Podcast-episode two
Reed: [00:00:00] Welcome to the second episode of the Tax Free Millionaires podcast. I'm your host Reed Scott. And in today's episode, we'll be doing three things. First, we'll discuss what are some of the real opportunities for tax free investing and some of the pitfalls you need to be aware of. Then I'm also going to introduce a truly tax free investment alternative that you may not know about.
And I call it the Super Roth. And this is not an ordinary Roth or even a backdoor Roth. And finally, I'm going to share with you my stock pick of the week. So be sure to stick around. You're going to want to hear about a stock that is taking advantage of the A. I. Software revolution. So what are tax reinvestments and what are some examples when it comes to truly tax reinvesting opportunities?
There aren't that many. And the ones that are available very often have low returns and more risks than most people are willing to accept. In the 1980s, the tax code was full of tax shelters. But after the 1986 Tax Reform Act, [00:01:00] Almost all of these legitimate tax shelters in the tax code were eliminated.
The one that is still a big part of the code and often used to offset taxes for high income taxpayers is the oil and gas depletion allowance. This is a legitimate tax shelter in the IRS code and allows investors in oil and natural gas drilling partnerships to write off almost 90 percent of their investment in the first year.
Another legitimate tax shelter or deduction in the code is the charitable deduction. And if you have a charitable intent, You can get a significant deduction for your charitable contributions, but the charitable deduction really isn't an investment is. It's simply a tax deduction. As a tax attorney, I had an endless line of promoters trying to get me to endorse their so called tax savings investments.
And I have to tell you, I found almost all of these to not only be bad investments, but often they were dangerous. Up until just recently, almost every financial advisor I know was promoting what is known as the Deferred Sale [00:02:00] Trust, or DST. They were telling everyone, especially business owners who wanted to sell their business, that this was a great way to avoid paying capital gains tax on the sale of their business.
I had several arguments with financial advisors telling them it was an abusive tax shelter and it would not be allowed by the IRS. They would quote to me the tax code sections that the promoters who developed the investment were pushing. to try and make this investment look legitimate. It didn't seem to matter to them that I was a tax attorney with a master's degree in tax law.
They were convinced that they had found the loophole. Often they usually had a tax attorney, our former IRS attorney, even write an opinion letter stating that in their opinion it was a legitimate tax deduction. I always told them the same thing. It doesn't matter what a specific code section says. And the tax courts have been consistent.
In applying this, the tax code has an overarching, all encompassing caveat that overrides any specific code section. [00:03:00] It is the nuclear bomb to these tax shelters, and just because you haven't been caught doesn't mean your shelter is legitimate. It just means you haven't been caught yet. And the caveat in the tax code is this.
Any tax reducing investment must first have a substantial economic purpose other than the saving of tax. If it does not, it will not be allowed. It's that simple. So unless you can prove that your deduction has a substantial economic purpose, other than it's a heck of a tax deduction, it is going to get you in trouble.
In other words, the investment must stand alone and be a good investment, even if there were no tax savings associated with it. And unfortunately, most of these schemes cannot meet this simple criteria. Sure enough, just this year, one of the most popular tax savings investments advisors have been pushing is the Deferred Sale Trust, or DST.
And it has recently been added to the list of abusive tax shelters on the IRS disallowed tax shelter list. [00:04:00] And the fact that a big four public accounting firm like KPMG or an ex IRS director wrote an opinion letter won't protect the people they sold these tax shelters to from substantial taxes and penalties.
Whenever I warned financial advisors of this part of the tax code that disallowed these types of shelters, they would always go back to quoting the code section. They were such good salespeople that sometimes they almost had me convinced. But not really. So what's left? You have tax free bonds, for example, which pay low rates of interest relative to the stock market and often lack the opportunity for appreciation.
Of course, there's always the old standby, real estate. Many millionaires have been made investing in real estate and it can gain in value and have compounded tax free growth. Or can it? In reality, real estate is not tax free in the sense that you can access the money without paying tax. Capital gains in real estate are taxed upon a realization vent, a sale.
There are many workarounds to get the capital appreciation out of [00:05:00] real estate without paying tax. For instance, you can borrow against the real estate value and use the loan proceeds for other investments. But then you have a loan repayment hanging over your head. So you had better have enough income to make your loan payments.
That's not exactly tax free, is it? Of course, you can always do a 1031 exchange in your property for like kind property. However, this is only tax deferral, not tax free access to your gains. Many real estate investors have made fortunes buying property and then leveraging the equity in the property to buy more real estate.
This can lead to huge fortunes if everything goes according to plan. It worked well in the United States for years. In fact, Jerry Buss, the former owner of the Los Angeles Lakers, He did just this over a period of 30 to 40 years. He started acquiring rental properties in the early 60s in the Los Angeles area.
And he leveraged his real estate to acquire more and more property. Property values kept going up. There was no major property value crash. And his real estate became worth more and more. [00:06:00] He looked like a genius. However, I knew many investors who tried to copy this strategy and started buying properties in the late 90s and early 2000s.
They also looked like geniuses for a few years. Then the 2008 recession hit, and those same investors had their properties drop as much as 50%. I know this because as an attorney during this period, I worked with several real estate investors to help them negotiate the unraveling of their real estate empires.
More than a few of these investors actually had to move out of California to states with more favorable asset protection and homestead laws so the banks couldn't force the sale of their personal residence to help pay the debt. I had one client who had two pieces of rental property sold at foreclosure and another one turned back into the bank at a short sale, but he had to move to Texas to get a homestead exemption on his house so his creditors couldn't take his personal residence.
Can real estate still be a good tax shelter? Absolutely. But many things have changed since Jerry Buss made his millions. Now you must prove you are actively involved in the management of your [00:07:00] properties to take full advantage of the tax write offs. And the depreciation rules have changed greatly since Jerry Buss time.
If you like fixing toilets, plumbing, and leaking roofs, then real estate investing may be perfect for you. But if you're like me, however, you may want to keep listening, because I'm going to discuss a truly tax free alternative that doesn't suck all your free time and allows you to enjoy life and is liquid.
Am I telling you not to invest in real estate? Absolutely not. And I agree with Robert Kurosaki in his book, Rich Dad, Poor Dad, when he states that real estate offers a great way to use leverage. Smart leverage is how the rich get richer, and you'll see in my book, Tax Free Millionaires, in all my courses, I recommend smart leverage in investing in stocks.
And I talk about how to do that. But many things have changed since Mr. Kurosaki wrote his book in the late 90s, and real estate investing isn't. As great a tax shelter with low risk investment as it once was. And real estate is not at all liquid. You had better make sure when you invest in real estate, you [00:08:00] won't need the money anytime soon.
If you still aren't convinced that being a landlord is not the risk free cash flow machine it used to be, that's okay. I don't want to convince you. That may be a good investment for you, but it doesn't mean you can't look at other things. I just want you to be aware that real estate has some risk, like any investment.
And it certainly lacks liquidity. Perhaps you might want to put some other tools in your arsenal to build truly liquid tax free wealth. In terms of tax free investing, real estate is truly only tax free when you die. Because at your death, your heirs will inherit the real estate and get a new basis in the property, equal to the market value at the time of your death.
For your heirs, real estate is truly tax free. But if you'd like tax free money while you're still alive to enjoy it, real estate is not tax free, it's tax deferred, and there's a big difference. Now, 401Ks and IRAs advertise tax free growth, and it's true, the growth is tax free. But these also aren't tax free, they're tax deferred, like real estate.
[00:09:00] The advantage of these types of accounts is you get to defer paying taxes on your earnings until you remove the money from your account, hopefully much later, after your earnings have grown with tax free compounding. The challenge of these types of accounts, however, is that you're choosing not to pay the tax in historically low tax rate environments.
Now, in exchange for paying taxes at some unknown point in the future, when tax rates could be much higher. If you listened to last week's podcast, you've learned how dangerous it can be to defer paying taxes. Now, just to pay them two decades from now, their rates could be twice as high. The other challenge with these accounts is that most people leave the management of these accounts to unknown portfolio managers their employer has hired, or they use mutual funds and ETFs their financial advisor recommends.
If you don't have a financial advisor, They often choose their own mutual funds and ETFs through Vanguard, Schwab, Fidelity, or some other financial institution. But the bottom line is that most people have very little control over the returns they get in these accounts. And they leave themselves open to [00:10:00] market fluctuations.
So they have no real guarantees that they will even make money in these investments. They turn over their financial future to strangers in the belief that they know more than they do. Then, when they want to retire, they may find their account is worth much less than they had projected when they first started saving 20, 30, or 40 years ago.
Or the tax rates have gone back to 1970s rates of a marginal rate of 70%, and people end up paying twice the tax rate on less income in the future than they had projected they'd pay when they started saving. In my book, Tax Free Millionaires, we show you how to prevent these outcomes by taking control of your tax rates and your returns.
What is an example of a truly tax free investment? A Roth account is truly tax free, and even though it's true you invest in it with after tax dollars, this is no different than real estate. Both the Roth and real estate investment will accumulate tax free, but when you want to take the money out of the Roth account, you won't have a loan payment on withdrawal like you do in real estate.
[00:11:00] You won't be creating a new liability just to access your cash. You can take money out of the Roth, and all the accumulated tax free growth is yours without paying any tax. Assuming you've waited the five year waiting period, and you're over fifty nine and a half. This is truly tax free growth. With real estate and traditional retirement accounts, like a 401k or traditional IRA, you only have tax deferred growth.
It's not really tax free. And this is an important distinction. If you remember what I said in last week's episode about the correlation between government spending and tax rates, if you're deferring taxes now,
When you. Combined tax rate might be 25%. Only to trade access. As to your account when you retire, when rates are 40 to 50%.
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That may not be such a good deal. Most financial advisors will tell you yes. But is it? And what are the investment alternatives they're not showing you? What are the tax rates that they are assuming? What's the inflation rates? And are they realistic? Now, I mentioned that [00:12:00] the Roth account is a truly tax free investment, but it has some limitations.
First of all, you're limited how much you can put into it every year. And, If you make too much income, you're not allowed to put money into it every year. You could do a backdoor Roth and pay the taxes on a transfer, and I think that's a great idea. But, as I said, the Roth account has limitations for a lot of people.
In the book Tax Free Millionaires, we do two things. First, we show you the importance of increasing the returns inside your tax deferred accounts and how to do it in a way to beat inflation and future tax rate increases in retirement. And then we also introduce you to legitimate and truly tax free investments, and one of them is what I call the Super Roth.
Now, what exactly is a Super Roth, and how does it work? I call this investment a super Roth because under the Internal Revenue Code, Section 72E, earnings inside this investment compound tax free. And then under Section 7702 of the tax [00:13:00] code, that money can be accessed in the form of tax free loans.
Now when people first found out about these types of investments in the 80s, that they could earn tax free money and then have access to the money tax free, many smart people started pulling their money out of IRAs and 401Ks and traditional brokerage accounts and put them into this investment product and it was so popular that the financial industry lobbied Congress to change the law to limit the amount of money that could be put into this type of investment, what I call the super Roth.
And this is exactly what happened. The Congress was lobbied, and they responded by changing the law, and the law was called the Technical and Miscellaneous Revenue Act of 1988, often called TAMRA, and it limited the amount of money that people could put into these types of super laws. However, Congress left a loophole in the law, which I explain in my book.
And this investment product is very unknown. Very few people are aware of it, or at least how to use it properly. [00:14:00] And basically, it's an, Indexed Universal Life Insurance Policy. But hold on, it's not what you think of typically when you think of insurance. It's not also just any type of indexed universal life policy.
Don't think of this as a regular insurance policy, because it's definitely not. What Congress left in the law, is an IUL. Was the ability to design this product in such a way to still get tax free growth and tax free access. Commerce said if the policy was designed as a max accumulation policy, instead of being designed for a life insurance death benefit, then you could still have a large part of your investment grow tax free inside the policy.
And what makes this product so appealing is that it allows you to participate tax free in the market through stock market indexes, have your earnings grow tax free, Just like a Roth account, and you can get the money out tax free. But there are three big differences that make this so much better than a traditional Roth.
And it's why I call it the Super Roth. What are the three big differences? Number one, unlike a Roth, there are no [00:15:00] income or contribution limits. You can put as much money as you want in this investment every year. You're not limited to the 7, 500 a year contribution limit, like a Roth. And it's also available to anyone, regardless of how much money they make.
Now, unlike an investment in a Roth, which are subject to the ups and downs of the market, for instance, if you invested in stock market indexes in a Roth account, and that index dropped 30%, you're going to lose 30 percent of your portfolio. But inside this index, Universal Life, Super Roth, you are protected by the insurance company.
They guarantee you that you can't lose your investment. So if the index you're invested in, inside the policy, goes down 20%, You can't lose 20%. Now, you may not make any money that year, but you're guaranteed that your principal is protected. You won't be able to get that in a traditional Roth. And three, and this is what I find truly amazing, that people are not really aware of this, but when you [00:16:00] access the money or the cash in your Super Roth, you don't actually take the money out.
Instead, you can borrow against the cash value of your account, and this creates a tremendous advantage over regular Roth because you can have the full cash value of your policy stay inside the account, earning money at a higher rate of interest than what you're paying on the loan you're borrowing. And by this way, you can actually create more tax free money.
And by the way, you don't actually need to pay the loan back or make payments like you do on a real estate loan. You just let the interest accrue. This creates a tremendous opportunity to create more tax free wealth through arbitrage. How is this possible? Again, because your money is not invested directly in the stock market.
Instead, it's tied to the market indexes like the S& P 500 or NASDAQ indexes inside the policy. And each insurance company uses different indexes, and you can allocate your investments among the choices they give you. You can also allocate every year to try and get the maximum [00:17:00] return by choosing the right indexes every year.
For the sake of illustration, let's say you invested 500, 000 inside your max accumulation policy. The insurance company does not invest that 500, 000 directly in the market. But instead they put that money inside their general fund, which they're required to keep as capital reserves. That fund is very conservatively invested in government and high grade corporate bonds.
Let's say for the sake of this example, those bonds are going to pay you 5 percent interest this year. But the insurance company gives you a choice. You can take the 5 percent on 500k and your new account balance would be 525, 000 next year. Or you can say, you know what, I don't want to take the fixed rate of interest.
Instead, I want to have my money invested in indexes inside my policy, like the S& P 500. You can choose just one index or you can divide your money up and allocate it across several indexes. And you get to start over again every year, as I said earlier. Now, [00:18:00] let's assume you choose a one year index, let's say the S& P 500, with a cap rate of 12%.
And cap rate means that you are capped at how much money you're going to earn. In other words, the insurance company is saying we're not going to let you lose money if that index goes down, but also if the index goes up 20%, we're going to cap you at 12%. And the cap rates change and vary between indexes and companies.
Now this is the trade off for the guarantee. The insurance company is protecting your principal, and they guarantee your principal, but in return, they get to participate in the upside above the cap rate. So let's say on December 15th of last year, the S& P 500 was at 3, 000. Now I know it wasn't, but just for the sake of argument.
And on December 15th of this year, the S& P 500 increased to 3, 600. A 20 percent increase. The insurance company , is contractually obligated to pay you the increase in your account. But they are only obligated to pay you that increase up to 12%, [00:19:00] the cap rate.
On 500K, that means they will put 60, 000 into your account balance, if it's, if the cap is 12%. That 60, 000 is added to the 500K already in the policy, and your new principal is 560, 000. Congratulations, you now have a new principal amount of 560K and it is protected going forward. That amount cannot go down no matter what happens next year.
If next year you make the same selection in the S& P 500 Index, but instead of going up 20%, it drops by 40%, the worst that can happen to your account is you are going to stay at 560. You may not make anything that year because you invested in an index and went down, but you won't lose anything either.
Reed: It would stay at 5. 60. You may have a year where you didn't gain in value, but you're not going to have any losing years. Your principal is protected from going down with the market. So that's a big advantage over a traditional Roth. In fact, one company I work with even allows you to lock in your index growth during a [00:20:00] year.
This means if the index is up 30 percent at the beginning of the year and you're satisfied with that, you can lock in that 30%. Now, granted, if you have a cap rate, You're still going to be limited to the amount of growth in your cap rate, but there are actually some indexes that don't have cap rates. That's a whole separate course I teach on allocating and picking the right indexes and allocating among them, so it's beyond the scope of this podcast, but believe me, you can get some pretty good returns.
So earlier I mentioned not a lot of people are really aware of this investment product.
And I believe. That's because most insurance agents are not really financial analysts. De-list and they don't understand how this works.
I was a financial analyst at Ford motor company for years. And as a tax attorney.
I can't guarantee you are always gonna make money, but I do work with people to get the best that we can.
So even if the cap rate on your investments is 10%, what rate of return would you need in a taxable [00:21:00] brokerage account to be equivalent to a 10% tax free rate? If your combined federal and state tax rate is 30%, you would need 13% to have an equivalent return inside a traditional brokerage account.
So that's pretty good, especially when you've got that guarantee that you can't lose money. Now do you see why these Super Roths, or what are also known as Max Accumulation Index Universal Life Policies, are an excellent alternative to the stock market? Now I'm not suggesting that you don't invest in your IRA or 401k at work anymore.
I am just suggesting that you might want to put some more , truly tax free investments into your portfolio because We don't know what the tax rates are going to be 30 years from now, 20 years from now, even 10 years from now. We just had a recent election, and due to the results of that election, probably for the next four years, we are going to have some predictability.
But if you've been around long enough to know, the ideology of the United [00:22:00] States differs in different cycles. So we have during the years after World War II, and even in the 70s, We had people that were okay to have those high tax rates. Now we have the low tax rates, historically low rates, but what's it going to be 10 or 15 years from now?
That's why I believe it's so important to have a truly tax free alternative in your investments because you are protected no matter what happens with inflation and tax rates. And by the way, this is true diversification. We're not 100 percent invested to the stock market. Now you're still investing in stock market, but you're protected on this amount of money you've got in the super broad so it can't lose money even if the market crashes, which is a nice safety feature to have.
And instead of having all of your eggs in a directly invested in stock market and with indexing your principle inside the policy is completely protected from market crashes. And every year you even better, you get to start all over to protect your new higher balance. For instance, if [00:23:00] you were invested 500, 000 in the market in 2008 and it lost 30%, it became 350, 000.
Now if your financial advisor even gets just 20 percent the next year, you're still only going to be at 420, 000, 80, 000 less than when you started. So you're now starting at a lower average and even if you got 10 percent returns, it's going to take you two to three to four years even to get back where you were.
What's truly staggering is with the super Roth, you can actually create as much as three times tax free wealth when you convert a traditional IRA into a super Roth as opposed to just converting to a regular Roth. And you don't pay a dime more in taxes for that conversion. So if that's the case, why are financial advisors pushing their clients to convert some or all of their traditional IRAs into regular Roths and not telling them about the super Roth?
I don't know. Maybe they don't know about it, but I do know that if you converted your money into a Super Roth, the financial advisor would no longer be able to [00:24:00] charge the annual 1 2 percent management fee. Because the money is no longer an asset under management, it's in the Super Roth policy. The annual fee goes away.
Now I'm not saying all advisors do that, but that is the result. I would probably say it's a combination of things. They're losing money in assets under management, and also they don't even know about the Super Roth. So why do more people not invest in a tax free option that gives you the chance to make above average tax free returns with no market risk?
Again, in my opinion, I believe it's a simple lack of knowledge. Or many consumers weren't presented with the investment of a SuperRAW. Now, when I say you must have a properly designed max accumulation policy , or Super Roth, a series of choices must be made when selecting and setting up the policy to make sure the money can accumulate inside the policy tax free.
And probably one reason more people don't have these policies in their portfolios is that most insurance agents are not experts in designing and managing the policies. [00:25:00] These policies require a series of choices to be made at inception and then once again every year to maximize your returns. This annual rebalancing is critical for maximum performance and it's something I insist upon with all our clients.
If you want to learn more about the Super Roth and get on the list for a copy of my book. Thank you. Book tax free millionaires. You can join up into our Facebook group at facebook. com forward slash groups forward slash tax free millionaires. Okay, so now that we talked about some tax free investment alternatives and some tax free investment shelters that you should stay away from.
Now let's discuss my stock pick of the week. If you listened to the last episode, on every episode of the podcast, I give a breakdown of one stock I like and why I like it. But first, I have to give the following disclaimer. The stocks I discuss on my podcast are for entertainment and educational purposes only, and I'm not making a recommendation to buy or sell.
You should do your own research before [00:26:00] purchasing or selling any stock or options, and you should never rely upon anyone else's opinion, including mine. Always do your own research. Any losses that you may incur if you purchase or sell stock or options that are discussed on this program are your responsibility alone and neither I, Reed Scott, Tax Free Millionaires, Scott Wealth Advisors, or anyone affiliated with me on this program or these companies will be liable.
I very often own the investments I discuss on the program and it could benefit me personally if the price of the stock increases. However, I am not paid by anyone for mentioning a stock or a company, and I'm not being paid a commission or endorsement fee for discussing any stocks or investments on this program.
Okay, with that out of the way, I want to discuss an interesting stock in a segment of the market I normally stay away from. But this company is so impressive, I've made an exception. The company is HubSpot. And as a stock symbol of H U B S HubSpot is software as a [00:27:00] service , and it's a company that provides cloud based customer relationship management and online marketing tools for small to medium sized businesses.
So I like to think of them as the sales force of the medium sized business space. Salesforce deals with large fortune 500 companies, and I think HubSpot has locked up that small to medium sized business space. Which is a very large space, by the way. HuffSpot has over 238, 000 customers and is growing.
Now, why do I not usually invest in the software as a service space? Because the software as a service space is so crowded, it's hard to predict which of the many competitors are going to take off. I think of it like the gold rush. There were tons of gold prospectors that went broke looking for gold, and only a few made it.
But the suppliers of picks and shovels got rich no matter what happened to the individual prospectors. The people that sold wagons that brought the prospectors out to the west coast made fortunes. But, again, most of those [00:28:00] gold prospectors didn't make any money. And I consider the end companies in the software space to be like those gold prospectors.
They're trying desperately to add AI functionality to their software to make their products so different and so unique that the end users must have it. But in reality, they're all competing with each other just to maintain their relevance. And the underlying AI pick and shovel providers like NVIDIA and AMD and data center owners like Google, Microsoft, and Amazon are the companies that are actually getting rich.
But I believe that HubSpot is such a standout That it has actually LeapFraud, their competitors and are leading the pack by being ahead of the curve on integrating AI functionality into their products. They've done an excellent job of getting ahead of their competitors and
their customers are demanding HubSpot over their competitors. By the way, they just released earnings and revenue and total customer numbers. Yesterday, and they, in both revenue, earnings, and customers added, [00:29:00] they beat the market expectations in all those areas. But the real reason I believe now is a good time to buy this stock, is I believe they are poised for a stock split in the next six to eight months.
Now, I don't know this, of course, because I have no inside knowledge, but when I look at their stock price over time, it leads me to conclude it's been going up and getting so pricey that its current price of about 600 a share, That it will continue to appreciate, and I believe that management will want to knock that price down to make it an attractive investment or attractive stock for people to put in their portfolio.
I believe management would like to keep the stock price down in the 150 to 200 range so that more investors can take advantage of it. Now, again, I want to be clear, I have no knowledge that this will happen. It's just my speculation based on trends in stock and other stocks and the market. And I could be completely wrong on whether they're going to have a stock split.
However, even if I'm wrong and there's no split in the next six to eight months, I still believe the stock is going to appreciate significantly over that [00:30:00] time, somewhere in the 25 to 35 percent range, which is not bad. Okay, and by the way, if you listen to my last week's episode, you'll know my stock of the week on that episode was Ion Q-I-O-N-Q.
At that time, I recommended the stock was selling at around $17 and I recommended it. Today, a week later it's selling at about 22 , which ist bad. So hopefully you listened last week and you made some money. Of course, I'm not always gonna be right and often it takes much longer than a week for investments to appreciate.
But last week I got lucky. Okay. However, no matter whether you invest in the stocks you hear about on the show or not, you should always use good risk management when you invest. You stop losses and puts and never risk more money than you can afford to lose because the stock market is essentially gambling.
Now, I don't think it's quite like gambling because you can do research and invest in good companies, but the stock market is highly unpredictable. There's a lot of emotions in the stock. If [00:31:00] people. If the market gets scared about something, a war or a political event, the market can drop for no reason other than emotions , even though the stock, the company you've invested in hasn't changed anything.
So always use good risk management. So okay, that's it for today's show. Thanks for listening and make sure to tune in on next week's episode where I'm going to discuss some unique ways to leverage investments inside your tax system. Deferred portfolios to increase your returns, and I'll be giving you the Stock of the Week next episode as well.
Thanks again. I hope that you'll tune in next episode.
