How to Build a Tax-Efficient Portfolio (Advanced Strategies)

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2:37Mindy Jensen:Index funds will get you to fire, but will they get you there fast? If you're willing to take on more risk for potentially faster wealth building, there's a whole world beyond the traditional stock bond portfolio. The question is, should you go there?

2:55Mindy Jensen:Hello, hello, hello, and welcome to the BiggerPockets Money Podcast. My name is Mindy Jensen, and with me as always is my trustworthy co-host, Scott Trench. Thanks, Mindy. Great to be here. You're my financial model co-host. Thank you so much for all you do. We are so excited to be joined by John Bowens from Equity Trust on today's episode. He has been on the podcast us before, and he's just such a wealth of knowledge. We're going to be talking about advanced portfolio strategies in today's episode. And before I monologue about them, I do want to welcome John. John, thank you so much for coming back.

3:23Hey, thank you, Scott and Mindy, as always, for having me. Awesome. All right. Now for the promised monologue here, we got to set this up because this is a really advanced discussion. If we're going to be investing in alternative assets like private equity, private lending, venture capital, real estate, private businesses, and other types of similar assets inside of our retirement accounts, we need to be aware of or have a philosophy, I believe, or strategy for where to allocate those assets and how to hold them in the context of our entire net worth or more broadly diversified portfolio. In the context of a broadly diversified portfolio, generally speaking, I believe that best practices are as follows.

4:06First, we're going to keep the most aggressive portion of our investment assets inside of a Roth IRA or an HSA or equivalent. Second, we're going to put the least aggressive, the most conservative portion of a portfolio inside of the 401k or tax deferred plans. That means by process of elimination, we're going to have the more balanced or hybrid assets inside of the after-tax portfolio outside of those retirement accounts. The reason for this is that the Roth grows tax-free and can be passed to heirs tax-free. We typically, in most withdrawal strategies or order of operations, will withdraw funds and assets from the Roth IRA last for tax maximization purposes.

4:50And therefore, we can stomach or handle the largest possible amount of long-term growth and largest amount of volatility inside of that Roth IRA. The pre-tax accounts like the 401k are often going to be withdrawn first or second in most retirement planning scenarios. These accounts are likely going to be taxed at some point, either in our lifetime or when they're past or heirs, and all withdrawals or conversions will generate ordinary income. While there are opportunities to convert or withdraw in low marginal tax brackets, as a rule, the 401k funds will be subject to higher relative tax brackets.

5:24Thus, it makes sense to have the relatively conservative portions of our portfolio more concentrated in these tax-deferred accounts. Last, our after-tax investment positions will either generate ordinary income or equivalents, short-term capital gains, or long-term capital gains in qualified dividends. And for many retirees, basis recovery and generous 0 % long-term capital gains brackets today means that there's going to be very little tax consequence, up to about$100 ,000 or so for those married filing jointly on their tax returns. So in a traditional stock bond portfolio, that might mean holding more bonds in a 401k or tax deferred account and holding all equities in a Roth IRA or Roth 401k with our after-tax brokerage account holding a mixture to get us to our desired overall portfolio allocation.

6:13But how does that change if we're investing in alternatives like real estate, private debt, private equity, crypto, gold, or commodities that aren't as common and may generate substantial amounts of ordinary income or simple interest. That's why we're going to talk to John Bowens today. I believe those rules will shift and change in specific scenarios, and there's additional considerations to think through. So John, first of all, grade me on my approach, on my setup here. How am I doing in framing the challenge of portfolio theory in the context of using self-directed accounts? I think you're doing well, Scott.

6:48What you're doing is you're presenting a lot of the foundational principles that are used in traditional financial planning. Now, having all that being said, you then mentioned at the very end, well, what happens when we introduce alternative investments like real estate? And within real estate, you have different forms or asset classes within real estate. For example, a single family rental property, a apartment building syndication, a private debt fund. We've talked a lot about that. You referenced interest income, Scott. And so you really have to look at it through the lens as an investor yourself, your specific facts and circumstances in terms of what we call asset location.

7:34So I think you may have referenced in there, Scott, allocation. So looking at how you allocate your overall, your broader portfolio across your taxable and non-taxable accounts. But I think that this is much more a topic of asset location, meaning where do we put specific assets like a single family rental property, real estate syndication. And then, of course, for those that also are diversified into publicly traded assets like stocks, mutual funds, bond funds, there's different nuances as we think about that. I think a good way to break this down, Scott, for viewers is there are three buckets that we always talk about.

8:19There's a taxable bucket, number one. So that's your brokerage accounts, your savings accounts, your checking accounts, your business checking and savings accounts. You can put that in there as well. That's your taxable account. Every dollar that you invest, if you're making profit, unless you can write off a bunch of that profit through depreciation, you're going to pay taxes, right? That's the reality of it. Bucket number two is what we call our tax deferred bucket. And then bucket number three is what we call our tax-free bucket. And you referenced that, Scott, which is traditional type accounts, 401k, pre-tax.

8:56And then you have Roth accounts, which would be funded with after tax dollars and grow tax-free and distributions are tax-free. We could also add in there if you wanted to, Scott, the HSA health savings account and the solo 401k plan. And once we get into those nuances, there are specific types of assets that we might want to consider using a solo 401k plan in comparison to a traditional IRA, Roth IRA, or HSA. And of course, as we always say here, Scott, Mindy, and certainly myself on behalf of Equity Trust, I don't give specific tax legal or financial advice or recommendations on allocation percentages, but I can certainly speak to these fundamental principles that are followed in traditional finance to help viewers.

9:46Mindy Jensen:Now let's hear a note from our show sponsors.

9:54Mindy Jensen:Welcome back to the show. What are some of the thoughts that you have around those allocation buckets? And do you agree that the aggressive portion from a principal's perspective ought to generally be in the Roth or HSA and the conservative portion in the tax-deferred accounts like the 401k and other traditional retirement accounts. You are right, Scott. So the general rule of thumb is your higher growth, higher yielding investment opportunities, whether those are publicly traded assets or are private investments like real estate, private equity, cryptocurrency, etc. You would hold in your tax-free accounts like your Roth IRA, and you could also include in there your HSA.

10:38Additionally, with a solo 401k plan, remember, you have a traditional side, call it a pre-tax side, and you have a Roth side of that solo 401k plan. So within the plan, you have traditional and Roth. They're not IRAs. You just have pre-tax money and post-tax Roth money. So your principle of higher yielding, higher growth investments in the tax-free account to reduce what we call tax drag can make a lot of sense. Now, Scott, there's always caveats, right, based on an individual's facts and circumstances. And here's what it is. In some cases, when you look at the risk to return continuum based on a specific type of investment that someone might be holding, higher yield or higher return might mean higher risk.

11:26And so if high risk could actually mean a loss in principle, well, now you've paid taxes to get the money into the Roth and now you're sustaining losses. Again, that's a caveat. That's a risk that an investor needs to take. They need to look at, they need to analyze, and maybe they need to talk to a professional like a CPA or financial planner as they navigate those waters. All that being said, Scott, I'll also say that in some cases, high return does not always mean high risk. I've been working with real estate investors almost exclusively for nearly 20 years, and I'm a real estate investor myself.

12:04And I see a lot of real estate investors that have a really good track record and success rate of investing in real estate. It's not for everybody, but for people that have a very high success rate, they might say, hey, I'm making a significant return in real estate already. And I would love to do that in my Roth IRA, my HSA, my solo 401k with the Roth component. And I feel that it's very low risk based on my specific facts and circumstances. So in that case, it would make a lot of sense for that person to hold those types of higher yielding, higher growth potential investments in their Roth IRA.

12:46One last item that I'll mention in this portion, Scott, is what about HSA, health savings account, in comparison to a Roth IRA? Well, a Roth IRA, you can't distribute until you're 59 and a half unless you're using the Roth IRA layered cake approach that we talked about, which is distributing from our contributions and our amounts that we've converted before 59 and a half. But your earnings have to stay in there until you're 59 and a half. Otherwise, you're going to have taxes and penalties. And so your longer duration investment opportunities, arguably in your Roth IRA, your higher yielding short term investments.

13:24For example, I have clients that lend money secured by real estate. So they lend money to like house flippers and they'll charge between 12 to 16 percent return in some cases. And so those types of investments I'll see anywhere between 12 to 18 month terms. So they're lending their money and they're getting their money back plus interest in 12 to 18 months. And remember, this is self-directed. So you make the decision on those terms and how long that investment is going to be held in your account. And so for those types of investments, someone might do that in their HSA because they can make a quick return.

14:04They can compound their growth tax-free, triple the tax benefits of an HSA, deductions going in, tax-free growth, tax-free distributions. And you can use that for your medical expenses well before the age of 59 and a half. And then like we've talked in other episodes, you can do what we call medical bill stacking. So you can distribute from your HSA and reimburse yourself for previous year's healthcare-related expenses. So you could use the rule of thumb of having your higher-yielding, shorter-term investments in your HSA, your health savings account, and then your higher-yielding, higher-growth investments, to your point, Scott, in your Roth IRA, in your Roth Solo 401k plan.

14:47I agree completely with that. And that's how I intend to structure my accounts there with the HSA and the Roth whenever the opportunity comes along to create a self-directed HSA for those purposes. So I completely agree. And I think that makes all the sense in the world to have realizable income that is reasonably liquid from the HSA because of that reimbursement component there. Whereas the Roth, you can just invest in the highest possible long-term growth thing, regardless whether it is liquid or not. Right. And the reason why that is, Scott, and you started to say that traditional IRA, money that went into a 401k, TSP, 403b, deferred compensation, 457.

15:27If it's all tax deductible money, you got the tax deduction now. But guess what? When you take the money out, you're going to have to pay taxes. So in your retirement years, you're going to have to pay taxes when you distribute the money. And that's where you start to feel the effects of what we call tax drag. So you're making returns in that account that are deferred, but eventually when you take the money out, whatever amount is distributed is added to your ordinary income. And remember, once you start bringing dollars into the proverbial tax net distributions from your traditional account, that impacts many different things in your overall tax situation, from IRMA to Social Security tax to the net investment income tax, if that might apply, if your income is too high.

16:14And even in your retirement years, those types of things can happen. And that's why there are folks out there that come from the school of thought of hedge against future tax rate increases, hedge against inflation using a Roth IRA or Roth solo 401k plan, even if that means converting from traditional to Roth. And add in here that Congress gave us the deal of the century with the one big beautiful bill making the tax brackets permanent. So now individuals can look at converting from traditional to Roth at potentially a much lower tax bracket than they would have had prior to 2018 and what would have ended up happening in 2026 when the brackets were to revert to the pre-2018.

17:00But now with the permanency of those tax brackets, one might be in a more favorable tax bracket to convert now rather than waiting until later.

17:09Mindy Jensen:John, I've heard people say that you shouldn't put your big real estate investments into these tax-deferred accounts because then you don't get the benefits of a cost segregation. I'm talking more like syndications where a cost segregation can have some really big tax impacts on you. What do you say to that? That can be correct in some instances. Of course, there's always caveats with that, which we can discuss. But what you're saying, Mindy, follows the principle of you put your tax efficient investments in your taxable bucket. So going back to our three buckets, taxable bucket, tax deferred bucket, tax free Roth or HSA bucket.

17:52So your tax efficient investments could be something like a real estate syndication where it's an apartment building, for example, or a self-storage deal, and they're doing a cost segregation study and with bonus depreciation, they're showing a lot of losses. And those losses, depending on your status, your tax status could potentially offset your W-2 active income. For example, if you meet real estate professional status, which I know you guys talk about quite routinely on this podcast. And so there can be an instance based on that individual situation where because of the tax efficiencies associated with those types of real estate assets, One may want to do that in their taxable savings or their taxable bucket.

18:37And then they would reserve other investments for their traditional and their Roth. Again, following the same principles that we talked about before, your lower yielding, lower growth investments in your traditional, and then your higher yielding investments in your Roth. A good example of a tax, call it inefficient investment. So a tax efficient investment, again, we're talking about real estate syndications in that example. But what about a tax inefficient investment? A great example is a loan secured by real estate or investing in a private debt fund. Why? Because it's all interest income. An interest income is subject to what tax rates?

19:21Your ordinary income tax rate. So let's say I'm married filing jointly and I have$300 ,000 in income, I'm at the 24 % tax bracket. So that means 24 cents on every interest dollar that I make on a private money loan or an investment in a private debt fund is going to be subject to 24 % tax, right? 24 cents on every dollar of interest income that I generate. So that would be considered a tax inefficient investment. And the tax inefficient investments we would want to, to our best ability, have in our traditional or Roth IRA or HSA. Arguably, if they're higher yielding investments, where would we put those?

20:05Just like Scott said, in the Roth IRA, Roth 401k or HSA. Yeah. And then we did a really in-depth episode with you a couple of months back, I think in Q1 of 2025 here, John, where we talked about investing in real estate, direct ownership real estate using an IRA? And the answer is that, yes, you can do that. And there can be advantages to that. And particularly those advantages are for folks who have most or all of their wealth in that vehicle, in their 401k or Roth IRA, and or who are just entirely comfortable with real estate comprising most or all of their portfolio, really skilled in that area.

20:43And I think that today, I think it's a good reminder, these syndications, for example, that have these big losses, for example, the tax losses, those might be something that many folks want to consider outside of the retirement accounts. If you've got a couple hundred thousand dollars and spread across these different buckets, the bucket that is going to be after tax, that would make a lot more sense for maybe like a traditional apartment syndication where you're a common equity participant, whereas a preferred equity or the lender on that deal, if you're a part of the loan on that deal, might make sense inside of the 401k or if it's very high yielding, like a hard money note, maybe the Roth or the HSA.

21:20Another example of that is the loss that you mentioned, right? I'm in a couple of these syndication deals after tax and they're going to get wiped out. I mean, I've written them off to zero at this point because of the way the market has gone. And if that was in a Roth, that would be absolutely soul crushing and devastating. Not only do I lose all that money, but there's no tax benefit. There's no tax overlining whatsoever. But because those were after tax, I will get a loss. So anything where there could be a loss, a total loss of principal, and that's a realistic probability, like any highly leveraged investment, that should be something you should be really careful about before putting in the Roth in particular, I think.

21:57I'm glad you brought that up, Scott, because there are some folks that will actually take on too much risk in their retirement accounts in comparison to outside of their retirement accounts. And that's not always a good way to go about things. Because if you think about it, your IRAs, your traditional IRA, your Roth IRA, they're highly tax privileged accounts. And there's also, in many cases, some rather high creditor protections in general, I'll say, associated with these types of retirement accounts. And so one could argue that you want to cherish those tax-free and tax-deferred dollars. And you may want to take on more risk with non - retirement accounts than in your retirement accounts.

22:44Again, that's all subject to the facts and circumstances of your individual situation or one's individual situation. Now, the caveats that I was mentioning before to Mindy's question about investing in real estate syndications. If I have a solo 401k plan and I invest in a real estate syndication, like an apartment building deal, a self-storage type deal, there's always going to be debt on these types of properties. And in a solo 401k plan, I would be exempt from a little known tax called unrelated business income tax. It's a special tax that would apply to an IRA, traditional or Roth, when investing in those types of real estate syndications.

23:26But under Section 514C9A of the tax code, qualified plans are exempt from that tax, which makes a solo 401k plan, whether traditional side or Roth side, potentially a very attractive retirement plan to invest in those types of real estate syndications. And the reason why I say that is because I know some investors out there that are very good at investing in real estate partnerships, real estate syndications. That's all they've done for many, many years. And so they say, well, John, I want to replicate my success investing in these types of opportunities in my retirement account, just like I do outside of my retirement account.

24:06That could be one of the exceptions to the, call it, general rules that we're talking about here or general principles that we're talking about. Thank you for bringing back John Hubit Bowens, by the way. That's one of my favorite versions here. Let's talk about some other assets. Let's talk about like traditional bonds and let's talk about crypto, you know, which have very different characteristics. Bonds being very conservative, but yielding essentially all simple interest and crypto being highly volatile, but presumably producing no income whatsoever, only short term or long term capital gains.

24:40Where do you think those fall into the bucket across these strategies? So our general principle for bond funds, because it's interest income, same as a private debt fund, or if I'm doing private money lending and I'm generating interest income. So a bond fund or bonds are going to be considered tax inefficient. Thus, we want to hold those where? Traditional or Roth bucket. Probably traditional bucket. Why? Because it's probably going to be a little bit lower interest bearing, right? So we're probably going to hold those in our traditional bucket, our more conservative bond funds in our traditional bucket.