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Welcome to personal finance for
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long-term investors, where we believe
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Benjamin Franklin's advice that an
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investment in knowledge pays the best
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interest both in finances and in your
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life. Every episode teaches you personal
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finance and long-term investing in
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simple terms. Now, here's your host,
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Jesse Kramer. Hello, and welcome to
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episode 113 of Personal Finance for
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Long-Term Investors. My name is Jesse
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Kramer. By day, I work for a fiduciary
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wealth management firm helping clients
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all over the country. For more details,
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you can go to bestinterest.blog/work.
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Link is in the show notes. And by night,
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I write a blog called The Best Interest
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and I podcast here on personal finance
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for long-term investors. I help busy
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professionals and retirees avoid costly
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mistakes and grow their wealth by
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simplifying complex ideas about personal
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finance from investing to taxes to
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retirement and beyond. And today is
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another one of our popular AMA episodes
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with some incredible questions including
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do social security and a pension replace
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bonds in our retirement portfolios.
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Another question about long-term care
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insurance what the costbenefit analysis
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of that is. Some questions about
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taxation and distribution of inheritance
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assets about RSUs, ISOs, other forms of
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equity compensation. A really good
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question about timing the market,
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especially now with the market at
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all-time highs. and a final question
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about the possible nasty interactions of
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RMDs that's required minimum
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distributions and the sequence of
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returns risk. But before we get into
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those questions, we have a review of the
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week from Brian 8110 who wrote in and
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said, "An informative podcast. I
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discovered this podcast a couple months
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ago and it's become a must listen. Jesse
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shared an HSA strategy in his latest
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episode I'd never heard of before.
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Saving receipts but letting the money
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grow tax-free instead of withdrawing it
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immediately." It's impressive how Jesse
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can break down these complex topics into
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a very clear and easy to understand way.
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Well, Brian, thank you very much for
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those kind words and the five-star
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review. I'd be happy to send you a super
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soft podcast t-shirt, Brian, just drop
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me an email to [email protected].
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And listeners, before we start this AMA
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episode, as always, if you have
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questions that I can help answer,
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especially if they're for a future ask
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me anything AMA episode, you can send
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those questions to my email,
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Okay, the first question today is from
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Cedar. Cedar like the tree. Cedar says,
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"I would like to hear more about
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diversification in a portfolio with
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examples. For myself, I am retired. I
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have a pension. I have social security
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and investment income. I don't own any
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bonds and I consider my pension and
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social security to be the fixed income
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portion of my portfolio. Most of the
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rest is in the S&P 500." So, listeners,
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this is a great and simple, somewhat
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universal question to start today. And
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the question really is, does everyone
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need bonds? And if not, why not? when or
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why might we need bonds in our
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portfolio. How do we answer this
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question for ourselves based on our own
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circumstances? And then I will go one
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step further and address what Cedar says
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at the end of his kind of
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question/statement, which is that most
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of the rest of his money is in the S&P
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500. To address the bond portion of the
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question, I want to start off with two
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important ideas. One, the first is
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called asset liability matching. It's
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one of the underpinnings of my financial
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planning process. And then the second
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idea is just a more simple and universal
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idea about the expectations for stocks
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versus bonds over various time periods.
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Asset liability matching. I have a
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really in-depth article that I'm going
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to link into the show notes that uses
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real examples with, you know, real ETFs
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from a real portfolio. The problem is
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it's kind of hard with all the numbers
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going on in that portfolio to adequately
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explain it over podcast, right? And make
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more sense for you guys to be able to
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see it with your eyes. So that's why I
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think it makes sense to go read that
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article in the show notes. But in short,
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okay, the concept of asset liability
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matching says in order for me to
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understand what assets I need to own, I
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first need to understand what my future
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liabilities are. Not necessarily
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liabilities in terms of like debts that
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you owe someone today, but really it's
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this idea of what's the liability in
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terms of what your portfolio needs to do
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for you in future years. So if you think
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of a very kind of typical average Joe,
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average Jane retiree who says, "Well, I
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have XYZ going for me. Maybe I have some
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social security. Maybe I have a pension
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like Cedar, etc., etc. But then after
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all that is said and done, I still need
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my portfolio to produce $50,000 a year
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in income for me. That's what I need for
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my portfolio. That's the living expenses
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that my financial plan tells me I have.
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And my portfolio is is where that
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$50,000 per year needs to come from. And
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if we assume average Joe and average
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Jane, they just are um kind of living
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the same year like Groundhog Day over
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and over and over again, we can say,
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okay, well, $50,000 per year, that's
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your quote unquote liability. That's the
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need that we require from your
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portfolio. And thus, whether it's here
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in 2025, they need $50,000. 2026, they
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need $50,000 inflation adjusted, 2027,
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on and on and on. And I can think about
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that asset's volatility and I can think
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about that asset's expected return when
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it comes to how much of a particular
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asset I need to match up to each future
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liability. For example, if this person
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needs $50,000 from their portfolio here
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in 2025, well, that's a very short
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timeline. That's a very short timeline
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to their need. Their need is occurring
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over these next few months. And
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therefore, I can't take stock risk over
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that kind of timeline. I probably need
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to match something like a money market
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fund or just a very low duration US
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Treasury bond to that liability. And if
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they need $50,000 from their portfolio
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this year, well, that money should all
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probably be in very low risk, very short
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duration bonds. But once I look out to
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say the year 2035 or the year 2045 in
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their financial plan and they still need
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$50,000 from their portfolio in each of
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those years, well, that's where I say,
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boy, if I have 10 or 15 or 20 or more
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years to grow these assets, I can start
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to take some risk. Maybe I can start to
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own stocks, even majority stocks for
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those future liabilities. And if I am
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owning stocks for that future liability,
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I don't have to assume zero return like
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I might with a bond. Yeah. You know,
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with a bond, I I pretty much have to
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assume that my return is simply going to
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match inflation, probably not beat
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inflation. And therefore, each future
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liability needs to be matched pretty
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close one to one in in terms of dollars
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today invested in a bond. Whereas with a
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liability that's so far out in the
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future, I can start to invest in stocks.
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That's where I can say, well, this
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liability that I have in the year, say
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2040, it's 15 years from now. I don't
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need to match 100% of that liability
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with stocks today because I assume that
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my stocks will grow. So maybe I only
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match that liability I assume a a 6%
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real rate of return and I only match
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that liability with say $20,000 today
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assuming that the $20,000 is going to
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grow up to $50,000 by the time I need it
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in the year 2040. That's the concept of
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asset liability matching. And going back
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to Cedar in his question today, I would
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say, well, Cedar, you know, does your
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security and your pension, your typical
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investment income that you mentioned,
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does that cover 100% of your annual
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expenditures? If the answer is yes, then
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your portfolio doesn't have any glaring
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short-term requirements. All your
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short-term liabilities are fully covered
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by the fixed income from social
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security, from your pension, from your
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investment income. And you might not
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have any need for bonds at all, right?
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because all those short-term liabilities
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are already covered. Now, that would beg
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a bigger and more broad question, which
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is, well, what is your portfolio for
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then? Is it going to just compound
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forever and then you leave it to your
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kids or to charity? Or should you adjust
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your financial plan such that you
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actually start spending some of your
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portfolio on an annual basis, which
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probably just means living life a little
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bit more, in which case there will be a
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short-term requirement for your
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portfolio. And all of a sudden, bonds
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begin to make sense from an asset
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liability matching point of view. you
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you're going to have that short-term
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requirement, those short-term
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liabilities from your portfolio, and
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those ought to be matched with a
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short-term asset like bonds. But now, I
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I do want to share a simple idea right
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now about our expectations for stocks
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and bonds. It's an idea that certainly
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can be explained a dozen different ways,
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but this way in particular, I think is
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very helpful. And I just want to start
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with a simple question, which is what
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will a diversified stock portfolio
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return this year or next year or the
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year after that? Now, I think if your
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answer is anything other than the
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phrase, I don't know, I think that's a
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problem. To me, short-term stock returns
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are absolutely a mysterious black box.
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Kind of like Schroinger's cat. It's
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Schroinger's investment. We just don't
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know what the returns are going to be
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over the short term. And therefore, if
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short-term portfolio returns are vital
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to your survival, then stocks simply
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aren't the asset for you. This is a a
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truism, a a simple and universal truism
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of investing. We need a different asset
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class for the short term. But on the
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flip side of the coin, if you need your
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portfolio to last you for decades, then
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all of a sudden stocks come into focus.
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We can use the long-term average of
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stock returns to smooth out any
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short-term uncertainty. Now, just
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because we're thinking long-term, it
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doesn't lead to a guarantee. It doesn't
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lead to 100% certainty. We can't quite
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peer through the foggy future that
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clearly, but it certainly becomes better
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if we zoom out on stock returns. And by
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measuring in a zoomed out way, by
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measuring over decades, we get this
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really convenient side effect, which is
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that we start to see the incredible
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power of compounding. So exactly what do
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I mean? Well, the basic investor might
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say that stocks return 10% per year and
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bonds return 5% per year and cash
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returns 3% per year, whatever percentage
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they want to use. But it doesn't really
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matter because the underlying framework
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of that is flawed for so many reasons.
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First, for the reason we already
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covered, stocks are just too volatile to
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make any reasonable one-year predictions
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or averages. And second, such a
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zoomed-in myopic view overlooks the
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concept of compounding. Now, one could
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look at those one-year averages and
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think, "Oh, well, bonds return about
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half of what stocks return. So, that's
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not great, but it's not bad." However,
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as you'll see in in a few seconds,
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that's also just a very flawed
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conclusion because instead, I'd implore
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long-term investors like us to think for
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decades and to think not in nominal
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terms, but instead to consider the
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undeniable impacts of inflation and
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taxes. And when we do that, when we
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think in real inflationadjusted after
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tax returns and we we think about them
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over decades, we come to the conclusion
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that for a reasonable 30-year period,
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I'm focusing on 30-year period right
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now, we see that stocks will compound
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our wealth by 300 to 400%. That bonds
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will compound our real wealth by 0% and
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that cash will lose 25 to 50% of our
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real wealth over that time. Those
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numbers might surprise you, maybe even
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shock you. I think that's a good thing.
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Now, yes, those are actual historical
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numbers using actual inflation data,
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actual tax rates, actual investment
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returns. Stocks compound our real wealth
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by 300 to 400%. Bonds compound our real
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wealth by zero and then cash loses 25 to
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50% of our real wealth. And so we see
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that bond returns aren't half of stock
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returns. It's not a fractional
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difference. They are orders of magnitude
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different. Now, bonds essentially do
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nothing over the long run. cash gets
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decimated over the long run, whereas
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stocks show real positive growth. So, it
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isn't really apples and oranges.
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Instead, it's night and day. And that
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begs a question, why should we own any
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bonds then? Right? This gets back to the
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question that Cedar submitted. Why
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should he own any bonds? To answer that
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question, we kind of have to go back to
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the beginning of this particular little
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uh stanza Quinton Tarantino style where
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I said, "The simple truth is that I
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don't know what stocks will return this
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year." It's just that simple. Stock
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returns cannot be relied upon. cannot be
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relied upon in the short or the medium
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term. And instead, we must use a more
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dependable, a less volatile asset for
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those future cash outlays. And then cash
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or bonds, those are suitable choices for
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such short-term outlays. And we must
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accept the lower returns from those
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assets as the price to pay for their
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lower risk for their guarantee. It's a
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continuation of asset liability
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matching, that concept we just
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discussed. However, bonds and cash do
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not provide long-term growth. Instead,
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the underlying growth engine of your
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portfolio has to come from real uh risk
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assets, actual risk assets like stocks
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to achieve that growth. However, higher
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volatility is the price that we have to
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pay. So, nothing is free. So, I hope
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that you start to see now that nothing
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is free. If you need higher growth,
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there's a cost and the cost is more
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volatility. If you need greater
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stability, there's also a cost there.
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The cost there is less growth. But
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that's why we diversify across asset
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classes. That's why we own both stocks
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and bonds, real estate alternatives,
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etc. If you want them to, they serve
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different simple important purposes. But
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the big one is different purposes. They
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serve different purposes. And that's why
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our measurement period, whether it's
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months or years or decades, that's why
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it really matters. So going back to
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Cedar's original question, if he owns
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100% stocks, should he own some bonds? I
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would think along those lines. Again, if
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he has short-term needs, bonds are the
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answer. If he doesn't, I could
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understand why he doesn't own any bonds.
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But last, the idea of having all of his
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portfolio in the S&P 500. This is the
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exact same question I answered back in
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the very first AMA episode, episode 81
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of the podcast. So, go back and give
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that a listen, but I'll give you some of
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the cliff notes right now. And the
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hypothetical I put out there back in the
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first AMA, episode 81 was uh let's
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imagine it's 1985. I'm living here in
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Rochester, New York, as I do. I'm close
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to 100% in Kodak. 100% of my portfolio
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owns Kodak stock. And it's worked great
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for me for a long time now. As more time
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has gone by, I've actually sold out of
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some of the rest of my portfolio and
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just gone all in on Kodak. And it's hard
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for me to see why that isn't a good
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strategy going forward. Now, that
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particular example probably sounds
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crazy. We'd never go 100% into one
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single company. And of course, I have
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cherrypicked a company that we now know
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with the benefit of hindsight went
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bankrupt. But some of the underlying
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principles here should ring true. Cedar,
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you own one single asset class. You have
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no other diversifying assets. You're all
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in on the USA. You have no geographic
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diversification. You're all in on large
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cap companies, S&P 500. You own just,
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you know, the 500 biggest companies in
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the world, which is fine, and it really
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is. It's far far far from the worst
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asset allocation I've ever seen. I just
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think it could benefit from some
00:14:04
polishing. I think we cannot and we
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should not say that the recent past has
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been one specific way and therefore that
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the future is going to be that that
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exact same way. that the recent past has
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been most beneficial for investors in
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large cap stocks and therefore the
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future will also be most beneficial for
00:14:21
investors in large cap stocks. It could
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be that way but I highly doubt it. And I
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think first we need to simply accept the
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fact that we can't predict the future
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and that in investing especially the
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past does not dictate the future. But
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more so Cedar I want to impart John
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Bogle's famous iron rule of investing to
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you which is reversion to the mean. No
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asset class can outperform forever. And
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when an asset class does outperform one
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decade, it tends to underperform the
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next decade. Reversion to the mean. In
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the long run, asset classes with a
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similar risk profile, for example,
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domestic stocks and international
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stocks, they have a similar risk profile
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to one another. In the long run, they
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also tend to have a similar reward
00:15:01
profile. Which means that when their
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reward profiles fall out of sync, when
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one is just beating up on the other,
00:15:08
much in the way that US stocks have beat
00:15:10
up on international stocks over the last
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15 years, eventually they will tend to
00:15:14
revert because they have similar risk
00:15:16
profiles. They ought to have similar
00:15:18
reward profiles. So, in a vacuum, Cedar,
00:15:20
my gut tells me that international
00:15:22
diversification and small and midcap
00:15:24
diversification would likely yield some
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long-term benefits for you. Anyway,
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thank you very much for the excellent
00:15:29
question. Okay, away from investing now
00:15:33
into a a deep planning topic. Michelle
00:15:35
wrote in for question number two, and
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Michelle asks, "Can you talk about
00:15:38
long-term care insurance? What
00:15:40
situations call for buying it? When
00:15:42
should you avoid it?" It seems like
00:15:43
there's a a cost benefit analysis that
00:15:45
can be done here along with risk
00:15:47
tolerance for self-insuring for your own
00:15:49
long-term plan versus buying insurance.
00:15:51
So, yes, excellent question, Michelle.
00:15:53
Let's do a deep dive on long-term care
00:15:55
insurance. So, long-term care, I'll
00:15:57
probably call it LTC throughout this
00:15:59
answer here. LTC insurance, well, LTC
00:16:02
itself refers to the help you might need
00:16:04
when you can no longer perform basic
00:16:06
daily tasks on your own. Stuff like
00:16:07
bathing, dressing, eating, using the
00:16:10
bathroom. To be clear, LTC is not
00:16:12
medical care. I think that's something
00:16:14
that from the financial, you know, we
00:16:15
aren't medical professionals. It might
00:16:17
be easy to confuse, but LTC is not
00:16:19
medical care. It's not hospital stays.
00:16:22
It's not RN nursing. It's human help.
00:16:25
LTC is human help. It might come from a
00:16:27
home health aid or an assisted living
00:16:30
facility or a nursing home. Generally,
00:16:32
Medicare, Medicare does not cover LTC.
00:16:36
It does not cover custodial care in
00:16:38
nursing homes or assisted living
00:16:39
facilities. Now, Medicare might cover
00:16:42
some skilled care services in certain
00:16:44
situations like short-term skilled
00:16:46
nursing facility after a qualifying
00:16:49
hospital stay because there's an acute
00:16:51
medical care need there instead of
00:16:53
ongoing non-medical care. But LTC is not
00:16:57
medical assistance. It's simply human
00:17:00
assistance to help people bathing,
00:17:02
dressing, eating, using the bathroom,
00:17:03
some of those daily tasks. And the cost
00:17:05
of LTC can be pretty jaw-dropping. Now
00:17:08
for home health care for someone coming
00:17:10
into an elderly person's home and
00:17:12
helping them there easily we can see
00:17:14
numbers in the 60 70 $80,000 per year.
00:17:17
Assisted living again upper five figures
00:17:20
per year. Nursing homes can easily get
00:17:23
into the six figures 100 to $150,000 per
00:17:26
year depending on the location or level
00:17:28
of care. Memory care can cost even more
00:17:30
than that. Now the average duration for
00:17:33
an LTC stay is 2 to 3 years for men or 3
00:17:37
to four years from women. Now that's
00:17:39
average. So some people might need more
00:17:41
care than that. So there is a real
00:17:43
financial risk here. A risk of needing
00:17:45
expensive prolonged care later in life.
00:17:48
If you take those averages 2 to 3 to
00:17:49
four years for men or women and multiply
00:17:52
them by the cost per year I just
00:17:53
mentioned before, you can easily get a4
00:17:56
million a half million dollars or more
00:17:58
for LTC costs. So that's where LTC
00:18:02
insurance comes into play. LTC insurance
00:18:05
is designed to help pay for those future
00:18:07
costs. You pay premiums now just like
00:18:09
you would with other insurance products.
00:18:11
And in return, the insurer agrees to
00:18:13
cover the future long-term care expenses
00:18:15
within some limits. And that sounds
00:18:17
pretty smart. And sometimes it is and
00:18:20
sometimes it isn't because there is and
00:18:22
there are some pretty big problems with
00:18:24
LTC insurance. Now, if we rewind back to
00:18:27
the early 2000s, LTC insurance was
00:18:29
affordable and popular, and insurers
00:18:32
were pretty sure they'd found a gold
00:18:33
mine. The insurance companies, they
00:18:35
needed to make some assumptions, of
00:18:36
course, and predictions, of course, in
00:18:38
order to properly price their LTC
00:18:40
insurance. They needed to answer
00:18:42
questions like, "How long will people
00:18:43
live and how much care will they need?
00:18:45
How expensive will that care be? How
00:18:47
will the insurance company's float
00:18:49
perform in the meantime?" And okay, a
00:18:51
quick aside, that term float, it is a
00:18:53
little bit jargony. So, imagine you're
00:18:54
running Geico or State Farm. Every
00:18:56
month, all of your customers, they send
00:18:57
in their monthly premium payments, and
00:18:59
that's a lot of money. Now, as the
00:19:01
insurance company, you know that a lot
00:19:03
of that money that just came in is
00:19:04
eventually going to have to go back out
00:19:06
to your customers to pay for future
00:19:08
insurance claims. But in the meantime,
00:19:10
you've got a bunch of their cash on
00:19:11
hand. That cash is called float. It's
00:19:14
money that the insurance company can
00:19:15
quote unquote play with, so to speak,
00:19:17
but the money that the company knows
00:19:19
that it can't keep forever. And many
00:19:21
insurance companies, they choose some
00:19:22
typically conservative investment
00:19:24
philosophy to earn a little bit of extra
00:19:26
return on their float. And float is in
00:19:29
short one of the unsung keys and and
00:19:31
probably one of the main drivers of
00:19:33
Warren Buffett's long-term success.
00:19:35
Berkshire Hathaway is roughly one-third
00:19:37
of its value is is as an insurance
00:19:39
company. And you better believe that
00:19:40
insurance flow played a huge part in his
00:19:42
investment returns over time. But
00:19:44
anyway, back to LTC insurance. The LTC
00:19:47
insurers underestimated three big pretty
00:19:50
big things. is between the early 2000s
00:19:51
and today. People are living longer than
00:19:53
expected. More people need LTC than they
00:19:56
assumed and it's more expensive than
00:19:58
they assumed and interest rates fell and
00:20:00
they stayed pretty low hurting the
00:20:02
insurers's investment returns, the
00:20:04
returns on float over that time. And the
00:20:07
result is that insurers simply mispriced
00:20:10
the risk of long-term care. So, they
00:20:12
ended up doing two things and those two
00:20:14
things have occurred kind of over the
00:20:15
last 10 years. they've drastically
00:20:17
raised the premiums, drastically raised
00:20:19
the cost of LTC insurance for people
00:20:21
like us, or they've pulled out of the
00:20:24
LTC market entirely. And that's why
00:20:26
today's LTC insurance policies are more
00:20:29
expensive, less generous, and harder to
00:20:31
find than they were 20 years ago. It's
00:20:33
also why many people who bought policies
00:20:35
in the early 2000s feel pretty burned
00:20:37
because they bought into a promise and
00:20:38
then they saw their premiums skyrocket
00:20:40
or they saw their coverage get cancelled
00:20:42
altogether. So, should you buy LTC
00:20:45
insurance today? And here's where things
00:20:47
get pretty nuanced because essentially,
00:20:49
like all insurance, it's a risk transfer
00:20:52
decision. You're asking, "Do I want to
00:20:54
pay a known cost, the insurance
00:20:56
premiums, to avoid an unknown future
00:20:58
cost of long-term care?" And here's how
00:21:00
I frame it with clients. Who should
00:21:03
consider LTC insurance? Well, first, you
00:21:06
have to be wealthy enough to afford it,
00:21:08
but not wealthy enough to self-insure.
00:21:10
So, if you have, say, 500,000 to 2.5
00:21:14
million in investable assets, a
00:21:16
long-term care event might seriously
00:21:18
dent your finances or impact your
00:21:20
spouse's well-being, insurance might be
00:21:22
worth exploring. If you're concerned
00:21:25
about legacy or spousal care, some
00:21:27
people aren't that worried about
00:21:28
themselves, but instead they're worried
00:21:30
about burdening their spouse or their
00:21:32
children. So, LTC insurance can provide
00:21:34
some peace of mind and some dignity to
00:21:36
those cases. The third reason, if you
00:21:38
are insurable and in good health. So,
00:21:40
not everyone qualifies for LTC
00:21:42
insurance. The underwriting can be
00:21:43
really strict and you need to pass a
00:21:45
health screening, especially if you're
00:21:46
over 60. And so, you should consider LTC
00:21:49
insurance if you're buying in your 50s.
00:21:51
Premiums are most reasonable in your
00:21:53
50s. Waiting until your 60s or 70s, not
00:21:55
only will it be more expensive, but
00:21:57
you're less likely to qualify at all.
00:21:59
The question there is, do you want to
00:22:00
potentially pay for three or four
00:22:02
decades of insurance premiums for an
00:22:05
unknown future payoffs? That's really
00:22:06
the trade. That's the transfer of risk.
00:22:08
And it's just one of those things where
00:22:10
the transfer of the risk is risky in and
00:22:12
of itself because it's so far off in the
00:22:14
future. So, who should avoid LTC
00:22:16
insurance? Well, the truly wealthy
00:22:18
should. And this is a bit of me pulling
00:22:20
a number out of a hat, but if you've
00:22:22
got, say, $45 million or more and you
00:22:25
have no strong desire to preserve assets
00:22:27
for your heirs, you can probably just
00:22:29
self-insure, right? You can take the
00:22:31
cost of LTC. You can take it on the
00:22:33
chin, so to speak. You can earmark a
00:22:35
portion of your portfolio for those
00:22:37
future care costs. who can self-insure.
00:22:39
If you're a lowincome household, though,
00:22:40
if you don't have significant assets,
00:22:42
Medicaid will eventually step up and
00:22:44
step in to provide long-term care
00:22:46
coverage, albeit with limitations on
00:22:48
quality and choice. LTC insurance just
00:22:51
doesn't make sense here. It's not
00:22:52
practical here. And yes, there's an idea
00:22:53
I've alluded to before, a
00:22:55
semic-controversial practice called
00:22:56
Medicaid planning, where people they
00:22:59
think a few years ahead. They
00:23:00
intentionally shelter their assets using
00:23:02
trusts and then by doing so they qualify
00:23:06
for Medicaid support even if otherwise
00:23:09
you wouldn't think that they qualify for
00:23:10
Medicaid but by sheltering their assets
00:23:13
in such a way they do and that's why
00:23:15
it's a little bit controversial. And
00:23:17
then the third group of people who
00:23:18
should avoid LTC insurance if you're a
00:23:20
risk tolerant DIYer. Some people are
00:23:22
simply comfortable rolling the dice.
00:23:24
they're fine setting aside a pool of
00:23:25
money for potential care costs and they
00:23:28
don't really see the need to further
00:23:29
risk out to an insurance company because
00:23:31
buying long-term care insurance is a
00:23:34
bet, right? You're betting that the care
00:23:35
will be expensive and you're betting
00:23:37
that you will need the LTC care to begin
00:23:39
with and the insurer is betting that you
00:23:42
won't. So, what matters is to understand
00:23:44
your risks, to understand if you can
00:23:45
afford the premiums, to understand if
00:23:47
needing care would drain your spouse or
00:23:50
drain your family, and if long-term care
00:23:52
and LTC insurance policy would offer
00:23:54
some sort of meaningful peace of mind.
00:23:56
So, thank you for that question,
00:23:58
Michelle. Here's a quick ad, and then
00:24:00
we'll get back to the show. I still
00:24:02
remember it was 2019 and a guy from
00:24:04
Fidelity came in to speak to my then
00:24:06
employer about personal finance in
00:24:08
general and about our 401k plan in
00:24:10
particular. There were 60 or so of us
00:24:12
who attended, mostly 50 plus years old,
00:24:15
clearly with retirement on their minds.
00:24:17
And nothing against this individual from
00:24:19
Fidelity, but unfortunately the guy just
00:24:21
didn't really know what he was talking
00:24:22
about. It ended up being a major
00:24:23
disappointment. And a bunch of my
00:24:25
colleagues afterwards said, in short,
00:24:27
you know, man, we're really thirsty for
00:24:29
good financial retirement information.
00:24:31
Where do we go find it? Now, does that
00:24:33
sound true, listeners, for you and your
00:24:35
colleagues? Last year, either in person
00:24:38
or via Zoom, I spoke to about 800
00:24:40
employees at 11 different organizations.
00:24:43
Sometimes about personal finance in
00:24:44
general, sometimes about specifics of
00:24:46
their retirement plans, sometimes about
00:24:48
the the nitty-gritty details of social
00:24:50
security and withdrawal planning and
00:24:51
retirement math. The point being, if
00:24:54
you're interested in inviting me to come
00:24:56
talk money to you, to your colleagues
00:24:57
where you work, that is absolutely
00:24:59
something I'm interested in talking to
00:25:01
you about. Simply drop me an email to
00:25:03
jessebinest.blog blog and let's start a
00:25:05
conversation. Now, on to question three.
00:25:08
Chris asks for a deep dive on the
00:25:10
taxation and the distribution of
00:25:12
inheritance assets. So, this is
00:25:15
something over the coming decades that
00:25:16
topic is going to be more and more
00:25:18
important. It's going to affect many of
00:25:19
us listening here today. To start, I
00:25:21
think it helps that we baseline
00:25:22
ourselves with the understanding of how
00:25:24
assets can be passed down to heirs in
00:25:25
the first place because they're really
00:25:27
only a few options. The first one, via a
00:25:29
will, right? A deedent, a person who
00:25:31
passes away, they specify in their last
00:25:33
will and testament who should receive
00:25:35
their assets. Could include cash,
00:25:37
investments, property, personal items.
00:25:40
Those assets will pass through probate,
00:25:42
which is a court supervised legal
00:25:43
process of settling an estate. And the
00:25:46
pro is that the deedent gets to direct
00:25:48
exactly who gets what. The con is that
00:25:51
probate can be a slow process, is a
00:25:54
public process, and can be sometimes an
00:25:56
expensive process. The second way that
00:25:58
we can pass down assets to our heirs is
00:26:00
by beneficiary designation. So some
00:26:02
assets, they bypass probate entirely.
00:26:04
They go directly to a person who is
00:26:06
named as a beneficiary. So this includes
00:26:08
assets that are in retirement accounts.
00:26:10
Right? In our IAS and 401ks, we name a
00:26:12
beneficiary. Life insurance policies
00:26:14
transfer on death accounts, payable on
00:26:17
death accounts, annuities. These assets
00:26:19
transfer automatically upon death to the
00:26:21
named beneficiary regardless of what the
00:26:24
will says. So, this is a fast and and
00:26:26
private way of passing down assets. The
00:26:29
con would be though, if beneficiaries
00:26:30
aren't updated, outdated designations
00:26:33
can cause some very unfortunate and
00:26:35
unintended outcomes. A third way that we
00:26:38
can pass assets to heirs is through a
00:26:39
trust. If a deedent sets up a trust, and
00:26:42
we'll get more into trusts in a little
00:26:43
bit, then the trust rather than the
00:26:45
person directly now owns the assets.
00:26:47
Upon death, a trust document can act as
00:26:50
the instructions for how assets should
00:26:52
be distributed. Again, a pro of this is
00:26:54
that it avoids probate. It maintains
00:26:56
privacy. It maintains control for the
00:26:58
deedent on how and when money is
00:27:00
distributed. But the con, it's usually
00:27:03
significantly more expensive and complex
00:27:05
to set up than a will. A fourth way, and
00:27:08
not exactly a good way that assets can
00:27:10
pass down to our heirs, is by state law
00:27:12
or intestasy. If someone dies without a
00:27:15
will or a trust, their estate is
00:27:17
distributed based on the laws of
00:27:18
intestasy in their state of residence.
00:27:20
Those laws create some sort of default
00:27:22
hierarchy of inheritance. Typically, you
00:27:24
know, the spouse is first, the children
00:27:26
are next, the parents are after that,
00:27:28
the siblings are after that, and then,
00:27:31
you know, if those people don't exist,
00:27:32
it's cousins and second cousins and
00:27:34
third aunts, whatever. The pro, okay,
00:27:36
yeah, ensures that assets eventually get
00:27:38
distributed. But the con is that there's
00:27:39
absolutely no control. The money may go
00:27:41
to heirs. It can cause family disputes.
00:27:44
So, this is one that we want to avoid at
00:27:46
all costs if we can. And then the last
00:27:48
one, although maybe this does belong in
00:27:49
the category with beneficiary
00:27:51
designation, I just carved it out on its
00:27:52
own. It's just joint ownership or joint
00:27:54
ownership with rights of survivorship.
00:27:56
Essentially, assets held jointly, like a
00:27:58
joint bank account or a real estate
00:28:00
deed, they pass automatically to the
00:28:02
surviving co-owner or a surviving
00:28:04
spouse, something like that. Very common
00:28:06
with married couples. It can be quite
00:28:08
common actually with aging parents who
00:28:10
have adult children. Sometimes the adult
00:28:11
children will come on as a joint owner
00:28:13
of an account or a joint owner of a
00:28:15
house because again it's simple to do
00:28:17
and it avoids probate. However, it's
00:28:20
worth consulting with some professionals
00:28:22
first because it can lead to some
00:28:23
complications or tax issues if not
00:28:26
structured carefully. Now, how do each
00:28:28
of these different inheritance pathways
00:28:29
handle the distribution of assets of the
00:28:31
taxation? Right, that's the question at
00:28:33
hand. So, first let's talk about a will.
00:28:36
The distribution of assets occurs
00:28:38
according to the directives of the will.
00:28:39
it's executed by the named executive of
00:28:42
the will. So this might mean something
00:28:44
like retitling financial accounts,
00:28:46
retitling real estate or other personal
00:28:48
property into the named beneficiaries
00:28:51
names. It could mean selling those
00:28:53
assets and we're transferring other
00:28:55
assets per the will's instructions. Now
00:28:58
for taxation, here's where people get a
00:29:00
little nervous. Most of the time
00:29:02
beneficiaries don't owe any sort of
00:29:04
taxes on inherited assets. Now, still
00:29:07
there are some exceptions and some
00:29:09
nuances. The estate tax is a big one.
00:29:11
The estate tax is a tax on the deceased
00:29:13
person's estate, not on the
00:29:15
beneficiaries. So, for 2025, the federal
00:29:18
estate tax exemption is around $14
00:29:20
million per person, meaning like 99.8%
00:29:24
of estates will not do not owe it. Some
00:29:27
states though, they do have their own
00:29:28
estate or inheritance taxes, but usually
00:29:31
at much lower thresholds. So, in other
00:29:33
words, some states will tax a deceased
00:29:36
person at thresholds lower than 14
00:29:38
million. After some quick Googling, I
00:29:40
think Oregon has the lowest state estate
00:29:42
tax with a $1 million threshold before
00:29:45
their estate tax kicks in. So, if
00:29:47
someone dies in Oregon with say $3
00:29:49
million, the first 1 million won't be
00:29:52
subject to an estate tax, but above that
00:29:54
$1 million threshold, it will be subject
00:29:56
to an estate tax. And there are five
00:29:58
states with an inheritance tax.
00:30:00
Kentucky, Maryland, Nebraska, New
00:30:03
Jersey, and Pennsylvania. So in those
00:30:05
states, it's not the deceased person who
00:30:07
gets taxed. It's actually the person who
00:30:08
receives the inheritance who gets taxed.
00:30:11
Just good to know. Now, as far as the
00:30:13
taxes though, there is a step up in
00:30:15
basis for these assets passed through a
00:30:18
will, which is important to know about.
00:30:19
For appreciated assets like stocks or
00:30:21
real estate beneficiaries, they don't
00:30:23
receive assets based on what the deedent
00:30:26
paid for them, but instead they receive
00:30:28
assets at a basis based on the assets
00:30:31
value at the date of death. Which means
00:30:33
in short no capital gains tax is owed if
00:30:37
they sell those assets immediately upon
00:30:39
inheriting them. Now, this is a huge
00:30:41
benefit. It essentially wipes out wipes
00:30:44
away potentially decades of unrealized
00:30:46
gains for tax purposes. Now, when assets
00:30:49
are passed by beneficiary designation,
00:30:52
the second way, so we're we're moving on
00:30:54
past the will. Now, we're moving to
00:30:55
beneficiary designation like IRA
00:30:57
accounts or 401k accounts or or
00:30:59
insurance policies. Things look a little
00:31:01
different. Now, the most common example
00:31:03
that I want to get into today, cuz it's
00:31:04
something that's very likely to affect
00:31:06
many of us listening is that you might
00:31:08
inherit an old IRA or an old 401k. You'd
00:31:11
been named the beneficiary. And so, the
00:31:13
question is, how does the distribution
00:31:14
and taxation work?
00:31:16
The distribution is fairly
00:31:17
straightforward. Typically, the deedence
00:31:19
custodian would set up an inherited IRA
00:31:22
account for the beneficiary and then
00:31:24
they would move the proper amount of
00:31:26
assets from the deedence account into
00:31:28
the inherited IRA and from there the
00:31:31
beneficiary or the inheritor is free to
00:31:33
transfer the inherited IRA account to
00:31:35
their custodian of choice. So, as an
00:31:37
example, grandma dies, grandma has an
00:31:39
IRA at Vanguard, naming you as the sole
00:31:42
beneficiary. So Vanguard is going to
00:31:44
create an inherited IRA account for you.
00:31:47
They're going to move grandma's assets
00:31:48
into that account and then you're free
00:31:50
to transfer that account to Fidelity or
00:31:52
Dwab or whatever custodian you typically
00:31:55
use for your other assets. Now the
00:31:57
bigger question is how are those assets
00:31:59
taxed? The inherited IRA taxation and
00:32:02
distribution rules are certainly more
00:32:03
confusing than they need to be.
00:32:05
Thankfully they they have been
00:32:06
simplified in recent years. They're
00:32:08
still a little confusing. So, what I'm
00:32:10
about to describe are the rules and how
00:32:12
the rules look moving forward. So, first
00:32:14
things first, if the beneficiary is a
00:32:17
spouse, then that spouse can inherit the
00:32:19
IRA and essentially treat it as if it
00:32:21
were always their own money all along.
00:32:23
Full stop. They can make contributions,
00:32:25
they can take distributions, they will
00:32:27
pay taxes based on their own age, their
00:32:29
income, their life expectancy, etc. It's
00:32:32
not even really an inherited IRA. It's
00:32:35
as if it always was their money all
00:32:37
along. But if the beneficiary is not a
00:32:39
spouse, you know, if you're inheriting
00:32:40
grandma's IRA, that's where things get a
00:32:43
little trickier. Thankfully, inherited
00:32:45
Roth IAS are pretty straightforward.
00:32:48
Something called the 10-year rule
00:32:49
applies. The account must be empty after
00:32:51
the 10th year of the deedent's death.
00:32:54
So, if someone dies here in 2025, they
00:32:56
leave you with an inherited IRA. It must
00:32:58
be empty by the end of 2035. That's the
00:33:01
10-year rule. And now, for a Roth IRA,
00:33:03
for an inherited Roth IRA, there are no
00:33:04
required minimum distributions, no RMDs.
00:33:07
So, that's nice. And for 99% of people,
00:33:09
unless they really need the money in the
00:33:11
inherited Roth IRA, the best advice is
00:33:14
just to keep the money there sheltered
00:33:16
inside the Roth account, right? It's
00:33:17
qualified money, tax sheltered money,
00:33:20
until the end of the 10th year and then
00:33:22
withdraw it all at once. There's no tax
00:33:24
consequence to doing so because after
00:33:25
all, it's a Roth account. Now, inherited
00:33:28
traditional IRA accounts are much more
00:33:31
nuanced and messy. First, the 10-year
00:33:33
rule still applies. The account must be
00:33:35
empty after the end of the 10th year
00:33:37
after inheriting it. If the deedent if
00:33:39
the person who died if they were already
00:33:41
taking RMDs those RMDs must continue but
00:33:44
in two forms. So in the first year so
00:33:47
let's say here in 2025 because the
00:33:50
deedent was still alive on December 31st
00:33:52
of 2024 this year's RMD must be based on
00:33:56
the deedants's age. And the hard part is
00:33:59
they might have already taken the RMD on
00:34:01
their own while they were alive before
00:34:02
they died. If they didn't though, then
00:34:05
you must take the RMD or at least your
00:34:08
fraction, your portion of the RMD from
00:34:10
the inherited IRA. Then in years 2
00:34:14
through 10, in those years, the RMD will
00:34:16
not be based on the deedants's age or
00:34:18
what their age would have been if they
00:34:20
had survived, but instead the RMD will
00:34:22
be based on your age, you the
00:34:24
beneficiary, the inheritor. There's a
00:34:26
separate RMD life expectancy table for
00:34:28
beneficiaries. And in my opinion, the
00:34:31
IRS website, the IRS tables are a pain
00:34:33
in the butt to deal with. So instead, I
00:34:35
recommend one of many RMD calculators
00:34:37
like Schwabs. That's traditional IAS. If
00:34:40
the deedent was already taking RMDs, if
00:34:42
the deedent was not taking RMDs, then
00:34:44
starting here in 2025, the inheritor of
00:34:46
the inherited IRA must start taking RMDs
00:34:49
based on their own age. And these are
00:34:51
traditional IRA dollars. So every
00:34:53
withdrawal is a taxable event. it's
00:34:55
taxed as income. And that's where we
00:34:57
have to ask like what's the smart way to
00:34:59
think about these withdrawals and the
00:35:00
10-year rule. In some cases, the smart
00:35:03
advice would be to divide the
00:35:04
withdrawals into 10 even annual chunks.
00:35:07
Now, those chunks will more than satisfy
00:35:09
the RMD requirements, and it will spread
00:35:11
the realized income relatively evenly
00:35:14
over the next 10 years. In other cases,
00:35:16
though, the smart advice would be to
00:35:18
wait on any major withdrawals until some
00:35:20
future year. And that advice to do even
00:35:23
chunks versus not to do even chunks is
00:35:26
almost always going to be a function of
00:35:27
personal tax rates and retirement plans.
00:35:30
If, for example, you're earning, you
00:35:32
know, $400,000 for the next couple
00:35:34
years, but then you're retiring in 2027,
00:35:36
I would say wait, don't take the even
00:35:40
chunks. It doesn't make sense for you to
00:35:41
realize extra income during these high
00:35:43
earning years and pay high taxes when
00:35:45
instead you could simply wait till 2027
00:35:47
when you're in a much lower tax bracket
00:35:50
and take a bigger withdrawal from the
00:35:52
inherited IRA then and pay much lower
00:35:54
taxes. So anyway, I think the takeaway
00:35:57
there is that inherited IAS, a lot of us
00:36:00
might inherit one and they have some
00:36:02
pretty funky withdrawal rules and the
00:36:05
strategy, the financial planning
00:36:06
strategy around an inherited IRA. It's
00:36:08
just worth thinking about before you
00:36:10
just start pulling money out and
00:36:11
realizing taxes. But last for this
00:36:13
question, I want to talk about the
00:36:14
distribution and the taxation of assets
00:36:16
from trusts. Now, in short, I think of
00:36:19
trusts kind of like a BaskinRobins ice
00:36:21
cream store in terms of just the dozens
00:36:23
and dozens of different flavors.
00:36:24
However, there are some universal
00:36:26
basics. I think first a quick definition
00:36:29
would help of the three main players in
00:36:31
a trust. In a trust, the grtor, also
00:36:34
known as the trust or the creator, is
00:36:37
the person who establishes a trust and
00:36:39
the person who transfers assets into the
00:36:41
trust. The trustee is an individual or
00:36:44
an entity that manages the trust's
00:36:46
assets and follows the granter's
00:36:48
instructions in the trust document. And
00:36:50
then the beneficiary is an individual or
00:36:52
an entity who benefits from the trust
00:36:54
receiving distributions or receiving
00:36:56
income, receiving principle according to
00:36:58
the trust's terms. So a trust is this
00:37:02
kind of living document/living
00:37:04
tax entity that we are allowed to set up
00:37:07
on our own. And a very common example
00:37:10
might be okay, how about a special needs
00:37:11
trust? How about parents say, "Hey, we
00:37:13
have an adult disabled child who we need
00:37:17
to be cared for if we were to die." And
00:37:20
the way that we're going to do that is
00:37:22
is they can't that that the adult child
00:37:24
can't necessarily be trusted to handle
00:37:26
all these finances on their own. So, we
00:37:28
are going to create a trust. We are
00:37:31
going to move some of our assets into
00:37:33
the trust. Maybe some now, maybe some
00:37:35
upon our death if we die early. So, now
00:37:38
there are going to be assets that are
00:37:40
moved into the trust. A third party,
00:37:42
that's the trustee. A third party is
00:37:44
going to be named as the person who kind
00:37:46
of manages the trust assets, who follows
00:37:49
the instructions in the trust document
00:37:51
and who makes sure that the beneficiary
00:37:53
of the trust is getting what they need.
00:37:55
So in this case the b uh that the
00:37:56
trustee might be maybe the trust
00:37:58
department of a bank is named and that
00:38:01
trustes job is to ensure that the wishes
00:38:04
outlined in the trust are properly
00:38:06
executed such that the beneficiary in
00:38:08
this case the adult disabled child is
00:38:10
getting what they need from the trust
00:38:12
assets so that they can live a
00:38:14
comfortable life but also that the trust
00:38:16
assets are handled very responsibly not
00:38:18
irresponsibly. So again, a grantor
00:38:21
creates the trust, a trustee watches
00:38:23
over the trust, and a beneficiary is the
00:38:25
one who benefits from the trust assets.
00:38:28
There are two major major categories of
00:38:30
trusts, revocable and irrevocable based
00:38:33
on the word revoke. So a revocable trust
00:38:37
is created usually during a grtor's
00:38:39
lifetime. And the grtor retains control
00:38:42
and they can even amend or revoke the
00:38:44
trust if they want. It's revocable. They
00:38:46
can revoke it. They can change it. They
00:38:48
can even end the trust. They can
00:38:49
terminate the trust early. And then
00:38:51
assets inside the revocable trust are
00:38:54
considered part of the granter's estate
00:38:56
for tax purposes. Usually the the the
00:38:59
main reasons to set up a revocable trust
00:39:01
has to do with skipping probate because
00:39:03
upon death the revocable trust turns
00:39:05
irrevocable and those assets can be
00:39:07
distributed skipping out on the probate
00:39:09
process. But the grantor maintains
00:39:11
control during life and therefore from a
00:39:13
federal and even state taxation point of
00:39:15
view the assets in the trust aren't
00:39:18
considered different from the grantor's
00:39:20
estate but are very much considered part
00:39:22
of the grand tours estate but then
00:39:24
there's the irrevocable trust cannot be
00:39:26
revoked cannot be changed and it really
00:39:28
means you know with very very few
00:39:30
exceptions once an irrevocable trust is
00:39:32
set up or once assets are put inside of
00:39:34
an irrevocable trust it can't be changed
00:39:36
can't be revoked can't be undone assets
00:39:38
that's placed in an irrevocable trust
00:39:41
are removed from the grtor's estate
00:39:43
which can offer some some pretty
00:39:45
powerful estate tax benefits. Typically,
00:39:47
these assets are technically gifted into
00:39:49
the trust. A gift tax returns filed and
00:39:52
the value of those assets count against
00:39:54
someone's lifetime estate exemption. So,
00:39:58
what exactly does it all mean? I know
00:39:59
that's a lot of jargon. So, you as an
00:40:01
individual, we've already talked about a
00:40:02
couple times today. You as an
00:40:04
individual, you have $14 million roughly
00:40:06
of federal lifetime estate tax
00:40:08
exemption. Imagine someone who maybe
00:40:11
they're 60 years old. They just sold a
00:40:13
business for 10 million bucks. Now, it
00:40:15
might be reasonable that that
00:40:16
60-year-old, they could look at the $10
00:40:17
million and it might grow to 20 or $30
00:40:20
million or more before their death. So,
00:40:23
at age 60, they choose to gift eight of
00:40:26
the $10 million into an irrevocable
00:40:29
trust, thereby using $8 million of their
00:40:32
lifetime exemption. the lifetime
00:40:33
exemption is 14, but once in the trust,
00:40:36
the $8 million can grow to 16 or 24 or
00:40:39
more, and it's no longer part of their
00:40:42
estate. It's now part of the trust, and
00:40:44
therefore, it's protected from estate
00:40:45
taxes. So in other words, in this
00:40:49
scenario, in this hypothetical I've
00:40:50
outlined, the grtor might be able to
00:40:53
pass far more than $14 million onto
00:40:56
their heirs through the trust without
00:40:58
actually going above and beyond the $14
00:41:00
million lifetime estate tax limit. So
00:41:03
this is again this is used for very
00:41:05
advanced tax and asset planning can be
00:41:08
used also just to maintain control of
00:41:10
assets after death. Now how are assets
00:41:13
distributed out of trusts? So upon the
00:41:16
grtor's death when the person who put
00:41:17
the trust together when they die if the
00:41:19
trust was revocable it becomes
00:41:21
irrevocable at death and a successor
00:41:23
trustee usually steps in to manage and
00:41:25
distribute the assets per the trust's
00:41:27
instructions and you know avoiding
00:41:29
probate in the process. The timing of
00:41:31
the distributions can vary. Sometimes
00:41:33
it's immediate lump sum. Sometimes there
00:41:35
are gradual payouts. It's kind of common
00:41:36
to see something like, okay, my my
00:41:39
beneficiary will get 1/3 at age 25, 1/3
00:41:42
at age 35, and the final third at age
00:41:44
45. Something like that. There can be
00:41:46
discretionary payments that the trustee
00:41:48
gets to decide when and how much is
00:41:50
distributed. Different clauses, like I
00:41:51
said, BaskinRobins 31 flavors, lots of
00:41:54
different ways to write trust documents
00:41:56
and distribute those assets. But the
00:41:58
taxation of the trust assets is
00:41:59
something that I wanted to focus on for
00:42:01
today. If the trust was revocable, the
00:42:04
assets, as I said, are still counted in
00:42:06
the estate of the grantor for federal
00:42:09
estate tax purposes. But if they're
00:42:11
irrevocable trusts, they're excluded,
00:42:13
helping reduce the estate tax exposure.
00:42:15
One of the major benefits, that's one of
00:42:17
the major benefits of an irrevocable
00:42:18
trust in the first place. And we already
00:42:20
discussed that many states impose their
00:42:22
own estate or andor inheritance taxes
00:42:25
with lower thresholds. So, if you think
00:42:27
you're flirting with estate tax issues,
00:42:29
I cannot recommend enough the power of
00:42:31
working with a good team of
00:42:32
professionals, specifically a trust and
00:42:34
estate attorney and an experienced CFP.
00:42:37
And the reason why you want both, I've
00:42:38
got a good story from work of a of a
00:42:40
family who working with a really good
00:42:42
and a really competent trust and estate
00:42:44
attorney setting up an irrevocable trust
00:42:46
for this family and recommended moving a
00:42:49
certain amount of assets into that
00:42:50
irrevocable trust. And from the
00:42:52
financial planning point of view, we
00:42:54
looked at the numbers and we said
00:42:55
actually this family might need access
00:42:58
to those taxable assets here during
00:43:00
life. And by putting them into an
00:43:03
irrevocable trust, we are limiting their
00:43:05
access to their own assets. And like
00:43:07
sure, we're protecting them from estate
00:43:09
taxes in the long run, but we think
00:43:12
they're going to spend some of these
00:43:13
assets anyway. So, because we had
00:43:16
insight into the planning side of the
00:43:18
conversation, we were able to work side
00:43:20
by side with the estate planning
00:43:21
attorney and make sure that a a very,
00:43:24
you know, kind of like a safe and
00:43:25
healthy amount of assets was moved into
00:43:27
the arrival trust. Not too much, but
00:43:30
also enough to make a real tax impact
00:43:32
for this family. But trusts are their
00:43:34
own tax entities. It's a weird They have
00:43:37
their own EIN numbers. They have their
00:43:38
own tax ID numbers. If a trust earns
00:43:41
income like interest or dividends or
00:43:43
capital gains, most trusts they
00:43:45
distribute that income annually to
00:43:47
beneficiaries and the income is then
00:43:49
taxed to the beneficiary. But some
00:43:51
trusts can retain the income or they can
00:43:53
make charitable contributions with the
00:43:55
income and retained income is taxed at
00:43:58
the trust's tax rate which hits its top
00:44:00
bracket 37% at just over $15,000 of
00:44:04
income. So in other words, the income
00:44:06
tax brackets that affect trusts are very
00:44:09
very harsh compared to the income tax
00:44:12
brackets that affect us as as people. So
00:44:15
any sort of principle that's that's uh
00:44:17
distributed out of a trust is usually
00:44:18
not taxable to the beneficiaries, but
00:44:20
income is and the recipient will usually
00:44:23
receive a a K1 tax document that covers
00:44:26
that trust income that they've received.
00:44:28
Capital gains are generally taxed to the
00:44:30
trust unless they're distributed out to
00:44:32
a beneficiary. And there are certain
00:44:34
types of capital gains that actually
00:44:36
aren't very beneficial to to receive
00:44:38
inside a trust. For example, if a home
00:44:40
is placed into a trust as an individual,
00:44:42
we usually get a very big capital gain
00:44:44
exclusion on a home sale. It's $250,000
00:44:47
for an individual or $500,000 for a
00:44:49
married couple. But trusts don't
00:44:51
automatically qualify uh for that kind
00:44:54
of capital gain exclusion unless
00:44:56
specific steps are taken. So long story
00:44:58
short, trust taxation is almost always
00:45:01
more harsh than the taxation placed on
00:45:04
individuals. So that's just another
00:45:05
reason why this is something that can be
00:45:07
a very beneficial tool, don't get me
00:45:08
wrong, but it's something that you want
00:45:09
to set up properly. You want to think
00:45:12
through pros and cons, possible
00:45:13
ramifications. Working with an attorney,
00:45:15
working sidebyside with the CFP is is
00:45:17
almost always going to be a good idea.
00:45:19
So next question four is all about RSUs
00:45:22
and ISOs and other forms of equity
00:45:24
compensation. And I've gotten questions
00:45:25
recently from Scott and Mark and a few
00:45:27
other people with different and unique
00:45:29
questions about these topics. But my
00:45:30
thought is I'd do a little bit of a deep
00:45:32
dive here on these different acronyms,
00:45:34
RSUs, ISOs, NSOs, ESP, some other equity
00:45:38
compensation and then talk about some
00:45:40
different kind of mindsets and and
00:45:42
frameworks to optimize your equity
00:45:44
compensation as you receive it. First, I
00:45:46
think we need some basic definitions.
00:45:48
So, let's start with RSUs, restricted
00:45:50
stock units. An RSU is a promise from
00:45:53
your employer to give you shares of the
00:45:55
company at a future date, to give you
00:45:56
stock at a future date, typically tied
00:45:58
to some vesting schedule like over four
00:46:00
years. So when the company comes to you
00:46:02
day one and they say, "Hey, we're giving
00:46:03
you RSUs." On that day, you don't own
00:46:06
anything. You don't own anything at that
00:46:08
day. Once they vest, which like I said,
00:46:10
usually might take something like four
00:46:12
years, you receive actual shares. You
00:46:15
receive actual shares of the company. So
00:46:17
you no longer own an RSU once it's
00:46:19
vested. You own a share of the company.
00:46:21
just like you bought it at Fidelity at
00:46:23
Vesting, the gift that the shares that
00:46:25
are given to you are taxed as ordinary
00:46:28
income based on the market value of
00:46:30
those shares. So if I'm promised
00:46:32
something, I was promised shares in 2021
00:46:35
and now finally is 2025 and they were
00:46:37
given to me. They vest now in 2025,
00:46:40
right? They're given to me and I have
00:46:41
shares and I look in my account with the
00:46:43
company and as of today I have $10,000
00:46:45
in shares because of the vesting. Well,
00:46:47
that $10,000 will get taxed as if it's
00:46:50
ordinary income. But I don't own cash. I
00:46:53
own shares and I'm allowed to sell the
00:46:55
shares today for the $10,000 that they
00:46:58
were given to me at. And there would be
00:46:59
no capital gains tax associated with
00:47:01
that. But if I hold on to the shares and
00:47:03
they grow over time, just like with any
00:47:05
other stock, as it grows over time after
00:47:08
you obtain it, after you buy it, a
00:47:10
future sale could trigger a capital gain
00:47:12
or a capital loss and a tax consequence
00:47:15
associated with that. So that's RSUs.
00:47:18
You don't own anything upfront. They
00:47:20
take time to vest. When they vest,
00:47:22
they're taxed as ordinary income. And
00:47:24
then if you sell the shares in the
00:47:26
future, they might realize capital gains
00:47:28
depending on if they grow or not between
00:47:30
the time they're vested and the time you
00:47:32
sell. Next up are ISOs, incentive stock
00:47:36
options. An ISO is an option to buy
00:47:38
company stock at a fixed strike price,
00:47:41
which is usually lower than the market
00:47:42
price. you probably wouldn't exercise
00:47:44
the option if it wasn't lower than the
00:47:46
market price. And then special IRS rules
00:47:48
apply to ISOs that do provide some
00:47:51
potential tax advantages. So some of the
00:47:54
key points here is that when ISOs are uh
00:47:56
granted or vested to you, there's no tax
00:47:59
then. And then if you hold the shares,
00:48:01
there's a specific time period here, two
00:48:03
years from grant and then one year from
00:48:06
exercise, you get long-term capital
00:48:08
gains treatment of the ISOs. If not,
00:48:10
it's what's called a disqualifying
00:48:12
disposition and then it's taxed as
00:48:14
ordinary income. So anyway, ISOs are
00:48:17
essentially just stock options that
00:48:18
allow you to buy a stock at a certain
00:48:21
price and if that price is lower than
00:48:23
the market price, then what you can do,
00:48:25
you can basically just arbitrage the
00:48:26
difference, right? If a certain stock is
00:48:28
trading today at $100, but your option
00:48:30
allows you to buy it at 60. Well, you
00:48:33
can buy it at 60 immediately turn
00:48:35
around, sell it at 100, and you get the
00:48:37
full $40 difference as just profit in
00:48:40
your pocket. You just get that
00:48:41
arbitrage. But again, depending on the
00:48:44
timing from when the options were
00:48:46
granted to you, when they were
00:48:48
exercised, and when you actually sold
00:48:50
the sold the stock, it sometimes can be
00:48:52
treated as long-term capital gains.
00:48:54
Other times be treated as ordinary
00:48:56
income. And it's worth thinking about
00:48:57
that ahead of time. Next up are
00:48:59
non-qualified stock options or NSOs,
00:49:02
which are very similar to ISOs, but with
00:49:04
fewer tax advantages, and therefore
00:49:06
they're more flexible for the employers
00:49:08
and for your company to give away. The
00:49:10
key points again here are that there's
00:49:12
no taxing at grant when they're granted
00:49:14
to you. When you exercise the NSO, the
00:49:16
quote unquote spread, which is the again
00:49:18
that market price minus the strike
00:49:20
price, that's taxed as ordinary income.
00:49:22
And then later, if you're going to sell
00:49:24
the stock, right, that you exercise with
00:49:26
the option, if there are any capital
00:49:28
gains, you will be subject to capital
00:49:30
gains tax. So, going back to the same
00:49:31
example as before, if your option, let's
00:49:33
say it says that you can buy a stock at
00:49:36
$50 and then today though it's trading
00:49:38
at $100. Great. So, you decide to buy at
00:49:40
50. The stock's worth 100. That
00:49:42
difference right there, the spread $50
00:49:45
in this case, that spread is immediately
00:49:47
taxed to you as ordinary income, but you
00:49:49
still own the stock. And so if you want
00:49:51
to, you can sell the stock for $100 the
00:49:54
same day that you exercise the option
00:49:56
and you can use some of your proceeds
00:49:57
there to pay the income tax on the
00:49:59
spread or you can choose to hold the
00:50:02
stock and then if you eventually sell
00:50:03
it, you'll be subject to capital gains
00:50:05
in which case you might have to pay some
00:50:07
sort of capital gains tax on top of the
00:50:09
income tax that you realized when you
00:50:11
exercise the option. The last one that I
00:50:14
just want to cover today because it's
00:50:15
pretty common are uh employee stock
00:50:17
purchase plans or ESPs. An ESP allows
00:50:20
employees to buy company stock at a
00:50:23
discounted price, often through payroll
00:50:25
deductions. Frequently, ESPs work
00:50:28
quarterly. And the way it will often
00:50:30
work is that once a quarter, an employee
00:50:32
will have the ability to buy their own
00:50:34
company stock at a discounted price.
00:50:36
Discounts are usually as high as 15% or
00:50:39
can be as high as 15%. And in most
00:50:41
cases, that is the discount that I've
00:50:43
seen. So basically um the company will
00:50:45
either on the day of that they're
00:50:47
offering this deal to you, they'll say,
00:50:48
"Hey, we'll take 15% off the stock price
00:50:50
today or sometimes there's a look back
00:50:52
period where the company will look back
00:50:54
over the previous quarter. We'll find
00:50:56
the lowest price in that previous
00:50:58
quarter. We'll knock 15% off that lowest
00:51:00
price. We'll offer the employees the
00:51:03
ability to buy stock at that price. The
00:51:05
tax treatment for this, it it depends.
00:51:08
Some ESPs are qualified like a 401k
00:51:11
would be. Others are non-qualified. And
00:51:13
with qualified plans, you get very
00:51:15
favorable tax treatment if you hold the
00:51:18
shares long enough. Again, which it's
00:51:19
that one year from purchase or two years
00:51:21
from grant rule there as well. So again,
00:51:24
the whole point is that or the way that
00:51:26
it can be optimized, we we'll talk about
00:51:27
this in a second in a little more
00:51:29
detail, but if an employee wants to,
00:51:32
they can use the ESP to buy discounted
00:51:35
shares today immediately turn around and
00:51:37
sell those shares back into the open
00:51:39
market. the arbitrage between the
00:51:41
discount that the employee receives
00:51:43
versus the current market price. It's
00:51:45
just extra cash in an employes pocket.
00:51:48
Okay. So, let's pivot right now. Defined
00:51:50
RSUs and ISOs and NSOs and an ESP. Are
00:51:54
there though best practices quote
00:51:56
unquote for dealing with these various
00:51:57
types of equity compensation? I say yes.
00:52:00
There are some best practices. There are
00:52:01
some rules of thumb that will certainly
00:52:03
apply to the majority of people
00:52:04
listening to this right now. First,
00:52:06
RSUs. The easy but risky mistake to take
00:52:10
with RSUs is to let your vested RSUs sit
00:52:13
and grow without realizing that they're
00:52:16
already fully taxed as income at
00:52:17
vesting. And that by letting them sit
00:52:19
there, all you're doing really is
00:52:21
exposing yourself to concentration risk.
00:52:23
Remember, a vested RSU is a stock. And
00:52:27
if you just let your company stock sit
00:52:29
there and grow and grow and grow, you
00:52:30
are exposing yourself to company risk by
00:52:33
just over overindexing on one single
00:52:35
company. So that's why the best practice
00:52:37
is usually just to sell immediately upon
00:52:40
investing or at least to consider doing
00:52:41
so. You've already paid the income tax
00:52:43
and holding the stock just exposes you
00:52:45
to concentration risk. So if you do
00:52:47
hold, I would set a sell trigger like a
00:52:50
price target or a time horizon to
00:52:52
eventually sell those stocks and and
00:52:54
make sure that you're not exposed to too
00:52:56
much concentration risk. It's very
00:52:57
typical to see people uh working for,
00:53:00
you know, big tech companies getting
00:53:01
RSUs every quarter or having RSUs vest
00:53:04
every quarter, something like that. To
00:53:06
have this steady cadence of, yes, I just
00:53:08
got $50,000 more of RSUs. I'm just going
00:53:11
to sell them all. I'm going to take
00:53:13
10,000 of that and put it over on the
00:53:14
side in a money market fund because I
00:53:16
know there's going to be a tax
00:53:17
consequence eventually. But anyway, it's
00:53:19
it's just better than having a a
00:53:21
concentration risk. It's also worth
00:53:22
understanding the withholding that you
00:53:24
have set up in your RSU account as it
00:53:26
were. Some companies default to 22%,
00:53:29
others default to 37% withholding which
00:53:31
might underestimate or overestimate your
00:53:33
real life tax liability. So at the end
00:53:36
of the day, thinking of your RSUs, I
00:53:38
would think of your RSUs like a bonus.
00:53:40
It's just like a cash bonus that you get
00:53:42
at the end of the year, except it's paid
00:53:44
in stock. It's not paid in cash. But
00:53:47
what's not right or what I wouldn't
00:53:48
recommend is to think of your RSUs like
00:53:50
lotto tickets, right? at like stock
00:53:52
lotto tickets that might hit the moon. I
00:53:54
think that's just exposing your
00:53:55
financial plan to to too much risk. ISOs
00:53:58
offer interesting tax treatment, but
00:54:00
they come with real complexity,
00:54:02
especially around something called AMT
00:54:04
exposure. AMT is the alternative minimum
00:54:07
tax. So, the best practice for for ISOs
00:54:10
is to understand the two holding periods
00:54:12
that we talked about here, the one year
00:54:14
from exercise and the two years from
00:54:15
grant that help qualify ISOs for uh
00:54:19
long-term capital gains treatment. And
00:54:21
before uh exercising large amounts of
00:54:23
ISOs, it's worth sitting down with a
00:54:25
professional to run some sort of AMT,
00:54:28
alternative minimum tax projection
00:54:30
because unexpected AMT bills are one of
00:54:32
the bigger regrets that come with
00:54:35
exercising ISOs. So if possible, if
00:54:38
allowed, you can consider early exercise
00:54:41
of those ISOs to start your holding
00:54:43
period when the value is low. You can
00:54:45
also exercise gradually over time,
00:54:47
especially when the spread between the
00:54:49
strike price and the stock price is
00:54:51
small. And then it's also worth
00:54:53
understanding, and this is true not just
00:54:54
for ISOs and RSUs, but really for any of
00:54:56
these things we're talking about today.
00:54:58
It's worth understanding that if you
00:55:00
were to leave your company, what were to
00:55:02
happen to that equity compensation?
00:55:04
ISOs, for example, expire 90 days after
00:55:07
separation with your employer. So, it's
00:55:08
worth planning ahead on that front.
00:55:10
Next, NSOs. What is the best thinking on
00:55:12
NSOs? The best thinking here is pretty
00:55:14
straightforward, but it's relatively tax
00:55:16
heavy. It's to know your strike price
00:55:18
and know the fair market value. And just
00:55:20
to know that the difference between
00:55:21
those is taxed at ordinary income rates.
00:55:24
If you have reason to believe the stock
00:55:25
will rise long-term, the best thing to
00:55:28
do is probably to consider exercising
00:55:29
your options as early as possible so
00:55:31
that you can start the capital gains
00:55:33
clock. You can reduce the ordinary
00:55:35
income tax you would owe and instead
00:55:37
increase the capital gains tax that you
00:55:39
would owe. It's important for NSOs to
00:55:41
monitor expiration dates. They often
00:55:43
lapse 10 years from grant or again 90
00:55:46
days after leaving a company. It's worth
00:55:48
knowing that NSOs, they don't trigger
00:55:50
the alternative minimum tax, but they
00:55:52
can push you into higher tax brackets at
00:55:54
exercise. So again, this really is it's
00:55:56
more than just a portfolio conversation.
00:55:58
It's also a tax planning conversation.
00:56:00
And then last, let's talk on the best
00:56:02
practices of the ESP plan. It's
00:56:04
definitely worth participating if your
00:56:05
company offers a discount, especially
00:56:07
with that look back feature. It is
00:56:09
definitely worth participating. I would
00:56:11
recommend uh selling immediately after
00:56:13
shares are purchased though, essentially
00:56:14
flipping the shares so that you can lock
00:56:17
in the discount with very minimal
00:56:19
concentration risk. If you want to hold
00:56:21
some of your company shares for the long
00:56:23
run, I understand that. It's just again
00:56:25
you need to understand the the
00:56:26
qualifying disposition rules as it were
00:56:28
so that you can get the best capital
00:56:30
gain treatment, the long-term capital
00:56:32
gains treatment if and when you you end
00:56:34
up selling those ESP shares. And then uh
00:56:37
it's definitely worth setting up an
00:56:38
automated contributions if your plans
00:56:40
allows you to do so just straight out of
00:56:41
the payroll deduction. Makes it pretty
00:56:43
seamless to to set up ESPs. In summary,
00:56:46
I would think of them as another form of
00:56:48
free money just like a 401k match. And
00:56:51
if your company uh has an ESP,
00:56:53
definitely look to take advantage of it.
00:56:56
So some universal best practices for all
00:56:58
of these different types of equity
00:57:00
compensation that we talked about. The
00:57:01
first one is simply to diversify. Don't
00:57:04
let your employer stock become, you
00:57:06
know, the majority or even a plurality
00:57:08
of your net worth, especially when your
00:57:10
paycheck depends on that company as
00:57:11
well. Uh, number two is to create some
00:57:13
sort of sell plan. You need to set rules
00:57:16
in advance about how much of your equity
00:57:18
compensation you'll sell, when you'll do
00:57:20
it, why you'll do it. We want to remove
00:57:22
emotion from this sort of decision-m.
00:57:25
The third important rule is just to
00:57:26
track important dates to know your grant
00:57:28
dates and your investing schedule and
00:57:30
your expiration dates and holding
00:57:31
periods. Sometimes your employer will
00:57:34
use some sort of broker that will keep
00:57:36
this really nice and organized for you,
00:57:38
but other times I've seen statements
00:57:40
where it's really hard to decipher
00:57:41
what's going on. And it might be worth
00:57:43
keeping your own sort of spreadsheet
00:57:44
somehow so that you understand all these
00:57:46
dates. Fourth, it's definitely worth
00:57:49
working with some sort of tax pro or tax
00:57:51
planning pro. As we've already talked
00:57:53
about, equity compensation can trigger
00:57:55
interesting different surprising tax
00:57:56
bills. So, a CPA or a financial planner
00:58:00
with with lots of equity experience can
00:58:02
help project your tax liability, help
00:58:04
you understand your AMT exposure can do
00:58:07
some year-end planning, gifting, donor
00:58:09
adise funds, those kind of things.
00:58:11
There's a couple CFPs I work with here
00:58:13
with a lot of experience on that. And
00:58:14
that's a big part of of what they do
00:58:16
with our clients is ensuring that
00:58:18
they're getting the most out of their
00:58:20
equity compensation. And fifth, I would
00:58:22
just think about coordinating with your
00:58:23
goals. This is a general financial
00:58:25
planning rule anyway, but your decisions
00:58:27
about exercising or selling should tie
00:58:29
back to your goals of buying a home or
00:58:31
retiring early or funding college or
00:58:33
whatever it might be. Right? These
00:58:34
different things in financial planning,
00:58:36
they all interact with one another.
00:58:38
Here's a quick ad and then we'll get
00:58:40
back to the show. Serious question. Why
00:58:43
do podcasters constantly ask for ratings
00:58:45
and reviews? Yes, they do help highlight
00:58:48
our shows to new listeners. They help
00:58:50
strangers find us on Apple Podcast and
00:58:52
Spotify. It's totally true and a good
00:58:54
reason to ask for ratings and reviews.
00:58:56
But I have something more important, at
00:58:58
least more important to me. I want to
00:59:00
know if you like this stuff. I want to
00:59:02
know if you like my podcast episodes, my
00:59:04
monologues, my guests, the information I
00:59:06
share with you and the stories I tell. I
00:59:08
want to improve and make your listening
00:59:10
more enjoyable in the process. So yeah,
00:59:12
I would love to read your reviews. And
00:59:14
sure, if you throw a rating in there,
00:59:16
too, that's great. If you like what I'm
00:59:18
doing, please share it with me. It's
00:59:20
such a great feeling to read your
00:59:22
feedback. I'd love to read your review
00:59:24
or see a rating on Apple Podcast or
00:59:27
Spotify. Thank you. And now on to
00:59:29
question five. Mike wrote in about
00:59:31
having money on the sidelines and is now
00:59:33
the right time to buy in. So he says,
00:59:35
"We're a late30s couple with two young
00:59:37
kids and two good careers. We're saving
00:59:39
through many different avenues, 401k,
00:59:41
529s, etc. We also have about $800,000
00:59:44
currently in a taxable brokerage
00:59:46
account. Of that 800,000, about 200,000
00:59:49
is currently sitting in a money market
00:59:51
fund. I made that choice a couple years
00:59:52
ago when the markets were choppy, and I
00:59:54
have maintained it ever since. The 4%
00:59:56
interest rate is pretty good, but I also
00:59:58
wonder if I'm missing out on something
01:00:00
better. For reference, the other 600,000
01:00:02
in the taxable account is all invested
01:00:04
in stocks. Interesting question, and
01:00:06
it's certainly a common question right
01:00:07
now. As I'm recording this on July 14th,
01:00:10
markets are at basically at all-time
01:00:12
highs. And so with people with cash on
01:00:14
the sideline are asking themselves, is
01:00:16
the market going to come back down or
01:00:18
have I simply missed out on an
01:00:19
opportunity over the past couple years?
01:00:21
So the question that I would always pose
01:00:23
to someone in this situation is why are
01:00:26
you holding on to the $200,000 in cash
01:00:28
in the first place? Why are you holding
01:00:30
the cash in the first place? Whether
01:00:31
it's right $200,000, $2 million, or $20,
01:00:34
why is that cash sitting in cash? Now,
01:00:37
there are a bunch of really good
01:00:38
possible answers. Maybe it's acting as
01:00:41
part of a family emergency fund,
01:00:42
providing, you know, x months worth of
01:00:45
living expenses. If you spend $15,000 a
01:00:47
month, this 200k represents one year of
01:00:50
of safety net cash. And Mike mentioned,
01:00:52
so both he and his spouse are are high
01:00:54
achievers with specific career goals. It
01:00:56
might take them some time during any
01:00:58
future job search should they need to
01:01:00
take that time. And for that reason, it
01:01:02
might make sense for them to have a
01:01:04
bigger than typical emergency fund. it
01:01:06
might make sense for them to have more
01:01:07
than just say 6 months of expenses and
01:01:10
that's a pretty unique thing that I
01:01:11
don't think many people think about. I'm
01:01:13
going to pick on say nurses here for
01:01:14
example because I know some people who
01:01:16
are nurses. Most of the people I know
01:01:17
who are nurses if they were to lose
01:01:19
their job they could very quickly find a
01:01:21
different job as a nurse. They're in
01:01:23
high demand. A lot of nursing jobs are
01:01:26
reasonably similar to one another and
01:01:28
therefore yeah 6 months for an emergency
01:01:30
fund makes sense for them. But if you
01:01:32
have a very specific set of skills or if
01:01:35
you have kind of built your career to
01:01:36
such a place where you'd really want to
01:01:38
take your time finding a new job that
01:01:41
there aren't many jobs out there that
01:01:42
could really light your fire and you
01:01:44
want to really scour the entire country
01:01:46
to find the right one. 6 months might
01:01:48
not be enough time for you to do that
01:01:50
and therefore you might want to lean
01:01:51
more towards say a 12-month emergency
01:01:53
fund. So anyway, that's a perfectly good
01:01:55
reason for Mike to have this much cash.
01:01:57
A second perfectly good reason is that
01:01:59
he's expecting some really large
01:02:01
spending out over the next, say, 24
01:02:02
months and he wants to keep that future
01:02:05
outlay sitting in cash. Maybe he's
01:02:07
redoing his roof next summer. Maybe he's
01:02:09
buying a boat next summer. Well,
01:02:11
whatever money is going to be required
01:02:12
for those outlays, that should be in
01:02:14
cash. That shouldn't be in the stock in
01:02:16
the stock market. And a third perfectly
01:02:18
viable reason is that maybe he just
01:02:19
doesn't want the risk associated with
01:02:21
owning 100% stocks in that taxable
01:02:23
account. and holding a meaningful money
01:02:25
market position acts as some sort of
01:02:27
ballast against the volatility of
01:02:29
stocks. That's fine. We want anyone's
01:02:32
portfolio to accomplish two important
01:02:34
things. It's got to grow enough during
01:02:35
bull markets so that it can meet their
01:02:37
long-term goals. And it has to be stable
01:02:40
enough during bare markets that they
01:02:41
don't totally freak out. Now that those
01:02:43
two statements that's true for any and
01:02:45
all investors including all of you
01:02:47
listening today is a good reason why two
01:02:49
similar investors or at least similar on
01:02:51
the outside they might have very
01:02:52
different looking portfolios. Our
01:02:54
portfolio it needs to grow enough during
01:02:56
the bull markets so that it can meet our
01:02:58
long-term goals but it has to be stable
01:03:00
enough during the bare markets such that
01:03:01
we don't totally freak out. That second
01:03:03
one especially how stable is too stable
01:03:06
or I guess I should say is how stable is
01:03:07
not stable enough. you know, at what
01:03:09
point do we start freaking out due to
01:03:11
lack of stability? That's going to look
01:03:13
a little bit different for everybody.
01:03:14
So, going back to Mike, the 200,000 he
01:03:17
has or the 25% of his taxable account in
01:03:19
a money market fund, it's definitely
01:03:21
going to dampen his upside potential,
01:03:23
but it's also going to dampen his
01:03:25
downside risk. That's a trade-off.
01:03:26
Totally reasonable trade-off. And if and
01:03:28
if that's his reasoning for holding this
01:03:30
cash, that's totally okay. But the main
01:03:33
reason to not hold money in that taxable
01:03:35
account is to think, well, the market's
01:03:38
been acting weird over the past one or
01:03:40
three months or six months or 24 months.
01:03:42
Tariffs have me worried. The market's
01:03:44
overvalued. I just want to hold some
01:03:46
money until the market figures itself
01:03:48
out. I want to hold some cash until the
01:03:50
market figures itself out. That's not a
01:03:52
good reason to hold cash in your taxable
01:03:54
account because the simple and harsh
01:03:56
truth is that the market has always had
01:03:58
weird behavior to it. You can read
01:03:59
accounts from a 100 years ago, from 50
01:04:01
years ago, from 20 years ago, any time
01:04:03
in the past, and you'll find people,
01:04:05
including really smart people, who
01:04:07
thought that those times were weird. And
01:04:09
sometimes those people, they chose to
01:04:11
hold on to cash to wait for the
01:04:13
weirdness to be over. And it's really
01:04:15
hard to get that timing perfectly right.
01:04:17
Most investors make really big mistakes
01:04:19
right here, doing exactly this. And and
01:04:22
that's what we want to avoid. Peter
01:04:23
Lynch has the perfect quote to describe
01:04:25
it. He said, "More money has been lost
01:04:27
trying to anticipate bare markets than
01:04:29
has been lost in the bare markets
01:04:31
themselves." As investors, we are much
01:04:33
better off saying, "I don't know exactly
01:04:35
when this weirdness will end, and maybe
01:04:37
a new type of weirdness will start, but
01:04:39
I'm going to slowly invest my money over
01:04:41
time anyway." And it's ironic because
01:04:43
we're all doing that in our 401k
01:04:45
accounts anyway, right? We're all
01:04:47
investing money slowly over time. We're
01:04:49
adding every two weeks, rain or shine.
01:04:51
And meanwhile, sometimes we're doing
01:04:53
that with, you know, out of our right
01:04:55
pocket. we're investing every two weeks
01:04:57
when in our left pocket we say, "Well,
01:04:59
everything's weird. I think I'm going to
01:05:00
hold on to cash." So anyway, if that's
01:05:03
the reason why Mike or any of you were
01:05:05
holding on to cash in your account, I
01:05:07
would recommend the following. On the
01:05:09
first day of every month, take a certain
01:05:11
amount of money, a pretty meaningful
01:05:13
percentage, maybe for Mike, it's 10,000
01:05:15
or 15,000 or $20,000 from the money
01:05:18
market assets and invest it into a
01:05:20
diversified manner into the stock market
01:05:22
or into the rest of the portfolio. If
01:05:24
you can dial that 10K or 15K or 20K
01:05:28
higher, go ahead. But the goal is that
01:05:30
over the next 6 or 12 or 24 months that
01:05:33
we trickle all of that cash back into
01:05:36
investable assets. It's pretty simple.
01:05:38
It's hard to time the market by holding
01:05:40
on to cash intentionally because of our
01:05:42
market concerns. We are timing the
01:05:44
market. You know, I've had great
01:05:46
conversations with clients and
01:05:48
listeners, and I can think of some from
01:05:49
the tariff tantrum in April 2025 of all
01:05:52
those tariff and related fears, whether
01:05:55
it made sense to time the market at that
01:05:56
point. Whether it made sense to put more
01:05:59
money in or take money more money out or
01:06:00
just do something drastic, we're
01:06:02
currently up 23% as I'm recording this.
01:06:04
We're up 23% from the April lows. We're
01:06:07
currently at all-time highs. I had
01:06:08
another great conversation with a
01:06:10
listener last August when we were at an
01:06:11
all-time high and they had similar fears
01:06:13
about the market being overvalued. Well,
01:06:15
we're up 11% since that conversation. I
01:06:18
spoke with a woman recently who who
01:06:20
shared with me some timing mistakes she
01:06:21
made during the early days of co when it
01:06:23
really seems like society would be
01:06:25
thrown off course for years. And on that
01:06:27
axis about society being thrown off
01:06:29
course, she actually might have been
01:06:30
right. But it certainly didn't affect
01:06:32
the market the way that she expected.
01:06:33
And I think the thing that's funny about
01:06:35
all these stories is that half the time
01:06:37
it feels like people are really scared
01:06:39
by the market's enthusiasm. They see the
01:06:41
market as overvalued, as too frothy, and
01:06:44
they want to hold their cash. They want
01:06:46
to hold on to cash, I should say, while
01:06:48
waiting for the market to crash and to
01:06:50
calm down. But the other half the time,
01:06:52
people are scared by the market's
01:06:53
pessimism. They're scared by real world
01:06:55
turmoil. And they see the market as
01:06:57
having no potential future growth. And
01:07:00
yet time and time and time again, both
01:07:02
of these groups of people are more often
01:07:04
wrong than right. And the magnitude of
01:07:06
their mistakes is greater than the
01:07:08
magnitude of their successes. At the end
01:07:10
of the day, it's really hard to time the
01:07:12
market. It's really hard to predict the
01:07:14
future of the world. It's really hard to
01:07:15
predict how the market will react to the
01:07:17
future of the world. And the best thing
01:07:19
we can do is just slowly dollar cost
01:07:22
average in over time and let the market
01:07:24
do its thing. And now on to the last
01:07:26
question for today from Paul. Paul wrote
01:07:28
in and said, "Jesse, I'm years away from
01:07:30
RMDs, but all the bad stuff that comes
01:07:32
with them makes me worry. I'm forced to
01:07:34
withdraw more than I need. My withdrawal
01:07:36
rates start too high. They just keep
01:07:38
going up. It triggers higher taxation of
01:07:40
Social Security. It increases my Irma
01:07:42
Medicare sir charges. No more stretch
01:07:44
provision for heirs. I'm going to skip
01:07:46
over that one because it has to do with
01:07:47
inherited IAS. But a particular fear is
01:07:49
the self-inflicted sequence of returns
01:07:52
damage. I rebalance my portfolio in May.
01:07:54
As part of that, I figured that's when
01:07:56
I'll take my RMD. Let's say my IRA
01:07:58
balance was $1 million as of December
01:08:00
31st. However, the market drops 30% in
01:08:03
February and it is not recovered. I'm
01:08:05
now forced to calculate my RMD against
01:08:08
an account balance that doesn't even
01:08:10
exist anymore. My balance is down to
01:08:12
700K, but I have to calculate my RMD
01:08:15
against the 1 million as of December
01:08:17
31st. Conceivably, this could happen
01:08:19
many times over 20 plus years. The RMD
01:08:22
might force me to withdraw five or 6% or
01:08:24
more of my account when if I were in
01:08:27
control, a guardrail approach might only
01:08:29
suggest 2% withdrawals for that year.
01:08:32
Basically, when there's a hole in the
01:08:33
boat, best not to make it any bigger. I
01:08:35
find this scenario very troubling. So,
01:08:37
Paul outlines a fascinating and and
01:08:39
possibly scary concern here, listeners.
01:08:41
And the question is, do required minimum
01:08:43
distributions, RMDs, have a destructive
01:08:46
synergy with the sequence of returns
01:08:48
risk? And can this combination really
01:08:50
sink your boat? So, let's dive in. I'll
01:08:52
add some color and explanation to Paul's
01:08:54
question. I'll walk you through my
01:08:55
thoughts and ultimately leave you with a
01:08:57
solid plan of how to mitigate or even
01:08:59
avoid these bad outcomes in your
01:09:01
retirement. So, some basics to provide
01:09:03
background on Paul's question just to
01:09:05
make sure you can fully understand what
01:09:06
he's asking. Required minimum
01:09:08
distributions or RMDs are mandatory
01:09:11
withdrawals you must take each year from
01:09:13
certain tax deferred retirement accounts
01:09:15
like traditional IAS and 401ks. RMDs
01:09:18
start at age 73 or age 75 depending on
01:09:21
your birth year, possibly at other ages
01:09:23
in the future depending on future
01:09:24
legislation. Your RMD amount is based on
01:09:27
your account balance and remaining life
01:09:29
expectancy. Just like other withdrawals
01:09:31
from tax deferred accounts, RMDs are
01:09:34
taxed as ordinary income. Now the
01:09:37
sequence of returns risk another
01:09:38
important thing to define states that
01:09:41
not only do the magnitude of your
01:09:43
investment returns matter but the
01:09:45
sequence of those returns matters as
01:09:46
well. More specifically if we see a
01:09:49
particularly poor series of investment
01:09:51
returns during the early years of
01:09:52
retirement it can permanently damage and
01:09:55
permanently derail a long-term
01:09:57
retirement plan. So Paul who asked the
01:09:59
question outlines a couple other
01:10:00
scenarios too. I'll explain them here
01:10:03
but won't dive much deeper. He talks
01:10:05
about higher taxation on social
01:10:06
security. Depending on your total
01:10:08
income, only a portion of your social
01:10:10
security is actually taxable. Now,
01:10:13
granted, those income brackets are
01:10:14
relatively low. So, for example, a
01:10:16
married couple earning $44,000 or more
01:10:20
per year, which isn't very high for a
01:10:22
married couple in retirement, $44,000
01:10:24
per year. But if they're earning $44,000
01:10:26
per year or more, then the full amount,
01:10:29
the maximum amount I should say, of
01:10:30
their social security is taxable. The
01:10:33
maximum amount is 85%. And now it is
01:10:36
worth noting a and you know this is a
01:10:37
side note to a side note that having 85%
01:10:40
taxability on your social security is
01:10:43
much different than saying it's taxed at
01:10:44
an 85% rate. Instead it means really
01:10:48
what it means is that 15% of this
01:10:50
couple's social security income is
01:10:52
totally tax-free while the other 85% is
01:10:55
taxed at one of the federal income taxes
01:10:58
income tax rates. you know, 10%, 12%,
01:11:00
22%, something like that. So, the whole
01:11:03
point is if you earn too much money,
01:11:05
more of your social security will be
01:11:07
taxed. However, the thresholds there are
01:11:10
pretty low and it's I would say most
01:11:12
retirees who I've encountered the
01:11:14
maximum amount of 85% of their social
01:11:17
security is subject to income tax. The
01:11:20
next thing that Paul was uh worried
01:11:21
about are Irma sir charges. So, right,
01:11:23
the income related monthly adjustment
01:11:25
amount, Irma. It's a Medicare premium
01:11:27
sir charge imposed on higher income
01:11:30
Medicare beneficiaries in addition to
01:11:32
the standard part B and standard part D
01:11:35
premiums they're already paying. The
01:11:37
amount of Irma sir charge that someone
01:11:38
pays is based on their modified adjusted
01:11:41
gross income. And in short, the more
01:11:43
money you earn in retirement, uh, the
01:11:45
more you will pay for Medicare. Paul
01:11:47
also mentioned no more stretch provision
01:11:50
for heirs. So in short, the withdrawal
01:11:52
rules for uh inherited IAS used to be
01:11:55
very beneficial for heirs, allowing them
01:11:58
to keep large amounts of money growing
01:12:00
in their tax deferred accounts for
01:12:02
decades and decades and decades. Now,
01:12:04
however, and they called it the the
01:12:05
stretch rule, but now the the 10-year
01:12:08
rule mandates that inherited IAS must be
01:12:10
emptied after 10 years. There's no more
01:12:13
stretching the withdrawals out for
01:12:15
decades. So for both the social security
01:12:17
and Irma concerns, RMDs can be negative.
01:12:20
RMDs can lead to uh higher social
01:12:22
security taxability and result in higher
01:12:24
tax rates on that social security
01:12:26
income. RMDs can also certainly result
01:12:28
in higher Irma sir charges. All those
01:12:31
things are possible. But this is where,
01:12:33
you know, forethought in your financial
01:12:34
plan can pay some huge dividends. It
01:12:36
won't always be possible to avoid extra
01:12:38
taxes and and sir charges, but a prudent
01:12:40
plan certainly thinks about these
01:12:42
questions ahead of time. I want to focus
01:12:44
the remainder of this answer though on
01:12:45
Paul's primary concerns which is can
01:12:48
RMDs combine with sequence of returns
01:12:50
risk to really torpedo your retirement
01:12:53
all completely out of your control. Now
01:12:55
I do think it's important we understand
01:12:57
how these things interact but with
01:12:59
proper planning I think we can turn this
01:13:01
perfect storm as it were into just a
01:13:04
passing rain shower and there are a few
01:13:05
reasons why. The first reason a sequence
01:13:08
of returns risk exists with or without
01:13:10
RMDs. the sequence of returns risk. It's
01:13:13
omnipresent for stock market investors
01:13:15
whether they're taking RMDs or not. The
01:13:17
three principal ingredients that can
01:13:19
turn the sequence of returns risk into a
01:13:21
real danger is one your withdrawal rate,
01:13:24
two the returns from the market, and
01:13:26
three where you are in your kind of
01:13:29
retirement withdrawal timeline earlier
01:13:31
being worse for you. Earlier is worse
01:13:33
than later. And it's kind of like a fire
01:13:35
or really like an explosion. It requires
01:13:37
fuel and oxygen and a spark. And if
01:13:40
you're missing one of those key
01:13:41
components, you won't really get an
01:13:42
explosion. To that end, RMDs only make
01:13:45
the sequence of returns risk worse if
01:13:48
the RMD is increasing your overall
01:13:50
withdrawal rate. For some retirees,
01:13:52
their RMD will do just that, at least a
01:13:55
little bit. But for many retirees, RMDs
01:13:58
might not actually increase their
01:14:00
withdrawal rate at all. Instead, RMDs
01:14:02
will simply shift which account they're
01:14:04
taking most of their withdrawals from.
01:14:06
The second reason I don't think Paul's
01:14:08
concern is that big of a risk is that
01:14:10
the sequence of return risk is usually
01:14:12
pretty well dissipated by the time RMDs
01:14:14
come around. There's some really good
01:14:16
charts out there that that cover kind of
01:14:18
how a certain sequence of returns will
01:14:20
affect a retiree at given points during
01:14:22
their retirement. And anyway, you cut
01:14:25
the cake. The earlier the worse, right?
01:14:27
So the earlier a poor sequence of return
01:14:29
strikes, the worse it is for the
01:14:31
investor. And by the time someone is 73
01:14:33
or 75 years old and at that point of
01:14:35
their retirement, the sequence of
01:14:37
returns risk simply isn't that bad at
01:14:39
that point, especially if the earlier
01:14:41
years of their retirement had positive
01:14:43
returns. Their portfolio is is in such a
01:14:45
healthy place that a a sequence of poor
01:14:48
returns at that age at age 75 simply
01:14:51
doesn't matter that much anymore. A
01:14:53
third reason that maybe is just the
01:14:55
biggest reason today is that asset
01:14:57
allocation helps everyone. So whether
01:14:59
you're at RMD age or not, proper asset
01:15:02
allocation plays a pivotal role in
01:15:03
mitigating the sequence of returns risk.
01:15:05
Our short-term needs, as we talked about
01:15:07
multiple times in this episode, our
01:15:08
short-term needs should be met with
01:15:10
lowrisk assets, and that in and of
01:15:13
itself will mitigate the sequence of
01:15:15
returns risk from kind of rearing its
01:15:16
head in your life. Fourth, Roth
01:15:19
conversions can be a massive help here.
01:15:20
I've written at length, talked at length
01:15:22
about Roth conversions. I highly
01:15:23
recommend you read up on some of my work
01:15:25
on Roth conversions and they play a
01:15:27
significant role in mitigating the risk
01:15:29
of sequence of returns risk plus RMDs
01:15:33
simply because for every dollar that you
01:15:35
convert to a Roth account, it becomes
01:15:37
one less dollar that will be subject to
01:15:39
a future RMD. It'll be one less dollar
01:15:41
that's subject to a quote unquote forced
01:15:43
withdrawal. The key though is that
01:15:45
you've got to start many years before
01:15:46
your RMD age hits. I've actually I've
01:15:48
got an email in my inbox, my blog inbox
01:15:51
right now waiting for me of an
01:15:52
individual who's facing down massive
01:15:55
RMDs starting next year and he's asking
01:15:57
me for kind of Roth conversion help. And
01:16:00
I'm not sure what the previous 10 or 15
01:16:02
years of this individual's life looked
01:16:03
like. All I know is that at this point
01:16:05
with RMD's one year in the future,
01:16:07
there's not a lot we can do on the Roth
01:16:09
conversion front. So, one thing that is
01:16:11
interesting though is that even if your
01:16:12
Roth conversion yields zero tax benefit,
01:16:15
which at the end of the day, the main
01:16:17
benefit of Roth conversions is tax
01:16:19
arbitrage. But you can have a situation
01:16:21
where you have zero tax arbitrage, but
01:16:23
you can still choose to execute the Roth
01:16:25
conversion anyway because it will move
01:16:27
those dollars away from the RMD
01:16:29
crosshairs. There's still that benefit
01:16:31
there. And I should say Roth conversions
01:16:33
can also be an excellent tool for
01:16:34
planning around Irma searchcharges. The
01:16:37
fifth reason why I think Paul's concern
01:16:38
is a little bit overstated is that in
01:16:40
his original question, Paul mentions his
01:16:42
plan to take RMDs in May because that's
01:16:44
when he performs his annual rebalancing.
01:16:47
And that's a choice. That's Paul's
01:16:48
choice. That's not a rule. And that
01:16:50
particular choice does magnify Paul's
01:16:52
specific risk. I would recommend instead
01:16:54
that Paul consider spacing out his IRA
01:16:57
withdrawals over the year, perhaps
01:16:58
monthly, perhaps quarterly. We can think
01:17:00
of it as dollar cost averaging out of
01:17:02
his account, diversifying through time.
01:17:05
I've heard it referred to by
01:17:06
diversifying that way, we decrease our
01:17:09
exposure to sudden market events or Paul
01:17:12
can just take the RMD in early January.
01:17:14
If the risk of RMDs plus sequence of
01:17:16
returns is really sticking in your craw,
01:17:19
I think that we can just take the RMD as
01:17:21
early as possible because as we already
01:17:23
covered, your RMD is calculated based on
01:17:26
the IRA value as of December 31st of the
01:17:29
prior year. Well, let's not even give
01:17:31
the market a chance to crash. just take
01:17:33
the RMD right away in early January and
01:17:36
you know that the RMD you take will be
01:17:38
based essentially on the same exact
01:17:40
account value where the the RMD amount
01:17:43
was calculated against. And then my my
01:17:45
last thing to keep in mind today is
01:17:47
simply to stay invested. There's no
01:17:49
reason why you can't take your RMD
01:17:51
withhold whatever taxes need to be
01:17:52
withheld and then take the remainder and
01:17:54
immediately reinvest that money inside
01:17:56
of a taxable account. In fact, you can
01:17:58
even in many brokerages and many
01:18:00
custodians, you can take your RMD in
01:18:03
kind. You can just pull the shares out
01:18:05
of your IRA. You don't even have to sell
01:18:07
the shares. You can just move them in
01:18:09
kind into your taxable account and then
01:18:11
you would just owe the taxes based on
01:18:12
the size of that withdrawal. And that
01:18:14
way you you you stay invested because
01:18:16
the sequence of returns risk it really
01:18:17
applies to a situation where you
01:18:19
withdraw money forever. You you sell the
01:18:21
stocks and you keep it sold. You spend
01:18:23
the money. you deplete your investable
01:18:25
assets by four or five or 6% in the
01:18:27
middle of a down market. But with RMDs,
01:18:30
I mean, yes, you might have to take four
01:18:32
or five or 6% out of your traditional
01:18:34
tax deferred assets, but that money
01:18:36
doesn't just disappear. You can go out
01:18:38
and just buy stocks or buy whatever
01:18:40
assets you held inside of a taxable
01:18:41
account. You might have to set aside 10
01:18:43
or 20 or 30% of the total for the
01:18:46
federal and state taxes, but the
01:18:48
remainder can be and probably should be
01:18:50
reinvested. So in conclusion, I think
01:18:52
it's really good for Paul to think this
01:18:54
far ahead because probably, you know,
01:18:56
99% of retirees would not have the
01:18:58
foresight to think of this question.
01:19:00
However, I do think if we apply some of
01:19:01
the tactics and strategies I've outlined
01:19:03
here, the true impact of RMDs plus
01:19:06
sequence risk is probably going to be
01:19:08
more um negligible than we think. So
01:19:11
listeners, thank you so much for
01:19:12
submitting your great AMA questions. And
01:19:14
I'm already taking questions for AMAs
01:19:16
number 9 and 10. Feel free to write in
01:19:18
01:19:20
Thank you for listening.
01:19:21
>> Thanks for tuning in to this episode of
01:19:23
Personal Finance for Long-Term
01:19:25
Investors. If you have a question for
01:19:27
Jesse to answer on a future episode,
01:19:29
send him an email over at his blog. The
01:19:31
bestinterest. His email address is
01:19:34
01:19:36
Again, that's jessevestinterest.blog.
01:19:40
Did you enjoy the show? Subscribe, rate,
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01:19:51
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01:19:53
for Long-Term Investors. Personal
01:19:55
Finance for Long-Term Investors is a
01:19:57
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01:19:59
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01:20:02
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01:20:03
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01:20:05
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