Safeguarding Your Retirement: Mastering Tax Diversification and Advisor Collaboration

How can you safeguard your retirement nest egg from unpredictable tax changes? Tune into the Wolf Financial Podcast to uncover the secrets of tax diversification and its critical role in shaping a resilient investment portfolio. We use the example of a hypothetical couple to illustrate the diverse tax treatments of accounts like traditional IRAs, 401(k)s, after-tax brokerage accounts, and Roth IRAs. You'll gain valuable insights into the strategic advantages and potential pitfalls of each account type, and learn how to maximize tax efficiency in your investments.

In the latter half of this enlightening episode, we stress the indispensable value of collaborating with seasoned advisors who have a deep understanding of the tax code. Discover why both investment and tax diversification are crucial, and explore the educational strategies that can help you navigate the inherent risks of investing. Remember, tailored advice from tax, legal, or investment professionals is key to making informed decisions. We'll also highlight the importance of regulatory memberships and professional affiliations that underpin the credibility of advisory services, and remind you that past performance does not guarantee future success. Don't miss out on this episode packed with expert tips to help you optimize returns and mitigate tax liabilities.

Learn more about Wolf Financial Advisory:
https://www.wolffinancialadvisory.com/

Disclosure: Robert Wolf, James Koenig, Sara Wolf, and Michael Rock are investment advisor representatives of, and securities and advisory services are offered through, USA Financial Securities. Member FINRA/SIPC. Additionally, Amanda Opulskas and Adam Wallace are registered non-solicitors of USA Financial Securities, A registered investment advisor. 6020 E. Fulton St., Ada, MI 49301. Wolf Advisory Services and Wolf Financial Advisory are not affiliated with USA Financial Securities.

The strategies and concepts discussed are for educational purposes only and do not represent specific investment, tax, or estate planning advice. Investing carries an inherent element of risk and it is in everyone’s best interests to consult a tax, legal, or investment professional. The opinions expressed herein are not meant to provide specific investment advice or serve as a prediction for future stock market performance. Past performance does not guarantee future results. Securities and advisory services are offered through USA Financial Securities, member FINRA/SIPC. A registered investment adviser. Wolf Financial Advisory and USA Financial Securities are not affiliated entities.

Transcript

Voiceover 0:01

The strategies and concepts discussed are for educational purposes only and do not represent specific investment, tax or estate planning advice. Investing carries an inherent element of risk and it is in everyone's best interests to consult a tax, legal or investment professional. Past performance does not guarantee future results. Securities and advisory services are offered through USA Financial Securities Member FINRA/ SIPC, a registered investment advisor. Wolf Financial Advisory are not affiliated with USA Financial Securities.

Voiceover 0:41

Wolf Financial Advisory. When it's important to you, it's important to us.

Rob Wolf 0:55

Good day, Rob Wolf here and today we're going to talk a little bit about portfolio construction in an uncertain tax environment.

Rob Wolf 1:00

You know many people who are very successful not only look at investment diversification, but they also look at tax diversification when it comes to building their portfolio. What do I mean by tax diversification? Well, what I mean is that you have different buckets of money that are taxed differently and because they're taxed differently, the IRS and Congress gives us some tax benefits over certain buckets of money that other buckets of money don't get those same tax benefits. So how do I build a portfolio, or how should I consider building out a portfolio through the lens of income taxes? So let's start with an example. Let's say I have a gentleman and his wife. They are 65. They have just hit the pinnacle of their work career. They are now retiring, they have traditional IRA, 401k, they got after-tax brokerage accounts and they have Roth IRAs. This is a common scenario that I see when people think they've done a really good job with tax diversification, but a few more tweaks will make it even better. First of all, how is your IRA and your 401k going to get taxed when you distribute the money? Well, it's going to get taxed at what's called ordinary income tax rates. Ordinary income tax rates right now is anywhere from zero to 37%. The more income you have, the higher your overall income tax bracket.

Rob Wolf 3:03

Okay, but from a risk standpoint, if I own a stock in my traditional IRA and that stock appreciates so let's say I own Amazon stock and I bought that Amazon stock for $50,000 and it's grown to $200,000. And I decide I'm going to sell that Amazon stock and I'm going to distribute it. Well, how is that going to get taxed? Well, I'm going to end up getting a 1099 from my IRA custodian for $200,000. Now you say well, wait a second, don't I get a capital gains treatment, which would be at a lower tax rate? No, you don't. The reason is the money's coming from a pre-tax investment. Reason is the money's coming from a pre-tax investment All pre-tax distributions are going to be subject to ordinary income tax.

Rob Wolf 4:12

So when I'm thinking about portfolio construction, how do I take this through the lens of taxes? Well, what gets taxed as ordinary income? Iras, 401ks, interest from the bank, bond, interest from an after-tax account All those things are subject to ordinary income tax. What is not subject to ordinary income tax? Well, let's say I had that same Amazon stock in my after-tax brokerage account. This is an account that I just funded over the years outside of my retirement plans and I bought $50,000 of Amazon stock in my after-tax brokerage account. It may be owned by me, perhaps me and my wife, or maybe it's owned by my trust. It's an after-tax account that, as it earns interest and dividends, I get a 1099 DIV at the end of the year. Well, if I sold that Amazon in that type of an account, I would get what's called capital gain treatment, which means, instead of probably paying ordinary income taxes in the 22 or 24% bracket, my maximum tax rate on capital gains assuming my overall income, married, filing jointly, is under 400,000, is only going to be 15%. What's better, 15% or 22? I would say 15%, wouldn't you? But here's the kicker Sometimes our investments don't always work out the way we hope they would.

Rob Wolf 5:55

So you may have your favorite horror story when it comes to investments. But let's just say you put that $50,000 into something that did not perform well and it dropped all the way down to $15,000. We all have investment stories like that. Well, if I had that in my traditional IRA and I ended up selling that loser for $15,000. When I bought it for $50,000, and then I distributed that $15,000 to me, guess what? I got to pay taxes on that $15,000. I don't get to write off the loss because you're not allowed to write off a loss on pre-tax dollars. But if I had that same investment in an after-tax investment, it went from $50,000 all the way down to $15,000, and then I cashed it out and I did something else with the money. Well, guess what? I get to write off $35,000 as a capital loss on my Schedule D on my income tax return. I get a tax benefit for realizing a loss on my after-tax account.

Rob Wolf 7:16

So now I need to be thinking okay. Well, my IRA is always subject to ordinary income, never get capital gains treatment, never get capital loss treatment. Oh and, by the way, all my pre-tax dollars, if it's taxable to me, it's going to be taxable to my kids. There's no step up in cost basis. So is Congress giving us any tax incentive to take risk with those dollars? I would say absolutely not. We have no tax incentive to take risk with those dollars, whereas we do have tax incentive to take risk with my after-tax funds because I get capital gain treatment, I get capital loss treatment and I get step-up in cost basis and I have even more tax incentive to take risk with my Roth IRA.

Rob Wolf 8:18

With my Roth IRA Because, unlike after-tax funds, as the Roth earns interest, as it earns dividends, as I distribute that money, it's never subject to tax. Once I've owned that thing for five years and I'm past 59 and a half, I have access to all that money income tax-free and those distributions don't cause any of my social security in of themselves to become taxable and I can leave all that money income tax-free to my kids. So if you're thinking about portfolio construction and you say you know what I really desire to have some safety in my portfolio, where should I have my safety? Well, obviously you're going to have your bank, you're going to have bank dollars where you're going to have your emergency fund and you're going to have your monthly cash flow budget, right. But the balance of your safety you may want to consider having within your IRA or your 401k, especially in retirement, because those are the dollars where you don't get any tax incentive to take risk with that money. Those are also the dollars that are meant to supplement your income. They were never meant to be dollars to take huge lump sums from. If I got a million dollar IRA, do I want to take $500,000 out of it? Probably not. Why? Because it's all going to be subject to ordinary income tax. I'm not going to be taking big lump sums from my IRA. In most cases, however, with my after-tax money or even my Roth money, those are designed for lump sum distributions. Why? Because we have tax incentives on those accounts capital gain treatment, tax-free treatment or, worst case, capital loss treatment if we have to trigger a loss.

Rob Wolf 10:39

Most people when they come to me're, they're just the opposite. They have all their risk in their ira because they built all their money in their 401k. They were the most aggressive there. They had all the equities, everything. Where do they have the safety? Well, they have all their a lot of their safety in the bank. It's in c, it's in the savings, or they may have an after-tax account that's got some bond and mutual funds. Guess what folks, if that sounds like you, then almost all your money is subject to the worst tax rates in the land.

Rob Wolf 11:23

You really need to consider not only portfolio diversification but tax diversification, taking risk with those assets that the IRS and Congress give you tax incentive to take risk with. By doing that, it's going to give you the best chance to be able to continue to build wealth and transfer wealth to the next generation. It sounds complicated, but it really isn't. The biggest thing that you have to do in order to do this is you got to make sure that you got more than one type of money. You can't have all your money in a traditional IRA or 401k. If you do, you have no tax planning that you can do realistically, because it's all going to be subject to ordinary income. Ideally, you would have three different buckets of money your pre-tax, your after-tax and your Roth IRA and then you choose to take risk through the lens of taxes on those accounts where you have incentive to take risk with.

Rob Wolf 12:50

I would argue that for most of my clients, they build their Roth IRA up as legacy dollars to go to their kids, because they want to leave those tax-free dollars to their kids. I can also make the argument that because it is for legacy purposes in that situation that money has the longest time horizon associated with it. It's the life expectancy of the surviving spouse plus 10, the maximum number of years an inheritance can be stretched as an inherited Roth. So if me and my wife are in our mid-60s and we expect one of us to live to 90, that's 25 years plus 10. That's 35 years that this money potentially can be growing tax-free. Do I want that to be my most aggressive piece of my portfolio? Probably that's the case, right, because we got the longest time horizon, we have the most tax incentives with that money. Everything fits the bill when it comes to that scenario, okay.

Rob Wolf 14:11

So when it comes to the after-tax money the accounts you get your 1099 DIV from, you got to pay taxes as you go. It's good to consider taking risk with that money too, because you're getting the capital gain treatment, you're getting the capital loss treatment and you get step up in cost basis, okay. So if I have Tesla stock, I have a client that's got Tesla stock over a million dollars of Tesla stock His cost basis is a hundred thousand dollars. He hit it just right. Well, guess what? If he leaves it upon death to his heirs, they inherit it at its current value of a million dollars. They sell it the next day no tax. Whereas if I own that Tesla stock all in a traditional IRA, it doesn't matter what my cost basis is. I'm going to end up having to pay tax on a million bucks and they're going to end up having to pay tax on a million bucks.

Sophisticated Tax and Investment Strategies

Rob Wolf 15:06

Where would you rather own that Tesla stock? Ideally, either your after-tax account or your Roth IRA right? Roth IRA? Even better, because I know I have access to all those gains income tax-free. I don't even have to worry about capital gains in my Roth in my Roth. So it's just a different way of looking at building your portfolio through the lens of taxes. If you are interested in this type of strategy, it's important to deal with an advisor and an advisory firm that understands how the tax code works, that understand the importance not only of investment diversification, but also tax diversification.

Voiceover 15:58

Thank you for listening to the Wolf Financial Podcast. For additional information about our firm, please visit our website wolfadvisoryservices. com. Wolf Financial Advisory. The strategies and concepts discussed are for educational purposes only and do not represent specific investment, tax or estate planning advice. Investing carries an inherent element of risk and it is in everyone's best interests to consult a tax, legal or investment professional. Past performance does not guarantee future results. Securities and advisory services are offered through USA Financial Securities member FINRA/ SIPC, a registered investment advisor. Wolf Financial Advisory are not affiliated with USA Financial Securities.