Today, we’re talking…taxes!
Specifically, we’re sharing our top three tax saving tips that tend to fly under the radar.
These little-known tax tips will teach you how to put more money in your pocket and less in Uncle Sam’s.
It’s only September, which may seem early to start talking about taxes. Most people don’t start thinking about tax planning until year-end.
But the end of the year is busy. And hectic. And important things like taxes don’t get your attention during busy, hectic times. So, we are tackling it now.
With that in mind, we’ve got our top three little-known tax saving tips. These are strategies that can save you a lot of money in 2018 and beyond:
- Donor-advised tax funds (DAFs)
- Mega back-door Roth IRA
- Asset Location
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- How Tech Billionaires Hack Their Taxes With a Philanthropic Loophole
- America’s Most Charitable Cities: San Diego tops the list
- Asset Location For Stocks In A Brokerage Account Versus IRA Depends On Time Horizon
- Traditional vs Roth: Breaking Down Retirement Accounts [SWSD Ep. 24]
- How to Lower Taxes in Retirement [Blog Post]
- What the Heck is a Mega Backdoor Roth
Episode Transcription
Top 3 Tax Saving Tips That Fly Under the Radar
Taylor Schulte: I get the tax deduction on the full $30,000 this year. So I win. I get the tax deduction that I wanted, but I can take my time and direct my donations at my leisure.
Welcome to Stay Wealthy San Diego. A show for successful professionals doing all the right things with their money and are ready to take their financial plan to the next level. I'm certified financial planner Taylor Schulte, and I'm here to teach you advanced financial planning strategies in plain English.
Taylor Schulte: Let talk about some taxes.
John: Let's do it.
Taylor Schulte: Do you know what the most hated taxes in America?
John: For me, I want to say the self-employment tax, but I'm biased. I pay the self-employment tax, so I couldn't imagine that would be it. Marginal income, so that's not a fun tax either.
Taylor Schulte: Think California.
John: State tax, state income tax?
Taylor Schulte: Getting closer.
John: Property tax?
Taylor Schulte: Property taxes.
John: Oh yeah, it's funny, I was literally writing about the cost of housing in a blog post just now. And yeah, California, or at least San Diego. Property taxes are brutal. They're brutal.
Taylor Schulte: Yeah, property taxes, so most hated tax in America and in San Diego we've got these pockets where you pay mello roos, it's like a tax on top of the tax, the stuff can get out of control, and then you've got HOAs on top of that. Anyways, property taxes are the most hated tax in America.
One thing I learned kind of prepping of this show is you can actually appeal your property taxes. You get that annual assessment in the mail and you can actually appeal the assessment and you can say, you know what? I don't think my house is worth what you're saying it's worth.
You can bring that annual notice to the board of tax assessors and they will run comps in your neighborhood for you. They'll give you those comps and then you can fill out this form and make your case and say, my house isn't really worth a million dollars. I looked at the comps, it's actually worth 800,000.
And it sounds like after reading some stuff on the internet, people have a lot of success with this. I mean, it takes some time, but it doesn't sound like it's very difficult. You just have to jump through some hoops and improve your case.
John: Any successful case studies here in San Diego of people doing that? We'll have to look. I think I could see myself going in there with the Schiller housing data and saying, look, this is a real estate bubble. You guys need to reevaluate my taxes and give me some of my money back.
But also, that's why I always make sure to go to the library regularly, take advantage of that tax, get my money's worth, and rent some free books.
Taylor Schulte: Alright, we aren't talking property taxes today, but we are going to share with you our top three tax-saving tips that we think tend to kind of fly under the radar. And if done right can literally save you tens of thousands of dollars.
So again, this shows for people who have kind of nailed down the basics and they want to take things to the next level, and that's what we're going to talk about today in terms of taxes and people hate paying taxes. So if we can find a way to mitigate those, everybody's happy.
You might be asking, why are we talking about taxes in September? Everyone probably feels like they just filed their taxes. That's all behind them now they're enjoying their summer. Why the heck are we talking about taxes in September? A lot of people, a lot of financial professionals will talk about year-end tax planning or the end of the year is such a great time to talk about tax planning.
I don't know about you John, but the end of the year can get pretty busy with holidays. You're going to Thailand, travel family, and sometimes we just don't get around to year-end tax planning and we say, okay, well maybe next year we'll get around to doing this stuff.
So we like to start talking about this stuff a little bit earlier so that you can start planning now and start putting these strategies into place now before the holidays hit and travel and family and all that good stuff.
John: Absolutely, and if you're doing stuff like Roth conversions, which is a great tax strategy, and if you want to learn more about that, you can check out one of our recent blog posts. We'll put that in the show notes about how to lower taxes in retirement.
Then September is a good time to check out how much money have I had this year in taxable income. And that'll help me figure out how much money I've left over to do a Roth conversion this year.
Taylor Schulte: And since I know you'll reference the show notes a few times in this episode, just a reminder, you can go to staywealthysandiego.com/podcast. All of our episodes are there. Some of the episodes have full transcripts. We have show notes, tons of resources, so check it out.
Alright, before we dive into our top three tax-saving tips, we do have another listener question a little bit different this time. I liked it and so we thought we'd read it out and attempt to answer it.
John: So Mark from Del Mar asks, how do I know if and when I should hire a financial planner? Good question. I ask myself that question.
Taylor Schulte: It's a common question.
John: Yeah absolutely. Mark continues. I've been managing my own investments for years. Well, good for you, mark. We make good money. We are saving for our future and I generally feel like I have a good handle on things, but my wife always got to listen to.
The wife has been asking me about hiring a financial planner and why we don't have one. If now is not the right time for us to hire one, she is okay with that. But we'd like to better understand when we should get serious about hiring someone.
Taylor Schulte: So you and I haven't really talked about this at all, so I'm curious to hear your answers here. My first reaction to this question always is, and it sounds kind of silly, but my response is kind of like you'll know. You'll just know life will start to get a little more complicated.
You no longer have a desire to spend your time managing your investments. Maybe your investments get so large or large enough to where you just don't feel comfortable managing on your own. But when people do come to us, there's this sense of I'm just not comfortable doing this on my own anymore or I just don't have the time.
I'd rather spend my time with my family traveling or I want to spend my time working and building my business, just I could do my taxes on my own, but I don't. I hire somebody because I'd rather spend time doing other things. So that's kind of my short answer. What do you think?
John: Yeah, I'm inclined to agree with you. The first thing I think about is I hired a tax preparer last year. For the first time I was dealing with a lot of self-employment taxes, sort of had no idea what I was doing. I have no idea what I'm doing. Sort of thought that makes me think, Hey, I should outsource this.
And it applies not just to financial planning or tax planning, but sort of anything. Video editing is a great example. I needed some videos edited and it's like I have no idea what I'm doing. I'm going to farm this out. So I think when I get the thought, I have no idea what I'm doing, that's when I want to put it into the hands of someone who does know what they're doing.
So if you feel like you've gotten to a point where you don't know what you're doing, then maybe you should hire a financial planner. Again. When I was doing my taxes on my own, I had some pretty easy W2 income. It wasn't very complicated, but when I got to the point when my life became more complicated and I felt like I have no idea what I'm doing, that's when it occurred to me I should farm this out.
Taylor Schulte: Yeah, that's a really good point. I think I'll leave it with one more answer. When people call us and they're interested in working with us, one of the questions we often ask is, are you maxing out your 401k or are you maxing out your retirement accounts critical?
And the reason we ask that question is if you're not maxing those accounts out yet, that's your priority right now. You should go and work on maxing those accounts out max out that 401k or 403B or 457, put money in those non-deductible IRAs or Roth IRAs, get those all maxed out and then you'll start to see that you've got some additional complexity in your life and it's kind of time to hire a professional to take things to the next level.
So that could be one of your questions too is are we maxing out all these different buckets yet? And if not, that's probably your priority first before you hire a financial planner unless you have something else going on.
John: Absolutely. That makes me think of another related point, which is are you at the point where you're on top of your household finances right now? If you are, then you should be able to know where your money's going. You do this by simply tracking your spending.
There's a lot of tools you can lean on to do this, and then if you do that, you'll figure out, oh yeah, I have the cash flow to put into all these accounts. If you're not already there, then maybe working with a financial planner doesn't necessarily make sense.
Financial planners probably aren't the number one. Go-to resource. If you have problems managing your cash flow, maybe a financial coach would be a better option for that. So once you've mastered your cash flow, when you're maxing out those accounts, I agree, then it could be the right time to work with a financial planner.
Taylor Schulte: Well, thanks for the question. As always, we love listener questions, so shoot us an email at podcast@staywealthysandiego.com. We read and respond to every email and we may read your question on the air. So thanks, Mark.
Alright, our top three tax-saving tips. Let's dive into this. This is fun stuff. What kicked this off for me was there was a New York Times article I think last week or the week before we'll find it and link to it. And it was talking about donor-advised funds and we love donor-advised funds and they are one of these tax-saving vehicles that does fly under the radar.
So I was excited to see the New York Times write this article. The article made its way to several different high-profile newsletters. It was great, but the headline was something along the lines of this is a tax saving tool that's for the ultra-wealthy, that this is only for the ultra-rich, it's not available to anybody else.
And there was just kind of some misleading statements in there and I found myself really frustrated and I was going to tweet something and I was going to write something and I just said whatever, I just forgot about it.
But it kind of led me to talk about this subject and add Donor-advised funds to this podcast episode because they are a great tax-saving tool. Absolutely they are underutilized. A lot of people don't know how they work, so I thought we would talk about them.
So donor-advised funds is our number one in no particular order here, but our number one tax-saving tip today. And donor-advised funds really are available to everybody. The median balance, Fidelity Charitable is one of the donor-advised funds that's out there and the median account balance is somewhere around $20,000. So it's not like hundreds of thousands or millions of dollars. Some people have a few hundred bucks and some people have a lot more, but the median account balance is about $20,000.
Anybody can use them. They're very low-cost and simple to use and set up. But the people who might benefit from them the most, especially with the recent tax changes, are people that are itemizing their deductions. So the standard deduction limits were increased, and if you're not itemizing your deductions using a donor-advised fund or charitable giving in general may not be a huge benefit.
Now, you might have other reasons to give to charity, but we're talking about saving money on taxes today. So if you are itemizing your taxes or your charitable giving will allow you to start itemizing your taxes, that's where this can really come into play.
John: The thing that I love about donor-advised funds is the same reason why I tell people ad nauseum to save money. It's because it gives your life flexibility. You have a huge tax bill coming in, you want to offset it, but you're not necessarily sure what you want to do. In so far as your treatable intentions, Donor-Advised Fund is the perfect vehicle. It gives you flexibility, it gives you choice, it gives you options.
Taylor Schulte: Yep, no really, really good point. And so let's talk a little bit about that. But first, fun fact charity navigator.org, which is a big website out there on all the different charities in the world. Charitynavigator.org named San Diego, the most philanthropic city in America.
Once again last year San Diego was tied for fourth and then I think in 2015 we were number one. So we've kind of been in that top five for a while. But in 2017 we were number one, which I think is really cool. So we'll provide a link to that, but you can also Google it and read more about how they came to that decision.
So we want to talk about what a donor-advised fund is because they can kind of seem complex, but they are actually quite simple. So I thought I would share a hypothetical story. Everybody likes stories to see if we can kind of bring this to the surface and really simplify what this is.
So let's just say my wife and I give $10,000 every year to the Labrador Foundation. I want a big, messy, dirty chocolate lab. She won't let me have one. So instead we just give a bunch of money to the Labrador Foundation every year. I like it and it's great. We get a tax deduction, but this year we sold our North Park rental property and our tax bill this year is going to be much higher than normal.
So we don't want a higher tax bill. And one option for us to consider is just to give a lot more to the Labrador Foundation. If we give more money to the Labrador Foundation, we're going to get a larger tax deduction and we can kind of mitigate some of that income that we didn't plan for. So maybe instead of giving them $10,000, we give them $30,000. It sounds good on paper, but I don't like that idea.
And John kind of alluded to this already talking about flexibility. I don't like that idea because I don't really want to give $30,000 to that organization right now this year. I'd rather spread my donations out over time as I see fit.
Maybe I like the Labrador Foundation this year, but maybe next year they do something kind of wacky. I'm like, I'm not going to give them that normal $10,000. So option one is yeah, just give more money to those organizations and get a bigger deduction.
Option two, which is what we're going to talk about, which is donor-advised funds is putting that $30,000 into a donor-advised fund instead of giving it all to the Labrador Foundation right now. So $30,000 goes into the Donor-Advised Fund. I get the tax deduction on the full $30,000 this year. So I win. I get the tax deduction that I wanted, but I can take my time and direct my donations at my leisure.
Maybe I give some next year, maybe I don't, maybe I wait five years, maybe I wait 10 years. I don't have to give that money away right away. Or I can stick to my normal schedule and I can give 10,000 to the Lab Foundation every year for the next three years and spend that 30,000. But maybe I decide that next year I want to give $10,000 to the French Bulldog Foundation or maybe I want to give $1,000 to 10 different animal nonprofits.
So the Donor-Advised Fund gives me this flexibility. It allows me to get that tax deduction today, which is what I'm going for. And the caveat is as long as you're giving money to 501c3s, but it allows me to give my money away over time, but get the tax deduction.
Now, one of the other cool things I like is you can give it a name. I can call it the Taylor Schulte Donor-Advised Fund or Taylor Schulte Taylor and Lara Schulte Foundation or give it a cool name and it's yours and you can direct those donations over time.
John: Donor-advised funds are absolutely fantastic. So I like your hypothetical example. I'm going to raise you and use a real life example. It's interesting because recently we had a couple young clients come in recently and they had almost identical situations.
So young guys working in tech did some neat tech coding stuff and as such, now they have a big buyout, a big liquidation event coming their way. So both of these guys, they've got a million plus coming their way in cash in a single year.
Now normally they don't earn this type of money, but again, there's a buyout, there's liquidation. So now they have all this cash. Now of course, both these guys, they're younger, they're millennials, they have charitable intentions, but they don't necessarily know what those charitable intentions are yet.
Certain causes are important to them. For example, for one of 'em, education is an important cause, but they haven't specifically identified any particular educational organization they're going to support. They just know it's something they want to do.
And of course now that they'll have this money, they'll have some leisure time to figure out what exactly those charities are that they do like and enjoy and want to support, but they don't know that yet. So what do you do? Enter the donor-advised fund, right?
You can put money into this account this year and offset some of that huge cash that you have coming your way. Get rid of a big portion of that tax bill and then figure out later which charities are important to you, which charities you want to give money to.
Maybe when you do figure out which charity that you want to give money to, you can give all your money to that charity or maybe you can parse it out over time. It's your call. But the point is the donor-advised funds give you flexibility. It gives you choice, it gives you options, and that's what makes them so great.
Taylor Schulte: That's a really, really good point. I'm glad you brought that up. So the tax benefit of the donor-advised fund is if you donate cash, you can deduct up to 60% of your AGI. You can also, what's really neat is you can donate appreciated securities and if you donate appreciated securities, you can deduct up to 30% of your AGI.
Again, it's going to benefit you the most if you're itemizing your deductions, but it's a nice tax break and I think we can emphasize it and say the best way to use this is to donate those appreciated securities.
So if you have a stock or a fund or some sort of investment that's appreciated over a long period of time, and man, you just don't want to pay those capital gains, but you do want to support charitable giving, you can donate that appreciated security.
John: Absolutely. And I want to give credit to or local tax expert, Cheryl Rowling CPA for sharing this exact tip with me. It makes more sense to move the appreciated stock or mutual funder or whatever directly into the donor-advised fund and get the deduction that way. And that gets better tax treatment than were you to sell the stock and then put the cash into the donor-advised fund.
Taylor Schulte: So hopefully you now know or have a clear understanding of what a donor-advised fund is. Of course you can Google it and continue reading and learn a ton about it. Some people ask, where do I even begin with opening a donor-advised fund?
The three big ones are Fidelity Charitable, Schwab Charitable, and Vanguard Charitable. All three, very, very similar in terms of cost. But take a look, learn more about each one and decide which one's best for you. A lot of local cities have their own kind of donor-advised fund as well. So you can search around in your city for something and support someone local.
John: Random fact, Vanguard's Donor-Advised Fund is actually not part of Vanguard itself, their related organization, but it's not under Vanguard just because with Vanguard being structured as a mutual company, it wasn't possible.
Taylor Schulte: All right, so our first tax saving tip, hopefully you learn something new. Our second tax saving tip that tends to fly under the radar and doesn't get talked about enough. We've talked about it briefly on another episode, but it's called the Mega Backdoor Roth.
A lot of people are familiar with the backdoor Roth IRA contributions. Google that and learn more about that. But what we're going to focus on today is the mega backdoor Roth. So John, you want to share what exactly the mega backdoor Roth is.
John: Sure, if you have a 401k at work and you're tracking your expenses and you're on top of your cashflow, you're putting in the full 18 five, $18,500 every year into your 401k or your 403B account. So good job for being such a great saver, but actually you're such an awesome saver that not only can you contribute 18,500, but you can do several more thousand on top of that.
Well, what do you do with that if you've already contributed to an IRA, if you've already maxed out a health savings account, what's the next place you can put some money into for really special tax treatment? And that's the mega backdoor Roth comes into play. The way it works is that once you've put in the 18,500, you can put in what's called after-tax contributions into your 401k. Now, not all 401ks allow this.
You have to check with your particular 401k check with your HR department if this is possible. But you put in after-tax contributions into your 401k. So now you have your 18 five in the 401k, you've got whatever thousand dollars thousands of dollars you put in on top of that inside your 401k. And these contributions have what's called basis.
So where you take that money out, you actually wouldn't pay tax on it in the future because you didn't get a tax rate when you put it in. It's an after-tax contribution. So the after-tax contribution, the money that's in there, you're going to take it out of a 401k and then you're going to put it into a Roth IRA.
Now of course, you can only do this if your 401k allows what's called in-service distributions. Now what's cool about that is once you take it out of the after-tax 401k account and put it into the Roth IRA. Now in the future when you take money out of the Roth IRA, it's going to be tax-free. But were you to leave that after-tax money inside the 401k, then the growth on that after-tax money would be taxable.
So that's the trick is taking the money out quickly enough so that you're not taxed on the after-tax conversion into a Roth IRA.
Taylor Schulte: So the first step is contact your hr, your benefits department, whoever your contact is there. And the easy request is to say, can you just send me a copy of our summary plan description? And that's also known as an SPD.
Every company has that on file. They'll send it to you and it'll tell you if after-tax contributions are allowed. And it will also tell you if in-service withdrawals are allowed as well. So both of these things are becoming more common, so don't be surprised if it is allowed. Like John said, you'll want to make those after-tax contributions and then you'll want to immediately roll those into a Roth IRA.
One of the things we should probably address, although we did talk in depth about this in a previous podcast today, we're talking about tax saving strategies and a lot of times people want to see that tax saving.
Today, especially, I don't want to bash CPAs or anything, but CPAs will often look at your tax situation today and how can we save taxes for you Today, we like to take a much longer-term approach and making a tax move like using a mega backdoor Roth may not give you a tax deduction today, but it's going to really, really benefit you from a tax perspective 10, 15, 20, 30 years down the road.
So this is a long-term tax-saving strategy. But John, what do you have to add there about why am I putting money in this after-tax account? I'm not getting a tax break on it. I could be doing other things with this money.
John: Sure, the after-tax money is going to go into a Roth IRA and what it makes a Roth IRA so magical is that you can take out your money when you hit age 59 and a half tax-free.
So your money's going to grow and grow and grow into a huge amount because you're investing and over a long time because of compound growth, because of compound interest, you're going to be sitting on a pretty big pile of money and that money's going to come out tax-free, no taxes. That is, oh, that's just simply fantastic.
Now compare that to a lot of retirees who have a lot of money sitting either in a traditional IRA or traditional 401k or either just they're just dealing with their RMDs that come out of their traditional IRA, the traditional 401k, every time money comes out of that account, it hurts. It hurts them because they have to pay taxes at their marginal rate and that's never fun.
Taylor Schulte: And one of the things we hear from time to time is, oh man, I wish I didn't put so much money inside of a 401k or a traditional IRA. And while that's important and we do want to put money in these tax-deferred vehicles, we want to use some of these other vehicles as well to give us flexibility in the future and the Roth accounts. If we can just get as much money in these Roth accounts as possible, I think you're really going to be thankful for it down the road.
John: Absolutely your future self will. Thank you.
Taylor Schulte: Alright, if we haven't put you to sleep yet, our third tax saving tip today, again, one that just kind of flies under the radar isn't really used a lot is called asset location.
Asset location is a strategy that helps you determine what type of securities should be held in a taxable account. Just think of a brokerage account, a taxable account, and what type of securities should be held in a tax-deferred account. A tax-deferred account would be an IRAA 401k, a 403B. Those are tax-deferred accounts.
So what types of securities should you put in the taxable account and what securities should you put in the tax-deferred account and how you balance that can make a huge impact on your tax bill over a long period of time. So who can benefit from this the most are people that have long-term investments in both of these accounts, in both a taxable account and tax-deferred accounts.
If you just have all your money in tax-deferred accounts, it's kind of difficult to take advantage of asset locations. So if you've got money working in both taxable and tax-deferred, you can really benefit the most from this.
Also, if you have that balanced portfolio of stocks and bonds and different asset classes, this will work much better too. You'll have more opportunity to take advantage of asset location. So why is this a tax benefit? Interest income income that you receive from a stock or a bond gets taxed at 37%, which is the highest?
Well, if you're in the highest tax bracket, interest income is taxed at 37% while dividends in capital gains are taxed at 20%. So a big difference there between those two tax rates, most stocks generate returns from both dividends and capital gains.
So investors will realize a lower tax bill if stocks are held in that taxable account. So putting those stocks in that taxable account, again, you're going to have those dividends and capital gains that are getting taxed at a lower rate, you're going to have a lower tax bill.
On the flip side, income-oriented investments, think bonds or REITs, which are real estate investment trusts, they generate regular cash flow that you would pay taxes on every single year if it was in a taxable account. But if you put these things in a tax-deferred account like your 401k or 403B or IRA, you can shelter that income.
John: Absolutely. And to take this strategy to one more level up, so we have your regular plain vanilla taxable accounts. We have your tax-deferred traditional IRA, traditional 401k, traditional 403B accounts. And then as we already talked about earlier, you have your Roth accounts, your Roth IRA, your Roth 401k, your Roth 403B, your Roth TSP, etc.
So if we're going to use our taxable accounts for our US stocks that we're going to hold for the long term, we're going to get qualified dividend tax treatment. And what that means is instead of getting taxed at 37% on the dividend that spit out by a US company, we're going to get the better rate of 20%.
If we hold that US stock or that US mutual fund or US ETF for a long enough amount of time in our tax-deferred accounts, we're going to have those coupon paying investments, right?
The bonds, the REITs. Now the next thing you want to do for your Roth accounts, you want to put in those investments that are going to grow the most, those that are the riskiest, those that have the highest expected investment return.
So that's going to be your small value companies. That's going to be your emerging market stocks. We're going to put the really growthy really risky stuff into the Roth accounts because when we take it out, it's going to be tax-free. Those investments are going to grow a lot. So we want that growth to get best tax treatment and the best tax treatment is no taxes.
Taylor Schulte: So let's sum this up and just try to keep it really, really simple. You can get really fancy with asset location financial advisory firms often have software that helps them utilize this strategy. But if you want to just keep it really, really simple, and if we could just summarize this, you have three different types of accounts.
You've got your taxable account, you have your traditional retirement accounts, and then you have your Roth retirement accounts In that taxable account, we're going to put stuff like large-cap US stocks, so just your boring large-cap US stocks, all of those are going to go in that taxable brokerage account.
Then you've got your bonds and your REITs and those are going to go in those traditional retirement accounts that traditional IRA, that traditional 401k, you're going to put all your bonds and REITs and those accounts. And then you have the Roth account.
And like John said, I love the term super growthy stuff. We're going to put the super growthy stuff in the Roth accounts, so your small-cap value stocks, which we love emerging market stocks, that risky stuff is going to go in that third bucket that Roth IRA Roth 401k bucket.
So Google around, there's a ton of information in there if you want to get super technical about it. You do have to think about your risk tolerance and the amount of money you're putting in each of these buckets and make sure that it aligns with your goals and the risk that you want to take and everything you're trying to achieve with your investments.
But if you can start to think more like this, it can make a huge impact on taxes now, but also the future growth of all your investments.
John: Absolutely, and a couple of caveats. First one is that if you're sitting on mostly short-term bonds, which right now aren't paying a lot in the way of return, then this strategy asset location is less impactful, right? It's going to make a bigger difference when your bonds pay more money.
If you're holding longer term bonds or on a long enough timeline, when interest rates rise to a historical average, then it's going to be more impactful. The other thing is that these are rules of thumb when it comes to asset location.
As strange and complex as asset location can be, there are rules of thumb for it. And if you get really into it, if you really get into the weeds, you can see that the timeline on this strategy can impact it.
So if you're looking at a longer amount of time, you can actually get a different answer on where to put your investments in which accounts. Michael Kitces has a great blog post on this when he really nerds out on how the strategy can change with the timeline.
Taylor Schulte: And the last thing I'll mention, it's a tough one. What did you call it again? Mental accounting. So for some, asset location doesn't work because this, we have a client that has half of their money in taxable accounts and half of their money in retirement accounts.
And on paper it looks like asset location would work great, but those taxable accounts to them is money that they're going to use sooner. They're going to touch that money sooner than they are going to touch those retirement accounts.
So because they're going to use it sooner, they think they might or they just kind of have this feeling that these are taxable dollars and I can access these at any time, and it just feels just a little bit different. They don't want to put a hundred percent stocks into this taxable account. That would be too risky for them.
They want to keep that balanced portfolio so they don't want to take advantage of asset location and put their bonds in their retirement accounts and their stocks in their taxable accounts because of this mental accounting. It's just like this psychological thing. It's like, well, I don't want my taxable brokerage account to be in all stocks.
That's going to scare the crap out of me, even though all of their bonds are going to be in their retirement accounts and the account balances are just about the same. So there's this psychological thing, you call it mental accounting. It's this kind of hurdle that some people just can't get over, and that's totally okay.
This isn't a strategy for everybody. We've beat this drum enough. You need to know what you own and why you own it and why you're doing this stuff. And if you don't understand it, then do not attempt to do it. That is one of the challenges we've come up against.
John: Absolutely. If you look at just one party, your portfolio, it could totally freak you out, but that's why we have diversification. If you're looking at, Hey, my emerging market stock did poorly well, yeah, sure, but we've got all this other stuff too, and that's effectively the problem behind mine accounting is that you're going to look at just one thing.
You're going to make these artificial dividers between what you own, but just take a step back, look at everything, and if that's the case, then you'll probably realize that you're okay.
Taylor Schulte: So our top three tax saving tips, are donor-advised funds, the mega backdoor Roth and asset location. Hopefully you learned something new. Hopefully we broke it down a little simply and you didn't get too lost there. Just know that you can go to the show notes and read some more of the resources that we'll link there. You can also just Google around and learn more about each of these different strategies.
Again, use September and even October to start your tax planning now before things get crazy towards year end. Reach out to your CPA now and start to put some of this stuff into place. If you have any questions for us, feedback, anything at all, please shoot us an email at podcast@staywealthysandiego.com.
Thank you all for listening and we will see you in a couple of weeks.
John: Stay wealthy guys.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.
Top 3 Tax Saving Tips
1. Donor-advised tax funds (DAFs)
DAFs are a flexible way to contribute to charitable 501(c)3 organizations, and they’re our favorite tax tip because the tax benefits are twofold: You get to you get to claim the money you contribute as a charitable donation on your taxes; and if you donate appreciated stocks, you avoid capital gains taxes on those assets.
The way it works is this:
You give your assets to a sponsoring organization, such as Fidelity Charitable, Schwab Charitable, or Vanguard Charitable.
You take the charitable donation deduction for the year in which you donate.
And then the sponsoring organization makes contributions to charities you choose whenever you give the say-so.
Although a recent article in The New York Times highlighted the use of DAFs by tech billionaires, they really are available to anyone. The median account balance for Fidelity Charitable, which is the biggest of these sponsoring organizations, was just under $20,000 in 2017. DAFs are also very low-cost and simple to set up and use.
The one caveat is that DAFs will only have a tax benefit if you itemize your deductions. Standard deduction limits were increased for the 2018 tax year to $12,000 for individuals and $24,000 for married couples filing jointly. So if you don’t plan to itemize going forward, you’re not going to get the full benefit of a DAF.
Assuming you do plan to itemize, here’s an example of how a DAF might save you.
Let’s say my wife and I give $10,000 every year to the Labrador Retriever Foundation. I want a big, messy, dirty chocolate lab. She won’t let me have one, so instead, we just give a bunch of money to the Labrador Retriever Foundation every year.
But this year, we sold a rental property and our tax bill is going to be higher than usual. One way to lower it is to give more to the lab foundation – let’s say we need to give $30,000 to the foundation this year instead of the usual $10,000 to lower our tax bill.
I could just give that amount outright. But, a DAF gives me the flexibility to spread those donations out over three years so I can stick to my original schedule — or, I can request that $10,000 goes to the Labrador Retriever Foundation this year and next year I give to someone else. Or I can put off distributing those funds to anyone indefinitely. They can go to any 501(c)3 organization that I want at any time I want.
That’s the beauty of a donor-advised fund: It gives you tons of flexibility.
DAFs make the most sense for folks who donate appreciated securities. Say you’ve got a stock or fund that’s grown in value over a long period of time. You don’t want to pay capital gains tax, but you do want to support charitable giving. If you donate the appreciated security to the DAF, you don’t have to pay the capital gains tax.
2. Mega back-door Roth IRA
Unlike the donor-advised fund, this is a long-term tax saving strategy. Its goal is to allow people who can’t normally contribute to a Roth IRA to do so.
When it comes to retirement accounts, 401(k)’s are important, but you also want to put as much money as possible into a Roth IRA. That’s because as the money in a Roth grows, the gains are not taxed.
Let’s say you put $5,500 into a Roth IRA this year and it grows to $55,000 in 30 years. For the sake of this example, we’re just assuming you don’t contribute anything else. When you start to withdraw that money in 30 years, none of it will be taxed. You’ve already paid taxes on the $5,500 principal, but you never pay taxes on the $49,500 worth of gains. That’s why a Roth is such a great investment vehicle. A 401(k) will save you on your tax bill now, but you will have to pay taxes on the principal and the gains when you withdraw the money in retirement.
The other benefit of a Roth is that it’s not subject to required minimum distribution rules, meaning you’re not forced to take your money out at age 70 ½, like you are with a 401(k).
The thing is, some people make too much money to fund a Roth. According to IRS rules, for 2018, individuals making $135,000 or more can’t contribute to a Roth. A mega backdoor Roth gets around that limit.
How? First of all, you have to max out your 401(k) contribution for the year – so that’s $18,500 for an individual in 2018. If allowed by the plan, you can make after-tax contributions of up to $36,500, bringing the total for 2018 up to $55,000. In this example, let’s say there’s no employer match, so we’ve made $18,000 in after-tax contributions ourselves.
Next year, you can withdraw that $18,000 after-tax contribution amount – assuming your employer allows in-service non-hardship withdrawals – and put it directly into a traditional IRA. You can then convert that traditional IRA into a Roth IRA.
Note that you can only do this if your employer 401(k) account allows you to make in-service non-hardship withdrawals. You’ll need to contact your benefits department and ask for a summary plan description (SPD). It will tell you if after-tax contributions and in-service withdrawals are allowed.
3. Tax-friendly asset allocation strategy
This strategy works only for people who already have long-term investments in both taxable accounts (such as a regular brokerage account) and tax-favored retirement accounts (such as a 401(k) and/or a Roth IRA). And it assumes that you’re investing in stocks and bonds. Along with bonds you maybe have other coupon-paying investments such as real estate investment trusts (REITs) that, like bonds, generate regular cash flow that you have to pay taxes on every single year.
The income you receive from bond interest or from your REITs gets taxed at the highest income rate, which is 37% if you’re in the top income bracket. The income you receive from stock dividends and capital gains get taxed at only 20%.
A tax-friendly asset allocation strategy says to put bonds and REITs into a tax-deferred account like a 401(k). That way, you won’t pay taxes on your income from those funds until you retire, when you’ll supposedly be in a lower tax bracket.
If you’ve got stocks, you put those into your taxable account because your taxes on any dividends you receive in the tax year, plus any capital gains you realize, will be only 20% instead of 37%.
The third part of this strategy says to put investments that are going to grow the most into a Roth IRA. That’s usually the riskiest investments you have, which also tend to have the highest returns. That means small-cap stocks and emerging market stocks. Assuming those investments grow a lot, all of that growth is going to be tax-free.
Keep in mind, these are just rules of thumb. Your strategy may differ if your needs are different or you’ve got a different kind of portfolio diversification.
– Stay Wealthy