Ah, the traditional pleasures of September. Summer's heat starts to recede. Pumpkin-spice-flavored everything starts to appear on menus. People get in their first complaints of the year at seeing retailers roll out the Christmas marketing before they've even picked out their Halloween costumes. And, of course, the month would not be complete without a mailbag show from Motley Fool Answers podcast hosts Alison Southwick and Robert Brokamp.
To help them address all your autumnal financial conundrums, Sean Gates, a financial planner with Motley Fool Wealth Management, returns to the studio. There are questions about how to short stocks (and if you should), how to pay for higher education, how to reduce risk, and more.
A full transcript follows the video.
This video was recorded on Sept 25, 2018.
Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I'm joined, as always, by Robert Brokamp, and because it's the monthly Mailbag, we are also joined by Sean Gates.
Robert Brokamp: Yay, Sean!
Sean Gates: Whoa! Nice to be back!
Southwick: Hey, he's a planner at Motley Fool Wealth Management, a sister company of The Motley Fool, and today we're going to cover your questions about shorting indexes? Do you prefer indexes or indices?
Gates: Indices.
Southwick: You prefer indices? Bro?
Brokamp: Sure, why not? I'll go with Sean. I think when I write about it, I almost always say indices. I think that's true.
Southwick: Well, you can say it either way, by the way.
Brokamp: OK, there we go! Alison has spoken.
Southwick: We're also going to talk about... It's not just me! We're also going to talk about how to invest $500 inheriting stock, and 401(k) Roth tax consequences. All that and so much more on this week's episode of Motley Fool Answers.
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Southwick: All right, Sean, are you ready to get into it?
Gates: Hit it!
Southwick: The first question comes from Eric. "I have been doing some research into how to minimize my tax burden in retirement and have been using the TurboTax TaxCaster. Just as an experiment, I entered the following information, and it said I would not owe any taxes for 2018." Are you ready?
Brokamp: We're ready!
Southwick: "Single. Head of household. Age 48. Taxable wages, zero. Qualified dividends, $65,000. Is this true or is there a catch?"
Gates: Yes, so this is true. There is no tax due because of the preferred nature of qualified dividends. So if you're head of household, that means you're sort of coupled up to some extent and the limits for that preferential rate can range, as a single person, from $0.00 to $38,600 [or] if you switch over to the married, filing jointly; $0.00 to $77,200. If you fall in those ranges your capital gains rates and your qualified dividends rates are at 0%, so you don't owe any taxes on it.
Now, you want to keep in mind that qualified dividends are a very specific type of result from a particular investment, and so you're concentrating yourself into a particular type of investment to get that tax qualification. I just want to make sure that you understand how that affects your overall diversification investment portfolio.
Brokamp: And by capital gains you mean long-term capital gains, of course; not short-term capital gains.
Gates: Correct. Exactly.
Brokamp: And it could even be better, for Eric's looking at this at age 48. Once you're 65 you get a higher standard deduction and, of course, in retirement you get Social Security and at least part of your Social Security is tax-free; so really, there are a lot of ways where you'll pay much less taxes in retirement.
Gates: And one other thing to keep in mind. In this case, particularly, you're looking at the current year and you get really excited because you see, "Oh, man I'm not going to pay anything in taxes." But what you really should start to think about is your lifetime tax liability, because if you're 48 and you have no taxable income; yes, you'll get the qualified dividends rate but maybe you could consider pulling money from your IRA early [now you have to be mindful of potential penalties and it gets complicated], but you could harvest income strategically in those low-income tax rates to potentially avoid future tax liability that might be higher because of things that Bro mentioned.
Southwick: The next question comes from Ron. "On last Friday's Industry Focus podcast, there was a question about shorting. I am in total agreement that shorting is super, super risky because of the unlimited downside, but what about ETFs that short the market or an index? I'm under the impression that if I am wrong, I would just lose what I invested." Why don't you start by explaining what shorting is?
Gates: It's basically the reverse of investing in companies for the long term. In this case you're taking a bet against the company that they will do badly. You want to profit from that company doing badly, so you borrow shares from either other investors or from the market and your bet is that that company will do badly and as a result of the deterioration in its stock price, you will gain value.
And typically, it's considered riskier, because when you short a stock you have a potentially unlimited loss potential, insofar as if you buy Amazon at $10.00 a share and you're short, if it goes up to $1,000 a share, you're on the hook for that continuing compound loss. It could go to $10,000 a share, etc. Theoretically, if you held that investment permanently, you would just keep losing money.
Southwick: The market keeps going up...
Gates: Yeah.
Southwick: ... but a stock can only go down to zero.
Gates: Exactly.
Brokamp: What this person's basically saying is if I instead put $100 in one of these short ETFs, in that way he's just risking the $100. So to a certain degree he is right in that he is somewhat limiting his losses.
Gates: That's right. In this case the ETF is creating a portfolio of shorts. You're participating in that collection, and your loss is capped at how much you've invested in that inverse ETF vs. directly shorting stocks, so you get a little bit of downside protection.
Brokamp: If he is looking to reduce his risk in the market, I would generally say these short ETFs are not the way to go. We, here, at The Motley Fool think if you're worried about the market going down too much, just have some money on the side. One of the problems with these inverse ETFs is that they don't often perform as you would expect.
You'd think, "Oh, if the market is down 10%, I would have made 10%." But the history of these is that they often don't perform that way. Sometimes they're a little better and sometimes they're a little worse, but they don't often perform as expected; so, if you're going to use one of these ETFs, research the history to make sure that you get a sense of how they perform given different market conditions.
Southwick: I could see how this could be tempting to someone who thinks that the market's due for a crash.
Gates: Totally, yeah!
Brokamp: Right, exactly. Just in the history of this show, and we've been on the air for over three years, now, we've been having these questions about [why] the market keeps going up. I'm worried. I should do something about that. For example, there's an inverse ETF called "DOG." It is the inverse of the Dow Jones Industrial Average. So if you became concerned in 2014 that the market was down and you bought this, you would have lost money in 2015, 2016, and 2017. At some point, it's just not worth it. Whereas opposed to if you had just moved some money out of the market and put it in cash and bonds, you would have made money along the way.
Southwick: The next question comes from Alistair. "Assume for a moment that we all arrive at retirement dewy-eyed and with an emergency fund, several years of spending money in low-risk assets, and a pile of stocks to last us through 30-plus years of retirement. There appear to be two general strategies for converting stocks into cold, hard cash. One, grow the basic value of the assets and then just sell the assets when we need cash; two, convert the assets into dividend-generating stocks and bonds to provide income, maybe accepting the lower rate of return, but preserving the assets. Which one is more Foolish?"
Brokamp: The quick answer is both. I'll take the one with the dividends. I personally like the idea of dividends for retirement income for lots of reasons. First of all, there are many studies that have shown that a diversified portfolio of dividend-paying stocks is less volatile than the overall market.
Dividends, again as a group, tend to be paid each and every year and go up every year, at least at the rate of inflation and sometimes higher. There have been a handful of years, over the last 50 years, when dividends have been cut by the overall market, but for the most part, if you're getting, say, $5,000 this year from your dividend-paying stocks, you can be pretty sure you're going to get at least $5,000 next year. So from a planning perspective, I like that if I'm a retiree. Whereas if I'm going to rely just on capital gains, I don't know what my portfolio is going to be worth.
There are many people who think that relying on capital gains is a better way to generate retirement income, and one of those people is none other than Warren Buffett. In his 2012 annual message, he explained what he called his "sell-off method." He said that you have a company that gets cash every year, and you can pay that as a dividend. But if you have managers who can reinvest in the company and grow the stock price even more, that's a better way to do it.
Plus, with a dividend you have to take it every year whether you need it or not. If it's outside a retirement account you have to pay taxes whether you need it or not. But Buffett points out that if you're going to use capital gains, you only sell stock when you need it. If you don't need it, you can just hold onto the stock. His other point was that with a dividend, it's completely taxable. With a capital gain, only part of it is taxable, because the part that comes back as basis is tax-free.
I think that argument is compelling, as well, so I would generally say a diversified portfolio of both is a good idea. One way to differentiate it is to say, "I have a certain number of expenses that I have to cover in retirement." You make sure that's covered with Social Security [a pension if you get it], and maybe some solid dividend payers so you know you have that income coming in, and then you can take a little more risk with the rest of your portfolio. Maybe invest in some of these stocks that don't pay dividends like Amazon and Netflix. They've been great stocks to own, even for retirees, even though they don't pay a dividend.
Gates: And a report from the field. Generally when I take calls from folks, almost the default thought is, "I have a pot of money." Let's say it's $1 million. "I want to live off of that $1 million, so how do I get you to keep the $1 million at $1 million and just pay me my desired income of $70,000? Tell me what dividend portfolio you have that can give me a 7% yield."
The reality is that a 7% yield, because you need $70,000 a year off your $1 million portfolio, doesn't exist. Or it does exist, but it's an extremely risky version of dividend stocks. So there are high dividend payers who are stretching their business sheets to reward their shareholders with cash and risking some of the business needs to pay that high dividend, and then there are more stable dividends like Bro was referring to; dividend growers and things like that.
The reality is you need a combination of both and ultimately you want the highest total return and how you mix it up doesn't matter. You just need that overall return profile.
Southwick: The next question comes from [Brian]. "As a relatively new investor at 30, I've adopted a moderately aggressive portfolio strategy consisting mostly of stocks vs. mutual funds, bonds, and index funds. For an apparently more stable base, I've invested in stocks like Apple, Google, Amazon, and a few others, figuring these companies would have to experience a massive meltdown to fail. That said, I can't help but be disappointed that I couldn't have invested in these companies in the '80s, '90s, and early 2000s. This leaves me searching for the next big thing in the hopes that I could buy 50 shares of an Amazon for $30 and reap the benefits in 35 years."
Brokamp: Amazon, by the way, is now trading for $2,000. That's what this guy is shooting for.
Southwick: "On the other hand, I look at those companies and think they have a pretty good thing going. I don't see anyone reinventing the wheel and taking over their semi-monopolized hold on our world. What strategies do you advise young investors to take in order to find those budding companies, or is it just as smart and lucrative to jump onboard of these already proven stocks assuming that no one is going to rise up and do it better?" Ah, the eternal question!
Gates: It's an excellent question and it brings in so many pieces of the investment universe. The first thing that I wrote down in response to this question was asset allocation and the reason that I wrote that down is because ultimately what you're describing is the difference between large, well established businesses like Google and Apple that have already established their dominance in the market, and smaller companies that are trying to be the next Amazon.
And so, one way to get exposure to those next up-and-coming companies is to invest in small-capitalization or medium-size companies with the hope that they grow into the large-capitalization companies.
But then the other component that's crystal clear is, "But Amazon's doing awesome and there's stability in that." That's the risk conversation. You don't want to risk your money in those next up-and-coming Amazons because there's a chance that they don't become the next Amazon. They could fail and then you might lose value in that investment.
That's why it circles back to asset allocation. As a young person you can certainly consider investing in small-and-medium-size companies potentially with a large percentage of your overall portfolio, betting that there's some next Amazon in that mix of stocks.
Southwick: That's a very David Gardner approach. The idea that if you're going to go for the rule breakers, you've got to get a large basket of them and you've got to have the stomach for it, too. It's not for everyone.
Gates: Exactly.
Brokamp: Given that [Brian] pointed out that he is a relatively new investor and he listed these stocks as apparently more stable [Apple, Google, and Amazon], I just want to make sure he's aware of the fact that these could definitely go down 50% or more just like each one of them have done in the past, and there are many stocks [in an upcoming question GE will come up] that people thought would be companies that will do well forever, and they often don't. You just never know. You always have to factor that into your plan.
Southwick: The next question comes from Rob. "What is the best way to handle inherited stocks with extremely low cost bases?"
Brokamp: Ba-see-see-sees.
Gates: Indices.
Southwick: Thank you!
Brokamp: Indices of bases.
Rick Engdahl: Basics-ses.
Southwick: Basically inheriting stocks that your grandparents bought for a very low price.
Brokamp: There you go!
Southwick: "Selling the stock would create a significant tax event, but I'm worried that continuing to hold the positions leaves me overexposed to just a handful of stocks; specifically ExxonMobil, Wells Fargo, and General Electric. GE, in particular in recent years, has wiped out a large portion of my net worth." Aw! "At the moment I have dividend reinvestment turned off to funnel those dividends to purchasing low-cost funds in an attempt to slowly rebalance the portfolio, but it's not moving as quickly as I'd like."
Brokamp: I'll start by saying it's generally not a good idea to let taxes determine your asset allocation. It's fine to consider them as a factor, but they should never be the primary factor. If you have a very concentrated portfolio that you think you should diversify and you're afraid of the tax consequences, go ahead and do it.
The important thing to know is that when you inherit a stock that isn't in a retirement account, like an IRA, your cost basis is the value of the stock as of the date of death. If the original owner bought the stock for $10 and it was worth $100 as of the date of death, your new cost basis is $100. That's known as a "step up in cost basis."
That said, you could have a "step down," too. It works the other way around. If your grandmother bought it for $100 and it was $10 on the day she died, your new cost basis is $10. There are some cases in which the value is actually six months after the date of death depending on how the estate was settled, but for most people it's as of the date of death.
It could be that that cost basis is actually higher than you think given that, especially with these three stocks. They've had a lot of ups and downs over the last decade or two. So in this situation, it actually could be possible where you sell some of it at a capital loss to offset the gains of selling some of the others. You actually might have more flexibility taxwise with this situation than you think.
That said, I still think even if you ended up having to pay capital gains to rebalance the portfolio, I think it's the smart thing to do, especially if you have a large portion of your net worth in these three companies.
Gates: And I would say just in dealing with these situations on a day-to-day basis and to Bro's point, one of the reasons that you might consider enlisting some help is there's this common wisdom that you shouldn't let taxes wag the investment dog; but, let's just say for the sake of argument you have $1 million worth of capital gains exposure in these stocks. If you shift your portfolio and recognize that all at once, your tax bill is enormous. So maybe you decide that you have the risk capacity to distribute it over a year, two, or three. The ultimate goal is still to diversify the portfolio but strategically recognize the taxes over time.
Then another reason why you might want to consider getting help is because your situation raises the opportunity to look at a more complicated investment where you might want to consider utilizing options, which can get complicated, but in your case, because you own the underlying investments like GE, you could implement an option that gives you the ability to participate in the deterioration of the stock and/ or strategically dole out those shares to other investors who the think the prospects are brighter and reduce your position over time. That can be a really smart strategy for these highly concentrated portfolios.
Brokamp: I would say that I think Rob is being smart in that he's not reinvesting the dividends.
Gates: Totally.
Brokamp: That's a great way to build up a cash cushion or to invest in something else. But as he points out, it can take a while for that to have a meaningful impact on the asset allocation.
Southwick: The next question comes from Jeff. "I'm transitioning from being an employee at one company to an independent contractor at another. I have a 401(k), pension, and HSA with my current employer and I wanted your general thoughts on two things. One, what options do I have in saving for retirement and in an HSA as an independent contractor and two, what should I do with my old 401(k)?"
Gates: That's a great question. Ultimately, as an independent contractor it can get complicated, in theory, but you're just self-employed. As a self-employed person, what is available to you for retirement purposes are all of the various self-employed retirement options. I can list them at a high level, but I would encourage you to look up each one for the specifics of it. You can invest in an individual/ solo 401(k). You can do a SEP IRA. You can do a simple IRA. You could do a defined benefit pension plan if you wanted to and if you made big bucks. You could also simply invest in a traditional or Roth IRA.
Any of those options are available. They each have different thresholds. Typically, if you make big bucks think about a defined benefit pension plan or more likely an individual 401(k). If you make less money, think simple SEP or traditional and Roth IRA.
As it relates to the HSA, the HSA is usually a function of what type of health insurance plan you have. As a self-employed individual, look for a high-deductible health insurance plan and that high-deductible health insurance plan, if it meets the high deductibility or the premium amount that you might need to pay, will open up the option to utilize an HSA and then you can start funding it. I would strongly encourage you to consider that if you're young, given the power of the HSA account.
Brokamp: Another question was what he should do with his old 401(k). Generally speaking it's better to move it. It could be in a plan with a really good 401(k). Chances are the employer is covering costs for employees, but once you're no longer an employee, they make you cover some of those costs. That's what we do at The Motley Fool. Generally speaking, you're probably better to move it either to an IRA or your new 401(k) if you just choose to open a solo 401(k).
For me it always starts with what you want to invest in. If you want to invest in individual stocks, mutual funds, or ETFs, find the broker that offers those options at the best prices and then move your money there.
[...]
Southwick: The next question comes from Nate. "I am planning to go back to school in a year for a two-year graduate degree. I have enough cash, now, to pay for it. Would it be smarter to put it into a conservative 529 plan to get some slight tax savings, or should I invest the money, take out loans to pay for the degree, and assume that at some point in the next decade my gains from stock investments will be greater minus capital gains taxes and interest on the loans? And then if they approve using 529 plans to pay for loans, should I do a more aggressive 529 plan?"
Brokamp: Well, Nate, first of all, good for you for saving enough money to pay for your graduate school degree. I would say play it safe. Use the money to pay for the degree. That way you can graduate debt-free, get your new job, and then start accumulating money in whatever -- a 401(k), an IRA -- whatever you're doing after that point. By doing it the other way -- taking out the loan and then investing in the stock market -- you just don't know what's going to happen.
At the end, there, he brings up an interesting point, and that is for 529s, the withdrawals are tax-free as long as the money is used for a qualified expense. Paying back a school loan is not a qualified expense.
Generally speaking, if you were to take out that money, you would pay the 10% penalty and taxes. However, there is a new proposal now [part of tax reform 2.0], which was just recently brought out that would allow 529 money to be used for school loans, as well as home-schooling expenses and apprenticeship fees. It's just a proposal. We don't know if it's going to become law or not, but it is on the table, so it's something to keep your eye on.
Southwick: The next question comes from Jodi. "I have two accounts that are pushing the boundaries of the SIPC coverage; a brokerage account at Ameritrade, thanks to great investment advice from Stock Advisor, and a 401(k) at Fidelity. I also have a much smaller investor account at Fidelity. Are there any recommendations on what to do if you pass the SIPC coverage limit? Do most full accounts at one brokerage each have their own SIPC coverage? Also, how do you go about splitting a 401(k) account in two? Can you just transfer holdings to another 401(k)?"
Gates: Yes. SIPC insurance is an insurance that is conceptually similar to the FDIC insurance, which enforces banks. If you have money at a bank or savings institution, you can have protection if that underlying institution were to go bankrupt, or if there was a run on the banks, you would be reimbursed. In this case the FDIC is sort of a federal program that you can rely on.
SIPC insurance isn't really backed by the government. It's a form of reinsurance that all of the different financial institutions pay into. They pay dues into it to support the program. It's also not protection on the value of your account if it went down just because the stock market went down. If Fidelity went bankrupt and in the proceedings of that bankruptcy were not able to give you the value of your shares back, then the SIPC insurance would work to make sure that you have renumeration for those shares.
So a little bit complicated, but as you get into the specifics of it, what's interesting is different than FDIC insurance, SIPC insurance is coverage levels at what they refer to as capacities. Typically, a decent analogy to think about it is the account type. So if you have a corporate account that has $500,000 worth of SIPC insurance, or if you have just a normal traditional IRA, that also has $500,000 of SIPC insurance. If you have a Roth IRA in addition to those two accounts, that has an additional $500,000 in SIPC insurance.
Then, you can also start to look at it if you have a joint account. That has its own $500,000. And then if you add an individual account, that has its own $500,000. In addition, you can also have $500,000 worth of SIPC insurance per the brokerage firm. So if you have a joint account at Fidelity, that has its $500,000. If you have a joint account at Charles Schwab, that has $500,000.
Long story short, SIPC insurance is something that people ask about because they want to make sure they're protected. The reality of needing to utilize SIPC insurance is quite low. I think there might be maybe a total of five claims against SIPC insurance, or some astronomically small amount. Also keep in mind, just further nerding out on this question, that most brokerage firms, because it's mostly supported by the brokerage firms, purchase excess SIPC insurance so they will basically get an additional layer. Now, it's not a ton. It might be another $150,000 worth of insurance per account, or something to that effect.
And the excess SIPC insurance, according to the records and the forensic analysis, has only been utilized twice in history, and these programs are only about 43 years old, give or take, so they're a relatively new program, but I think I would assuage any concerns that you have. It's just very unlikely that these firms go bankrupt and you have to worry about that.
Southwick: And what about part two? Splitting a 401(k) account in two?
Brokamp: That depends. First of all, if you're talking about the 401(k) account you have with a current employer, they will have their own rules about whether you can move the money. If it's a 401(k) with an old employer, you can transfer it to an IRA. You can split it up into multiple IRAs if you want. That's really the big difference, there.
Southwick: The next question comes from [Brian]. "If you had $500 to invest, would you put $100 into five different ETFs [maybe an ETF in five different sectors, for example] or would you put all $500 into one more diversified ETF?"
Brokamp: I choose this one because...
Southwick: It makes it look like a bunch of Motley Fool investing teams are sitting around a campfire. It sounds like one of those questions that a bunch of Motley Fool analysts would talk about for days around a campfire.
Brokamp: That's probably true.
Southwick: Why did you choose this question?
Brokamp: I chose it because my wife and I recently added some money to our kids' brokerage accounts and we were thinking how we wanted to do that. And we chose to split it up. We chose a couple of stocks [with a little bit of input from the kids] but then also chose three ETFs. I chose a large-cap ETF, a small-cap ETF, and then an international stock ETF. If I were feeling saucy, I would have also chosen an emerging markets ETF which have been clobbered recently. You just have to be ready for a wild ride. I think over the next 10 years, they'll be one of the best investments you can make, but who knows?
Gates: I'll take the other side of this because typically if I get the question, "I have $500. How should I invest it," it means that that person is new or they are just getting started with their savings journey. In theory you should be diversified, but one of the things that I run into from a behavioral finance perspective is that if you invest $500 in a diversified ETF, you could maybe expect it to go up 8% over the course of a year. 8% on $500 isn't going to jazz anyone to the sky. And so what you could do is invest that $500 in maybe one or two stocks, because the potential that that $500 turns into something more meaningful is greater and then you've hooked them on the idea of investing and longer term that develops good habits. But that would always be couched in the fact that they need to be able to risk this $500.
Brokamp: With small amounts, you always have to be concerned about commissions. The good thing about ETFs is that most brokerages, now, have some commission-free ETFs, so that's part of where we started, as well.
Southwick: The next question comes from Daniel. "My wife and I make a combined $140,000 per year. When we did our taxes for 2017, we had about a $6,000 tax bill. We could not figure out why.
"When we entered our W2s into the nifty tax software, it was mine that skyrocketed our tax bill into Sadland. The only thing we could think of is that I contributed to a Roth 401(k) whereas she contributes to a traditional 401(k) plan. Would this affect our tax bill? We're desperately trying to avoid another hard-hitting tax bill. In fact, I've even reduced my exemptions from one on my W-4 to zero, since we had to pay up. Please, for the love of all things Foolish, help us!"
Gates: Well, as the president of Sadland, I think I might qualify to answer this question. Yes, I think you've identified the primary reason why your tax bill went up and the reason for that is that when you save to a 401(k) pre-tax, you are essentially deferring taxes on the amount that you contribute to that 401(k) and your paycheck is higher, because they're not clipping those taxes out of your paycheck per contribution.
If you have a $2,500 a month salary and you save $700 a month into your 401(k), that turns your salary from $2,500 a month to $1,800 a month and you don't owe the taxes on that extra $700. Come the end of the year, your tax bill is lower because your income is lower and taxes on lower income are lower. So by saving to the Roth, you are paying that tax in real time. It doesn't act as a deduction on your salary, and so that's pretty much the primary reason why you're facing it.
Then the question you have to ask yourself is whether that higher tax bill is worth saving into the Roth because in the future you won't owe taxes on those Roth contributions; whereas if it's pre-tax you will. You just have to decide whether your tax bracket is currently low in totality of your future and in totality of the different tax brackets.
Brokamp: It's an interesting question. Thanks to the new tax law, most people are in a lower tax bracket. And many people will say they're at the lowest tax bracket they possibly could be given that Social Security is underfunded. Medicare is underfunded. Growing deficits. At some point taxes have to go up.
But we've been saying that for years. And the decision of the Roth is am I going to be in a higher tax bracket in the future when I want that tax break or am I in a higher tax bracket today? They make a decent income, so it's a tough question. I think part of what they're doing is actually smart where they're saving in a traditional account with the wife's income and the Roth with his income, so they're getting that tax diversification. But when you work with clients, do you make any sort of projection about what tax rates will be in the future?
Gates: We do. As you've been pointing out, everyone has been saying that tax rates will go up in the future and we'll keep saying it because we just are in a historically low tax environment.
Now other planners and researchers will say that you can raise taxes without raising income taxes, so you could increase sales taxes. You could create a VAT tax system or all sorts of policy mechanisms that would increase the overall tax collection process to account for those debts without raising taxes on income. And so it's possible that we never see higher income tax rates.
And really, when I work with clients, we will look at their specific income projections and we'll say, "Right now you're at $140,000 a year. Do you see that getting to $300,000 in the future and at what time do you think you'll retire?" And we'll just map out the next 40 years of their life and just make sure that we're tending to the tax brackets each year to maximize their overall total lifetime tax liability.
Personally, I save pre-tax. I don't make a huge amount of money. I prefer tax deferral so that I don't have to pay that tax liability up front and can get my growth engine on the investments going as fast as possible. It is a hard question to answer.
Southwick: The next question [and it's our last question] comes from @DTShelt. "I have been having a hard time justifying my use of Robinhood over buying stocks in my Roth IRA, especially with The Fool ideology of buying and holding for the long term. Is there a place for Robinhood if I have an IRA? Stocks!" That always makes me laugh.
Gates: Bonds!
Southwick: I just love when people yell stocks at me.
Gates: I picked this question because I'm not sure whether the question is if Robinhood is available inside an IRA, because I don't think it is.
Brokamp: It's not.
Gates: I think it's only available for taxable brokerage accounts. But if that's the underlying question, there are alternatives to Robinhood where you could get commission-free IRA investments.
Brokamp: Which is what's attractive about Robinhood. That fact is that you do not pay commissions on the trade.
Gates: Exactly. And so there are alternatives. We could spend a little while going through that. Or alternatives that are very low cost, so maybe you pay a dollar per trade.
If the underlying question is whether there is a place to save both to the Roth and to a taxable brokerage account where I utilize Robinhood, I think the answer is clearly yes. I mean, it's going to depend on your ability to have the income and save that income, but I certainly would prioritize saving to the Roth first and then if you have extra money coming in, save it in a taxable brokerage account.
Brokamp: I would say the tax-free growth of Roth is very powerful, and it's not worth giving up just to have free commissions, because there are too many other places to pay very low commissions or no commissions. Definitely go with the Roth, first. And the great thing about the Roth IRA is that if you need the money before you're 59 and a half, you have more flexibility with getting it out early if you need it; especially just the contributions. I would definitely say max out the Roth IRA first. You're going to have to do it somewhere other than Robinhood. Then turn to Robinhood if you want those commission-free trades.
One of the ways Robinhood is able to have commission-free trades is that like a lot of brokerages, they don't pay you much on cash. [They're not paying any interest] on all the cash that's sitting in those accounts, so they can make a little money off of it. That's one way that you actually are paying some money to be part of Robinhood if you have a lot of money in cash and you're not doing anything with it.
Gates: They also sell the order flow, which is a little bit more complicated. All the brokerage firms could, in theory, have what essentially amounts to front-running trades. Let's say you want to buy a hundred shares of Apple. When you place that order, they can pause that order and then go to high-frequency traders and say, "Hey, look, high-frequency traders, this person wants to buy a hundred shares of Apple. Do you want to sell that company or do you want to do something differently?" And there are some firms that don't do that, but just keep in mind that they make money on that order flow, because those institutions will pay for that insight. That's another way you're potentially paying for the cost.
One final note is I think you're ahead of the game with asking this question, because I run into folks a lot of times who all they do is think that they need to save to their retirement accounts. They meet the contribution limits, and then they stop saving. They're like, "I'll spend the rest." So thinking about saving additional money to a taxable account is a very good thought. It creates good habits, and it should provide you with a good setup for a good retirement.
Southwick: Well, that covers it for the questions, but we have other housekeeping. Thank you for joining us!
Brokamp: Thanks, dude!
Gates: Thanks for having me!
Southwick: Well, Bro, it's time for the rest of the housekeeping of the show. We got a lot of great feedback from you guys on our caregiving episode and also on our how to get rid of stuff and help others you love also get rid of stuff episode, so thank you for that, particularly Dave and [Erin], who shared their personal experiences. Your feedback is a gift, especially when you say nice things about us.
We've received some fantastic postcards. Here we go. Tony is listening while riding his roo all over Australia. Josh, we got your Seattle postcard. Don't forget to send us one from Japan, which is what Jim did from Tokyo. Bro, you'll remember him as the guy who listens while he's got the waterproof MP3 player and he listens while he swims laps. Ian sent a card from Namibia. He says that The Fool podcasts have provided the soundtrack for 50-plus hours of bus rides to Africa, which is a lot of Chris Hill and Jason Moser talking about Amazon.
Jody essentially said that our podcast is as boring as Wyoming, but it was a postcard from the Tetons, which are gorgeous, so I'll take it as a huge compliment.
Brokamp: She's saying we're gorgeous? That's awesome!
Southwick: I know! Trip and Drew, brothers, are eating barbecue in North Carolina and they think I'm as cute as a button. They called you a curmudgeon. Fad in Mississippi has been listening for a year, now, and has learned so much! Eric graduated last spring from Eastern Illinois University and with our help he says that he has no debt and a pretty good-size portfolio.
Brokamp: That is awesome!
Southwick: I would say any size portfolio, if you've graduated from college, is a good-size portfolio. Rich sent in a couple of more reports from his trip on the road, including from New Mexico. He sent some conspiracy theories about Roswell, which we'll need to discuss later.
The Wild Thing sent a card from Niagara Falls. Said it was awesome. Don is on a long motorcycle trip and he says he couldn't take months off to do it without The Fool. Kurt was going to send a card from Iraq, but sent one from Minnesota, instead, after coming home safely.
Brokamp: Oh, good! I'm glad to hear that!
Southwick: Glad to hear that! Where in the world is 50BillionCents? Well, this time it's India where he says there aren't any traffic laws, but how you keep from getting run over is just by giving people the hand. Apparently, they stop and then you can cross. I don't know.
Brokamp: That's power!
Southwick: I know! Todd sent a card from North Carolina. Says we're the best. Joseph sent a card from Barcelona. If you've been there you get to say it that way. Someone sent a card from the Marvin Window and Door Museum, but they didn't leave a name. I mean, they weren't proud that they visited the Marvin Window and Door Museum. I looked all over it. I also had you look at it. I didn't see a name on it. Melanie sent a card from Minnesota. This is the second of six weddings she has to go to this year. Oh, so expensive. And Dedrick sent a card from the new Legacy Civil Rights Museum. He says it's a must-see in Montgomery, Alabama.
Oh, man, you guys live the best lives, and thank you for bringing us into your lives, whether you're riding a bus in Africa or you're in North Carolina. A lot of North Carolina this time around. I guess that's the place to be.
That's the show. I want to thank Sean, again, for joining us and if you want to send us a postcard, our email is 2000 Duke St., Alexandria, VA. Also our email is [email protected]. We do this Mailbag episode at the end of every month, so get your questions in.
The show is edited fairy-dust-ingly by Rick Engdahl. For Robert Brokamp, I'm Alison Southwick. Stay Foolish, everybody!
