Unlock More with Brokerage Accounts

Speaker 1 – 00:00
Welcome to EWA’s FinLit podcast. EWA is a fee only RIA based out of Pittsburgh, Pennsylvania. We hope all listeners
of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And
we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your
family and also save time. Welcome everybody. Joined today by Jameson. We’re talking about why brokerage
accounts are one of the most powerful tools in financial planning, but I think one of the most overlooked tools. So
James, why do you think that is?
Speaker 2 – 00:49
So they’re definitely extremely flexible and liquid and you know, you can use them for opportunities, business
investments, anything, you know, any retirement accounts locked up. So I would say the ultimate control and
flexibility and liquidity would be why.
Speaker 1 – 01:05
Yeah, I think to the a lot of times like financial planning is sometimes like, you know, like a workout or diet, like you’re
gonna do exactly kind of the bare minimum of what you’re told to do. And I think in the financial planning, like if the
obvious education out there as you go, you know, you max out a 401k, you max out a Roth IRA, you put money in 529
plans for your kids and then people get to where else should I save? And they go to a brokerage account. Then the
common misconception is it’s not tax efficient when it can be one of the most tax efficient things you do. But we’ll
get to that in a little bit and there’s no limit to how much you can put into it.
Speaker 1 – 01:45
So a lot of people, and even we’ve seen advisors will say like after you put in your 401k Roth IRA529 plans like start
putting money and life insurance or other tax deferred vehicles. And this often gets overlooked. But a lot of times we
find that life, you know, is not necessarily on pause until 59 and a half when these other accounts become available.
So having the liquidity is going to be super important in your 30s, 40s and 50s when kids are going through school,
maybe you’re doing renovations, your house, maybe you’re wanting to buy a second vacation house. And all these
other type of accounts aren’t available unless you know, 529 plans are being used for college. With the 401k, you
know, you can take a loan up to 50,000 out, but you’re going to miss market appreciation and pay interest.
Speaker 1 – 02:33
That can be probably the most expensive loan in history that you could do other than Like a credit card going really
bad. So, you know, with a brokerage account, there’s a lot of ways to put tax efficiency into place and there’s a lot of
flexibility with them. So before we go further though, Jameson, and high net worth clients that we work with, which I
would define, let’s just say 5 million plus. And then let’s also talk about a second subset, 10 million plus. So in most
of the clients that we work with, 5 million plus, what percentage of their net worth do you think? Like, how is it broken
down typically?
Speaker 2 – 03:12
So it’s 5 million?
Speaker 1 – 03:13
Yeah, probably.
Speaker 2 – 03:17
Depends how long we’ve worked with them. I mean, so I would say normally there’s a couple. How old are we
talking?
Speaker 1 – 03:25
Say 50s or 60s.
Speaker 2 – 03:27
Okay. There’s probably a couple million, say 2 million in IRAs. 401ks may or may not be Roth. Say they have a million
Roth, and then the rest is brokerage, which would be what, 2 million?
Speaker 1 – 03:41
Probably.
Speaker 2 – 03:42
They probably have a million to 2 million in a brokerage account.
Speaker 1 – 03:44
Yeah. And so, and when we work below 5 million, I would say we typically, I would say we’d see like a 70 qualified
exposure. So in 401k, a 403b IRAs, probably 20 real estate exposure. So someone’s worth $4 million. Let’s say
typically they’re gonna have like two and a half million. In 401k IRA type environment, maybe their house is worth
half a million to a million and then the rest would be kind of the liquid, but be a very of their net worth. Now when you
get to higher net worth, like 5 million, it becomes a bigger representation. But when you go over 10 million, I’m
thinking of all the clients we work with, the brokerage account represents the majority of their liquid net worth.
Because you’re only throughout your lifetime.
Speaker 1 – 04:29
And typically these clients have either sold a business they didn’t like, come into the wealth like slowly like you would
in a 401k. It was typically a big event. They sold a business or they, you know, were part of a business that they had
equity in, or they were extremely high income earner and they maxed out all these other avenues of like 401k. You
can put, you know, the 415C70000, you can do the backdoor Roth IRA after that. If someone’s, you know, has a
couple hundred thousand of extra cash flow, there’s no other place for that to go other than a, you know, a brokerage
account. So I would say if you plan on or already are a higher net worth person. A non qualified type of investing is
going to represent over 50% of your net worth easily.
Speaker 1 – 05:12
So how you do that becomes extremely important. So let’s just break this down. Brokerage account, let’s say is
worth 10 million bucks. And you walk in and you see a client has a mix of bonds and mutual funds. What would be
immediate issues that you would bring up with that?
Speaker 2 – 05:32
Well, he’s probably working with an advisor. So the first steps, fire your current advisor.
Speaker 1 – 05:37
Why is that?
Speaker 2 – 05:39
Let’s start at the mutual funds. So mutual funds, I mean number of reasons. What’s the statistic? Like US mutual
funds like 90% of fund managers underperform the corresponding index or some number like that.
Speaker 1 – 05:52
Yeah, one year, like over half of them outperform the index. But then if you look over like 20 year periods, it’s like less
than 10%.
Speaker 2 – 05:58
So mutual funds, a side note from whether in a brokerage account or not in the US equities high in fees, usually
paying 100 basis points, close to maybe 80 basis points, they’re underperforming the index. So that’s bad. But then
from when they’re inside of a taxable account, mutual funds tend to have a lot of turnover. Meaning the fund
manager inside of that fund is going to sell stocks and sell and buy and sell investments. And so those capital gains
get pushed out to the mutual fund owners. Even if you didn’t sell it. Even if you didn’t sell it. So you could maintain
that holding and let it ride. But the fund manager is making trades and kicking out taxes and capital gains to you
every year. So it’s unnecessary tax that can be avoided.
Speaker 1 – 06:41
So let’s just break that down. You have a $10 million mutual fund accounts non qualified. Typically let’s say there’s
turnover one and a half percent in a mutual fund because you’re all mutual funds, totally normal, 150,000, you’re the
client, 150,000 of capital gains. You’re in the top tax bracket. You owe 30 grand over 30 grand in taxes. You didn’t
even touch your money. So as this money is growing, it’s like it’s working for you, but it’s also working for the
government. Like you’re writing this big check to the government.
Speaker 2 – 07:10
It’s probably underperforming and expensive.
Speaker 1 – 07:13
And so that’s one red flag we want to, you should never own mutual funds inside of a non qualified environment. In a
brokerage account. Now the other thing would be bonds. So you could hold municipal bonds and it’d be tax free. If
you’re retired, this isn’t good because the interest still qualifies as part of your MAGI modified adjusted gross
income. And so when you’re qualifying, like your Medicare calculations of how much you pay Medicare premiums,
when you’re doing Roth conversion, what rate you’re converting in, there’s all these considerations that tax free
interest still goes into your tax calculations and does affect other things. So now with that being said, if someone
held corporate bonds, let’s say you had $10 million in corporate bonds paying 4% interest, what do the taxes look like
on that?
Speaker 2 – 07:55
Would you say 10 million?
Speaker 1 – 07:56
Yeah, 10 million.
Speaker 2 – 07:57
It’s what, 400,000. You’re paying your income tax rate that year.
Speaker 1 – 08:04
It’s 37 probably states plus 3% state in Pennsylvania it’s 40, that’s 160 a year you’re covering in taxes. So all of this.
So typically these are some of the reasons why someone would avoid a brokerage account like a plague is because
you’re paying tax along the way, then you have to pay tax when you unwind it. So how we have to structure this,
structure these very strategically. So I would say first of all, what you hold in your brokerage account is of ultimate
importance. So number one, ETFs are going to be much more efficient than mutual funds, specifically because of
the turnover. So if you invest a million dollars, it turns into $2 million. Generally speaking, in a mutual fund, you’re
going to be paying taxes along the way as it grows.
Speaker 1 – 08:50
If you’re in an index, you’re not going to pay taxes until it liquidates. Now there’s going to be some turnover because
like companies do change. In the S P500, for example, there’s not going to be nearly as much turnover as there
would be in a mutual fund. So ETF is by far a large improvement over a mutual fund. But even going farther than
that, we would want to eliminate bonds. And so if you need to hold bonds or safe money, we don’t hold those inside
of your 401k where that interest is growing tax free. And then inside of a non qualified account, we’re big believers in
something we offer is called direct indexing. So direct indexing, you’re creating the index yourself with individual
stock purchases. And so the benefit of that is you can completely control the turnover.
Speaker 1 – 09:31
So you’re not going to pay tax unless you want to. But on the flip side of that, you, in a good way if A stock goes
down, let’s say Pepsi goes down, you sell it, you have a hundred thousand dollar position, it goes to 50, you sell it,
you buy Coca Cola. So your diversification and sector allocation is still the same or similar. That loss, as long as you
don’t go back to Pepsi in 30 days, that carries with you for the rest of your Life. So that $50,000 now goes in a bank
on your tax return.
Speaker 1 – 10:02
And any gain you have in the future in a passive environment, it could be a stock gain, it could be a real estate sale at
a gain, it could be a business sale, it could be, if you’re structured, you know, as an S Corp, for example, at a gain, all
the dollar for dollar that’s going to offset the taxes you own, any gain. So on, you know, $10 million account, we’re
able to get hundreds of thousands of dollars of those tax losses. So in the back end, when someone is selling the
account, we’ve achieved index returns.
Speaker 1 – 10:28
But while that’s happening, we can get those tax loss harvests on the books to get ready for a race, you know,
erasing a large part of the tax liability on the back end, all while staying within the tracking error that you would be in
normally within an ETF or close to. So anything to add on the direct indexing?
Speaker 2 – 10:49
Yeah, I think the other, I don’t. You may have said this or not, but I don’t know if you did. With an ETF or mutual fund
like we talked about, where the taxes are just pushed out to you, this gives you total control over. Obviously some of
the stocks may pay some dividends that you can’t really avoid, but you’re choosing, we’re choosing when we buy or
sell the stocks. And so you can avoid a lot of those unnecessary capital gains taxes being pushed out like an ETF or
mutual fund.
Speaker 1 – 11:16
Yeah, no question. The direct indexing. There’s a lot of other things you can do from a. You could decide if you want
to fund a donor advised fund and you do that. So you can use 30% of your adjusted gross income. So if you’re
making a million dollars a year and that’s your adjusted gross income, you could take $300,000 of that, put it in a
donor advice fund, get the deact deduction on that, but you could also fulfill that $300,000 contribution from an
appreciated stock.
Speaker 1 – 11:40
So if you’ve invested in a stock worth, you know, for 100, it’s now worth 300, and you take that stock out of your
direct index account and throw it in your donor advice fund, which then could pay your charity donations for the next
10 years if you’re doing, you know, whatever, 30 or 40,000 a year, because that also that donor advice fund’s going to
grow. We now got a 37% deduction in that 300, just like you would have if it was cash. Plus, we avoided that capital
gain, that $200,000 gain, 23.8% federal capital gain rate. So now we’ve, we just saved over, you know, 50% of the
contribution. We saved 23.8% of the 200, plus we saved 37 of the 300. So we saved over well over $150,000.
Speaker 1 – 12:25
So now for a lot of people that give charity that are using a standard deduction, they’re not getting any tax benefits.
But the direct index account, we can double dip, we can get the deduction and we can avoid the capital gains if we’re
able to take that sniper shot of an individual stock. If you have an etf, it’s all mixed together. We have to sell overall
shares of the ETF or overall shares of the mutual fund. So it provides a lot of flexibility and typically higher net worth
clients are going to want to be extremely tax efficient, have that flexibility and control. So direct indexing is not just a
tax savings along the way. It’s a tax savings in the future, but it also enhances other endeavors you could do, like
charities along the way as well. So. Well, let’s talk about.
Speaker 1 – 13:11
So, you know, I think it’s. It’s common for people to think, I’m going to get a financial plan, it’s going to go on
autopilot. Well, the reality is life happens. And every year things change. Life evolves, life has eb and flows. And so a
lot of the times in a financial plan, you’re going to need money unexpectedly. And this happens every year. For most
of our clients, stuff comes up. So a lot of people think, well, shouldn’t I have cash for that? And we’ve seen, you know,
clients before they become our clients, sometimes carry an astronomical large cash on their balance sheet. So one
of the strategies we’ve secured around the brokerage accounts, that enables clients to really put that cash to work,
but also maintain the liquidity is called a secured line of credit.
Speaker 1 – 13:58
So, James, let’s break down the benefits of someone carrying cash, not investing, wondering if they’re going to need
it, versus investing their whole life in a brokerage account and then temporarily making, you know, withdrawals and
putbacks along the way. What are the break the down the math for us.
Speaker 2 – 14:17
Yeah. So I mean if you keep it in cash, obviously the last couple of years you’ve gotten probably 4 to 5% interest.
That’s not going to happen long term. That interest is also taxed each year at your income rate. If you’re a high
income earner, it’s 37%. So what’s the net? I don’t know. You’re probably getting 2.5% interest on that cash after taxes
and you may or may not use it. A lot of times people hold it for longer than they need to. And so if we invest it and
open a line of credit, let’s say you have $5 million in an investment account, you know, you get a secured line of
credit, same thing as a home equity line of credit, but your investment account is the collateral.
Speaker 2 – 14:58
And you know, they may give you two and a half million dollars available in a line of credit. There’s no cost to have it
open. You only pay interest if you draw on it. So if you draw a million bucks on it to do a house project, whatever you
need it for, all of that money stays invested into in the direct indexing. So opposite of like a 401k loan where the
money comes out of the market so it stays invested. You know, ideally you’re getting whatever the annual rate of
return is on it, the money’s growing and then you just pay interest on the money that you take out. So this makes a
lot of sense of your high income earner.
Speaker 2 – 15:33
And instead of keeping it in cash and you can pay this off in three to six months, for example, you know, the interest
would be a few thousand dollars, very minimal and it’s worth in that scenario could be worth it to keep the money
invested and let it grow in the market where it’s not going to make sense. As if you don’t want to do this for like a
long term, you know, five year, seven year loan. Because interest rates higher than usually than you would get on just
like a fixed loan.
Speaker 1 – 15:59
No question. Yeah. And I think you know, just like super high level cash, it is what it is. You keep it there, you know,
you’re paying interest on that, whatever. If it’s 2% that interest, you’re paying taxes on that really, you know, for if
you’re a high income earner, it’s almost the returns are getting cut in half. But if you’re in this direct and direct index
account with a secure line of credit against first of all, the secure line of credit is not going to cost you anything if
you never use it, there’s no interest, there’s no setup fee. We use Goldman Sachs as the main provider for that. But I
have on myself and the reason I love it is it’s like it feels like I still have the cash, but all the time, 99.9% of the time I
don’t need the cash.
Speaker 1 – 16:39
It’s earning mark the market returns because it’s allowing my money to be in the market. But I still, if an emergency
happens, I can pull from it and put it back in as needed. So I still carry an emergency fund of six months, but above
that. That’s why everything with goes in the market. But the other major benefit of that is, you know, if you don’t have
this and you’re like, oh no, I need money, you pull out of your investments and you’re going to pay capital gain taxes
or if you’re direct index, you’re going to use some of your tax loss harvest to offset those capital gains. But if this is a
short term thing, if you have an emergency, you’re putting it, like you said, a couple months, you’re taking it out,
putting it back in.
Speaker 1 – 17:14
Wouldn’t it be nice to not have to pay these capital gains? And that’s what a secure line of credit does. You know, if
you have 10 million bucks in here and suddenly you need a million for something, you can let your 10 million go
untouched. You take the million from the secure line of credit, a couple months later you pop back in, portfolio goes
untouched. So it doesn’t matter if the market was down during that period. Like if you know the 15% drop we just
occurred, if you needed money during that, the bottom of that you could have avoided a costly mistake and pulling
when the market’s low by having the secure line of credit. So we’re avoiding taxes and market timing, which allows
you to really follow the number one principles of financial planning. Invest with the market long term.
Speaker 1 – 17:52
You know, it’s time in the market, it’s not timing the market’s time in the market that matters. So, okay, so let’s talk
about, so we’ve talked about the, obviously the flexibility, you know, these accounts you can pull from any time for
any reason. Just like cash in a bank. Let’s talk about the for business owners, let’s first talk about estate planning
and then let’s talk about some of the benefits also for business owners. So estate planning, currently the law exists
that gives this an extra benefit of like this is money that you want to pass on. So James, can you break down, like if
you’re passing money on to kids, you have a Roth ira, a traditional IRA and a brokerage account. Let’s walk through
how those each. Look, assuming you’re under the exemption, so you’re under that $14 million exemption,
approximately.
Speaker 1 – 18:45
And so we don’t have federal estate taxes, we’re just talking about investment tax or, you know, income taxes on the
money. How would that work? So let’s just use an example like a million dollars in a Roth, a million dollars in a
traditional IRA and a million dollars in a brokerage account with the. And let’s say the brokerage account has half a
million dollars of basis, half.
Speaker 2 – 19:02
A million dollars of gains, the Roth IRA passes. Well, everything is going to hit state inheritance tax, depending on the
state. So Pennsylvania and some states don’t have it, But Pennsylvania is 4 1/2% everything except life insurance. So
you know that you can’t really avoid. The Roth IRA would go tax free outside of that inheritance tax, the state
inheritance tax, the beneficiaries have 10 years to pull it out. So they could take it a little bit every year. They could
take it one year, all of it. They don’t pay any taxes on it because it’s Roth just has to come out in 10 years. The
traditional IRA passes to them also have 10 years to take it out. They’re going to pay their income tax rate on it when
they take the distribution.
Speaker 2 – 19:49
So depends what income tax rate the beneficiary’s in, what the best strategy is to pull that out, but they’re paying tax
on it, the taxable account, let’s say. Would you say there’s a million bucks?
Speaker 1 – 20:00
Yeah, half a million dollars of basis. Half a million dollars of gain.
Speaker 2 – 20:02
Yeah. So that under current law receives what’s called a step up in basis. So if there’s a $500,000 basis, a million
dollar account, if the parent were to sell that the day before they die, they pay capital gains taxes on that. If they
didn’t, and that goes to the kid, the basis gets stepped up. So now instead of the basis being 500,000, the basis is a
million. And so they theoretically could sell it all and not pay any taxes or let it ride. And now all the growth is based
on that million dollar basis. So it can be a good estate planning tool. You know, you get that step up basis and kids
can avoid some of the tax.
Speaker 1 – 20:42
Yeah, that’s a great breakdown. So I would say one of the last benefits then would be if you’re a business owner,
you’ve seen a lot of business owners, you know, recently are doing with that a lot of decision fatigue, a lot of burnout,
you know, post Covid running a company. And a lot of times if industries change and the business owner, you know,
has most of their net worth in the business, which is typically the case if something happens, you know, depending
on the marketplace, it’d be hard to get a loan or the business owner may not take a loan. So having a brokerage
account, you know, you can, if you’re a S Corp or an LLC or whatever you are, you can always loan yourself money
through your business.
Speaker 1 – 21:22
And the easiest way to do that would be if you have a brokerage account taking that line of credit and then putting it
in and putting it back out. So I think as a business owner, it’s really healthy to stack chips outside. It may not be the
best return that you can get, but it’s going to prevent you from having to take unnecessary capital and inopportune
times to keep your business running, which is inevitably going to have ebbs and flows. That’s personally something
I’m always, you know, focused on, you know, for our company is making sure that there’s always capital. So, you
know, we’re never in a bad position if market drops or, you know, things have been flow condition change. We don’t
have to take on the wrong partner, you know, for some reason.
Speaker 1 – 21:59
So one of the best things I think as a business owner you can do is really try to stack your brokerage account
because it’s one of the, it’s a way to insulate, you know, put a kind of a moat around your castle of your business.
Anything to add there? I know you’ve, you work with a lot of business owners and I’m sure have that perspective as
well now.
Speaker 2 – 22:14
Just creates some flexibility and peace of mind that you have some money growing that’s available that’s outside of
the business.
Speaker 1 – 22:21
No question. No question. Well, I think that’s it. Yeah. So as a the. And you know, the other thing I would say is if
you’re later in life and your tax brackets have dropped, you know, you probably want to strongly consider some Roth
conversions. And when doing a Roth conversion, if you’re over 59 and a half, like you could take a hundred thousand
from a traditional IR convert to Roth, you could pay the taxes out of that, but it’s always best to pay the taxes out of a
different source. And so if you have a brokerage account that allows all hundred to Stay in the Roth and you pay the
taxes out of pocket. So clients that have brokerage accounts, we see their retirement plans work a lot better. You
may fill, you know, traditional ira, Social Security and a pension payment.
Speaker 1 – 23:05
You may be taking out required minimum distributions out of your IRA and kind of filling those low brackets, the 10,
the 12, the 22 and the 24. Well, let’s say you need more money. If you have a brokerage account, then instead of
going to a 32% bracket like most people would if they had all their money and stuck in a 401k, you can stay at that.
You can actually drop and go to a 15% capital gain bracket, start withdrawing from your brokerage account, or go to
zero if you have a Roth account and go over. So it gives you complete flexibility. Brokerage accounts and Roth
exposure give you complete flexibility in navigating tax brackets, keeping those low. You control what bracket you’re
in versus the government controlling what bracket you’re in when you retire.
Speaker 1 – 23:44
So this is not only a flexibility thing, it greatly enhances your distribution planning later in life. Another thing I would
say too is it is one of the best retirement planning tools. So we talked about pre retirement, but post retirement, a lot
of people want to be financially independent, may take a sabbatical in their 40s or 50s, take a year or two off. If all
your money is just stuck in a forum, you don’t have that flexibility. A brokerage account gives you flexibility to retire
early, become financially independent, take semi, you know, many retirements along the way. It gives you all the
flexibility. That’s why I value it as the number one tool in financial planning for high net worth or high income earners.
Speaker 1 – 24:22
You got to still do all the easy stuff first, max out your Roth 401k backdoor Roth HSA, got to fund the 529 plans. If
you have kids, make sure your risk management plan is in place with your insurance. After that you should be really
stacking a brokerage account. And now with direct indexing in play, that it’s not tax efficient is crazy. I think it’s, it’s
one of the, literally one of the most tax efficient and flexible things you can do if you’re with the right partner that’s
able to direct index and mitigate the taxes. So thanks for joining everybody and look forward to catching everybody
next week. Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and
impactful to as many people across the nation as possible. So hit the follow button.
Speaker 1 – 25:07
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