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Creating Wealth Episode 10: Investing in Common Stock, Part Two

Creating Wealth is an in-depth conversation between Bill Taber, an experienced financial advisor, and his millennial daughter about personal finance, investing, and financial planning.

Bill Taber is President of TABER Asset Management, a Registered Investment Advisor (RIA) and fiduciary firm located in Des Moines, Iowa since 1998. For decades, Bill has provided investment management services to clients, creating wealth, building wealth, growing income, and preserving capital for each and every client. TABER offers personalized asset management, wealth management, retirement planning, financial planning, and services such as 401(k) rollovers.


His daughter, Anastasia, works in accounting at a global law firm in Washington D.C. She enjoys discussing finances and her cats’ latest antics with her dad.


Creating Wealth Episode 10: Investing in Common Stock, Part Two: What should high income earners do once they have maxed out their tax advantaged accounts? What is a back door Roth? In what scenario should you invest in the stock market yourself and when should you consider hiring an investment manager? Bill and Anastasia continue their discussion from Investing in Common Stock, Part One to answer more specific questions about how young high income earners can optimize wealth building.


Be sure to check out Investing in Common Stock, Part One before listening to this episode.


For questions and comments, you can email us at askcreatingwealth@taberasset.com.


Click here to listen to the episode.


Anastasia: Welcome to Creating Wealth, I’m Anastasia.


Bill: Hi, I’m Bill.


Musical Intro


Disclaimer: The views expressed today are our own, solely for informational purposes, and it is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investment strategy. The views are subject to change and are not intended as a forecast or guarantee of future results.


Anastasia: Alright, I have another question. If someone’s on the high earner scale of things, what should they invest in after they’ve maxed out every available tax advantaged account. And maybe we need to explain a little bit about what a tax advantaged account is or some examples?


Bill: A tax advantaged account is an account where you either defer taxes or eliminate having to pay taxes. And there are a number of different ways of doing that. Typically, the priority that I suggest for people is if they have access to a 401(k) would be to invest enough money in that 401(k) through your employer to be able to get the employer’s match, because that essentially is free money. Secondly, in your effort to get to at least a 15% savings rate, you would then max out what you could do potentially in a Roth IRA, if you’re eligible, or if your employer has a Roth 401(k) provision within their 401(k) plan, take advantage of that as well. And if that still doesn’t get you to at least the 15% savings rate, you would then go back and invest in the pre-tax 401(k) beyond the match.


Anastasia: And you can do that, you can invest in both a Roth 401(k) and a traditional 401(k) at the same time or?


Bill: What I’m saying is that it depends on the employer. When employers started with 401(k) plans they were are traditional, they were all pre-tax, but when the Roth IRA began and there was a way to get other types of tax advantages; some of those employers shifted their plans to allow an employee the opportunity to invest in either a pre-tax or a Roth after tax 401(k), so it depends totally on your employer.


Anastasia: Okay.


Bill: Once you’ve done that, if you’d like to invest more, let’s say getting to 15% plus, 20% plus of your gross income, there are opportunities for other investments, and these are investments that would be a taxable or a brokerage type account. One of them would be municipal bonds and municipal bonds are moneys that municipalities--cities, states, sometimes universities--will issue in debt so that they can do various projects like infrastructure or building an additional academic building. And they were allowed through the IRS code to issue that debt, have people buy the debt, and those people who buy it don’t have to pay federal income tax on the interest that they receive for owning those bonds. So if you are in a high enough tax bracket, an investment in a municipal bond might be an actual higher after tax return than putting your money in, say, a bank, or a U.S. Treasury. Another type of investment that is tax advantaged are annuities. Annuities are offered through insurance companies, and they typically have many, many different features, some of them offer fixed interest rate returns, some of them offer variable rate returns. But the two things that they have in common is number one, if you put money into it and you use after-tax dollars to go into it, the money is in the annuity and earning a return that is tax-deferred. You do not have to put the interest that you earn from that on your tax form each year. What happens at the point where you take it out, the distribution phase allows you to take out a fixed amount per month for the rest of your life.


Anastasia: Without having to pay the tax?


Bill: Well, it’s a hybrid. Part of what you receive back at that point, in that calculation is the interest or earnings that it made and that portion is taxable, but also part of it is the principal that you originally put into it that’s being guaranteed by the insurance company that they’ll pay out monthly for the rest of your life. And so the payment on that is partially tax free because it’s a return of your own money, or principal, and part of it is the interest or earnings that you made which is considered taxable.


Anastasia: It should be only the returns that are taxed because--


Bill: Yes.


Anastasia: --You already paid taxes on what you contributed to that.


Bill: Exactly.


Anastasia: The principal!


Bill: Yes!


Anastasia: (Laughs) Sorry I’m just rewording exactly what you said.


Bill: You’re right on track with it. Then there’s another type of investment and that’s what we discussed in a previous podcast which is individual stocks. Individual stocks can be tax advantaged from the standpoint that if you hold a stock for a period of one year and a day, that the profit that you make on it is subject to long term capital gains tax.


Anastasia: Hmm.


Bill: There are two types of capital gains, there are short term gains and long term gains. Long term gains are when you held the actual investment and then sold at least a year and a day after you bought it. Short term gains are if you sell someone that went up in value, but you held it for less than a year. The taxation difference on it is that at the current time depending upon your level of gross income and what your marginal personal tax bracket is, the tax on a long term gain on a stock could be zero, could be 15%, or could be a maximum of 20%.


Anastasia: Wait, say that again.


Bill: Depending upon your level of personal income, you could qualify to have that gain taxed at either a zero, 15%, or 20% rate. That is different from income that you make from your job, which is considered earned income. And there are currently seven tax brackets that range from the lowest bracket of 10% up to the highest bracket of 37%. And so the tax advantage to owning stocks and holding them for longer than a year could be the difference between the 37% rate on your personal income vs. a maximum of 20% on that capital gain.


Anastasia: What you’re ultimately saying is that there is a huge advantage to holding a stock for longer than a year.


Bill: Yes, because the taxation rate on a short term gain, something that you’ve held for less than a year, is taxed at the very same higher rate as your earned income or salaried income is.


Anastasia: This is going to be a super basic question, but what happens if the stock went down, and you didn’t make any money and you lost money on it?


Bill: Well, if the stock goes down then that’s considered a short term or a long term capital loss and you can offset any losses that you have against gains in a particular year and not have to pay any tax. But if your losses exceed the amount of gains that you have in that year, then the IRS allows you to carry $3,000 of that accumulated loss forward each year until you finally use it up. So for example, if you had $30,000 in gains in a year and $60,000 in losses, you can offset the first $30,000 of losses against the $30,000 in gains and pay nothing. You’d be left with a net capital loss of $30,000 and you could then use $3,000 of that each year over a ten year period to put on your taxes which would reduce your taxes.


Anastasia: Interesting, okay.


Bill: But the main point is that when people start saving money and when they start investing, then they can take advantage of things like this that allow money to be made through investments (considered unearned income) to be taxed at a lower rate than what they pay on what they earn in their job (considered earned income). So it really helps those people that are able to have the discipline to save and invest, to eventually be able to accumulate money faster than people that are simply not able to save any money and the only source of income that they have is their job and they’re paying a higher rate on those dollars of income. Does that make sense?


Anastasia: Yeah, it’s a different way of thinking about it. The money that you earn through your job is getting taxed at a higher rate, so why not create unearned income from investing some money in the stock market which is taxed at a lower rate?


Bill: Exactly.


Anastasia: Could you just sum up where a person can go to after they’ve taken advantage of every tax advantaged account?


Bill: The options that we discussed were municipal bonds, federal tax free on the interest, annuities that are after tax contributions but tax deferred while they’re growing, and individual stocks, which if held for longer than a year are subject to the lower capital gains tax rates. There’s one other possibility and that gets to a “backdoor Roth IRA”.


Anastasia: Aha! So another high earner income question, but high income earners are not allowed to contribute to a Roth, because of income limits on a Roth IRA or a Roth 401(k) account. There is this strategy called a backdoor Roth, do you want to discuss that a bit, what that option is for the people who are exceeding in income over $139,000 a year if you’re a single filer and $206,000 a year if you’re married?


Bill: Yeah, a backdoor Roth allows you, if your income is too high to make an after-tax contribution to an IRA. The contribution can be up to $6,000 a year if you’re under the age of 50, it can be $7,000 a year if you’re over the age of 50, and you essentially can put in money that you paid tax on, so it’s an after-tax contribution into an after-tax IRA and then immediately convert it into a Roth IRA before you have any earnings on it. And what that will allow you to do is have the earnings converted into this backdoor Roth IRA grow tax-free. When you decide when you want to take the money out and have it distributed, it will not be taxed when it comes out. The important part of this is that whether a person can do this or not depends on their eligibility- which means looking at the various options that they have for retirement plans, it also depends entirely upon their level of income, gross income, and so to answer the listener’s question on this, I would suggest that they discuss this with a tax advisor, like a CPA or a financial planner that is also a CPA to make the determination that this is something that they want to do.


Anastasia: Yeah because at a certain point if you’re earning a bunch of money, you should probably be working with a CPA or tax professional, you should not be doing your own taxes anymore?


Bill: There’s a point at which young wage earners, if they’re make a high enough income, perhaps they’re doing their own taxes either with TurboTax or using some sort of service like H&R Block, that they want to seriously consider working with a tax advisor that’s a CPA, because the current complexity of the tax laws is almost incomprehensible and they keep making it more complex every year. CPAs, their entire job is basically to stay up on these changes and there are so many different ways to approach tax returns, etc that are legal, that it really makes a lot of sense, particularly for higher-income people or people who have accumulated a certain amount of money and wealth to work with a tax accountant. Because they will more than pay for their services. The money that you spend for their services is extremely well-spent.


Anastasia: Okay, so with all of this in mind at what threshold is it too risky for someone to invest their own money without advice from a professional advisor?


Bill: I think the answer to that comes back to the time, talent, and temperament issue. If you feel that you have those or are willing to pay the “cost of tuition”, so to speak, to learn those and that you have acknowledged that you are going to make mistakes and perhaps accepted a certain amount of losses in getting to the result that you want, what amount is it for that to be too risky? It’s what they personally feel. If you choose to invest with a professional who has a systematic approach that we discussed that has a proven way of over time navigating all the uncertainties of the stock markets, then you can put more serious money into that type of investing. If you don’t have that advisor and you don’t have that experience, you have to make a decision as to how much you’re willing to put up, so to speak, put at risk, in the process of learning how to do it better. Does that answer your question?


Anastasia: Yeah, it does. I mean we’ve already discussed what an investment manager does in the last episode so at this point, people understand that if you want to spend the time and you feel like you have the right talent and temperament to choose your own stocks and you’re comfortable with that, then it sounds like you can get set up with buying securities through a very minimal fee broker like Charles Schwab or one of those other organizations, but if you prefer to work with someone whose whole business, their whole career is choosing stocks for their clients, then maybe you should look into hiring an investment manager.


Bill: Very well said.


Anastasia: And then you can ask them how they’re compensated and how much they’re compensated for and figure out if the value added is worth it.


Bill: There is a portion of the investing public out there that likes to do things themselves, and there is a greater portion who like to maintain control over their investment process, but have absolutely no problem seeking input or second opinions from professionals on some of their own ideas for investing or hearing some of the professional’s ideas and then agreeing to go ahead and invest in those things. And then the third element of this is people who say, “There’s a lot to this. I don’t understand it. I don’t have the time for it, I don’t have the talent or temperament for it. I’ll let a professional do it. I’ve talked with them, I’m confident that they have a proven process that more than pays for the fees that they charge and I’m willing to allow them to invest my money.” So those are the three elements of the investing public that are out there and it really, what it comes down to is how do you personally feel about it?


Anastasia: Yeah, I know that in general, at least the people I’ve talked to, everyone is very eager to get started. They know that the stock market, that you can earn a lot more there than you can just growing your money in a savings account. So they’re eager to get started and they’re eager to have that ‘wealth’ that they’ve heard about (laughs) they’ve heard discussed, they hear that people have wealth so they’re like, “How do I do that?” And I think what we’ve discussed so far in our podcast has been, alright, so you save money, you get good at budgeting, you watch your expenses, you make sure that you have more coming in than going out. And then once you build that account and maybe you have purchased a house or you feel comfortable setting aside a portion of your money to invest in stocks or whatever it is that you want to invest in, then have at it. And it’s up to you whether you want to hire someone to shepherd you through that process and help provide expertise, or if you would rather do it on your own.


Bill: I think that is very well summarized. And you think, when I started my career a number of years ago, there were far fewer resources for people who wanted to do it themselves. Basically, the only options, the only access that they had to the stock exchange was through professional brokerage companies or stock brokers. That’s changed dramatically. And today, if you are interested in learning about it, then the opportunities exist for you to do pretty much whatever you want. But it does require a learning curve, it’s like taking a course in college and paying tuition for it. And it can be common stocks or it can be real estate--I’ve seen people in my career that will have some of their retirement funds in stock, but then what they do is they invest in a portfolio of single family homes and they wind up being a property manager or they have someone else be the property manager for it. Real estate is something that you got involved with early in your career?


Anastasia: Yeah, I haven’t invested anything but I worked for a REIT--Real Estate Investment Trust--and then I also worked for a property management company that owned its own apartments and managed them. So I’ve seen the business from a couple different sides of it, and it’s definitely a very lucrative business, which is why people invest in real estate.


Bill: Yeah, and there’s quite a few tax advantages to investing in real estate, in fact after the last tax code change here a few years ago, there might actually be a bit more tax advantages in real estate. But both of those areas, historically, have had annual returns that have exceeded the rate of inflation. I think stocks over a 80 to 100 year period have averaged somewhere around 8-9% a year and I think returns on real estate have been very similar. So those are the areas that you can build your wealth in, and have at it.


Anastasia: So looking ahead then, what advice do you have for people who have paid off their debt, who have gotten to a point in their career where they’re making a sizable amount of money, what advice do you have for those people looking ahead?

Bill: Well, this will summarize what we discussed but as I said, learn about areas of either stock investing or real estate investing. You’ll find over time if you gravitate towards one or the other. Expect to make mistakes. Study and learn from those mistakes, and then just simply get better at it. And realize that over a period of years that you will improve.


Anastasia: Excellent.


Bill: As an example, one of the things that really gets some people in investing messed up is that they go into something and they think that it’s going to do great and then it doesn’t, and then it goes down and they think, “Well, this is going to get better,” so they invest more money and it goes down further and they think, “Well, I couldn’t have made a mistake, and it’s cheaper now so I’m going to buy more.” (Laughs) And then it gets really bad and they think, “Well now it’s selling for less than a dollar a share. It’s really cheap so I’m going to buy more.” And then the business goes out of business. And it’s simply a matter of--and I’ve seen some stock brokers in my career do that with their money and their clients’ money--it’s the inability to say, “I’ve made a mistake,” set your ego aside, cut the loss and get out, and move on to something else. And that takes a certain amount of discipline and that takes a process. And that’s where professionals can help you. But most people will really not know where they’re at on that scale until they actually get involved with investing. It really requires, I mean you do all the “paper” investing that you want in the world, the hypothetical portfolios, etc, but you really won’t know until actually have money in the market or in a stock, as to how you’re going to react emotionally.


Anastasia: Yeah, that makes sense. You won’t really understand until you’re involved in it and you’re experiencing it.


Bill: Yes, and so the long and short of how do you start doing this is at least just get started. Either buy a stock hoping it goes up or sell a stock short hoping it goes down- just get started and be in the market.


Anastasia: Yeah, also I do want to put a plug in thanking people for reaching out and asking us questions. We’d really like this podcast to be based on any kind of questions people have, no question too small, and really provide benefit to you guys. So thank you for listening and please provide any feedback, any questions that you have to us at askcreatingwealth@taberasset.com. Anything else, Dad, that you think we should discuss today?


Bill: No, I think we’ve covered it.


Anastasia: Cool.


Bill: Great, thank you.


Anastasia: Thanks, Dad!


Musical Outro


Anastasia: Thank you for listening to Creating Wealth! If you liked our podcast, please subscribe and consider recommending it to your friends or leaving us a review on your podcast app. We would love to discuss your questions. You can email them to us at askcreatingwealth@taberasset.com. You can also find full transcripts of every episode on taberasset.com. That’s Taber with an “e” not an “o.” Thank you for joining us on the path to financial abundance. We’ll see you next time!


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