Transcript
Intro
Noah Lewis: Welcome back to the Scholar Wealth Podcast. Stephan’s handing us the mic today for a face-off. Five questions in personal finance where thoughtful planners land on opposite sides. We’ll walk through the history, the trade-offs, and where each of us lands with clients. Let’s get into it.
Question 1 – Emergency Fund: High Yield Savings Account or Brokerage?
Noah Lewis: All right. So the first question, emergency fund, where are you putting it? In a high yield savings account or a brokerage account? Evan, I’ll give you the serve here.
Evan Mills: Yeah, I think the brokerage account is where I tend to see clients put their high yield savings, and where I typically advise clients to put it, strictly from past recommendations in dealing with clients that had high yield savings accounts. I tend to see a lot of promotional periods where they’re having to pay attention to whether their yield is actually what they were promised a year ago or two years ago. And often I start looking at it and say, during the past six months, you haven’t been earning as much yield as you could, and now you have lost that purchasing power.
And the brokerage account still adds enough liquidity, safety, and again, maintains the purchasing power for the long run. That’s where I tend to think brokerage accounts are a great place to put your emergency fund, in a money market. You can switch between different types of money markets, but often I advise for a treasury money market, and that’s strictly because T-bills and other US government debt tends to be a little bit safer. And again, I look at safety and liquidity when I’m looking at emergency funds, and that’s where I end up being in a brokerage account over a high yield savings account.
Noah Lewis: Okay, so you argue a little bit on the side of brokerage, especially referencing things like promotional periods. What do you say to different high yield savings accounts, like, let’s say Capital One or Ally, where there’s a variable rate, but it’s not just a promotional period, it’s technically indefinite? The rate can fluctuate as it can in money markets with short-term yields. But what do you see as the primary advantage of keeping it in the brokerage account in a money market fund, if yields are relatively similar and it’s not a promotional period?
Evan Mills: Yeah. I bank at Capital One, I enjoy Capital One’s interface. The difficulty with Capital One is, say I end up building a relationship with another bank and I want to switch. Now again, I’m having to make sure that other bank has a high yield savings account. I have to make sure that they don’t have a promotional period. So especially when you get older and you get into the retirement ages, or again, busy lives of high net worth individuals, I don’t want them worrying about what the yield is that day, if the promotional period has or has not expired.
And if there is no promotional period, then you’re worrying about who you’re banking with. Whereas a brokerage account, you kind of set it, forget it, exactly what an emergency fund’s supposed to be. It’s going to be liquid, it’s going to maintain purchasing power, and that’s all I’m looking for in an emergency fund. I don’t want to play the game of, well, I’m banking here, but I really want to switch over to bank here because I get more perks. Whether that’s with Capital One or Ally that offers that high yield savings account not as a promotional period, again, I want to look at a brokerage account as something that I put my emergency fund in, don’t have to look at it until I really need it. And when I need it, it’s going to be there, and it’s going to be earning the yield that I want it to be over the last couple years.
Noah Lewis: Yeah. I want to argue that point a little bit, because I tend to fall on the side of high yield savings account, and honestly, the key word for me is the access. For example, in a Capital One high yield savings right now, you can get a yield of 3.1%, and in an Apple high yield savings account you can get a yield of 3.5%. So the yields are actually relatively competitive. I think it avoids the issue we see with checking accounts, where your checking account tends to be out there along with everyday transactions and more exposed to fraud. So we need to move that emergency reserve somewhere else. I think that’s pretty obvious. Checking accounts just tend to be more out there.
And so where do you go? High yield savings account, or do you go brokerage? I would argue that in a high yield savings account, you still get a little more protection moving out of the checking account, but at the same time there’s still that protection for purchasing power. With high yield savings yields, as long as it’s not a promotional period, I would agree with the argument against that, that you want to avoid things that look great but after 12 months, for example, will cease. But I think you can still get that purchasing power protection and the fraud protection in the high yield savings account.
And I would argue that the access for me is the differentiating point. Because, for example, I’ve known people, and even myself, I’ve had the experience of, let’s say you’re keeping around a month’s worth of spending in the checking account. You don’t want to let that grow too high, because obviously if someone is able to hack into the account, it could be a problem. At the same time, you don’t want less than a month’s worth, probably, because you want to be able to pay the mortgage, your rent, etcetera, or whatever it may be. But I would argue that the ability to just have that immediate transfer capability, to say, okay, I have six months of reserve, I have a year’s worth of cash sitting in my high yield savings account, it’s still earning a yield, purchasing power protection, and then at the same time the risk of fraud is lower than it is in a checking account.
I really like the ability to just transfer instantly. And I think in things like a spontaneous car purchase, I’ve actually seen this example come up a couple times in real life, where you’re going to browse cars, maybe you kind of know you need a new vehicle, but you’re not certain of it yet. In the situation where you go there and you’ve got your emergency reserve in your high yield savings account, it’s really easy to say, well, I didn’t plan on buying a car today, but I found one I really like, and I can just transfer it over and make the purchase today. No financing, no lines of credit necessary. Not that those are bad things, if they’re available. But I really like that ability, whereas I feel that in a brokerage account, the constraint of waiting one to three days for those funds to come over does become a problem a little bit.
Evan Mills: Yeah. I think that totally makes sense for people that bank at something like Capital One that has a checking and savings account there. But for those that don’t bank or have their high yield savings account and checking account at the same bank, because they’re looking for a high yield savings account, now that transfer, that easy transfer, you run into the same problem. If they have their high yield savings account at Capital One, and now they have to transfer money over to their checking account at a different brick-and-mortar bank, now you run into the same problem as that brokerage account. So I think, pay attention to whether you want to worry about having a checking and high yield savings account at the same bank. If you don’t have to worry about that, then I recommend moving over to a brokerage account, because you’re running into the same problem unless you’re banking at a place that has both high yield and checking account at the same location.
Noah Lewis: Yeah. I tend to agree with that point. I think if you are going to go for the high yield, it does make sense to have the checking and savings at the same bank. I think we can both agree on that point. And then the other thing I think we would agree on also is there are certain limits as far as protection goes, like FDIC protection on a bank account, up to $250,000. I think we can both agree, if you have, for example, a short-term reserve of like $500,000, even if you decide, hey, maybe I want more of that accessibility, keeping a good amount of that in the high yield savings account — if you’re going $500,000 as a short-term reserve, maybe throw some of that in a brokerage. You can always go hybrid approach, I think.
Evan Mills: Exactly. If that makes sense. Yeah, that’s perfect.
Question 2 – Roth IRA: Value Tilt or Growth Tilt?
Evan Mills: All right, next up, the Roth IRA. Value tilt or growth tilt? What’s the case? You threw it over to me last time, so I’ll throw it back over to you.
Noah Lewis: Yeah, absolutely. So I am arguing on the side of value tilt in the Roth IRA. There are a couple of reasons. If we look at value versus growth, I think we’re going to be practicing tax location, and saying, okay, you’ve got your entire portfolio, your aggregate portfolio, where we want those percentages to match up with what you want. But we can still practice tax location and say, well, if we’re going to add money in a Roth IRA, and we’re going to have, let’s say, a mix of bonds, value, growth, and international, what are we actually going to put in the Roth IRA?
Well, I think because a Roth IRA is tax-free perpetually and it’s never going to be taxed again, the highest growth assets do tend to make sense going into the Roth IRA, to get the highest after-tax benefit on the entire portfolio, right? So the first argument I would make is the tax. If you’re going to have value versus growth, and we’re practicing tax location, not just in a vacuum here looking at the Roth IRA, but the entire portfolio, I do like allocating large cap value to the Roth IRA, knowing that it’s kicking off dividends. Those could be ordinary income potentially, or qualified dividends. But either way, it’s a tax-sheltered account, so it’s not increasing your ordinary income in a given year if those dividends are being kicked off in the Roth IRA. Because if you’re competing where to put the funds, and you have a brokerage to fund too, I would rather have the large cap growth, for example, in the brokerage, where there’s high growth potential still, but it’s not kicking off dividends that you can’t control and increasing the tax rate. Do you want to argue that point, or do you want me to go to the next point?
Evan Mills: Yeah, I think the main point that I would say — the tax drag is my goal when looking at a portfolio allocation. Again, exactly what you said, we’re looking at the portfolio as a whole and where to locate each asset to be the most tax efficient. And sometimes that means most tax efficient today, in minimizing as much 1099 income as you can get. The other side of that is, now I’m trying to maximize the after-tax wealth that someone’s going to have in their account. So maybe you are going to have a little bit more tax drag if you put value into a brokerage account because of those dividends.
But I would say, is the tax drag really going to make a big difference between putting that in a brokerage account or putting that in a Roth IRA that really protects it from those dividends being taxed at ordinary income? Or do you put growth that has the ability — and those companies tend to reinvest those dividends into their own company — and now you’re missing out on years of compounding in those holdings? And that’s where I tend to lean more towards growth being in the Roth IRA, because I’m not worried about today’s tax bill, I’m worrying about the after-tax wealth after years of compounding.
Noah Lewis: Yeah, that’s an important point. That point definitely holds, assuming that the dividend reinvestment into the company instead of distributing the dividends pays off, and that it becomes successful. So that’s a good point. I think my other side of this is the concept of the value premium. This is really interesting. Just from today’s perspective, if you imagine value versus growth stocks, and really even in just the words, right? You look at a value stock, and what is Walmart? I don’t want to trash on Walmart, but, great value, right? It’s there. Sure, it works. And then you’ve got growth stocks, and that’s really exciting, ’cause it’s like, growth, let’s go, let’s go to the moon, we’re going to have a lot of growth in the future, and it’s exciting.
But I think when we actually break down the concepts of what these asset classes are and how they’re classified — growth stocks, the definition, if you’re looking at things like a price-to-earnings ratio, you’re kind of paying a lot for the fundamentals of the company, and you’re betting that maybe the company’s going to grow into the fundamentals. There’s going to be a significant amount of improvement in the future in, let’s say, cash flows or profitability. And with a value company, you’re saying, well, based on the fundamentals I’m getting, I’m actually paying a pretty good price. The price is lower relative to the growth stock.
And so that’s the fundamental classification. And maybe it’s intuitive in saying, well, if I pay less for a given set of fundamentals, maybe that’s going to improve my returns over time, because I’m getting in at that cheaper price, and maybe over time it’s going to pay off for me. And I think that’s exemplified in, let’s say, the Fama French 1993 paper, where they looked back at the period between 1963 and 1991. And during that time period, there was a determined value premium, which is saying that value stocks over that time had a premium in return over the market of around four, four and a half percent.
And so I think that exemplifies a little bit, okay, it’s a little bit intuitive that if you pay less for a given set of fundamentals, your returns could be increased over time. That time period exemplifies that a little bit. At the same time, though, if you look in the last twenty years, for example, and you go to large cap value versus large cap growth, maybe large cap value’s returned around nine percent, I think is a fair estimation, and large cap growth has returned around thirteen percent. And so it’s like, well, what happened to that value premium we’re talking about? Does it really hold over time?
And I think the paper from Fama French in 2020, where they reexamine the value premium, finds that in that first period, maybe the value premium was around four, four and a half percent. But between 1991 and 2019, actually, that realized value premium decreased to around half a percent, and is statistically indistinguishable from zero. So that’s basically saying it’s not a negative premium, it’s saying if you invest in value companies, you’re not necessarily going to lose versus the market. But at the same time, the perceived or realized advantage over the market by buying value companies has diminished in that time period.
And so I think that’s really interesting, and it helps explain — well, it makes sense. If growth has outperformed value over the last twenty years, that explains it: the value premium probably diminished. I will say this, though. The fact that we can examine two different periods of history, one from 1963 to 1991, with a substantial value premium of around four, four and a half percent, and then 1991 to 2019 and see that that realized premium has diminished — I would argue that’s evidence that the value premium changes over time. And I would also argue that if we believe that, and we look at the market today — a lot of people today believe large growth is overvalued. And if you’re convicted in the argument that the price of growth companies today is insufficient relative to the fundamentals and the earnings that they’re going to provide, then there’s an argument that there could be an expected value premium in the future over the market, and potentially outperforming growth. So that’s my argument for long-term value, being bullish on that.
Evan Mills: Yeah. And of course, I’m not here to argue with Fama French at all. I’m in no position to do that. But what I will say is, the idea behind the value premium can certainly be real, but that’s one aspect of the risk-return model. So if you look at CAPM and beta — what beta basically is, is the systematic risk that people are rewarded for taking, because it’s undiversifiable. So what you’re really looking at is, every unit of risk that you take is a unit of return, and you’re not going to get return without having added risk. And what the value premium is, is that there is a slight increase in the amount of risk that you’re taking, and the reward is just a little bit higher.
That can certainly be true. The difference becomes, when you look at beta — and if the beta of growth right now, and VUG in particular, because those are funds that we often recommend — the beta of growth right now is 1.26. The normal market beta, S&P 500, is one. So growth tends to be a little bit riskier, but then you are compensated with a little bit more return. Value right now, VTV, is sitting at a beta of .75, so a little bit less risky than the total market, so you would expect a little bit less return. Even with the value premium, you can expect a little bit of increased return. However, does that offset the drastic difference in growth’s beta and the expected return, strictly from a beta perspective?
Noah Lewis: Yeah. I can definitely agree with that. Anytime — obviously CAPM is a much older model, and it’s a single factor model, using only beta, or the correlation to the market, as a measure of risk and the input to the expected return. I think when we get into multi-factor models like the three factor or the five factor model, which tend to be a little bit closer as far as the correlation and expected return, obviously we understand that beta by itself can’t explain expected return, and neither really can value. You kind of take all of those factors into account when you’re trying to figure out what the expected return is.
So I do concede that point, that value exposure as a factor can be a determinant of expected return. But if the market exposure is more prominent, it can only do a higher expected return, even when both exist in unison. So even though there can be a positive value premium, if the market premium is higher than that, and your beta is sufficiently higher than another fund, for example, it could definitely outperform. So I think that’s a really interesting debate. And the most fun part, I think, is that none of it is settled. None of it can be proven certainly, but it’s kind of fun to go back and forth.
Evan Mills: I mean, you put it perfectly, that you look at a value premium, and it was, what, four percent over a certain period of time. Now, more recently, it’s dropped. And who’s to say in the next twenty years it doesn’t go back up and we find another value premium? So this is where the constant debate of asset location always becomes interesting, if you’re going to find the value premium again, or maybe it’s diminished and we’re using old tools for a new market.
Question 3 – VGIT vs. BIV: Should Your Bond Ballast Include Corporates?
Noah Lewis: Yeah, that’s a good point. All right, let’s go topic three. We’re going to debate VGIT versus BIV. So, government intermediate-term treasury fund versus an intermediate-term bond fund that has a mix of corporates and governments. The distinction there is the inclusion of corporates in BIV. So I’ll let you take this one point first.
Evan Mills: Yeah. I’m strictly looking at the point of bonds in a portfolio. So obviously, when you’re looking at returns and yield right now, BIV is giving back to your portfolio a little bit more than VGIT. But when you look at why bonds are in the portfolio, you’re not really chasing returns, you’re chasing a ballast in your portfolio, a little bit of safety in uncertain times. And that’s when I look at, okay, is BIV going to outperform VGIT when I need it most, and is it going to do its job when I need it most?
And that’s where I tend to look at adding corporate bonds into an equity-heavy asset allocation. I don’t know if you’re gaining as much safety and protection as many people look at bonds supposedly being. And when I say that, if you look at any recession, prices drop, the Fed wants to stimulate the economy, they try to pull yields down. Yields and prices of bonds are inversely related, so yields get pulled down, prices for bonds go up, and this is exactly what you want. This is when bond prices go up. You have bonds in your portfolio, so now it’s a little bit of a ballast when stocks start to drop.
That changes when you start adding in corporate bonds, because even highly rated corporate bonds, investors are looking at it and saying, well, people aren’t spending money, these corporations are starting to decrease in revenue, and are these really the places where I want to be parking my money? Probably not. So now all of a sudden, those yields have to go up to compensate investors for taking on added risk.
Noah Lewis: Mm-hmm.
Evan Mills: Now all of a sudden, the investors that have BIV or corporate bond exposure in their portfolio, those prices therefore drop. And exactly at the moment where you need bonds the most, the price of bonds simply falls, and again, doesn’t act as the true ballast in the portfolio where a lot of people look at and want the exposure to bonds to be most prominent.
Noah Lewis: Yep. Yeah, I think that’s a really good point, and that makes the argument pretty clear for just purely government bonds. There’s not the credit risk that you have with corporations, right? Because when we think about why we add bonds into the portfolio in the first place, it does get into that core argument. If equities have an expected return of eight percent, let’s say, and bonds have an expected return of four or five percent, why am I choosing a lower return asset? It’s because we do want some return, but at the same time, if equities experience a downfall, we want to diversify against that a little bit and say there’s some kind of ballast there. If equity prices become completely depressed and there’s a massive drawdown, there’s something there that’s going to retain its value. In the meantime, it’s still earning a solid return.
And so in that framework, I do think it makes a lot of sense to go purely VGIT and say there’s not that extra risk. If I wanted extra risk, maybe I would just go and buy more equities.
Evan Mills: Exactly.
Noah Lewis: However, I will make a couple of arguments. I guess the first argument is the position as a ballast that BIV can continue to serve, which still has corporates. I think it does get down to the correlation versus magnitude, which you’ve heard before as well. As far as correlation goes, VGIT is going to have more of a negative correlation. Maybe not significantly or extremely negative, but there’s probably going to be a slight negative correlation between VGIT and equities. Whereas the correlation is probably going to be a little bit higher in the positive direction for BIV to equities, because they’re both corporations and there’s credit risk. And so from that pure framework, I do agree that as a pure ballast, even if marginally, VGIT may serve better.
I will argue there are a couple of things I want to get into. One is BIV’s yield differential. I think the difference is, like, 40 pips. So you’re coming ahead, like, 40 basis points, if you’re going BIV versus VGIT. So you’re adding a little bit of return, like you said, because you’re taking on a little bit more risk. As a pure ballast, I don’t really think that makes sense. But if we back up a little bit and look at how we construct portfolios or financial plans — if you’re assuming, for example, a client’s retired, and we say, you know, we want your investment portfolio with your stocks and bonds every year, but maybe we want you to have some cash set aside as well. So maybe you have one or two years’ worth of cash set aside, and that’s your brake lights in case of emergency, the short-term reserve emergency fund.
And so I would argue there that you can take on a little bit more risk in the bond holdings, which can still act as a ballast. Because like I said, from a pure ballast standpoint, VGIT beats BIV. However, if you have that emergency reserve that you can tap in case of emergency, BIV, because of the lesser magnitude — even if it’s positively correlated with equities, okay, equities have a 30% drawdown, maybe BIV has a 5% drawdown. Because there’s the lesser magnitude, it can still serve as a relatively stable place where you can rebalance. Maybe you’ll sell bonds and buy back equities again. But I would argue that because you already have a cash reserve set aside, the need to pull from it for something like living expenses may be diminished. And so you can still earn a little bit of a higher return over time.
Evan Mills: My question would be then, why would someone still invest in bonds if they’re taking on that added risk and it’s not as strong of a ballast — which, again, that’s the overall point in a portfolio with bonds. Why not just hold more cash? You said one or two years’ worth of cash to tap in extreme market downturn or market turmoil. So let’s increase that to three or four years, and then we just go a hundred percent equities in a portfolio. Again, if we’re looking at bonds being a ballast, then it makes perfect sense to have one of the safest assets, VGIT, as the ballast. But if we’re pushing that to the side and saying, well, we can have it be a ballast and try to make a higher return by taking on that added risk, I’d much rather have a client go, well, I want to hold more cash, and then we’ll just go a hundred percent equities, because I have three or four years’ worth of cash over here in a money market that’s extremely safe. We’re not worrying about a yield, it’s maintaining purchasing power. For me, I’d be holding it in a brokerage account. For you, it’d be in a high yield savings account. But we would have the cash on the side, and now we have that break-glass moment, and you have four years of cash waiting for a market recovery, and you just ignore bonds altogether.
Noah Lewis: Yeah, that’s a fair point. That does get to the spectrum of, for example, are you going to just literally hold your money in cash? Then you’ve got short term, intermediate, and long term. Then maybe at the higher end of the spectrum, where the risk really gets turned up but also the potential yield, is junk bonds, for example. I think it’s all across that spectrum, and saying, if I want a ballast, do I keep it in cash and sacrifice some return? But maybe then you take the next step and say, well, VGIT has a little bit of a higher return than cash, so maybe I’ll step up to that. So I think there’s kind of a spectrum you choose. It’s weighing the return you want over the long term versus how well you want it to hold its value there.
Evan Mills: Yeah. Again, it makes perfect sense to ask, how much return are you getting for how much risk you’re really giving? And that balance is all up to the investor and how much risk they’re comfortable taking. And that’s the difference between VGIT and BIV, that marginal increase of risk and that marginal increase of return. It might be worth it for somebody taking a little bit more of a chance.
Question 4 – Inflation Hedge: Equities or Gold?
Evan Mills: Perfect. All right, shifting gears. When inflation shows up, what do you want doing the work in the portfolio? Equity or gold? And this is tough, because coming from a person that absolutely loves commodities, I have to give you commodities. I guess you’re going to make the argument that gold is a better inflation hedge, and we have clients all the time asking us if they should increase their commodity allocation. So I’m excited for you to build them up, and hopefully I can crush them back down.
Noah Lewis: All right, well, I’m going to attempt to make my argument here. There are a couple of considerations. I think gold, when we look at history, over the last couple centuries, arguably the purchasing power of gold has remained the same, right? Maybe an ounce of gold can buy the same thing over the few centuries. I think where the argument does break down for gold, I will admit, is over the short term. If interest rates are fluctuating, the price of gold can change. Speculation can also be built into the price of gold, which changes things. And obviously, there’s no built-in mechanism for gold to automatically track the CPI. When the CPI reports come out, that doesn’t mean gold price is going to increase automatically.
What I will say is there still is that fundamental aspect. Gold, or any kind of good, is going to maintain some fundamental value independent of the value of a currency. And this isn’t a perfect comparison, maybe, but a cheeseburger, let’s say, in the 1950s, a nickel — I feel like I’ve seen signs that say that — versus a cheeseburger today is like $8. The question is why? It’s not perfectly comparable to gold, but ultimately there’s still some utility to that good, and in the case of gold, there’s still scarcity to it. So there’s always going to be some fundamental value of gold that is separate from currency. So even though you see inflation in gold, maybe you’ll compare it as returns, but as an asset, just because there’s a higher quantity of dollars necessary to buy a certain good, I would argue gold is one of those goods where the purchasing power has the potential to maintain over time.
I will say this, and get it out there: short term, gold is very volatile. A big reason for that is a lot of speculation is built into the price, and it can fluctuate based on things like interest rates. I will say, in my opinion, if you’re going to hold gold, I don’t think you make the play and say, hey, over the next three years I want to hedge against inflation, so I’m going to buy a bunch of gold. I think you have to have that long-term mindset, because the price of gold’s going to be completely volatile over the short run. I think where purchasing power becomes a lot more consequential is over fifty years. If inflation runs at 4% for the next three years in a row, it sucks, but are you going to perish because of that? I don’t think so. The erosion of purchasing power over fifty years is much more consequential, which I think would be the case for all people.
Evan Mills: Yeah. And I think your hamburger example is perfect, and I’ll use it for my illustration as well. So, hamburger, back in the 1950s, a nickel. Cost of meat was lower, so McDonald’s would be able to purchase meat for lower, would be able to sell the burger for lower, so that’s why it only cost a nickel. Now it’s $8. What happens is, equities are a better inflation hedge in the long run. In the short run, most times prices go up, the corporation will absorb that margin loss for the short run. Once inflation continues on, they start increasing their prices. So, burger, perfect example. You have shares of McDonald’s. You’re an owner of McDonald’s. McDonald’s now charges more for a burger.
So everybody’s complaining about inflation getting higher, burger costs keep going up, you’re paying $5 for a burger, now you’re paying $8 for a burger. McDonald’s is then able to increase their margins, pass on the revenue, and their stock price appreciates, and you as an investor gain in that stock appreciation. And you not only maintain the purchasing power, which is a good example for gold, but you increase your purchasing power in the long run, because inflation gets passed on from the consumer. Corporations charge higher, revenue goes up, revenue increases stock prices, and then those stock prices increase and hit you as the investor. So that’s why I think equities are the safer asset when it comes to maintaining purchasing power. If you look at it truly just as an inflation hedge, I lean towards equities.
Now, I love commodities, because anybody who has worked with Deon — and Deon’s a huge part of this — you hold gold for catastrophic risk. So, a doomsday scenario, the economy of stocks and bonds turns into golden bullets, is what he always says. But when you’re looking at pure inflation hedge, you’re looking at how does me paying more for goods and services also benefit me once it comes full circle, and that’s where equities really take the win. Gold can’t innovate, gold can’t pass on any income or revenue, but equities can. And that’s where I look at long-term appreciation of stocks really rewarding people for inflation, even when a lot of people complain about inflation being high. It does stink, but if you’re an investor, it kind of helps you in the long run.
Question 5 – Gifting: Direct to Your Children or Into an Irrevocable Trust?
Noah Lewis: Yeah. I can’t argue against that. I think that’s the age-old thing to remember for commodities. A commodity’s nice, gold is nice, but at the end of the day, it doesn’t produce cash flows. So that’s an important one to remember. But we can go now into topic number five, which is direct gifting to your children, for example, versus gifting into an irrevocable trust for their benefit. I think we can get into this. Either I can start or you can start.
Evan Mills: Yeah, go ahead and start.
Noah Lewis: Yeah, I want to make my argument to you. When it comes down to gifting, there are a few considerations. Obviously, we may have gone through a few of these in our clients’ plans. Gifting into a trust, there’s some sense of maybe more protection, and a sense of, it’s going to have provisions that guide them in how they can spend this money, and that’s what a lot of people think about. Versus maybe directly gifting, there are a couple of advantages there, too. It’s building financial acumen. This is showing them how to invest on their own, showing them that you trust them, and that you need to build up that financial acumen. I’m going to be making the argument here to be gifting into a trust, especially as the amounts get larger.
So there are definitely a few advantages of gifting into a trust. One, as everybody has heard maybe, is creditor protection and divorce protection. Anytime you’re transferring a dollar amount over, the ownership is going to matter for those two things. If the owner of those funds, which is the corpus, or the amount you’ve gifted, is the trust as opposed to the kid, it’s definitely less vulnerable to creditors and divorce settlements.
I think another thing to consider is the provisions you can throw on there. If you gift directly, it’s really good for building financial acumen. At the same time, there are a few risks, which maybe you can afford, maybe you feel like it’s a little too risky. What happens if your kid ends up being really financially irresponsible, they tend to blow a lot of money, or your fortune has been squandered within the one-, two-generation horror story that we’ve heard before? Another thing is things that are a little more sad to see, like what happens if you gift money to your kid, and maybe they have a spouse or partner who’s manipulating them, or what if they’ve fallen into something like addiction, where it’s almost been categorized as something like a mental illness where they can’t really control it. It’s not their fault that they’re in a bad situation, but now they’re spending these dollars and it’s not being spent accordingly.
So I think throwing it into a trust and saying, now there’s health, education, maintenance, and support provisions, maybe there’s an independent trustee that has discretionary distributions from that trust — that money’s probably going to go to a better cause. Even though it’s locking it away from them and taking the trust out of their hands, at the same time you kind of know where that money’s going to go, and that it is going to be used for at least a reasonable purpose.
The other part of my argument is the generational concerns. For example, you can gift dollars directly into your kids’ hands, and maybe you’re saying, okay, maybe I have an estate problem, my estate is projected to exceed $30 million, so maybe I need to start gifting now, get some of that money out of my estate and get it to my kids’ estate, and that way I don’t have a problem. Well, even though that fixes your estate problem, you may just be passing it down to your kids. So I would argue, what if you go something like a dynasty trust, where this isn’t just for your kids, you know that this is a generational thing where it’s going to last for multiple generations? And you said, you know what, I’m going to gift this fortune into this trust, maybe I’m not only going to apply my estate tax exemption, so I can transfer a good amount of funds over, but I’m also going to apply my generation-skipping transfer tax exemption and say, not only is this going to benefit my kids, but it’s also going to benefit my grandkids. And there’s not going to be that double taxation event where you get the money out of your estate, but now your kids have it in their estate and it compounds. Maybe it should compound within that trust instead, using your generation-skipping transfer tax exclusion, and that way you avoid that problem. I think for the most part, those are my arguments for it.
Evan Mills: Yeah. When you start looking at estate limits and start exceeding estate limits, or projections have you exceeding estate limits, so that $15 million per person, or $30 million for a couple as of right now, it’s really difficult to argue against gifting into a trust and getting that out of your estate. The difference would be, exactly what you said, the trust is used for control. And if you don’t need that control, then you don’t need that tool through a trust. So that’s where I would tend to sway the other way, that direct gifting can help out, can really increase that financial literacy, because they have that burden of — we’re going to gift you $19,000, and then next year it’s going to be, me and your mom are going to gift $38,000. And then once you get married, we’re able to do the $76,000. So you’re able to pass on a lot of your wealth to the next generation without needing that increased complexity. And the increased complexity doesn’t mean that it’s warranted sophistication.
And that’s how I always look at a trust, that if you don’t need the tool, there’s no reason to add more complexity into your estate, especially when, again, if you’re not going to be exceeding the estate limit, then you’re creating a tool that’s going to live longer than the actual problem you’re trying to solve, which is giving to your kids, allowing your kids to have the money when they need it. Again, you can put different provisions into the trust, but it comes down to, if you trust your kid, if you trust their spouse, if they’re able to be financially responsible with their money now, then when they get an inheritance, you’re no longer worried about them gaining a larger pool of money all at once. And that’s what the trust can take out of the hands of you and your child. But direct gifting allows that child to have significant wealth right now and really understand, while you’re still alive and while your hands are warm, what it means to have that wealth, and what the responsibility is for that child to have the wealth at the time.
Noah Lewis: Yeah, that makes perfect sense. And not to be a bummer on this debate, — I tend to agree, in that it’s not necessarily all or nothing.
Evan Mills: Yeah.
Noah Lewis: It really is a hybrid approach. Maybe if I have an estate problem, not only do I have to gift annually and use the annual exclusion limit and gift over to my kids, but also maybe I have to throw 10 or 15 million in at once and try to really shift the future appreciation from my estate to, whether it’s the trust or my kids’ estate. And so I think what we find a lot of times is it’s not just one answer. It’s not just all or nothing, direct or trust. Sometimes it’s, hey, let’s over time ramp up the amount we’re giving them directly, they’re building financial acumen, while knowing at the same time, if I have 15 million, probably not handing it straight to them right now. But maybe that goes into a trust. It all depends on the situation.
Evan Mills: Yeah, exactly. The last thing you want to do — and there are different ways for distributions to work on the trust — but the last thing you want to do is be withholding a lot of money or wealth from the next generation, and then all of a sudden you’re no longer in a position where you can advise on what they do, and they just get this massive lump of money, and now they don’t know how to act because they’ve never had exposure to that in the past. So that’s the benefit of the trust and direct gifting as a hybrid approach really working in their favor.
Well, that’s our five. If there are other contested questions you want our advisory team to take on, send them our way at scholarfinancialadvising.com/podcast. Thanks for listening, and we’ll see you next week. sure to tune in. Thanks for listening, and we’ll see you next week.
Outro
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