Tax Efficient Asset Location

Shawn (00:00): Are you placing your investments in the right types of accounts to minimize taxes? Smart asset location could help you keep more of your investment returns over time. We’ll explore how strategically positioning your stocks and bonds across different account types can lead to better tax efficiency in your portfolio. Let’s get some perspective. Bob (00:27): Welcome to Christian Financial Perspectives. This is Bob Barber, the host of this program today, and we have a very unique program that we’re going to bring to you that Matthew has put together most generously. And we had some really good discussion about this before. It was kind of a little bit of hot discussion going back and forth. It wasn’t hot, but I mean it was like, what about this and what about that? But today we’re going to be talking about tax efficient asset location and Matthew put this together. So I’m going to put Matthew on the spot today. Matthew (01:00): Yep. That’s great. Bob (01:01): This is a unique idea I’ve heard about, but you want to bring it to our audience. Matthew (01:07): Yep, yep. I think it definitely can add value to clients’ portfolios long term. Bob (01:13): Yeah. Matthew (01:14): So let’s get into the verse. Proverbs 13:11, “Dishonest money dwindles away, but whomever gathers money little by little makes it grow.” I feel like this really, especially the second part of that exemplifies this. This is not a get rich quick scheme or anything like that. This is one of the building blocks for building long-term financial wealth and of course we’re going to look at it from a biblical perspective. Bob (01:43): So you mentioned asset location. What do you mean by asset location? Matthew (01:48): Yeah, so asset location is essentially the strategic placement of putting certain types of assets in certain types of accounts. Okay. Bob (01:57): So what do you mean by certain types of assets? Matthew (02:00): Yep. So stocks versus bonds and then the different account types that one may have a Roth IRA being one, a pre-tax IRA being a second, and then any non IRA account being a third. That can be a joint account, an individual account, a trust account, et cetera. And all three of those different types of accounts are taxed differently. And the two different types of assets, stocks and bonds are known for two different things. Generally, one friend come one for price per share increase, which we’ll talk about. This asset location strategy is really about concentrating the assets in proper places, locations, to take advantage of and optimize the tax efficiency of the portfolio, which over the course of time can be very beneficial. Bob (02:52): So somebody that would be in a high tax bracket would definitely be interested in this. Matthew (02:58): Absolutely. The impact can be for anyone who has, and we’re going to talk about this, who is this for? But for anyone who has different types of accounts, there’s going to be some benefit. But yes, absolutely. Individuals who have larger balances, the impact will be larger. Absolutely. Bob (03:17): Is it still a strategy for somebody in a lower tax bracket? Matthew (03:20): It absolutely can be, yes. Again, the marginal impact, incremental impact may not be as significant, but it’s a step in the right direction and a positive nonetheless. So why wouldn’t you do it? Bob (03:35): Absolutely. I agree with you because I just had a brainwave about something. Sometimes the capital gain tax can be zero depending on what your income is. It can be, right? Matthew (03:43): Yeah. Bob (03:44): So it looks at that income to determine whether you have to pay 0%, 15%, 20%, and of course if you’re in a real high tax bracket, you could be paying 23.8% in long-term gains. But still that’s better than an income tax bracket, which can be at 35% – and if you’re in a state with state income tax could be you could be at 40%. Matthew (04:09): You could be. Bob (04:11): Some places like California, you might be at 45%. Matthew (04:14): Yeah, yeah. Bob (04:15): Alright. Matthew (04:15): So just one point before we move on to who is asset location really for, I want to talk about asset allocation, right? Individuals from the beginning might be thinking, wait, don’t you mean asset allocation not location. Now they’re two different things. So while asset location is important, asset allocation continues to be the most important thing in one’s portfolio. So the location strategy or concepts that we’re going to talk about takes a backseat to making sure that your overall stock to bond ratio in your portfolio is being met because that is the strongest determinant of risk over the long term. And so we want to make sure that we’re… Bob (04:56): And how much risk can you take, right? Matthew (04:58): Exactly right. Bob (04:59): Yeah. So you say is this for everyone? It can be really. Matthew (05:07): It can be. So let’s go through some primary examples though. The first is you have to have multiple account types. If you only have a rollover IRA, then you only have one account and there’s no asset location opportunity. But for someone who has a Roth IRA, a taxable account like an individual or a joint account, a pre-tax IRA, now you have different types of accounts that are taxed differently and you can take advantage of those differences in the taxation law. Bob (05:41): Well the reason you and I had such a good discussion before this was because I fit that scenario and especially because we sold some family land for a sizable amount, I have a sizable amount that is not in an IRA, it’s outside of an IRA and I’m scared to death the time to ever sell anything because I’m in such a high tax bracket for that. So this tax efficiency is extremely important for me. Yeah. Matthew (06:05): We already touched on the second thing here, which is having a large enough account balance to make it meaningful. So certainly there can be an advantage for anyone who has different types of accounts, but for an individual who says has $100,000 in a joint account and then has a Roth IRA with $2,000, there’s an asset location opportunity, but it’s not going to be significant compared to someone who has a more even distribution amongst different types of accounts. Bob (06:37): Meaning that like $300,000 in non IRA accounts like a joint account and $300,000 inside of an IRA account. Matthew (06:47): Correct. Exactly. Bob (06:47): That’s a real scenario that would work here. Matthew (06:51): That is a recipe for allowing this to be more prevalent and have a larger impact. Bob (06:56): What are some other things that you point out here? Matthew (06:59): So I’d say the other big thing is the psychological impact. So for some individuals, this may not work for them simply because they are uncomfortable with having certain accounts in their portfolio more aggressively invested than others, right? So there needs to be an understanding that asset allocation of the overall portfolio is top priority, but underneath that you can have different accounts invested more aggressively or more conservatively and the individuals psychologically need to be okay with, hey, this account is performing differently than that account because they’re invested differently. Bob (07:39): I want to point something out there then. Okay. Because I’ve been through so many cycles with how long I’ve been in this business. You’ve heard me probably mention the bucket strategy. And the bucket strategy is where you have your different buckets of money and where one bucket is for your aggressive account and that’s going to be the most volatile, have the most up and downs like a rollercoaster ride, in another bucket, more conservative. And I’ve actually helped some people by taking a moderate portfolio, a balanced portfolio, and dividing it up and saying the aggressive portfolio is a long term, let that ride. And then you have your other money over here that is in the least aggressive and it’s helped them with the psychology of the markets. Does that make sense? Matthew (08:29): Absolutely. Yeah, that’s great. That’s great. So yeah, the individual needs to be comfortable with that. If this is going to be something that keeps someone up at night, don’t do it. It’s not worth it. It’s not worth the stress. Bob (08:42): Like I was saying, I’ve actually, it’s helped with people not keeping up at night by doing this kind of strategy. Matthew (08:47): It’s great. Alright, so how does it work. Now let’s get to the details finally. How does it work? Bob (08:52): Okay. Matthew (08:53): All right. So first, bonds, what are bonds known for primarily? Bob (08:57): Their interest. They produce interest. Matthew (08:59): Interest income. Exactly. So where can you put bonds? You can put them in an individual account or let’s say an IRA, Roth or Pre-tax. If you put bonds who are known for interest in an individual account, you are going to pay taxes at ordinary income rates every year in which those interest payments are distributed. If you instead have your bonds insulated in an IRA pre-tax, ultimately you’re going to pay those same ordinary income taxes on the interest, but not until you withdraw. So on the bond side of the equation you are paying the same tax, but by putting your bonds in the pre-tax IRA, you actually have more control on when you realize the tax. It’s not until you withdraw. So that’s one side of the equation. Let’s talk about stocks now. What are stocks known for? Bob (09:55): Well, they’re known for equities. They’re known for their capital gains. I mean you want capital gains as much as you don’t like to pay the taxes on ’em, you want capital gains. Matthew (10:05): So price per share increase, capital appreciation, right? So if we put stocks in a pre-tax IRA and you have it grow when you pull it out, you’re going to pay tax at ordinary income rates, which is what you pay when you would do a withdraw from a pre-tax IRA. If you instead concentrate your stocks in the individual account or what we call it… Bob (10:31): Or joint account, yeah. Okay. Matthew (10:32): You are going to pay, as long as you hold onto it for over a year, you’re going to pay long-term capital gains on that same capital appreciation, that same price per share. Bob (10:43): Which are much lower than the income tax rate. Matthew (10:45): Every taxable income level is lower than the ordinary, right? So you put bonds in your pre-tax IRA gives you more control, okay? You put stocks in your non-qualified individual accounts, take advantage of lower tax rates through the long-term capital gains. And it’s, it’s a great strategy. Bob (11:04): Why isn’t every accountant talking to their clients about, especially if they’re in a high tax bracket scenario. But if you’re in a low tax bracket scenario, like I said earlier, and my lights kind of went on after we’ve talked about this today before we made the program, is that, wait a second, really you can be at a point where you don’t have to pay any capital gain tax depending on if your income’s low enough, your long-term capital gain tax can be as low as 0, 15%. So it can actually be very, very low. So I can see where this scenario could work for maybe somebody that they have $100,000 in a non-qualified account. Matthew (11:46): And there are certainly situations where this strategy may not be exactly the best strategy for certain individuals, but as a general rule, this is the approach people would strongly consider taking. Bob (11:59): Now you remember one of the arguments I was talking to you about? Well this means though that do you have to, if you buy that set of stocks and that unqualified account, I feel like I’m nearly forced. I got to hold it at least a year so I have that lower tax bracket. But in a situation where the economy is starting to go south and it’s going to go farther south, it is still better to do the right thing asset allocation wise and take those gains. I’ve heard some people say I don’t want to sell any because I have to pay taxes on the gains. Well, there’s a saying, I always come back at ’em. We can wait for all the gains to go away and you won’t have to pay any taxes. Right? Matthew (12:41): Right. Exactly. That’s exactly it. So going back to something I said earlier in the conversation, right? Asset allocation is still a primary consideration here. Bob (12:50): So this has to be looked at each person individually to see where they fit with this. This is an individual tax strategy. Matthew (13:00): Correct. Bob (13:01): But I think a lot more people could do it than we both maybe realize. The more that we talk about it and I could see where we’re going to look at my portfolio more like this and do this with it. Matthew (13:16): So let’s look at a simple example just to illustrate it. So let’s say we have an individual with $200,000 in their overall portfolio and they’re targeting hypothetically 60% stocks, 40% bonds. Let’s say that they just happen to have a joint account with their spouse of $120,000 and a pre-tax IRA worth $80,000. Well I did this intentionally. The math works out perfectly. (13:41): You can put the $120,000 joint account in equities and stocks. The 80% IRA pretax IRA, in bonds, you maximize the asset location while also simultaneously for the overall portfolio meeting the asset allocation to make sure that your risk level of the overall portfolio is what it should be. So that’s a very simple example. Individuals may say, well what if it’s not so straightforward? What’s the process? I’d say the process you would want to follow is going to be putting your stocks as much as you can in the non-qualified accounts, putting your bonds as much as you can in your pre-tax IRAs. And if one fills up before the other, then the pour over goes into the other account with the Roth IRA being in the middle, right? So if you fill up a joint account per se, a non-qualified account, and you still have more stocks to meet your asset allocation strategy, then you put stocks in your Roth, putting the bonds in the pre-tax IRA, and then the overflow into the Roth as well. So that’s just an overall process and you can kind of think of it as if you have three cups and you’re pouring equities into the non-qualified cup and bonds into the pre-tax IRA cup. Once one of them gets filled up, it kind of goes into the Roth IRA cup. Bob (15:10): You know why I’m grinning, I just think about this as my wife was listening to this. She lost you by the way about three minutes ago. But the bottom line is you could help, can help anyone to figure this out. Matthew (15:22): Absolutely. Bob (15:22): Because it’s on an individual basis and do this through software programs, and we can show the actual tax savings that could be there. All right. Matthew (15:31): Sounds good. Bob (15:32): Okay, well I think that’s going to finish up for today. This is a very interesting subject that I think all of you need to look into. And if you’d like to give us a call at (830) 609-6986 during business hours that you’d like to talk about this or you can also text that number and just say, I’d like to talk about this strategy, or you can go visit us on our website and there’s also, there’s a contact tab on our website which you could actually set an appointment and by going to www.ChristianFinancialAdvisors.com. I think that’s going to do it for today. Matthew (16:05): That’s great. God bless y’all. Bob (16:06): Thanks. [DISCLOSURES] * Investment advisory services offered through Christian Investment Advisors Inc dba Christian Financial Advisors®, a registered investment advisor registered with the SEC. Registration as an investment advisor does not imply a certain level of skill or training. Comments from today’s show are for informational purposes only and not to be considered investment advice or recommendations to buy or sell any company that may have been mentioned or discussed. The opinions expressed are solely those of the hosts, Bob Barber and Shawn Peters, and their guests. Bob and Shawn do not provide tax advice and encourage you to seek guidance from a tax professional. While Christian Financial Advisors® believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability.