Navigating Uncertain Markets, Direct Indexing, Tax-Loss Harvesting, & Roth Conversions
On this week’s Money Matters, Scott and Pat examine the complexities of financial planning during uncertain market conditions. Then, they take calls about direct indexing, explaining the potential benefits and downsides to help you decide if it's the right choice for your portfolio. Plus, they offer guidance on the timing of Social Security withdrawals, tax-loss harvesting for bonds, and the strategic use of Roth conversions, to ensure you make the most of your retirement savings.
Join Money Matters: Get your most pressing financial questions answered by Allworth's co-founders Scott Hanson and Pat McClain live on-air! Call 833-99-WORTH. Or ask a question by clicking here. You can also be on the air by emailing Scott and Pat at questions@moneymatters.com.
Man: Would you like an opinion on a financial matter you're dealing with? Whether it's about retirement, investments, taxes, or 401(k)s, Scott Hanson and Pat McClain would like to help you by answering your call. To join Allworth's "Money Matters," call now at 833-99-WORTH. That's 833-99-WORTH.
Scott: Welcome to Allworth's "Money Matters." Scott Hanson.
Pat: Pat McClain. Thanks for joining us.
Scott: Myself and my co-host here are both financial advisors and have been helping people for a number of years with their finances, helping them make good choices. And we like taking calls.
Pat: Yes. And we should point out that because of our travel schedule, we are recording this on March the 17th.
Scott: Just because it's when the markets are volatile, just to put things...
Pat: At 10 a.m. Pacific.
Scott: Just because you don't know what's going to happen.
Pat: Oh, it's anyone's guess. It's normal though, Scott.
Scott: The markets are normal. The political environment is not normal.
Pat: Correct. But the attribution to the fall in the market.
Scott: Well, I mean...
Pat: The market goes down.
Scott: And the market might have gone down if there were no tariffs.
Pat: That's right.
Scott: And so, when the market goes down, people find something to blame. That's why the markets are going down. And I think to put things...I had dinner last night with my parents, my mom and stepdad, and one of my sisters. My sister is 65, maybe, still working, and she's a little concerned about the market. So I'm talking to her for a bit. And, like, I've been her brother for forever, right? And she's heard all this stuff from me. And she's got roughly half her portfolio is out of the markets and fixed income and out of the stock market at all. But she's still freaked out about the markets. And she's not the only one. This is very common.
Pat: Very common.
Scott: People are concerned. And if you kind of step back for a moment, first of all, if you go back 75 years, there are declines throughout...even in years when there's positive returns, there's usually periods like this when there's a 10% or more correction. The average intra-year decline, so during the year, intra-year, is just over 14%. So on any typical year, you can expect a 14% decline in stock prices.
Pat: At some point.
Scott: At some point, right? Not every year, obviously. Some years worse, some years not so bad.
Pat: And the market declines like this on average, what, every 27 months? Is that...?
Scott: There's a correction, 10% correction, historically, every 9 months and a bear market every almost 4 years.
Pat: Okay.
Scott: Bear market being a 20% decline.
Pat: So the attribution is different this time. It's always different.
Scott: Yeah, because there's different factors, different circumstances.
Pat: Correct. But the market decline is not unusual. It's a risk premium. That's why you get higher rates of returns out of equity portfolios over time.
Scott: Because they swing in prices.
Pat: Which is you know there's risk in there. And if you have a broadly diversified portfolio, all right, which is...I talk about this investment thesis that you should have, right? And the reason I...I actually have to remind myself.
Scott: I do too. Look, we don't like it when our portfolios go down any more than anybody, right?
Pat: Yes.
Scott: Not only do we have a fiduciary responsibility to our clients, but we're also investors ourselves.
Pat: Yes. And so this article, Wall Street Journal, "The Days of Set-and-Forget Investing Just Ended for Many Americans."
Scott: What does that mean? It means, like, what are you supposed to do now, then?
Pat: I don't know. Well, it talked about how people...
Scott: You should never really set and forget.
Pat: Well, that's...
Scott: You should have a plan.
Pat: A rebalance. You should have a rebalance in your portfolio so that you stick to your investment thesis, right? So people let their portfolios run, right? And so think about if you let your portfolio run over the last two years. What was the returns last year?
Scott: The last two years, the S&P, if you invested January 1st of 2023, by the end of December 31st, 2024, you had a 53% gain.
Pat: Which means...
Scott: Massive.
Pat: Which means if you had a portfolio of 50% stocks and 50% bonds, by the end of that period, your portfolio would probably look like 70% equity.
Scott: Or whatever, 65%, whatever the percentage.
Pat: Whatever the number is. And the rest is in fixed income. So your portfolio has progressively gotten more risky as the markets go up. And if your investment thesis is, which I advocate should look like pension plans, which is they trim the gains and they bolster the losses, so that they're keeping a relatively constant equity to fixed income.
Scott: What happens often if you were to set and forget, you end up getting overweighted in stocks as the years go on.
Pat: And you may be comfortable with that, but most people...what happens is nobody wants to sell their winners.
Scott: That's right. Things go up, they're like, "Whoa, whoa, things are...it's doing so well. Like, why would I want to get rid of this?"
Pat: This article went on to say how people are actually moving money out of the U.S. markets into some European markets, the DAX, the German market, and some European, because they're doing so well. And I thought this article has got some revealing things in it, one being that...
Scott: Maybe you should have a globally diversified portfolio through all market cycles.
Pat: Right? Which is what we talk about all the time, why the average investor underperforms the index in which they're actually invested in, because they do it at the wrong time, right? So if a European market was down and the U.S. market was up...
Scott: Nobody wants to sell. Nobody, Pat. In the last...I have not had one person in the last couple of years saying, "Hey, Scott, I've noticed the U.S. market has completely outperformed the rest of the globe. Why don't we trim our U.S. stocks and buy more global?"
Pat: Yes, I had it happen to me once in my career.
Scott: Instead, you're fighting the opposite. Why do we have global in our portfolio?
Pat: This thing is losing money.
Scott: Why do we have anything outside of the United States?
Pat: Which is why rebalancing a portfolio is so, so important.
Scott: And with new technologies that can rebalance quickly and easily, without the transaction costs that there used to be. Just a couple of years ago, there was trading costs on everything.
Pat: Yeah, friction.
Scott: Selling a stock now, they're virtually free. For example, direct indexing. When it's turbulent times like that, they really take advantage of harvesting losses.
Pat: That's right.
Scott: It could be very powerful to help their overall portfolio.
Pat: Well, this article, when I read it, I thought, "Well, there's four or five things we can learn from this," one being that the political environment should not be shaping. Look, I know someone that when Joe Biden was elected president, they took all of their money out of the stock market and didn't go back in until Donald Trump was elected again.
Scott: Whoopsies.
Pat: I'm like, "What? We're not managing the portfolio?"
Scott: Obviously.
Pat: It's like, what? But then I know people that when Trump was elected the first time, they took all of their money.
Scott: That's right.
Pat: You don't have an investment thesis. You are driving your portfolios purely emotional.
Scott: And every, well, not every, the vast majority of any article you look at, all that clickbait online, it's not designed to make you a better investor.
Pat: That's correct.
Scott: It's designed to get you to read the article and hopefully click on an advertisement.
Pat: That's what their job is.
Scott: That's 100% of their business model.
Pat: That's what their job is.
Scott: Don't forget otherwise. You read those articles, don't forget, "Wait a minute, are they here to really help me?"
Pat: They're there to sell you something.
Scott: Yeah. James Mackintosh writes for "The Wall Street Journal." He's one of the market guys. And I read this stuff, and I'm thinking, "I don't think you do anyone any help here."
Pat: But in all fairness, Scott...
Scott: Jason Zweig is another guy, but he's more on the opinion side. He's much more longer-term.
Pat: But in all fairness, we're here to sell you something. Our ideas.
Scott: That's right.
Pat: We don't sell advertising in the podcast by design.
Scott: That's right. Obviously, we don't do this just because we hope that people become clients. That's fully transparent.
Pat: And many do. They call from out of the United States.
Scott: Which is why we've been doing this for three decades.
Pat: Yes. And if, by the way, you never become a client and you find this helpful...
Scott: Great.
Pat: ...sounds good.
Scott: Perfect. Yes, perfect.
Pat: Absolutely. Great. And maybe one day you think, "Well, either I don't want to do this anymore or it's gotten away from me, or I'm not doing this as tax efficiently as possible."
Scott: I was reviewing some notes. We had a conference last week with all of our advisors, all gathered for their annual conference, and we had a speaker who was on this program last year, Apollo Lupescu.
Pat: Incredible.
Scott: They call him the master of communication and finance, or something, I don't know. He can take very complex ideas and make it very simple and really help people with just understanding the importance of focusing on long term and not getting caught up in the noise. And I was reviewing some of his notes this morning from a speech, and I thought to myself. Here's what I thought to myself. I thought, "Boy, the more he could be mainstream, the better the average investor can do."
Pat: Yes. And what he left his talk talking about is the resiliency of companies that are able to change for different environments. He said, this tariff thing, it's real. It's going to cause some upset for some companies over this short term. But he said...
Scott: Then they're going to pivot.
Pat: And then they'll pivot. Then they'll pivot.
Scott: Do something different.
Pat: Or not. They will go the way of the dinosaurs.
Scott: Well, some companies will be very successful, and some companies won't. And you need to ask yourself if you believe you have the ability to predict which ones are going to be successful and which ones are not going to be successful.
Pat: That is...
Scott: And considering most professional money managers have a hard time doing that, I think that's a fool's play for many people.
Pat: Yes. The allocation and the tax efficiency is key.
Scott: Yep. All right, we're going to take some calls. If you want to be a part of our program, callers are one of my favorite parts of it because no two calls, no two situations are identical. And you might have a work colleague. Maybe you're a couple of years from retiring. Maybe you started the same day as your work colleague. Maybe you share offices together, across the hall, whatever, had very similar career paths. Your portfolios can still look very different. Your financial lives can be very different. Anyway, to join us, 833-99-WORTH, or you can send us an email at questions@moneymatters.com. And we're starting off here with Dave. Dave, you're with Allworth's "Money Matters."
Dave: Hey, guys. How are you doing?
Pat: Good.
Scott: Thanks for joining us.
Dave: Thank you for taking my call. I have a question on direct indexing. I'm going to be having an investment be liquidated on me. So it will produce a significant amount of cash. And normally, I would just roll it into an index, one of the index funds that I already own. I should say, this money will probably eventually just become my kids'. So it's not really an asset allocation issue. That's why I'm just going to put it in the stock market. I was considering, as an alternative, direct indexing, with the idea that the after-tax return would be slightly higher than just a normal low-cost index fund.
Scott: Yeah, absolutely. So this investment that's being liquidated, is this a private company or something, or real estate?
Dave: It was a private credit investment, essentially, loan money to a real estate partnership. And the loan is coming due, and so they're going to be paying it off something.
Scott: So there's not...you don't have a large capital gain that you had offset?
Dave: No. No.
Scott: Okay.
Dave: No, I don't. So I've done some research on direct indexing, and I guess I've come to the conclusion that it's not a good idea in this situation. And I just wanted to run my thinking by you guys.
Scott: Yep.
Pat: And why do you feel that way?
Dave: Well, okay, so it's going to be a large lump sum put into that account and probably not added to. So it will just sit there and, like I said, eventually, pass probably to my kids.
Scott: How old are you?
Dave: I'm in my mid-60s.
Scott: Okay.
Dave: And so the reason why I think it might not be a good idea is that...again, the only reason I'm going into this is for the tax benefits. But those tax benefits, from my analysis, are going to decline over time.
Pat: That's correct.
Dave: And so after perhaps three to five years, there'll be very little tax benefit. But the higher maintenance fees will continue, and these maintenance fees probably are significantly higher than I would be paying, just like the Vanguard S&P 500. And at some point, the capital gain, hopefully, at least, the basis on this investment is going to be so low. I mean, it'll step up at my death, but again, that's hopefully a long time from now. And so I'm thinking that the accumulated management fees are going to offset the tax advantages eventually because the tax advantages are going to decline over time while the higher management fee will stay with me forever.
Scott: Yeah. So let's back up for the rest of the listeners to kind of...
Pat: By the way...
Scott: You're spot on.
Pat: ...you're 100% correct.
Scott: I still might argue why you might want it.
Pat: And we'll tell you a couple of things that we'll touch on, that your financial situation can change and allow for gifting of those highly appreciated individual stocks to your children while you're alive rather than at death.
Scott: So direct indexing, think about the S&P 500, I think most people understand, an index is where an ETF or a mutual fund accumulates shares in, essentially, the 500 largest companies in the United States, and they have a weighting based upon how large the companies are relative to one another. So Apple will have a much higher weighting than some little tiny company that nobody is thinking of that's part of the S&P 500.
Pat: They're capital-weighted.
Scott: And instead of some individual saying, "Hmm, is this a good company to buy? Should we sell this and buy that?" they say, "Look, forget about it. It's fool's game. Let's just own the broad index." Now, with direct indexing, instead of having an ETF or mutual fund, technology creates an index for Dave. And with this, Dave might own...and maybe it's the S&P 500, maybe it's a global index where it's 80% U.S., 20% global, and they'll go out and buy maybe not 500 companies but maybe 350 companies to get 98%, 99% confidence level that you're tracking the index. And then it's managed for a tax basis. And typically, Dave, you can dial in how aggressive you want to be in harvesting losses.
So here, it works really well if let's say you've got a business that you're going to be selling in a year or two, or you know you're going to trigger capital gain in the future. You can use a strategy like this and accumulate losses that you can carry forward that will offset future gains. Or if you said to us that this lump sum you're getting right now is going to have a trigger capital gain, we'd say, "Look, it's great. In the first quarter of this year, you can have direct indexing. They can accumulate significant losses for you to help offset that." It sounds like you don't have any significant gains that you're having to report on. Is that right?
Dave: Well, I mean, I can always use losses, I shouldn't say that, but I can always use losses to...I always have a use for losses, let's put it that way. But again, since you're owning individual in a direct indexing situation, you're actually owning individual stocks. Eventually, you're going to get into this almost handcuffed situation where, "Geez, I'm not crazy about owning this individual stock anymore, but it's got such huge gains in it that I don't want to sell it." And so you've lost some of the flexibility. I mean, one of the reasons why the index fund over time has performed well is that it's not static.
Scott: Static, that's right.
Dave: You know, it's essentially, by default, taking the cream of the crop because it's taking the 500 biggest.
Pat: Yeah. But in a direct index too, it isn't just tax-loss harvesting. They're going to take gains as well, right?
Scott: That's right.
Pat: So they're not going to let it flow out. But your big question is...and what are they charging you to do the direct index?
Dave: You know, I checked in the Schwab and the Vanguard, I think, it depends on the size of the account, but it starts at 0.4 and trends down.
Pat: Yes.
Dave: And you know, that's obviously many multiples higher than you pay.
Scott: You can get it less than that, I think, if you search around. And I think, also, those numbers are going to decline because it's just technology. Once the technology is built, it's plug-and-play.
Pat: So it will get less expensive over time. And we didn't talk about this four or five years ago because it wasn't really available. If there's fresh cash coming into a portfolio, we would always prefer direct indexing because even that associated cost with a higher management fee...
Scott: With taxable accounts, not retirement accounts.
Pat: Correct, with taxable accounts. Even that higher management...
Scott: Not always, typically. Never usually.
Pat: Okay. Fair enough, Scott. Fair enough.
Scott: I mean, I'm just thinking of situations. It's not always.
Pat: But it's the first place we would go as an alternative. That fee is going to be higher. But if you're gifting to charity at all, then you use those appreciated assets in those individual stocks.
Scott: That's where it becomes really powerful for those that have some sort of gifting strategy as part of their estate.
Pat: And the other thing is that you may decide to start gifting to your children while you're alive rather than waiting until you pass away, you or your spouse. And if they're in a lower tax bracket, then you gift appreciated shares out of that individual. You can identify the shares. You can gift it to whoever you want. And then when they liquidate, they pay it at a lower basis. Obviously, that gain still needs to be paid. The taxes on it need to be paid. But it's a great technique to actually move from one tax bracket to another if you're gifting to someone that is in a lower marginal tax rate than you.
Dave: But you could do the same thing with an index fund? I mean, I could gift shares in an index.
Scott: You don't have the same...
Pat: But you don't have the same benefit because...
Scott: You don't have the losses.
Pat: ...you're gifting losses inside that portfolio as well. So an index...
Dave: But in 10 years, there's probably not going to be losses...
Pat: No, no.
Dave: ...if any, significant losses.
Scott: There'll still be...
Pat: There will be losses on those individuals inside of those, that 500. There will be losses in that because it's constantly, as you said, it's constantly changing. They're buying and selling.
Scott: They'll trigger gains as well. And again, you can dial in how aggressive you want to be with the losses. So if you don't need to be terribly aggressive, you don't have it. You structure it so it's not terribly aggressive.
Pat: But over time, you're correct. It becomes harder and harder to manage that portfolio because the embedded gains become... But still at 40 basis points...
Scott: I'd do it for myself.
Pat: I don't have any fresh cash. I don't have any money in direct indexes because when I invested the money, the best option was index. If you gave me fresh cash today, it would be 100% into a direct index.
Dave: Even if you weren't going to do anything with it for 20 years.
Pat: That's correct.
Pat: That is 100% correct.
Scott: I mean, one, I think you can get lower costs than 40.4%. And two, I think the cost is going to come down in time. And three, you can always stop. I don't want to pay this anymore.
Dave: Yeah, but then you're stuck.
Pat: That's right. Then you're no longer mimicking the index.
Scott: That's right.
Dave: Yeah. I guess the other thing I was surprised about, I was surprised at the net advantage, I guess. The amount of losses actually thrown off on average each year were only, like, 100 or 200 basis points of the portfolio.
Pat: That's significant.
Dave: Then you take your... And the value of that is maybe 30% of that in terms of tax losses, and then it declines over time. I hear what you guys are saying. I'm not sure the handcuffs...I'm not sure...
Pat: All right.
Scott: All right. Okay, good.
Dave: I'm not sure the juice is worth the squeeze.
Scott: Then don't do it. I mean, it's not that big of a deal relative to everything else. It's not going to have any impact, frankly, on your lifestyle. Most likely will not have much impact on your net worth. We could run some analysis, but my guess would be that 10, 20 years out, your net worth would be a little higher if you use that strategy.
Dave: I appreciate that.
Scott: Yeah.
Pat: Yeah.
Scott: Either way, it's not going to...I mean, it's...
Dave: By the way, I know...I think he's your COO. Pete's a great guy, by the way. I coached one of his boys in lacrosse. I always enjoyed talking to him. That's actually how I got to kind of turn on to you guys.
Pat: Oh, we appreciate that. Yeah, he is a good guy.
Dave: Shout out to Pete.
Scott: All right. Well, thanks, Dave. Yeah, yeah.
Dave: All right. Well, thanks for your time, guys.
Scott: It's not, like, this is the silver bullet and life is going to be much different.
Pat: It's just more efficient, even with the added cost. And, Scott, you are correct. The cost, we've seen them come down already in the relatively few years that they've actually...
Scott: That's right.
Pat: And what caused them to come down was computing power and the fact that...
Scott: And competition.
Pat: Competition and that there's no cost to trade.
Scott: Look, honestly, I don't know what the cost is here at all. I don't recall. I know it's come down, and I know that there's multiple providers who can do that service for us. And so we play them off one another and get the cost down as low as we can for our clients. I personally have direct indexing. And last fall, I went basically and said, "Hey, please give me an analysis of gifting X dollars or Y dollars of shares to my donor advice fund and where these would come from." And I got this nice analysis back, super quick and easy, and I transferred some shares to a donor advice fund.
Pat: And you could do the same if you were gifting to a relative.
Scott: Or gifting to a relative. The advantages, of course, I avoid the capital gains tax entirely, and then I've got losses. Particularly if you're one that's still contributing to investments, you could add additional cash to that as time goes on, and it becomes even more powerful.
Pat: Yes. This is all predicated on current tax law. Let's just give that disclaimer.
Scott: Correct. So you wouldn't want 100%. Yeah, it's all predicated on current tax law.
Pat: All predicated.
Scott: But you can still pick and choose. There's still an argument to be made about, you know, the pick-and-choose, how much taxes you're going to pay on withdrawals from your portfolio.
Pat: That's right.
Scott: Because oftentimes, year by year, things change.
Pat: Yeah. And an index fund...
Scott: I mean, if you've got a very basic...even if you're wealthy but a very basic portfolio, you've got the majority of your assets in, let's say, IRAs, maybe a small pension, Social Security, and you've got a little bit of extra, a brokerage account, it may not be worth the hassle and might not add that much benefit to you.
Pat: But for him, saying that he's not going to spend this money, it's going to go to his children...
Scott: Yeah. And made it sound like he had money in his assets.
Pat: Which would lead me to ask the question, "Well, then, shouldn't we be having a discussion right now about getting some of these dollars to your children now so it can grow, and theirs? And how close are you to death?" Because of the step-up in basis.
Scott: Well, he's mid-60s. Most people in their mid-60s, unless you have substantial wealth, you're not really willing to part with the money because you don't know.
Pat: You don't know.
Scott: And most people, look, even if they have substantial wealth...
Pat: They don't want to give it to the kids.
Scott: Well, they don't feel that wealthy oftentimes. So they're like, "Well, I might need this. Who knows?"
Pat: Yes.
Scott: Nursing homes are expensive or whatever, you know.
Pat: Or maybe you've just seen how your kids spend money and thinking, "Nope." Like, I had a client who keeps money to their kids, and the kid came home with a new Corvette bright red.
Scott: Are you kidding me? This is recently?
Pat: A number of years ago. Because they talked about giving them all kinds of money. And I said, "Why don't you just give them a little now and see what happens, see how they act with it?" I said, "This will be a good indicator on whether you want to put together a big plan to give them money while you're living and even a good plan that you might want to put some restrictions on the money after you die." And they did.
Scott: I couldn't imagine. Oh, it would tear me up.
Pat: The dad has always wanted a red Corvette but never would spend the money. He gives the money to the kid. The kid comes home with a brand new bright red Corvette. Dad said, "God, I would have wanted that." And I said, "Well, you got it. You're just not driving it."
Scott: Yeah. Well, tough. Well, there is something to be said. If you plan on leaving assets to your kids, two things. One is you can gift to see how they deal with it today. Two, have a conversation with them as the years go on.
Pat: And the third is you can put restrictions on the money after you've passed. Tell them how much money they can spend, where it comes from, how much, and you could put it in a third-party trust.
Scott: You could structure it such that you could say, "Look, you can't get anything unless you have a job. And then we're going to give you dollar for dollar or 50 cents for the dollar. So you earn 50 grand, then you can have 25 grand from the portfolio," or whatever it is.
Pat: Yes. Or you can't take more than 30 grand a year out, or whatever you want.
Scott: You can structure it a variety of different ways to give yourself some protection.
Pat: Then you hire financial advisors and trust companies to administer.
Scott: That's right. It is a little complex. The legal profession loves it. All right, let's continue on here. We're talking with Dan. Dan, you're with Allworth's "Money Matters."
Dan: Good morning.
Scott: Hi.
Dan: Hi. You want my question?
Scott: Yes, sir.
Pat: Please.
Dan: Okay. I just heard the previous conversation, and this touches on that a little bit. So you've talked about setting up stock ownership so that you can tax harvest the losses. Can you do anything similar with bonds?
Scott: Absolutely.
Dan: Bond funds.
Scott: Oh, absolutely.
Dan: Yeah?
Scott: Same way, yeah.
Dan: So in 2023, when the bond market crashed, I could have sold off those bond funds?
Pat: We did.
Dan: Yeah. All right. And then we bought the similar bond fund and realized the gain...
Scott: Yeah, you can't... So there's what's called a wash sale rule. So you can't sell something and immediately buy it back. You have to wait 31 days. But you can buy something similar.
Pat: But not identical.
Dan: Right.
Scott: But not identical.
Dan: Right. Right.
Pat: So you can't sell a Vanguard fund, ABC fund and buy Vanguard ABC, but you can buy ABD.
Scott: If it's slightly different.
Pat: If it's slightly different. In fact, you should. Across the whole portfolio, you should.
Scott: Assuming this is when you're outside of retirement accounts.
Pat: Outside.
Scott: If it's inside of retirement accounts...
Pat: It doesn't matter.
Dan: Right. I understand, yeah.
Pat: Yes. But for the rest of the listeners. And in fact, there are programs now that you can actually apply to your portfolio that will do it automatically. So what happens is...so imagine you've got, like, this portfolio that's got these 12 holdings in it, and it's in a brokerage account outside of an IRA, and it's got these 12 different holdings in it, right? We're not talking about direct indexing now. And you've owned these portfolios for years and years. The first thing you do is you quit dividend reinvestment and capital gain reinvestment, because you're going to pay taxes on those anyway, and you actually funnel those off. We just did a very, very large account, that they had been with the same advisor for years and years, and the advisor kept telling them how great they were, but they had dividend reinvestment and capital gains reinvestment for the last 10 years. I'm like, "This is just..."
Scott: They already overweighted in a particular area.
Pat: And this is just...
Scott: Some fund they've had for 25 years.
Pat: And this is just lazy. That's flat-out lazy. And so what happens...
Dan: That was in a brokerage account?
Pat: It was in a brokerage account.
Dan: Okay, yes.
Pat: So the first thing we recommended at the very first meeting, even though the money was at another firm, we're like, "Have this go to cash, and when that cash accumulates, then you go back and rebuy a position, hopefully, tax-efficiently." But these programs will actually build multiple portfolios behind each other. So you've got an A, B, and C. So if you own a bond fund that's lost value, it will sell that automatically and buy the B portfolio of that particular bond fund. And then it waits 31 days and decides whether we're going to go back and buy the original one or keep the one you have based upon whether there's gains or not. And this is all driven by technology. All of it.
Dan: Well, that sounds great. Yeah.
Pat: It's great. Look, this stuff didn't exist. I've been doing this for 30 years.
Scott: Well, historically, Pat, it would be near the end of the year, you do one. You'd look at every account, pull up the cost basis in the portfolio, run the analysis through your calculator or maybe through an Excel spreadsheet, highly time-consuming, not perfect.
Pat: We would just pull from the data across all the clients to see, "Okay, who has losses greater than $1,000?"
Scott: But we've been doing this since we began in our career 30 years ago, and as time has gone on, it's the technology.
Pat: It will take your portfolio and look at it once a week.
Dan: Yeah. So I have another question along those same lines. What do I keep in my IRAs then? If I wanted my stocks and my bonds and my brokerage account, what do I keep in an IRA?
Pat: What do you have in your IRA now?
Dan: Well, I don't invest very well. So I do have a stock portfolio through Schwab, through something called ThomasPartners. And so they own stocks, or it has me owning stocks, dividend-paying large-cap stocks. And then I have a series of bond funds.
Pat: In the IRA?
Dan: In the IRA.
Pat: Okay.
Dan: And I'm thinking all of that should be in the brokerage account.
Scott: You're almost there.
Dan: Which I'm building up because I've accumulated a lot of cash over the last couple of years through my small business.
Scott: Well, but think about this. So dividends from bonds, interest paid from bonds are taxed as ordinary income. Dividends from stocks, typically, they're qualified dividends and are taxed at capital gain qualified dividend rates, which are lower.
Dan: Okay.
Pat: And then capital gains rates are lower than ordinary income tax rates for most people.
Scott: Everything being equal. Let's assume you didn't take any money from these accounts. Let's forget about any long-term estate plan.
Pat: And you had $1 million.
Scott: You would want all the stocks outside of the retirement account and all the bonds inside the retirement account.
Pat: And the reason behind that is...
Scott: Assuming there's no people involved in...
Pat: You had no emotion.
Scott: Or income means.
Pat: And the reason behind that is because, as you know, a distribution from the IRA is taxed as ordinary income.
Scott: Ordinary income.
Pat: So you want to put the most tax-efficient things, which are things that will appreciate in value and get a step-up in basis at death that deliver very little dividend or income from them in the brokerage account, and you want all your bonds in the IRA.
Scott: Everything being equal and setting aside emotions. The challenge is we tend to not...as humans, we usually don't view the accounts as one. We look at them a little bit differently. One is the brokerage account is liquid. So if we need to buy a new car or whatever, there's the account we can go to. The retirement account, we know it's a taxable event. Every time we take a withdrawal, we also have required minimum distributions in the future. So it gets much more complex than just the kind of the concept of...
Pat: And people have a tendency to compare portfolios to each other.
Scott: That's exactly right. And they don't make better decisions off that comparison.
Pat: That's right.
Scott: They make worse decisions off those.
Pat: So in a perfect world, you would have your bonds in the IRA and highly appreciative things that you believe will appreciate over time and are tax-efficient in the brokerage account.
Dan: Okay.
Pat: And my guess is you did not have this conversation with your advisor of the firm you're working with.
Dan: No.
Pat: And the reason is...
Dan: In fact...
Pat: What's that?
Dan: I'm about to have the conversation because I've had just accumulated a pretty large amount of cash over the last couple of years and going to put that into a brokerage account. And then I want to move stuff. Then I want to start managing this a lot smarter.
Scott: And you said you've got a business. Are you planning on selling that at any time in the future?
Dan: It's up in the air. I would like to have the employees take it over. It's a small business. Some kind of a...
Pat: An ESOP?
Dan: An employee-owned... Yeah, not necessarily an ESOP. The fees would be too high for the size business we are.
Scott: They haven't bought you out?
Dan: Yeah, some type of employee-owned, maybe a co-op.
Scott: That all comes into play with how you invest today as well because...
Dan: Right. That'll be taxable.
Pat: Dan, that is a very, very, very tough decision right now to sell to employees the business. If there's a market for the business outside the employees, right, if there's a roll-up happening...
Scott: In almost every industry, there are roll-ups.
Dan: I get legitimate offers for the business at least quarterly. Yes, there's a market for it.
Pat: So the problem with selling to employees, and some employees that are listening to this are thinking, "God, this is crazy."
Scott: Shut up.
Pat: Just be quiet.
Dan: Right, right, right. You made me promises, and now you're going to break your promises.
Pat: Right. Well, no. But you can still sell them part of the business. They just get shares in the roll-up that sits above it. The thing you have to think about is that it takes a long time for you to get that risk off the table.
Scott: Yeah, that's right.
Dan: Right.
Pat: A long time. And quite frankly, some of them may not be capable of running your business.
Dan: Well, that's one of the challenges. I'm working on getting them intellectually capable, but none of them are close to being financially capable to support the lines of credit.
Scott: And they probably never will be.
Dan: Right.
Pat: Right?
Scott: And then you're the one who's carrying the note.
Pat: You carry the note.
Scott: Or you sign a personal guarantee for financing.
Pat: It's a big decision, and it isn't an all-or-nothing, right? So if you sold to a roll-up, you can actually take some of the shares, right, because it doesn't have to be an all-cash deal. Normally, they're not. You can actually take some of those shares...
Scott: And allocate it.
Pat: ...and allocate it to the employees. And actually put handcuffs on it that say, "You don't get these shares until you've worked here for three years."
Scott: Or whatever.
Pat: Whatever you want. It is a very, very difficult environment in order to pass a business down to employees.
Scott: It's an easy environment to sell your business.
Dan: I started on this path three to five years ago, and I just keep waiting for the employees who I love, if they're listening, for them to step up and get into this position where they could take it over. And I'm approaching 66 now. I do intend to work for a long time. Mainly, what I want is I want a company...I want to get out of the day-to-day management, but I want a company that I can comfortably work for into my 70s.
Pat: Okay.
Dan: And yeah, so I'm trying to work with them.
Scott: So I don't know the industry, but I'm writing a book right now with Forbes Books on all the things to consider when selling your business to either private equity or private equity-backed firms, right? There are so many...in almost every industry right now, there's private equity involved, and there are these private equity-backed firms that are buying smaller companies and rolling them in. And it is designed for people like the Dans who maybe they want to retire. But oftentimes, there are people that are great at whatever their trade is, their skill set. They want to get back to doing just what they enjoy doing. They're tired of running a business.
Pat: I don't want to deal with insurance, copiers.
Dan: Right. That's exactly my position.
Pat: And, Dan, the thing that you forget is that your risk tolerance is much higher than those people that work for you.
Dan: Oh, yeah, absolutely.
Pat: Right? How long ago did you start this business?
Dan: In 2002.
Pat: Okay.
Dan: But I've been in the industry since '92.
Scott: What percentage of your net worth is this business comprised?
Dan: My net worth, maybe a quarter, depending on what I could sell it for.
Scott: All right. Good. Okay, good.
Pat: Okay. And the other thing to remember is in that time period that you've started the business till today, was there months or quarters that you missed a paycheck?
Dan: Never.
Pat: You've always been able to pay yourself?
Dan: Oh, myself?
Pat: Yes.
Scott: Yes.
Dan: No, I have missed a paycheck.
Pat: Right?
Dan: I've never missed a payroll, but I've missed a paycheck.
Scott: Not payroll, yeah.
Pat: Yeah, you've missed paychecks to yourself.
Dan: Right.
Pat: Right? And the reason you did that is because you had faith in the long-term viability of the business and things would get better. Correct?
Dan: Yes. Yes.
Pat: You go to your employees and say, "Okay, you're going to own this business. Oh, and by the way, over the next five years, there's probably going to be a three-month, six-month period where you don't pay yourself."
Dan: Right.
Pat: It has such an emotional impact on them that it's really, really difficult for them to comprehend that.
Dan: Yeah. Yeah.
Pat: I tell you, I have a neighbor that sold his business to his employees, and he said to me, "Look, I know it wasn't the best financial thing to do." He said, "But my team was ready, and they were ready." He said, "I haven't had any problems in the transition whatsoever." But he said, "You know, it could have gone either way." Right?
Dan: Yeah.
Pat: So you have to assess those people. Everyone raises their hand when it looks free.
Dan: Right. Oh, absolutely.
Scott: Yeah. Everyone says they want to work for themselves.
Pat: Yes, until they do.
Scott: Yeah, that's right.
Dan: Right, right, right.
Pat: Anyway, it is a big decision, and you might want to actually sit down with someone who's done it, or when Scott's book comes out, to read it.
Dan: Okay. I will look for the book.
Scott: And frankly, I would think, also, talk with a financial advisor who has had experience with these things, because some of your planning today is probably going to be a little different if there's an anticipated sale of a business in the next year, two, three, four, five years.
Pat: How many of these...? We're a platform that rolls up other firms. How many have we done? I did 31 myself.
Scott: We've done, like, 42, 43.
Pat: And about, I'd say, 85% of the time, being fair, 85%...
Scott: Yeah, I don't know where you're going with 85%.
Pat: ...is that the people that have sold are neutral or happy.
Dan: Okay.
Scott: Oh, yeah.
Pat: And about 15% of the time...
Scott: It's all a mindset thing.
Pat: Yes.
Scott: It's 100% a mindset thing.
Pat: And 15% of the time, those that have sold said, "This was terrible. You came in, and changed things." We're like, "Yes, we told you we would."
Scott: In our mind, making them better.
Pat: Yes, in our mind, making them better, but in their mind...
Scott: Better experience for the client.
Pat: But in their mind, less control.
Dan: Yeah, yeah.
Scott: That's what happens.
Dan: Right, right.
Scott: You go from being the man to working for the man.
Dan: Right, right.
Scott: It is a mindset.
Dan: You know, I feel like, you know, if everything collapsed, I could go and work for somebody else tomorrow if I had to. I still have some value in my industry. But I don't want to.
Pat: That's right. That's right.
Scott: You don't want to that. But you might want your next chapter to not have to deal with all the stuff that run in the business that you have to deal with and just...
Dan: I definitely don't want that.
Scott: And just focus on what you enjoy doing.
Pat: And large organizations always have room for that.
Scott: Yep.
Dan: Yeah.
Scott: Right. Look, some of our top advisors were small business owners. They went independent years ago. Now, they're part of the Allworth team. They shed all that stuff they used to do of running the business. Now, they can focus on being the best financial advisors they can be. They're having a ball. Their clients have great outcomes.
Pat: Yeah. And then you backfill, as I had a little bit about our firm. I had one advisor say, "Look, I gained 40% more time in this transaction. I left half of the company and took half for myself."
Scott: Great, right?
Dan: Yeah.
Pat: So, what's that mean? He says, "I travel a lot more." Actually, he bought a vacation home. And he said, "I've never had to deal with anyone in HR. No one's ever come to my office." Right? You get it.
Dan: Yep.
Scott: All right, Dan.
Dan: No. Well, thank you very much.
Pat: Say what you were going to say. The what?
Dan: The worry is, you know, I have some employees that have been with me 10-plus years. I understand that I would do well. I just want to make sure that my employees are in a position to do well as well.
Scott: I think, well, then, when you're looking at your partner, you know, who you might end up partnering up with, selling to, or whatever, that's a big consideration. And where would they have the best career opportunities? And frankly, we look at Allworth, we're 500, 600 employees, somewhere in there, a lot of our leadership have come to us through these other firms that someone used to work for a firm, there were five employees, they had very...I mean, they did all kinds of things. Part of a large organization, they can thrive in their own unique abilities.
Dan: That's what I think, too.
Scott: Not everybody, right? There might be some that don't want to change.
Pat: And you can still tie them into equity.
Scott: Yeah.
Dan: Yeah. Okay.
Pat: Anyway, congrats on...you said you started the business in 2002?
Dan: Yes. Yeah.
Pat: Damn.
Scott: Good for you.
Dan: Yeah, yeah. Thank you.
Pat: You know, someone asked me, like...
Scott: Appreciate the call, Dan.
Pat: ...what was it like running a business? And I said, "It was a lot of fun until it wasn't."
Scott: Well, Pat, like, we are no longer see co-CEOs of Allworth.
Pat: It is so awesome.
Scott: Our CEO had been in our industry for his entire career, led much larger organizations than this
Pat: He's good.
Scott: Super good. He's delivering better results than we could have. The boys are happier.
Pat: Oh, I'm so much happier.
Scott: Our client service is better.
Pat: More services. It's incredible.
Scott: And we get to focus on doing what we love to do, which is helping people like you as we take these calls. We certainly appreciate it.
Pat: Servicing my existing clients and riding my bicycle.
Scott: We're going to talk now with Lisa. Lisa, you're with Allworth's "Money Matters."
Lisa: Hi, thanks for taking my call.
Scott: You're welcome. Thanks for calling.
Lisa: So I have some questions about doing an IRA conversion.
Pat: Okay.
Lisa: So I'm 66 and retired, and I put off taking Social Security until I'm 70. And I'm living off the smallish pension and my non-retirement brokerage account.
Pat: And how much is in your non-retirement brokerage account?
Lisa: There's two. One is 1.7 billion. The other is 470,000.
Pat: Okay.
Lisa: And while my taxable income is low right now, I'd like to do some IRA conversions into a Roth. And my thought is to take a little money each year out of one of my traditional IRAs and put it into a Roth.
Scott: So let me just get clarification. So we have two brokerage accounts. One has 1.7 million, one has 470?
Lisa: Well, I have two traditional Roths. One is 1.7, and the other is 470.
Pat: Wait, wait, excuse me, are those Roths or brokerage accounts?
Scott: Or regular IRAs or traditional IRAs?
Lisa: They're traditional IRAs.
Scott: Okay.
Pat: Okay, okay. How much do you have in brokerage accounts?
Lisa: Two hundred and thirty-six thousand.
Pat: And how much are you living on?
Lisa: I think probably about 100,000 a year.
Pat: And where are you taking it from?
Lisa: So it's going to come from the pensions and the brokerage, primarily, though, in another three or four years, I may need to pull a little out of one of the traditional IRAs.
Pat: And how much is your pension a month?
Scott: Your gross amount.
Lisa: About 2,000.
Pat: Gross. That's your gross.
Lisa: Yeah.
Scott: And so, what's your question for us?
Lisa: So I don't have to convert the entire IRA.
Scott: Oh, no, no. You can convert a dollar. You can convert 10,000. You make up the dollar amount. And each year you can make up a different dollar amount.
Lisa: Good. And once I start taking the required minimum distributions, if I don't need it all that year, can I put the rest into a Roth?
Scott: No.
Pat: No. But look, you've got a lot of years to go before you start your required minimum distribution. You've got nine years. You've got tons and tons and tons of room for planning around this. So just you called to ask a question about the Roth conversions. Did we answer those questions? Because I have some opinions here that I'm going to share.
Lisa: I have one more question.
Pat: Okay.
Lisa: So I am getting minimum distributions from an inherited IRA. Does that prevent me from doing this?
Scott: No.
Pat: It may. It doesn't prevent you, but it might stop you, depending upon the size of the distribution, if it drives you into a higher marginal tax rate. So the answer is nothing prevents you from doing it. The question we should ask is more to do...
Scott: How much do you receive on an annual basis from that?
Lisa: Oh, $700 or $800.
Scott: Oh, okay.
Pat: Okay. No, okay. No, it doesn't.
Scott: No impact.
Pat: Okay. So if you're living on $100,000 a year, and your pension is $24,000, it tells us that you're taking out $76,000 a year from your brokerage account. Is that correct?
Lisa: Probably. Yeah.
Pat: I don't know if I'd do it in that methodology. I think that I'd actually start distributions from my IRA now and preserve some of that...
Scott: I would, too.
Pat: ...and not worry too much about the Roth conversion. But it still makes sense to go through the math. You're single. You've got almost $2.2 million in IRAs.
Scott: And so when you look at...what you've got in brokerage account of money that's already been taxed is relatively small in relation to your overall net worth, right? And I don't think I'd want to change those percentages too much.
Pat: I wouldn't be taking any money out of the brokerage account.
Lisa: Oh, Okay.
Pat: I wouldn't I wouldn't take a dime out. I'd start distributions from that IRA. So if we started distribution from the IRA, so the first thing you do when you look at a financial plan is, do we have enough money overall, right?
Scott: Yeah. Keep up with the spending.
Pat: And then I question whether we should be putting off Social Security till age 70 as well, right? You're not married. Do you have children? If someone's going to, who's going to inherit this money?
Lisa: No, but I come from a very long-lived family on one side.
Pat: Okay.
Scott: I got to tell you, Lisa, if I were in your situation, there's not a chance in the world I would delay Social Security. Because Social Security is not...there's no promise that this is going to be paying for the rest of your life. There's a promise that it's going to be paid until the Social Security trust fund becomes insolvent, which is somewhere around 2033, 2034. At which time, there's a mandatory reduction in benefits. That's the current statute. So Congress is going to need to step in and make changes for people who are on Social Security to continue to receive their benefits. And if I were in your situation, my concern would be, like, "Hmm, maybe they're going to look at me, and I'm a one percenter here, and they're going to look at me as a..."
Pat: You're a one percenter.
Scott: Or maybe 2%, somewhere right in there.
Pat: You're certainly in the top five, for sure, right? And you don't think about it that way, Lisa, right?
Scott: Because you don't feel that way.
Lisa: No.
Pat: Has anyone ever told you that you're in the top 5% most wealthy people in the United States, which probably makes you the top 1/2 of 1% in the world? Has anyone told you that?
Lisa: No.
Pat: You are, for sure.
Scott: Most people, a 66-year-old woman with over 2.5 million bucks in savings is extremely rare.
Pat: I agree with you, Scott. So here's what...so you had called about a Roth conversion, and we took it a completely different direction, right? Which is part of the financial planning process, right? Which is, "Hey, I've got this itch, right? How do I scratch it?" You're like, "You're worried about the wrong thing" Look, I would...
Scott: And some Roth might make some sense. You got to run the numbers.
Pat: I doubt it.
Scott: I doubt it, too, because she's already going to be pushing into the higher tax rate.
Pat: Yeah. So I would look at Social Security prior to age 70, whether it's today or next year or the year after. I certainly wouldn't decide just to postpone it to age 70, and I wouldn't touch another dime in that brokerage account. I got to tell you what I think I would do. I'd go through a financial plan, but I'd start Social Security next year. I'd started pretty close to immediately. I'd started distribution from the IRAs, and I wouldn't touch another dime in that brokerage account.
Scott: Unless you need it...you have an expenditure. Use it for a car.
Pat: Cars, big vacation, cruise. But even then, at $100,000, you should be able to cover all that. How much is your monthly house payment, or do you have one?
Lisa: I don't have one.
Pat: I knew the answer to that. How much money do you have in bank savings accounts?
Lisa: I don't try and keep too much in there, so it's maybe $13,000.
Pat: Okay, perfect, perfect. Yeah, yeah, yeah. So you probably will never do a Roth conversion, but I would start Social Security. I'd sit down and get a financial plan done.
Scott: You do a financial plan. Because what's important now, it's like, retirement ages, how do we deal with our retirement savings, and which accounts do we withdraw from, and at what level? And we got to look at not just what's going to save us the most in tax in 2025, it's what's going to save us the most over the next 10, 20 years? What's going to give us the highest net worth in 10 to 20 years relative to the amount that we're spending? And so it's all those different scenarios that we need to walk through. So, yeah.
Pat: But the answer to your question is yes, you can do a Roth conversion, but you'd be crazy to.
Scott: Well, no, she wouldn't be crazy to do it. It might make sense for her to do some.
Pat: That doesn't make any sense. Scott, how could you walk that back?
Scott: Her requirement of distributions are still going to be pretty significant. Your point is just start taking some money and spending the money today out of your retirement account.
Pat: Yeah, not worry about the Roth conversions. And that brokerage account is really important to keep that thing intact.
Scott: I think so, too.
Pat: It's $236,000. As a percentage of your overall net worth...
Scott: It's not that much.
Pat: ...it's not that much. And if something comes up and you need to get the cash in the financial plan, you know that it's there.
Scott: For who knows what the reason is...
Pat: That's right.
Scott: ...you need cash for something. Otherwise, you're stuck pulling out of your retirement account.
Pat: Which could drive you into a higher marginal tax rate. Appreciate the call.
Scott: There's lots of stuff we talked about that she wouldn't question. Anyway, appreciate the call. Hey, as we're wrapping up the program, wanted to let everyone know we have a March live event. These are in, basically, the cities of Sacramento and Cincinnati. You know, like, Sacramento and Cincinnati, I live in wherever. Sacramento is where our roots are. We've got three offices in the Sacramento region. We've been here forever. And Cincinnati is...why are you looking at me weird?
Pat: We have more than that.
Scott: In the Sacramento region, more than three offices?
Pat: I think we have four, and it depends on what you call the Sacramento.
Scott: Okay, whatever. We have some offices around here. We've been here long. Okay, you're right. Now, I started thinking about it. It depends on what you consider.
Pat: We have a number of offices within driving distance of this workshop.
Scott: And myself and Pat, we've both been in the community for a long time. So we've got lots of clients and lots of people that are interested. So March 26th and 29th in the Sacramento and Cincinnati areas. And essentially, the workshop is advanced wealth strategies for high-net-worth investors. And during this, we're going to share some advanced tactics that high-net-worth investors use to preserve their wealth. We're going to talk about some advanced strategies that we use with our clients.
Every once in a while, we talk about these on the air, but we're going to go into a little more detail about that. And also the tactics designed to help create income and reduce the taxes while you're at it. So those are the main things we're going to be talking about. Again, March 26th, March 29th, in Sacramento and Cincinnati areas. Workshop is free. You do need to sign up. And there are times they fill up. So yes, it's not just, like... allworthfinancial.com/workshops. And looking forward to seeing you there.
That is all the time we have in the program. We will see you next week. This has been Scott Hanson and Pat McClain. Allworth's "Money Matters."
Man: This program has been brought to you by Allworth Financial, a registered investment advisory firm. Any ideas presented during this program are not intended to provide specific financial advice. You should consult your own financial advisor, tax consultant, or estate planning attorney to conduct your own due diligence.
Scott: Welcome to Allworth's "Money Matters." Scott Hanson.
Pat: Pat McClain. Thanks for joining us.
Scott: Myself and my co-host here are both financial advisors and have been helping people for a number of years with their finances, helping them make good choices. And we like taking calls.
Pat: Yes. And we should point out that because of our travel schedule, we are recording this on March the 17th.
Scott: Just because it's when the markets are volatile, just to put things...
Pat: At 10 a.m. Pacific.
Scott: Just because you don't know what's going to happen.
Pat: Oh, it's anyone's guess. It's normal though, Scott.
Scott: The markets are normal. The political environment is not normal.
Pat: Correct. But the attribution to the fall in the market.
Scott: Well, I mean...
Pat: The market goes down.
Scott: And the market might have gone down if there were no tariffs.
Pat: That's right.
Scott: And so, when the market goes down, people find something to blame. That's why the markets are going down. And I think to put things...I had dinner last night with my parents, my mom and stepdad, and one of my sisters. My sister is 65, maybe, still working, and she's a little concerned about the market. So I'm talking to her for a bit. And, like, I've been her brother for forever, right? And she's heard all this stuff from me. And she's got roughly half her portfolio is out of the markets and fixed income and out of the stock market at all. But she's still freaked out about the markets. And she's not the only one. This is very common.
Pat: Very common.
Scott: People are concerned. And if you kind of step back for a moment, first of all, if you go back 75 years, there are declines throughout...even in years when there's positive returns, there's usually periods like this when there's a 10% or more correction. The average intra-year decline, so during the year, intra-year, is just over 14%. So on any typical year, you can expect a 14% decline in stock prices.
Pat: At some point.
Scott: At some point, right? Not every year, obviously. Some years worse, some years not so bad.
Pat: And the market declines like this on average, what, every 27 months? Is that...?
Scott: There's a correction, 10% correction, historically, every 9 months and a bear market every almost 4 years.
Pat: Okay.
Scott: Bear market being a 20% decline.
Pat: So the attribution is different this time. It's always different.
Scott: Yeah, because there's different factors, different circumstances.
Pat: Correct. But the market decline is not unusual. It's a risk premium. That's why you get higher rates of returns out of equity portfolios over time.
Scott: Because they swing in prices.
Pat: Which is you know there's risk in there. And if you have a broadly diversified portfolio, all right, which is...I talk about this investment thesis that you should have, right? And the reason I...I actually have to remind myself.
Scott: I do too. Look, we don't like it when our portfolios go down any more than anybody, right?
Pat: Yes.
Scott: Not only do we have a fiduciary responsibility to our clients, but we're also investors ourselves.
Pat: Yes. And so this article, Wall Street Journal, "The Days of Set-and-Forget Investing Just Ended for Many Americans."
Scott: What does that mean? It means, like, what are you supposed to do now, then?
Pat: I don't know. Well, it talked about how people...
Scott: You should never really set and forget.
Pat: Well, that's...
Scott: You should have a plan.
Pat: A rebalance. You should have a rebalance in your portfolio so that you stick to your investment thesis, right? So people let their portfolios run, right? And so think about if you let your portfolio run over the last two years. What was the returns last year?
Scott: The last two years, the S&P, if you invested January 1st of 2023, by the end of December 31st, 2024, you had a 53% gain.
Pat: Which means...
Scott: Massive.
Pat: Which means if you had a portfolio of 50% stocks and 50% bonds, by the end of that period, your portfolio would probably look like 70% equity.
Scott: Or whatever, 65%, whatever the percentage.
Pat: Whatever the number is. And the rest is in fixed income. So your portfolio has progressively gotten more risky as the markets go up. And if your investment thesis is, which I advocate should look like pension plans, which is they trim the gains and they bolster the losses, so that they're keeping a relatively constant equity to fixed income.
Scott: What happens often if you were to set and forget, you end up getting overweighted in stocks as the years go on.
Pat: And you may be comfortable with that, but most people...what happens is nobody wants to sell their winners.
Scott: That's right. Things go up, they're like, "Whoa, whoa, things are...it's doing so well. Like, why would I want to get rid of this?"
Pat: This article went on to say how people are actually moving money out of the U.S. markets into some European markets, the DAX, the German market, and some European, because they're doing so well. And I thought this article has got some revealing things in it, one being that...
Scott: Maybe you should have a globally diversified portfolio through all market cycles.
Pat: Right? Which is what we talk about all the time, why the average investor underperforms the index in which they're actually invested in, because they do it at the wrong time, right? So if a European market was down and the U.S. market was up...
Scott: Nobody wants to sell. Nobody, Pat. In the last...I have not had one person in the last couple of years saying, "Hey, Scott, I've noticed the U.S. market has completely outperformed the rest of the globe. Why don't we trim our U.S. stocks and buy more global?"
Pat: Yes, I had it happen to me once in my career.
Scott: Instead, you're fighting the opposite. Why do we have global in our portfolio?
Pat: This thing is losing money.
Scott: Why do we have anything outside of the United States?
Pat: Which is why rebalancing a portfolio is so, so important.
Scott: And with new technologies that can rebalance quickly and easily, without the transaction costs that there used to be. Just a couple of years ago, there was trading costs on everything.
Pat: Yeah, friction.
Scott: Selling a stock now, they're virtually free. For example, direct indexing. When it's turbulent times like that, they really take advantage of harvesting losses.
Pat: That's right.
Scott: It could be very powerful to help their overall portfolio.
Pat: Well, this article, when I read it, I thought, "Well, there's four or five things we can learn from this," one being that the political environment should not be shaping. Look, I know someone that when Joe Biden was elected president, they took all of their money out of the stock market and didn't go back in until Donald Trump was elected again.
Scott: Whoopsies.
Pat: I'm like, "What? We're not managing the portfolio?"
Scott: Obviously.
Pat: It's like, what? But then I know people that when Trump was elected the first time, they took all of their money.
Scott: That's right.
Pat: You don't have an investment thesis. You are driving your portfolios purely emotional.
Scott: And every, well, not every, the vast majority of any article you look at, all that clickbait online, it's not designed to make you a better investor.
Pat: That's correct.
Scott: It's designed to get you to read the article and hopefully click on an advertisement.
Pat: That's what their job is.
Scott: That's 100% of their business model.
Pat: That's what their job is.
Scott: Don't forget otherwise. You read those articles, don't forget, "Wait a minute, are they here to really help me?"
Pat: They're there to sell you something.
Scott: Yeah. James Mackintosh writes for "The Wall Street Journal." He's one of the market guys. And I read this stuff, and I'm thinking, "I don't think you do anyone any help here."
Pat: But in all fairness, Scott...
Scott: Jason Zweig is another guy, but he's more on the opinion side. He's much more longer-term.
Pat: But in all fairness, we're here to sell you something. Our ideas.
Scott: That's right.
Pat: We don't sell advertising in the podcast by design.
Scott: That's right. Obviously, we don't do this just because we hope that people become clients. That's fully transparent.
Pat: And many do. They call from out of the United States.
Scott: Which is why we've been doing this for three decades.
Pat: Yes. And if, by the way, you never become a client and you find this helpful...
Scott: Great.
Pat: ...sounds good.
Scott: Perfect. Yes, perfect.
Pat: Absolutely. Great. And maybe one day you think, "Well, either I don't want to do this anymore or it's gotten away from me, or I'm not doing this as tax efficiently as possible."
Scott: I was reviewing some notes. We had a conference last week with all of our advisors, all gathered for their annual conference, and we had a speaker who was on this program last year, Apollo Lupescu.
Pat: Incredible.
Scott: They call him the master of communication and finance, or something, I don't know. He can take very complex ideas and make it very simple and really help people with just understanding the importance of focusing on long term and not getting caught up in the noise. And I was reviewing some of his notes this morning from a speech, and I thought to myself. Here's what I thought to myself. I thought, "Boy, the more he could be mainstream, the better the average investor can do."
Pat: Yes. And what he left his talk talking about is the resiliency of companies that are able to change for different environments. He said, this tariff thing, it's real. It's going to cause some upset for some companies over this short term. But he said...
Scott: Then they're going to pivot.
Pat: And then they'll pivot. Then they'll pivot.
Scott: Do something different.
Pat: Or not. They will go the way of the dinosaurs.
Scott: Well, some companies will be very successful, and some companies won't. And you need to ask yourself if you believe you have the ability to predict which ones are going to be successful and which ones are not going to be successful.
Pat: That is...
Scott: And considering most professional money managers have a hard time doing that, I think that's a fool's play for many people.
Pat: Yes. The allocation and the tax efficiency is key.
Scott: Yep. All right, we're going to take some calls. If you want to be a part of our program, callers are one of my favorite parts of it because no two calls, no two situations are identical. And you might have a work colleague. Maybe you're a couple of years from retiring. Maybe you started the same day as your work colleague. Maybe you share offices together, across the hall, whatever, had very similar career paths. Your portfolios can still look very different. Your financial lives can be very different. Anyway, to join us, 833-99-WORTH, or you can send us an email at questions@moneymatters.com. And we're starting off here with Dave. Dave, you're with Allworth's "Money Matters."
Dave: Hey, guys. How are you doing?
Pat: Good.
Scott: Thanks for joining us.
Dave: Thank you for taking my call. I have a question on direct indexing. I'm going to be having an investment be liquidated on me. So it will produce a significant amount of cash. And normally, I would just roll it into an index, one of the index funds that I already own. I should say, this money will probably eventually just become my kids'. So it's not really an asset allocation issue. That's why I'm just going to put it in the stock market. I was considering, as an alternative, direct indexing, with the idea that the after-tax return would be slightly higher than just a normal low-cost index fund.
Scott: Yeah, absolutely. So this investment that's being liquidated, is this a private company or something, or real estate?
Dave: It was a private credit investment, essentially, loan money to a real estate partnership. And the loan is coming due, and so they're going to be paying it off something.
Scott: So there's not...you don't have a large capital gain that you had offset?
Dave: No. No.
Scott: Okay.
Dave: No, I don't. So I've done some research on direct indexing, and I guess I've come to the conclusion that it's not a good idea in this situation. And I just wanted to run my thinking by you guys.
Scott: Yep.
Pat: And why do you feel that way?
Dave: Well, okay, so it's going to be a large lump sum put into that account and probably not added to. So it will just sit there and, like I said, eventually, pass probably to my kids.
Scott: How old are you?
Dave: I'm in my mid-60s.
Scott: Okay.
Dave: And so the reason why I think it might not be a good idea is that...again, the only reason I'm going into this is for the tax benefits. But those tax benefits, from my analysis, are going to decline over time.
Pat: That's correct.
Dave: And so after perhaps three to five years, there'll be very little tax benefit. But the higher maintenance fees will continue, and these maintenance fees probably are significantly higher than I would be paying, just like the Vanguard S&P 500. And at some point, the capital gain, hopefully, at least, the basis on this investment is going to be so low. I mean, it'll step up at my death, but again, that's hopefully a long time from now. And so I'm thinking that the accumulated management fees are going to offset the tax advantages eventually because the tax advantages are going to decline over time while the higher management fee will stay with me forever.
Scott: Yeah. So let's back up for the rest of the listeners to kind of...
Pat: By the way...
Scott: You're spot on.
Pat: ...you're 100% correct.
Scott: I still might argue why you might want it.
Pat: And we'll tell you a couple of things that we'll touch on, that your financial situation can change and allow for gifting of those highly appreciated individual stocks to your children while you're alive rather than at death.
Scott: So direct indexing, think about the S&P 500, I think most people understand, an index is where an ETF or a mutual fund accumulates shares in, essentially, the 500 largest companies in the United States, and they have a weighting based upon how large the companies are relative to one another. So Apple will have a much higher weighting than some little tiny company that nobody is thinking of that's part of the S&P 500.
Pat: They're capital-weighted.
Scott: And instead of some individual saying, "Hmm, is this a good company to buy? Should we sell this and buy that?" they say, "Look, forget about it. It's fool's game. Let's just own the broad index." Now, with direct indexing, instead of having an ETF or mutual fund, technology creates an index for Dave. And with this, Dave might own...and maybe it's the S&P 500, maybe it's a global index where it's 80% U.S., 20% global, and they'll go out and buy maybe not 500 companies but maybe 350 companies to get 98%, 99% confidence level that you're tracking the index. And then it's managed for a tax basis. And typically, Dave, you can dial in how aggressive you want to be in harvesting losses.
So here, it works really well if let's say you've got a business that you're going to be selling in a year or two, or you know you're going to trigger capital gain in the future. You can use a strategy like this and accumulate losses that you can carry forward that will offset future gains. Or if you said to us that this lump sum you're getting right now is going to have a trigger capital gain, we'd say, "Look, it's great. In the first quarter of this year, you can have direct indexing. They can accumulate significant losses for you to help offset that." It sounds like you don't have any significant gains that you're having to report on. Is that right?
Dave: Well, I mean, I can always use losses, I shouldn't say that, but I can always use losses to...I always have a use for losses, let's put it that way. But again, since you're owning individual in a direct indexing situation, you're actually owning individual stocks. Eventually, you're going to get into this almost handcuffed situation where, "Geez, I'm not crazy about owning this individual stock anymore, but it's got such huge gains in it that I don't want to sell it." And so you've lost some of the flexibility. I mean, one of the reasons why the index fund over time has performed well is that it's not static.
Scott: Static, that's right.
Dave: You know, it's essentially, by default, taking the cream of the crop because it's taking the 500 biggest.
Pat: Yeah. But in a direct index too, it isn't just tax-loss harvesting. They're going to take gains as well, right?
Scott: That's right.
Pat: So they're not going to let it flow out. But your big question is...and what are they charging you to do the direct index?
Dave: You know, I checked in the Schwab and the Vanguard, I think, it depends on the size of the account, but it starts at 0.4 and trends down.
Pat: Yes.
Dave: And you know, that's obviously many multiples higher than you pay.
Scott: You can get it less than that, I think, if you search around. And I think, also, those numbers are going to decline because it's just technology. Once the technology is built, it's plug-and-play.
Pat: So it will get less expensive over time. And we didn't talk about this four or five years ago because it wasn't really available. If there's fresh cash coming into a portfolio, we would always prefer direct indexing because even that associated cost with a higher management fee...
Scott: With taxable accounts, not retirement accounts.
Pat: Correct, with taxable accounts. Even that higher management...
Scott: Not always, typically. Never usually.
Pat: Okay. Fair enough, Scott. Fair enough.
Scott: I mean, I'm just thinking of situations. It's not always.
Pat: But it's the first place we would go as an alternative. That fee is going to be higher. But if you're gifting to charity at all, then you use those appreciated assets in those individual stocks.
Scott: That's where it becomes really powerful for those that have some sort of gifting strategy as part of their estate.
Pat: And the other thing is that you may decide to start gifting to your children while you're alive rather than waiting until you pass away, you or your spouse. And if they're in a lower tax bracket, then you gift appreciated shares out of that individual. You can identify the shares. You can gift it to whoever you want. And then when they liquidate, they pay it at a lower basis. Obviously, that gain still needs to be paid. The taxes on it need to be paid. But it's a great technique to actually move from one tax bracket to another if you're gifting to someone that is in a lower marginal tax rate than you.
Dave: But you could do the same thing with an index fund? I mean, I could gift shares in an index.
Scott: You don't have the same...
Pat: But you don't have the same benefit because...
Scott: You don't have the losses.
Pat: ...you're gifting losses inside that portfolio as well. So an index...
Dave: But in 10 years, there's probably not going to be losses...
Pat: No, no.
Dave: ...if any, significant losses.
Scott: There'll still be...
Pat: There will be losses on those individuals inside of those, that 500. There will be losses in that because it's constantly, as you said, it's constantly changing. They're buying and selling.
Scott: They'll trigger gains as well. And again, you can dial in how aggressive you want to be with the losses. So if you don't need to be terribly aggressive, you don't have it. You structure it so it's not terribly aggressive.
Pat: But over time, you're correct. It becomes harder and harder to manage that portfolio because the embedded gains become... But still at 40 basis points...
Scott: I'd do it for myself.
Pat: I don't have any fresh cash. I don't have any money in direct indexes because when I invested the money, the best option was index. If you gave me fresh cash today, it would be 100% into a direct index.
Dave: Even if you weren't going to do anything with it for 20 years.
Pat: That's correct.
Pat: That is 100% correct.
Scott: I mean, one, I think you can get lower costs than 40.4%. And two, I think the cost is going to come down in time. And three, you can always stop. I don't want to pay this anymore.
Dave: Yeah, but then you're stuck.
Pat: That's right. Then you're no longer mimicking the index.
Scott: That's right.
Dave: Yeah. I guess the other thing I was surprised about, I was surprised at the net advantage, I guess. The amount of losses actually thrown off on average each year were only, like, 100 or 200 basis points of the portfolio.
Pat: That's significant.
Dave: Then you take your... And the value of that is maybe 30% of that in terms of tax losses, and then it declines over time. I hear what you guys are saying. I'm not sure the handcuffs...I'm not sure...
Pat: All right.
Scott: All right. Okay, good.
Dave: I'm not sure the juice is worth the squeeze.
Scott: Then don't do it. I mean, it's not that big of a deal relative to everything else. It's not going to have any impact, frankly, on your lifestyle. Most likely will not have much impact on your net worth. We could run some analysis, but my guess would be that 10, 20 years out, your net worth would be a little higher if you use that strategy.
Dave: I appreciate that.
Scott: Yeah.
Pat: Yeah.
Scott: Either way, it's not going to...I mean, it's...
Dave: By the way, I know...I think he's your COO. Pete's a great guy, by the way. I coached one of his boys in lacrosse. I always enjoyed talking to him. That's actually how I got to kind of turn on to you guys.
Pat: Oh, we appreciate that. Yeah, he is a good guy.
Dave: Shout out to Pete.
Scott: All right. Well, thanks, Dave. Yeah, yeah.
Dave: All right. Well, thanks for your time, guys.
Scott: It's not, like, this is the silver bullet and life is going to be much different.
Pat: It's just more efficient, even with the added cost. And, Scott, you are correct. The cost, we've seen them come down already in the relatively few years that they've actually...
Scott: That's right.
Pat: And what caused them to come down was computing power and the fact that...
Scott: And competition.
Pat: Competition and that there's no cost to trade.
Scott: Look, honestly, I don't know what the cost is here at all. I don't recall. I know it's come down, and I know that there's multiple providers who can do that service for us. And so we play them off one another and get the cost down as low as we can for our clients. I personally have direct indexing. And last fall, I went basically and said, "Hey, please give me an analysis of gifting X dollars or Y dollars of shares to my donor advice fund and where these would come from." And I got this nice analysis back, super quick and easy, and I transferred some shares to a donor advice fund.
Pat: And you could do the same if you were gifting to a relative.
Scott: Or gifting to a relative. The advantages, of course, I avoid the capital gains tax entirely, and then I've got losses. Particularly if you're one that's still contributing to investments, you could add additional cash to that as time goes on, and it becomes even more powerful.
Pat: Yes. This is all predicated on current tax law. Let's just give that disclaimer.
Scott: Correct. So you wouldn't want 100%. Yeah, it's all predicated on current tax law.
Pat: All predicated.
Scott: But you can still pick and choose. There's still an argument to be made about, you know, the pick-and-choose, how much taxes you're going to pay on withdrawals from your portfolio.
Pat: That's right.
Scott: Because oftentimes, year by year, things change.
Pat: Yeah. And an index fund...
Scott: I mean, if you've got a very basic...even if you're wealthy but a very basic portfolio, you've got the majority of your assets in, let's say, IRAs, maybe a small pension, Social Security, and you've got a little bit of extra, a brokerage account, it may not be worth the hassle and might not add that much benefit to you.
Pat: But for him, saying that he's not going to spend this money, it's going to go to his children...
Scott: Yeah. And made it sound like he had money in his assets.
Pat: Which would lead me to ask the question, "Well, then, shouldn't we be having a discussion right now about getting some of these dollars to your children now so it can grow, and theirs? And how close are you to death?" Because of the step-up in basis.
Scott: Well, he's mid-60s. Most people in their mid-60s, unless you have substantial wealth, you're not really willing to part with the money because you don't know.
Pat: You don't know.
Scott: And most people, look, even if they have substantial wealth...
Pat: They don't want to give it to the kids.
Scott: Well, they don't feel that wealthy oftentimes. So they're like, "Well, I might need this. Who knows?"
Pat: Yes.
Scott: Nursing homes are expensive or whatever, you know.
Pat: Or maybe you've just seen how your kids spend money and thinking, "Nope." Like, I had a client who keeps money to their kids, and the kid came home with a new Corvette bright red.
Scott: Are you kidding me? This is recently?
Pat: A number of years ago. Because they talked about giving them all kinds of money. And I said, "Why don't you just give them a little now and see what happens, see how they act with it?" I said, "This will be a good indicator on whether you want to put together a big plan to give them money while you're living and even a good plan that you might want to put some restrictions on the money after you die." And they did.
Scott: I couldn't imagine. Oh, it would tear me up.
Pat: The dad has always wanted a red Corvette but never would spend the money. He gives the money to the kid. The kid comes home with a brand new bright red Corvette. Dad said, "God, I would have wanted that." And I said, "Well, you got it. You're just not driving it."
Scott: Yeah. Well, tough. Well, there is something to be said. If you plan on leaving assets to your kids, two things. One is you can gift to see how they deal with it today. Two, have a conversation with them as the years go on.
Pat: And the third is you can put restrictions on the money after you've passed. Tell them how much money they can spend, where it comes from, how much, and you could put it in a third-party trust.
Scott: You could structure it such that you could say, "Look, you can't get anything unless you have a job. And then we're going to give you dollar for dollar or 50 cents for the dollar. So you earn 50 grand, then you can have 25 grand from the portfolio," or whatever it is.
Pat: Yes. Or you can't take more than 30 grand a year out, or whatever you want.
Scott: You can structure it a variety of different ways to give yourself some protection.
Pat: Then you hire financial advisors and trust companies to administer.
Scott: That's right. It is a little complex. The legal profession loves it. All right, let's continue on here. We're talking with Dan. Dan, you're with Allworth's "Money Matters."
Dan: Good morning.
Scott: Hi.
Dan: Hi. You want my question?
Scott: Yes, sir.
Pat: Please.
Dan: Okay. I just heard the previous conversation, and this touches on that a little bit. So you've talked about setting up stock ownership so that you can tax harvest the losses. Can you do anything similar with bonds?
Scott: Absolutely.
Dan: Bond funds.
Scott: Oh, absolutely.
Dan: Yeah?
Scott: Same way, yeah.
Dan: So in 2023, when the bond market crashed, I could have sold off those bond funds?
Pat: We did.
Dan: Yeah. All right. And then we bought the similar bond fund and realized the gain...
Scott: Yeah, you can't... So there's what's called a wash sale rule. So you can't sell something and immediately buy it back. You have to wait 31 days. But you can buy something similar.
Pat: But not identical.
Dan: Right.
Scott: But not identical.
Dan: Right. Right.
Pat: So you can't sell a Vanguard fund, ABC fund and buy Vanguard ABC, but you can buy ABD.
Scott: If it's slightly different.
Pat: If it's slightly different. In fact, you should. Across the whole portfolio, you should.
Scott: Assuming this is when you're outside of retirement accounts.
Pat: Outside.
Scott: If it's inside of retirement accounts...
Pat: It doesn't matter.
Dan: Right. I understand, yeah.
Pat: Yes. But for the rest of the listeners. And in fact, there are programs now that you can actually apply to your portfolio that will do it automatically. So what happens is...so imagine you've got, like, this portfolio that's got these 12 holdings in it, and it's in a brokerage account outside of an IRA, and it's got these 12 different holdings in it, right? We're not talking about direct indexing now. And you've owned these portfolios for years and years. The first thing you do is you quit dividend reinvestment and capital gain reinvestment, because you're going to pay taxes on those anyway, and you actually funnel those off. We just did a very, very large account, that they had been with the same advisor for years and years, and the advisor kept telling them how great they were, but they had dividend reinvestment and capital gains reinvestment for the last 10 years. I'm like, "This is just..."
Scott: They already overweighted in a particular area.
Pat: And this is just...
Scott: Some fund they've had for 25 years.
Pat: And this is just lazy. That's flat-out lazy. And so what happens...
Dan: That was in a brokerage account?
Pat: It was in a brokerage account.
Dan: Okay, yes.
Pat: So the first thing we recommended at the very first meeting, even though the money was at another firm, we're like, "Have this go to cash, and when that cash accumulates, then you go back and rebuy a position, hopefully, tax-efficiently." But these programs will actually build multiple portfolios behind each other. So you've got an A, B, and C. So if you own a bond fund that's lost value, it will sell that automatically and buy the B portfolio of that particular bond fund. And then it waits 31 days and decides whether we're going to go back and buy the original one or keep the one you have based upon whether there's gains or not. And this is all driven by technology. All of it.
Dan: Well, that sounds great. Yeah.
Pat: It's great. Look, this stuff didn't exist. I've been doing this for 30 years.
Scott: Well, historically, Pat, it would be near the end of the year, you do one. You'd look at every account, pull up the cost basis in the portfolio, run the analysis through your calculator or maybe through an Excel spreadsheet, highly time-consuming, not perfect.
Pat: We would just pull from the data across all the clients to see, "Okay, who has losses greater than $1,000?"
Scott: But we've been doing this since we began in our career 30 years ago, and as time has gone on, it's the technology.
Pat: It will take your portfolio and look at it once a week.
Dan: Yeah. So I have another question along those same lines. What do I keep in my IRAs then? If I wanted my stocks and my bonds and my brokerage account, what do I keep in an IRA?
Pat: What do you have in your IRA now?
Dan: Well, I don't invest very well. So I do have a stock portfolio through Schwab, through something called ThomasPartners. And so they own stocks, or it has me owning stocks, dividend-paying large-cap stocks. And then I have a series of bond funds.
Pat: In the IRA?
Dan: In the IRA.
Pat: Okay.
Dan: And I'm thinking all of that should be in the brokerage account.
Scott: You're almost there.
Dan: Which I'm building up because I've accumulated a lot of cash over the last couple of years through my small business.
Scott: Well, but think about this. So dividends from bonds, interest paid from bonds are taxed as ordinary income. Dividends from stocks, typically, they're qualified dividends and are taxed at capital gain qualified dividend rates, which are lower.
Dan: Okay.
Pat: And then capital gains rates are lower than ordinary income tax rates for most people.
Scott: Everything being equal. Let's assume you didn't take any money from these accounts. Let's forget about any long-term estate plan.
Pat: And you had $1 million.
Scott: You would want all the stocks outside of the retirement account and all the bonds inside the retirement account.
Pat: And the reason behind that is...
Scott: Assuming there's no people involved in...
Pat: You had no emotion.
Scott: Or income means.
Pat: And the reason behind that is because, as you know, a distribution from the IRA is taxed as ordinary income.
Scott: Ordinary income.
Pat: So you want to put the most tax-efficient things, which are things that will appreciate in value and get a step-up in basis at death that deliver very little dividend or income from them in the brokerage account, and you want all your bonds in the IRA.
Scott: Everything being equal and setting aside emotions. The challenge is we tend to not...as humans, we usually don't view the accounts as one. We look at them a little bit differently. One is the brokerage account is liquid. So if we need to buy a new car or whatever, there's the account we can go to. The retirement account, we know it's a taxable event. Every time we take a withdrawal, we also have required minimum distributions in the future. So it gets much more complex than just the kind of the concept of...
Pat: And people have a tendency to compare portfolios to each other.
Scott: That's exactly right. And they don't make better decisions off that comparison.
Pat: That's right.
Scott: They make worse decisions off those.
Pat: So in a perfect world, you would have your bonds in the IRA and highly appreciative things that you believe will appreciate over time and are tax-efficient in the brokerage account.
Dan: Okay.
Pat: And my guess is you did not have this conversation with your advisor of the firm you're working with.
Dan: No.
Pat: And the reason is...
Dan: In fact...
Pat: What's that?
Dan: I'm about to have the conversation because I've had just accumulated a pretty large amount of cash over the last couple of years and going to put that into a brokerage account. And then I want to move stuff. Then I want to start managing this a lot smarter.
Scott: And you said you've got a business. Are you planning on selling that at any time in the future?
Dan: It's up in the air. I would like to have the employees take it over. It's a small business. Some kind of a...
Pat: An ESOP?
Dan: An employee-owned... Yeah, not necessarily an ESOP. The fees would be too high for the size business we are.
Scott: They haven't bought you out?
Dan: Yeah, some type of employee-owned, maybe a co-op.
Scott: That all comes into play with how you invest today as well because...
Dan: Right. That'll be taxable.
Pat: Dan, that is a very, very, very tough decision right now to sell to employees the business. If there's a market for the business outside the employees, right, if there's a roll-up happening...
Scott: In almost every industry, there are roll-ups.
Dan: I get legitimate offers for the business at least quarterly. Yes, there's a market for it.
Pat: So the problem with selling to employees, and some employees that are listening to this are thinking, "God, this is crazy."
Scott: Shut up.
Pat: Just be quiet.
Dan: Right, right, right. You made me promises, and now you're going to break your promises.
Pat: Right. Well, no. But you can still sell them part of the business. They just get shares in the roll-up that sits above it. The thing you have to think about is that it takes a long time for you to get that risk off the table.
Scott: Yeah, that's right.
Dan: Right.
Pat: A long time. And quite frankly, some of them may not be capable of running your business.
Dan: Well, that's one of the challenges. I'm working on getting them intellectually capable, but none of them are close to being financially capable to support the lines of credit.
Scott: And they probably never will be.
Dan: Right.
Pat: Right?
Scott: And then you're the one who's carrying the note.
Pat: You carry the note.
Scott: Or you sign a personal guarantee for financing.
Pat: It's a big decision, and it isn't an all-or-nothing, right? So if you sold to a roll-up, you can actually take some of the shares, right, because it doesn't have to be an all-cash deal. Normally, they're not. You can actually take some of those shares...
Scott: And allocate it.
Pat: ...and allocate it to the employees. And actually put handcuffs on it that say, "You don't get these shares until you've worked here for three years."
Scott: Or whatever.
Pat: Whatever you want. It is a very, very difficult environment in order to pass a business down to employees.
Scott: It's an easy environment to sell your business.
Dan: I started on this path three to five years ago, and I just keep waiting for the employees who I love, if they're listening, for them to step up and get into this position where they could take it over. And I'm approaching 66 now. I do intend to work for a long time. Mainly, what I want is I want a company...I want to get out of the day-to-day management, but I want a company that I can comfortably work for into my 70s.
Pat: Okay.
Dan: And yeah, so I'm trying to work with them.
Scott: So I don't know the industry, but I'm writing a book right now with Forbes Books on all the things to consider when selling your business to either private equity or private equity-backed firms, right? There are so many...in almost every industry right now, there's private equity involved, and there are these private equity-backed firms that are buying smaller companies and rolling them in. And it is designed for people like the Dans who maybe they want to retire. But oftentimes, there are people that are great at whatever their trade is, their skill set. They want to get back to doing just what they enjoy doing. They're tired of running a business.
Pat: I don't want to deal with insurance, copiers.
Dan: Right. That's exactly my position.
Pat: And, Dan, the thing that you forget is that your risk tolerance is much higher than those people that work for you.
Dan: Oh, yeah, absolutely.
Pat: Right? How long ago did you start this business?
Dan: In 2002.
Pat: Okay.
Dan: But I've been in the industry since '92.
Scott: What percentage of your net worth is this business comprised?
Dan: My net worth, maybe a quarter, depending on what I could sell it for.
Scott: All right. Good. Okay, good.
Pat: Okay. And the other thing to remember is in that time period that you've started the business till today, was there months or quarters that you missed a paycheck?
Dan: Never.
Pat: You've always been able to pay yourself?
Dan: Oh, myself?
Pat: Yes.
Scott: Yes.
Dan: No, I have missed a paycheck.
Pat: Right?
Dan: I've never missed a payroll, but I've missed a paycheck.
Scott: Not payroll, yeah.
Pat: Yeah, you've missed paychecks to yourself.
Dan: Right.
Pat: Right? And the reason you did that is because you had faith in the long-term viability of the business and things would get better. Correct?
Dan: Yes. Yes.
Pat: You go to your employees and say, "Okay, you're going to own this business. Oh, and by the way, over the next five years, there's probably going to be a three-month, six-month period where you don't pay yourself."
Dan: Right.
Pat: It has such an emotional impact on them that it's really, really difficult for them to comprehend that.
Dan: Yeah. Yeah.
Pat: I tell you, I have a neighbor that sold his business to his employees, and he said to me, "Look, I know it wasn't the best financial thing to do." He said, "But my team was ready, and they were ready." He said, "I haven't had any problems in the transition whatsoever." But he said, "You know, it could have gone either way." Right?
Dan: Yeah.
Pat: So you have to assess those people. Everyone raises their hand when it looks free.
Dan: Right. Oh, absolutely.
Scott: Yeah. Everyone says they want to work for themselves.
Pat: Yes, until they do.
Scott: Yeah, that's right.
Dan: Right, right, right.
Pat: Anyway, it is a big decision, and you might want to actually sit down with someone who's done it, or when Scott's book comes out, to read it.
Dan: Okay. I will look for the book.
Scott: And frankly, I would think, also, talk with a financial advisor who has had experience with these things, because some of your planning today is probably going to be a little different if there's an anticipated sale of a business in the next year, two, three, four, five years.
Pat: How many of these...? We're a platform that rolls up other firms. How many have we done? I did 31 myself.
Scott: We've done, like, 42, 43.
Pat: And about, I'd say, 85% of the time, being fair, 85%...
Scott: Yeah, I don't know where you're going with 85%.
Pat: ...is that the people that have sold are neutral or happy.
Dan: Okay.
Scott: Oh, yeah.
Pat: And about 15% of the time...
Scott: It's all a mindset thing.
Pat: Yes.
Scott: It's 100% a mindset thing.
Pat: And 15% of the time, those that have sold said, "This was terrible. You came in, and changed things." We're like, "Yes, we told you we would."
Scott: In our mind, making them better.
Pat: Yes, in our mind, making them better, but in their mind...
Scott: Better experience for the client.
Pat: But in their mind, less control.
Dan: Yeah, yeah.
Scott: That's what happens.
Dan: Right, right.
Scott: You go from being the man to working for the man.
Dan: Right, right.
Scott: It is a mindset.
Dan: You know, I feel like, you know, if everything collapsed, I could go and work for somebody else tomorrow if I had to. I still have some value in my industry. But I don't want to.
Pat: That's right. That's right.
Scott: You don't want to that. But you might want your next chapter to not have to deal with all the stuff that run in the business that you have to deal with and just...
Dan: I definitely don't want that.
Scott: And just focus on what you enjoy doing.
Pat: And large organizations always have room for that.
Scott: Yep.
Dan: Yeah.
Scott: Right. Look, some of our top advisors were small business owners. They went independent years ago. Now, they're part of the Allworth team. They shed all that stuff they used to do of running the business. Now, they can focus on being the best financial advisors they can be. They're having a ball. Their clients have great outcomes.
Pat: Yeah. And then you backfill, as I had a little bit about our firm. I had one advisor say, "Look, I gained 40% more time in this transaction. I left half of the company and took half for myself."
Scott: Great, right?
Dan: Yeah.
Pat: So, what's that mean? He says, "I travel a lot more." Actually, he bought a vacation home. And he said, "I've never had to deal with anyone in HR. No one's ever come to my office." Right? You get it.
Dan: Yep.
Scott: All right, Dan.
Dan: No. Well, thank you very much.
Pat: Say what you were going to say. The what?
Dan: The worry is, you know, I have some employees that have been with me 10-plus years. I understand that I would do well. I just want to make sure that my employees are in a position to do well as well.
Scott: I think, well, then, when you're looking at your partner, you know, who you might end up partnering up with, selling to, or whatever, that's a big consideration. And where would they have the best career opportunities? And frankly, we look at Allworth, we're 500, 600 employees, somewhere in there, a lot of our leadership have come to us through these other firms that someone used to work for a firm, there were five employees, they had very...I mean, they did all kinds of things. Part of a large organization, they can thrive in their own unique abilities.
Dan: That's what I think, too.
Scott: Not everybody, right? There might be some that don't want to change.
Pat: And you can still tie them into equity.
Scott: Yeah.
Dan: Yeah. Okay.
Pat: Anyway, congrats on...you said you started the business in 2002?
Dan: Yes. Yeah.
Pat: Damn.
Scott: Good for you.
Dan: Yeah, yeah. Thank you.
Pat: You know, someone asked me, like...
Scott: Appreciate the call, Dan.
Pat: ...what was it like running a business? And I said, "It was a lot of fun until it wasn't."
Scott: Well, Pat, like, we are no longer see co-CEOs of Allworth.
Pat: It is so awesome.
Scott: Our CEO had been in our industry for his entire career, led much larger organizations than this
Pat: He's good.
Scott: Super good. He's delivering better results than we could have. The boys are happier.
Pat: Oh, I'm so much happier.
Scott: Our client service is better.
Pat: More services. It's incredible.
Scott: And we get to focus on doing what we love to do, which is helping people like you as we take these calls. We certainly appreciate it.
Pat: Servicing my existing clients and riding my bicycle.
Scott: We're going to talk now with Lisa. Lisa, you're with Allworth's "Money Matters."
Lisa: Hi, thanks for taking my call.
Scott: You're welcome. Thanks for calling.
Lisa: So I have some questions about doing an IRA conversion.
Pat: Okay.
Lisa: So I'm 66 and retired, and I put off taking Social Security until I'm 70. And I'm living off the smallish pension and my non-retirement brokerage account.
Pat: And how much is in your non-retirement brokerage account?
Lisa: There's two. One is 1.7 billion. The other is 470,000.
Pat: Okay.
Lisa: And while my taxable income is low right now, I'd like to do some IRA conversions into a Roth. And my thought is to take a little money each year out of one of my traditional IRAs and put it into a Roth.
Scott: So let me just get clarification. So we have two brokerage accounts. One has 1.7 million, one has 470?
Lisa: Well, I have two traditional Roths. One is 1.7, and the other is 470.
Pat: Wait, wait, excuse me, are those Roths or brokerage accounts?
Scott: Or regular IRAs or traditional IRAs?
Lisa: They're traditional IRAs.
Scott: Okay.
Pat: Okay, okay. How much do you have in brokerage accounts?
Lisa: Two hundred and thirty-six thousand.
Pat: And how much are you living on?
Lisa: I think probably about 100,000 a year.
Pat: And where are you taking it from?
Lisa: So it's going to come from the pensions and the brokerage, primarily, though, in another three or four years, I may need to pull a little out of one of the traditional IRAs.
Pat: And how much is your pension a month?
Scott: Your gross amount.
Lisa: About 2,000.
Pat: Gross. That's your gross.
Lisa: Yeah.
Scott: And so, what's your question for us?
Lisa: So I don't have to convert the entire IRA.
Scott: Oh, no, no. You can convert a dollar. You can convert 10,000. You make up the dollar amount. And each year you can make up a different dollar amount.
Lisa: Good. And once I start taking the required minimum distributions, if I don't need it all that year, can I put the rest into a Roth?
Scott: No.
Pat: No. But look, you've got a lot of years to go before you start your required minimum distribution. You've got nine years. You've got tons and tons and tons of room for planning around this. So just you called to ask a question about the Roth conversions. Did we answer those questions? Because I have some opinions here that I'm going to share.
Lisa: I have one more question.
Pat: Okay.
Lisa: So I am getting minimum distributions from an inherited IRA. Does that prevent me from doing this?
Scott: No.
Pat: It may. It doesn't prevent you, but it might stop you, depending upon the size of the distribution, if it drives you into a higher marginal tax rate. So the answer is nothing prevents you from doing it. The question we should ask is more to do...
Scott: How much do you receive on an annual basis from that?
Lisa: Oh, $700 or $800.
Scott: Oh, okay.
Pat: Okay. No, okay. No, it doesn't.
Scott: No impact.
Pat: Okay. So if you're living on $100,000 a year, and your pension is $24,000, it tells us that you're taking out $76,000 a year from your brokerage account. Is that correct?
Lisa: Probably. Yeah.
Pat: I don't know if I'd do it in that methodology. I think that I'd actually start distributions from my IRA now and preserve some of that...
Scott: I would, too.
Pat: ...and not worry too much about the Roth conversion. But it still makes sense to go through the math. You're single. You've got almost $2.2 million in IRAs.
Scott: And so when you look at...what you've got in brokerage account of money that's already been taxed is relatively small in relation to your overall net worth, right? And I don't think I'd want to change those percentages too much.
Pat: I wouldn't be taking any money out of the brokerage account.
Lisa: Oh, Okay.
Pat: I wouldn't I wouldn't take a dime out. I'd start distributions from that IRA. So if we started distribution from the IRA, so the first thing you do when you look at a financial plan is, do we have enough money overall, right?
Scott: Yeah. Keep up with the spending.
Pat: And then I question whether we should be putting off Social Security till age 70 as well, right? You're not married. Do you have children? If someone's going to, who's going to inherit this money?
Lisa: No, but I come from a very long-lived family on one side.
Pat: Okay.
Scott: I got to tell you, Lisa, if I were in your situation, there's not a chance in the world I would delay Social Security. Because Social Security is not...there's no promise that this is going to be paying for the rest of your life. There's a promise that it's going to be paid until the Social Security trust fund becomes insolvent, which is somewhere around 2033, 2034. At which time, there's a mandatory reduction in benefits. That's the current statute. So Congress is going to need to step in and make changes for people who are on Social Security to continue to receive their benefits. And if I were in your situation, my concern would be, like, "Hmm, maybe they're going to look at me, and I'm a one percenter here, and they're going to look at me as a..."
Pat: You're a one percenter.
Scott: Or maybe 2%, somewhere right in there.
Pat: You're certainly in the top five, for sure, right? And you don't think about it that way, Lisa, right?
Scott: Because you don't feel that way.
Lisa: No.
Pat: Has anyone ever told you that you're in the top 5% most wealthy people in the United States, which probably makes you the top 1/2 of 1% in the world? Has anyone told you that?
Lisa: No.
Pat: You are, for sure.
Scott: Most people, a 66-year-old woman with over 2.5 million bucks in savings is extremely rare.
Pat: I agree with you, Scott. So here's what...so you had called about a Roth conversion, and we took it a completely different direction, right? Which is part of the financial planning process, right? Which is, "Hey, I've got this itch, right? How do I scratch it?" You're like, "You're worried about the wrong thing" Look, I would...
Scott: And some Roth might make some sense. You got to run the numbers.
Pat: I doubt it.
Scott: I doubt it, too, because she's already going to be pushing into the higher tax rate.
Pat: Yeah. So I would look at Social Security prior to age 70, whether it's today or next year or the year after. I certainly wouldn't decide just to postpone it to age 70, and I wouldn't touch another dime in that brokerage account. I got to tell you what I think I would do. I'd go through a financial plan, but I'd start Social Security next year. I'd started pretty close to immediately. I'd started distribution from the IRAs, and I wouldn't touch another dime in that brokerage account.
Scott: Unless you need it...you have an expenditure. Use it for a car.
Pat: Cars, big vacation, cruise. But even then, at $100,000, you should be able to cover all that. How much is your monthly house payment, or do you have one?
Lisa: I don't have one.
Pat: I knew the answer to that. How much money do you have in bank savings accounts?
Lisa: I don't try and keep too much in there, so it's maybe $13,000.
Pat: Okay, perfect, perfect. Yeah, yeah, yeah. So you probably will never do a Roth conversion, but I would start Social Security. I'd sit down and get a financial plan done.
Scott: You do a financial plan. Because what's important now, it's like, retirement ages, how do we deal with our retirement savings, and which accounts do we withdraw from, and at what level? And we got to look at not just what's going to save us the most in tax in 2025, it's what's going to save us the most over the next 10, 20 years? What's going to give us the highest net worth in 10 to 20 years relative to the amount that we're spending? And so it's all those different scenarios that we need to walk through. So, yeah.
Pat: But the answer to your question is yes, you can do a Roth conversion, but you'd be crazy to.
Scott: Well, no, she wouldn't be crazy to do it. It might make sense for her to do some.
Pat: That doesn't make any sense. Scott, how could you walk that back?
Scott: Her requirement of distributions are still going to be pretty significant. Your point is just start taking some money and spending the money today out of your retirement account.
Pat: Yeah, not worry about the Roth conversions. And that brokerage account is really important to keep that thing intact.
Scott: I think so, too.
Pat: It's $236,000. As a percentage of your overall net worth...
Scott: It's not that much.
Pat: ...it's not that much. And if something comes up and you need to get the cash in the financial plan, you know that it's there.
Scott: For who knows what the reason is...
Pat: That's right.
Scott: ...you need cash for something. Otherwise, you're stuck pulling out of your retirement account.
Pat: Which could drive you into a higher marginal tax rate. Appreciate the call.
Scott: There's lots of stuff we talked about that she wouldn't question. Anyway, appreciate the call. Hey, as we're wrapping up the program, wanted to let everyone know we have a March live event. These are in, basically, the cities of Sacramento and Cincinnati. You know, like, Sacramento and Cincinnati, I live in wherever. Sacramento is where our roots are. We've got three offices in the Sacramento region. We've been here forever. And Cincinnati is...why are you looking at me weird?
Pat: We have more than that.
Scott: In the Sacramento region, more than three offices?
Pat: I think we have four, and it depends on what you call the Sacramento.
Scott: Okay, whatever. We have some offices around here. We've been here long. Okay, you're right. Now, I started thinking about it. It depends on what you consider.
Pat: We have a number of offices within driving distance of this workshop.
Scott: And myself and Pat, we've both been in the community for a long time. So we've got lots of clients and lots of people that are interested. So March 26th and 29th in the Sacramento and Cincinnati areas. And essentially, the workshop is advanced wealth strategies for high-net-worth investors. And during this, we're going to share some advanced tactics that high-net-worth investors use to preserve their wealth. We're going to talk about some advanced strategies that we use with our clients.
Every once in a while, we talk about these on the air, but we're going to go into a little more detail about that. And also the tactics designed to help create income and reduce the taxes while you're at it. So those are the main things we're going to be talking about. Again, March 26th, March 29th, in Sacramento and Cincinnati areas. Workshop is free. You do need to sign up. And there are times they fill up. So yes, it's not just, like... allworthfinancial.com/workshops. And looking forward to seeing you there.
That is all the time we have in the program. We will see you next week. This has been Scott Hanson and Pat McClain. Allworth's "Money Matters."
Man: This program has been brought to you by Allworth Financial, a registered investment advisory firm. Any ideas presented during this program are not intended to provide specific financial advice. You should consult your own financial advisor, tax consultant, or estate planning attorney to conduct your own due diligence.