How The Tax Act Impacts Retirement Planning

Posted On February 3, 2018 By Scott Stratton, CFP(R), CFA In Retirement Planning /

With all of the new changes in the Tax Cuts and Jobs Act (TCJA), we’re looking very thoroughly at how this will impact retirement planning. Some of the impacts are direct and immediate, but we are also considering what might be secondary consequences of the new rules in the years ahead.

Although taxes will be slightly lower and more simple for many middle class retirees, the tax changes may mean that some old strategies are no longer effective or that new methods can help reduce taxes or improve retirement readiness. Here are seven things to consider if you are now retired or looking to possibly retire in the next decade.

1. Plan ahead for RMDs. The new lower tax rates will sunset after 2026 and the higher 2017 rates will return. Once you are past age 70 1/2, retirees must take Required Minimum Distributions and must have started Social Security. There are many retirees in their seventies who actually have more income, and therefore way more taxes, than they require to meet their needs. I think we should be doing much more planning in our fifties and sixties to try to reduce retirement taxes, because once you are 70 1/2, you have no control.

See 5 Tax Saving Strategies for RMDs

If you want to reduce your future RMDs, consider doing partial Roth Conversions before age 70 1/2 – converting a small part of your IRA each year, within the limits of your current tax bracket. This is valuable if you now are in a lower tax bracket, 10% to 24%, which is scheduled to rise after 2026.

If you are retiring soon, consider delaying Social Security and starting first with withdrawals from your retirement accounts. Withdrawing cash for several years can help reduce future RMDs, and delaying Social Security benefits past Full Retirement Age provides an 8% annual increase in benefits. That’s a rate of return that is higher than our projected returns on a Balanced (50/50) portfolio. If you delay from age 66 to 70, you’ll see a 32% increase in your Social Security benefit, which reduces longevity risk. Social Security is guaranteed for life, but withdrawals from your portfolio are not!

When higher rates tax return, your (delayed) Social Security benefits are taxable at a maximum of 85% of your benefit, whereas, 100% of your IRA distributions are taxable as ordinary income.

2. Roth 401(k). If you are in a moderate tax bracket today because of the TCJA, you might prefer to contribute to a Roth 401(k) rather than a Traditional 401(k). You don’t get a tax deduction today, but the Roth will grow tax-free and there are no RMDs on a Roth. Therefore, having $24,000 in a Roth is worth more than having $24,000 in a Traditional IRA. In retirement, if you’re in the 25% tax bracket, a $24,000 Traditional account will net you only $18,000 after tax.

Rather than looking to convert your IRA to a Roth after it has grown, the most cost effective time to fund a Roth is likely at the beginning. If you currently have substantial assets in a traditional 401(k) or IRA, consider the Roth option for your new contributions.

3. Second Homes less appealing. The new tax law has placed a cap of $10,000 on the deductibility of state and local taxes. If you own a second home, or are considering purchasing one, this cap may make it more expensive.

Many retirees have paid off their primary residence and then use a home equity loan to purchase a second property. Starting in 2018, you are no longer able to deduct home equity loans. This makes it less attractive to use a home equity loan (or line of credit), and it also makes paying off your mortgage less appealing. If you have a mortgage, it can still be deductible, but if you pay it off, you cannot then borrow from your equity in a tax beneficial way.

If you were previously paying more than $10,000 in state and local taxes, you will either be capped to $10,000, or more likely, be unable to deduct ANY of those taxes, because you are under the standard deduction of $24,000 for a married couple. Going forward, I think more retirees will find it financially appealing to downsize and minimize their housing expenses since they are effectively getting zero tax benefit for their property taxes and mortgage interest.

4. Charitable Strategies. Another casualty of the increased $12,000 / $24,000 standard deduction: Charitable Giving. Most retirees will no longer receive any tax deduction for their donations. Two planning solutions: establish a Donor Advised Fund, or if over age 70 1/2, make use of the Qualified Charitable Distributions from your IRA. We have begun several QCDs this month for our clients!

5. In-State Municipal Bonds. For high income retirees in states with an income tax, it is not difficult to exceed the $10,000 cap on the SALT taxes. In the past, many of these high earners invested in National municipal bonds to get better diversification, even if it meant that they paid some state income tax on their municipal bonds. “At least you are getting a Federal Tax Deduction for paying the State Income Tax”, they were told. Going forward, they won’t receive that benefit. As a result, I expect that more high earning retirees will want to restrict their municipal bond purchases to those in their home state, where they will not owe any State or Federal tax on this income (especially New York, California, Illinois, etc.). Here in Texas, with no state income tax, we will continue to buy municipal bonds from any and all states.

6. Estate Tax. The TCJA doubled the Estate Tax Exemption from $5.5 million to $11 million per person, or $22 million for a married couple. Now there are only a very small number of people who really need to worry about Estate Taxes. Most retirees will not need a Trust today. (If you might still be subject to the Estate Tax, we can definitely help you.)

7. Health Insurance Costs Will Rise. The repeal of the Individual Mandate of the Affordable Care Act will allow many healthy young people to skip having health insurance. I think that’s a mistake – no one plans to get sick or injured. But what it means for society is a loss of healthier individuals from the insurance risk pool. Adults between age 55 and 65 should expect to see large increases in their individual insurance premiums. More people will be unable to retire until age 65, when they become eligible for Medicare, because they cannot afford the rising individual health insurance premiums. Just this week, a client informed me that they are delaying their retirement for one year because their health insurance bill is increasing from $575 a month to nearly $800.

Wondering how the new tax law will impact your retirement plan? Let’s get together and take a look. Even if your retirement is years away, there are steps we can take today so you can feel confident and prepared that your finances will all be in place when you need them.

Self-Employed? Buy an SUV

Posted On January 23, 2018 By Scott Stratton, CFP(R), CFA In Tax Strategies /

In the new Tax Cuts and Jobs Act (TCJA), there are quite a few provisions which will help small business owners, whether you are an Independent Contractor (1099), a self-employed Sole Proprietor, or owner of an LLC or Corporation. One of the key provisions is the expansion of Section 179, which enables owners to expense certain items (take an immediate tax deduction) instead of depreciating those purchases over a longer number of years.

Section 179 has existed for many years, but Congress has continually changed the rules, setting caps on how much you can deduct. At the start of 2017, you could only take bonus depreciation of up to 50%. Under the TCJA, for 2018, bonus depreciation is increased to 100%, the cap increased from $520,000 to $1 million, and now you can also purchase used equipment and receive bonus depreciation.

As a business owner, Section 179 can help you deduct:

Equipment for the business
Office furniture and office equipment
Computers and off the shelf software
Business vehicles with a Gross Vehicle Weight Rating (GVWR) of over 6000 pounds

You cannot use Section 179 to deduct the costs of real estate (land, buildings, or improvements), for passenger cars or vehicles under 6000 GVWR, or for property used outside of the United States.

One of the most attractive benefits of Section 179 is the ability to deduct a vehicle for your business. Under Section 179, your first year deduction on a 6000 GVWR vehicle is limited to $25,000. You would first deduct this amount. Second, you are eligible for Bonus Depreciation, which used to be 50%, but now is 100%. That means that a business owner can effectively deduct 100% of any qualifying vehicle in 2018, even if it is a $95,000 Range Rover.

To be deductible, you must use the vehicle for business at least 51% of the time. If you also use the vehicle for personal use, you may only deduct the portion of your expenses attributable to the percentage of business miles. The way to maximize your Section 179 deduction, is to use the vehicle 100% of the time for your business. If the IRS sees you claim 100% business miles on your tax return, you had better have another vehicle for personal use. You might use your spouse’s vehicle, or perhaps keep your old vehicle, for personal miles. Don’t forget that commuting between home and the office are considered personal miles, not business miles.

The 6000 pound GVWR doesn’t mean that the vehicle literally weighs over 6000 pounds, but has a total load rating (vehicle, passengers, cargo) over this weight. If a manufacturer lists the weight of the vehicle, that is not the GVWR; the GVWR is often 1500 or more pounds higher than the vehicle weight. Make sure you are looking specifically at the official GVWR. You can generally find the GVWR printed on a sticker in the driver’s door frame to confirm.

The list of qualifying vehicles varies from year to year and from model to model, but includes most full-size trucks and SUVs. Be careful – sometimes a 4WD model is over 6000, but the 2WD version is not. On one SUV, a model with 3rd row seating was over 6000, but without the extra seats, it was under 6000. An another SUV, 2016 models were over 6000 GVWR, but the new and lighter 2017 model was not.

There are many lists on the internet of which vehicles qualify; in addition to full-size pick-up trucks and vans, most large SUVs such as a Tahoe, Suburban, Expedition, or Escalade are also above 6000 GVWR. Several mini-vans qualify (Honda Odyssey, Dodge Grand Caravan), as do some more medium size SUVs (Jeep Grand Cherokee, Toyota 4Runner, Audi Q7, BMW X5, Ford Explorer). Again, be absolutely certain your vehicle will qualify before making a purchase. One of the nice things about the new law is that now you do not need to buy a new vehicle to qualify for bonus depreciation; used vehicles are also eligible.

Please check with your tax preparer. You cannot deduct more than you earned, so don’t buy a $50,000 SUV if you only show $30,000 in net profits. Lastly, consider these caveats:

You have a choice between taking the “standard mileage rate” of 54.5 cent/mile for 2018, or using the “actual cost” method. When you take the standard rate, that already includes depreciation. If you use Section 179 to purchase a vehicle, you are going to be locked in to using “actual costs” for the life of that vehicle. You cannot take the Section 179 deduction upfront and later switch the standard mileage rate.
If you are using “actual costs”, you can also deduct your other operating expenses such as gasoline, oil changes, maintenance, insurance, tolls, and parking, but will need to document your costs. Keep those receipts!
You may still be required to keep a mileage log to prove you are using the vehicle for more than 50% business miles. If business use falls below 50%, you may be required to pay back some of the depreciation. Let’s just say that would be expensive and a headache.
If you depreciate 100% of the cost of the vehicle upfront, that will reduce your cost basis to zero. When you sell the vehicle, you may be creating a taxable gain.

Under the TCJA, these expansions to Section 179 are temporary through 2022; bonus depreciation will be phased back down from 100% to 0%. So if you want to buy an SUV or truck, you have a five-year window to take advantage of this full depreciation.

This tax deduction is especially effective if you have a banner year of high income and anticipate being in a very high tax bracket, because it will let you accelerate future depreciation on a vehicle into the current year, provided the vehicle is purchased and placed into service that year. Please remember that this section 179 deduction is available only to the self-employed and not to W-2 employees.

I feel I should point out that driving a large SUV or truck may not be the most cost effective decision. I am not suggesting everyone rush out and buy a Suburban just to get a tax deduction. But if you do need a vehicle for your business, or were thinking about buying a vehicle this year, it can certainly help to know about this tax deduction. And it might influence which vehicle you choose to buy!

The Seven Deadly Sins of Investing

Posted On January 20, 2018 By Scott Stratton, CFP(R), CFA In Behavioral Finance / 1

Successful investing is as much about managing our personal tendencies and behaviors as it is about picking funds. You don’t have to be a financial whiz to be a thriving investor, but you do have to avoid making mistakes. Investing errors do not mark you as a novice or as unintelligent; even professionals can easily fall into these traps. Mistakes are easier to see in hindsight, but in the present moment, the choices we face may not be so obvious.

Here are what I consider to be the Seven Deadly Sins of Investing. I firmly believe that if we can avoid these errors, we will have a much higher chance of success as long-term investors.

1. Not Accepting Losses (Pride)
If you’ve made a losing investment, sell it and move on. Too many investors are unwilling to do this, hoping that if they wait long enough, they will be proven correct or at least get their money back. Unfortunately, this may not occur, and even if it does, there may be an opportunity cost in waiting. With today’s strong markets, you might not have losses, but if you have high-expense funds that are under-performing the market, you should recognize that this too is a mistake and move on.

2. Market Timing (Greed)
Speculating to make as much profit as possible and trying to avoid temporary market drops drives many people to move in and out of the market in a largely futile attempt to improve returns. Neither individual investors nor professionals have demonstrated any success in market timing, although great time and effort are spent in the process. The reality is that market returns are a good return, but when investors say “I want more, I need more”, they are very often rewarded with lower returns rather than higher returns.

3. No Asset Allocation (Lust)
Did you pick the funds for your 401(k) by selecting the options with the best one-year performance? If so, you likely will end up with a poor investment plan, because you are investing based solely on past performance. Don’t fall in love with today’s hot funds, those are the ones that will break your heart at the next downturn, when you discover how much risk they were taking. At any given point in time, one or two categories may dominate returns, fooling investors to think that owning 10 different technology funds makes you diversified. Start with a globally diversified asset allocation and then pick funds that represent each category. Yes, even buy those segments which are out of favor and under-performing today. That’s how you build a better portfolio.

4. Performance Chasing (Envy)
With thousands of mutual funds and ETFs at our disposal, it takes only a few clicks to find a “better performing” fund than the ones currently in your portfolio. There are hundreds of funds which have outperformed their benchmark over the past year. Of course, that number will fall dramatically over time, and typically 80% or more of funds fail to match their benchmark over five or more years. But even still, that means some funds have beaten the index. Unfortunately, there is no predictive power in past returns of actively managed funds, so even those that beat the mark over the last five years are unlikely to continue their streak over the next five years.

Perhaps even more dangerous is when investors “discover” that a sector or country is outperforming. Maybe it’s a technology fund, or Argentina ETF, which has rocketed up in the past six months, and they switch from a diversified fund to a narrow investment. Performance chasing creates a lot of risk which may go unnoticed until it’s too late. We avoid single sector and country funds; almost every argument for these funds is some version of performance chasing.

5. Single Security Risk (Gluttony)
Most of the heart-breaking investing stories I’ve heard from the past 20 years were caused by investors having a large investment in a single company. The 55-year old Nortel employee who had his whole retirement account in his company stock and rode it down from $1 million to $100,000. The Cisco employee who exercised $600,000 in stock options, but kept the shares to try for long-term capital gains; the shares tanked, and he didn’t know he would owe AMT on the original $600,000. The IRS had a lien on his house while he paid them $200,000 over five years.

Diversification is the only free lunch in investing. The average stock will return about the same as the index by definition, but you take on tremendous risk when you have a concentrated position in one stock. The best choice is to not have too much in any one stock, including that of your employer.

6. Breaking Your Plan (Wrath)
Anger, frustration, and despair were what investors felt in 2008 and 2009, and we will undoubtedly feel the same way when the next bear market occurs. Some investors threw in the towel near the bottom and missed out on much of the rebound. The best way to prevent future frustration is to make sure you have the right asset allocation and understand how your portfolio might perform in up and down years. When you begin with a smart plan and take the time to educate yourself, it is much easier to understand the importance of staying invested rather than allowing emotions to get the best of us.

7. Failing to Monitor (Sloth)
Even for passive investors, you still need to do some work monitoring and managing your portfolio on a regular basis. Rebalancing annually or when funds move a large amount is important to maintain your target risk levels and to create a process to “buy low and sell high”. Additionally, too many investors have stayed with poorly performing active funds and variable annuities they don’t understand, paying high expense ratios, unnecessary 12-b1 fees and sales loads, without having any idea about how they are doing. You only have three or four decades of work and investing, you can’t let 5 or 10 years go by without knowing if your plans are on track. It’s your money, surely you can spend a handful of hours every quarter to analyze your situation and make changes when they are needed.

Successful investing is not complicated, but it can be difficult to have the patience with how boring it can be most of the time and how unpredictable it can be other times. Establish a diversified asset allocation that will help you achieve your long-term goals, then invest in low-cost, tax-efficient vehicles with a good track record. Focus on what you can control: your allocation, costs, and diversification, and don’t worry about the short-term movements of the market.

We all face the temptation of these seven investing sins. Maybe the greatest attribute for an investor is faith. Do what is right, do what is smart, but then to let go of the worry about what will happen today or tomorrow. Market returns will be whatever the market returns. We have no control over the market, but we can focus on our own saving (frugality), patience, and positive thoughts. In the end, the true measure of wealth is more about our faith and gratitude than it is about the dollars and cents.

How Much Income Do You Need In Retirement?

Posted On January 13, 2018 By Scott Stratton, CFP(R), CFA In Financial Planning /

Many people significantly underestimate how much income they will need to maintain their lifestyle in retirement. We’re going to point out how people underestimate their needs, explain why a common “rule of thumb” is a poor substitute, and then share our preferred process.

If we begin with the wrong budget, then our withdrawal rates, target nest egg, and portfolio sustainability are all going to be inaccurate, which is very difficult to correct after you’ve retired.

In general, when I ask someone to estimate their monthly financial needs, they use a process of addition. They think of their housing expenses, utilities, taxes, food costs, etc., and try to add those up. Unfortunately, the number many arrive at can be significantly too low, and here’s how I know.

They tell me that they spent $5,000 a month, or $60,000 last year. But I ask how much they made and they tell me $150,000. How much did they save last year? $30,000. To me, that suggests they spent $120,000, not $60,000. If they only spent $60,000, they would have saved more than $30,000. You either spend or save money; if it wasn’t saved it was spent, even if that spending wasn’t discretionary.

Here’s why most people fail with the “addition method” of trying to create a retirement income budget:

They don’t include taxes. Taxes don’t go away in retirement; pensions, Social Security (up to 85%), and IRA withdrawals are all taxable as ordinary income.
Unplanned expenses such as home repairs, emergencies, or car maintenance can be substantial and fairly regular, if not consistent or predictable.
Your health care costs may be much higher in retirement than you anticipate, especially in the later years of retirement.
You may finally have time to pursue activities which you did not have time for while working, such as travel, golf, or spoiling your grandchildren. With an additional 40 hours a week available, you will likely be spending money in new ways.

Some financial calculators use a rule of thumb that most retirees will need 75% (or 70-80 percent) of their pre-retirement income. This is called the “replacement rate”. And while there have been a number studies that confirm this 75% estimate as an average, its applicability on an individual basis is poor.

We know for example, that lower income people will need a higher replacement rate than higher income people. That’s because the lower income levels may have had a lower savings rate, a smaller proportion of discretionary spending, and little tax savings in retirement. Higher income workers may have been saving more and find significant tax savings in retirement, and therefore have a lower replacement rate.

Instead of trying to use an addition method or a one-size-fits-all rule of thumb, I’d suggest using subtraction:

Begin with your current income.
Subtract any immediate savings you will experience in retirement, including: the amount you were actually saving and investing each year, payroll taxes (7.65% if a W-2 employee), and work expenses, if significant.
Examine your sources of retirement income and if you calculate any income tax reduction, subtract those savings.
Consider any increases in retirement spending, starting with health care costs and discretionary spending (travel, hobbies, etc.). Add these back to your spending needs.

Unless you are planning to have paid off your mortgage, substantially downsize your house, get rid of a car, or stop eating out, I think most people will initially continue their spending habits in retirement very much the same as they did while they were working. Like everyone else, retirees spend a significant portion of their income on things which they did not want (property tax, income tax, insurance) and on things which were not planned (replacing a roof, medical expenses, etc.).

Underestimating your retirement income needs could lead to some very painful outcomes, such as depleting your nest egg, being forced to downsize, or impoverishing your spouse after you pass away. You have to still plan for occasional expenses, such as replacing a car, home repairs, and emergencies, in a retirement budget.

If you’ve calculated your retirement income needs and your planned budget is significantly less than your pre-retirement income, please be careful. When the number you reached through addition isn’t the same number I reach through subtraction, it’s possible you are not budgeting for some costs which you currently have and are likely to still have in retirement.

Markets Soared in 2017

Posted On December 30, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

2017 was an outstanding year for investors. Markets went up throughout the year with little volatility and no significant pull-backs. This certainly has been a pleasant surprise, given the political uncertainty, noise, and dysfunction in Washington. Here’s a quick overview of the performance of major indices this past year.

The S&P 500 Index was up 21.83%, in total return. US stocks were already fairly valued at the start of the year, but investor enthusiasm for technology companies has pushed markets even higher. That means we start 2018 at even higher valuations than those which concerned us a year ago.

I’d also note that growth stocks outperformed value strategies, by nearly 2X in 2017. I think this will reverse at some point as value stocks have a widening discount to growth companies. US Large Cap outperformed Small Cap by a wide margin, reflecting the more expensive valuations of small companies.

Look at international markets, the MSCI EAFE index, representing developed economies outside the US, was up 25.03%. The MSCI Emerging Markets Index soared 34.35% on the year. Both of these were boosted by a sagging dollar in 2017. We don’t make active bets on currency direction, so we don’t have an opinion on whether or not this continues to enhance returns in 2018. However, economic growth and stock fundamentals are both favorable for international stocks in the year ahead.

Turning to bonds, the Barclay’s Aggregate Bond Index was up 3.54%, a decent return for a year in which the Federal Reserve raised rates three times. We believe that bond investors should have modest expectations for 2018. Rising rates suggest favoring shorter duration bonds for defense.

We’ve updated our portfolio models for 2018 and can celebrate the returns we received in 2017. We remain broadly diversified and get most of our equity exposure from low-cost, tax-efficient index ETFs. Our overweight to Emerging Markets has been beneficial this past year, although our allocation to US Value has been a drag on performance. The rationale for both positions remains unchanged so we will continue to hold both.

We spend considerable time on investment management, but generally, think it is more beneficial to you to write here about financial planning topics. As always, if you have any questions about investment strategies, please feel free to reply or call anytime.

Source of data: Morningstar as of 12/30/2017.

Charitable Giving Under The New Tax Law

Posted On December 21, 2017 By Scott Stratton, CFP(R), CFA In Tax Strategies / 2 Comments

Starting in 2018, it is going to be much more difficult to deduct your Charitable Donations. That’s because the standard deduction will rise from $6,350 (single) and $12,700 (married) in 2017 to $12,000 and $24,000 in 2018. You will need to exceed this much higher threshold to deduct your charitable gifts.

It will be even more difficult to reach those levels because the Tax Cuts and Jobs Act (TCJA) is also capping your state and local taxes (property, income, and sales) to $10,000. And they completely eliminated your ability to deduct “miscellaneous” expenses including unreimbursed employee expenses, home office expenses, tax preparation, and investment advisory fees.

Let’s take a look at a hypothetical scenario for a married couple:

In 2017, a typical year, let’s say you have $12,000 in local taxes, $4,000 in mortgage interest, $10,000 in charitable donations, $5,000 in unreimbursed employee expenses, and $6,000 in investment and tax preparation fees. (Let’s assume these miscellaneous amounts are the amounts above the 2% of AGI threshold.) Your total itemized tax deduction would be $37,000 for 2017. That’s well above the standard deduction of $12,700.

In 2018, you spend exactly the same amounts. However, under the TCJA, your local tax deduction is capped at $10,000. You keep the mortgage interest deduction of $4,000 and the $10,000 in charitable donations. The $5,000 in unreimbursed employee expenses and the $6,000 in investment and tax preparation fees are both disregarded. Your new tax deduction would be $24,000.

$24,000 is also the amount of the standard deduction for a married couple, so you are in effect getting no tax benefit for any of your spending, relative to someone who had ZERO local taxes, mortgage interest, or charitable donations. That doesn’t sound like a very good deal to me. The IRS expects that the number of taxpayers who itemize will fall from around 33% to 10%.

That poses a problem for charitable giving, because many people will in effect no longer be able to get any tax benefit at all. For people who do regularly give, it’s discouraging. Nonprofit organizations worry that this might reduce how much people are able to give.

We can help you potentially get more of a tax deduction if you can plan ahead for your charitable giving. Here’s how: by using a Donor Advised Fund (DAF). A DAF is a non-profit entity which will hold an account for you, to give grants to charities of your choosing when you instruct them. When you make a deposit into a DAF, you receive a tax deduction that year, even if the funds are not distributed until later years.

Let’s go back to our original scenario and imagine that you plan to give $10,000 a year to charity for the next five years.

Original scenario: You have $24,000 in total deductions each year, same as the standard deduction. Total over 5 years: $120,000, same as every other married couple.

Scenario Two, with a DAF: In year one, you make a $50,000 donation to the Donor Advised Fund and then give out $10,000 a year to your charities as planned. Your total itemized deduction in year one is $64,000. In the following years, you only have $14,000 in itemized deductions, so elect to take the standard deduction of $24,000 (years 2-5). Total over 5 years: $160,000. That’s $40,000 more than the first scenario, even though you still donated the same $10,000 a year to charity. If you are in the 33% tax bracket, you’d save $13,200 in taxes by establishing a DAF in this example.

With a DAF, your gift is irrevocable, however, you can change which charities receive the money and when. Or you can leave the money in the account to invest and grow for later. If you pass away, the DAF is excluded from your taxable estate, and you designate successors such as your spouse or children, who can decide on when and how to distribute money to charities.

If you risk losing your ability to deduct your charitable donations under the TCJA, let’s talk more about the Donor Advised Fund and how it might work in your situation. You can also gift appreciated securities, such as stock or mutual funds, to the DAF and not have to pay capital gains tax on those assets when you fund the DAF. That can give you a double tax benefit.

As your Financial Advisor, I can help you establish a Donor Advised Fund that will be held at our custodian, TD Ameritrade, using the Renaissance Charitable Foundation. This means your account will still be held with your other accounts and professionally managed to your objectives. While a DAF is clearly more cost effective than establishing a Private Foundation with under $1 million in assets, even many ultra-wealthy families find that a DAF can accomplish their philanthropic goals with less expense, compliance headaches, and time commitment.

One other option to get a tax benefit on your charitable donations: If you are over age 70 1/2, you can make a charitable donation directly from your IRA in place of your Required Minimum Distribution. See my previous article on the Qualified Charitable Distribution. The QCD reduces your above-the-line income, so you do not have to itemize to receive a tax benefit for your donation.

Charitable giving is near and dear to our hearts at Good Life Wealth Management. We donate 10% of our gross profits annually to charity and will continue to do so as we grow. Charitable giving is never just about the tax deduction, of course. But if we can stretch those dollars further, we have an opportunity to make an even bigger impact with the donations we make.

Introducing our Ultra Equity Portfolio

Posted On December 21, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

We are launching a new portfolio model for 2018, Ultra Equity, a 100% stock allocation. Previously, our most aggressive allocation was 85% stocks and 15% bonds. This type of approach clearly is not for everyone, but if you want the highest possible long-term return and can ignore short-term volatility, Ultra Equity might make sense for you.

Bond yields remain very low today, and bond investors face rising risks, including interest rate risk, that rising interest rates depress bond prices, and purchasing power risk, that inflation eats up all your yield. While defaults have been quite low in recent years, as interest rates rise, it will be increasingly difficult for distressed companies, municipalities, and countries to meet their obligations. The level of debt globally has swelled enormously with the cheap access to capital since 2009, and yet the bond market is acting if all this debt hasn’t changed risks at all.

While the Federal Reserve raised the Fed Funds rate again this week, income investors have been disappointed that there are not more attractive opportunities in bonds today. Unfortunately, the rising rates have not benefited all types of fixed income vehicles equally. On the short end, yes, yields are up. We can now access short-term investment grade bonds with yields of around 1.5% to 2%.

However, the yields on longer bonds have barely moved. The 10-Year Treasury is at 2.35% and the 30-Year remains shockingly low at 2.71%. As a result, we have a “flattening” of the yield curve where short-term rates have increased, but long-term rates are virtually unchanged.

I expect this trend to continue in 2018: rising short-term rates and a flattening yield curve, which means there will continue to be a dearth of opportunities for yield-seeking investors. As a point of reference, the historical rate of return for intermediate bonds was 7.25%, but today, you can’t find anything at even half of that rate. We are always thinking about how we can position portfolio allocations to aim for the best possible return with the least amount of risk and the maximum amount of diversification. But at this point, bonds offer little potential for high returns. Instead, we have to think of bonds as risk mitigators, that the primary purpose of our bonds is to offset the risk we have with our equity holdings.

I’ve been reluctant to roll out a 100% equity allocation with the stock market at an all-time high in the US, because it risks falling into the behavioral trap of becoming too enamored with stocks during a bull market, and ignoring stocks’ volatility and potential for losses. For investors with a horizon of more than 10 or 20 years, there is little possibility that a bond allocation will increase your rate of return. If you are comfortable with ignoring volatility, I think some younger investors may want to invest 100% in equities.

Consider this: the expected return on intermediate bonds is only 3.5% over the next 10 or so years. If you have a 60/40 portfolio and earn 3.5% on your bonds, you will need to make at least 11% on your stocks to reach an overall return of 8%. Many investors are coming to the conclusion that to achieve their goals, the optimal allocation to bonds may be zero.

If you are making regular contributions to an equity allocation, you also have the opportunity to dollar cost average, and buy more shares at a lower price, if the market does drop at some point. And while dollar cost averaging does not guarantee you will not experience losses, it is nevertheless an effective way to accumulate equity assets and possibly benefit from any volatility that does occur.

Our Ultra Equity portfolio will differ from our other portfolio models in that we are not looking to reduce risk or to achieve the best “risk-adjusted” returns. Instead, we will invest tactically in areas where we believe there is the greatest potential for strong long-term rates of return. We will always be diversified, investing in ETFs and mutual funds with hundreds or thousands of different securities, but will have no requirement to hold any specific category of investments.

We cannot know how a portfolio like this will fare over the near term, and there will undoubtedly be times when the stock market is down, sometimes even down significantly. If your attitude is that those drops represent opportunity, rather than adversity, then you should ask us more about Ultra Equity to see if it might be right for you.

I Had $562 in Unclaimed Property

Posted On December 10, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Several years ago, I changed firms, and in the process of moving, apparently my old firm did not forward a check for an insurance commission they had received. With the $562 check going unprocessed for more than one year, the insurance company filed an “Unclaimed Property Report” and turned the funds over to the State Comptroller of Texas.

To my surprise, I found my name on a list of unclaimed property and was able to receive this $562 from the state last year. Here in Texas, the Comptroller has returned more than $2 Billion in unclaimed property. Maybe you moved and missed a check? Maybe you had an old bank account that you forgot about? Maybe a company owed you a credit and was unable to reach you?

Here’s how you can find if there is any unclaimed property under your name. You will need to check for each state where you have lived. You can start by going to the website of the National Association of Unclaimed Property Administrators and clicking on your state. Search for your name and city.

For Texas residents, you can go directly to the Texas Site here.

It’s worth spending two minutes doing this, even if you believe as I did, that no one owes you any money. Let me know if you have any success. I hope you do!

Advantages of Equal Weight Investing

Posted On December 3, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

The four largest stocks in the United States are all tech companies today: Apple, Microsoft, Amazon, and Facebook. For 2017, these stocks are up significantly more than the overall market, 49%, 38%, 55%, and 52% respectively.

These are undoubtedly great companies, but as a student of the markets, I know you can look at the top companies of previous decades and notice two things. First, top companies don’t stay at the top forever, and second, the market goes through phases where it loves one sector or industry more than it should. (Until it doesn’t…)

And this is the knock on index funds. Because they are weighted by market capitalization, an index will tend to own a great deal of the over-valued companies and very little of the under-valued companies. The top 10 stocks of the S&P 500 Index comprise nearly 20% of its weight today. If you go back to 1999 and look at the valuation of the largest tech companies like Cisco, you can see how those shares were set up for a subsequent period of substantial and prolonged under-performance.

In spite of this supposed flaw in index funds, the fact remains that typically 80% of all actively managed funds perform worse than their benchmark over any period of five years or longer. If the index is hampered by all these over-valued companies, why is it so difficult for fund managers to find the under-valued shares? One possible reason is that the higher expense ratio of an active fund, often one percent or more, eats up the entire value added by the manager.

But there is an interesting alternative to market cap weighting, which avoids over-weighting the expensive stocks. It’s equal weighting. If you have 500 stocks, you invest 0.2% in each company. Your performance then equals that of the average stock, rather than being dependent on the largest companies. To remain equal weight, the fund will have to rebalance positions back to their 0.2% weight from time to time.

There have been extensive studies of the equal weight process, most notably by Standard and Poors which calculates an equal weight version of their S&P 500 Index, and by Rob Arnott, of Research Affiliates, who wrote about equal weighting in various papers and in his 2008 book “The Fundamental Index.”

But even better than studies, there has been an Equal Weight ETF available to investors since April 2003, a 14-year track record through Bull and Bear Markets. The results have been compelling.

– Since inception in 2003, the S&P 500 equal weight fund has had an annual return of 11.21% versus 9.53% for the cap-weighted S&P 500 Index.
– Equal Weight beat Market Cap over 57% of the one-year periods, on a rolling monthly basis since the fund started in 2003. However, the fund out performed over 84% of the five-year periods and 100% of the 10-year periods.
– You might think that by reducing the supposedly over-valued companies, the fund would have lower volatility, but that has not been the case. Instead, the fund has had a slightly higher standard deviation and actually lost more in 2008 than the cap weighted index. It’s no magic bullet; it’s primary benefit appears to be return enhancement rather than risk reduction.

We plan to add an Equal Weight fund to our portfolio models for 2018. Although some of our concern is that today’s tech stocks dominating the index are over-valued, we should point out that there is no guarantee that Equal Weight will be better than the Cap Weighted approach in 2018 or in any given year. However, for investors with a long-term outlook, the approach does appear to offer some benefits in performance and that’s the reason we are adding it to our portfolios.

Before August, the cheapest fund offering an equal weight strategy had an expense ratio of 0.40%. However, there is a new ETF that offers the strategy at an ultra-low cost of only 0.09%, which makes it very competitive with even the cheapest cap weighted ETFs.

If you have any questions on the approach, please feel free to email or call me. For positions in taxable accounts, we have significant gains in many portfolios. In those cases, we will not be selling and creating a taxable event. But we will be purchasing the new fund in IRAs and for purchases going forward.

Source of data: Morningstar.com and from Guggenheim Investments All Things Being Equal dated 9/30/2017.

Investment Themes for 2018

Posted On November 26, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Each year, we look closely at trends and valuations to create themes which will be incorporated into our Investment Porfolios. In addition to the Defensive Managers Select portfolio which we highlighted last week, our Premiere Wealth Portfolios are tactical asset allocation models with 10-15 funds or ETFs, at five risk levels: Conservative, with a benchmark of 35% Stocks/65% Bonds, Balanced (50/50), Moderate (60/40), Growth (70/30), and Aggressive (85/15). We are also rolling out a new allocation, Ultra Equity, which will be 100/0.

We will always remain broadly diversified, invested both in Core Assets, which we believe should always be in a portfolio, and in Satellite Assets, which are typically in a more narrow category which we feel offers a benefit to the portfolio at the present time. The Satellite holdings may be changed from year to year, and while the Core funds are “permanent”, their size and weighting in the portfolio will change each year based on their relative valuations and attractiveness of other categories.

We always start with the overall asset allocation in our process, and then choose funds which we think will accurately represent each category. With our themes each year, I think you will see that we are far from being entirely passive. Here are our big picture thoughts for 2018.

1) Foreign over Domestic Stocks. US Equities are quite expensive relative to the rest of the world. The strong performance in 2017 has stretched those valuations even further. We are presently overweight US stocks relative to our benchmark (the MSCI All-Country World Index), but will reduce our weighting to US stocks to an underweight.

2) Overweight Emerging Markets. For 2017, we increased our allocation to Emerging Markets Equities to two-times the level of the index, approximately 17% compared to 8.5%. EM had a phenomenal year in 2017, currently up nearly 30%. When we rebalance, these positions may be trimmed, but please note that we are not reducing our target allocation!

3) Reduce Risk in Fixed Income. While short-term rates rose nicely in 2017, long-term interest rates did not. This was our “low for longer” theme from last year. We sold our high-yield bond ETF over the summer, but will continue to look to reduce the duration of our bond holdings and increase the credit quality. When we do eventually get a correction in the stock portfolio, we want to have high quality bonds to provide support to the portfolio.

4) Increased Volatility. We don’t have a crystal ball and believe that trying to make predictions is not only futile but damaging to your returns. However, we have gone an exceptionally long time without any sort of correction. I don’t know when it will occur, but just as autumn turns to winter, I think investors must not forget that there will be down periods, and be prepared to weather potential storms in 2018 and beyond.

We published Four Investment Themes for 2017 in November of 2016. Click the link if you’d like to see how we did. I think we were generally successful in identifying themes for this year, except that I was expecting Value stocks to take the lead from Growth stocks, which did not occur. However, we saw the gap in valuation between Value and Growth widen in 2017, so I believe that Value offers less risk and potentially a higher long-term return than Growth.

2017 was the first full year to include a 10% allocation to Alternatives within each portfolio. With the stock market producing double digit returns in many categories, our investment in Alternatives was a drag on performance. Still, I think many investors will appreciate that we are looking for more stable sources of returns than just being in stocks and bonds. With high valuations in domestic stocks, and low bonds yields globally, risks remain elevated.

Overall, we will be making only small adjustments to our portfolios for 2018. But compared to two or three years ago, we have already made significant changes to reduce risk and further diversify our portfolios. As always, I am happy to discuss our investing approach in greater detail with anyone who is interested.