Investing Before Tax Filing: A Guide for Choosing Accounts and Investments

Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler talking about the financial world, money, and investing. We’ve got so much to talk about regarding the investing world.

Tax Advantages

A lot of people are thinking about taxes this time of year, trying to figure out how much money can be put into IRAs and how much can be deducted and if contribution limits should be deducted and all those types of things.

There are three types of tax advantages, number one is tax deductibility, second is tax deferral, and the third is tax-free. Now, unless you’re looking at HSAs, which have the ability to get all three, it doesn’t actually happen.

That’s why I like HSAs, Health Savings Accounts, if you have access to them, you can end up with all three tax advantages.

Let’s just talk about retirement accounts. So, if we’re looking at a retirement account like a 401(k), a 403(b), simple plans, IRAs, the contribution limits differ in between these different types of things.

What happens is that for most people who work for a large employer, you’ll have a 401(k). So, I can put a much larger contribution level in a 401(k) than I can a regular IRA.

First of all, I often teach about what you have to watch out for with 401(k)s. If you ever want to know some of the problems I find with them—for example, target date funds can be really problematic, just check it out on my website. The diversification issue is really what it gets down to.

Well, all these different plans have them. Yeah, and they all do the same thing and they all tend to focus more on one area of the market, large U.S. stocks, simply because they’re more familiar to people, yet they avoid really good diversification.

More risk comes with putting all your eggs in one basket.

That can not only lower returns, because you’re focusing all the money on big U.S. companies which historically pay the least to use your money of all the different asset categories, but they also can come with more risk simply because you’re putting all of your eggs in one basket.

Contribution Limits

As far as contribution limits go, the reason that 401(k)s are so popular is because of the fact that you can contribute so much more than you can a regular IRA. The beauty of that is you look at income right now and have some income that’s taxed at 10%, some that’s 12%, some 22%, some 24%, all the way up to 37%.

Let’s say I’m at a really, really high tax rate, if I can avoid that and then take it in a future when I’m not working and my income is lower, what ends up happening is I can end up with a much, much lower tax rate in the future. So, the reason that people do that is because they don’t need the income today.

Give me the income at some point in the future when I’m not earning as much or not earning anything and then therefore, I can end up with a whole lot lower taxes. And you look at it, I’ve heard this re-explained before where somebody says, “Well, your tax amount is higher in the future.”

You don’t look at the amount, that is wrong and bad math. You don’t look at it that way.

Look at the rate that was avoided in the beginning versus the rate it was taken at, because the money that was not paid in taxes can continue to grow for you if it’s still in the account. 

It’s going to whatever the account grows at. So, that’s why it is bad math to look at the gross figure and say, “Well, I avoided $2,000 in taxes but paid $6,000 when I pulled it back out.” What did the $2,000 grow to if it was not taken out and sent off to the Federal government? That’s the real issue.

So, that can get really confusing to people. But some people think they have done as much as they can in a 401(k) or they don’t have a 401(k) at all. If you don’t have a 401(k), you can put money in an IRA and you won’t have the income limits.

Company Gimmicks

You do have income limits when it comes to IRAs if you have a 401(k). Now it is not unlimited and this changes from year to year. It’s really easy to find the limits. You can find out on the internet, you don’t need me for that.

But you can go on there and say, “Hey, I’ve got an IRA and I want to put money into it, can I still deduct it if I have a 401(k)?” You have higher limits if a spouse has a 401(k), but you don’t.

So, it gets higher than those numbers that I was just mentioning. In essence, it’s really super easy to find those numbers. As far as where to get IRAs, there are a lot of different outlets.

You can go straight to a mutual fund company. The problem when you deal straight with a mutual fund company is, guess which mutual funds that they like? Theirs. When you go to a bank, they’ll have a broker dealer.

I used to work for a broker dealer. We would be given a list of investments to recommend. Think of it as a car dealership. If you want to buy a car, which brand will be recommended to you?

Brokers will recommend whatever is in their best interests first.

If you want something else, they aren’t going to tell you that something is better. When I worked for a broker dealer that was the problem I always had.

What I found was that there were so many gimmicky things, like right now ESG investing is really popular. After the stock market goes down, all of a sudden fixed income or bonds or CDs or those types of things will become popular.

After the stock market goes up, they start recommending stocks. And that’s really, really frustrating. So I ended up collecting financial planning degrees.

One of the degrees I have is actually in academic principles of investing. It gets into the academics of how you put a portfolio together and how you maximize expected return for given levels of standard deviation or risk of the portfolio and the multifactor model investing.

There is research out there on how to put a portfolio together, and none of it was taught to me when I was investing or worked as an investment advisor and worked for insurance companies.

Choosing a Fund

I’ve got guys that work with me that have worked for the banking industry, for mutual fund companies, for huge broker dealers and big investment firms.

In those places, advisers were not taught the academics of investing. That is how I ended up going rogue and starting what’s called a registered investment advisory firm.

That’s in essence what we do. We’re a registered investment advisor.

We don’t represent the investment companies and we don’t represent the broker dealers. We represent our clients.

When people ask about recommendations, I recommend that type of a platform, so that you’re not worrying about who has the dog in the fight, so to speak. Big mutual fund companies have software that can go through over 30,000 different mutual funds and hundreds of thousands of sub-accounts and have information on them.

I don’t look for funds based on names or who has the lowest management fee. In reality, when a portfolio is managed based on criteria that I look for, it may cost a little bit more than a fund.

And I’ve talked about this before, where you’ll have a mutual fund with a very, very low cost, but the problem is they’re very lazy when it comes to managing the portfolio.

They will actually have larger companies in the portfolio. They won’t do off the market block trading. They won’t do securities lending and take the revenue and pay it back to the investor.

Since we don’t get paid by the fund companies, we’re not drawn off course based on who has the lowest management fee or the best track record.

This is another thing people do, they invest based on track record. One fund had such and such performance over the last 10 years. Yeah, it’d be great if I could go back and relive the last 10 years, but unfortunately I can’t do that.

What is going to do the best in the next 10 years? Nobody knows.

Yet it is great for marketing. If I can convince you a fund had great past performance, you may believe that it’ll have great performance in the future. The problem with the investing industry is it is so driven by whatever had the best performance recently.

The Necessity of Diversification

That is what sells investment products, but it is rarely much of a good idea to use that when choosing funds. Now, if you can’t choose short-term past performance, what do you look at?

Well, in the academic world, you look at as much data as you possibly can. You’re looking back 70, 80, 90 years for the expected return of a portfolio based on asset mix.

What areas of the market are actually being invested in? Why? Because we know that different size companies and different risk companies have to pay different amounts to use your money.

A large, well-established company doesn’t have to pay as much to use your money historically as a smaller company. It just stands to reason that a value company, a distressed company, has to pay more to use your money than a growth company, which is a non-distressed company. That just makes sense.

The interesting thing is when we put these things together in a portfolio, what we know from academic research is that because they don’t move together, we can reduce the risk of the portfolio. In the year 2000, when growth stocks, which are supposed to be the least risky areas in the market, went down 10%, value companies went up 10%.

They offset each other. In 2001, when growth stocks went down 12%, small value went up like 30%. Well, what had less risk? A portfolio with riskier companies in it, value companies. So, you think about it, that is the idea of diversification.

Even in the writings of Solomon, he talks about putting your money into seven or eight places because you didn’t know what calamity would befall the earth. That’s the idea of diversification.

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