What’s More Important: Saving or Investing?

00:00:00.000 | [music]

00:00:16.400 | Welcome back. Portfolio Rescue. We're answering questions from the viewers. Duncan, one of

00:00:21.000 | the reasons I love our audience so much is because we get such a wide range of questions

00:00:24.440 | from a wide range of people. Last week, there were people with $3 million writing in. Sometimes,

00:00:28.920 | you need to help people with the basics. Sometimes, it's more of a really detailed question. Sometimes,

00:00:32.560 | people are just starting out. Sometimes, they're close to the finish line, and they just need

00:00:36.440 | a little bit of help. But I think no matter where you are in your financial life cycle,

00:00:40.560 | someone can get something out of all of these questions. It's really more about the decision-making

00:00:44.520 | process than knowing what goes into this stuff and finding the perfect answer. Most of the

00:00:48.660 | time, the answer is, there is no perfect answer. We get a lot of the same questions, and you

00:00:53.000 | can think about it from ten different directions every time. Anyway, that was just patting

00:00:57.780 | ourselves on the back there. Or the audience.

00:00:59.240 | Yeah, we're doing a great job.

00:01:00.440 | Credit to the audience. Remember, if you have a question, askthecompoundshow@gmail.com.

00:01:05.280 | I think we have a good range of questions today, so let's get to it.

00:01:07.960 | We do. Okay. Up first, we have a question from Rosie. "Need help with dad. He's never

00:01:15.400 | been much of an investor, but was always a saver. After a fairly successful sales management

00:01:20.240 | career, he lost his job right before the pandemic. Since then, he's been slowly spending his

00:01:24.520 | nest egg while delivering DoorDash for some income to stay afloat while he's looking for

00:01:29.000 | a job. He's 61, single, and doesn't spend money frivolously. He recently started investing

00:01:34.440 | small amounts weekly, but he thinks he should cut that to compensate for a recent rent increase.

00:01:39.560 | He doesn't see much growth in such a small portfolio and feels like his weekly deposits

00:01:43.920 | are being flushed down the drain given recent market volatility. Any words of wisdom to

00:01:48.200 | convince him to weather the storm? He's very healthy and should have another good decade

00:01:52.760 | or two of a healthy life. What would you guys suggest?"

00:01:55.800 | Unfortunately, I think giving financial advice to family and friends, that's some of the

00:02:01.280 | hardest people to talk to. There's just so much that goes into that. You could have your

00:02:07.060 | own feelings about it in trying to portray what you feel into them. It's really tough.

00:02:12.320 | I think the good news is, dad has his spending under control. He's a good saver. That's the

00:02:17.400 | hardest first step for a lot of people. That's a good thing. You're right that your dad could

00:02:21.900 | have plenty of time ahead of him. If you look at the average life expectancy, there's actually

00:02:25.640 | a social security calculator you can do this on. You can type in "social security life

00:02:28.880 | expectancy calculator." For a 61-year-old male, it's around 84 years old. That's average,

00:02:33.420 | so it could be much longer than that. I actually wrote a whole chapter about this in my book,

00:02:38.880 | Everything You Need to Know About Saving for Retirement. Shameless plug. I wrote a book

00:02:42.520 | about what to do if you get a late start on retirement savings. I've had a lot of questions

00:02:45.920 | on this over the years. I share this example -- John, throw up the table here -- of this

00:02:50.560 | couple who's trying to figure out, "We're 50 years old. We don't have much save for

00:02:53.680 | retirement. What do we do?" I looked at the baseline of, let's say we save 10%, and you

00:02:57.440 | get a 6% investment return on a diversified portfolio. What does it look like after 10,

00:03:01.600 | 15, and 20 years? Then I said, "Okay, what if we supercharge our savings? The kids are

00:03:05.560 | out of the house. We have these catch-up provisions for our IRAs and our 401(k)s, and we save

00:03:10.040 | 20% and still earn that same 6%. What does that do?" Then I thought, "Well, what if you're

00:03:14.320 | really Warren Buffett, and you double up that return on the market, and instead of 6%, you're

00:03:19.040 | in 12%, but you still save that same 10%?" The interesting finding here is that doubling

00:03:24.480 | your savings rate to 20% from 10% leads to more money than doubling your investment return

00:03:28.880 | from 6% to 12% over 10, 15, 20 years. That's interesting, because for a lot of people,

00:03:35.400 | obviously, doubling your savings rate is not easy, but it's much, much easier than doubling

00:03:39.600 | your investment return. Doubling up the market and getting double the returns in the financial

00:03:44.080 | system, that is really tough. The good thing is, saving is the most important step here,

00:03:49.640 | for someone who's this late in life. People have control over their savings rate, so your

00:03:52.960 | dad's on the right track if he's still saving money. But he still needs to earn a return

00:03:56.320 | on his capital. If we look at an inflation rate of 3%, 3% over the next 20 years would

00:04:01.140 | turn $1 into $0.54. That's a half-life of 20 years at a 3% inflation rate. You still

00:04:07.880 | need to invest something to keep up your standard of living, even if you're spending now. I

00:04:13.040 | do think it's not going to be easy to convince someone at your father's age to simply accept

00:04:16.560 | stock market volatility, even if you've already figured that out. It's the old dog, new tricks

00:04:20.600 | kind of thing.

00:04:22.560 | So, here's what I'm going to do. By the way, someone, Cliff, in the comments here called

00:04:27.040 | this. He said, "I think Ben's going to talk about the bucketing approach today." You know

00:04:30.000 | what, Cliff? I'm going to talk about the bucketing approach, because I think it helps. Let's

00:04:33.000 | look at three different buckets for your dad. Short-term, which is just cash, money, market

00:04:36.800 | funds, online savings account, maybe a CD. Intermediate-term, which could be bonds and

00:04:41.580 | other income-producing assets. And I put bonds in intermediate-term, because as we've seen

00:04:44.600 | this year, bonds can lose money. They can go down if interest rates rise. And then long-term,

00:04:49.440 | which is risk assets, like stocks or real estate. So, let's assume that long-term bucket

00:04:53.480 | your dad's not going to touch for, call it, 5+ years. 5, 7, 10 years, something, right?

00:04:58.580 | Intermediate-term bucket could be more like, I don't know, 3-5 years, maybe. And then the

00:05:02.360 | short-term bucket would be, call it, 2 years or less. Help him figure out what mix of those

00:05:06.920 | buckets makes sense for his spending needs. How much he needs to pull out of the portfolio.

00:05:11.560 | Figure out how many years worth he needs in that short-term bucket to make him feel safe.

00:05:15.760 | Is it 2, 3, 4, 5? Some people could have 7 years worth of safe assets if you're approaching

00:05:21.440 | retirement. And then, maybe that helps him know that he has this long-term bucket that's

00:05:26.400 | 5, 7, 10 years in the future that he's not going to touch for that point. And he can

00:05:29.640 | feel safe putting more money in his sleeping sounder at night, knowing that's there. I

00:05:34.040 | think there are some other levers you can pull. Your dad's 61. He could always just

00:05:37.680 | delay retirement. So, like, the average monthly payment right now for a retiree in Social

00:05:41.480 | Security is about $1,600 a month. And that's actually one of the few annuities that is

00:05:48.040 | indexed to inflation. So, it's actually gone up over the last year or so. If your dad waits

00:05:52.580 | until he's 70 to claim, he gets 8% per year. So, that's 70% more in his payout. Retiring

00:05:58.720 | later also means you can let your nest egg compound for longer. It gives you more human

00:06:02.360 | capital to save, and it means you don't have as long for your portfolio to last, right?

00:06:06.080 | Of course, not everyone wants to work until they're 70 and delay retirement. But maybe,

00:06:10.520 | if you want to hedge a little bit and just keep working part-time, if he hasn't saved

00:06:14.080 | enough, even that could help really put things off, so he's not just completely living off

00:06:17.760 | the portfolio. But I think the main point here is approaching this from a retirement

00:06:21.360 | planning perspective and not just portfolio management. I think you have to just figure

00:06:25.920 | out a way to make it psychologically easier on him. Trying to figure out stock market

00:06:30.120 | volatility this late in life, I think, is going to be really difficult to teach. So,

00:06:33.840 | I think you have to approach this from a few different angles and make it easier on him.

00:06:38.580 | Wathen: One thing, I would say, as a non-finance professional, it seems like now is probably

00:06:45.300 | the preferable time for him to be putting money into the market, as opposed to if he'd

00:06:48.920 | been putting it in for years and was seeing it cut back significantly right now. It seems

00:06:53.980 | like, psychologically, that's probably a little better for him.

00:06:57.040 | Lewis: And that's the thing to tell him. This is the reason that you do diversify, especially

00:07:01.320 | when you're retired. You don't want to be tapping stocks. And especially since he's

00:07:03.960 | still working and saving, you're right. He's buying stocks that are down and they're on

00:07:07.880 | sale. So, yeah, that has to go in the equation, too. Good call. Let's do another one.

00:07:12.160 | Wathen: Okay. Up next, we have a question from Samuel. "I'm 25 years old, no dependents,

00:07:17.560 | with a little over $4,000 in my HSA. I'm lucky to be in good health, knock on wood, and have

00:07:22.940 | great employee health, vision, and dental insurance. So, my out-of-pocket HSA eligible

00:07:28.080 | expenses are $300-$500 a year. My bi-weekly contribution to my HSA totals $500 a year,

00:07:34.540 | and along with a matching employer contribution, more than covers my yearly expenses. Does

00:07:39.280 | it make sense to invest 50-75% of my HSA in a low-cost healthcare ETF as a quasi-hedge

00:07:45.160 | against rising healthcare costs, or am I overthinking things and should just put it in an S&P 500

00:07:50.680 | index fund? I'd like to do something with my cash since it is currently losing value,

00:07:54.960 | but don't want to invest more than 3/4 of it in case of unforeseen healthcare expenses."

00:08:00.480 | All right. See, Samuel's bucketing in his own head here. I understand the thinking here.

00:08:05.040 | There's 70 million-plus baby boomers who are going to be -- we've never had a generation

00:08:10.120 | that's this big that's going to live this long. So, the whole idea that -- like, if

00:08:14.520 | you work in healthcare, your job is set for years and years until the robots come, I guess.

00:08:18.400 | But it's hard to see the demand for healthcare going down in years ahead, right? So, from

00:08:21.400 | a macro perspective, this thesis sounds right. But I do think you have to look at the risky

00:08:26.040 | side of betting on any one sector. So, first of all, John, let's do the number of holdings

00:08:30.400 | first, this S&P sector ETF holdings. Let's look at this chart. So, this is all the 11

00:08:35.240 | sectors in the S&P 500 broken out by the number of holdings. You can see it's way more concentrated

00:08:39.340 | than you would think. So, more than half of these sector ETFs have fewer than 32 names

00:08:44.880 | in them. XLV is actually the healthcare one. So, that one's not quite as bad, but it's

00:08:50.400 | still 65 names. But let's look at the performance next. So, this is my sector performance quilt.

00:08:57.240 | Now, I have a bone to pick with Standard & Poor's, because in 2016, they added the real estate

00:09:02.920 | sector. In 2019, they added the communications sector. It totally screwed up my quilt. Look

00:09:07.840 | at this. It's like a quilt that's hanging over on the side. They just totally messed

00:09:11.780 | it up for me. So, I'm a little angry with them. But this just shows sector performance

00:09:15.760 | by year, and it's ranked from best to worst, right? Best up top, worst in the bottom. And

00:09:20.080 | you can see, it's all over the map. It's all over the place. So, this goes back to 2009.

00:09:25.340 | If we took the best performer and the worst performer each year, in terms of sectors,

00:09:30.240 | and we did that every year since 2009, and again, I did 2022 through yesterday, the average

00:09:36.080 | spread between best and worst is 40%. So, you pick the best and you pick the worst.

00:09:41.240 | It's a huge spread. This year is a perfect example of how wide this can get. Energy is

00:09:45.240 | up 67%. You can see from that chart, energy is one of the worst performers for a long

00:09:49.440 | time, since the last two years. You can see energy in the tan there. Look, from basically

00:09:53.760 | 2014 to 2020, it was at the bottom of the barrel for most of those years. But this year,

00:10:00.480 | energy is up 67% through yesterday. Consumer discretionary stocks are the worst, down around

00:10:05.200 | 25%. That's a spread of more than 90% between the best and the worst. So, the S&P is obviously

00:10:10.520 | always going to be somewhere in the middle. But you could own a sector that does awful,

00:10:15.200 | even when the whole market is going up. So, energy stocks from 2014 to 2020, I already

00:10:18.960 | mentioned, they were down 44% while the S&P was up 130%+. 2006 to 2016 financials were

00:10:25.200 | down 4% in total. The S&P was up 100%. So, I guess you'd have to think, what's the risk

00:10:30.320 | to healthcare here, though? Energy and financials are cyclical industries. I guess you could

00:10:34.400 | think more regulations, maybe Amazon gets in in some way, and that bumps down the rest

00:10:38.640 | of the universe. You could have some sort of expanded universal healthcare. I'm not

00:10:41.520 | holding my breath there, to assume the government can come in and fix the healthcare system.

00:10:45.440 | But I guess you have to understand the idea is, it could work out spectacularly, and you

00:10:51.600 | put in your money in healthcare and you do way better. But I think there are risks here,

00:10:54.880 | so I would put a cap on it. I think 50-75% is probably a little too much for my taste

00:11:00.400 | in terms of, because I want to still have some diversification. So, maybe you put a

00:11:04.920 | cap of, I don't know, 20-25% on this, if you want to stray a little bit and make a sector

00:11:09.120 | bet. But there are risks here, even if the market itself does fine.

00:11:13.600 | Wathen: Yeah. Like you've talked about before, how many companies don't make it over X number

00:11:18.760 | of years. Just because healthcare costs go up doesn't mean that healthcare companies

00:11:23.120 | are all going to be doing really well, right? I mean, some, I guess in theory, would be

00:11:26.640 | doing well, but not all of them.

00:11:29.400 | Lewis: John, put that quilt up one more time. I just want to say, as someone who's been

00:11:32.560 | blogging for about 10 years now, the quilt plays. People love the quilts.

00:11:37.320 | Wathen: I was just saying in the chat, I've got to be honest, every time I see these,

00:11:40.560 | it's just pretty colors. I can't focus and figure out what exactly I'm looking at. It

00:11:45.600 | takes me like 5 minutes.

00:11:47.000 | Lewis: The whole point is that there's no discernible pattern, right? The only pattern

00:11:50.760 | really is that the S&P is kind of in the middle somewhere. But that's the beauty of these

00:11:55.400 | charts, is that you never know from one year to the next what's going to be the best and

00:11:59.560 | worst performer. People love a good visual, and the quilt plays because it tells a good

00:12:06.000 | story. Alright, let's do another one.

00:12:08.960 | "My wife and I max out our Roth 401(k)s, and I also max out my 457(b), so I don't blow

00:12:20.160 | us up financially. I only contribute to two funds in these accounts, 75% in VTI, total

00:12:25.520 | U.S., and 25% in VT, total world. Given the uncertainty in Europe, should I increase the

00:12:31.520 | U.S. allocation? On what are your thoughts, it's been referenced that Europe will feel

00:12:35.360 | greater economic impacts from Ukraine/Russia than the U.S. I realize the contrarian play

00:12:40.800 | could be to increase Europe, but complete history of both charts says otherwise. In

00:12:47.240 | reality, could a total world fund be a drag on a portfolio? We are early 30s, $300,000

00:12:53.000 | household income, and $600,000 net worth."

00:12:56.680 | Alright. 457, Duncan, is just another type of, think about it like a 401(k) plan. That's

00:13:03.080 | probably the easiest way to think about it. I understand the sentiment here. The U.S.

00:13:06.360 | has been crushing the rest of the world for some time now. Since 2009, Vanguard total

00:13:10.160 | U.S. stock market index is up like 280%, call it. Total international stock market index

00:13:14.840 | fund is up 57%. Alright, this is since 2009. Owning foreign stocks has been a drag for

00:13:20.480 | a while now. But it's not always like this. Each year, Credit Suisse puts out this Global

00:13:24.800 | Investment Returns Yearbook. You've probably heard me talk about this before. John, throw

00:13:27.600 | up the return chart here. This is the very, very long term. So, this is real annualized

00:13:34.200 | returns on stocks, and it shows bonds here, too, from 1900 to 2020. And this is, again,

00:13:42.320 | real after inflation. You can see the U.S. is up there at the top. It's 6.6% per year.

00:13:45.920 | It's one of the best ones, of course. Which makes sense, because we have the biggest stock

00:13:49.840 | market in the world by a healthy margin, right? But Canada, Australia, South Africa, Sweden,

00:13:54.080 | and the U.K. are pretty comparable over the very, very long term, right? You can see some

00:13:59.280 | of the ones at the bottom. Austria had their stock market decimated by World War II. I

00:14:03.800 | think it basically shut down.

00:14:04.800 | Yeah, that's crazy.

00:14:05.800 | There are some bad ones. So, obviously, again, the point of diversification here. If you

00:14:09.680 | have all your money in Austrian equities in 1940, good luck. So, here's one of my favorite

00:14:14.720 | examples about how cyclical things are, though. If you look at the returns of European stocks

00:14:18.200 | versus U.S. stocks from 1970 to 2009, they had identical returns. I'll throw up the chart

00:14:22.960 | here. This is the growth of the wealth since 1970. Identical returns of 9.9% through 2009.

00:14:28.720 | These SCI country indexes, they go back to 1970. So, that's how far we have back. Since

00:14:34.040 | 2010, however, again, the S&P has been crushing it. S&P is up 13.4% per year. European stocks

00:14:39.560 | are up 5% annually. So, now the 1970 to today is like 10.7% for the U.S., 8.7% for Europe.

00:14:47.400 | Now, you're probably saying to yourself, "Okay, fine. Let's assume the returns of stocks in

00:14:50.720 | Europe and the U.S. are going to be, or other countries on the globe, are going to be similar

00:14:53.600 | from here. Even if the U.S. doesn't continue this, it's going to be similar. Why would

00:14:56.920 | I need to diversify internationally if returns are going to be close in the future?" Good

00:15:01.240 | point. Right? I think the whole point is risk management. So, MSCI Japan, 1970 to 1989,

00:15:07.800 | it was up, so two decades, 5,600% in total, 22.4% per year. Just an amazing run. Like,

00:15:15.720 | the 1980s and '90s for the U.S., Japan in the '70s and '80s blew it out of the water.

00:15:19.440 | Not even close. By 1989, Japan was 45% of the global stock market. The U.S. today is

00:15:23.960 | 55%, so it was pretty close, actually. Everyone thought Japan was going to take over the world,

00:15:28.040 | right? Didn't happen. 1990 to present, Japan is up 20% in total, 0.6% per year.

00:15:34.480 | Lewis: Not great.

00:15:35.520 | Lewis: Again, that's before inflate. Not great. Interestingly enough, though, if you go 1970

00:15:40.000 | to present, the MSCI Japan index is up 8.4% per year. So, it's actually, since then, it's

00:15:45.660 | actually not bad. So, here's my line of thinking. You don't want to miss out on a Japan-like

00:15:50.040 | boom from the '70s and '80s, just like you don't want to take part totally and be over-concentrated

00:15:55.960 | in a Japan-like bust from 1990 to today. Obviously, that's an extreme example, but from 2000 to

00:16:01.240 | 2009, the S&P had a total return of -9%. Put up the lost decade chart here. I've used this

00:16:06.520 | one many times over the years. S&P 500, over a decade, the first decade of the century,

00:16:10.960 | down 9%. Emerging markets were up 160% and change. Small-cap stocks, REITs, all these

00:16:15.720 | other things. So, would you probably be fine with a U.S.-only portfolio, if you could stick

00:16:20.600 | with it? Yeah, I think so. It's by far the biggest, most diverse stock market in the

00:16:24.080 | world. But the winners write the history books. And I don't know for sure if the U.S. will

00:16:27.680 | dominate like it's dominated in the past. Diversification, in my line of thinking, is

00:16:32.560 | it's a hedge against the unknowable future. I personally own stocks outside of the U.S.

00:16:38.140 | because I don't know if the stock market will be able to repeat what it's done over the

00:16:40.520 | past 100 years or so. There's just no way to know it, right? And so, that's the line

00:16:44.840 | of thinking. Like, yeah, Japan is a very extreme example. We talked about this in the past,

00:16:49.040 | Duncan. When someone says, "Now do Japan." What about Japan? Yeah. Yeah. They get blocked.

00:16:53.800 | But it's still a really good example to show, like, the thing is, everyone talks about it

00:16:59.320 | since 1990, but people fail to talk about what it did in the two decades before that,

00:17:03.560 | where it just went crazy. And that's one of the reasons it was so bad in 1990. So, that's

00:17:07.600 | -- again, Jack Bogle totally disagrees with me. He said, "International stocks don't make

00:17:12.320 | sense. The S&P 500 is global companies. You're fine." I still think, by diversifying further,

00:17:18.800 | it's a risk management strategy, and that's why I do it.

00:17:21.360 | Yeah. I mean, would you say, looking at this chart here, is the idea to buy calls on REITs

00:17:30.060 | and then short the S&P? Is that what you're saying?

00:17:33.000 | In the last decade? Yeah. As long as there's a real estate bubble, you're going to be fine.

00:17:37.080 | Okay.

00:17:38.080 | All right. We got another one?

00:17:40.000 | Yeah. So, up next -- and also, I need to give a little shout out to John here. We've been

00:17:44.280 | having a technical difficulty in the background, but he's been managing to get Bill, our guest,

00:17:49.000 | up and ready. So, yeah. In the background, there's been a lot happening this episode.

00:17:53.080 | All right. I can kind of tell, just by the look in your eyes, Duncan, your eyes get a

00:17:56.880 | little wider when something's going wrong. And so, way to pull it together. Keep it together.

00:18:01.800 | Okay. So, up next, we have, "If an investor wants to add some real estate exposure to

00:18:06.920 | their portfolio, what are the benefits of REITs versus directly owning real estate rentals?

00:18:12.240 | Many people seem passionate about directly owning real estate and enjoy the leverage

00:18:15.780 | of a mortgage. When looking at total return after taxes, maintenance, vacancies, and realtor

00:18:20.480 | commissions, direct ownership seems to make REITs look very compelling. Are there some

00:18:24.900 | tax advantages of owning real estate directly that make direct real estate ownership better?"

00:18:29.880 | All right. It's funny because just this week, I had a personal real estate tax question

00:18:34.240 | that I needed some answers on. I didn't know what I was doing. And I have a 1A and 1B when

00:18:40.200 | it comes to taxes. And my 1A, Bill Sweet, was out of town. Can you believe it? He didn't

00:18:44.320 | pick up my call because he was out of town on vacation. Jeez, can you believe him in

00:18:47.480 | the summer? So, my 1B is Bill Artsaronian, who heads up our tax practice at RWM. So,

00:18:51.760 | let's bring Bill in. Bill's helping with my text.

00:18:55.080 | Bill, it looks like you are muted.

00:18:57.960 | Just like a Zoom call.

00:19:00.360 | Good to go.

00:19:01.360 | Yeah. Very good.

00:19:02.360 | All right. Bill, I've heard a lot of renters over the years complain that the government

00:19:06.960 | favors home ownership. Maybe walk us through how they do this and some of the benefits

00:19:11.280 | of actually owning a home and then we can talk about the differences between that and

00:19:14.120 | just owning a bunch of REITs.

00:19:16.080 | Yeah. There's no doubt there are tax advantages to real estate, rental real estate, home ownership.

00:19:22.280 | No doubt. Taxes, there's large incentive there. But it's not as simple as some dude on TikTok

00:19:28.240 | telling you that real estate investing is the only way to go. Not that cut and dry.

00:19:32.920 | Wait, are you saying that we shouldn't get all our financial edition from TikTok?

00:19:36.280 | Just half of it. Half from the compound, half from TikTok. That's the allocation there.

00:19:41.280 | It's diversification.

00:19:42.280 | That's right. That's right. So, let's talk about three benefits to investing in, say,

00:19:46.960 | rental real estate. Number one is you get a deduction for depreciation. You can take

00:19:52.200 | a deduction for depreciation. This is an expense that you can write off on your tax return,

00:19:56.640 | but it's just to account for wear and tear on the asset. So, it's powerful because it's

00:20:01.760 | a tax expense, but it's not actually a cash expense. You're never going to write a check.

00:20:05.680 | This does seem like one of those things that, like, because houses appreciate over time,

00:20:10.040 | generally, but you get to take a write off for depreciation. That sounds like a pretty

00:20:13.240 | good deal to me.

00:20:14.240 | So, you're getting leverage. You're not paying. You're not writing a check for depreciation,

00:20:18.240 | but you get to write it off in your tax return. It's very, very, very powerful. So, number

00:20:23.600 | two in terms of real estate is all the other expenses that you can use. So, we're talking

00:20:29.280 | mortgage interest, real estate taxes, repairs, maintenance, even CPA fees. They're deductible

00:20:34.700 | against your rental income. So, that can essentially create the best of both worlds where you have

00:20:39.760 | positive cash flow, but you have a tax loss on paper. So, number two, very, very powerful.

00:20:47.460 | Number three is potentially capital gain deferral through the 1031 exchange, which is kind of

00:20:52.520 | a hot button issue. But if done correctly, a gain on the rental property or other investment

00:20:59.320 | properties can be deferred when you sell the property if you purchase a replacement property

00:21:04.560 | of greater or equal value. So, that gain can be deferred until you sell the replacement

00:21:10.800 | property or if the replacement property is replaced, then you can just keep deferring

00:21:14.480 | that gain.

00:21:15.480 | So, you have a rental property right now. There's a ton of equity in it. You go, "I'm

00:21:17.680 | going to trade up to a place that has even more units or something that I can rent out."

00:21:21.280 | You take the equity you have in that and you roll it into the new place, defer those taxes

00:21:25.600 | until you sell the other place basically.

00:21:27.240 | Yeah. I mean, longest term, I mean, if we're thinking generationally, you can die with

00:21:32.040 | that asset and you can get a step-up basis for your errors. So, it's possible you never

00:21:36.240 | pay tax on that gain. But that's super, super long-term thinking.

00:21:39.960 | Okay. So, how much should taxes even factor into an investment decision like this? Because

00:21:43.520 | this person points out, you can write a lot of this stuff off, but you have the headaches,

00:21:48.360 | the maintenance, the taxes, all this stuff that goes into it, the realtor commissions

00:21:51.720 | if you're going to sell it, the closing costs, all this stuff. Should people ever make this

00:21:56.580 | decision strictly based on taxes? Or is that just for a very select group of people who

00:22:00.560 | know what they're doing in this stuff?

00:22:01.560 | So, short answer, no. Taxes should not drive the decision-making here. For all three of

00:22:06.960 | those benefits I just gave you, I could take the total opposite side. So, with depreciation,

00:22:12.120 | yes, you get a short-term deduction. Longer term though is if you have that depreciation

00:22:18.000 | accumulates over time, that's recaptured when you sell the property. And that's recaptured

00:22:22.880 | at higher rates than your 20% long-term gain rate. The depreciation portion of the gain

00:22:27.360 | can be taxed up to 25%. So, there's one. Number two is all these other expenses, you may be

00:22:32.080 | creating losses, but if you're not a rental real estate investor and you make over $150,000,

00:22:37.680 | you can't use these losses on your tax return. They're considered passive losses, and they

00:22:41.480 | just flow forward year over year. So, you're creating losses, but you might not even benefit

00:22:46.040 | from them in the short term. And then number three on that 1031 exchange is it's really

00:22:50.320 | complicated. Yes, you can defer gains, but the time it takes, you need to hire an intermediary

00:22:56.240 | so you don't actually accept cash. It can be really complicated. And to get that longest

00:23:00.320 | term benefit I mentioned of a step-up in basis means you have to hold a rental property until

00:23:05.240 | you die. Personally, I don't want to hold a rental property in my 80s and 90s and try

00:23:09.440 | to manage that. It just doesn't sound like fun.

00:23:11.800 | And plus, if you own one place, you're not diversified at all, right? You have one place

00:23:15.380 | versus owning a fund of different holdings in a REIT or something where you have plenty

00:23:19.920 | of different places around the country potentially. Yeah, and this doesn't even take into account

00:23:24.720 | the time involvement it takes to own and operate a rental. Yeah, you can hire a property manager,

00:23:29.920 | but there's just another cost. What REITs do is REITs give you exposure to real estate

00:23:34.160 | across rentals, across commercial real estate, all types of real estate, typically at low

00:23:38.720 | costs and pretty liquid.

00:23:40.840 | Yeah. I think, yeah, owning rentals for people who can do it, it's probably a pretty good

00:23:45.520 | strategy. If you've never done it before, the dream of it sounds way better than the

00:23:48.280 | actual reality. It's not an easy job to have. Do another one, Duncan. Last one.

00:23:53.720 | Yeah, Bill Sweet always talks about how much work being a landlord does. Okay, so up next

00:23:59.720 | we have, "I'm 35, married, and live in a high-cost-of-living city with two dogs." And if you say you have

00:24:06.720 | dogs, you have to include a picture, you know, but whatever.

00:24:09.720 | Ah, that's right.

00:24:10.720 | "Make about $225,000 gross and have a net worth of about $800,000. I currently max out

00:24:16.080 | my 401(k), backdoor Roth, family HSA and have contributed about $80,000 to taxable accounts.

00:24:23.080 | Only debt I have is my mortgage, $380,000 at 2.75%. My company just started offering

00:24:29.000 | what is known as a mega-backdoor Roth that would allow me to contribute $61,000 minus

00:24:34.200 | my pre-tax contributions and any matching. The plan is to shore up retirement savings

00:24:39.200 | before transitioning to a career that would likely pay less but address important issues

00:24:43.260 | like climate change and homelessness. Should I try to max out the mega-backdoor option

00:24:47.760 | or balance it a bit more between the mega-backdoor and regular taxable accounts?"

00:24:53.320 | Kudos to the audience today because we had a lot of people in the questions maxing out

00:24:56.760 | their retirement accounts. So first of all, way to go.

00:24:58.920 | And kudos to them for, you know, going on to do a job that sounds like it's gonna be

00:25:04.040 | really fulfilling.

00:25:05.040 | Mm-hmm, credit to them. Yeah, not to brag. All right, Bill, I've heard of the backdoor

00:25:09.680 | Roth IRA. Bill, so we just talked about that. Explain to me what the mega-backdoor is and

00:25:13.800 | how does that work through a workplace retirement plan?

00:25:16.000 | Yeah, so this is another topic that's become very popular with clients, with friends, family,

00:25:22.320 | all types of people I talk to. So a quick primer on the backdoor Roth 401(k). So your

00:25:27.080 | traditional 401(k) is tax-deductible. You make a contribution, it lowers your income.

00:25:32.600 | What the backdoor Roth is, is it's a non-deductible, an after-tax contribution separate from Roth

00:25:39.240 | to a 401(k). Then it could be eligible to be converted tax-free to Roth. This is above

00:25:44.360 | and beyond those traditional 401(k) contributions. So this is used typically by higher-income

00:25:50.160 | taxpayers that are already maxing out their 401(k), and they want to do a little bit more.

00:25:56.680 | Once converted to the Roth account, the assets grow tax-free just like any other Roth account.

00:26:01.000 | So the logistics of this all is max out that 401(k) first, and then make the non-deductible

00:26:07.040 | 401(k) contributions. Most plans allow an in-plan conversion from after-tax to Roth.

00:26:14.040 | Some make you do it yourself, but it's important in the downtime between that contribution

00:26:18.520 | and the conversion, don't invest the money because if you invest the money, it grows,

00:26:22.280 | then you owe tax partially on that conversion. In terms of contribution rates, so the most

00:26:28.260 | you can do to any employer plan in 2022 is going to be $61,000. If you're over 50, you

00:26:36.200 | get a $6,500. It sounds to me like this is almost like

00:26:38.560 | a SEP IRA or a solo 401(k) kind of deal. It's pretty similar, it sounds like.

00:26:43.080 | It's above and beyond the normal 401(k) limit. It gives you more opportunity to invest long-term

00:26:49.960 | for retirement. Our emailer here, he's already maxing out at $20,500. Let's say he's got

00:26:56.600 | a $5,500 employer match, that gives him another $35,000, give or take, that he could do to

00:27:01.960 | this after-tax bucket. Obviously, if you're planning on retiring

00:27:08.120 | and you want to defer as many taxes as possible, why wouldn't you do this? Is that the idea?

00:27:12.280 | Yeah. There's pros and cons. Our emailer asked, "Should he be contributing to the brokerage

00:27:16.880 | account versus the after-tax option?" The pros of the brokerage account are flexibility

00:27:21.000 | and liquidity. There's also basically unlimited investment options, stocks, bonds, crypto,

00:27:26.100 | NFTs, masterworks, whatever it is. The cons on the brokerage account are taxes. You pay

00:27:30.200 | taxes on your portfolio income, your capital gains. With the after-tax and the Roth, you

00:27:35.640 | could potentially have decades of tax-free compounding, and that is super powerful. Longer

00:27:40.560 | term, there's no RMDs. Required distributions do at $70. The cons of that Roth are that

00:27:46.280 | if it's in a 401(k), you may have limited investment options. You may have only a few

00:27:50.320 | funds to choose from, and you could have taxed penalties if these are not distributed according

00:27:55.720 | to the very specific rules. In my conclusion, I'm like, "Give me all

00:28:00.560 | the tax-free growth I can get in that Roth bucket." Our emailer here sounds like a super

00:28:05.900 | diligent saver, so chances are he's going to continue to have excess cash flow, especially

00:28:10.120 | because he's 35. His income will probably increase over time. If he's already contributing

00:28:15.360 | $80,000 to his brokerage account, he can do the first $35,000 to the after-tax bucket

00:28:20.040 | and still have $45,000 left over for his brokerage to invest in whatever he wants.

00:28:24.720 | The thing that I like to remind people is this is a problem, but a good problem to have.

00:28:29.320 | If you're getting down to the nitty-gritty of these details, you've kind of already won

00:28:32.560 | in a lot of ways. You're ahead of the game from what most people are in. That doesn't

00:28:35.920 | mean you don't need advice, and you don't have to think through these things, but he's

00:28:40.080 | way ahead of the game. Thanks to Bill for hopping on for his tax

00:28:44.280 | stuff. I have a request from the audience. Duncan, this is maybe you, too. At the end

00:28:48.000 | of this month, we are going to have an expert in all things credit cards, travel, and rewards

00:28:51.400 | points. If you have a question on any of these topics, the best cards for airfare, hotels,

00:28:56.360 | how to maximize points, Duncan, I think you mentioned a card that you could use to pay

00:28:59.560 | your rent and get rewards points for it. Best deals, best credit cards for certain rewards.

00:29:04.240 | Don't ask. Askthecompoundshow@gmail.com. It's going to be the end of this month. It's going

00:29:09.000 | to be Chris Hutchins from AllTheHacks who's going to answer all these questions. I've

00:29:11.840 | used him for my own personal advice on this stuff, because I like to dabble here and there

00:29:16.660 | for credit card rewards points. I've used all of them over time, I think. Remember,

00:29:20.860 | askthecompoundshow@gmail.com. Keep those questions and comments coming. We'd like to thank everyone

00:29:24.760 | in the chat today. Again, some people even predicted what I was going to talk about today.

00:29:28.560 | Am I getting predictable? Next week, I'm going to throw a change up.

00:29:31.840 | I think our listeners are that good.

00:29:34.400 | Yes, that's a good spin, Duncan. Thanks, everyone, for listening.

00:29:39.760 | Dave Wilson asked when we're going to have a portfolio brag segment as a regular segment.

00:29:44.140 | I think we have one question every week that's just a little bit of a brag. I have a lot

00:29:47.360 | of money. I save a lot. Sorry. Remember, askthecompoundshow@gmail.com, and we'll see you next time.

00:29:52.940 | Thanks, everyone.

00:29:53.440 | [music]

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