Transcript

[00:00:00] : Welcome to Retirement Unlocked with Larry Heller, Your Life, Your Way, Unlimited Possibilities. Join us as we explore how tailored financial planning and investments can help you navigate life transitions with confidence. Let’s dive into this week’s episode

[00:00:22] Bill Tucker: And welcome back to Retirement Unlocked with your host, Larry Heller. Joining Larry today is Angela R. Berkosky, chartered financial analyst, an MBA, and the director of investment strategy in our Lancaster, Pennsylvania offices here at Savant. When we talk about investing, we usually focus on one thing, how much money did you make?

[00:00:44] Bill Tucker: But there is another question that’s just as important. How much of that money do you actually get to keep? That’s where tax-aware investing comes in. If you’ve sold a business, you’re sitting on a highly appreciated piece of real estate, or you have a large amount of low-basis [00:01:00] stock, the tax consequences can be strategic and significant.

[00:01:04] Bill Tucker: So today we’re gonna talk about some strategies that can help you invest with taxes in mind, and more importantly, when those strategies might actually make sense for you. Larry, it’s good to be with you, and it’s like that old saying, it’s not how much you make, it’s how much you keep. Good to see you.

[00:01:22] Larry Heller: Absolutely, Bill. Nice to see you. Angela, thank you so much for being our guest today. I’m real excited to be talking about this. I know so many people when I, when I meet them and I tell them what I do, the first thing is, “Well, what should we be investing in today?” And, uh, so but that’s not really the, the whole picture.

[00:01:39] Larry Heller: Besides planning, we wanna see how much money, like Bill said, how much we can keep. So, uh, so Angela, why don’t you kinda like start our audience off and let’s talk about what is tax-aware portfolio management and why it’s so important.

[00:01:53] Angela R. Berkosky: Well, thank you very much, Larry. It’s a pleasure to be here, and I’m very excited to talk with you today about tax-aware [00:02:00] portfolio management Which is basically the practice of managing investments with a focus on what you actually get to keep after taxes, not just the pre-tax return.

[00:02:13] Angela R. Berkosky: ‘Cause really, what you wanna do is try to maximize your after-tax wealth. And just as we said, it’s not just about what you make, it’s about what you keep. So here at Savant, our philosophy is really rooted in evidence-based investing and the belief that things like asset allocation, diversification, costs, and taxes are among the most controllable drivers of long-term success.

[00:02:39] Angela R. Berkosky: And we do believe the markets are largely efficient. So rather than trying to predict short-term market movements, we wanna focus on improving the factors that we can control, and taxes are one of the biggest and most overlooked of those factors. And really focusing on that tax-aware piece can [00:03:00] really have a big impact for investors over time, because every dollar that isn’t paid in taxes can then stay invested within your portfolio, and it can continue to grow year after year.

[00:03:13] Larry Heller: Yeah. So l- let’s talk about some, you know, some examples, ’cause some of it is real relevant today. There are a lot of people out there that have bought some stocks and seen them greatly appreciated, and they got low basis. There’s also decisions on asset location. So why don’t you kind of give us some examples of what you see in some of the tax-aware investing that’s, that’s available?

[00:03:35] Angela R. Berkosky: Sure. Yeah. There’s actually a lot of different things that you can do, and some things start at the most basic level of just research and due diligence when you’re trying to decide what types of investments, whether it’s mutual funds, exchange-traded funds, ETFs, within your portfolio. You can do things like choose investments that maybe minimize unnecessary [00:04:00] turnover or more efficiently manage capital gain distributions.

[00:04:05] Angela R. Berkosky: That’s one thing you can do. Another thing is something that you just touched on, Larry, and that’s tax-efficient asset location. And that really is just a fancy way of saying you wanna take full advantage of the tax status of all your different investment accounts within your portfolio. Whether it’s an individual account, maybe it’s a joint account with your spouse, or an IRA or a Roth IRA, all of those different types of accounts have different tax characteristics, and putting investments in each of those accounts that make the most sense given those tax characteristics can really help you to keep more of what you make over time.

[00:04:52] Larry Heller: Is there a kind of a general rule or what classes should be and what, whether it’s [00:05:00] qualified, like you said, IRA, 401, or individuals that you, uh, that you see?

[00:05:06] Angela R. Berkosky: Yeah. Yeah, there are some basic, I’ll say, rules of thumb. So let’s take Roth IRAs, for example. Those accounts typically grow tax-free, right? So it makes more sense to include investments in Roth IRAs that aren’t as tax efficient, because just the sheer fact that it is a Roth IRA is going to shield you from some of the tax effects.

[00:05:32] Angela R. Berkosky: So some things that may make sense to put in Roth IRAs are things like maybe stocks that pay ordinary dividends or investments that maybe have the highest expected growth. So some examples of things like that could be value stocks or small cap stocks or emerging market stocks Then you have traditional IRA accounts, and those accounts grow tax [00:06:00] deferred.

[00:06:00] Angela R. Berkosky: So similar to a Roth, as your investments grow over time or as you receive income or dividends into the account, that is not taxed for you. Mm-hmm. But withdrawals later on are taxed as ordinary income. So in these accounts, it makes the most sense to include things that have maybe lower expected growth, because again, you wanna limit the growth in these accounts so that when you take withdrawals down the road, you’re not paying as much in taxes.

[00:06:29] Angela R. Berkosky: So some things you might wanna put in these types of accounts are maybe bonds, right? ‘Cause they have a little bit of a lower growth rate over time. Then you have taxable accounts, so that could be, like I said, joint accounts or individual accounts, and these accounts really are taxed on both income that you receive into the account, so dividends and things like that, as well as growth when you sell securities to withdraw funds.

[00:06:56] Angela R. Berkosky: But the difference here is that some of that growth could be [00:07:00] taxed at capital gains rates, which are lower than ordinary income rates if you hold the investment for longer than a year. So it could be okay to include some higher or medium growth investments inside these accounts. For example, maybe large cap stocks.

[00:07:17] Angela R. Berkosky: But another thing that if you do own municipal bonds, you want to make sure you’re holding them in your taxable accounts, because the income on those bonds is federal and sometimes state tax-exempt, so you wanna be able to take advantage of that.

[00:07:30] Larry Heller: You know, and some of the planning that, that’s done is really around this because, like you mentioned, the taxable account y- you’ve got capital gain tax rates.

[00:07:40] Larry Heller: But in a qualified account, an IRA, when you pull the money out, it’s ordinary income, and now with the required minimum distributions being pushed back to 73 or 75 if you’re born in 1960 or later, your required minimum distributions can be very large and put you in a very higher ordinary [00:08:00] income tax bracket.

[00:08:00] Larry Heller: So all this planning is some of the things that we do at Savant, not just exactly, um, just, um, what to invest the money, but how to invest the money. Let’s switch gears a little bit for a s- for a second. We talked a little bit about at the top about, you know, concentrated stock or large position in a stock with low cost basis.

[00:08:19] Larry Heller: So what are some of the ways to be mindful of taxes when, when selling a concentrated position, and what are some of the, uh, ways to diversify that don’t involve selling?

[00:08:31] Angela R. Berkosky: Yeah. So really, when you take a look at a portfolio, and actually we are seeing a higher instance, I’ll say, of some of these more low basis concentrated positions that have really grown over time, and part of that is just because of the natural, I’ll say, increase in concentration in the US stock market over the last few years with the growth of a lot of these, what they call the Mag Seven names.

[00:08:56] Angela R. Berkosky: So these big tech names like [00:09:00] Google, uh, Facebook or Meta, Amazon, and names like that. So there are some things that you can do within your portfolio that if you do wanna diversify a concentrated position, that you can, um, harvest losses that can be used to offset gains from selling down your concentrated stock.

[00:09:20] Larry Heller: So harvest loss is just that, let everyone else, it’s just selling some positions you may have losses in your taxable account to offset against the gains.

[00:09:29] Angela R. Berkosky: Right. There is a strategy called direct indexing that can be helpful with that, and that strategy is basically a strategy that is designed to provide a higher level of tax loss harvesting.

[00:09:45] Angela R. Berkosky: It’s basically built on the fact that while the markets do tend to have a positive trajectory over time, some stocks are going to hit a bump in the road. So let’s say, for example, you’re talking about the S&P 500, ’cause everyone’s pretty [00:10:00] familiar with that index. There’s 500 stocks, right, within the S&P 500.

[00:10:04] Angela R. Berkosky: But just because the S&P 500 is positive in any given year, that doesn’t mean that every single one of those 500 stocks is positive. Some are gonna be positive and some are gonna be negative. So direct indexing is a way of investing in a way that can mimic from a risk and return standpoint, the broad index, in this example, the S&P 500, but do it with a subset of individual stocks.

[00:10:31] Angela R. Berkosky: So maybe instead of owning 500, maybe I only own 200, right?

[00:10:36] Larry Heller: Mm-hmm.

[00:10:36] Angela R. Berkosky: But then as some of those stocks hit a bump in the road, right, you can sell them Via tax loss harvesting, put that loss in your pocket, so to speak, and use it to offset gains from other part of your portfolio. Right. So direct indexing is a strategy that can help with that.

[00:10:55] Larry Heller: Right. Yeah, and the nice part about that, even if you don’t have gains in during that year, [00:11:00] you can carry forward the losses.

[00:11:01] Angela R. Berkosky: Right. Exactly. Mm-hmm.

[00:11:03] Larry Heller: And so what are some other ways to diversify that don’t involve selling?

[00:11:08] Angela R. Berkosky: So there are other ways to diversify that don’t necessarily involve a direct sale.

[00:11:13] Angela R. Berkosky: There’s various planning strategies that could help with that. Um, you could gift a low basis or concentrated stock, whether it’s to a family member or to charity. Um, there are other things such as exchange funds that allow you to basically exchange a very low basis position for a basket of stocks in return for that, a basket of diversified stocks.

[00:11:41] Angela R. Berkosky: There are some complexities around that, given holding period requirements. A lot of times you have to hold that for seven years, and there’s some other complexities to that too, but there are other solutions other than just flat out selling.

[00:11:56] Larry Heller: Yeah. One of the things that we talk about a lot is [00:12:00] when somebody is giving large cash contributions to charity, um, like you said, the nice thing to be able to do is be able to give an appreciated, um, stock or even ETF or fund because when you’re doing that, you no longer have to worry about the gains in that, so you can diversify out by giving that and avoid paying m- void paying capital gain taxes.

[00:12:23] Angela R. Berkosky: Right. Basically, that’s a, a win-win. It’s a win for you as the investor from a tax perspective, and it’s a win for obviously the charity that you are donating the stock to.

[00:12:33] Larry Heller: Absolutely. So let’s talk about kind of businesses, ’cause that- that’s really what we, we’re starting to see and hearing about more and more businesses being, being sold, and some of these business owners, you know, started the business a long time ago and have no cost basis in there.

[00:12:51] Larry Heller: So, uh, why don’t we talk about some of the strategies that can defer or hedge the gain, um, and why are they gaining on popularity and, and, [00:13:00] and what are they?

[00:13:01] Angela R. Berkosky: Yeah, exactly. Yeah, selling a business is definitely, um, a very maybe sometimes emotional thing to do for someone. They build a business for their whole life, but there’s also a lot of financial ramifications and things to consider.

[00:13:15] Angela R. Berkosky: And you’re right, a lot of times there are very large gains that are realized as part of that business sale. There is a strategy that is called long/short equity strategies that, um, have become a little bit more popular here over the last few years, that have some pretty powerful characteristics that can help to offset or defer some of those gains and tax liability that you see when you sell a business or have other type of liquidity event, whether it’s selling real estate too.

[00:13:50] Angela R. Berkosky: And how those strategies work is it basically is it starts with, I’ll say, a direct indexing strategy in that you have, [00:14:00] um, an account that maybe you fund with maybe a basket of individual stocks that you have or maybe cash. If you have proceeds from your business sale, a lot of times they’ll take some cash from that and use it to fund this particular strategy.

[00:14:14] Angela R. Berkosky: And then the manager purchases individual stocks, right, with those proceeds, and it’s managed similar to direct indexing in that tax loss harvesting opportunities are taken advantage of. But there’s an additional level of complexity here, where the reason why it’s called long/short equity strategy is because you’re basically going to use margin borrowing or leverage to build what’s called an additional long extension and an additional short extension on top of the account, okay?

[00:14:51] Angela R. Berkosky: And that is really what drives the ability to provide a higher level of potential tax loss harvesting, and I [00:15:00] can explain to you why that is. So you’re buying additional stocks long and selling additional stocks short, and if you think about the profit and loss scenario in each of those situations, that’s what really, like I said, drives the tax loss harvesting.

[00:15:16] Angela R. Berkosky: So when you buy stocks long, what does that mean? Buying stocks long just means you’re buying stocks just like most people do e- every single day. You buy a stock at a certain price. When the price goes up, you make money When the price goes down, you lose money. Selling stocks short is the exact opposite of that, basically.

[00:15:38] Angela R. Berkosky: So you’re actually going to borrow shares of stock from, let’s say, a custodian, and immediately sell them in the open market, okay? So you’re gonna borrow shares, let’s just say it’s Coca-Cola. Borrow a share of Coca-Cola, sell it in the open market, let’s say at $10, okay? Now, you have $10 in your hand, right?

[00:15:58] Angela R. Berkosky: But because you borrowed that share [00:16:00] of stock, you have to pay it back at some point in the future. And in order to do that, you’re gonna have to buy the stock back on the market to deliver the shares. So you’ve sold it at $10, right? Let’s say the stock goes down to $8. Now you have to buy it back at eight, which means you made $2, so you profited.

[00:16:20] Angela R. Berkosky: But if the stock goes up, let’s say to $12, then you have to buy it back at 12, right? Remember, you sold it at 10.

[00:16:28] -: Mm-hmm.

[00:16:29] Angela R. Berkosky: So now you have lost $2, right? So it basically has a different profit and loss profile between selling stocks long and selling stocks short, which allows you to tax loss harvest regardless of market direction, both when the market’s up and when the market is down.

[00:16:49] Angela R. Berkosky: And that leverage and the utilization of those long and short extensions is what makes the tax loss harvesting ability so much more [00:17:00] powerful, which then helps to offset, or sometimes we say defer, and I’ll explain that, too, to offset the gains that you may have, um, incurred from selling your business.

[00:17:13] Larry Heller: Wow. So that’s a great, great explanation to bring that explanation down. Uh, it’s a little bit more complicated than that, but the, the way you’ve explained it, uh, hopefully out there in the audience, you understand that. But all these different strategies are so important to be aware of, because if you’re sitting with concentrated stock or you’re sit- sitting with a piece of real estate with low basis and about to sell or selling a business, um, or even just investing and investing properly by having the right stocks and equity allocation in the right asset allocation is, is so important to how much money that you can actually net after, after tax and keep a lot more money in your pocket and a lot more money for you to grow.

[00:17:57] Larry Heller: So Angela, this has been great. A lot of [00:18:00] good ideas. Any final thoughts on tax aware investing?

[00:18:04] Angela R. Berkosky: Sure. You know, every single tax-aware strategy, I’ll say, has pros and cons, so it’s really important to weigh them to your specific situation and determine what’s really right for you. And it really just is even more of an example of why it’s so important to work with an advisor that knows about these strategies, is familiar with your situation, and can marry the two together to do what’s best for you.

[00:18:32] Larry Heller: Great. Angela, thank you so much for your time today. Really appreciate you coming aboard on the podcast.

[00:18:37] Angela R. Berkosky: Sure. It was my pleasure. Thanks, Larry.

[00:18:40] Bill Tucker: And Larry, thank you for facilitating that conversation because it is cliché but it’s true, you wanna keep as much of what you earn as you possibly can. It’s an important conversation to have.

[00:18:52] Bill Tucker: And listeners, remember, investing isn’t just about what you earn, it is also about what you keep after taxes, as this conversation has so [00:19:00] well illustrated. And when you’re dealing with a business sale, real estate, or a concentrated position with a low cost basis, having a tax-aware strategy can make a meaningful difference.

[00:19:10] Bill Tucker: Now, the content today is provided for informational and educational purposes only, and should not be construed as personal investment advice. If you want that, and you enjoyed today’s episode, be sure to like, subscribe, and share Retirement Unlocked, and give us a call. We would love to have a conversation.

[00:19:31] Bill Tucker: You can reach us at Savant Wealth Management to schedule a complimentary 20-minute consultation. Thank you for listening to Retirement Unlocked, and we’ll catch you next time.