Tax Free and Tax Advantaged Strategies Part 1

Jeff Kikel: 00:00:00

Hello, Freedom Nation. It's Jeff here with the freedom nation podcast. And today's episode is actually going to be a little bit different from what we've done in the past. Today, we're going to do a pretty long episode that we're going to break into two separate episodes about tax free and tax advantaged investing. So this will be some things that I am passionate about and I want to share with you, so stay tuned for Episode One of tax free and tax advantaged investing.

Jeff Kikel: 00:00:32

FN Intro/Outro: Welcome to the Freedom Nation podcast with Jeff Kikel. On this show, Jeff shares his expertise in financial and retirement planning from a different perspective, planning for your Freedom Day, which is the first day that you wake up and have enough income or assets and do not have to go to work that day. Learn how to calculate what you need, how to generate income sources, and listen to interviews from others who've done it themselves, get ready to experience your own Freedom Day.

Jeff Kikel: 00:01:07

Hello, Freedom Nation. It's Jeff here, once again with the fFeedom Nation podcast. And I am super excited today to share with you one of the things that I am most passionate about when it comes to Freedom Day. And it's become more and more I think important to look at ways to limit or, you know, as much as possible, eliminate taxes, and making sure you stay in a tax low tax or no tax situation when it comes to income. The reason for this is the less tax you pay, that means the less assets you have to actually accumulate over time if you're not having to pay taxes. So there's a few strategies and vehicles that you can use to do that. So today, we're gonna go over five vehicles. We will do this both in the podcast here. And I'm also recording this to be on our YouTube channel. So if you want some of the visuals that I will go over during the different sections, you can also go to our YouTube channel, it's just Freedom Day with Jeff kichel K ik yell, and you can check these things out on the channel. I'll also include a link to the playlist for these on in the shownotes for the audio portion of this on the podcast. So let's get started. I'm looking forward to really sharing you with you some of these ideas and some of these ideas. If you follow some of the the Dave Ramsey's of the world and the other Suze Orman's, some of these will be things that they would just tell you, Oh, they're the most horrible things ever shouldn't do these. But I'm going to explain to you why and when and how you would use these, you don't have to, I'm not requiring you to this doesn't mean that if you don't do this, you're doing something wrong, it's just you're going to want to figure out what's going to be the most effective way for you what's going to be the thing that helps you the most over time. So let's get started with my personal favorite of a tax advantaged investments not tax free. But it's really tax advantaged, and that is real estate investing. There are some key key key benefits when it comes to real estate investing. And we're talking real estate investing, you know, in this case, it can be residential real estate that you're doing, or you can do commercial, I typically am not a fan of commercial just because I've not gotten into it. I've done mostly residential real estate investing. And it's worked extraordinarily well for me over time. So let's talk a little bit about real estate and we need to I think before we get started talking about some of the tax advantages, we want to break down the four ways that you can make money when it comes to real estate. So the first way is income of course cashflow so you know you have a let's say a mortgage on a property you put down a down payment so you know that downpayment is your assets that you have put into the deal then you have a mortgage on the property so that you know you can leverage and get the most property you possibly can and then you get a renter into your property that renter hopefully if you've done this right and I would not do any real estate deal where I didn't have positive cash flow I'm sorry, I'm just not doing it. You know people argue the point with me Well, I can raise you know rates or I can raise I can get somebody in there have negative cash flow and then all I am is one rent raise away from being positive cashflow? Yes, but you're also one rent raise away from the taxes on the property going up. And now all of a sudden you're in the negative again, so I would not get myself into any Need any deal, and there are 1000s of possible real estate deals out there, you need to keep looking until you can get one that has a positive cash flow. So off my high horse, let me jump off that box with my soapbox, and get into the four ways that you make money when it comes to real estate. So the first one is income, whatever income, you know, whatever's above whatever you're paying out in expenses and mortgage, that's positive cash flow, and that is income. So you make money on that income. So that's one way to make money. The second way is somebody is paying you a check every month for their rent, you're applying that towards your mortgage, and your mortgage is the balance of that is going down over time. So that is what's called amortization. So over time, your value of your mortgage, the principal on that will go down. Now, how a mortgage works, is in the early years of a mortgage, it's mostly interest that you're getting paid, or that you're paying on your mortgage, as it gets closer to about mid time. So let's say it's a 30 year mortgage, you're getting out there at around 12 to 15 years, then more and more of that payment that's coming in is principal, or is the payment you're making is principal. So that means that your principal will go down farther in the later years, you can do a 15 year mortgage or something like that, to make that acceleration happen much faster, you also could theoretically apply some of the positive cash flow that you're making towards that I am not a big fan of that I just kind of let that ride however it works on my properties.

Jeff Kikel: 00:06:44

The next way you make money is depreciation. So remember, in the first situation, you had a positive cash flow. So let's say I have a mortgage of $1,000. I'm able to rent my property for 1400 or $1,500. I have positive cash flow after any other expenses of let's say $400 a month. Well, that's profit. To me, that is positive cashflow. Well, depreciation is simply the fact that a property the IRS lets you deduct a portion of the value of your property every single year. Because the property is depreciating every year, you know, it's getting used up, it's getting older, it's going to require repairs at some point in time. So the IRS allows you to recapture that cost every year by a portion. So it might be over 26 years might be over 30 years could be faster than that on certain parts of depreciation on the property. But the advantage to this is, the more you depreciate that property down, it can eliminate the earnings that you make. This is not something that actually comes out of your pocket, it just comes out it's a tax calculation. And that could make your interest or in your positive cashflow, be either tax free or pretty dang close at that point, by using the depreciation of your property over the time that you hold it. The last way that you make money on real estate, this is the one that most people the only one most people think of, because they watch all the shows on TV. And you know, it's really boring to talk about long term holds the properties. But you've got the flipper shows and everything else where you know, they buy a property for $30,000. Yeah, they put $20,000 work in, sell it for $80,000. And that profit that they keep is, you know their profit in those cases. So it's the appreciation of the property. Well, the challenge with that is in their case, the appreciation of the property is 100% taxable to them. And in most cases, it's a short term, it's a short term capital gains. So that's treated as ordinary income, and they won't really recapture enough depreciation for them to offset that. So typically, they're paying a lot of tax on those flips, which they don't tell you about on TV. They just focus on how much money they made or how much they made on their sale. So those are the four ways that you make money on real estate. How the tax advantages happen in real estate. Well, first off, we talked about depreciation, that's number one, being able to depreciate a piece of property over time. So as long as you hold it, a portion of that, let's say, you know, let's say it's $100,000, you divide that by 26. You know, that's going to be how much you get to take off, tear from your taxes. That will eliminate some kind of game that you have on the other side. It is a wonderful vehicle depreciation is one of the greatest vehicles for real estate investing and this is one of the pros problems I have with all the people that talk about, well take, you know, get your 401 K and turn it into a self directed IRA, and then dump the money into you know, or, or invest in real estate. Well, the problem is, you're investing in real estate, you don't get to capture the depreciation at that point. And then when you decide to start taking the money out, you're paying 100% tax on that money that came out of your 401k. If it was pre tax, there is no Divya depreciation or anything like that. So it's not exactly the best place to invest in real estate from because you lose a lot of the tax advantages of investing in real estate, real estates best invested in outside of retirement accounts, because there's a ton of benefits. The other benefit of investing in real estate is the ability to do what's called a 1031 exchange. So all of this is funky, all these numbers and all that. But let's talk about what a 1031 exchange is. So a 1031 exchange is the ability for you to take a property. So let's let's give you an example. You and I buy a property and it's worth $300,000. Today, we buy rental property, we put our money into it. And over the next five to seven years, that property appreciates $100,000. So it goes from 300,000 to $400,000. In the next five years, so we've made $100,000 on our property. Now, remember, we've got appreciation, but we've also got amortization. So let's say we had a $250,000 loan on the property when we started. And we've amortized that down over five to seven years. And so now, we not only have you know, the property that's worth, at the beginning 300,000, we put in, let's say 50. So it's worth 300,000. Now we have $100,000 Gain on our property, and we decide to sell it for $400,000. Now, if we were just to take the money, that $100,000 that we made, is going to be considered a capital gain. So we're not even going to think about the amortization at this point, we're just going to say the capital gain. So we've now made $100,000, that is a long term capital gain. So in most cases, depending on how much money you make, it's 20% capital gains tax or less depending on how much you make, but you're most likely going to pay some kind of tax. However, there is a rule, and it's called 1030. Law, the laws 1031 in the IRS or IRS section 130 1031. And that IRS 1031 section allows us to say, I'm going to find a like kind property within 60 days, so that when I sell this, I want to take my profit and I want to roll that into 123. However many properties I can buy for that extra, you know, money, that is my profit, I can buy that without paying taxes on the capital gain. And now I might own two properties or three properties, instead of the one that I owned before. Because I grew the value of my property, I grew my equity in the property. So that is a tax free exchange. And throughout the time that I'm a real estate investor, I can continue to do that very thing. I can continue to invest in other properties that are a like kind property if I sell one of my other properties. So that's a strategy that we've used in our own personal investing where, you know, we might have started with one property as with a partner. And you know, once that's grown, once we get to the point where we're ready to move on from that property, then we've turned that into two properties and then later into four properties. And we'll continue to do that. And we're doing that across multiple partnerships that we have with other investors, and they're happy, we're happy. We're all growing our wealth together, but we're able to postpone paying the taxes on that until we eventually sell the properties and we don't do anything for us. We intend to go as long as we can. That's the way that we're growing our wealth. And that's the way we build our income over time. Leveraging depreciation in 1031 exchanges. Now a couple of the things that help reduce taxes and this depends on the state that you're in, but in your you know, if you have some deductible expenses, you also get mortgage interest deductions. So you know on your properties, you can get a mortgage interest deduction. If it's Your personal property, then it's going to fall under your personal taxes. And if you're not able to amortize above whatever the standard deduction is, this is a moot point. And if you live in states where the rules say, okay, that gets cut off at 10 grand, now, it's not going to really help you much. But it can help a little bit from that perspective. The last piece of the pie when it comes to real estate is really more of your personal real estate. And that is that you get a capital gains tax exclusion of federal capital gains, it's the exclusion on your personal property on your primary residence. So you can exclude up to $250,000 as an individual, or $500,000, a married couple of capital gain when you sell your property. So if you know if you're saving money over time, and are you you know, been in a property a long time to get ready to retire, or you reach a point where you want to start downsizing your home, up to $500,000, for a married couple can be excluded. Now, this includes any work that you do on your property over time, specifically things, you know, let's say you put in a new kitchen and you put in a bathroom, you do anything like that, you need to be saving the receipts, because that's going to count as improvements on your property. And you'll get to recapture those, at the end of the time whenever you sell your property. So this is important to maintain these kind of records, when you do any kind of improvements on your home, I would highly recommend that you scan those, instead of putting them in a folder someplace, scan them, upload them into a cloud drive, and have those records there. You'll hear a little bit about this later on some other strategies I have of how to maintain those records. Throughout times, just make sure you kind of keep them in a tax record folder, so that when you sell your property, you've got those that you can work with. So that is real estate, real estate's one of my favorite ways to do all of this. So now let's talk about Roth IRAs and Roth 401. K accounts. So the Roth IRA was created late 1990s, I think it was 1999, the person who created it was the the senior senator from Delaware, Representative Roth. So that's where this came from. And the Roth IRA is a vehicle that allows you, as a taxpayer, to put money away, and now the current strategy, or the current amount that you can put in is $7,500 per year into a Roth IRA. Now, if you are over the age of 50, there's a ketchup contributions an extra $1,000, that you can do into the Roth at that time. So that's it's a wonderful savings vehicle. Here's my belief, when it comes to tax advantaged vehicles set up by the government, I do not like to make the government my partner. So there's always the argument of Well, should I put my money in pre tax, or should I put it into a Roth, here's my take on it. And this is my personal belief, you can think differently. The government allows you to put money into a, a traditional IRA, if you're eligible for it if you if your income is or if you don't have a retirement plan, you can put in that same $7,500 and get a tax deduction from it. The problem is, it's only a small amount, and the government will give you, let's say, if you put the full $7,500 in, and you are in the normal tax bracket for everybody, that's only going to get you about a $1,200 tax savings every year. However, when you decide to retire and you start pulling money out, the government is still your partner. Now they've been a partner with you. And they've partnered with you to say, well, you know, we'll give you for every $7,500 you put in, you get $1,200 back. However, when you start taking this money back, we want 25% of everything you're taking out. So now after I've spent all this time building up my assets in either a traditional 401 K, or a traditional IRA, the government is your partner and they give you nothing in return. They're your partner and they want 25% or more of your tax money when you start taking that out. Now the argument is well, but I won't be taking out as much. As you know, I won't be paying taxes as high of a rate as I do. Now, when I'm earning an income. Maybe maybe not Most people need that amount of money over time. And so they're going to need a pretty good portion of what they're earning today. So if you're taking that amount out the government saying, hey, hand me 25% of that, and I'll take that and go buy a $300,000 hammer or something. The difference is, with the Roth IRA. Think of it as a farmer, would you rather pay tax on the seed? Or would you rather pay it on the whole crop? So with a Roth IRA, it's always after tax money. So you're putting in money after tax, you've paid that, let's say $1,200 Extra, that you would have put in or the you would have gotten a benefit from. However, over the next 30 years ish, you grow your Roth IRA to several 100,000, maybe a million dollars, and you're not going to pay tax on that money ever again. So your crop that you've grown for the 30 years, or 20 years, or however many years it is your crop is protected from taxes. Now, the Roth IRA, the Roth 401, K, can be invested in virtually anything. Specifically, it's usually mutual funds might be some individual stocks and bonds, it could be invested in things like gold, you cannot put anything inside of an IRA or Roth or a traditional Roth 401 K, let's say through your employer, you're not going to get to invest in anything like collectibles, or life insurance or anything along those lines. But you're gonna get to invest in stock market assets, including options inside the Roth, whether it's 401k, whether it's a Roth IRA, and you're going to get the benefit of growing that money over time tax free, which means that for two equal people, let's say they both saved $100,000. Or let's say they saved a million dollars into their 401 K accounts. And one is in a Roth one is in a traditional 401k. And they decide to start taking out $50,000 a year, which is a safe rate of return, which you can take out of a traditional type of vehicle like that, well, if they both Withdraw $50,000, remember, in the traditional case, because I got my money at the front end off of my taxes while I was earning money. Now, for the person that's taking out $50,000 from a traditional account, you're gonna have to take some money out of that it might be 15, or 20%, of whatever you're taking out, that's going to go to pay taxes because you not pay taxes on that money at this point. Now, for the other person who has the same $50,000 coming out, they put a million dollars into, or they've grown a million dollars into a Roth IRA or 401 K, they're going to get to pocket $50,000, they're not going to have capital gains tax, they're not going to have tax at all, they're gonna have income tax on that money. So that means that they didn't even really need to, for them to net the same as that person with the traditional retirement account. They didn't even have to have as much money, they could have $850,000 and still be able to net net the same as someone else. So it's less work to get there if you're doing it on a tax free basis. The other part with Roth accounts is there are no RMDs registered or required minimum distributions. So if you have a traditional 401 K, or a traditional IRA, and age 72, that's up from 70 and a half. So 72 and a half now, this rule was changed at the beginning of the pandemic, by the Trump tax cuts, they made the ability to postpone required minimum distributions to age 72 and a half. Well, at age 72 and a half, the government says, Alright, you've had that money hidden for long enough from us, we want a part of that and you have to begin taking out a portion of those dollars that are in your Roth or they're inside your traditional accounts every year up until the point you die. And there's a federal calculation that you use to figure out how much that is per year. Well, in the case of Roth's, whether it's a Roth 401 K or it's a Roth IRA, you do not have to do right or required minimum distributions. So let's say you had enough income outside from real estate or other investments that are passive income you And you're sitting there going, well, I don't need any more. And I can just leave the money in my Roth forever or use it only occasionally, to pull money out for big dollar things, I need to buy a car, I'm going to take a trip, something like that, I want to give a gift to my, my kids or my grandkids, well, I can just do that as a withdrawal and not pay taxes on that money and continue to grow it from there. It's also an interesting vehicle to use. If let's say grandparents are above the age of 59 and a half, which you can withdraw from my Roth tax free without paying any penalties. grandparent could use this to pay for a child, one of their grandchildren's college out of there and not have to pay taxes on that. If they have a large enough account to be able to do that. I think it's a wonderful vehicle to do that. If you've got if you've been saving in a Roth. Now, let's say it's later in life, you've worked a couple jobs. So you've you know, add a couple 401k Is that you've built up over the years. And you know, you're sitting there looking at okay, well, I've got all this traditional money. And I really don't want to pay taxes on this when I get to retirement. So what's my solution? Well, the Roth, or any IRA is going to have a cap as far as how much money you can put into it. So like we said, that $7,500, or if you're over 50, and you get a little extra money that you can put in per year, that's the max that you can put in. However, if you have a traditional 401k, or maybe you had a traditional 401k, that you rolled over to a traditional IRA, you do have an unlimited ability to convert those dollars from a taxable account to or from a tax deferred account, to a Roth account. So that allows you inside there every year, you could do this all in one lump sum. So let's say you had $100,000, in a, an old 401k, it's sitting in an IRA account, a traditional IRA account, you can convert all of that in one year, regardless of age, so it doesn't matter, you're not going to pay a tax penalty, you're just going to pay taxes on those dollars. So I put it there, I do $100,000, assuming I had no other income for the year, I'm going to pay anywhere from about 18 to 20% in taxes to convert that to a Roth IRA. Now, from that point forward, that money is now tax free. So all the earnings on it, are completely tax free. So this is one of the things that I work with clients all the time on. And it was not something I used to do, until I really started to dig into what I saw, were some of the challenges of people going into retirement and having to pay taxes. And you know, it just made no sense to me. And it made a lot of sense to do conversions of assets from traditional to Roth. So it's something that we do on a regular basis with our clients, we manage that. And you know, if you can't afford to take the hit all in one year, let's say you're in a really high tax bracket, you can spread it out over five, five to 10 years and get that all converted over. And then now you're rolling forward. The only instances where I don't recommend people doing this is if it's later on in life, let's say you you didn't retire early, you kind of stayed continuing to work, you get into your 60s and you're like okay, early 60s, you're probably going to retire by 66, there's not enough years left at that point for you to convert, and then make up that difference in the tax free world, you're just going to have to take too much of a tax hit up front. So I'm not a big fan of doing it when you're in your 60s Unless you're not going to use that money. Let's say you build another passive source of income, you built a real estate portfolio that adequately covers your expenses. And you're looking at this Roth IRA, or you're looking at your IRA as well, this will be money, fun money to use down the road, go ahead, that's a great time convert this thing over, then you don't have RMDs down the road, you don't have to take money out, you can just take it out whenever you want. And it's much much better from a tax standpoint at that. So that is Ross. And I think it's a wonderful vehicle. I think it's one of those things that everybody should consider doing. The beauty of it is you also have tons of investment choices in those vehicles. You know, if you've got old 401 K's, I would be converting over to IRAs and then hopefully converting into Roth IRAs where you've got more choices or investments you can do and really diversifying your portfolio's out a little bit more.

Jeff Kikel: 00:29:58

FN Intro/Outro: Thank you for listening to the The Freedom Nation podcast. You can find us on Apple podcasts and all the major channels wherever you're listening. Please subscribe to the channel and leave a rating and review. If you have friends and family that could benefit from their own Freedom Day. Please share with them. Finally, join freedom nation by following us on Facebook, Instagram and Twitter.