With Phil DeMuth, Managing Director at Conservative Wealth Management and author of The Overtaxed Investor: Slash Your Tax Bill and Be a Tax Alpha Dog
When it comes to figuring out the tax code, most of us meander between Confusion Lane and Anxiety Road. You want to pay the legal amount but not a penny more, so how can you arrive within that safety zone?
Phil DeMuth addresses this conundrum in his new book, The Overtaxed Investor: Slash Your Tax Bill and Be a Tax Alpha Dog, an especially important read if you’re an investor in a high-bracket watching the earnings from your portfolio being poured out each year into the coffers of the tax authorities.
A California resident in this group, for example, could be looking at 33% of all earnings from dividends and capital gains going to the state and federal governments, a sure roadblock to building wealth. As a counter-measure, Phil advises that all dividends, stocks, taxable funds, everything which is tax-intensive, be held in tax-qualified accounts such as 401ks or IRAs and to steer clear of mutual funds that pay dividends and incur capital gains.
And if you are invested in high-dividend stocks, make sure to house them inside a tax-qualified account, like an IRA.
For those approaching retirement, you want to avoid finding yourself in a higher tax bracket because you’ve saved diligently and socked away a large portion of your income into a large IRA which requires you to begin taking distributions each year according to the government’s life expectancy schedule. Phil says that somewhere before retirement, perhaps in your 60s, it would be smart to convert some of your IRA to a Roth IRA, transferring only an amount that puts you in a more reasonable tax bracket.
When it comes to taxes, avoidance doesn’t pay, but a well-thought out strategy to keeping your hard-earned money working well for you into retirement does. Phil DeMuth’s entertaining book, The Overtaxed Investor: Slash Your Tax Bill and Be a Tax Alpha Dog, can help steer you away from your tax code worries.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: Who understands the entire tax code? The answer is no one. No one understands this tax code. Finding your tax rate is like shooting a ball into a pinball machine. You watch it getting slingshot around the board lighting lights, buzzing buzzers, and ringing bells, until the end when you look up at the game board and you find out what you owe. Well, that’s craziness. How do you get this craziness under control, so you end up paying the legal amount due in your taxes but not a penny more? Well, my next guest, Phil DeMuth, answers that question for us in his new book The Overtaxed Investor: Slash Your Tax Bill and Be a Tax Alpha Dog. Phil DeMuth, welcome back to the show.
Phil DeMuth: Hey! Great to be here. Thanks for having me.
Steve Pomeranz: It’s my pleasure. You write, “For the first time in years, it pays to take a lifetime perspective on your taxes.” What does that mean?
Phil DeMuth: Well, the tax code, believe it or not, it’s gelled like an aspic into place for a while. It’s unlikely that the presidential candidates will be able to do very much mischief to it, so now the tax code is stable and the rates are high, and your investment returns are now relatively low. You’re not making 30% year after year after year. It makes a lot of sense to pay close attention to frictional investment costs. It’s how much you’re paying in fees, how much you’re paying in taxes. Then to really try to get these down, especially if you look out ahead, you can actually start to do some lifetime tax-planning. If you hadn’t been doing it—which you couldn’t do before because the tax code would always change at the end of the year with all these last minute shenanigans by congress—it’s time to start.
Steve Pomeranz: Well, you say that investment returns are variable, but taxes are a constant. The smart move is to plan around the constants and not the variables; in other words, deal with realities instead of fantasies. Give us some examples of how these taxes are a constant. Let’s talk about dividends on common stock.
Phil DeMuth: Absolutely. One of the most horrible things—I live in a state called California. In California, for a high-bracket earner, you have to pay 33% of all your earnings from dividends and capital gains and pay them to California and the federal government every year. Now, if you have a hedge fund, and they charge a lot, you’d be paying 2% and then 20% on your earnings. In California, it’s 33%. In New York, it’s 31%. These tax rates are astronomically high. It’s impossible to really build very much wealth if you’re constantly taking that much money and just shoveling it into the open “jaw” of the taxing authorities every year.
Steve Pomeranz: Yeah.
Phil DeMuth: Instead, you want to keep that money in your portfolio compounding year after year without having to pay the croupier. That’s why I encourage especially high-bracket types to get out of these mutual funds that pay dividends and a lot of turnover capital gains every year, and try to invest in companies like Berkshire Hathaway that are like mutual funds all by themselves, but they don’t pay dividends, this compounds internally.
Steve Pomeranz: Remember on this show we don’t recommend stocks, but I think Berkshire Hathaway is kind of a special case, and it’s a very good example to talk about a company as diverse and as well-managed as Berkshire Hathaway. Let’s get this clear. Most people think, “I’m going to be retiring,” or, “I am retired so I want stocks that pay high dividends because also those companies, the better ones, increase their dividends faster than the rate of inflation over time. I want to be a part of that.” You’re saying, “Hey, wait a minute. Maybe that’s not the best strategy.” Let’s say I wanted to invest in companies that are paying high dividends. Should I not invest in them at all, or should I put them in a different kind of an account that maybe you don’t have to pay taxes on?
Phil DeMuth: Absolutely. I love high-dividend stocks. I’ve been writing about them for years. The thing is, if you are going to be paying taxes on these hydrocodone online mexico dividends, it’s better to house the dividend stocks or the dividend mutual funds inside a tax-qualified account, like an IRA. That way you only have to pull out as much as you have to pull out. Even if there are a lot of dividends on there, you don’t have to pay taxes on them unless you break open the piggy bank and actually pull them out of the account for your personal use. Whereas if you put them in a taxable account, you got to pay taxes on them whether you need them or not. That’s clearly the answer.
Steve Pomeranz: In accounts that are not tax-deferred, or in the case of a Roth, which the earnings are tax-free. Therefore, you’re saying put those kinds of investments in there that actually don’t pay a lot of cash flow in terms of, let’s say, taxable interest or taxable dividends. Right?
Phil DeMuth: Right. This is one of the things that comes across loud and clear when you look at how investors approach their accounts. Most people just shove everything into the same kind of account willy-nilly. The same thing’s in their taxable accounts, on their IRAs, they’re on their Roth, as on their 401ks. This is wrong. This is the wrong way to go about it. You want to keep anything that’s tax intensive—dividends, stocks, taxable bond funds, alternative funds—you want to house those in your tax-qualified accounts like your 401k or your IRA. You want to try to keep your taxable accounts, your brokerage accounts, full of things that are fairly tax efficient. Especially you want to avoid mutual funds that have a lot of internal turnover, or you’re going to get taxed on the turnover whether they make money or not, like happened in 2015.
Steve Pomeranz: My guest is Phil DeMuth. The book is The Overtaxed Investor: Slash Your Tax Bill and Be a Tax Alpha Dog. When do I know, how do I know how much, or whether, I should fund a retirement plan and, let’s say, get a tax deduction against ordinary income? Or whether I should just fund a Roth instead, or not fund them at all, and just save it in a taxable account? How do I make that decision, Phil?
Phil DeMuth: Well, for the vast majority of people, the default answer is fund your all retirement accounts to the limit every year. If you want to get to the next level—and let’s talk about should I fund a Roth versus a traditional IRA—then it’s a big question of what are your taxes now versus what kind of taxes do you need to be paying in retirement. For most people, what they’ll find is they’re paying a lot of taxes now while they’re working, but they won’t be paying taxes in this high a bracket when they retire. They want to grab the upfront tax deduction and put everything into a traditional IRA. There are some people whose taxes might be the same when they retire. It might even be higher when they retire for whatever reason. People in that situation ought to be funding a Roth now.
Steve Pomeranz: We occasionally get clients who come in, individuals seeking advice, and so on. We realize that over the years they’ve put almost all of their savings into tax deductible 401k plans or IRAs. Then as they age and they retire and they get to age 70 where they’re now required to take that money out, I find, in some cases, they have very little in taxable money, and all of their income that they’re taking out is out of these qualified plans. They’re paying the taxes. Even sometimes, especially as you get older, you’re required to pull more and more and more out of these taxable plans, even though you may not be spending it all, so your tax bill is huge. You know, I can’t say that word huge anymore. Right? I got to be really careful on how I say that. Let me just say it. Huge. Okay. Only one U in that word. Anyway, shouldn’t you do some planning beforehand? You say, fund your retirement accounts fully, but shouldn’t you have a bunch of money sitting in taxable accounts, too?
Phil DeMuth: What we find is that, for most people, there is a window of opportunity between the year they retire and the year that they turn 70 and a half and start to have to take these distributions out of their IRAs. People that have these large IRAs…you’re a doctor and you put everything in an IRA every year. Suddenly you retire, and you’ve got an IRA worth $5 million and you got to start taking distributions every year. It gets worse because the IRS forces you to take out the distributions on a schedule of their making.
Steve Pomeranz: Right.
Phil DeMuth: What happens is this schedule wraps up over time. It starts out low, but then 10 years later they’re making you take out ever larger and larger fractions of the account. Suddenly you see, if you look out ahead, if you could just do lifetime planning, you say, “Wait a minute. I’m going to be 85 years-old, and I’m going to be in a super high tax bracket and just giving all this money to the government.” What you want to do is in that window of opportunity, typically in your 60s, between retirement at age 70 and a half, you want to start doing partial Roth conversions.
You want to take some of the money out of your IRA and you want to convert it to a Roth IRA right after the top of whatever tax bracket makes sense. That way you bleed down your IRA as fast as you can and still at a lower rate. You want to pay taxes at a smooth, low rate forever. What you want to really avoid in our tax system is getting bumped up into higher brackets because the tax code rises very steeply, and you won’t like a haircut you get at the top.
Steve Pomeranz: Yeah. I think it’s very good advice to start thinking about it as soon as, let’s say, when you retire, if you’re, in fact, in a nice, low bracket to start taking some money out of your big IRAs, moving it into a Roth. Yes, you’ll pay taxes but only take out that amount that brings you up to a reasonable tax bracket and don’t take out any more. Make sure you do your calculations correctly so you don’t make a mistake on that. That way, you’re finally taking money out at a relatively low bracket because in later years, as that money builds and builds and you’re required to take more and more and more, you may end up with a very, very big tax spike.
Unfortunately, we’re out of time. My guest is Phil DeMuth. The book is The Overtaxed Investor: Slash Your Tax Bill and Be a Tax Alpha Dog. It’s a terrific book written very entertainingly, and I think that is something that everybody can understand and enjoy. Hey, Phil. Thanks for spending the time with me.
Phil DeMuth: Thanks for having me.