(audience applauding) - So we're on to our last module of the day before the Q&A session. Mike Piper earlier covered investing in tax-advantaged accounts. In this session, he'll talk about how to invest tax efficiently in non-tax-advantaged accounts, like taxable brokerage accounts. We'll bring Mike up here, and then we'll do a Q&A after that.

If you do have a question you'd like to submit, it looks like we've been getting a ton. Gauri is collecting them, and you can just drop off your question with him. Thank you. - All right, so last time we talked about the different types of tax-advantaged accounts, and Alan and Rick both talked with you about minimizing your investment costs.

And in that case, they were talking about the expense ratios that you pay on your mutual funds. But one of the biggest expenses that most investors pay on their investments are the taxes. So what we're going to talk about here are the three most impactful things that you can do to minimize that investment cost, to minimize the investment taxes that you're going to be paying.

The first one is pretty straightforward. Max out your retirement accounts if you have enough cash flow to do that. Second one is fill your Roth accounts with the assets that have the highest expected returns. And finally, when you're investing in taxable accounts, try to fill them with things that are tax-efficient.

So let's go through these one by one. Max out your retirement accounts. The idea here, generally speaking, is to make the maximum contribution every year to a Roth IRA, or if your income is too high, then we're looking at maximum backdoor Roth IRA contribution if that's available to you.

And if you have access to a plan at work and you have enough cash flow to max out that contribution as well, do that. And the idea here, the reason for this, is exactly what I was talking about last time I was standing here, which is that taxable accounts incur tax drag, meaning there's taxes that are dragging down the returns that you earn every year, because you're paying tax on the interests, you're paying tax on the dividends, and you're paying tax on the capital gains every single year, with the net result being that taxable accounts, they literally earn a lower rate of return than retirement accounts.

And just like Rick was showing you, even a relatively small difference in the annual return has a huge impact when we compound it over an entire investing career. And so we max out retirement accounts simply because retirement accounts don't have tax drag. You get to keep the full rate of return every year, and that's a really big deal.

Now, one thing that somebody will always ask if you tell a room full of people to max out their retirement accounts is what if I'm planning to retire early, right? 'Cause there's the age 59 and a half rule, so there might be a 10% penalty. So what if I'm planning to retire at age 50, right?

Should I still max out my retirement accounts? And the answer, in almost every case where I've done a serious analysis, the answer is yes. It still makes sense to make the maximum contributions if you can, if you're planning to retire early. And there's a few reasons for that, so let's go through them.

Reason number one is that in order to retire early, you have to save and invest a whole lot of money every year. That's how early retirement happens. You have fewer years to accumulate, so fewer years to save, and fewer years to earn investment returns, and more years of retirement to pay for.

So the only way to make that happen is by saving a whole darn lot every year. And usually what that looks like is maxing out your IRA, maxing out your 401(k), and saving more than that. And so in that scenario, the more than that pile, the pile number three, that's in a taxable account, so you'll have some assets that you can tap into that aren't in retirement accounts in the first place.

The second reason that it still makes sense to max out retirement accounts even if you plan to retire before 59 1/2 is this thing that I keep saying, 'cause it's important, is that Roth IRAs, you can take your contribution back out, tax-free, penalty-free, at any age. You just don't have to be 59 1/2.

That's not a rule. And so you'll have access to this money early. And then similarly, a lot of people don't realize this, but with Roth 401(k) and Roth 403(b) plans, after you separate from service, so after you've left the employer with whom you had that Roth 401(k), you can roll that Roth 401(k) or Roth 403(b), you can roll it over to a Roth IRA, and then from that point going forward, all the money that had been Roth 401(k) contributions or Roth 403(b) contributions, now it counts as if it had been Roth IRA contributions the whole time.

So again, tax-free, penalty-free access, regardless of your age. And so you're going to be accumulating a significant amount of money where there's just no 10% penalty to begin with. And then there's also the age 55 rule. The way this works, so it's specifically for traditional 401(k) and traditional 403(b) plans, and this rule basically says that if you separate from service in a year that you turn 55 or older, then from that point forward, you can take money out of that 401(k) or that 403(b) without a 10% penalty.

So it's another way to get money out before 59 and a half without a penalty. And then we're not gonna go through all of them because there's just a really long list of all of the exceptions, and Congress adds more and more and more things to this list every couple of years.

So the reality is that most of the time, you're gonna have access to money penalty-free even if you retire before 59 and a half. You just have a whole lot of options. So that's it for our first item, max out your retirement accounts. Items two and three, fill your Roth accounts with the highest returning assets, and when you're investing in a taxable account, fill those accounts with tax-efficient stuff.

I highlighted them both together because together they have a name, and that name is asset location. And the idea of asset location is basically after you've decided your asset allocation, so what Christine and Jim were just talking about, so it's this much in US stocks and that much in international stocks and then that much in bonds, then take some time to think about what goes where, which thing in which account.

And so we call that asset location as opposed to asset allocation. And the two most important points here are fill your Roth accounts with the stuff you expect to grow the fastest and try not to own anything in a taxable account that's tax-inefficient or try to stick with things that are tax-efficient.

So to go through those one by one, highest returning assets in Roth. The idea here, there's two reasons we wanna do this. Reason number one, Roth accounts grow tax-free. We don't have to pay tax on it every year. And if you meet the appropriate requirements, you never have to pay tax on all of the growth.

So that's a good thing. Reason number two is that unlike tax-deferred accounts, Roth accounts don't have RMDs at all. You're never forced to take the money out during your lifetime. And so with those two points combined, the takeaway is that if you could choose one type of account that you would want to grow the fastest, you would want your Roth accounts to grow the fastest.

Like if you could have a pile of money in one type of account, Roth account, that's the answer. And so really all this means is that you wanna fill your Roth accounts with stocks because that's what grows the fastest. So the reasoning might be complicated, but the to-do list item is really easy.

You just have a total stock market index fund in your Roth accounts or total international or a combination thereof. That's basically the gist of it. The third item, when investing in taxable accounts, use tax-efficient funds. There's a little more going on here, so we have to dig into this one.

Basically, there's a few characteristics that are good and a few characteristics that are bad for a taxable account. One thing that's good is low turnover in the portfolio of the mutual fund. So portfolio turnover is just what it sounds like. It's when the fund sells something to buy something else, that's turnover.

And the reason that that's so important in a taxable account is that if you own a mutual fund in a taxable account, if the fund sells something for a gain, so the fund sells an investment for more than what the fund paid for it, if you're a shareholder of that fund, you have to pay tax on your share of the gain.

So even though you didn't sell anything at all, the fund sold something and now you have a tax cost. So the more often the fund is selling stuff, the more often you'll have those tax costs. And we call those capital gain distributions. That's just the tax term for the capital gains that you have to pay tax on even though you didn't sell anything.

And the other important point here is that the higher the rate of the turnover within the portfolio of the mutual fund, the more likely it is that the capital gains will be short-term capital gains. So remember that's when an investment is sold after being owned for one year or less, that's a short-term gain.

And those are taxed at higher tax rates than long-term gains. So the more frequently the fund is selling stuff, the more often, just that's the way the math works, the more often the capital gains will be short-term and you're gonna have to pay a higher tax rate. And so two examples here, at the very tax efficient end of the spectrum, we have total stock market funds, index funds and ETFs, because they've got a super low rate of turnover.

And that's simply just because if you think about the investment strategy of a total stock market fund, it's just buy all of the stocks and that's it, that's the whole strategy. And that requires very little selling every year, almost none in fact. And so total stock market funds have very low turnover and they're very tax efficient, they're a good fit for a taxable account.

And then at the other end of the spectrum, something that's really bad for a taxable account is an actively managed fund with a really high rate of turnover. So the classic example there, if you imagine, it's a mutual fund and the fund manager is just trying to own the stocks that he or she thinks are the very best ones right at this minute.

And so they're just constantly buying and selling and buying and selling and buying and selling, there's gonna be a ton of capital gains every year, a bunch of them are gonna be short-term and it's gonna create a ton of costs if you own it in a taxable account. And moving on to the bond side of the portfolio, the general rule is that safer bonds have lower yields, because riskier bonds have to pay a higher interest rate to get people to buy them.

So safer bonds have lower yields, which means less taxable income, which means less tax, which means they're more tax efficient. So safer bonds tend to be more tax efficient than riskier bonds. And so short-term bonds tend to be more tax efficient than long-term bonds because short-term bonds usually pay a lower rate of interest.

There are exceptions and we are currently living in one of those exceptions, but typically short-term bonds have a lower interest rate than long-term bonds, which usually makes them a better fit for a taxable account. And then with regard to credit quality, so the credit rating of the bond, the higher the credit rating, the lower the interest rate and therefore the lower the taxable income that it creates and the lower the tax costs.

So bonds with better credit ratings are more tax efficient than bonds with worse credit ratings. And so treasury bonds, those are the bonds that have the very highest credit rating of all, they tend to be really tax efficient relative to other bonds. In addition, treasury bonds are exempt from state income tax, or specifically the interest that you get on treasury bonds is exempt from state income tax.

So if you live in a state where you're paying a significant income tax rate, that's another point in favor of treasury bonds being a good fit for a taxable account. And then lastly, we have municipal bonds, AKA muni bonds. And those are bonds that are issued by state and local government entities.

And the interest on them is exempt from federal income tax. And in many cases, if you buy muni bonds from within your own state, then that interest is going to be exempt from your state income tax also. Now granted, there's some risk involved, right? Because muni bonds have some credit risk much more than treasury bonds.

And if you're specifically limiting it to only ones in your state, you're kind of compounding that risk 'cause there's a little bit less diversification going on there. But they can be a very tax efficient choice. Now, one thing you'll have to decide if you have taxable assets is do you want stocks or bonds in the taxable account?

And one very important factor here is that the returns you get from stocks are dividends and capital gains, right? Those are the two ways that stocks provide returns. And both of those things have tax advantaged treatment, right? There's lower tax rates for dividends and long-term capital gains than there are for most other types of income.

And so, in general, stocks tend to be a better fit than bonds for a taxable account, although there are some exceptions. Now, moving on to things that we specifically want to avoid in a taxable account. One of them, Jim talked about this, all-in-one funds. So that's anything that owns stocks and bonds altogether.

They're not, so a target date fund, balanced fund, that sort of thing. They generally aren't a good fit for a taxable account, although there are some exceptions, just like most of the stuff I'm saying. And the reason for that, number one, is that the bond side of the portfolio is going to include some corporate bonds, which have a higher rate of interest, more taxable income, more tax.

And so, basically, the idea here is that they own some stuff that you'd rather not own in a taxable account, so it's not a great fit. The other point, and Jim also mentioned this, is that sometimes the outer layer of fund, the all-in-one fund itself, creates another level of turnover.

So if you think about, for instance, Vanguard target date fund, most of them own four underlying mutual funds. You've got a total U.S. stock fund, a total international stock fund, a total U.S. bond fund, and a total international bond fund. And so each of those four funds will have its own level of turnover, whatever it happens to be, and you'll have whatever tax cost you have from that.

But then the target date fund itself is going to have some turnover, because sometimes it sells one of those four funds. And that could be just the little rebalancing from day-to-day, but the bigger issue is what we saw from Vanguard a couple of years ago, where they just changed their mind.

They decided, all right, we're kicking out this fund and adding this other one instead, and people weren't expecting that, and so anyone who owned it in a taxable account had a big tax cost every year. There were lawsuits about it. And that's not only Vanguard, by the way. Any fund company could do that, and sometimes does do that.

So if you have a fund like a target date fund, you're exposing yourself to that risk that they're just going to change their mind, and then you've got some taxes to pay. So all-in-one funds are not usually a great fit for a taxable account. Real estate investment trusts, REITs, Jim talked about those.

They're just stocks in the real estate industry. They typically aren't a good fit for a taxable account, because they generally pay a higher level of dividends than most stocks, so more taxable income. And those dividends are taxed at a higher tax rate than other dividends. So more income, higher tax rate, not a great fit.

They are a perfectly fine thing to own. It's just if you own them, you want them in a retirement account and not in a taxable account. So just to summarize here. Things that are tax-efficient. We've got total stock market funds. They have a very low rate of turnover, 'cause the fund hardly ever has to sell anything.

So that low rate of turnover makes them very tax-efficient. Treasury bonds are typically tax-efficient as bonds go, because their high credit rating makes for relatively less taxable income, and because their interest is exempt from state income tax. Municipal bonds are a good fit for a taxable account, because their interest is exempt from federal income tax and potentially state income tax if you buy bonds from within your own state.

And shorter-term bonds tend to be more tax-efficient than longer-term bonds, because they typically pay a lower rate of interest. And then stuff you want to avoid in a taxable account, things that are tax-inefficient. Number one, actively managed stock funds with high turnover. All of that buying and selling creates costs to you as the investor, because you have to pay tax every time they sell something for a gain, and you've got no control over it.

High-yield bonds, junk bonds. They pay a lot of interest. That's a lot of taxable income. That's not good. All-in-one funds, again, not a great fit, because they own some bonds with higher yields, which you'd rather not own in a taxable account, and because you don't have control over the turnover.

The fund can sell something, can sell one of the underlying funds, and then you've got a big tax cost to pay. And real estate investment trusts, just because relative to other stocks, they pay more dividends, and those dividends are taxed at a higher tax rate. So the way this whole asset location thing typically looks, you've got your Roth account, and you fill it up with the highest returning asset, stocks.

And again, that doesn't have to be complicated. Total stock market fund, and you're done. Or total international, or total world, whatever, just a basic stock fund and call it a day. And then the tax-deferred account usually owns a mix of stocks and bonds. And the reason for that is that, remember, our rules are highest returning assets in Roth, tax-efficient stuff, and taxable.

There's no rules about tax-deferred. Anything is a fine fit for tax-deferred. So the job of the tax-deferred accounts is basically just to own whatever else we need to own to get the overall asset allocation for the portfolio to be what we want it to be. So because we filled up the Roth account with stocks, so there's no bonds there, and we probably want some bonds in the portfolio, we put bonds in the tax-deferred account.

And then if there's also more space, we put some more stocks in there. That's basically the idea. And then in the taxable account, we want to stick with things that are tax-efficient. So low turnover funds, like total stock market funds. And with regard to bonds, treasury bonds, because of their lower rate of interest and their exemption from state income tax.

And muni bonds, because of their exemption from federal income tax and potentially state income tax. So that's it. (audience applauding) (audience cheering)