GRD Season 4 Episode 6-Should you invest your IRA differently than your Taxable account_mixdown
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[00:00:00] Hi, I'm Ed Slott. And I'm Jeff Levine. And we're two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver, so that you can make better decisions because better decisions on the whole lead to better outcomes. And here's how we're going to do that. Each week, Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard-earned money.

At the end of each debate, there's going to be one clear winner you. A more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation to decide what's best for you and your family. So here we go. Welcome to the Great Retirement Debate.

Hi everyone, and welcome to the latest episode of The Great Retirement Debate. I'm Jeff Levine, with me as always Ed Slott. Ed, good morning.. Good morning, good evening, and whenever you are watching, somebody's watching this at three in the morning, so let's get, wake them up. It's five o'clock somewhere. Right, right, right. Let's wake them [00:01:00] up with an interesting topic today. Yeah, our discussion topic for today, ed, our question for today is, should you invest your IRA differently than you do your other accounts?

And so I think before we get into our, our thoughts on that issue, let's just talk about the potential types of accounts, right, that someone may have and. And we'll start by saying we're really talking about the differences here in the tax treatment of some accounts. So Ed, why don't you break down the potential accounts that someone might have for us?

Well, it's basically three buckets. Uh, you know, your taxable money, I don't even like calling it tax already taxed money, non IRA money. So basically something that's not in a retirement account. What might be typically. Titled at a, at an investment, uh, a brokerage account or something like that. A brokerage account as like an individual account, your own account or a, a joint account or a revocable trust account, right?

Something like that. That's one bucket already. Tax money, uh, even a savings account you pull out, you generally don't have to pay tax, but if you sell something, you know, it could be a tax. [00:02:00] Then you have your IRAs that's tax deferred. And then another bucket, uh, your Roth IRA, and if that's treated correctly, everything there can come out totally income, tax free for the rest of your life and even 10 years beyond.

So those are all right. So, and effectively you would say like. 401k would get thrown into the IRA bucket, 403b and then like 401k, 403b, anything tax deferred. Yeah, let's call that bucket. Uh, it's the IRAs but it's tax deferred. All right, so we've got like tax free, tax deferred and already taxed.

Is that fair? Already? Tax. Tax-free is Roth already. Alright, I think we, people know what we're talking about. You, your investment account, non IRA, your tax deferred and your Roth. Tax. All right, so the question then becomes, should you invest these accounts differently? Um, and look, you know, for the most part, Ed, I think the answer here, and I'm gonna go with a yes, uh, you should consider investing these differently.

Now, obviously, every situation is [00:03:00] different, and you should always make sure to, you know, to do what's best for you and right for you, considering everything going on. But I think the answer here is yes, because. At the end of the day, it's not how much you have or how much your account statement shows that matters.

It matters how much you get to keep, how much you get to spend and locating certain investments within certain types of accounts can have a really significant impact on that bottom line number. Now it's, let's, let's think about the tax. Treatment of each of these accounts. So we said there are three types of accounts.

Let's start with your taxable accounts or what Ed referred to as, uh, you just referred to Ed as the, the already taxed accounts. Those in some sense are. Like the, in some sense, it's the worst type of account because whenever you make a dollar, you're gonna pay tax on that dollar, right? Like if you have a dollar of interest, you're gonna pay tax on the dollar of interest.

If you have a dollar of dividends, you're gonna pay tax on the dollar of dividends. On the other hand, there are some real advantages [00:04:00] to taxable accounts, for instance. There are different tax rates for long-term capital gains and for qualified dividends. There are lower tax rates for that income, but you only get the benefits of those lower tax rates if that income is inside a already taxed account, like a joint account or a revocable trust account.

If you create a dollar of capital gain income, long-term capital gains in an IRA. It doesn't matter when you take it outta the IRA, it's going to be taxed as ordinary income because everything that comes out of an IRA is ordinary income. Similarly, if you, let's say, buy a piece of real estate and you want to depreciate that, well, that depreciation tax benefit is only available to you if you're using the already taxed money.

So while we often think about that as the least favorable money from a tax perspective, it also comes along with a lot of benefits. Even if we look at things like tax lost harvesting. Now, Ed, [00:05:00] I know that. When we make investments, we generally, well, not generally. We always want the value to go up. Like that would be really good, but nobody's perfect, right?

People have investments that go up and down. In a taxable account, there's a benefit. When your value goes down, you can. Sell a stock, a bond, a mutual fund, an ETF, whatever you happen to hold. And that loss can be captured and used to offset other gain effectively providing tax deferral, if you will, on your already taxed monies.

So all of those things are only available when you use already taxed money. Now, when we think about a traditional IRA or a 401k, a 403b B, there, you know, one of the, the, the big benefit there is that. Everything inside that account is going to be tax deferred growth. Uh, you're going, you're not going to have to pay tax on your interest, your dividends, your capital gains, and so if you are investing in something that throws off a lot of [00:06:00] income or you have a lot of turnover in your portfolio.

You don't have to worry about that ongoing tax bill. What a lot of financial professionals call tax drag. That's the, the, uh, decrease in your account value as a result of taxes on your gains each year. You don't have to deal with tax drag in an IRA. The trade off, of course, is that. In the future, whenever you do take those dollars out, everything is going to be subject to ordinary income tax rates, even the things that would've otherwise been taxed at more favorable rates if they had been used with, uh, the already tax money.

And then of course, finally we have the Roth accounts, Roth IRAs, Roth 401ks, Roth 403bs, etc., where you not only get tax deferred growth so you don't have to worry about tax drag like you do with your already tax money, but if you follow certain rules, as you already said, ed, that all that future gain is going to be tax free.

The caveat of course, is that in order to get that [00:07:00] treatment, you have to add onto your tax bill today, right? Right now, go back to the already tax money. That bucket, there's another huge benefit to having money there, not in a retirement account, and that's at death. When all capital gains are forgiven, you get a huge step up in basis.

Uh, that doesn't happen with your IRA. Uh, the Roth IRA doesn't matter because it's all, uh, it's all, uh, income tax free, but the Roth is still subject to estate taxes, even. That's right. Income tax free, so you have to figure that in, but that's a huge benefit in the taxable account you mentioned. You have a, a piece of property, you depreciate it, you get a tax benefit, you die holding it, it gets a step up in basis for the beneficiaries and the, uh, capital.

And by that you just mean like the beneficiaries get to treat it as though they bought it on the day of death, and so, if you had something that was worth, you know, a million dollars when you died, that you paid a hundred thousand [00:08:00] for it. If you sold it the day before you died, you'd have $900,000 of long-term capital gains.

But if your heirs sold it the day after you died, they could sell it for the million dollars and have no tax whatsoever. Right. And the thing with the IRA, which I love, they're being a tax, uh, preparer, and this may not be the best advice, but when I had clients that were, well, that's what we're after here, Ed. Only not the best advice. Good enough. Well, it depends on who your clients are. I had clients that were stock jockeys, you know, they used to buy and sell and buy and sell, and I'd have to record before you could do it by computer and have it all thrown into the, I mean, they would have pages and they would've seven and eight brokerage accounts.

I would say, you know what? You're gonna trade like that. Do it in your IRA so I don't have to record the transactions. And they would also do the things that you were talking about. I have this one client in mine. Uh, you know who he is, but he would match up the gains and the losses and give me his worksheets for each of his seven or 10 brokerage accounts.

Uh, you don't have to [00:09:00] worry about any of that in your traditional or Roth IRA because none of those gains are ever realized within the account in the Roth. They're never realized for income tax purposes for IRAs. The downside, as you said, uh, when it does come out, there's no capital gain rates. It's all ordinary income.

Yeah. So ultimately, you know, we, we go back and circle back to our, our, our topic, uh, question for today, should you invest differently? What I, I think the, the big issue here is that if you had one, if you only had, let's say a hundred thousand dollars just to make it simple, and you either had all of your money in a traditional IRA or all of your money in a revocable trust account.

We're not, I, I, I think the answer to like, should you have different investments there, the answer is no. Right? You, you take your investments because you think they're gonna be good investments for the long term, right? But most people have a variety of different investments, right? They've got some stocks and some bonds.

Oftentimes [00:10:00] even inter. In between those, it's not just stocks, it's large US stocks, and then middle US stocks, and then small cap stocks. And then with bonds, they might have some treasuries, and then they have municipal bonds, and then they have, uh, you know, some long-term bonds and they might have international bonds.

Like it's often a mix of these things and throw in things like real estate and alternative investments. And the point here is that your investment pie probably has a lot of different slices to it, and if you have not only an investment pie with different slices, but you also have a tax pie with different slices, what do I mean by that?

I mean. You have some of your money in the already taxed accounts. You have some of your money in the traditional IRA and similar accounts, some of your money in the Roth. That tax pie can be overlaid, if you will, on your investment pie in a variety of different ways. So you might say like, if I have stocks, should I like, should [00:11:00] I have a little bit of everything in all of my accounts?

In other words, one way you could go about this Ed, is you could say. Just making things really simple. If you are supposed to have 60% of your money in stocks and 40% in bonds, what's classically referred to as a quote unquote balanced portfolio, you could, if you had money in your already taxed, put 60% of your already taxed money in stocks and 40% in bonds, and then you could put 60% of your IRA in stocks and 40% in bonds, and you could put 60% of your Roth in stocks and 40% in bonds, right?

You could do that. And each one of your accounts from an investment perspective would look identical. Another way to do that is you could say, boy, my IRA is, uh, an account where I don't have to worry about taxes right now because it has tax deferral. What can I put in there that is not very tax friendly to me so that I am maximizing the value that's provided to me from [00:12:00] my IRA and so.

You might, for instance, put all of your stock in your taxable account 'cause you say it's got capital gains and I get to step up in basis, etc.. And then you might put some of your less tax efficient assets, maybe like fixed income inside your traditional IRA. Where you don't have to worry about that ongoing tax drag.

So that's what I think we're really trying to get at, as should you invest differently. And there's tons of research out there. What we're really talking about here today, ed, is a concept known as asset location, not asset allocation. Asset allocation, how much you should own in stocks and bonds and mutual funds, etc..

Location. Yep. But asset location, which is once you have already decided what you own. Where should you own those things? Well, I think with a Roth IRA, and this is always the case, except you never know when people say, well, I always say and, and you never know, well, uh, this they have a certain investment [00:13:00] or a stock or some IPO, where should I own that?

Well, obviously. The appreciation potential is through the roof. Uh, obviously a Roth, IRA, I mean, that's where you want to have all your growth. Something that will never be taxed for income or capital gains. So that's, we want that, but you never really know. But that's what we always tell people. If you have items that you think have future great appreciation potential, that's, you want that in your Roth, IRA.

Uh, technically would be referred to as your highest expected return assets. Right. And I think it's also worth noting that there's a combination there too, because, you know, the Roth provides two benefits. It provides tax free. Distributions in the future, but it also provides that tax deferred growth while you're in there.

Right. So when you're thinking about sort of the ideal investments for different accounts, the Roth benefits, like the first order of decision making is what has the highest return, right? What's gonna have a big [00:14:00] return over the long? But the other thing you consider is, what do I have from an investment perspective that has a, uh, that is somewhat inefficient, right?

Your ideal investment for a Roth account is something that has, uh, kicks off a ton of ordinary income because not only are you getting a high return, but you're taking something that would've otherwise been taxed at a very high tax rate all the time and making it tax deferred and tax free over the long run.

And when we think about. A taxable account. Right? And when I say taxable, I mean you're already taxed money. The right, the joint account, the revocable trust account there, you generally want things that are super tax efficient. Like a municipal bond would be a great example, right? Because it's federally tax free and you know who look if you had a municipal bond that was paying 30%.

That would be amazing, right? First off, we'd all love to have That doesn't exist. At least as far as, what's the name of that one I was writing down? You gonna write that one down? Yeah. But if you had one, who [00:15:00] cares that it's making 30% 'cause it's tax free. So in the the, the taxable money, you're generally looking for something that is highly tax efficient.

And then as a second order of decision making, something that has a relatively low tax. Excuse me, a relatively low expected return on top of that. So I'll give an example here of what I mean. If you're thinking about bonds, right? Bonds tend to be relatively inefficient because they kick off income every year and they're generally, that interest is generally subject to ordinary income, tax rates, regular bonds, right?

But if we go back just a few years ago, ed Bonds were paying almost nothing. Right. So I mean, think about a, if someone had cash as part of their allocation, right, as part of their investment mix, which is a fine thing to hold. If you had money a few years ago and your cash was making two tenths of 1%. Who cares what the tax rate on two tenths of [00:16:00] 1% is.

Right right, right. It could be a hundred percent. It doesn't matter. There's nothing to be taxed. So it's a function of two things. The way I look at this asset location, ed is often your taxable account. You want things that have low return. And are efficient. Your Roth IRA, you want things that have high return and are inefficient.

And of course that, uh, leads to like, well, what about your traditional IRAs? Ed, to me, traditional IRAs are the Danny DeVito of the I, right? The garbage can. That's right. You remember the, the movie, uh, uh, twins, right? Yeah. Right, right. There was two accounts. You know the Roth, I a to me is like the Arnold Schwarzeneggers.

Yeah, the Julius from that movie. Yeah. Yeah. Julius got all the good things right? Yeah. And the, the traditional IRA with Danny DeVito got all the leftovers. What they said that all the, you know, you, whatever they called it, the left. That's right. All the crud. I, I didn't use that word in the movie, but all the crud you see in front of you in the mirror every day, I will give you.

Uh, you know, we talked about [00:17:00] in the Roth you like things that have high appreciation potential, but uh, there are things that don't make money and actually lose money. Now nobody looks for that. Nobody says, you know, I wanna do some good tax planning. Jeff, you have anything that will absolutely like sink, uh, l lose me a ton of money.

Uh, nobody does that, but let's say that happens. I a, well, at least the government shares your pain. Yes. Because when the value goes down, obviously, let's say, uh, just extreme, you lost it all. Obviously, we hope that never happened, but, uh, then there's no tax on the way out because there's no value. If it loses money in the Roth, IRA, you lose, there's no, uh, government subsidy, so to speak.

The government doesn't share your pain, so obviously we hope everything in a Roth IRA goes up. But if things go down, uh, you lose the tax benefit from, from the loss that you would have in your IRA. Overall, [00:18:00] obviously I'm a big Roth fan. The Roth is the Holy grail. I mean, everything in there is absolutely income tax free for your life and 10 years beyond, even under the secure act for most beneficiaries.

Uh, the taxable account, I guess second place has the step up in basis. The Roth doesn't need it because there, there is no problem with that. Uh, they're both included though. In your estate, and so is the IRA. Actually all three are included. The problem with the IRA is not only included for estate tax taxes, but also subject to income taxes.

And if you happen to pay estate taxes an offsetting uh, IRD deduction, but it gets involved. And, and you know, Ed, of course, it's worth noting that, you know, no strategy i I is perfect. You know, you talked about some of the benefits. Perhaps if you lost money in a traditional IRA being better there, there are all sorts of, uh, weird things that could happen when you do asset location, for instance, uh, you [00:19:00] might have a an IRA that does really, really well and you might have a taxable account that does really, really poorly or vice versa.

It can be weird. To see statements where your accounts are doing dramatically different things or sometimes, right, and I've seen this before. Let's say that you're working with a married couple, right? And one of the individuals has a lot of money in a, a Roth account, but the other one has money in a traditional account.

Oh yeah. One might look at their accounts and go, I'm doing great, and the other person looks and goes, I'm doing terrible. Because the investments are doing different things. If you're planning as a household, you shouldn't be concerned with what each individual is doing, but rather what the full picture is.

But it can be very weird and also a little uncomfortable when someone looks at their own account where they have saved and say, my account is not doing well, but they see their spouse's account doing much better. So there are all sorts of little nuances here. To keep in mind and look, we can even go [00:20:00] further.

For instance, ed, um, money inside a trust, right? We would consider already taxed money, but trusts have different brackets Oh yeah. Than individuals. The tax rates for trust, while you get to the same highest rate, it's much, much sooner. So there's a lot more significance of that. You know, tax, like tax drag inside a trust can be even more significant than the tax drag inside, let's say a joint account.

So there can even be like. Subclasses inside these three. Another example there would be, uh, HSA accounts, right? Where it might be tax free, but right when you die, if you leave any money to your kids, then the HSA sort of ceases to exist and it may not be tax free if it's not used for qualified medical.

Expenses. Yeah. Whereas the Roth is gonna be tax free potentially no matter what it's used for. So there are differences in here. It's why it's important to work with a financial professional who can help you to do these things. But ultimately, when you look at the [00:21:00] research, the research would say that there is a material A, a very material benefit from properly locating your assets in different accounts.

Again, we're not here today to tell you what you should own. That's a decision for you and your family and potentially with your financial professional. On top of that, what we are talking about today here is once you have decided what to own, the next question is, where should you own it? Again? How to superimpose your tax pie with your investment pie in order to have the maximum amount available for you and your spouse, your heirs, to be able to spend after taxes, which is what really matters.

Okay, we'll leave it there. That's it for this episode of The Great Retirement Debate. Remember, Ed and I are here to talk about these things so that the winner of every one of our debates is you a more informed consumer who can make better decisions for themselves and their families. That's what we're about.

We hope you've learned [00:22:00] something today that can help you do that. Thanks so much for joining us, and we'll see you next time on the Great Retirement Debate.

Jeffrey Levine is Chief Planning Officer at Focus Partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice.

Certain information mentioned may be based on third party information, which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The topic discussed and corresponding arguments are those of the speakers and may not accurately reflect those of focus partners.