The Optometry Money Podcast Ep. 153: How to Invest Tax-Efficiently and Keep More of Your Returns (After-tax)

Evon: [00:00:00] Hey everybody. Welcome back to the Optometry Money Podcast, where we’re helping ODs all over the country make better and better decisions around their money, their careers, and their taxes. I am your host, Evon Mendrin, Certified Financial Planner(TM) practitioner, and owner of Optometry Wealth Advisors and independent financial planning firm just for optometrists nationwide.

And thank you so much for listening. Really appreciate your time and your attention today. And on today’s episode, I wanna dive into tax efficient investing, or what I often call tax smart investing because taxes basically show up in every aspect of your finances. It’s just always something that we’re planning around in one way or another.

And that’s no different than investments. In fact, if you think about two investors like you and I, we can have the exact same. Pre-tax returns over time, but end up with very [00:01:00] different after-tax Wealth throughout our careers. And that may not be anything to do with market timing or picking the right investments or taking more risk or less risk.

It can come down to which investments you own and which accounts they’re held in, and how taxes show up along the way. So taxes have to be thought about when you’re investing. And, today I wanna go through why taxes matter in the first place.

I wanna talk about the different types of accounts, the containers that we can use, the tax characteristics of common investments, and how to pair the right investments with the right accounts.

And the goal here when trying to invest tax efficiently, is not to avoid taxes at all costs.

It’s to maximize after tax returns, after tax Wealth over your lifetime. and I say that because there are far too many investment pitches out there, marketing, tax savings, but they may not actually be good investments in the first place. And we see [00:02:00] versions and variations of this in insurance pitches.

We see this with real estate deals. We see this. I would even add qualified opportunity zone funds in here as things that lean really heavily on tax savings, on, on tax law, but may not actually be something you’d want to invest in in the first place. And so we don’t wanna let the tax tail wag the dog. We want to first own good investments and then try to maximize return over time. While minimizing taxes along the way.

Why Do Taxes Matter for Optometrists When Investing?

Evon: So why do taxes matter? well, if you own a taxable investment account, you’re about to be reminded of that over the next month or two as you get your 1099s from those accounts, and it’s gonna show you exactly how much income those accounts created.

because especially in taxable brokerage accounts, let’s set aside retirement accounts and all that stuff, but just focusing on taxable investment accounts. taxes are a [00:03:00] real cost to you. It’s a real drag on your investment returns, whenever you have dividend and interest kicked off in those accounts.

When you have capital gains distributions from mutual funds, when you have. Capital gains created from your activity, from selling things that you’ve owned at a higher amount than you bought it at all of that income shows up in your tax return, in that year in those taxable investment accounts.

And the taxes you have to pay on that income is a true cost to you. Now you don’t really see that in like the returns data, although you can very often find after tax returns using like assumed tax rates, but those taxes are a real cost to you. It’s a real expense that you’re incurring over time, and it’s a drag on your investment returns.

And unlike market returns, the ups and downs day to day of the market. Taxes are something you can usually control to a meaningful degree. And zooming out even beyond that, if we zoom out even further, taxes don’t just impact [00:04:00] this year’s return. They also affect future taxation through, especially through retirement.

because when you think about the investment accounts that you use, like retirement accounts, pre-tax, Roth or taxable investment accounts. even the different assets you have, like directly held real estate or things like that, or if you are a passive owner, active owner in a practice, all of those things impact the tax costs through retirement, which is a major expense to plan around at that phase in your life.

So the type of accounts you use to invest can impact your lifetime taxes in that way.

And so when I think about tax smart investing or tax efficient investing, I think there’s two parts to it. There’s the account types that you use, the type of investment accounts that you use. Which all have their different tax characteristics, and then there’s the actual investments themselves and the type of income they kick off.

Both of those things can impact your lifetime taxes.

1st Layer of Tax-Efficient Investing for Optometrists: The Type of Investment Account You’re Using

Evon: and so [00:05:00] let’s start with the containers, the type of accounts you use while investing. And the first one we’ll talk about are taxable brokerage accounts. How are those taxed? when you put money into a taxable brokerage account, you don’t get a tax benefit like you do with a retirement account, you don’t get a deduction for putting money into it, but you also don’t get taxed when you withdraw from it, however, in a taxable brokerage account, all of the investment income that’s kicked off in those accounts shows up on your tax return, as we talked about in that year.

How Different Types of Investment Income is Taxed

Evon: So that’s dividends in interest. It’s capital gains when you sell, plus any capital gains distributions passed on by mutual funds and the exact tax rate you’re gonna see depends on the type of income that’s kicked off from those, from those accounts. So long-term capital gains, if you own an investment for longer than one year and then you sell it, that’s considered a long-term capital gain. That type of investment income has more favorable tax rates.

it’s gonna be 0% or [00:06:00] 15% or 20% depending on your taxable income. And then with all of this investment income, there’s a potential extra 3.8% net investment income tax that you have to think about as well, depending on your income.

However, if you own something for exactly one year or less, and then you sell it, then it’s taxed as a short-term capital gain, and that’s taxed just like all of your other income.

Less favorable tax rates, 22%, 24, 32, so on and so forth. So usually you’re wanting to try to avoid those short-term capital gains. and then we have dividend income. And dividend income can either be qualified dividend income, which there’s a certain definition of which ones are qualified or non-qualified.

So if it’s qualified dividend income, then they get that same favorable tax rate as long-term capital gains 0%, 15% or 20%. If it’s non-qualified dividend income, then it’s taxed at those ordinary income tax rates, the less favorable ones.

And then some investments, which we’ll talk about a little bit later, [00:07:00] especially REITs or bonds tend to create income that’s taxed less favorably in taxable investment accounts for example, the interest that bonds tend to kick off, so,we’ll talk about that in a little bit.

So the type of investments that, that you’re investing in, those taxable brokerage accounts, and it could be an individual account. It could be a joint tenants account or a community property account. It could be a living trust account for all of those taxable type non-retirement type accounts.

The type of investments that you’re owning in them have a really big impact on the tax outcome over time. The second one are pre-tax retirement accounts, like traditional IRAs. 401(k)s pre-tax, 401k contributions. Those accounts, when you put money into ’em, you get a deduction. So you’re deferring tax on that income and then it grows and all that investment income just stays in this retirement account bubble.

You don’t pay taxes on any of that income while it’s growing, and then in retirement, when you withdraw dollars from those accounts.

[00:08:00] then those dollars are taxed as ordinary income, whatever amount you withdraw from those accounts. So that’s pre-tax r etirement accounts, and then you have Roth retirement accounts. It could be a Roth IRA, it could be a Roth 401k. And Roth accounts are the flip opposite Roth accounts.

You don’t get a deduction for putting money into it. you’re just putting after tax dollars into it. And, and those dollars just continue to grow and compound. You don’t pay tax on the income along the way. And then once you get to retirement, assuming you follow the rules.

the full amount should come out tax free. So the tax advantages are flipped there. And then lastly, we have health savings account. The HSAs. HSAs are, at least at a federal tax level, triple tax advantage, you get a deduction for putting money into it.

You can invest the funds in an HSA and it grows just like a Roth IRA federally. And then when you withdraw from it, as long as you’re withdrawing for qualified medical expenses, those withdraws come out tax free. Now, each state can treat [00:09:00] that a little bit differently. California, for example, recognizes none of those b enefits, but at our federal level, you get this really awesome triple tax advantages with an HSA.

And so you have all of these different accounts, all of these different containers, and each of them have a different tax characteristic. Of course, they all have different levels of flexibility too, because retirement accounts have certain restrictions around when you can get access to them without penalty.

HSAs you have to withdraw for a very specific category of expenses , and then with taxable investment accounts, you have full flexibility. You can use the funds whenever and however you want. And you can put as much into those accounts as you want.

. So,various levels of flexibility, but also different type of tax characteristics, especially when you take money out of them.

2nd Layer of Tax Efficient Investing: The Types of Investments You’re Choosing

Evon: So those are the accounts. Now let’s talk about the second layer, the actual investments themselves and these, this is what you’re actually gonna be buying in these accounts. And the first one are stocks, what type of income do stocks kick off? Well, it’s dividends, right? And it can be [00:10:00] qualified dividends. It could be on a non-qualified dividends, but,stocks generally tend to be more on the tax efficient side because what you’re seeing from stocks tends to be the more qualified, more favorably tax dividend.

and then there’s capital gains of course, when you sell those stocks specifically in a taxable investment account, right? So dividends and then you do have to worry about tax, capital gains as well.

Bonds, On the other hand, bonds are really tax inefficient. It kicks off a lot of yucky income. taxable bond interest generally is taxed as ordinary income, so it’s taxed just like interest from a savings account at all of your regular income tax rates.

which is very often why you don’t wanna see these in something like a taxable investment account. there are some exceptions. For example, municipal bonds, that interest from muni bonds are federally tax free. And then the state tax rules around that may actually vary from state to state.

And then treasuries are the flip opposite. Interest from US treasuries are exempt from state tax, but are taxed federally. usually the saying is that [00:11:00] governments will tax themselves but not each other.

So a state muni bond,is often taxed by the state, but not federally, US treasuries taxed by the US government, but not by the state.

Evon: and then lastly, we have REITs. And REITs are high income investments. REITs are required to distribute most of the taxable income. that means the tend to throw off larger regular distributions compared to a broad stock market index. those distributions are usually non-qualified dividends, so they’re commonly taxed at ordinary income tax rates.

possibly, again, subject to that 3.8% additional tax. but, but that being said, qualified REIT dividends may actually be eligible for the 20% QBI deduction that your Optometry practice benefits from.

So a little bit of a benefit there, but overall, a lot of income, usually non-qualified income coming outta these REITS.

So we have stocks, we have bonds, we have REITs, and then we have the mutual funds and ETFs that own them. For the most part, especially if you’re a client in my firm, we’re gonna be [00:12:00] owning ETFs and potentially mutual funds. And those funds basically just pass through the same type of income based on what’s inside of them.

So stock mutual funds. Those stocks inside of those funds are creating dividends. And so the funds are gonna pass those dividends onto you and you’re gonna be taxed that same way and that dividend income is gonna show up on your tax return. Same thing with REIT funds.

same thing with bond funds and if it’s a mix of all those, it’s a mix of this different income. So it really depends on the type of mutual fund or the type of ETF you own. Is it? A stock mutual fund? Is it a bond mutual fund? Is it something else? Those mutual funds are just passing that income along to you, the owner.

The Fund Management Plays a Large Role in Taxable Income Passed on to

Evon: And what’s also really important about mutual funds or ETFs are how those funds are managed. So for example, actively managed mutual funds. Tend to trade more, the manager tends to trade more on those funds and pass through more taxable capital gains to you at the end of the year. [00:13:00] Index funds and more passive factor-based funds, they tend to be more tax efficient.

They are more rules-based. There’s gonna be a lot less turnover on those funds, a lot less trading, I should say, buying and selling in those funds. And they very often are more tax efficient. And they’re very often more tax efficient.

And there are, in the decades of academic work around how often these actively managed mutual funds underperform their benchmark or the market as a whole. among the list of reasons why that is and why we would assume that continues on are taxes. assuming an active manager’s able to get over the hump of a highly efficient and highly competitive market, assuming they’re able to overcome their own management fees with high performance.

That additional tax barrier, if you’re owning these things in a taxable investment account, makes it a, an extremely high barrier for these managers to get over. And so it is just a really tough proposition in [00:14:00] general if you’re going to be investing in actively managed mutual funds versus a passive approach.

I, I believe available research supports a passive style of investing, but especially if you’re doing that in a taxable brokerage account, that’s a really high hurdle for them to jump over.

and then ETFs in general. So exchange traded funds, often just send out less capital gain distributions at the end of the years, based on how they work.

ETFs in general tend to be more tax efficient than mutual funds.

Differences in US vs. International Stock Fund Taxation

Evon: There’s also some differences in US versus international funds versus emerging market funds. And that, US funds tend to be broadly speaking, The dividends in those funds tends to be more qualified, international funds, especially like passive indexed or factor-based funds, international developed funds, if they’re really good about managing taxes, most of those dividends should also be qualified, although would likely be more [00:15:00] non-qualified in international funds.

And then emerging markets are likely going to be more non-qualified than the other two. And so. Whether they’re US and international emerging markets, and what the management strategy is, is it an active investment approach versus a passive style investment approach.

And really just how good the fund company and the manager is at managing taxes as they’re buying and selling it as they’re trading all of those things can impact the tax bill that you’re gonna pay, particularly if you’re gonna own those in taxable accounts.

Hey, optometrists. Quick break. If you want. A simple way to apply all that we’re talking about today. We made an optometrist’s guide to tax efficient investing that you can download. It walks you through all the steps to help you review what you have, what you own, and how to map those investments to the right accounts. You can grab it at the link in the show notes.

with that, let’s get back to the episode.

Putting It Together – How to Invest Tax Efficiently with the Appropriate Investments in the Appropriate Accounts

Evon: And so we have these different types of accounts. We have these different types of investments that kick off their own different types of income. Now let’s put it all together and talk about how we [00:16:00] invest tax efficiently.

And the jargon term we usually use is asset location. Basically what that means is you’re being really careful about putting certain categories of investments in the most appropriate accounts to improve after tax outcomes.

And so when I’m working with a family for the first time and then ongoing, my approach looks something like this, I tend to think of all of a family’s investment accounts that are going towards the same investment goal. for example, retirements or long-term financial independence. I tend to think of all of those accounts as one big household investment mix. One big household investment pie, and each of those accounts are just one slice of that pie, but they’re all included here.

So it could be the 401k, could be a SEP IRA, could be could be traditional IRAs, Roth IRAs, taxable accounts, HSAs. If all those accounts have the same goal, I am bringing them all together and investing them in a coordinated way.

And then the first thing we’re doing is deciding on our overall mix of [00:17:00] investments, our overall mix of different investments,how much stocks versus bonds, for example.

and it might be a hundred percent stocks, it might be 80% stocks, 20% bonds, whatever it might be. That’s our first decision. And then I look at all these household accounts and I say, okay, I know my targets. I know what we’re aiming for. X percent stocks, X percent bonds. Now I can work on putting the most appropriate investment types or categories into the most appropriate investment account.

And I wanna put the most tax inefficient assets and the most tax sheltered accounts, and then put the most tax efficient assets. That taxable account. so for example, the typical ordering of operations might look like if we have pre-tax retirement accounts like, 401(k)s, for example.

We want to prioritize putting taxable bonds or bond funds really in those 401k accounts or traditional IRAs. We might wanna prioritize putting REITs in those accounts. We [00:18:00] might wanna prioritize anything that kicks off a lot of yucky in tax inefficient income.

in Roth accounts or HSA accounts, which I treat the same way.

Because those are essentially tax free dollars. we wanna prioritize growth. We often wanna prioritize the, the type of investments with the highest expected returns or highest expected growth over time. So that’s certainly gonna be stocks or maybe REITs.

but we might even be prioritizing like certain categories of stocks, like for example, small cap value or emerging markets or something like that. we’re putting the highest growth categories in those Roth accounts. and what do we wanna avoid? we wanna avoid bonds.

Basically, we wanna keep bonds, if at all possible, out of those Roth IRAs and out of those HSAs. Because we want those tax free dollars to grow. We do not wanna see bonds in those accounts if we can avoid it.

And then lastly, we have those taxable accounts.

with the taxable accounts, we wanna prioritize really tax efficient stuff. So we wanna prioritize stock market investments [00:19:00] especially broad passive style, low turnover, stock funds like index funds or certain, factor-based funds.

We wanna avoid if we can, high dividend type strategies, high dividend type funds, I’m sorry, to dividend investors, but you’re really just hurting yourself by forcing unnecessarily, in my opinion, a lot of investment income on your tax return. REITs, if we can avoid it, we wanna try to keep those in a retirement account rather than a taxable account.

and then taxable bonds. When possible, we wanna avoid putting those bond funds or taxable bonds in taxable investment accounts. And then we’ll also think through, okay, are we using international, are we using in, US or emerging markets?

we probably wanna start with US because again, we’re getting more of that qualified, more favorably taxed Dividend income. International develops is probably okay If it’s something like an index or a factor-based fund, emerging markets, I would try if possible, to prioritize away from the taxable account just because of that non-qualified, [00:20:00] like less favorably taxed, dividend income.

And and so you can look at these accounts and try to place the most appropriate investments in the most favorable type of accounts.

And then you just keep that balance over time. And if you need to rebalance. Rather than looking at it as each account being handled separately. You can rebalance across all of these accounts as a household. And this is something we do to try to optimize that after-tax Wealth over time.

And of course there are always constraints.

These are very general guidelines. Obviously, everyone’s situation is a little bit different. Everyone’s constraints are a little bit different.

Like everything else investment related. You wanna look at your own specific situation, talk with your own advisor about what makes sense for you. For example, in those taxable accounts, you have to look at taxes. If you sell a bunch of those funds to reinvest them, is it gonna create too much capital gain income, or should you be doing that over time?

Another example are 401k accounts, your 401k is gonna have a certain list of investments you can invest in And you’re kind of at the mercy of that list, right? So that’s the first constraint that I’m always working around [00:21:00] is what funds are available in the 401k. Now, sometimes you’ll get a brokerage account feature in the 401k that’s gonna give you more flexibility, but that’s one constraint. The other constraints are just the type of accounts you have.

Hey, if you have all Roth dollars, there’s just not much you can do. Right? It’s just sort of is what it is. And it may just not need to be that complicated. If you have an investment mix of a hundred percent stocks and all you have are retirement accounts, well, there’s really not too much thought you gotta put into it. I mean, it’s, it’s pretty simple at that point.

It’s really when you start to add bonds into the mix. Or taxable investment accounts. That’s where this really starts to get more important.

And then lastly, you do wanna think about the goals of the investments. a lot of what I’m talking about are primarily around long-term retirement focused dollars. But if we’re using like a taxable brokerage account.

And investing that for a shorter term goal. that’s gonna determine the mix of investments. in that case, you may want to prioritize bonds in that account, maybe thinking about municipal bonds or treasuries, for example, depending on your tax situation. So a [00:22:00] lot of, when it’s a lot of this tax optimization is really for.

Longer term retirement type dollars. But if you have different goals for these accounts, that’s gonna be different. That’s gonna determine your investment mix.

And so these are some things you wanna keep in mind as you’re investing or as you’re working with your investment advisor. One thing I see quite a bit, especially as I work with new families for the first time. And particularly when they’re coming from more like larger box financial companies of some sort.

Very often what I’m seeing with those families is that they have these different accounts, Roth IRAs, traditional IRAs, taxable accounts, what have you. but they’re all looked at separately. they’re more so looked at as products that are being offered and not so much as the families being served holistically, looking at everything together.

And so each account is managed separately. , Each account has its own mix of investments. sometimes it’s the same mix of investments across the board. And when they’re all managed separately, very often what you see is it’s just tax [00:23:00] inefficient investing. Less favorable account categories going into the less favorable accounts. So very often we see bonds and Roth IRAs or bonds in tax for brokerage accounts, for example.

It’s something we can very often clean up and improve and add something right away to the family and their investment. So you do wanna think about taxes as you’re investing.

And then you can think about tax planning activities moving forward. So for example, if you have taxable investment accounts, you can use tax loss harvesting when it makes sense.

And that’s one way to improve the after tax returns of that account. if you’re preparing for a very specific event, so for example, the sale of a practice or the sale of a property, or if you’re planning immediately after the sale of your practice, there’s even more we’ll just say like exotic. Tax planning opportunities with those types of accounts.

And so there’s things that I, as an advisor would look at in an ongoing fashion to again, to improve the amount of dollars a family is gonna have to spend over their lifetime after taxes. and keeping in mind those stealth taxes, that 3.8% [00:24:00] net investment income tax, even those, student loans on an income-driven repayment plan, that’s a stealth tax that you don’t necessarily think about. And then when you get into retirement, there’s things like additional higher Medicare premiums.

There’s additional taxation on social security. So there’s a whole other list of additional taxes or things that are like taxes that you have to think about.

Conclusions – Focus on good, prudent investing, while managing taxes along the way

Evon: And to wrap up, what are we focusing on? Well, remember, we don’t wanna let the tax tail wag the dog. Don’t only invest with taxes in mind. You want to invest in good investments, prudent investments. You wanna take a sound, evidence-based investment approach. While trying to minimize those taxes along the way, and because taxes are a real cost to you, it is a drag on your returns and it’s a drag on your Wealth, over time, it’s going to lower the future potential spending capacity you have, especially as you get into retirement.

And so just like management costs on the expense side, we wanna make sure we’re planning around taxes on the investment side as well.

And again, for [00:25:00] me, it starts with knowing your target mix of investments you’re aiming for as a household, what accounts are included in that goal, and based on the goal that you’re investing toward, inventorying all of your accounts, what accounts are going towards that goal, and then trying to put as much as possible , the most appropriate category of investment in the most favorable category of account and that’s what we call tax smart investing.

hopefully this is helpful for you.

If you wanna actually apply what we talked about today, we’ve put together a free tax location review checklist you can download. It walks you through how to inventory your accounts. Identify tax and inefficient holdings and think through whether your investments are in the right place. You can use this on your own or together with your financial advisor. You can download it using the link in the show notes.

Or at www.optometrywealth.com/taxsmart.

And if you don’t wanna do this alone or you’d wanna a second set of eyes to sanity check your setup. Reach out. Happy to talk more about this over [00:26:00] a no pressure conversation and with that, really appreciate your time today. We will catch you on the next episode.

In the meantime, take care.