks to
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themselves oh it must be an educational
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personal finance podcast so we're making
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a small change to Target the fact that
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we want people to find this show and we
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want people to know exactly what we're
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all about so we'll be making that
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announcement in episode 100 and plus in
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episode 100 we'll have a fun look back
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on the journey that got us this far into
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the podcast and this far into the best
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interest as a brand and a few more
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things that I won't spoil quite yet and
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with that let's begin the AMA the first
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question comes from Randy Randy said
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Jesse I've been thinking about what it
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means to be rich and I'm curious to hear
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what you think for me you're rich if you
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have enough net worth to generate
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passive income like dividends rent or
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interest yield to equal what the top 10%
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of workers make so for example in the US
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the top 10% of households earn about
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$200,000 a year so you'd need around $5
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million of net worth to be considered
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rich assuming a 4% passive income
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because 4% of5 million is $200,000 per
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year of course it varies by city and
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where you live what do you think how do
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you define being rich So Randy
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interesting question and it reminds me
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of the way uh an engineer might answer
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that question so I I can appreciate your
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thought process there and I'll try to
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answer it a few different ways now the
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first one I want to start by asking why
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exactly does this matter why does being
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rich matter and a step further why does
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my definition of Rich matter now my hope
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is that you're asking this question to
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me because maybe you respect my opinion
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and you're interested to hear my
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definition of rich as opposed to someone
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else's definition of Rich maybe to act
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as a guidepost toward your own
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definitions I do that all the time in my
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own life right I ask my mentors
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questions simply to hear their answers
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and ultimately to guide or inform my own
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answers in thinking about this I have
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clients who have more than 10 million I
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have clients with a few hundred thousand
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or $1 million now is one of those people
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rich is one of those families rich and
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is one of them not rich now I would
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think it's somewhat up to them as
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individuals to determine if 10 million
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or 1 million or some other number has
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them feeling Rich part of your question
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Randy it made me think of the book
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factfulness which I've talked about here
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on the podcast as before and the book
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factfulness divides the world into four
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unique tiers every person on earth falls
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into one of those four tiers based on
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the resources they consume on a daily
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basis now tier four is the richest tier
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and it's defined as living on $32 per
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day or more now granted the book was
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written in 2018 so today's tier four
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might be more like $40 per day and
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almost everyone listening to this
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podcast falls into tier three or tier
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four almost everyone listening to this
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podcast in the USA is almost assuredly
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in tier 4 but that said only about one
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in seven people on planet Earth as a
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whole are in tier four in other words
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about 80% of our planet maybe even more
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they live on less than $40 per day they
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live on less than $116,000 per year and
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what does it actually look like to them
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well it might mean that they don't have
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an indoor tap for water they probably do
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have an outdoor pump from a well or
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something like that they likely
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transport themselves on motorcycles
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mopeds bicycles maybe on a bus but way
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more than they would in a personal car
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for them schooling probably goes through
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age 18 but it probably does not go
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through college likely they cook on a
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proper indoor stove but maybe on a small
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gas stove they certainly don't or they
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most likely don't have a grocery store
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that's teeming with Foods the way that
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we might Envision one in the west now
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part of me wants to define the word Rich
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by comparing myself or comparing us
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listening to that 80% of the global
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population who I just defined who don't
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have indoor running tap water who are
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are almost assuredly not going to
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college who very rarely are sitting
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inside of a personal car so the framing
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of the question though is actually the
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opposite of that kind of person right
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the framing of your question Randy you
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took the top 10% of earners from the
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richest country in the world and then
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posed that we have so much money or that
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someone can only be rich when they have
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so much money that they can passively
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out earn those top 10% of earners in
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other words by sitting on our butts and
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doing nothing we can earn more than the
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90th percentile earners in the richest
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country on Earth so yes I'd say the
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person who can do that is certainly rich
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and for that matter I I think many of us
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listening to this podcast are rich do we
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always feel rich no we don't should we
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compare ourselves to rural cambodians in
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order to feel rich or poor no not
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necessarily I totally understand that
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that part of us our our natural instinct
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is to compare ourselves to the Joneses
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we're going to Benchmark ourselves based
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on the soci that we live in the
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neighborhood that we live in and the
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lifestyles that we want and hope for but
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even on that axis I'm not sure I have a
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specific dollar amount in mind in order
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to be rich but I do have some
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interesting criteria to work through and
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I think you'll see that some of these
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questions that I'm about to pose and the
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answers to them certainly can point you
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in the direction of quote unquote being
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rich so the first question or criteria
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that comes to mind do I need to work or
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could I choose to stop the next one how
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much more money do I need in order to
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live my desired lifestyle how much
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Choice do I have where I live what I do
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and when I do it without Financial
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constraints how much can I afford to
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travel to indulge in hobbies to create
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meaningful experiences regularly do I
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have ample free time to spend with loved
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ones or pursue passions without any sort
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of financial worry do I feel Financial
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anxiety or do I feel Financial Security
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now those are some interesting questions
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and criteria to work through that I
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think can start to point you towards
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whether you are
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rich or wealthy or however you want to
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put it I mean honestly it's a bit
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semantics right the word itself doesn't
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matter it's more about the the feeling
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that we actually have of our connection
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with the money or the resources that we
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have in our life for me I think of those
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criteria that I just listed out and I
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say well I still need to work but I'm
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living a very desirable lifestyle right
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now at least for my desires and I feel
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like I have a lot of choice in what I do
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and when I do it though perhaps that's
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because I I love my job I love the side
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work I'm doing here on the best interest
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podcast
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for that point of view I feel like I
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have a lot of choice in what I do and
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when I do it because I'm doing something
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I like I have lots of meaningful
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experiences you know the fun stuff in
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life all the time I do sometimes wish I
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had more free time to spend with my
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loved ones and the only way to carve out
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that time would be to work less I don't
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feel much Financial anxiety though that
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is I I think one of the great benefits
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of being on top of your financial plan
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you simply know what's going on and
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there's a huge positive benefit to that
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so in some ways I feel rich right now in
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other ways I'm working on it and and
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getting closer I suppose for me I could
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tell you which financial numbers matter
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most in my life where my income or net
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worth would actually have to be for me
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to feel even more comfortable but I'm
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not sure how my number would actually
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apply into your life in fact I think
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that if I gave you my numbers it would
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probably lead you to draw more bad
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conclusions than good ones right because
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my numbers are pretty unique to me and
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my brain so the amount of money that
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you're really searching for is enough
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that's the amount enough and and that's
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what you want so interesting question
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Randy and I I think it led to a pretty
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good thought experiment and an answer
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even if maybe it wasn't quite the answer
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that you were looking for okay the next
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question question number two is from Bob
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he's got a 529 College savings question
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but really it expands out into more of a
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tax question that is more General in
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nature so Bob says Jesse for New York
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529 accounts for my grandchildren I've
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always had a concern that if they don't
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use the funds for Education there will
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be a penalty to with draw those unused
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funds now the recent buyin by New York
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state of the Roth conversion rule it
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lessens my concern but let's imagine a
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future where they use some 529 for
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college they convert some into their
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Roth IAS and then there's still money
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left over my question is if either their
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mom as the future owner of the account
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or when the kids become adults the
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beneficiaries themselves if and when
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they remove money for non-educational
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expenses are they required to pay back
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my tax credit given years and years
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earlier if so how would that work their
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tax bracket may not be the same as mine
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at the time of the credit or they may
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not even be a resident in the same state
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at that point okay Bob interesting
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question a little bit of a complicated
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question and listeners I will work
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through some of that complication to
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make sure that you really understand
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what what Bob is asking and to be fair
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listeners this is going to involve
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federal taxes and state taxes and the
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only fair thing for me to say upfront is
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hey consult with your CPA or other tax
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tax professional to understand how you
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might be affected by some of what I'm
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about to say but in short a lot of tax
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Things They simply care about the amount
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of income that was received or not
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received in the specific year of the tax
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filing by the individual who is filing
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that tax return based on the state in
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which they are filing okay what do I
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mean by that so Bob is pointing out that
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his current 529 contributions are
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providing Bob himself a tax benefit on
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his 20 2 tax returns based on his income
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in 2025 and based on the fact that he's
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a New York state resident and as Bob
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points out his grandkids could choose to
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use the $529 for a non-educational
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purpose and that's going to create a tax
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liability and a penalty and Bob's
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question is well does that penalty does
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that tax liability does it undo the
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benefit that Bob receives today and if
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so how does that work the answer is no
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it doesn't undo the benefit that Bob
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receives today so I'm going to go back
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and and kind of repeat the phrase I said
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a minute ago which is that a lot of tax
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things they care about the amount of
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income that was received in the specific
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year that one is filing taxes by the
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individual who is filing that tax return
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based on the state in which they're
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filing so in the case of Bob's grandkids
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if they fulfill Bob's fear of pulling
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out some of the $529 for non-qualified
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purposes they will realize some sort of
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income and penalty in a future year on
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their own tax returns based on the state
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in which they are filing that future tax
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returns there's no retroactive clawback
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of Bob's benefit but instead the
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grandkids are likely going to have to
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pay a tax and a penalty on their own on
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their personal tax returns or if they're
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still considered dependence of their
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parents it might be on the parents tax
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returns in whatever state that occurs in
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that future year okay it doesn't undo
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Bob's benefit right now it's simply
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going to be a tax owed in a future year
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in some cases for some types of accounts
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it could mean that someone is saving tax
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dollars today at a 35% rate and that
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someone else is going to end up paying
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taxes in the future at a 12% rate which
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is just an an accidental tax savings
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that they stumbled into and that's
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pretty nice in other cases though it
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could mean that the person putting money
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in is saving dollars today tax dollars
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at a 12% rate but that someone else is
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going to pay taxes in the future at
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their much higher 35% rate which is just
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accidental EXT ra tax burden which if
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you had known about it you never would
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have contributed the money in the first
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place right it doesn't make sense to
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save 12% today in order to pay 35% in
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the future so for many of us what I just
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described is possible and will affect us
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through the form of inherited IRA
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accounts when someone dies with a
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traditional IRA or a 401k or a Roth IRA
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although I'll get to that later
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basically when someone dies with an IRA
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or 401K their beneficiaries will receive
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those assets that's via an inherited IRA
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a new legislation recently passed so
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that all new inherited IAS going forward
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are subject to the 10year rule they must
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be drained of all their assets within 10
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years of formation which is really more
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or less within 10 years of when the
00:13:43
person died if it's a Roth inherited IRA
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there's no tax burden right it's those
00:13:48
are rth dollars so that principle of rth
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dollars passes through to the inherited
00:13:52
IRA and there's no tax burden but for
00:13:54
all traditional inherited IAS those
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withdrawals over the 10-year period
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period they will be taxable as income
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the withdrawals can be equal over 10
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years it could be all at once after year
00:14:05
10 in some cases rmd rules are going to
00:14:08
apply and also what I should say is for
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older inherited IAS that already exist
00:14:13
well different rules are going to apply
00:14:14
to those so be careful it's definitely
00:14:17
worth chatting with a financial planner
00:14:18
to make sure that you don't get in
00:14:19
trouble with the IRS when it comes to
00:14:21
your personal inherited IRA but the
00:14:24
point of this question and answer right
00:14:26
now is that the decedent the person who
00:14:29
died they saved taxes on the front end
00:14:31
when they contributed into their 401k or
00:14:34
their IRA and they saved taxes based on
00:14:37
whatever tax rate they were paying in
00:14:39
that particular year it could have been
00:14:41
2015 it could have been 2000 it could
00:14:43
have been in it was in whatever state
00:14:45
they were living in at that time but
00:14:47
here you are say you've inherited the
00:14:49
IRA now and it's 2025 or 2026 or
00:14:52
sometimes in the future and you are
00:14:54
going to have to pay taxes on those Ira
00:14:56
withdrawals and it's based on however
00:14:58
much income you are earning during that
00:15:00
year and there are some cases where it's
00:15:02
a little unfortunate if you will you
00:15:04
know it's a nice problem to have I
00:15:06
suppose but someone will be in the
00:15:07
middle of their career they're in some
00:15:08
of their higher earning years their
00:15:10
their marginal tax bracket is say 32 or
00:15:13
35 or 37% at the federal level and then
00:15:16
their grandfather dies Unfortunately
00:15:19
they get an inherited IRA from their
00:15:20
grandfather and now here they are they
00:15:22
they have to take Ira withdrawals out of
00:15:24
the inherited IRA it counts as income
00:15:27
they're already in the highest tax
00:15:29
they're already paying 37% and so
00:15:31
Grandpa he might have made those
00:15:33
contributions Once Upon a Time and saved
00:15:35
money at 22% and unfortunately for him
00:15:39
his grandchild is now paying the federal
00:15:41
government back at 37% unfortunate but
00:15:44
unavoidable but the important Point
00:15:46
getting back to Bob's original question
00:15:49
is that the government is not clawing
00:15:51
back Grandpa's tax savings that is not
00:15:54
how it works instead the government is
00:15:56
simply looking at today's situation
00:15:58
which is you've inherited this Ira what
00:16:01
state do you live in what is your income
00:16:04
in this current tax year and the
00:16:06
applicable tax rates based on whatever
00:16:08
state you're living in will apply
00:16:11
excellent question I hope that answers
00:16:13
your question if it doesn't let me know
00:16:15
and as I mentioned Bob's specific 529
00:16:18
question likely is not going to apply to
00:16:20
many people listening but the inherited
00:16:22
IRA example is definitely going to apply
00:16:25
to a lot of people listening right now
00:16:27
here's a quick ad and then we'll get
00:16:28
back to the to the show did you know my
00:16:30
written Blog the best interest was
00:16:32
nominated for 2022 personal finance blog
00:16:35
of the year and it's been highlighted in
00:16:37
the Wall Street Journal yahooo finance
00:16:39
and on CNBC I love writing especially
00:16:42
when that writing is to share financial
00:16:44
education and I usually write one or two
00:16:46
articles per week you can read them all
00:16:49
at bestter interest. blog again the web
00:16:52
address is bestter interest. blog check
00:16:56
it out okay question number three from
00:16:59
Jesse I've seen this mentioned a couple
00:17:01
times in forums but kind of wondering
00:17:03
why it is not mentioned more let's say I
00:17:05
do not have very much in taxable
00:17:07
accounts in my retirement and I need to
00:17:09
pull $100,000 from my IRA every year for
00:17:12
living expenses until Social Security
00:17:14
kicks in I could pull that amount and
00:17:16
put it into a money market fund to spend
00:17:19
or I could actually do a Roth conversion
00:17:21
of the same exact amount and then pull
00:17:23
the money from the Roth when I need it
00:17:24
for living expenses any interest income
00:17:27
I received in the Roth would then not be
00:17:30
taxed it seems like it would work and
00:17:32
save on some taxes paid on interest I
00:17:34
feel like I must be missing something
00:17:36
since this is rarely mentioned by other
00:17:38
people I would love your thoughts on
00:17:39
this so listeners Tom in short has a
00:17:43
pretty good point there are two distinct
00:17:45
paths that Tom is describing in his
00:17:47
question the first one is withdrawing
00:17:49
$100,000 from a traditional IRA just a
00:17:51
normal distribution out of the IRA which
00:17:54
counts as taxable income putting that
00:17:56
money after taxes are paid into a simple
00:17:59
taxable brokerage account investing it
00:18:01
into a money market fund and then using
00:18:03
that money for this year's spending the
00:18:05
second path that Tom describes is to do
00:18:07
a Roth conversion of the $100,000 from
00:18:10
the traditional IRA into a Roth IRA
00:18:13
doing so will realize the same exact
00:18:15
amount of taxable income but then the
00:18:18
money is sitting not in a taxable
00:18:20
brokerage account but instead in a Roth
00:18:22
IRA where Tom could choose to buy the
00:18:25
same exact money market fund for that
00:18:27
year spending now in the first scario as
00:18:29
our spending money in the money market
00:18:31
fund ACR some interest that interest
00:18:33
will end up as taxable interest income
00:18:36
at year end but in the second scenario
00:18:38
in the Roth IRA the money can acrew
00:18:41
interest and the interest will be
00:18:42
tax-free so Tom is right you can save
00:18:45
money doing it in the way he describes
00:18:47
now there are some caveats so one thing
00:18:50
to keep in mind and a big thing to keep
00:18:51
in mind especially depending on how old
00:18:53
you are there are two separate and
00:18:56
therefore very confusing 5year rules
00:18:59
that apply to Roth contributions and
00:19:01
Roth conversions yes there are two
00:19:03
different rules they're similar in some
00:19:05
ways mainly in the way that they both
00:19:07
deal with a period that's five years
00:19:08
long they're both often called the
00:19:10
fiveyear rule but they're different
00:19:12
rules and they both apply to rth IRAs
00:19:14
and that's quite confusing the first one
00:19:16
is sometimes called the five-year aging
00:19:18
Rule and what it describes is that at
00:19:21
least five years must elapse between the
00:19:23
beginning of the tax year of your first
00:19:25
contribution to a Roth account and the
00:19:28
withdrawal of earnings if fewer than 5
00:19:31
years have passed before you make a
00:19:32
withdrawal of earnings the withdrawal is
00:19:35
considered a non-qualified distribution
00:19:37
and will likely be subject to taxes or
00:19:40
penalties or both uh of course many of
00:19:42
us are familiar with the withdrawal age
00:19:44
for uh retirement accounts which is 59
00:19:46
and a half years old but this 5-year
00:19:48
rule also applies so even if you're 61
00:19:51
years old let's say uh you still need to
00:19:53
wait for your Roth IRA to be five tax
00:19:56
years old before you can withdraw
00:19:58
earnings in that account if this example
00:20:01
61-year-old did withdraw earnings uh
00:20:04
those earnings would be considered
00:20:05
income and they'd pay taxes on them once
00:20:08
the 5-year rule has been met the
00:20:09
earnings are no longer considered income
00:20:12
and importantly there you will notice
00:20:13
that I kept on using the word earnings
00:20:15
there's a difference in any account but
00:20:18
especially now we're going to make a
00:20:19
difference we're going to highlight the
00:20:20
difference between contributions and
00:20:22
earnings this five-year Rule The
00:20:24
Five-Year aging rule applies to the
00:20:26
earnings in an account you can with draw
00:20:29
the contributions at any time tax or
00:20:30
penalty-free from a Roth IRA now the
00:20:34
second 5-year rule is very specific to
00:20:36
Roth conversions and it applies often in
00:20:39
the early retirement community where
00:20:41
people utilize Roth conversions for
00:20:43
annual spending in retirement that
00:20:45
five-year rule the second one states
00:20:47
that if someone converts traditional IRA
00:20:49
assets to Roth assets and even if they
00:20:51
pay all the required taxes on that
00:20:53
conversion they must still wait 5 years
00:20:56
before withdrawing those converted
00:20:58
dollars
00:20:59
this could be a little confusing it
00:21:00
probably is because some of you might be
00:21:02
asking well how could they withdraw the
00:21:04
money anyway if they are under 59 A2
00:21:07
years old well we have to go back to
00:21:09
contributions versus earnings anything
00:21:11
that you contribute to a Roth IRA
00:21:13
account can be pulled back out at any
00:21:15
time for any reason tax and penalty-free
00:21:17
at any age earnings cannot be touched
00:21:20
until age 59 and a half lest penalties
00:21:23
and taxes apply so this second 5-year
00:21:26
rule says hey just because you converted
00:21:28
money from a traditional to a Roth and
00:21:30
just because you have paid the taxes on
00:21:32
it that does not mean that you can
00:21:34
immediately withdraw it as if it was a
00:21:36
contribution it's not a contribution
00:21:38
it's a conversion and because it's
00:21:39
conversion you have to wait five years
00:21:41
before you can touch it so those are the
00:21:43
two fiveyear rules now once we've
00:21:45
successfully navigated any five-year
00:21:47
rule concerns then Tom's idea makes a
00:21:49
lot of sense if we're pulling money out
00:21:51
of a traditional IRA anyway why not
00:21:53
convert it to a rth instead of
00:21:55
depositing it into a bank account a
00:21:56
money market account or other
00:21:58
non-quality if account I believe the
00:22:00
reason why Tom's idea isn't discussed
00:22:02
very often is simple Logistics and it's
00:22:04
a question of is the juice worth the
00:22:06
squeeze so to explain let's use Tom's
00:22:08
hypothetical numbers we want to pull
00:22:10
$100,000 out for living expenses so
00:22:12
either way whether we're converting it
00:22:14
to a Roth or depositing it into a
00:22:16
taxable account our income tax bill is
00:22:18
going to be the same on that actual
00:22:20
$100,000 change if you will and in both
00:22:23
cases due to the timeline of our future
00:22:25
spending right it's this year spending I
00:22:27
want to assume we're investing those
00:22:28
dollars into a money market fund which
00:22:30
as of this recording we will say is
00:22:32
yielding
00:22:33
4.0% so we'll pull on the money monthly
00:22:36
to fund our lifestyle so one 12th of the
00:22:39
money is going to earn interest for a
00:22:40
month and one 12th of the money is going
00:22:42
to earn the interest for two months and
00:22:44
three months and four months etc etc so
00:22:46
by the end of the year we're going to
00:22:47
earn about $2,000 in interest in the
00:22:49
account in the Roth account the $2,000
00:22:52
is not taxed at all and in the
00:22:53
non-qualified account it's taxed at
00:22:55
probably a combined Federal and and
00:22:57
state tax l level of something like 25
00:23:00
to 40% so it's probably going to be a
00:23:02
$500 to an $800 total tax bill in in the
00:23:05
tax bill account and in this world of
00:23:07
financial planning yes every penny count
00:23:09
a penny saved is a penny earned and when
00:23:11
we realize that we're talking about a
00:23:13
05% to a 8% savings using Tom's plan i'
00:23:17
say yeah that that moves the needle but
00:23:19
for some people the annoyance caused by
00:23:22
the Roth conversion UPF front and the
00:23:24
extra tax forms that come along with
00:23:26
that and the extra transfers every month
00:23:28
from the Roth account into a taxable
00:23:30
account from which you can spend those
00:23:32
Logistics might not be worth it you know
00:23:34
the juice as I said might not be worth
00:23:36
the squeeze there's no doubt about it it
00:23:38
is a way to save money uh but the Roth
00:23:40
conversion path will take some extra
00:23:41
time and some vigilance to set up and to
00:23:43
get correct is that few hundred worth it
00:23:46
in tax savings for some people yes and
00:23:48
for other people no okay the fourth
00:23:51
question comes from loyal listener Yogi
00:23:54
who writes in from the Pacific Northwest
00:23:56
and Yogi says Jesse my question is in
00:23:58
regards to the AMA question from fellow
00:24:00
listener Dan in episode 95 with regards
00:24:03
to bonds there was a great lesson from
00:24:05
you as I too did not know how to
00:24:07
evaluate Bond performance correctly or
00:24:09
how interest rate movements have a
00:24:10
direct impact on bond prices my question
00:24:13
is in regards to bonds role as a
00:24:15
diversification asset in our portfolio
00:24:17
if total bond funds such as vbl TX
00:24:20
include bonds of various durations
00:24:22
investment grades and types government
00:24:24
or corporate wouldn't it be better to
00:24:26
invest in short-term government bonds
00:24:28
such as t- bonds municipal bonds if my
00:24:30
goal is to minimize My overall portfolio
00:24:33
risk Yogi I think this is a great
00:24:35
question and I want to start the answer
00:24:37
with a little story I sit on the board
00:24:39
of directors uh for nonprofit here in
00:24:41
Rochester it's called lollipop Farm
00:24:43
we're considered one of the preeminent
00:24:45
Animal Welfare organizations in the
00:24:47
country it's a physical location you
00:24:48
know a shelter an animal shelter an
00:24:51
amazing fostering unit worldclass
00:24:53
Veterinary Services we have an animal
00:24:55
humane Law Enforcement Officers we have
00:24:57
five officers on staff so we serve this
00:24:59
huge geographical region enforcing
00:25:02
Humane Animal laws a lot of Education
00:25:05
goes on and we help any sort of
00:25:08
companion animal or farm animal that you
00:25:09
can think of dogs cats Geral emo horses
00:25:12
pot belly pigs whatever it's a cool
00:25:14
place now the point I'm bringing it up
00:25:17
is that uh I had a really interesting
00:25:18
conversation with some folks who are on
00:25:20
the investment committee for the
00:25:21
nonprofit about exactly your question
00:25:24
Yogi the question is does it make sense
00:25:27
to dial up the the risk inside of a bond
00:25:30
allocation because ostensibly we own
00:25:33
bonds because of their stability over
00:25:35
short durations at least that's how I
00:25:37
think about it if there's one thing that
00:25:39
I harp on whether it's in my blog post
00:25:41
or here on the podcast when it comes to
00:25:43
goals-based investing or financial
00:25:45
planning and thinking about our unique
00:25:47
goals assigning a timeline to those
00:25:48
goals and then finding the proper asset
00:25:51
class based on that timeline the reason
00:25:54
for bonds is if we say well I have a
00:25:55
short-term goal and I I need money and a
00:25:58
year or two years or four years maybe I
00:26:01
don't want to hold it just in cash I'm
00:26:03
willing to get a little bit of extra
00:26:04
return and a bond is the right
00:26:06
investment in that case stocks are not a
00:26:08
two-year asset class but bonds are if
00:26:11
it's the right bonds so the reason we
00:26:13
own bonds is because of their stability
00:26:15
over such a short duration I have a very
00:26:18
high level of confidence that if I
00:26:20
invest my money today in a high-grade
00:26:21
bond and I need it for a goal that I
00:26:24
have in three years that I will get my
00:26:26
money back in three years with some
00:26:28
interest and that confidence it doesn't
00:26:31
exist for stocks not over threeyear
00:26:32
timeline so that's why bonds are more
00:26:34
appropriate for that timeline than than
00:26:36
stocks so we own bonds for the feeling
00:26:38
of guarantee that our principal will be
00:26:40
there exactly as we intend in the next
00:26:43
six or 12 or 24 48 months something like
00:26:45
that we own bonds so that not if but
00:26:48
when our stock allocation is negatively
00:26:51
affected by a market correction or a
00:26:52
crash that our bond balance will remain
00:26:55
largely unaffected in fact it might even
00:26:57
go up while stocks go down
00:26:58
we own bonds for that kind of
00:27:00
dependability and the bonds that we
00:27:01
choose for this type of job must be by
00:27:04
definition quite liquid in nature right
00:27:06
we want them to be an asset that other
00:27:08
people are willing to buy from us at
00:27:10
just about any time but especially at
00:27:12
times when the rest of the world or the
00:27:14
rest of the financial markets are
00:27:15
panicking we want to own bonds that we
00:27:18
can convert to spending money during
00:27:19
those panicky times so to Yogi Point
00:27:22
what if we introduce long duration bonds
00:27:25
into our portfolio what if we introduce
00:27:27
a low credit quality bonds or other
00:27:30
exotic types of fixed income not
00:27:32
necessarily bonds but they have a fixed
00:27:34
income like return that just happen to
00:27:37
have some sort of narrow thin trading
00:27:39
liquidity the answer or part of the
00:27:41
answer is just that yeah not all bonds
00:27:43
are equal we have one-year treasuries we
00:27:45
have 30-year treasuries well there's a
00:27:47
big difference there the shorter the
00:27:48
bond the less it it is affected by
00:27:51
changes in global interest rates and
00:27:52
therefore the more dependable it is
00:27:55
credit quality was another thing I
00:27:56
brought up there and credit quality is
00:27:58
another way of saying do I believe that
00:28:00
the bond issuer will actually pay me
00:28:02
back you can go out listeners right now
00:28:04
and find bond funds that are going to
00:28:05
yield eight or %. well a government
00:28:08
Bond's only yielding 4% the difference
00:28:11
is that the higher yielding bond fund
00:28:13
it's full of individual bonds from
00:28:14
companies or from municipalities like a
00:28:16
city or a county or a state where the
00:28:18
promise of getting paid back is very
00:28:21
much up in the air basically someone has
00:28:23
lent money to a risky business or to a
00:28:25
risky municipality and there's a
00:28:27
distinct chance of of bankruptcy before
00:28:29
the loan could ever be repaid so the
00:28:31
seven or eight or 9% yield it's far from
00:28:34
guaranteed and the reason why it's so
00:28:36
high is to try to compensate an investor
00:28:38
to take that risk in the first place do
00:28:40
you want the fixed income in your
00:28:42
portfolio to have that specific feature
00:28:44
I would argue no and lastly on the
00:28:46
liquidity front not all bonds and not
00:28:48
all fixed income in general is created
00:28:51
equal us treasuries they are bought and
00:28:53
sold and trusted all over the world but
00:28:56
a bond issued by Monroe County New York
00:28:58
that's the county I live in well it's
00:29:00
not the same right it's not bought and
00:29:02
sold and trusted all over the world and
00:29:04
far fewer investors are willing to own
00:29:06
or trade it so what happens if you need
00:29:09
to raise money for something in your
00:29:11
life for one of your stated goals and
00:29:13
all you have are some sort of exotic
00:29:15
fixed income asset that trades very
00:29:17
thinly that not many people are are
00:29:19
trading on the open market well option
00:29:21
one is that you don't get to trade that
00:29:24
day you don't get to raise money that
00:29:25
day you don't get to sell your bond that
00:29:27
day you need need to do it but you don't
00:29:29
get to do it because there isn't a buyer
00:29:31
on the other side of the market you're
00:29:32
kind of screwed option two isn't much
00:29:35
better it's that someone is willing to
00:29:37
trade with you but only at a dumpster
00:29:39
Fire price it's either trade with me for
00:29:41
50 cents on the dollar or go back to
00:29:43
option one where you don't get to raise
00:29:44
money at all so for all those reasons
00:29:47
Yogi I'm of the belief that you
00:29:49
absolutely need to consider Bond quality
00:29:51
bond duration Bond liquidity as part of
00:29:54
your portfolio construction you know the
00:29:56
whole purpose for Bonds in the first
00:29:57
place is to deal with these short-term
00:29:58
needs and we need to depend on them now
00:30:01
it doesn't necessarily mean that you're
00:30:02
only allowed to own one-year us
00:30:04
treasuries it is possible and reasonable
00:30:07
and even I'd say an outright good thing
00:30:08
to diversify your bond portfolio in
00:30:10
other ways but just know that there are
00:30:12
differences here worth paying attention
00:30:14
to a 6040 allocation is fine it's great
00:30:17
whatever but if the 40% Bond allocation
00:30:20
is really just a loan that you made to
00:30:21
your brother-in-law's you know Pizzeria
00:30:23
franchise I find that to be pretty scary
00:30:26
not all bonds not all loans are created
00:30:29
equal and hopefully this answer shines a
00:30:31
little bit of light on that here's a
00:30:33
quick ad and then we'll get back to the
00:30:35
show serious question why do podcasters
00:30:38
constantly ask for ratings and reviews
00:30:41
yes they do help highlight our shows to
00:30:43
new listeners they help strangers find
00:30:44
us on Apple podcast and Spotify it's
00:30:47
totally true and a good reason to ask
00:30:49
for ratings and reviews but I have
00:30:51
something more important at least more
00:30:53
important to me I want to know if you
00:30:55
like this stuff I want to know if you
00:30:57
like my podcast episodes my monologues
00:30:59
my guests the information I share with
00:31:01
you and the stories I tell I want to
00:31:03
improve and make your listening more
00:31:05
enjoyable in the process so yeah I would
00:31:07
love to read your reviews and sure if
00:31:09
you throw a rating in there too that's
00:31:11
great if you like what I'm doing please
00:31:13
share it with me it's such a great
00:31:15
feeling to read your feedback I'd love
00:31:18
to read your review or see a rating on
00:31:20
Apple podcast or Spotify thank you the
00:31:23
last question today comes in from Hector
00:31:26
Jesse I recently came across Ross an
00:31:28
entertaining book an old style paperback
00:31:30
all about taxes and the book is called
00:31:32
tax Topia where the author discusses how
00:31:35
wealthy people use the buy borrow die
00:31:38
strategy to live off their Investments
00:31:40
without incurring capital gains taxes
00:31:42
the idea is that eventually they leave
00:31:44
the loans and Investments for their
00:31:46
children to inherit free of capital
00:31:48
gains tax can you explain this idea do
00:31:50
you ever use it with your clients and
00:31:52
can you discuss the pros and cons of
00:31:54
something like this yeah Hector it goes
00:31:56
by different names but yes buy borrow
00:31:58
die it's a strategy that is popular
00:32:00
although I use that word lightly popular
00:32:03
popular approach reportedly utilized by
00:32:05
the ultra wealthy to minimize tax
00:32:08
liabilities and preserve Capital across
00:32:10
Generations at its core the method
00:32:13
leverages three steps to purchase an
00:32:16
appreciating asset like a stock or real
00:32:18
estate or something like that something
00:32:19
that's growing to borrow against that
00:32:21
asset for liquidity instead of selling
00:32:23
it that's the big step and we'll we'll
00:32:25
dive into this in a little more detail
00:32:27
you're not selling the asset after it's
00:32:28
gone up in value instead you're
00:32:30
borrowing money and using the asset as a
00:32:33
collateral when you borrow and then
00:32:35
ultimately upon your death to transfer
00:32:38
the assets to your heirs where they will
00:32:40
receive a stepped up cost basis and
00:32:43
therefore they will not inherit any sort
00:32:45
of capital gains burden and that's just
00:32:47
a a feature or a bug of the current tax
00:32:49
code where when you die your heirs
00:32:51
receive your assets uh not at the price
00:32:54
at which you paid for them but instead
00:32:56
at the price of which they worth today
00:32:58
so the benefit people would argue is
00:33:00
that you're saving a lot of capital
00:33:01
gains taxes by never selling your
00:33:03
appreciated assets but in my opinion it
00:33:06
doesn't seem like anyone ever wants to
00:33:07
talk about the interest because right
00:33:09
there's a borrow in there you're
00:33:10
borrowing money essentially you're
00:33:12
paying loan interest no one ever really
00:33:14
wants to talk about the loan interest
00:33:15
that you're paying along the way and the
00:33:18
question or at least one of the
00:33:19
questions that jumps to my mind is would
00:33:20
I rather pay a onetime 15% or 20%
00:33:23
capital gains tax versus paying 8% ual
00:33:28
interest on a loan that grows year over
00:33:31
year over year because I'm continually
00:33:32
borrowing more money for the rest of my
00:33:34
life now granted the interest rate of
00:33:37
the loan is going to be an incredibly
00:33:39
important factor here and and we'll get
00:33:41
into that so while the strategy might
00:33:44
appear elegant interesting uh and
00:33:46
straightforward there are a few
00:33:47
misconceptions that seem to surround its
00:33:49
application and definitely carry some
00:33:51
potential risk and drawbacks if it's
00:33:53
mismanaged and then I'll also explain a
00:33:55
little bit of the math as I'm want to do
00:33:57
put together a spreadsheet to help me
00:33:59
understand this better and then I asked
00:34:00
a bunch of my colleagues what they
00:34:02
thought of it or if they've heard of it
00:34:03
so I've got some of their opinions too
00:34:05
so one of the big misunderstandings and
00:34:07
false assumptions is that one can
00:34:09
indefinitely borrow money against their
00:34:11
assets without repercussions in reality
00:34:14
A lender will assess the value of your
00:34:16
assets and impose some pretty strict
00:34:19
limits on the amount of credit or the
00:34:21
amount of of loans that are extended to
00:34:23
you and then Market fluctuations
00:34:25
negative fluctuations can reduce asset
00:34:28
values potentially triggering what's
00:34:29
called a margin call or the urgent need
00:34:31
to repay your loan that constraint can
00:34:34
make buy borrow die impractical or
00:34:36
unreliable or a little bit risky if
00:34:39
borrowing is the only way that you're
00:34:41
supplying your liquidity needs and
00:34:43
that's why Market volatility is a major
00:34:45
risk of the strategy if the value of the
00:34:48
underlying assets drops significantly
00:34:50
again it leads to a margin call here's
00:34:52
an example and this applies not only to
00:34:54
this buy borrow die strategy but just
00:34:57
about any kind of loan that exists here
00:34:59
in our current economic system so let's
00:35:01
say I have a million dollars in stocks
00:35:03
and and we'll use that as an example
00:35:05
because that's probably how buy borrow
00:35:06
die is going to work and I want to
00:35:09
borrow
00:35:10
$500,000 let's say I want to build a
00:35:11
house the bank or maybe even The
00:35:14
Brokerage because a lot of Brokers like
00:35:15
Schwab or Fidelity they have lines of
00:35:17
credit too they're going to look at me
00:35:19
and say okay Jesse yep you want to
00:35:21
borrow $500,000 on a million doll
00:35:23
balance your loan to value is 50% is you
00:35:27
know 00 divided by a million and and we
00:35:29
say that's okay to us our limit is 60%
00:35:32
that's where we draw the line as soon as
00:35:34
your loan is more than 60% of whatever
00:35:37
the underlying value is we're going to
00:35:38
give you a margin call okay so but for
00:35:40
now I'm fine right but then let's fast
00:35:43
forward and say that a couple weeks down
00:35:45
the line after I secure this loan
00:35:47
there's a pretty big correction in the
00:35:49
stock market and my stock portfolio is
00:35:51
cut by 20% so I still have a $500,000
00:35:54
loan but now I only have $800,000 of of
00:35:57
assets right my million dollars dropped
00:35:59
by 20% it's only $800,000 now and if you
00:36:02
do some Mental Math 500,000 divided by
00:36:05
$800,000 is
00:36:07
62.5% well the lender they had a pretty
00:36:09
strict 60% limit and I'm now violating
00:36:13
that limit so what they're going to
00:36:15
force me to do and it really is forced
00:36:17
it's not like they're going to give me
00:36:18
you know a few months to figure this out
00:36:20
they are going to immediately Margin
00:36:22
Call me and they're going to say Jesse
00:36:24
you need to immediately pay us enough
00:36:26
principal against this loan to drop your
00:36:28
loan value down to 60% so you say well
00:36:31
what's 60% of uh 800,000 I believe it's
00:36:35
48,000 so I just borrowed half a million
00:36:38
dollars now I'm only allowed to have
00:36:40
$480,000 of credit the difference there
00:36:42
is 20 grand so pretty much overnight I
00:36:45
have to come up with 20 grand to
00:36:46
immediately start paying back this loan
00:36:48
that's a margin call and in the buy
00:36:50
borrow die strategy margin calls are
00:36:53
very possible and then there's the
00:36:54
possibility of of regulatory and tax
00:36:56
changes you know tax laws are subject to
00:36:58
change legislative reforms could alter
00:37:00
or eliminate key benefits of the
00:37:02
strategy in the first place um for
00:37:04
example if the stepup in basis is
00:37:06
somehow repealed or if estate tax
00:37:08
thresholds are lowered the strategy's
00:37:10
advantages might be significantly
00:37:12
diminished leaving heirs with a lot more
00:37:14
tax liability than the dying person the
00:37:17
decedent intended so all that said uh
00:37:19
one of my guiding principles here on the
00:37:21
best interest is to let the numbers be
00:37:23
thy guide so I used my trusty Microsoft
00:37:25
Excel to look at the long-term costs and
00:37:28
benefits of such a buy borrow die
00:37:29
strategy versus the much more
00:37:31
traditional path of of normal
00:37:33
withdrawals and Associated capital gains
00:37:35
taxes I'll admit this much the results
00:37:38
are not what I expected depending on
00:37:40
your assumptions which you know are very
00:37:42
important here what's the interest rate
00:37:44
on the loans on the borrowing what do we
00:37:46
assume are the Returns on investment and
00:37:48
what kind of volatility is associated
00:37:50
with those what are the capital gains
00:37:52
tax rates is a huge one etc etc now
00:37:55
depending on those assumptions one could
00:37:57
make a pretty plausible argument in
00:37:59
favor of buy borrow die and I'd be happy
00:38:02
to make that spreadsheet publicly
00:38:03
available if you're curious and the
00:38:05
reason in short you know the underlying
00:38:07
numerical reason is that the buy borrow
00:38:09
Dice technique allows the investor to
00:38:12
keep more of their Capital working in
00:38:14
the investment markets and as long as
00:38:16
those extra investment returns can pay
00:38:19
for the cost of their growing debt then
00:38:21
the buy borrow die strategy is is
00:38:23
definitely a net positive but the
00:38:26
problem and it is a scary problem comes
00:38:28
when we begin to add volatility to the
00:38:31
expected returns now no retirement plan
00:38:33
is going to look great during periods of
00:38:35
negative investment return or negative
00:38:37
volatility but the buy borrow die plan
00:38:40
faces a really nasty possibility of that
00:38:43
Margin Call that we just talked about in
00:38:45
short the amount of debt grows too high
00:38:47
compared to the amount of invested
00:38:49
principle and the bank or the the lender
00:38:52
forces the borrower to immediately pay
00:38:53
down the debt and because there's
00:38:55
leverage involved and this is true true
00:38:57
in so many Financial situations whenever
00:39:00
Leverage is involved the good tends to
00:39:02
be extra good and the bad tends to be
00:39:05
extra bad Leverage is um what Warren
00:39:07
Buffett calls it and it's basically a
00:39:09
financial weapon of of mass destruction
00:39:11
now specifically he was using that
00:39:13
language to talk about options and
00:39:14
options trading but a lot of options
00:39:16
trading is simply just leverage you're
00:39:18
Levering up your bets 20 to1 and that is
00:39:22
a a weapon of financial mass destruction
00:39:24
and this is no different so buy borrow
00:39:27
die and The Leverage involved in it
00:39:29
assuming markets perform really well
00:39:31
it's actually going to be pretty good
00:39:33
but when markets perform poorly it's
00:39:36
going to be extra bad quite simply and
00:39:38
so under those circumstances under the
00:39:40
circumstances of pretty reasonable
00:39:42
negative volatility I could find many
00:39:44
scenarios in my spreadsheet where the
00:39:46
normal retirement path ended up being
00:39:49
perfectly healthy and the buy borrow die
00:39:51
retirement path ended up spiraling out
00:39:54
of control with Rising levels of debt
00:39:56
and diminishing levels of assets and
00:39:59
then as a last measure I asked some of
00:40:01
the financial planners the accountants
00:40:02
the attorney I work with here what their
00:40:05
opinions on it were and we're talking
00:40:06
about families with right 1 million
00:40:08
three million five million all the way
00:40:09
up to we work with some families with
00:40:11
hundreds of millions of dollars offering
00:40:13
them a true kind of family office style
00:40:15
service so I figure well if there's
00:40:17
anyone out there maybe some of them we
00:40:20
use or recommend bu borrow and die and
00:40:22
the universal answer came back and it
00:40:24
was well what do the numbers say and how
00:40:26
much risk are we taking
00:40:27
are we avoiding a 20% capital gains tax
00:40:30
just to pay an 8% loan forever how many
00:40:33
years are we going to pay that loan for
00:40:35
the strategy backfires is the individual
00:40:37
in question are they 90 years old and on
00:40:39
death's door because if we expect them
00:40:41
to live for a few decades it's hard to
00:40:43
see how the math would ever work out in
00:40:44
their favor and yeah what if Investments
00:40:47
decline what if there's a margin call
00:40:49
are we just exposing them to way more
00:40:51
risk than they need to and if someone
00:40:52
has this much money why are we exposing
00:40:54
them to that much risk and it actually
00:40:56
brings up another interesting point one
00:40:58
of the biggest misconceptions that I
00:41:00
hear and see on a regular basis is that
00:41:02
somehow wealthy people with all their
00:41:04
accountants their financial planners
00:41:05
that they simply avoid taxes and in my
00:41:08
experience at least that is simply not
00:41:09
true the tax code is going to get us
00:41:11
every single one of us and the question
00:41:13
though is whether you understand the tax
00:41:15
code well enough to make sure that you
00:41:17
pay your share but not any more than
00:41:19
your share and every week it seems like
00:41:21
every month I come across a situation I
00:41:23
look at a tax return where I think oh
00:41:25
this person paid more than they should
00:41:27
have
00:41:27
definitely more than they had to now I
00:41:30
can't get that number to zero doll not
00:41:32
even close but I can work with their
00:41:34
accountant I can point some things out
00:41:36
and most likely give them some advice
00:41:37
that will start saving them tax dollars
00:41:39
tomorrow I think that's the value of
00:41:41
working with a holistic financial
00:41:43
planner I think anyone out there who
00:41:45
says that you can get your long-term tax
00:41:47
bill down to zero uh most likely they're
00:41:50
cutting Corners they're what I would
00:41:52
consider an aggressive accountant uh if
00:41:54
that's you listening I apologize but uh
00:41:57
I think the promise of no tax burden is
00:42:00
is a false promise but that said I think
00:42:02
the idea of buy borrow die it continues
00:42:04
on because some people just hate the
00:42:07
idea of paying taxes some people in fact
00:42:09
would rather end up with less money
00:42:11
themselves as long as it meant they also
00:42:13
had to pay fewer taxes along the way the
00:42:16
funny kind of metaphor is that they'd
00:42:18
rather have 100% of a grape instead of
00:42:21
60% of a watermelon now that's not me
00:42:24
I'll take 60% of the watermelon I can
00:42:26
you know VIs ize that in my head but it
00:42:28
is some people some people would just
00:42:30
rather have 100% of their little grape
00:42:32
and it's those kind of people who
00:42:34
probably look at buy borrow Dy with Rosy
00:42:37
colored glasses so awesome question
00:42:39
Hector thanks for writing in and
00:42:41
listeners thank you all for tuning in
00:42:42
today please send me your future AMA
00:42:44
questions to Jesse best bestin interest.
00:42:46
blog and we'll do our best to get them
00:42:48
answered here on air and I'll see you in
00:42:50
a couple weeks for episode 100 it is
00:42:53
sure to be a fun
00:42:55
one thanks for tuning in to this episode
00:42:57
of the best interest podcast if you have
00:43:00
a question for Jesse to answer on a
00:43:01
future episode send him an email at
00:43:04
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00:43:07
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00:43:10
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00:43:21
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00:43:27
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00:43:29
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00:43:33
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00:43:36
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