Tax Alpha: Thoughtful asset location

0:09Raul Shah:Welcome, everybody, to a special new series that we are having on investing experts. I'm very happy to welcome back Raul Shah, who runs Doc Shaw Financial, back to the show. We've had him on a couple of times talking different stocks that he's invested in, notably HIMS, UnitedHealth, and he's also talked most recently about the tax tips that he has for investors. And I was very taken with the idea of feeling that we are bereft of good tax insight specifically for investors. So I've asked Raul and he has graciously accepted the invitation to appear monthly on this podcast. We're calling this series Tax Alpha.

0:48Raul Shah:So if you have any questions, If you have any particular topics in the tax world that you feel like we should cover, please let us know what they are. Please leave us a comment. Raul, I'll let you take it from here in terms of what we're focusing on this very first week. And if you want to reintroduce yourself to our audience, I, for one, am very excited about this series. So thanks for doing it with us. Well, Raina, it's always great to be back on air with you. I really enjoy our podcast and our conversations. And, you know, this is going to be an incredible series. I mean, investors are going to learn tax planning tips that they have never heard of that is going to make a huge difference in their lives and in their investing journeys.

1:31You know, a lot of savvy investors are on Seeking Alpha and there's so much great content on there and they're making great returns, but they're also paying a fortune of these returns to taxes. So these strategies are going to save potentially hundreds of thousands of dollars in lifetime taxes for many viewers who have larger portfolios. But it applies for anybody from smaller portfolios all the way to the bigger portfolios. You mentioned earlier in the intro, I run DocShot Financial. We're an investment management firm that not only does value investing, classic value investing, but we also do tax planning for clients.

2:11And so we create the alpha on the investment side and we do the tax alpha on the tax planning side. And so I'm so excited to share some of these strategies with you. And the first one that we're going to cover is called asset location.

2:25Raul Shah:Let's get into it. And I think a perfect place to start is what is asset location, even for those that may not know. I think start like as basic as you can for those wanting the deepest dive. Absolutely. So I'm going to go ahead and pull up the slides here for our viewers on YouTube, but don't worry if you're listening to this during your commute or just around the house. I'm going to explain everything to you guys, even just for audio purposes. So you're going to understand it. Now, asset location is really just a fancy way of saying putting your investments in the right accounts to pay the least in taxes.

3:07It kind of makes sense, asset location. We're taking our assets and we are deliberately choosing in what accounts to put them in. If I take two investors that have the exact same portfolio, but they all put them in different accounts, well, they're going to wind up with completely different tax consequences at the end of the year. And so asset location is a question of, okay, what is our overall portfolio? What investments do we want to hold? But then where do we put those investments? We're going to use a very simple example here. Okay. You know, a lot of seeking alpha viewers and content consumers, they're retired and they've got, let's just say a$900 ,000 portfolio.

3:50You'll see why I picked that number there and not a round number is a million. But we're going to start with that basis. But again, this applies to everybody wherever you are on your investing journey. Let's say you have a$900 ,000 portfolio that is evenly split between three accounts. Let's say there's$300 ,000 in your brokerage,$300 ,000 in your traditional IRA account, and$300 ,000 in your Roth IRA account. Now, I know a lot of people will say, well, hey, Roth IRAs are generally so much smaller than the other accounts that we have. And trust me, I completely understand that. I see that even with the clients that I work with at the firm.

4:30But again, I want to really get the concept of asset location across. And so to do that conceptually, we're going to assume that we've got an even split across all these three different types of accounts. Now, I picked these three types of accounts because these are the three different tax classification accounts. You see, in your traditional IRA, it's a tax-deferred account. That means, generally speaking, when you fund that account, it's with pre-tax money, which means that ultimately when you pull it out in retirement, you're going to get taxed at your ordinary income rate. That's very important when we're trying to pick what investments to put in that account.

5:11In your brokerage account, you benefit from long-term capital gains tax rates, which are much lower than your ordinary tax rates for most people. And in your Roth IRA account, that's your tax-free account. So you pay tax when you put money into the account, but everything that you would draw, assuming you're over 59 and a half and the account's been open and funded for five years, is completely tax-free. It doesn't matter if your gains are a million percent in that account. When you pull that money out, it's completely tax-free. So that's why we start with this basis, okay? So$900 ,000 in a portfolio split evenly between your brokerage, your traditional IRA, and your Roth IRA.

5:52Now we can get into asset location. So we're going to say, right, you're retired, okay? You want a 60-40 portfolio, right? That's is the fancy way of saying, we want 60 % of our money in stocks and we want 40 % of our money in bonds. So that would roughly be 540K in stocks, 360K in bonds. Don't worry about those numbers for now. But the reason we start here is because we always start with, okay, we've got this pool of money. What assets do we want to own and in what proportion? And that's question one. And once we know the answer to that question, that's when we can choose where to place those assets to pay the very least in taxes.

6:33And I'm not exaggerating. This strategy can save you hundreds of thousands of dollars in lifetime taxes.

6:39Raul Shah:Why have an IRA as opposed to a Roth IRA? Is this a good place to ask that question? Absolutely. And that's a fantastic question. So going back to what I was saying earlier, we've got really three types of tax classification accounts. Your traditional IRA being a tax deferred account, that's a fancy way of saying when you put money into this account, generally speaking, you get a tax deduction. So when you're in a high tax bracket year, if you're earning a lot of money, you want to utilize that account, generally speaking, because you'll save more in taxes by putting money into that account. In a Roth IRA, you generally want to use that when you're in a low tax bracket, because you want to pay that small tax today in exchange for never paying tax again over the growth of that portfolio.

7:28So traditional IRAs and Roth IRAs are flip sides of the same coin, and they become utilized depending on where you are in terms of your earnings in that year. And your brokerage account is sort of in the middle. It's this very flexible, happy medium account that has no contribution limits. It has no income limits. And so that's kind of That's the reason why we have all three of these accounts. It covers you on all tax fronts. Let's look at an example. So we've got$300 ,000 in our IRA,$300 ,000 in our brokerage, and$300 ,000 in our Roth IRA. If you paid no attention to asset location and you just put your 60-40 portfolio haphazardly in these accounts, let's kind of look at what that would look like.

8:11Just sort of this example. Let's say in your IRA you bought$300 ,000 of the S &P 500. Okay, so VOO, right? It's just an S &P index fund. Well, if it returns 8 % for 10 years and your ordinary income tax rate is 24%, the total amount of tax you're going to pay in that account is$155 ,000 based on the value of the portfolio growth at 8 % and your tax rate. Now, let's say in your brokerage account, right, you've got$300 ,000 and you buy$240 ,000 of NVIDIA stock and$60 ,000 of U.S. treasuries. You know, Nvidia stock, if it returns 15 % a year for 10 years and you sell it, you'll pay long-term capital gains tax of about 15 % most likely.

8:56Your US Treasuries are paying 4 % in bond interests and you'll pay ordinary income tax on that at 24%. And so in 10 years, you'll pay$117 ,000 in taxes. Don't get too caught up in the numbers. Just pay attention to the concepts. In your Roth IRA, if you put 300 ,000 of corporate bonds, okay, bonds are taxed as ordinary income but because it's in your Roth IRA, all the interest is tax-free, so you won't owe any tax at all on any of the interest that you accumulate. Now, you will have paid taxes on that contribution, the$300 ,000 you put into your Roth over many, many years. If you're in the 12 % tax bracket, you're looking at about$36 ,000 in taxes paid to put money into that account.

9:38And so your overall taxes in this scenario between your IRA, your brokerage, and your Roth IRA, if you're just randomly putting these investments in your accounts, is going to be$308 ,000 by year 10. It's a very large number. But if you're a savvy investor and you know a little bit about tax planning, you're not going to do that. You're not going to just go pick the investments and just randomly put them accounts. You're going to be extremely strategic about where you put your investments. So let's look at that and what that would actually mean. Right now, we're going to recompose that same portfolio, but just shift around the investments in different accounts so that they are taxed most favorably.

10:19So let's start with your IRA. What we're going to do is we're going to take those corporate bonds that were in your Roth IRA, and we're going to move$240 ,000 to your traditional IRA. And we're going to take those U.S. treasuries from your brokerage, and we're going to move that to your traditional IRA. Now, why do we do that? Well, your IRA is going to get hit with ordinary income tax, and that's the highest tax rate that you're going to pay. So we want to put our slowest growing assets in that account, which is going to be the bonds in this case, because we don't want to put high growth assets in this account where they grow a lot really fast.

10:59So then you have to pay a very large tax bill, right? We want to put those in the Roth IRA, which we'll get to in just a second. So when we shift, when we move those bonds and treasuries from the Roth and the brokerage to the traditional IRA, our taxes get dramatically decreased in that account. And now in this case, in 10 years, you only owe$115 ,000. Don't worry about that number. I'm going to add them all up together, and then we're going to compare at the very end. Okay, in your brokerage account, we had VOO, right, the S &P 500 in your IRA. We don't want to have a high growth asset like that in that account if we can put it in our brokerage account.

11:38Because if we shift$240 ,000 from the IRA to your brokerage account, what we've done is we've moved all the taxation from 24 % tax, your ordinary income, to 15 % at the long-term capital gains tax rate. So we've saved 9 % in tax on every dollar of growth by doing that. If we then swap out 60K of those corporate bonds with municipal bonds, which have no tax, we've now moved the corporate bond tax rate from 24 % to 0%, saving another fortune in taxes. And in this case, in your brokerage, you'll owe$42 ,000 in taxes in 10 years. In your Roth IRA account, if we took the$240 ,000 of NVIDIA stock and we moved it from the brokerage to the Roth IRA, well, what we've done is we've moved all of those gains that were going to get taxed at 15 % in your brokerage to now being taxed at 0 % because they're in the tax-free account.

12:39Remember, the Roth IRA is the aggressive account. We want to put our fastest, highest growth assets in this account because all the gains are tax-free. We don't want to put them in the traditional IRA where all the gains are going to get taxed at your ordinary income rate, which is the highest level of taxation. And the last step is we can move 60K of VOO from that traditional IRA to the Roth IRA. And now you've moved an asset that was going to get taxed at 24 % to 0%. And if we add up the taxes, when we apply asset location, we are only paying$193 ,000 in taxes by year 10. So the difference, if you had no strategy and you just bought these investments and placed them in random accounts, you would have paid$300 ,000 in taxes over 10 years.

13:33If you actually are strategic and you apply asset location, you only paid$193 ,000 in your 10-year tax window. So the total tax savings in 10 years in this example is$115 ,000. And if you annualize that, that's$11 ,500 in tax to save every single year just by being deliberate and thoughtful about where you're placing your investments. So that's it. That's all I wanted to show. I wanted to keep it simple. And I figured at this point, Reina, you and I can kind of discuss some of the strategies and how it could help the Seeking Alpha audience.

14:13Raul Shah:Much appreciated. I would say my first question would be, does dividend income affect this strategy at all? Great question. So dividends are going to be taxed at your ordinary income rate. Generally, it depends if they're qualified or if they're unqualified dividends. But when we think of dividends, what are they attached to? They're attached to a stock. And so if we can keep stocks in our brokerage account or in our Roth IRA account, we're going to wind up paying less tax more than likely than if we place them in our traditional IRAs. To give people kind of a broad brush to think about how to place their investments.

14:56You want to take your slowest growing investments and place them in your traditional IRA. So that's like corporate bonds. It could be US treasuries. It could be anything that doesn't have high growth potential. And the reverse is true for the Roth IRA. We want to put our fastest growing assets in that account. So if you're going to buy growth stocks, you want to put that in your Roth IRA. Even certain dividend paying stocks go in there. If you buy a dividend paying stock cheap, if you buy Philip Morris at a really cheap price and you're getting a sweet dividend, you've got a mix now of capital gains and dividends that you might not want to get taxed.

15:33And so you always have to kind of weigh what's the growth potential and how can I shelter that from the most taxes.

15:41Raul Shah:And I would imagine that also plays into the fact of where are you in the horizon of investing? Are you closer to retirement? Are you in retirement? or are you just getting started? I imagine that also plays a factor. Yes. Your age and your time horizon to retirement does play a factor. One of the things that I always see with clients that come in is they have all their money in their IRA account. They've rolled over their 401ks into the IRA, and it's all just tax-deferred money. When you go and you have that type of an account, it's really going to get slammed with income taxes. You can just basically rule out a third of your IRA as, you know, being going to get sent to the government.

16:23So when you start young and, you know, you want maybe more flexibility, you know, I always tell people, utilize the brokerage account, you know, even if, you know, you might pay a little higher tax in certain cases, you know, there's, it's all financial planning. There's always a balance, right? There's, there's this idea of, okay, we want to save a lot of money in taxes, but we also need to live, right? There's a time value to money. We have to be able to access our money. So for somebody who maybe is young and they want to buy a growth stock, sure, the logical place for taxes would be to put it in their Roth IRA.

16:56But if they can't access it for 30 years and they want to buy a house in 10 years with their family, well, then maybe they put that in their brokerage account where, okay, they'll pay a little bit of a higher tax. But the trade-off is you get total flexibility on when to pull your money out and use it for any purpose that you feel like. So we're always balancing where do we pay the least in tax, but also what gives us the flexibility to actually use our money for the things that we want.

17:20Raul Shah:And herein lies the alpha because nothing is black and white. Nothing should be painted with a broad stroke. There is so much nuance. There is so much art to investing and specifically how to avoid paying the most taxes. any other caveats you would add or any other factors that you would encourage investors to think about when it comes to asset strategy, asset location? Yeah, the number one thing I'll say, the thing that you want to take away from this is just be more thoughtful with where you place your investments. So when you look at your overall portfolio tonight, you know, you're going to say, okay, I've got muni bonds, bonds that have no federal income tax sitting in my Roth IRA account.

18:05And I've got Nvidia stock sitting in my traditional IRA account. Now, maybe you can't flip them for the time being, but going forward, think about that and say, okay, you know what? Why don't I move my muni bonds and I put them in my brokerage account where they'll be tax exempt. And I'll take my growth stocks, put them in my Roth IRA where all the gains will be tax-free. and put my slowest growing assets in my traditional IRA account. So just when you look at your portfolio, kind of identify what's fast growing, what's not fast growing, and place those accordingly. What's going to get taxed as ordinary income?

18:41And can I shelter that in a Roth IRA or by buying a muni bond and placing it in my brokerage account? Things like that are really the things to kind of look at, right? You just broad picture, look at your investment portfolio, and then take it step by step.

18:55Raul Shah:Well, I'm very excited about this series, Raul. I think this is going to be really helpful for a lot of people. So I would encourage anyone listening, anyone watching to share any questions that you have with us. Where can our audience find more of you, your writings, your insight? Where can they get in touch with you? How do they reach Doc Shaw Financial? Lay it on us. Well, I've been a Seeking Alpha contributor for, I believe now, nine years. I'm almost coming up on a decade. So you can find me on Seeking Alpha, Raul Shah. I'm on X. It's Raul underscore DSF. And Raul is R-A-U-L. The firm I own is Doc Shah Financial.

19:33You can just Google me. I've got the website there. The firm is actually named after my father, who is a physician and taught me a lot about investing. So he is the Doc Shah in Doc Shah Financial. But I'm all over the internet. So you just got to search my name. And I love hearing from people. I get so many emails actually from the podcast that we've done and so many really just wonderful things to say. So even if it's just to say hi, I'm always happy to hear from Seeking Alpha viewers and the community.

19:58Raul Shah:Awesome. Love hearing that. So we're going to be doing these the first Wednesday of every month. Share your questions and insights and comments and concerns with us. Well, thanks again. Talk to you soon. Thank you. Just a reminder, anything you hear on this podcast should not be considered investment advice. This is for entertainment purposes only, and you should seek advice from a licensed professional before investing. If you enjoyed the episode, leave a rating or review on your favorite podcasting app. And we'll see you soon with a new episode.