Last month we discussed the importance of asset location. For assets located in taxable brokerage accounts, focusing on after-tax total return, rather than simply total return, can add significant value to your net worth over time. Let’s explore the short- and long-term capital gains rates, qualified dividends, and tax-loss harvesting.

Unlike traditional IRAs, where the saver pays taxes on withdrawals and can trade within the account without tax implications, trades within a taxable brokerage trigger capital gains or losses. For example, if you buy 100 shares of a stock trading at $10 per share, and sell it for $20 per share, you would trigger a capital gain of $1,000. If you held the stock for one year or less, the IRS would tax the $1000 gain at your ordinary income rate. If you held the stock for one year or more, you would pay the far more favorable long-term capital gains rate of 0%, 15%, or 20%, depending on your income level for the year. Unless you have an extremely compelling reason to sell a stock within a year after buying it, try to hold out until day 365.

Not all dividends are created equal. The IRS taxes ordinary dividends (the default for all dividends) at the ordinary income rate. However, if a common stock or mutual fund is held for at least 60 days, and the dividend is paid by an American or qualifying foreign company and is not listed as unqualified by the IRS, then the dividend is “qualified” and taxed at the favorable long term capital gains rate. Make sure your taxable investments pay qualified dividends.

Buy and hold is a fine strategy, but you can add significant value to your after-tax total return by employing a tax loss harvesting strategy in your taxable account. Imagine you bought $50,000 of an SP500 ETF in December 2021. In 2022, you were down about 20% and your investment was only worth $40,000. Rather than just waiting for the market to recover, you could have sold your SP500 ETF, realized the $10,000 loss, and bought something similar like a large-cap mutual fund (but not so similar that you create a wash sale, and kill the strategy) so that when the market recovers, you also participate in the upside.

By harvesting the $10,000 loss, you create a tax asset, which can be used to offset gains in other parts of your portfolio. If you have no other triggered gains, which you wouldn’t if your advisor manages your assets in a tax-aware way, you can deduct up to $3,000 against your income. The remaining $7,000 would carry forward to the next tax year to offset gains or deduct $3,000 against income, and so on. Over time, the $10,000 tax asset is worth $10,000 multiplied by your marginal tax rate, for as much as $3,700 of real dollars in your pocket come April.

Holding investments for at least one year, making sure your portfolio pays you qualified dividends, and harvesting tax losses can all help you save money on taxes and keep more of what you earn. Remember, though, that if you wait for tax season to think about these strategies, you’re too late! Now is the best time to reach out to a financial advisor to optimize your tax strategy.

Tune in next month when we’ll evaluate the relationship between financial planning and investment management!

You’ve probably heard the phrase, “The three things that matter in property are location, location, location.” Similarly, when optimizing your investments to maximize after-tax returns, you should emphasize asset location. Today we’ll explore three types of locations or accounts: Traditional IRA, Roth IRA, and taxable brokerage account.

A traditional IRA is funded with pretax dollars, grows tax-deferred, and then is taxed as ordinary income when withdrawn in retirement. People in high tax brackets can take advantage of an upfront tax deduction now while their marginal tax rate is high and wait to pay taxes until they retire when their income will be considerably lower and taxed at a lower rate.

A Roth IRA is funded with dollars that have already been taxed, grows tax-free, and is withdrawn tax-free in retirement. People who are starting their careers and anticipate large raises in their future may want to consider paying taxes now while they are in a lower tax bracket than they will be after receiving raises, and take advantage of the traditional IRA during their peak earning years.

Be careful, withdrawals from either type of account could face a 10% tax penalty if you withdraw before age 59 and a half, with few exceptions. This penalty incentives savers to keep their retirement savings in their retirement accounts. There are also limits as to how much money you can invest in each. A taxable brokerage account, on the other hand, is funded with dollars that have been already taxed, incurs income taxes on interest earned, and triggers taxable events when investments are sold.

When savers sell investments that were held for less than one year, the gains are taxed as ordinary income. When savers sell investments that were held for one year or more at a gain, the gains are taxed at the capital gains rate, which is lower than the ordinary income rate. When investments are sold at a loss, a tax ASSET is created (more on this next month). There are no penalties for accessing the money or limits on dollars invested in taxable accounts.

Savers should also consider the direction of taxes when deciding which location to choose. The conventional wisdom says that the US government will have no choice but to raise taxes to sustain its excessive borrowing and spending habits. This thinking would favor paying taxes now and contributing to a Roth instead of taking a deduction now by contributing to a traditional account.

Of course, your unique situation will dictate the best path forward for you. Talk to your financial advisor about your asset location and ensure you have a solid tax strategy in place.

Put on your overalls and tune in next month to learn about tax-loss harvesting!

The adage goes, “A penny saved is a penny earned.” Most people think about this when budgeting their expenses but they should also consider it when managing their debt. Not everyone realizes that paying down a 20% credit card balance contributes the same value to net worth as earning 20% on investment. It does! Let’s talk about the right amount of debt, when to take a loan, and how to build an interest-rate waterfall.

What is the right amount of debt? Many cultures shun debt altogether (Islam deems interest haram or forbidden), and for others at the other end of the spectrum, it’s a way of life! Surprisingly to some, the answer’s usually not zero but somewhere in between. People often mistakenly prioritize paying off debt at the expense of growing net worth. For those looking to optimize their household balance sheet and maximize net worth, carry as much debt as you can afford to pay each month so long as your highest interest rate debt has a lower rate than the expected return on your lowest-yielding investment.

When deciding to take out a new loan, the borrower should ask two questions. Can I afford to make this purchase without the loan? And, is this expense being paid for a necessity to live, or is it a nice-to-have? See the table below for answers:

This table is a general rule of thumb and there are of course exceptions given certain circumstances, which is why it’s always helpful to talk with a financial professional whose business is to know your relationship with money and help you define YOUR (not the advisor’s) line between necessities and nice-to-haves.

If you have income that exceeds your expenses and proper emergency funds, and you want to deploy excess savings in the most efficient way possible, use the interest rate waterfall. Create the interest rate waterfall by lining up all your loans and potential investments in order of interest rate paid on debt, or earned on investment, from highest to lowest. Remember, the loan balance or the investment value is 100% irrelevant to this exercise. For example:

Now let the savings flow down the interest rate waterfall, meaningfully take advantage of the employer 401k match before paying down the credit card debt, paying down the personal loan, investing in stocks, etc. The second dimension of this exercise is to evaluate the risk of investing in paying down debt.

For example, stocks probably will beat 6.5% over the long run, but it may not be worth the headache of watching the account value plunge 20% like it did this year, which would favor getting 6.5% risk-free by paying down the private student loan instead. It may also make sense to go against the interest rate waterfall if you anticipate applying for a mortgage, mortgage refinance, or business loan and need to reduce your debt-to-income ratio by paying down loans with high minimum payments.

I challenge you to create your interest rate waterfall to let the savings flow in 2023 and drench you in its financial-optimizing glory!

Tune in next month for a guided tour of not asset allocation but asset LOCATION.

Without writing out all four letters of the most satisfying and versatile curse word, Urban Dictionary defines “eff you money” as:

“An amount of wealth that enables an individual to reject traditional social behavior and niceties of conduct without fear of consequences.”

I often hear the misconception that only people with this level of wealth have or need financial advisors. Maybe you have this much money, but chances are you are like me and have what I call “Hi, how are you? money”. Everyone can benefit from sound financial advice no matter where they are on this wealth scale. Let’s explore the measure of the value of a financial advisor and when the best time to employ one would be.

When measured in dollars of value created, a financial advisor’s advice is worth more to a person with more money. However, this is the wrong measure of value. When measured in percentage terms, a far more exact standard, a financial advisor’s guidance is worth the same to everyone.

For example: If an advisor employs a tax optimization or investment strategy that adds 1% of value to an investment portfolio annually, regardless if your portfolio is worth $10,000 or $10,000,000, you should be happy to earn an extra 1%. An additional 1% per year brings you “that much closer” to achieving your financial goals. It can be as simple as having a few extra dollars for a vacation or, over a long enough time horizon, something far more meaningful like years shaved off your retirement age.

The importance of time horizon cannot be understated. Therefore, the best time to have a professional review your finances is now. I don’t say this so you’ll pick up the phone and call me (but feel free!), I say it because of the hidden cost of waiting: compound interest. Albert Einstein described compound interest as:

“[Compound Interest] is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it”.

Seemingly trivial mistakes or inefficiencies can negatively impact wealth over the long run. Let’s assume markets return 8% per year on average. If you were to misallocate $1,000 now, you would miss out on $80 of potential returns next year, the equivalent of a fancy lunch out, no big deal. However, over the next ten years, you would miss out on over $1,000 of returns, you would miss almost $10,000 over 30 years, and, if you are at the beginning stages of your career, you’ll miss out on over $100,000 over the next sixty years!

Tremendous strides in the sophistication of financial planning software have streamlined the process of identifying these inefficiencies and illustrating their effects over the long run. Getting your finances organized ahead of the new year makes sense from a tax perspective and also feels great. I use and love RightCapital, and you can try it for free by scanning this QR code:

Stay tuned for next month as we investigate the effects of compound interest on the other side of the ledger—Debt!

In Charles Dickens’s timeless classic, A Christmas Carol, two gentlemen approach Ebenezer Scrooge in his office and say:

“At this festive season of the year, Mr. Scrooge, it is more than usually desirable that we should make some slight provision for the Poor and destitute, who suffer greatly at the present time.”

Indeed, many of us reflect on our blessings during the holiday season, setting aside some time or money for those less fortunate. At the risk of pouring cold water on the warm and fuzzy feelings we feel after helping someone in need, we must remember one thing. Taking a moment to plan and strategize our charitable giving can create significant savings come that other—Far more dreaded season—Tax season. For those unfamiliar with tax-efficient giving, we will introduce the concepts of itemized deductions, cash versus appreciated securities, and Donor-advised Funds. ‘Tis the season!

For filers to enjoy the tax benefits of charitable giving in 2022, they must itemize their deductions and not take the standard deduction. That means the sum of all itemized deductions, including charitable donations, must be more than $25,900 for married couples filing jointly and more than $12,950 for single filers. For those whose itemized deductions total something very close to the standard deduction, it may make sense to “bundle” 2022 and 2023’s donations in 2022. Imagine a single person who donates $1,000 per year to charity and whose other itemized deductions (excluding charitable donations) total $12,000. By not bundling, she would itemize $13,000 in deductions in 2022 and then take the standard deduction of $13,850 in 2023. By bundling her ’22 and ’23 donations in 2022, she would have $14,000 in deductions in 2022 and still take the standard deduction of $13,580 in 2023, thus maximizing the tax savings of her charitable donations.

Before cutting a check to your favorite charity, look to your brokerage account first for appreciated securities. Do you have stocks or mutual funds you’ve held for more than a year that have appreciated significantly? Donate the stock or mutual fund instead of cash! If you give a $10,000 check to a charity, you’ll get a $10,000 deduction. However, if you donate $10,000 worth of stock that you only paid $5,000 for, you’ll not only get the $10,000 deduction, but you’ll also avoid paying capital gains. In this case, that could be up to an additional $1,000 in tax savings (based on a top capital gains rate of 20% for $5000).

Sometimes, our charitable inclinations do not perfectly align with our optimal tax strategy. Fear not—A Donor Advised Fund can help bridge the timing gap. For example, you may want to donate $5,000 per year for the next five years to charity but do not yet know which charitable organizations most closely reflect your core values. You may also own highly appreciated company stock and wish to diversify your investment portfolio. Rather than sell your company stock and trigger a capital gains tax, donate $25,000 ($5,000 times five years) of that stock to a Donor Advised Fund. You will avoid the capital gains tax, reduce your investment exposure to the company, and receive a $25,000 upfront tax deduction. You then instruct the Donor Advised Fund to make $5,000 donations each year for the next five years to the charities of your choice.

We’ve only scratched the surface of tax-efficient giving, but hopefully, some of these examples have given you a glimpse of what’s possible. Talk to a financial advisor before employing any of the strategies discussed above, as nuance and specifics of the tax code (and the giving strategies) are beyond the scope of this article, and there may be better options for your unique situation. Tune in next month to see who can benefit the most from financial planning in 2023!

Environmental, Social, and Governance (ESG) investing, once a niche offering, has pushed itself into the forefront of institutional and retail investment strategies alike. ESG encompasses several, often very different, investment philosophies. We’ll define a few here, discuss whether ESG should play a role in your portfolio, and make you feel like an ESGenius.

ESG investing covers an extensive array of strategies and investment styles. One version of ESG buys across all sectors and industries but avoids or screens controversial industries such as tobacco, alcohol, and pornography. Another version will only buy companies whose business actively pursues positive social or environmental impact, such as renewable energy companies. A third will buy everything and leverage its position as a shareholder to actively engage with companies to improve their governance, reduce their carbon footprint, promote equitable treatment of employees, etc. Think of ESG as a spectrum of strategies, where some are more selective than others, and some are not selective at all and still carry an ESG name, a practice known as greenwashing.

Should ESG play a role in your portfolio? It depends if you value principles over profits. If someone tells you that you can have both, they’re likely selling you an ESG strategy (and maybe has a bridge to sell you, too!). Constraints to a portfolio, such as not investing in oil or tobacco companies, by definition, can only limit returns, never enhance them. If a portfolio manager expects a constrained portfolio to outperform the broader market, they can replicate the same constrained portfolio in her unconstrained fund. However, if she anticipates the broad and unconstrained portfolio to outperform, she cannot reproduce that portfolio in the constrained fund.

However, one could argue that market participants focus so much on ESG factors in their investment process that companies that score higher in ESG factors may outperform companies that score lower in the future. Maybe, but what about the companies that score very low in ESG factors and get shunned by the market? Their price falls, and the cost of buying $1 of future profits decreases significantly compared to the same $1 of a high-scoring ESG company. One could argue that you can find deep value in low-scoring ESG companies for this reason and reap the rewards over time.

In the end, ESG should only influence your investment decisions if you care deeply about specific issues, and by that, I mean enough to give up potential returns on your investment. Constraining your portfolio is one way to show you care, but maybe giving to charity is a more direct and efficient expression of your core values and beliefs. Tune in next month to learn how to maximize the impact of your charitable donations on your favorite charities and your tax bill!

In 2022, Diversity, Equity, and Inclusion (DEI) seem to dominate the discussion in politics and corporate America, but let’s not forget that financial advisors have diversified their clients’ portfolios since the advent of Modern Portfolio Theory back in 1952! Buying different mutual funds, ETFs, and asset classes can make us feel diversified, but we should also explore correlation and how it affects diversification and portfolio performance. How can we apply these measures of risk used by institutional investors to our portfolio?

Counting the number of holdings in a portfolio and ensuring no one holding takes up a too-big share of the pie can determine the most basic level of diversification. By spreading out investments over many companies, a saver reduces the risk that the bankruptcy or failure of any one company will result in financial ruin for that saver. By this measure, the S&P 500 is well diversified, and the Russell 3000 is even more diversified. Most people know they should not put all their eggs in one proverbial basket.

However, company stock prices can suffer substantial losses even if the company is nowhere near bankruptcy. Although well diversified, the S&P 500 and Russell 3000 experienced double-digit declines this year. It didn’t even help to own the S&P 500 or the Russell 3000 because they both went up and down simultaneously. These coincident moves in price imply a strong, positive correlation between the indices. Modern Portfolio Theory goes far beyond counting the number of holdings by analyzing the correlation among holdings in a portfolio and favoring non-correlated investments, or those that go up and down at different times than the others, or those that zig when others zag. These investments march to the beat of their drum.

Even this advanced statistical analysis has limitations because it only looks backward at historical data, which doesn’t help us predict the future. How do we know if we have sufficiently diversified our portfolio for the uncertainty of what’s to come? As a conservative fiduciary, I recommend assuming that any investment not guaranteed by the government will have a strong positive correlation with everything else in a big selloff. By this definition, the only true diversifiers are Series I bonds, FDIC-insured savings accounts and CDs, and short-term Treasuries. Ensuring sufficient funds in these safe assets not only dampens the hit to the overall value of your investments in a down market but also provides the security that breeds confidence to take appropriate risks in other parts of the portfolio. Would your portfolio pass Diversity Training?

Tune in next month to see how environmental and social issues like DEI should or should not play a role in your portfolio construction!

Only Rip Van Winkle could escape the pain of overpaying for a piece of furniture and waiting ten months for delivery or filling up the gas tank of a large SUV. The term “sticker shock” takes on new meaning as car dealers now charge thousands over sticker price rather than offering potential customers incentives to buy. Jerome Powell of the Federal Reserve and Janet Yellen of the Treasury described the rapid inflation of 2021 as “transitory” or temporary. Unless you have just awoken from an extended nap, you know that inflation has not only persisted but also permeated nearly every corner of the global economy.

In the years between the Great Recession and the pandemic, deflation, or falling prices, rather than inflation, concerned the Federal Reserve. The theory says that if prices continuously fall, consumers will hold off on spending in hopes of buying things for lower prices in the future, causing retailers and producers to slash prices further, creating a vicious cycle of falling prices and declining economic activity. To make matters worse, the Fed’s aggressive response to the 2008 Financial Crisis of cutting rates close to 0% meant that the Fed no longer carried that arrow of cutting rates to fight deflation in the quiver. Structural economic factors such as increasing globalization, China’s endless supply of cheap labor, rapid technological improvements, and razor-sharp efficiency of big box retailers like Walmart all kept a lid on prices despite the Fed’s Zero Interest Rate Policy (ZIRP).

Fast forward to 2022, and things look very different. Not only has China developed large middle, upper, and billionaire classes and reduced the supply of cheap labor, but it continues to lock down its economy like it’s March of 2020 in an attempt to eliminate COVID-19 infections. Then, Russia invaded Ukraine, disrupting Ukraine’s exports, and the rest of the world rightfully imposed sanctions on Russia, driving up the price of wheat and oil, respectively. The Fed cannot control these supply-side shocks but can only blunt demand by raising interest rates and potentially throwing the economy into recession.

Is cash king when faced with higher rates, tighter monetary policy, and a looming recession? Not when it loses purchasing power at eight-plus percent per year! If you haven’t already, try researching Series I Bonds from treasurydirect.gov. Speak with a financial advisor before purchasing because you cannot take your money out for the first twelve months, there is a three-month interest penalty for redeeming between years one and five, and there is a $10,000 per calendar year per person purchase limit. They are guaranteed by the US Treasury and pay 9.62% for the first six months if purchased before November 2022. After that, the interest rate adjusts for inflation. Don’t sleep on this chance to protect your purchasing power!