Finance - Budgeting - Financial Planning - Accounting - Asset Allocation - Taxable and Tax-favored Accounts - Cash

Asset Location: Taxable vs. Tax-favored Accounts (401k, IRA, HSA)

Intro

Asset Location (AKA Asset Placement) is a strategy for organizing your assets in an optimal way that helps you meet your financial goals. In the previous episode, we focused on asset location strategies for reducing taxes and simplifying your tax return. In this episode, we focus on asset location considerations for allocating capital between your taxable and tax-favored accounts (TFA) such as 401(k), IRA, and HSA.

Topic discussed:

  1. Seeing TFAs in a different light and deciding what your long-term strategy is for each account
  2. Using your projected tax liability to help guide your allocation
  3. Deciding what assets you want to invest in, which will help determine your allocation
  4. Asset protection

Podcast

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Hey everybody, welcome back to the Bigger Insights Finance podcast where we’ll help

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you live a life you don’t need a vacation from.

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In the previous episode, we discussed asset location strategies, also known as asset placement,

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with the focus on reducing taxes and simplifying your tax return.

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So if you haven’t listened to that one, go ahead and check that out after this one,

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unless of course you like paying extra taxes.

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In this episode, we’re going to talk about asset location again, but this time we’re

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going to focus on strategies specific to allocating capital to your taxable accounts

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versus your tax-favored accounts (TFA), such as your 401(k), IRA, or HSA.

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And yes, you can invest your HSA funds tax-free, which we’ll discuss in a future episode.

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But before we get started, as per usual, nothing in this episode is financial advice, so make

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sure you consult your financial and tax advisors before acting on any of the information discussed

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in this episode.

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So this might sound a little bit strange, but one of my motivations for making this episode

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is I was once watching a Q&A video with Mark Kohler that he did on YouTube about taxes.

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He produces some good tax information if you’re into that.

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But anyway, people kept asking him questions about why you would invest in real estate

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in your tax-favored accounts if you don’t get some of the benefits like deducting losses

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against your ordinary income.

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And it was funny because he was getting all frustrated because from his perspective,

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you should invest whatever money you already have in your tax-favored accounts to maximize

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returns in general.

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But the piece that he was missing is actually a good question, a question about asset location.

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People were basically asking, “If I have new money to invest and I want to invest in real

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estate, should I do that in my taxable portfolio or in a tax-favored account like my IRA?”

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Now this is a good question because there are pros and cons to investing in real estate

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in either account.

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And if you screw that up, the consequences can be significant.

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For example, if you’re going to buy a rental property in your IRA, you can do that, but

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there are very, very strict rules.

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So let’s say that you buy the property and then you go in there and paint it.

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Well, guess what?

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As far as the IRS is concerned, that’s a contribution because you’ve just contributed

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value to your IRA.

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And if you don’t handle that properly, or if you knowingly or unknowingly engage in

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a prohibited transaction, the IRS will distribute your entire IRA, which will hit your tax return

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and give you a huge tax bill.

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But assuming that you know the rules, this is still a good question.

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If you have new money to invest, should you invest that in a taxable or a tax-favored

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account?

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Now, from a personal finance standpoint, we may discuss this in a future episode, but

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you would want to consider things like your time horizon.

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You know, if you think you might need that money in five years, it wouldn’t make sense

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to put that in a traditional 401(k).

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You see what I mean?

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But assuming that you’ve done your personal finance homework and you decide, “I’ve got

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this $10,000 in what accounts should I invest it in?”

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So let’s talk about that.

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First of all, you should avoid seeing all of these accounts as what they’re supposed

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to be and look at all of them agnostically as simply being tools in your toolbox.

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What I mean by that is a “retirement account” doesn’t need to be for retirement.

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A “Health Savings Account” neither needs to be a savings account nor does it

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need to be for your health.

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These accounts are just a collection of rules.

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And if you can understand those rules, you’ll see them differently.

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Let’s talk about HSAs real quick.

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I invest every penny of my HSA and it’s funny because every time I make a trade, I get this

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warning like, “Oh my God! These are your HSA funds.

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Are you insane?

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Make sure you have liquidity for your health expenses!” Or something along those lines.

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And it makes me laugh because it’s just an account and money is fungible.

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If I get a medical expense, I have many options for paying that, not to mention, once I hit

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my deductible, my insurance company pays for everything else.

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And I shoebox my medical expenses anyway, so I can pay out of pocket and reimburse myself

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from my HSA at any point in the future, like when my HSA is performing really well, for

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example.

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So for me to park my HSA funds in cash, like most people do, wouldn’t be very smart from

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an opportunity cost standpoint.

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And also keep in mind that when you have HSA funds, when you reach retirement age, you

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can distribute them penalty free, just like an IRA.

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So basically an HSA can effectively be used as a retirement account, as I understand the

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rules as of the time of this recording.

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Regarding 401(k)s and IRAs, these are intended for retirement, but you don’t necessarily

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need to use them that way.

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These accounts can be used for other purposes, like asset protection – 401(k)s in particular

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offer good asset protection. And you don’t necessarily need to lock up your funds until

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retirement anyway. I’m not saying that you should or shouldn’t, but just that you don’t

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necessarily need to do that.

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So when we get new clients, especially if they’re younger, or if their income is lower

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than they expect in the future, we often encourage them to contribute to a Roth IRA. Why?

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Because you can withdraw your Roth IRA basis tax and penalty-free anytime you want.

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So just think about that for a second, you can park some money in your Roth IRA, generate

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tax free income, and withdraw your basis before you retire tax and penalty-free.

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And in the meantime, if you run into legal trouble, that money might be protected, although

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the protection varies a little bit from state-to-state.

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And retirement funds are excluded from student financial aid calculations

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as far as I know. Are you picking up what I’m putting down?

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So this can’t be a great place to stash some cash, retirement not withstanding.

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For me personally, I have a document that details all the different ways that I can

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raise cash if I need to, or for some big opportunity.

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And in that document, I’ve written that I can withdraw Roth IRA contributions, as well

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as reimburse myself for shoeboxed HSA expenses at any time.

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But of course, I’m going to wait to do that because while I wait, those funds are growing

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tax-free.

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So Roth IRAs are really powerful for this purpose.

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But if you have funds in other retirement accounts, don’t kick yourself because you still have

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some options.

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Funds in traditional accounts can generally be converted to Roth, so that’s probably

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an option for you.

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Of course, if you do that, and you deducted those contributions previously, you’ll have

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to pay ordinary income taxes on that conversion, but that might still be worth it depending

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on your situation.

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If you have money stuck in a 401(k) at work, you may be able to convince them to change

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the rules to allow you to do a full or partial rollover to an IRA, or you can just wait till

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you quit or get canned, at which point you could make that rollover, then withdraw your

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Roth basis.

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So to make a long story short, it behooves you to learn what you can and can’t do with

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these accounts so that you can craft an effective strategy.

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For me personally, I rank my accounts in terms of duration and risk tolerance.

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I’m a little bit more conservative with my taxable portfolio because this is highly liquid.

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If something bad happens or if there’s a big opportunity, I can’t have that all tied

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up in something risky that’s in the toilet at the time.

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My Roth IRA is next because I can liquidate my cost basis at any time, but I can’t do

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that with my other accounts.

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My 401(k) is next because I can play the rollover, conversion, and distribution games that I talked

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about earlier.

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And this is probably pretty unintuitive, but I’m most aggressive with my HSA because other

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than reimbursing my shoeboxed expenses, it’s pretty limited in terms of what I can do with

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it.

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My long-term plan with my HSA is to continue to shoebox my health expenses and allow my

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HSA to grow pretty much indefinitely.

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But for you, your situation may be different and there may be a better approach for you.

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What do these accounts mean to you and what is your long-term plan for them?

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Answering these questions may help clarify where you should allocate your capital.

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Another thing to consider is your tax liability.

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Now if you become a Bigger Insights client, which you should if you know it’s good for

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you, you’ll learn quickly that we’re big fans of tax planning.

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Tax planning is a year-round process, not just dumping your documents on your tax

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preparer at the beginning of the year and hoping* for the best.

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So what we recommend that people do is have a tool to project and calculate their tax

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liability throughout the year so they can make prudent tax decisions.

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You might think that you want to put $6,500 in your Roth IRA, but when you sit down and

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estimate your tax liability, you might see that your adjusted gross income (AGI) is high enough

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to have negative consequences like losing a deduction or credit, for example.

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In that case, it may make sense to put some or all of that in a traditional IRA then do

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a [Roth] conversion in a later year.

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I’ve actually helped people with this before and determined, for example, that they should

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put something like $2,150 in a traditional IRA and then the rest in their Roth IRA to

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knock their AGI back down to a more optimal level.

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But what I was saying before about these accounts being tools is pertinent here.

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They’re tools for tax planning.

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The more tools you have in that toolbox, the better off you are.

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Ideally, you would have and be able to contribute to an HSA, Roth and traditional 401(k)s, and Roth

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and traditional IRAs.

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This would give you more options to manage your taxes.

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And finally, on this point, if your income is low enough, you should also determine whether

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you can get the retirement savings contribution credit and how much of it because that might

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affect whether you contribute to a retirement account or just keep that money in your taxable

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portfolio.

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The next thing to consider is – what are you looking to invest in?

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Now, this is important from a tax standpoint because some assets like foreign stocks are

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better in your taxable account, whereas REITs may be better in your tax-favored accounts

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and so on.

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We did discuss that in some detail in the previous episode, so you should definitely

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review that if you haven’t already.

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But along these lines is your capital requirements for these investments.

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Some mutual funds have high minimum investments.

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Portfolio managers typically require at least $100,000 in assets to manage.

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Some individual stocks cost thousands of dollars apiece.

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Brokerage CDs are often in $1,000 increments and other assets like real estate can have

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large capital requirements, especially in a tax-favored account.

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So let’s say you want to invest in rental properties.

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You can do that in your tax-favored accounts, but in addition to the other complications

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that we discussed earlier, capital requirements can be a major sticking point.

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First of all, you’re better off doing this in a 401(k) than an IRA because if you use debt,

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401(k)s are not subject to unrelated debt financed income tax or UDFI, whereas IRAs are.

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A lot of people don’t know that.

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But in either account, capital is still a sensitive area, especially in an IRA, because

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you can’t just arbitrarily contribute money to it at will.

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Just imagine you bought a rental property in your IRA and after closing, you have $5,000

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in capital.

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So far, so good.

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But then, uh-oh, the sewage backs up in the basement and you find out that tree roots

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have gotten into the sewage line and now you need $15,000 to get it excavated and replaced

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and the insurance isn’t going to cover it.

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Or maybe you have a tenant that pulls a [Slippin’] Jimmy and does a slip and fall on the stairs.

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Now you’re looking at a serious lawsuit.

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That $5,000 ain’t going to cut it, but what are you going to do about it if you’ve already

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maxed out your contributions for the year?

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The point is that you need to plan ahead for whatever it is that you want to invest in.

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So in this particular case, you would want to focus your contributions, ideally on one

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401(k) account, even if that isn’t necessarily the most tax-efficient in the short term.

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This is as opposed to spreading out your contributions over several accounts, which would reduce

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your capital in any one account.

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And along these lines, you should also be thinking about contribution limits.

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If you’re going to buy rentals in your HSA or IRA, just keep in mind that this will be

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tougher to do because the contribution limits are so much lower than they are for 401(k)s.

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And finally on this point, if you want to start a business, you might want to invest

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more in your taxable and Roth accounts than your traditional or HSA accounts to preserve

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some liquidity.

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The final consideration we’re going to discuss is asset protection.

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Tax-favored accounts aren’t just about taxes, they can also be about saving your

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assets.

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I’m going to share a quick story that I heard.

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I haven’t verified it myself, but I don’t have any reason to believe it’s untrue.

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But the story goes that when the whole Enron situation blew up, the assets of some of the

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people involved got pwned, except for one person because they invested a lot of their

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money in an annuity, which gave them good asset protection.

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Now, we’re not talking about annuities here, but it’s a similar concept.

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It’s kind of a funny story, but a good lesson to consider because your 401(k) can give you

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good asset protection and IRAs to a lesser degree.

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This is something you really should keep in mind, especially if you have higher legal

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risk than the average person.

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Perhaps you’re like Larry David – you’re very vulgar and you get sued a lot. Or perhaps

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you own a business, you’re a doctor, a landlord, or one of these other characters that attract

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a lot of lawsuits.

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In this case, putting some money in a 401(k) or other tax-favored account might protect

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some of your assets in such an event.

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00:15:33,480 –> 00:15:38,760
Now that obviously isn’t foolproof. These accounts won’t save you from divorce and probably

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00:15:38,760 –> 00:15:41,680
not from the tax man or anything like that.

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00:15:41,680 –> 00:15:46,080
But the protections they offer are better than nothing, so you should consider this as

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00:15:46,080 –> 00:15:48,040
you allocate your capital.

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Alright, that’s it for this episode.

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I realize that this content is somewhat high level and may not give you the specific answer

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you’re looking for, but that’s because how you allocate your capital is very specific

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00:16:00,280 –> 00:16:05,720
to your individual circumstances, so the best we can really do here is to provide you with

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some general purpose information to help get you thinking and point you in the right direction.

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00:16:11,720 –> 00:16:16,440
If you’d like help with your asset allocation or financial planning in general, consider

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00:16:16,440 –> 00:16:18,800
becoming a Bigger Insights client.

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00:16:18,800 –> 00:16:24,160
We help clients like you achieve their financial goals in one-on-one consulting sessions.

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00:16:24,160 –> 00:16:29,600
And in case if you’re wondering, we are located in Cincinnati, but we do the vast majority

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00:16:29,600 –> 00:16:34,480
of our work over the internet, so if you’re in another state, we can still serve you.

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00:16:34,480 –> 00:16:39,280
If that sounds interesting to you, go to our website, biggerinsights.com, and fill out

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00:16:39,280 –> 00:16:44,160
the short form at the bottom of the page so we can schedule your initial consultation.

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00:16:44,160 –> 00:16:48,840
We are once again asking you to share and subscribe to this podcast so we can spread

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00:16:48,840 –> 00:16:52,280
our message and make the world a more prosperous place.

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00:16:52,280 –> 00:16:54,320
Thanks for staying until the end.

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00:16:54,320 –> 00:16:59,320
Work with your financial advisor to develop an effective asset location strategy.

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00:16:59,320 –> 00:17:16,760
Stay healthy and stay wealthy.

Disclaimer

We are not attorneys, CFAs, CFPs, CPAs, tax attorneys, or enrolled agents, and nothing in our podcast is tax, financial, legal, or other advice. We highly encourage you to consult your attorney, tax, and financial advisors before making any changes to your legal, tax, or financial situation. See our full Disclaimer for details.

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