281 | Don’t Risk Bad Investments for Good Tax Breaks: Introducing Ultra Tax Efficient Wealth Management℠, Part Two

[INTRODUCTION]

[00:00:00] Hilary Hendershott: Well, hi, Money Lover. This is the second part of a conversation between myself and my husband, Robert, who’s my firm’s new Chief Investment Officer, and we’re talking about a new-to-market offer that can help you and your friends and colleagues save a lot of money on capital gains taxes. If you haven’t listened to the first part. Please stop, go back, and listen to that before you listen here today because otherwise, this won’t make much sense to you.

[00:00:35] Today, we’re talking about Ultra Tax Efficient Wealth Management^SM, which I’m going to occasionally abbreviate as UTEWM^SM. UTEWM^SM is a term unique to my firm. We’ve actually applied for a trademark on it, and it describes a suite of services my team of advisors is wrapping around a managed taxable account, the net result of which has you, the investor, accumulate market-like returns at the same time as you accumulate large amounts of taxable losses. Those taxable losses don’t limit your real returns but do allow you to cancel out gains, saving you potentially millions of dollars in capital gains taxes. Like I said, this is new-to-market, so you probably haven’t heard about this before because it’s now being offered to everyday investors for the first time.

[00:01:22] It’s being offered by investment managers who have the technical skill, experience, research, and wisdom to accomplish it accurately and effectively, and that part’s important. Robert and I both, Robert especially, have decades of experience evaluating these kinds of investment opportunities, and our due diligence process is extremely detailed. In the last episode, we talked about how we both overcame our disbelief and got on board with this particular strategy. We decided as a couple that Robert would come out of his new retirement to provide consultation to my firm and my clients to make it, well, now they’re our firm and our clients, to make it easier for people to take advantage of this offer. It is exciting, it’s flexible and it’s widely applicable, and it is better than most, if not all, of the current methods to minimize capital gains taxes.

[00:02:13] Today, we’re going to talk specifically about how some of those other methods stack up against Ultra Tax Efficient Wealth Management^SM, the technical underpinnings of UTEWM^SM, and an example of what it would look like if you deployed a UTEWM^SM strategy when it comes to taking your retirement distributions. All right. Let’s get into it.

[EPISODE]

[00:02:35] Hilary Hendershott: Robert, welcome back.

[00:02:38] Robert Hendershott: Thank you. Thank you.

[00:02:39] Hilary Hendershott: Robert, you and I have both had many conversations with investors over the years about how they’ve decided to minimize and avoid capital gains taxes, and we’ve never been fully on board with some of those ways. Can you share with our listeners a few of those methods, their characteristics, and their downsides?

[00:02:56] Robert Hendershott: Sure. And first, with a caveat, let’s be clear, I am not a CPA, I’m not giving tax– I’m not even giving investment advice here. And I do know a fair amount about this, because there are ways to avoid capital gains taxes, and they generally fall into a category that I call bad investments with good tax benefits. Like, the most extreme example of that is don’t make any money and you won’t owe any taxes but that’s a terrible strategy for building wealth. So, we are looking at a way for you to have good investments with great tax benefits.

[00:03:31] Now, there are alternatives. People often get into residential real estate that they rent out because they can take depreciation allowances, and that has its upsides and its bad sides, but it’s not a great investment with great tax benefits. People talk about opportunity funds, and I’m going to use the IRS’s exact language here: “An investor can defer tax on any prior eligible gains”–so they can take gains that they currently have and roll them forward–“to the extent that a corresponding amount”–which means that money is timely invested–“in a qualified opportunity fund.” So, if you take money that you have and you roll those gains into a qualified opportunity fund, boom, you’re deferring your taxes. And if you defer long enough, it’s like not paying taxes, and in this case, you can actually not pay taxes. So, qualified opportunity funds, let’s go with that.

[00:04:29] Hilary Hendershott: Qualified opportunity fund. I like the name.

[00:04:34] Robert Hendershott: Yeah. I like the name, too. The investments, not so much. See, this is a particular program based on particular goals that Congress had around which the IRS was tasked to create niche rules that would govern this opportunity. So, you have to follow very specific rules. There are reporting requirements, there are a bunch of requirements, but the primary is you have to invest in what’s called an opportunity zone. These are usually economically depressed areas–Detroit has a big opportunity zone–where the government wants private investment dollars to go in order to counteract what has been passed blight.

[00:05:20] Now, this sounds noble but it’s not worth sacrificing your retirement egg to do it. People do it for the tax benefits, and there are juicy tax benefits, although you only get them if you keep your money locked up for a decade.

[00:05:36] Hilary Hendershott: So, you wait to see what your returns are for a decade. Meanwhile, the overall stock market is expected to be producing something like 8% to 9% returns. So, that becomes your opportunity cost. I’ve never recommended an opportunity zone investment because the core of what we do for clients is secure those expected returns of the market, and that’s what all of our retirement calculations are based on. You can’t effectively plan when your money is locked up for 10 years in an investment with unknown returns.

[00:06:21] So, it could be, at the end, tax-free, but all that c omes at the cost of planning, confidence, peace of mind, and maybe dollars. If your opportunity zone investment ends up paying 3% a year for 10 years, yes, it’s tax-free, but that’s like having invested in a CD. You’ve lost quite a bit of money.

[00:06:47] So, I don’t like them, and we’ve never used them as a firm.

[00:07:10] People also sometimes talk about solar tax equity financing. Robert, what do you know about that?

[00:07:39] Robert Hendershott: That’s another of a long list of bad investments with good tax benefits. And, look, when I say bad investment, I don’t mean that these things never pay off. Sometimes they do. What I mean is that they fail the big benefits, low-risk requirement that I have for a good investment. What you want is a strategy that produces reliable gains, at least as reliable as possible, in the real world, and doesn’t create gains on your tax return.

[00:08:09] So, you need the investment to be diversified. If you do a bunch of solar tax equity financing, that’s not diversified. Opportunity zones are not diversified. You want to make money on your investments without taking too much risk but have the IRS insist that you don’t owe any taxes yet. Or better, yet, you could have those same investments that are making returns without too much risk, have them produce taxable losses.

[00:08:40] Hilary Hendershott: Yeah. The IRS is an incredibly bureaucratic institution, but if you figure out how to play by their rules, you can come out better for it.

[00:08:48] Robert Hendershott: Right. Tax efficiency opportunities are created by IRS rules. That’s what makes them legal. You don’t want to go outside those rules. That is a very bad idea, and people sometimes do crazy things, break the rules, and try to avoid taxes. They hate taxes, and they end up in jail. I’ll give you an example. Larry Conner is a guy who was indicted last summer for selling complicated trust structures that violated everything about tax law, the letter, the spirit. And his clients have been indicted too so they paid him tons of money for the privilege of bad advice that ended up with him in jail and some of them in jail. And actually, when I think about it, I guess we need another category, which would be Bad Tax Benefits and Bad Investment.

[00:09:37] Hilary Hendershott: I would call that category Do Not Do. Mr. Conner’s clients were probably initially really excited and happy. They thought they were going to save millions of dollars in taxes, and then they ended up in jail.

[00:09:51] Robert Hendershott: Yeah. You want to be clear what the basis is for the tax benefits that you get from any of these strategies. In the Conner case, there was a whole series of trusts that each created phantom deductions that ended up with a charitable foundation that lent money back to the original taxpayer, I guess, non-taxpayer. And you can probably see where that ends up.

[00:10:13] Hilary Hendershott: You think? Straight to jail. Do not pass go. But somehow the clients, they didn’t see it–or didn’t want to see it.

[00:10:21] Robert Hendershott: Yeah. People do crazy things trying to avoid taxes.

[00:10:25] Hilary Hendershott: That they do. You really have to pay attention to your North Star when it comes to tactics like these. I remember Wesley Snipes going to jail for three years after getting caught in a bogus sovereign citizen tax scheme, and he didn’t pay his taxes.

[00:10:40] Robert Hendershott: And that is a pretty extreme example. You do not want to do that one but, ya know, in my opinion, you don’t want to pursue niche schemes that may abide by the letter of the law but often violate the spirit of the law. Captive insurance is something that a lot of small business owners consider using. This is where the business owner sets up their own insurance company, and it’s set up to insure their brain or their eyes or their fingers or something because they wouldn’t be able to run their business without them. It’s a niche policy that isn’t easily acquired, so you have to set up a new insurance company in order to get the policy.

[00:11:16] And voila, you can deduct the premiums you pay for the insurance. You have access to all the tax benefits of an insurance company. It’s really a great deal, but is it legal? Maybe. It depends on whether the new insurance company was formed with the intention to pay legitimate claims. Was it? How do you prove that? Is it even true? I mean, it seems crazy to risk your wealth and your freedom on what’s potentially an illegal tax scheme, no matter how tempting it might look.

[00:11:48] Hilary Hendershott: Yeah, but Ultra Tax Efficient Wealth Management^SM is not crazy.

[00:11:53] Robert Hendershott: No, no, no, this is so far from that. It’s based on a fundamental feature of our tax code. It’s not an IRS niche rule that can be legally exploited. It’s a core principle that the tax consequences of investment gains and losses, those consequences occur when those gains or losses are realized, not before.

[00:12:13] Hilary Hendershott: Right. So, your portfolio goes up in value, but you don’t pay taxes until you sell. So, that’s tax deferral.

[00:12:21] Robert Hendershott: Yes, your stocks, your home, your business, all capital assets operate under this rule. It’s a foundational principle of the US tax system. And actually, it’s a foundational principle of all practical tax systems.

[00:12:37] Hilary Hendershott: And when there are rules, you want to plan based on those rules.

[00:12:41] Robert Hendershott:  Yes. The rules create an opportunity. A good analogy might be the three-point shot in basketball. That rule means that you want to take more long shots, at least if you want to win.

[00:12:52] Hilary Hendershott: So, how does Ultra Tax Efficient Wealth Management^SM help people hit those three-pointers and win the game?

[00:12:59] Robert Hendershott: Well, fundamentally, by planning to optimize the timing of investment gains and losses. So, Ultra Tax Efficient Wealth Management^SM looks across the entire portfolio for an investor, across the rest of their lives, and plans to give the investor the benefits of deferring gains while strategically realizing losses to enable some of those gains to be taken without triggering capital gains taxes.

[00:13:29] Hilary Hendershott: Just like when we do tax-loss harvesting.

[00:13:51] Robert Hendershott: Good point. It’s exactly the same, and we talked about that in the last episode. The challenge with tax-loss harvesting is the opportunity to take losses tends to dry up over time, at least we hope so. We want good tax benefits with a good investment. Good investments don’t naturally provide losses to harvest, but Ultra Tax Efficient Wealth Management^SM is different. By using an actively managed market-neutral, long-short overlay, along with the existing portfolio, we get something that’s designed to make sure there are consistent losses available to harvest while deferring the offsetting gains. And the overlay is also designed to enhance investment returns by design. Of course, that’s not guaranteed.

[00:14:34] Hilary Hendershott: There’s really a lot to unpack in everything you just said, What do you mean by actively managed?

[00:14:46] Robert Hendershott: Well, basically, it means you do a lot of trading in pursuit of your investment goals. So, you’re selling stocks and buying stocks with a particular goal in mind, which is usually, first and foremost, earning a higher return, which is hard. And, spoiler here, that’s not the primary goal of Ultra Tax Efficient Wealth Management^SM.

[00:16:21] Hilary Hendershott: Yeah. And to a degree, I’m a little nervous bringing something that includes active management to my listeners and my clients. I mean, active management is something we’ve vocally and clearly shied away from at Hendershott Wealth. To say it really plainly, for the most part, I considered it anathema.

[00:19:09] Robert Hendershott: As well you should. I mean, history shows that active trading and pursuit of returns doesn’t work out very often. I mean, there’s lots of research that shows this. Even when I ran the hedge fund, we were largely buy-and-hold small bank stocks waiting for them to be acquired. We did not do a lot of trading.

[00:19:25] Hilary Hendershott: Right, but with this solution, which trades liquid stocks in the most efficient markets, the active management is primarily in pursuit of tax benefits, not maximizing returns. So, I really had to kind of reverse my thinking about the badness of active management in order to wrap my arms around that.

[00:19:48] Robert Hendershott: Yes, and I had to reverse my thinking about maximizing returns. And once I got that new perspective, it was easy to get excited about this because returns are very elusive. Nobody knows whether publicly traded stocks–or any stock–will go up next week, down next week, month, the year. We don’t know.

[00:20:12] Hilary Hendershott: Right. At the risk of sounding repetitive, there really is, despite what the media will continue to say, there is no Wall Street Nostradamus. Tax benefits, though? Those can be predictable and reliable. I mean, that isn’t to say that return benefits are impossible. Ultra Tax Efficient Wealth Management^SM uses a systematic quantitative trading strategy that’s intended to produce a small return benefit in addition to tax benefits.

[00:20:51] Robert, can you explain for our listeners why “small return benefits” should be of interest to our listeners?

[00:22:30] Robert Hendershott: Sure, because that’s not the main goal of the Ultra Tax Efficient Wealth Management^SM strategy. The real juice comes through the tax benefits, and that’s the more reliable piece of the puzzle.

[00:26:17] Hilary Hendershott: All right. Everyone listening is going to want to know what this strategy costs. So, I’ll talk about costs. The costs come from trading, financing, and managing the strategy. So, these days, trading costs in this strategy are super low, virtually zero. There are financing costs to the investor because the UTEWM^SM strategy is built on a market-neutral, long-short overlay. but you’re basically betting that a stock price will go down. That produces the taxable losses. Financing a long-short portfolio is generally pretty cheap because while you’re paying interest on the money you borrow to buy the stocks, you’re earning interest on the money you receive when you short-sell the other stocks and all you end up incurring is the modest net cost.

[00:27:21] The strategy has management costs because you need the strategy done right. The total cost depends on precisely how the strategy is designed, which depends on the individual investor’s situation, and that’s something we can consult with you about.

[00:27:44] Overall, the costs are high compared to an index fund. So, this is another place where investors are going to need to rethink previously strongly held beliefs, right? We all come from a strongly held belief–and it’s true–that when it comes to standard investing costs, low costs are the best predictor of high returns. So, in this case, yes, I’m saying flat out, the costs of this are high compared to an index fund, but the costs are very low compared to the tax benefits.

[00:28:24] And the cost could be totally offset by any incremental return on the long-short overlay.

[00:28:32] So, Robert, you mentioned earlier that the strategy is designed to produce a positive return despite being market-neutral. That could offset the cost too, right?

[00:28:42] Robert Hendershott: Absolutely. That’s the goal with any market-neutral portfolio. Market portfolio is going to go up and down with the market. A market-neutral strategy is going to perform regardless of the direction the market goes. It’s not guaranteed, but the goal would be that the strategy generate 1% to 2% a year, and that would more than offset costs. Now, market-neutral strategies that generate 1% to 2% a year are very plausible. These kind of strategies that generate consistent maybe 10% returns are very hard to sustain. They’re difficult to find, and they tend to go away because everyone is searching for them. They also tend to be hard to scale.

[00:29:32] Market-neutral strategies that earn double-digit returns and scale make billionaires, and that attracts competition, so that would be very hard to do. And, in fact, in my past life, our hedge fund delivered double-digit returns, but it didn’t scale beyond a few $100 million. And even then, we saw performance erode over time as competitors mimicked our strategy. This is looking for 1% to 2% returns. That’s a very different animal because that kind of strategy doesn’t attract competition because that kind of strategy isn’t worth very much.

[00:30:10] Hilary Hendershott: Right. The positive returns created by it aren’t worth very much, but when you’re also creating large tax benefits at the same time, that’s worth a lot. Okay. So, now it’s a good time for a reminder of what we mean by market neutral.

[00:30:27] Robert Hendershott: That is when you borrow money to buy stocks while offsetting the risks of having these additional stocks by shorting another group of stocks. So, together, the long stocks and the short positions make up what we call the long-short overlay, and the two pieces are balanced. So, the overlay is designed to perform the same whether the stock market is going up or it’s going down.

[00:30:51] Hilary Hendershott: So, like we mentioned, the investor’s core portfolio will still rise with the market, but the long-short overlay will not add to returns.

[00:31:01] Robert Hendershott: Exactly. The overlay is designed to make small profits, whether the market goes up or down, and of course, that’s not guaranteed. That’s the strategy risk. But at the risk of sounding like a broken record, all of Ultra Tax Efficient Wealth Management^SM‘s reliable juice comes from the tax benefits. The returns are just a little extra.

[00:31:23] Hilary Hendershott: The investors’ returns are basically the same, hopefully, a bit higher, as they would have been with globally diversified, low-cost portfolios I’ve always built for clients, and tax benefits are the big difference. And long-short is how you get market-neutral.

[00:31:40] Robert Hendershott: Yes. You’re holding hundreds of stocks both long and short with the overall long and short positions pretty much canceling out. But the key thing is long-short is how you get the reliable tax benefits.

[00:31:53] Hilary Hendershott: Say more about that.

[00:32:01] Robert Hendershott: Ultra Tax Efficient Wealth Management^SM is way more powerful than other strategies like tax-loss harvesting and direct indexing because at any time when you have hundreds of positions long and short, there will reliably be stocks showing a loss. That’s not true with the other strategies.

[00:32:21] Hilary Hendershott: Right, particularly short positions, given the market tends to go up over time. And that is the Achilles heel of tax-loss harvesting and direct indexing.

[00:32:31] Robert Hendershott: Yes. You’ve got to have that short piece to produce reliable, ongoing tax benefits indefinitely.

[00:32:38] Hilary Hendershott: But as you take the losers out of the long-short overlay to realize losses, aren’t you shrinking the portfolio and giving up diversification?

[00:32:48] Robert Hendershott: Well, you definitely would be if this was just fire and forget. But every time you take a stock out of the long-short overlay, you’re going to replace it with another stock that fits the underlying quantitative strategy. So, the portfolio is continually changing and evolving strategically but not shrinking. You’re taking losses, you’re deferring capital gains, you’re getting the full benefit of compound returns, and you can keep doing this indefinitely.

[00:33:30] Hilary Hendershott: And you, dear money lover, might be thinking, “What about when it comes time to spend my money? The strategy you describe, Hilary and Robert, it sounds like it provides great tax benefits now, but what about all those deferred gains later? Like, I still have to sell this stock to spend my money. So, isn’t there a huge tax bill waiting to happen?”

[00:33:51] And that’s one of the best parts. Ultra Tax Efficient Wealth Management^SM is designed to handle the fact that you get into retirement with a massive portfolio that has huge unrealized capital gains. That situation is exactly where the strategy can bring the most benefit. So, Robert, please tell them how the strategy would work while the investor is taking account withdrawals in retirement.

[00:34:17] Robert Hendershott: Well, this is where the design is so clever. Because of the short piece, you have ongoing, basically forever, tax benefits being created by this portfolio you’re going to have anyway. So, you’ve got this large portfolio, you’ve built up this great nest egg for retirement, and instead of just spending it down, you’re also using it to create value that then supports the nest egg itself. So, let me give you a simple example. This is back of the envelope, but it’ll demonstrate why this is so important.

[00:34:52] So, let’s imagine a couple had worked hard and accumulated a $5 million nest egg. So, you’ve got this big chunk of money, some of it is capital gains, probably a lot of it is capital gains, and so as the couple spends this money in retirement, they’re going to be paying taxes. So, maybe they take out $250,000 a year in order to be able to spend $220,000 a year because they have to pay $30,000 in capital gains taxes. This sounds pretty awesome. They worked hard all their careers, and now they’re enjoying the benefits.

[00:35:44] Hilary Hendershott: But they’re still paying $30,000 a year in taxes, spending an after-tax account because of the gains.

[00:35:53]Robert Hendershott: Yes, and that’s where Ultra Tax Efficient Wealth Management^SM can help–by creating losses that contemporaneously offset the gains that are being realized when the investor starts spending their nest egg.

[00:36:10] Hilary Hendershott: So, they’d have $250,000 to spend instead of $220,000 or they could withdraw and spend $220,000 instead of withdrawing $250,000 to spend $220,000.

[00:36:30] Okay. So, Robert, does the tax bill eventually come due?

[00:37:40] Robert Hendershott: Not necessarily under the current law. I mean, the benefits are big, even if they defer taxes, but because of the tax basis step-up at death, which is that provision that adjusts the cost basis of inherited assets to fair market value, at the date of death, there are no taxes due on the money that gets left to the kids.

[00:38:39] And this is a really important consideration. It’s something that Ultra Tax Efficient Wealth Management^SM allows couples to do rather than spending down their money. So, if you think about it, either– You’re going to spend $220,000 a year. Without Ultra Tax Efficient Wealth Management^SM, you are taking out $250,000 a year in order to get that spending power. With Ultra Tax Efficient Wealth Management^SM, we’re saying you could spend the $220,000 a year by taking out $220,000 a year because the UTEWM^SM gives you enough losses each year to offset the gains embedded in the distribution. So, it’s easy to imagine, taking out $250,000 a year, that this couple could maybe spend down most of their $5 million over the remainder of their life.

[00:39:55] Hilary Hendershott: Yes. And just as a reminder, we’re just using this example to make a point that Ultra Tax Efficient Wealth Management^SM leaves people with far more money than they would otherwise have. It’s not like we at Hendershott Wealth let our clients draw their portfolios down to nothing or even anything close to nothing in retirement. We closely calculate what the portfolio can afford to pay and still maintain its original principal balance.

[00:40:19] Robert Hendershott: Exactly. Now, I’m using this example so everyone can get their arms around the difference that this can make for their long-term portfolios. Our investor is taking $250,000 out to spend $220,000. Over time, their nest egg is going to dwindle. Unless the market is doing amazing, that’s too much. But with Ultra Tax Efficient Wealth Management^SM, they would only need to take out $220,000 a year. That extra $30,000 over the entire decades of retirement is likely to leave them with the same quality of retirement without digging into their nest egg, which means leaving $5 million to the kids because each year they don’t have to take as much out of the account.

[00:41:55] Hilary Hendershott: So, this example kind of illustrates for you why Robert and I both got just so excited about this opportunity and why I think you should be excited about it too. I mean, in the case of these two investors we’re talking about, they get a great retirement, far more spending than they otherwise could have done, and they still get to create generational wealth. By the way, for those of you with a keen ear to the numbers, here you can find all of our backup calculations in the show notes for this episode.

[00:42:47] Robert Hendershott: Ultra Tax Efficient Wealth Management^SM isn’t suitable for everyone, but it can be absolutely huge. It’s really amazing. You have this portfolio, and that portfolio itself is awesome, and it can also provide you with valuable tax benefits. So you get the same portfolio, not just financing your retirement, but offsetting the taxes that you would have had to pay during your retirement. So, last episode, we used the ‘have your cake and eat it too.’ That’s what we’re talking about. And to extend that analogy, now you have icing on your cake, and it’s not just any icing. It’s yummy cream cheese frosting.

[00:43:27] Hilary Hendershott: And this couple could just eat a bigger cake and spend a quarter million dollars a year in retirement. Either way, this can make a massive difference in your financial freedom, and really, without risking your personal freedom. I’m looking at you, Wesley Snipes. No jail time.

[00:43:56] Hilary Hendershott: And that really is it. You have made it through a comprehensive conversation about Ultra Tax Efficient Wealth Management^SM. I’m sure it felt complex, but it really is real. We can help you implement it. For all of you Money Lovers out there, I hope this pair of conversations between me and Robert has helped you see why we’ve altered our lives so significantly over the past five months to bring you this opportunity. We gave the example of investors heading into retirement in this conversation, and there are powerful applications of this strategy for investors who are selling businesses, earning equity compensation, who find themselves with large, concentrated, taxable portfolios, and more.

[00:44:37] You know if you have large capital gains looming, and the sooner we can start planning for that, the more impact my team and I can have on your ability to grow your nest egg. Part of the Ultra Tax Efficient Wealth Management^SM offer with Hendershott Wealth is that we will create custom analyses for your specific situation. As each of these situations call for custom planning, we’re here to help you find the one that best fits your circumstances and keeps your money in your accounts. To find out if you’re a suitable client and get started on a custom proposal for Ultra Tax Efficient Wealth Management^SM, head to HendershottWealth.com/contact to get in touch.

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