Do you want a wealthy retirement without worrying about money? Welcome to “Retire in Texas”, where you will discover how to enjoy your faith, your family, and your freedom in the State of Texas—and, now, here's your host, financial advisor, author, and all-around good Texan, Darryl Lyons.
Darryl: Hey, this is Darryl Lyons, CEO and co-founder of PAX Financial Group, and you're listening to Retire in Texas, so thanks for tuning in today. I have to give you the legal disclosure as usual. This information is general in nature only. It's not intended to provide specific tax or legal advice. Visit PAXFinancialGroup.com for more information. [00:47.4]
This podcast, I want to talk about tax diversification. A lot of times we talk about diversifying your money into different baskets. Don't put all your eggs in one basket. We hear that a lot. And then like the nerds will say, “Hey, you need it,” and I guess I'm in that camp. “You need some small cap. You need some large cap. You need some cryptocurrency. You need some bonds. You need some real estate. You need some cash. You need some gold,” right? Those are all what we consider different asset classes.
This is, I'm actually talking about tax diversification. How can we diversify from a tax perspective? I consider there's really three ways to consider tax diversification, and, really, three. There are subsets of these three, but there's really three, and so I'm going to dive into all three of those and give you kind of an idea of how you should be thinking about these along the way. Maybe you split it up into thirds. Maybe you don’t.
I think this is where it kind of gets into healthy dialogue with a financial advisor, because it certainly depends on the bracket you're in now. If you're in a high-income bracket, I may want you to get deductions today. But there's a part of me that also wants you to have some tax-free income down the road. So, there's very much a judgment call in how to organize the tax bucket, so to speak, and then I’ll give you insight into that thinking. [02:05.8]
But, again, there's three different ways to execute tax-- Not execute. There's three different types of tax-diversification strategies and how you execute that is slightly different. Let's talk about the first one. The first one is considered non-qualified accounts. Non-qualified, usually in your bank account, it's titled, joint tenants with rights of survivorship. It could also be, in other states, tenants-in-common, JT TEN.
That titling is really recognizing the ownership structure if somebody should die, who takes over the account, and I'm not necessarily going to get into that specific structure of beneficiary designations. I'm just helping you recognize, if you see those letters on your bank account or your investment statement, then it's under the category of a non-qualified account. Does that make sense? I hope it makes sense. It's not an IRA. You can't have, you cannot have a joint IRA. It's basically considered a non-IRA, and, oftentimes, we call it a non-qualified account. [03:14.8]
What are the tax ramifications of a non-qualified account? Any growth on that non-qualified account, depending on the type of growth, will be subject to income taxes due next year. Now, not all growth in a non-qualified account is taxable in that year.
For example, if you own a stock and the stock went up in price, but you didn't sell it, then you don't have any taxes that year, but if you sold it, you could be subject to capital-gains tax. If you sold it, without holding it for an entire year, it's going to be higher capital-gains tax. So, any stocks that you hold, you want to hold it longer than a year, but in a non-qualified account is where it really matters. [04:06.6]
Interest and dividends are going to be taxable that specific year in a non-qualified account, with the exception of municipal bonds, generally speaking, municipal bonds which are bonds that are issued by counties and municipalities. They could be utilities. They could be states. Those specific types of bonds that pay interest are typically not taxable in your non-qualified account.
So, you can put a lot of things in non-qualified accounts. You can actually be intentional about what you put in there. For example, if you put your stocks in there that you're never going to sell, then that's probably a pretty good move because you won't ever really have to pay taxes on that until way down the road, so it grows tax-deferred and a pretty efficient investment to put into a non-qualified account. [04:55.4]
But just know that the non-qualified accounts, generally speaking, like a CD or a money market, those are going to be taxable each year, and right now the interest on them is pretty good. I mean, you're earning. It depends, I mean, I’ve seen as high as 5% and it's kind of hanging around 4% right now, but because interest rates have gone up, that's pretty good, a pretty good place to have your money in non-qualified accounts that are interest-bearing accounts. So, not terribly opposed to anybody considering CDs or money markets.
By the way, if you're a PAX client, we’re always exploring the interest-bearing alternatives out there, so just keep checking with us on those. We feel that that market is changing quite a bit. But we might actually say, hey, here's a good question for you to ask about a non-qualified account. Is it better for me to base it on my tax bracket? Is it better for me to own a CD or a money-market fund, or is it better for me to own municipal bonds? Because in a municipal bond, if it's tax-free, maybe you're getting a lower rate, but because it's tax-free, you get to keep more of it than a CD. [06:04.5]
So, ask your advisor in a non-qualified account, depending on the time horizon, ask them if it's better for you to own municipal bonds or a municipal-bond fund than it is some CDs, or money markets or CDs. That's kind of how you think about a non-qualified account.
Now, a tax-deferred account is going to be there's a lot of things that go in a tax-deferred account, but like traditional IRAs, traditional 401(k)s. Those are typically going to be tax-deferred, even annuities. Life insurance, generally speaking, although some life-insurance salespeople say it's tax-free, but to make it tax-free, you borrow against it down the road. I don't have a lot of conviction that those things work as well as they're sold, but that's an episode for another time.
For now, let's just talk about the tax-deferred vehicles that are more common, and there's tax-deferred vehicles where you get a deduction today. Those are very nice, like a traditional IRA. If your income is below a certain amount, you can deduct that. Don't forget, your spouse can typically deduct it in a spousal IRA, even if she doesn't have a job or he has a job. [07:07.3]
So, just so you know, you can get a nice tax deduction with traditional IRAs. You just have to check those income limits. Then the 401(k)s get a real nice deduction, too, really awesome, and SIMPLE IRAs are another way. Those are all investment solutions or, let me say this, they're kind of wrappers around your investment solutions that give you a nice tax deduction if you put money in there. Then within those wrappers, you buy whatever you want.
So, you might want to buy like dividend-paying stocks in those because they can pay dividends all day long in those IRAs and you'll never have to pay taxes until you pull it out, which is what I want to bring to your attention right now, which is what is it look like down the road when you pull it out.
This is why tax diversification makes sense, because a lot of people have money in these 401(k)s and IRAs, and they don't have to pay any taxes now, but down the road, you need to, and it still makes sense. I still want you to own it, but we just have to plan on, what does this look like down the road when we pull it out? Because there's a certain age called required minimum distribution age and that is changing, so that under the SECURE Act, there are some peculiarities about when you take your RMDs. But, generally speaking, it used to be 70 and a half and now it’s 72. But just check with your advisor on the exact age based on your date of birth. [08:20.8]
But you're going to have to take money out and the reason that you want to plan accordingly is because those required minimum distributions could be large enough that it causes you to pay more on your Medicare insurance. I mean, your Medicare could go, right now the Part B could be $164 and it could jump up all the way to $500. $560 is the max. So, it could go up 400 bucks. Now, that's a huge example, but I just want you to know, if you don't plan that RMD down the road accordingly, you might end up paying more Medicare taxes than you expected.
So, I just want you to be very aware that not only could it push you up in a different tax bracket down the road, but it could also cause pressure on your Medicare premiums so be careful. That's why good tax planning is good with your advisor. [09:08.2]
The tax deferred stuff, the IRAs, the traditional IRAs, the 401(k)s are really good, but you’ve got to pay attention to how it impacts you down the road and you just model that out with some calculators. Any good advisor can do that. Any good advisor can do that. So, that's when we kind of say, maybe we should consider converting some of these tax-deferred.
This brings me to the third bucket. We've already talked about non-qualified and then the tax-deferred. Now we're talking Roth. That third bucket is the Roth. Sometimes we look at it and say maybe we should convert some of these traditional IRAs to a Roth, and now when you do that, just know you pay taxes in the year of conversion and you don't pay taxes from the IRA that you converted.
Let me say that again. When you make this transition or conversion from a traditional IRA to a Roth, you pay taxes in that calendar year and you don't take it from your IRAs. You actually have to take the tax money from a different account. I'll go into the reasons later or it's probably beyond the scope of this conversation. You can talk to your advisor about this. I want to try to keep this high level. [10:06.7]
But just, I want you to know, let's say you have a bucket of money and you're going to convert to Roth, I want you to know that you need to have enough excess cash savings in your savings account to pay that tax bill next year. It's going to happen. It's going to come. But it might be in your best interest, because what we'll do, you're not forced to take money out of Roths, so down the road, you've just lowered that RMD, the required minimum distribution, by converting money to your Roth.
So, it's a really good strategy to reduce your future required minimum distribution by converting a portion of your IRAs to Roth. It’s a really, really good strategy. It's nice to convert Roths when the market is down. It's nice to convert to Roths when your taxable income is low. Those are really good times to convert to Roths. And remember, Roth IRAs are completely tax-free. [10:57.0]
A senator from Delaware—his last name is Roth. I think it was in 1994 or 1993—created this. The government actually likes it, because you're putting money into a retirement account and you're paying taxes on it today, so you don't get any deduction when you put money in there. But it's completely tax-free when you retire.
Now, just recently, they did some changes on the beneficiary. You used to be able to leave your entire large bucket of money, which was awesome. We’d call it the legacy bucket. You used to be able to leave that entire big bucket of Roth money to the kids and grandkids, and they never had to take—I dare say never—they took a required minimum distributions over their life expectancy so it wasn't a very large amount. It was really cool. You could stretch these things over generations almost.
But now, they’ve changed the rules. They don't like that anymore. They require, if you leave your money not to your spouse, your spouse is not an issue. That's a really easy one. But if you leave your Roth IRA to your kids or grandkids, they do require the required minimum distributions to come out over 10 years, which is kind of stupid, but those are the rules that we're playing with according to the SECURE Act. [11:58.0]
So, I love Roth IRAs. In fact, if we kind of summarize this conversation, I hope it wasn't too boring for you—I hope it was at least educational and you got some good nuggets out of it—but if I could suggest anything, I'd suggest some tax diversification. Have a little bit of each, non-qualified, tax-deductible, tax-deferred, and then the Roth, and just work with your advisor on how much and what bucket.
What's cool is, even if you have a 401(k) plan with your company, the 401(k) plans now have a Roth feature, so make sure you're checking the box, and if you're retired, maybe tell your kids, “Hey, be sure to check that Roth box in your 401(k),” because I'm telling you guys, I’ve seen it over the years—I’ve been doing this for a long time now now—the people that accumulate money, man, they just save it and they just pound it away, pound it away, pound it away, and they just keep growing it, and sometimes the 401(k) is one of the best ways to do it. And if you tell your kids or your grandkids, do it through the Roth, they'll have a huge bucket of money when they retire and it'll be completely tax-free. It's crazy.
So, I really love the Roth 401(k). I want you to lean into that. But don't forget about the other elements of tax-diversification through the non-qualified accounts and the tax- deferred accounts. [13:04.3]
Hope that helps. That's an executive summary. There's a lot of little details I left out because they're anecdotal kind of exit ramps, but check with your advisor and say, “Hey, Darryl talked a little bit about tax-diversification. Can we jump into that and start strategizing, planning that out?” That's right up there nerd wheelhouse and they'll be happy to help you with that.
So, hope it helped today and I hope you got a few nuggets. And as always, I want to remind you that you think different when you think long-term. Have a great day.
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