[00:02:24] Rebecca Hotsko: Okay, so the first question I got it was from a listener who said they have a fairly large sum of money and they need to use it in about a year to pay for school, but in the meantime, they wanna know if there’s any options so they can earn some return on that money so that it’s not just sitting in a savings account, but also they can’t afford to lose a principal.

[00:02:43] Rebecca Hotsko: They asked about a one year T bill since it’s paying nearly 5%, but they wanted to know what you would recommend in this case. and I just thought this was interesting. Even though it’s a specific example, I think we can extrapolate it so it’s relevant to various situations, whether you need [00:03:00] money for school or maybe even a down payment for a house or any large purchase in the near future.

[00:03:05] Rebecca Hotsko: In these situations where someone can’t afford to take a lot of risk in their investment, what are some options you would recommend for these individuals? . 

[00:03:12] Dave Alison: Absolutely. And the T-bill is a fantastic idea. It’s something we’re using a lot with our clients right now. Now there’s also different options depending on, to your point, Rebecca, when they’re actually going to need the money.

[00:03:25] Dave Alison: There’s 13 week T-bills that are paying around four and a half percent. There’s 26 week T- bills, so essentially a six month maturity. And then there’s of course, one year, two years, and even longer duration. And so if you don’t want any market risk or exposure to potential losses, those are great ways that you can enhance and juice up your interest rate more so than the banks are certainly providing these days and talk about taxes.

[00:03:53] Dave Alison: Those T-bills are also state income tax free. So if you’re in a state with a high tax rate, it’s even a better net after tax return than you maybe originally. . 

[00:04:05] Rebecca Hotsko: It’s really interesting right now because it’s maybe not a normal environment where you can earn such a good return by taking such little risk and these options that are available in the near term.

[00:04:17] Rebecca Hotsko: So I guess beyond those, would the answer be different if you know the date you need to take it out versus if you aren’t sure, because I guess with the T-bills, you’re locked in for that certain amount of time. So what if you needed it in a pinch? Would that change your answer? 

[00:04:33] Dave Alison: It could be a little bit. So when clients say, Hey, I got a chunk of money and I wanna do better from an interest rate perspective, the first thing I ask is, when do you think you’ll need it?

[00:04:42] Dave Alison: Right? And I try to time up. So for example I’m holding a bunch of cash for next April when I know I’m gonna have to pay income tax. I don’t want to have that cash subject to market volatility. And so I might time up the right T bell with that date. For a lot of our clients also, they’re, they’ve traditionally sat on what I would call like an emergency fund.

[00:05:04] Dave Alison: It’s an amount of money they had at the bank that they really don’t have anything earmarked for or a date when they’re gonna spend it. But it’s a decent sum of money and they’re not earning anything on it at the bank. And so in those cases, I still use those T-bills because you don’t have to hold it to maturity.

[00:05:23] Dave Alison: You could cash it in before, let’s say that 13 week or 26 week period. Now, if you cash in a bond before it matures, you could subject yourself to a little bit of volatility, but typically the rule of thumb is the shorter the duration of the bond. The less volatility that would exist. And so for example, how bonds become volatile is when interest rates go up or down.

[00:05:51] Dave Alison: So if interest rates went way up during the period that the 13 or 26 week bond is maturing, you could see principal value go down a little bit. But again, it’s still a really reliable source if maybe you didn’t wanna commit to it. There’s other really good more liquid money market funds that exist out there.

[00:06:12] Dave Alison: Now, they might not be paying as high as four and a half percent, but they’re probably paying two and a half to three, and that gives you a little more price stability if you need quick liquidity without having to wait til duration. . 

[00:06:26] Rebecca Hotsko: Okay. That was super helpful. I think that gives our listeners some options to think about.

[00:06:32] Rebecca Hotsko: And then the second question that I got, it was kind of similar, but for the longer term. So I had a listener ask what you would recommend for an investment in their later bucket, which we talked about in your last episode, where they wanna invest for the long term, but they are extremely risk averse and they want more of a guaranteed return, even if it’s low. They just don’t wanna see that principle be very volatile or go down, even though it’s money that’s invested for the long term. And so I’m wondering what you would recommend for this individual. 

[00:07:04] Dave Alison: Yeah, definitely. So in that case of course they know that expected return isn’t gonna be as high as they took on risk like in the stock market.

[00:07:13] Dave Alison: But preservation, stability, and peace of mind is important to them. Then it’s looking for alternatives to invest in that are outside of the stock market, and the biggest one is through insurance companies. Traditionally, if I had worked 50, 60, 70 years ago for a company, that company would’ve put money into an employer pension for me, and essentially that pension would’ve built up in value the longer I worked at that company and when I retired, that pension would pay me or my spouse, or both of us, essentially a guaranteed paycheck for as long as I’m alive now in this country, most places don’t have pensions anymore unless you’re maybe a government worker. But an individual can essentially replicate a pension by more or less by buying a private pension through an insurance company. It’s where they give that insurance company money through their paycheck, through their savings.

[00:08:09] Dave Alison: It’s not in the stock market. There’s essentially no risk of loss of principle because of stock market volatility, and it’s gonna build up in what’s called an annuity in annuity. It’ll continue to build to a point in time where they’re ready to start turning it into an annuitized income stream for life.

[00:08:28] Dave Alison: And so that’s one area where they can build up retirement savings without having stock market volatility. Those annuities are very common in countries outside of the United States. But you know, for younger people, they’re typically not as common in the United States because we’re all forced to just think about our 401k.

[00:08:49] Dave Alison: Our 401K only has a limited amount of mutual funds in ETFs, and so you’re kind of forced to either the stock market or the bond. Now, there was some major legislation that was passed a few years ago to make annuities more accessible within a 401k. So I would envision over the next couple years, when you log into your 401k, you’ll see that as an option for investing and building retirement savings.

[00:09:14] Dave Alison: But outside of annuities, at a life insurance company, you could also buy permanent cash value life insurance. Again, permanent cash value. Life insurance has a death benefit component too. But more importantly, it builds up cash value in a savings account. And it could either pay a dividend or it could pay an interest rate that’s tied to the performance of a stock market index, but with a floor so that if the stock market goes down, you don’t lose anything in that given year.

[00:09:43] Dave Alison: And so those are really the two most viable options for somebody that’s like, I want no stock market risk, no bond market risk, nowhere that I could potentially lose my money because of a market crash, then you really start to look at an insurance company, cuz everywhere else outside of banks, right?

[00:09:59] Dave Alison: Banks, you could keep money in your savings account or in certificates of deposit. But real estate has volatility. Stocks have volatility, and bonds have volatility. 

[00:10:10] Rebecca Hotsko: That’s interesting. You mentioned those two options because for annuities then, would you say that is worth checking out if the individual doesn’t have a pension, because that would serve as a substitute?

[00:10:23] Rebecca Hotsko: Or are there any other situations where you think beyond what we just talked about, where you think an annuity would make sense for a millennial to start even looking at today? 

[00:10:32] Dave Alison: Yeah, I think they could potentially. Right, and it’s really for a millennial who doesn’t have an appetite for risk or volatility, like I would still say I’m a millennial.

[00:10:42] Dave Alison: For me, I don’t own an annuity today. I will own an annuity once I approach retirement age because at that point, I won’t want as much stock market risk on my nest egg when I go to retire, but for right now, I’m all in on the stock market because I know I have a long time horizon. But if [00:11:00] you don’t have that appetite for risk, then yes, there are really good deferred annuities where, you know, maybe in today’s rate environment, you could earn between four and six, four and 7% without any market risk.

[00:11:14] Dave Alison: Defer that until the time you need it for retirement income and then turn it on for income down the road. 

[00:11:20] Rebecca Hotsko: Gotcha. And life insurance is really interesting. I’ve been looking into it recently myself as an option and there’s different ways that you can use it. I had a guest a little while ago talk about how you can borrow against it and that opens up so many opportunities.

[00:11:38] Rebecca Hotsko: So is there anything else you would share on maybe why you like life insurance? . 

[00:11:44] Dave Alison: Yeah I like it because it has two components, right? It has a death benefit in the event that I prematurely pass away, and that death benefit would pay to my spouse or to my kids’ income tax free to basically self fulfill what I otherwise would’ve earned in income had I been alive to be able to support my family.

[00:12:03] Dave Alison: And so for the peace of mind of that, it to me is worth its weight in gold. Now the second component is I can build money up in the cash value component of it, and again, assuming I take it out the right way while I’m alive, it would come out income tax free. So I can supplement tax free income in retirement.

[00:12:25] Dave Alison: A third resource that it brings is healthcare is a major expense in retirement that we should all be thinking about. Medicare in the United States does not cover the cost of long-term care events or chronic illness events. Like if I need a nurse to the house or I go into a nursing home or assisted living.

[00:12:42] Dave Alison: And so if I have a permanent life insurance policy, I could access or accelerate that death benefit while I’m alive to help cover the cost of. And last but not least, if you’re more of an aggressive investor like I am, we know the best time to buy into the market is when the stock market is down. Well, if I have a big chunk of cash in a permanent cash value life insurance policy, and the market goes 20%, 30%, 40% down in value, I can borrow that cash out of the life insurance policy, put it into the stock.

[00:13:16] Dave Alison: Hopefully the stock market recovers. I make a big gain through the rebound. Sell some of the profits and pay back the loan in the life insurance policy. So it gives me a place to be able to leverage my money in a really efficient way, and I think it’s important for a lot of people to look at. And so I think it’s a good resource, but it’s kind of that last line of savings.

[00:13:39] Dave Alison: I, I talk about something I call the order of money, which we’ll talk a little bit about later, but to me, permanent cash value life insurance is one of the last places you save after you’ve maxed out some of the other really critical components to build financial. 

[00:13:55] Rebecca Hotsko: Yeah, I think that’s a great thing to point out, and we’ll definitely get into that later where there’s the order.

[00:14:01] Rebecca Hotsko: So maybe if you don’t have everything maxed out, maybe you shouldn’t focus on that. But for people who do and need to take it to the next level, then there’s some great options, which I wanna dive into. And so I think let’s get into the big topic for today, which is tax optimal investing. How we can be more proactive at tax management and just invest in the most tax optimal way to make sure that we’re keeping most of our wealth once we’ve built it.

[00:14:27] Rebecca Hotsko: And so many of our listeners are likely in their accumulation phase. And I think it would be helpful if you started out by sharing what your framework is for building a tax efficient savings and accumulation plan. 

[00:14:39] Dave Alison: Yeah, absolutely. I mean, the challenging thing with this, Rebecca, is taxes are just not intuitive whatsoever.

[00:14:47] Dave Alison: Right? Like the intuitive answer with taxes is, I wanna do whatever I can today to save as much as possible in taxes today. Right? That’s where we search for all these deductions to lower our taxable income. But there’s no way to avoid taxes. Like if you avoid taxes, you’re gonna get to retire in an orange jumpsuit.

[00:15:10] Dave Alison: Behind bars, it’s illegal to avoid or evade taxes. And so there’s the decision that we all have to make is we have to pay tax. Do we pay it now or do we pay it later on? And I think that’s the really important trade off for millennials to consider. I mean, there was a Southern Circuit Court judge his name was Judge Learned Hand.

[00:15:32] Dave Alison: He was the Southern district in New York back in the thirties. And he had a really famous tax court case where he was quoted as saying, anyone may so arrange his affairs that his taxes shall be as low as possible. He’s not bound to choose the pattern, which pays the treasury the best. It’s not even a patriotic duty to increase one’s taxes.

[00:15:57] Dave Alison: And so this was like that first precedent. People really should be thinking about tax planning and tax management because it’s not about what you make, it’s about what you get to keep. And that’s really starting to think about how to integrate taxes into your investment, your savings and your wealth building can pay huge dividends, five, 10, and 15, 20 years down the road.

[00:16:21] Rebecca Hotsko: So I know in one of your YouTube videos, the tax management journey, you talk about how there’s a specific order of how we should accumulate money as we’re building wealth, and there’s an order of how we should allocate our savings and investments into these three accounts. So if we’re thinking about how to invest from a tax optimal sense, I was hoping that you could walk us through the three places that we can funnel our money and maybe which investments we should ideally buy in each.

[00:16:49] Dave Alison: Yeah, absolutely. This is so important, and so essentially if we think about accumulating and building wealth, there’s three places or funnels that we could accumulate money into. There’s our pre-tax funnel, which most people are fairly familiar with. These are things like our IRAs, our 401ks, and maybe you’re even lucky enough to have a pension plan at work.

[00:17:13] Dave Alison: You’re making a cognitive decision to defer income taxes until sometime into the future. You’re getting a deduction today to put the money into these plans. That’s gonna grow tax-deferred over time. And then when you take that money out, it’s gonna be fully taxed at ordinary income rates. So those are the traditional rates that we see in the tax code today.

[00:17:39] Dave Alison: 10%, 12%, and so on and so forth, up to the top rate that exists today, which is 37%. So when you’re putting money into here, you’re gambling a little bit and I don’t mean gambling like you’re going and buying some exotic stock that you’re betting the house on in these accounts. I mean that you’re gambling in the sense that you’re saying that you’re in a higher tax bracket today than you will be in the future.

[00:18:05] Dave Alison: You’re trying to play that tax arbitrage that your taxes will go down in the future. And that’s a misconception because actually what happens is as many people build more and more wealth up, they actually go into a higher tax bracket. I mean, I hope that I have more wealth and more money when I’m 65 than when I’m 35.

[00:18:29] Dave Alison: And so I might in fact be at a higher tax bracket down the. The other thing they say is, well, maybe I’m gonna retire and I won’t have any more employment income, so I will be in a lower bracket. But if you’ve built up a big investment portfolio that could be kicking off investment income, dividends, interest, you could be forced to take money out of these retirement accounts because in today’s world, at age 72, you have forced distributions.

[00:18:55] Dave Alison: You could also lose deductions in retirement. Like right now, I’m able to write off child care expenses. I hope I don’t have any child care expense. When I get to retirement. I can write off my whole mortgage interest today to create deductions. I hopefully won’t have a mortgage when I go to retire. So in fact, we see many retirees are actually in a higher marginal tax rate in retire.

[00:19:17] Dave Alison: Than they actually were when they were working. Now, the exact opposite side of that gambler that bet is you could accumulate money in tax advantaged funnels. This is where you don’t get a deduction or an incentive to put money in today. It’s still gonna grow tax deferred over time, and when you take that money out, it’s gonna come out completely income tax free.

[00:19:42] Dave Alison: So the more money you accumulate into our tax advantaged funnel, you’re essentially eliminating the government. Good old Uncle Sam, the i r s, from dipping their hand into our future retirement wallet. These accounts, the most common one are Roth IRA accounts. I love Roths. They’re my, one of my second favorite accounts to put money into.

[00:20:04] Dave Alison: There’s also Rebecca, like we mentioned, cash value life insurance. There’s also my favorite account, which is a health savings account. It actually is the only account that’s triple tax advantaged, meaning you get a deduction to put money in just like your IRA or 401k. It grows tax deferred, and then when you take that money out for qualified medical expenses later on in life, it’s tax free.

[00:20:28] Dave Alison: There’s flexible spending accounts if you have that offered by your employer. There’s dependent Care HSAs if you have childcare expenses you can use with pre-tax dollars to fund healthcare. And then last but not least, college 5 29 plans in that tax advantage funnel if you’re helping fund pre-K K through 12 private school or college degrees or advanced schooling for children or grandchildren.

[00:20:55] Dave Alison: Those are great accounts to do so. And then the third funnel is the middle one. The middle one is post-tax. This is where you’re actually double taxed. You’re taxed when you make the money. Then you invest the money. That money grows over time, hopefully. And when you sell that investment, you realize your tax again the second time.

[00:21:18] Dave Alison: Now, because it’s the second time you’re taxed, the government is a little more favored. They tax it as a preferentially taxed capital gain instead of ordinary income. So those tax rates are between zero, 15 or 20, even up to 23.8% depending on your overall income level. And so as somebody is thinking about saving, they need to be thinking about how much of my saving.

[00:21:44] Dave Alison: Should be going into the pre-tax funnel. How much of it should be going into the tax advantaged funnel, and then how much of it should be going into the post-tax funnel? Now, there’s typically IRS limits to how much you can put in the pre-tax funnel because the government doesn’t want you to defer all your income.

[00:22:02] Dave Alison: They need some tax revenue today to pay for all the great stuff that they do. Similarly, there’s a limit to how much you can put in the tax advantaged funnel. You know why? There’s a limit to how much you can put in tax advantaged, Rebecca? It says they don’t want billionaires going and putting all their money in tax advantaged and not being able to tax any of that money in the future.

[00:22:21] Dave Alison: And the only one that has no limit is that middle funnel, the post-tax funnel. But there’s absolutely an optimal dollar amount that people should be thinking about how much they’re putting in each of those funnels from a tax diversification standpoint. And then to your second part of the question, there’s an optimal investment that they should be making.

[00:22:42] Dave Alison: What stocks, bonds, mutual funds, ETFs, real estate bonds, cash, T-bills that they should hold in those different accounts. Because there’s a very real thing called tax sensitive asset allocation, which is incredibly important in building wealth.

[00:22:59] Rebecca Hotsko: I would love to dive a bit deeper into that because I know that is something I struggle with.

[00:23:05] Rebecca Hotsko: They have different names in Canada, but I think anyone who’s listening globally, they can listen to a tax advantaged account or the tax deferred account and they can match up, which there is called. But I’m hoping you can share what is, I guess, the most tax optimal way we should be allocating our assets and helping our listeners out.

[00:23:25] Dave Alison: Yeah, and you’re right, like pretty much, I mean most of the different countries that I’m aware of, they have a similar structure. Like we have a lot of clients in the UK and there’s ways you can build tax advantaged money. There’s ways you can build tax deferred money, and then there’s certainly post-tax or after tax money, so, Wherever you’re listening from, think of these three different compartments because it’s relevant.

[00:23:47] Dave Alison: Now, if you think about it, some of this stuff might make common sense, but again, taxes are not intuitive. So a lot of people overlook this, but I would want my assets in my portfolio that have the greatest opportunity for capital appreciation, that have the greatest, highest, and highest expected. To be in my tax advantaged funnel, right?

[00:24:14] Dave Alison: So if I was going to be an early investor in Tesla, I wish I was, I would want that in my tax advantaged funnel because that stock has the greatest chance at doubling, tripling, quadrupling, or 10 Xing. That’s where people are familiar with the news articles that came out in the United States of Peter Thiel, who is the founder of PayPal.

[00:24:39] Dave Alison: Peter Thiel has the largest Roth IRA in existence because he was able to put his early stage founder stock of PayPal in his Roth. I rra. PayPal became one of the largest companies in the world, and a lot of that appreciation happened in his Roth IRA. I mean, 4 billion was one of the reports that I saw of what he had in his Roth IRA that the government had no ability to tax.

[00:25:06] Dave Alison: Now, if you flip that over on its head, The investments that have the lowest expected rate of return, I would want those in my tax deferred investments like my IRAs or 401k. And the reason for that is because I don’t wanna have a high flying growth investment in an IRA because all that’s gonna do is create a greater tax deferred liability for me in the future because when I put money in a tax deferred, Like in IRA or 401k, I actually have a partner in that account.

[00:25:45] Dave Alison: That partner is the federal government, right? Think about Rebecca. If you and I were gonna go start a business together, and I said, cool, Rebecca, here’s the deal. We’re gonna put money into this account, this business, and in our operating agreement, the rules are gonna say that I can change the ownership percent.

[00:26:05] Dave Alison: At any time in the future that I want. So if we’re 50-50 partners today and this business becomes really successful, I’m allowed to change the ownership where I now own 80% of it and you only own 20% of it. Would you wanna get into that business deal with me? 

[00:26:22] Rebecca Hotsko: It would be more challenging to say yes,

[00:26:26] Dave Alison: Yeah, it would be more challenging to say yes, and that’s exactly like a retirement account because the federal government has the ability to change tax rates at any time they want into the future. So I’m putting money into this business deal today. My IRA or 401k and the government can change the rules on me at any time down the road into the future.

[00:26:47] Dave Alison: And so I think there’s an importance of having money in this account. I’m not saying don’t go use IRAs in 401k. I think that everybody, at least in America, where we have a standard deduction in the tax system, should retire with some money in a retirement account because the government’s gonna allow us to extract money out of our income tax free.

[00:27:11] Dave Alison: The standard deduction is about 26-20 $7,000 today. That means the government is gonna allow us to get 26 or $27,000 every single year in retirement income tax. I want that money coming out of my retirement. But I still need tax free money or tax favored money to take higher income limits out in retirement so that ultimately I can retire in a very low tax bracket or tax threshold.

[00:27:39] Dave Alison: And so again, there’s certain investments, maybe like my fixed income or my bonds that I would hold in my retirement account because they have a lower expected return than stocks and equity. In the post-tax account, this is where you’re taxed twice. Like I mentioned, you’re taxed when you earn the money.

[00:27:57] Dave Alison: Then it grows and defers over time, and you’re taxed a [00:28:00] second time when you take money out. There’s also investments that are more favorable there. Like if I invested in bonds, treasury bonds, or corporate bonds, the interest is taxed as ordinary income, which is the top marginal rate that exists out there.

[00:28:17] Dave Alison: But if I took that same money and I invested it in capital, meaning let’s say a stock that pays a dividend, take Apple for example. Or Proctor and Gamble, that dividend income that gets kicked out to me is gonna be taxed more preferentially at capital gains in dividend rates. And so if I was gonna hold dividend paying stocks, I would wanna hold those in my post-tax brokerage account instead of my IRA, because if those dividends get paid into my IRA, they’re gonna come out as ordinary income instead of preferentially taxed at capital gains and long-term di long-term capital gains in dividend rates..

[00:28:56] Dave Alison: And so you not only need not only to think about where you’re accumulating the money, but then what investments you’re buying inside of those different account types. , 

[00:29:06] Rebecca Hotsko: That was super helpful and I think that was such a great example where there’s so many nuances that we don’t really think about when we’re buying investments all the time, and it can really make a difference in the long term.

[00:29:18] Rebecca Hotsko: Cause I remember last time you mentioned one of the biggest mistakes you see your clients make is they have the biggest portion of their wealth tied up in a pre-tax account. , and that was something that you told our listeners about last time. And so one thing that I was thinking about is one of the things that’s appealing about the tax deferred accounts though is for high income earners where they get that immediate tax deduction.

[00:29:43] Rebecca Hotsko: That’s something that. I guess that could be a reason why they want to use that account instead of the tax advantaged one, even maybe if they have room in the other one. So I guess what other options would you say are maybe better for those high income earners than going that route? 

[00:30:00] Dave Alison: Yeah, and it’s a little bit different in every scenario, but you’re exactly right.

[00:30:04] Dave Alison: Like I have a lot of clients in California who are in the top federal tax rate of 37%, and then state income tax of 13%, which means every dollar they earn, they lose 50 cents on the dollar to taxes. Now for them, we’ve historically still deferred in pre-tax accounts, especially if maybe in the future they’re gonna retire outside of the state of California.

[00:30:28] Dave Alison: So if they’re gonna leave California and retire somewhere else, I want to be on the gamble that I want to defer income now. Because if they’re gonna move to Nevada or Florida or Texas or a state with no state income tax, that can be a great tax saving. But the other thing to consider is where the market is at.

[00:30:45] Dave Alison: Also, because going into 2023, I’ve advised my clients to flip over and not defer in the pre-tax going into this. I want them foregoing that tax deduction, no matter how big it is to get more money in the Roth account. And the reason that I’m doing that is because the markets are down 15, 20, 25, 30%. I want them to get and buy more shares of these companies in the Roth account in January, February, and March when the markets are down because I want that recovery to happen in the Roth.

[00:31:21] Dave Alison: If I buy into stocks right now in my IRA, and let’s say I go buy a company that’s down 40 or 50%, And then it recovers. I don’t want that 100% return to happen in my I R A where it’s gonna be taxed at ordinary income when I could have had that recovery happen in my Roth account. And so the deduction is like a drug.

[00:31:44] Dave Alison: And sometimes we need to kind of think past the instant gratification that we get today by getting that deduction in order for some sort of massive, long-term economic or financial benefit down the road. [00:32:00] And so I always share when it comes to tax management that it’s like playing the game of chess and not checkers.

[00:32:06] Dave Alison: Like checkers. You can be playing and only think one move ahead. Like let me take the deduction. It’s gonna save me $4,000 in taxes today. Chess is like thinking 5, 10, 15 moves ahead, that if I forego this one $4,000 deduction today, how is that gonna benefit me five or 10 years down the road? My Roth IRA is not gonna cause taxation on my social security benefit.

[00:32:29] Dave Alison: It’s not gonna cause additional Irma tax on my Medicare benefits down the road. I’m not gonna have a required minimum distribution where the government’s gonna have to tell me how much money I have to take outta my accounts each and every year whether I want to or not. So there’s just a lot of different factors to think about in terms of that decision of deferring now or saving money later.

[00:32:52] Dave Alison: Other than that, though for a high income earner, there’s just limited opportunities to create tax deductions. To your question, it’s like I’m a mortgage interest. Is it tax deductible? Charitable giving. We have a lot of high income earning clients that are incredibly philanthropic, so they’re giving to charity.

[00:33:13] Dave Alison: But outside of that there are investments that you could put money into. They’re very speculative in nature, which is why the government gives you a tax deduction to put money in. Things like oil and gas exploration, right? The government needs to give you an incentive to put money into those things because quite frankly, a lot of times, more often than not, the investment doesn’t pan out itself.

[00:33:35] Dave Alison: There’s things like qualified opportunity zones, but again, those tend to get pretty complex, and a lot of people tend to steer clear of those things because of the complexity of them. 

[00:33:46] Rebecca Hotsko: And then I guess, what about selling a losing investment? Does that ever make sense for tax purposes?

[00:33:55] Dave Alison: Yeah. This is something that we’re talking a lot about with our clients, and so I would say selling a loser just to sell the loser doesn’t make sense.

[00:34:02] Dave Alison: You have to have another strategic reason why you’re selling that loser. So, for example, if I look at my portfolio and I own three stocks for simplicity’s sake, and one of those stocks has done really well, right? I bought Tesla eight years ago and now that Tesla stock is a huge part of my overall portfolio.

[00:34:21] Dave Alison: And I’m not comfortable with that much concentration in Tesla, but I don’t wanna sell because I’m worried about the taxes. Well, let’s say I bought a different stock and that stock has declined in value and actually has a loss in it. I could sell that stock that has a loss. And I can use that loss to offset some of the gain of selling my Tesla stock, and now I’m bringing my portfolio back into an allocation level that I’m comfortable with.

[00:34:50] Dave Alison: I could take the proceeds from Tesla and I could go buy some other stocks to continue diversification. That’s an example where it does make sense. The other area, ma, where it makes sense is if you don’t have any other gains, at least in the United States, you can sell up to $3,000 as a capital loss and use that $3,000 to offset your ordinary income, your paycheck, and money.

[00:35:18] Dave Alison: So if I put $10,000 into a stock last year and now it’s only worth 7,000, I could sell that stock, realize a $3,000 loss, and if I’m in a let’s say a 30% tax bracket, that’s $900 of tax savings. I could offset that loss and I could even go and buy that same stock again as long as I wait more than 30 days to not violate what’s known as the wash sale rules from an I R S perspective.

[00:35:50] Dave Alison: So for anyone, as we’re closing into the end of the year here, if you have a loss, recognize three grand of it. You’ll get a tax benefit for that. But [00:36:00] if you sell any more than that, let’s say I sell $50,000 of a loss. And I don’t have any other capital gain to offset it with. The IRS allows me to take that $3,000 loss against ordinary income, but the other $47,000 is a carry forward into the future that could be used to offset future gains.

[00:36:23] Dave Alison: And so again, I don’t see much value in just parking that carries forward loss unless you really just wanted to be out of the stock from an investment perspective, right? So don’t let the tax tail wag the investment dog. If it’s a good investment, keep holding it because hopefully it’ll rebound. But if it’s a bad investment, you don’t like the company anymore, then get out of it.

[00:36:45] Dave Alison: You’ll still get that loss at some point in the future, and you can relocate those dollars to something better. 

[00:36:52] Rebecca Hotsko: And I guess that’s just worth pointing out that this is just for the non-tax advantaged accounts, right. 

[00:36:58] Dave Alison: So again, the pre-tax funnel and then the opposite, the tax advantaged funnel, there’s no economic benefit to trading investments cuz you’re deferring that tax in the pre-tax until the time you actually take the money out.

[00:37:12] Dave Alison: And with that tax advantage, it’s never taxed in the future. And so the tax harvesting concept is only relevant in the post-tax. And vice versa. Something I teach a lot of financial advisors, CPAs, is there’s something actually called tax gain harvesting as well. There’s a certain amount of money, capital gain income you could potentially generate each year and not pay any income tax on it.

[00:37:39] Dave Alison: And that’s a little bit more of a complex topic, but there’s reasons to do, like I said, tax harvesting or tax gain harvesting in that post-tax funnel. 

[00:37:48] Rebecca Hotsko: And I was also hoping that you could talk to us about Roth conversions. I remember last time you mentioned that you have been doing them for some clients and it makes sense in this environment.

[00:37:58] Rebecca Hotsko: So can you walk us through when it might make sense for someone to consider doing this? 

[00:38:03] Dave Alison: Yeah, absolutely. So the first thing on the Roth conversion, they’re a phenomenal vehicle. Anybody can do ’em. There’s no income limit to being able to do a Roth conversion. So I don’t care if you make 10 million a year, you can put a bunch of money in an IRA and then you could immediately convert it to a Roth to start building up tax free income and tax-free assets later on.

[00:38:25] Dave Alison: Now the first thing is doing it. You would not want to do a Roth conversion if you’re doing pre-tax contributions to your I R A, because those would just contradict themselves, right? And so the first thing from a planning strategy is to switch all of your contributions in your 401K over to Roth. That’s gonna allow you in 2023 to get about $22,500 into your Roth.

[00:38:52] Dave Alison: Then what you could do is look at your overall income level, and there’s these marginal brackets that exist. So for example, right now the 12% tax bracket tops out at about $81,000 for a married couple of earned debt. Taxable income, which is taxable income, is when you take all of your income minus like your contributions to your 401k and stuff, minus your standard or your itemized deduction gets you to your taxable income.

[00:39:25] Dave Alison: So for a married couple, it starts at 81,000. For a single individual, it’s about half of that, about 40,500. And so let’s just use a married couple as an example. If I had about $70,000 of taxable income, I know I can go and think about it like a measuring cup. I know I could go to the kitchen sink and I can fill up another $11,000.

[00:39:50] Dave Alison: Of water into that measuring cup before it’s gonna spill over into the next bracket, which is 22%. In the United States, any dollar is a married couple’s taxable income. Over $81,050 is gonna get hit with a marginal tax rate of 22%. In that case, it would behoove me to go and do a $10,000 Roth conversion because a $10,000 Roth conversion is gonna cost me $1,200 of tax, and the 12% bracket is a very low rate.

[00:40:24] Dave Alison: Now, you could even be a high income earner and maybe you’re building a bunch of wealth, or you’ve built a nice nest egg and you’re in a 22 or even a 24% bracket. Well, the jump from 22% to 32% is at 329,000, almost 330,000 of taxable income. So maybe you’re making 200 grand and you think tax rates are gonna be higher in the future, like I do from a macro perspective, we have over 30 trillion of debt.

[00:40:57] Dave Alison: We’re gonna have to pay that down somehow in the United [00:41:00] States, and it’s gonna come in the form of higher taxes. And so you’re like, wow, at 24% I can pay tax. Now to be able to shift that money to the tax advantaged funnel, invest it aggressively and grow it, and now hopefully that money doubles, triples, or quadruples over the next 20, 30 years.

[00:41:19] Dave Alison: Well, what you can do in this case is let’s say you’re making $200,000 of taxable income. You can do a Roth conversion up to $129,000. That $129,000 is gonna get taxed debt, 24%, and you’re gonna shift that money over to the other pocket now, which is gonna be tax free forever. And so it’s a strategy we call bracket bumping Roth conversion.

[00:41:47] Dave Alison: It’s where you’re trying to bump yourself right up to the bracket without going over it. The other timing strategy that we do with Roth conversions is what I call market timing, Roth conversion. So let’s say [00:42:00] I own a stock in my 401k and now that stock is down 30 or 40 or even 50%. If I just convert that one stock from my IRA to my Roth, I’m essentially getting a 50% discount on the taxes.

[00:42:15] Dave Alison: If I think about Roth, that stock is gonna get back to even. . Now, let’s say, so let’s say I had a stock at a hundred dollars. It’s now worth $50. I convert that stock to my Roth account, so I have $50 of income that I pay tax on. And let’s say I’m at a 20% tax rate, so I pay $10 of tax. Now I have that $50 stock in my Roth IRA.

[00:42:40] Dave Alison: And let’s say it gets back to a hundred dollars a share. Well now I have $50 of appreciation that the government can never. And so the best time to pay taxes is when taxes are on sale. Taxes are on sale in two ways right now. Number one is because market valuations are low. And number [00:43:00] two, it’s cuz historically the tax brackets are low.

[00:43:03] Dave Alison: We know that on December 31st, after December 31st, 2025, tax rates are going. It was a sun setting provision. In the Tax Cuts and Jobs Act of 2017. They lowered the tax rates for almost everyone. So at the top level, the 39.6% tax rate went to 37. At the lower levels, the 15% bracket went to 12. Those are all gonna sunset.

[00:43:30] Dave Alison: So we know in 2026 we’re all gonna be in a higher tax bracket in the United States. On the same amount of income, and I would argue actually we’re gonna be in a higher tax bracket because the income ranges are suppress or are expanded right now and they’re gonna compress again to where we were before 2018.

[00:43:50] Dave Alison: And so now is the time when tax rates are on sale. Market values are down, which is why I made the comment on our last episode, we’re doing a lot more Roth conversions than we were doing last year when market values were very high. Because we can convert more shares for the same dollar amount. . 

[00:44:08] Rebecca Hotsko: That was super helpful and I think touching on your last point there, where it is likely that taxes will be higher in the future just due to macro factors, and there’s lots that can change, but if you look at the macro picture, I think a lot of people would agree it seems likely that could be the case.

[00:44:26] Rebecca Hotsko: And so, It seems like it’s more important than ever for investors to think about these tax optimal ways to invest now sooner than later and take advantage of these opportunities that you just shared with us. And then the last thing that I wanted to do. Touch on with you today briefly, as we talked about how to invest in the most tax optimal way, but then thinking about taking distributions from the accounts that we discussed earlier.

[00:44:54] Rebecca Hotsko: Can you touch on this aspect with our listeners and think about, I guess, the most optimal way to take out the money that we’ve put in? 

[00:45:03] Dave Alison: Absolutely. Just like I shared, there’s this kind of tax efficient roadmap for building money. And let me just, I’ll share this kind of with you real quick cause I think it’ll help a lot of listeners.

[00:45:12] Dave Alison: If you’re writing this down, I’d write these 10 steps down, and some of you might have this already done, but step number one is establish a one month emergency fund. Step number two is with your savings, start paying off high interest. Step number three is to contribute to your 401k. My preference would be the Roth side right now, at least up to your company match.

[00:45:37] Dave Alison: Step number four is if you have additional savings after establishing your emergency fund, paying off high interest debt, contributing your 4 0 1 up to the match. Then you wanna expand your emergency fund to have three months worth of an emergency fund. From there, if you have excess savings, you should match out your health savings account if you’re on a high deductible health plan to take that deduction, grow money, tax deferred, get money tax free later on.

[00:46:03] Dave Alison: Number six is you should max out your Roth IRA with additional savings. So if you’re a high income earner, I would look at a strategy called a backdoor Roth, where you put the money in a traditional IRA and you do a tax-free conversion. Number seven is then you should go max out your 401k or your Roth 401k, depending on where the stock market is at and what marginal tax bracket you’re in.

[00:46:29] Dave Alison: Number eight is you should contribute to a 5 29 plan if you’re trying to build savings for a child’s education, if that’s applicable to you. Then number nine and number 10 is any extra savings you have left over after you’ve already done one through eight. You should put a portion of it into an after-tax brokerage account, investing in the stock or bond market.

[00:46:54] Dave Alison: And a portion of it into cash value, permanent life insurance. So you’re diversified because at this time you’ve maxed out all the other savings components we can do that the government allows us to do in steps one through seven. We need to defer that money somewhere. If you’re more risk aggressive, maybe it’s like 80% to the stock market in 20% to life.

[00:47:15] Dave Alison: I. If you are more risk averse, maybe it’s 80% to life insurance and 20% to the stock market, but that’s something that maybe working with a professional would help you figure out and determine. So just like there’s an order to how you should save money. Once you do decide to retire, there’s an order to how you should take distributions.

[00:47:39] Dave Alison: It’s called a tax efficient withdrawal strategy, and in this case it’s kind of reverse engineering the scenarios, right? When we were in a low tax bracket, when we were accumulating, we were wanting to save money in a Roth IRA, right? To build up tax-free money later on. Well, when we go to retire, we [00:48:00] wanna be in the low tax brackets, take money out of our retirement accounts because those accounts are only gonna be taxed at, let’s say 10 or 12%.

[00:48:09] Dave Alison: But then we wanna take the higher income amounts out of the tax-free accounts like Roth Life Insurance, HSA plans. That’s when we start getting our income into the 22, 24, 32, 30 5% bracket. And you gotta be careful on how you mix all these ingredients together because there could be unknown taxes. I always talk about when you’re accumulating, you’re in a two tax system.

[00:48:33] Dave Alison: Ordinary income and capital gain and qualified dividend income. But when you retire, you go to a three tax system, ordinary income capital, and gain income in what’s called provisional income. Provisional income is used to calculate how much of your social security benefit from the government is gonna be taxable.

[00:48:53] Dave Alison: And also factors into how much of your Medicare premiums are gonna be subject to what I call a stealth tax, which is Irma. Irma is an additional tax on high income earners in retirement for the cost of their Medicare. So these things are like a teeter totter, right? If you get all the way to retirement and you didn’t structure it.

[00:49:14] Dave Alison: Accumulation plan. You’re not gonna have many options in retirement to optimize your retirement income plan, which means you maximize your income, in minimizing your taxes. And so it’s so important and why? I don’t work with a ton of millennials today, but I love getting on these podcasts because I feel like this is such an important message to get out to as many people as possible.

[00:49:39] Dave Alison: Because if I had a time machine of my 75 year old clients and they wish they could jump in it and do one thing differently, it would’ve been investing in their accumulation years more efficiently. So they didn’t just have this tax time bomb at retirement age, that now they’re staring down the pipe of.

[00:49:59] Rebecca Hotsko: Thank you so much. That was such a great way to end it off. I learned so much from today’s conversation. Thanks again for coming on. Dave, before I let you go, can you remind our listeners where they can go to connect with you and learn more about everything that you do? 

[00:50:15] Dave Alison: Yeah, so I’m a founder of a national financial planning and wealth management organization, Prosperity Capital Advisors.

[00:50:23] Dave Alison: We have trained advisors all around the country who specialize in exactly what I mentioned. I help do a lot of coaching and mentoring of them. And so you can go to prosperitycapitaladvisors.com. If you’re looking for an advisor who understands all of this, you can find an advisor in your area and that’s the best way to find more information about what we’re doing.

[00:50:49] Rebecca Hotsko: Thank you so much, Dave. 

[00:50:50] Dave Alison: Thanks, Rebecca. It’s always a pleasure. 

[00:50:53] Rebecca Hotsko: All right. I hope you enjoyed today’s episode. Make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I would really appreciate it if you left a rating or review.

[00:51:08] Rebecca Hotsko: This really helps support us and is the best way to help new people discover the show. And if you haven’t already, make sure to sign up for our free newsletter. We Study Markets which goes out daily and we’ll help you understand what’s going on in the markets in just a few minutes. So with that all said, I will see you again next time. 

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