Bogleheads® 2022 Conference – Bogleheads University - Principle 8: Minimize Taxes
00:00:00.000 | [APPLAUSE]
00:00:08.440 | Thank you, Alan.
00:00:10.600 | Now the moment you've all been waiting for.
00:00:12.480 | It's my last introduction today.
00:00:14.840 | Mike Piper's the secretary of the Vogel Center.
00:00:17.960 | He is a licensed accountant in Colorado.
00:00:20.080 | He's not licensed to do anything in Chicago,
00:00:21.960 | so no asking personal questions to him afterward.
00:00:24.720 | He is the creator of an extremely successful investing
00:00:27.240 | blog, and that was actually the inspiration.
00:00:29.480 | One of the inspirations for my blog.
00:00:31.360 | He's been doing that for a long time,
00:00:33.680 | decade and a half or more.
00:00:35.760 | He is also the creator of the best social security
00:00:37.880 | tool on the web.
00:00:39.200 | He's the author of-- did I get this right?
00:00:41.080 | Is it 11 financial books?
00:00:43.720 | He doesn't know even.
00:00:44.720 | That's how many he's lost track.
00:00:46.920 | He's a top-rated speaker at conferences,
00:00:49.000 | been the top-rated speaker at my conference before.
00:00:51.920 | And he has over 4,000 posts on the Vogelheads forum.
00:00:55.720 | And the truth is, despite being the smartest person
00:00:58.680 | on the stage today, he's also the most humble person.
00:01:01.240 | So Mike Piper, come on up.
00:01:03.000 | [APPLAUSE]
00:01:08.800 | If I start wandering, because that's my natural inclination,
00:01:11.640 | please, somebody in the front row,
00:01:13.060 | just tell me to come back to the mic, please.
00:01:16.000 | So today, I get to talk to you about minimizing taxes.
00:01:18.320 | And there are a ton of things you can do
00:01:20.520 | to try to minimize your taxes, of course.
00:01:22.880 | But since we have limited time, we're
00:01:24.720 | going to talk about the two most important things you can do
00:01:27.260 | when investing related.
00:01:28.920 | And those are to max out your retirement accounts,
00:01:31.480 | if you have enough cash flow to do that every year.
00:01:34.100 | And when you're investing in taxable accounts,
00:01:36.720 | so when you're investing outside of a retirement account,
00:01:40.600 | make sure to use tax-efficient mutual funds.
00:01:43.720 | So starting with the first one, the idea
00:01:45.720 | here is basically, every year, make the maximum contribution
00:01:49.340 | to a Roth IRA if your income is such
00:01:51.360 | that you are allowed to contribute to a Roth IRA.
00:01:53.700 | If your income is too high, then look into the backdoor method
00:01:56.280 | for making Roth IRA contributions.
00:01:58.560 | And if your employer offers a 401(k), 403(b), et cetera,
00:02:02.520 | to generally make the maximum contribution to that plan
00:02:04.860 | as well, if you have enough cash flow to do that.
00:02:08.000 | Now, why is this a good idea?
00:02:10.160 | Why did this make it onto the list of Boglehead's Principles?
00:02:13.320 | It's because taxable accounts, so things
00:02:15.120 | that aren't retirement accounts, they
00:02:16.960 | incur tax drag every year, meaning
00:02:19.060 | that you have to pay tax on the interest that you earn,
00:02:21.640 | you have to pay tax on the dividends that you earn,
00:02:23.520 | and you have to pay tax when you sell something
00:02:25.480 | that's a taxable gain.
00:02:26.400 | So the net result is that taxable accounts,
00:02:29.160 | they have a lower rate of return.
00:02:30.720 | They compound more slowly than retirement accounts.
00:02:35.200 | And as we know from talking about mutual fund expense
00:02:37.400 | ratios, even a small difference in the annual rate of return
00:02:41.960 | makes a huge difference in the ending value
00:02:45.080 | when you compound that return over many, many years.
00:02:48.080 | So the idea here, you just max out retirement accounts
00:02:50.980 | because they don't have tax drag.
00:02:52.640 | They grow more quickly because you
00:02:54.200 | get to actually receive the full rate of return
00:02:57.000 | every year that your investments are providing.
00:03:01.120 | And a question that often comes up
00:03:03.160 | is, what about people who are planning
00:03:04.740 | to retire before 59 and 1/2?
00:03:07.240 | If you're planning on retiring before 59 and 1/2,
00:03:09.400 | people often ask, should I still be contributing
00:03:12.160 | to my retirement accounts?
00:03:13.320 | Because there's that rule where you
00:03:14.780 | might have to pay a 10% penalty if you take money out early.
00:03:17.880 | And the answer overwhelmingly, in almost every case
00:03:21.040 | that I've looked at, is yes, it still
00:03:23.520 | makes sense to max out those accounts.
00:03:25.680 | And there's two reasons.
00:03:27.760 | Reason number one is that if you're
00:03:29.280 | planning on retiring early, you have to save a lot of money
00:03:33.680 | every year.
00:03:34.480 | If you're planning on retiring at, let's say, age 50,
00:03:37.240 | well, the earlier you retire, the longer your retirement
00:03:40.640 | is going to be, obviously.
00:03:42.360 | And so that means you need to accumulate a larger sum.
00:03:45.140 | And the earlier you retire, the fewer the number of years
00:03:48.000 | that you have to accumulate that sum.
00:03:50.440 | So really, the only way to do it is
00:03:52.680 | by saving a whole lot every year.
00:03:54.120 | And in most cases, it actually means
00:03:56.360 | saving more than the contribution limits.
00:03:59.280 | So you're saving enough to max out a Roth IRA,
00:04:01.600 | max out your 401(k), and then still invest more
00:04:05.000 | in a taxable account.
00:04:06.580 | So you're maxing out those retirement accounts
00:04:08.540 | and still accumulating some money in a taxable account
00:04:11.480 | that you'll have access to before age 59 and 1/2
00:04:14.640 | without having to jump through any hoops.
00:04:17.060 | And the second reason that it still
00:04:18.560 | makes sense to max out retirement accounts
00:04:20.760 | is that money in retirement accounts
00:04:24.160 | isn't as inaccessible as people often think
00:04:27.160 | that it is before 59 and 1/2.
00:04:29.760 | Because number one, with Roth IRAs,
00:04:31.880 | any money that you put right into the account,
00:04:33.800 | any contributions that you make to the account,
00:04:36.000 | you can take that money back out, tax-free and penalty-free
00:04:38.560 | at any time.
00:04:39.640 | Somebody who's 24 could contribute to a Roth IRA,
00:04:42.320 | three months later need the money, they can take it out.
00:04:45.060 | No tax, no penalty.
00:04:46.800 | Similarly, with a Roth 401(k),
00:04:50.000 | after you separate from service,
00:04:51.760 | so after you leave that employer,
00:04:53.800 | you can roll that money into a Roth IRA,
00:04:56.760 | and then anything that you had contributed
00:04:58.160 | to the Roth 401(k) now basically counts
00:04:59.920 | as a Roth IRA contribution.
00:05:01.440 | So you're allowed to take it back out,
00:05:03.080 | tax-free and penalty-free,
00:05:04.040 | even if you're younger than 59 and 1/2.
00:05:06.040 | Then we have the age 55 rule.
00:05:09.320 | The way this works is if you leave an employer
00:05:13.680 | in a year in which you turn 55 or older,
00:05:17.720 | then from that point forward,
00:05:19.480 | you can take money out of the 401(k) or 403(b)
00:05:22.040 | with that employer without having to pay the 10% penalty.
00:05:25.200 | So basically, instead of 59 and 1/2,
00:05:27.480 | now it's age 55, so you can access the money penalty-free
00:05:30.000 | a little bit sooner.
00:05:31.560 | And then we also have the series
00:05:33.680 | of substantially equal periodic payments rule,
00:05:36.440 | which is a mouthful,
00:05:37.280 | so people often just call it the 72(t) rule,
00:05:39.960 | because that's the part of our tax code that it comes from.
00:05:42.520 | And the way that rule works is it basically says
00:05:44.320 | that if you take money out of a retirement account,
00:05:48.160 | and it's a certain percentage
00:05:49.520 | that's based on your life expectancy,
00:05:51.280 | and you keep taking these distributions
00:05:52.920 | for a certain length of time,
00:05:54.680 | then they won't be subject to the 10% tax,
00:05:57.600 | even though you're younger than 59 and 1/2.
00:05:59.640 | And there's some complicated rules that go along with that,
00:06:02.200 | so if you're considering using that,
00:06:04.200 | make sure to do your research
00:06:05.160 | or work with a tax professional.
00:06:06.240 | But the point is it's another way
00:06:08.560 | that you can access this money before 59 and 1/2
00:06:11.440 | without paying a 10% penalty
00:06:13.160 | and without needing something bad to happen to you.
00:06:14.760 | You don't have to become disabled.
00:06:16.480 | So thing number one that you can do to minimize your taxes
00:06:20.160 | is to max out those retirement accounts.
00:06:22.160 | And the second thing you can do
00:06:23.080 | is when you're investing in taxable accounts,
00:06:25.400 | make sure to use tax-efficient mutual funds.
00:06:28.760 | The idea here is after you have decided
00:06:31.720 | your asset allocation,
00:06:33.040 | so you've decided, for instance,
00:06:35.760 | you want this much in US stocks
00:06:38.120 | and this much in international stocks
00:06:39.600 | and this much in bonds,
00:06:41.000 | then take some time to think about what should go where,
00:06:44.600 | which funds should go in which accounts.
00:06:47.520 | And we call that asset location
00:06:49.200 | as opposed to asset allocation.
00:06:51.240 | And the idea, very briefly,
00:06:53.120 | is just to make sure to use tax-efficient funds
00:06:55.600 | in taxable accounts.
00:06:57.480 | And there's a number of things that you can look for
00:06:59.600 | that would make a mutual fund tax-efficient.
00:07:01.920 | Number one is you can look for low portfolio turnover.
00:07:05.000 | Portfolio turnover is exactly what it sounds like.
00:07:07.200 | It's just turnover within the mutual fund's portfolio.
00:07:10.040 | So when the mutual fund buys and sells stuff,
00:07:12.200 | that's portfolio turnover.
00:07:13.840 | And the reason that's relevant from a tax point of view
00:07:16.480 | is that if you own shares of a mutual fund
00:07:20.800 | in a taxable brokerage account
00:07:22.560 | and the mutual fund sells something from the portfolio
00:07:25.640 | and it sells it for a gain,
00:07:27.440 | you have to pay tax on your share of that gain.
00:07:30.000 | So even though you didn't sell anything,
00:07:32.800 | you're still paying a capital gains tax.
00:07:35.280 | So it's the turnover,
00:07:37.000 | it's creating what we call capital gain distributions
00:07:39.080 | that you have to pay tax on.
00:07:40.480 | And the higher the rate of turnover,
00:07:42.080 | the more capital gains distributions
00:07:43.480 | you're going to have to pay tax on.
00:07:45.640 | And a higher rate of turnover also generally means
00:07:48.680 | that it's more likely that the capital gains
00:07:51.560 | will be short-term capital gains
00:07:54.040 | because the fund held whatever it is that it sold.
00:07:57.760 | It held it for one year or less,
00:07:59.160 | which means it's a short-term gain,
00:08:00.400 | which has a higher tax rate.
00:08:01.880 | So high turnover creates high tax costs.
00:08:05.480 | So examples here, something that's very tax-efficient
00:08:08.840 | is a total stock market index fund,
00:08:10.840 | because that's a strategy where the whole idea
00:08:12.800 | is just buy everything and hold it,
00:08:15.000 | so it doesn't take hardly any selling at all.
00:08:17.240 | So there's very little turnover
00:08:18.360 | and that makes it tax-efficient.
00:08:20.280 | And at the tax inefficient end of the spectrum,
00:08:22.480 | we have actively managed funds
00:08:24.240 | with really high rates of turnover.
00:08:26.400 | It's going to create a lot of capital gains
00:08:27.720 | that you have to pay tax on.
00:08:29.840 | Now, when we move to the bond side of the portfolio,
00:08:33.680 | the general rule is that safer bonds
00:08:38.480 | have lower yields, which means there's less tax.
00:08:41.680 | That makes them more tax-efficient.
00:08:43.200 | And that's just multiplication, right?
00:08:44.480 | The less income something pays,
00:08:46.680 | the less tax you have to pay.
00:08:48.320 | So safer bonds, lower yield, more tax-efficient.
00:08:51.960 | And so when we talk about duration,
00:08:53.880 | shorter-term bonds are generally more tax-efficient
00:08:56.800 | than longer-term bonds because they pay a,
00:08:59.680 | shorter-term bonds being safer,
00:09:00.840 | pay a lower rate of interest.
00:09:02.000 | So that generally makes them more tax-efficient.
00:09:04.720 | And when we talk about credit quality,
00:09:06.480 | bonds with better credit ratings pay lower yields,
00:09:09.360 | and that makes them more tax-efficient as well.
00:09:11.280 | So junk bonds, high-yield bonds,
00:09:14.240 | they're tax inefficient because they pay a lot of income
00:09:17.200 | and it's fully taxable as ordinary income.
00:09:19.320 | And on the tax-efficient end of the spectrum
00:09:24.000 | with regard to bonds, we've got treasury bonds,
00:09:26.480 | which are particularly tax-efficient
00:09:27.920 | because their high credit rating
00:09:30.160 | means they have relatively low yields, so low tax cost.
00:09:33.720 | And the other thing that's applicable with treasury bonds
00:09:36.880 | is that they're exempt from state income tax.
00:09:39.160 | And so if you live in a state with an income tax
00:09:40.800 | or especially one with a high tax rate,
00:09:42.720 | that makes treasury bonds even more tax-efficient.
00:09:45.960 | And then lastly, we have muni bonds,
00:09:48.520 | which are bonds issued by state
00:09:49.680 | and local government entities,
00:09:51.160 | and they are completely exempt from federal income tax.
00:09:54.080 | And in many cases,
00:09:54.920 | they're exempt from state income tax as well
00:09:56.680 | if you buy muni bonds from within your own state.
00:09:58.920 | That's why you see state-specific tax-exempt bond funds.
00:10:01.680 | That's the idea.
00:10:02.520 | You buy bonds that are then gonna be exempt
00:10:04.360 | from state and federal income tax.
00:10:06.440 | Now, when we're choosing between owning stocks or bonds
00:10:11.360 | in a taxable brokerage account,
00:10:13.560 | we have to figure out which one's more tax-efficient.
00:10:16.120 | One relevant point is that qualified dividends
00:10:19.200 | and long-term capital gains are taxed at lower tax rates
00:10:22.200 | than ordinary bond interest income.
00:10:24.920 | So that's a point in favor of stocks
00:10:26.360 | being more tax-efficient.
00:10:27.600 | But we also have to think about how much income
00:10:31.800 | something pays in the first place, right?
00:10:33.680 | Because even if you have to pay a high tax rate,
00:10:36.640 | if there's very little income,
00:10:38.320 | there's not gonna be much tax.
00:10:40.280 | So the lower that interest rates are
00:10:43.280 | relative to, sorry, relative to bond yields,
00:10:46.160 | the more tax-efficient bonds become relative to stocks.
00:10:49.480 | So it's something that shifts over time.
00:10:51.480 | So just to summarize,
00:10:54.040 | on the tax-efficient end of the spectrum,
00:10:56.800 | we have things like total stock market index funds.
00:10:59.160 | They're tax-efficient
00:11:00.000 | because they have very little turnover.
00:11:01.960 | Treasury bonds are tax-efficient
00:11:03.280 | because their high credit rating
00:11:05.440 | means that they have relatively lower yields,
00:11:07.240 | which means less taxes,
00:11:08.720 | and they're exempt from state income tax.
00:11:11.280 | Muni bonds are exempt from federal income tax,
00:11:13.240 | and in some case, state income tax
00:11:14.600 | if you buy ones from within your own state.
00:11:16.960 | And shorter-term bonds are more tax-efficient
00:11:18.880 | than longer-term bonds because they're safer
00:11:20.720 | and therefore usually have a lower yield.
00:11:22.840 | And then on the tax-inefficient end,
00:11:25.760 | we've got actively managed stock funds.
00:11:28.200 | That high rate of turnover
00:11:29.560 | means more capital gains distributions
00:11:31.160 | that you have to pay tax on.
00:11:33.400 | High-yield bonds are extremely tax-inefficient.
00:11:36.120 | They pay a high level of income,
00:11:38.120 | and that income is fully taxable
00:11:39.800 | at ordinary income tax rates.
00:11:41.200 | So high-yield bonds, junk bonds,
00:11:43.400 | they are tax-inefficient.
00:11:45.640 | And lastly, we have all-in-one funds.
00:11:48.160 | That's things like target date funds
00:11:49.360 | and life strategy funds.
00:11:50.840 | And we haven't talked about that yet
00:11:52.440 | because that's actually our next topic.
00:11:54.520 | So the two most important things you can do
00:11:57.600 | to minimize taxes when it comes to investing
00:11:59.600 | are simply max out your retirement accounts
00:12:01.280 | if you have enough cash flow to do that every year.
00:12:03.680 | And when you're investing in a taxable account,
00:12:06.040 | make sure to use tax-efficient mutual funds.
00:12:08.280 | (upbeat music)
00:12:10.880 | [BLANK_AUDIO]