Three Tax Strategies for High Net Worth Investors: Jarvis® Update July 14, 2023

It's never too early to think about taxes. We cover that topic along with another strong week in the market in this week's Jarvis Update. I'm your host, Brian Dress, Director of Research here at Left Brain, joined as always by our CEO and Chief Investment Officer, Nolan Langford. Nolan, welcome to the program.

Thank you, Brian. It's great to be here.

And it's great to be back here talking about taxes, everyone's favorite topic. We do want to ask everyone to like and share the video if you do find these video is useful and subscribe and hit the bell for notifications. That way you know next time the next video comes out. We also want to have a little more interactivity in the community here at Left Brain. We're going to ask you to leave a comment below the video with the answer to the question: are you bullish or bearish on the markets now, and, and why or why not? Let's get started with a preview. Another strong week in the markets. Two topics we will cover as we usually do. The first is our outlook for the second half of 2023 And the second is our top 3 tax strategies for investors. First of all, we'd like to ask you to sign up for the Jarvis newsletter. We come out monthly with those, and next week is the next, next edition. The last letter was entitled It's a Bull Market. Now What? So a lot of answers and a lot of strategies in there for you. We do produce this show for you, the everyday investor, whether you have a 401(k) or an IRA, whether you work with an advisor or you do your investing on your own. We'd love to be a resource for you. If you'd like a second opinion on how you're positioned for the current bull market, definitely give us a call. And I'm going to put the number here, 630-547-3316, for those of you who are listening on the podcast. For institutional investors, we've got something for you as well. That's our research service. We put out 6 to 8 full-length stock and bond reports from our analyst team every month. We've also got a library of hundreds of reports in the hopper. So if you want to take a look at what we feel about a number of stocks, out there, this is a great resource for you. And we've also got The Chosen. That's our favorite bond and favorite stock opportunity each quarter. We're out with that coming out this weekend. So, uh, great time to get started with the research service. Let's start with the market recap. First of all, all the 3 major averages that we cover— the S&P 500, the NASDAQ, and the small-cap Russell 2000 Index— we're up this week, but the Russell 2000 is a leader by far. When we tape this video, the Russell 2000 is up nearly 6% over the last 5 days of trading. We're seeing major leadership out of the growth world. So that's a— that bears well for those of us who are bullish on the markets. And we also had some important macroeconomic news, which is the inflation data. We found out on Wednesday morning that the CPI, the Consumer Price Index, came in at 3%, another month of decelerating, decelerating inflation. And this is as low as it's been in over 18 months. And all you have any general impressions of the market action this week?

Let me start with the, the inflation data that you mentioned. Very bullish. Inflation data as far as the Consumer Price Index having printed a low for the year. And it's something that was telegraphed. I know we started talking about this last fall at the end of last year. Finally, the data is starting to catch up. A lot of this data is lagging, so it happens first and it reports weeks or months later. So I think most investors and even the man on the street had an understanding that inflation was on its way down. You know, as you were just talking, talking about CPI, and I'm just thinking about how focused we've been the last 12 to 18 months on inflation. And it wasn't that long ago that it was the opposite. We were worried about deflation. I remember coming out of COVID Just tells you how things lurched from one crisis to another here recently. So inflation's on its way down, and I think the market and investors are breathing, breathing a sigh of relief. It's probably one of the reasons that the Russell Index was up 6% that you mentioned over the last 5 trading days. That index tends to be littered with smaller companies. Smaller companies tend to be more domestically focused, so their revenues and earnings come from US only. And if the inflation data is headed down, it looks likely that the interest rate increases will start to crest and settle down. And I think what the market's telling you is we're not going to have any nasty recession. We may have a garden variety recession, But with the strength we see in small caps, that's investors telling you that they're forecasting pretty much a short and shallow recession.

Nolan, I think the doomsayers will probably start telling us that deflation is coming soon. So we can always make an argument for why not to get into stocks. Uh, this seems like a really good time for investors to be investing. Let's jump right into our topics. Topic 1 is our outlook for the second half of 2023. So Markets have started out pretty strongly in the first half. Down here, the S&P is up around 17%. The Nasdaq's up over 30%. A lot of positive action, especially in the mega-cap stocks, the Facebooks, the Googles, Apple, and those type of stocks. But it is starting to trickle down to the smaller stocks, as you mentioned, Nolan, in the Russell 2000. Momentum appears to be growing for the last few weeks, and we are ramping into earnings season here in a couple weeks, so Uh, that's our next data point that we'll be looking for. We'll be looking to see our company's actually doing quite well on the business side of things. We know their stocks are doing better this year, but we really want to know what's going inside the business. Nolan, what is your outlook for the rest of the year?

I am like you. I'm looking for a very positive second half of the year. I think the first half of the year, particularly the first quarter, whatever positive momentum or rally we had was, we're very skeptical of it. To say the least. There wasn't a lot of news behind it, no earnings growth behind it. It was pretty much speculation that things would get better, and some of the more heavily shorted companies were the ones that were doing best in the first quarter. As the year has progressed, particularly the last few weeks, the rally has broadened. Matter of fact, the last couple of weeks, those big-cap stocks that you mentioned that led the S&P earlier have really started to flatline the last couple of weeks. and the rally's starting to broaden to some of these areas of growth that hadn't participated earlier in the year. So I think that's positive, broad-based rally. I think the end of the year, a lot of it, I, I think we can kind of throw out inflation and, and the Fed. I think that's probably going to be a, a page 10 story. And I think what's going to be a page 1 or 2 story is just how individual businesses are performing. What's happening with revenue? Is revenue accelerating or is it stagnant? And what's going on with margins? With higher inflation the last couple of years and slower sales, are companies able to hold margin, or in the best case, are they able to grow margin? So those are the things that we'll be looking for in the next two quarterly earnings reports. To the banks report here in the next week or two, and then after that we get Netflix that reports. And so when we get to the last week of the July and the first week of August, we'll be in the full swing of earnings season. How earnings season goes, goes a long way to determine the second half of the year. But again, my bet is that it'll be a bullish second half of the year. Remember, a lot of these growth companies that have just been clocked the last couple of years, expectations had been lowered because earnings had been lowered. So as they start to report, the year-over-year comparisons will get easier. So some companies can meet those expectations and then raise guidance that's generally a recipe for really handsome returns.

That's great to hear, Nolan. We do talk obviously to a lot of investors. What we've really heard in the last few months is things have already moved quite a bit. Stocks have already made positive moves. You have any advice for investors that are kind of thinking, oh wow, I may have already missed the move. It's, it's too late for me to get invested.

It looks like we're just getting started. It doesn't look like we're at the, the end of the the bull market. It looks like we're at the beginning. And it tends to happen in markets that momentum begets momentum, and that's both upside and downside. And as you mentioned on our last taping, you think about bull markets and bear markets— bear markets are a lot shorter and more violent, so 5 to 8 months, and then bull markets last much longer and they're kind of slow growing. So no, I think it's, it's still time to get in. And what we like more than just kind of looking at the headline, seeing what the returns are year to date. You take underneath and look at some of these individual businesses and looking at the prices at which you can buy shares versus the value you're receiving and how well the business is positioned. I really like it. I think we haven't been this optimistic in many, many years, to be honest with you. You know, coming out of COVID the second half of COVID in 2020 was a really fruitful time in the market, but the first half of the year was unbelievably scary. And a lot of the end of 2020 was just anticipating better times ahead. It actually hadn't happened. Where now you're starting to see tangible results. It's just people aren't giving the shares a higher price and pricing them at a premium. So no, I think it's not too late to get involved. And again, it's not just stocks. There's many, many bonds that we follow that we track in Jarvis. Where yields are 8 to 10%. So we think there's a chance not only for steady income but also in capital appreciation because some of these bonds are trading much less than their maturity value. So there's a lot to like and no, it isn't too late.

Very good advice there, Nolan. Plenty of opportunity out there and we definitely encourage you to get in touch with us if you're not sure exactly what to do. With that, we'll move on to our second topic. So topic 2 is our top 3 tax strategies for investors. So We know it's July. We just got past— we just got through taxes about 3 months ago. Really, now is the time to start thinking about how to position ourselves to be the most tax efficient that we can be. We don't want to wait until after the fact and try to make something happen with the tax return. We want to be proactive ahead of time. So the first thing I want to talk about, Nolan, is capital gains. So, you know, we had some tax changes a number of years ago that really disadvantaged taxpayers, but it did leave behind a few advantages for taxpayers, and one of those is capital gains treatment. So investors get preferential treatment relative to wage earners. So if you hold an investment for more than one year, you're eligible for capital gains taxes, which are much lower than your ordinary income rates. If you hold an investment for less than one year, those are short-term capital gains and you're going to pay your normal ordinary income rate. So that's definitely a distinction you want to keep in mind. Nolan, do you have any comments on capital gains or how do you, how do you think about capital gains taxes?

We like capital gains. We may not be thrilled about paying the tax on capital gains, but certainly we want some gains. And the question is, where are those gains? You can have gains in two places, either in a tax-deferred account. So this would be like an IRA or a 401(k), or you can have it in a taxable account, i.e., a brokerage account. Now, if you have capital gains and you have it in a retirement account, this discussion is not going to mean that much to you because you're sheltered from paying capital gain. Anything that happens in an IRA or retirement account is not tax reportable in that year, and none of those transactions are, and you're not taxed on that money until you actually withdraw. So the discussion we're going to have on capital gain pertains to brokerage accounts. These are accounts that at the end of the year you get a 1099 tax reporting form. You turn that into your accountant who then reports that on your 1040. And just a quick reminder to the investors, ordinary tax rates go from 10% all the way up to 37% depending on your tax filing status and your earned income or your taxable income for the year. But capital gains We get capital gains tax treatment on any investment. So your home, your rental property, and also your stocks and bonds that are held within a brokerage account, those are taxed at capital gain rates. And like Brian mentioned, those are either going to be short term if I've held the asset for less than 12 months or long term if I've held the asset for 12 months or longer. And the benefit of the long-term capital gain treatment is the tax rates are lower. So again, on the income side, they go from 10% to 37%. But on capital gains, there's actually a 0% capital gains bracket. And the most I'm gonna pay for capital gains is 20% as long as they're long-term. So again, 0 to 20 on long-term capital gains versus 10 to 37 on ordinary income.

That's helpful, Nolan. We will put those, those figures up on the screen. And then I wanted to make one simple point as well with capital gains is that you pay the tax when you realize the gain. So if you hold the stock for 10 years, you're not going to pay any tax on that until you actually sell the stock. So that's another advantage of being a long-term investor is you don't pay tax until you actually realize the gain. So we can easily hold the stock for 30 years and never pay tax.

So I think that's interesting because earlier we had this discussion about the bull market. Is it too late to get in? And one of the things that we've lamented over the last couple of years is one by one, all of our sort of tax strategies and tax deductions have been taken away. And the most recent one was that state and local tax, the SALT thing, that got removed. So now the interest, you know, your mortgage interest, your taxes, your, your state and local taxes, they're all capped. And more tax filers now do the standard deduction than ever. Very little itemizing going on. One of the few sort of tax benefits that we do have left is this capital gains. The fact that you're right, Brian, you can own a stock, you can own it for many years. The stock can go up 3 or 4 times what you paid for it and you not have a tax bill, no tax bill until you decide it's time to sell it. and then once you sell it, then you decide and you can trigger the tax. This is one of the reasons that in taxable brokerage accounts, I know with our clients at Left Brain, we prefer to own individual stocks and we do not own mutual funds just because of the tax efficiency and us being able to time when we take the gain and pay taxes.

Yes, it gives us much more control. Let's talk about number 2, our second tax strategy for investors. That's Roth IRAs. So As Nolan said, you know, a lot of the tax advantages that we used to be able to enjoy are not there anymore in the tax code. But Roth IRAs is one that is still there. So a lot of people here may have 401(k)s and IRAs. Those are tax-deferred vehicles. That, that means you put in pretax money and then you pay tax when you sell the shares during your retirement. So that's tax-deferred. Roth IRAs are a little bit different. In Roth IRAs, we put after-tax wages into the— into our Roth IRA. We never pay tax again. So all the growth that we— that we enjoy in that Roth IRA, whether it be 10 years or 30 years or 50 years, is all tax-free. And at the end, you don't pay tax. So we really like Roth IRAs. And the younger you are, the more important it is to have money in a Roth IRA. Nolan, can you talk a little bit more about Roth IRAs? Who can use it? And then talk a little bit about a strategy we call Roth IRA conversions.

There's a lot to talk about here with Roths. I think it should be that way. It is one of the last tax-friendly accounts that we have left. And with all the deductions being gone, I think the focus is going to go to the Roth and it should. Typical IRAs and 401(k)s are a tax-me-later plan. So I put money in, I deduct it from my taxes in this year. and then I'm going to settle up with my partner, the government, many years in the future. So it's a tax me later. With Roth accounts, it's a tax me now plan. So I'm going to pay taxes today, but then I'm not going to have to worry about tax rates in the future. And the reason that this is— maybe before it kind of went quietly underneath the table. The reason that we've been bringing a lot more attention to it is our country is $31 trillion in debt. That doesn't include the unfunded liabilities from Social Security and Medicare and unfunded pensions. And if you take a look over time, the way the government's— their strategy for handling these higher obligations have been to raise taxes on people. Now, it doesn't seem like that the last few years because, again, the highest tax bracket today is 37%. But if you take a look at all the deductions they've removed, it's effectively has been a tax increase. And so if you're concerned about the $31 trillion in debt, the Social Security haircut, the unfunded liabilities, one of the ways to buy yourself some insurance is to say, I'm just going to pay the taxes due to the government today at today's tax rates. And if they go up in the future, I've already paid my taxes. Roth is a way to implement that strategy. So that was— that's the first remark I would make. Just in principle about doing a Roth versus doing a traditional 401(k) or IRA.

Excellent analysis of why we like Roth. So let's bring it into the practical a little bit here. So, Nolan, we have— we talk to a lot of investors. They've got 401(k)s, they've got traditional IRAs, which are pretax money. How do they get that money into a Roth and take advantage of this, of this opportunity?

Good question, Brian. So there's two ways to get money into a, to a Roth. One of them is just you can just make a contribution. I think, you know, I think people are familiar when IRAs first started, you could just take $2,000 and go to your local bank or financial institution and what they call buy an IRA. With the Roth, you could do the same thing, which is you can take your $6,500 per year right out of your checking account and just put the money in a Roth IRA if you qualify. And you have to qualify by income in your income caps. So if you're single and you earn $144,000 in modified adjusted gross income or less, or if you're married and it's $214,000 joint or less, then you can just write a check and just fund a Roth IRA right out of your checking account. That would be the first way. The other way that I can get money into a Roth is I can just move it. So if I have $1,000,000 in my 401(k) or traditional IRA, I can move some part or all of that money from my traditional IRA to a Roth IRA and move it from my left pocket to my right pocket. Anybody can do it. So it does not matter what your income is. Bill Gates, Elon Musk, Warren Buffett, they can all do it. There's no income limitations. Years ago, there was a $100,000 income limitation. That's been gone for many, many years. So anybody can do it. However, if I move that money from my left pocket to my right pocket, I do have to pay taxes on any money I move today. Put it in just practical terms. I've got $1 million in an IRA. I like to move $100,000 to a Roth. I do that today, mid-July 2023. No problem. But at the end of the year, when I go to my accountant, I'm going to have to pay taxes on $100,000 I move and then any money I earn from work. So if I earned $100,000 in my salary from work, I'm going to pay taxes in April on $200,000 in income. Even though my job only paid me $100,000. So that would be the downside of converting to a Roth is I do have to pay taxes today and whatever my marginal tax rate is today.

Excellent. And so there is a trade-off there. A financial advisor like us could help you make the decision and do the calculation of whether it makes sense for you to do a Roth IRA conversion. So definitely get in touch with us. We'd be happy to walk you through that.

Let's talk about really one more, one more point. Sorry, Brian, on Roth IRA. Conversions and paying the taxes, generally what we like to do— so there's these tax brackets. If you're married and filing jointly, that 24% bracket goes from $190,000 up to $364,000. So if you're a joint married couple and your modified adjusted gross income between the two of you is $250,000, then there's about another $90,000 that you can use and stay within that 24— that 24% bracket. One of the strategies that we like to take a look at is if you can convert up to $90,000, that keeps you in that same bracket. And so that's one of the strategies that you want to look at when you look at converting to a Roth and paying the taxes.

Excellent. And the third strategy we want to talk about is something that's starting to gain more prominence in the, in recent years, and it's more Roth. This time we're talking about Roth 401(k). Nolan, can you talk about what Roth 401(k) is and how investors can take advantage?

Yeah, I think this was a great innovation on the part of plan administrators to— I don't know if it was the plan administrators lobbying Congress or Congress coming out with the rule and plan administrators adopting, but I think to the benefit of many, many workers in the U.S., you now have the ability when you take money out of your paycheck to fund your retirement. To have it go in either the bucket on the left or the bucket on the right. The bucket on the left is a traditional bucket. I make $100,000, I put $10,000 into my 401(k). I only pay taxes on $90,000 this year, and the other $10,000 is deferred until future years. If I put money in the right pocket, in the right bucket, and I make $100,000, the right-hand bucket is the Roth bucket. I make $100,000, I put $10,000 in. At the end of the year, I still pay taxes on $100,000. So no deduction today. The benefit is, though, is I'm not income restricted. So before, again, remember, if I'm married filing jointly, it's $214,000 and then I'm tapped out of making a Roth IRA contribution. But there's no such income cap if I do it through a Roth 401(k). So that's one of the benefits. The other thing is the amount that I can put in. It's a lot higher putting money into it. It's the normal 401(k) limits, which are much higher than the $6,500 that I can just put in a traditional IRA for making a contribution. So that's a really big benefit. I can put money in and that income cap doesn't hit me. It allows you to compound money in a tax-free in the future account at a much more rapid rate. So I think it's a great innovation. I think any investor that has access to a Roth 401(k) at work So certainly consider taking a look at it. If you're our client, don't hesitate to give us a call and send me— send us your summary plan description. If not, we'd love to be a resource for you. Basically, you want to run the calculation to determine at today's income tax bracket, if you forego giving up the deduction today for the compounding in the future, does it make sense for you given your situation? Those are the things to consider. But let's not kid ourselves, this is a great big boon to investors who take advantage of it.

So if you have a 401(k) at work, definitely get in touch with the plan administrator and see if a Roth 401(k) is an option for you. Now let's, let's tie up this conversation. What are some of the most important considerations beyond what we've just mentioned in terms of taxes for investors? And how, how do you think investors should approach being tax efficient with investments? And then finally, how do we do that for our clients?

So you really have to be careful. The tax rules and the tax laws are constantly changing. You know, the last session of Congress last year during the last election, one of the issues that came up was how do we get, you know, getting rid of the Roth and the backdoor Roth. And so it's on the table now, but things are constantly changing. We just had SECURE Act 2.0, which means if you had money in a 529 account, you've had it there for over 15 years. That's money that you then can convert and move into a Roth tax-free account. My point is these rules constantly change. Congress is constantly updating their framework, so you need to stay on top of them. But two that come to mind that you didn't mention that I think investors can take advantage of, one of them regards the retirement plan at work and the ability to fund it with after-tax contributions. So many times employers will have a 401(k) plan and then for whatever reason, there's a cap to the amount you can fund it. But they'll also have the ability for you to put after-tax dollars in your 401(k). And many, many, many investors have done that. Thing is, decades later, you've kind of forgotten about it. So if you have this bucket of money, that's this after-tax bucket of money that you funded in your 401(k) account or your profit-sharing account, that's money that you then can move out. Don't roll it to a traditional rollover IRA. You can roll that money into a Roth. So that could potentially be a huge pot of money. So that would be the, the first consideration. So if you're an investor, you're watching this, you're not a client, give us a call. We'd certainly be happy to review your statement to let you know if this strategy is eligible for you. If you are a client and this pertains to you and we don't know about it, give us a call or send us your statement. And if you have a coworker or a family member who could take advantage of this strategy, don't hesitate to give us a call. The second thing I wanted to mention is company stock inside the 401(k). So there's hundreds, literally thousands of companies that allow their employees to purchase their company stock inside their retirement plan at work. And millions of workers have absolutely done that. Well, there's an associated tax strategy that you can use when you separate from your job as well. If you're over 55 and you own company stock, there's a tax strategy called net unrealized appreciation. In essence, what it'll allow you to do, if you have an appreciated stock inside your retirement plan, it'll allow you to withdraw the stock. So not roll it over to a retirement plan where there are further restrictions, but actually go in and physically remove it and move it from your retirement account to your brokerage account. So that money's unlocked and it's available for you to use right away. The tax benefit comes in, in the fact that, hey, this is a stock, it's a $100 stock. I paid $25 for it years ago. When I remove the stock, instead of being taxed at today's market value for $100 at ordinary income rates, the tax payment is split up, split up, and the $25 that I paid for the stock is taxed to me at ordinary income rates. But that $25, that, the amount between the $25 and the $100, that $75 is taxed at long-term capital gain rates, not ordinary income tax rates. And depending on your tax bracket, this could be a benefit of many hundreds or thousands, or in some cases millions of dollars if you own a lot of stock. So it's something that not even a lot of plan administrators are aware of, and certainly not non-professionals, there's not very many that are aware of it, but it could be a very lucrative strategy. There's some things that you need to do to preserve the tax benefit and to make sure that you don't mess it up. But it could be a powerful benefit that we've used for a lot of clients, particularly ones that would like to retire early and particularly ones that want to retire before Social Security payments kick in.

Well, Nolan, I'm excited we got the opportunity for you to talk about net unrealized appreciation, one of your favorite topics and techniques. We want to thank the viewers for being with us. We hope you gain a lot of value from learning about some of the tax strategies that are available to investors. And we also wanted to thank you for being with us and discussing what's going on in the markets. We definitely see a lot more positive momentum in markets and we're feeling much more ebullient. Nolan, any final thoughts as we bid the viewers adieu for the weekend?

Yes. Want to wish the viewers a happy vacation. I know it's the summer season and we've all got the travel bug. But now you can be on the beach with your book and not have constant consternation about what's happening in the market or the economy. Right now things are just fine, so enjoy the beach.

Thank you for that, Nolan, and we'll see you again next time.