What to Do When You Become a Millionaire -- Part 3: Taxes

Hello and welcome again to our Fundamentals of Investing series. These videos are designed to explain important investment concepts you need to know to grow your retirement nest egg and build your personal wealth. I'm 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. This is an exciting topic and I'm looking forward to it.

Yes, here we are on part 3 of our What to Do When You Get $1 Million Net Worth series. And we're going to talk about everyone's favorite taxes. Of course, we've covered a couple of areas already in part 1 and part 2 of the video. The first part, we covered investment strategy. That's our bailiwick. That's our favorite. So if you want to check that out, go to part 1. We'll talk about a little bit more about what you need to do from an investment point of view. The second topic we talked about protection, which of course you need to talk, think about how you're going to insure yourself and how also you're going to ensure that your belongings and your estate moves down to who you want it to go to through a will and also, also through a personal trust. So if you want to learn about those topics, go to part 2 of the video. We're going to link all of that down below. Right now we're going to jump into the third part of the video, and that's taxes. As again, you know, when you're below a million in net worth, maybe taxes aren't as salient of an issue for you. But when you get to $1 million in net worth, taxes really do become top of mind issue for pretty much everybody. That's because taxes do tend to get high for investors in this bracket. Your income tends to be high. You tend to be in a high tax bracket. So what can we do to minimize taxes when we get to $1 million in net worth? And Nolan, to that end, should folks be working with a tax professional to sort of minimize their tax exposure?

So, first off, again, congratulations if you're at this mark where your net worth is now $1 million and thinking about taxes and having a tax problem. It's really a high-class problem. And so, we salute you in being in the top half. I'm not sure you're aware, but here in this country, only half of the citizens that are adults actually pay taxes. The other half does not. And the bottom percentage actually receive money back every year in terms of credits. So welcome to the top income taxpaying half. We have a lot of heavy lifting. First thing we want to think about with taxes, we don't want to make our situation worse. Each taxpayer responsible for their fair share, but not anymore. And so we really want to be, uh, forward with this. You should have somebody on your team that has some familiarity with taxes and your situation and tax code. We, we are big proponents of high net worth investors working with CPAs. If you have one that you like and that you're using, we suggest you lean into them. If not, feel free to reach out to us. We have CPAs that we refer out to. We don't receive any compensation or anything for it, but we feel strongly that good, competent tax help is an investor's friend on their journey from $1 million to $5 million. Your investment team. Should also be cognizant of taxes and the tax code. Those are two things right off the bat I would say, Brian, are really important to investors as they're growing their net worth.

Okay. And then we're gonna put on the screen here the, a slide that shows all the tax brackets, uh, just so you can understand kind of where you fit in that. And, uh, also as Nolan said, make, not making your situation worse, you know, as to the extent that we can control when we realize our income, you know, this year or next year, we want to make sure we don't push ourselves into higher tax brackets. So having a slide like this where you know what tax bracket you're in and where you kind of sit vis-à-vis the next tax bracket is always important for tax planning purposes. Definitely keep that in mind. And then we're going to talk a little bit more from the investment side of things on how to be tax efficient. So as investment managers, of course we want to make the right investments. That's our number one concern. But the second concern right behind that is tax efficiency. As Nolan said, we want everyone to pay their fair share and not a single penny more. So to that end, we want to make sure that the investments we make are tax efficient. So from that point of view, Nolan, what can we do from the investment side of the equation to improve tax efficiency for investors?

That's a really good question. There are a number of things that we can do. The first thing that came to mind for me is if you're an investor and you're investing money in a brokerage account, this is a taxable account. Think about tax-free investing. So if you're investing for income, you know, most of us the last few years, we have not received much on our money market because interest rates have been so low. But at the end of the year, you do get a tax form. Whatever interest income you receive from your account has to go on your 1040, your annual tax return, and that interest income is taxable at ordinary tax rates. So Brian put up the chart. If you're in a 24% tax bracket, then those dollars are taxed to you at 24 cents on the dollar. However, you could think about tax-free municipal bonds. These are bonds that are issued by a state or local government or local county. They're usually used— the money is for public works. And because of that, the federal government allows that interest income to come to you tax-free. Muni bonds now, municipal bonds pay, you know, 3% to 4% depending on the maturity. This is interest income that comes to you tax-free. The other thing you can think about, again, you're in a money market, interest rates are higher, so you certainly should be receiving a lot more interest income today than you have been the last 4 or 5 years. However, rates still aren't great. There are such things though as tax-free money market funds. The underlying security are tax-free municipal bonds that'll pay you interest income from your liquid money, but it'll give it to you tax-free. And so those are two things right off the bat that come to mind.

Yes. No. And so there are tax-free investments. But, you know, in terms of a comprehensive portfolio, we can only have so much of that. And then a lot of the other investments are, of course, going to be taxable. So what are some of the things we can do with our taxable investments to make them more tax efficient?

So the one thing that comes to mind is a strategy that we've been using, which is a low-priced bond strategy. So I mentioned normal bonds in brokerage accounts. This is after-tax accounts. They pay interest income. And now the interest income, depending on the maturity, their credit quality, anywhere between 4 to 7%. But again, this interest income is taxable at ordinary tax rates. So at the end of the year, you can get a form for your, your bank or your brokerage firm or the custodian that owns your money. They'll tell you how much interest income you've received, and then your accountant will report that on your, your 1040 at the end of the year. We like the idea, though, of what we call discount bonds. These are bonds today that you can buy for less than their maturity value. And so your return is made up of two things. One is the coupon rate that you're getting from a bond. So let's say a bond was issued and the coupon is 3%. That bond today, because interest rates are higher, it may be priced at 80 cents on the dollar. So the yield to maturity may be 6%, and half of my return comes from the stated coupon of 3. The other half of my return comes from when that bond that was issued, it's going to mature at 100 cents on the dollar. But if I bought it at 80 cents on the dollar, that's 20 cents of capital gain that I'm going to receive. Capital gains, if you look at the chart that Brian has on the screen, are taxed at different rates. And for most investors, that's going to be well below your ordinary tax rate. And so that's a way to be more tax efficient with your investments in taxable accounts.

And then you talk— you mentioned capital gains in the discount bond example, but capital gains more broadly, of course, if we own stocks or bonds, oftentimes we sell the asset at a higher price than what we paid for the asset. Of course, that generates a capital gain and kicks off a tax liability. What's another strategy that we can use to minimize our tax liability from a capital gains perspective?

I think we should all be cognizant of it. In a year like this, 2022, where there aren't many securities that are showing gain in the portfolio, I think investors ought to take a look at what's happened year to date with their realized transactions in their accounts. So at the end of the year, there's two things that can happen in your taxable brokerage account. One is I've had transactions that have generated a gain for me, and at the end of the year that'll be taxed at either a long-term rate or short-term rate. If I've held the security for 12 months or less, that's taxed at short-term rates, which is the same as my ordinary income tax rates. But if I've held the investments for 12 months or more, then that gain is taxed at a long-term rate. Long-term rates can either be 0, 15, or 20% depending on what my tax bracket is. Again, refer to the chart that you see on the screen. Those are with gains, but I also could have losses. So imagine earlier this year in January, I went out and bought Tesla stock or Netflix stock, or unfortunately maybe I bought them both and I put $10,000 in each. Today they may only be worth $5,000. Now, if I just keep them, could rebound at some point in the future, and both of them probably will. Who knows when, but they could. So I could just wait. The other thing I could do is sell those securities today and realize those losses, wait 31 days and repurchase them. Now, if I end up at the end of the year with a net loss, then I get to write that loss off on my tax return. The current tax law allows each investor to deduct up to $3,000 per year against their tax return. If I have losses beyond $3,000, then I have to roll them over to subsequent tax years. So we think tax loss harvesting this time of the year, you should be doing a portfolio review anyway because the economic conditions have changed. but consider whether it makes sense for you to take some unrealized gains, unrealized losses, and turn them into realized losses to reduce your tax liability this year.

Thank you for that, Nolan. That's just— we're just scratching the surface on the types of tax strategies that we can employ from an investment point of view. There's also Roth conversions. There's also making sure the right investments are in the right buckets, meaning your Roth IRA, your traditional IRA, and your taxable. These are all things that we can help you with. We'd love to have a conversation and discuss a little bit more what makes sense for your situation. So please do reach out if you're, if you're looking for ways to minimize your tax bill, if you just hit that million-dollar mark. So we want to mention again, we want to congratulate you for getting to a million in net worth. We want to help you get to those next milestones of $2 million, $5 million, and $10 million. So definitely reach out to us and we'll help you from this point forward. Thank you, Nolan, for being with us. Thanks. Thanks to everyone for listening. And also, if you want to learn more about what to do when you make a million, get to a million in net worth from the investment point of view and the protection point of view, check out parts 1 and parts 2 of the video. Thanks, everyone, and we'll see you next time.