The Geography of Retirement

Retirees move for various reasons: to find a better climate, to spend more time pursuing activities they love, or to be closer to family.  Sometimes, the decision is based on a desire to downsize and reduce their cost of living. There are many financial considerations regarding your choice of retirement location, but there are three key factors that I would use as a starting point when weighing your options.

1) Look at total costs and not just income taxes if moving out of state.  Every year, I see articles about retiring to “tax-free” states like Florida or Texas.  There are seven states which have no personal income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.  Additionally, New Hampshire and Tennessee do not tax personal wages, but do tax dividends and interest.  While moving to a tax-free state sounds like a great idea, there may be other costs of living that could offset those state tax-savings.  Be sure to calculate the cost of property taxes, property insurance, and sales taxes.  For a retiree who has $50,000 in annual income, the savings in income tax may be relatively small and your total living expenses could actually increase if you move to another state.  It’s better to look at your whole cost of living, especially if your income in retirement will be modest.

When you look at property taxes, make sure to research whether your state offers any property tax programs for seniors.  Texas, for example, will freeze school taxes for residents over 65, placing a ceiling on the tax on your primary residence.  Some states offer seniors an income-based reduction on property taxes; it’s worth going through that paperwork to confirm you are eligible, rather than assuming you’re eligible and finding out later that you will not receive the tax rebate.

2) Consider travel costs.  It’s one thing to enjoy a vacation for a few weeks, but some retirees find themselves feeling disconnected and missing out on family activities if they move away permanently.  They find themselves coming back “home” more frequently and for longer periods.  Before long, they’re spending $5,000 a year or more on travel costs between two locations.  That’s fine if that’s the lifestyle you want, but it is an expense that you must consider if you’re thinking that moving is going to be a cost-saving plan.  How will you feel about not spending holidays with your family, or missing your grandchildren’s birthdays and soccer games?  Is the cost and hassle of travel going to make it worth while to move?

3) Know your health care coverage.  If you are part of a health care network, such as a Medicare Advantage Plan (part C), what is covered out of state?  This is a common issue for snowbirds who divide their time between a northern home and their southern winter get-away.  I’ve spoken with quite a few whose “plan” is to have all of their appointments and check-ups take place when they’re home.  But what happens if you get sick while you’re away?  Out-of-network care may be very expensive or not covered by your insurance.  It’s a risk both to your health and your finances.

This concern also applies for US citizens who are looking to move abroad to a low-cost location.  It’s relatively easy to receive your Social Security and Pension out of the country, but for Medicare, you will have very limited or no coverage.  Be sure to read this Medicare brochure before deciding to move overseas: Medicare Coverage Outside the United States.

If you decide to live abroad, you may think you don’t need to enroll in Medicare Part B.  But if you later move back to the US, there will be a penalty (permanently higher premiums) to enroll in Part B if you didn’t sign up at age 65.  And you must have Part B in order to participate in Medicare Advantage or to enroll in Prescription Drug coverage (part D).  So be very careful you understand the potential future costs if you are planning on turning down Part B at age 65.

5 Techniques for Goal Achievement

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Goal Setting is a key step to the financial planning process, and helping clients achieve goals is the value I provide.  Everyone would like to be wealthy, but that is not a goal.  To me, it only becomes a goal when we can state a clear, tangible objective.  So, if you’d like to retire, we’d calculate how to make that happen and develop a specific goal like “accumulate $2.1 million dollars by 2026.”  That long-term goal gives us a timeline and dictates what we need to do each year and month to make your goal a reality.  We can observe if you are on track and make adjustments as needed in the years ahead.  The key step though is translating an ambiguous desire into a goal which is measurable.

Below are 5 Techniques For Goal Achievement, starting with high-level and moving to detail-oriented.  The key is finding not the tool which you like the most, but the tool which helps you address the area where you are most likely to fall down or become distracted or disillusioned with your goal.  If you need motivation and confidence, focus on the the high-level tools; if you need help with implementing goals, focus on the daily tools.  And while I’m writing about financial goals specifically, these concepts could be applied to any goal you want to achieve.

1) Visualize your goal with a daily reminder and affirmation.

For the retirement goal above, write a check to yourself for $2.1 million, with a date of January 1, 2026.  Put the check someplace you will see it everyday.  Over time, our goals will naturally start to shape our behavior.  Daily repetition helps internalize the goal and we come to see it as inevitable, rejecting any fear or self-doubt.

2) Chart your goal road map.

Why do you need a road map?  Imagine you wanted to drive from Dallas to New York.  You could just start driving and figure you’ll get there eventually through trial and error.  But most people prefer to know where they are going and to choose the most direct route.  This makes perfect sense for a long drive, but most people haven’t taken the same step of putting together a plan of how to accomplish other long-term goals relating to their finances, career, or health. Sometimes our destination is not on the road we are on today and we have to know when it’s time to change direction.  This is the difference between hoping we accomplish our goals versus knowing what we need to do today and tomorrow to get to a destination that may be years away.

3) Keep a daily goal journal.

Often times, to reach our goals, it requires that we upgrade our daily habits.  This can apply to financial behavior, but also to improving your diet, exercise, or your performance at work.  Making a change is challenging because our habits become ingrained and second nature to us.  It’s helpful to be able to see ourselves and our behavior from an objective, outside point of view.  The best way I’ve found to increase our self-awareness is through keeping a daily journal.  The journal becomes a mirror to see ourselves better.  Write down what you do each day relating to your goal, your progress or set-backs, and how you felt about the day’s activity.  This focuses your attention on today which is the only day that you can really control.  A journal motivates you to do what you need to do and feel good about your progress.  Sometimes, simply knowing that you have to write down your day’s activities will keep you on track and prevent you from old behaviors which you want to change.

4) Focus on accomplishing the essential with the 90% rule.

Imagine a pyramid of goals, with long-term at the top, supported by intermediate goals, and short-term goals at the base.  Start each day with a short to-do list of what is essential to complete today to advance your goals.  It’s easy to get bogged down in putting out fires and responding to issues, rather than following your own agenda. For a perfectionist, it’s difficult to leave a task, email, or project, until it is 100% complete to the best of your abilities.  The reality is that there is not enough time to be a perfectionist about everything and it is a better use of time to focus on touching everything that is on your essential to-do list.  The 90% rule is asking yourself if each task truly requires 100% perfection or if it just needs a 90% summary.  Do you really need to write a 10-page essay with footnotes, or will a 2-page overview accomplish the desired outcome?  It may take 2 hours for a “100% job”, but only 45 minutes for a “90% job”.  Some tasks do require 100%, but recognizing the difference allows you to spend more time on the essentials that will get you closer to accomplishing goals.

5) Stop procrastinating by using a timer.

Oftentimes, a task seems so monumental that we don’t even know where to begin.  Or it’s something we don’t enjoy doing, so we put it off for as long as possible.  We become so concerned about how long it will take to finish that we never even begin.  Take the pressure off yourself!  Instead of worrying about finishing the task, just pick an amount of time you can spend right now: 15 minutes, 30 minutes, whatever. Set a timer and let yourself to focus exclusively on that one item, with no checking email or other interruptions, until the timer rings.  You can do anything for 15 minutes.  You’ll surprise yourself how often you can complete a dreaded task in 15 minutes, or get 90% of it done.  This tool takes advantage of the fact that we have a limited amount of concentration (often only 15-30 minutes) on any subject. Our use of electronic media today can often hinder our focus. Consider setting specific times each day to check email, Facebook, etc., to avoid having your schedule hijacked by distractions.

The AFM Pension Plan: What Every Musician Needs to Know

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If you’re a professional musician in the US, you likely received your annual statement from the American Federation of Musicians Employers’ Pension Plan in the past several weeks. The main purpose of the mailing is to verify your Covered Earnings from the past year. Professional musicians often have basic questions about the AFM Pension, in part, because the annual statement doesn’t tell you very much about your personal situation other than your reported earnings and the amount your employer(s) contributed to the pension fund.

Give the importance of the Pension Fund to the retirement planning of musicians, here are five key questions about the plan that every musician should know.

  1. What is the Fund?

The AFM Employers’ Pension Fund (EPF) is a Trust Fund established by the AFM and funded through contributions from employers throughout the country, as required under a Collective Bargaining Agreement. Whether you’re a member of the Chicago Symphony, a Broadway theater musician, or a free-lance performer, you may be covered by the EPF. Currently, there are over 50,000 musician participants (active and retired) in the plan, and the fund has assets of over $1.7 Billion.

  1. How do I find out how much I am going to get?

The pension benefit you will receive depends on your contributions and the age you retire. While it is possible to calculate your benefit manually (it’s just algebra), it is much easier and simpler to use their website at www.afm-epf.org. Create your own Participant Login and use the Pension Estimator tool. Please note that while your contributions and earnings are always in annual amounts, the pension amounts shown are monthly benefits.

To be vested in the pension, you must have received covered earnings for 5 years, or 20 quarters. You receive a “quarter” of credit for $750 of covered earnings, and you will receive a full year of credits if you earned at least $3,000 in that year.

The normal age of retirement is 65 for the pension, but you can start as early as 55, provided you are retired at that age. If you are still working after 65, you can elect to start your pension at 65 and keep working, or you can delay benefits until you do retire and your benefit amount will be actuarially increased based on the age you decide to start benefits.

Once you’re logged on to the website and are on the Pension Estimator, you can create various scenarios to see what your pension benefit might be. If you’re vested, you’re guaranteed a benefit. If you want to find out how much benefit you’re eligible for based on your past earnings, enter 0 under Estimated Additional Contributions, and then hit “Calculate Benefit”. This defaults to age 65 for retirement, but you can make it for any age between 55 and 65. When you enter 0, your estimate doesn’t include any future earnings, so you will probably also want to create other estimates based on the future number of years you plan to work. As a simple estimate, you might take the past year’s employer contribution to the plan and multiply it by the number of years you plan to work.  Just remember that the estimate is based on today’s payout and crediting rules, which could be changed in the future.

  1. What are the payout options?

First, if your expected lifetime payments total less than $5,000, the EPF will give you a “cash-out” and send you a lump-sum payout. This is mandatory. However, if the expected payments exceed $5,000, there is no option to take a lump-sum or a rollover. You must take the monthly payments.

You can elect a Single Life Benefit (SLB), a 50% Joint and Survivor, or a 75% Joint and Survivor. The survivor options will pay you for life and then pay a reduced benefit (50% or 75%) to your “joint annuitant” for the rest of their life. If you are married, the plan defaults to the 50% J&S, but anyone can elect one of the joint and survivor options, regardless of your marital status. The joint amount is calculated as a percentage of the SLB, with a reduction based on the age difference between you and your joint annuitant. The younger your joint annuitant, the greater the reduction and the lower your monthly benefit amount. Your joint annuitant must be within 19 years of your age to elect the 75% plan.

The joint benefit is a valuable resource to take care of your spouse or partner, if they should outlive you, and it’s a relative bargain. Choose carefully, because your election at retirement is permanent. If you do outlive your joint annuitant, there is no option to change your plan or to select another joint annuitant.

The amount of your AFM pension is highly sensitive to the age of the participant at retirement. If you started benefits at 55, you’d receive only 37% of the benefit amount you’d receive at age 65. And that is assuming you didn’t work after 55 and had no additional contributions! Also, if you work past 65, your benefit also can grow significantly. For example, if you work to age 68, your benefit base would be increased by 35%, on top of the additional benefits you accrued from working between 65 and 68. This is one reason (of many) that some musicians are reluctant to retire – for every year they keep working, their pension is increasing by at least 10-11%.

  1. How does the AFM-EPF compare with Social Security benefits?

With Social Security, Full Retirement Age is 66 (increasing to 67 for individuals born after 1954), but you may start benefits as early as 62, or delay to 70. With the AFM EPP, Full Retirement Age is 65, but you can start as early as 55; you can delay the EPP past 65 only if you are still working and contributing to the plan.

One big difference is that Social Security has Cost of Living Adjustments (COLAs) based on inflation, whereas the AFM EPP does not. The amount you receive will remain the same for the rest of your life. Because there are no COLAs in the AFM plan, you have to be careful and not start benefits too early. If you can afford to wait until 65, it is a huge advantage to wait to full retirement age to receive benefits, even if you stopped working earlier. The reason is that you are guaranteed a 10-11% increase in benefits for each year waiting, which is better than Social Security (which increases by a maximum of 8% a year). You may or may not get 10-11% in your investment portfolio, but waiting on the pension is a guaranteed increase for life. Most musicians will receive both the AFM EPP and Social Security, but you do not have to start them at the same time.

With Social Security, your spouse may receive a survivor benefit. If your Social Security benefit is greater than your spouse’s benefit, then he or she will receive your benefit amount for the rest of their life, and their own benefit goes away. (If their SS benefit is already greater than your amount, they will not receive any increase or survivor’s benefit.) With the AFM plan, you don’t have to be married to have a joint annuitant and they can receive 50% or 75% of your amount after your death.

  1. I heard the plan is in trouble. Is my pension safe?

The AFM EPP is overseen by the Federal government and is covered by the Pension Benefit Guarantee Corporation (PBGC), which is similar to the FDIC in regulating pension plans and providing protection for individual participants. The plan itself has been considered to be in “critical status” since 2010, which occurs when the projected assets are insufficient to cover the projected liabilities. That description is a bit of a simplification, but the current “red zone” status means that the plan is required to create a rehabilitation plan to address the potential shortfall. They have reduced the benefits that will be paid on earnings contributed after 2010, and the board trustees, actuaries, and investment managers are working to monitor and fine tune the plan to ensure that it will be solvent for future retirees.

In the very unlikely event that the plan should fail, individual participants would have their benefits insured by the PBGC. While this should give some comfort, I should point out that there are limits to PBGC coverage based on the number of years of service, so it is possible that some participants would not be fully covered if their benefit amount exceeded the levels of protection under the PBGC.  I don’t think we need to be overly concerned about the viability of the pension plan, but I would council any musician to not rely solely on the pension.  You need to have other sources of assets and cash flow to provide a strong and secure retirement.

I don’t think anyone becomes a musician for the money, but musicians have the same financial needs and concerns as any other professional.  Unfortunately, a lot of musicians don’t pay much attention to their own financial planning, and don’t know where to turn for honest advice. I’ve been a member of the AFM since I was 19 and take great joy in helping my fellow musicians plan for a secure financial future. If you have retirement planning questions that might be a good topic for a blog, please email me at scott@goodlifewealth.com. Chances are that others may have the same questions! And of course, please feel free to call me at 214-478-3398 if you’d like to chat about any of your financial questions or concerns.

5 Tax Mistakes New Retirees Must Avoid

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New retirees often overlook the bite that taxes will take out of their income.  Even though they are no longer receiving a paycheck, taxes can still add up in retirement.  There are quite a few ways to reduce these taxes, which unfortunately, most people will miss on their own. Here are 5 mistakes you can avoid through careful planning.

1) Taking a large withdrawal from a retirement account in one year. If your income is modest and you will require $60,000 from an IRA, you will pay much less in taxes by taking withdrawals of $20,000 over three years versus taking $60,000 out in one year.  Plan ahead and aim to smooth your withdrawals from qualified accounts, or better yet, take only RMDs.  Don’t wait until an emergency or for a large expense to plan your IRA distributions.

2) Taking a withdrawal from a retirement account to avoid a capital gain on selling a stock.  The IRA withdrawal will be fully taxable as ordinary income, but a long-term capital gain would be taxed at the lower rate of 15% (or 20% if you’re in the top tax bracket).  Only the gains portion of the sale is taxable, whereas 100% of the IRA distribution is taxable.  For ETFs and individual stocks, you can even specify which lots to sell, giving you the opportunity to sell the lots with the highest cost basis, rather than the default first in, first out, or average cost method used by mutual funds.

3) Inefficient Asset Location.  I often see that portfolios are set up with bonds in a taxable account and stocks in the IRA, so that retirees can take the income from the bonds and avoid touching the stocks in the IRA.  Actually, it would be much more tax efficient to reverse the locations and place the bonds in the IRA.

Bond interest is taxed as ordinary income, as are IRA distributions. Put your bonds in the IRA and take your bond income from the IRA, as the distributions will be taxed exactly the same.  Place your stocks in the taxable account, and you can receive favorable tax rates (15%) on capital gains and dividends, and you won’t have any capital gains until you sell.  (If you’ve been burned by taxable distributions from equity mutual funds, it’s time for you to learn about ETFs.)

Keeping high growth stocks out of your IRA will also reduce your future RMDs and reduce the taxes that will have to be paid by your heirs.  Heirs receive a step-up in basis on stocks in a taxable account, but not in an IRA.  By placing bonds in your IRA, you can reduce future taxes in many ways.  This concept can often be difficult for people to grasp, so if you’d like an example, feel free to email me or give me a call.

4) Selling the oldest savings bonds.  Many retirees hold EE savings bonds but are not managing these bonds.  Some older bonds had fixed rates or guaranteed minimums, whereas bonds issued starting May 2005 currently pay only 0.50%.  (This resets every 6 months, and this rate is current through 10/31/2014.)  As a result, you’re better off selling your newer bonds and keeping the older ones (pre-2005) which have higher interest rates.  Don’t forget that the bonds are guaranteed to reach their face value in 20 years, so you may be rewarded by holding on to a 17 year old bond for a couple more years.  EE bonds will receive interest for up to 30 years, which is the maximum time you should hold bonds.  By selling the newer bonds, you will pay less in taxes compared to selling older bonds which have appreciated more.  Use the tools at TreasuryDirect.gov to keep track of the current values and interest rates on your EE bonds.

5) Failing to harvest losses on investments. While your heirs will receive a step-up in cost basis for an appreciated security, they will lose any tax benefits associated with a position at a loss.  Sell the position and redeploy the capital as needed to maintain your target asset allocation.  A loss can be used to offset any capital gains in that year, plus $3,000 can be used against ordinary income and any remaining loss will carry forward to future years.

New retirees can undermine their retirement planning if they ignore the impact of taxes.  It can be costly to make changes after the fact, so it’s best to make sure you have a plan in place before retirement.  It’s not a once and done event either, because managing taxes is an ongoing process.  Many people turn to a financial planner for selecting investments, and discover that they receive even greater benefits from other areas such as tax management.

Machiavelli and Happiness in an Age of Materialism

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Hence it is to be remarked that, in seizing a state, the usurper ought to examine closely into all those injuries which it is necessary for him to inflict, and to do them all at one stroke so as not to have to repeat them daily; and thus by not unsettling men he will be able to reassure them, and win them to himself by benefits. He who does otherwise, either from timidity or evil advice, is always compelled to keep the knife in his hand; neither can he rely on his subjects, nor can they attach themselves to him, owing to their continued and repeated wrongs. For injuries ought to be done all at one time, so that, being tasted less, they offend less; benefits ought to be given little by little, so that the flavour of them may last longer.

– Niccolo Machiavelli, The Prince (1505)

Machiavelli’s political treatise, The Prince, remains an interesting, at times brutish, study of human nature 500 years after being written. If you’ll grant me some liberty in interpretation, his advice to experience pain quickly and reward slowly applies nicely to today’s field of behavioral finance.

The Hedonic Treadmill is a psychological premise that people require constant effort to maintain satisfaction, or “happiness”, if you will. A related concept is Habituation, which is that we tend to have a baseline state of happiness, and that when events move us above or below that level, we gradually become used to the new situation and revert back to our previous levels of satisfaction. Both principles suggest that to increase and maintain happiness, we have to work at it continually.

Consumer spending is important to our economy, but at the household level, we’re spending more and more money to realize a middle class lifestyle. Economists look at things like the change in the price of a gallon of milk as inflation, but it might also be relevant to consider how living has changed for the typical family. In 1973, the average new house size was 1,660 square feet, compared to 2,679 square feet last year. Over the same time, the average household size has shrunk from 3.01 persons to 2.54. Today, we have many more bills – cell phone, internet, satellite TV – than existed 40 years ago.  These are all great improvements over previous technology, but the cost of a middle class lifestyle has likely grown well in excess of the reported inflation rates in the CPI.  But are we happier for the increased spending?

We experience a brief increase in happiness from buying new items, but habituation has two effects: (1) the enjoyment we get from a new item quickly wears off, and (2) once we do become accustomed to the “bigger and better” item, we are generally unwilling to replace it with a lower cost option. Once we have a smart phone, there’s no going back to a regular phone. After living in a 3,000 square foot house, a 2,000 square foot house feels too small. If you’ve owned a luxury car, you won’t want to drive a simpler car. Will a Kia get you to work as effectively as a Mercedes? Yes, of course, but that’s not the reason we buy an expensive car. We decide what we want and then we rationalize why we have to have it.

I chose the name Good Life Wealth Management, because I view money as a tool to help us enjoy life. Not in the materialistic sense of fancy cars or fine wine, but in the holistic pursuit of finding meaning and balance. The Good Life, then, is not achieved by the acquisition of items, but by enjoying a state of financial independence and using those resources to live fully. It’s my job to help investors find that freedom and I love my job. It’s the last thing I think about at night and the first thing I think about in the morning.

I share the following six principles to define what we stand for. This is how we can seek happiness and financial security in an age of materialism.  If these make sense to you, then I think our financial planning approach and sense of purpose will resonate strongly with your goals.

  1. Spend money on experiences rather than things. I went on a hot air balloon ride this summer. If I considered the cost for a one-hour flight, it was perhaps expensive. However, I have since spent many hours thinking about that wonderful experience and enjoying my photographs of that day. I’ll always have those memories.
  2. As Machiavelli suggests, take pain quickly and rewards slowly. If you decide to make spending cuts to be able to save more, make the cuts deep and immediate. If you want to save an additional $1,000 a month, you’re not going to get there by giving up a daily coffee. And you’re setting yourself up for continual frustration because you will have to make that sacrifice every day going forward. By making many small changes, it will feel like a death by 1000 cuts. Instead, have the courage to make a big move like downsizing or finding a different job. Once you adjust to the new change, it will be fine and it is not going to impact your happiness in the long-run. (To see an extreme example of a human’s ability to adapt, two friends recently completed a Buy Nothing Year, with interesting reflections on their experience.) Take your rewards slowly to enjoy them. Feed your Hedonic Treadmill gradually.
  3. Saving is not self-denial. Some people view saving and investing from a negative view – they only do it out of fear. Fear of falling behind, fear of not having enough, fear of dying broke. No one wants to experience any of those unpleasant things, but fear will only motivate you to save so much. And you’ll resent the saving because you’re doing it because you have to and not because you want to. Saving can be its own reward. Make it fun and a game to see how much you can save. If you want to be financially independent, take the steps that will get you there as soon as possible. Do it for yourself – the more you save, the faster you achieve your next goal. Be laser-focused, driven, and determined when you have a goal. Saving is a virtuous cycle when it becomes an ingrained habit.
  4. Money doesn’t define us and our value is not a number. If I did lose everything, I know I could make it all back. And I’d make it back even faster because I wouldn’t make all the mistakes I did the first time around! That doesn’t mean it’s okay to be reckless with investing, only that money is not the most important thing in life. And once you have money-making knowledge and skills, you realize that wealth is abundantly available for those willing to save and invest.
  5. Our concept of frugality was framed by our parents or grandparents who lived through the Great Depression in the 1930’s. They learned to be self-reliant and strong, but for some, those tough times created permanent fear and mistrust. (Can you feel fulfilled and happy if you bury cash in coffee cans in your back yard because you think banks will lose your money?)  The new frugality is about simplicity, optimism, and making the decision to place financial independence ahead of consumerism. It’s a positive choice and not a negative reaction based on hoarding, fear of loss, or mistrust of the system. Used properly, frugality is having the maturity to make decisions today that will be smart 10 years from now. It’s a recognition that “more stuff” does not create lasting happiness.
  6. Tis better to give than receive. Donate, volunteer, make a difference. Happiness comes from a sense of purpose and living to the best of your abilities. Daniel Kahneman found that higher income increased happiness, but only up to about $75,000. Above that level, individual differences prevailed. Money does not create happiness, but we do know what is the most common cause for unhappiness: loneliness. Connect with people. Use your money to visit friends, take someone to lunch, or travel and make new friends.

Is your money helping you move closer towards financial independence or is the rising tide of middle class materialism keeping those goals a distant dream?  If you’re not sure where to begin, give me a call and let’s get to work on your financial plan.

Retirement Withdrawal Rates

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If you’re close to retirement, a key planning question is How much can I withdraw from my portfolio annually?  Or in financial planning terms, what is a safe withdrawal rate?  It’s a challenging question because we don’t know future rates of return.  But what we do know is that you can’t just project “average” or historical returns in a straight line and use that as your basis for withdrawals.

Unlike a portfolio in accumulation, a portfolio under distribution is greatly dependent on the order of returns.  We might have a 7% average return over 30 years, but in certain rare circumstances, a portfolio under distribution could be wiped out if there were negative returns in the first handful of years.  This is known as sequence of returns risk.

Today, we have several reasons to believe that future returns may be lower than historical returns.  This impacts the level of withdrawal that we can safely achieve in a retirement portfolio.  In my planning process, I use projected returns rather than historical returns, because I am concerned that historical returns may over-estimate the likelihood of success.

This issue is too complex to address in the space of a blog post, but I want to educate as many people as possible about the challenges of funding a retirement in a lower return environment.  I have written a whitepaper on this subject and strongly encourage anyone interested in their retirement to read more:

Five Reasons Your Retirement Withdrawals are Too High

If you’re not close to retirement, this is still a relevant issue because the amount you need to accumulate is determined on your future retirement withdrawal rate.  A simple way to calculate your finish line is by multiplying the reciprocal of your withdrawal rate times your annual need.

For example, a 4% withdrawal rate (1/25), gives us a multiplier of 25.  A 5% withdrawal rate equals a multiplier of 20.  If your annual need is $100,000, your portfolio target would be $2,500,000 under a 4% withdrawal program. Decreasing the withdrawal rate from 5% to 4% would increase your portfolio target from $2 million to $2.5 million.  And that’s why the safe withdrawal rate matters to everyone seeking financial independence.

Socially Responsible Investing

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Socially Responsible Investing (SRI) has taken off in recent years as many investors want to align their portfolio to reflect their personal beliefs.  Fortunately, it is becoming easier to access high quality SRI investments and we are happy to incorporate our clients’ wishes whenever possible. This year, the amount invested in SRI funds surpassed $100 Billion and I think it’s safe to say that SRI has moved from being a small niche to a mainstream approach.

I want to emphasize two very important considerations for anyone contemplating adopting SRI principles for their portfolio.  First, you may want to support an idea or sector, such as Solar Energy.  You might think that by buying stock in a solar company, you are supporting that company, but you’re not actually providing new capital.  Other than in an Initial Public Offering (IPO), trading shares is just buying and selling between investors in the open market.  Although solar power is a great idea, many investors suffered losses in recent years when the stock market eventually recognized that solar panels had become a commoditized product with low profit margins. If you want to buy individual stocks, be sure that you buy the company based on its investment fundamentals and not just because you believe in the idea or think it will be “the next big thing”.  Otherwise, you’d be better off investing in regular funds and using your profits to make donations to the causes you want to support.

For most investors, I suggest you avoid individual stocks altogether and instead choose from the many Socially Responsible funds and ETFs that are available today.  This brings me to my second recommendation: when selecting an SRI Fund, always look at its holdings, weightings, and diversification. SRI guidelines limit which stocks a fund manager can select. For example, they may be prohibited from owning alcohol, tobacco, nuclear power, or defense companies. As a result, SRI funds are often heavily weighted in just two or three sectors of the economy. Today, many (if not most) SRI funds have their largest holdings in the technology industry. Concentrated funds can look attractive when those sectors are performing well, but often perform very poorly when their top sectors tumble.  Make sure your funds are well diversified and that you are not buying a sector fund in disguise.

For a core US equity holding, consider the iShares KLD 400 Social Equity (ticker: DSI).  This is an index Exchange Traded Fund (ETF) that holds the 400 largest US companies that have been screened for positive environmental, social, and governance qualities.  If you currently have a large cap mutual fund in your portfolio, you could use DSI as a replacement to add an overlay of socially responsibility, while maintaining a liquid and diversified portfolio.  With an expense ratio of 0.50%, it is a relatively cheap way to build a core SRI equity position compared to most actively managed mutual funds.

I would, of course, use several other SRI funds to build out a more complete portfolio.  While equity investing tends to get most of the attention in SRI, investors should also consider their fixed income holdings.  When you own the bond of a company or government, you are in fact a lender who has provided capital and receives interest from that entity.  So if you decide to embrace the Socially Responsible Investing approach, don’t forget to also include your bond funds.  Alternatively, you could work with an advisor such as myself to help select individual bonds and build a bond ladder for your portfolio.

Unfortunately, I do not expect an SRI portfolio to outperform a traditional asset allocation, and anticipate it may even lag over time. SRI reduces sector diversification, but also SRI funds tend to have a higher expense ratio than the ETFs we use for our core equity positions. Still, I admire what SRI aims to accomplish, which is to tell corporate management that as owners, shareholders demand companies do the right thing for the environment, human rights, and society. It’s clear that corporate lapses can contribute to increased risks for our economy, not to mention for the company itself. Too many mutual funds and ETFs are not proactively using their capacity as the largest shareholders to advocate for improved corporate governance. That’s a bigger issue than I can tackle as an advisor and investor, but my hope is that SRI will help apply pressure to corporate boards to do better.

Health Savings Accounts: 220,000 Reasons Why You Need One

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The Health Savings Account (HSA) is one of the best savings vehicles, yet remains underutilized by many investors. Used properly, you can get a tax deduction for your contributions, like a Traditional IRA, and be able to take your money out tax-free, like a Roth IRA. No other account has this remarkable benefit! And that’s why I’ve been telling clients about the HSA every chance I get, as well as contributing the maximum to my own HSA for the past 8 years.

Most people know that you can use your HSA to pay for co-pays, deductibles, prescriptions and other medical expenses not covered by your health insurance, including expenses for dental and vision care. But fewer people are aware of some of the longer-term benefits of an HSA which make it a very attractive tool to help fund your retirement.

In addition to IRS-qualified medical expenses, after age 65, you can take tax-free withdrawals from your HSA to pay for Medicare premiums for parts A, B, D, and a Medicare HMA. You can also use your HSA to pay for long-term care insurance premiums. If you’re still working after age 65, you can even use your HSA to pay (or reimburse) the employee costs of your employer health plan.

But why do you need an HSA? According to a 2014 study by Fidelity, the estimated cost of health care for a 65-year old couple is $220,000 in today’s dollars. This is the amount not covered by Medicare, and by the way, assumes zero nursing home expenses. Having tax-free dollars available in an HSA can fund these costs while helping retirees reduce their need for withdrawals from taxable sources such as their 401(k) or IRA to pay for medical expenses or insurance premiums.

If you are healthy today, you might not be thinking about an HSA, but it is still a valuable idea to accumulate pre-tax dollars in your HSA now to pay for your health insurance or LTC premiums in retirement. Many families were familiar with Flexible Spending Accounts, which were “use it or lose it”, so when HSAs became available, a lot of participants were still in the mode of contributing only their expected annual expenses. HSAs have no expiration date on contributions, yet I still hear some people say that they “don’t want to have too much money in their HSA”.

Prior to age 65, there is a 20% penalty for non-qualified withdrawals from an HSA. After age 65, the penalty is waived, but you will have to pay tax on any withdrawal for a non-qualified expense. It would obviously be preferable to take a tax-free withdrawal for a qualified expense, but if you were to need the funds for other purposes, then the account would be treated the same as a 401(k) or Traditional IRA. And that’s still a benefit, because you had an upfront tax-deduction followed by years of tax deferred growth. Unlike a Traditional IRA, however, there are no income restrictions on contributing to an HSA, so this is a tax deduction that many high income families miss. And there are no Required Minimum Distributions on an HSA.

The only negative is that the contribution limits are relatively low. For 2014, the maximum contribution is $3,300 for a single plan or $6,550 for a family plan. Account holders who are over age 55 but not enrolled in Medicare can contribute an additional $1,000 catch-up. Once you’re enrolled in Medicare (Part A or B), you are ineligible to fund an HSA. Not all high deductible health plans are HSA eligible, so please do not open an HSA until you have confirmed you can participate.

A high deductible plan is generally a good deal if you have few medical and prescription expenses and primarily want coverage in case of a major illness. On the other hand, if you have a lot of on going medical bills for your family, a high deductible plan may be more expensive if you will hit the annual out of pocket maximum each year.

Given the significant size of medical expenses in retirement, the high inflation rate of medical care, and the troubling state of future Medicare funding, starting an HSA early makes sense. Looking at the remarkable long-term tax benefits of an HSA, I suggest clients consider an HSA on equal ground with funding a Roth or Traditional IRA.

Student Loan Strategies: Maximizing Net Worth

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For today’s young professionals, student loans have grown to become a significant financial obstacle. A common question is if it makes sense to pay off these loans early.

First, before considering making additional payments, I’d counsel investors to:
1) have paid off any credit card balances;
2) establish an emergency fund of at least 6 months reserves, and 12 months if their income is unknown or employment is in any way tentative; and
3) save up for a house down payment, if home ownership is a goal.

Having the cash available to pay off a loan is terrific, but I caution people to not forgo their retirement savings in lieu of their student loans.  I know that for many recent graduates it seems appealing to get out from under those loans as quickly as possible, so they think they should wait on contributing to their 401(k) and put as much as possible towards the loans.  When you look at the effects of compounding, however, the money you invest in your 20’s and 30’s into your retirement accounts is much more valuable than the same dollars invested in your 40’s and 50’s.  Often times your net worth will be higher by starting to invest earlier and taking your time with the loan repayment.  And of course, you can test this projection with most financial planning software programs or a spreadsheet.

Another factor to consider on the decision to repay is the tax deduction.  For 2014, you can deduct up to $2,500 in student loan interest from your federal tax return.  This deduction is limited, however, based on your modified adjusted gross income (MAGI).

Single taxpayer: full deduction below $65,000 MAGI, phaseout $65,000 – $80,000
Married filing jointly: full deduction below $130,000 MAGI, phaseout $130,000 – $160,000

I would note that student loan rates are variable and have crept up in the past couple of years. Additionally, as your career progresses and income increases, many families lose their eligibility to take advantage of this tax deduction. I point this out because another important question is: Which is better to pre-pay, student loans or your home mortgage?  The mortgage interest deduction does not have an income limit and is not capped at $2,500.  Also, most mortgages are fixed, not variable.  That’s why I suggest most borrowers make extra payments towards student loans rather than their home mortgage.

For those who can receive the student loan interest tax deduction, it lowers your cost of borrowing, so I would consider the after-tax cost of borrowing when deciding if early loan repayment makes sense.  Most borrowers I counsel have multiple loans at various interest rates, so it is often best to send extra payments towards the student loan with the highest interest rate and make only the minimum payments on the other loans.  Over time, we will pay off the highest rate loan first.  Then that monthly payment can be applied towards other loans.  Additionally, paying off one loan first will reduce your total monthly minimum payments, which is highly valuable should you have any sort of temporary setback like a job loss.

The earlier you can make extra payments, the better.  If your interest rate is 5%, paying an extra $1,000 today will mean that you are saving $50 in interest in every year going forward.  Early principal payments will shorten the length of the loan more dramatically than extra payments made in future years.  If you scrimp a bit now and make extra payments, you will reduce your total interest payments over the life of the loan.

Be careful about consolidating loans. Most people consolidate to lower their monthly payment amount, but inadvertently add years to their loans and thousands in interest payments. Additionally, if you are consolidating Federal loans, such as Stafford Loans, into private loans, you will be giving up access to Federal loans benefits such as forbearance, income-based payments, or loan forgiveness. Before consolidating, make sure you are not going to lose any pre-paid interest if you are ahead on your payment schedule.

Many people think a financial plan deals only with the Asset side of your balance sheet, but some of the most important choices are about how to manage your Liabilities. Student loans are an investment in yourself, so make sure your subsequent cash flow decisions are helping to maximize your net worth in the long run.

Catching Up for Retirement

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A common rule of thumb is to save 10% of your income each year for retirement. If you started in your 20’s and invested for 30-40 years, this may well be adequate. But if you currently aren’t saving at this level, 10% can seem like a daunting amount. And if you got a late start or had some financial set-backs along the way, you may need to save even more.

What can a late starter do to get caught up on their retirement goals? Here are 5 ideas to help you take positive steps forward.

1) Save half your raise. When you get a raise, before you receive your next paycheck, increase your 401(k) contribution by 50% of the raise. You’ll still see an increase in your paycheck, but have a better chance of keeping the money which is automatically withheld, rather than taking the cash and hoping to have some left over to invest at the end of the year. This strategy works well for careers which have predictable, steady raises.

2) Downsize. If your kids are out of the house, you may not be needing all the space in your current home. By downsizing to a smaller home, you may be able to free up some home equity and invest those proceeds into investments with a potentially higher return. Additionally, a smaller home will have much lower expenses, including utilities, insurance, and property taxes.

If you really want to make a big impact on your finances, you have to look at the big expenses. For someone in their 50’s or 60’s, cutting out a daily latte just isn’t going to make enough of a difference. Many people have an emotional attachment to their home, which is completely understandable. However, if downsizing makes sense for you, you should try to make that change as soon as possible. Your home is one of your largest expenses and you want to make sure that it isn’t holding you back from achieving other important goals.

3) Spousal IRAs. Most people are aware of the catch-up provisions available after age 50 in their 401(k) or 403(b) plans at work, but many couples aren’t aware of their eligibility to fund an IRA for a spouse who doesn’t work or who doesn’t have a retirement plan. For 2014, the IRA contribution limits are $5,500 or $6,500 if over age 50. Here are the rules for some common scenarios:

– If neither spouse is covered by an employer plan at work, then both can contribute to a Traditional IRA and deduct the contribution, with no income restrictions. Both can contribute to an IRA, even if only one spouse works.
– If only one spouse is covered by an employer retirement plan, then the other spouse can contribute to a deductible Traditional IRA, if their joint MAGI is below $181,000 (2014).
– My personal favorite: if either spouse does not have any IRAs, that spouse can contribute to a Back-Door Roth IRA. There are no income restrictions to this strategy.

4) Social Security for divorcees. A common reason why individuals are behind in their retirement saving is divorce. If you were married for at least 10 years, you are eligible for a Social Security benefit based on your ex-spouse’s earnings. Many divorcees are not aware of this because spousal benefits are never listed on your Social Security statement.

The spousal benefit does not impact your ex-spouse in any way and they will not know you are receiving a spousal benefit. You do not have to wait for (or even know if) your ex-spouse has started to receive their benefits. We’ve often found that someone who was out of the workforce to raise a family or had a limited earnings history will have a very small Social Security benefit based on their own earnings and isn’t aware they are eligible for a benefit from a high-earning ex-spouse.

Details: you must be at least 62, unmarried, and the spousal benefit will only apply if greater than your own benefit. To apply, you will need your ex-spouse’s name, date of birth, social security number, beginning/ending dates of marriage, and place of marriage.
See: http://www.ssa.gov/retire2/divspouse.htm

5) Don’t get aggressive. For many investors, the temptation is to try to eke out extra return from their investment portfolio to make up for the fact that they are behind. They take a very aggressive approach or try to day trade. This is very risky and the results can be devastating. Invest appropriately for your risk tolerance, objectives, and time horizon, but stay diversified and don’t gamble your nest egg.