What Not to Do With Your 401(k) in 2015

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In a recent article,  “Are You Smarter Than a Fifth Grader? You Better Be If You Want to Participate in a 401(k)”, I mentioned that a basic financial education might help prevent investors from making common mistakes with their 401(k) accounts.  What are those mistakes?  Here are the top five blunders to avoid with your 401(k) in 2015 and a preferred outcome for each situation.

1) Using your 401(k) as an emergency fund.  It’s all too common for participants to cash out their accounts if they have an emergency or when they leave a job. Withdrawals before age 59 1/2 are subject to a 10% penalty and ordinary income tax, in which case you end up losing 30 to 50 cents of every dollar in your account to the IRS.  Preferred Outcome: make sure you have sufficient emergency funds before starting a 401(k).  When changing jobs, roll your 401(k) to the new 401(k) or an IRA, or leave it at the old plan, if possible.

2) Contributing only up to the company match.  Getting every matching dollar available is a smart idea, but a significant number of participants contribute only up to this level.  Just because the company matches 4%, doesn’t mean 4% will be enough to generate the amount of money you need to retire!  Preferred Outcome: aim to save 10-15% of your salary for retirement.  If you can, contribute the maximum to your 401(k), which is $18,000 for 2015, or $24,000 if over age 50.

3) Giving up when the market is down.  No one likes to open their 401(k) statement and see that the account is worth thousands of dollars less than the previous month.  Unfortunately, if you move into a money market fund, or worse, stop contributing, you may actually be making things worse.  Preferred Outcome: focus on your long-term goals and not short-term fluctuations.  When the market is down, consider it an opportunity to buy shares on sale.

4) Not Being Diversified.  Although it’s tempting to pick the fund with the best 1-year return, there’s no guarantee that particular fund will continue to outperform.  (In fact, it’s quite unlikely.)  Other participants put their 401(k) into a money market fund, which is almost certainly going to be a poor choice over 10 or more years.  Your best bet is to be thoroughly diversified in an allocation appropriate for your age and risk tolerance.  Preferred Outcome: develop a target asset allocation; if in doubt, use a target date fund to make these decisions for you.

5) Taking a 401(k) Loan.  While taking a 401(k) loan is an option, I rarely meet participants with significant balances who take loans.  You have to pay back loans with cash, not salary deferrals, which means that many participants stop their contributions in order to pay back the loan.  Any amount not paid back on time is considered a distribution, subject to taxes and the 10% penalty, if under age 59 1/2.  Additionally, if you change jobs or are laid off, you will have to pay back the loan within 60 days.  Preferred Outcome: don’t sabotage your retirement by taking a loan.  Consider other options first.

At Good Life Wealth Management, we know how important 401(k) plans are to your retirement planning.  And that’s why all our financial plans include detailed recommendations for each of your accounts.

Year-End Tax Loss Harvesting

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Each December, I review taxable accounts and look at each investor’s tax situation for the year.  I selectively harvest positions with a loss so those losses may offset any capital gains realized by sales or distributed by your funds this year.  If realized losses exceed gains, $3,000 of the losses may be applied against your ordinary income and any excess loss is carried forward into future years.

Depending on the time of your purchases, some investors have small losses in International and Emerging Market stocks for the year.  Although these positions may be down and have lagged US stock indices, I’m not suggesting that we abandon an allocation to these categories altogether.

What we can do is swap from one ETF (or mutual fund) to another ETF or fund in the same category.  This enables us to maintain our overall target allocation while still harvesting the loss for tax purposes.  And thankfully, with a proliferation of low-cost ETFs available in most categories today, it is easier than ever to make a tax swap while maintaining our desired investment allocation.

Tax loss harvesting reduces taxes in the current year, but is primarily a deferral mechanism, as new purchases at a lower cost basis will have higher taxes in the future.  Still, there is a value to the tax deferral, plus a possibility that an investor might be in a lower tax bracket in retirement or could avoid capital gains altogether by leaving the position to their heirs or through a charitable donation.

Most of our ETFs have no taxable capital gains distributions for 2014, a nice feature of ETFs compared to actively managed mutual funds, many of which are generating sizable distributions, even for new shareholders.  Focusing on individual after-tax returns is another way we can add value for our clients.

If you’d like to study tax loss harvesting in greater detail, I recently read an excellent article, Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of Tax Loss Harvesting, by Michael Kitces.

Are Your Retirement Expectations Realistic?

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While many individuals have very realistic ideas about retirement, I find that some people may be significantly overestimating their preparedness for funding their financial needs.  Here are three specific mistakes which can hurt your chance of success in retirement, and a realistic solution for each issue.

Mistake #1: Thinking you can live on a small fraction of your pre-retirement income.
Occasionally, I’ll meet someone who is currently making $100,000, but who thinks that they will need to spend only $40,000 a year in retirement to maintain their current lifestyle.  On a closer look, they’re saving about $15,000 today so they are really living on about $85,000 a year.  This is a key problem with creating a retirement budget: when we add up projected expenditures, it is very easy to underestimate how much we need because we often forget about unplanned bills like home and auto repairs, or medical expenses.  And don’t forget about taxes!  Taxes do not go away in retirement, either.

Realistic Solution: Even though some expenses will be lower in retirement, most retirees find that they need 75-90% of their pre-retirement income to maintain the same lifestyle.

Mistake #2: Taking too high of a withdrawal rate.
20 years ago, William Bengen published a paper that concluded that 4%, adjusted for inflation, was a safe withdrawal rate for a retiree.  While this topic has been one of the most discussed and researched areas in retirement planning, most financial planners today remain in agreement that 4%, or very close to 4%, is the safe withdrawal rate.  However, many individuals who have a million dollar portfolio think that they might be able to take out $60,000, $70,000, or more a year, especially when the market is performing well.

There are two important reasons why it’s prudent to use a more conservative 4% rate.  The first is market volatility.  The market is unpredictable, so we have to create a withdrawal strategy which will not excessively deplete the portfolio in the event that we have large drop, or worse, a several year bear market at the beginning of a 30-year retirement.  The second reason is inflation.  We need to have growth in the portfolio to allow for the increased cost of living, including the likelihood of increased medical costs.  At just 3% inflation, $40,000 in expenses will double to $80,000 in 24 years.  And with today’s increased longevity, many couples who retire in their early 60’s will need to plan for 30 years or more of inflation in retirement.

Realistic Solution: At a 4% withdrawal rate, your retirement finish line requires having a portfolio of 25 times the amount you will need to withdraw in the first year.

Mistake #3: Assuming that you will keep working.
Some people plan to keep working into their 70’s or don’t want to retire at all.  They love their work and can’t imagine that there would ever be a day when they are not going to be working.  They plan to “die with their boots on”, which in their eyes, makes retirement planning irrelevant.

Unfortunately, there are a number of problems with this line of thinking.  The Employee Benefits Research Institute 2014 Retirement Confidence Survey found a significant gap between when people planned to retire and when they actually did retire.  Only 9% of workers surveyed plan to retire before age 60, but 35% actually retired before this age.  18% planned to retire between 60 and 64, versus 32% who actually retired in that age range.  The study cites three primary reasons why so many people retire earlier than planned: health or disability, layoff or company closure, and having to care for a spouse or other family member.  The study also notes that one in 10 workers plan to never retire.  Even if you’re willing to keep working, the statistics are clear: most people end up retiring earlier than planned.

For a healthy 65-year old couple, there is a good chance that at least one of you will live into your 90’s.  If you still think you don’t need a retirement plan because you will keep working, do it for your spouse, who might have 25-plus years in retirement if something were to happen to you.  Don’t make your plan’s success dependent on your being able to keep working in your 70’s and 80’s.

Realistic Solution: Make it a goal to be financially independent by your early 60’s; then you can work because you want to and not because you have to.

A comprehensive financial plan addresses these concerns and establishes a realistic framework for funding your retirement.  And whether you’re 30 or 60, it is never too early, or too late, to make sure you are on track for financial independence.

5 Retirement Strategies for 2015

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For 2015, the IRS has announced that contribution limits will increase for a number of retirement plan types.  For 401(k) and 403(b) plans, the annual contribution limit has been increased from $17,500 to $18,000.  The catch-up amount for investors over age 50 has increased from $5,500 to $6,000, so the new effective limit for participants over 50 is now $24,000. Be sure to contact your HR department to increase your withholding in January, if you are able to afford the higher amount.

Traditional and Roth IRA contribution limits will remain at $5,500, or $6,500 if over age 50.  SIMPLE IRA participants will see a bump from $12,000 to $12,500, and SEP IRA contribution limits are increased from $52,000 to $53,000 for 2015.

If you’re not sure where to start, here are my five recommendations, in order, for funding retirement accounts.

1) Choose the Traditional Plan 

More and more employers offer Roth options in their 401(k) plans, but I believe the most investors are better off in the traditional, pre-tax plan.  The only way the Roth is preferable is if your marginal tax rate is higher in retirement than it is today. The reality is that your income will probably be lower in retirement than when you are working.  Even if your income remains the same 20 years from now, it is likely that tax-brackets will have shifted up for inflation and you may be in a lower tax rate.  Lastly, there has been continued talk of tax simplification, which would reduce tax breaks and potentially lower marginal tax rates, which would also be negative for Roth holders. So, my advice is to take the tax break today and stick with the pre-tax, regular 401(k).

 2) Maximize Employer Plan Contributions

Your first course of action will always be to maximize your contributions to your employer plan.  Many individuals do this, but I’m surprised that with many couples, the lower paid spouse often does not.  If you’re being taxed jointly, every dollar contributed reduces your taxes at your marginal rate. And don’t forget that since 2013, on income over $250,000, couples are subject to an additional 0.9% tax on Earned Income and an additional 3.8% on Investment Income to provide additional revenue to Medicare.  Add the 3.8% Medicare Tax to the top rate of 39.6%, and you could be paying as much as 43.4% tax on your investment income.  That’s a big incentive to maximize your pre-tax contributions as much as you can.

 3) Traditional IRA, if deductible

If you maximize your employer contributions for 2015, and are able to do more, here is your next step: If your modified adjusted gross income is under $61,000 single ($98,000 married), then you can also contribute to a Traditional IRA and deduct your contribution.  If your spouse is covered by an employer plan but you are not, the income limit is $183,000. This opportunity is frequently missed by couples, especially when one spouse does not work outside the home.

And of course, if neither spouse is covered by an employer retirement plan, both can contribute to a deductible Traditional IRA, without any income restrictions.

 4) Roth IRA

If you make above the amounts in step 2, but under $116,000 single, or $183,000 joint, you are eligible to contribute to a Roth IRA.  If your income is above these amounts, you would not be eligible to directly contribute to a Roth IRA.  However, if either spouse does not have a Traditional IRA (including SEP or SIMPLE), he or she would be able to fund a “Back-Door Roth IRA”.  This is done by contributing to a non-deductible IRA and then immediately converting to a Roth.  Since there are no gains on the conversion, the event creates no tax.

 5) Self Employment 

If you have any 1099 income, are self-employed, or work as an independent contractor, you would also be able to contribute to a SEP IRA in addition to funding a 401(k).  You can contribute to both accounts, subject to a combined limit of $53,000, if you have both W-2 and 1099 Income.

One option I’ve not seen discussed often is that someone who is self-employed could also fund a SEP and convert it to a Roth.  If you don’t have any other Traditional IRAs, this could, in theory, be used to fund a Roth with up to $53,000 a year. The conversion would be a taxable event, but it would be cancelled out by the deduction for the SEP contribution.

There are quite a few variations and details in terms of eligibility for each family.  Want to make sure you’re taking advantage of every opportunity you can?  Give me a call to schedule your free planning meeting.

An Attitude of Gratitude

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It’s Thanksgiving week and I want to thank all of my clients and readers for supporting me and my new company which we launched six months ago this week.  I am incredibly grateful for the opportunities I have received and look forward with eager anticipation to the year ahead.  I visited Thanks-Giving Square this week in downtown Dallas and was inspired by their story and mission.  Dallas has the drive and ambition to do great things, but also the humility to do so with a greater purpose and perspective.  And that’s why I’m proud to call our city home.

I spend most of my time dealing with the minutiae of financial planning, but I know that knowledge alone is not the source of success.  To make it work, you have to be an optimist, you have to believe in the process.  Over the past 15 years, we’ve had tremendous opportunities to create wealth, and many have grown their net worth dramatically.  And still there are people who will tell you that the market has been terrible over this time period and that they’ve not made money.

People who are thankful, who have gratitude, tend to have more success in their finances.  Gratitude and optimism are two sides of the same coin and maintaining that positive attitude goes a long way towards accomplishing goals.  But I don’t think we always feel grateful.  Most of us have to be reminded from time to time to step back and consider all the things we should not take for granted.

Is it worthwhile to try to be thankful?  Can you become more grateful?  In a 2003 psychological study, participants were asked to keep a journal.  One group was instructed to write things they were thankful for, while a second and third group recorded negative thoughts, or neutral events (no positive or negative instructions).  Researchers found that those with a “gratitude journal” felt better and were more optimistic.  They were also more likely to have made more progress on their personal goals.

We will all think of reasons to be grateful this Thursday, but why let it be a one-day event?  What if, instead, you wrote down just one thing you are thankful for, each day for the rest of the year.  That’s what I will be doing and I invite you to do the same.  I hope you will accept, and if you do, please send me a message after January 1 to tell me about your experience.  Thank you!

 

 

How Some Investors Saved 50% More

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While some people view risk as synonymous with opportunity, the majority of us don’t enjoy the roller coaster ride of investing.  Our natural proclivity for risk-avoidance can, unfortunately, become a deterrent in deciding how much we save. Without having specific goals, investors often default to a relatively low contribution rate to retirement accounts and other investment vehicles.  They commit only how much they feel comfortable investing, rather than looking at how much they actually need to be saving in order to fund their retirement or other financial goals.

In the November issue of the Journal of Financial Planning, Professors Michael Finke and Terrence Martin published a study of 7616 people born between 1957 and 1965, looking at whether working with a financial planner produced improved outcomes for accumulated retirement wealth.  Here are their conclusions:

Results indicate consistent evidence that a retirement planning strategy and the use of a financial planner can have a sizeable impact on retirement savings.  Those who had calculated  retirement needs and used a financial planner… generated more than 50% greater savings than those who estimated retirement needs on their own without a planner. 

When I read the executive summary of their article, I wondered if perhaps the results reflected that higher income people were simply more likely to use a financial planner.  However, the authors took this into consideration.  They controlled for differences in household characteristics such as income, education, and home ownership… Even after controlling for socioeconomic status, households that used a financial planner and calculated retirement needs had significantly higher retirement wealth accumulation across all quantiles relative to households with no plan. 

Interestingly, the authors noted that this result of 50% higher wealth was not due to investment performance.  When they looked at individuals who used a financial advisor who was not doing a comprehensive plan (such as a stock broker), they noted that using a planner without estimating retirement needs had little impact on accumulation compared to having no retirement strategy at all.  

And that’s why we put planning first at Good Life Wealth Management.  Goals dictate actions.  Only when we have a clear picture of what you want to accomplish will we will know if you are on track or behind schedule.  We’re more willing to save when we are working towards a finish line, as opposed to worrying about what the market is going to do next.  If you’re looking for a comprehensive advisor to bring clarity to your goals and to carry out your game plan, I hope you’ll give me a call.

5 Ways to Save Money When Adopting a Pet

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Americans love their pets, and although they repay every penny with their love and devotion, the amount we spend on our pets can be astronomical.  I’ve been a volunteer in animal rescue since 1997 and here are my top five suggestions for ways to save money if you’re looking to add a four-legged companion to your family.

1) Adopt Don’t Shop.  Puppies in a pet store or from a breeder can cost hundreds or thousands of dollars.  Adopting from a shelter may cost a fraction of this amount, and often, a shelter pet has already been vaccinated, wormed, and neutered, saving you $300 to $500 in initial vet bills.  Additionally, adopting a shelter pet saves a life, as currently, approximately 4 million unwanted pets are euthanized each year in the US. Take your time and make sure the dog or cat will be a good fit for your household – many pets are returned or wind up in shelters when people underestimate how much time and effort it will take to train a puppy to become a well-behaved adult dog.

2) Crate Train.  Although cute, puppies love to chew and can be quite destructive when left unsupervised.  They are naturally attracted to shoes, furniture, and other expensive items in your home.  Besides being costly to replace these items, it can also be dangerous for dogs to ingest these items.  There have been many expensive vet visits from dogs who got sick from eating something in their home that should have been off-limits.  Save yourself this headache and expense by buying a crate to keep your dog from causing trouble when you’re not home.  This has the additional benefit of helping with house training, which will save your carpets!  Over time, dogs really do start to like their crates.  My dog goes into his crate immediately when we get ready to leave the house – it’s his safe place.  Read up on crate training.  The $50-100 you spend on a crate may save you hundreds or thousands in preventable destructive behavior.

3) Ask Friends for a Veterinarian Recommendation.  The price of vaccines, neutering, or heartworm treatment can vary significantly from vet to vet.  Ask friends for a recommendation for a low-cost vet.  Some clinics offer one or two days a month that they provide discounts on vaccines.  Ask your shelter if they know of any free or low-cost vaccination or neutering clinics in your city.  Still, make sure to develop a relationship with one veterinarian who knows your dog or cat, to monitor changes in your pet’s health over time and make sure you stay up to date with any needed care.

4) Consider a Mixed Breed Dog.  A lot of people want a specific kind of dog, but unfortunately, many breeds have a higher likelihood of developing certain health issues.  For example, some breeds are prone to hip dysplasia, cancer, or ear infections.  These can be expensive to treat and often result in a shorter life expectancy for the animal.  Mixed breed dogs tend to be healthier, live longer, and have fewer of these genetic predispositions for certain ailments.  If you do want a specific breed, you can still probably find one through a local shelter or rescue group.

5) Buy Smart.  A 15 pound bag of my dog food costs $35, but a 30 pound bag only costs $45.  Buy the larger bags and use an airtight storage container.  Buy a high quality food and skip the expensive treats, such as rawhides, that have limited nutritional value and can upset a sensitive stomach.  Keep up with heartworm preventative and flea/tick medicine.  Although it is one of the largest ongoing costs, these preventative medicines are much less expensive than treatment, should your pet become sick.  And here in Texas, even indoor dogs have a very high likelihood of developing heartworms without prevention.

If you are looking for a pet, let me know and I will look for a good fit for you at Operation Kindness.  We also have fosters in our home several times a year, if you are interested in a puppy.

5 Tax Savings Strategies for RMDs

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In November each year, we remind investors over age 70 1/2 to make sure they have taken their Required Minimum Distribution (RMD) from their retirement accounts before the end of the year.  If an investor does not need money from their IRAs, the distribution is often an unwanted taxable event.  Although we can’t do much about the RMD itself, we can find ways to reduce their taxes overall.

Clients who have after-tax contributions to retirement accounts often ask about which account they should take their RMDs, but it doesn’t matter.  The IRS considers IRA distributions to be pro-rata from all sources, regardless of the actual account you use to make the distribution. Whichever account you use to take the RMD, the tax due is going to be the same.

If all your contributions were pre-tax, your basis in all accounts is zero and you can ignore the comments above.  Note that you do not have to take a distribution from each individual account, even though each custodian is likely to send you calculations and reminders about your RMD for that account. All that matters is that your total distribution meets or exceeds the RMD for all accounts each year.

For investors taking RMDs, here are 5 steps you can take to reduce your income taxes:

1) Asset Location.   Avoid generating taxable income in your taxable accounts by moving taxable bonds, REITs, and other income generating investments to your retirement account.  This will keep the income from the investments out of a taxable account, leaving your RMD as your primary or only taxable event.  Placing stable, income investments in your IRA will also be a benefit because it will keep your IRA from having high growth.  Otherwise, if your IRA grows by 20%, your RMDs will grow by 20%.  (Actually more than 20%, since the percentage requirement increases each year with age).

Keeping stocks and ETFs in a taxable account allows you to choose when you want to harvest those gains and also allows you to receive favorable long-term capital gains treatment (15% or 20%), a tax benefit which is lost if those positions are held in an IRA.  Lastly, if you hold the stocks for life, your heirs may receive a step-up in basis, which is yet another reason to hold stocks in a taxable account and not your retirement account.

2) Charitable Donations.  If you itemize your tax return and are looking for more deductions, consider increasing your charitable donations.  And instead of giving a cash donation, donate shares of a highly appreciated stock or mutual fund and you will get both the charitable donation and you’ll avoid paying capital gains on the position later.

3) Stuff your deductions into one year.  Many investors in their 70’s have paid off their mortgage and it is often a “wash” between taking the standard deduction versus itemizing.  If this is the case, consider alternating years between taking the standard deduction and itemized deductions.  In the year you itemize, make two years of charitable donations and property taxes.  How do you do this?  Pay your property tax in January and the next one in December and you have put both payments into one tax year.  Do the same for your charitable contributions.  The following year, you will have few deductions to itemize and will take the standard deduction instead.

4) Harvest losses.  Investors are often reluctant to sell their losers, but selectively harvesting losses can save money at tax time.  Besides offsetting any capital gains, losses can be applied against ordinary income of up to $3,000 a year, and any leftover losses carry forward indefinitely.

5) Roth IRA.  If you don’t need your RMD because you are still working, consider funding a Roth IRA.  There is no age limit on a Roth IRA, so as long as you have earned income, you are eligible to contribute $6,500 per year.  If you qualify for a Roth, then your spouse would also be eligible to fund a Roth, even if he or she is not working.  Although the Roth is not tax deductible, the contribution does enable you to put money into a tax-free account, which will benefit you, your spouse, or your heirs in the future.

There is a “five year rule” which requires you to have a Roth open for five years before you can take tax-free withdrawals.  This rule applies even after age 59 1/2, so bear that in mind if you are establishing a Roth for the first time.

One additional suggestion: although you have until April 1 of the year after you turn 70 1/2 to take your first RMD, waiting until then will require you to have to take two RMDs in that year.  It may be preferable to take your first RMD in the year you turn 70 1/2, by December 31.

Retirement Cash Flow: 3 Mistakes to Avoid

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Living off your portfolio is unfamiliar territory for new retirees, and although it’s sounds simple, there are a number of common pitfalls which many people encounter in their first few years of retirement.  Here are three mistakes you should avoid to help keep your retirement cash flow safe.

1) Not including everything in your budget

A retirement income plan establishes a safe withdrawal rate designed to last for 30 or more years of retirement.  For example, we may determine that a couple can safely withdraw $4,500 a month from their accounts, in addition to their Social Security and pension.  They set up a $4,500/month transfer and this works well until they encounter a large, unanticipated bill.  Then, they require additional withdrawals to cover their expenses and suddenly their plan to withdraw only 4% that year balloons to 6% or 7%.

When we create a budget, it should include everything, and not just your ordinary monthly bills.  The following are some “unexpected” expenses that have caused retirees to request additional withdrawals in recent years:

  • Home repairs, such as a new roof or AC
  • Needing $35,000 for a new car
  • Medical expenses not covered by insurance
  • Property taxes
  • Vacations
  • Buying a Vacation Home
  • Boats, or RVs

It’s easy to consider a 401(k) account or Pension Lump Sum payout as being all available, but it’s better to view the account as a 30-year stream of income.  Rather than looking at the account as a $1 million slush fund, consider it a $40,000 salary with a 3% raise each year.  A retiree needs to have an emergency fund just like everyone else and to budget and save for large expenses.  The principal of your retirement account cannot be both your permanent source of income and your emergency fund.

2) Reinvesting Dividends in a taxable account.

If you are taking withdrawals, or will need to take withdrawals, from your taxable account, I’d suggest turning off dividend reinvestment on all your positions.  Have your funds pay dividends and capital gains in cash and hold the resulting cash for your withdrawals.  This will save you from having to sell positions and creating taxes on capital gains in order to access your money.

You probably have substantial gains in mutual funds if you’ve owned them for a long time.  Mutual funds typically use the average cost basis method, so if you have a 75% gain in the position, any withdrawal will be considered to have a 75% gain.  ETFs and individual stocks use the specific lot method, and sales are generally considered to be First In, First Out (FIFO), unless you specify lots at the time of the trade or change your default cost basis disposal method to another option.  While that does give an investor more flexibility in managing the tax implications of ETF sales than with mutual funds, I find that most don’t bother and simply go with the default of FIFO.

The easiest way for retirees to avoid this headache is have distributions paid in cash.  If you end up with more cash than you need at the end of the year, you can always use the money to rebalance your portfolio.  (Which is preferable to having to make sales in order to rebalance the portfolio, anyways.)

3) Ignoring the Low Interest Rate environment.  

Today’s low interest rates present a challenge for retirees and many of the conservative ideals of the past are simply not providing the same level of financial security today.  This applies to both assets and liabilities.  On the asset side, keeping the majority of your money in a bank account or CD may be safe in the short-term, but with today’s historically low interest rates running below inflation, you’ll lose purchasing power each year.  We call this a negative real return.  A balanced and properly diversified portfolio has short-term risk, but is likely to increase your wealth over time.  If you’re investing for the long-term, make sure all your investments aren’t designed as short-term holdings, or they may be setting you up for eventual disappointment.

Many near-retirees have a goal of being debt-free, which is a laudable ambition, but with today’s low rates, you could lock in a mortgage in the 3% range.  Selling investments or cashing out a 401(k) and paying taxes on the withdrawal to pay off a 3% mortgage could hurt your long-term financial strength, provided you are willing to hold investments that can potentially return more than 3%.  By paying off their mortgages, some home owners inadvertently wind up house rich and cash poor, which does not give you much flexibility in paying your living expenses.  From a cash flow perspective, you may be better off keeping a mortgage versus tying up a majority of your net worth in home equity.

One additional note on mortgages: eligibility for a mortgage is based largely on your income.  If you are going to refinance a mortgage, do so while you are still working and before you retire.  Once you are retired, it will be more difficult to underwrite a mortgage with no income, even if you have sufficient assets to buy the property outright.

These types of issues come up frequently with new retirees, and we give a lot of thought to the pros and cons of each choice.  Individual situations can vary and there are sometimes reasons why no rule of thumb can apply 100% of the time.  If you have questions about retirement cash flow and your personal portfolio, please send me a message and we can discuss your options.

Adversity or Opportunity?

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In the past two weeks, market volatility has spiked and major indices have traded down 7% or more.  I follow the market closely and monitor the situation for news which might impact our portfolios.  Generally, I prefer to use this space to discuss beneficial financial planning topics, but I know that everyone is wondering about the market, so here is my take on the situation.

The recent pull-back has been relatively minor and probably long-overdue, given that we’ve gone five years since a significant correction.  The good news is that stock fundamentals are strong and the US economic recovery remains in place, although actual growth is somewhat tepid. While equity prices have risen, valuations are within a normal range and not at the elevated levels we saw in previous bubbles.  With interest rates remaining extremely low, “risk” assets like stocks still offer greater potential return than cash or fixed income.

Having shared my opinion, I have to say that it really doesn’t matter what I think will happen.  Anyone who thinks that data is “proof” of what the market is going to do is fooling themselves.  No one can predict the market.  Fortunately, long-term investment success does not require a crystal ball.  What it does require is a well-researched and executed plan, a diversified allocation, and most importantly, the fortitude and discipline to stick to your plan.

I was asked this week if I got my clients out of the market before the recent turmoil.  No, I didn’t and I didn’t sell any of my own stock positions, either.  I was doing the opposite this week: buying in a number of portfolios.  And I was quite happy to have the opportunity to pick up ETF shares 5-10% lower than they cost just three or four weeks ago.  I’m focused on the long-term opportunity and not the present adversity.  Although I don’t know where the market will be one month from now, I strongly believe that the market will be significantly higher in 10 years from now and that is what really matters.

So rather than worry about the troubles of the day and the things you cannot control, I believe investors are best served by focusing on the things you can control, such as:

  • establishing a target asset allocation to match your risk tolerance, required return, and time horizon;
  • diversifying to eliminate company-specific risks;
  • keeping investment expenses low and reducing tax drag to a minimum; and
  • how much you save and invest.

Of these four, the last one is crucial to your individual success.  The news tends to make us focus on trying to improve short-term investment performance, instead of how much you should be saving.  If your goal is accumulation, it’s more important to be thinking about how to increase your saving than how to increase your return.  We have to learn to ignore the noise of the daily media so we can stay focused on how to achieve our long-term objectives.

Optimism is key.  Not a blind naivete, but the confidence to know that you are on the right path, and the recognition that sometimes the path is uphill.  I remember a bit of wisdom I heard years ago “You make your money in bear markets, you just don’t know it until later.”  If you’ve got five or more years to retirement, you should welcome each pullback in the market as a tremendous opportunity.

With this understanding, there are some small ways to take advantage of the recent market turmoil and use the recent drop in prices to your advantage:

  • Put excess cash to work; if you haven’t made your IRA contribution, now is a good time.
  • Rebalance your portfolio.
  • Swap losing positions to harvest tax losses; replace your high expense funds with tax-efficient, low cost ETFs.  Use the downturn as an opportunity to clean up your portfolio.
  • Add Emerging Market equities, if you don’t have any.  EM is down more than domestic equities and has lagged for several years.

Market timing may be an alluring mirage, but ultimately is a counterproductive distraction for investors.  If you’re able to take advantage of the pullback, that’s fine, but if you’re already invested, don’t think that you have to “do something”.  Most of the time, doing nothing is ultimately the best option!