Listen Now:
The Smart Take:
Have a sizable brokerage account? Have unrealized capital gains? Pay income taxes at the highest rates? Want to pay your fair share but no more? If so, this is an episode not to miss.
In part 1 of this series, Kevin Kroskey, CFP®, MBA explored why adding the TALS strategy may yield significant investing and tax benefits. He described how TALS can help you defer, avoid, and potentially eliminate your capital gains.
For the most successful investors that meet the definition of an SEC Qualified Purchaser, generally one with $5m+ of investments, there is another leg to the TALS strategy that can help you solve your ordinary income tax problems too. Whether derived through your business or from non-business income such as wages, interest, non-qualified dividends be sure to tune in and listen closely.
Here’s some of what we discuss in this episode:
- Why should you care about this investing strategy?
- The tax benefits to TALS and the keys to smart trading and executing.
- Applications of how realizing capital losses can be beneficial.
- The TALS separately managed account and limited partnerships strategy.
Tax-Loss Harvesting: Wall Street’s New Strategy Cuts Rich Americans’ Bills – Bloomberg
Watch Wall Street Finds Another Workaround With Taxes, Losses – Bloomberg
Tax-Aware Strategies for Successful Investors & High-Income Earners – True Wealth Design
The Key to Tax-Aware Investing – True Wealth Design
Tax-Aware Investing in Practice – True Wealth Design
Learn more about the Retire Smarter Solution ™: https://www.truewealthdesign.com/ep-45-retire-smarter-solution/
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The Hosts:
Kevin Kroskey, CFP®, MBA – About – Contact
Tyler Emrick, CFA®, CFP® – About – Contact
Episode Transcript:
Kevin Kroskey:
Have a sizable brokerage account? Have unrealized capital gains? Do you pay income taxes at some of the highest rates? Do you want to pay your fair share but no more? If so, today’s episode is a not-miss for you.
Walter Storholt:
Ah, it’s that time again, Retire Smarter, back. Walter Storholt here with Kevin Kroskey, CERTIFIED FINANCIAL PLANNER, wealth advisor at True Wealth Design, with offices in Northeast Ohio and the Greater Pittsburgh area, and all sorts of surrounding communities as well. But doesn’t really matter, wherever you are, we’ve got some helpful information on today’s show as we pick up part two of our conversation about our friend TALS. Nils and TALS are back, our Scandinavian friends, to join us again for another show. Now, we’re talking about a really in-depth element of the financial planning world that’s kind of on the forefront. Something a bit new that Kevin’s been, I kind of picked up articles, I think, have been kind of launched into the national exposure a little bit on this. So this is really neat to get it from the source and to hear your in-depth planning here, Kevin, to get some more details here. So I’m looking forward to diving into all of this and you’ve got a great episode mapped out for us today. I hope you are doing well.
Kevin Kroskey:
Likewise. Walt, and you too, and Nils and TALS, I thought you were going to say Hans and Franz are going to prop up-
Walter Storholt:
Hans and Franz too.
Kevin Kroskey:
… to the investing audience today.
Walter Storholt:
There you go. We have a Hans and Franz episode at one point? I don’t know, we’re like 160 in, maybe Tyler did one of those. I think they made an appearance at some point.
Kevin Kroskey:
If we didn’t, he should.
Walter Storholt:
Yes.
Kevin Kroskey:
I think we should make that a requirement, absolutely.
Walter Storholt:
We’ll go back in the archives and check to make sure. I love it.
Kevin Kroskey:
So, last time when the recording was launched and it came in at I think around 40 minutes, I’m like, oh my gosh, did I have some pent-up podcast demand? And it’s one of those things when you continue to get more experience over time, you have more context and more stories and that pent-up demand. And we definitely, candidly, I was quite happy with the way that it turned out in large part to you and your team, my friend. But what I wanted to do after reflecting on at least the end part of it, it definitely ran longer than what I was hoping. And there’s certainly a lot more onion layers to go ahead and peel back and rather than going from just a single episode and then thinking as we progressed through the last show, okay, this is definitely a two-parter. As I’ve had some more time to focus and put a few key talking points down and not just speak off the top of my head, I think this is going to be a three-parter, Walt.
Walter Storholt:
Nice.
Kevin Kroskey:
So, plenty of details here and we’re going to dive into them.
Walter Storholt:
I love that. So a three-part series on the way, this is of course part two. If folks missed part one, Kevin, and they’re hearing this for the first time, should they go back and listen to that? Do we need a lot of that context to go back to the first episode to build into this one do you think?
Kevin Kroskey:
I would say this, if this is something that you see really potentially applying to you, something you want to learn about, absolutely. Is it going to be a requirement to go back and listen to the first part before you consume this part? No, it won’t, nor will part three be.
So in each episode we’ll do a little bit of a recap, in part because these topics are fairly complex and to learn solely from audio means it’s not necessarily the easy thing for many people. So if you do look in the show notes, we do have some articles linked there to the Bloomberg articles that Walt had mentioned and I briefly discussed last time, as well as to a few that I’ve written over the last two months on the True Wealth Design website as well. So, it’s one of those things where these will be independent, but there’s… I once had a listener tell me, “Hey, I’ve listened to every episode twice.” I’m like, “Oh my gosh, you need to find a hobby.” But this is one of those areas where a little bit of recap and re-listen is probably not a bad thing. So if you’re a podcast listener, generally listens to like a 1.25, 1.5 times speed or greater-
Walter Storholt:
Yeah, it might be hard on the listener.
Kevin Kroskey:
You may want to slow down a little bit. Yeah, yeah.
Walter Storholt:
Love it. All right, well let’s start with that brief recap, if you want to go back through what we talked about in part one and T us up for what we’re going to learn about here in part two of this conversation.
Kevin Kroskey:
You got it. Yeah, I mean, in part one, again, we kind of covered a few things, but there’s a lot of overview and background. We really talked about how the stocks in the stock market have been shrinking, not in terms of size of the market or the stocks themselves aren’t necessarily shrinking, but the number of stocks that comprise the publicly traded stock market. Walt, if you didn’t listen, Walt did a fantastic guessing of about how many stocks are available to invest in in the publicly traded market. And then we talked about, well, how’s that changed over the years, over the decades? And the conclusion was the number of stocks is actually decreased in about half, and we talked about some of the reasons why, and some of the investment implications of that as well. And that won’t be in this series, but that’ll be something different that we speak about as well, because that also is coupled with really the rise of private market investing and really trying to build that good diversified portfolio.
We also talked about some product innovation over the last, particularly the last 10 years, definitely things have evolved. A lot of people kind of have the core of the portfolio, call it stocks and bonds, whether that’s in mutual funds or ETF format, but there’s been a significant amount of innovation that’s been helpful to build a better portfolio, to go ahead and get exposure to different asset classes that were maybe relegated solely to private markets previously or alternative investments or hedge funds. And it’s also brought the cost down quite significantly as well. So all good things there.
And of course, we have the perpetual tax law changes. So there have been some tax rules that have changed over the last few years that the strategies that we’re going to be discussing again today and in the next podcast episode, the investing strategies have been around for a while. The application and the evolution of them is a little bit different, and part of that is coupled with some of the tax changes.
So what we’re going to talk about today is, I would say is really the sizzle, Walt. You get that steak, you get a nice eight ounce steak maybe Pittsburgh style and seared on the outside and raw or I wouldn’t say raw but rare. Yeah, you probably don’t want it raw, right? Rarer.
Walter Storholt:
Some people, some people, yeah.
Kevin Kroskey:
Yeah, or medium rare in the middle. So, who doesn’t like to save taxes, right? Sure, we should all pay our fair share, but you don’t necessarily have to leave a tip or pick whatever sort of colloquialism you may want to say, and that’s what we’re going to talk about today. And then in the next episode, assuming that this is three, this could become a four-parter. I’ll put a little asterisk to what you said at first, Walt.
Walter Storholt:
Oh, my, okay.
Kevin Kroskey:
Yeah, lions, tigers and bears, oh, my. So we’ll see, but I want to make sure that we do a great job in breaking this down so people can understand it because it really can not only be impactful, but I can seriously see this fundamentally changing the way that taxable investors invest, particularly-
Walter Storholt:
Wow.
Kevin Kroskey:
… if you have a sizable, taxable account, so.
Walter Storholt:
I mean, that’s a statement, fundamentally change. That’s big. That perks my ears up, right?
Kevin Kroskey:
Completely, and so we’ll talk about who, I think that’s a good segue here, but and in the third part we’ll go into some of the investing reasons and you can access some of these strategies through mutual funds, through ETFs. So it really can be pretty broad based in its application. However, there’s some additional tax benefits and different structures of these types of investments and strategies that we’re going to be talking about that as you move up the wealth ladder, it opens up some additional opportunities.
So if I go back and if I think of that and look at this, so why do we care about this? So at the heart of it, we’re talking about TALS, which is T is tax, A is aware, L is long, S is short. So tax, aware, long-short strategies. And I happen to remark because it came off the top of my head in the first episode. I’m like, I don’t like that acronym, but I couldn’t think of a better one so now that’s what we’re using, Walt. So we’re using TALS for short, tax, aware, long-short investing.
And again, these long-short strategies, I didn’t know this. I was researching this just from the last episode. The first fund that did these strategies was actually 1946 was its inception. So certainly that application, I didn’t dig any deeper than that, but I’m sure it looked very different from what we’re talking about today, but things evolve. Look over the last few decades too, just the technology and the ability to manage some pretty complex portfolios is a lot easier today than it was. It’s pretty much impossible if you go back into the ’70s or even the early ’80s. So things continue to evolve, things continue to improve, but that long-short strategy has been there many decades, and it’s really been, I would say more modern probably over the last 20 to 30 years, where typically it’s been relegated to the area of hedge funds and you’ve actually seen more funds, mutual funds generally at first, using these strategies say for the last 10 to 15 years. So it’s out there, there’s a Morningstar long-short category. That’s the investing component, that’s what we’re going to talk about next time.
On the tax side as you move up the wealth ladder, so we mentioned last time an SMA, a lot of acronyms in this business, I apologize, separately managed account. So this is just something where you would hire a specialist to go ahead and manage this strategy in a separate account. It could be held at Fidelity or Schwab or what have you, and this is generally going to be required to be an accredited investor. You can have SMAs that aren’t for accredited investors, but the ones that we’re talking about today are. And Walt, we went over some of these definitions last time, but the accredited investor definition, I know that was one that you’re familiar with. Do you happen to recall what characteristics that entails?
Walter Storholt:
I feel like I was at least in the ballpark where you needed a certain amount of investible assets and you needed to have prior approval to get access to certain accounts. It was the big short idea, I remember that one coming into play.
Kevin Kroskey:
So we’ll get there. The accredited is a little bit easier. You don’t have to get into your ISDA. It’s just, yeah.
Walter Storholt:
The ISDA was the one that I was harking on. Yes, that’s right.
Kevin Kroskey:
Yeah. So for the SEC accredited investor definition, there’s some income requirements that you can meet the test and it’s different whether you’re a single tax filer or a married filing joint, just do a quick Google search, you can see those. And there’s also a net worth requirement that you can meet, and so generally, like a million dollars and you meet that definition. So much more broadly applicable than the next one we’ll talk about when you get into your more complex ones. And that one, I’ll mention it now, but that’s the SEC qualified purchaser, big bucks, five million plus in investments. And that one opens up an additional layer of tax planning opportunities.
So we talked about, we mentioned this TALS SMA. So again, you’re going to have an account, this could be at Fidelity, could be at Schwab, it could be at Pershing, one of the big custodians, and then there’s a third party manager for it. So they’re going to manage the account, and here again, you have to meet that SEC accredited investor definition. So, what tax benefits, what’s the sizzle, Walt, that we’re trying to pursue here? So in short, for the SMA, and I’ll just use SMA going forward, we’re trying to reduce, we’re trying to defer, and maybe even potentially eliminate capital gains. Walt, what’s the difference between the rate for capital gains versus ordinary income?
Walter Storholt:
We’re talking like 15% versus 20s, right? Maybe upper 20s?
Kevin Kroskey:
Well, let’s see.
Walter Storholt:
30s? [inaudible 00:11:49].
Kevin Kroskey:
We may not hire you to work in our tax and accounting division Walt, but hey, that’s not a bad step, buddy. I appreciate that, thank you for playing. So, and you weren’t expecting that either, were you?
Walter Storholt:
No.
Kevin Kroskey:
So whenever you have capital gains, it’s really a preferential tax rate. It’s in short, the way you can kind of think of it is that it’s a layer cake. Your ordinary income is always going to be at a higher rate, and that’s going to be at the base. And then you’re going to have these other things that are more preferentially taxed, such as your qualified dividends or your long-term capital gains that are on the top layer. So you combine those two layers, of course it’s more complex than this one comes to taxes, but in short, you combine those two layers and then you put it through your 1040, you file your tax return. Any deductions you get first come against that higher rate of ordinary income. And then again, the capital gains, the qualified dividends are the preferential rates that sit on top of that.
So here, it’s always important in tax planning to know what your marginal tax rate is. And again, here we’re talking about those capital gains rates. And for federal purposes, they can reach as high as 23.8%. So they kind of tier up progressively. It could be zero for certain lower taxable income investors, it could be 15%. Walt, as you mentioned, it tiers up to 20% but then there’s also something called the net investment income tax or the NIIT, another acronym, two I’s in the middle, the NIIT that could add another 3.8%. That’s how you can get to the-
Walter Storholt:
At least NIIT is a good acronym, that one works.
Kevin Kroskey:
You got it. We need a dictionary of all these different acronyms, I think.
Walter Storholt:
Yeah, a little cheat sheet would be great.
Kevin Kroskey:
You got it.
Walter Storholt:
It would be 40 pages long though, that’d be the only problem.
Kevin Kroskey:
It would be. We’d have to put a limit to it on how many we can use. So we’re trying to again, reduce, defer or potentially eliminate these capital gains. So what’s one way to do it? We can lose money, Walt. Does that sound like a great idea?
Walter Storholt:
Not a great option.
Kevin Kroskey:
No. So again, we want make this very clear, but the purpose of any of these strategies is to make money. But I would add that we’re going to do it in a very tax smart way. So, just because we have some clients that have come to us with significant capital losses or may have a hobby account or whatever the case, but.
Walter Storholt:
That’d be like, I don’t want that raise at work because I’m going to have to pay more in taxes.
Kevin Kroskey:
Or in business owner world, I mean, particularly we’re in Q4 right now and having a lot of tax planning meetings and it’s like, oh man, my income’s too high. I should go out and buy this or I should do that. My first question is, well, do you need that? No, but I don’t want to pay the taxes. Well, do you need that? Let me ask the same question again. But yeah, there’s a lot of that. We’re not talking about just having a write-off here. We’re talking about attempting to make money and have a positive expected return. But I would reframe it as rather than going out and just trying to buy some bad investments, we really want to do some precision type or surgical loss making. I like that term. What do you think, surgical loss making?
Walter Storholt:
Surgical loss making, I do like that, yeah.
Kevin Kroskey:
We’re doing investment surgery here today, Walt.
Walter Storholt:
Yeah.
Kevin Kroskey:
So here, we’re really trying to steadily accumulate losses while expecting to achieve an overall positive return. And really the key here is what I mentioned last time, individual stocks have more volatility than the stock market. Again, however, 4,000 stocks in the publicly traded stock market wallet, you put them all together and obviously they’re going to have different return streams. So it kind of smooths out the total return stream of the stock market. But when you look at an individual stock, and it varies whether you’re talking about a big stock or small capitalization stock or what have you, but you’re typically going to see this volatility, or Walt, what do we call it?
Walter Storholt:
The wiggle factor.
Kevin Kroskey:
Yes, come on, Walt.
Speaker 4:
The wiggle factor, wiggle factor, wiggle factor.
Kevin Kroskey:
Walt, I know you’re on Mountain Standard Time and it’s early for you, but come on buddy, you got to be on that.
Walter Storholt:
I was ready to hit it. I just wanted to get credit for saying it first before the founder got credit for it.
Kevin Kroskey:
All right. All right, good save and gold star for Walt. So we’re looking at this volatility and inevitably, stocks do go down, right? The stock market does go down, hardly at all over the last couple of decades. But inevitably, if you have a larger wiggle factor, volatility, standard deviation, all different ways of seeing the same thing, that volatility is inevitably going to result in some stocks losing a lot more than the stock market and other stocks winning a lot more than the stock market.
So when we’re looking to do the surgical loss making, again, we’ll get into this more in episode three, but we talked about how we may want to go long, a group of stocks with certain traits that we like to own, high quality stocks, and then we would go short, a basket of stocks that really have opposing characteristics, which I said were junk stocks. And Walt, you got a bit of laughter out of that when I said that, but that’s actually how they’re written about in the academic literature. So, there we go.
Walter Storholt:
Really? that’s the technical term.
Kevin Kroskey:
That is the technical term. Kudos to the academics for doing that. You get all these crazy acronyms and everything, let’s just call something junk. We don’t have to call it high yield like they do for bonds. Let’s just call it a junk bond, that was what it was called originally. And then some marketing department said “No, who wants to buy a junk bond?” Would you rather prefer a high yield bond? And then boom, the market just goes off and selling away.
Walter Storholt:
Oh, gosh.
Kevin Kroskey:
But let’s call it like it is, Walt, right?
Walter Storholt:
I like that, yes.
Kevin Kroskey:
Here’s the big difference when you’re looking at one of these long-short strategies on how we would suggest doing it and how it’s evolved to today with the help of technology and just a really good quantitative backing behind it.
So if you go back, say 20 years ago or longer, ultimately you would have a much smaller number of stocks in the long-short portfolio. Here, we won a large number of stocks because it increases our opportunity set. If you have 500 or 1,000 stocks that are going long and short, well of course you want to go ones that are long with the favorable characteristics and short the ones with opposing, but you’re going to be able to play on that individual stock volatility even better with the bigger opportunity set and realize more what I will call net capital losses.
Now, one could go ahead and add another acronym. Net capital loss, is kind of a long one, so I won’t fill in the blank, but I think you get the idea and you’ll see that I use that abbreviation when I write about it if you read any of the writings. The stock market is really important because the stocks are volatile and have about twice the volatility of the stock market, and then the trading strategy and the proper execution of it are the other key that goes into doing this in a profit-based tax smart manner. You have to regularly monitor the stocks and the volatility to realize the losses, as well as make sure that you’re not letting the tax tail wag the investment dog as we pursue those profits.
All right, so some applications of the SMA. So again, we’re dealing with capital gains here or unrealized capital gains and we’re trying to reduce, defer, and potentially eliminate those. So how could that be applied? Well think about what’s happened to people’s portfolios over the last several years. The US stock market specifically, Tyler did a recent episode with you on it, Walt, it’s done really well. And so if you owned US stocks inside of your taxable account, your trust account, your joint account, your TOD account, those generally have appreciated, in some quite a lot. So that part of your portfolio could be overweight and if you want to go ahead and bring it back into balance it with your target and with your investing allocation recipe, you could have to realize capital gains. So this could be one application to help you go ahead and tax efficiently rebalance your portfolio.
Or, suppose you have a concentrated stock position and it’s prudent to diversify. I hope we all agree on that, but I say I hope because there’s a lot of FOMO in the market seemingly driving prices higher these days, but a topic for another day. But you could be corporate executive that’s receiving significant stock compensation through options that maybe you exercise and hold through restricted stock grants that you receive. And rather than sell once they’re vested, which I don’t think is generally a good idea to hold them because there’s no tax benefits to doing so. But suppose that you do and they appreciate significantly over time, you could certainly build a significant amount of wealth in a very concentrated position there.
So if you have a concentrated position from one of these scenarios, could be an inheritor as well, maybe you inherited some stock years ago and just kind of let it ride and it’s grown quite a bit. Or maybe you were one of these people that predicted the future, looked into your crystal ball and said NVIDIA is going to rule the world, and you have a very large unrealized gain there. So just a few applications of what I would call a concentrated position. And that’s something again, at some point in time, generally a good idea to diversify. There’s people that maybe got lucky with a certain investment. And again, I would probably call it luck because hopefully you picked up on the tone of sarcasm when I talked about the crystal ball because nobody has it. But at some point you have to diversify and again, it’s a prudent thing to do.
You also could have, and we have clients that have done this. I haven’t heard this one talked about as much, but you have some clients that bought mutual funds, say back in the ’80s or even the early ’90s or in and throughout the ’90s. And obviously the ’90s market was quite good before the tech bubble burst, but American Funds is a very large fund company that’s commonly found in some people’s portfolios and it’s a very generally a tax-inefficient mutual fund strategy to own. So it’s not uncommon to see that you’ll get capital gain distributions being spewn out from these funds each December. It could be maybe 5% of the fund. So say if you have a million dollars in American Funds and they got a 5% distribution, even if you just hold onto the fund and you don’t sell it, you’re still going to realize about $50,000 in capital gains because the fund is going to distribute it to you. And sometimes that 5%, we’ve seen it as high as 20 or some funds even close to 30% or 40%.
So it’s one of those things you could be a head-scratcher here and say, “Hey, maybe this investment has done well over time, but man, I’m losing a lot to taxes or could be a better way. Maybe I should diversify out of it.” So another application there.
Or, and I would say two more things to kind of wrap up the applications. You could have a future liquidity event. So any of these sales could be an asset sale and again, even if you’re not planning on selling right now, but maybe you will be in the next year or two, which is often the case in business. You have kind of an exit plan for your business and hey, I’m going to work for X more years and then I’m going to start selling, whether internally or externally. And with that foresight you can actually use these strategies to go ahead and accumulate these net capital losses, or NCLs acronym for short. And then once you accumulate those over time when the big liquidity event comes in, you can go ahead and reduce and defer and again potentially eliminate some of those capital gains.
And then lastly, Walt, for those, there’s certain applications in the estate planning realm when you have an irrevocable trust, could be particularly helpful, or if you’re using something called a GRAT, and some of these get into the upper echelon of wealth levels in the US, but they definitely can have some really positive applications in those areas too. So, about a handful of different, I’d say categories of applications that we have there. And again, the reminder is, we’re going to try to reduce, defer, or potentially eliminate these capital gains. And again, this is with the SMA portion of the strategy. So let me give you an example. All right, and we have about a handful of these in our client base, so I’m not talking about anybody specifically, these are just some broad characteristics, but certainly good characteristics to have too in your financial planning.
So let’s assume that we get two docs, Walt, and they go to school, they’re in medical school for a while and spending a lot of time together and a lot of them happen to, they meet, they fall in love and they end up getting married and now they have two good incomes throughout the rest of their life. So that tends to bode pretty well for their financial future. And let’s assume that these docs are specialty docs and so specialists tend to make more than generalists. And let’s add one more layer to the case here, let’s say that they’re partners and a physician-owned hospital, which we have a few of those in our backyard in Northeast, Ohio. So these docs are doing pretty well. They’re making wage income, so W-2 income, over a million dollars, and let’s just assume that they have another $500,000 of business income. And so business income, this is, think of pass-through income here.
Walt, I know when you file your tax return, being the savvy business owner that you are, you get this K-1 and then you pick up the K-1 on your 1040. So it passes through the business over to your 1040, and that’s business income or AKA, pass-through income that is coming through via that K-1. You got me buddy?
Walter Storholt:
I’m with you.
Kevin Kroskey:
All right, so they’re doing pretty well. Our two docs, let’s call it a million in wage income for round numbers, and practice specialists are probably going to be well over that when you’ve got two of them in the family, and then you have another $500,000 for K-1 income. So the rate on that ordinary income, the top rate is 37% for federal, plus any state or local taxes that may be applicable. So just round it up, let’s call it 40%. So for every $100,000 that they have at the top of their tax rate, they’re paying $40,000 to Uncle Sam for ordinary income taxes. Good problem to have, right Walt?
Walter Storholt:
Sure, but starting to hurt a little bit.
Kevin Kroskey:
It hurts, believe me. Yeah, it hurts. I see the pain.
Walter Storholt:
Mentally, like, ouch.
Kevin Kroskey:
Now whether they get sympathy from other people, it’s a completely different question.
Walter Storholt:
Sure.
Kevin Kroskey:
And one that we’re not going to explore today.
Walter Storholt:
But if all things are relative.
Kevin Kroskey:
No, absolutely. So it’s one of the key pain points that a lot of our problems have and again, it’s something that we have a lot more control over because again, nobody has that crystal ball. So it’s not just about, I would say this, it maybe a quick tangent here, but it’s not just about what you make, but it’s about what you keep. Whether that’s your ordinary income or whether that’s your investing income. When it comes to investments, you can really think about your pre-tax return and your after-tax return. So another way to say what we’re trying to do is, I think the strategies have a reasonable basis to go ahead and really help with both of those. We’re really pursuing a profit motive here with the investing component to increase our pre-tax return, but the tax strategy that accompanies it can really help increase our after-tax return too. So we’re competing well in both halves of the game to hopefully optimize what’s going to happen at the end. How’s that, Walt? That was kind of off the cuff here.
Walter Storholt:
I like that.
Kevin Kroskey:
That make sense?
Walter Storholt:
It was. Yeah, and then I can already see this all coming together with this example, so this is good.
Kevin Kroskey:
All right, so let’s go ahead and we’re talking about the SMA here. So again, the SMA is designed for capital gains and kind of helping avoid, defer, or potentially eliminate those. So let’s assume that they did well, they invested, the markets have been really well over the last couple decades, particularly after the financial crisis. And let’s say that they have a trust account between the two doctors that has about a $500,000 basis, but it’s worth $2 million today. Fantastic. So they have a 1.5 million unrealized capital gain. Hypothetically, if they were going to sell all of it, who knows for what reason, maybe unlikely, but it just helps illustrate the point if nothing else. On the 1.5 million, when you look at their gains rate and you add in at least in Ohio a couple points for the state tax rate, they’re going to end up paying about $400,000 of the two million in taxes. And so they’re going to keep about 1.6 million. So that’s their outcome there if they’re going to sell everything. Now, again, not saying that they will or they should or anything like that, illustrative purposes only here.
And also, I’ll kind of weave this into the next example, but let’s also assume that their business sale, when that occurs, they’ll have a million dollar gain at the time of their retirement when they sell their interest and ride off into the sunset. So when we look at the SMA benefits just solely on the trust account, so we can assume, and this could vary, it could be greater, but it’s a fairly reasonable potentially conservative number that we’re using here. Let’s assume that we realize about 15% of the value of the account.
So in this case, again, it’s a $2 million account, but we’re realizing about 15% by utilizing that individual stock volatility, by using the smart trading strategy to go ahead and capitalize on those losses while seeking to make money, that we can get about $300,000 in net capital losses per year. So 15% times the two million, $300,000 per year. So simple way to kind of think of this is, so for every $100,000 in losses that we’re able to realize and help avoid gains, that’s going to save somewhere around $24,000, $27,000 if you’re a lower tax bracket, still could be beneficial. But Walt, if you’re in that 15%, maybe it’s 15,000. So it kind of depends on your tax bracket. But nonetheless, you can see here where you can really start saving some pretty profound dollars or at least avoiding them, pushing them into the future, potentially eliminating them. But again, at least you’re going to be able to keep your money working for you longer and avoiding them currently and helping your money grow is only going to help you create more wealth and help maximize or optimize that after-tax return.
Let me pause that felt like a mouthful there, Walt. You with me?
Walter Storholt:
I’m with you, yes. We do nothing and we just go kind of the standard route. We pull the money out, pay capital gains, we’ve got that $400,000 impact in this example, or we apply this strategy into the account and we’re starting to see how this is going to unravel a better situation.
Kevin Kroskey:
You got it, and so if we’re talking about $100,000, Walt, if you 10x that, or what’s that word?
Walter Storholt:
Decouple? That was the decouple, right?
Kevin Kroskey:
That’s right. So if you have a larger unrealized gain, I gave the example, we have a business owner with quite significant gain this year, but if it’s $24,000 say, given your tax rate on 100,000 in loss realized and gains avoided, if you add a zero to that and now we’re talking about, hey, it’s not 100,000 but it’s a million dollars, well just add a zero onto that 24,000 or whatever your tax rate is. So now we’re talking about $240,000 in savings and if you have a really, really, really successful business exit, you can certainly get higher than that too.
But again, it kind of scales proportionally with the amount, I just try to normalize it there for the $100,000. But even for say, I mean, a lot of our clients that most people would consider them wealthy, they sure don’t. They worked hard, they saved, they invested in the magic of markets and compounding did a lot of work over time, and then they end up in a position like, okay, hey, we have this trust account, it was pretty small, but now it’s actually a couple million dollars. Hey, maybe we’re not working, maybe we’re not in the highest tax bracket, but we’re still getting some of these benefits by just avoiding the capital gains, being able to better manage our portfolio tax efficiently, diversify a little bit more. Maybe we’re producing an income from that account to help have our retirement lifestyle funded and now we’re doing it in a way that’s really not jacking up the taxes on our tax return.
So it’s certainly, again, with anything tax related, the more dollars, the more zeros you have, the more benefits or potentially are there, at least in terms of dollars. But this really can have broad application and it does for many of our clients. And again, this is just on the SMA component when we’re looking to solve for capital gains.
Next, and I think we can wrap up after this one, Walt, we make a transition here and we’re going to talk about, this is the more complex one. So this is more of the rarefied air here, five million plus, SEC qualified purchaser definition. And rather than just using an SMA, here we have to use a limited partnership investment. It could be a hedge fund, there are kind of two ways of somewhat saying the same thing. Hedge funds are more of a strategy rather than a structure, but here we’re using a partnership and we would be limited partners or LPs of that partnership. So again, already getting a little bit more complex and I think you can see that and why some of these rules from the SEC do exist.
So the underlying strategy is very similar to the SMA. We’re using volatility, we’re using the long-short component, going along the favorable traits and going short stocks with the unfavorable or opposing traits. The fund structure is different and certain tax elections, which we will not get into in this podcast because it would definitely put anybody to sleep that’s still listening, but there’s certain elections that are made by that hedge fund by the general partner that will help allow us to realize some tax benefits. And then the underlying investments in the taxation of those are a little bit different too. In the SMA we just use stocks, we went long stocks and we went short stocks. In the LP we are using swaps. Walt, this is what you were talking about here.
Walter Storholt:
Yeah, that’s from big-short. Yeah.
Kevin Kroskey:
This is the big-short. We’re not using credit default swaps or some other swaps. Here, we’re just using swaps to go ahead and get similar exposure just like we do in the SMA. So what happens here is, you get the large investment banks like a JP Morgan, Deutsche Bank, Barclays, what have you. The fund will go out and get a swap contract for these individual stocks. And now the key difference here is that how those swaps are taxed, and again, this is done in the context of this fund structure. So where you’re dealing with stocks, you’re talking about a capital gain or capital loss. Swaps are different. This is pretty complex, but high level, you could potentially have capital gain or ordinary income taxation depending on your hold period. All right?
So we’re getting down in the weeds here a little bit. So, and this is what the managers of the strategy are going to be doing because already using, we’re really going to use these two in conjunction with each other. Some of these managers will just have kind of a little bit of both the SMA and the LP and one LP and you’ll get some cap gains benefits, you may get some ordinary income benefits. There’s others and the number of managers that are out there doing this, or you can probably count them on no more than two hands at this point in time, but huge area of innovation and certainly a lot of money flowing into it. So there’s going to be more and more competition. But you can also, and one of the preferred ways that we have of doing it is kind of like a two-part strategy. So you’re using the SMA and then you’re coupling it with the LP, if this part does apply to you and you meet that rarefied error of the SEC qualified purchaser.
And the swaps within that LP, if you go ahead and you hold them, then you’re going to say it could be a month contract, could be longer, but generally you’re seeing people using monthly resets on these swaps, and if you hold it to the end of the term, then that’s going to be an ordinary income transaction. But if you go ahead and you terminate that or terminate it early, it’s called an early termination in the IRS code, that’s going to be a capital transaction.
So when you think of this, what do we have from the SMA? We have these net capital losses that we realized, and now what we’re talking about here is say okay, hey, we’re going to couple it with this LP, similar strategy but different tax characteristics. And now what we’re going to do is we’re going to use this management of these swaps to go ahead and we’re going to realize short-term capital gains.
Usually you would never want to do that. You’re like, why would you do that? That’s just tax like the highest rate. It’s not the preferential rate of long-term, but we already have the net capital losses from the SMA so properly designed. You can think of it as, hey, the losses that you realize on the SMA are offset by the gains in the swap contracts that you have. Then what are you left with, Walt, if you have netting out of short-term capital gains and capital losses? The swap leaves you with ordinary income because really, you’re going to let those losses on the swaps go ahead and go to the end of the month and it’s going to be taxed as that ordinary income transaction.
I know that was a lot. Sometimes it’s helpful with a little picture there, but we’re on podcast and airwaves right here but it’s really kind of, I guess you can think of it as transforming smartly the taxation of your investing strategy. Obviously in the SMA, just to recap this one more time, you have the net capital losses. And then in the LP, similar underlying stock exposure, but you’re not using stocks. You could just have a swap with JP Morgan that says hey, let’s replicate the investment return of Apple stock over the next month. And yes, JP Morgan is going to go ahead and charge you a fee for that, but then they can also go out and basically hedge that risk very easily in the public stock market.
Walt, if you go back to your example in the big-short and this credit default swaps, ultimately that risk wasn’t able to be easily hedged out. It was just kind of ended up all on the balance sheet of AIG, who partly blew up the financial world for many years. But here in the stock market, it’s a lot easier for JP Morgan or these other investment banks to go out and just reduce the risk and offset that into the public equity market.
Walter Storholt:
This is helpful. I definitely feel like I’m going to retire smarter after listening to today’s episode. So that’s the spirit of the show, right? I think the big thing here is just awareness. It sounds like that’s one of the big goals that you probably have is not for somebody to come away from today’s episode knowing all the ins and outs of these strategies, but just to be aware of the option, aware of the idea and the concept of, hey, there’s a better way to do some of these things for high-income earners and these accredited investors. Let’s be cognizant of what we have in front of us, and as we all want to do, make the most of our dollars and save as much as we possibly can, pay the fair share, but not more.
Kevin Kroskey:
Perfectly said, Walt. That’s why you’re here buddy, and thank you for doing that. There’s definitely some details. Part of the reason why I mentioned some of the… and the complexities are much more than what I shared, but you can see how some of the complexities just pile up pretty quickly in here. But it’s again, at its core, we’re seeking to make money on the investment strategy, because you have to do that. If you’re just doing something as a tax avoidance or something, I mean, that’s prohibited by the IRS, so that’s not what we’re doing here.
And to take that a step further, the people that are preparing these K-1s, they’re often the big four CPA firms. They’re the Deloittes, Ernst & Young, Pricewaterhouse or PWC. So they’re not going to fill out a K-1 and do that tax return for the fund because unless they felt good about it, if it was a sham, of course they’re not going to put their name on it and have all that risk. Remember Arthur Anderson 20 years ago? You may not because they put their name on WorldCom and Enron in these companies and basically, not only did those companies blow up through those accounting scandals, but it also blew up the big four, or it used to be big five CPA firm and Arthur Anderson is no more.
And again, with the SMAs even, you have these custodians like Schwab and Fidelity and others that it’s passed their due diligence test and they’re putting on their platform. They’re not going to do that lightly. So maybe that provides a bit of comfort, just knowing that these very large institutions, it’s passed all their compliance and legal checks. It’s not like they’re endorsing the strategy or anything like that, they just don’t do those things. But they certainly have passed their due diligence checks, if you will.
So let me wrap into the applications and go back to our two docs example and then we can wrap this one up. The applications here, again, a little bit different. Now we’re talking about, what are we going to do with these ordinary losses? Well, you can offset business income. Again, that K-1 income that you can think about that we would get passing through to us from our closely held business, or, you can offset your non-business income up to certain thresholds. So it depends on filing status, tax filing status but in ’24 you can actually offset up to $610,000 for a married couple filing jointly. So a pretty sizable amount of money here that you can do even if you don’t have a business but you are one of these high income professionals.
And again, that non-business income, think W-2s, could be IRA distributions, could be IRA distributions that we convert into a Roth IRA. You could have significant interest. We have a lot of clients that are investing in a private credit these days, which the yields and the interest that is being earned on those is pretty significant, it could offset that. It could even offset passive real estate investing income. So there’s a whole slew of tools in the tool belt that we can do to ultimately get a better tax result and make sure that we’re optimizing the second half of the investing and tax gain there.
So if we go back to our two doctors, again, their wage income, a million dollars. They have their business income, $500,000. So, what are we going to do here? Well, again, they’ve done both of these so they have the SMA account on their trust, so they’re realizing those net capital losses. They also made a cash investment into the limited partnership so we can properly design that so the capital gains and losses offset, and what they’re left with are ordinary losses. Now those ordinary losses can go ahead and offset first the business income, and then the wage income up to $610,000.
So previously we talked about, hey, about how much money can this save? And I said okay, hey, if we’re talking about saving at cap gains rates for every $100,000 and that we’re avoiding, deferring, potentially eliminating. Could be 15,000, it could be 27,000. If you’re in a high tax state, it could be over $30,000 on every $100,000 that you’re avoiding here, because the tax rate on the ordinary income is greater or the savings are greater as well. So again, for our tax, excuse me, two doctors, we have their ordinary income rate around 40%. You got the federal 37, add in some state and local, again, certainly could be higher in other states or a little bit lower if it was a non-taxing state. But generally, for every $100,000 in ordinary losses that they’re using to offset that income, they’re saving $40,000 ish per year. So Walt, if we go 10x on that, what does that amount to?
Walter Storholt:
400,000.
Kevin Kroskey:
Yes, so very significant and very doable if you have those kind of traits, which is just, it’s one of those things when you may hear about this or research it the first time, it’s almost like, hey, this sounds too good to be true or what is this? And it most certainly is not. It’s definitely a newer innovation, a different application of a strategy that’s been around for a while. There’s been some tax rule changes over the last handfuls of years that have also made this possible. And candidly, even just the technology applications have had to go ahead and develop so you can actually execute this in a good sound strategy and really try to not only manage the tax component, but also making sure that we’re really trying to manage the investments well as well.
So, a lot here, I’m almost scared to see, look at the timer and see how long we’ve gone, Walt.
Walter Storholt:
I bet you thought [Inaudible 00:43:46]-
Kevin Kroskey:
That laugh does not give me any reassurance to that.
Walter Storholt:
You thought you were going to be better than part one, but you were not.
Kevin Kroskey:
So I’ll let you and your editors figure out if this is going into a longer, a more series, more episodes, excuse me, in the series. But again, there’s a lot to this and we haven’t even got into the investing components, but when I said earlier and you said, “Man, that was a big statement,” when I said this is going to fundamentally change the way that we invest for taxable investors. These are parts of the reason why. The tax benefits are significant, there’s a broad-based application here to many people for many different purposes, and we haven’t even spoken about the tax benefits yet, and those in my view are pretty significant as well.
So when you put it together, and these are things that we can control. Again, whether the S&P does 10%, 20% or minus 50% or anything in between, we have pretty much no control over that. Sure, we can try to build a better portfolio. Sure, we can diversify, but really what we’re talking about here is kind of taking that next step, that next evolution to build a better portfolio and making sure that we keep a lot more of our gains and then even transform some of those capital gains that would otherwise be capital gains in stocks. By using a different investment vehicle and swaps combined with some tax elections in the fund structure, we’re actually able to offset and save at ordinary income rates.
And again, I’m sure these two doctors are getting very little sympathy from broad-based America, but we have several of them in our client base. I’m sure there’s several that are listening, and the benefits and the potential benefits are significant. So, this is why I’ve spent a lot of time researching these over the last several months. Our clients are already benefiting from these. We’re talking about it quite a bit to an extent here, Walt, that violating all the rules of podcast and podcast length. But I’m sure that the people that this applies to, I think they’re probably still listening and I think they’re going to be pretty interested in learning more.
Walter Storholt:
I think they will appreciate the depth to which we went in today’s episode. So, no doubt about that. The rules are meant to be broken from time to time, Kevin, and I think this is a good example of that. So I’m just glad you let me redeem myself at the end with a nice, easy 10 times 40,000 and give you the $400,000 answer there. So after a landmine-filled episode of responses and trying to remember acronyms and those kinds of things, you let me bring it home with a nice easy one at the end there.
Kevin Kroskey:
Walt, I love you, buddy, you do great. We’ve been together since 2018. It’s a long-term relationship, man.
Walter Storholt:
That’s right.
Kevin Kroskey:
I don’t just set you up, I want to make you look good too.
Walter Storholt:
That’s right.
Kevin Kroskey:
That’s right, yeah, and you do.
Walter Storholt:
It’s a little bit of both, so.
Kevin Kroskey:
It’s symbiotic.
Walter Storholt:
It is, it is. I appreciate that. It is just a great way to retire smarter when you listen to the show. I mean, it really is. We’re going to go in depth here more so than I think you’re going to hear the majority of advisors out there, and that’s why I love chatting with Kevin on these episodes and Tyler too. But Kevin, you just reach this extra level of depth when it comes to topics like this and your passion for it really rings true as well.
So like I said a few minutes ago, it’s all about raising awareness today. Hopefully you got some good nuggets. I know some of you got a couple of nuggets, some of you got a lot of nuggets, but no matter where you are on that spectrum of the takeaways you got from today’s episode, I hope the one that’s clear is that there are opportunities and there’s some shifting ground here, this foundational change that’s happening.
And so if you want to explore a little bit more deeply and start to get into the specifics of your situation, how it can be affected by these foundational shifts, here again, if you’re new to the show, the easy way is to get in touch with Kevin and the team at True Wealth Design. Easiest is to go to truewealthdesign.com. It’s linked in the description of today’s show. Click the, are We Right for You button, and you can schedule a 15-minute introductory call with an experience advisor on the team and start just getting to know each other, see if you’d be a good fit to work with one another. Again, truewealthdesign.com, click, Are We Right for You. And you can also call if you prefer, (855) TWD-PLAN is the number. That’s (855) 893-7526.
Kevin, great episode. It seems likely that this might be a four-parter instead of the three-parter, just based on today, we’ll see, but I know at least we’re getting you back for part three coming up soon.
Kevin Kroskey:
Sounds great, Walt.
Walter Storholt:
All right, appreciate it. That’s Kevin Kroskey, I’m Walter Storholt.
Kevin Kroskey:
We’ll see you next time.
Walter Storholt:
Right back here on Retire Smarter.
Speaker 3:
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