WCI #21: Tax Diversification

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's your host, Dr. Jim Dahli.

Welcome back to the White Coat Investor podcast. This is podcast number 21, tax diversification.

No more wading through dozens of books at the library, scrolling through hundreds of blog posts on dozens of blogs, or checking in daily with online forum trying to gain a financial education the way the hobbyists do for a fraction of the price of hiring a professional financial planner. The Fire your financial advisor online course will take you from feeling anxious and having no plan to having a written financial plan. You can follow the rest of your investing career as a professional and a retiree. This course is the material that should have been taught to you in college, medical school or residency, but never was. Fire your financial advisor also has a version eligible for CME credit. Get your financial life in order today. Go to whitecoatinvestor.com courses to sign up. You can do this and the White Coat Investor can help.

Welcome back to the podcast. It's only been about an hour since we recorded the last one as we tend to bunch these each month, but it's been a fun hour. Cindy's been sitting here making fun of me because I have 48,000 emails in my email box. I don't think that's too many, but she apparently thinks you're supposed to delete them as you go along. Not a big believer in that because sometimes I need to go back and find something. At any rate, Cindy's great. I appreciate all the work she does on this podcast. This entire organization is run by three part timers, myself, my wife and Cindy, along with our employees, the children who are models, and now one of them is a columnist for the White Coat Investor. But it's been a lot of fun keeping this empire running and I really appreciate Cindy and all the hard work she does on this podcasting. Production is an entirely new skill she had to learn that just got handed to her. And you know, it's really amazing what you can learn from Dr. Google. Our quote of the day today comes from Phil Demuth, who says parents should contribute to Roth IRAs on behalf of their working teens, if any such teens still exist. And that's the truth. You can even give them a daddy match so that they can still have some spending money from what they earn while still being able to put everything they earn into a Roth ira. Where it will never be taxed again. You're probably on your way into work and I want to encourage you to make a difference today. You really can make a big difference in the lives not only of your patients or clients, but also in the lives of your peers and co workers. I'm amazed constantly talking to doctors, doctors that I've known for years and years and years, sometimes doctors that sit next to me for eight hours at a time, how much there is still to learn about personal finance and investing. For example, I have a very successful partner who recently learned that yes indeed, you can still contribute to an IRA even though you have a 401k and this is a multi millionaire doctor that's debt free. You know, so little tidbits that you share with your colleagues really can make a difference in their lives. So don't be afraid to teach somebody else about finances. Also, remember that happiness is a choice. You know, money isn't going to make you happy. It's interesting when you go to a third world country doing mission work or just traveling and you realize just how happy people can be with very, very little. And in the end, we've all got to choose to be happy. Thanks for listening and thank you for sending your questions in. We'll get to as many of them on the podcast as we can. Today's topic is tax diversification. Now, what do I mean by that? Tax diversification refers to the way that money you have in various accounts is treated by the tax man as you take it out and spend it. So there's lots of different types of accounts, right? There's taxable accounts, there are tax deferred accounts such as a 401. There are tax free accounts such as a Roth IRA, there are HSAs health savings accounts, and there is borrowed money, which gets entirely different tax treatment. And each of these have their advantages in decreasing your tax bill at various stages of your life. But having the option of which one to withdraw money from and when is huge in creating the tax bracket that you want to be in. For example, there's a book out there by a guy who's trying to encourage you to pay zero taxes in retirement. And that's probably not the right move. The truth of the matter is you want to decrease your lifetime tax burden, but by using tax diversification, you can do that. And the reason why tax diversification is so useful is because you can avoid having your money taxed at the highest brackets if you're careful with it. For example, consider a doc who has all of his money in a tax deferred account and then retires and starts spending that money out of the tax deferred account. All of that money is subject to taxes as it comes out. And if he has a lot of savings, you know, that tax burden can be substantial. But if he has some of his money in a tax free or Roth account, he can choose how much he takes from tax deferred, how much he takes from tax free account, and really adjust his, you know, really set his own tax bracket in retirement. And that's pretty darn useful to reducing your overall tax burden. Unfortunately, you've got to set that up in advance as you go through your earnings years and your early retirement years. That's when you set up your tax diversification. What that usually means is trying to get a little bit more money into tax free accounts. Now, there's no definite ratio anywhere that says why you should, you know, what percentage you want to have in a Roth account and what percentage you want to have in a tax deferred account, and what percentage you ought to have in a taxable account, etc. But the usual problem that most people have is what's called a required minimum distribution problem. Basically they have to take these huge required minimum distributions out of their tax deferred account every year and pay taxes on it. Now that's a pretty good problem to have. Don't get me wrong. That is a total first world problem. If you have this 5 million dollar IRA kicking out all kinds of money during your retirement. But if you want to decrease how much you pay in taxes at that point, it's good to have some money in some other accounts. For example, let's look at the tax treatment for each of these various accounts. First, we'll start with the taxable account. Now this is just your standard non qualified brokerage account where you're buying stocks or bonds, or more likely and hopefully some index mutual funds. Now this account is taxed at long term capital gains rates, assuming you leave the investment in there for at least a year. And so what does that mean? Well, if you have lots and lots of taxable income, that could be as high as 23.8% under current tax law, but it could also be zero percent. Same with the qualified dividends that this account may kick off. Could be 23.8%, could also be 0% if you can keep your income low enough. If you're married and your taxable income is down below, or your adjusted gross income is down below about $75,000 a year, you don't pay any taxes on qualified dividends or long term capital gains. So that's pretty awesome tax treatment. A tax free account like a Roth IRA is an account into which you put post tax money, money that's already been taxed and then it grows in a tax protected manner. And when you take it out to spend it in retirement, it comes out tax free. And that is obviously a good thing because then you don't have to pay taxes on it. Tax deferred accounts like your typical 401k give you a big tax break up front, which is super useful in your peak earnings years. If you're a 45 year old doc working full time and really making good money, a tax deferred account is huge. If you're in the top tax bracket, you may be saving 40, 45 if you live in California, maybe even 50% on your taxes right up front. When you put money in that account, then it grows in a tax protected manner. And when you pull it out, you then have to pay taxes on it at your ordinary income rates, but hopefully at a rate lower than what you were at during your peak earnings years. Health Savings accounts are one of my favorite tax protected accounts and the reason why is they're triple tax free. You get the tax break going in just like a tax deferred account, it grows tax protected just like any other retirement account. When you take the money out, as long as you spend it on health care, it comes out tax free just like a Roth ira. So that's pretty awesome. You definitely want to be funding that every year because it allows you to have significant tax free income in retirement. Basically, if you have an account big enough, everything gets spent on health care is tax free in retirement. Another source of money is borrowing money. Now a lot of people might be borrowing against a cash value life insurance but policy that they have, whether it was the right thing to do for them to buy it or not, if they already have it and have had it for decades, borrowing against it is one option for spending money in retirement. You can also borrow against your house with a home equity line of credit or reverse mortgage. You can borrow against your car, you can just borrow against your credit cards. All that income is completely tax free. It's not interest free, but it is tax free. And so by having a mix of various accounts, it allows you to determine exactly where you want to take money from and really set your own tax rate in retirement. Now a couple of things to keep in mind with tax diversification is a lot of people decide, well I'm not going to max out my 401k because I don't want to have everything locked up in my 401k. So instead of putting money into a tax deferred account I'm eligible for, I'm going to put it into a taxable account and just invest it there. And that's usually folly. You're usually better off just investing it into a tax deferred account. And the reason why is because of the very nice tax treatment you get in the account. Not only do you get the upfront tax break, but you also get tax protected growth. And there's often an arbitrage between the rate you contributed the money at and the rate you're pulling the money out at, which also allows for additional boost to your return. So it's not generally a good idea to pass up a tax deferred account. And that includes early retirees. People are worried, well, what am I going to do if I need the money before age 59 and a half? Well, the truth of the matter is there's so many exceptions to that rule, it's really foolish to end up paying on that, paying that penalty ever. If nothing else, you can do what's called the substantially equal periodic payments plan. So let's say you retire at 55 and want to start spending some of your tax deferred money. Well, you can do so you just have to take out the same amount every year for about five years, for a minimum of five years and until you're 59 and a half. And well, how big of a deal is that? Well, that's no big deal at all because it's a small amount you take out about the amount you'd want to be withdrawn anyway. And so it's really not that big a deal to get to tax deferred money before age 59 and a half. And the truth is, if you're saving enough to be eligible to retire early, you probably have a taxable account anyway. And you'll want to burn through that for the most part before you start getting into the tax protected account. Now in retirement, the more outside income that you have, the more useful tax free income. And money in tax free accounts becomes, for example, if you've got a military pension or some pension from some other organization, that money is going to go to filling up your brackets, your lower brackets. And that's the reason why people whose only taxable income in retirement is tax deferred accounts don't end up paying all that much money on them, because first they get to fill up the 0% bracket, you know, all their deductions and personal exemptions. Then they get to fill up the 10% bracket and then the 15% bracket and then the 25% bracket. And you can take all kinds of money out of a tax deferred account if that's your only source of income, while paying a very low tax rate on it. But if you have a lot of other income, whether it's a pension or Social Security or, or rents from real estate properties you own, if you have a lot of other income, well, you're not going to take that tax deferred money out at nearly as low of a tax rate. And so the more useful it becomes for you to have more money in Roth type accounts, those tax free accounts. So why is 0% tax rate in retirement a bad idea? Well, it's a bad idea for a couple of reasons. And those reasons are, number one, somebody's probably selling you something if they're trying to convince you that this is a good idea. What they're usually selling you is cash value life insurance, with the idea, of course, that you can borrow against it tax free in retirement, but they usually don't mention that it's not interest free and of course that you get a lower return by investing in those sorts of investments that mix insurance and investing. The other reason it's a bad idea is because if you have a 0% tax bracket or 0% tax rate in retirement, you've wasted all those low tax brackets. That 0% bracket and 10% and 15%, you just wasted them. And you want to make sure you get those because those help you lower your overall lifetime tax burden. The other issue with this is that a lot of people don't get that you can get money into a Roth account even in early retirement. You can continue to get money in there. And the way you do it is by paying the taxes in advance on your tax deferred account. This is called a Roth conversion. So if you have a big taxable account, you have a big tax deferred account, but you have a very small tax free account, well, what you do is you use some of that taxable account money to pay the taxes on, converting some of the tax deferred money to tax free money. And so that's a great way to basically move money out of a taxable account and into a tax free account. Okay, so some rules of thumb, obviously this becomes very complicated as you try to figure out what ratios you want to have between your tax free and tax deferred accounts, etc. You know, there's no exact percentage that is ideal, but here's some general guidelines. When you're in the accumulation stage, you're still saving money. Residents should go Roth. If you're a resident or a fellow or for whatever reason, you have a really low income compared to what you're going to have later in your peak earnings years, you should be using a tax free account. That might be a time when you're in the military. It might be a time you're working part time or you're on the mommy or daddy track or whatever. But those are times in which you should use a Roth account preferentially. That includes Roth IRAs. That includes Roth 401ks and Roth 403B's. You should max out your personal and spousal backdoor Roth IRAs each year. You know, when I first started saving for retirement back in 04 or so, I looked and could see that, wow, I'm only going to be able to use a Roth IRA for a few years once I become an attending. I'm not going to be able to. So I worked really hard to make sure I maxed that out. And then about the time I became ineligible to contribute directly to a Roth IRA, Congress changed the rules in 2010. And I've been able to do backdoor Roth IRAs ever since. And so every year since we started investing, my wife and I have maxed out our Roth IRAs. Sometimes directly and sometimes through the back door. But the beautiful thing about that is now, you know, 15 years, 14, 15 years into this process, our Roth account, our tax free account is still equal to about a quarter of our investing accounts. And that's just from putting a little bit in each year. So it does make a difference, especially if you can do it over many years. Another general rule is that during low income years, you want to convert your taxable and tax deferred assets to Roth assets, use the taxable assets to pay the tax bill, while you move money from a tax deferred to a tax free account. You should Also read your 401k document to see if a mega backdoor Roth IRA is an option for you. There are some 401ks out there that allow you to make after tax contributions, not Roth contributions, but after tax contributions, and allow you to either pull that money out without separating from the employer and putting it into a Roth IRA or to convert it to a Roth account within the 401. If your 401k allows that, that's a great way to get more money into a tax free account. Remember that Roth money is better than tax deferred money, but you generally don't want to pass up opportunities during your peak earnings years to contribute to tax deferred accounts unless you expect to be in the top tax bracket in retirement. You know, if you're just a mega saver and you're going to have some eight figure nest egg that you're going to be retiring on, well, maybe it does make a little bit of sense for you to use Roth 401ks and Roth 403s during your peak earnings years, but for the most part, most people will not be in the top tax bracket in retirement and they're going to be a lot better off taking advantage of those tax deferred accounts during their peak earnings years. If you happen to have a very low Roth to tax deferred ratio, that might also be a time in which you want to consider doing a few Roth 401 or 403 contributions. That flexibility may be worth losing what's likely to be a little bit of a tax arbitrage, particularly if you look like you're going to have a really big tax deferred account. If you just haven't saved much money throughout your career, that's not as big a deal. If you end up with only a little tiny tax deferred account, the required minimum distributions on that just aren't going to be that high. If you expect significant taxable income in retirement from real estate investments or pensions that are going to fill up those lowest tax brackets, make sure you do more Roth contributions and more Roth conversions during your peak earning and early retirement years. If there's really no tax arbitrage between the tax rates at contribution and at pulling the money out, it really doesn't matter which one you use, whether it's a Roth or a tax deferred account, so you might as well use the Roth one in those sorts of a situation. If you expect huge required minimum distributions in retirement due to having huge tax deferred accounts, then you probably ought to start converting relatively early in your life. For example, an orthodontist on a forum noted to me that his required minimum distributions were larger than a salary ever was. Well, that's a super saver, right? If you're in that situation, then it makes sense to do a lot more Roth conversions and maybe even Roth contributions earlier in your career. Another general rule is to consider easing into retirement if possible with part time work. When you're working part time, you're in a lower bracket and that gives you a few years where your earnings are relatively low and you can do some Roth conversions and Roth contributions to increase your Roth to tax deferred ratio. You may also wish to use proper tax location strategies to maximize the size of your retirement accounts. Although it's really nice to have tax inefficient assets in your tax protected accounts, you also need to take into account the expected return of the asset. If you put a really risky asset that you expect a high rate of return from into your Roth accounts. Yes, that on an after tax basis does increase the amount of risk you're taking with the portfolio, but it also is likely to increase the ratio of your Roth to other accounts, which is a good thing if you're trying to get that ratio higher. It's also important that you only contribute to taxable accounts after the other accounts are already full. Doing otherwise is generally not a good idea. And the reason why is the later you contribute to taxable accounts, the higher your basis is and the more that money comes out tax free. For example, if you pay $50,000 for some shares of a mutual fund and it appreciates to $100,000 and then you sell it all, well, 50,000 of that comes out tax free. That's your basis. And the other 50,000 comes out at long term capital gains rates. Whereas if you contributed that money early in your career and maybe you only paid $10,000 for those shares, well, $90,000 is going to be taxable when you pull that money out, rather than only $50,000. If you're in the distribution stage and you want to improve your tax free to tax deferred ratio, you might consider delaying Social Security to age 70. Not only does that increase how much you're going to get paid by Social Security, but it gives you more years to do Roth conversions. You should also determine how close you're going to be to the Social Security taxation range. Now, we're talking down below about $50,000 worth of taxable income in retirement. If you're going to be anywhere close to that, well, you want to be careful because a little bit more taxable income can really increase the percentage of your Social Security that's taxed. But if you're a reasonable saver as a doc, you probably shouldn't be anywhere near that range. And that's really not something you should worry about because you're going to pay the full taxes on your Social Security. Now, the full taxes is paying taxes, at least under current law, on 85% of what Social Security pays you. Once you hit age 70 and a half, there's not much you can do about required minimum distributions. You're going to have to take them out, pay your taxes and spend them. So if you have a very high ratio of tax deferred to Roth and taxable accounts, you might have to take your required minimum distributions out and invest them in a taxable account to make sure you don't run out of money. But for the most part, you can usually spend your entire required minimum distribution without having to worry about running out of money in retirement. You also want to use your Roth IRA to keep you in a lower bracket. Try to fill the 0, 10, 15% and maybe even the 25% brackets using tax deferred money. Then if you need more money to spend, take it from the Roth ira. Same thing with taxable accounts. Those can be used to keep you in a lower bracket as well. You want to spend your taxable assets with a high basis first. That will lower your tax bill, but it also maximizes the benefit of the step up in basis at your death. And remember, of course, that your heirs will prefer a Roth IRA to a taxable account and a taxable account to a traditional ira. They basically get the taxable account tax free. But the Roth IRA they get and can stretch and continue to take tax free money as it continues to grow tax free. Obviously, if they inherit a traditional ira, they're gonna have to pay taxes on everything they take out of it. So if they're given their druthers, they'd rather have the Roth ira. But if they're in a much lower bracket than you are, it can make a lot of sense to have them pay the taxes. Bear in mind though that charities don't really care. They don't have to pay taxes when they pull money out of a traditional ira they're given. So charity is a great person to leave your traditional or great organization to leave your traditional IRA to. If you want to give money to charity, that's the asset you should use. All right, let's move on to some questions that have been sent in by readers. This one comes from a reader who says, help. I'm trying to follow your advice about the backdoor Roth ira, but I hit a snag. I opened a new traditional IRA at Vanguard and put in my non deductible 5500 for tax year 2017. I have a Roth IRA there, but I also have a rollover and SEP IRAs with Vanguard. They tell me that I'll have to pay tax when I convert the 5500 to a Roth IRA because I have money in other non Roth IRAs. Should I put the non Roth IRA money into an individual 401 to make those balances zero? If so, who will allow me to open an individual 401 and put IRA money into it? Vanguard won't. All right, well Vanguard's correct in this instance in what they told you on the phone. You have to zero out any traditional SEP or simple IRAs before year end. You don't have to do it before you make your contribution or conversion to a Roth IRA, but you do have to do it before December 31st or you're going to screw up your tax paperwork and end up falling victim to the pro rata rule. It's also true that Vanguard's individual 401 won't accept rollovers, but you can go to Fidelity or E Trade and open an individual 401k there as long as you have some self employed income and an employer identification number from the irs and then do the rollover there if you like. So your choices in this sort of a situation are really four. The first is to convert the entire SEP or traditional IRA and pay the taxes on it. That's a great option if you have a small account. This is a four figure account or so I just can pay to convert the whole thing. Another option is to get some self employed income and roll those IRAs into an individual 401k at Fidelity or E Trade. And 401k money doesn't show up on your tax form where you report the backdoor Roth IRA. Your third option is to roll those IRAs into the 401k at your employee job. That works just as well as rolling them into an individual 401. And of course your final option is just don't do backdoor Roth IRAs, which a lot of people have decided it's just not worth their hassle if they have big huge traditional IRAs they don't want to pay taxes on. You can learn more about that at the blog posts on the forum or on the website entitled the Backdoor Roth IRA Tutorial and where to Open your solo 401k. This question comes in from a radiologist. Thank you for all your help. I refinanced my Great Lakes student loans of $260,000 with an interest rate of 6.8% through DRB, which is now Laurel Road at a variable rate of 4.1%. I have another loan through another organization for $4,000 at 5%, should I pay off the smaller loan first or attack the larger loan? Well, this is kind of the classic question that people paying off debt have. Should you pay the highest interest debt first or should you pay the smallest loan first? And there's really no right answer. The mathematically correct answer is to always pay on the highest interest first. But people don't generally get into debt because of math. They get into debt because of behavior. And so you sometimes want to choose what is the behaviorally optimal choice, even if it costs you slightly more money. And the behaviorally optimal choice for most people is to pay the smallest debt first. The reason why is because you feel momentum as you pay them off. You see payments disappear as you snowball your smaller payments into the larger payments and start knocking out some debts and making some progress. And so most people who actually work with real people in debt paying off their debts tend to use this snowball type method where you pay the smallest debt first. But it certainly isn't wrong to pay the highest interest rate debt. But for me, if I had a 5,000 or $4,000 debt like this radiologist, I'd knock that out pretty quick just to get it out of my life. Another question. If you hold total stock market in your health savings account and your taxable account, will that affect the ability to do tax loss harvesting? I'm worried about that, and so I'm considering investing in something else in my health savings account. Well, it's certainly fine to invest in something else in a health savings account. You just want to make sure it's a diversified option. You know, you don't want to necessarily put everything in your HSA into a REIT index fund, for instance, or some other sector fund, or heaven forbid, you know, an individual security. But as far as affecting your ability to do tax loss harvesting, the truth of the matter is when you buy something in another account within 30 days after you sell it in your taxable account with the hope of taking tax loss harvesting it, that does trigger a wash sale, but only what you bought in the other account, only an amount equal to what you bought in the other account. So if you reinvest a $100 dividend and you tax lost harvest $50,000, a $50,000 loss, well, you're only going to lose $100 of that loss. It's not like you lose the whole thing. So that's one thing to keep in mind. The other thing to keep in mind is you just don't tax loss harvest all that often. Only really when the Market is tanking. Are you doing any significant tax loss harvesting? And of course, keep in mind that nobody's really watching. You know, the IRS doesn't get a list of all these transactions you do in your HSA or in your 401k. And so while it is not correct to do, you know, to sell something in taxable and then immediately buy it somewhere else like a Roth IRA or 401k, there's really not a way for the IRS to catch on to that. And so I wouldn't spend a lot of time worrying about it, especially tiny little amounts like a reinvested dividend in a health savings account. Okay, here's another question. We are debt free and want to invest $200,000 into the Vanguard Total Stock Market Index. Should we do it in one shot or should we do it weekly at intervals to benefit from dollar cost averaging? And this is the classic question of whether you should lump sum new money or whether you should dollar cost average new money. Now, the theory behind dollar cost averaging is if the market tanks shortly after you invest, well, you'll be able to buy some new shares at a lower price. And so that is appealing to a lot of people who are worried about the market going down right after they invest. But the truth of the matter is that the mathematically optimal thing to do is usually to invest the money when you have it, because two thirds of the time the market goes up and only one third of the time does the market go down. So if your dollar cost averaging and the market keeps rising like it usually does, you end up buying shares at higher and higher prices. And that really doesn't help you to improve your investing returns. And so if you're nervous about putting a big sum of money into the, into the market all at once, sure, you can dollar cost average it in. But the truth of the matter is you still have that same risk of it tanking right after you finish dollar cost averaging it. It's not like you're going to spread it out over the rest of your life. You'll do it over three months or six months or a year, and at that point, maybe it tanks. And so you really can't get away from that. So if you're really uncomfortable putting a lump sum of money in, maybe your asset allocation is a little too aggressive and you need to dial it back. But for the most part, I would consider investing when you have the money to be the right thing to do.

No more wading through dozens of books at the library, scrolling through hundreds of blog posts on dozens of blogs or checking in daily with online forums trying to gain a financial education the way the hobbyists for a fraction of the price of hiring a professional financial planner. The Fire your financial advisor online course will take you from feeling anxious and having no plan to having a written financial plan. You can follow the rest of your investing career as a professional and a retiree. This course is the material that should have been taught to you in college, medical school or residency, but never was. Fire your financial advisor also has a version eligible for CME credit. Get your financial life in order today. Go to whitecoatinvestor.com courses to sign up. You can do this and the White coat Investor can help.

Head up. Shoulders back. You've got this. All your patients, family and friends expect you to be a wealthy doctor, so you might as well be a wealthy doctor. Get started today. See you next time.