Speaker 1 (00:01.954)
Welcome to the Physician Family Financial Advisors Podcast, where physician moms and dads turn today's worries about taxes, investing, and extra money into a comfortable feeling of financial security. I'm Ben Utley.
And I'm Nate Renneke. Today's topic is on what we would consider the better way to invest for the overtaxed doctor. And that is by utilizing index funds. So then we hear about them, we talk about them, we use them all the time, especially in taxable accounts or brokerage accounts. But why are index funds good for doctors? Like what's the big deal about index funds?
Yeah, well, there's a lot to love in this overlooked world of investment stuff we call index funds. You hear about them a lot, but not very many people really understand what goes on in an index fund. Basically, an index fund is a mutual fund that owns a list of securities, like what you might find in the Standard & Poor's 500 or the Dow 30. It's a relatively unchanging list. It might be reconstituted once a year. The neat thing about that is
that there's not a manager behind the scenes picking and choosing things. And what that means is it drives out the human error. So you're not prone to the mistakes that that person is going to make. Also, you don't have to pay their bill. So the costs and index fund are very low. And because there's not a lot of trading back and forth in a different securities all the time, that means that the tax consequences, the incidence of taxable events is low as well. So.
They're cost effective, they're tax efficient, and they're resistant to idiocy. And that's one of things I love, all three things I love about it.
Speaker 2 (01:43.798)
Yeah, that's true. also just resistance to, like the human era is just talking with someone about this yesterday. It's also just emotion. It allows you to just let go and let it be, let your investments do their thing, which is kind of the idea. You said something about tax efficiency. So the term low turnover is traded very seldomly.
Talk about tax efficiency in a taxable account because you shouldn't pay any taxes out of your 401k, but why is it important if you're using a taxable account to look at tax efficiency?
Yeah, so I'm going to start with the basic essence of what is a taxable event. so a taxable event is when you own a security like a stock. I'll use a stock for an example. And that security pays a dividend. Okay, so that's a cut of the profits from that company. And it comes to you as a dividend payment. You can actually see that in an account as a little cash flow, okay?
is akin to interest that you might get in a certificate of deposit, stocks are not guaranteed like CDs are. So it's a little bit of interest and every time that little bit of interest or dividend comes out, that's a taxable event. And you're going to see that reported to you on form 1099 probably about February of the next year. Okay. And so you're going to get taxed on that in some cases as ordinary income. All So that's one taxable event that's very common. Another taxable event happens when you sell a stock. So
If that stock has a loss, that taxable event is a loss and you can deduct some of that loss against ordinary income taxes. So it reduces your tax bill. Okay. If you sell that stock at a gain, that's known as realizing a capital gain and that could be a short-term gain or a long-term gain. Short-term gains are taxes ordinary income at your highest marginal tax bracket, which for some of our listeners could be in the thirties, could be higher than that if you're in a state that has income taxes.
Speaker 1 (03:48.01)
If it is a long-term hold, which means a year or more, then that could be taxed high as 20 % plus your state income tax rate. And there's also a Medicare surtax on top of that, which can be 3.8 % for some taxpayers. So, I mean, when you, when you think about it, like, in high tax states like California or New York or other places like that, that have high state income taxes, maybe the high single digits or low double digits, you take that and you add it to, you know,
high earning physicians tax bracket and you add on that surtax, you're talking about, you know, maybe 44%. So if you buy a stock for, you know, $10,000, you sell it for $20,000, then you're going to lose $4,400 in capital gains and income taxes on that deal. So the way that you avoid that is you hold onto that security and you can continue to defer those gains while that position has an opportunity to grow. All right. So.
To be clear, we do not recommend picking stocks. I think that's for idiots. But we do recommend owning mutual funds, which is a way to kind of spread the risk across a number of securities. right? So when you buy an index fund, you're buying a basket of stocks. It's all packaged up, but those same capital gains tax and those same taxable events rules apply. What happens in that mutual fund ultimately
comes through in the form of taxable events to you. They can't just be balled up inside the mutual fund, so they bleed through in what's known as capital gains distributions and dividend distributions. So if there's a lot of trading back and forth inside that mutual fund, then there's gonna be a lot of taxable events, all right? So the trick to tax deferral is to own a mutual fund that has very little in the way of trading back and forth, and that trading back and forth is known as turnover.
So a low turnover, so a mutual fund that maybe turns over 1 % of its holdings in a year's time would be a low turnover. And to flip that fraction, that would be a mutual fund that on average holds each position for a hundred years. So that's a real long-term, but it's also super tax efficient because there's not a lot of transaction costs and you don't have any calling shots in there that drives out some human error and it also drives out expenses.
Speaker 1 (06:11.95)
That's a long story on taxable events. I don't think I answered your question about the taxable account. So I'm gonna go there now. Is that okay, Nate? Yes. Okay, so now when you have like an IRA, which is not a taxable account, what happens in the IRA stays in the IRA? When you have a 529, what happens in that college savings account stays in that college savings account. 401k, same story.
We don't really care about taxable events in those accounts because we're not going to feel that in our tax bill. It's like Vegas. What happens there stays there. But when you have a taxable account, so that would be a joint account, you know, one where you and your spouse own securities jointly. could be a solo or an individual account that you yourself have. It could be a trust account for maybe a revocable or living trust, or it could be a separate property accounts, which is what we get in community property states like Louisiana and some of the Southern states.
In those accounts, everything that happens gets taxed in the year that it happens. So, you know, this is 2022. If you recognize a taxable event in that account, whether it's trading a security or having a capital gains distribution from a mutual fund, that becomes a taxable event in this tax year. And you're going to have a tax liability that comes due in April of 2023. So watching what happens in these taxable accounts can make a big difference in your tax bill.
Mm-hmm, okay So that makes a really good case for owning index funds and taxable accounts Yeah I think that the big question that some of our listeners may have is if you if you can kind of Understand that you're set your hear what you're hearing is starting fresh I should start buying some index funds, but that's not really where everyone is at and we recognize that
you might have inherited, let's say you'd inherited a portfolio, Ben, or you're using a broker who's buying anything but index funds. So you have a taxable account where taxable events affect you that coming tax year. And you're looking inside this account and you're thinking, how do I get rid of what I know now that I don't want and get into what I need to stop paying high tax bills? And kind of...
Speaker 2 (08:27.158)
One thing is you may not still understand if you're in what you need to be in. Like if you've bought index funds, before we get into the steps on kind of how to untangle a messy brokerage account and get into index funds, I want to give some kind of clues on, I guess, without looking inside your account, how you could tell that you're not in index funds. Does that make sense?
yeah. Well, you can't, you can't know without looking inside your account. So the first step is to, is to look, right? So, mean, you, yeah, you cannot know what you own without looking at what you own. Right.
Understood, maybe to give a kick in the rear to people to go look, if you're experiencing surprise tax bills where one year you owe and the other next year you don't owe, you can't really tell why, one reason could be that you're experiencing taxable events in your taxable account.
Yeah, another way you could tell whether or not you have index funds is if you have complicated statements a lot of activity that you're getting you you get a statement from your your broker and there's tons of activity in the account or there's a hundred positions in the account. You could be pretty sure you're not in index funds.
So do you want me to go over kind of step by step about how to look at a statement and kind of see a little bit what you got?
Speaker 2 (09:47.318)
Yeah, so if you're experiencing those things, then you should certainly be looking into your statements. And so there's three steps, Ben, I think that's what you're getting at here. So analyze what you got, make a plan to get out of it and get into what you want to be in, which is index funds, then execute the plan. So how do you analyze what you have in your taxable account?
Yeah, well first you got to start by getting organized. All right. And that can actually be a really challenging step for some folks because maybe they've got, you know, accounts spread all over the place. You've got some, some money from when you were in training, you've got maybe an old 401k, maybe your spouse has got some money that their folks gave them and perhaps they have an IRA they started when they were young employees. You know, money can be spread all over the place and you might have like a, a betterment account. You might have a
a Schwab account or something that you started trading in before you knew better. And, you know, it's just kind of, it's kind of everywhere. So the first thing to do is just gather up all the statements from all the accounts that you have, you know, kind of make a list, pull together the statements and then look at those statements and every statement has a legal registration. And that basically says your name or your name and your spouse name, your street address, whatever. If it's an IRA,
it will say IRA. It will usually say CUST for custodian because IRAs are custodied at a trust company. Okay. So that's the first thing is looking and seeing what you got. All right. Now in there, you want to look for taxable accounts. Okay. Taxable account would be a joint account or an individual account, a trust account, accounts that I mentioned before. Those are the ones you really want to boil down to because they are the ones that have the taxable events that come through and cause these surprise tax bills. Okay.
So you pull those out. First thing you want to do is look and see what kind of positions you have. Most of them on the first page of these statements will break down mutual funds, stocks, and bonds, and sometimes options. They categorize them those three ways because it's easy to categorize like that. All right. Then what you want to do is look at your holdings. So all statements will have a holdings section or position section, and that'll tell you what you own. So if you look at the section in there and you can see stocks and bonds,
Speaker 1 (11:57.486)
then you're already in the deep end of the pool. You're already in a position where you're getting taxable events because those stocks are likely to pay dividends. Bonds in particular pay ordinary income and unless they're tax exempt bonds, those are gonna pay income that's taxable every year. And a lot of times, a lot of times we see physicians, they're in the top marginal tax bracket owning fully taxable bonds in their taxable account. And it's a no-no, it shouldn't be done.
We see brokers with years of experience doing this to clients who brought in portfolios and I still scratch my head as to why it's done, but it's not right and people pay extra taxes. All right, so now you look at the mutual fund section. All right, so under your mutual funds, if you have index funds, it will usually say something, something index or IDX or IND. It'll have an abbreviation, but it almost always says index if it's an index fund.
That's how to know. And if you look and there's a list of mutual funds that doesn't have that, then the chances are good that you have securities that are paying more taxable events is causing you to pay more taxes than you have to. Okay. Another big indicator that you have a tax inefficient account is when you look and there's a long list of securities, I'm talking like at least 10, sometimes 40 or 50, maybe even a hundred securities in there.
We see this a lot when someone has been with a broker for a number of years and there's a lot of positions and for entertainment value and for reasons that are unknown to me, these brokers will trade those accounts on a regular basis. They'll buy something, they'll sell something else and the turnover is huge. Well, every time they sell a security, there's a risk of a taxable event, could be a gain or a loss and that constant churn makes you pay more taxes than you have to.
That's kind what to look for as you look at your statements and you kind of get organized and do a little analysis.
Speaker 2 (13:57.77)
Mm-hmm. Yeah a little further into that is that you can most people can be easily talked into an investment that based on performance, but they're not looking at after tax, you know return or performance so
Performance is tricky because if you want to game the system, you just show a person a period that contains your best performance rather than the period that contains all of the performance.
Right. And for someone who's paying, you know, almost, let's say half, mean, for over 40 % in taxes, it's hard to beat that, you know, so tax efficiency. OK, so you found out your your taxable account is totally, totally jacked up. What do you do? Right. You know, plan. What does that plan normally look like?
Well, for us, know, internally, we always begin with the end in mind and every one of our clients has to retire, someday will retire, may not want to retire, you know, we see that quite a bit, but has to retire someday. And so we began with the retirement plan and that retirement plan begins with the goal. That goal is going to talk about how much money you need for retirement, how much you need to have, how much you need to save.
and we get some idea about how aggressively or conservatively a person needs to invest in order to be able to get there. Now with that idea in mind that perhaps someone needs a moderate investment, that gets us to what's known as asset allocation. So the asset allocation is the breakdown of exposure to stocks and bonds, and in our case, it's through index mutual funds. So that kind of sets up the target, that's your target asset allocation.
Speaker 1 (15:41.802)
And you can fill an asset allocation with anything you want, know, stocks, bonds, mutual funds. In our case, we use index funds. So, what we do is we look at the securities a person has and we determine whether or not it makes sense to continue to hold those securities. So, so an example is, maybe they have a taxable bond fund in that account, like I mentioned before, very seldom does it make sense to continue to own one of those, but they might have a mutual fund or even a stock.
that they've held for years and years and years, like there's some technology stocks that have huge appreciation. And even if they're tax efficient on an tax inefficient on ongoing basis, it makes sense to go ahead and continue to have those because the long-term tax savings of being more tax efficient is less than the cost of selling that security and paying the taxes. So it pains me to see places where they will, they'll swab the decks, they'll sell everything in the account.
They'll harvest all those capital gains. You'll pay a huge tax bill and then you turn around, you reinvest in brand new stuff. is a stand amount to malpractice and it's not required. You can cherry pick securities and keep the better ones and not pay taxes on those if necessary. So it's really with an older account, know, one that's got some lower basis in it, some lower price securities. It really requires some craftsmanship to be able to.
pick and choose and figure out which ones to sell and which ones to keep.
Yeah, a good example of that might be if you're close to retirement, you know, you can slowly sell some of those low basis securities versus doing it all at once in your last year where you earned a lot of, you know, earned income.
Speaker 1 (17:29.422)
Yeah, that's a good trick. You know, if you're, if you're making mid six figures, you know, you're going to pay taxes in the top marginal tax rate and capital gains in the top capital gains tax rate. But, you know, if you retire next year and you're living solely on your income from your portfolio and or social security, you're going to be in a lower tax bracket. And maybe it makes more sense to wait until next year to clean house.
Right. Okay, so that that's the personalized plan and and executing the plan I mean, it's pretty straightforward to say execute and then in practice it could be what I'm from what I'm hearing it could be years of executing or you know if you you bought some some Securities last year and they haven't You know appreciated very much you it might be one day where you're selling and buying yeah
It could be,
Speaker 2 (18:21.76)
I'm kind of thinking more like how does a listener hear this and go execute this plan? How do you decide when it's worth it to sell a security that is not an index fund and go buy one?
Yeah, well now you're standing in what I like to call the deep end of the pool. I should say swimming in the deep end of the pool. So, this is where you have to do a cost benefit analysis for each position and weigh, weigh the cost of selling it in terms of taxes paid and capital gains and all that good stuff versus the cost of holding onto the security for a period of time. And that period of time might be until retirement. It might be for years and
there are several variables that go into this calculation. You know, the depth of the basis, which is to say how much gain there is, that's one variable. How relevant the security is, whether or not it's a fit for the portfolio is another. mean, if it's it's out left field position, there's a lot of risk in it. And that might be the kind of thing that would one, one would want to, want to get rid of regardless of taxes. So those are two things I can think of.
And it's really just kind of weighing the pros and the cons. And then you also need to think, you know, is it, is it a fit? You know, is, this a conservative portfolio? We have an aggressive stock fund in there, or is this a, an aggressive portfolio? We have, you know, too much bonds in there. So reshaping the portfolio to be a match for your plan, but should be a match for your life is, is job one.
and quite frankly taxes are a second consideration behind that but they're very close second so you know there at least three factors that we look at and and more but honestly you have to sit down and crank the numbers
Speaker 2 (20:07.214)
Right. Yeah, and there's a little bit of forecasting there. It's like, you know, what securities are going to continue to force you to pay taxes. But yeah, it's an art if it's really tangled up in that taxable account. So I think that's it. there is there anything else you want to add?
videos here.
Speaker 1 (20:28.134)
Um, no, I think that's, that's it for today. Um, I do want to take a moment and thank everybody who's been listening. Um, sometimes I'll talk with folks that are thinking about coming to see us and they've listened to the podcast. Uh, I love it when clients tell us, Hey, we heard your podcast. And, uh, I was flattered when one said I have a voice that's made for radio. Uh, unfortunately I have a face that's made for radio as well. So, uh, yeah, but I appreciate the feedback.
and everybody who's listening has been great. So the way to reach us, if you have a question, you know, we have an answer line. It's voicemail. You can record and let us know what your questions are. That Physician Family answer line is 503-308-8733.
Again, 503-308-8733. You can send your questions to podcast at physicianfamily.com. That comes straight to our inboxes. We'll regard your message with tender loving care. You can also find us at physicianfamily.com slash podcast or physicianfamilypodcast.com.
Thank you for listening to the Physician Family Financial Advisors Podcast. Is there a question you would like answered on our next show? Go to PhysicianFamily.com to record your question. While you're there, sign up for our newsletter and gain access to tools you can use to turn worries about taxes, investing, and extra money into a lifelong feeling of financial security. That's PhysicianFamily.com.
