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Roth vs. Traditional, and Other Vital Tax Topics - E53

January 29, 2024 / 41:32

This episode of the Best Interest Podcast covers the intersection of taxes and investing, focusing on federal tax brackets, common misconceptions about raises, and capital gains taxes.

Host Jesse Kramer discusses how federal tax brackets work, using the example of a fictional character named Ben, who mistakenly assumes his tax burden based on his income. The episode clarifies that only a portion of Ben's income is taxed at the highest rate, resulting in a significantly lower tax bill.

The conversation also addresses the myth that accepting a raise can decrease take-home pay, explaining that only the additional income is taxed at the higher rate, not the entire salary.

Jesse introduces the acronym RR TT LL U, which stands for risk, return, timeline, taxes, liquidity, legal concerns, and unique situations, emphasizing the importance of understanding tax implications when investing.

Finally, the episode provides insights into capital gains taxes, including how they are calculated, the different accounting methods, and strategies to minimize tax burdens, such as tax loss harvesting and the benefits of holding investments until death.

TL;DR

Jesse Kramer discusses taxes and investing, clarifying tax brackets, common myths, and capital gains tax strategies.

Video

00:00:00
hello everybody Welcome to episode 53 of
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the best interest podcast my name is
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Jesse Kramer today we're going to talk
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all about taxes now it was just tax
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season we're not necessarily talking
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about how to file taxes we're not
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talking about income taxes we're going
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to talk about this intersection this
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very very important intersection of
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taxes and investing so I've got a few
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different articles that I'm going to
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pull some important information from all
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those articles will end up in the show
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notes so if you want to read those
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articles
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and especially if you want to consult
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some of the charts in those articles
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check out the show notes check out those
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links read those articles before we get
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started I am trying to be more
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intentional with growing the best
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interest podcast it's been going really
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well so far this year and one thing that
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really helps growing the podcast and
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attracting potential listeners helping
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them decide if they want to listen to
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the show is the show's ratings and
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reviews so if you've listened to the
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show before if you're listening right
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now and you enjoy this episode I'm
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hoping that you could leave a rating and
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a review if you have the time on Spotify
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you can only leave a rating if you use
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apple podcasts you can leave a rating
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and a review either one works thank you
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in advance if you choose to do that and
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thank you for listening to the best
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interest podcast welcome to the best
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interest podcast 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 investing in simple terms
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now here's your host Jesse
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Kramer So today we're going to tackle
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the topic of taxes from a few different
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angles mixing in a few different
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thoughts three things are certain in
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life death taxes and a couple weekly
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articles from the best interest this one
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this idea addresses death and taxes
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we're going to talk about the most
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common mistake in understanding taxes
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our current federal tax brackets how tax
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brackets work a common myth about
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getting a raise at work and how you can
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save thousands off your tax bill every
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year and we'll answer these questions
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using some easy charts which I know you
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won't be able to see but if you refer to
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the link in the show notes you can see
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them and some easy math so let's go on
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let's start with the opposite of how tax
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brackets work let's say we have a person
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Ben Ben is a side Hustler he builds some
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kites he writes almanacs he designs
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bifocals and he makes $100,000 per year
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Ben looks at the federal tax brackets
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which you can just Google online and he
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says Ah based on my $100,000 salary I
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fall in the 24% income tax bracket
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therefore my tax burden must be 24% of
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$100,000 or $24,000 in taxes the math is
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pretty easy there 24% times 100,000
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leads to 24,000 in taxes but Ben is
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wrong that is not how tax brackets work
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and he's off by thousands and thousands
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of dollars the federal tax brackets are
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a progressive system the chart below the
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table here in the in the article
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visually shows you exactly what that
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means it means your early dollars are
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taxed less and your later dollars are
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taxed progressively more and now how
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much more that answer is given by the
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federal tax brackets for recent years
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they've stayed relatively stable the
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federal tax brackets might change in
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future years but roughly speaking here
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your first $10,000 are taxed at 10% the
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next $30,000 you earn are taxed at 12%
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the next
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$45,000 you earn are taxed at 22% I
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won't keep going from there but you can
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see as you earn more dollars your
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marginal dollars eventually start
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getting taxed at higher and higher rates
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but the earlier dollars they're still
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taxed at the original lower 10 12 22%
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rates now once you see this visually
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once you see this graphically you'll see
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how the portion of Ben's
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$100,000 that's actually taxed at 24% is
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pretty small only about
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$15,000 of his income are taxed at 24%
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$10,000 is taxed at 10% 30,000 at 12%
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45,000 at 22% and so in summary the
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important summary is that Ben his
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federal tax burden ends up being about
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$18
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,000 significantly less about $6,000
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less than what Ben originally assumed
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was
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$224,000 in fact I'm even leaving out
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something important what I'm talking
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about here is that that's the standard
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deduction you might not know this but
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everybody right now you can either
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itemize your deductions or you can
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choose to accept a standard deduction
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and what that means is that the first
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block of your income is literally exempt
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from federal taxes right right now the
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standard deduction for a single filer I
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believe is about
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$112,500 and for married couples it's
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about
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$25,000 so if your itemized deductions
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are more than 125 or as a couple your
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itemized deductions are more than
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$25,000 then it makes sense for you to
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itemize and deduct as much money as you
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can from your taxes but even if you
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don't have any itemized deductions you
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still get that standard deduction and
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the first 12 or $25,000 of your income
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is literally tax-free
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so the progressive tax system with a
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standard deduction is significantly
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different than what many people assume
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the tax system looks like and it's
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important that you understand that
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because one of the most common
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misconceptions or I shouldn't it's it's
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a very common it's probably not the most
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common but it's a very common often
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repeated personal finance myth is that
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accepting a raise could actually
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decrease your take-home pay and the
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reason why this this myth persists is
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that people think well I was in the 22%
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bracket and that little $2,000 raise
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pushed me into the 24% bracket and they
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mistakenly think that that bump in taxes
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applies to all their income which we've
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just gone over that's that's not how it
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works that the bump in taxes only
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applies to the the most recent income it
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only applies to the the very tippy top
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income so accepting a raise cannot hurt
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your income tax burden now how did this
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here in the first place well based on
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what we've learned today we we
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understand
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[Music]
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that all right let's now switch over and
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talk about how taxes affect investing if
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you aren't familiar there's this
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important acronym that isn't used that
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often but many investors think about the
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individual portions of This Acronym and
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This Acronym is is just a way to
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remember the important factors when you
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are thinking about investing the acronym
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is RR TT LL U okay is it rudoo is it
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raloo Rudy I'm not sure RR TT LL U and
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individually those letters stand for
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risk return timeline taxes liquidity
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legal concerns and then unique
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situations okay I won't spend a ton of
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time going over each one of them but
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real quick risk how much risk can you as
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an investor tolerate and what kind of
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risk is associated with the investment
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fairly straightforward we talk about it
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a lot on the best interest and then
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return of course what's the expected
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Return of the investment or what return
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is required to meet your goals remember
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from a financial planning point of view
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you should think about your goals first
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and then understand what return you need
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to get there that's the kind of stuff I
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do at work all day risk and reward we
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talk about that a lot timeline another
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thing we talk about a lot how much time
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do you have to get to your future goals
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how old are you can you make short-term
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sacrifices for long-term gains those are
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some timeline questions to ask we're
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going to come back to dive into the tax
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a little bit deeper that's why we're
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here today but first the other letters
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liquidity do you have enough liquid cash
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to cover your near-term expenses do you
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have an emergency fund can you afford to
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invest in some ill liquid ways can you
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lock up some of your money for the long
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term legal do you have any particular
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legal constraints that might prevent you
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from investing in certain things a lot
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of us see this there might be
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contribution limits for certain types of
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investing accounts like a 401k or an IRA
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there might be withdrawal mandates on
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certain types of accounts especially for
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older people right required minimum
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distributions that kind of stuff unique
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situations that's kind of a catchall
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some people maybe they have a moral or
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ethical constraint against a particular
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investment they don't want to invest in
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tobacco or alcohol or Firearms companies
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they're worried about ES SG
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environmental sustainability and
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governance objectives maybe they have
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inside knowledge of a particular
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corporation they're in the C suite and
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therefore they can't invest there so
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those are some of the unique stuff maybe
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that last one's a legal thing but either
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way let's go back to taxes the second T
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in this rrt llu framework talks about
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tax situations do you have any unique
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tax situations as an investor what tax
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bracket are you in how will that tax
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bracket change over time based on your
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expected income what are some of the
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potential tax implications of your
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different investment choices many of us
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asks these questions and then execute
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some tax efficient strategy via accounts
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like a 401k IRAs 403bs hsas Etc and we
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can go a step further and for taxable
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accounts consider interest dividends and
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capital gains we're definitely going to
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dive into the capital gains in a little
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bit and then finally we can ask
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questions about Estate Planning and
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inheritance how will various Investments
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affect the future estate of the investor
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and any beneficiaries children grandkids
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Charities those kind of things they
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might wish to leave money
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to so let's dive a little bit deeper on
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this tax and investing topic what kind
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of return can you expect from the
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American Stock Market most sources would
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say 10% per year nominally on average
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account for inflation the real return
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ends up around 6 and half or 7% of
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course we know that actual returns are
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disturbingly different than average
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returns that's something I write about a
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lot on the best interest it's something
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that a lot of good investing
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professionals will tell you while the
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average might be 10% per year you're
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rarely going to hit that average you're
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usually either way over or way under and
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that's why it's important to be a
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long-term investor in order to capture
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that average but let's talk about the
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tax side of things there are three types
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of tax treatments in American Investment
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accounts tax-free accounts have no
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long-term tax burden typically that's
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because income taxes have already been
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paid before the investment deposits Roth
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accounts are one example of that tax
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deferred accounts are as the name
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implies a way to defer taxes to the
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Future traditional 401K accounts are one
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example you pay no income tax today
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invest in a 401k and pay income taxes
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upon your future 401K withdrawals
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finally we have taxable accounts that's
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the third leg of the retirement stool
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they provide none of the tax benefits
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outlined above before but they're
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significantly more time flexible most
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tax-free and tax deferred accounts have
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age restrictions associated with their
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use but not so with taxable accounts as
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for the taxes themselves the money going
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into taxable accounts has already
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suffered income tax and the funds in the
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account will be subjected to both
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dividend taxes throughout the life of
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that tax bill account and then
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eventually capital gains tax ta when you
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withdraw from that account so with these
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extra taxes the dividend taxes and the
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capital gains taxes in taxable accounts
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how are investment returns affected how
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much do the 10% Pere nominal returns
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decrease after we account for taxes to
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answer this question I downloaded the
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dividend tax rate capital gains tax rate
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over the last 100 years as well as
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Robert Schiller's very highly cited and
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well-respected S&P 500 data set I ended
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up zooming in on the data from 1950
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until today that's a good post World War
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II date providing 72 years of data and I
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divided the period into 700 plus rolling
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10-year periods you know an example
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would be March of 1954 to February of
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1964 that's one period I looked at each
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10-year period as a modern investor
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might do as an opportunity to dollar
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cost average into the market buying an
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even $100 of the S&P 500 every month
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and for each period I asked what's the
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nominal tax-free stock market return
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then if we include dividend taxes every
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month as various Dividends are paid and
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we include capital gains taxes as a lump
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sum at the end of the 10-year period how
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much did the returns decrease and then
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finally I asked how did inflation
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decrease the spending power of those
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returns over the 10year period so on
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average each of these 10year periods saw
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a total compounded return of
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170% or 10.4% per year that does not
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include taxes nor inflation that's
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pretty close to what we expect about 10%
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per year a tax deferred account like a
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traditional 401K would see the same
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returns except for a big bite of income
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taxes upon final withdrawal if someone
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was paying a 22% federal income tax
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their 170% Total return would decrease
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to
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133% which makes more sense when we
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annualize it you go from 10.4% per year
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down to 8.8% per year some of you though
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will max out your 401K and your IRA and
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then the next smartest option is a
00:14:12
simple taxable Brokerage in that case
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dividend taxes will trim profits every
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month and capital gains taxes will cause
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a big haircut upon final
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withdrawal on average each 10-year
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period in that case saw an annual rate
00:14:27
of return of 7 . 2% per year versus the
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original
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10.4% in other words taxes decrease
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stock returns basically by 41% overall
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from 10.4% down to
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7.2% in this article I've plotted out
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those returns over 10 years both in
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total returns and also
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annualized but we still need to adjust
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for inflation to see real returns real
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returns in other words measure how much
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did my actual spending power change it
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accounts for inflation and taxes the
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average real return of this data in the
00:15:04
completely tax-free account the first
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account is 6.8% per year in the
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traditional 401K that has no taxes until
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the end then we pay income tax the
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average real return was 5.2% per year
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and then the average real return in a
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taxable account was
00:15:24
3.6% per year so that 3. 6% per year
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rate of return that's that's better than
00:15:31
a kick in the pants right that's that's
00:15:33
better than zero but 3.6% annualized is
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a far cry from that pre-tax
00:15:39
pre-inflation Assumption of 10% per year
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it's pretty easy to plan a retirement if
00:15:44
your real spending power increases by
00:15:46
10% yearly but it's much harder to do
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that at 3.6% per year so what's the
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point of all this the point is that most
00:15:55
retirement calculators especially the
00:15:56
quick and easy ones on the internet do
00:15:58
not appropriately account for that tax
00:16:01
drag as such they estimate that
00:16:03
investors will increase their spending
00:16:05
Power by six or 7% per year that's the
00:16:09
nominal 10% minus 3.5% for inflation but
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as we seen today that's incomplete your
00:16:15
Roth and your 401k assets will grow in a
00:16:18
tax advantaged manner totally true but
00:16:20
for many of us a significant chunk of
00:16:22
our stock portfolios that are in our
00:16:25
taxable accounts will only see real
00:16:27
growth of 3 to 4% per year assuming that
00:16:31
future growth will mimic the past which
00:16:33
of course is no guarantee some of you
00:16:35
might be thinking well Jesse tax rates
00:16:37
have changed over time and that's
00:16:39
completely correct as previously stated
00:16:41
taxes took an average 41% bite out of
00:16:44
investment profits Over The observed
00:16:45
10-year period since 1950 but recent tax
00:16:48
rates have relaxed with many recent
00:16:50
periods seeing only only a 25 to 35%
00:16:54
reduction now I'd argue that's still a
00:16:56
significant drag what does the future
00:16:58
hold for taxes well taxes are currently
00:17:01
historically low so don't be surprised
00:17:03
if future taxes go up from here and post
00:17:07
tax investment returns go down now
00:17:10
finally some of you might see this and
00:17:12
say well the ideal zero tax account
00:17:15
which is essentially like a Roth account
00:17:17
returned 6.8% per year and the
00:17:20
traditional accounts returned 5.2% per
00:17:23
year so does that mean that Roth
00:17:25
accounts are simply better well we have
00:17:28
to recall that traditional accounts have
00:17:30
terrific tax benefits upfront before any
00:17:32
of the analysis that I've talked about
00:17:34
today if I had identical income tax
00:17:37
rates today and at retirement then the
00:17:39
benefit of traditional accounts and Roth
00:17:41
accounts would be exactly the same
00:17:43
that's just the
00:17:44
math Roth dollars do have a higher
00:17:47
long-term return only because they've
00:17:50
already had their tax haircut up front
00:17:53
traditional dollars are equal but
00:17:55
opposite there's no tax up front but
00:17:57
their future taxation affects the
00:17:59
investment returns and finally some of
00:18:01
you might be asking should I avoid
00:18:03
investing in taxable accounts altogether
00:18:06
now the way I approach it is that a
00:18:08
positive real return like our 3.6% per
00:18:11
year is way better than nothing the
00:18:14
dollars in your bank account over the
00:18:15
last year or so have suffered a negative
00:18:18
real return that's a loss in purchasing
00:18:20
power so compared to that I would take
00:18:22
3.6% any day you know the point of this
00:18:25
section of the podcast is not to
00:18:27
discourage you from investing in a
00:18:28
taxable account rather the point is to
00:18:31
correct a common and overly optimistic
00:18:33
assumption about investing returns if
00:18:35
you want a Shand metric to plan your
00:18:37
future I'd recommend using these
00:18:39
historical averages but round it down
00:18:41
since I'm investing for long periods in
00:18:43
a diversified stock portfolio I use 6%
00:18:46
real return per year for Roth accounts a
00:18:49
5% real return per year for traditional
00:18:51
accounts and a 3% real return per year
00:18:54
for taxable accounts and that's for the
00:18:55
stock portion of the portfolio now I do
00:18:58
want to dive deeper into the Roth versus
00:19:00
traditional debate because it's a very
00:19:03
hot debate I'd say it's not necessarily
00:19:05
contentious but the question comes up
00:19:06
all the time when I'm reading online
00:19:08
should I invest in Roth should I invest
00:19:10
in traditional accounts now I would go
00:19:13
deep on this topic here the thing is I
00:19:16
need quite a bit of visual aids to
00:19:18
support what I'm saying the shorthand
00:19:20
answer is and I kind of already went
00:19:21
over it a minute ago it all depends on
00:19:23
tax rates current tax rates versus
00:19:25
future tax rates with Roth accounts you
00:19:27
get tax taxed up front but you never get
00:19:29
taxed again so if you think that current
00:19:32
tax rates are lower than the future then
00:19:34
you'd rather pay taxes now which makes a
00:19:37
Roth more beneficial if you think tax
00:19:39
rates might go down in the future or
00:19:41
your personal tax rates might go down in
00:19:43
the future then a traditional account
00:19:45
makes more sense so it depends on not
00:19:47
only the federal tax rates and how you
00:19:49
think they might change but also how
00:19:51
your personal income is going to change
00:19:52
over time how will your income fit into
00:19:55
those tax brackets personally I try to
00:19:58
max out my traditional 401K as best I
00:20:02
can and I also try to max out my Roth
00:20:05
IRA as best I can I have a mix of both
00:20:07
so no matter what kind of tax situation
00:20:09
is thrown at me in retirement I can try
00:20:12
to take advantage of what's going on by
00:20:14
either paying some taxes when the tax
00:20:16
rates are low out of my traditional
00:20:18
account or not paying any taxes when tax
00:20:21
rates are high out of my Roth account if
00:20:24
you want to see how this all works if
00:20:27
you want to see some charts that
00:20:28
supports the detail if you want to see
00:20:29
some graphs and even a few mathematical
00:20:32
examples check out the show notes
00:20:34
there's a link to an article and the
00:20:35
article is called Roth is better than
00:20:38
traditional it's a blog post good posts
00:20:41
good reading lots of good info there I
00:20:43
highly recommend you check it
00:20:48
out how can a quick math error plus some
00:20:51
faulty logic cost someone
00:20:55
$120,000 this was a a link or a story
00:20:59
from October 2021 that I saw on the
00:21:01
bogleheads Forum on Reddit someone was
00:21:03
asking for investing help the quick
00:21:05
highlights of this person's situation is
00:21:08
they had a 401k that offered a 2% match
00:21:11
now 2% Is Not Great compared to the
00:21:13
industry standard of 4 or 5% but still
00:21:15
2% it's free money assuming they
00:21:18
contribute to their 401K the 401K has
00:21:20
funds or investing vehicles with a 1%
00:21:23
expense ratio 1% fees now that's really
00:21:26
high if all you're getting is an
00:21:28
investment product right if you're going
00:21:30
to pay 1% you expect much more than just
00:21:32
an investment product and that
00:21:34
combination of poor employer matching
00:21:37
and high fees made the person writing
00:21:41
this post asking these questions it made
00:21:42
them want to say well screw it screw the
00:21:44
401K I'd rather just invest in a taxable
00:21:47
account but they hadn't done the math to
00:21:50
back up that gut instinct so let's
00:21:54
highlight some important points about
00:21:56
their question and what's going on here
00:21:58
now open questions about money lead to
00:22:00
important lessons and this is a great
00:22:02
question for this person to ask but we
00:22:04
can learn two quick lessons from the Bad
00:22:06
and the Ugly aspects of this
00:22:08
question first we have to separate what
00:22:11
feels bad from what is bad it might feel
00:22:14
bad to pay a higher expense ratio than
00:22:16
what's standard or typical and it might
00:22:18
feel bad to have a low employer match
00:22:20
but the math of the problem is a fact
00:22:23
and that math holds true irrespective of
00:22:25
any feelings Charlie ER tells a story
00:22:28
from when birkshire hathway bought BNSF
00:22:31
railroad some of Burkshire Hathway's
00:22:33
shareholders felt that they were only
00:22:35
getting a good deal while the BNSF
00:22:37
shareholders were getting a great deal
00:22:39
on the transaction and those
00:22:41
shareholders wanted berkshire's
00:22:42
leadership meaning Warren Buffett and
00:22:44
Charlie Munger to negotiate a better
00:22:45
deal and Charlie Munger wisely pointed
00:22:49
out if you're getting a good deal why
00:22:51
the hell do you care what the other guy
00:22:53
is getting his point there being that
00:22:55
Envy Envy is a potent drug
00:22:58
now going back to the second lesson from
00:23:00
this this person's question about their
00:23:02
401K they mentioned that they hadn't
00:23:04
done the calculations for the long term
00:23:07
but they're pretty sure that they were
00:23:08
getting a bad deal and right there time
00:23:11
out that's a dangerous statement in
00:23:13
personal finance if you don't know the
00:23:15
calculations that is okay and you should
00:23:17
ask for help and the internet is an
00:23:19
amazing resource but to be pretty sure
00:23:22
about a mathematical outcome without
00:23:24
doing any math that is not a wise thing
00:23:27
to do so to get a real answer you've got
00:23:29
to do real math so that's what I did and
00:23:32
we're going to talk about it now so
00:23:33
remember this curious redditor believed
00:23:35
that their 401K would surely do worse
00:23:37
than a taxable account and I I'll give
00:23:39
them the benefit of the doubt I used
00:23:41
conservative assumptions for my
00:23:43
hypothetical 401K investor and then I
00:23:45
used comparatively kind assumptions for
00:23:48
my hypothetical taxable investor I
00:23:50
wanted to be extra gracious to this
00:23:52
redditor's Theory could his gut instinct
00:23:54
be correct the assumptions in the math
00:23:57
can all be found in a a Google
00:23:58
spreadsheet that I'll I'll link here in
00:24:00
the show notes we have both investors
00:24:03
contributing the same amount the 401K
00:24:05
investor receives a 2% company match but
00:24:07
ends up paying a 1% expense ratio the
00:24:09
taxable investor pays income tax upfront
00:24:12
receives no matching funds but also pays
00:24:14
no expense ratio no fees both investors
00:24:17
see the same investment performance
00:24:19
before fees both investors pay taxes
00:24:22
upon withdrawal we're going to say
00:24:23
that's 30 years in the future though I
00:24:25
assume a 22% income tax rate for the
00:24:28
401K investor and only a 10% capital
00:24:31
gains rate for the taxable
00:24:34
investor now even with my harsh
00:24:37
assumptions right even though I'm being
00:24:39
conservative with a 401k investor and
00:24:41
liberal with the taxable investor the
00:24:44
401K in this case outperforms the
00:24:46
taxable investor by
00:24:48
$120,000 or about 12% over a 30-year
00:24:52
period that's a huge amount the 2%
00:24:55
company match and the tax deferred
00:24:57
nature of the 401K are extremely
00:25:00
significant and outweigh the fact that
00:25:02
there's this 1% fee involved not to rub
00:25:05
salt in the wound but recall that this
00:25:07
person was fairly certain that their
00:25:09
taxable account was the smarter choice
00:25:11
so the lesson here is to always question
00:25:14
your assumptions especially if math can
00:25:16
help you I guarantee you know someone
00:25:19
who could build a spreadsheet like this
00:25:20
in 15 minutes or less you can call me if
00:25:23
you want help with that it's not that
00:25:25
much time but there's a large amount of
00:25:26
money to be gained
00:25:28
[Music]
00:25:41
now finally we're going to do a deep
00:25:42
dive into capital gains taxes a reader
00:25:45
recently wrote into me and said Jesse
00:25:47
after a tough tax season for me can you
00:25:49
offer any advice on capital gains tax
00:25:51
planning should I set up a tax
00:25:53
withholding on my taxable accounts what
00:25:56
general framework should people use use
00:25:57
and that's a question from Jennifer
00:25:59
Jennifer is a reader of the blog thank
00:26:01
you Jennifer that's a great question so
00:26:03
let's devote some time to the basics of
00:26:05
capital gains taxes capital gain occurs
00:26:07
when you sell an asset for more than you
00:26:09
bought it for it's like profit right
00:26:11
it's a synonym for profit a capital loss
00:26:13
occurs when you sell an asset for less
00:26:15
than you bought it for capital gains or
00:26:18
Capital losses become realized upon such
00:26:20
a sale until that sale the gain or loss
00:26:22
is considered unrealized sometimes those
00:26:25
are called paper gains or paper losses
00:26:27
when they're unrealized while realized
00:26:30
capital gains are taxed that's the point
00:26:32
of what we're going to talk about here
00:26:33
never forget that capital gains are
00:26:35
evidence that something good has
00:26:37
happened right you've turned a profit
00:26:39
how are capital gains calculated and
00:26:41
what accounting methods are used this is
00:26:43
kind of important in their most simple
00:26:44
form obviously capital gains are
00:26:46
synonymous with profit but there are
00:26:48
three different accounting methods that
00:26:49
can be used to calculate capital gains
00:26:52
the first one is called First in first
00:26:54
out and it assumes that you're selling
00:26:56
your oldest shares first if you bought
00:26:59
shares over a number of years and then
00:27:01
you decide to sell some of those shares
00:27:03
this year the gain or the profit is used
00:27:07
assuming that you are selling your
00:27:08
oldest shares the second method is
00:27:11
called specific share identification as
00:27:14
the name implies it involves identifying
00:27:16
exactly which Shares are being sold at
00:27:19
any given time now to keep taxes low
00:27:22
this is probably the method that I would
00:27:23
use because you would sell whichever
00:27:25
shares would result in the lowest
00:27:27
capital gain but since you're
00:27:29
identifying specific shares you need to
00:27:31
ensure that you're keeping excellent
00:27:32
records of everything the last method is
00:27:35
called the average basis method to use
00:27:38
that method you would average the cost
00:27:40
basis or you would average the purchase
00:27:42
price of all of your shares over the
00:27:45
number of years that you've bought them
00:27:46
and you would get the average price per
00:27:48
share and then you'd use that average
00:27:50
price to calculate the capital gains on
00:27:53
a current sale once that method is used
00:27:56
then all remaining unsold shares get
00:27:59
reconstituted at that cost
00:28:02
basis so now how are capital gains taxed
00:28:05
capital gains are subject to tax in
00:28:07
taxable accounts there are no capital
00:28:10
gains in 401ks in IRAs in hsas or in any
00:28:15
other qualified or tax advantaged
00:28:17
investing accounts there are no capital
00:28:19
gains in tax advantaged qualified
00:28:22
investing accounts only in taxable
00:28:25
accounts the first major consideration
00:28:26
in determining capital gains tax is the
00:28:28
duration of holding the asset if you
00:28:30
held an asset for less than a year
00:28:32
before selling it it generates a
00:28:33
short-term capital gain or loss if you
00:28:36
held it for more than a year it
00:28:38
generates a long-term capital gain or
00:28:39
loss short-term capital gains are taxed
00:28:42
as normal income for many Americans that
00:28:44
equates to a 12 to 24% tax rate
00:28:48
long-term capital gains are taxed
00:28:50
anywhere from 0 to
00:28:52
23.8% depending on the Investor's total
00:28:55
income we'll we'll dive into that a
00:28:57
little a little bit later now
00:28:58
importantly Capital losses offset
00:29:01
capital gains going even further Capital
00:29:03
losses can offset some of your normal
00:29:06
income up to $3,000 per year and excess
00:29:09
Capital losses can carry forward into
00:29:11
future tax years that's why the concept
00:29:14
of tax loss harvesting is important to
00:29:16
consider when thinking about capital
00:29:18
gains which assets are subject to
00:29:21
capital gains most common assets are
00:29:24
stocks bonds some real estate Vehicles
00:29:26
can be subject to capital gains and
00:29:29
other reasonable capital gains assets
00:29:31
include Gems and Jewelry digital assets
00:29:34
household furnitur gold silver other
00:29:37
medals coin collection stamp collections
00:29:40
there's quite a list but for most of us
00:29:42
the most common capital gains will run
00:29:44
into in our life are stocks bonds real
00:29:48
estate now how are long-term capital
00:29:51
gain taxes calculated this is an
00:29:53
important concept that is very often
00:29:56
misunderstood in personal finance
00:29:58
circles and it's often it's it's
00:30:00
misunderstood on on the wrong side
00:30:02
usually people think that they can get
00:30:04
away with paying less tax than they
00:30:06
actually can so long-term capital gains
00:30:09
are taxed based on a tax filer's taxable
00:30:13
income not just based on their capital
00:30:15
gains alone as a reminder taxable income
00:30:19
includes many sources including wages
00:30:22
salary commissions bonuses unearned
00:30:24
income such as canceled debts or
00:30:26
government B benefits and then it
00:30:28
includes the capital gains themselves as
00:30:30
well as investment dividends and
00:30:32
interest all of those things combine to
00:30:35
create your taxable income and then your
00:30:38
capital gains tax bracket is based on
00:30:41
that taxable income so I'll just go
00:30:44
through there there's a table here in
00:30:45
the article in the show notes and I'm
00:30:47
not going to go through Section by
00:30:49
section of the table to read you the
00:30:50
entire long-term capital games tax rates
00:30:53
but long story short you can be taxed at
00:30:55
0% for the first 44 $4,000 15% from
00:31:00
44,000 up to
00:31:02
$500,000 and then 20% over
00:31:05
$500,000 now for a single filer what
00:31:08
that means if your total taxable income
00:31:12
Falls below 44,6 25 then you'll owe
00:31:16
nothing on any capital gains that is the
00:31:19
where the confusion comes in because
00:31:21
many people see that and they mistakenly
00:31:23
think that their first
00:31:25
44625 in cap capital gains is not taxed
00:31:29
which would be great well that's only
00:31:31
true if someone has no other taxable
00:31:33
income right because it looks at the
00:31:35
total taxable income if your total
00:31:37
taxable income is under 44,000 then none
00:31:40
of your capital gains are taxed there's
00:31:42
a really nice chart in the article in
00:31:45
the show notes that graphically shows
00:31:47
this showing some normal income some
00:31:50
deductions how your total income tax
00:31:53
works then how the capital gains are
00:31:54
stacked on top of that and then which
00:31:57
portion of the capital gains are taxed
00:32:00
so next when are capital gains taxes due
00:32:02
normal income tax is withheld from your
00:32:04
paycheck to make estimated tax payments
00:32:06
throughout the year now capital gains
00:32:08
are a bit different nevertheless you
00:32:10
should consider making capital gains tax
00:32:12
payments on a quarterly basis using
00:32:14
estimated tax payments in other words
00:32:17
you should not wait until the end of the
00:32:19
year to make a large lump some capital
00:32:21
gains tax payment instead you should
00:32:24
make estimated tax payments and and
00:32:26
there are some rules here about making
00:32:28
estimated tax payments you should
00:32:30
definitely make estimated quarterly tax
00:32:31
payments if you think that you'll owe a
00:32:34
capital gains tax of at least
00:32:36
$1,000 and your current year's tax
00:32:39
withholding is less than 90% of what you
00:32:42
owe for the year or less than 100% of
00:32:45
what you owed last year that's a little
00:32:47
bit confusing at least the way that
00:32:49
Andor logic and and some of the wording
00:32:52
there so a little example might clear
00:32:54
things up and this example and these
00:32:56
numbers are written out in the article
00:32:58
if you want to consult them there so
00:33:01
let's say last year John and Jamie
00:33:03
earned
00:33:04
$160,000 and they paid
00:33:07
20736 in federal taxes so income was 160
00:33:11
their federal taxes was approximately
00:33:14
$21,000 now this year their combined
00:33:16
salary is $170,000 and they're on Pace
00:33:18
to pay a federal withholding of
00:33:21
essentially
00:33:23
$23,000 but in February John and Jamie
00:33:26
decide to sell assets for a $50,000
00:33:28
long-term capital gain these capital
00:33:31
gains all happen to fall in the 15%
00:33:33
bracket based on their total taxable
00:33:37
income and that means that they're
00:33:38
incurring a tax burden a capital gains
00:33:41
tax burden of
00:33:42
$7500 the question is should John and
00:33:45
Jamie make estimated quarterly tax
00:33:47
payments so let's go back to those two
00:33:48
rules above are they going to owe
00:33:50
capital gains of at least $1,000 the
00:33:53
answer there is yes they're going to owe
00:33:54
7500 but then the second question is
00:33:57
is their current year withholding less
00:34:00
than 100% of what they owed last year
00:34:02
well the answer to that is no because
00:34:04
their current year withholding is on
00:34:05
Pace for
00:34:06
$23,000 and last year they owed $21,000
00:34:09
so they're definitely withholding enough
00:34:11
out of their normal taxable income
00:34:13
however is their current year
00:34:15
withholding less than 90% of what
00:34:17
they'll owe this year and the answer
00:34:19
there is yes because this year they're
00:34:21
going to owe 23,000 plus 7500 but
00:34:25
they're only withholding the 23,00 part
00:34:27
they're only withholding about 75% of
00:34:30
what they're going to owe which is under
00:34:31
the 90% threshold therefore the federal
00:34:35
government is going to say to them you
00:34:37
need to make up for that you need to
00:34:39
make some quarterly estimated tax
00:34:40
payments so that we the government are
00:34:43
going to receive at least 90% of what
00:34:45
you owe us throughout the year those
00:34:48
quarterly tax payments are due on April
00:34:50
15th June 15th September 15th and
00:34:52
January 15th that's boring logistical
00:34:54
stuff that you can Google okay next
00:34:57
topic can you set up a withholding for
00:35:00
capital gains this is one of Jennifer's
00:35:02
original questions above withholding is
00:35:04
a concept that comes from the income tax
00:35:06
world when a final tax bill is
00:35:08
predictable based on income the capital
00:35:11
gains world is not so clear the reason
00:35:14
why is because we have to ask questions
00:35:16
like well will there be more capital
00:35:17
gains later this year will there be
00:35:19
Capital losses to offset the capital
00:35:21
gains will you even owe capital gains
00:35:24
taxes or will you fall into the 0%
00:35:26
capital gains bracket for all those
00:35:28
reasons it's hard to set up a fixed
00:35:30
percentage withholding for capital gains
00:35:32
purposes instead many investors elect to
00:35:35
create a a DIY withholding account to
00:35:38
ensure that they maintain enough cash to
00:35:41
fully cover their capital gains tax
00:35:43
burden on a quarterly basis essentially
00:35:45
what it means is if you're the people we
00:35:47
talked about before John and Jamie you
00:35:49
sold assets for $50,000 in long-term
00:35:51
capital gains and you know that you owe
00:35:53
that $7500 you should set aside $7,500
00:35:56
in cash in your bank account to act as a
00:35:59
a personal withholding from which you're
00:36:01
going to make your your estimated
00:36:03
quarterly tax payments there's something
00:36:06
important to talk about here called the
00:36:07
net investment income tax the nii tax
00:36:11
the nii tax is relatively recent and it
00:36:14
effectively States or it effectively
00:36:16
acts I should say as an additional
00:36:18
capital gains tax at a 3.8% rate the nii
00:36:22
tax applies to investment income so only
00:36:25
investment income
00:36:27
above $200,000 if you're filing singly
00:36:30
or above $250,000 if you're filing
00:36:33
jointly and so what it really means is
00:36:35
that it applies to some of the 15%
00:36:39
capital gains bracket and it applies to
00:36:41
all of the 20% capital gains bracket in
00:36:45
other words there are effectively four
00:36:47
capital gains brackets it's not 0 15 and
00:36:49
20 it's zero and 15 but then part of the
00:36:54
15% bracket is affected by nii and
00:36:56
becomes for all intents and purposes an
00:36:59
18.8% capital gains tax and then all of
00:37:02
the 20% bracket is affected by nii so it
00:37:05
becomes a
00:37:06
23.8% capital gains tax
00:37:09
bracket let's get to some good stuff how
00:37:12
should you avoid or minimize capital
00:37:15
gains taxes I'm going to keep these tips
00:37:17
brief we can always go into more detail
00:37:19
reach out to me if you want more ideas
00:37:21
number one take advantage of tax
00:37:23
deferred investing accounts number two
00:37:25
invest for the long-term avoid
00:37:27
short-term capital gains tax rates
00:37:29
number three try to offset capital gains
00:37:31
with capital losses number four utilize
00:37:34
tax loss harvesting and carryover losses
00:37:36
to Future years number five utilize tax
00:37:39
gain harvesting in lowincome years
00:37:42
number six use the best accounting
00:37:44
methods for your situation from the
00:37:46
accounting methods we talked about
00:37:47
before number seven wait to die
00:37:50
seriously we'll we'll get into that one
00:37:52
later number eight asset location place
00:37:55
your high tax investments in qualified
00:37:58
accounts and place your low tax
00:38:00
investments in taxable accounts number
00:38:02
nine use high gains assets for your
00:38:05
donations the charity that you donate to
00:38:08
gets full value you pay no capital gains
00:38:10
taxes and you get a tax deduction and
00:38:13
number 10 you can use high gains assets
00:38:16
as loan collateral now I've never done
00:38:18
this and I'm not necessarily sure I
00:38:20
would recommend it but if you're looking
00:38:22
to avoid capital gains taxes you can
00:38:24
reach out to your brokerage firm many
00:38:26
firms offer loans against shares so you
00:38:30
can get a loan giving you some cash
00:38:32
liquidity that you need without selling
00:38:35
the underlying shares now let's go back
00:38:37
to number seven about waiting to Die the
00:38:39
question is well what if someone dies
00:38:41
who pays the capital gains taxes if
00:38:43
someone dies with a lot of unrealized
00:38:45
capital gains under current tax law if
00:38:48
you die and you leave High gains assets
00:38:51
to your heirs no capital gains tax will
00:38:54
be paid on the transfer nothing is paid
00:38:57
by your estate and nothing is paid by
00:38:59
your heirs now not only that but your
00:39:01
heirs they receed the assets on a
00:39:03
stepped up basis now what that means is
00:39:06
let's say you bought Apple in the year
00:39:08
2000 when it was less than $1 per share
00:39:11
and today it's
00:39:12
$166 per share if you sold it today that
00:39:16
$165 gain per share is subject to
00:39:19
capital gains but if you die today your
00:39:23
heirs will inherit those Apple shares at
00:39:25
A6 $6 cost basis if they sold the shares
00:39:29
tomorrow let's say it's the same price
00:39:31
tomorrow the IRS would look at that and
00:39:33
say you received the shares at 166 you
00:39:37
sold the shares at 166 there is no
00:39:39
capital gain and therefore no tax for
00:39:43
that reason capital gains tax planning
00:39:45
is especially important in retirement or
00:39:47
in older years it's especially important
00:39:50
for any assets that you plan on handing
00:39:52
down to your heirs or simply it's
00:39:54
important if you think you have enough
00:39:56
asset assets that you don't need to sell
00:39:58
and incur any capital gains you can just
00:40:00
wait to die and absolve yourself of any
00:40:03
unrealized capital gains taxes granted
00:40:07
that area of the tax code is hotly
00:40:09
debated and it's in legislative
00:40:11
crosshairs in general capital gains
00:40:14
taxes right a a tax on Capital they're
00:40:17
significantly lower than income taxes
00:40:19
which are a tax on labor and for a few
00:40:22
different reasons many people don't
00:40:24
really think that makes sense and think
00:40:27
that it's quite the loophole to allow
00:40:30
people to die and absolve themselves of
00:40:32
capital gains taxes kind of interesting
00:40:35
stuff okay everyone that is the episode
00:40:38
that is all I've got today on taxes I
00:40:41
hope it helped and if you have any
00:40:42
questions feel free to reach out thank
00:40:44
you again for
00:40:45
[Music]
00:40:47
listening thanks for tuning in to this
00:40:49
episode of the best interest podcast if
00:40:52
you have a question for Jesse to answer
00:40:54
on a future episode send him an email at
00:40:56
Jesse bestin interest. blog again that's
00:41:00
Jesse bestter interest. blog did you
00:41:03
enjoy the show subscribe rate and review
00:41:05
the podcast wherever you listen this
00:41:08
helps others find the show and invest in
00:41:10
knowledge themselves and we really
00:41:12
appreciate it we'll catch you on the
00:41:14
next episode of the best interest
00:41:16
[Music]
00:41:19
podcast the best interest podcast is a
00:41:21
personal podcast me for education and
00:41:24
entertainment it should not be taken as
00:41:26
Financial advice and is not prescriptive
00:41:28
of your financial
00:41:30
situation

Episode Highlights

  • Understanding Tax Brackets
    Tax brackets are progressive, meaning only the highest portion of income is taxed at the top rate.
    “Ben is wrong about how tax brackets work.”
    @ 02m 58s
    January 29, 2024
  • The Impact of Taxes on Investment Returns
    Taxes can significantly reduce investment returns, with taxable accounts seeing a 41% decrease.
    “Taxes decrease stock returns basically by 41%.”
    @ 14m 35s
    January 29, 2024
  • Roth vs. Traditional Accounts
    Choosing between Roth and traditional accounts depends on current vs. future tax rates.
    “It all depends on tax rates.”
    @ 19m 23s
    January 29, 2024
  • The Cost of Poor Decisions
    A quick math error and faulty logic can cost someone $120,000 in investing.
    “How can a quick math error plus some faulty logic cost someone $120,000?”
    @ 20m 51s
    January 29, 2024
  • Understanding Capital Gains Taxes
    Capital gains taxes can be complex, but understanding them is crucial for investors.
    “Capital gains are evidence that something good has happened; you’ve turned a profit!”
    @ 26m 35s
    January 29, 2024
  • Tax Strategies for Investors
    Learn how to minimize capital gains taxes with smart investing strategies.
    “Take advantage of tax-deferred investing accounts!”
    @ 37m 23s
    January 29, 2024
  • Understanding Capital Gains Taxes
    Exploring the implications of capital gains taxes and their perceived loopholes.
    “It's quite the loophole to allow people to die and absolve themselves of taxes.”
    @ 40m 30s
    January 29, 2024
  • Closing the Episode
    Wrapping up the episode with gratitude and an invitation for listener engagement.
    “Thanks for tuning in to this episode of the best interest podcast!”
    @ 40m 47s
    January 29, 2024

Episode Quotes

Key Moments

  • Tax Season00:08
  • Tax Misconceptions05:44
  • Investment Strategies06:46
  • Investment Returns11:00
  • Math Matters23:27
  • Capital Gains Basics26:05
  • Tax Strategies37:21
  • Podcast Conclusion40:47

Words per Minute Over Time

Vibes Breakdown

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