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Published On

May 14, 2019

Economist Dr. Allison Schrager, author of An Economist Walks Into a Brothel and Other Unexpected Places to Understand Risk, explains how the risk management techniques of surfers, prostitutes, magicians, and soldiers might relate to our own investing and retirement planning. Plus, does it matter which assets you withdraw first from your retirement portfolio? Joe and Al dive deep on this one – stick around to find out why it’s less about stocks vs bonds and more about your tax bracket, your asset allocation, and your asset location. And just how much can you convert to a Roth IRA without incurring the 3.8% Medicare surcharge?

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Show Notes

(00:57) Economist Dr. Allison Schrager Walked Into a Brothel…
(20:16) Does It Matter Which Retirement Assets I Spend First? (video)
(34:45) How Much Can I Convert to Roth Without Incurring the Medicare Surcharge?

Transcription

Ever wonder how big wave surfers or magicians or prostitutes or soldiers manage risk in their lives? Yeah me either, but luckily, Economist and author Dr. Allison Schrager did, and she wrote a book about it called An Economist Walks Into a Brothel and Other Unexpected Places to Understand Risk. She joins us on Your Money, Your Wealth® today to explain how the risk management techniques of these very risky professionals might relate to our own investing and retirement planning. Plus, does it matter which assets you withdraw first from your retirement portfolio? Stick around to find out why it’s less about stocks vs bonds and more about your tax bracket, your asset allocation, and your asset location. And just how much can you convert to a Roth IRA without incurring the 3.8% Medicare surcharge? The fellas will talk that one out too. I’m producer Andi Last, and here with our guest, Dr. Allison Schrager, are the hosts of YMYW, Joe Anderson, CFP® and Big Al Clopine, CPA.

00:57 – Economist Dr. Allison Schrager Walked Into a Brothel…

Joe: Allison thanks so much for joining us and welcome to the program.

Allison: Hi, thanks so much for having me.

Joe: Hey let’s start here. Why did you write the book and how did you come up with the title?

Allison: Well, for a book about – well it’s not all about brothels, but it opens in a brothel – you’d probably be surprised, it was actually largely inspired by my work with financial planners. And I found that financial planners, you work in risk, you manage risk. My background as an economist is studying retirement finance. It’s like the lifecycle problem – like moving money throughout your lifetime and managing money over your lifetime is this very sort of classic, basic risk problem, and a very difficult one. I think personal finance sort of gets a bad rap and people think it’s simple – a lot of personal finance books say it’s simple – but it’s actually, even Bill Sharpe says, one of the hardest problems out there. And I found while a lot of financial planners understood risk, explaining it to their clients always was a struggle in terms they could understand and internalize. They’d have a client in, they’d give them a quiz, they’d decide they’re risk-averse, and then they’d put them in relatively safe assets, and then the stock market would go up and they’d say, “well, my friend’s advisor has them in triple-levered beta funds. Why aren’t you beating them?” And it’s like, “because you said you were risk averse!” So I felt like, based on my time with planners, that they needed better tools to explain risk to people. And I have a background as a journalist and in storytelling, and I just, I guess, like adventure. So I figured I really wanted to write a book that could explain these basic concepts of risk, especially around the risk around the lifecycle problem, in terms people could understand and enjoy. And so that brought me to a brothel.

Joe: (laughs)

Al: (laughs) Of course, that’s my first thought.

Joe: Right? Why not?

Al: There’s a lot of risk there, by all parties.

Allison: That’s what I figured.

Joe: But you’re so right – people fill out a risk questionnaire and it’s all based on a belief, what their emotions are maybe on that given day, or what the environment looks like maybe in the given month or the given quarter, and so they fill it out, but it really has nothing to do with what they should be doing. Of course, you have to take a look at their ability to take risk but how much was should they be taking and how much do they need I think is a little bit more important to help people figure this stuff out.

Allison: Yeah. And I think that’s an important role that financial planners play. I mean, this book is different a lot of ways – it’s not really technically a personal finance book because it’s more storytelling, but I think a lot of personal finance books almost suggest you can do this yourself. And I think risk management is hard, and that’s one of the huge value-adds of financial planning is you need that counselor to determine how much risk is appropriate and help with risk management because it’s too hard to do it on your own. Even if you’re professionals.

Al: So you interviewed a bunch of interesting people – people that we would think are taking risky careers or doing risky things, like prostitutes, like gamblers, like magicians. Big wave surfers, I think that’s a really interesting one. Laird Hamilton riding these 50-foot waves or bigger. What were some of your takeaways from talking to some of these people?

Allison: Well I think – which was what I suspected going in – risk is so much beyond just financial markets. They’re everywhere. And it was surprising to me how people we least expected are using some really interesting and sophisticated strategies. When I went to Hawaii to meet with the big wave surfers, it was because they have an annual risk conference where they discuss various hedging and insurance strategies and systemic risk and they have a very interesting debate about it, because that’s really what’s tearing their community apart right now is debating personal responsibility around risk. And that’s the thing – I think everyone has the capacity to really understand risk and make good risk decisions. It’s just really about framing, so people can understand it in all areas of their life.

Joe: When you look at the principles that you talked about in your book to assess risk, what should people be thinking about? And I think you do a very good job of kind of relating different stories of how different industries or different professionals assess risk. But how do we bring that back to, “I want to retire. I have to get in the financial markets. I hear the word risk, but I really don’t understand how much risk that I should be taking on.” How could you use some of your analogies to help our listeners to figure out what they should be doing, I guess, in regards to their capital assets?

Allison: Well, I think when it comes to retirement or any problem in any industry, I found people were the most successful when they really had a well-defined goal of what they were taking and thought about what they meant even by “risk-free.” I think a risk-free asset is the foundation of all financial modeling and all financial decisions. But you need to define it properly in terms of your goal. So for retirement, I think where a lot of people get confused and don’t know how much risk to take is we define the retirement problem in wealth. So it’s like, “How much money do I need to retire with? Is it a million dollars, two million dollars whatever?” But really, you’re saving and investing for income. It might be $50,000 a year. And that’s a completely different goal. $50,000 a year for 30 years, the rest of your life is a very different goal than a million dollars on day one of retirement. And it also requires a completely different strategy and a completely different definition of what we mean by “safe asset.” A T-bill is not a good hedge for a regular stream of income 20, 30, even 10 years from now. And I found no matter what you’re doing, whether or not you’re a surfer or an investor, that’s so important. Like I think surfers also realize this. Laird Hamilton always would say – when I first looked at the community, I wasn’t sure it would work for my book because he would just say, “if the wave is there I have to ride it.” And I’m like, “well that’s not good risk management.” (laughs) But when I actually met this community of surfers, the big wave risk assessment group, they don’t think that way. They think “what is the best wave for me to surf given the risks?” For instance, they take a very common hedge, which is waves travel in packs of five. And often the bigger waves are in the beginning of the pack. But you would never surf that wave because then you’ll have four or five large waves barreling on you, and that’s really dangerous if you wipe out. So they might take a smaller wave, a less perfect, pure wave, because it’s later in the set and because it’s safer. They make that tradeoff of, “how can I get that rush of riding a big wave, but also not take any more risk that I have to take?”

Joe: So there’s always a tradeoff I guess. It’s looking at, I could take the bigger wave that’s in front but then I could get crushed. (laughs)

Al: I will get crushed because I’m getting off this wave at some point.

Joe: Yes. Or you just kinda wait a little bit, it might be smaller, might be not as perfect but there are no other waves coming behind. Explain the difference – you say hedge. What is a hedge and then can you explain the difference to that of insurance? So if I’m constructing a portfolio there are hedges there or I can insure it. So can you briefly talk a little bit about both of those?

Allison: Yeah. So a hedge is effectively just taking less risk. So in finance, it is, if you have a risky portfolio, say, a stock index fund or whatever, and you hedge by investing a little bit in a safe asset – say short term or long term bonds, depending on your time horizon. So the hedge is deciding how much you’re going to go into the safer asset. And what it means is you give up upside – like, the stock market goes up 100%, you’re going to get less of that because you were in bonds, but you also reduce the risk of the stock market crashing. As opposed to insurance is you buy protection. So you give someone money, effectively what they’re doing is taking on your downside risk, but you technically keep all that upside less whatever the premium is. I think people confuse the two, and they often also confuse the difference between diversification and hedging. Because hedging is, in a way, diversification, because you’re going into a different asset but that assumes you already are in this nice combination of risky assets to begin with that is diversified. Does that make sense?

Joe: Yeah absolutely. So I guess with insurance, I could take on the full brunt of it, but I’m losing because I have to pay someone else to cover my downside.

Allison: Yeah. On the other hand, though, less that premium, all the upside is yours. So it’s like I said, if you insure on a stock, whatever upside, if that stock goes sky high you still get all that upside as opposed to with a hedge you have to always give up a whole fraction of that upside.

Joe: With prostitutes to surfers to magicians what was the most interesting? I mean all of this stuff is absolutely interesting. I mean did some make you go, “What the hell?” Tell me about the whole process of making this book.

Al: He mainly wants to know about the brothel.

Joe: Oh whatever! Actually, I want to learn about the magician because that’s what I wanted to be as a kid.

Allison You know, one of the reasons I did a magician was because Robert Merton who taught me finance, the guy who won the Nobel Prize for Black-Sholes…

Joe: Oh, just Robert Merton. (laughs)

Al: Yeah, that’s all. Just hangin’ out. (laughs)

Joe: Yeah my good friend that won the Nobel Prize. Besides that, go ahead. (laughs)

Allison: Well his father is a famous academic too. But that was only because a career in magic didn’t work out. He was going to be a professional magician. But that didn’t work out for him so he became a famous sociologist and magic is incredibly important to the Merton family. So that was partially why I wrote about a magician for insurance, but generally, I think you get the sense, I mean the process of writing the book was just pure fun. I gotta say I enjoyed every minute because I got to meet all these amazing people and learn all these interesting things. Like you would never think a brothel, in a lot of ways, it’s just like any other workplace. It is all one big hedge in that you give up so much money of your earnings to work in a brothel but you get all the safety – including all the annoying bits of working in an office. The politics between the sex workers are like anything you’d see. They have financial planners, they’ve got financial literacy, they’ve got staff meetings, and like all the structure and politics of any workplace.

Joe: (laughs) That was the bunny ranch.

Al: Yeah, Nevada. There’s a TV show or something.

Joe: I have no idea. (laughs)

Al: (laughs) It was on HBO, it was a special.

Allison: The mundane parts are sometimes the most interesting. There was a woman who, whenever I was there would always pull me aside and always complained. She’d always be like, “you know, Alice makes so much more money than I am. And like, no one values me here!” And she would like then give me her sex resumé. Some other workplaces would be like, “they don’t pay me enough anyway. I went to Harvard.” She actually gave me, she started listing all these obscene things she’d done with these people I’d never heard of. And I would always just be like, “you should advertise that more! Us women don’t really trumpet our accomplishments enough!” Because I just never knew quite what to say to that. I’m like, wow, there is one in every workplace- that one person who feels like they’re not valued for their skills!

Al: I can just imagine at the end of every day you’re trying to take all these interviews from the people of the brothel and just try to make sense of it.

Andi: It’s also interesting to realize that you can actually go into sex work and you still have to do your Tuesday afternoon meeting.

Joe: Absolutely, you’ve got to get that staff meeting involved. What’re your numbers? How are you performing here?

Allison: That’s exactly what they discuss. Like I said, sometimes the most interesting thing about the brothel was just what a normal workplace it was, except everyone’s in their underwear. Obviously, that was different. But otherwise, it was really just like any other workplace.

Al: So it was one of the principles you found is that we’re irrational beings, and I guess the more that we know that, the better the outcome or the better the risk-taking could be.

Allison: Yeah, I kind of reject the idea that we’re just hopeless and can’t understand risk. A lot of people say that. The research says it really comes down a lot to framing and how you think about risk, and people can really overcome these biases with more experience and more education and depending on how you frame problems.

Joe: Without question. It’s all about framing to some degree. S I’m just stuck on the old magician. So explain to me – and I don’t want to give too much of the book away. I don’t want to just go through chapter by chapter and you explain it to our listeners because we’ve got to get them to buy the book, right Andi? That’s the whole point?

Andi: Absolutely, yes. AllisonSchrager.com. Go get your copy of the book.

Joe: Andi does a really good job of selling it, maybe you want to say that another? (laughs)

Andi: Go to AllisonSchrager.com and get yourself a copy of An Economist Walks Into a Brothel and Other Unexpected Places to Understand Risk by Allison Schrager.

Joe: Thank you.

Allison: Thank you.

Joe: So with the magician, tell me about how you explain insurance with that?

Allison: Well I mean, performance – and I actually just spoke to a comedian who said that he did something similar to what she does – is a very risky thing. You’re putting yourself out there and you realize magicians – I guess we always knew this – everything they do is a con, right? Like you go in and they manage to completely make you feel trusting and safe, and then they trick you. And so if a trick goes wrong it’s shattered and the whole show just goes to hell. So people are always interested in seeing magicians tricks, like how they did it. And I honestly find that less interesting, because usually there is such technical skill involved I can’t even appreciate it. I think what’s more interesting, what magicians really won’t tell you, is how they save tricks when they go wrong. Like they have all these little – insurance is technically anything that gives you a payoff in a certain state of the world. And so they have all these “in case this goes wrong” backup plans. It could be things like if they can’t find the card and they start panicking. They don’t panic. They say, “here’s the deck, just check and make sure your card is still in there.”

(Joe & Al laugh) Al: Until they find it. Joe: Right.

Allison: It sounds like such an obvious thing, but because there’s all this buildup, they invest so much throughout the act that you feel comfortable with them and that they can get away with that. It’s interesting, I just saw Belinda, the magician I profile, she invited me back to her show and I gave her a book and to get people to be in these chapters, it’s like a journalist trick is you have to make someone feel trusting and like you’re gonna do a good job telling their life story that they have no control over and then putting it out publicly. And I was surprised when I left, I was like, “thanks Belinda, thanks so much for letting me include you in your story,” and she just looked at me, she goes, “takes one to know one.”

Joe: (laughs) Are you getting pulled over, by the way?

Al: (laughs) Yeah there are sirens in the background.

Joe: Are you speeding?

Allison: Oh can you hear that? I think it’s New York’s traffic, sorry.

Al: (laughs) So I’ve got a question for you, I feel like I’m a bit of a planner, hence I’m in the financial planning field, so fortunate thing – CPA by nature, by profession and by nature, I guess. But it seems like the absolute best plans, there are things that you can’t possibly plan for, there’s uncertainty. And I know you talk about that in the book, but for our listeners, how should people deal with uncertainties or things that happened that they just couldn’t really anticipate?

Allison: Well, that’s where you need flexibility because I think planning is important. I know other people are very critical of financial models and planning because the plans always shall fall short. I mean what we’re doing is we’re taking stabs to the dark trying to predict what’s going to happen in the future, and we try to think of everything that could happen and how likely it is. But you know there are always going to be things we don’t anticipate. And that can be a shortcoming of risk models in that if you think you plan for everything and then you haven’t and you’re counting on it, then it’s a problem. Like I was watching Billions the other day and they said, “we’re going to lever up and then we’re going to protect our downside risks.” And I’m like, “That is a bad idea, (laughs) because if you lever up, I mean, what you need to deal with uncertainty with the unexpected is flexibility. Like you need to have that ability to pivot and change your plan if you need to. For that chapter, I interviewed H.R. McMaster, who is this General. The military loves to plan everything down to the wire, but then battle inherently always goes differently than they expect. So there is always tension in the military – how much can we plan in advance and how much flexibility are we going to leave our soldiers in to change things up on the fly? Which no one likes but is also really necessary. So like in Billions when they’re like, “we’re gonna lever up and protect our downside risk” I’m like, “well you protecting the downside risk of the things you can imagine.” But this is where hedge funds or any financial firm gets into trouble is when they lever up and then think they’re covered. And there’s nothing wrong with leverage, sometimes it works. But what you gotta do is leave enough flexibility in there where if something happens you don’t expect, that you can still make that pivot. And that’s why debt is potentially so risky is it ruins your flexibility.

Joe: Hence, the credit crisis.

Allison: Exactly.

Al: Yes. Real estate loans, credit crisis, yeah everything.

Joe: A little leverage there. Allison thank you so much for taking the time. This was awesome. It was a lot of fun. I really really appreciate it. So where can we find the book, Andi?

Andi: They can go to AllisonSchrager.com to get a copy of An Economist Walks Into a Brothel and Other Unexpected Places to Understand Risk.

Joe: You also write a great blog. Where can they find you there?

Allison: Oh thanks. I have a newsletter and you can sign up for it on my website, and I also write for Quartz – Qz.com.

Joe: Something about millennials are not having enough sex and that’s why there’s…

Andi: That’s at Qz.com.

Allison: It is. It’s a high risk-free rate of return because you know, Netflix is just so good there’s no reason to go outside.

Joe: Netflix is really good.

Al: And you’re single so you would know. (laughs)

Andi: AllisonSchrager.com is the website. Allison Schrager, thank you so much for joining us.

Check out the podcast show notes at YourMoneyYourWealth.com to read the transcript of this interview, to share it far and wide via social media and email, to subscribe to Your Money, Your Wealth for free access to all future and past interviews, and for links to Allison Schrager’s website and her book, An Economist Walks Into a Brothel. YourMoneyYourWealth.com is also the place where you scroll down to the bottom of the page and click “Ask Joe and Al On Air” to send the fellas a voice recording or an email right through the site, and they’ll answer it here on YMYW – and I might even post the video of their response, just like I did for this first one – check it out in the podcast show notes at YourMoneyYourWealth.com:

20:16 – Does It Matter Which Retirement Assets I Spend First?

Joe: Rich from Chicago. “Hi Joe and Big Al, love the show.” Thanks, Rich. “Have a question on spending my retirement funds. As long as I rebalance when needed, does it matter if I take from stocks or bonds? Or should I only sell what’s high to keep my allocation where I want it? I’ve also read that you should only sell bonds, and then rebalance when needed. Not sure what the best way is. Thanks, guys.” Rich, that’s one of the most intelligent questions I think we have ever received on Your Money, your Wealth®. Would you say so, Alan? One of them?

Al: It’s a good question because everyone is faced with this and hardly anyone would even think about it.

Joe: Right. It’s like, “I want to spend $30,000 a year for my portfolio. I’m going to put it in cash and then go from there.” So multiple ways to look at this, Rich. It really depends on, A, how much money that you have, where you’re pulling the money from, and what other income sources that you have, and your tax bracket. So let’s break this down because it’s not as simple as should I sell bonds, should I sell stocks – or a certain asset class is higher so should I sell that one, a certain asset class is lower. So there’s a lot of moving parts that are going on with this overall question. So I think what would make sense is just to kind of give a high-level outlook of what you need to be thinking about as you start taking dollars from your portfolio. First things first is to see how much money does Rich have or how much money should Rich have? OK. So that’s kind of the first part of the equation. So if you’re looking at retiring here soon, Rich, here’s the math that you would want to look at: figure out what are you spending? What’s your goal? How much money that you want to spend entirely, let’s say this year, and then thereafter for life expectancy. So let’s just assume it’s $100,000 a year. You with me so far? Second step is to figure out what other income sources are going to come to the household that is not part of your portfolio. So that could be real estate income, that could be Social Security income, that could be pension income. Or maybe part-time work income or whatever. But don’t count dividends or interest or anything like that from the portfolio. Just look at what your fixed income sources are going to be. So let’s say $100,000 is what he wants to spend, his pension, Social Security is $50,000. So that reaches his shortfall of 50. So the rule of thumb Al would be what?

Al: Well you take the $50,000 shortfall and you multiply it by 25 to give you an approximate amount that you need to have saved, which in that example would be $1,250,000.

Joe: OK. So he needs about $1.2 million to create that income. So that’s kind of his first step. So that’s assuming you’re pulling 4% out of the portfolio, that the portfolio is growing 6%, the other two helps with inflation and taxes. The second step of all of this – so that’s kind of your first step. Do I have enough? Then the second step is really to take inventory to see where are your dollars at? Are they in a retirement account? Are they outside of a retirement account? Are they in a Roth account? So just start taking inventory to say, “well what percentage do you have that $1.2 million in each of these different accounts?” Because let’s say if he had a third, a third, a third in retirement accounts, Roth accounts, and non-retirement accounts, I mean that would be ideal, but the likelihood of that happening is probably low.

Al: We don’t see it very often.

Joe: Very, very, very seldom. I would say 90% is probably in a retirement account, 10% in Roth and other. So you might want to start looking at diversifying your overall situation, getting a little bit more money into Roth, maybe looking at, “if I have a fixed income what’s my RMDs going to look like?” So just kind of really getting the hands-on tax because if he can save money and tax that’s going to have a direct correlation on your overall asset allocation, which I’m coming full circle to your point. Because if I have a lot more and if I can save more money in tax, then I can take less risk. So I will have more bonds, more cash, more fixed income-type investments in the overall portfolio because I don’t necessarily need to shoot for a higher rate of return.

Al: So said another way, if he needs $50,000 in your example and if he’s got more money in a Roth IRA or outside of a retirement account, it’s more tax-favored. And so to get that $50,000 there’s going to be more tax efficient and so you don’t have to take as much risk in your portfolio to earn that same money.

Joe: Absolutely because Roth money is all yours. Tax-deferred, maybe only a third of that or 2/3s is yours, where a third might have to go to the IRS. So looking at the tax implications of everything is going to determine how you should be allocated. Because how we believe is that you want to take the least amount of risk possible to accomplish the goal. So if I’m shooting for 6%, 5%, 4%, let’s just take the least amount of risk to try to get that target rate of return. Then how you’re going to be pulling your income is going to determine on your tax bracket of where you’re going to be pulling the funds from. So if I need to pull $50,000 from the overall portfolio, well I might want to only pull let’s say $30,000 of the $50,000 from my tax-deferred account. That might get me to the top of, let’s say, the 12% tax bracket. The other dollars would want to come from the other two pools. So I could potentially pay zero tax on those dollars and remain in the 12% tax bracket, instead of paying 22% tax rate.

Al: Right. So before you even get to selling stocks versus bonds, you’re looking at which tax pool to pull money from. And the key there as you said, Joe, is to manage your tax brackets to stay in as low a bracket as possible.

Joe: And then from there as you’re looking at the different pools, that’s of course when you want to start looking at which asset class is up, which asset class is down, and then yes, you would want to sell the asset class that is up to create that income. Some people will look at taking dividends and putting them into cash and then spending that. You might want to put a year’s worth of income just in cash and keep it easy. But yeah, I think you’ve got the right point, but then trying to tax manage it, rebalancing it, and then keeping your tax pools in check – that’s where it gets a lot more complicated.

Al: The different tax pools determines what kind of investments go where. So if you have money in a Roth IRA, well that’s tax-free. So you want your asset classes that have the highest expected rates of return. And those tend to be smaller companies, U.S. value companies, same internationally – maybe emerging market-type stocks. Now they’re more volatile, yes, but over the long-term, they tend to do a little bit better than the larger company stocks which then you would put those probably in your non-retirement account. Your safest assets, your fixed income. you might want to put in your IRA because fixed income produces ordinary income interest, which by the way, that’s what a retirement account does and you don’t want your highest growth in the retirement account because you just end up paying more taxes. So you’ve got to think about that.

Joe: Or if you have a like tax-inefficient type investing. If you have a lot of turnover let’s say in a mutual fund that’s highly active, or maybe your day-trading or something like that and doing well? Maybe you do that in your retirement account just because those short-term profits, if you’re successful, is taxed at ordinary income. You can defer that tax by just doing it in the retirement account vs. outside. REITs are also kind of a quasi-investment where sometimes you get high appreciation in REITs but it also kicks out really terrible tax income so you might want to put that into a maybe a Roth as well. So different things that you want to look at, and as you boil this thing down it can really make a huge difference.

Al: Yeah. And so I guess the way that we kind of think about it is after you’ve got the right assets in the right type of tax pools, then you tend to look at everything as if it were a single account to try to determine, “are we still in balance here?” In other words, if I want to have 60% in stocks and 40% in bonds, the market’s going to move and at some point, you’re going to have higher than 60% stocks, some points, maybe less. And so there are different schools of thought on how you take money out of the portfolio for income. My belief is to try to reduce trading costs, every time that you need to take money out, you’re going to have a rebalancing opportunity. So you take the money out of the account – or I should say the asset class – that is higher than it should be. Let’s say you want 10% in large company stocks and now it’s 11%, and you need some dollars. Well it would be obvious to sell 1% of those large company stocks, and that’s where you take your distribution, and then you basically rebalanced and created distributions at the same time. The problem with that, in a bubble, is if those assets are in your retirement account and you’ve got a lot of different assets outside your retirement account and you’re already in a high tax bracket, you may want to rethink that. So there are a whole bunch of things that you’ve got to look at it at one time.

Joe: Right. So it’s going to boil down to the planning that you look at upfront. OK, we’re in now May. Can you believe it’s May?

Andi: Mid-May even.

Joe: Right. So next month we’re halfway through the year. So as you get closer to let’s say maybe October, you’re going to have a little family summit like the Clopines do.

Al: (laughs) That’s right. We usually have ours in January to kind of plan for the year.

Joe: Well when you retire you’ll probably have it in October just to plan for the following year just a couple of months in advance.

Al: Yeah well what we’ll do it quarterly because I’ll have more time. (laughs)

Joe: (laughs) Probably monthly.

Al: Yeah probably.

Joe: So here’s what I would do, OK well now we’re getting close, so I’m planning now for 2020 and I’m gonna be like, “here’s how much money that we need from the overall portfolio. We need $100,000, $50,000, $10,000, whatever that dollar figure is.” And then I’m gonna look at my tax situation and say, “OK, well this is where we were, this is where we fell last year. So let’s just try to keep our taxes neutral.” So then that’s going to help tell you what pools you want to draw from. Here’s how much money that you want to draw from tax-deferred versus your Roth versus other assets. Then you can build your allocation appropriately and say, “I need enough fixed assets or safe assets in my Roth or in my non-retirement and my retirement account so if the market implodes, I still have that safety net to not blow myself up tax-wise.” Because what Al and I’ve seen so many times is that when the market implodes and they don’t have a tax strategy, then everything is going to come out from probably the wrong account. So now their accounts are down and they’re pulling out more dollars, more shares, and it’s getting killed in tax. So you’re getting hit from both sides.

Al: Right. So something else I’ll bring up, which is maybe a little unrelated, but kind of somewhat related is when we talk about investing and having the right allocation, a lot of folks get confused about an emergency cash fund. An emergency cash fund would be cash outside of your retirement account that is not part of your allocation. It’s just completely separate.

Joe: It’s outside of your retirement accounts strategy.

Al: Correct. It’s in just a normal bank account or savings account, and the purpose of that is just for that – for emergencies. It’s not to be used for vacations or things like that, it’s for emergencies. But before you kind of come up with the assets that you want to allocate into whatever allocation you want, make sure you have an appropriate level of emergency cash and that should be maybe six months of living expenses, maybe a year. It’s a little bit of personal choice – some people want to have more. It depends upon the safety of your income. Those that have less regular or safe income might want to have a higher emergency fund. So you do that first. And that’s your cash outside of retirement, and then everything else you invest like we’re talking about. So you want to have a certain amount of stocks and bonds, and then you got to look at whether you’ve got the Roth, the non-retirement, the retirement, which asset classes go into which pool to make the best tax-efficient investing.

Joe: Yeah. There’s a lot to it, huh?

Al: There is, it turns out. Probably could do another segment. We really haven’t got to the question. (laughs) Well I guess we sort of did – at least my opinion is, if you have the ability to sell out of an asset class that’s higher and it’s in the right tax pool – I’ll sort of qualify it with that – then go ahead and sell that asset class because you’re getting a distribution.

Joe: How about if he needs more then where does he go?

Al: Well then it’s more complicated because if you sell one asset class -g nothing is going to be perfectly in balance at any time. So there’d be certain asset classes that are more likely to rebalance than others. And if there just isn’t, like let’s say everything’s in balance like the perfect storm, where do you get the money from? And so, in that case, to me it doesn’t matter as much. But you’ve then you’re going to have to rebalance if you want to stay in perfect harmony. Whatever you sell out of, you’re going to need to buy back.

Joe: So would you’d take it equally out of each asset class that you own?

Al: No because–

Joe: The trading costs would probably kill you.

Al: Too expensive. So when we talk about keeping things in balance, perfect balances is not realistic. You want to get as close to perfect as possible without creating too many trades.

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There are 10 key principles that can improve your odds of investing success – find out what they are. Download the white paper from the podcast show notes at YourMoneyYourWealth.com. It’s called Pursuing a Better Investment Experience, it’s free, and it’ll give you the direction you need so that you’re properly allocated when it’s time to start withdrawing from your portfolio in retirement. Download the Pursuing a Better Investment Experience white paper from the show notes for today’s podcast episode at YourMoneyYourWealth.com. Now we’ve got one more email question for the day:

34:45 – How Much Can I Convert to Roth Without Incurring the Medicare Surcharge?

Joe: Linda from Kansas: “I would like to ask regarding Roth conversion. I will be 70 years old and would like to convert money from IRA to Roth without incurring the 3.8% Medicare surcharge. What is the total amount that can be on line 43 so I won’t incur the surcharge? Thanks for your advice, I appreciate your help.” Okay, let me set this up for you, Al. A couple of things. So Linda from Kansas is talking about a Roth conversion. Roth conversion is taking money from a retirement account – IRA, 401(k), 403(b), TSP, whatever you got – and then converting it into a Roth IRA. And the reason why individuals would want to look at that strategy is that if the money is in the Roth, then those dollars will forever grow tax-free. You do pay tax on the conversion. So if I convert $10,000 from my IRA to a Roth IRA, then $10,000 shows up on my tax return as taxable income, I pay tax on that. There is not 10% penalty if you’re under 59 and a half. But I can do the conversion, I pay the tax, now I have $10,000 in the Roth, that $10,000 grows to $20,000, it doubles in the next 10 years, I pull the 20 grand out, I pay zero tax whatsoever. So I’m hedging, in a sense, of saying, “let me take the money out. I’ll gladly pay the little bit of tax now to have all future growth of those dollars forever grow tax-free.” So, Linda has been thinking about doing a conversion. And so then she’s getting a little smart with us, here, Alan. She’s like Medicare surtax?

Al: Right. So she doesn’t want to convert too much because then she’s got to pay additional taxes.

Joe: So I like how she says “line 43.” So it’s line 10 no, Linda. Your taxable income is what she’s referring to there. So line 43 was taxable income on the old return because that tells you what tax bracket that you’re in. But now, the Medicare surcharge, the additional 3.8%, you would want to look at a different number probably entirely.

Al: That’s correct.

Joe: It’s adjusted gross.

Al: Yes. That’s right. So another name for that is the net investment income tax. And it happens at adjusted gross incomes, when you’re single, above $20,000, married, $250,000, so those are your thresholds. And if you’re above that, then any passive-type income, there’s an extra tax on top of your regular tax. 3.8%. It’s interest, dividends, capital gains, rental income, things of that sort. So those are the thresholds. Right now under the new tax return, it’s line 7. So line 7 is the line to look at if you’re below $200,000. So in other words, let’s just say Linda’s income is normally $80,000, just to throw at a number. So then she could do a $120,000 Roth conversion if she was single and be at $200,000 and not have to pay any net investment income tax. On the other hand, if her income is only pension and Social Security, there is no net investment income.

Joe: She would never pay it is what I was going to say.

Al: That’s right. It’s only on interest, dividends, capital gains, rental income. So you have to look at the character of your income to know whether this is even a problem or not.

Joe: So Linda, to say it a different way, we get this question often – they hear the net investment income tax or the 3.8 surtax or surcharge or whatever you want to call it, “oh, am I going to be affected by that?” Well, you have to have a lot of income, and you have to have a lot of income that is generated by investments. So if you have a lot of income via wages, don’t worry about it. If you have a lot of income with pensions, don’t worry about it. If you’re pulling a lot of money out of your retirement accounts, you don’t have to worry about it. But if you are selling let’s say a highly appreciated asset that all of a sudden will kick you up, then you will have to worry about it. If you have stock, dividends, interest, things like that, then that’s where do you have to start thinking about this 3.8 surtax. Or if you have a multi-million dollar portfolio that’s just kicking out a ton of income from the portfolio, then yes, you want to be concerned with it. But in other cases, we don’t really see this 3.8% surtax or surcharge affect a lot of individuals, just because most of their assets are in a retirement account. Or if they sell like a piece of property or their business.

Al: Yes. So in that particular case when it’s a property they’d have to pay the 3.8% on, when they sell their own business that they’re actively involved in, that’s not considered passive and most accounts would then consider that 3.8% tax would not apply. One thing to kind of augment what you said about salary – there actually is a surtax there, it’s .9%. So if your salary is over $200,000 then you could have an extra .9% on top of that.

Joe: And if you’re over a million and something?

Al: Well that’s only California.

Joe: I bet you have to pay that Big Al.

Al: Uh, not quite. (laughs) You do.

Joe: (laughs) Oh, yeah!

Al: At any rate, I want just sort of go maybe one other little direction, just in case she’s thinking of something else. Because the higher your income, the higher your Medicare premiums are.

Joe: Okay. Yeah. Good point.

Al: That is not the question she asked but it could be what she’s thinking. Because when you are single and when your adjusted gross income is above $85,000, this was back in 2017 because they do a two-year look back, so for 2019 they look at – so $85,0000 or less, you’re paying the lowest premium, which right now is about $135 per month. Once you go above that, between $85,000 and $107,000, it’s $189. And then above $500,000 of income, that’s the highest level, it’s about $460 per month. When you are married, the lowest bracket is $170,000 of income or below. So sometimes when people do Roth conversions they get a little bit tripped up in that as well.

Joe: Right. Their Medicare premiums were paying 150 bucks roughly. And then now they’re paying 400 bucks a month. It’s like what happened? Well, you did a giant Roth conversion and then that affected your Medicare premiums.

Al: Yeah. And we’re going to say, you should still consider Roth conversions, we still think it makes a lot of sense. But just consider this an extra cost. It’s only a one year cost, and so if you’re doing a Roth conversion right now in 2019 it could affect your Medicare premiums in 2021.

Joe: Yeah. You just want to look at everything – of how every transaction, strategy, is going to affect your overall bottom line because most people, they’ll listen to this show for like 10 minutes. If we’re lucky.

Al: (laughs) That’s being generous.

Joe: Then they’ll hear one thing and then they’ll be like, “oh, that sounds like a good idea!” Then they do it themselves and then they blow themselves up and then we get these weird emails.

Al: Yeah, “your strategy doesn’t work very well!”

Joe: yeah or, “hey I’m getting these letters from the IRS because I thought I did a conversion but I took a distribution and then the 60-day rollover am I still qualify….?” Oh my gosh no. You kind of hurt yourself there. So just be careful. If you’ve got it dialed, God bless you. I mean that’s why we do this show. We want to help those that are really dialed into their overall situation, try to give them some nuggets to chew on. But others, we want to make sure that you are aware that there are strategies out there that could really enhance your overall wealth long-term, save money in taxes, grow your wealth, pass it to the next generation. And then if you need help, you know, we live in such a Do It Yourself environment where a lot of times you just kind of break stuff versus fixing it the right way. So I would seek advice from any qualified advisor. Like my closet for instance. I got a project and it’s like, I broke part of my closet. Don’t ask me how I did it. (laughs)

Al: Was that on a Saturday night? (laughs)

Joe: (laughs) No! So I have all these drawers and stuff like that within my closet. And then I snapped one of the drawers and then the things came off the rails and I tried to put that thing back together. It’s like Humpty Dumpty, man.

Al: Oh, those are complicated.

Joe: That thing ain’t coming back right. So now I’ve got to hire someone.

Al: Yeah. And I think just to follow up on your point, I think it’s a good one – which is if you hear tips from us or anybody, then don’t take that as gospel. Take that as an idea to research and get more information so you can do it properly.

Joe: Right. It’s like we hear, “oh, I love Roth conversions.” It’s like, “well that doesn’t make any sense for you.” Even though a lot of you think that that’s all Al and I talk about.

Al: Yeah. In fact, I just had someone call me Mr. Roth at my church.

Joe: (laughs) All right guys we’ll see you next week. The show is called Your Money, Your Wealth®.

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Special thanks to Dr. Allison Schrager for coming on YMYW today, check the podcast show notes at YourMoneyYourWealth.com for the link to her book, An Economist Walks Into a Brothel, to share this great interview, and to subscribe to the Your Money, Your Wealth® podcast and newsletter for free. Subscribe to the podcast on Google Podcasts, Apple Podcasts, Spotify, listen on YouTube or find it on your favorite podcast app. Click to subscribe to the podcast on any of the following apps:

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