Keeping Investment Returns in Your Pocket | AWM Insights #167
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Episode Summary
Being a diligent, long-term investor is a very rewarding proposition, but most investors ignore the impact that taxes can have on their investments and what they get to “take home.”
Our industry is almost solely focused on total returns and fixates on specific return figures, but those numbers don’t tell you what you get to keep, which is what really matters.
Ignoring this dynamic and not proactively working to reduce returns that are lost to taxes can corrode wealth and complicate your journey to building multi-generational wealth.
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Episode Highlights:
0:00 Intro
1:01 What tools can we use to reduce and defer our tax liabilities?
2:33 Why are after-tax returns so relevant?
5:28 Why an integrated and multi-faceted investment and tax team is so important.
7:39 How can you tie your charitable interests with tax efficiency?
10:15 Why tax planning is a year-round responsibility.
11:13 Text us!
+ Read the Transcript
Brandon Averill (00:02): All right, everybody. Welcome back to another episode of AWM Insights. It's Brandon and Justin here. We're working our way through the net worth formula and we're down to everybody's favorite subject, taxes. There's no secret taxes take a big portion out of your paycheck, but they really impact your wealth in ways that maybe you don't realize even on the surface. Nobody likes to pay taxes. I think taxes are a necessary evil. We all like driving on roads and all those types of things, but at the same token, we want to make sure that we're minimizing the tax that we're paying as much as humanly possible. And I think kind of it's interesting, we're actually talking about this, this will be hopefully an evergreen episode, but we're talking about this in August, and I think most people only think about taxes in April. So for all clients listening, that's not the case for us here at AWM. It's something that we're focused on all the time. We're definitely not going to be able to cover everything in a 10 to 15 minute podcast.
Justin Dyer (01:06): Nor do you want us to.
Brandon Averill (01:08): Yeah, we're going to hit on some of the high-level stuff. We talked about last week, just about the different types of income. And so, we're going to start there and talk a little bit about how you can actually implement some different tools to reduce your tax liability, or at least defer those taxes down the road coming from those different sources.
(01:27): So, really starting off with endorsement income. We talked about this last week, or any other income you're going to earn as an independent contractor, this is going to be income that you receive, no taxes are withheld, that's your obligation. But there are some neat things that you can do really with this income, you can defer a good portion of it into something called an individual 401(k). For those of you listening, you know we're pretty opinionated on this. Most people will utilize something called a SEP-IRA, and they will get some of the same benefits, but even little nuances like this, you want to make sure you're considering, because if you're using a SEP-IRA, now you lose the ability to do something called a backdoor Roth conversion in the future. And that really is something that we won't get into today, but you should be taking advantage of as you're going through.
(02:24): So, moving from endorsement income, Justin, it might be a good time for you to talk about even just on the investment side, how do we look at taxes? How do we manage those? What are some of the different things that we can consider there
Justin Dyer (02:37): With this whole tax conversation, you have to think about net income or after-tax returns. Oftentimes, especially when it comes to investing, people are just highlighting the gross performance numbers, gross potential returns of an investment, and that really only tells you part of the story. You have to dig in to think about, "Hey, what's the after-tax impact of this investment to me?" Which is a very individualized answer or question, because each and every person can have different tax implications depending on the account you're holding it in, depending on your tax situation from other income sources. So, suffice it to say it's a complex individualized question, but it's critical. You do have to think about every single investment as an after-tax rate of return.
(03:31): Sometimes that's really easy. If it's in a Roth IRA, you just mentioned that, that's basically, hey, gross is your net return, your after-tax returns. There's no tax, but it's really hard to get investment and assets into those types of accounts. Most of us are dealing with some sort of tax impact when it comes to an investment and thinking about the tax efficiency of it, and it's a complicated topic, this whole topic is really, really complicated, I don't want to go too much down the weeds, but just suffice it to say that you have to ask the question, "Hey, what's the net return of this investment type to me? How much of the return is coming from income that's generated on an annual basis versus capital appreciation?"
(04:15): Those two things drive vastly different returns because ordinary income is generally taxable in the year in which it's paid. Capital gains can be deferred until you sell the actual investment. The other big piece of it is, if it's a fund of some kind, how much turnover is the manager doing in the fund? You can have an ETF, let's call it. I think everyone's familiar with those. That's tracking the broader US stock market. You can have two ETFs, let's say, that are doing the exact same thing, but for some reason, this manager over here is doing a lot more trading within the fund to have a closer tracking error or tie closer from a performance standpoint to the S&P 500. But guess what? That impacts your after-tax return versus somebody who's a lot more thoughtful from an after-tax standpoint.
(05:08): So really, really nuanced and complicated, but just it can be incredibly corrosive to your end rate of return, because what we're talking about here is tax, but really what tax is doing is giving you net income or net investment returns, and that's really, at the end of the day, what you can consume and continue to invest or donate, et cetera, et cetera. So it's a critical, critical piece that we think about every single day.
Brandon Averill (05:33): And I think it's a big thing. We often hear the argument usually from our competitors that, "Hey, you never want to have tax in house. You want to have tax separate. You want these checks and balances," and we've talked about this in a podcast previously. But the reality is, if you're of any substantial means, you actually want tax expertise on your team so that way you can have these conversations. Because as you're managing our investment team, there aren't decisions made in isolation. We're always looking at the tax situation of the client before we're pulling the trigger and doing different things. If we had to pick up the phone, call some CPA, we'd be in a world of hurt. The reality is you just wouldn't do it. And so getting past that illusion that your CPA is actually checking on your investment team or your investment team's checking on your CPA is a big move. I understand it's a mental hurdle for people, but that is why we've built the company and the way that we have, because these are connected.
(06:28): And I think even going back to that and talking about employment income, that's another way. If you're an athlete, you're getting paid from the team, or if you're an entrepreneur, you're getting paid from a company. Well, there are different rules on how much you actually have to withhold based on your prior year or expected future year earnings. And if you've got a really integrated team, you can take advantage of things like a safe harbor-type opportunity. Your income's jumping big in all of these different years, you get to hold onto your money that the government would withhold for no benefit to you.
Justin Dyer (07:03): Yeah, they're earning the interest on it.
Brandon Averill (07:04): Exactly, over a period of time. And now you go buy a treasury bill that is as close to a risk-free type return as you can get. And nowadays, with interest rates where they are, there's real money that's coming back into the portfolio. So I think these are all really integrated-type different approaches. And then you even go back to, this is probably where we could wrap up, but I think we see it missed all of the time, and it's such a shame, is on the charitable side, is really doing that in a very thoughtful way.
Justin Dyer (07:32): Exactly. That ties back into the investment piece and people might be saying who are unfamiliar with this, "How does charitable tie back to the investment piece?" Well, and it even, most importantly, ties back to the fully integrated side of what we're talking about and why we're set up the way we're set up, but being thoughtful around it, using efficient, effective vehicles as opposed to just taking out your checkbook, writing a check to charity that pops up or that you might be familiar with on a regular basis and is important to you, there are things called donor-advised funds.
(08:03): That's one way that's a real efficient pool of capital that is yours. But then funding it is really what you're getting at, and thoughtfully funding it with appreciated assets, that can be a number of different asset types. It can be individual stocks that you inherited from a long time ago, it could even be real property, but just think about something that's highly appreciated, instead of selling that, realizing the capital gain, paying taxes on that, and then taking the after-tax cash and putting that into, even a donor-advised fund or charity of some kind. There's less dollars there that you're able to utilize as opposed to using the entire asset before you sell it. You're getting the benefit of the contribution and you're eliminating ever having to realize that gain. So it's kind of a one-two punch from a tax benefit perspective to really thoughtfully utilize, and at the end of the day, have more money to give. By thoughtfully planning from a tax perspective, you're increasing your ability to make an impact.
(09:06): One other thing that I failed to mention earlier on with respect to the investments is this idea of tax-loss harvesting. It does kind of relate to thoughtfully utilizing assets for tax purposes, kind of like we're hitting on with from a charitable standpoint. But tax-loss harvesting, it's very straightforward if you think about it on paper, but it's really hard to intuitively understand. But just think about it as, you're selling one asset that's at a loss on paper and you're buying an asset that's basically very, very similar. There has to be some difference from an IRS standpoint, but your exposure is all but the same and you're harnessing, you're harvesting that loss on paper and there's substantial benefits for long-term tax planning purposes to harvest that loss. It ends up on your tax return. You're able to utilize that against and offset other gains elsewhere and you never lose them. And it's really, really, really powerful so your wealth can continue to grow and compound over time.
Brandon Averill (10:07): As you guys can hear, and you've certainly heard us over the years as we've worked together, talk about taxes, we often say it's the number one destroyer of wealth and is something that we focus on a lot. I think the big takeaways here is yes, there are a lot of tools and tactics that we just hit on. There's so many more that we employ throughout the year, but throughout the year is the big part of this. This isn't something that just pops up in April, or even the most progressive advisors out there, maybe they're doing some tax planning in December. It is really something that has to be done throughout the year.
(10:43): Because at the end of the day, what we're trying to get to is we hit on our human capital, we hit on our income sources, now we're at taxes. We're trying to get to the most net income we possibly can, and that's really where we're arriving now. And then the big question becomes, "Okay, now that we have this net income, what do we ultimately do about it and or do with it?" And that's what we're going to hit on in next week's episode. But hopefully you're tracking with us. Hopefully this was helpful. Shoot us any questions that you have, we'd love to hear from you, (714) 504-7689. Shoot me a text directly. We'd love to answer it. Until next time, own your wealth, make an impact, and always be a pro.