(upbeat music) - Welcome to Bogle Heads on Investing, podcast number 32. We're talking taxes today with Phil DeMuth. Phil is an investment advisor and the author of nine investment books, including "The Overtaxed Investor", "Slash Your Tax Bill" and "Be a Tax Alpha Dog". (upbeat music) (upbeat music) Hi everyone, my name is Rick Ferry and I'm the host of Bogle Heads on Investing.

This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a non-profit organization dedicated to expanding John Bogle's legacy by promoting the principles of successful investing and financial wellbeing through education and community. The website is boglecenter.net and your tax-deductible donations are greatly appreciated.

Today, our special guest is Phil DeMuth. Phil is a PhD, an investment advisor, a prolific writer about financial topics, and one of Phil's books is called "The Overtaxed Investor", which he updates frequently. John Bogle said, and all Bogle Heads know, that costs matter. And one of the biggest costs in investing is taxes.

So today we're talking with Phil about strategies for reducing your cost by reducing your investment taxes. So with no further ado, I am pleased to welcome Phil DeMuth. Welcome to the Bogle Heads on Investing podcast, Phil. Rick, great to be here. Thanks for having me. Phil, you're a, well, I call you a tax expert because you wrote a book called "The Overtaxed Investor, Slash Your Tax Bill and Be a Tax Alpha Dog".

And you update this quite frequently. I imagine you're gonna be updating it again with all the different changes to the tax code. Why did you write the book and tell us a little bit about it and yourself. Well, I wrote the book 'cause I'm an investment advisor and I manage money for clients.

And what happened is we had a little family business that never made any money, but it made my tax form like a phone book. I had to file it in six states. I had no clue what my taxes were about. But once the family business went away, I suddenly could see it in its naked form.

And I saw I was paying all these taxes on dividends and capital gains that I didn't want, I didn't need. Holy smokes, what can I do about this? So then I dove into the tax code and tried to find some way to figure it out so I could help myself and help my clients.

Before we jump into the book, let's make some observations about what's going on about 2020 tax returns. Can you give us a quick review? Well, of course, the big news is that we don't have to file our federal tax returns until May 17th. So they've given us an extra month and two days.

Although I think we still have to pay our quarterly estimated taxes, first quarter taxes on April 15th. So we can't postpone that. Well, Phil, I wanna just go over the major taxes that everyone is liable for first. And then we'll get into different phases of people's lives and how different taxes begin to affect us as we go from early in our career to midlife to pre-retirees, retirees, and then passing money on to our family members.

Then we're just gonna talk about federal taxes. We start with just the basic income tax. Well, it started in 1913, and it's been a popular idea with the government ever since. And it's gone up quite a bit, and it may be about to go up again. This is probably the largest single tax that most of our listeners will be paying.

It's a graduated tax, and it's basically thought of in terms of buckets. So up to a certain level of income, you might not pay any tax because everybody gets a tax deduction to start off. And then you fill up the 10% bracket, 12% bracket, 22% bracket, 24% bracket as your income rises, 32% bracket, 35% bracket, 37% bracket, and it'll probably be going back to a 39.6% bracket.

So it's just depending on your income level and which thresholds you cross, you will be paying each additional tax tier at that level. You know, when you're filling out your 1040, there are three important lines, right? There's your total income line, and then you have deductions from that. And meaning if you're putting money away into say a retirement plan of some sort or an IRA, and this gives you your adjusted gross income.

And then once you have your adjusted gross income, you subtract from that your either itemized deduction or standard deduction generally. And this thing gives you your taxable income, which would go to the tax tables and figure out how much you owe. Is that generally how it works? Perfectly said.

Oh, thank you. Perfectly said. All right, so that's the income tax. I mean, we're all very familiar with it because we pay it every year. But in addition to that, it gets a little more complicated when you're working or if you have a business where you have to pay FICA, which is Federal Insurance Contributions Act, which is Social Security and Medicare.

Now, this gets a little complicated because we all have to pay it. If you're working for somebody else, you pay half and your employer pays half. If you're doing it as a self-employed person, of course, you have to pay both sides. So could you talk with us a little bit about FICA?

Again, it covers Social Security. That's about 6.2%. Medicare is about another one and a half percent. Then it's paid by both you and your employer. So basically about 15%, a little bit over that, is subtracted. It's a lot of money, although you never see it in the bank. So you don't feel it's lost quite as keenly as other things.

And of course, it's become controversial recently because President Biden had proposed to increase the level at which this would be taxed. You know, it's taxed up to a certain level now at $142,800. And then there would be a gap, and then anybody earning over $400,000 would have it reinstituted again on all the money above that.

But the good news is that that's not gonna happen because under the Senate's rules to pass a tax bill under the reconciliation, which is what he would have to do 'cause the Republicans won't sign on to it, you cannot change Social Security in any way. So this is not gonna be happening to us.

So that tax will stay the way it is, even though many other taxes might be going up. - We have to pay this tax, either half of it or the whole thing, if we're self-employed, of approximately 15.3% is what it comes out to, up to $142,800 this year. And it goes up every year, that number.

If you look at all the different inflation numbers, like how much extra you get in Social Security, or me as a military retiree, how much extra I get, it seems to creep up by about 1%, 1.5% per year. Yet this number seems to creep up faster than that. But then it stops for Social Security, but it doesn't stop for the 2.9% Medicare tax.

It just keeps on going. In fact, there's another Medicare surtax that kicks in for single people at 200,000 and for people filing jointly at 250,000. Married filing separately, it actually starts at 125, and it's an extra 0.9%. This tax is on your wages going forward forever. - And that's not adjusted for inflation.

- And you have the Affordable Care Act, NIIT tax, which is 3.8% on capital gains and dividends that starts at the same place, also not adjusted for inflation. And this is deliberate because they wanted to only catch rich people, so to speak, the millionaires and billionaires earning more than 200,000.

But eventually, with inflation, the middle-class incomes will rise, and they will also be smeared by this. And they did that because they knew that these programs are incredibly underfunded. So it's just sort of a backdoor way of trying to get more revenue to keep them afloat. - Yeah, let's talk about that net investment income tax because it gets laid on top of any investment income from dividends or capital gains or rent, not municipal bond income, but anything that's taxable, it gets laid on top of that.

So if you have a long-term capital gain and you're paying 15%, if your adjusted gross income is above 200,000 if you're single or 250,000 if you're married, filing jointly, this 3.8% tax gets laid upon the 15%. And of course, once you have higher capital gains or higher income and you get above 500,000 for married, filing jointly, now you're at 20% capital gain and you get this 3.8% laid upon that as well.

So I think that people really should be watching then how much dividend, interest, capital gain, and rent they're getting from their taxable portfolios. - Yeah, well, plus it's part of the Biden tax plan proposal to bring back the P's limitation on deductions. And that is an additional tax of about 1.2% on dividends, capital gains, rent.

So that really takes for people, say earning more than 400,000 married, filing jointly, that's gonna take their capital gains, dividends tax up to 25%. - It adds up. Let's talk about another tax. And this doesn't hit you until you're 65. And that is Medicare Part B and Part D, how much you pay for that, which is a backdoor tax.

- Yes, well, there's a certain base rate that everybody pays. But then what happens is at certain levels of income, the rate for the Medicare Part B, there are surcharges that are put on that tax. If you're married, filing jointly, it starts rising at 218,000. And then it just keeps stepping up as a number of step ups until finally, if your income is as high as 750,000 married, filing jointly, the premium is basically two and a half times what it was when you started.

And the bad part about that is that would be true for both you and for your spouse. And that would carry on as long as you have that higher income. So potentially this could go all the way through retirement. So it adds a lot of dollars to your healthcare expenditure and retirement.

And nevermind the fact that there's a ton of stuff that you'll need during retirement for healthcare that is not even covered by Medicare. So it's not cheap. And it's also, of course, still woefully underfunded relative to what Medicare pays for the services it gives you. - A lot of the incomes that we're talking about to determine what you pay in Medicare, what you might have to pay for net investment income tax is based on modified adjusted gross income, which has many different meanings in the tax code.

- We try to get a big picture on how to address our taxes in the tax code. And that's great. But at the same time, the devil is in the details. And taxes is about the 73,000 pages of rules and regulations getting it right, getting all the details correct.

And these general answers will only carry us so far 'cause it's gonna come down to the specifics of everybody's tax situation. - Only a portion of your social security is going to be taxed but what portion that is depends again on your income. - Right. And of course, the great danger here, here as elsewhere in the tax code, there are discontinuities.

You expect if you earn a little bit more money, you'll pay a little more tax. Little more money than that, you'll pay a little more tax. And that might generally be how it works. But there are also places, sort of trigger points where you can earn a little bit more money and suddenly your marginal tax rate might go up 100%.

These places actually exist. So that's why you have to be very careful in calculating your taxes. And by the way, this is not for millionaires. This is people that earn $60,000 or show $60,000 of income or people that might show $150,000 in income. You have to be very careful.

At the end of the year, when you figure out your taxes, you have to basically just plug in another $100 and see what that $100 does to your tax bracket. And if it shows it jump exactly what the marginal tax rate says it should jump, you're fine. But again, with Social Security, it can jump way, way above that.

So you have to make sure you're not hitting one of these bump zones, one of these discontinuities in the tax code. Otherwise you're gonna have to maneuver to get around it. And this is exactly the kind of thing that your accountant may not even be aware of and may not point out to you.

So this is something you have to ask the accountant to check or you have to check yourself during your own taxes. - Let's do one more tax. And this one has always confused me. This is the alternative minimum tax. This is a completely different methodology for figuring out taxes to ensure that certain people pay enough in taxes.

- Well, fortunately, I've forgotten a lot of it because under the Trump Tax Cuts and Jobs Act, very few people were paying it. But prior to that, a lot of people were paying it. It started out as a alternative tax system to make sure that rich people were paying their fair share.

But then what happened is thanks to bracket creep, it suddenly started to ensnare a lot of the middle class and the upper middle class. So everybody had to figure out their taxes twice once the IRS way, once the alternative minimum tax way, and then pay whichever is more. - Well, I'll tell you a story about myself.

I sold a business and did an installment sale and I did it over three years. - Very smart. - Well, thanks, except that last year, 2019, the big part of the installment came to me. And I wasn't subject to the net investment income tax because I own the company and I manage the company, but I did get hit with the alternative minimum tax because the capital gain that I took from the sale of my equity bumped me up to a threshold where when we did the alternative minimum tax, I did get hit with that.

So if you're selling a business, you might still see the alternative minimum tax come into play. You know, you think you did your taxes right, but you skipped over the alternative minimum tax and you send all your information into your CPA and next thing you know, it's like, oh, by the way, yeah, it's this extra $10,000 over here that you got to pay.

Okay, we've been over all of these taxes, the income tax, the social security and Medicare tax called FICA. We've been over the capital gains taxes and the net investment income tax that you might get hit with. We've talked about taxes for Medicare, how they can go up based on your income and taxes for social security.

Oh, and then the net investment income tax. We have all these different taxes that we have to look out for and they kind of come in and hit you. You know, it's like, zing, boom. Oh, I didn't see that one coming. Anyway. But Rick, you've left out a lot of taxes.

I mean, there's the federal unemployment tax, which is about 6%. State unemployment tax. You've got your state taxes. You've got property taxes. You've got licensing taxes on your car. You've got excise taxes. It's an endless list. It's really, it's astonishing. You know, when you start adding all the state taxes in there, especially if you have your own business and you have employees, it just gets to be crazy.

I know if you live in some states like California, just, you know, the income taxes and state income taxes alone, and you're over the 50% tax bracket, not even including your property taxes or any of the other taxes that you may have to pay 'em, it's a lot of money.

And we could see a migration in the country out of these high-tax states towards low-tax states or no-tax states just to avoid all of that. And, you know, and there's a tax strategy that I talk about with clients. Let's say a client who lives in California. I might be getting ahead of myself here.

I say, you know, if you put a lot of money into a retirement plan, like a 401(k) or a 403(b), you don't have to pay income taxes on that, federal income tax, or state income tax. And then when you retire, if you move out of state, you still have to pay the federal income tax when you withdraw that money, but you have avoided paying the state income tax.

And thus far, states have not been able to come after you. - Yes, wonderful. If you can retire and move to a no-tax state, you've done yourself a great favor. - Now that we've briefly gone over all the different taxes that you could get hit with, we're gonna talk about, at different stages of your life, how you can plan, do tax planning, and adjust your investments, and where you invest and how you invest.

And you call this the stages of a dog's tax life in your book, "The Overtaxed Investor." Let's go ahead and go through these stages. You know, they're trying to, but only paying what you're required to pay, you know, by law. And so let's start with a young person who graduated from college, or graduated from school, is now going out into the world, going to get a job.

This is all new to them. So take us from there. - The basic idea is that young people should, that are in low-income brackets, ought to place money in a Roth IRA and let that compound for the rest of their lives till retirement. - Well, let's clarify a couple of things.

First of all, a Roth IRA, the money goes in after tax. So there's no current tax break on putting money into a Roth. And the idea is you put money in, it grows tax-free, and then later on down the road, you could take it out tax-free. And in fact, if you don't ever use it, your children, if you have children, or whoever's gonna inherit your money, inherits that account tax-free, and they have 10 years to take the money out, but it's all tax-free.

So coming out of school, you get your first job. You go to your employer. Your employer says, "We have a 401(k) or a 403(b), "and you should put money in it." What are the first question you should be asking? - Well, the first question you should be asking, I would say, is do you have an after-tax or a Roth option on this?

'Cause as a young person with a relatively low income, I would want to take advantage of that. And the second question, which is equally important, is what's the employer match on this contribution that I make? - I agree that if you're not making much money and you're in a low-tax bracket, that putting the money in the Roth side of a 401(k) is a smart idea.

Your employer, by the way, can't do that. Your employer has to put their match into a pre-tax 401(k). - Correct. - So you're going to get a statement of some sort that shows pre-tax side and after-tax Roth side. All right, so now we get married. We're going to buy a house.

We're pregnant. We're going to have children. And we need to save money for college. How do we do that? - The smart way to save money for college these days is through the 529 plan, which is a plan where you can put money in. You don't get any federal tax benefit for doing it.

Some states will offer you a tax benefit for using their plan if you're a resident of their state. And you can put in $15,000 apiece, husband, wife. That could be $30,000. And they let you front load the contribution for five years. So that's $75,000 apiece or $150,000, if you've got it, for both of you.

Put that in the 529 plan, and that covers the five years worth of contributions. This money inside the plan compounds as Junior grows up. And then when it comes time for college, you can take the money out and you can spend it on college tuition and on room and board, books, college expenses, computer.

And this is a fabulous way to pay for college, especially as opposed to the alternative, which is either having to pay ordinary income or having to sell stocks, pay capital gains taxes, and then send the tuition checks to college. These are sensational vehicles. Some people have even used them in ways that were not intended by the original legislation as de facto retirement savings plan for themselves, naming themselves as beneficiaries, take the money out, paying the penalty for not using it for education.

Or else they can take the money out and they can take golf lessons at Hilton Head. But those are unusual uses. The real idea is kids' college education, and it's a terrific way to go. - You could also use it nowadays to pay for private school up to a certain point.

- It is, but it's generally less valuable because the point is to have, again, a long-term compounding. You can fund the plan the day the child is conceived. Then you've got a real running start for college. And if you have enough money, you can then start using it for high school or elementary school or even kindergarten.

- So I have clients who even go further than that. They will fund a 529 in their own name. And then when they start having children, they will change the beneficiary to the child. - And you can do that too. And you can also rope grandma and grandpa into this, and they can set up plans for the kids.

- Interesting that you have the grandparents saved because when you do the FAFSA form, the money that the parents have counts more towards whether the child gets financial aid than what the grandparents have saved. - But then there's also the question of graduate school. Because graduate school is not gonna be looking at parent income, 'cause they'll assume your child is an adult.

- So now that we are working and we have a family, we have children, we're saving in a 529, at what point do we decide, as we make more money, decide that we're not going to do the Roth 401(k) anymore, but we're going to start doing the pre-tax 401(k)?

And then since the 401(k) of 403(b) isn't being fully utilized, we start doing what's called a mega backdoor Roth. Can we get into those? - Sure. Well, the question about, should I put money in a Roth, or should I put it in a traditional 401(k), 403(b), IRA, is a one variable problem.

All you need to know is this. Am I paying more taxes now, or will I be paying taxes at a higher rate when I pull the money out? You know what you're going to be paying this year in taxes. You don't know what you're going to be paying after year 72, or whenever you're going to have to start pulling the money out.

But at that rate, you're going to have to estimate what your tax bracket is going to look like. And if it looks like your tax bracket is higher today than it is then, which it is for most people, most people are earning more in midlife, and they're going to be earning less in retirement.

And so it's the smart move for most people is to put money in a traditional plan. You want to pay the taxes when your taxes are lower. - I want to talk about what's called a mega-backdoor Roth, because I find it's very useful. And here is where you have a 401(k) or a 403(b), where you're putting in the maximum.

And if you're below the age of 50, the maximum this year is 19,500. That's what you can put in. Once you get over 50, it goes up to 26,000. But your employer on the other side puts money in also, and that's the match, or sometimes the profit sharing. And for people under the age of 50, the maximum this year is 58,000, and that includes your 19,500 plus what the employer puts in.

So if it's not being utilized, let's say the employer, you're putting in 19,500, and the employer is putting in 10,000, I'll call it 10,500 to make a nice round number. So they're putting in total of 30,000 is going in, but a total of 58,000 could be going in. It's $28,000 worth of that 401(k) or 403(b) that is not being utilized.

It is, it's a window of opportunity that is not being used. And you could do, maybe, depending on the plan document, could do what's called a mega backdoor Roth. If you have the capacity to put money into a 401(k) or a 403(b) in excess of the 19,500, and the plan document allows you to put that money in after tax, and then the plan document allows you to do what's called an in-service distribution, which means nothing more than you're continuing to work there, but you can take this money out and put it into a Roth account.

So those two things, you can put money in after tax, and then you could take that money out and roll it over to a Roth after tax. You could potentially, in my scenario, where you're putting in 19,500 and the employer's putting in 10,500 and that leaves 28,000, if you have the ability to do it, you could potentially put $28,000 a year into your Roth account using this mega backdoor Roth.

- It's a fabulous strategy. - If you have the funds available to do that, that's a great way to go. And even if your employer won't let you roll the money out immediately, it's not the employer, if the plan documents don't let you roll it out immediately, even if you have to wait 'til you retire to roll it out, that's fine, especially assuming you've got some decent investment options inside the 401(k), which increasingly you do.

And if you have the kind of plan that allows this kind of sophisticated strategy, you probably also have pretty good investment options within the plan. So it's a great move. And one of the few nice moves available to higher income people. So they should definitely take advantage of it.

- One more concept for the midlife accumulators is this idea of asset location. If you've decided that you wanna have some bonds in your portfolio, where do they go? If you wanna have stocks in your portfolio, where do they go? Can you address that? - Well, this has been thrashed around in the financial planning community forever.

And the answer seems to be this, the short answer. Stocks go in taxable accounts, bonds go in qualified plans. Now, there could be some exceptions to this. For example, with municipal bonds, you might wanna put those, you would put those typically in a taxable account. And if you have other more tax intensive assets, such as real estate investment trusts, commodities, you would wanna put those in a qualified plan.

That's the general picture. - What about the idea of putting growth stocks in a taxable account and putting high dividend paying stocks in a Roth or a tax deferred account? - A great idea, I think that dividend stocks are very tricky because people love dividend stocks, but they have to understand that a dividend is basically a capital gain with a zero cost basis, the worst kind you can have.

So I've come to love dividend stocks a lot less unless they're in retirement accounts. I love dividend stocks in retirement accounts. And just as you say, I much prefer growth stocks that don't pay a dividend or pay very low dividends in taxable accounts, that's great advice. - I wanna get into another issue, and this doesn't have anything to do with saving for retirement, but it has to do with buying a house and whether you should take out a mortgage or whether you should make a big down payment.

And I wanna tie that into the standard deduction that we have nowadays. What do you think about when you're talking with clients who may have the ability to pay cash, maybe they had some RSUs, restricted stock from a company that they sold, and they have a lot of after-tax cash, and they're thinking about using that to pay off their mortgage or buying a home without a mortgage, what's the formula that we're using these days?

- Well, I may be doing something perverse, I don't know. I tell clients, and we're talking about people in their 50s, 60s, that I encourage them to take as big a mortgage as they can get as they approach retirement. But this is not for tax reasons because they're not gonna get, of course, this will change under President Biden.

Currently, most of them are not able to use the itemized deductions. They won't get a big mortgage deduction for it. The reason I like it is because a mortgage is a inflation-sensitive asset. So if you conceive of inflation as being the number one enemy of a retiree, this is a great way to have a lot of, to have a sort of defensive position.

Your mortgage will decrease with inflation while other assets on the other side of the ledger will be decreasing as well. So it's a way of decreasing your liabilities. But that's just, that's not so much a tax strategy as it is a retirement inflation strategy, especially now that the new stimulus bill has been passed, America's Rescue Plan, it's called.

We suddenly find inflation poking up its head for the first time in 20 years. - Generally, the way I frame it, and now we're getting into the midlife accumulators, you know, age 50 or so, we'll continue to march here, is that if you're gonna hold a lot of cash in your taxable account, you're not gonna hold CDs or short-term municipal bonds in your taxable account.

That buying back your mortgage, if you're not doing itemized deductions because you're doing standard deduction, buying back your mortgage is the best bond you could buy because it gives you an after-tax return based on the amount of your mortgage interest. Now, again, this is for people who are going to hold fixed income anyway.

I try to encourage them, well, don't hold so much fixed income. If you're gonna hold fixed income, take some of that fixed income and just buy your mortgage back. - Yes, yes, a mortgage is just a negative bond. And so the two cancel each other out, except to the extent to which you have a liquidity preference.

And it's not irrational to have a liquidity preference. So there's that as well. I should also say that I've been pushing the idea of mortgages when the mortgage rate has been two and a half, 3%, figuring that this is gonna likely to go up over time. As mortgage rates starts to amp up themselves, I'm gonna become less geeky about trying to take advantage of that.

- Let's talk about large, unrealized gains in stock that someone may have, might be A shares of stock, which are original owner stock of a company that went public, or maybe somebody was fortunate enough to buy Amazon 20 years ago, or Apple 20 years ago in their account, and they have a very large capital gain in one stock.

How do we deal with that? - This is a very tough problem. Every sensible person you talk to will say, sell and diversify. Sell the stock, pay the taxes, and diversify into a broad index portfolio. And I can't argue with that. And whatever you do will turn out to be wrong.

So if you hang on to what the stock's gonna crater, if you sell it, it's gonna immediately double. It's a tough position to be in. And there are different strategies. You can try to buy a portfolio of stocks that are going to complement it and behave differently than how Amazon might behave, if you can figure that one out.

Or you can use some option strategy. You've gotta be careful there because if you get it too tightly bound, you can end up with a constructive sale of the stock anyway. The people that are selling those tends to be quite expensive service they're providing when you look at all that.

You can use these exchange funds where people will take it off your hands and they'll give you shares of a mutual fund made from other people's discarded, unloved big holdings. But that is also one I've never really seen work out that well. The fees tend to be very high and it's hard to know what you're gonna actually be getting when these things terminate.

So I don't know. What do you think, Gregg? What do you do? - Well, you could use gifting to gift a portion of your shares to a charity through a donor advised fund so that you could take a big tax deduction upfront. And then now that you have a big tax deduction, you can offset that with taking a capital gain on the rest of the shares.

So you're gonna be popping up probably to a 20% capital gain tax and then you have your 3.8% net investment income tax on top of that. And so whatever you gift to charity can help to offset that at the same time. So they go hand in hand, right? A gift to charity, sell some of your appreciated assets.

And once you sell the appreciated assets, by the way, I tell people to do this at the beginning of the year, the beginning of the year. Why do I say do it at the beginning of the year? Because then you could take the money and you could buy a total stock market index fund, total international index fund, call it ETFs.

I like ETFs and taxable accounts. And why would it be wise to do this at the beginning of the year? Because once you buy the total stock market ETF and the total international ETF, if during the year the market goes down, you could do tax loss harvest by selling the total stock market ETF or one of them and turning around and buying another one that's similar, but not substantially identical.

You could sell the Vanguard total stock market ETF, you can buy the iShare total stock market ETF. There are two different companies, there are two different indices, not substantially identical, but you get to take a tax loss. And that's the key. So if you did these trades, you wanna do them at the beginning of the year so you could take the money and do something else with it so that if the market does go down, you could do tax loss harvesting and swapping into similar funds, take the tax loss from that and offset some of the gain.

- Very good. The only caveat I would say is that under the new Biden plan, the idea is to cap the deductions at 28%. And of course, the devil's in the details, we'll see what actually emerges. But if your deductions are capped at 28%, the benefit from donating your appreciated stock to a donor advised fund might not be as much as it was before.

So it's gonna make the strategy slightly less good. It's better than nothing. It's a great way to go. It's better than holding onto the stock and watching it go down 90% because of something you didn't see, which is what will happen if you keep it. - There are some people who say that doing what's called direct indexing is a good idea, which is to take from the sale of a highly appreciated security, taking that money and putting it into a direct indexing portfolio, which is nothing more than you give it to an investment advisor who buys all 500 stocks in the S&P 500 in one account.

And then as the individual stocks one by one have losses to harvest the losses and therefore in the first year, again, if you did this at the beginning of the year, in the first year, you could harvest a lot more losses than doing the ETF strategy that I talked about.

The problem with that is number one, you have 500 stocks. That's a problem right there. And secondly, 20 years from now, you still have 500 stocks, even though this thing has played out and you've gotten your losses from it. And you have to continue to pay management fees along the way.

It makes it very cumbersome for you and complicated to try to do this direct indexing. And getting back to your concept of turning your stock in and getting a basket of stocks later, I think you have to wait seven years. Yes, seven years at very high fees typically too.

Right. So there's really no great solution to what to do about the highly appreciated stock in the portfolio. Selling little by little as you move along might be helpful. It's always a question that people have. What do I do with this? And my answer was, well, you should have done a mega backdoor Roth and you should have bought it in a Roth.

(laughing) Yes. And you wouldn't have any tax issues. In fact, I tell people, going forward now that we finally cleaned up your portfolio, if you're ever gonna buy stocks again, individual stocks, please do them in your Roth. So we don't have any tax issues. That's where you would wanna buy individual stocks.

If you have the capacity, buy them in your Roth. I am a fan of the idea of direct indexing. I don't think the implementation is quite where we want it to be yet, but I think it will get there. I think there's real potential there, especially if it will let me tweak the portfolio along the dimensions that I wanna tweak it.

And that will go into factor investing or zero dividend investing and stuff like that. So I think it has potential, but I haven't seen a solution to it that I'm been on board enough with yet to say, okay, let's do that. - Yeah, I think the solution in the end, I've been putting this out there for years, has been if somebody, some entrepreneurial person came up with a methodology for taking that portfolio and turning it into an ETF company and getting shares of one single ETF at the cost basis of the entire portfolio, that would be a marvelous idea.

Of course, the direct indexing companies are not gonna do that because they don't wanna lose those management fees every year. So it would have to be an ETF company that actually comes up with that solution. Take your direct indexing portfolio, turn it into us, and we will give you shares of S&P 500 index fund at the cost basis of the whole portfolio if the IRS will buy off on that.

- Well, I think it's up to you to do it, Rick. - No, no, no, no. - Can I just say one more thing about this? Under the new Biden tax plan, it could well be the case that if you earn over a million dollars, that you would be paying 39.6% on capital gains.

Now you're looking at your Amazon stock that's appreciated, and you're thinking, "Well, gee, do I wanna pay 20% on capital gains this year, or do I wanna roll the dice and maybe pay 40% on capital gains next year?" So these are the kinds of things that investors are gonna be thinking about by the end of 2021.

- I think we will know by the end of 2021 which direction these tax changes are gonna go. Next year, remember, is another election year. Let's go ahead and move on to getting ready for retirement. Again, getting ready for retirement. We have money in a 401(k). We have money in a Roth account.

We have something in our taxable account. We need to take Social Security at some point, but we don't know when. We may wanna do some Roth conversions. This period between age 59 1/2 and call it 69 before, if you decide to delay Social Security, or even 65 when you get Medicare, there's a lot going on during this period of time.

- This is the most underrated period for tax planning imaginable. There is suddenly a lot of potential. I think it really starts when you decide to retire. Between the retirement and between when you have to start taking required minimum distributions from your retirement plans, you have a window of opportunity to look ahead over the entire sweep of your retirement and do some canny tax planning.

And so I strongly encourage people to take advantage of this time because suddenly your income is low. You're not getting a big paycheck from your job and that means that you have the potential to possibly do some Roth IRA conversions. If you fail to take advantage of this, what will happen is that you'll be forced to withdraw money from your traditional IRAs, 401(k)s, 403(b)s, all of your traditional qualified plans.

And that check starts out being 3.6%, something like that. But the amount of the check is going to escalate as a percentage of the plan every year until by the time you're 90 years old, you're taking out 10% of your plan every year. And so it's gonna knock you into higher tax brackets over the course of your retirement, or at least that's what you wanna guard against.

So you need to sort of step back and take a look at what's gonna be happening. The second big thing you need to take a look at is in the event that you don't live forever or your spouse doesn't live forever, what's gonna happen when you or your spouse die and the remaining party, the last person standing, is gonna suddenly be filing single rather than married filing joint.

And they're gonna find, wait a minute, I've got a whole different set of tax brackets that I've gotta apply now. And so I'm paying taxes at a much higher rate than I was before. So you've got to step back and see, how can I plan for these contingencies and what's the best way of doing it?

- Well, let's also throw into this that at age 65, you're gonna go on Medicare. And Medicare is gonna be based on the decisions you make at age 63, unless you file a form otherwise, where if you're doing these Roth conversions, 63, 64, 65, it could bump you up into higher Medicare costs.

You have to take into account so many variables, it's unbelievable. And they're variables that are in many cases, we just don't know the answer. We don't know what the future of the tax code is. We don't know how long you're gonna live or your spouse is gonna live if you're married.

We don't know what the future of your investment returns are gonna be. So this is not an easy Rubik's cube to get lined up. There are all these different thresholds you've gotta be watching out for. And this is why we have to resort to the use of tools, financial planning tools, to try to wrap our brains around the problem.

- Well, there's a lot of good software out there now, new retirement and income solver. There's several software packages that help you do this. - And I encourage people to be very judicious in their use of it. I don't think people should just plug in the numbers, push the button and then do what it says.

They need to really think about how all these things interact and ask questions. What happens if I live longer? What happens if tax rates rise more than I think? What if my investment returns aren't as good as I hope they are? And look at many different kinds of scenarios to get a sense of where's the sweet spot in terms of my Roth IRA conversion strategy and my retirement income drawdown strategy.

- I'll give a plug to the Bogleheads on bogleheads.org. If you go to bogleheads.org wiki, tools and calculators, there's a whole range of calculators that Bogleheads have created for free and put it up on the wiki. And there's all types of RMD calculators, retirement calculators, social security calculators, Roth conversion calculators.

If you're looking for a calculator to come up with some numbers and for free on bogleheads.org, the wiki under tools and calculators, you're gonna find it there. - A sensational resource. - So we've got this dilemma here where we have to look at all this and we have to make a determination at some point.

When do we take social security and how did social security work into all of that? - This is something that I would turn over to a calculation, to a tool of some kind. Social Security Solutions offers one, Kotlikoff offers one, I think with Maxify Planner. There are free versions of this floating around.

- Michael Piper has a great version. - Michael Piper's version, exactly. - Open social security.com. - And there's a little bit of judgment involved in using these, but basically you want to plug in your numbers, spouse numbers or earnings, longevity estimates and find out when to take social security.

Maybe it's just me, I have an inherent bias towards, let's put it off to the last possible minute. The idea of being able to get an inflation adjusted annuity from the government is, I mean, this is not sold in stores. You can't buy this from any private company. So I love the idea of watching that grow 8% a year from full retirement age to the maximum age at which I can take it.

I just don't see anybody offering anything like that. - And especially if you are married and you die first, that annuity is gonna be very valuable for your spouse. - Yes. - So my bias is to wait, but the claiming strategies do get complicated and you should pay close attention to them because there are occasions when one person should wait, the other person should file early.

You need to look at the software and then before you start getting cute with your own opinions about things. - So at age 72, at least that's the age now, you have to start taking required minimum distributions and you take your ending balance of December 31st to divide it by 25.6 is the number right now.

And it tells you how much you have to take as an RMD. And then it goes up, have to take out more and more and more and more, so your taxes go up. But I've got some clients who looked at that and said, you know, that's okay because my children are not making much money.

So, and maybe my health isn't all that great. So I wanna die with a lot of money in my pre-tax retirement account so that my children will inherit this money. And even if they had to take it out over a 10 year period of time, which is the new law, they're in a low tax bracket and they can actually get the money out at a lower tax bracket than I can.

And then I have the opposite, by the way, where there are some people who are retired who say, no, you know, our children are making a lot of money and they're all in the highest tax brackets. We are retired and we're in the low tax bracket. So we're gonna take out as much as we can up to say the top of the 32% bracket every year, more than what we need to take out.

We're gonna put that into a Roth because even though we're paying the taxes currently on that, we're paying it at a lower tax bracket than what our children would pay it at when they get their inheritance. Now it just depends on each person. - Well, it goes back to the same question as earlier.

These retirement plans are owned partly by you and partly by the government. And you want to pull the money out when your share is the greatest and the government share is the least. So if your taxes are higher than your kids, then that dictates a different plan than if your kids' taxes are higher than yours.

If your kids' taxes are higher, you wanna give them a Roth. If your taxes are higher, then you want to give the kids a traditional, let them inherit the traditional IRA. - Now there is one thing we could do to lower our required minimum distribution, and that is a qualified charitable distribution.

I wanna touch on this and then get into, last thing we'll talk about is estate planning. What is a qualified charitable distribution? - Well, the IRS has said that anybody over 70 can apply up to $100,000 of their required minimum distribution. And instead, they can ship it to a charity, not a private family foundation, not a donor-advised fund.

But if it's a public charity, they can give the money to that, or they can split it to 20 public charities if they want. Up to $100,000 will count towards their RMD. So this is gonna become very useful, especially for higher income individuals in retirement. You can use it to target a particular number for Medicare or capital gains or whatever you want.

You could just look at the tax code and say, I wanna have my income this year hit this number. And using strategically these qualified charitable distributions, it's a way to do it. Just make sure that the qualified charitable distribution comes out before the rest of your RMD. You can't pull out the RMD and then think at the end of the year, well, now I'll take out this qualified charitable distribution.

It's too late. That'll just count as you won't get the tax benefit from it. - Oh, thank you. I didn't know that. I appreciate that. Let's talk about some more estate planning things as we're now at the end of life and what can we be doing tax-wise to help future generations?

- One of the big things now, again, I'm looking at the Biden plan. It's gonna reshape estate planning significantly because the goal is to get the estate tax exemption from whatever it is, 11.68 million, cut it 70% down to three and a half million, which means suddenly lots of people that thought, oh, estate problems, we don't got them.

Suddenly they have estate problems. So your estate planning attorneys, tax planning attorneys are gonna be doing a booming business this year, redoing everybody's estate plan. So the big question is gonna be like, a small business owner, holy smokes, I don't wanna pay 40% of the taxes on the sale of this business to IRS.

I've gotta find some way of getting this business, this personal business out of my estate. And I'm gonna have to maybe do an installment sale to a trust of some kind, but somehow I don't want it to be part of my estate because it could even be taxed twice.

It could be taxed as part of my income tax, and it could also be taxed as part of my estate tax if I were to sell it. 'Cause remember, they're talking about enforced capital gains recognition at death. And this is another whole new thing that's going to really stir the pot in estate planning.

And it's gonna even have implications for people that are retired, who suddenly think I've got my $10 million in Amazon stock, so do I wanna pay the tax on it at 40% where I wanna ship $4 million to the government when I die, or do I wanna ship just 2 million to the government if I sell it this year?

There are gonna be all these issues rising to the forefront one way or the other. We don't know what the final plan's gonna look like. We know what has been discussed, but it's gonna have very, very big implications and coordinating your tax planning and retirement with your estate plan is going to be absolutely crucial.

- Phil, it's been wonderful to have you on the show today. Really appreciate your insights. And the name of the book is called "The Overtaxed Investor, Slash Your Tax Bill and Be a Tax Alpha Dog." And I imagine that when the new Biden tax bill comes out, you're gonna be doing another edition?

- Back to the drawing board, you bet. - (laughs) Okay. Well, thank you so much for being on the Bogle Heads on Investing show. We greatly appreciate having you today. - Thanks so much for having me, Rick. Take care. - This concludes Bogle Heads on Investing, podcast number 32.

I'm your host, Rick Ferry. Join us each month to hear a new special guest. In the meantime, visit bogleheads.org and the Bogleheads Wiki. Participate in the forum and help others find the forum. Thanks for listening. (upbeat music) (upbeat music) (upbeat music) (upbeat music)