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David, what have we got today?

Hey, Mike. I have $1,000,000 on my savings account from the sale of my business and nothing in April. How does this change my retirement planning?

Yeah. So notice the difference. This is from the sale of my business. If you are an entrepreneur, you sold a business. There's a certain trajectory of wealth growth that is often neglected.

Because how do you get money into a four zero one k at work? Usually, it's through an employer, and there's a match program. What if you're using all of your money to grow your wealth in a different way? Like a business owner. Okay.

You don't sell your business and then get it all in the four zero one k.

Because you couldn't put, like, a million dollars in one go

in four zero There's so much there's a limitation on how much it can go into a four zero one k every year. It gets complicated. There's so much you can put into a SEP IRA versus a simple IRA. There's certain restrictions on how long it has to be in there before you can pull it out. A four zero one k itself versus the IRA, and and then the ERISA law.

There's just there is a lot of things that happen in there. But overall, you have a limited amount of money you could put into a retirement account, which is a four zero one k. Retirement account, this is an important definition, is something that grows without capital gains tax issues. So you can buy and sell it whatever you want, and you're not paying a capital gain every time you sell the position. So it's a more efficient way to grow your money.

Yes. So this individual, they would have had to create a business, grow the business, kinda like Home Depot, but a smaller size. Let's say it's pest control. Let's say it's a painting business, whatever it is. They they created a business, and then they were able to sell it.

And after the proceeds, after capital gains tax, after all of that settles, it sounds like they got a million dollars in their bank account.

Good for them. So what do you

do with this? This gets a bit complicated. Let me explain why. You know how I like to pick on the oversimplified plans? Yes.

So let's do that. Let's say he puts it into the market. Puts it all in the market. It's a nice stock bond fund portfolio. Excellent.

He can take out four percent each year. Let's forget about market crash risk for a second. The fact that if the markets crash, you take income out, you've accentuated the losses, making it more difficult to let's forget about that.

Okay.

How do you manage a a portfolio, a brokerage account, a nonqualified? So it's not a retirement account. It's just your typical account. It's your typical money in the market. Every time you place a trade, if that position was held for less than a year, it's a short term capital gain, which means you're paying income tax on it.

Just regular ordinary income? Ordinary income, whether it's ten, twelve, 22, 24%, whatever it is.

Because you held it less than a year. Mhmm. Okay.

And so when you run your calculations, this would show up on your ten forty, I believe line seven, if I remember right. You're gonna find the short term and long term capital gains summed up in there. That's basically income. So let's say you had 50,000 of short term capital gains. It's basically you had a salary or w two income or $10.99 income of $50,000, and you're getting taxed on $50,000 as ordinary income.

Okay.

So if you were to actively manage this million dollar portfolio, 5%, that's $50,000, you're basically trying to grow your assets, and you're getting taxed all along the way. Uh-huh. So then you have to ask yourself, okay. Well, what about long term long term investment time horizons? Let's say you just buy some indexes and you hold them for a while.

K? Now you might not deal with short term capital gains, but you still got long term capital gains, which is 15, and 20. But this is the wrench in the system.

Okay.

What do you pay a financial adviser for if their job is to assess your portfolio and not touch it for over a year? What if your goal long term is to not create short term capital gains? Maybe you realize that a 20% effective tax rate is a big pill to swallow. And does that make sense, by the way, if if someone is charging you 1% and all the growth has a 20% tax bill on top of it, that slows down the growth. It makes it more difficult to keep up with the markets.

Whatever your risk level is, and I'm not saying to keep up with the S and P 500 unless your risk tolerance, your risk level, the volatility, the roller coaster is equivalent to what you want with the S and P five hundred. Some people don't want the ups and downs that the S and P five hundred has. Maybe they don't want the ups and downs of what the Dow Jones has or the Russell two thousand, whatever index fund you're looking for. Maybe they want some bond funds to stabilize it. That's another conversation.

So now you've gotta ask yourself, what's the purpose of the adviser if you're buying and holding something?

Yeah. Because ideally, you would want the adviser assessing where you should be in actively trading if you're gonna pay him.

Many people hire a financial adviser for one purpose, and that's to grow their money better than had they grown their money on their own. And that makes sense. If you look at the net of fee performance, if you can get more money by paying a fee, that would make sense. Yeah. But just consider for a moment, you have to get rid of 20% of all your gains.

So if you made 10% in the market, you really made 8% because 2% went away to to taxes.

Okay.

So I'm assuming a 15% federal effective tax rate, and then let's say a 5% state tax rate. That's an issue. And then you have the 1%. So now it's 7% growth instead of 10%. That difference is huge.

And so there's this very interesting conversation you have to have with yourself about how do you enjoy your money while being tax efficient. How do you get the best net of fee portfolio and plan structure to get more out of your money? Now we're ignoring market risk with this. We're ignoring all sorts of risks in that oversimplified assessment. I'm just talking about performance and short term versus long term capital gains.

There's a reason why people like retirement accounts, IRAs, and Roths. So now you've got the other side. Okay? K. The other side is is the fixed index annuity is the most popular.

Some people will argue the variable annuity. Some people will argue the fixed annuity. But annuity by definition is to get your money back typically at a lifetime income, the situation or contract. So you give an annuity, let's say for easy math, million dollars, and they're gonna give you 80,000 back for life. I'm not quoting any sort of specific product.

I wanna highlight that it's gonna seem like a good deal. Instead of taking 4% from your portfolio and hoping it works out, you're taking 8% guaranteed for life.

Yeah. On paper, it sounds great.

Yeah. But you gotta understand inflation risk and liquidity risk. So inflation risk, after ten years, assuming a 3% inflation, it's going to eat away at your buying power. So let's say I mean, basically, you lose 25% of your buying power after the first ten years. By the twentieth year, you've lost 37 and a half percent, if I remember the calculation right.

That's a lot. It's hard to keep up with inflation if your income does not increase with it. Therein lies the issue of the lifetime income stream. And by the way, if you put nonqualified money, like money in your bank account into an annuity. Annuities are taxed as ordinary income.

Oh, okay.

So any gain that comes out is going to be taxed as ordinary income. Right. If you annuitize it for life, then the gains are spread out over your lifetime, but your basis is negligible. Right? They spread it all out, but you're paying income tax on it.

An income tax can affect your long term capital gains brackets. It can affect your modified adjusted gross income. It can affect your supplemental income. That's Social Security taxes, standard deductions that you qualify for. All these different things, it affects your tax bracket and how much you're paying in taxes.

So anyone that has the majority of their assets in nonqualified accounts, think of a brokerage account, think of a TOD account, think of your checking and savings account. Everyone has a different name for it. Their retirement plan, I believe, becomes inherently not more complicated, but more sensitive to tax planning. Does that all make sense?

Yeah. Yeah. So there's a reason that we love the IRAs. Right? Anything that's a retirement account, it's quote unquote qualified money.

Yeah. That's great because you're deferring taxes. It's not even a consideration.

You're not even deferring it. You're just not paying capital gains. I guess you're deferring the income tax to a later date.

Okay.

But you have control over how much you would take from it. Yeah. There's RMDs, but you can plan around that.

But this this sort of non qualified money that's just regular old money.

Yeah. Now there's a benefit to this. Oh, okay. Let's talk about the benefit.

The benefit to having a

A million dollars. Yeah. If the plan is done right, if the portfolio is built right, if these strategies are explored correctly, could be more valuable than a million dollars in an IRA. Here's the argument. A million dollars in your IRA, you still have to pay income taxes off that.

Mhmm. Well, how much are income taxes? Let's assume that 20% effective tax rate. That means your million dollars is really probably worth around 800,000. Million dollars, if it's managed correctly, kind of can stay around a million dollars.

Because if you're taking it out and you can navigate the long term capital gains brackets, you're very tax efficient. Ugh. So here's a couple of things just to consider. They said it's in the bank account. Right?

Yeah. A million in savings.

Okay. So there's no gain on this. They're getting taxed on the interest, but that would be it. Not a huge amount, 4% or 3%, whatever it is. Some of them are two percent right now.

So that means everywhere they invest, that's the basis, the baseline from a tax standpoint. So just hear me out for a second. What if you were to take something like this, you build your plan together, and you realize how much income you need in different parts of your life? Maybe the first five years, you're going to need oh, let's see. How old do you think this person might be?

Let's see. They sold a business? Let's say 62.

Okay.

So at 62 years old, they could take Social Security income, their benefits. So 62 and one month old, they're receiving their benefits, and now they are taking their benefits, and their income for their portfolio, and kind of just blending it together. Or they could delay their benefits to 67. That means they would have to take more income from their portfolio for the first couple of years, and then once Social Security starts, they could take less from their portfolio. So you wanna optimize what you're taking and when you're taking it and so on, and then determine how much income do you need each year.

And if the markets are up, it's really easy. You can take income from anywhere. But if markets are down, you have to take income from a principal protected source because you don't want to accentuate losses. Are you with me so far on all that?

Yep. Just tell me where what are a couple of quick examples of principal protected sources?

Yeah. So on the fixed side, these are fixed investments or products. Like, a CD grows at a fixed rate. A treasury grows at that fixed rate, not treasury funds, but treasuries themselves. You've got a fixed annuity, which grows at a fixed rate.

Then you've got your indexed products. They have growth potential, but no or little downside risk. When I say no or little downside risk, you can increase your growth potential, but there's gonna be some downside exposure potentially. So this would be like a buffered ETF. You have up to 7% or up to 12% or whatever it is.

But if you've got that 7% upside, maybe there's no or very little downside risk. So, like, the market would have to crash over 60% for you to start losing money. Okay. There's a buffer in there that buffers out those losses. Maybe you want 10 to 12% upside potential, but you're gonna take the first 5% downside or these are complicated instruments, so do your due diligence.

But that's a nice thing. Because if you put some money in there and you hold it for longer than a year, it's taxed as long term capital gains. So then you've got structured notes. Okay? So you're gonna be paying taxes on the dividend or the payout structure, but you can set those up to be monthly.

Maybe you hold them till two or three years. There's a lot of different mechanics within that, or you've got the fixed index annuity. Now for fixed indexed annuities, they might be more preferential. There's an argument to say they should be more used in retirement accounts, because if you put nonqualified assets in annuity that's taxed as ordinary income. So you see how there's a discrepancy here.

If you want lifetime income, if you want income over a certain period of time, maybe a fixed indexed annuity could make sense. But if you're looking to be more dynamic about your portfolio, that if the markets go down, you're taking income from these sources and kind of managing things on a a more systematic basis, but you want that flexibility, maybe they're not appropriate for you.

Right.

You gotta be careful with the tax side of it. Now just for an oversimplified example, I don't like oversimplified anything, but I wanna articulate the idea for a minute. K. What if you put, I don't know, 40% and don't go home and do this, by the way. This is a hypothetical example.

This show is not financial advice. Don't say, well, I heard on the radio or I heard on a podcast. Don't But do let's just say, for argument's sake, you put 40% of your assets in buffered ETFs as opposed to bond funds. So they've got growth potential. They've got a buffer to help hedge against that downside market risk.

And then 60% of it, you just bought boring index funds, SPY, QQQ, RS is it RSP? So total market even weighted. You could do is it PKW, which is like a that's an interesting one. It's a large cap growth index fund that favors companies that buy back their shares instead of paying a dividend, it's more tax efficient. Yes.

But now you've built a portfolio that's 60% focused on growth. So if markets are up, easy place to take income from. And because you just bought everything at the beginning, what's the gain? It shouldn't be huge, but there's some gains. So you're selling some shares strategically to make sure that maybe your total gains being realized is less than 96,000 a year.

So if your total gains are less than 96,000 a year, your income is tax free. And that's because? Long term capital gains. As long as you could structure it right. So now imagine that you wanna take a majority of your income for the first, let's say, five years, so '62 to '67 or so.

All of it comes from your portfolio because you just invested. There's a good chance that there's not as much of a gain to be concerned about. You've got your growth portfolio that you're taking income from, and that you're basically not paying tax on that because of the gains and long term capital gains. And then at 67 to seven years old, you then turn on Social Security, which is taxed as ordinary income, But maybe 50, or 85% of it is subject to taxes based on your provisional income calculation, which is your modified adjusted gross income. But you've structured it in a way that then your Social Security, when it turns on, is tax efficient, and then you pepper in on top of that just some other gains, and then you're still incredibly tax efficient.

But one of the last things you're gonna wanna do is buy a bunch of, let's say, dividend stocks, and you're gonna grow your assets by taking dividends and reinvesting it. Because you get the dividend, you pay ordinary income on the dividends, and you're reinvesting them into something that creates a larger tax bill year over year over year. You wanna be mindful about not only what you're investing in, but how you're gonna pull the funds out and the headwinds along the way. So it's not, in my opinion, for people like this about putting everything into municipal bonds and being tax efficient. There's a lot of missed opportunity because you're getting a low yield that still has reinvestment risk, a low yield that still has credit risk depending on if you're buying whatever type of bond that could go bankrupt.

Or maybe they're more stable, and if they're more stable, you're getting less of a yield. You gotta be aware of the risk versus potential reward balance and the tax implications. When people actively try to avoid one risk, they end up taking a lot more of other risks on, and they have no idea that they're doing it.

Should any of this million dollars go into a Roth IRA?

If they're working, they can continue to contribute. So we talk about having an encore career. Maybe this person decides they wanna keep working, but part time just for fun. But if they earned over 7,000 a year, great. Or over 8,000, you know, whatever the catch up might be Uh-huh.

Depending on how old they are, and they could just put the funds into a Roth. But you have to earn income to be able to qualify for that. I see. Overall, I wanna emphasize, too often we assume a financial adviser's job is just to grow your money. That is what many people assume, and they've hired their adviser to do just that.

In my opinion, that is one part of an overall important comprehensive conversation, because you're always looking at net of fee performance. Could you get more out of your money if you hired an adviser or not? Someone that really had a good grasp on tax law in conjunction with growing your wealth, growing your assets, investing in the market, and making the adjustments, and saying, hey. Markets are about to turn over. Maybe we do just sell, pay the taxes, and reposition you.

There's a very healthy balance here, but it has to be, in my opinion, a more comprehensive conversation. Because if you hired the right person, there is so much money you could save over your entire lifetime when you're pairing investments and taxes in the conversation. And we haven't even touched how you could manipulate your health care premiums because if this person is 62 years old, they need Affordable Care Act insurance. If they need Affordable Care Act insurance, there's all sorts of subsidies that you could utilize, saving you hundreds of dollars just in that year. So this is the tip of the iceberg.

But if you have most of your money saved into a four zero one k or IRA, it's a very different conversation than if you have most of your money in a brokerage account or savings account, which is a very different conversation if you have, let's say, an equal amount in your IRA, a brokerage account, and your Roth, and so on. The amounts and percentages that you've put into each of these different buckets will likely significantly shift your conversation on how you prepare for retirement. That's all the time we've got for the show today. If you enjoyed the show, consider subscribing to it wherever you get your podcast. Just search for how to retire on time.

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