Ep11: Optimizing Cost Saving Opportunities with The Affordable Care Act

About This Episode

If you are considering enrolling in the ACA, find out how you can structure your income to take advantage of cost-saving programs and tax saving strategies. Patti and her Chief Planning Officer discuss how assets have no impact on eligibility to get a premium tax credit under the ACA – a little known fact!


Patti Brennan: Hi everybody, welcome back to the “Patti Brennan Show.” Whether you have $20 or $20 million, this show is for those of you who want to protect, grow, and use your assets to live your very best life.

With me today, once again, is Eric Fuhrman, our Chief Planning Officer. The topic today is on the Affordable Care Act. One of the things that I will tell you about Eric Fuhrman is this is a man who takes a subject and takes it deeper, and deeper, and deeper than anybody I know.

When he does this, and the benefit that we get, and hopefully you get, we learn things and are able to apply these concepts to your day to day life. I mean, it’s just incredible. Wait until you hear about some of the things that we would like to see many of you benefit from this year.

Eric Fuhrman: Wow. [laughs] Thank you, Patti. I appreciate it. Most people that know me would say I’m usually one that is not for a lack of words. That’s very nice of you. I think anyone that’s listening to these podcasts would know that I am absolutely delighted to be here and can’t wait to dive into another.

What we believe is a really interesting topic that can have a real impact for those out there in our audience.

Patti: The reason this became really evident is that what we have found over the last few years as we do our year end tax planning and financial planning initiatives is that we’ve discovered a subset of clients who are covered under the ACA, receiving or anticipate signing up for it.

Whether those people had retired early or maybe widowed or separated. As we were learning more about the ACA, we realized there are unique planning opportunities that a lot of people may not realize. Basically, today we’re going to talk about the Affordable Care Act and some statistics, and then explain how the premium is actually calculated.

We’re going to go over some investment in tax strategies that you got to be careful about because they might have some unintended consequences, and then really hone into the sweet spot. What are the steps that you can take to capture the best premium credit?

Eric: Patti, I think it’s so interesting, just to fill out the narrative there, is that, as we were going through your tax planning, we really just stumbled over this because normally we’re engaged and thinking about how can we do a Roth conversion or maybe do some really interesting tax strategies?

The focus is always on taxable income. We realized these folks out there and our client base that are on the Affordable Care Act, taxable income is not the number that you want to focus on and they really need some unique planning strategies.

Patti: It’s an important point, Eric. Why don’t you explain to our listeners exactly how that’s calculated, because it’s very different than how you would normally figure out adjusted gross income, for example?

Eric: Yeah, I would love to. For those of you out there, you might be hearing this term Affordable Care Act. You are probably wondering what’s that. Is that some new law? No, this is what is known as Obamacare. It was branded that way. That’s not the official name of the law.

We’re not here to pass judgment on the merits of the law or issue any kind of opinion, one way or another. Just to explain what it is and those of you that have health insurance for the market place to be sure…more so than anything being aware of how your income can affect your premium tax credit.

Basically, this is a law that was very controversial, but the key provision is really to extend coverage to millions of uninsured Americans, as a means to lower cost and eliminate some industry practices like denying people on the basis of preexisting conditions.

What we’re going to talk about today is really how is the premium taxed credit, the subsidy determined, as well as cost sharing subsidies depending on the type of plan you select. Patti, why don’t you bring us into the next part about some stats?

Patti: I think it’s really important that people understand, that this is affecting a lot more pre retirees than I think people realize. For example, close to 12 million people who are under the ACA, 29 percent of those people are 55 years and older.

There’s this subset of people who again may have retired early or may be widowed or widowers etc., who are receiving the benefits of the ACA. We’re going to talk about some strategies so that you get a higher premium offset from the subsidies. Eric, why don’t you take us through exactly how the calculation…How that’s determined?

Eric: It certainly came as a surprise to us, that assets have no impact whatsoever on your eligibility to get a premium tax credit under the Affordable Care Act. Neither does your 2018 income. It has absolutely nothing to do with it. It doesn’t matter how much money you’ve made.

Patti: In other words, if you made, for example, a million dollars in 2018, and if you have $5 million sitting in retirement account and another $2 million in a regular account, those people can qualify for the ACA with a significant premium offset?

Eric: They can. I still remember this day when we made the phone call to healthcare.gov. I almost fell out of my chair when it came to that realization that that’s how it was done, but you’re absolutely right.

When open enrollment happens, which is November 1st until December 15th…Unfortunately, open enrollment is over for 2019. What happens is if you’re a new enrollee or an existing enrollee in the Affordable Care Act, you basically have to provide an estimate of what your 2019 income is going to be.

A lot of the websites will tell you to use last year’s adjusted gross as a starting point, but if you’ve gone through some kind of life change or so forth, that may or may not be a good starting point. It’s a recommendation.

It’s based on your estimate because what happens is when you give that estimate, that income number will determine if and how much of a premium tax credit you get. That tax credit is advanced right from the beginning of the year, and you’ll get that all throughout the entire year.

Patti: Let’s you and I try to gain the system, all right? Let’s gain the system and say, “Why don’t we go ahead and estimate an income of $40,000 so we get this juicy tax credit so that we don’t have to pay as much money for our medical insurance?”

Eric: Patti, I love that you went into it and said it that way because I’m going to quote this right now. For those of you out there, sorry, we’ll get a little technical here but it’s Form 8962. That’s where you file and have this premium tax credit.

This is verbatim from the instruction’s page from the IRS. It says, “Reckless disregard for the facts.” That will disallow you for the premium tax credit.

What happens is you can tell them whatever number you think, but at the end of the year on Form 8962, you are going to reconcile what your estimated income was versus your actual income. That tax credit is either going to be adjusted upwards or it’s going to be reduced.

If you actually made more income than you estimated, the premium tax credit will be reduced, and you’ll owe more or have to pay it back and vice versa. If you actually made less than what you estimated, you will get more of the premium tax credit, and you’ll get a higher refund or less taxes out.

Patti: The one thing we don’t want to have happen is you estimate too low, and all of a sudden, you’re getting a big fat surprise in April of the following year.

Eric: I would say I’m going to put a little plug in here that’s why it’s so important to work with a qualified accounting professional and a good financial advisor.

Patti: Exactly. For those financial advisors who are listening today, this is a wonderful, wonderful benefit that you can provide to your clients. It’s a really big deal. The key here though is let’s talk about how is that modified adjusted gross income calculated because it’s very different than the way you would normally do your taxes.

Eric: Modified adjusted gross income sounds scary, but it’s not as bad as you think.

Patti: Not nearly as bad. Also, when it’s calculated for this purpose, it’s even calculated differently than, for example, how you would calculate how much of your social security is taxed.

The way it works is you figure out your adjusted gross income, which is the number on the bottom of the first page of your 1040, and then you add back three things. Number one, your tax exempt interest. Number two, any foreign income, and number three, the nontaxable portion of social security if you’re even receiving it.

Modified adjusted gross income is we’re basically adding back a few things. For most people, it’s probably going to be tax exempt interest. The most important thing that I want you to get from this part of it is that if you have a rental property and you’re showing losses, you don’t have to add that back in. That comes off of your income like it does for normal tax purposes.

Here’s where the real strategic planning comes. Capital losses also stay in. You can do some interesting things at the end of the year, or even throughout the year, to increase your capital losses to keep that modified adjusted gross income lower.

Eric: It’s so interesting too because we had many phone calls over the past two months before the end of the year. A lot of accountants too were not exactly sure how they arrive at modified adjusted gross. What we’re talking about is literally on…What is it, page six of the instructions, I think it is, for how you figure this out.

What came to light as we went through this is that modified adjusted gross income is not always defined exactly the same way. Again, the Affordable Care Act seems to do it a little bit differently.

We would always recommend that anytime you’re doing this, it’s really important to work with a qualified accounting professional to do these calculations and make sure that you’re doing the things the right way.

Patti: OK, folks, did I warn you or did I warn you? He gets into detail. We’re talking page six of this big booklet, and Eric actually reads every paragraph of all of those forms. It’s important, because again, this is where these opportunities bubble up.

With that in mind, Mr. Detail, let’s go through an example for our listeners just so that they can get a feel for, gee, if I’m a single person, how much income can I still show and still get this premium tax credit?

Eric: There’s really, when you do it, and we’re going to give an example here. We’re in Pennsylvania but you can go on the healthcare.gov website and there’s a calculator on there that will help you estimate and figure out all this stuff.

Patti: Believe it or not, that calculator is actually easier to use even though it was created by the government, a lot easier than most people might think.

Eric: It’s pretty intuitive in going through it, but basically there’s a couple of income tiers that you have to be aware of.
All these tiers are based on the federal poverty limit.

That’s a whole another thing. We’re not going to dive into. If you were a single, one person household with no dependents living in Pennsylvania, if your income is below $16,753, and again that’s modified adjusted gross, you’d be basically in Medicaid territory.

Ideally, in a lot of cases, anything above $16,753, now you’re going to start to get the premium tax credit. The way it works out is if you’re above $16,753 but below $48,560, you’re going to get some amount of premium tax credit. The moment you go over $48,560 of income, there is no premium tax credit, it goes away.

It’s an all or nothing thing, but within that band, there’s a sliding scale. The closer you are to the lower end, the greater the premium credit. The more you get towards the higher end, the less of a credit there is.

Patti: The key here with this is, to keep in mind, it’s based on the number of people in the household. For example, we have a husband and wife who are looking to qualify under the ACA for some of these wonderful credits. For a household of two, that band is wider so that you can show income of $22,800 on the low side all the way up to $65,840.

Just round it off to, say, $22,000 to $66,000. That’s the sweet spot where you can qualify for premium tax credit and maybe even additional subsidies through the cost sharing.

Eric: Those cost sharing subsidies are only if you’re on a silver plan that they come through. When we’re thinking about it, and how about you walk us through an example? The things that we can really control on our end would be things like how the investment portfolio is structured, and so forth.

There’re certain elements you’ve got to be aware of that we’re going to dive into here in a minute.

Patti: Exactly, and as we go into this, we’re focusing on the silver plan because it does seem to be the most popular plan. The nurse in me is going to come out, and I’m going to say to all of you, you got to really make sure that that’s the right healthcare plan for you and your family. You got to really make sure that that’s going to cover the things that you need covered.

For purposes of today, we’re going to take the silver plan, and what we’re looking at is a female aged 60. We’re in Pennsylvania, so if this woman, for example, has a modified adjusted gross income of $18,000, she’s getting a subsidy of $1,244 per month.

As the income increases, let’s say that we go to $45,000 of that MAGI. We’re still looking at a subsidy of $910. That’s a big benefit. We don’t want to lose that through some of the other things that we create in unintended consequence.

Eric: It’s really important, especially as you come to the year end, that there are certain things you can do depending on how your investments are structured and certain decisions you make, to ensure that you’re getting the best benefit of that tax credit. When we think about this, things that we can control as it relates to our client.

There are certain investment decisions that we can control. There’s also certain tax strategies that seem common sense and are widely recommended, but may actually diminish or undermine the credit if you don’t pay close attention.

Patti: Exactly. For example, on the investment decisions, if in the non retirement accounts, we’ve got too much of an emphasis on income producing investments, which by the way, does include your tax exempt interest, because that gets added back. If we’ve got too much of an emphasis on that, that may take away this subsidy.

You got to look out for things like frequent trading, lots of turnover, capital gains. Also, if you’re retired or you’re receiving cash flow from your portfolio, you want to make sure you want to minimize capital gains. Don’t sell those highly appreciated assets, let’s go somewhere else.

Last but not least, something that we were able to do last year and we were able to preserve or create a significant credit for our clients was taking advantage of the unfortunate circumstance we had in the fourth quarter of 2018, with a big, big loss in portfolios.

I say big, 20 percent on the SNP, international markets even more. To take advantage of tax loss harvesting opportunities. Those strategies, again, don’t create too much income, etc., avoid frequent trading. They can really impact or diminish whether you get a credit at all. Eric, why don’t you go into the tax strategies?

Eric: I will, and just as an add on to that last point, because I think it’s so critical, is the tax lost harvesting. Not only did that allow us to basically preserve a credit for so many of our clients by doing tax lost harvesting, but in certain cases, that created a carry forward that then gives us a reserve that we can work with in future periods, say in 2019 and beyond.

It gives a lot more flexibility to the client, which was huge.

Patti: Great point. That is a really important point. That’s a juicy opportunity. Unfortunately, these things happen, but boy, what can we do to make sure we capture that deduction, not only for 2019 but for many years? Again, good news, bad news, for years to come.

Eric: Common tax strategy, so this is actually how we stumbled across this. You learn a lot of things as you go along, but we were looking, in our focus, how can we take advantage of Roth conversions, or maybe accelerating capital gains and get a zero percent tax rate for our clients?

Again, that focus is purely on taxable income, which is after you factor in your standard deduction and anything else.

Patti: It’s important, let’s do a sidebar conversation. Under the new tax law, the people that are 12 percent bracket is actually wider than ever before and we’re finding more people, if we do some planning, can actually land in that 12 percent tax bracket.

If you’re in the 12 percent tax bracket, I got news for you, folks, if you didn’t listen to the other podcast, which I hope you did, on tax planning strategies at year end, if you’re in that 12 percent bracket, guess what? Capital gains are taxed at zero. That is a huge perk.

We were looking at ways of , gee, A, who’s in the 12 percent tax bracket, because we’ve got real awareness of that opportunity. Should we be creating some gains in that calendar year or in years to come so that, gee, we pay no capital gains tax?

As we were looking into this, that subset of clients who were also receiving premium tax credits under the ACA, there was the unintended consequence. If we did that, then they might lose their subsidy.

Eric: That was a real aha moment where we sat there and are giving ourselves a pat on the back thinking we’ve done a great job shifting income from a high period to a period of relatively low marginal tax. It suddenly dawned on us that, “Hey, we are jeopardizing this significant premium tax credit,” that these people who are basically not old enough for Medicare, they’re in the Affordable Care Act.

We’re going to lose because of that activity. That’s what really led to this podcast, this emphasis on really focusing on how can we plan for the Affordable Care Act, making sure we’re doing the best job for our clients.

Patti: The same thing goes for the Roth conversions. Roth conversions, in certain situations, are a great strategy. Just because it may not work, either this or the Capital Gains Strategy, may not be the ideal thing to do right now in that period of life while you’re on the ACA.

Keep in mind that once you go on Medicare at age 65, chances are your tax bracket is going to be about the same. These opportunities are not evaporating. We’re just delaying them. Until you can get on Medicare, you’re going to be in a low tax bracket, then we’ll go back to looking at can we take some capital gains at zero percent or do a Roth conversion?

Eric: You know what? I’m going to steal word that you use all the time, but it’s about optimization. We’re looking at the phases. Here’s another one of your words, the seasons of life. What’s important is in this season, for people that are on the Affordable Care Act, great, you could do a Roth conversion. Maybe save some taxes, but the greater opportunity is preserving the tax credit.

We’re always looking at the season of life. What’s the optimal way to preserve the best benefit that’s out there during that period?

Patti: I’ll take it one step further. You know me. I am very big on running the numbers. When you run the numbers, it’s black and white. It tells you what’s the ideal option.

Again, many of you listening may not have access to the software. Hopefully some of the people listening, our financial planners, you’re running numbers for clients. This is another scenario that you need to consider.

Eric: For those of you listening out there, I’ve worked for Patti for 15 years. I can say 100 percent accurate that we exhaust every possibility we run, every scenario it seems. That’s how these things come to bubble to the surface.

Patti: To the nth degree.

Eric: That’s right.

Patti: That’s why we exist really.

Eric: That’s right.

Patti: All right. Let’s take a look at what are those step by step? What are the real key takeaways from this? Number one, you want to take a look at last year’s tax return. Get a sense of what your modified adjusted gross income would have been and what you’re projecting it out to be.

Again, understand, you may have had that life event where last year’s tax return is just not relevant.

Eric: Absolutely. The next would be is to really find the sweet spot. This is if you were one household or one member of the household, and you’re applying for it under a silver plan, if you’re between $16,753, and I believe it’s $30,350, that’s the sweet spot.

If you’re on a silver plan, that’s where you’re going to get the most generous tax credit. You’re going to get the cost sharing subsidies, which means lower deductibles and minimum out of pocket. That’s the real sweet spot to target if you can.

Patti: Again, sweet spot or the range for married couples would be about $22,000 to $66,000 is the wide range of when you can qualify for something.

Eric: Yeah, great point. Depending on the members of your household, that will increase the range that you have to target.

Patti: The other important thing is you want to consider rebalancing your non-retirement accounts away from income producing investments.

As always, you want to talk to your investment professional, your financial planner, before you do any of this to make sure it’s really appropriate for you because there are other issues such as your total return that you need to earn on your portfolio, your risk tolerance, and any other tax implications in doing so.

Eric: Absolutely. The next step would be, and this is not advocating for passive over active management. As it relates to your non retirement accounts, really look at very tax efficient funds to keep not only the capital gains distributions down, that’s the big one, which is really unpredictable from year to year.

Basically using index funds or active funds that have low internal turnover, that’s going to make sure that you can hopefully control or keep or minimize the capital gains distributions on your taxable accounts.

Patti: If you’re taking cash flow out of your portfolio, you want to use investments that have the smallest unrealized capital gains. We’ll get technical here on you. Prioritize your tax lots by using the last in first out wherever possible. You really want to look at your tax planning strategy so that you maintain these premium tax credits.

Eric: Next, I would say, stop trying to time the market. The critical piece about all this that we found is that you want to preserve flexibility. The more you’re buy and hold, the less activity that you’re taking, more unlikely the more flexibility you’re preserving for year end where you can take tax losses or do other things that can help preserve the credit.

Patti: To your point, Eric, you really want to be proactive with that process. In 2018, we did not wait for the end of the year to take tax losses. We did it after February also. You don’t have to wait till the end of the year to harvest those losses, because they just build on top of each other.

Whenever possible, make sure that you or your advisor is looking at the portfolio for those opportunities.

Eric: Another point is you have to be very careful about, the conventional wisdom of doing Roth conversions are taking capital gains at zero percent, if you’re somebody that’s on the Affordable Care Act, doing these things.

While they may appear to be good, it can be very bad for the tax credit that you’re actually currently receiving. They could really undo a lot of good other tax credit. You’re not going to know that until you file your taxes for that tax year.

Patti: Exactly. The takeaway from this podcast is, again for those of you who are considering getting on the ACA, there are wonderful plans that are out there. No pre existing conditions, limitations, etc. You want to make sure that you’re choosing the plan that’s right for you.

As you do that, also consider how can you structure your income in such a way to optimize those premium tax credits and the cost sharing reductions. Those cost sharing reductions are your deductibles.

When you visit the doctor, how much you have to pay versus how much the government is paying. Whenever possible, these are…it’s not just a deferral. These are complete avoidance of significant costs for medical care. With that in mind, that’s it for today’s show.

Thank you so much for spending some time with us. If you want to learn more about the ACA and how to optimize your income to qualify for more tax credits, just head over to the website at keyfinancialinc.com. You’re welcome to give us a call, schedule a meeting.

We can do some brainstorm on these ideas and any others. Also, be sure you hit the subscribe button. If you liked today’s episode, share it with others. That’s why we exist, is to share this information. Again, as Eric and I both said, we stumbled across this.

A lot of advisors don’t have an Eric firm that’s doing these deep dives, but they can be significant when you’re doing your planning.

Eric: A lot of advisors don’t have a Patti Brennan either.


Patti: Again, thank you so much, Eric.

Eric: Thank you.

Patti: Thank you so much for joining me today. You always lighten it up and add color. Until next time, I’m Patti Brennan. Thank you so much for tuning into the Patti Brennan Show. We’ll see you in the next episode.

Ep10: New Tax Law Changes that Will Benefit YOU when Filing your Corporate Return

About This Episode

Patti strategizes with one of the Philadelphia area top CPAs, Bruce Boylston of Rothman, Boylston LLC. Together they break down nuances in the New Tax Law to share with their listeners how to save money when filing their corporate tax returns. Business owners will appreciate how easily these actionable steps can benefit them both this year and in years to come.


Patti Brennan: Hi, everybody. Welcome to “The Patti Brennan Show.” Whether you have $20 or $20 million, this show is for those of you who want to protect, grow, and use your assets to live your very best lives.

I am so honored to have with me today Bruce Boylston. Bruce is a CPA and one of the founding partners of Rothman Boylston, located right here in West Chester. Among the many accolades that Bruce has, he is an adjunct lecturer at the University of Pennsylvania, and also at Drexel.

One of the cool things that Bruce does is, as part of his work with the people at Wharton, he does work for the Lipman Prize, which is a really neat prize that they are involved in. Bruce, why don’t you do a quick overview of what that’s all about?

Bruce Boylston: The Lipman Prize was founded or was created by the Lipman family, Barry Lipman and his wife. What the prize does is it goes out and tries to find socially responsible and socially innovative not for profit organizations. What they do is they review what they’re doing and then they give them if they meet the criterion the prize committee says their worthy of it then they get the prize.

Our position is simply to look at the financial information of the candidates that are being presented. We then break that down for the committee as well as for the fellows that are part of the Lipman Prize and give them the financial tools that they can use to make certain decisions.

Patti: What a privilege that is. Among all of the firms that we have here locally in Philadelphia, they chose to work with you. That just really shows the quality of the work that you guys do.

Bruce: It certainly is an honor. It’s impressive because there are days…One of them was about two Mondays ago. We’re sitting on top of Huntsman Hall, which is the building for Wharton now, used to be Steinberg, now it’s Huntsman Hall.

You all of a sudden you go, “Wow. Look at where I’m sitting.” It’s a little humbling when it all gets said and done. The Lipman Prize does great work because it gives money to the people that truly can use it and really can be innovative in what they do. Good people.

Patti: That’s terrific. Thank you so much, and thank you for your work in that.

Today, we’re going to be talking about the new tax law as it relates to businesses. One of the things that you and I have been able to work on together over the 20 years that we’ve known each other is really helping our businesses, the businesses that we work with, structure themselves and to optimize the tax laws as they present themselves and change throughout the years.

We’ve got this brand new massive tax legislation that does have important implications as it relates to business owners. Let’s talk about some of the highlights that you see as a result of the law. Let’s really zone in on some of the opportunities that the law could also present.

Bruce: We’ll take the Mac review for a minute. What’s the stuff that grabs the headlines? What was grabbing the headlines was the reduction of the corporate tax rate from 35 percent to 21. That was everybody’s focus. If you remember about a year ago, all these corporations started handing out 1,000 dollar bonuses to say look, we’re giving the money back to the employees, and so on.

I won’t comment on that, but I will tell you that there’s a significant saving that’s taking place at the corporate level. In addition to that, they can also then bring their earnings from overseas back into the United States at another reduced rate.

That is giving the corporations’ the ability to have more cash flow, which I’m sure is driving the market to an extent and all that you folks deal with the politics of who’s going to get the money at the end of the day and so forth.

From that perspective at the C corporation level…C corporation means that’s a corporation that has shareholders but the income does not flow to the shareholders. It stays in the corporation, gets taxed in the corporation. What gets taxed to the shareholders in a C corporation is dividends.

As an example, Costco is a C corporation. I was just looking at their books, and it looks like they’re going to save probably $300 million in taxes in 2018 based on the new tax law.

Patti: That’s a big deal.

Bruce: It’s a significant deal. Therefore, put that [inaudible 4:18]. The question becomes what are the companies going to do with it, and that’s a political question. From a practical standpoint, corporations will have more cash because of the change in the tax law.

Patti: I just hoped that when I go to the cash register, the cost of my food is going to be lower.

Bruce: Well, that’s OK. [laughs]

Patti: So, I’m dreaming?

Bruce: Exactly. [laughs]

Patti: That’s interesting. One of the other things that I thought was also pretty big deal is the repeal of AMT, alternative minimum tax, for corporations. That’s also pretty significant, isn’t it?

Bruce: It is pretty significant, but again that operates at a level that certainly my firm doesn’t operate in. That’s more in the public traded companies. C corp level was never really a big issue at our level. But certainly again, it’s another benefit to large corporations that they’re going to be paying less tax.

That was the whole thrust of the law. We need to become more competitive at a global level. We had the highest corporate tax rate in the industrialized world. They certainly have made some adjustments for that.

Patti: I thought it’s also interesting you may had mentioned earlier when we were talking about the changes in the accounting methodology that is now available again for companies.

Bruce: Let’s take it down a step and get out of the publicly traded companies and come down to the privately held companies, probably more people that are your kind of client base or our kind of client base. One of the things that we always struggle, and I love talking about this in class, is what’s the difference between accrual and cash?

The accrual method says you recognize income when earned and expenses when incurred. A negative side of the accrual method of accounting is you have to recognize income before you actually get the cash. In a small business, that may not work well.

Congress has always been fooling around with this and we’ve all been jerking around this. Now it’s $25 million. You can use the cash method but you have to be in certain industries. It’s an overreaching if you’re under $25 million of gross receipts. You don’t have to do anything, you can use cash.

You’re still going to have to use certain methods. You may still end up having to use the accrual method, but it certainly expanded the opportunity for some companies to change to the cash method that may be possibly be using the accrual method at this point.

Patti: From your perspective and from my perspective for the businesses, it’s really a cash flow management issue. Is that correct?

Bruce: Absolutely.

Patti: It’s not a tax issue, it’s just how do you manage the business and make sure that you have the money for payroll and other expenses without having to allocate money for the taxes on money that you’ve really didn’t get yet.

Bruce: Right. Potentially maybe you don’t get paid on that receivable. Now I’ve paid tax and I’ve got to wait till next year to claim it as a bad debt. In the world of taxes, we all like to be on the cash basis.

Individuals by nature, 99 and nine tenths percent are cash basis anyway, but clearly, at the corporate level and at the partnership level, business level let’s say, it’s clearly an opportunity that’s going to present itself in more and more cases. Good thing.

Patti: I also thought it was really interesting how they expanded the use of the bonus depreciation, the ability to do 100 percent expensing, etc. Why don’t you talk a little bit about that as well?

Bruce: There’s a perfect example of where it’s a wide open playing field now. If you buy something, you can write it off within one year. Let me give you a caveat on that that may take a little of the excitement away.

I go out and I borrow let’s say half a million dollars to go buy a half a million dollars’ worth of equipment. It’s great. I get a half million dollar deduction and if you think about it, I borrowed the money. I didn’t put any cash out. In 2019, the year I did that, it’s a home run but what happens is you’ve got to pay it off.

Now you’ve got to generate income in the subsequent years to pay off the loan, but the deduction sits back in the year that’s closed. You can somehow come up with some timing differences. You have to be careful how you do that.

Patti: This is a perfect example of what I so appreciate about the way that you think, Bruce, because you’re not just looking at it from a tax perspective. You’re looking at it from a business planning perspective with the understanding that we have got to pay this thing back. What’s going to make the most sense for you as the business owner, etc.?

Here’s a question. I don’t know the answer. Can a business choose not to do 100 percent expense?

Bruce: Yes.

Patti: Let’s say that same example. You borrow the $500,000. Can the business say hey, I’m just going to deduct it over a period of five years?

Bruce: There’s an election you can make to get out of bonus depreciation, but usually the motivation to go do what we just talked about is because the company has profit and the company wants to get rid of that profit. Therefore, they will use after they’ve funded their pension plan, they’ve give employees their bonuses and so on, they’ll go buy equipment.

I have concept here in the United States that we’re the only country where we’ll spend two dollars to save one dollar in tax. Sometimes it’s better just to pay the tax. Therefore, in cases like this, maybe the half a million dollars of depreciation isn’t really worth it when you’re really…Do you really need the machine?

Patti: That’s exactly right. There is a practical aspect of all of this. Don’t let the tax tail wag the dog.

I’ve got to tell you, Bruce, you and I do this all the time. That is a statement I must tell people at least three times a week. Let’s make sure that we have our ladders on the right wall.

Bruce: Absolutely.

Patti: We talked a little bit about C corporations. Then we’ve got this whole world of other types of entities S corporations, LLCs, etc. Let’s talk a little bit about that and some of the reasons why you might choose one over the other, especially as it relates to Pennsylvania State tax.

Bruce: The one thing with Pennsylvania State tax, I don’t know if I said this before, but if you’re looking at a lower marginal rate for corporations at 21 percent…Excuse me, not a marginal rate. It’s a flat rate at 21 percent. Pennsylvania’s corporate tax rate is 9.9 percent. So, it’s 31 percent. Is the bargain really sitting there in the C corp? Not so sure.

Then we take the next option, which is to say let’s go to what we call pass through entity. The pass through entity is an S corporation. It’s a corporation, you get all the legal protection, but the income passes out to you as the shareholder.

Then we can go one step further and we use an LSA. Go ahead.

Patti: Let me stop you right there. Let’s give people an understanding of what that really means to them. When it passes through you as the shareholder, you’re taxed personally instead of into the company. Therefore, you pay taxes theoretically one time. We’ll get into that in a minute. The most important concept is it flows through to your personal tax return.

Bruce: It flows through your personal tax return, so you’ve escaped the corporate level tax. It mixes up with the rest of your income and potentially there’s some savings there. We like pass through entities because it lets us manage the tax liability sometimes as best we can.

You have the S corporation. Then you have the LLC, which is Limited Liability Company. The limited liability company can elect to be an S corporation if it wants to, but its default it will be treated as a partnership if there’s more than one owner or it will be considered a Schedule C or sole proprietorship if there’s only one owner.

It gives us a flexibility of moving income around within the corporate structure to the parties potentially. If we use an LLC as a partnership, we can maximize depreciation and so on. In my perfect world, we like an LLC as a partnership versus sole proprietorship. However, that all came to an end in 2018 with the invention of Code Section 199A.

Patti: That’s interesting. Tell us more about 199A.

Bruce: 199A is the one when Congress is putting this together, the issue was we’re going to give these corporations a 21 percent tax rate. Everybody raised, what about the S corporation? Why does the C corporation get the benefit, not the S corporation?

Congress came up with 199A which says, at the very macro level, that a business will only pay tax on 80 percent of its net income that flows through to the shareholders. That sounds like a great deal. I get a 20 percent deduction of net income.

But, like all things good in Congress, there’s always a but and maybe and a comma after everything that goes on. 199A has several restrictions that are difficult to deal with sometimes. One of them is the fact that if you are, say you’re filing a married joint return, the 199A deduction begins to phase out between taxable income of 315 to 415.

One of the things that you’ll have to watch out for is, once your income goes above…Taxable income. I have to keep emphasizing that because it’s taxable income. Goes above $315,000 if you’re filing a married joint return and you are an SSTB my suggestion is…I can’t remember what all the acronyms are, so look it up.

An SSTB is basically a doctor, a lawyer, accountant, potentially an investment advisor. These are all companies, professional companies is really what they’re looking for. They’re saying once you get above 315 and then at 415, forget it. You’re not going to get the 20 percent at all. It phases out.

The interesting thing in all of that surprisingly is architects and engineers were not included in the profession.

Patti: That’s an interesting carve out. What about real estate professionals? Didn’t they get a break on that as well?

Bruce: They got an interesting break. This was, I believe, don’t quote me on this, but I believe it was Senator Corker from Tennessee that sat there and held his breath and said look, unless you put something in for rental properties, the way the law was written, they weren’t going to get any benefits.

Rental properties got thrown in because what’s usual with most rental properties? They don’t have salaries. Once you get above that 315 mark, all of a sudden we have to start using salaries as a fraction of something. It goes away.

If you have a real estate company, you can use two and a half percent of the unadjusted basis of the property. Let’s say you have a building for $100,000 and its land is 50, you can’t use the land but you can take two and a half percent of the building cost. It’s not the depreciable value. It’s the actual cost of the building.

There’s all sorts of other caveats that go with this, but that becomes the basis for your 20 percent deduction. Not that you’ll get 20 percent. You may only end up with two and a half percent of the basis. It was something that was thrown in there to give real estate people a benefit.

Maybe I should explain how tax law is structured. Congress passes a law, then they empower the Internal Revenue Service to write regulations. The regulations just came out for this 199A cap as it relates specifically to this issue with regard to real estate.

The regulation now says that for you to qualify as a real estate company that can take advantage of this 199A, you have to show 250 hours of services. They don’t have to be services from the owner standpoint.

It can be the person that cuts your grass, the person that paints the house, whatever. If you can combine all those and they said there’s at least 250 hours being spent on this property, then you can get the 199A deduction.

Patti: It’s so interesting because I will tell you, I was out at the National Conference for the AICPA. I’m a member of it just because that I think your industry is phenomenal as it relates to helping us talk about tax planning.

This time last year was all the rage. Gee, is there a way that we can create real estate entities for those people who would otherwise not be able to take advantage of that 20 percent tax deduction? It’s so interesting that it took like a year for them to come out and say before you do that, here’s what you need to do in order to actually be able to qualify.

Bruce: Taking the IRS for what they are, the other issue is they’ve now said for 2018, as long as you can demonstrate somehow that you’ve got the 250 hours, we’ll let you go. Going forward, you have to keep contemporaneous records. That means that you have to write down that on March 4th, John Smith came to our place and shoveled snow for an hour and a half.

Again, that’s what the regulations say, that’s what we have to do and that’s what we have to abide by. It is going to become somewhat onerous for the real estate people that maybe only have one or two properties to have to keep track of all this stuff.

Patti: Let’s talk about some of the deductions that were retained and some of the deductions that were eliminated. We can do some brainstorming also about what do you think Congress was thinking when they actually passed this? For example, we can talk about the entertainment deduction.

Bruce: The other thing you have to look at when a bill goes through Congress is what they call scored. It’s scored for its revenue gain or its revenue loss. Through the scoring process, what you end up with is them having to take away some things to offset some revenue losses on the other side.

Entertainment was one that came off the table. Therefore, no entertainment. Although entertainment by itself was somewhat limited anyway, but now entertainment in no way, shape or form is deductible.

One of the other things and this goes to the individual level, is the fact that, let’s say a transit pass. It’s still tax free for the employee but no longer deductible for the employer. What’s that all about? Again, we’re trying to score the bill.

Same thing with home equity interest. Trying to score the bill. Where can we take? We’re going to take it from here and hopefully, nobody will complain. Salt is another perfect example of that.

Patti: It’s just so interesting. The bottom line to this for businesses is it basically means you can deduct the cost of the hot dog but you can’t deduct the ball game tickets?

Bruce: Correct.

Patti: It does have interesting implications. You think about the concept of the transit pass that you’re using as an example. Employers and employees like that perk. That’s a really important perk. Does the employer now, because they can’t deduct it, do they take away that perk? What does that do to morale? What does that do to the ability to retain the talent?

Again, getting back to something we talked about earlier, you want to look at these things and make good sound business decisions irrespective of the tax implications. You’ve got to keep good people. That’s one of the ways that you can do that.

Bruce: Absolutely. If there’s one complaint that clients have over and over and over again at the business level is we’ll accept whatever the law says, but hey, can you give me a break and keep it consistent.

If you think about it, we do probably within every three to four years, we’re changing something else. Something that was deductible is no longer deductible. That piece of equipment is now only deductible 50 percent, not 100 percent. To run a business, you need to know what’s coming down the pike, and tax laws don’t give you that option.

Patti: On a bigger level, we’re not going to talk about it right now, but think about that on a global basis and the impact of these potential tariffs. You’re running the company in Apple and there’s a possibility of a new law that will completely change the operations of your business.

Same thing on our level with small businesses, you come out with a wonderful employee benefit for your employees, it works from a cash flow basis. The employees love it. They love working for you. Then all of a sudden it’s taken away. Now you have to make a different, maybe a new business decision. It’s one thing to give something to people. It’s another thing to take it away.

Bruce: That’s what a lot of our clients are trying to decide. Is this something we really want to take away? We’ll forego the deduction. From the employee’s standpoint, it’s still tax free. There’s really no harm, no foul there. Again, it starts to create other issues in the corporate level that they have to think about.

Patti: Another thing as it relates…We’ll talk about this in the next podcast as it relates to planning from an individual perspective. Those employees who have miscellaneous expenses related to their job are no longer going to be able to deduct them. It’s an interesting dilemma for salespeople who buy trinkets to give to their customers. That creates a little bit of an issue too.

Bruce: Sure. Again, there’s caveats to everything. There’s no such thing as an absolute statement that I can make. Under the new law, the home office deduction is gone if you’re an employee. If you’re not an employee, it still exists for sole proprietors and things like that.

The other thing that I have to tell your audience too is the fact that although it’s gone for federal purposes if you meet the criteria, it’s still there for Pennsylvania and local. Just because you can’t take it doesn’t mean you shouldn’t look at it because it can work on your state and your local return as well.

Patti: That’s a really good point. That is a really, really good point. We’re talking about the federal law, but there are state income tax implications as well.

You talked about the home office deduction. This is something that I talk with people all about. I’d like to hear your thoughts about the home office deduction, whether people should be really worried about an audit if they take a home office deduction.

Bruce: No, not at all. In fact, actually, the IRS made it easier. They came up with what they call the simplified method. Let’s say your office is 100 square feet. I believe it’s five dollars per foot. Your home office deduction is $500 and we’re finished.

The IRS doesn’t look a this because, again, as an employee’s perspective, home office was difficult to get because the business expenses had to exceed two percent of adjusted gross income. Very hard to get.

At the Schedule C level, it’s easier to get because there is no limitation, but it’s just not a big number. Everybody should also remember it’s not just your office. If we’re using your house for storage, things like that, make sure you include that square footage as well.

Patti: Great point. Thank you so much. That’s a great, great point.

Let’s go back to the corporations. One thing that has changed relates to this concept that I know you’ve done it for our mutual clients, and that’s related to net operating losses. We can no longer carry them backwards in order to get the tax benefits. You can still carry them forward, but you can’t get the backward benefit that we used to be able to get.

Bruce: The carryback period, if memory serves, was two years. I would have to say, in most cases that never came up. I think we maybe do two or three carrybacks a year. The fact that you’ve lost the carryback, I don’t think is super critical.

However, you do have the carryforward going forward, which comes in handy. The mutual client we were talking about before with regard to real estate losses. We’ve been able to carry those losses forward. This is the year they have income. Now they have income but they don’t have to pay any tax. The carryforward of those losses are helpful. There’s no doubt.

Patti: Isn’t that a beautiful thing?

Bruce: It is when it works.

Patti: Having income and you don’t have to pay taxes on it. It sounds like an incredible deal.

Bruce: Yeah, but here we go back to the same issue. You had to spend money to lose it. At the end of the day, if you can break even, we’ll call it square. Again, it serves itself well in the year that you can actually use it because it’s somewhat of a relief rather than just continuing to dig a deeper hole.

Patti: Let’s talk strategically now. We’ve got this new tax law. You might have someone who is above that $415,000 limit, not able to take the 20 percent deduction. What do you think, from a practical perspective? When do you think, if at all, would it make sense for those people to think about changing the entity and going to the C corporation where they get that 21 percent rate?

Bruce: That, I’m going to say is probably a hard push. I haven’t seen anything in our analysis yet, but what we have done, I think we’ve done four or five this year if memory serves, is we’ve taken people that are in partnerships, specifically LLCs that are taxed as partnerships, and converted them to S corporations.

The short end of that story is once you get above 315, the formula changes with respect to the 20 percent and you have to start using 50 percent of the wages as one of your measurement points. If you’re a sole proprietor or you’re a partner with not a whole lot of payroll, you’re going to lose that deduction.

If we create an S corporation and we take some of which you’re taking out and call it compensation, which we have to in an S corp, now we’ve brought up the 199A deduction back up to where it has some benefit. It’s one of those things that’s a case by case basis, but that’s one of the conversion points we’ve been looking at, which is to say go from the partnership, sole proprietor to an S corp.

Patti: Bruce, it really is a good example of, especially during tax season when you’re sitting down with your CPA, with you, really these conversations have to come up and early in the year so that you’re able to take advantage of it.

Bruce: The conversion is a perfect point. Again, and this is not to toot our own horn, but we’re always in contact with our clients because it’s not a static issue with respect to tax planning. It’s constant throughout the year. If [indecipherable 26:17] comes to us as a partnership and they say, it’d really be great if you were a partnership, well the door is closed for 2018. It becomes a looking forward issue.

People have to be proactive if they’re not hearing from their firm. They have to be proactive and say am I in a situation where I could take benefits that I’m not looking at right now.

Patti: That goes with all aspects of this planning. Basically, we talked about the carryback. We talked about the income threshold. The ability to convert from different entities, etc. Here’s a question. I know the answer, but just for our listeners.

Let’s say that you’re located in Pennsylvania. If it doesn’t work because of the 9.9 state income tax, would it ever make sense for a business to move to, for example, Delaware and incorporate in Delaware? Does moving the business entity to a different state that might have a lower tax bracket, does that make it look more favorable in your eyes?

Bruce: Possibly, but I’m going to have to cite the recent Supreme Court ruling with Wayfair. I think it was Justice Kennedy said guess what, this whole nexus nexus is physical location it’s not working in today’s world. Therefore, we’re not going to be so much concerned about where you’re physically located, we’re going to be more concerned about where your company is actually doing business.

Let’s take the State of California as an example. If you have $500,000 or more of sales to people in California, you are subject to California income tax. They just came out with a recent ruling that said if you have sales of over $100,000, you have to start collecting sales tax for us.

If you think about California, which I believe is the fifth or sixth largest economy in the world. Everybody’s doing business in California. You’d say, OK, that kind of makes sense but we live in a world where we have 50 states. None of them do things exactly the same.

We had a situation last year where we had a client who tripped the half a million dollar rule for California. So I called Pennsylvania and I said, excuse us but what are we going to do? We’re not going to pay tax in two states. Pennsylvania’s attitude was, well, our provisions don’t work that way. Tough, you’re going to have to deal with it.

These are the things that we have to watch out. It’s just not as easy as moving to another state because you can still get trapped pulling that income right back to where you were.

Patti: Very interesting, Bruce. Really good points. Let’s summarize this in terms of takeaway for our listeners. What I’m hearing from you, and I’m going to paraphrase it, and fill in as you wish. Takeaway number one is look at your business structure. Make sure that you’re talking with your CPA early in the year as it relates to should you be a C corporation, LLC, Sub S LLC, etc.

Bruce: Correct. Status quo is no longer acceptable.

Patti: Boy, that is the takeaway. The status quo is never really acceptable because things change so much.

Number two, understand the deductions that were enhanced, for example, the depreciation deduction, things of that nature.

Also, understand that there are some deductions that have been taken away. Very important to know going into this year what you can and cannot do.

The third one, most important, is don’t let the tax tail wag the dog. As it relates to running your company, run your company from a practical perspective doing the right thing for your employees and the customers that you serve. If we all do that in what we do for the people that we serve, you’re going to win no matter what.

Bruce: That’s true. The tax you have to look at as it’s a cost of doing business. It’s probably the worst cost that anybody wants to deal with, but it is the cost of doing business. Therefore, you have to keep it in control from the standpoint that you’re not going to try to eliminate it at the expense of something else.

Patti: Exactly.

Bruce: That’s what you need to do.

Patti: Excellent. Bruce, thank you so much for joining me today.

Bruce: My pleasure.

Patti: This was terrific. I think our listeners got so much out of this today. That’s it for today’s show. Thank you so much for spending time with us. If you want to learn more about business tax planning, just head over to our website at keyfinancialinc.com, where you can schedule a call with me. I can introduce you to Bruce. You can learn more about what you can do for your business.

Also, make sure you hit the subscribe button if you like today’s episode. Be sure to turn on notifications so you don’t miss a single episode.

Bruce is going to be joining me again. He’s going to be talking with us about the individual tax benefits. You really want to hear that because there’s a lot of juicy stuff in that show, as well. Please leave us your comments on the show. Tell us what you liked or didn’t like. We would just love to hear from you.

Until next time, I’m Patti Brennan. I will see you in the next episode. Thanks so much for joining us.

Ep9: Ready to file your individual return? Consider these money-making tips first regarding the New Tax Law!

About This Episode

Patti sits down with one of the top CPAs in the county, Bruce Boylston, to discuss key tax planning strategies designed to save their clients’ money when filing their individual returns. Patti and Bruce break down the complexities of the New Tax Law into easily comprehensible tips and strategies – just in time for the filing deadline! You do NOT want to miss this episode!


Patti Brennan:

Hi, everybody. Welcome to “The Patti Brennan Show.” Whether you have $20 or $20 million, this show is for those of you who want to protect, grow and use your assets to live your very best lives.

With me today is Bruce Boylston. Bruce is a CPA and one of the founding partners of the firm of Rothman Boylston here in Westchester. Bruce is an incredible resource for us.

Whenever we have a complicated situation, or even a simple situation, he’s my go to person to really drill down and look at the nitty gritty detail. It is not unusual. Bruce, I’m going to be getting you into trouble, I think.

Bruce Boylston: OK.

Patti: It is not unusual for you and I to be spending a Sunday on the phone together going through mutual clients to look at opportunities for those people. I think that that says a lot about you and how important your clients are to you.

Bruce: Most definitely. One of the things that I always say about a professional is a professional is usually more concerned about being right than making money. That carries through with being there on Sundays.

Patti: Absolutely, absolutely. I think one of the other notable things about your background is that you are an adjunct lecturer at University of Pennsylvania school. It’s an incredible honor to be that person and to be one of those people chosen.

You also assist with the Littman prize, which is a program under the auspices of Wharton that helps non profits. Again, they could go to any firm in the Philadelphia area, and they have chosen you to help them ascertain which of the non profits are so deserving of the prize that’s being given each year.

Bruce: No doubt. Especially, I tend to take Penn for granted sometimes. In fact, let me tell you a great story. I’m walking down Locust Walk, which is the center of Penn. I guess it was about two weeks ago.

A former student comes running up to me. He says, “Guess what?” Before I tell you that story, let me give you some background. This gentleman came to us from Ethiopia. I forgot on what scholarship he was, but anyway, he declared in the first class that he was a socialist.

That’s great. We have opposing points of view sometimes. The next thing you know, three, four weeks later, he comes up to me very quietly and says, “I’ve got a story. You can’t tell anybody else.” I said, “What’s that?” He said, “I just got a summer internship at Goldman Sachs.”

I said, “Ah, going to the dark side, I see? OK, good.” With all that said, now we roll forward a year from now. Here he is on Locust Walk. He says, “I have something to tell you.” I said, “What’s that?” He said, “I just was awarded a Rhodes Scholarship.” He’s going to be a Rhodes Scholar.

That’s when sometimes you have to step back and go, “Wow. This is where I am.” Pretty impressive that you’re dealing with Rhodes scholars.

Patti: That is amazing. The fact that you were an influencer in his life says a lot about you, Bruce.

Bruce: It also says something about Goldman Sachs because they turned him over to the dark side.

Patti: Absolutely. Today, we’re going to be focusing on the new tax law as it relates to individual tax benefits. There’s so much to this new law. Today, let’s focus on each one of us on a personal level. Maybe we can just start out with how it was structured, especially as it relates to, let’s just take the standard deduction.

Bruce: Let me frame the new tax law first. There are some things that we’ve all heard in the press that this is a significant change, and it is. But there’s a lot of changes, and they’re just not all super big huge changes. It’s little nuances, twist here, twist there. But the big one that got changed was the standard deduction.

In the past, as an example of the standard deduction, was relatively low. Maybe about 12, 14 thousand dollars for a married couple. Now, it’s $24,000. Plus, if you’re over 65 or blind, you get another $1,300 per person. Potentially, you could be as high as somewhere in the 26, 27 thousand dollars for a standard deduction.

You take that, and then you push it up against the fact that they’ve taken away some itemized deductions, and all of a sudden there is this issue that, OK, the standard deduction may be the way to go for a lot of clients now, even clients with significant income.

Patti: It’s really interesting, Bruce. We’re running numbers. We do tax projections for all of our clients, and it is fascinating to me because of what was taken away. For example, the new limitations on medical deductions.

This year, it’s going to go to 10 percent of adjusted gross income. Therefore, a lot of people aren’t going to be able to take deductions for their medical expenses. The limitation on state and local taxes. The complete removal of miscellaneous deductions. There are a lot of things that fell in that category.

Bruce: Yeah. Especially if you look at the state and local taxes, because you think of that and you say, “OK, my income taxes are going to be limited to $10,000.” But that’s not true because you have to throw your real estate taxes in.

Take somebody who’s retired but owns two homes. Real estate taxes could be 20, 30 thousand dollars. In that case, that’s all now gone, because it’s going to get capped at 10. The other thing that disappeared was the home equity loan interest. That used to be, if it was up to $100,000, you could still deduct the interest no matter what you use the money for.

I want people to remember one thing, it’s not gone, because what you have is if you’ve used that home equity loan to either acquire the property or make improvements to the property, it’s still deductible interest.

Now let’s put something on top of that. Under the new law, the most you can borrow and deduct interest on is $750,000. Mindful that’s both homes. You can’t say it’s on a per home basis. If you’re over that 750 mark, you don’t have to worry about it as long as the mortgage rolls and plays part of the enactment of the law, somewhere in December, if I remember, of 2017.

What I don’t want people to do is say, “Well, home equity loan’s no longer deductible.” No, it could be deductible if you can do tracing and go back and see where the money was spent.

Patti: The $750,000 limitation also includes the home equity loan.

Bruce: Correct.

Patti: It’s a total of the loans against all of your real estate.

Bruce: You could see where Congress is trying to basically pull back the subsidy on the acquisition and ownership of a house. Right, wrong, or indifferent, that’s clearly what they’re trying to do.

Patti: As a result, more people are going to be taking the standard deduction and not itemizing at all.

Bruce: Correct.

Patti: That’s an important distinction. Another important thing that we need to point out is we are no longer getting the benefit of our personal exemptions, which for a couple, two kids, it was $4,000 about per person. That was a $16,000 deduction a family of four used to get. We’re not getting that anymore.

Bruce: We’re not getting it, but then again the other thing you have to look at, and the same thing with the itemized deductions, is they used to phase out based on income. Depending upon what your income level is, you potentially weren’t getting those deductions anyway. They have been lost for a lot of people, but not lost for all. They might have lost them years before.

Patti: The other important point to keep in mind is the impact of alternative minimum tax in prior years. A lot of times, people would have those deductions, get the income down, but then they got smacked with alternative minimum tax.

Bruce: Exactly. Tax has been one of them. Tax is what we call the preference item. When we calculated your alternative minimum tax, we couldn’t take a deduction for taxes paid. People are going to say, “I’ve lost a deduction because of salt,” but potentially you didn’t lose anything because now you’re not subject to the AMT on that preference item.

Again, there’s no quick easy answer to tell what the impact is going to be of this new tax law because there are so many pieces that move back and forth.

Patti: Exactly. It’s also important for everybody to understand as they do their taxes this year, to also understand that the withholding was changed as of January to accommodate the new law. You might go and get your taxes done, if you do it yourself, etc., and finding you actually aren’t getting that big fat refund that you were hoping for. That in fact, you owe, simply because not enough was withheld.

Bruce: They changed the tables but they didn’t…I think they asked, but nobody did probably, redo your W4. Your W4 also had to be redo, because let’s say you had a lot of state and local taxes. Let’s say you had a lot of miscellaneous itemized deductions. These no longer exist. There was no way to simply adjust the tables and say everything is going to work out correctly.

I can guarantee you there’s a lot of people that are going to come up short this year. My suggestion is, which you should do now if you haven’t done it yet, is rerun your W4. Make sure you get your withholding correct, because if not, you’re going to be repeating your problem.

I’ve been reading that the IRS is going to go easy on penalties. There are also other ways to get penalties abated. Even if you do get hit with a penalty, there are several ways to get them abated. However, one of the things that the IRS won’t abate is if it’s a habitual issue. If you get out of the penalties this year, it doesn’t mean you’re going to get out of the penalties next year.

Patti: Excellent point. Let’s talk about what the tax law actually gave in terms of young families, in terms of the child tax credit, which is a big deal.

Bruce: Yeah. That credit went from $1,000 to $2,000 per child.

Patti: Doubled it.

Bruce: Yeah, but remember everything is tied to phase outs. Just because you have two kids, it doesn’t mean you’re going to get the credit. It’s one of those things you have to base on the facts of your return itself.

Patti: Exactly. Speaking of kids, I think the expansion of the 529 plan is another important element of the new law as it relates to now you can use 529 plan for secondary education, up to $10,000.

Bruce: Yes.

Patti: It does warrant some thinking, some planning, because if you use the 529 plan for high school, for example, that means that there’s less available for college. That may or may not be a bad thing as it relates to if you’re trying to qualify for financial aid.

All of these things have implications. It’s important, under this new law, that you take advantage of some of the things, the doors that have been opened that didn’t exist before.

Bruce: No doubt about that, but again in the context of what’s going to be the ultimate outcome. You talk about taking $10,000 out for high school education. That’s great, but now you’ve taken $10,000 out of the person’s college fund.

You spend all this money to send them to very expensive high schools, and what’s the outcome? They go to very expensive colleges. From that perspective, you want to keep your eye on that 529 plan.

Remember, one of the small little benefits you get out of the Commonwealth of Pennsylvania is you do get a deduction for your 529 contributions up to $15,000 per person per year. Although you’re not going to get wealthy off of that deduction, it’s worth continuing to fund 529s for a lot of reasons, that being one of them.

Patti: Absolutely. The other part of that is that you can do five years’ worth of contributions and it’s not subject to a gift tax. However, the Pennsylvania income tax deduction is still limited to that $15,000 per person.

Bruce: Correct. It doesn’t carry forward either. It’s 15 and lost. But if I can put $75,000 into a 529 plan, a regular tax free for five years, I gladly would give up the 3.07 percent tax break.

Patti: Very good perspective.

Bruce: No doubt.

Patti: Very, very interesting perspective. This is what I love about, because you just get to the bottom line and say, OK, here’s a decision point, here’s what…

Bruce: Yeah. That’s what a lot of tax decisions are about.

Patti: Exactly. What are some of the other things that you think our listeners can really look at in terms of strategic thinking, strategic planning as it relates to their taxes?

For example, we’ve got many people, many clients who are 70 and a half and have to take required minimum distributions. This is something that I know you and I are both really pounding the pavement and sharing with our clients to say, hey, there’s a really good opportunity here to continue to fund things that are important to you and still get the tax deduction even though you’re not itemizing.

Bruce: Let me put that in context so people understand. There’s an opportunity that exists with regard to using your RMD, your required minimum distribution, as a way of actually getting a deduction for charitable contributions that you may not get.

The issue here is, let’s take an example, you have a couple that’s both 72 years old. The standard deduction is 26, 27 thousand dollars. Their only real deductions at this point are taxes. Let’s say they have real estate taxes, but it’s kept at $10,000, so it doesn’t make a difference. Let’s say they also give away $10,000 a year.

So, they have a $20,000 itemized deductions, but they’re going to take the standard deduction at 26. They’ve lost the tax benefit of that deduction as far as contributions are concerned. However, if they were to pay those contributions out of their RMD, they’re going to reduce the amount of income that’s reported and they’ll still get the 26, 27 thousand dollars standard deduction.

You’ve effectively gotten the benefit of the charitable contributions because you’ve reduced your taxable income, because you don’t report all of the RMD, because you gave to charity, but you still get the standard. Effectively, you’re still getting the effect of the deduction.

My point to you or my question to you is, “What should clients do?” Let’s say they want to make contributions of $500 or whatever, is there a mechanism that is set up so that they can do that, or does the broker say no, it’s got to be a minimum of $1,000 or whatever?

Patti: I can tell you that from our perspective, there is no minimum. We just get a list of the charities that people want to contribute to, the addresses, we put it on a form, and we send the money directly from the IRA to those charities of choice. It’s an administrative thing that we take care of for our clients.

For those people who manage their finances themselves, it is just really important that you go to the custodian for your IRAs and make sure that they have the proper paperwork and that they’re able to send it directly from your IRA to the charity. If you take receipt of that money, it is then considered taxable income, and you’re not going to get the benefit that Bruce is referring to.

It’s really important that this is done correctly, dots some Is, cross some Ts. But boy, what a home run that is for people who want to continue to contribute to charities.

Bruce: Yeah, and they get a tax benefit. Again, the issue there is the fact if the mechanism can be made fairly easy, because everybody said, oh jeez, how am I going to do this? There’s confusion that reigns. I have got to believe that it’s going to get up, it’s going to be fairly easy. It’s almost like a no brainer that’s the way you should do it.

Patti: It is absolutely no brainer. From my perspective, I don’t care what kind of work is involved. It’s the right thing to do.

Bruce: It’s perfect.

Patti: The other kind of domino effect to this is also that it reduces a person’s adjusted gross income. You go back to those Schedule A deductions, because the medical expense deduction is tied into adjusted gross income and we are lowering the adjusted gross income, you may be able to take more of your medical expenses as a deduction.

Because you’ve lowered it because of the generosity that you had to the charities that you want to contribute to. As with all of these things, there can be a domino effect that can create a benefit for you. It’s just important to talk to your CPA, your financial advisor, to see how you can optimize it.

Bruce: I’ll give you one other benefit that comes into play, and I don’t know what the terminology is, but when your income gets above a certain level, your Medicare premiums go up. This is a way to bring that income down.

Patti: Oh boy, Bruce, that is a very good point.

Bruce: There is a planning opportunity for people that they can use, especially if they’re on the bubble with respect to that increase in Medicare tax, maybe do their contributions this way and potentially reduce it accordingly.

Again, what I would say is, and this is the important part about it, these are all things that have to be done during the year. If you come to us on April the 10th…

Patti: You’ve closed the barn door after the horses got out. It’s too late.

Bruce: Planning is critical in this. Again, none of these are home runs. They’re not tens of thousands of dollars in tax savings, but that’s not the game we play anymore. We play at $100, $200, $500, $1,000 at a time.

Patti: You know what, like a baseball game, Bruce, isn’t it true that the team…It’s a bunch of singles. But isn’t it true that the team that hits and just gets people on base, those are the teams that win the game?

Bruce: My opinion is, men on base are what score rounds.

Patti: Here’s another opportunity for those of our clients that retire early, or retire period, or they’re downsize and decide, you know what, I’m done. There’s a unique planning opportunity that may exist.

For example, let’s say that we’ve got somebody and they’re retiring. They’re 62 years of age. Because the sources of income and the way that that is taxed is going to be very different probably, we’ve got a great opportunity for the next seven years to really optimize a person’s financial situation that really has a compounded effect for the rest of their lives.

You and I do this together all the time. I call it the bracket racket. Let’s talk about that a little bit for our listeners.

Bruce: Specifically, are we talking about brackets or do we really want to get into the discussion about Roth IRA conversions?

Patti: It’s a little bit of both. To me, the brackets are because, for example, the 12 percent tax bracket is wider for joint filers and because of the fact that, for example, in a 12 percent tax bracket, you can take capital gains up to a certain limit and pay no tax on those gains. That’s an important planning opportunity.

Anything that we can do during those years where the brackets may be close to that 12 percent or below, we want to understand that we’re there during the tax year, and do some proactive planning where we can take advantage of it.

Bruce: That’s true. Eric and I worked on a couple cases like that where it was like, “OK, where is the threshold of capital gain?” Therefore, in the one situation somewhere around $40,000 with zero tax. It was a unique financial situation where her client’s income had dropped significantly but nonetheless gave planning opportunities to effectively escape all tax on the income.

Patti: That was a situation where that person would have otherwise had to have paid 23.8 percent. Because of that heads up planning that we do every December that person had the effect of a $10,000 in their pocket benefit.

Bruce: Yes. No doubt about it.

Patti: Those are the things that are important for you to take a look at for our listeners, I should say, to understand throughout the year in terms of where they are from a tax perspective. The point that you brought up earlier, Bruce, is also an excellent point that we look at and I know you look at as well. That relates to Roth conversions.

Bruce: Yes. I had a perfect example of that come in my office yesterday. Gentleman was working for a company, retired early. It was a large company. He’s going to get a deferred comp pay out. It’s not going to be for five years.

He has enough liquid assets to live comfortably for the next five years. His income is going to be relatively low. I said to him, “You know this is a perfect opportunity to convert some of your IRA money to Roth IRA.”

Now, the benefit of the Roth is the fact that once the principal is in there none of the income is taxable as long as you meet certain requirements. It gives him an opportunity to take money that would have been taxed at a higher rate, tax it at a lower rate or no tax at all, put it into the Roth, and then let it grow tax free from there.

Patti: Another sidebar benefit of that is, had he left it in that IRA or 401K when he hits 70 and a half his required minimum distributions would have had to have been higher. That money needed to be pulled out based on the formula.

If it’s in a Roth, there is no such thing as required minimum distributions on a Roth. Every year from 70 on, you’re having less taxable income. That’s going to be a wonderful side benefit that has a compounding effect.

Bruce: No doubt about it. That’s why every situation is different. A lot of people want to do Roth conversions but they’re sitting in a 28 percent tax bracket. It’s like, “Well, why would you do that?” These unique situations that come up, they have to be looked at. It’s a proactive thing. You got to be in advance.

This person has a five year runway before his income goes back up again. I said to him, “We have to plan for the next five years. If anything changes, we can always turn it off.” To me, if we can plan properly, he could probably move, I’m going to guess, probably a half a million dollars, possibly.

Patti: That’s a big deal. That’s a lot of money to be growing tax free.

Bruce: With a tax burden of less than 10 percent. I said, “You’ll have to figure out what the rate of return is.” At the end of the day, the math, to me, is very simple in situations like that.

Patti: It sure is. We also had a situation. We always have to be careful of the unintended consequences of these decisions. One of them had to do with a case that we had.

In December of last year, we were looking at doing this Roth conversion. The person was on the Affordable Care Act. They were getting their medical insurance through Obamacare. They were receiving a really juicy subsidy.

If we actually recognized this income through the Roth conversion they were going to lose their subsidy.

Bruce: And have to pay it back.

Patti: Exactly. That was one case where even though on a global basis from a tax perspective, it made zero sense. They were going to lose a subsidy of almost $2,000 per month. The tax benefits aren’t going to make up for that.

Bruce: No. Those are the things that you have to look at. Big jigsaw puzzle. Got to make sure you have all the pieces for sure.

Patti: It sure is. Absolutely. You got to run the numbers. As it relates to the new tax law, what are some of the other things that you think are important for our listeners to understand? How can they optimize? How can they take advantage of some of the things there?

Bruce: As an example, we’re talking about moving money around and such. Some of the things is, don’t assume. In other words, everybody’s home office deduction is gone. No, it’s not. It’s still available if you’re a sole proprietor or partner, still there. Still applicable if you meet the requirements. Still applicable in Pennsylvania local. Don’t miss it there.

As far as the loss in the deductions, yes, you’re going to lose the miscellaneous. Your fees aren’t going to be deductible. My fees may still be deductible though. Depending upon what the types of businesses you have on your return, rental properties, things like Schedule C sole proprietorships.

We can move some of our accounting fees, not all of them but we can move some of them into those categories. That’s what we worked on to create the deduction. Those are things that we have to look at. That and the biggest thing that I would also say is don’t throw the HELOC loan interest out. Potentially how you use the money is important.

The other thing to watch out for is that alt min credit, what we call the minimum tax credit. You may have it, most people don’t. Just because you paid alt min tax doesn’t mean you have an alt min credit.

The alt min credit only applies to what we call temporary alt min differences. Permanent differences like tax deductions things you will trip the alt min tax but you won’t be able to get it back.

Patti: Let’s stop there. Let me go back and, just for our listeners, why don’t you explain what the alternative minimum tax is, the reason that people used to get hit with it?

Bruce: The alternative minimum tax goes back a long ways. It was Congress’ way of trying to level the playing field, shall we say? They created this, basically, second tax code that ran parallel to the regular tax code. What had happened is a lot of things that were deductible for regular taxes were not deductible for alt min tax.

Once your alt min tax was higher than your regular tax you had to pay the alt min tax. Deductions such as state and local taxes, miscellaneous itemized deductions, those were things that were permanent changes. That created the alt min tax.

The alt min tax also had some temporary differences. I’m going to use ISOs. Nobody gets ISOs anymore. They’re like a…

Patti: These are incentive stock options.

Bruce: Yes. Companies have gone more to restricted units and things like that. Nonetheless, if you got an ISO, the beauty of an ISO is the fact that you exercise the ISO but you didn’t have to pick up the income. That’s absolutely, positively true. Except, for alt min tax you did have to pick up the income.

If you did some ISO exercises, you could end up with a very low regular tax bill but a pretty high alternative minimum tax. That, though, is a temporary difference. Eventually, when you sell the ISO stock, you’ll recapture that minimum credit. That’s been going on for a while. Those are the permanent differences.

People may still have those. If they have the permanent, what we call the minimum tax credit, which is on form 8801, I believe. You should look at that and say, “OK, do I have anything that I can roll forward because I may…?” The law was changed so you may be able to take that credit this year.

Patti: It’s really important that you don’t want this tax credit to be thrown away just because you’re not going to be hit with it on an ongoing basis.

Bruce: You have to be careful if you’re changing accounting firms, if you’re doing TurboTax, carry forwards are critical. You have to make sure that you’ve picked them all up.

Patti: Let’s talk about another group of people that are going to be affected by this new tax law. That is those people who have decided that perhaps this marriage is no longer going to work. People who are going through a divorce, the tax law has significantly impacted, frankly, what they’re not going to be able to deduct. That is alimony.

Bruce: Correct. Don’t quote me on this, I think it’s for agreements written after 2018.

Patti: Correct.

Bruce: There must be some congressman or something that had divorces that were pending. They didn’t want to pass the law right away.

The end result of that is, yes, it’s going to change the structure of divorce settlements. Don’t call me sexist because I’m going to do it this way. Usually, the husband was the higher earner. The wife was the lower earner.

Alimony made sense. We could move money from him to her. He gets a higher deduction. She picks it up at a lower rate. We could work some numbers to make things happen. That’s not the case anymore. Now, it’s a non deductible event. Really, when you get into divorce planning, you have to take that into account. It’s a big shift.

Patti: It is a big, big shift. It’s important as it relates to how property’s actually divided as well.

Bruce: Exactly.

Patti: This was excellent. We’ve talked about a lot of important things, some of the deductions that have been removed. There’s also opportunity, some really good tax planning ideas that you shared with us. There’s always opportunities. You have to know what they are and whether they apply to your situation.

Bruce: Correct.

Patti: Let’s summarize this with three takeaways. What you said regarding the 12 percent tax bracket, anybody that can get themselves into the 12 percent tax bracket by making decisions as it relates to maybe deferred comp, things of that nature, there could be a terrific opportunity to take capital gains and have no out of pocket tax that you have to pay on those gains.

Also, take a look at Roth conversions. These items are especially relevant for people who have retired and are in that window of time between the date of retirement and 70 and a half for most people. That’s really important.

It is a year by year decision point that you want to take a look at. More people are going to be taking the standard deduction. That does create the opportunity for the charitable contributions. It’s called a qualified charitable deduction.

Bruce: Right. I also want to point out because we’ve had clients coming in. They’ve already thrown their hands up. “Oh, I’m going to take the standard deduction.” I said, “Whoa, whoa, wait, wait, wait. Let’s run the numbers.”

About three out of four so far, they actually still could itemize. They didn’t understand what they had on Schedule A. You should always look every year and not assume the standard deduction applies.

Patti: Really good takeaway, Bruce. Thank you. That’s a really good point.

If you are one of those people that it’s better to take the standard deduction, as you look at taking your required minimum distributions and if you want to continue to contribute to charity and maybe get a tax benefit, the best way you could do that is to have a portion of your required minimum distribution go directly to the charities of your choice.

It’s got to come directly from the custodian. You can’t receive it as a check and then make it. It doesn’t count. That’s a home run. You get the standard deduction plus the charitable contribution.

Bruce: Plus, as you talked about, potentially lowering your adjusted gross incomes. Maybe you’ll get medical deductions. Then you may not have to deal with a Medicare tax increase because you’re being able to keep your income lower. I don’t see a downside I guess is what I’m trying to say.

Patti: I’m with you on that one. Absolutely. If you’ve paid alternative minimum tax in the past, understand why you might have a tax credit that you can use against capital gains and other forms of income.

529 plans, home run, especially in Pennsylvania. It’s a great way to pay for or save for college education and reduce the amount of student loan debt that perhaps your children and grandchildren have to take on.

Bruce: No doubt. I had a client this morning, grandchild’s five months old. Client is of significant means. Think of what that child, if they put $75,000 in today and then 18 years from now where that money’s going to be after you manage it properly. Where’s it going to go? Your college is paid for.

Patti: Exactly, with tax free dollars.

Bruce: With tax free dollars.

Patti: That’s an example of a home run, in my opinion, not a single or a double.

Bruce: Absolutely.

Patti: It is a home run. Everybody wins except the government, although maybe the government does win because most of the student loan debt is federally funded.

Bruce: Absolutely.

Patti: Given the default rate on the student loans today, I think the government’s going to be winning as well.

Bruce: Nobody’s going to get hurt in this process, for sure.

Patti: Exactly. Bruce, thank you so much for joining us today. You always bring color and practical insight into how we can take advantage of some of the things that are still available in the tax law.

Bruce: My pleasure.

Patti: That’s it for today’s show. Thank you so much for spending some time with us. If you want to learn more about tax planning, just head over to our website at keyfinancialinc.com, where you can schedule a call with me. I would be happy to introduce you to Bruce as well.

Also, be sure to hit the subscribe button if you liked today’s episode. Turn on those notifications so you don’t miss a single episode. The next podcast that we’re going to have, Bruce and I are going to be joining together again.

We’re going to be talking about the new tax law as it relates to businesses and all of the opportunities that exist for business owners and how you can structure your planning in the calendar year to take full advantage of it.

Thank you so much. Tell us what you like about the shows. If there’s a topic you’d like us to talk about, I’d love to hear from you. Until next time, I’m Patti Brennan, and we’ll see you in the next episode.

Ep8: Forbes Top Advisor Summit: Highlights from Industry Leaders

About This Episode

After presenting at the Forbes Top Advisor Summit in Las Vegas last week, Patti shares some highlights of what she learned from the nation’s thought leaders. Top economists discuss why the Federal Reserve will most likely not increase interest rates this year and Patti also tells a thought-provoking story she learned about Pope John Paul II regarding capitalism.


Patti Brennan: Hi there. Welcome to “The Patti Brennan Show.” Whether you have $20 or $20 million, this show is for those of you who want to protect, grow, and use your assets to live your very best lives.

This week, I’m going to be talking and giving you some of the highlights of what I believe is one of the best conferences that I go to each year. It’s the Forbes/SHOOK Conference. It is an invitation only conference comprised of about 1,000 of the top minds in the country as it relates to financial planning, tax, investments, etc.

I got to tell you, this year was no exception. It was outstanding. As I was sitting there, furiously taking my notes to bring back to my office, it occurred to me that you might appreciate hearing some of the things that I learned this year. I’m going to share with you the highlights of everything that I learned at this conference.

Before I do so, I want to tell you a story about something that happened to me as I was traveling. I knew I was going to be sitting on a plane for about 13 hours. Just as I was leaving, a friend of mine had dropped off a book that she really enjoyed, and I just throw it into my bag.

The name of the book is called “The Pope and the CEO” by Andreas Widmer. As I was reading this, I was captivated by so many of the things that he wrote about as it relates to what we do in our world today.

Basically, the book is about a man who was chosen to be a Swiss Army Guard for Pope John Paul II. He talked about all of the things that he learned from John Paul that, honestly, I never realized. For example, I never realized that the pope was such a fervent believer in capitalism.

By the way, I should do this sidebar. This man, Andreas Widmer, went on to become the CEO of many very, very successful businesses. He took the principles that he learned from the pope and applied them to his business life.

He talked about the idea, for example, of John Paul’s beliefs, real, fervent beliefs. One of them was the impact of vocation. John Paul believed that vocation, which is defined as someone’s calling, is something that we all are brought to this world to do. He believed that a vocation in business was as honorable as the priesthood, or a social work, or anything else.

Capitalism, which he also strongly believed in, was defined by John Paul as the ability to serve the need and the want of another human being, because as we do that, when we serve another individual who is also a child of God, in so doing, we also serve God.

I don’t know about you. I just thought that that was so powerful. I take that with me every day now and understand that as I sit with anyone, as I do this podcast, it is my hope that in so doing, I am fulfilling my vocation.

Moving forward, as we get into this [laughs] Sorry about that, everybody let me tell you some of the things and explain what I learned in this incredible conference, the Forbes/SHOOK Conference in Las Vegas.

One of the first speakers was Rick Rieder, the Chief Investment Officer of Blackstone’s fixed income department. Blackstone is one of the largest fixed income managers in the entire world. Rick was amazing.

I will also tell you that one of the main themes that just kept on popping up time and time again through the conference was that the Federal Reserve is probably done. He said the Federal Reserve, Jerome Powell, has literally taken 180 degree turn and probably will not increase interest rates at any point this year.

He also said, as it relates to your bond portfolio, etc., something that was I thought really interesting, he said there’s not enough fixed income in the world to go around. He said the size of the market has halved while the demand has doubled. He went on to say that markets go down five times faster than they go up. We certainly felt that in the fourth quarter of 2018.

The one question that was asked of him, which I thought was a really great question, someone in the audience said, “If you could know something now instead of having to wait until the end of the year, what would it be?”

His answer, right away, was, “Is China growing?” I thought that was fascinating. Just this morning, there was a commentator on CNBC talking about the importance of the Chinese consumer.

He went on to say that the Chinese consumer loves luxury goods and is the second largest consumer of the luxury goods market, and yet it represents 85 percent of the growth according to Bain Capital. It’s a very, very important country. It’s a very important economy as it relates to the rest of the world.

Steve Forbes came on next. He was one of the keynote speakers. He was especially entertaining with his perspective on a whole bunch of different topics. He talked about the wealth tax that is being proposed and tossed around in the Democratic Party.

His only comment on that was that the wealth tax, if it didn’t work in France, it’s not going to work anywhere. He went on to make almost a moral case for capitalism. I loved his definition of it.

He said capitalism is simply defined as meeting the needs and wants of other people. If you’re in business and if you’re doing a really good job, if you have goods or services, if you are growing, it is because you are successfully meeting the needs or the wants of other people. Sometimes they don’t even realize that they want it yet.

Think about Apple. Think about the iPad and what that has morphed into in terms of the iPhone and the impact of the iPhone on economies all over the world and people all over the world in terms of their ability to get knowledge much faster than ever before.

It’s kind of like when the car was invented, right? When the car was invented in the early 1900, it would cost $138,000 to build a car. Nobody could afford a car. Then Henry Ford came along with the assembly line.

Basically, capitalism, as Steve Forbes talked about, it turned scarcity into abundance. More people could afford to buy a car and think about the impact of people having cars on our economy. He then talked about trade and tariffs. His feeling I think probably most of us would agree is that it’s far better to have trade across borders than troops across borders.

Tariffs probably are not a good idea. Tariffs especially hurt China, but they also hurt us. His belief is it is better to slap on a sanction against specific abusers than a tariff affecting everyone.

Getting back to the general theme over and over again as it relates to interest rates, he didn’t really have a prediction on this but reinforce the concept that interest is the rent that we pay for money. Michael Farr, in his February 28th commentary, explained why interest rates are the grieves of the economy. On the face of it, everyone loves free money.

If I can borrow with zero percent for five years for my car, I’m more inclined to buy a car or maybe an appliance. I’m certainly going to think about buying a bigger car or bigger house if I only have to pay four percent on my mortgage instead of six.

This can lead to reckless decisions because the principal has to be paid back. That’s especially not a great outcome if you’re buying an asset that is declining in value. He compares this to kids and candy. I have four grown children. I will tell you that if I let them, they would eat candy all day long until they were sick and throwing up.

Eventually, kids need nutrition. Eventually, the economy, if there is too much debt, you have to pay the debt back. There’s got to be income in order to do so. The good news is that the Federal Reserve is probably done, but we have to be very careful about debts and the rise in the federal debt.

Brendan Ahern, again, the Federal Reserve, same topic, etc. He went on to give real data as to why he believes the fed is done. Inflation is running at 1.9 percent. GDP is at three percent. Wages are increasing. It was interesting. I wish I could tell you who it was, but somebody else said that wage increases don’t cause inflation. Inflation causes the need to increase wages.

I thought that was a very interesting perspective. On a global basis, expectations are very, very low but especially in the emerging markets. A central theme over and over again is that the emerging markets represent valuations that are really appealing.

Professor Jeremy Siegel from Wharton, University of Pennsylvania came in. Boy, he is always just so interesting because he’s got that academic approach. He’s got the practical approach that reinforces why he so passionately believes in what he believes.

He started out with the discussion, among other things, of the Shiller/CAPE ratio. Dr. Shiller, he acknowledged that there’s different ways to try and ascertain whether or not a market is valued fairly, or undervalued, or overvalued.

A lot of people look at the CAPE ratio and get really nervous because as of December, it was just about 30, when the mean over a long period of time has been about 17. It would be natural to freak out and say, “The market is way overvalued. The CAPE ratio is 30. We should get out. It’s going to crash.”

A lot of people come into my office with that concern. What Dr. Shiller pointed out very coherently is that…By the way, as a sidebar, he and Bob Shiller are very, very good friends. They almost have this interesting competitive academic debate as it relates to what their theories are.

He doesn’t believe it’s a relevant way of measuring valuation mainly because of a big change in the accounting rules that occur in 1997 by FASB. That was a point in time when they introduced this thing called mark to market. Among other things, it’s just not relevant anymore because the way the accounting is done is different. The old rules don’t necessarily exist.

Then Dr. Siegel gave a very clear example 10 years out of the financial crisis. He said when you look back to May of 2009, understanding that the historical mean of the CAPE ratio has been 17 in May of 2009, it climbed over 17 for the first time since the crisis.

Keep in mind, if we can go back, the market bottomed at 6,500. At that point, the market was trading at 8,500. Of course, it had gone up 2,000 points. The CAPE ratio was over 17. It was massively overvalued according to Shiller.

Let’s fast forward. It is now 10 years, that magic period of time that makes up the index. It went from 8,500 to 26,000 on the Dow. Again, probably not a relevant index to determine whether or not the market is overvalued, undervalued, or fairly valued.

He also reinforced another theme regarding the emerging markets. Giving a little bit more content as it relates to the why, he said the currencies in the emerging markets are stronger than they were last year. The P/E ratios are running between 8 and 10. The dividend yields in the emerging markets are running between five and six percent.

While this area of the world, emerging markets, are probably the lowest hanging fruit as with everything that I talked about in this podcast, do not go out and load up on this asset class. Please talk to your adviser and understand the risks associated with this in all asset classes. Make sure that it fits within your financial plan.

Finally, Dr. Siegel acknowledged the climb of the US debt to $22 trillion. That’s trillion with a T. It’s almost hard for me to even say. He compared the US debt to GDP, which is the way that most economists look at it. He acknowledged that it is definitely high on an absolute basis but not on a financing basis.

In my opinion, the only thing that’s going to motivate politicians to do something about the deficit is when the debt becomes completely unsustainable on a financing basis. When does that happen? When interest rates rise, recessions occur, etc.

While most of the content with the meeting was educational, there were people speaking on topics relevant to all of us. Dr. Jordan Slane talked about the 10 strategies to optimize your life and longevity. Jon Fussell, a former SEAL team leader, spoke about the power of people working together.

It might be that I loved his presentation because it reinforced everything I believe, but I just found the way that he presented it to be so compelling. He asked all of us. He said, “When you think about your businesses, do you have a group or do you have a team?”

What a team can accomplish is very different than a group. This is me talking. This is the way I look at it. A team is comprised of people who are interdependent, with complementary skills.

It’s like a baseball team. If you have a team of nine absolutely amazing pitchers and the best pitchers in the league, you’re not going to win a game. Someone needs to be able to hit the ball. A team of people with complementary skills is much stronger than those people are individually.

To summarize this conference…Of course, I haven’t gone through all of the things that I learned. I just want to give you the highlights. There were three major takeaways that I got from the conference.

Number one, the Federal Reserve is probably done increasing interest rates. That is important for all of you as it relates to not just your bond portfolios but also your entire portfolio.

Number two, while growth is probably going to slow this year, no one is really seeing a recession for 2019. That’s good news for all of us. Finally, I think that what Steve Forbes said about almost the moral benefit of capitalism is the definition of simply the ability to serve the needs and the wants of other people. That just resonated with me. I hope it resonates with you.

As I close this podcast, it is my hope that this and all of our podcasts serve you and the people that you care about most.

I am Patti Brennan. I am so grateful that you tuned in the today’s show. If you want to learn more about conferences and the things that I’m learning, just head over to our website. There is so much more content that we can share with you. That’s at keyfinancialinc.com.

Feel free to schedule a call with me as well as anyone on this amazing team that I have. Also, be sure to hit the subscribe button if you like today’s episode. Turn on notifications so you don’t miss a single episode.
Please leave your comments on the show. I’d love to hear from you. Tell me what you liked, what you didn’t like, and what you want to hear more about. Until next time. I am Patti Brennan. I will see you in the next episode.

Ep7: Market Crisis and Portfolio Recovery Rates

About This Episode

In this episode, Patti and her Chief Planning Officer, Eric Fuhrman discuss the economic realities that determine how quickly or slowly portfolios will recover from this last market crisis. Patti will leave the listener with three actionable steps to implement during a market drawdown period to help aid in quicker portfolio recovery. These concrete steps provide a sound foundational reminder to help weather any market crisis.


Patti Brennan: Welcome to “The Patti Brennan Show.” Whether you have $20 or $20 million, this show is for those of you who want to protect, grow, and use your assets to live your very best life.
With me today is Eric Fuhrman, our chief planning officer. Today, we’re going to be talking about bear markets. We’ve just gone through a very painful period in the fourth quarter of 2018. We thought it would be really important to put it into perspective and talk about. Gee, when these times have happened historically, how long did it take to recover?
Eric, welcome to the show.

Eric Fuhrman: Patti, thank you so much. I have to be honest. These podcasts have become more of a regular thing. I literally stay up at nighttime just wondering what the next topic is that we’re going to be talking about and sharing with our audience.

I literally count the days between the time when you and I can come in studio again and talk about all of these very interesting things that we find fascinating and hope that our audience does, too.

Patti: You know, folks, he’s not kidding. I have received emails from Eric in the middle of the night and on weekends on various topics that he thought might be a good idea for us to talk about.

Eric: So true. My wife would verify that as well.

Patti: [laughs] Let’s talk about what just happened. Historically, when we think about it, we’re about to celebrate, if that’s a real thing, the 10th anniversary of the financial crisis. The scars of the financial crisis, they’re still with people today. It feels like it happened just yesterday.

When we were going through that awful drawdown period at the end of 2018, a number of people were worried and thinking we were going to have another experience like we had in the financial crisis.

Eric: That’s so right, Patti. It’s still just such an awareness and a heightened sensitivity to market volatility since that financial crisis for so many of our clients that lived through it. This topic is so timely because there’s a lot to unpack here.

The reality is that risk and return are inextricably linked. We can’t deny that. Over the long run, stocks are going to provide higher, long term returns than cash because the very existence of the capital markets depend on it. That’s why they’re there.

It’s important, imperative for anybody who desires to reap a return in excess of, say, a government Treasury bill. You have to accept that certainty is the enemy of growth.

Patti: Oh, Eric, very well said. That’s worth repeating. Certainty is the enemy of growth. Hey guys, I understand. We all want great returns. We all want that wonderful long term trajectory that you see on those mountain charts. If you look closely at those mountain charts again, there are periods of time those where markets also go down. They don’t go straight up.

Eric: Right, and you have to remember too that uncertainty is the very mechanism that makes those long term returns possible that allow people to help fund college, purchase that dream home, or retirement in so many cases. If anything, I would say you have to embrace uncertainty. Nobody likes these periods of time, but they’re a reality that we have to deal with.

Patti: It reminds me of when I was in the ICU. People go in for open heart surgery. Nobody wants to go in for the surgery, and it’s an uncomfortable period of time because it’s a really traumatic event in a person’s life. There’s so much focus on that patient when they’re in the ICU, and what is equally if not more important is that period of recovery.

Ultimately, how quickly that patient recovered had to do with how good of shape they were in before they had the surgery. It’s really important as we talk about this to keep in mind that how quickly you recover, the impact that it has on your financial life ultimately depends on the planning that you did going up to the bear market as part of your overall financial plan.

Eric: Normally I would like to avoid unnecessary comparisons between the financial industry and the medical field, but you can actually speak intelligently towards that as a former ICU nurse. Wouldn’t you say that the more acute that condition is, usually there’s a longer recovery period that comes along with that.
The more severe whatever the patient was going through, the longer you can expect the recovery to be, and you see that in the markets as well.

Patti: No question about it. If you go in for outpatient surgery, your recovery time could be in weeks. If you’re going for major major surgery, whether it be abdominal or heart or what have you, it could be six months or a year. It ultimately depends on many different factors. Again, nothing to be afraid of. At the end of it all, you’re going to have a healthy heart, you’re going to have better working legs or whatever it might be, but it’s painful to go through.

Eric: Listen, before we start unpacking all of this here in this relatively 15 to 20 minute session, why don’t we start with some definitions because in order to help the audience and the listeners out there truly understand what we’re talking about they need to have a good understanding of some very important definitions. Why don’t you go into that?

Patti: There’s three definitions that are important for you to understand. First is the drawdown period. That is the period from the tippy top peak of the portfolio down to the bottom, from peak to trough.

Eric: That’s basically the event.

Patti: Exactly.

Eric: The drawdown event, something that’s causing that.

Patti: Then there’s the recovery period. Once it hits that bottom, how long does it take to get from that bottom back up to where it was before the event occurred?

Eric: Or the highest statement that you got in the mail, how long does it take to get back to that point where we’re happy again?

Patti: The underwater period, which I think is real key, is the combination of both. From the beginning of the event, down to the bottom back up, that’s called the underwater period. We’re going to go through periods of time when we’ve had these drawdowns and what happened afterwards.

Eric: Why don’t we get into a couple of examples for the audience to give them the sense of an extreme event and then maybe an event that was more similar to what we just went through over the last two or three months, just to give them some idea of what these look like and how long it took to recover?

Why don’t you start off with probably the most notorious and extreme event that most people would remember, which would be the financial crisis that was about 10 years ago?

Patti: Sounds good. I’ll take the tough one. Basically, during the financial crisis, if you had 100 percent of your money in the stock market, you lost during that drawdown period 51 percent. It took a year and four months from beginning to end. The recovery took just over three years. That total underwater period was four years and five months. That’s 100 percent invested in the market.

Eric: What you’re saying is for our listeners is the round trip or the peak to peak from the start of the selloff to actually getting back if you were in all stocks was almost four and a half years if you were a buy and hold portfolio.

Patti: Exactly. I was just going to say that. We’re not taking money out of the portfolio. We’re not adding it either. If you take a more balanced approach, 60 percent in stocks, 40 percent in bonds, that drawdown was 31 percent, and the underwater period from beginning to end was three years. Even more a conservative portfolio, 20 percent loss, two years complete round trip.

The takeaway here is that so that a more balanced approach you didn’t go down as far, and your complete recovery period was shorter.

Eric: The lesson is if I buy and hold or if I become more conservative that the drawdown’s going to be less, and as such then our recovery times will be faster. The underwater period will be faster if we take a more conservative approach, but if I’m a long term investor trying to grow for retirement…


Patti: It’s important that we keep all this in context. We’re going to be talking generalities here, but everybody is different. It’s not to say that everybody should have a 40/60 portfolio, 40 percent in bonds, 60 percent in stocks because that portfolio, generally speaking again, on average is going to have a lower long term rate of return than one that would have more in stocks.

Sometimes people need a higher rate of return to accomplish their objectives. What’s the right balance for you? That’s going to be a case by case basis.

Eric: What you’re telling me is there’s no magic bullet. If I’m trying to get good long term returns I have to deal with the drawdowns and the longer recovery period as long as I have enough time.

Patti: Exactly. Let’s now go through an example that is probably closer to what we’ve just experienced, the Russian default on their currency that occurred in 1998.

Eric: This is going back about 20 years now. When the Russian debt default happened this bears a striking resemblance to the selloff that we just had in terms of the magnitude of the selloff but also the duration because it was so fast. Let’s take your example. If you look at a portfolio that’s 100 percent in the US stock market, your portfolio, the maximum drawdown was about 17 and a half percent.

That occurred in a short window of two months. Just as you said before the more conservatively positioned portfolios are going to experience much less drawdown. The other extreme is if you were 40 percent stock, 60 percent bond portfolio, you were only down about 6 percent. In all these cases, despite that extreme drawdown and probably how bad it felt these portfolios, all of them recovered within three months.

Despite a 17 percent selloff or somewhere in between, within a five month period from beginning to recovery, that’s all it took is five months to recover a 17 percent loss. Again, it’s important for people to have some resolve and some resiliency, despite what we went through, that we’ve had periods like this before.

To become very conservative or start making changes…You could probably talk to this…could definitely affect that recovery period if you become more conservative at the wrong time.

Patti: Absolutely. It’s going to take much longer to recover if you make changes while it’s happening.

Eric: After the drawdowns already occurred.

Patti: The worst thing that anyone could possibly do. It’s also important for us to recognize, for those of you who are not feeling great about what happened, it was pretty bad. In fact, we have to go back to 1972. It was the fourth worst drawdown since 1972. The two worst ones occurred between the tech bubble and the financial crisis and that’s a long period of time.

If you’re not feeling great about what just happened, I understand because it was a tough period of three months.

Eric: The crazy part is I’ve been in the business for about 15 or 16 years, so what you’re telling me is I should feel good because the three worst drawdowns happened in the first 15 years of my career. It should be good from this point on, right? [laughs]

Patti: I will tell you something that someone said to me. Because you’ve experienced these at a relatively young age, it will make you and has already made you a better advisor because you’re going to help that many more people go through these periods of time and get on the other side.

Eric: What’s interesting about that, let’s take the other side. Yours truly over here, you have 30 plus years in the business, so you could probably speak to other events and drawdowns that we’ve lived too, going back in the ’90s and even back in the ’80s.

Patti: I was a brand new financial advisor in 1987 with the crash of ’87, 29 percent in one day. It was interesting because the number one selling book the end of that year was “The Great Depression of 1990.”

Eric: Oh, my goodness. [laughs]

Patti: The fear and the hype and all of that was so palpable, and yet it didn’t happen. We want to keep all of this in perspective and make sure that everyone listening understands that this is not that unusual, and we’re going to get on the other side of this.

Eric: What’s interesting is the two examples that we framed are looking at a buy and hold portfolio. They’re going to recover as things come back. What if you’re taking cash flow? That is so important for a lot of our clients and other people who might be listening that are retired and are actually taking money because taking cash flow from the portfolio can have a dramatic, a profound effect on how long the recovery actually takes.

Patti: Not only does it have a profound effect on the numbers, retirees I find feel it more, A, because they’re probably watching television more or they’re reading the newspapers. They’re that much more vulnerable to the headline risk that is out there. That’s all these newspapers and TV is talking about, “The market dropped so much today. The market dropped so much today.”

Meanwhile, that retiree is taking money out. They’re feeling, “Oh, my goodness. I’m not working. I’m never going to be able to recover from this.” Let’s talk about that aspect of it because there are times if we do this incorrectly where that person won’t recover.

Eric: Let’s go into our first example, and you can give us the detail here. You and I, in talking about this and researching the subject said, “What about somebody who just completed a 20 year retirement horizon?” Basically, they retired on January 1999, and they’ve officially completed a 20 year period in retirement.

What would that look like if that person started out with a million dollar portfolio, and they needed to take $40,000 in year one for retirement? What was their experience in terms of the drawdown, how long it took to recover, the underwater period, and where they stand now? Why don’t you dive into that?

Patti: Eric and folks listening, it really depends on their spending policy. If they’re going to be taking a rigid approach to the spending policy, in other words, a $40,000 fixed every year increasing by inflation every year, their outcome, which is all we care about is the outcome is going to be very different than someone who will take a more flexible approach to it.

In that fixed spending policy, you take out $40,000 a year every year, in that, given this period of time, in that situation 100 percent stocks had a drawdown of 64 percent. A lot of loss during that drawdown period and the drawdown period was eight years and six months. The real kicker with this is that person is still underwater.

Eric: Meaning they still are not at a million dollar balance. After 20 years they have less money than they started with.

Patti: That’s exactly right. Whereas if we take a more balanced approach, say a 60/40 blend, the drawdown was almost half at 38 percent. It was still the same period of time, but the recovery was the total underwater period was 13 years. That person has about $1.1 million as of the end of 2018.

Eric: Let’s put a little context here. This person, they started at precisely the wrong time. What we’re talking about here is a sequence of return risk, which is so important for retirees on cash flow. Basically, this person experienced the dot com crash and the financial crisis, a double whammy if you will, in their 20 year period.

Patti: All within a very short period of time.

Eric: Basically, if they started then it took until 2012, 2013 before they finally got back to even despite that.

Patti: Exactly.

Eric: Wow.

Patti: Plan B, and you know we’re always big on plan B.

Eric: Advisors love plan B and plan C, right? [laughs]

Patti: Exactly, and by the way, there’s 26 letters in the alphabet.

Eric: [laughs]

Patti: Many, many alternatives.

Eric: Have a contingency plan.

Patti: Always. By the way, we’re joking about that. That is so important for all of you to really understand to have a contingency plan, to take a flexible approach to all of these decisions. Plan B is instead of sticking with that $40,000 fixed plus inflation, how about we take that four percent withdrawal each and every year based on the account value at the prior year.

In that case, the drawdown on 100 percent stocks was still painful, that 58 percent. In that situation, your underwater period is closer to 14 years. You did recover, and you did end up with more money, frankly even more money than the prior at $1.4 million as of the end of 2018.

Eric: I guess what you’re saying here is if you took a percentage rather than a fixed dollar amount, assuming you have flexibility in your spending. Basically, if you were getting four percent on a million, you start taking $40,000, but if the market drops and now, you’re at $900,000 you’re only taking four percent of that or $36,000. Having that flexibility leads to a faster recovery rate.

In this case, you actually ended up with a good deal more money at the end of the 20 year period.

Patti: The sidebar to this, Eric, is if you’re taking that flexible spending approach, it’s really important to have a really good buffer in that emergency fund so that instead of taking from the portfolio, you’re making up the difference with that emergency fund.

Eric: The takeaways here are once you go into needing cash flow, asset allocation is supremely important, as well as your spending policy. Those are the two big takeaways.

Patti: It’s especially important in this one, because if you just dial down the equity versus bond, 60 percent in equities, 40 percent in bonds, yes, you still felt that terrible period of time, but the total underwater period was only five and a half years.

Again, in this case, the ending value was almost $1.4 million. In that case, your principal actually grew, and because of that, the way this works, so did your income.

Eric: You know what, Patti, that’s a fantastic point to reiterate. What you’re saying is that a 60/40 portfolio with the same requirements recovered in five and half years versus almost 14 years for the all stock portfolio. Asset allocation, the amount of risk you take in retirement, is unbelievably important to minimize drawdowns and speed up recovery rates.

Patti: Exactly. To me, the perfect approach to this is flexible all the way around. In other words, you can start out with that $40,000 per year increasing by inflation. If you come out of the gate with a great stock market environment, and this portfolio is doing great, that’s actually going to work out really well for you if you just stick to that 40 plus inflation.

If markets begin to crater, especially early in retirement, then the latter is going to be the better alternative.

Eric: Taking the fixed percentage.

Patti: You can flip from one to the other during this entire retirement period. You don’t necessarily have to have anything cast in stone. That’s where the longer term projections really help. Again, things are going to happen.

We’re talking about a bear market that happened so quickly. What is the impact on your longer term financial plan? Are you still tracking well? Should we dial back on the cash flow being taken out of the portfolio?

Eric: It’s a dynamic process. We’re always making decisions. The key is flexibility seems good in portfolio management as in most everything else in life.

Patti: Exactly. It does, but I think there’s something else important, Eric. Flexibility is fine and it’s great, but not when it comes to your asset allocation. I think it’s important for everyone listening to understand that discipline during this process is going to be really key.

Just because markets are going down and even if you’re taking cash flow, it doesn’t mean that you want to change your portfolio allocation to be more conservative and, frankly, maybe even more aggressive.

A lot of people think markets are down, I should ramp up my portfolio and go 80/20 on the portfolio. I don’t know for sure that this thing is over. It could go back down again. We could have a double bottom that is so characteristic of many bear markets.

Eric: The drawdown period might just be taking a breather. It might not be complete.

Patti: It happens more often than not.

Eric: Absolutely.

Patti: Not a prediction, just be aware of that.

Eric: Perspective, is what we’re getting here, is really important. I know both of us when we talk to different folks on the phone or through email and so forth, there seems to be the sense that this time it’s different. We have this trade wars going on, gridlock in Washington, all these things. Somehow, this is going to be unique and it’s unlike any other thing.

I think the reality is, again, uncertainty is a feature of the investment landscape. It’s always going to be there. The point is, looking at really significant events the dot com crash, the financial crisis, Black Monday, back when the inception of your career started drawdowns of 30 percent or more are very rare. Not that they can’t happen, they’re just not likely to happen.

If you go back to 1980, there’s only been four events, four drawdowns of 30 percent or greater during that time period. Despite those, the market is phenomenally high and has provided a great rate of return over that period.
What about the more intermediate drawdowns, like what we just experienced? They tend to have a higher frequency, right?

Patti: Absolutely. Let’s just really make sure that that’s clear, the point that you just made is really clear. We’re talking 40 years. 40 years is a long term. We’re talking about 1 year out of 10. The hype, the headlines. If it bleeds, it leads when it comes to newspapers.

Eric: [laughs]

Patti: They’ve got to really hype it up, and make it awful, and tell people to stay tuned because you have to hear about what’s happening next.

Eric: You always have so many wonderful little sayings that I have to compartmentalize them. I think I’ve heard at least three or four in the short conversation we had that I got to remember to put in the memory bank for the next time.

Patti: Yeah, 30 years will do it to anybody.

Eric: [laughs] What do you say we package this up with a bow here and take us down the runway? What are some observations on recovery periods? What are some of the things people should be aware of? Let’s wrap it up with some key takeaways about what those in our audience should be thinking about as it relates to the drawdown and recovery.

Patti: It’s real clear. If you’ve got 100 percent of your money in the stock portfolio, it’s going to take longer to recover, because it’s got to go deeper down. To do that round trip takes a lot more effort.

Eric: If you’re down 50 percent, it takes 100 percent to get back to even.

Patti: Exactly. If you’re taking cash flow out of the portfolio, it’s even more so. Very, very important. Each person listening today is in a different season of life. Keep that all into consideration. As it relates to cash flow, Eric, as we both pointed out, a flexible approach is going to be the most important thing.
All equities, drawdowns of 30 percent or greater they do happen. More frequent are the 5 to 10s. If you have any money in the market, you got to plan on losing 5 to 10 percent at least once a year. On average, that’s what happened, but as long as you don’t do anything, you haven’t experienced a loss.

Eric: I would say history is never a predictor of future. There’s never a guarantee of what will happen in future drawdowns, but when you observe historically when we’ve had a 30 percent drawdown or greater, an all equity portfolio, if you’re not taking cash flow, usually takes three to four years to recover.

In a lot of instances, drawdowns that are 20 percent or less, sometimes they’re recovered in a couple of months, maybe upwards of a year. That’s been historical experience. Again, going through what we just went through, just keep that in mind, that yes, it’s temporary, but usually within if it’s a fairly minor drawdown a couple of months to a year is the typical time it’s taken to recover.

Patti: The one thing that I really want to emphasize as we close this program today is this is not even taking into consideration that many people listening today are working and probably contributing to your 401(k)s and IRAs. That will accelerate your recovery period. You are buying low. Every paycheck that you make those contributions will accelerate your recovery period.

Eric: What are some key takeaways here that we can? Maybe we’ll end with the quote of…We always like to end with the sage quote from somebody far wiser than both of us.

Patti: To me, and Eric, I think you’ll agree, the key here is lack of diversification will magnify your drawdown. It will extend your recovery period. The theme here is diversification. Don’t make it harder than it already is. Your stock to bond ratio is really critical to manage the risk versus return that you get on your money.
Second point, taking cash flow can dramatically affect your recovery period and the total period that you go through this. Flexibility is the mantra. Rigid spending policies make you more vulnerable to that sequence of return risk.
The third thing is if you are saving money, if you are continuing to work, consider periods like the fourth quarter of 2018 to be a blessing because you bought stocks. You added money into your whether it’s the United States or even worse, the international market, at a deep, deep discount.

We don’t know for sure when it’s going to recover. We seem to be coming out of the gate here in January, but boy, if you can just keep that discipline, don’t change the portfolio. If you have extra cash flow, add to it. That will accelerate your recovery period.

Eric: That is a perfect way. It’s a shame we can’t play a little dramatic music before we end with our quote from our legendary investor, Benjamin Graham, the father of value investing.

It’s so pertinent to this topic of drawdown. What he said was the essence of investment management is the management of risks, not the management of returns. You can probably speak to this.

Returns are something that nobody can really influence or affect, but the management of the risk you take is so critical. That’s something that we can control.

Patti: Absolutely. As with all of the things that we talk about in these podcast, it is so important for you to control the things that you can. Understand that there are things that nobody can control, whether it be US markets, international markets, the strength of the dollar, what’s going on in Washington. We’re not going to be able to control all of that, and yes, it will impact markets.

At the end of the day, the most important thing is to control how much your portfolio experiences the risk that comes along with all that drama.

Eric: Well said.

Patti: That’s it for today’s show. Thank you so much for spending some time with us. If you want to learn more about bear markets and recovery, just head over to our website. That’s at keyfinancialinc.com. You’re welcome to schedule a call with me and with Eric.

By the way, Eric, thank you so much for joining me today. I don’t know about you, I had a lot of fun. You always lighten up these really heavy subjects.

Eric: Patti, thank you. Thank you the audience out there, all of you folks that are tuning into these podcast, and hope you continue to do so, and we bring you ideas that are interesting and relevant.

Patti: By the way, be sure to hit the subscribe button if you liked today’s episode. Be sure to turn on notifications so you don’t miss a single episode.

Eric: Feel free to like it two or three times. [laughs]

Patti: There you go, absolutely. If you have any comments, or if there’s a subject that you want to hear about, let us know. We’re doing this to hear from you. To make sure that it’s making a difference in your life.
Until next time, I’m Patti Brennan. I’ll see you in the next episode.

Ep6: What To Do When Crisis Hits

About This Episode

In this episode, Patti shares the story of a family medical emergency that, by sheer luck, did not end in crisis…or worse. Crisis can happen at some point anyone’s life. Patti will offer actionable steps to make sure that if it does happen, it will not cause financial ruin and more importantly, she offers specific examples of what to do to avoid these potential financial landmines altogether.


Patti Brennan: Have you ever been faced with a situation that you weren’t prepared for? Typically, in our financial lives, financial difficulty and family hardship usually come from one of two sources. It’s either a slow leak or an unexpected event.

Let me give you an example of something that happened in my own family. As you probably know I have four kids. My youngest, Jack was skateboarding one day. Ed and I happened to be up in New York City at a black-tie event.

To make a long story short, I got a phone call from Jack, he didn’t feel right, and I was up in New York City. He was at the house. He was actually going to bed. I sent someone over there. To make a really long story short, he ended up with a traumatic brain injury with two bleeds in his brain and on a ventilator.

Now, I will tell you by the grace of God he was 17 years and nine months old. As this crisis was happening for our family we were able to get the information from the hospital. We were able to find out what the diagnosis was and the fact they were going to medevac him to a hospital in Philadelphia. We had to get out of New York City right away so that we could be at his bedside.

Here’s the point, a lot of us don’t realize that once a person turns 18, they’re adults. The fact of the matter is, if Jack was 18 years old we would not have been able to get any information. We would not have been able to authorize brain surgery if that was something they were recommending. We would have been completely in the dark. I think a lot of us forget about this when we send our kids off to college, for example. Once you do, you realize that the college isn’t going to tell you anything about the kids’ grades. They’re not really communicating with Mom and Dad, even though we are paying the tuition, but it’s because they are adults.

Before you send them off, I would highly recommend, sit down with an attorney or go online. Get a financial power of attorney as well as a healthcare power of attorney so that if that particular crisis hits, and I pray to God it doesn’t for you, but you’ll be prepared that you will be able to get the information that you need so that you can do the things we as parents want to do for our kids.

This also applies for young adults. They’re in their 20’s. They may have jobs. They may have girlfriends, boyfriends. They may even be married and have kids of their own. This is not something that most people think about. It’s not top priority for most young families. I got to tell you, it’s important. It is really important.

With HIPPA these days, these places are not going to release any information even though you might be a parent, you might be married, etc. It’s an easy document. Easy thing to get. Think about who would be primary, who would be successor. It will save so much family hardship at a time when you just don’t need that inconvenience. That’s number one.

Number two, we have a lot of people who are retiring or changing jobs. A couple of things have happened this year that I really want to bring your attention to. When people do that, first of all, a lot of times they have 401(k)s or pension plans, etc. Some people, it’s not everybody is going to roll that over into their own IRA. We’ll talk about that in a minute.

The people that do choose to roll it into an IRA, you’ve got to understand what the rules are, because on two occasions this year even though the underlying 401(k) company were given instructions in terms of who to make the check payable to, that they wanted it to be a trustee-to-trustee transfer.

The 401(k) custodian actually sent the check to the address of record, which most of them are doing these days payable to the individual. I got to tell you, folks, that is a taxable event.

If you’re listening to this podcast and if this applies to your situation, please understand the difference between a trustee-to-trustee transfer and a rollover, they are not the same. Trustee-to-trustee transfer means that there is no withholding. It would otherwise be 20 percent. Also, you can do an unlimited number of trustee-to-trustee transfers in a given year. You’re only allowed one rollover.

The take away from this is, if this is your situation and you’re watching this podcast, make sure that the check is made payable to the new custodian of your IRA. Otherwise, you’re going to be paying a big tax bill come April. That’s number two. The third crisis that often hits families and it’s especially important given where we are in our economy. We’ve been in a season in our economy where unemployment has gone down and down and down and down.

Eventually, the bad news is, that’s going to be over and layoffs are going to start to occur. That is a crisis for a lot of people. First I want to raise the flag and say, “No matter what you do, what your position is, be ready for that potential crisis to occur for you.”

We all talk about emergency funds. Again, depending on your situation you might want to have three months, six months or up to a year in an emergency fund if this occurred to you so that you would be in a position to be able to choose the next position, the next job that you take. That you’re not going to be having to take the first thing that comes along. That’s the purpose of the emergency fund there.

The second thing is to understand the do’s and don’ts. For example, do not, under any circumstances, if you can possibly avoid it, don’t ever cash your 401(k) in. The statistics on this are alarming. 40 percent or more people actually take their 401(k) as cash, pay their taxes pay the 10 percent penalty and move on. That’s really one of the worst things that you could possibly do.

Here’s an idea. By the way, I totally understand that if this is your situation, let’s say you’ve been laid-off. You’ve gone through the severance. Unemployment benefits have stopped and you still got the mortgage payment, the tuition, all the bills that we all have. You might be looking at that juice six figure 401(k) account and say, “You know what? I’ll just take the money out of there. “I’m just going to tell you guys, please resist that urge. Here’s plan B. Instead of taking the money out of the 401(k), leave it in the 401(k). Do not even roll it over to an IRA. As things evolve and as you get your new position, what I’m going to tell you to do is take the old 401(k), roll it into the new 401(k) because hopefully, your new employer will offer one, creating an instant balance that you can borrow from.

You can take out and borrow up to 50 percent or $50,000. You can pull the money out, pay off those credit card bills or that home equity line of credit and then pay yourself back through payroll deductions. No taxes, no 10 percent penalty.

Here’s the point. When crisis occurs, always know there’s plan B. Here’s the point. When you think about crisis, the problem with them is, we’re not expecting them. These three areas are things that have happened to either us or people that we take care of.

Number one, whether adult children or anybody, make sure you have financial powers of attorney and healthcare powers of attorney. It’s an easy document. Just get it done. Number two, for those of you who may have changed jobs, etc., and you’re rolling your 401(k) into an IRA, make sure those checks are made payable to the new custodian. If you don’t, then you could be hit with not only taxes but a 10 percent penalty. After 60 days it’s all over. You’ve missed a great opportunity.

Number three, we have to recognize that we’re in or approaching a new season of our economy. We’ve had unemployment going down. For those of you who are working, no matter what your position is, just be prepared. Make sure you have that emergency fund. By the way, make sure you also have that home equity line of credit and remember, don’t ever, ever, ever cash in your 401(k). Remember, there’s always plan B.

Thank you so much for joining us on the Patti Brennan Podcast. I hope you have a wonderful day.

Ep5: Economic Outlook for 2019

About This Episode

Is America headed for a recession or is this economic expansion part of the typical business cycle? Patti explains what is really happening and what to look for in 2019. Her Chief Investment Officer, Brad Everett, joins her and explains what YOU, the investor should be doing with your portfolio as they both navigate the world markets and how it will be affecting our investment decisions this year.


Patti Brennan: Hi, everybody. Welcome back. This is the “Patti Brennan” show. Whether you have $20 or $20 million, this show is for those of you who want to protect, grow, and use your assets to live your very best life.

With me today, I have Brad Everett. Brad is our Chief Investment Officer. We’re going to break down what’s going on in the economy. Just to give all of you listening today a sense of what stage are we in in terms of this economic expansion and even more importantly, are we headed for recession?

Patti: Brad, welcome to the show. Thanks for joining me.

Brad Everett:: Hi, Patti. Thank you.

Patti:Let’s talk about this thing. We’re hearing it. There’s headlines, recession right around the corner, Fed reserve is tightening, lots of different signs of a late stage economic expansion. Can you elaborate on that a little bit for us and for our listeners? Talk about the four things that we look at when we’re trying to determine what stage we’re actually in.

Brad: I think any analysis like this is relatively crude. I think there’s an infinite spectrum in between the early growth phase and a recession, but I think if you can try to put it into quadrants you can have a little bit of success in trying to figure out what things have worked in the past during similar types of times.

When we talk about late expansion, there’s a few things that we consider that seem relatively obvious signs. The first one would be labor markets tightening. There seems like a real shortage of workers, which can begin to constrain activity. If you can’t find somebody to hire, then you can’t invest, you can’t build your business, and that can tend to slow an expansion down.

Patti: It’s interesting because I’m working and gave a keynote to the Economic Development Council. This is a very big issue for small business owners. They can’t find qualified people to hire. They want to hire people. They can’t seem to attract people either moving into their business or what have you, because there’s just a lack of qualified workers out there.

We certainly are feeling that here in this county and on a national basis.

Brad: Sure.

Patti: What else?

Brad: I think another sign is probably tightening credit. Mortgage credits begin to rise. It’s harder to get a loan. Even parts of the loan process other than just the interest rates seem a little tougher to get a loan. Order rates begin to creep up.

Patti: You know what it is? Banks are getting stingier.

Brad: Sure.

Patti: We’re seeing that as well. Our clients are applying for mortgages. It’s taking longer. They want more information. They’re getting stingier, whether it be for mortgages, for their business, etc. That again is classic late business cycle activity.

Brad: Also, so then in addition to that, the Fed typically will begin to contract, that they’re very forthright with what they are trying to do, what they’re trying to stop, and Fed minutes are 75 pages long. You can figure out what they’re projecting in the economy.

Patti: Exactly what we want to do late at night is read this 75 paper from the Federal Reserve. Yet, it is interesting that in December when they raised rates, the commentary was very, “Look, you’re not going to like it, but we’re going to stay on this path of increasing interest rates whether you like it or not. That’s our job.”

The market reacted so negatively to that, losing in December 13 to 15 percent just on large cap US alone. The markets are very sensitive to what Jerome Powell actually says. Fast forward, what did he say in January?

Recognizing the impact of his words, he came out and said, “You know, I know what I said, but here’s what that really means. Yes, we are looking to continue the interest rate increases and the tightening cycle, but we are still going to be data dependent. We’re taking a flexible approach.”

The market went nuts. It’s exactly what the market wanted to hear. “Hey, listen, don’t push us in this box. Don’t put us into a recession.” The Federal Reserve doesn’t want to put us into a recession. What their mandate is, two things, number one, their mandate is full employment. Well, we certainly have that with an unemployment rate of 3.7 percent.

Control inflation. Inflation is below two percent. That’s their two mandates. Guess where we are? We are also at a period of still historically low interest rates. Since they seem to have the buffer of they’ve solved the problem, we’re where they want us to be. They’re increasing interest rates.

I think that people felt much more comfortable that he was going to take a flexible approach to that whole thing.

Brad: I think as a sleep aid, too, it is nice in the sense that if you can get through one or two pages a night before you fall asleep, by the time you get through one version, the next one will be out shortly after you finish that.

Patti: Absolutely. We’re waiting with bated breath, that’s for sure.

Brad: It’s exciting stuff.

Patti: Then last but not least…

Brad: You finally start to see pressure on earnings growth. That is not yet, but I think when you see the fourth quarter numbers come out, and it’s certainly most analysts do expect that in the next three to nine months to start seeing not declines in earnings, just slower growth, not the same high growth rates that we’ve seen over the last few years.

Patti: I think it’s important for our listeners to understand that the growth is measured year over year. Embedded into 2018 was this wonderful tax cut for corporations that actually helped their earnings. It helped those comparisons. Compared to 2017, wow, that was terrific earnings growth!

Once we get that 2017 out and now we’re comparing 2019 to 2018, we may not see that double digit earnings growth. It still doesn’t mean that those companies are not good companies to invest in because there’s still some growth. It’s just might not be as fast as it was before.

I think that that’s important to keep in mind, that there was that fiscal stimulus in all of this that helped things along. The goal there was to extend the economic expansion that we’ve been enjoying for the last 10 years.

Brad, as a chief investment officer, we take all of these things in. If we believe that we are in the later stages of this business cycle, what do you recommend for the people that are listening today?

Brad: I think it’s never the same for everybody, I guess, first of all. We look at it on an asset class basis. Some things aren’t going to matter to you because that’s not something that’s in your portfolio, and it’s not an appropriate investment.

We look at it on a broad asset class basis. What does this mean for bonds? What’s it mean for US equities? What’s it mean for alternatives? What’s it mean for international investments and go that way. To think about what it means for bonds, a rising interest rate environment does not mean that you should avoid bonds.

If I remember correctly, the Barclay’s Egg has actually only been negative four times since 1980. A bond is a total return investment, so as long as you’re receiving income and coupons.

Faster than the value of the bond itself is declining, you can still have a positive rate of return. Bonds are not something you need to avoid. I think for us, this is a time to be shorter duration, higher quality.

The effect of a change in rates is far more drastic to a longer term bond, so we want to stay short. Especially for people that have the money set aside for spending, we want to go much higher quality. If there is a lot more volatility in the stock market, high yield bonds often can almost act more like an equity investment than a bond investment.

I don’t know that the extra yield that you can get from a high yield poor quality bond can give you enough to offset the downside. If the S&P goes down 20 percent, I don’t think high yield bonds, they’re not going to save you from that and they’re not going to be a safe haven during that time.

Patti: Let’s go back to something earlier you said about duration. For our listeners today, let’s define that so that they can wrap their brains around this. It’s a neat kind of simple and easy way to determine how much risk are you actually taking with that bond or bond fund? Let’s define it for them.

Brad: I think duration, there’s a few different ways to measure it. We think of it as a weighted average of when you’re going to receive the money. To use an extreme example, if we had a bond that matures in a week from now for $100, I don’t particularly care what the interest rates are in the economy because I’m going to get my money in a week.

If the bond doesn’t mature for 100 years and interest rates go up, there are going to be a flood of new investments that will look very appealing compared to this old one I have at the old interest rate. I’ve got to sit with that one for the next 100 years.

The value of that could drop significantly, so there’s going to be pressure to sell that and to buy the new one at the new higher interest rate. You would tend to think that longer duration bonds would preferred stock to it can affect preferred stock in similar ways would be much more volatile in times of changing rates.

Patti: Basically, duration, to narrow it down, it’s a way to determine the sensitivity of that bond or bond fund to rising interest rates. By definition, give or take a little bit, but basically for every one percent rise in interest rates, a bond will fall by its duration.

Let’s go through a real example. Let’s say that you’ve got a bond that’s paying three percent. Let’s say the duration is five. The price loses five percent but remember during that year, you got three percent interest. Your total return on that bond is 2, not 5. By shortening the duration, if you got duration of two, and you’re still getting your three, you’re actually getting a positive return.

Brad: You’ll still capture that same three every year for the next five, as long as you continue to hold it.

Patti: That’s the other thing. That is the other part of duration. Just because it goes down one year, you’re still getting that interest every year that you continue to hold that bond or bond fund.

It gets a little bit trickier when you’re talking about ETFs and bond funds. The goal or the hope there is if you choose to have professional management that you’re having those professionals manage duration, manage the risk of that bond portfolio so that you won’t be subject to as much volatility.

Or conversely as we’re going to learn in a minute, sometimes you want that higher duration. Especially after we go through that tightening cycle, you think it’s close to done or you’re done, that’s often a good time to extend that duration, right?

Brad: Yeah. Lock in to a higher coupon for as long as you can.

Patti: Exactly. That’s terrific. We’ve talked about the bonds. We can scale back on the riskier asset classes, go shorter duration, higher quality, etc. That’s especially true for people who are receiving distributions retirements, etc.

One thing I don’t want anybody to interpret or hear in this. We are not changing the asset allocation of the total portfolio. If your goal or if your financial plan suggests that you should have 10 percent in cash, 30 percent in bonds, and 60 percent in various types of equities, that ratio stays exactly the same.

What we’re trying to do is within each of these asset classes, reduce the risk during the later stages of economic expansion. Again, I’m saying that as if it’s a fact. It is not a fact that we are in a last stage of this business cycle. We just want to frame it within that context of, gee, we’ve just gone for a terrible bear market of a loss of 20 percent.

The market is a leading indicator trying to anticipate what’s going to happen in the economy in the next 9 to 18 months. Keep in mind, everybody listening, the market is not always right. Just keep that in mind.

Let’s talk a little bit about, gee, if we’re in the later stages, 10 years into this thing, what are we doing on equities? What should be people begin to think about as it relates to their stock funds.

Brad: There’s arguments to be made on both sides for stocks and they’re valid. That’s how the market has gotten where it is because there’s 50 percent of the money on the one side of the price, and 50 percent on the other side. You can see a lot of the negatives. Volatility has begun to return to the market. Again, like we talked about before, there’s expectations for fading earnings growth.

There has been, despite the lack of workers, surprising lack of inflationary pressure on wages. But if that does arrive, companies would again…It almost feeds itself. If you can’t find employees, then you have to pay them more. As you’re going into this late stage recessionary cycle, now your profit margins are lowering because you’re having to pay employees more and things like that. That can feed on itself.

The other thing that works against the stock market now is for so long, there’s not really been a compelling alternative to stocks anyway. Would you consider cashing out something that had a three percent dividend in order to put it at the bank and earn a tenth of a percent? I think stocks had a staying power there just because there was very little appeal to investing in anything else.

That’s not true anymore. If you can find a short term bond fund that pays three percent, then maybe you consider just taking the yield and taking the volatility out of your portfolio. There are compelling alternatives that begin to arise as interest rates begin to go up again.

Patti: It’s really interesting because we saw that through 2018. That came through in terms of the trading volumes on a day to day basis and the volatility. In 2018, for example, the stock market rose or fell by one percent 84 times last year. Just to give you a feel for how much that is, in 2017, it did that only six times.

Volatility, up or down, has definitely increased because people are trying to figure out, gee, where should I be? They’re restructuring portfolios. Again, understand that this is a lot of traders, not necessarily investors. You don’t want to necessarily make your portfolio decisions based on what traders are doing, because they’re being paid to trade.

You’re an investor. The most important thing is let the financial plan guide you in terms of how your allocation should be and some of the decisions that you might make, if we are in fact in this later stage cycle.

Brad: I think there’s a difference in incentives there too. The traders probably got a time horizon of 30 seconds to 10 minutes in a lot of cases. That’s just not the case for most people. They have certainly a different trading pattern and incentive to act.

Patti: There are certain sectors within that 60 percent again, just using that as an example that are a little bit more resilient during this period of time, aren’t there?

Brad: Yeah. On a whole sale basis, we have definitely made shifts from more volatile growth oriented stocks to value…

Patti: Folks, if you were watching us today, I’m knocking on my head because we got really lucky there. Did that earlier in the year only to see that large growth stock like Apple. I don’t know if you hold Apple. If you have Apple, you watched your stock, your holding, fall by 40 percent. That’s a lot more than the overall stock market lost during this period of time.

The GOGO stocks, they go, go, go, but boy when they fall, they fall like a rock. By shifting a little bit less…Again, we’re not talking all in or all out. We are talking tweaking and reallocating. Taking those gains. Yes, you have to pay your taxes, but I think that’s what you’re supposed to do, right? Sell high?

Brad: That’s the goal, yeah.

Patti: What do you think?

Brad: The goal to investing is to make money, right?

Patti: You got it. OK. That’s good. Defensive sector. Let’s define for people who are listening. How do we translate that?

Brad: It’s interesting. There’s a couple of ways to think about it in what are the things that are still necessary? Not necessary consumer staples. I think that’s almost even more necessary than what we’re thinking. But when times get tough, you find that discretionary spending would drop. What are the things you still need? You need energy. You need to buy toothpaste still.

Patti: Utilities.

Brad: You can’t give up brushing your teeth just because the stock market’s down five percent.
Patti: Don’t tell Lily that, right? [laughs]

Brad: I know. No kidding. We want to drift into those staple sectors that have shown a lot of resilience. I think valuation matters too. Some things will arise as just being cheaper relative to what they had been in the past. That makes it more attractive too, and a valuation comes into the sweet spot where you’re ready to invest again. Energy is one of those things for sure.

Patti: Certainly. If you just take a look at the broader bases after the 20 percent loss, P/E ratio on the S&P 500 went down to 14.1. Anybody who is an expert in this area would say, “Hey, that’s pretty low.” It’s probably undervalued if average is about 15. It’s not dirt cheap, but it’s certainly not overvalued by that measure.

Other areas that got especially hit before that were underperforming significantly were small cap stocks, especially value, small cap value. They got hit especially hard prior to this. While they certainly took it on the chin as well, it does present some interesting opportunities. Again, if you buy low and it goes lower, it’s OK because you didn’t buy high and watch it go lower. Does that make sense?

Brad: Yeah, absolutely.

Patti: That’s the key here in managing and taking a fresh look at the portfolio. What about international?

Brad: Sure. The case for international has actually been relatively strong for a while. We just haven’t seen it, as US investors we just haven’t seen the returns. I guess there’s two components to your return if you’re investing in international stock. One is the return in the local currency. What did someone who lives in Japan earn on their Japanese investment.

The second component is bringing the money back in the United States. For you to actually sell your investment, you have to get your investment back in dollars. You have to sell yen and buy dollars. That currency return can be a pretty significant portion of the change in the value of your investment.

At the beginning you sell dollars to buy yen. Let’s for a year, you invest in a Japanese company. At the end of that year, you have to sell your yen and buy dollars again for you to spend it. That currency change can be a pretty significant one.

Patti: It’s interesting because when you look on a worldwide basis, the US has been the one economy that has been growing. The other economies, they’ve also been growing but not at the same rate. That can have a significant influence on the value of the dollar because people want to invest in the area that is actually growing. That’s definitely a factor.

What’s really fascinating is to look at the different periods of time when international has outperformed versus the US and the amount of the outperformance that is attributable to the currency. It’s fascinating.

Brad: Yeah, can be a lot.

Patti: If we take a look at the seven cycles since 1970, it’s pretty interesting to see. First of all, in each one of these silos, the outperformance they’ve changed hands. One period of time it’s the international, then the S&P outperforms, then the international, then the S&P. Literally, they trade places in each particular period of time.

What I think is also fascinating is the amount of the outperformance that’s primarily attributed to currency. It can be, for example in the ‘70s, the outperformance on international was 48 percent of the result. If we go back to…Let’s look at the S&P 500 during the ‘80s. That was 90 percent of the outperformance just had to do with the dollar strengthening.

We have got to keep that in mind as we’re looking at the international investments. For those of you who are listening at home, does that mean that we want you to study the dollar, to study the currency and pick only those areas where the US currency is going to start falling relative to that particular local market? The answer’s no.

We don’t want you to be doing that. It’s just bringing up that to the surface. Letting that bubble up and understanding that it is a factor in how these investments perform. Just because the international hasn’t performed as well in the last 10 years…

By the way, the underperformance is significant over this time period. As of the end of 2018, the international markets as measured by the world index was up 90 percent. Not bad for 10 years, right? But the US was up 271 percent. That’s a significant outperformance.

Here we talk about diversify, diversify, diversify. We add that into our portfolios, and yet we’re doing it and it’s just pulling away, reducing the returns. We all know that eventually these things will trade hands, and you want to have something in there to add a little bit of a turbo charge to your portfolio.
Brad: The tough thing is that I guess this is another form of market timing it’d be tough to figure out, especially with currency, when will the cycle change? We’d expect at some point, there will be some significant amount of time where international stocks outperform the US, but when that begins and when it ends is pretty tough to figure out.

Again, we always want to have access to both and have investments in both. Again, like you said, you were just tweaking back and forth in minor amounts to try to take advantage of where we think everything falls.

Patti: Excellent. Let’s talk about the trade deficit, because that does have an impact on the international, etc. We’re talking about trade, and the tariffs, and all of this. Our president is really concerned about the imbalances that have occurred over the years, especially with China. How does that impact all that? What creates the trade deficit? How concerned are we? What should we be doing about it?

Brad: That’s just one of the other things that can affect the value of the dollar. We just have to think through this equation, for some reason very unnatural to me. If we’re exporting more than we’re importing, then the dollar is going to rise in value because people need to buy dollars in order to buy our goods. The opposite would be true if we’re net exporting.

The tariffs. This is probably the thing that would cause the direction of US and international stocks to go one way or the other. We don’t know how it’s going to turn out, but that could be the dominating factor of the next relatively major market move. That’s the thing that’s on the horizon that’s so unclear. It affects a lot of things. Like long term business investments, things like that.

Politically, it matters. Jimmy Carter, probably the last person to try to get reelected during a recession, and it did not go well for him. You get reelected based on economic strength, other than a few other things, like wartime or something like that. But for the most part, you need a strong economy as you’re going into reelection.

China needs it too. They’re further along this process than we are. Probably more in a recessional period than we. There’s certainly incentive on both sides to get it done. It’s easier to start a war than to finish one.

Patti: Boy, is that the truth. We have got to be really careful, because as this thing takes on and continues, etc., it is those tensions between those two countries. It’s pretty scary. The one thing that is classic and textbook is that tariffs can definitely cause recessions. It can cause slowdowns, and it’s bad for the entire world economy. One way or the other, they have got to get it solved.

For those people who are concerned about some of this stuff that China has been doing, there are legitimate concerns about the fact that China has been cheating a bit. It’s hard to do business in China. You run the risk that the government is going to take over your company whether you like it or not. You’ve invested billions and billions of dollars.

I just had a pharmaceutical executive in. They were looking at starting operations over there. They decided not to for that fear. Sure enough, a competitor did. Opened operations in China with a particular division. Within a few years once it was up and running billions of dollars later, the Chinese government took over, and they were SOL.

It is a concern. Something does need to be done. Hopefully, the two sides can come together and figure it out.

Brad: Even the greater effect that I’ve heard than the actual price of the level one cost of the tariffs, it was one of Fidelity call. They use the example of the iPhone 15. The tariffs change very little the phones that are for sale now and what’s in the pipeline.

But when you’re looking that far away, how do they make the plans for their development not knowing what all the components are going to cost? They can’t lock in the long term contracts to do things like that. The real cost is in the business development that was never undertaken.

Patti: That’s the thing that is very difficult to measure. What would Apple have been able to launch if this wasn’t going on at this point in time? It’s like all decisions, it’s a wait and see. You do that for six months, a year, two years, etc. You’re not going to get your iPhone 15. It really undermines innovation and undermines progress if it lasts too long. It is a fine balance.

When we take a look at the overall… We often talk about the impact of a president. Typically, a president does not have really that much of an impact on either the economy or the markets. This is an unusual period of time where we’ve got someone who is very visible and is tweeting, and things of that nature. It does seem to be affecting sentiment.

That level of uncertainty that is typical in the contraction of the economy. People just not knowing what we’re really dealing with and deciding, “I’m just not going to make any decision. Let’s just wait and see how this thing plays out.” That will definitely undermine confidence and what people do. Therefore, it affects the stock market. It affects the bond market as well. Everything.

Brad: In a lot of ways, the president is like the chief public relations officer for the country. That’s his influence on, like you said, sentiment, the feelings, consumer confidence, things like that. But the business cycle will last three or four presidents.

Patti: That is a really good point. Just because this thing lasted 10 years doesn’t mean that it has to be over. We look at Australia. Australia has had 26 years of growth. They have not had a recession at all. Just because it’s lasted for 10 years doesn’t mean that it has to be over, which is I think the most important takeaway.

We can talk about all of these things, but the most important takeaway is nobody really knows where we are. For those of you who are uncomfortable, we got our bear market. It happened. Hopefully, we run that excess out of the system and we can look forward to better times ahead.

I think that for those of you who are listening, let’s wrap this up for everybody, Brad.

I think there’s three takeaways three key takeaways. Number one, don’t panic. Just because we could be closer to the end, it’s not the time to be changing your overall investment policy, your asset allocation.

We were talking earlier, and you mentioned David Kelley’s comment. Why don’t you tell listeners what his comment was about the light switch?

Brad: [laughs] We try not to think of investing as a light switch that you turn on and off. You don’t just decide that you’re all in on equities or all out on equities. It’s a series of dimmer switches where you fade one way, fade another way.

You fade a little bit between geographical regions. You fade a little bit between market caps. You fade a little bit between different sectors and things like that. You need to participate. The money that you need in three months probably shouldn’t be in the stock market anyway.

This is all for things that with a much longer investment in mind than any single piece of news that you’re going to hear tonight on the news or any headline. These are all things that are for way down the road. We’ve had terrible times before, and there’s always a disaster on the horizon.

The stock market has steadily ticked up over the decades. I think that’s what we want to keep our eye on. If you need the money shorter than that, then let’s think of something else to put it in.

Patti: OK, everybody, so the three key takeaways, first of all, Brad Everett, thank you so much for joining us today. I think it was a great, important, timely conversation. Three takeaways, number one, don’t panic.

Number two, remember the light switch and the dimmer. It’s not on and off. You want to fade one way or the other. Last but not least, just because we’ve been doing this for 10 years, we’ve had this wonderful expansion, doesn’t mean that it has to be over any time soon. Remember Australia.

That’s it for today’s show. Again, thank you so much, Brad, for joining me.

Brad: Thank you, Patti.

Patti: Thank you all. Thank you all for listening to us today. It means a lot that you tune in, spend 20 or 30 minutes with us hearing about these different subjects because we do this for you.

Number one, I do think it makes us better. It helps us to zero in on the things that we believe are important. More importantly, we want to make sure that it’s helping you. If there’s anything else that you’d like to hear about, definitely go on our website, send us a message, say, “Hey, Patti and Brad, can you talk about A, B, or C?”

Sometimes we can, sometimes we can’t. We’re going to talk about the things that we believe we’re experts at, where I believe that we do real financial planning, which might include portfolio management, risk management, how to put your kids through college, making sure that you never run out of money for the rest of your life.

That, to me, is real financial planning. The things that we’ve talked about today are things that give us the tools and the intellectual capital to help make decisions that are right for you. Again, thank you so much. I’m Patti Brennan, and we’ll see you in the next podcast.

Ep4: Headlines and Havoc

About This Episode

In this episode, Patti and Michael Brennan discuss how to differentiate the “noise” from the “substance” in today’s headlines. We are living in an era of information overload and newspaper headlines are designed to inspire reaction. Patti and Michael share some alarming headlines that are aimed at inspiring action, while explaining why reacting to them, is the last thing a listener or a reader should be doing!


Patti Brennan:  Hi there. Welcome to the “Patti Brennan show.” Hey whether you have $20 or $20 million. This show is for those who want to protect, grow and use your assets to live your very best life. Joining me today is Michael Brennan. Michael, thanks so much for coming on the podcast this afternoon.

Michael Brennan:  Thanks for having me.

Patti:  We’ve got an interesting topic, don’t we? It is called “Headline Havoc.” Let’s talk about that a little bit. The amount of financial news that’s published these days is staggering. Even if it were to go down by 90 percent, it would still be overwhelming for most people. How do we distinguish the signals from the noise?

What’s useful versus what’s just distraction? What’s just mediocre? That’s the real question.

Michael:  Right. It is almost never a look in the part, filtering it all takes a lot of time and effort. This is especially true with an always on real‑time news cycle. There’s extreme competition for eyeballs and attention from all over the place. We have journalists, we have blogs, we have massive information overload.

Patti:  They’re in business. They’re in business to get eyeballs. Right?

Michael:  That’s right. Today, just looking at the Yahoo finance earlier today, there’s quarterly reports. There’s economic reports. There’s upgrades, downgrades, fed minutes on and on and on.

Patti:  You know what? It goes according to the formula. If it bleeds, it leads. It’s like the tabloids. Simplify then exaggerate. We know that fear sells. If it’s uncomfortable, if it’s a topic that people think, “Oh my goodness, I better listen to this otherwise, I’m going to lose…” fill in the blank. Pay more money taxes, lose money.

Whatever the case might be, they’re going to really pay attention to that particular article or show.

Michael:  To their own detriment, they pay attention to that. These headlines often stir emotions and make people want to change their investment strategy. That is no bueno. These different headlines as you said if they bleed they lead, they do have the potential to cause these knee‑jerk reactions, which negatively can affect their investment returns over the long run.

Patti:  Exactly. Think of them, for the most part, they’re going to be distractions. We call it Headline Havoc. Let’s take that to another level.

Michael:  All of these discussions got me thinking. If even I have a difficult time sorting through the noise of the financial news, can you imagine how confusing it must be for regular investors? Plus, today I feel like people don’t really read the news. It’s really all consume through headlines.

With that, I have created a little exercise here I want to do with you and have aptly titled it “Headline Havoc.” How it is going to work is I’m going to read a headline and I want to know how Patti Brennan, the financial advisor interprets that headline. I want to know what goes on in between the ears of a financial advisor like yourself.

For example, I’m just going to do this one real quick by myself. For example, headline “Stock Markets Enters Painful Correction.” My interpretation of that headline, “Hurray, stocks on sale. Retirement savers rejoice as stock prices fall. [laughs] Those with time to save and money to invest should hope it continues.”

Patti:  That’s exactly the way you would want people to interpret that headline or to respond but that’s really not the way most people. It’s human nature to say, “Oh my goodness, what’s going on? What do I need to stop?”

Michael:  With that, let’s give us a shot here.

Patti:  OK.

Michael:  Headline, “Popular Economist Expects Market Volatility to Pick Up Later This Year.”

Patti:  My response to that would be saying you expect volatility to pick up at some point in the future is saying you expect it to rain at some point in the future. By the way, it works both ways. Volatility is to the upside and the downside. Basically, what we’re saying here in this headline is markets are going to fluctuate. OK, what else is new?

Michael:  Right. [laughs] I like that analogy. Today, it seems like everyone’s a market weatherman. Relying on these experts could result in either being caught outside in the rain or maybe even worse, caught inside during a beautiful, sunny day.

Patti:  Remember, even rain is important.

Michael:  Of course. Here we go. Headline, “George Soros Lost $1 Billion.”

Patti:  OK, guys, George Soros is worth about $25 billion. What he does with his money really shouldn’t concern you and I.

Michael:  Headline, “Markets Got Slaughtered Today ‑‑ A Sign of Worse Things to Come.”

Patti:  Here’s the deal. Nobody really knows why stocks go up or down in a single day. Everybody’s going to give their opinion after the fact. Really, ultimately, nobody knows why it does one thing or another. Stocks go up half the time, stocks go down half the time. Just keep that in mind as you’re listening to these people or reading these headlines.

Michael:  Headline, “Investors are Dealing with More Uncertainty.”

Patti:  Again, here is where I go. OK, the future is always uncertain. The past just feels more certain because we already know what happened.

Michael:  God point. Like Sir John Templeton says, “I don’t know the direction of the next 1,000 points. But I do know the direction of the next 5,000 points.”

Patti:  Exactly. We’re going to go through these ups and down, etc., just stay focus on the long term and you’ll do just fine.

Michael:  Here’s a layup here for the Patti.

Patti:  All right. [laughs]

Michael:  Headline, “Are Markets Overbought Here.”

Patti:  I have no idea. Ask us again in a few months.

Michael:  Next. Headline, “The President Cause 15 Percent of Stock Market Growth This Year.”

Patti:  Here’s the deal. News alert, everybody, presidents and political parties don’t really control economies or stock markets. We have an adaptive system called the US economy. Things don’t just come with levers that you can pull like you do with the polling booth. There’s a lot that goes into what makes up the economy and how markets are responding.

Michael:  Headline, “Inflation Could Cause Gold to Rise More Than $1,500 an Ounce.”

Patti:  That’s a total guess. No one really has a clue.

Michael:  [laughs] Headline, “Is This the Stock‑Picker’s Market We’ve Been Waiting For?”

Patti:  Here’s the deal. It is and always will be a stock picker’s market because it all depends on the ability of the stock picker not the market. Stock pickers theoretically are going to make money in all kind of market environments. That’s the definition.

Michael:  Headline, “Goldman Sachs Expects Stock to Rally for the Next Three Months.”

Patti:  These big firms have lots of strategists and experts. Boy, one week they’re saying one thing and the other week, they’re saying something else. You can’t even believe how often these bigger firms and it’s not just the bigger firms. It’s the contradictory pieces that come out even from the same entity.

Michael:  Headline, “When Will the Fed Raise Rates?”

Patti:  Has the Federal Reserve, do you happen to know who Jerome Powell is? Is he ultimately going to help you make better investment decisions? No offense but he doesn’t know who you are. Why are you making investment decisions based on what the Fed does?

I understand we have all been programmed to think that the Federal Reserve ultimately determines whether we are in an expansionary period or we’re going into a recession. But really, nobody really knows. In fact, they don’t even know.

In December, in January, they basically went from “We are raising rates three times in 2019” to “Hey, you know what? That’s not cast in stone. We’re going to take a thoughtful approach. It’s data dependent. We’re going to be flexible and really do what we believe is best.” They don’t even know what they’re going to do.

Would you actually change your investment policy based on something that they don’t even know?

Michael:  Right. Even if we did exactly know what they were going to do in the future, we still have no idea how the other investors are going to react. It’s all really a crapshoot.

Patti, there’s just a couple more so then we can take off the hot seat. Just a couple more to get through here.

Patti:  I’ll tell you what. This is an easy. Thanks a lot for putting me on that hot seat but it’s what we do every day, right, Michael? It’s just we have to respond to what’s out there to help people understand that just because you read it in the newspaper doesn’t mean that they need to do anything about it.

Michael:  That’s exactly right. Headline, “Investors Panic as Stocks Enter a Bear Market.”

Patti:  Investors aren’t always right. Stuff happens in the markets and we’ve got to be careful not to react to something that might be happening a day or two.

Michael:  Headline, “A Perfect Storm Caused Markets to Fall.”

Patti:  It sounds really important. That sounds really important narrative. A hundred years’ storm now seem to come around every once a month or so. Again, it’s a headline. They’re grabbing eyeballs.

Michael:  Got you. Headline, “Expert Who Predicted the Tech Bubble Predicts a Market Crash Worse than 1987.”

Patti:  There are some people who make a living out of predicting. These terrible perils in these times of huge losses. Literally they’re called permabears. Eventually, they’re going to be right. They just keep on doing it until they’re right. Just be really careful, understand who is the person that’s actually saying that, what did they say five years ago in the midst of a secular ball market.

Michael:  I love this next one especially because I see it at least twice a day. Headline, “The Top 10 Best Stocks to Own Right Now.”

Patti:  My initial response to that, Michael, is here’s 10 random stocks. We think they could go up for reasons we have absolutely no idea. It’s catchy.

Michael:  Right. It reminds me of the “Cosmopolitan,” or the men’s health journals that we read. “Six Tips to Rock Hard Abs in Six Minutes.” It doesn’t work like that. It’s not going to happen.

Patti:  Exactly.

Michael:  Headline, “Investors are Cautiously Optimistic.”

Patti:  The way I look at that is that’s the journalist who’s basically saying, “I got nothing to write about so I’m just going to write this and add a little bit of fluff.”

Michael:  Got you. Two more then we’re done. Headline, “Earnings Growth is a Second‑Half Story.”

Patti:  It’s interesting. Nobody really checks on these predictions to see whether or not the second half of the year really did turn out that way. It’s easy to predict stuff when you’re not being held accountable.

Michael:  Final headline is “Fill in the Blank Hot Stock Du Jour a Buy Here.”

Patti:  I’ll never forget I was at a meeting one time. There was a money manager on the stage and I’ll never forget what he said. He said, “You know, I just want you to understand that when I get a phone call from a journalist and they’re asking me what stocks I’m buying or what do I think is a really great investment right now.”

He said, “This happen to me a couple of years ago and I gave him that one stock that I would buy right now. By the time they did their checking and their writing, etc., and they actually published it in the magazine, it was nine months later.” He said, “The thing about that was nobody called me nine months later to say, ‘Is that still the one company that I would invest in now?'”

“They just published the article.” Be really careful when you’re acting upon headlines like that. You don’t know when that person might have said it.

Michael:  That’s it for Headline Havoc. Thank you so much for participating in that with me, Patti. With all of that being said, I have one final question for you. If what we’re saying is a lot of these headlines are really nothing more than noise, what type of headline really gets your attention.

Patti:  There is a lot of good stuff out there. Again, we’re just talking about some random headlines that are out there. There are great periodicals, great magazines, great newspapers that really provide good content that has been fact‑checked, etc. I read four to five newspapers every morning before I even come into the office.

Papers like “The Wall Street Journal,” “The New York Times,” “The Philadelphia Inquirer.” There are really gifted writers who are trying to give real information. By all means there is good content. I would say that I would really pay attention to headlines that say congress is eliminating state taxes. That’s one that I’m going to put aside, highlight, underline, and want to dig a little bit deeper.

Things of that nature that are actually relevant and also actionable. That’s something that I need to pay attention to because it does impact our clients. We can be proactive when it comes to things like that.

Michael:  In conclusion, maybe we can just go over a few quick tips that readers could keep in mind when going through the morning papers. For starters, I would say avoid reading things that confirm what you already have theories on. It’s what we call confirmation bias.

Patti:  It’s a good one, Michael.

Michael:  It’s what occurs when you start with a theory or an answer and then you dig for information that backs it up. It’s really dangerous because once your find someone else who agrees with you, you become more convinced that you’re right.

Patti:  Actually, you might want to think about doing the opposite. It’s a Charles Darwin approach who basically went out there and tried to disprove his own theories. At worse, you can continue to disagree with it but at least that way, you’ve gotten some perspective in terms of what you’re thinking about and why you have that particular opinion.

Michael:  You know what else will give you that perspective? Reading old news. I know it sounds a little crazy but if you read enough old news and headlines, you quickly realize two things. The majority of predictions never come close to being true. Most of what we think is important news is really trivial in the long run.

Once you become convince of this, you react differently to today’s newspaper. One more headline, I know I’ve said we were done but I have one more. Take this headline from August 2011. “Dow falls 502 Points and Steepest Declines Since ’08 Crisis.”

Patti:  You know what, Michael? That’s really a good example. Guess what? That wasn’t a bad prediction. It actually did happen and it felt like such a big deal at that time. I remember it like it was yesterday. Fast forward, the Dow Johnsons regained all of its loses and then some. What seems so monumental at that time is irrelevant now.

You only get that perspective in hindsight. I love your idea of looking at past predictions and see how we’re feeling about those things today.

Let’s pull this together. In conclusion, we want to be wary of these scary financial headlines.

As always we want to focus on the long term. You’ll hear that time and time again. You don’t want to change your asset allocation or react to something just because something got published in the paper today. You don’t want to have any impulsive changes. If you have a goal that changed, yeah then. Absolutely. That might be when you make adjustments.

Don’t do it based on someone’s article or an opinion piece.

Michael:  Bottom line, know your goals, know your time horizons, and don’t trade too much. Don’t think every news story is actionable. There are thousands of news articles published every day. Very few of them, if any, should ever compel you in action.

Patti:  Michael, I can’t think of a better way to conclude today’s podcast. Thank you so much for joining me today. I think that was a unique look at the newspapers, the news, etc. Again, thanks for being here today and that’s it for today’s show.

Michael:  Thanks for having me. I really appreciate it and also huge thanks and shout‑out to Ben Carlson and his blog, his books, “A Wealth of Common Sense.” If you guys, if you listeners want some great sources to get your headlines from, Ben Carlson has some really great stuff.

Patti:  I’ll tell you what I get his stuff every day. He is such a thought leader in the industry, well worth it. Michael, thank you so much for joining me for today’s show. We wanted to have a little bit of fun with the headlines and the Headlines Havoc, and what that tends to do to people and their emotions. Again, as always don’t necessarily act on that.

Thanks again so much for tuning in to this podcast. Be sure to hit the subscribe button if you like today’s show. Feel free to visit the website if you have any questions, want additional insights. That’s what we’re here for. Also, again, as always if you have ideas of things that you’d like to learn about, let us know. That’s what we’re here for.

Until next time, I’m Patti Brennan. Thank you so much for joining us today.

Ep3: Man vs. Machine

About This Episode

In this episode, Patti Brennan and Brad Everett discuss the pros and cons of robo-advising and using online financial calculators. There are many pros and cons to using these online tools – so why and maybe more importantly, when, is it the right time to seek out a professional? Patti and Brad use their years of experience, combined with real life examples, to help answer these questions.


Patti Brennan: In this episode, we’re talking robo‑advisors versus human advisors. What are the pros and cons of each one? Let’s just really look at it down the line. With me today, I have Brad Everett. He’s our chief investment officer.

Brad, what do you think about this subject, robo‑advisors versus human advisors?

Brad Everett: There’s certainly a valid case for each. Maybe, I wouldn’t think of a robo‑advisor as a full advisor. They can be great for single‑goal projects, things like that. If you were 22 years old and you want to retire in 40 years, I don’t doubt that a robo‑advisor can give you a great allocation.

Your job at that point, at that point in your life, is to save as much money as you can and be aggressive. I don’t think that a robo‑advisor would have trouble guiding you to that goal. From there as you get older and you start to have competing goals, goals that, maybe, you should go in one order or another, accomplish this before you do this.

If you do this, you might not be able to do this anymore. That would probably require a human advisor that can help you prioritize those things, help you see which ones might conflict with the others.

Patti: It’s like to your point, when people are first starting out, the most important thing is just start doing something.

Brad: Just participate.

Patti: Just participate. Get in there. You don’t necessarily have to over‑complicate things. I think that sometimes can negatively affect people, where it gets so overwhelming. Just start with something. We often use the Starbucks example when we’re talking with young people.

The old, if you avoid going into Starbucks every day, saving that $5.48 a day, that adds up to about $2,000 a year. If you invest that money at about eight percent, that person who just decided to make coffee at home that morning will have $675,000 more money than the person who stopped at Starbucks.

Those little things can add up to a lot, and it can make a big difference. To your point, you don’t necessarily need a human being there all the time watching and making sure that you’re not stopping and that you’re actually saving that money.

Once you get the discipline, and you get started, and you get in the habit of putting that money away every month, you just get used to it. You want to do it. It feels uncomfortable when you’re not seeing that account growing.

Brad: You’re not going to want to stop. I guess the other side of that too is that you will probably find that your life is getting complicated far sooner than you thought. Your life is really only simple for how many years out of college before you have a kid and a marriage.

You’re trying to then debate whether you fund a 529 Plan, or pay off your own college debt, or save for your own retirement, or buy your own car, or finally get off your parent’s cellphone plan. Those complicating goals show up relatively early.

Patti: It’s amazing to me. That’s a really good point. I have four kids. It’s amazing to me, even with my 30‑year old. He’s looking at buying a house. He’s looking at all of these things and trying to figure out how am I going to do this?

Fortunately, he’s a financial planner so he’s been able to do that. He grew up with this thought process. Again, for those people who don’t have a mom who’s a financial planner, you can start out with a robo.

The advantage to the robo is that it’s cheap, it’s inexpensive, and it just gets you started. There’s value in that. Do you absolutely have to have a robo? Not necessarily, you could actually go and invest in a no‑load mutual fund, stick it in one of the target date funds.

Again, long‑term be as aggressive as you can. Understand that markets are going to go up and down. I think that that’s the most important differentiation is what happens when things go wrong?

Brad: You would definitely understand about yourself. You have enough discipline to stick it out at times like that. A very valuable service that an advisor can offer is to smooth out those emotional highs and lows.

They can explain, and educate, and talk about why this is happening and why it’s happened a hundred times before. A robo can give you an optimal asset allocation theoretically, but it can’t force you to keep it. You could save for 10 years and leave the market at the wrong time.

The robo has no ability to stop you or to protect you from yourself.

Patti: Exactly. I use that phrase all the time. Most of the time, or a lot of the time I should say, what we end up doing for people is just really saving them from themselves because, again, it’s human nature to be fearful.

It’s human nature to say, “Oh my goodness, the markets are going down. I’m going to pull it out, or I’m going to stop contributing.” That’s exactly the opposite of what they should be doing. I think your statistic, the Fidelity statistic, was fascinating.

Brad: About how it seems like clients always seem to add money to the asset class that’s the exact wrong thing to be adding to at the time like chasing returns or investing in an asset class that has recently done well or avoiding one that’s recently done poorly.

You’re doing the exact opposite of…You’re buying high and selling low.

Patti: It’s the rear‑view mirror thing. I’ve been doing this for 32 years. One thing that hasn’t changed is, again, that human nature. You want to be investing in the thing that you think is going to continue to do what it’s been doing the last year or two years, etc.

Usually, that’s exactly the opposite of what you should be doing. That’s where a good advisor can point those things out. Just as those questions become apparent and someone’s asking that, we can show the data to say, “The reason that we’re doing this is A, B, and C.”

Again, nobody really knows, that’s the most important thing to recognize. That we’re all making educated guesses, but it’s the underlying experience, having been through it time and time again that can really make a difference.

Again, starting out robos can be a perfect way to start out, get you in the habit of just saving money, investing in aggressive. Go through a couple of rough spots, but an algorithm isn’t going to necessarily get you to do the thing that’s probably going to be the right thing for you.

When we think about this whole thing and the idea of automation and the online stuff, I think also the other thing about it is is that people’s financial situations are far more diverse. They’re much more all‑encompassing.

An advisor, whether it be a certified financial planner, hopefully, or just another advisor, a financial advisor of any kind, they can take a look at your tax return. They can remind you to update your will, get the power of attorney updated, things of that nature.

You might have questions about parents. They can help you with those things. Healthcare, it’s a holistic approach to your financial situation. You’re not a pie chart. When you start out, really what you need is what you’ve said.

Save as much as you possibly can, especially before your life becomes complicated. You got the life, the wife, the kids, the cars, that’s the complicating factors. That’s when sometimes it’s important to be able to bounce ideas off of somebody who already knows you.

We may have clients who come in who are in the exact, similar situations. They may be the same ages. They may have the same level of income, kids, etc. Yet the advice that we give them is different because they’re different.

They have different priorities. Some people want to pay for a full college education. Some people want their kids to have skin in the game. Some people, cars are important to them, the other family. They drive them until they drop.

Everybody’s different and then to take all of that, including the human emotion, and to create strategies that are actually going to be workable for those people.

Brad: Also, there’s a real benefit to the ability to coordinate with other professionals. As your life does become more complicated, you have somebody that can coordinate with your accountant, coordinate with your estate planning lawyer, and things like that.

Which an advisor can quarterback that from the financial planning side and either work with them or even bring things to their attention that they never would have thought to ask their accountant in the first place.

Patti: It’s amazing some of the insights that just reading someone’s documents that we’ve been able to bring to their attention that they didn’t realize was in there and the implications. Because we’ve worked with so many people over the years, we see the before, the during, and the after.

When I’m able to point out to a couple that based on what their will says, this is what’s going to happen. Is that what they really wanted to do? I’ve got to tell you, Brad, I can’t tell you the number of times people come back and say, “Is that really what we said?”

I said, “Well, it’s what this says. Tell me what you want.” It’s a wonderful, wonderful way to bring this full circle. To make sure that what they really want is actually going to occur.

Brad: In the end, it is a tool that you can use for a very specific purpose. It’s programmed to do exactly what you want it to do. It’s great for an individual with simple cases.

We use several different, call them software programs, or robo‑advisors that we use internally to make a lot of decisions and to monitor across a broad spectrum of points of data, clients, and all kinds of things that we rely on.

Whatever the word for it you want to use, it’s a robo. It’s a robot. It’s a computer that’s giving a decision based on information we ask it to give us. We need them every day.

Patti: It’s so interesting that you bring that up because I think that the longer that I do this, the more I realize the less I know. The advantage of those programs, it allows us to recognize our own humanity, go into this with humility, and understand that for most of the families, this is a stewardship.

This is pretty much everything that they’ve got. We can’t let our emotions…We’ve got to have the discipline that a lot of people who, maybe, are working for pharmaceutical companies, or they may own a business, etc. It’s not what they do.

They don’t realize that the discipline is actually really important. The experience is also very key with this. To combine the two, to use as much of the artificial intelligence and the software and to program it customly for each client so that we get alerts and alarms when something needs to be attended to.

That’s what that’s there. That’s a beautiful way to use systems like that.

Brad: Absolutely. We have the same emotions that clients have. We’re just an added level of experience and discipline that…

Patti: And we have each other to bounce things off of. That’s the real key. To check‑in and just make sure that we’re always doing the right thing or what we believe is the right thing at the time. Let me play devil’s advocate here for a second for our listeners.

We look at the cost factors of these things. You get a young person and young person might say, “Gee, a financial planner is not going to want to meet with me. I don’t have any money.” That’s the one, one thing.

A second would be, “I’ve got kids in college. I’m planning for retirement. I can’t afford a financial planner.” The robo is an alternative that may, and I caution everybody listening, it’s not always lower cost.

You got to be careful with that as well, but it may provide a solution for people that is easy to use and gets people started. Again, it’s not to say that they’re bad, they’re great if the option is doing nothing. If it’s a way of someone getting motivated and beginning the steps of, “Let me just pull this together and make sure that, at least, I’m tracking towards those one or two things.”

That’s where I think the application is. I encourage everybody to do that. Maybe, when someone does that, you can run the numbers or take a look at it and then bring it to a financial planner or an advisor. Again, I’m biased here, a CFP, to get an extra set of trained eyes on what you’re doing, etc.

To me, planning is a verb. It’s not something that you do once and have it sit on the shelf. It’s something that you’re going back to time and time again to make sure that what you’re hoping for is actually occurring.

Now, as lives get so busy, you may or may not have time to do those things. The key here is to know thyself, be honest with yourself, and understand that that may or may not be something that you’re interested in doing.

If it is, fantastic, all power to you. Do those things. Use the robo approach, and then you’re going to know when, maybe, it’s not enough anymore. That’s the key with all this. There’s no perfect answer for everybody, but to be honest and to recognize this is where I am and to take the step of running numbers and deciding this isn’t working.

Do the things that are necessary to get you on track to the things that are most important to you. If you’re not sure how to prioritize, if you’ve got those competing goals as we all do, that’s when, maybe, having an extra set of trained eyes, someone with experience to sit down with and then to meet with from time to time to say, “What’s new in your life? What’s different?”

Then adjust the recommendations accordingly. Let’s talk about the cost of these things. What was your quote?

Brad: I quoted this morning and said actually, “A price is only a major factor in the absence of value.” I think the point being you don’t want to just compare a financial advisor to a robo‑advisor based on cost. They’re very different products. They’re very different offerings.

You just want to know what you’re paying for with either.

Patti: It’s so interesting. We’ve talked about this. Vanguard has a white paper that they’ve got on their website. The reason that this came about, as I understand it, is apparently Vanguard has three silos, their 401(k)s, the do‑it‑yourselfers, and then the advisor‑led portfolios.

They have been monitoring each one of those silos. They’ve noticed significant differences in, frankly, performance. They did this white paper. They went back and tried to figure out what was the difference and tried to measure the difference between the three, in terms of not only the return according to the Vanguard paper.

A good advisor can add about 2.3 percent per year. It’s not always going to come in performance. It may come in tax benefits and things of that nature. They went into a lot of depth in terms of the things that were done in that third silo that they felt made the difference.

I am reminded of a quote that was on the back of my grandfather’s card. It really is something that meant a lot to me. I’m going to read it to you, and you’ve probably heard this. It’s from John Ruskin. He’s a philosopher.

“It is unwise to pay too much, but it is worse to pay too little. When you pay too much, you lose a little money. That is all. When you pay too little, you sometimes lose everything because the thing that you bought was incapable of doing the thing it was bought to do. The common law of business balance prohibits paying a little and getting a lot.

“It can’t be done. If you deal with the lowest bidder, it is well to add something for the risk that you run, and if you do that you will have enough to pay for something better.”

That is so interesting. As people listen to this and start to look at that, keep that in mind. There are certain things where you definitely want low cost. You want low cost investments, etc. Is that always going to be the case with the advisor‑led piece? Maybe, maybe not.

As you go through this, let’s pull this together and think about how you might want to approach this decision. Number one, be honest, figure out where you are. Is what you’re doing going to help you to accomplish all the things that you want to do?

Whether you do it yourself, again, be careful with some of the online programs. They will create a fairytale. They’re not very accurate but, at least, do something. The next step is, do some research.

Look at the different programs out there, pros and cons for each. Figure out how much each one would cost and then, maybe, interview two or three financial planners to get a sense of what that relationship might look like.

Get a sense of what feels better to you and then act. Make the decision and move forward with something because doing something is going to be far better than doing nothing.

Thank you, Brad, for joining me. I appreciate your time. All of you who are listening, thank you for your time and listening to the Patti Brennan podcast.

Ep2: Investing with Emotion

About This Episode

In this episode Patti Brennan and Eric Fuhrman discuss what it means to Invest with Emotion. Great real world examples of why you shouldn’t let emotion get in the way of good decision making. Plus a head to head battle between Patti and Eric to help you, the investor to truly understand what it means to invest with emotion.


Patti Brennan:  Welcome to “The Patti Brennan Show.” Hey, whether you have $20 or $20 million, this episode is for those of you who want to protect, grow, and use your assets to live your very best life.

Joining me today is Eric Fuhrman. We’re going to be talking about behavioral investing. Now, I know that sounds odd, right? Of course, we all want to think about, “Oh, that middle thing. I want to grow my assets. To do that, I’m going read the ‘Wall Street Journal’ every day, look at the business section, and watch CNBC. That’s how I’m going to make more money.” Right?

Well, Eric and I are going to talk today about, really, what is the big driver of investment investor returns? Not just investment, investor returns. Eric, thank you so much for being here today.

Eric Fuhrman:  Patti, I wouldn’t spend my time any other way.

Patti:  All right, good deal. Good deal. Let’s talk about, really, the three things. There are three major things that contribute to how well a person does in their 401(k), or their portfolio. Why don’t you tell our listeners today what are those three things?

Eric:  I think when you look at it, obviously one of the important things that drives long‑term returns, and again, the focus here is long‑term returns, but number one is going to be your asset allocation, your overall mixture between stock and bonds.

That’s really going to dictate the volatility, but also the long‑term returns in your account, investment selection and…

Patti:  Hold off, can I just stop you there? Because a lot of people listening today, they hear this thing called asset allocation, and all of a sudden, I can just imagine that your eyes are beginning to glaze over, and think, “Oh, God. This is so boring.”

What exactly is asset allocation? What is it in English, Eric?

Eric:  Asset allocation is just really the mix of different investments that you own in your portfolio. For example, that would be the different type of stocks that you might own, it could be bonds, it could be cash, it could be this new emerging area called alternative investments, but the idea is they’re really just investments that react to a set of economic conditions in a different kind of way.

Essentially, everything is not moving in the same direction at the same time in the same order of magnitude.

Patti:  One of the things that we tell people is that asset allocation really isn’t the same thing as diversification. You could be well diversified by going to 12 different banks and getting a CD from these 12 different banks. That’s diversification, but that’s not really asset allocation because it’s all the same kind of investment.

Asset allocation takes it to another level, to make your returns more, I hate to use the word predictable, but more resilient in various economic scenarios because nobody really knows what’s going to happen in the near term, or frankly, even the long term. We want you to be able to participate in it, but not get killed, you know?

It’s using that same metaphor with baseball. Just hit a whole bunch of singles. Don’t worry about the home run. In baseball or many games in life, the people who hit a whole bunch of singles end up winning the game.

Asset allocation number one. What’s number two?

Eric:  Investment selection and diversification. Again, a lot of people think if they own a bunch of different investments, they’re diversified. That might not be necessarily true. You have to think again about the different types of investments that you’re going to own in your portfolio.

The third thing, which is really the focus of this podcast, is behavior. I think that’s often the most overlooked and missing element. Ultimately, the behavior of the investor is going to be the long‑term determinant of whether or not you realize successful long‑term returns in the market.

Patti:  When we think about behavior, I think back to my four children. I think about behavior when they were toddlers. That’s not really what we’re talking about. It’s really, what do people do? What is the natural instinct that you want to do when things are going really well, or not so hot?

What I think is interesting and really brings this home for people are the DALBAR and Lipper studies. They’ve been doing these studies year after year after year. What is amazing to me is how consistent the results are. Eric, why don’t you share with us what they are?

Eric:  Again, this is going back from 1998 to 2017. We’re basically covering roughly a 20‑year period. DALBAR’s been doing these studies for a really long time.

The essence here is to show that when you look at the returns of different areas of the market that are quoted, let’s say the S&P 500 or even a diversified portfolio, 60/40 portfolio and so forth, oftentimes the average investor not only underperforms the market, but more importantly, they actually underperform the very investments that they own.

Again, the result of that is from behavior. If you look, for example, over the past 20 years in this study ‑‑ this is a very general categorization ‑‑ bonds on average generated a 5 percent annualized average return. A 60/40 portfolio between bonds and stocks earned about 6.4 percent. The S&P 500, an all‑equity portfolio, did 7.2 percent.

The average investor generated a 2.6 percent rate of return. Again, even if you just think about a blended portfolio, they underperformed by almost 400 basis points or 4 percent per year, on average, which is huge. A lot of that can potentially stem from the behavior of that individual.

Patti:  Basically, what I think is interesting about the DALBAR studies is, they’ve been doing these studies for the last 20 years. They take rolling periods of time. This happened to be the last 20 years. The year before, it was from the 20 years prior.

It’s also interesting, even in shorter time periods, that people tend to confuse investment returns with investor returns. It’s a very big deal and it’s a very big difference. What causes that difference?

Eric:  Again, I think you have to look, really, at the sources. I think part of it, no fault of their own, is the investment community. I think there’s a hyperfocus. Whether it’s somebody who watches the business news or a lot of commercials that come on TV, the focus is on what investments to be in and when to be in them. What and when are the key things that are coming across.

Ultimately, poor investor behavior arises from this emphasis, this hyperfocus on timing and selection as the primary drivers of return. If I can go back to when we just started out this podcast, that asset allocation and behavior are really the critical determinants that people have to think.

I’m reminded by a great quote from Bobby Jones. Some of you in the audience who may not be golfers, he was the Tiger Woods of his day back in the ’20s or ’30s. He has a quote that I think really parallels this theme, this narrative of behavior. He basically said, “Competitive golf is played mainly on a 5.5‑inch course, the space between your ears.”

Ultimately, to me, behavioral investing is all about the space between your ears and how you react that determines on making the difference between the average investor and realizing the returns that the market can offer.

Patti:  You know, it’s a really good point. I think that, as well‑intentioned as the media is…and they are, they generally want to give people information…the problem is that there’s almost too much information. We also have to keep in mind, let’s face it. It reminds me of the story about the guy who was a fisherman.

He’s a fisherman, right? He goes into the bait‑and‑tackle shop, gets all of his stuff, puts it in his basket, comes up to the counter, drops it all off on the counter, and says, “Do fish really like these lures?” The guy behind the counter says, “Well, I don’t know. I don’t sell to fish.”

Eric:  [laughs]

Patti:  The point here is that TV, newspapers, they’re not really selling education. They’re selling to their advertisers. People will watch. They will read. They will pay attention when things are being hyped up. That’s often the antithesis of making good decisions.

When people get emotional, get all ramped up, that’s when you want to take a step back and say, “OK, what does this really mean for me?”

Eric:  Right, and Patti, I couldn’t agree more. By the way, in your joke, I would be the guy that’s buying all the lures, and probably not asking the questions. I’d be buying the shiny objects.

I think your point is well‑taken. When you think about the messaging that’s being put out there today to today’s people that are investors or even retirees, it’s this narrative of take control, about empowerment to make decisions. I think, as Americans, that speaks to our cultural heritage. We love that idea.

The reality is, this process has been occurring since the 1970s. We have moved from a defined benefit retirement system to defined contribution through the 401(k). The reality is that those critical decisions about funding, about investing, have been placed squarely in the palms of every individual investor’s hand.

I think the issue that we have when it comes to the messaging is that the focus is on more data and news. It’s about being able to make lightning‑fast decisions, to be able to be quick. There’s a premium on speed.

My feeling on this is that it cultivates a transactional and reactive person. It’s really highlighting, as you said, behaviors that are antithetical to realizing the long‑term returns that the market can offer. Could you tell us, maybe, about some of the solutions that you would think that are important for them to look at?

Patti:  It’s really interesting. I think a really interesting statistic…I wish I could cite it to the wonderful people who have published this. It’s consistent, and for you and I, it’s common sense. There is an inverse relationship to a person’s results with how many times they make changes.

The more someone makes a change in their portfolio, the lower their return. This doesn’t mean that you set it, and forget it, and never look at it again. It does need to be monitored, but this rapid‑fire change based on what’s happening, what the latest guy or woman said, it really works against you.

The thing about it is, and I understand because we watch it too, it’s important to get the data and understand what people are listening to. The thing is, it sounds really good. It sounds really smart.

You don’t want to make long‑term decisions based on what your life is going to look like, or how to create the life that you want, based on what some guy said at six o’clock last night.

Eric:  Yeah, totally. I’ll tell you what, what I think is a great segue into this next part is really to crystallize this in the minds of our listeners for both them to really distinguish and say, “What does this performance mindset truly look like versus somebody who has an outcome or goal‑oriented mindset?”

Our premise on this is really that really investment decisions need to be tethered to a goal‑based framework that is ultimately anchored by a long‑term financial plan. Really, that plan is going to then dictate the asset allocation. The plan itself and the asset allocation are going to be the things that drive really the long‑term returns for the result.

Patti:  It’s interesting because I often tell people I think, and frankly, again, even people in our own industry do this completely backwards. They look at the different choices that they have in their 401(k), and they say, “Well, this one looks good and this one did really well. And I’ll do a little bit of that,” etc.

That’s the last thing that you want to do. The best way you approach this stuff is to say, “OK, what do I want in my life? What’s the outcome that I’m looking for? What do I want this money to do? When do I need it? What’s realistic, given our resources?”

You start with the big picture. Once you have that laid out, you figure out, “OK, how much do I need to save per month to put my kids through college, be able to retire in comfort and maybe get a house, a second home, if we accomplish those things.”

This is the fun stuff that comes along with real financial planning. You start with the big picture, then you get down to, “OK, what’s the combination of cash, bonds, and stocks that will give us the highest probability of earning the rate of return that we need to do all those wonderful things in our life?”

Then you say, “Hey, should I pick investment A or investment B?” That’s the last thing you do, and by the way, you do want to monitor it because things are not going to continue exactly in a straight line, and you make adjustments from time to time.

Eric:  Absolutely. I couldn’t have said it better.

Patti:  We’re outcome‑oriented. It’s a very subtle difference that we hear and we see on a day‑to‑day basis. Let’s give our listeners and viewers a feel for the nuances between the two different mindsets.

Eric:  Sounds good. Do I get to be the performance guy and you can be the outcome‑oriented person?

Patti:  I’ll be outcome.

Eric:  Perfect. If I’m a performance mindset, I might think my mindset might be under maybe the following. Let’s start with number one. Patti, here’s the deal. I want a return that beats the market because that’s what I need to retire.

Patti:  That is very different than someone who’s outcome‑oriented. Someone who’s outcome‑oriented wants an income they could never outlive.

Eric:  Oh, there you go. That’s good. How about this? Patti, I only buy four and five‑star funds to ensure that I’m going to get good returns in my portfolio.

Patti:  An outcome‑oriented person understands that those stars have to do with past history, and are completely irrelevant as it relates to how is it going to do in the future. An outcome‑oriented person is looking for a portfolio that provides the highest likely of earning the lifetime returns that they need to accomplish their goals.

Eric:  How about this one? Patti, I think I should invest more in pharmaceutical stocks because their returns have been incredible. They are going through the roof.

Patti:  An outcome‑oriented person says, “OK, that sounds great, but again, they’re already going through the roof. It’s already happened. I want enough exposure to participate in attractive industries, but not so much to undermine my chance of success.”

Eric:  Last point here, Patti. I hear what you’re saying, but this market has been going crazy. It has got to go down at some point. I think it’s time to get out of all my stocks.

Patti:  An outcome‑oriented person says, “Well, gee, I know the market. It is volatile right now, but I still want to put my kids through college. I still want to retire. I still would love to have that second home, so I’m not going to change my investment policy for something that happens to be happening right now.”

Eric:  Wait a minute. If I hear right what you’re saying, basically, if my financial plan hasn’t changed, then I shouldn’t be changing my investments?

Patti:  That’s exactly right. Remember, a financial plan, let’s kind of talk about that because it tends to be this kind of nuanced thing. What’s a financial plan? All a financial plan is are the steps that you need to take to accomplish the things that you want to accomplish in a cohesive package.

Understanding what your resources are, understanding what your desires are, it’s a set of progressive strategies to get what you want.

Eric:  Beautiful. Absolutely. How about next, why don’t we transition a little bit here, and let’s go back and talk about the experts? You can’t help it in this day and age, in the age of communication, we are constantly bombarded with what the market is doing through the little tickers and little informational windows they have on all the business news channels.

People are always talking about what you should be buying or selling, why the market’s going up, why is it going down? It really creates this mindset, at least when we talk to a lot of investors, where they always feel like they should be doing something.

I think maybe we could reference the Survey of Professional Forecasters. This is actually produced by the Philadelphia Fed, which is actually not too far from where we’re located. This is one of the oldest quarterly surveys of macroeconomic forecast in the United States dating all the way back to 1968, I believe.

It’s distributed every quarter, but it’s meant to provide forecast for GDP and inflation. They usually have a number of panelists, 30 or more panelists from some of the top investment industries, academic research industries across the country.

It’s really the consensus of all these people about what GDP and inflation might be like.

Patti:  We should be listening to the Philly Fed because, after all, these are really smart people. Don’t they know more than we do?

Eric:  Exactly right. You would think of anybody, forget about the nightly businesses that you might see. These are very credible people in the industry that you would think have a good history of success.

When you look at the forecast that come out, what you find are, number one, the range depending on whether you go out a year or two years out, the range is very wide. It’s a little bit difficult to say the market could have a massively different reaction to say one percent GDP versus three.

The forecasts are very wide in terms of their accuracy, but then they also tend to miss crucial turning points.

Case in point, if you look back into the report that was filed in the fourth quarter of 2007, there was a prediction that GDP in 2008 was going to be a positive 2.5 percent. The actual result was a negative 2.5.

Now, we’re probably picking them on a little bit because that was an extreme event, but it just goes to show that, again, there was a forecast, and then there was reality.

Their assessment of negative GDP in 2008 was a negative five percent…I’m sorry, was about five percent that we’d have negative GDP, so it’s about 1 in 20, if you work that out. Again, missed a crucial turning point, and we’re using the Professional Forecaster Survey.

Patti:  It just goes to show you that statistics really don’t tell you much, especially when you’re averaging things out. I think it’s really important that our listeners and our viewers understand, that nobody really knows what’s going to happen in the future.

This is one of those areas that the more…I often talk about this, we don’t get to queue. We don’t pretend to know what’s going to happen. The more somebody has this strong position, the firmer they believe it, the less I respect that person, because nobody can be that confident and that sure.

Eric:  The ability to be flexible. You remember the old joke, that economists have predicted nine out of the last six recessions correctly, so it just goes to show.

Patti:  I think for those of us who do this on a day‑to‑day basis, it’s interesting to get a sense of the cycles, and understand what’s happening on a real‑time basis. I think that’s valuable.

What I don’t think is valuable, is trying to anticipate and predict what it’s going to be three months or a year from now. I think that could sabotage people, and it could make them do things that are really not in their best interests.

Eric:  That actually brings us to the next point, which is short‑term volatility. This is actually highly relevant if you look at the month of October and into November here.

We’ve had some really extreme moves in the market, a lot of short‑term volatility. Folks at home that may be opening their October, and even November statements, might see a rather large departure in that account value from a month‑to‑month basis.

Talk a little bit about short‑term volatility, and how that can influence somebody to make, potentially, a bad decision, just by reacting on what’s happened over, say, the last month.

Patti:  It’s really interesting. We had a meeting early this morning, and the clients came in and they brought their October statements. Their October statements showed that they were down a lot of money, it was about a 10 percent loss.

Theirs was an unusual situation, most clients’ weren’t. It was fascinating, because what they didn’t realize, is on a year‑to‑day basis, they were flat. They were so focused on this one month that they didn’t realize, “Oh, I didn’t lose any money this year. It was just in the last month.”

In other words, they basically gave back what they had earned earlier in the year, but that’s not what they were focusing. They were focusing on the most recent loss. The key here is to understand that over short‑term periods, whether it be a month, three months, etc., markets are going to do their thing. Let’s talk about the probability of success in your investments over different periods of time.

There’s a chart that we’re going to put up that talks about the last 20 years. In the last 20 years, if you look at what’s happened on a daily basis, markets were up 53 percent and down 47 percent.

On a week‑by‑week basis, it was a little better. 56 percent of the weeks, it was up, 44 percent of the weeks, it was down. Monthly, 61 percent, 39 percent. If you just hung in there for a full year and didn’t do anything, 80 percent of the time, your portfolio would’ve been up. Again, if it was 100 percent in the S&P 500, versus 20 percent it was down.

Again, we talk a lot about, “Think long‑term, think long‑term,” and you’re probably out there thinking, “Yada, yada, yada, I hear that all the time, it’s so trite.”

Eric:  [laughs]

Patti:  There’s a reason why we do that, because it really does make a difference. If you can just understand, again, be outcome‑oriented and ignore the noise, markets lose 14 percent on average, once a year. Understand, if you have any of your money invested in markets, you’re going to have periods where it is down. Ignore it. Go into a coma if you have to.

Eric:  [laughs]

Patti:  Don’t open your statements. The key here is, don’t do anything about it.

Eric:  I think there’s also a quality of life issue here. If you’re somebody that watches, just remember, just being exposed to the market by, say, watching TV, looking at your statements day‑in and day‑out, that doesn’t necessarily lead to higher quality decisions.

What some of these numbers lead to, that Patti just highlighted, is that shorter time‑frames leads to worse odds of success. Just think about in terms of your emotional state, the time that you’re spending. If you’re looking at daily returns every day, you’re checking the market, over the course of 10 years, several thousand times.

Think about the time you save, and the emotional mindset of somebody who looks at it once a year, 10 times. They’re probably feeling a lot better about things, than somebody that’s checking it each and every day, and experiencing that roller coaster of being up and down, over and over again.

The other important part is, just think about it too is, if you’re looking at it every day and it causes you to be transactional, you have to be right not once, but twice. If you’re going to sell, that means you have to buy, and what you have to buy is, hopefully, going to end up better than the thing that you had just previously sold.

Long‑term, again, I think the numbers are there to show that frequent decision‑making is usually at odds with your long‑term success.

Patti:  Eric, it reminds me of the story of what we did during the tech bubble. During the tech bubble, markets were really volatile. It was an unusually long bear market.

Typically, we’ll have people who come in calling, concerned, worried. The first year, I was able to keep them comfortable, confident, they didn’t do anything. Second year, kept them comfortable, they were really getting a little bit more scared. It was the third year, that’s when it all happened.

We kept track of the clients. Let’s say that we, at the time, had 400 clients. I was able to keep everybody confident, comfortable, etc., except for seven people. We did this thing, we tracked what the Dow and the S&P 500 were. The day that they called, nobody sold out completely, but we moved a portion of their portfolio out.

We logged what the S&P was on that particular day, and then we just waited. Not once, not twice, but in every single, solitary time, those same people…so they sold when the market was down. The market, in many cases, continued to go down.

Initially, those clients felt really good, “I made the right decision, we moved out. That was really smart.” What happened was, as the markets started to recover, and it recovered and it recovered, not one or two, all seven clients called and came in, and said, “Hurry up, we gotta get back in.” In every single case, they got back in when the market was much higher than what it was when they pulled out.

Eric:  When they sold out.

Patti:  It’s human nature, I understand that. Again, I often say it to people in this podcast, part of what we’re here to do is to, first of all, create a portfolio that that person can live with, so that they don’t panic. That they’re not in that situation, and they understand the process and the thought that went in to putting those investments together.

Eric:  I think another way of saying this is, focus on what you can control. What do you think are the elements for an investment’s success, if we think about, what are the things that we can control?

Patti:  Exactly. We can’t control markets, we can’t control what they do or when they do, but we can control what we do about it when these events do occur. Eric, let’s talk about, what are the most common mistakes people make when it comes to what they do.

Eric:  The first one I’d say is, maybe overdiversification. It seems like you can’t possibly have overdiversification, but the reality is, it can take several different forms. I think one of the common things that we see on a regular basis when we look at people’s portfolios, is that they end up having a lot of overlap.

For example, they may own 5 or 10 large cap stock funds. Really, even if these are some of the best managers that you could ever buy, in terms of a large cap stock fund, the reality is, you just own a more expensive version of an index fund by just owning multiple funds in the same category.

Patti:  It just goes to show, it’s much easier to buy an investment, it is much harder to sell it.

Eric:  [laughs] So true. I think another area is probably panic. I’m sure you’ve heard the saying all the time, “This time, it’s different.”

Patti:  Absolutely, we hear it all the…

Eric:  It’s never different. Who was it, Samuel Clemens, or Mark Twain, once said that, “History never repeats itself, but it does rhyme”? I think that’s true to the market.

Patti:  What’s interesting is, if we go back to earlier, what makes people feel like it’s different, is what they hear in the media. The media is pushing that, and saying, “This is really different, it is different.” The catalyst is often different, what causes it could be different, but the mechanism, the result, it’s usually the same.

Eric:  I think it really stems from this irrational fear, that basically, that the client is never going to end, that there’s a loss in faith in the future, that this long‑term upward slope in the equity markets is somehow forever broken, that it will never be repaired.

Patti:  Here’s one that we often get, and that is, “Well, wait a minute, if I sell this investment, I’m gonna have to pay all of these taxes,” or the other side of that is, “Wait a minute, I’ve lost this money. I wanna wait until it recovers.”

Eric:  Yes, oh my gosh. This is such a good one, too, because this is one that is really hard when you talk to people, to get them over and around this emotional bias…

Patti:  Hurdle.

Eric:  …or hurdle, if you will, is that somehow the basis, what you paid for the investment, somehow has anything to do with the fundamentals of that investment, and whether or not it should be held or sold, or if it’s a significant risk in the portfolio.

Patti:  In other words, that stock or that large cap fund has no clue what you paid for it, nor does it care. If the CEO of the company doesn’t know how his company is going to do next quarter, why should you be making investment decisions based on what you pay for it?

Eric:  In a lot of situations, you could have a highly appreciated stock, and people don’t want to pay the tax. The reality is, folks, if you look back to whenever the capital gains tax was initiated, it has never been lower than where it is today.

The cost to get out of a highly‑appreciated stock is lower than it’s ever been. For some people, a part of that could be at zero percent, depending on your tax bracket.

Patti:  We both know people who have investments in companies like GE, and CISCO, etc. They never wanted to sell…

Eric:  …because of the tax.

Patti:  …because of the tax. Boy, when looking back, they would be very happy to have kept 85 percent of what they earned.

Eric:  Remember, too, that any stock, a single stock, could easily move 20 to 30 percent, up or down, in a single year. A 15 percent tax on the gain is a small price to pay to protect and remove the rest out of harm’s way. Even, what about people with stock at a loss, where they say, “I have to earn back my investment. I can’t sell, because I’m at a loss”?

Patti:  You know what I always say on this one, and Eric, you’ve heard it a million times, my question is, if you paid $10,000 for something and now it’s worth $8,000, the question to ask yourself is, “If I had $8,000 of cash today, would I be buying that stock?”

If the answer is, “Yes,” you want to hold it. If the answer is, “No, there’s no way I would ever buy that stock again. Are you kiddin’ me, Patti? I lost money,” then the answer is, you need to sell it, because that’s the reality. You have $8,000. What are you going to do with it?

Eric:  By the way, that’s not an exaggeration, I actually have heard it 10,000 times. [laughs]

Patti:  I’m sure you have. It’s a common thing, it’s just human nature.

Eric:  It is, very common.

Patti:  We have to understand human nature, and then frame it in a way that people say, “Oh yeah, that’s right. You probably make sense.”

Eric:  What about, we hear this in a certain population of the client as well, is that they believe when they go into retirement, that they want to invest for yield? They don’t invest for total return, they expect that they’re going to be able to live just on the interest or the dividends that their portfolio throws off.

Is it that realistic, and does it make sense?

Patti:  Wow. My first response that came to my head when you said that is good luck. Good luck with that one because when you look at yield, if you’re lucky, the yield that you get on your investments is just keeping pace with inflation. Most of the time, it doesn’t. Then you have to pay taxes, etc.

The key here is giving yields today. Is that realistic? Is that going to replace your salary because that’s what you need to do when you retire? Total return, I believe, is a much better framework to look at your investments because the key here is let’s ignore that word, income, from your investments.

What you need is cash flow. What’s the best way to create the cash flow that you need to live the very best life that you want to lead? How are we also going to make sure that that cash flow is growing with inflation?

By the way, it’s really important, especially for retired people because people who are retired feel inflation more than people who are younger.

Eric:  Absolutely. To give you an example, the St. Louis Fed publishes numbers on this. The 10‑year AAA corporate bond, as of the end of September, was paying just a hair over four percent.

If you’re somebody that, say, needed $6,000 a month to live on, $72,000 a year, if you were just going to live on the interest, you’d need nearly $1.8 million just so you’re extracting the interest. If you’ve a more diversified portfolio, the dividend yield on stocks is even lower than that.

You would need a significant amount of capital if your goal was just to live on the income alone.

Patti:  What we’re not even paying attention to is that $72,000 and using those numbers, that $72,000 isn’t growing. You’re just using all of the interest. Well, 10 years from now, you’re going to need a lot more than $72,000 to buy what it buys today, especially with healthcare. Healthcare’s rising at six percent per year.

It is astounding how much people have to spend. Even with Medicare and good supplemental plans, it’s not a couple thousand dollars a year. We’re talking 10, 20, 30 thousand dollars a year just for healthcare. It’s growing much faster than average inflation.

Eric:  That’s an excellent point because, again, as you said, people feel inflation differently when you’re older and you consume a different basket of goods. What do you say, before we wrap up this podcast, that we play a little game between you and I?

Patti:  I love games.

Eric:  Who doesn’t like a game? I have two kids at home. We play games all the time. Let’s play a little game called, “Are you a speculator or an investor?” How about this?

Patti:  Sounds good.

Eric:  You want to start us off on this little one?

Patti:  Sure, I’ll start off.

Eric:  Sounds great. Go on.

Patti:  Eric, I know the stock is down, but all the analysts say the company’s going to turn things around the second quarter. Am I an investor, or am I a speculator? If so, why?

Eric:  Man, you gave me the softball pitch here. This is definitely a speculator when you look at it. Number one, they’re talking about an individual stock. That tells me that, maybe, they’re not properly diversified to begin with.

Again, if we’re just focusing on a single investment and what the analysts say, the fact that the stock is down, you are speculating on that investment. You’re hoping for it to go up. The more important thing is to look at the fundamentals.

Is the risk of that investment appropriate for your portfolio in your long‑term financial plan? This is definitely in speculator territory for sure.

Patti:  Perfect. Sounds good. All right, your turn.

Eric:  Gotcha. Here it comes. Patti, everybody knows we are going to have a correction at some point. Look how much the market has gone up. I think it’s time to sell and go to cash.

Patti:  You’re a speculator. By the way, I agree with you. The market is going to go down at some point in time. You know what, we don’t care. We’re not going to pay attention to that.

We’re going to assume that it is going to go down, but we also understand that you’ve got a beautifully crafted, well diversified portfolio that is far more resilient than you might even realize.

Eric:  Perfect.

Patti:  My turn.

Eric:  You got it.

Patti:  Let me see. Going back to you. I’m comfortable holding an investment for 10 years or so. I’d like to purchase some growth stocks. Am I an investor or a speculator?

Eric:  I’ll tell you what, that’s music to my ears. You sound like an investor to me. Now, let’s keep in mind here, again, the big defining characteristics here is that you’re comfortable holding an investment for 10 years.

You have a long time horizon that suggests to me that you’re willing to stay invested through the ups and downs, even though you said that you wanted to invest in growth stocks. Again, this is one area of the market. You’re looking for a long‑term time horizon.

As long as that growth stock allocation fit in with your long‑term financial goals, then it could definitely be appropriate. Again, time horizon here and your comfort level of staying in something for a long period of time. You’re an investor.

Patti:  Also, the key here is to make sure that you’ve got something to balance that thing out, so you’ve got complementary assets.

Eric:  Absolutely.

Patti:  Excellent. Go ahead.

Eric:  My turn. I know this stock is most of my portfolio, but I can’t sell it. My mother worked for the company 30 years before passing it on to me. Are you an investor or a speculator?

Patti:  You’re a speculator, but you also have a sentimental attachment to that stock, don’t you? That’s important to recognize. I think that your mom would have wanted you to enjoy whatever that company did for her. She worked there for 30 years. They were good to her.

She gave you that stock because the company was good to her. Let’s acknowledge that. Now think forward and say, “What would your mom want for you today? Would she want all of your eggs to be in that one particular company?”

Maybe, it might make sense for you to take a portion of it and keep it if that sentimental attachment is important to you. Then take the balance because your mom would have wanted you to be diversified.

When you were little, she didn’t feed you eggs every morning, noon, and night. You had a diversified meal plan. She gave you lots of different things. It’s the same thing with your portfolio. She’d want your portfolio to be as well balanced as your meals were.

Eric:  Well‑balanced diet.

Patti:  I’ve never used that metaphor before. It’s a weird one.

Eric:  [laughs] First time ever, right?

Patti:  These things pop into my brain, Eric. I have no idea where they come from.

Eric:  I gotcha. I didn’t hear dessert in there anywhere.

Patti:  Mm. OK.

Eric:  I guess it’s your turn.

Patti:  Let me see. The market’s fallen about 10 percent since the beginning of the year. I feel like now is a good time to get in. I’m comfortable making this investment as part of my long‑term investment plan. Am I a speculator or an investor?

Eric:  I would say, in this case, that you would be an investor. Again, because of the context of how this is framed is that, yes, the market has fallen 10 percent, but you’re comfortable getting in. You’re comfortable with the risk, acknowledging that the market has gone down, but with the idea that this is going to be part of your long‑term financial plan.

You were not transactional, that you have a very long‑term view on things. You’re willing to be patient and wait. I would say you would definitely be an investor.

Warren Buffett had a great quote. He said, “The market is a very efficient mechanism for transferring money from the inpatient to the patient.” Again, patience is key.

Patti:  Terrific. Let’s pull all of this together. Let’s bring this together. We’ve got three points that we want to make. Number one, don’t let your emotions get in the way to good decision‑making. Number two, do not, please, please, please don’t let short‑termism impact your decision to what you do. Short‑termism is a disease that is usually fatal.

Number three, focus on your outcomes. Remember, it’s all about your outcomes not your performance. It’s about your financial plan. The plan is just a series of steps that you’re going to take to accomplish the things that you said you wanted to accomplish in a cohesive plan that is based on your resources and what’s realistic over time.

Focus on your outcomes, forget performance. That’s short‑termism. That’s the disease and understand that you’re a human being. When in doubt, talk to your advisor. Talk to a professional. Make sure that before you do something that could be fatal, that you’ve gotten a second opinion.

That’s it for today’s show. Thank you so much, Eric, for joining me today. This was an important topic.

For those of you who might be interested in learning more, feel free to go onto our website, keyfinancialinc.com. I know you’re probably driving in your car, or you might be watching it on TV. We are open to any questions you might have. We’re happy to help you any way we can.

Most of all, don’t forget, hit “Subscribe.” These podcasts are going to continue, and we want to hear from you. Let us know whether or not this resonated with you. Would you like to hear more about this subject, or is there something else that you’d like to learn about?

That’s what this is all about. We want to improve the outcomes for all Americans, not just you but your friends and anybody that you care about.

Thank you so much for listening to us today, watching the podcast. Thank you, Eric, for a great game session. I didn’t realize we were playing games.

Eric:  I enjoyed it.

Patti:  Again, don’t forget to hit “Subscribe.” Share it with your friends and join us next week. Take care. Have a good one.

Ep1: Year End Tax Planning Tips

About This Episode

In this episode Patti Brennan and Eric Fuhrman discuss Year End Tax Strategies, Roth IRA’s, Tax Loss Harvesting, QCD’s, 529 Contributions, Roth Conversions and much more.


Patti Brennan: Welcome again to the Patti Brennan Podcast. Today, joining me is Eric Fuhrman. He’s our Chief Planning Officer. Thank you so much for being with us today, Eric.

Eric Fuhrman: Patti, it is my pleasure. I couldn’t think of anywhere I’d want to be right now. Not only do I get to spend the afternoon here with you today, but also we get to talk about taxes, which are terribly exciting to us.

Most of our listeners here don’t realize that at this time, but I think by the time we get to the end of this podcast, they’re going to get some really insightful and new and exciting tips that they’re going to get out of this.

Patti: You know, Eric, it’s something I say all the time. When we get to this subject, I always warn clients, “I’m about to nerd out on you.”

Eric: [laughs]

Patti: It’s a very nerdy kind of subject. I’ve got to tell you. Isn’t it fun when you know certain things are going to make the difference? It could be $1,000. It could be $5,000. If people don’t know these things that we’re going to be talking about today, they’re not going to do them. If they don’t do them, then guess what?They’re paying more taxes than they have to.

Eric: Absolutely right. They get a lot out of it, but the best part is it gives us a lot of excitement and something to talk about to have a lot of deep and important conversations with our clients.

Patti: Let’s talk about what are the things that people should be thinking about today. Here it is, beginning of November, and markets are in a turmoil. They were doing really well. Now, they’re doing terribly.

What’s the first thing? What are we doing for our clients, and what should clients be doing for themselves?

Eric: As the year draws to a close here, there’s a lot of really important things that clients need to think about. That applies to a lot of different situations.

Now that we’re here towards the end of October, we have about two months left, but there’s some really critical things that they can do here in the next 60 days or so that can really make the difference for their taxes and going forward.

One of the things they have to be thinking about, especially when we have a really volatile market, is something that we talk about all the time internally, which is tax loss harvesting.

Patti: Eric, it doesn’t sound great. Why would I want to harvest a loss? Don’t we want to make money in our investments?

Eric: That is the goal, is for appreciation over time. Nobody invests with the expectation of a loss, otherwise, it wouldn’t be a very good investment.

You’re absolutely right, investments are something where when we set them up, these are things that we’re thinking about over many years, whether it be 5 years, 10 years, or possibly a lifetime, but within any given period of time, not all investments are always going to be producing gains.

You’re going to have certain investments that may have a loss at different point in time. That is not, relatively, a permanent thing. It might be a temporary thing, but it’s an opportunity that we can harvest and take advantage of in each tax year that can certainly deliver long‑term benefits for our clients.

Patti: For the folks that are listening and watching us today, let’s talk about the difference between the amount a person invested and what their cost basis is. Even though, for example, they may have a tax loss, it doesn’t necessarily mean that they lost money. How does that work? Can you explain it to our listeners?

Eric: If you think, if originally you put $10,000 into an investment, over time, that investment paid out dividends and capital gains, and if you’re someone that has opted to reinvest those capital gains and dividends, like many investors do, that will increase your basis over time.

While you may have originally invested $10,000, you may look five years down the road from now, and you might have a basis of, say, $14,000, because you’ve been reinvesting all that income that has been distributed.

It might so happen that you run into a period, like we’ve experienced over the last couple weeks, where all of a sudden your investment, the actual value of it, has now dropped below your basis. If you originally put in $10,000, your reinvestments have taken you up to a basis of $14,000. Basically, now, you might have a loss if the investment’s now at $13,000.

Remember, you still put in $10,000, you still have a gain in the investment, but you have a tax loss that is available to take advantage of.

Patti: That is powerful. That is so very important. We talk about these things, cost basis and the amount invested. These are things that we talk about all the time, but it’s important for people who are listening to understand the difference.

By the way, to clarify this further, what we’re really talking about are your non‑retirement plan accounts.

Eric: Good point.

Patti: This doesn’t apply to your 401(k) or your IRAs. It’s really your non‑retirement plan accounts.

Let’s say that you’ve got one account and another account. Let’s say that those losses add up to $10,000. Why don’t you explain to our listeners what is the process of harvesting a loss? What does that really mean in English?

Eric: Tax loss harvesting, like you said, it only works with, obviously, non‑retirement assets.

It really works well for portfolios that are really well diversified, where you have a lot of assets that are going to be doing different things. If you have, basically, a portfolio that’s full of large company stocks, you’re not going to get a lot of tax harvesting opportunities.

What we would do is look through your portfolio and try and find investments that have current losses before year‑end, with the idea that we’re going to actually sell those investments to capture the loss before year‑end.

Then what we’re going to do with those gains is basically reinvest it. You can’t invest it back into the exact same security, but reinvest it into something that’s of similar quality to keep you invested, but harvest the loss.

Patti: What you just said raises a red flag in my mind, because it sounds like you’re market timing. It sounds like you’re selling these investments, but, wait a minute, don’t we usually tell our clients and tell people you want to buy and hold?

You don’t want a lot of buying, selling, and transactions, because that generates cost, so what’s the value of this?

Eric: Basically, the idea is we’re not market timing, because ideally when you sell to capture the loss, we’re going to be reinvesting those proceeds back into the market.

Patti: To clarify, it’s really important, you go from literally blue chip investment A to blue chip investment B. It could be the exact same asset class.

To Eric’s point, it can’t be the same investment, but it can be the exact same asset class. It can be a same day.

We’re not market timing. All we’re doing is capturing a tax deduction that you otherwise wouldn’t have had. Sounds like a win‑win. It’s a heads you win, tails you break even, because you’re going to save money on your tax return.

Eric: Ultimately, it’s really about managing your tax exposure and the timing of it. There’s different ways where tax loss harvesting can make sense, such as if you have an investment that happens to pay out a really large taxable gain, then you want to look through the portfolio for losses where you can offset that gain and minimize your taxes in a given year.

Tax loss harvesting can also really work well when we go into different market cycles, like, say, a bear market where probably your equities, your stocks are going to be down. In this way, you can actually capture the losses, but we’re going to be reinvesting the proceeds so you stay invested.

Then, when the business cycle picks back up again, the economy starts doing well, a lot of those losses may turn into gains, but now, we have a bank of losses that we can use to offset those capital gains in the future. It’s a better way to manage your tax picture all around to follow this strategy.

Patti: I love the way you described it as the bank. Now, you’ve captured these losses. It literally is like a bank account that is sitting there waiting to be used. You carry forward your losses indefinitely until they’re used up.

One thing that we know about investments and portfolios is markets don’t go straight up and they don’t go straight down. In those periods of time that we all really don’t like, let’s make lemons out of lemonade.

Grab a tax benefit today. That way, when the market does recover, you can rebalance your portfolio and not have to worry about the taxes you’re going to have to pay on those gains, because guess what? You’ve got this great bank account, and it’s got this wonderful $30,000 loss, you have no out of pocket cost. Fundamentally, everything’s beautiful.

Eric: Couldn’t have said it better.

Patti: [laughs] You know what? You’re the one that gave me the idea. You’re the chief planning officer, and I’m so grateful for planning these ideas.

Let’s talk about what else? We’ve got tax loss harvesting. What do you think is the next best thing that people should be considering today?

Eric: We’re trying to think about year‑end tips or strategies that people can put in place. Another one would actually be purposefully creating capital gains.

This is the opposite of tax loss harvesting, where we’re purposely trying to create losses. Here, we’re actually trying to create gains on purpose.

That sounds counterintuitive. Why would you want to do that? The reason is because under the existing tax law, and this existed before the new tax law that was passed in December 17th of 2017, is to the extent that your income remains what it is now under the 12 percent bracket, used to be the 15 percent, any kind of qualified dividends or capital gains are actually taxed at zero percent.

The question is who does this apply to or who would it make sense for? Really, it’s these people that are newly retired, probably in your 60s, have a fair amount of non‑retirement assets that have been saved up in investment accounts.

You also probably haven’t elected social security benefits or have a really robust pension at this point. The rationale is that somebody in this situation, at some point in the future, their income is probably likely going to go up significantly when they elect for social security benefits, or maybe they have a pension that doesn’t start until 65, 67, or 70.

Also, there’s this thing called required minimum distributions that is going to start at age 70 and a half, whether you like it or not. The confluence of all these different factors can push somebody into a much higher tax bracket later on in life.

The strategy is when you’re in this window, this golden zone, is to actually create capital gains at zero percent to effectively reset the basis of that taxable account higher, so that once you get into this high tax phase, now, you’re going to minimize the capital gains that would otherwise flow through to your tax returns.

We’re taking much greater control. We’re being much more proactive about managing the life cycle of their investments, not just now, but in the future.

Patti: Isn’t it true that by doing that proactively we have literally taken somebody’s investment, and instead of paying what could be 23.8 percent on the gain, to zero. Sounds like a good idea to me, Eric.

Eric: There’s not many wonderful opportunities in the tax code, but a zero percent tax rate is a pretty good one.

Patti: Let’s do a deep dive and nail this down. For people who are married, who’s in the 12 percent tax bracket? Up to what amount of taxable income?

By the way, guys, taxable income, to clarify, is not what you see on the front page. Taxable income is line 37 on your 1040, after you’ve taken your tax deductions.

When you’re trying to figure out whether this applies, you want to look at your 1040. Don’t look at the first page. You want to go to the top of the second page to find out what is the taxable married filing jointly income after you’ve taken all your deductions, including the new standard deduction, which for married people is $24,000.

A lot more people may find themselves in this 12 percent bracket. That’s why you want to really, really pay attention to this.

Eric: People that are the top of the 12 percent bracket is $77.400. If you’re someone who’s single it’s $38,700.

An important distinction is that it’s not all or nothing. Let’s say you do this. It doesn’t require surgical precision, because even when we do this, we have to make estimates, because ultimately, we’re not going to know exactly where you’re going to be on December 31st. We do our best.

Realize if you realize capital gains and go a little bit over that $77,000 number, and it spills over into the next bracket, you only pay capital gains on the excess above that bracket. Everything else is still protected at the zero percent rate.

Patti: That’s a great point. Sometimes when we talk about things, people say, “Well, I don’t think that that’s going to apply to me.” You know what? If it’s an investment that you kind of want to sell, you feel like you need to sell, why not?

Worse comes to worst, in this situation, you’re paying a 15 percent capital gains tax, but you could be avoiding a tax altogether on, pick a number, $10,000, $20,000, $50,000.

Eric: It can be huge, especially depending on the size of your gains. We’re in the eight or ninth year of a bull market, up until about a month or so ago, at least it seemed. A lot of people have really, really significant gains that have accrued in that run‑up, this is a great strategy for them.

There’s two important caveats that people really need to consider. Is, number one, we’re taking about the federal tax. If you’re a resident of PA or some of these other states, you may not pay federal tax, but you may be creating an additional state income tax by doing that, because a lot of states will tax capital gains.

PA, for example, they don’t allow you to write off losses, but you have to report your gains. Sorry, it’s very one sided.

The other important point to remember is that if you are somebody on social security and you can do this, remember that you’re increase your income by realizing capital gains, which means more of your social security benefit might actually become taxable because of that.

You have to be very careful and you have to be strategic. It is has to be very customized to the individual. You can’t use general rues of thumb, because that will get you into trouble.

Patti: Exactly. It’s one of those unintended consequences. You think you’re doing the right thing, and there’s this consequence on the other side.

Eric: Domino effect, right?

Patti: That’s why you really want to understand, holistically, the impact on your personal situation.

To highlight the people and understand, especially for those of you who are listening, if you are retired, you’re newly in retirement, you really want to think about this, because typically, what we find is that people go from a really high tax bracket, and then all of a sudden, you go into a really low tax bracket.

Let’s say you retire at 62. For the next seven or eight years, you’re probably going to be a really low tax bracket, much lower than you probably even realize. Then, as Eric said, when you hit 70 and half, you get hit with those required minimum distributions and you’re right back up there again.

What we’re talking about here is to be aware of where you are from a tax perspective. Think about where you’re headed, and optimize these years when you’re in the lowest tax bracket you’re probably ever going to be for the rest of your life.

Eric, this is so much fun. What else are we going to be talking about for year‑end? We’ve talked about tax loss harvesting, and then, on the other hand, accelerating gains. What else can our listeners do, our viewers do before the year‑end?

Eric: I’ll tell you what, I feel like we are hitting on all the high notes here, so why don’t we talk about something called Roth conversions? Have you hear about this concept before?

Patti: Yes.

Eric: I bet.

Patti: It’s one we preach.

Eric: [laughs] All the time. As you know, Roth conversions are something that, again, this is situationally dependent. It really depends on the situation and whether it makes sense. It also really takes somebody that can do a good forecast to where you’re going to be in the future.

In terms of Roth conversions for our clients, who do you feel is the typical client where this really makes sense for? What do they look like?

Patti: You go back to those people who are recently retired. If they don’t have a lot of non‑retirement assets where there’s lots of gains, this is a great plan B.

Plan B is, “Gee, should we take some of that 401(k), and take some of it out, convert it into a Roth, and take you up to the tippy top of that 12 percent tax bracket?” Because chances are you’re never going to be back here again, so let’s take full advantage of it. That’s a perfect situation.

Younger people who might have 401(k)s. They may have left their position and they’ve got this 401(k) hanging out there. Chances are, depending on their situation, it might be a good idea for those people also to consider converting that into a Roth IRA.

They’re, again, hopefully, in one of the lowest tax brackets they’ll ever be, because the goal, of course, is to always earn more income. If that’s the case, your bracket’s going to go up. Why don’t you convert that 401(k) into a Roth IRA while your tax bracket is still low?

Eric: That’s really key for our listeners, is that ultimately you have to be in this golden zone where the expectation is that your tax rates are temporarily low, but could be significantly higher in the future.

Under the new tax law the reality is that it’s going to sunset, anyway, in 2025. We’ll see whether there’s the political will to actually let that occur, but tax rates are scheduled to go up right now unless Congress acts.

Patti: That’s a great point. This is another example of being proactive. Let’s be proactive.

Here, for the people who’re listening, why the Roth? What’s the big deal with the Roth?

Were talking about converting into a Roth. What’s the big deal? Where’s the value coming into play?

Eric: The big thing with a Roth, number one, is that requirement distributions do not occur, where they do with a traditional IRA. There’s nothing that will ever compel you over your lifetime to force distributions from this account.

If you do have to take distributions, those distributions are never taxable. The earnings, anything that accrues in the account isn’t taxable, whether it be as part of a broader income retirement plan as you age, or maybe this could be an excellent vehicle for legacy intentions, where you can leave money to an heir that will never, ever be taxed during their lifetime.

Patti: It is absolutely the best thing that you can leave to the next generation. You look at your house. You look at your retirement plans. You look at your after‑tax, your bank accounts. Then you have this Roth. The Roth is a home run for those kids or the people that you care about most.

Also, to just frame it and understand, what is the value? You have two accounts. One is growing tax‑deferred. The other one is growing tax‑free. Same investment, same starting point, same rate of return.

Eric: The reality is, Patti ‑‑ that’s a great point ‑‑ is whether you have a traditional IRA or a Roth, the reality is the tax has to be paid somewhere. You’re going to have to pay taxes.

Whether you elect to pay them now with a Roth IRA or you elect to pay them some point in the future with a traditional IRA, the tax is going to have to be paid. It’s unavoidable. The real critical question is “What is the best rate to pay those taxes at?”

If you’re in this golden opportunity zone that we’ve talked about, depending on your situation, where your tax rate is really low, a Roth conversion is a great way to basically pay taxes now at a really low rate and avoid them in the future, when they could be a lot higher when other things come into play.

Patti: Isn’t it even better, Eric? If you have time, which is why I always bring up the point of younger people, if you have time, that ‑‑ pick a number ‑‑ $50,000 that grew to $100,000 that grew to $200,000 and maybe $400,000 over that lifetime, you can pay taxes on the $400,000 if you’d like, or you can have this $400,000 account.

You already paid taxes on the $50,000. You did pay taxes on that when you did the conversion. Guess what? You never have to pay taxes on $350,000. That’s about as good as it gets. The key here is time.

Eric: That’s a great point, too. A lot of people don’t realize when they retire that their traditional IRA or 401k has an unfunded tax bill that’s due to Uncle Sam at some point in time. Whatever that balance is, there’s still an amount that hasn’t been paid. Roth is a great way, or a Roth conversion is a great way to try and take advantage of a better tax rate.

Patti: We’re not going to get into it today, but maybe an idea for a future episode would be, Eric, is for…

Eric: I love ideas.


Patti: I know you do.

Eric: [laughs]

Patti: I know you do. Here’s the thing. What we should talk about ‑‑ let’s make a note of this ‑‑ is for those people who are in that zone, those people are really worried about or thinking about retirement income.

How am I going to create cash flow to replace the salary that I’m no longer getting? How do you choose one account over another account? Furthermore, how do you invest for that period of time? Again, we’re not going to talk about it today. We’re talking about year end tax planning ideas. Just know we’re going to be talking about that in the future.

Eric: Another reason to tune in to the next podcast.

Patti: You got it. We did Roth conversions. We’re talking about retirement plans. I’ll just throw this out there. For those of you who may be working, may have a spouse who is a stay‑at‑home parent, keep in mind that you can do IRA contributions for that non‑working spouse.

The income limitations have risen. You really want to take a look at that. The good news is you have until April 15th to fund it. It’s not a year end…You’re not up against the wall at this point in time.

Eric: That’s a good point. It’s something you have until April 15th, when you file your taxes, to do. It doesn’t have to be done by December 31st. You can still make a deductible IRA contribution or a spousal IRA contribution, as you’re alluding to, Patti, at any point in 2019 up until the tax filing deadline.

Patti: The one thing that I think does get overlooked, Eric, is this thing called the backdoor Roth, which does have to be funded before year end. Why don’t you walk people through what a backdoor Roth is? Just real quick and simple.

Eric: Basically, a backdoor Roth is normally most people that make over a certain income ‑‑ I believe it’s 189,000, is where the phaseout begins ‑‑ you have a limited ability, or, if anything, you’re precluded from making a direct contribution to a Roth. You can’t do it, but there’s a backdoor way that allows you to do it.

Ideally, this would be, again, for someone that doesn’t have substantial pre‑tax IRA assets. If you don’t have an IRA, anybody can open an IRA and contribute, regardless of your income. Ideally, you’re going to make what’s called a non‑deductible contribution.

Then you can immediately convert that over to a Roth IRA after you make that contribution. You’re not going to get a tax deduction for it, but the big part is that after‑tax contribution in that IRA moves right into a Roth. There’s no tax that’s due on it.

Again, it doesn’t really work too well for people that have pre‑tax money that’s out there, but it is a really, really powerful strategy. It’s a great way, as you point out, to get money in a Roth when most people thought they couldn’t because they make too much money.

Patti: Here is another example of just know the rules, know whether or not it applies to you, and make sure that you are avoiding any of the landmines. In this case, this landmine’s called the pro rata rule. Just understand it. Know whether or not it applies. Boy, if you can do these backdoor Roths, again, another…

We talk about home runs. These are singles. You’re hitting singles all along the way. You do this every year. I’ve got to tell you these are things that really can really leverage your retirement income later down the line.

Next topic. Again, year end, we’ve got people who are retired, who are 70 and a half. We’ve got a new tax law. One of the most powerful tools we have available in this arena is something called a qualified charitable contribution. A QCD is what we refer to it. Why don’t you walk people through that.

Eric: The QCD is a really powerful tool and is actually more and more relevant now, with the new tax law, than it ever was. It doesn’t matter if you’re somebody that has a very large IRA account or somebody that has a more modest balance. This is applicable to you.

The reality is with the new tax law, they raised the standard deduction. A lot of people, where they would itemize, that’s how you get credit for the charitable deductions you might give to your church or local charity when you make cash contributions.

You don’t really get the benefit from that now if you have to standardize. Most taxpayers will have to standardize. There is a way to leverage your gift through what’s called a qualified charitable distribution, basically, through your IRA.

The way it works is basically as long as you’re over 70 and a half when you make the contribution, you have to make the check directly payable to the charity, say, to your local church, local food bank, whatever it is, the organization that you’re supporting.

You have to make the check directly payable to them. It counts towards your required minimum distribution, to the extent that you haven’t taken it for that year, but it is a non‑taxable distribution from your IRA.

Patti: Basically, just to use an example, let’s say that your required minimum distribution is $20,000. Let’s say that you typically donate $5,000 a year to charities of your choice.

If you take that $5,000 out of the $20,000 that the IRS is forcing you to take out, guess what? You’re only paying taxes on $15,000. You’ve got the $24,000 standard deduction, and you’ve got another $5,000 that you otherwise wouldn’t have gotten if you didn’t do this.

Again, another tip, tool, thing that you can do before year end to really get some leverage and get some benefit next April.

Eric: With the new tax law, you might not be able to take that deduction otherwise. One important point too is just remember that your year‑end tax document is not going to reflect the QCD. This is something you have to remember to tell your tax preparer to put on your return.

They won’t know otherwise, unless you have, basically, the proof from the charity. You also have to tell your tax preparer to put it on there. Your 1099 will not show it. It comes up a normal distribution.

Patti: That is a really, really important point. How often do we find people don’t take the deductions that we set up for them just because they didn’t tell their CPA? Great point there, Eric.

Eric: You bet.

Patti: Taking on to the next subject. Since we’re on charitable contributions, given the fact that most people are not going to be able to get the benefit that they used to get from charitable contributions, what are we telling people today?

Eric: I guess there’s a couple concepts or strategies that are out there for people. Again, you’re absolutely right.

With the new standard deduction that is going to minimize the ability to take a charitable deduction, what a lot of people are suggesting now is rather than giving each and every year, as you might, it’s this concept of bunching or taking five, maybe six years of charitable contributions and putting them all together in one.

That way, you’re going to be able to itemize that charitable deduction, rather than taking the standard deduction. That’s a concept that people can do and they might want to think about.

Another is, a really great way to leverage a gift is if you have appreciated securities, an appreciated stock maybe that you owned for many, many years or in a company that you used to work for, so forth. A great way to do this is that you can actually donate that appreciated stock to what’s called a donor‑advised fund.

This is a bit of an advanced concept here. Obviously, we encourage you to talk to a qualified professional and have them help you out with this. It’s a great way where you can make a gift, get a charitable deduction, and you can avoid the capital gains tax on an appreciated security.

Patti: Again, it’s lots of things wrapped up in one to give you many benefits just with this one tool. That’s excellent. I guess the other thing that I’m thinking of is for the families in our audience. We’ve got lots of families who are putting kids through college, etc.

There are 529 plans. We live in Pennsylvania. Pennsylvania actually is one of the states that gives you a Pennsylvania income tax deduction on your contribution to a 529. You can gift up to $15,000 per person per year. Husband and wife can do $30,000. You write it right off of your Pennsylvania income tax.

It saves about $900. It’s $900 that you wouldn’t have had otherwise. That money also grows tax‑free for that important objective of putting your kids through college and now, under the new tax law, even high school. Again, it’s just one of those things out there.

Eric: There are very few things out there that really help you to leverage the tax benefit. A 529 is definitely one of those. As you just alluded to, you’re getting a PA state tax deduction. The money’s growing tax‑free. As long as you’re using it for a qualified education expense, there’s no taxes due on any of the earnings.

It’s really a great vehicle and far superior to some of these things that I had when I was a kid. My parents used things like UTMA or UGMA accounts. A lot of times, these were set up for educational purposes. The 529, in terms of tax benefits, is far superior to what these older vehicles used to have. Definitely a great way to go and a great thing to do before year end.

Patti: Again, remember, there is full reciprocity for any state, whether your child wants to go to college. That is not a restriction. Pennsylvania’s one of the only states that does give you the tax deduction even if you wanted to invest in another state’s 529. Eric, like I said, I’m really jazzed up about this subject. We’ve talked about a lot of things.

Eric: How could you not be?


Eric: It’s taxes, for goodness sake.

Patti: I know. How about it? How about it? You know what? It’s one of those things where if we can save somebody $5,000, $10,000 that they otherwise wouldn’t have had, that’s a good day. I think that’s a really good thing.

Eric: You know what, Patti? It’s such an important thing. I think it’s why we both love what we do. It’s these little things that add up with each person. Every situation is different.

Again, like you said, you had this great concept that I love, of hitting singles. I’m going to have to put that in the memory bank and remember to use it again. It’s this whole concept of hitting singles.

Lot of people are always looking for that home run. What’s that big thing we can do? That’s not really how it works. It’s about finding these little things that we can do each and every year, that will add up to a big difference over the long haul.

Patti: Let’s wrap this up and talk about action items. Number one, we talked about tax loss harvesting. Look at your non‑retirement accounts. See if there’s any losses to harvest.

Eric: You got it.

Patti: Number two, we talk about accelerating capital gains. If you’re in a 12‑percent tax bracket, go ahead and take those capital gains. You pay no tax when you realize that gain. Again, that’s a really, really big win for you. We also talked about…Go ahead.

Eric: I was going to say rarely is zero a good thing in life, but in this case, it is.

Patti: Boy, you’re not kidding.

Eric: [laughs]

Patti: You’re not kidding. We also talked about QCDs. For those people who are 70 and a half or older, take your charitable contributions from your required minimum distribution.

Instead of writing out the check, just take it out of the required minimum distribution. That way, you get your standard deduction and you get the charitable deduction, as well. What else?

Eric: Just again, with IRA contributions, just remember they don’t have to be done by year‑end. Don’t panic. If we are in between Christmas and New Year’s and you’ve forgotten about doing it, you have until April 15th.

Patti: Roth conversions.

Eric: Yup, Roth.

Patti: Remember Roth conversions. If that situation applies to you, if your tax bracket is low, it’s usually a temporary situation. Certainly with the way the tax code is currently working, think about Roth conversions. Also, 529 plan contributions. By the way, not just for parents. Also for grandparents. Hey, everybody gets the benefit, especially the kids.

Eric: Yup, absolutely. You’ve brought up a lot of great points. I think the big thing underlying all this is just remember that all of it is so much based on the individual situation. It is truly customized. This is not something where just rules of thumb or conventional wisdom always work out so well.

Patti: Because our listeners have listened today, at least they’ve got some new tools, new nuggets that they can ask somebody about. If you don’t know what your situation is, whether or not they apply to you, go to your advisor.

Again, it doesn’t have to be Patti Brennan and Eric Fuhrman or Key Financial. There are a lot of good advisors out there. Talk to your tax professional. Just do these things. Do these things. These singles lead to runs and lead to World Series championships. With that, thank you so much for tuning in. We will see you next week for the Patti Brennan Podcast.