Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
Time Stamps:
[0:00] – What’s going on in Great Britain?
[1:15] – The escalating Private Equity market
[5:15] – How REITs can rule in real estate investing
[7:25] – Why the time may be right for a Roth IRA conversion
[10:00] – Tax-impacting moves to make by December 31 – Don’t Delay!
[11:10] – Strategic uses for a Donor Advised Fund
[12:10] – Why not to miss your IRA’s full annual Required Minimum Distribution
[13:00] – How a Qualified Charitable Distribution can be a difference-maker at tax time
[13:50] – Using non-performing assets to your advantage
[14:10] – The risk associated with making a late-year, large-sum mutual fund investment
[15:05] – Peter Mallouk’s tip of the month
[17:05] – Jonathan Clements’ tip of the month
Transcript:
Jonathan Clements: This is Jonathan Clements, Director of Financial Education here at Creative Planning in Overland Park, Kansas. It is December 2nd, and sitting with me here today is my co-host Peter Mallouk, President of Creative Planning and we are down the middle. So Peter, we’re rolling into the end of the year, only a month to go. Looking back at 2019, what would you say you’ve learned over the past year?
Peter Mallouk: One of the things I learned is that for as crazy as the United States Congress, President, political system is that Great Britain is infinitely crazier, absolutely, horrifically crazy. Watching the debates in Parliament and what’s going on with Brexit and just what an absolute mess it is, I learned that they even passed a law that you can’t slander the parliament. And so if you watch the John Oliver show anytime he’s making fun of parliament, instead of seeing that segment, you see somebody reading three star Yelp reviews during that period of time. So, no matter how crazy it seems here, it’s crazier even in other parts of the developed world, and you see the impact that craziness has on the economy and the volatility in their markets.
More than that, I’ve been fascinated by the move from public markets to private markets that I’ve watched unfold in the last five years, but really the intensity of it in the last year. We have an ultra-affluent practice here that works with the highest net worth folks, and most of those folks became that way by selling their business to a strategic buyer or private equity funds. We have lived in the world of being used to those transactions. Some of our higher net worth clients and institutions invest with private equity.
But the radical shift, the number of public companies is coming down very, very, very quickly of late. The number of private equity funds is expanding very dramatically. The amount of money that’s going into the private equity space for all the wrong and right reasons, has created a marketplace now where firms that used to go public to be able to create succession planning and scale and institutionalization and to monetize what they built, they can now get almost the same, and in some cases a greater valuation in the private markets. And what the implications are for the regular investor is, if this trend continues for the next five years, we’re all going to be investing in the same 900 stocks. I mean, it’s really become very intense to where the average stock is now much, much larger than it used to be. The ones that are really left in the public space are very, very large. And so it’s been very fascinating to watch over the last 12 months this trend hit a tipping point where it’s really accelerated.
Jonathan: And do you think we should be concerned about it?
Peter: I don’t if I’m concerned, but I’m watching. I think our investment policy committee here is watching very carefully and saying, what is this ultimately going to mean to investors as the universe of public stocks contracts, and you have a larger and larger move towards indexing and more and more goes to the private market? How are we going to get our clients diversified? How are we going to find ways to, in a low cost, tax efficient way, provide them diversification?
Right now we’re watching the public universe really condense, but the private universe expenses haven’t come down. And so it’s not like we can just say, Hey, let’s go add this asset class over here for everybody. I mean, there’s laws that prohibit it for people that have less than a million, in some cases 5 million. But also the cost to access it doesn’t make sense for the typical investor and the illiquidity that comes with it. I think the marketplace is going to react in a lot of ways to this. I think if this trend continues, we’re going to see costs come down in the private space. We’re going to see major institutions make these investments accessible. Vanguard at a press release a few months ago, or somehow it came out that they’re thinking about creating a private equity type fund. I mean, Bogle turned 20 times over in his grave hearing about that and if they would’ve done that while he was here, he would just light the place on fire and walked out like he was the equalizer, right? He would’ve lost his mind.
So I don’t know. We don’t know what’s going to happen yet. And we also don’t know that the trend will continue. We could have a very negative event in the private space. This big explosion has happened since the ’08-’09 crisis, so a lot of people haven’t been burned yet. It’s paid off for all investors. And so when we go through the next cycle, the next downward move tends to be a cleansing event and we’ll see how all of this washes out. But if the trend in general continues, I think there will be implications to the average investor. We just don’t know what they are yet.
Jonathan: One of the concerns about investing in private equity beyond the expenses involved, is simply that if you invest in a private equity fund, you are not getting the sort of diversification that you get with a broad market index fund. I mean, these are, I’m not going to say they’re lottery tickets, but there’s going to be a lot more variation in the returns of these funds than there would be if you had two total market index funds, which might only be a few basis points difference in performance. And so if you’re going to invest in the private equity, you really need to be picking your funds carefully. And even if you do, it’s still a bit of a crapshoot.
Peter: I think the easy example for the typical investor is real estate. The overwhelming majority of our clients should just buy the rate index and be done with it. You’re going to get general exposure to the real estate across the country. You’re going to be diversified geographically, you’re going to be diversified by sector, so you’ll have a little bit of storage, you’ll have a little bit of apartment complexes, you’ll have a little bit of commercial buildings. If one place goes wrong, you’ll be fine. Do you get all the tax benefits? No. But you’ve got diversification, you’ve got exposure. You’re not a hundred percent correlated to the stock market. You’re maybe 83% correlated whatever the most recent study says.
If you hire an extremely experienced local real estate fund and you invest with them and they’re going to only go buy four places and you’re going to realize the tax benefits and you’re going to control when you go in and you’re going to control when you go out and the exact profile of what you’re buying, so it might fit your portfolio better, are they probably going to do better, even though they’re going to be more expensive? Are they probably going to do better than the index? In the aggregate, the answer is no.
But if you get the right people and here managers make a difference. I mean, in every market there’s 20 or 30 groups doing this, you can pretty much sector out, here’s about who’s going to be at the top half of this and who’s going to be the bottom half, and a couple people are going to surprise you, but I wouldn’t say lottery ticket. I’d say that the experience and the manager and the sophistication of the team involved, all of those things really do impact their ability to buy well and sell well in a different way.
And I think that private equity is the same way. I think the problem with private equity, there’s 8,000 funds, so it’s like 8,000 people running around buying private companies. It’s like 8,000 real estate funds and the aggregate, they’re going to lose to the index. But are some of the managers who’ve done this through 20 different cycles, or 20 different funds, are they probably better at it than other people? I’m in the camp that believes the evidence that suggests that may be true. I think there’s another camp that says that evidence isn’t going to persist, because there’s a lot of money there. We don’t know what’s right, which is why you can’t go all into one thing. The point of diversification is we’re not certain what’s going to happen at any time. We’re going to put the eggs in different baskets and do the best we can with every basket.
Jonathan: So, when I look back at 2019, one of the things that really was hammered home for me, was the opportunity that the current tax code present for doing Roth conversions. I had not realized the degree to which we saw a flattening of tax rates as a result of the 2017 tax law. And what it means is that going from the 12 to the 22 and so on higher tax bracket, is very gradual. And one of the consequences is that you can have a lot of taxable income in any particular year before you end up in that 32% tax bracket. So in other words, you could do a large Roth conversion, moving money from a traditional IRA to a Roth, and the tax rate would be 24% or less. And so as a consequence, people who want to move money into a Roth and don’t have a super high income but expect to be taxed or roughly high rate down the road, particularly once they start to take required minimum distributions from their IRAs once they get into their seventies, may want to look at this chance to do a Roth conversion.
And it’s certainly something that I’ve been thinking about for myself. So for instance, if you look at 2019’s tax law, if you’re married filing jointly and you’re taking the standard deduction, you can have something like $346,000 of taxable income and remain within the 24% tax bracket. If you’re a single individual, the number’s around $173,000. By contrast, if you go back to 2017,, you would be moving into the 25% tax bracket if you had just one third of that taxable income.
So for anybody who’s interested in doing a Roth conversion, this year and next year are going to be great years to think about doing that. After the next presidential election, who knows? And even if we get a Congress and a president that’s divided and there aren’t going to be any big tax law changes, one of the things that we know about the current tax law as it relates to individuals, is that all of the provisions pretty much are going to sunset at the end of 2025, at which point we will be reverting back to the tax law that existed in 2017. So this window of opportunity to do large Roth conversions may be relatively limited and it’s something that you may want to talk to your financial advisor about.
Peter: That’s great advice and applies to a lot of people.
Jonathan: So, Peter, as we wind down towards the end of the year, one of the things people always do at the end of every year, is various tax moves. So if somebody’s in the final month of 2019 and they’re thinking about smart things to do from a tax point of view, what would you suggest they think about?
Peter: The way that tax law works now, a lot of people don’t itemize anymore? It’s really made tax returns a lot easier for CPAs. So I think for people that have expenses, that are doing charitable giving and have other things that might be itemized deductions, they should really look at, is there a way to bundle these in one calendar year? If is there a way that they can accelerate some of these expenses to pull them into this year if it will allow them to itemize, or if they should defer certain things in the next year?
A good example would be charitable giving. So if you are giving 5,000 this year and 5,000 next year, but if we could do it all in one year, we can get a bigger tax break, that’s what we want to do, rather than make the same gift in two years, one in December and one in January and get no break at all. The best thing to do here is to talk to your CPA from now. A lot of people talk to their CPA in March. The time to be doing it is right now and saying, look, this is what I’ve done so far, this is what I’m going to do next year. And work with your advisor to really figure out, should I be bundling these or not?
Jonathan:
And if you’re going to be bundling, one of the things that you might want to think about doing is setting up a donor advised fund. So for instance, if you want to get out of the standard deduction, be able to itemize and you’re going to take two or three years of charitable contributions and put them into a single year, but you don’t want to give away all the money right away. You could set up one of these donor advised funds. You can do it through Vanguard, Fidelity, Schwab, T. Rowe Price. I just heard about a new one called Grow Fund that apparently has no investment minimum in order to set up a donor advised fund. So you can set up one of these donor advised funds, put a big chunk of money into it, get your tax deduction in 2019, and then use that fund to contribute to your favorite charities in the years ahead.
Peter: A lot of our wealth managers here set up hundreds and hundreds of those for people all over the country using a lot of the custodians you just mentioned. And it’s not uncommon for us to pre-fund 10 or 20 years of giving if it really can make sense for the client to get the breaks right now.
Jonathan: One of the things that people should also be thinking about doing in December, if they haven’t done it already, is to take their required minimum distributions from their retirement accounts before the end of the year, because the penalty for getting it wrong is really, really rough. If you don’t take your full required minimum distributions before the end of the year, the penalty is equal to 50% of the money that you should’ve withdrawn but didn’t. Now this in 2019 applies to those who are age 70 and a half and older. There is talk in Congress of raising the age for require minimum distributions to 72. That has not yet become law, so 70 and a half is still the age if you haven’t done it yet, get it done.
Peter: Penalty is ridiculous and punitive and totally consistent with the way Congress passes laws in the United States.
Jonathan: And then just while we’re talking about required minimum distributions, one of the things that people who are over age 70 and a half can do, is do something called a qualified charitable distribution, which means you can contribute directly from your IRA or other retirement account to a qualified charity and count the money that you give as part of your required minimum distribution for 2019. And if you run the numbers, what you find is that this has various tax advantages, particularly if you are taking the standard deduction rather than itemizing your deduction. So if you’re charitably inclined and you haven’t yet taken your full required minimum distribution and you’re over age 70 and a half, all those caveats, consider doing a qualified charitable distribution.
Peter: And if you have a donor advice fund, you cannot use that distribution to go to your donor advice. So you basically give it to any charity you want other than your own.
Jonathan: All right. And then a couple other last few tax tips. If you have tax losses to take, you’ve got investments that are under water and you want to use those losses on your current tax return, sell before the end of the year because that way you can use those losses to offset capital gains and up to $3,000 of ordinary income.
And then I say this piece of advice with some nervousness, because it’s often misinterpreted. If you have a large amount of money that you are going to invest in a mutual fund and you’re going to be doing that in December, just call the fund first and ask where they’re going to make a large capital gains distribution. Because if you buy the fund and then the next day they make that capital gains distribution, you’ll owe taxes on it, assuming you’re doing the purchase in a regular taxable account. The reason I give this advice with a little bit of nervousness, is I’ve sometimes suggested in this past and people are like, You mean I shouldn’t send off my a hundred dollars this month to my favorite mutual fund? That’s not what we’re talking about here. If you’re going to invest a hundred thousand dollars, think about it. If it’s a hundred dollars or a thousand dollars, don’t sweat it.
Peter: That’s very good advice.
Jonathan: And so, we’re rolling into the end of the podcast for December, Peter, and what time it is, it’s tip of the month. So what’s your tip of the month?
Peter: All right, so my tip of the month, just because I see this with folks that are just starting out all the way to people that have a huge amount of money, it’s prioritizing debt. So people have all kinds of ways of doing this. There’s, I’m going to pay off the smallest debt first. Or you get a house, they get a loan against the house, you get a car, you get a loan against the car, you have student loan and you personally guarantee it.
Really the way to approach this is what’s your highest cost debt and get rid of it first. Attack the highest cost debt. And to the extent you can restructure your debt, restructure your debt. So if you have a car loan and a home equity loan that’s not maxed out and your car loans is 5%, your home equity loan is 3, pay off your car loan with your home equity loan. So a lot of people tend to tie their debt to the asset and really your debt is your debt. Get it all aggregated to where it costs you the least, and then start to pay off the highest cost debt first.
Jonathan: The only small exception I might mention to that piece of advice is, I occasionally hear from people with that question. And if you dig deeper, sometimes you find that say their car loan is roughly low cost, but they only have a couple of payments left. And so even though the interest in that loan is relatively low, if they pay off the car loan quickly, it’ll immediately improve their cash flow situation. And for anybody who’s really struggling with debt, probably not the typical person who’s listening to this podcast, but if they are, getting that loan paid off and then giving themselves some financial breathing room, can be a smart move.
Peter: That’s wise advice. I mean, I think that the advice I’m giving is in a vacuum advice, and what you’re talking about is the advantage of knowing the client, having a financial plan, and then the third component is psychology. If you’ve got a car loan that’s only got three grand on it, a lot of people just want to attack that first because they don’t want to see that anymore, and that makes some sense too. You have to balance all three of those things.
Jonathan: And so, when it comes to my tip month, a lot of people are still looking around, deciding what sort of health insurance they should buy for 2020. And what I would suggest to folks is that you focus on two numbers, focus on the minimum amount you’re going to pay in 2020 and the maximum amount you’re going to pay in 2020 and make sure you can live with those two numbers. So to figure out the minimum amount you’re going to pay, all you have to do is take that monthly premium, turn it into an annual number, and you’ll know the minimum annual cost you’ll pay in 2020 for health insurance.
Meanwhile, to find out the maximum cost you’re going to pay in 2020, you take that annual premium and you add the out of pocket maximum and that that will to tell you the most that you will end up paying in 2020. And so you look at those two numbers, the minimum you pay, because the premiums and the maximum you pay, because of that combination of the premiums plus the out of pocket maximum, and you can have some sense for what your financial life is going to look like in 2020, depending on whether things are really good or really bad.
Peter: Very good. I have actually never heard that before and it’s something that makes a lot of sense for people since it’s one of the biggest expenses they’re going to face.
Jonathan: So anyway, that’s the end of another podcast. It’s me sitting here with Peter Mallouk. This is Jonathan Clements, Director of Financial Education here at Creative Planning in Overland Park, Kansas, and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed to be reliable, but is not guaranteed.
