Three Tax Tips

It is time now for Mr. Stillman's Opus with John Stillman of Rosewood Wealth Management, and today John is going to talk about three common tax mistakes.

John, we're looking forward to hearing this. So tax mistake number one, and we could just study the life of Willie Nelson and come up with some pretty interesting tax mistakes. My favorite Willie Nelson tax mistake, he'd done something with buying cattle. I can't remember exactly the details, but some tax advisor had told him that he could use cattle as a tax shelter, and I don't know, for whatever reason, it wasn't the deduction that he thought it was going to be, and this was one of the first times that he ever found himself owing the IRS money was because he thought this cattle was a tax shelter and it was not.

Okay, he got some bad advice, in other words. Anyway, that has nothing to do with what we're talking about today, as that is not going to apply to most people. So tax mistake number one, and I see this one all the time, and it's just something, it's a mistake because people don't ever think about it. And that's not investing aggressively enough in your Roth IRA. You say, well, what does that have to do with taxes?

You're talking about investment choices. Well, let's think about what the Roth is. The Roth is an account where all of your money is growing tax-free. So if we put in $5,000 and it grows to 50, we can take out 50 without paying any taxes.

You're not paying taxes on the gains, you're not paying taxes on any of the growth. That's the power of the Roth. And so what I see a lot of people do is they'll come in, they'll bring all their statements and they'll have a couple hundred thousand in an IRA, half a million in their 401k, and maybe a hundred thousand in a Roth. The 401k and the IRA are both invested pretty aggressively.

They're paying attention to it, trying to maximize their growth. And they have the Roth just sitting in cash basically, like sitting in a money market fund or something. And it's because they're not thinking about why they're using the Roth. It's just that somebody told them a while back, hey, you really should be contributing to Roth. So they'll put their 5,500 or 6,500 a year into the Roth and think, okay, well, I'll invest that at some point. And the next thing you know, you've contributed to the Roth for 15 or 20 years and never really got around to paying attention to the investments. The problem with that is if we just put money in cash in a Roth, we're not experiencing any of that tax free growth that the Roth gives us the opportunity to have. So if you put in $5,000 and it grows to $5,200, well, big deal. You know, we haven't accomplished much.

All that tax free growth, we just didn't take advantage of it. So generally speaking, in most of our plans, and this is not always the case, there are exceptions if we need it for tax planning purposes, but for the most part, we want the Roth to be the most aggressively invested account that you have. We want that to be the last money you touch because the bigger we can make that account, the more tax free dollars you've accumulated for yourself. So that's one that we want to, in a lot of cases, shake up the way that you've invested. Sounds like everybody else or so many people look at it in just the opposite way. It's the least aggressively invested. Yeah. And I, it's not like they have a strategy behind that. It's just, that's kind of how it's happened for whatever reason. So that brings us to mistake number two, which is withdrawing from the wrong accounts in the wrong year.

So what do we mean by that? Well, we're talking about when you're retired and let's suppose that you need $120,000 of income. So part of that $120,000 is going to be your social security. Obviously for whatever other money you need, we don't want to just take all of that money out of a 401k or an IRA.

Why is that? Well, because if you look at your tax brackets, your first roughly, if you're married filing jointly, your first $100,000 or so of income is going to be in that 12% tax bracket. If you take out more than that from an IRA or a 401k, it's going to be in the 22% tax bracket. So that means our first $100,000 will have paid 12% on, but the next 20,000 that we're taking out in this scenario, we're paying 22% on.

Whereas if we have an after tax account where we can just sell some stock or sell some mutual funds and just pay capital gains on that, we're going to pay a much lower tax rate overall to generate that income than if we took it out of a 401k or an IRA. Frustrates me to no end how little communication there often is between financial advisor, client, and if there's a CPA or tax preparer involved, how little communication there is between these three people about this tax planning kind of stuff. And we do a lot of this kind of tax planning here because I feel like it's so important. And very often we're having the conversation, we're coordinating with clients CPAs to be sure we're making the best choice that we can. But so often across the industry, I see these conversations not happening and it's so important, not just what you invest in, it's when you take money out of certain accounts in certain years. And we have to be really careful about that when we're putting together your retirement income plan. Most people don't give that any thought at all.

Well, those are two tax tips for all of us. And it sounds like, you know, these are insights that most people just don't have, Jon. I mean, you know, a lot of those things you just talked about I haven't really thought about and I'm betting that a lot of people listening to this are in that same category.

Yeah. And there's a lot of things in the financial world where it's like you're thinking about it wrong and we need to change your thinking. But very often with this tax planning stuff, it's not that you're thinking about it wrong, it's just that you're not thinking about it.

It's never even crossed your mind. Oh yeah, this is something I should consider. So just something you want to be paying attention to. So as Meat Loaf once said, two out of three ain't bad, but what's the third tax tip?

It's a very loose Meat Loaf quote. So the last thing is not understanding the inefficiency, the tax inefficiency of mutual funds. So you never notice this at all. If you have mutual funds in your 401k or your IRA, this isn't an issue. This conversation doesn't apply.

But if you have mutual funds in an after tax account, if you've bought mutual funds with after tax money, you'll notice that every year you're going to have some sort of tax liability with those mutual funds and here's why. Let's say you own a stock. Pick a stock that you want to go buy.

Name the company. Apple. You want to go buy some Apple and let's say you bought Apple at $100 a share.

Okay. And as we record this, let me just check my stock ticker now. We'll see where Apple is today. Apple right now is at $229 a share. So you bought it at $100 a share.

It's now at $229. That means if you turn around and sell Apple, you have $129 of capital gains. You'll pay taxes on those capital gains. But the thing is you were in control of that transaction. You sold the stock whenever you wanted to and you're going to pay those capital gains. If you own a mutual fund, the fund managers within that fund are constantly buying and selling within their management of the fund.

And you don't have any control over. You have no control over when you buy and sell and as they're buying and selling, they're creating capital gains very often. And as someone who's invested in that fund, you're going to have to pay your share, your proportional share of those capital gains. So again, if you have money in an after tax account, very often, much more efficient if you'll invest in ETFs, which are a lot like mutual funds, but they don't have this tax inefficiency that mutual funds have. Now is that to say that you should never, ever invest in mutual funds and an after tax account? No, we're not saying that because there are cases where it makes sense if we need a particular fund to do a particular thing. But in general, if you're just looking for a sort of a buy and hold strategy, mutual funds and an after tax account are not the best idea. Although that makes perfect sense.

Thanks for explaining that. If all the things John just talked about sound interesting to you and if you would like to follow through on some of these insights, then get in touch with John Stillman at Rosewood Wealth Management. You can go to rosewoodwealthmanagement.com. That is rosewoodwealthmanagement.com and you can find out more. John Stillman would be happy to talk with you and help you with these tax ideas, three of them or just one of them, whatever your choice. John Stillman, Rosewood Wealth Management. You've been listening to Mr. Stillman's Opus.