In this month’s edition of “Money Matters,” Scott talks about how to save money by choosing the best types of investments, as well as understanding taxable, tax-deferred, and tax-free investment accounts based on your investment goals and timelines.

Money Matters: Investment Options to Maximize Tax Savings Transcript

0:00:00.1 CJ: Scott Oeth is a financial planner and adjunct professor. He's taught retirement planning and wealth management strategies to hundreds of financial professionals and his new edition of Money Matters is coming up right now. Scott joins us by phone. Good morning, Scott.

0:00:21.4 Scott Oeth: Good morning, CJ.

0:00:22.5 CJ: Glad to talk with you again. I always look forward to these.

0:00:26.0 SO: Yes, likewise.

0:00:27.1 CJ: I've got my notebook ready, so let's talk about tax saving tips for investors.

0:00:34.1 SO: Yes, yes. So, I'm gonna ask you a question up front, CJ. Now, I know these days, when a lot of folks go to the grocery store, for environmental reasons, they bring their own bag but have you ever, in the past, when you got to the end of that check out line, were asked, "Paper or plastic?" And maybe you looked at your groceries there and you thought, "Well, paper is fine for the cereal and bread," but you look at that gallon of ice cream or maybe some chicken, or something and you maybe chose plastic for some of the items

0:01:08.2 CJ: Yeah, in the past, I would have done that. Definitely, yeah.

0:01:11.2 SO: Yes, yeah, okay. So, I like to think of this as paper or plastic decision, what container you're putting your shopping list in. And recently in the news, a billionaire, Peter Thiel, made headlines because it was uncovered that he has $5 billion in his Roth IRA account, and this caused quite a hubbub. Roth IRAs were typically designed with income limits designed for everyday folks to save for retirement, how did he get so much money into the Roth IRA? And the thing is, not everyone's gonna have access to what's called founder stock, where you're buying for fractions of a penny, stock in a technology startup company that you're gonna build into a wildly successful company. But the core of the strategy, what he did, it is available to most people, and I wanted to talk about it 'cause not many folks are really doing this or taking advantage of it.

0:02:09.6 SO: So usual disclaimer, whenever especially on taxes or investments, this is not specific advice for everyone. Everyone's situation is different and this might not apply for everyone, so do your own homework, seek your own expert advice. But getting back to the paper or plastic, there are different types of investment accounts that most folks have available to them. There may be company or employer retirement plans, IRA plans, Roth IRA plan, and then maybe just saving in a bank savings or a regular taxable investment account, and I view those as the containers. That's like your shopping bag, your paper, your cloth, your plastic. And it's not just what investments you wanna choose for a suitable asset allocation, that's the first level decision.

0:02:56.4 SO: The next level decision that I really encourage people to take a look at, and see if there's something there for them is what we might consider the asset location strategy, where you're putting these different investments. And there's a potential for real bang for your buck here. Vanguard, huge investment company, one of the largest in the world, has done the study called Advisor's Alpha and they look at it and they say, "Depending on the individual's circumstance, that could be anywhere from nothing but up to, say, 0.75% of extra annual value by using an efficient tax location strategy in your investments." That's huge, CJ. If there were an investment manager that was outperforming the market by 75 basis points, that's 0.75% per year, they would be at the very top of the heap. And just by doing some smart planning in terms of where you hold the assets, you could likely capture that type of extra return, and at least very, very few people are doing this. I've looked at hundreds of accounts of people who've come in to my office over the years and I'd say, essentially, none of them were set up effectively to capture the most return after tax.

0:04:04.1 SO: And I think its because individual investors are either unaware of this or it's too complex and sadly, I think a lot of professionals shy away from it because it's a lot of extra work and it doesn't show up on the investment returns. When you look at a statement, you just see that raw return number. Taxes are in a different form, they're on your tax return over there, and so you have to marry the two of those returns together to figure out what is your actual after-tax return. And for most folks, when you get down the road and you wanna tap your savings, you can only spend after-tax dollars. So it's going from playing tic-tac-toe, what type of investments do you want? You might think big company stocks, small company stocks, bond, that type of thing, to trying to solve a Rubik's cube. It does become much more complex but there can be real value there.

0:04:58.7 CJ: Okay. So, walk us through step-by-step how somebody might do that.

0:05:03.1 SO: Well, I think the first thing to think about is there are different types of investment accounts. You have to take a look at and see what's available to you and what dollar amounts do you have in each of these types of accounts. And then getting to that Rubik's where you're twisting around there, sometimes you're limited by the investment choices in each account or the time constraints, when you can put money in, what amount.

0:05:23.7 CJ: When you can take it out.

0:05:25.4 SO: When you can take it out. But basically, you wanna start thinking about three broad buckets. First would be taxable accounts, like your bank savings or just opening up a traditional brokerage account, and you can hold anything from cash savings in a bank and CVs up to stocks and bonds and mutual funds, very wide open. But those accounts are... All the earnings are taxed each year and the gains will be taxed also in those types of accounts. The second type, which is available to most folks, very broadly available, and where there's a lot of... Most of Americans hold most of their wealth in what we'd consider tax-deferred accounts. So these are things like your 401k, a 403b, a traditional IRA. You're putting money in, you're getting a tax deduction in the year that the dollars go in.

0:06:13.5 SO: The great thing is that those dollars sit tax-deferred, so as they have gains and they go up and down in value or if they spit off interest and dividend, it's not taxed until the money comes out, and then it's taxed as ordinary income. And then the third type is tax-free accounts, like a Roth IRA or Roth 403b or a Roth 401k. So those are dollars, taxes have already been paid, the dollars are tax-deferred while they sit in there, and as long as you follow the rules, it comes out tax free. So, we've talked a bit about Roth IRAs in the past episodes and potentially converting, but those are your three main types of buckets.

0:06:52.8 CJ: Okay. And then does this asset location approach change the types of investments you wanna choose?

0:07:00.8 SO: Yes. I think it may or it might certainly warrant consideration. So, kinda getting back to another food analogy that I like to use here is, we live in Minnesota, my wife makes these wonderful hot dishes, as we call them, right?

0:07:17.7 CJ: Yes, yes.

0:07:17.9 SO: Where everything's all on one pot, I love it, there's meat, there's carbs in there and cheese grouped all over everything, it's fantastic. But if I'm trying to get in shape, maybe lose a few pounds, it's probably not best for me to just weight a lot of couple of scoops of my hot dish onto the plate and bulldoze through it. I try and say; Okay, maybe I need a plate here or I need a chicken breast and what else will be good? Maybe some broccoli over here and some rice, and I separate the holdings and I think about portion control. I can be more selective in terms of what I'm eating. And if we're trying to be smart about the tax efficiency of our portfolio, there are some investment approaches, which I think work well for a lot of people, but they're kind of that all-in-one hot dish approach, lifestyle funds, target date funds, asset allocation, mutual funds or balanced mutual funds.

0:08:07.0 SO: A lot of those, they can be very good strategies, if you look at them as kind of stand-alone, simple strategy. You've got stocks in there, you've got bonds in there, maybe it's real estate, a lot of different types of holdings, but it's all in one. And to potentially maximize the tax efficiency of your portfolio, you might wanna separate those holdings into specific asset classes instead of using that hot dish, all-in-one approach and probably, very importantly is to for the holdings that would make sense to have in a taxable account, you really want those to be tax-efficient type approaches, like potentially an index mutual fund or an exchange traded fund, something like that.

0:08:49.5 CJ: Wow, I have a feeling that we could talk about this for an hour and still be scratching the surface, that Rubik's Cube analogy, kinda is making all kinds of sense to me right now.

0:09:00.2 SO: Yeah.

0:09:00.7 CJ: Alright, well, we're talking with Scott Oeth. We'll be talking finances with Scott on the first Wednesday of the month on North Shore Morning, usually, we had to delay it this month, but anything you'd like to add quickly, Scott?

0:09:14.3 SO: Well, I would just say, I appreciate the time. It's always fun talking with you. It is, this does get into more complexity, you're not gonna have it all figured out with a short phone call here, but if you Google search or whatever your search tools, asset location, tax asset location of investments, there's some really good information out there. Fidelity has a nice piece, there's an investment research company called Morning Star, they have a nice paper. There's an industry commentator, Michael Kitces, he has a very deep extensive piece. So a few individuals are looking for more information, those are some good sources. Certainly, you'll consult your tax professional, hopefully, would have some ideas on this, financial advisor, and I just say I've enjoyed having some follow-up conversations with listeners as well, so feel free to reach out to me.

0:10:08.0 CJ: Alright, well, thank you so much for giving us at least a taste of what we need to know on the tax asset location. So, we will check in with you next month.

0:10:17.6 SO: Sounds great, CJ.

0:10:18.4 CJ: Thanks, Scott. Bye-bye.

0:10:19.7 SO: Thank you. Bye.