WCI #12: Investing in Taxable Accounts - What You Need to Know

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here is your host, Dr. Jim Dahlia. Welcome to the White Coat Investor podcast number 12. Love what you hear on the podcast. Looking for more great White Coat Investor content? Head over to our YouTube channel where you can watch video recordings of our podcast, short snippets of financial tips explained succinctly by me and others, and deep dives into topics for more in depth learning. You can even learn all about real estate with webinars from our real estate partners. Check out all this and more@YouTube.com thewhitecoatinvestor you can do this and the White Coat Investor can help. Thanks for what you do. What you do matters. Your daily work is important and that is continually reinforced to me as I go in and do my various work in the hospital. I was in there yesterday and I'm amazed sometimes at just how much work doctors are doing and wedging into such a short period of time. So if you're on your way into work or even on your way home, even if nobody else said thank you today, at least I can tell you thank you for what you do. Our quote of the day today comes from David Swenson, the manager of the Yale Endowment Portfolio, and he said ironically, upon acquiring sufficient information to assess the skill of an investment service provider, investment individuals end up empowered to take control of their portfolios and make their own decisions. Basically, he's saying by the time you know enough to pick a good advisor, you know enough to do it yourself. Our subject today is going to be taxable accounts. And by taxable I mean a typical non qualified brokerage or mutual fund account. When people talk about a non qualified account, they're talking about qualified with the IRS. So a qualified account is a 401k or an IRA or something that gets some sort of tax break from the irs. But a non qualified account doesn't get those tax breaks. It's just a fully taxed account. And I hear from people a lot that wonder what can I do now that I've maxed out my 401k and backdoor Roth IRA and HSA. I'd like to save more, but I don't know what to do. Should I go buy an annuity or whole life insurance or something like that? And it's like they've never heard of a regular old investing account and so these poor people fall prey to whole life and annuity salesmen. Of course, when you compare whole life insurance to a taxable account, it compares better than when you compare it to an IRA due to the much better tax treatment that the retirement account gets. But it's still usually dramatically inferior. You certainly don't have to invest in those insurance products just because you've already maxed out your available retirement accounts. But if you have a chance to use retirement accounts, do use them. As Phil demuth says, especially for young high earners like like us, retirement accounts are a money machine. This is one of the few hiccups in the tax code that favors the high net worth. So take advantage of the opportunity. But it's not like there's no advantages of a taxable account. Think about all the advantages. For example, the first one is liquidity, right? You can get at that money anytime you like with no restrictions whatsoever. Yes, you have to pay the taxes on any gains you may have when you sell it, but that's it. It's not money that just has to be used for retirement or just has to be used for college, or just has to be used for healthcare. You can blow it all on a boat if you want. So it's nice to have liquidity of that account. It's also pretty easy to keep your costs down in a taxable account. You can buy stocks and ETFs and many brokerages for basically no commission at all. If you go directly to a mutual fund company, particularly a low cost one like Vanguard, you can buy their super low expense index funds. I mean, you can keep your expenses to the single digit basis points without paying any other fees. So it's really nice that you can keep your costs low with the taxable account. Another benefit of a taxable account is you can use margin. I don't necessarily recommend you invest on margin, but it's very easy to do. So you can basically borrow against the account, whereas you can't really do that in most typical retirement accounts. Another benefit of a taxable account is that you get reduced tax rates on the income and the gains from the account. The income gets taxed oftentimes at the lower qualified dividends rate, which is 0% if you're in the 10 or 15% bracket, 15% if you're in the 25 to 35% bracket, and 20% if you're in the 39.6% bracket. So that's a significant benefit. You get that same rate on the long term capital gains, meaning if you held the investment for at least a year before selling. Even the gains on that are only taxed at the lower rates. Bear in mind, of course, the Obamacare taxes are added on top of that. So that might be as much as 3.8% more if you are single earning over 200,000 or married earning over 250,000. Another great advantage is that you can get tax efficient investments pretty darn easily. At a mutual fund company like Vanguard, you can buy funds that are naturally tax efficient. They might be tax managed funds or broadly diversified index funds like the total Stock Market index fund or even municipal bond fund. And they don't pay out very many dividends. The dividends they do pay out tend to be qualified dividends. You can even buy investments that don't pay any dividend at all, such as Warren Buffett's company Berkshire Hathaway. Microsoft didn't pay dividends for a long time either. And so you can buy very tax efficient investments in a taxable account. But even better, Uncle Sam will share your losses with you. And this concept of tax loss harvesting is a little bit difficult to wrap your mind around. But basically you should never hold an investment that you have a loss in in your taxable account. You should sell it and exchange it for something that's very similar to it, but in the words of the irs, not substantially identical. And so basically what you do is you change from one investment to another that has very high correlation, you book that loss to use against your taxes, and you're basically still invested in something very similar that's going to perform the same way. So it's nice to be able to use that on your taxes up to $3,000 a year against your regular income, but you can use it indefinitely against capital gains income. When you die with a taxable account, you get a step up in your heirs rather get a step up in basis at death. And that's nice because then they basically it's like they bought the investment on the day you died and so they can sell it right away without having to pay any capital gains taxes at all. Interesting. The whole life insurance guys always like to talk about the tax free benefits of whole life. And the issue they don't realize is in a lot of ways you get the same tax free benefit from a simple mutual fund. Not only do you can you borrow against it, just like you can borrow against a whole life policy without any tax cost to that borrowing, but also when you die and what's left is given to your heirs that also passes tax free. Another cool Trick with the taxable account is to donate your appreciated shares to a charity. If you give money to charity every year anyway, why not just give them your appreciated shares? You get the same deduction for the charitable donation. And in addition you get to flush out those low basis shares, you know, the ones that you would owe a lot of capital gains on, out of your portfolio. And then you don't even have to wait 30 days like with tax loss harvesting. You can just buy the same exact investment the very next day if you like. Finally, you can get what's called a foreign tax credit. If you're invested in a mutual fund that owns foreign stocks every year, that mutual fund pays some taxes on the income from those stocks on your behalf. If you are investing in that fund in a retirement account, you don't get any benefit for doing that. But if you do it in a taxable account, those losses are passed on to you and you can then use that as a credit on your taxes. So how do you invest in a taxable account? Well, there's lots of ways to do it. The two main ways are to either hire someone else to do it or to do it yourself. The benefit of hiring somebody else is that you don't have to hassle with it. And in fact, some of the robo advisors like Betterment are pretty darn good at managing a taxable account in a very tax efficient way. Their computers will take care of all your tax lost harvesting. And in fact they've got some pretty good data that shows that might for some people even make up a big chunk of the fees they charge just from the value you get from their computer run tax loss harvesting. You could hire a regular financial advisor as well. Obviously that's going to be a little bit more expensive than a robo advisor, but hopefully you're getting some other value out of it other than just the tax loss harvesting. Of course you can do this yourself as well, but if you're doing it yourself, you've got to weigh it against the value of your time. So here are a few principles to think about as you manage your taxable account yourself. Principle number one is max out your tax protected accounts first. I mean, it seems silly, but a lot of people are investing in taxable while they still haven't even maxed out their 401k for the year. Don't do that front load all your tax protected accounts and try to max those out earlier in the year and save your taxable investing for later in the year. Make sure you follow a regular savings and investing plan. You should have a written asset allocation or written investing policy statement. And make sure you're saving an adequate amount and working toward reasonable goals. That matters way more than trying to save a few bucks in taxes here and there. Make sure when you invest in a taxable account that you're using tax efficient investments, particularly with mutual funds. You know, there's lots of debate about whether, you know, stocks should go in taxable or whether bonds should go in taxable. And that comes down to a lot of different factors, many of which are personal and many of which are unknown because they're in the future. But either way, make sure you're putting tax efficient funds in that taxable account. So if you're putting stocks in there, you want things like a tax managed fund or a total stock market index fund or a total international stock index fund, especially if you're trying to get that foreign tax credit. If you're investing in bonds, you want something like a municipal bond fund out there that's not kicking off all this taxable income. You should try to simplify your holdings at every opportunity possible. As you go through the years, you'll have a few chances to do that. Tax loss harvesting may get you a chance to reduce the number of investments you have or the number of lots of an investment you may have. Tax lots, meaning the number of shares you bought on any given day. It also, you may be able to simplify by not. You may be able to simplify as well by waiting 30 days to buy back the investment after tax loss harvesting. But again, I don't generally recommend you do that. I recommend you swap the same day for a similar investment, just in case it goes up a whole bunch in the next month. You can also, as I mentioned earlier, donate your appreciated shares if you have an investment you really don't like and it has bunch of appreciation. So you know a lot of tax money if you sold it. Shoot. Use that one for your charitable donations. It can also simplify things if you save regularly but invest a little bit less frequently. For example, just because you're pulling money out of your paycheck every couple of weeks doesn't mean you have to buy shares of a mutual fund every couple weeks. You can save it up and buy it once a month or once a quarter. Even then you have a lot fewer transactions to keep track of. It also helps if you only buy one investment at a time. For example, if you're trying to split your $2,000, you have to invest across six investments. You're going to Have a lot of transactions to keep track of and a lot of tax lots to keep track of. Now granted, the brokerage companies generally do a lot of that keeping track themselves, and you don't actually have to do it. But buying one investment at a time is a heck of a lot simpler. So whatever is the most behind that month on your asset allocation from what your written investment plan says you should be invested in, just put all the money in that investment. The next month it'll be a different one of your investments, and so that helps you keep things simpler. It also keeps things simpler. If you hold your bonds in your taxable account, you simply don't have to worry nearly as much about tax loss harvesting because there aren't a lot of tax losses in a bond fund. They just don't go up and down that much. If you look at what the share price has been for the last 10 years, you may find it's only varied by 5 or maybe 10% at the most over that time period. You can also use exchange traded funds instead of traditional mutual funds, especially if your brokerage gives you a bunch of free commissions or free trades with commission free trades on your investments. While I use traditional mutual funds a lot in tax protected accounts, oftentimes will use an exchange traded fund in taxable. But be sure that you're only using ETFs with a high volume so that the bid ask spreads are tiny. You want to only use the most liquid ones. When you start investing in stuff that isn't very liquid, you may be better off with the traditional mutual fund. And of course, don't necessarily reinvest all your dividends in your taxable account like you might in your Roth IRA or your 401. You'll still reinvest them, but don't put them back into the exact same investment. That creates a little tiny tax lot every time you do it. I think you're probably better off just having those all accumulate into your money market fund or whatever your sweep account is at your brokerage, and then adding that to whatever you're investing the next time you invest at the end of the month or the end of the quarter. Remember that tax loss harvesting done in the beginning of the investment. Once you have held an investment for a year or two, chances are you're never going to be able to tax loss harvested again because the market generally goes up over the years and so you really don't have to pay attention so much to looking at the value of all those older tax lots. It's really mostly the ones you bought recently that you'll be tax loss harvesting. I've mentioned briefly a little bit about tax location, which is whether you put stocks or bonds into your taxable account or into your Roth IRA or into your 401k. The mistake that too many people make is they only pay attention to the tax efficiency of the asset class rather than paying attention to both the tax efficiency and the expected return of the asset class. So while a typical bond fund is less tax efficient than a typical stock fund, you also have to weigh the fact that the stock fund is likely to appreciate at a higher rate. And so putting your stocks into a tax protected account may make the tax protected account larger in the long run and that effect may outweigh the tax efficiency issue. And so in general, there's three general rules. The first is if you have a tax inefficient asset class with a high expected return, such as real estate, investment trusts or hard money loans, those should go into a tax protected account. If you have a tax efficient asset class with a low expected return that should go into a taxable account. This all of course assumes that you've maxed out your tax protected accounts. If you have another asset class that isn't necessarily either one of those, it doesn't matter that much where you put it. Whether it's a tax inefficient low returning asset class or a tax efficient high returning asset class, don't spend a lot of time worrying about that. It's pretty hard to know in advance which location for those assets is really going to work out ahead for you. So that's my summary of what you should do with your taxable investing account. Let's do a couple of questions I've gotten by email. Here's the first one. I'm one of those applicants who won't begin medical school until the age of 25. That means I had about three years to work in the real world and earn some income before I begin medical school. I was able to save some money. Not much around 50,000. And this is what I will have in my bank account before beginning medical school next year. A question I have is what is the most financially sensible thing to do with this money? Should I invest it in stocks, bonds, etc. Put it in a retirement account? Apply it all to tuition to mitigate my loan burden? Because I will most likely attend a private school for which tuition costs $54,000 a year, or should I do a mixture of all of the above? That's a great question. I occasionally run into a non traditional medical student who has this issue. They oftentimes have some retirement money and wonder if they should withdraw it from the retirement account and use it to pay for medical school. In general, I'd recommend against withdrawing from retirement account. In fact, medical school may be a great time if you have a tax deferred retirement account from your prior career to do a Roth conversion of that money at no tax cost whatsoever to you. So that is a great thing you can do. You also have to keep in mind that there are some may or may not be consequences to tapping that money. For example, if it's invested in taxable assets like a mutual fund with very low basis, you might normally have to pay a bunch of capital gains taxes to get to that money. But in med school, when you have almost no income, chances are you're not in anything higher than the 15% bracket and you don't have to pay anything but a 0% capital gains tax on selling those assets. So I think that's perfectly fine to sell taxable assets and use it to reduce your medical school debt. But here's the deal. If you're going to spend that money in medical school, if you're going to use it to reduce the cost of your schooling, invest in something conservative until you need it. If you're going to leave it invested for retirement for the long run, then invest it aggressively. But for the most part, I don't think there's necessarily a wrong thing to do. Leaving it invested, particularly in a retirement account, is a good thing. Tapping it to pay for medical school, as long as you're not pulling it out of a retirement account, I think is probably a good thing. So basically, if you're going to spend your money while you're in medical school, invest it in something conservative, maybe even keeping it in cash. But if you're not going to do that, then invest it aggressively because you've got a lot of years before you're going to need that for retirement money. Bear in mind, of course, that there are some exceptions to pulling money out of a retirement account such that you can pull it out without having to pay the penalty. And because you're in such a low tax bracket, you might not even have to pay taxes. So it's not the worst thing in the world to pull that money out as long as you're using it on education. That's one of the allowed exceptions. But in general, I think once money's in retirement accounts, it ought to be left there until retirement. I don't like People getting in the habit of either borrowing against their 401 s or withdrawing money from them when they have other needs. But it's not like medical school is a bad investment. It's probably going to increase your income dramatically. All right, second question. Recently you described the process of doing a backdoor Roth ira. One of the requirements you mentioned was not having money in another IRA account, such as a rollover IRA from a 403. At what point do the costs of taxes on converting an entire rollover amount to a Roth IRA? In order to have access to backdoor Roth IRAs exceed the benefit, assume a physician on an attending level salary between $150,000 and $400,000. Well, that's actually an excellent question. Obviously, when your account is very tiny, if you've got a thousand dollar ira, yes, you should just convert it, not deal with the hassle of trying to roll it over somewhere. On the other hand, if you have a half a million dollar IRA and you can't figure out a way to do something else with it, you may not want to do a backdoor Roth IRA. I mean, you're only putting in $5,500 a year into it. You may still be able to do one for your spouse. Remember, IRAs are always individual. But I probably wouldn't pay taxes on a half million dollar IRA just to be able to do backdoor Roth IRAs. So there's a few factors you have to think about. One is the earlier you are in your career, the more time you have to do backdoor Roth IRAs and the more you should be willing to pay to do a conversion that would allow you to do that going forward. Of course, the smaller the ira, the more likely you should be to be willing to pay the taxes on it to convert it to a Roth ira. Another factor is how much money you have sitting around that you can use to pay the taxes on the conversion. If you have a hundred thousand dollar IRA that you want to convert to a Roth IRA and you have forty thousand dollars sitting around in a taxable account, by paying for that conversion using the taxable money, you're basically moving more money into taxable, into tax protected accounts and out of a taxable account, that's a good thing. That money will grow faster in the future. It's probably getting better asset protection in your state and especially if you don't have to pay much in taxes to liquidate it. That's an excellent thing. So in general, if you've got a four to five figure ira, I think that's worth paying the taxes on in order to be able to do backdoor Roth IRAs going forward. I think if you got a six figure IRA, I'd really think twice about it. Certainly if you're at a very high tax rate, think 33% plus, you probably don't want to be doing very many large conversions. It's just really expensive and there's a good chance you're going to be able to get that money out later at a lower tax rate. But there's one other consideration here. You don't have to have much of a side business to open an individual 401k. There's no lower limit on the amount of profit you need to open an individual 401k. Even if you're not putting any contributions into it, you can still do a rollover into it. So maybe you need to get a business where you do some online surveys and make yourself 100 bucks and open an individual 401k for it and just roll your IRA in there. Okay, that's it for our questions for today. I appreciate you tuning in to today's episode. Love what you hear on the podcast. Looking for more great white coat investor content? Head over to our YouTube channel where you can watch video recordings of our podcast, short snippets of financial tips explained succinctly by me and others, and deep dives into topics for in depth learning. You can even learn all about real estate with webinars from our real estate partners. Check out all this and more@YouTube.com thewhitecoatinvestor you can do this and the White Coat investor can help. Head up, shoulders back. You've got this. See you on the next podcast.