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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm wrapping up our year-end tax planning content by sharing three simple tax planning strategies for everyone to consider. We have exactly two weeks left in the year, and my goal is to help you take action before it's too late. So if you want to lower your tax bill today and reduce your future taxes in retirement, today's episode is for you.
For all the links and resources mentioned, head over to youstaywealthy.com forward slash 91.
Before we dive into today's topic, I thought that I would share some fun personal news that I've been anxiously sitting on for a few months now. So in June of next year, my wife and I will be having a baby girl. And as some of you guys know, we have two little boys already. Our oldest is three and a half. Our youngest, he just turned two. So this will be our third and it will also be our final. So we're going to be talking about
It's been a long, challenging road for us, and we're just feeling extra blessed right now to be able to complete our little family. I'm excited to have completed my foursome for the golf course. I've got me and three little kids that I'll be able to take out there and hopefully play some golf with. So I'm excited. We're all excited. If you're on my email list, I'll be keeping everyone updated and sharing pictures from time to time.
And by the way, we plan to stick with another S name. My two boys are Sawyer and Sutton, and we're going to stick with another S name this time around. So if you have any favorite S names, feel free to send them on over.
Also, before we jump into today's topic, I want to clarify a point that I made in episode number 89 when I talked about coordinating donor advised fund contributions with Roth conversions. And I'm actually kind of surprised that nobody out there called me out on this. You guys are really smart. I get emails from you all the time, but this one, you didn't call me out on it and that's okay. But I made a comment that
Contributing appreciated securities to a donor advised fund is a way to maximize the tax benefit of a contribution.
However, I just want to point out that that's not always true. And I feel like I led you to believe that that's the way to do it if you're going to do it. And that's not always true. It really depends on a number of factors, including your capital gains tax rate today, projected cap gains tax rate in the future. Of course, if tax laws change, that's going to be factored in. And then lastly, the amount of gain on your stock, you might have a just a small little gain on a long term appreciated stock, it may not make sense to contribute that stock.
When donating appreciated securities, you are limited to a tax deduction of 30% of your adjusted gross income or your AGI. When you donate cash, you can deduct up to 60% of your AGI. And then some of you know that this year under the CARES Act, you can actually deduct up to 100% of your AGI when making a cash donation to a qualified public charity. So
While donating appreciated securities is one way to maximize your contribution, it's not always the best solution, especially when there are tax law changes like we saw here in 2020. So I just wanted to clear that up. With all of that out of the way, let's get into some final tax planning opportunities. Specifically, I'm going to be sharing three simple tax planning strategies for you to review and consider taking action on before the end of the year.
And I've said it before, but I'm going to say it again because it's important. It's important to me. The stock market and investments always seem to get all the attention. Retirement savers and investors love to obsess over 1% allocation here and a 1% allocation there. And what's the stock market doing today? Where do we think it's going to be tomorrow? Which mutual fund is best? Which stocks should I should be buying? It's fun stuff to talk about.
And while investing is important and being a smart investor is important, you can only control so much when it comes to managing investments and building a portfolio. And you guys all know this by now, but doing nothing with your investments and staying the course and staying true to the strategy that you have in place is often the best course of action. On the flip side, per
proactive tax planning year over year over year is one of the most impactful, if not the most impactful areas of financial planning. And it's something that you have control over. A lot of people think, well, the taxes are what they are. I don't have control over it. That's not true. I've shared before, but it's not uncommon for us to see six or even seven figures of projected tax
savings through the end of someone's life. And that's just by doing very legal, but intentional tax planning each and every year. So don't underestimate this stuff. And don't think that tax planning is just for the ultra wealthy, just about everyone is going to end up with money in retirement accounts, you're going to have income streams of some sort. Maybe it's a pension, maybe it's Social Security.
That money, no matter how large it is, is going to be taxed in the future. And how much of that money you give to the IRS is up to you. And it's up to how proactive you really want to be with this stuff.
So in addition to everything else we've talked about on the podcast this year, here are three final tax planning strategies to consider as we wind down 2020 and finally put this year behind us. The first one is asset location, not allocation, but location. So
asset location. And I've talked about this in the podcast before. It was not this year. I think it was prior years, but actually, no, maybe I did touch on it a little bit, but anyways, it's a big one. It's important. And I wanted to revisit it before the end of the year and just share how impactful it can be. So in its most basic form, asset location is a strategy where you're very careful about what investments you hold and
in the different types of accounts that you might have. So for example, maybe you have a traditional IRA account and you have a plain vanilla brokerage account. Maybe it's held in the name of your trust or in joint tenancy with your spouse. So you have these two accounts, you have a traditional IRA and you have a plain vanilla brokerage account.
Well, those are two very different accounts with two very different tax treatments. Let's just say you primarily in these accounts, you invest in an S&P 500 ETF and a handful of different bond funds. And once again, those are two very different investments with very different tax consequences.
Now, through all this, we don't want to change our overall asset allocation, right? We don't want to change that. But we can reduce our current and potentially future tax bill by changing the location of where these assets are held or where these investments are held.
We can do this by holding tax inefficient, that's inefficient investments in our IRA account and tax efficient investments in our taxable plain vanilla brokerage accounts. So in my working example here that I just mentioned, you've got these two different accounts, a tax inefficient investment would be your bonds, those multiple bond funds that I said you might be holding, especially if you have higher yielding bond funds or international global bonds.
Bonds are income producing instruments and they generate a current year tax bill because of the interest that's paid. And that current year tax bill drags down your returns when those bonds are held in a plain vanilla brokerage account that's taxed in a given year. Other examples of inefficient investments would be REITs, Real Estate Investment Trusts, TIPS, Treasury Inflation Protected Securities.
and also high turnover funds like commodity funds, but there's others out there that are often turned over. There's a lot of trading going on that can trigger a lot of tax consequences. So those are tax inefficient funds.
or investments. A tax efficient investment would be that S&P 500 ETF that you're holding on to, which although it might pay a small dividend, it's not primarily focused on generating income. That's not its primary goal. Its primary goal is long-term growth, which will of course create a tax liability in the future in the form of capital gains.
Other tax efficient investments would include municipal bonds, growth oriented stocks, and there are tax managed stock funds out there as well that can be more efficient than some others. So if you had these two accounts and you had $500,000 in your IRA account and $500,000 in your plain vanilla brokerage account,
And you're targeting just, again, keeping things simple here. You're targeting a 50% stock, 50% bond allocation, right?
you might consider taking advantage of asset location, holding your bonds, those tax inefficient investments, holding your bonds in that IRA account, right? IRA is tax advantaged. So all that current income you're getting from the bonds is sheltered inside of that IRA account. So you'd consider holding your bonds in your IRA and your stocks, your S&P 500 index fund in your brokerage account. And by doing that, it can improve your tax efficiency of your investments.
Now, as always, this is not a blanket suggestion. It's not a fitting solution for everyone. It depends on a number of different factors. One of them being how many years you have or you'll be saving and investing before you start to tap into your investments to provide income in retirement.
The longer the runway you have to take advantage of this, the more time the strategy has to play out and work to your benefit. Who knows what's going to happen in the next year or five years or even 10 years for that matter. So the longer your runway, the better this can work, but it does depend on your situation. There are a lot of people in retirement that aren't tapping into their portfolio. They have other purposes for it. So you can still use asset location, but it does depend on a number of things.
At the very least, if this doesn't really sound like it's a fit for you, one reason why it might not be a fit that we run into sometimes is sometimes people have all of their money in IRA accounts. So they don't have a plain vanilla brokerage account. They've been putting money into 401k accounts and IRAs their whole life. So they don't really have that plain vanilla brokerage account with a meaningful amount of assets in it. And in that case, there's not much you can do with asset location.
So if it's not fitting for you, at the very, very least, most people do have some form of a plain vanilla taxable brokerage account. And I'd like everybody towards the end of the year when you get your year end statement to open up that statement. And I want you to review the dividend and interest income that was generated this year from that account. Remember, that account is taxable in the given year. So all that dividend and interest income you're going to get taxed on here in 2020 when you go to file your tax return.
And I bring this up because far too many investors over the last several years have flocked to these dividend paying stocks because they're starved for yield. Cash in the bank is earning nothing. They're afraid of the bond market. And so they're buying these dividend paying stocks thinking that they're a safe alternative. And while dividend paying stocks might have produced some positive returns recently and kind of kept up with the market,
It's important to take taxes into consideration before you start celebrating. On qualified dividend income, you can be paying up to 20%. And on non-qualified dividend income, your tax rate can be as high as 37%. Meaning for every dollar you earn in dividends, at least 20% of it might be, or starting point there, 20% of it could be going to the IRS.
And you have to look up the tax tables for qualified and non-qualified dividends to kind of see where you fit. So it's not, again, just a one size fits all. And remember, just because a company doesn't pay a dividend doesn't mean it's a bad investment. Sometimes people screen for dividend paying stocks. Just because a company doesn't pay a dividend doesn't mean it's a bad company or bad investment. It just means they're spending money in a different way. Now, there are unprofitable companies that can't pay a dividend. That's a little bit different of a story, but
a high quality, good, profitable company, if they're not paying a dividend or they're paying a really small dividend, it just means that they're reinvesting profits into other areas of the business instead of paying them out to you as the shareholder. So through this exercise, you might find out that you're holding some really tax inefficient investments
And either you might consider getting rid of them and swapping them for something that's more efficient, or you might decide to hold them in a different type of account. So one of the two you might determine through going through this exercise. There is a lot to know about dividend paying stocks and dividend funds. I'll link to an article in the show notes as well as an article on asset location if you want to learn a little bit more and dive deeper. Again, show notes can be found at youstaywealthy.com forward slash
forward slash 91. So again, first tax bonding strategy, consider asset location. If for some reason it's not really a good fit for you at the very least, I just want you to open up that taxable brokerage account statement, the year end statement. And I want you to see how much you earned in dividend and interest income that year and see if you're holding onto some tax inefficient investments that you might be able to swap out or move to a different account.
All right, so tax planning strategy number two to consider here is qualified charitable contributions or QCDs. Now you may have heard of these before, but I'm gonna share some new stuff with you hopefully, so bear with me. So here's the deal. I was talking to a family friend the other day and charitable giving came up in the conversation.
It's something that I often talk about a lot in conversations. Again, the stock market and the economy is always a hot topic, but I always try to shift the conversation to something a little bit more meaningful. So I always like to ask about charitable giving when it feels comfortable and right to bring it up. So I was talking to his family friend and she mentioned that she had recently made some cash donations ahead of year end. She knows that towards the end of the year, she likes to make some donations. And so she made some ahead of the end of 2020 here.
And so I asked how she made them. How did you make these contributions? And she said, you know, I just took out my checkbook and just wrote some checks out of my checking account. That's what I always do. And this is pretty common. However, I know this person. I know that they're over age 70 and a half. And I know that they, I don't know for sure, but like, I assume that they had money in a traditional IRA given everything I know about them. So I was kind of cringing as she was telling me all this because
instead of donating money from her checking account and writing a check, instead of donating money that's already been taxed,
she could have donated it directly from her pre-tax IRA, which would have done three things. One, it would have allowed her to donate more money, potentially. Number two, it would have allowed her to avoid taxes on the withdrawal. And then number three, it would have helped lower her future RMDs. Taking money out of your IRA will lower future RMDs. I'll
explain each of those in a little bit more detail. But first, yes, you do need to be 70 and a half to follow this strategy. And I don't know how many of our listeners we have over 70 and a half, but I'm sharing this because I'm willing to bet 100% of our audience has someone in their life who's of that age. And it doesn't matter if they donate 500 bucks, maybe they donate 100 bucks a month to their church. It doesn't matter how much they donate, if it's 500 or $100,000,
Donating money from an IRA is usually the better route, and I want everyone to be aware of the benefits. Also, most people don't know this, that a lot of the major custodians, you know, Fidelity and Schwab, a lot of the major custodians actually allow you to write checks from your IRA account, making it really easy to process qualified contributions.
So I mentioned that writing a donation check from her IRA would have done three things. The first was to allow her to donate more money. Let me explain. Let's say that she wanted to donate $5,000. Well, in order for her to get $5,000 into her checking account, at some point she had to earn money through either investing or working.
And then she had to pay taxes on those earnings. So just hypothetically throwing a number out there, maybe she had to earn $7,500 in order to get $5,000 of after-tax money into her checking account. Well, since her IRA account hasn't been taxed yet, right? Pre-tax account.
She might go ahead and donate the full $7,500 to charity instead of $5,000 through a qualified charitable contribution. She knows that if she took money on her own out of that IRA account and to go spend it on her own, she would be taxed at ordinary income. So $7,500 is not really $7,500 to her once it comes out and gets taxed.
But she's thinking to herself, well, I'd rather give money to a charity than to the IRS. So she factors that into her giving plan. And instead of donating $5,000 from her checking account, she realizes the tax benefits of this. And she says, you know what? I'm going to go ahead and give $7,500 from my IRA instead, instead of paying taxes on that money down the road. Now, you don't have to adjust for the potential tax situation that I just laid out there. You could just write a check for $5,000 from your IRA versus $5,000 from your checking account.
It would still be a tax benefit there. But a lot of people will look at it like, okay, I have the ability here to maybe donate a little bit more money since this money has never been taxed before. And if I don't send it to a charity, I'm going to get taxed on it and the IRS is going to get more money.
The second thing I mentioned was that she avoids taxes on the withdrawal, which I've already alluded to. In 2020, required minimum distributions are waived. You might know that. So you aren't forced to take money out as a required distribution this year. But that doesn't stop you from processing a QCD or Qualified Charitable Contribution.
the withdrawal is still tax-free if it goes directly to a 501c3 nonprofit. In a year where you're required to take minimum distributions, which might be next year, you can offset those required distributions by making a QCD. So if next year in 2021, the IRS says, okay, you've got to take $10,000 out of your IRA this year. If you're charitably inclined,
you can go ahead and make a $10,000 QCD to offset that tax bill. And then you're not taxed on that required distribution. I said something a second ago that I want to highlight, which is you do have to be charitably inclined and never, ever, ever suggest that somebody uses one of these charitable giving strategies to try and get a tax break. It doesn't really work that way.
If you're already charitably inclined, if you're already going to give money away, there are often tax advantage ways to go about doing that. So you're not going to do a QCD if you're not already charitably inclined, but if you are, it is one way to help offset taxes or lower your future taxes, which was the third thing I mentioned that one of the benefits is lowering your future RMDs. If you have a million dollars in your IRA account,
and you process a $100,000 QCD this year, well, now you have $900,000. And that $900,000 balance is a part of the formula that's used for your required distributions. So as that IRA balance goes down, you're going to reduce your future RMDs, which reduces your future tax bill. Now, again, you're missing $100,000, right? That money went to charity.
But again, if you're already charitably inclined, if you're already going to give that money away more often than not, again, it depends, right? Talk to your trusted advisors, but donating that money from that pre-tax account is likely more tax advantage than writing a $100,000 check from your checking account.
The last thing that I want to mention here is that QCDs are often not documented correctly when tax returns get filed, even when experienced CPAs are in the picture. So just be sure to document your QCD when you do it, or if you do it, and just triple check your taxes before filing to ensure that it gets processed correctly. We've seen too many times QCDs not getting documented correctly, and it can be a costly mistake.
and tricky to fix. So just pay attention if you're going to do a QCD, make sure your CPA has all the information and just triple check that thing before it gets filed.
Okay. The third and final strategy to consider this year is a 1035 exchange. So here's the deal. Too many people I'm meeting with these days hold sizable amounts of money in cash value, whole life insurance policies, and variable annuities that are just riddled with fees. Just the other day, I think we came across one that was charging 1.8% per year. So
And as much as I just, I want to blow these policies up and just cash them out and have these clients start over. We of course have to be careful because a lot of these policies have capital gains built into them, especially the ones that have been held for a long period of time. So my suggestion here is twofold. As part of your year-end planning, if you have any, I'd like you to zone in on any of these cash value life insurance policies or annuities that you might have.
And this first step is to zone in on those and contact the insurance company. You just call the 800 number on your statement. You don't even need to call your advisor if you have one. Just call the 800 number on your statement, contact the insurance company, and ask them two questions. Ask them when the policy can be surrendered without fees, and also ask them what the tax consequences will be if you were to liquidate the policy. This is just hypothetical. Just ask them these hypothetical questions.
When can the policy be surrendered without fees? And what are the tax consequences if I were to liquidate this policy? And they'll give you that information. They'll run a tax scenario for you and show you exactly what the tax consequence will be.
The second step, once you have that information, you can devise an action plan for swapping those investments, those policies for something that might be more suitable. And just a quick side note here, there are unique situations where a cash value life insurance policy makes sense.
specifically if your estate is in need of a large sum of money when you pass away. There are other situations as well. A very, very small percentage of the population really needs a permanent cash value life insurance policy. But if you have a unique situation like
that, then you probably should hold on to your policy. So I'm not making this blanket recommendation here that everybody go out and blow up these policies. In some circumstances, there are reasons for holding on to them. But for most people that we meet with, for most retirees, it really doesn't make sense.
If you aren't an ideal candidate for a permanent life insurance policy or one of these variable annuities, and you found out that by selling it, you're going to trigger a tax bill, then you might consider a 1035 exchange. So for example, maybe you've had this cash value whole life insurance policy for the last 20 years. It's kind of just sat there doing its thing. Today, the cash value is $250,000.
But you find out through your conversation with the insurance company that you have a cost basis of $100,000. In other words, you'll pay taxes on the difference that $150,000 of gains, that's the difference that you're going to pay taxes on.
Instead of selling and liquidating this policy and paying the taxes and then reinvesting the proceeds somewhere else, you might instead consider exchanging it into a low-cost deferred annuity or another similar insurance product that's more fitting. These low-cost deferred annuities are offered by Vanguard, Fidelity, Schwab. I think Nationwide has one, Jackson National. They're low-cost. Like I said, they don't have any upfront fees.
And if they do have ongoing fees, again, they're palatable and really, really competitive and low. By doing this, you're able to get out of an expensive insurance product. Again, some of them are charging 2% or more per year. You're able to get out of an expensive insurance product that you, again, probably don't need.
defer the capital gains tax, continue investing and growing this pot of money that you have, and then take your time developing a longer term strategy for paying the tax bill. Maybe paying the capital gains tax bill right now doesn't make sense. Maybe it makes sense to do it in the future or slowly over time. You can build out a longer term strategy while also getting out of this expensive product that you don't need and putting that money in something more efficient.
I'm sure you're familiar with 1035 exchanges. You've heard them before. There are three important things that I just want to leave you with on these things. Number one is only certain insurance products are eligible for a 1035 exchange. So just be sure to check on what you have and what your options are for exchanging it.
Number two, and this is a big one, the 2006 Pension Protection Act modified the law to allow exchanges into long-term care products. So for a lot of our clients, we're able to repurpose these high-cost insurance policies that they don't need.
especially when they have capital gains in them, we're able to repurpose them to provide long-term care protection in retirement. So instead of this cash value, whole life insurance policy, that's going to pay out at your death, you know, something that you're not going to benefit from or, and something you don't need, you can actually repurpose that for something that you really might need like long-term care, right? Like 70% of people over age six, you're going to need some form of long-term care.
So 2006 Pension Protection Act modified that law. So that's really good to know. Number three, if your insurance policy is currently under a surrender period, exchanging into another product will still cause you to get hit with those surrender fees. So in other words, an exchange is considered a surrender. It's not a way around surrendering the policy. However, if and when the surrender fee gets low enough,
sometimes it makes sense to go ahead and surrender it early or exchange it early, pay that surrender fee, and then move that product somewhere else. It depends on the cost, right? So you have to do a cost benefit analysis here, but depending on those internal costs of the current product versus the product that you might be moving to, in some cases, once you get down to one year left or two years left, depending on that surrender fee schedule, sometimes it does make sense to process it early, just do the analysis, but at the
big thing I wanted to highlight was in exchange is considered a surrender. So if your policy is still under a surrender period, in exchange is not a way around that. As always, just be very, very careful with processing exchanges and surrendering insurance policies. There are a lot of nuances. Talk to your trusted advisors, make sure you understand the tax consequences and the fees before just going and doing anything. While a 1035 exchange might not lower your tax bill today,
It can help lower your fees, which is really, really important. And it can also help you mitigate future taxes and give you more control over your tax bill in retirement. It's also going to help improve the growth of your money, depending on what kind of product you move it to, because you're lowering those internal fees.
Alternatively, again, the money might be able to be better optimized for something that's more fitting for you like long-term care or even just a low cost deferred annuity to continue growing that pot of money. For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 91. I hope you have a safe and wonderful holiday season and I look forward to seeing you back here in 2021.
This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.