Show Notes
Investing in the stock market is one of the best tools available to help you reach financial independence. However, there is one variable you must factor in that, if neglected, could result in a longer path to get there: taxes.
Jeff Harrell shares his experience which suggests that even the professionals often neglect this key component of financial planning, and there’s a rather disturbing reason as to why. Sometimes in the financial services industry, you don’t get what you pay for.
Relying on both empirical evidence, experience, and his own personal tax situation, Jeff illustrates how better understanding the impact of asset location can shorten your path to FI—and lead to more spending power once you get there.
(Season 2 Episode 5)
Resource Mentioned in Episode:
Vanguard article, “Asset location can lead to lower taxes. Here's how to get more value.”
Other Episode Referenced:
Podcast produced by Ted Cragg of QuickEditPodcasts.com
Music Credit: Dream Cave / Adventure Awaits / courtesy of www.epidemicsound.com
Transcript
When it comes to building an investment portfolio, two of the most important things to consider are diversification and security selection. Obviously, factors such as your personal risk tolerance and time horizon play a major role in this process. However, there is another crucial variable that also must be considered before you make your final decision on how to invest your different accounts…taxes.
Welcome to the second season of Invested Poorly: Sad Tales of FInancial Fails, a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.
Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with show.
We have all heard the saying the only guarantees in life are death and taxes. Now it’s up to you to take care of yourself to delay the first one as long as possible, but the second one is something this episode should be able to help you minimize. But before you listen any further, in Episode 2 of Season 2, I provided a comprehensive review of diversification. I need to make sure you understand what the real purpose of diversification is, so if you haven’t listened to that episode yet, it might not be a bad idea to do so before continuing with this one.
Okay, so one of the most frustrating things I saw time and time again when I was working in the financial services industry was the lack of importance both do-it-yourself investors and very often financial advisors seemed to place on asset location. I know, more jargon, so put simply, asset location is the process of choosing which accounts such as your 401k, IRA, Roth IRA, brokerage account, etc. you actually place your different type of investments in, such as stocks, bonds and cash.
The reason this is important to fully understand is because each of these accounts has different rules when it comes to distributions and taxes. I’m not going to get into the specifics of each account during this episode, so if you are unaware of the differences, you should definitely “search it up,” as my inquisitive nephew would say, to see for yourself how they vary.
Also, your personal situation will play a major factor when determining the value of asset location. For example, if almost all your investments are in one account type like a 401k or an IRA, then you don’t have any opportunities to further optimize your accounts through asset location. However, my experience suggests that those pursuing FI eventually accumulate assets in various account types, which is where the benefits of asset location show up.
Vanguard has done some research on asset location and I’ve included a link to their findings in the show notes. Their conclusion suggests you can reduce your taxes by over 20%, over a 30-year time horizon, by optimizing asset location, and this assumes a very simplistic and basic scenario. As powerful as this is, my personal experience as a financial advisor suggests the savings can be even higher when you optimize this year after year based on an individual’s specific situation.
While the degree of benefit that proper asset location can make will vary for all of us, I highly recommend you read the Vanguard article regardless of your situation because it outlines the thought process you should take when selecting which investments you put in your different account types, such as IRAs, 401ks, Roth IRAs, brokerage accounts, etc.
I’ll go ahead and just cut to the chase by summarizing the strategy. You basically want to put your growth investments that are subject to capital gains tax in taxable accounts and your income-producing assets that are subject to income tax in your tax-deferred accounts.
Unfortunately, all too often I saw portfolios that didn’t take this into consideration at all and sadly it was very common to see this when I reviewed professionally managed accounts. So, why do you think that might be? Well I’ll tell you, it’s because the financial services industry is notorious for trying to make their internal processes simpler for themselves, which oftentimes is detrimental to their clients.
Remember, I have seen how the financial services industry works and when you talk to the C-suite executives about how to make their companies more profitable, they all focus on the same thing. Scale. That’s right. Scale. It is absolutely crucial that large asset management firms make sure everything they do is scalable because it minimizes costs and maximizes profitability.
This is just the frustrating reality if you ask me because based on the fees many of these companies charge, I wish they would focus more on customization, because that might actually justify their fees. Which is ironic because my experience suggests that smaller, more independent firms tend to do a much better job in this area because they know they have to be different to compete. Just something to think about if you are looking for a professional to help you with your investments. Smaller might in fact be better.
As far as real-world stories of how asset location can make a big difference go, I can’t think of anything better than my own personal situation. So, in our first full year after reaching FI and having absolutely no earned income between my wife and myself, our investment portfolio still managed to generate over six figures of dividend and interest income. This income was a combination of fully taxable income from high-yield bonds and savings accounts, dividends from stocks (both qualified and non-qualified), and finally tax-free income from municipal bonds.
It might be hard to believe, but by optimizing the asset location of these different investment types, our tax liability for the year was less than $1,000. Even though I knew this was going to turn out like this, I can’t begin to tell you how happy I was paying the tax man that year.
Although I always loved helping clients optimizing things like this over the years and, no doubt, it felt great to chat with them about how much they saved in taxes due to some smart strategic moves we made, when you see something like this on your own tax return, I’m not going to lie. The grin on my face was just a little bit bigger than anything I’d felt before. I hope this episode can one day help you experience something similar.
I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.
Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen”! So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.
I’m your host, Jeff Harrell. Thanks for listening.
Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results.
This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.