Creating Retirement Income

Creating Retirement Income

Posted On November 5, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

Today, we are starting a five-part series to look at creating retirement income. There are various different approaches you can take when it is time to retire and shift from accumulation to taking withdrawals from your 401(k), IRA, or other investment accounts. It is important to know the Pros and Cons of different approaches and to understand, especially, how they are designed to weather market volatility.

In upcoming posts, we will evaluate SPIAs, the 4% rule, a Guardrails Approach, and 5-Year Buckets. Before you retire, I want to discuss these with you and set up an income plan that is going to make the most sense for you. Today, let’s start with defining the challenges of creating retirement income.

Sequence of Returns Risk

During accumulation, market volatility is not such a bad thing. If you are contributing regularly to a 401(k) and the market has a temporary Bear Market, it is okay. All that matters is your long-term average return. If you invest over 30-40 years, you have historically averaged a return of 8-10 percent in the market. Through Dollar Cost Averaging, you know that you are buying shares of your funds at a more attractive price during a drop.

Unfortunately, market volatility is a big problem when you are retired and taking money out of a portfolio. You calculated your needs and planned to take a fixed amount of money out of your portfolio. If the market averages 8% returns, can you withdraw 8%? That should work, right?

Let’s look at an example. You have a $1 million portfolio, you want to take $80,000 a year in withdrawals. Imagine you retired in 2000, having reached your goal of having $1 million! Here’s what your first three years of retirement might have looked like, with $80,000 annual withdrawals:

  • Start at $1,000,000, 9% market loss = $830,000 ending value
  • Year 2: start at $830,000, 12% market loss = $650,400 ending value
  • Year 3: start at $650,400, 22% market loss = $427,312 ending value

This would blow up your portfolio and now, your $80,000 withdrawal would be almost 20% of your remaining funds. This is Sequence of Returns Risk: the order of returns matters when you are taking income. If you had retired 10 years before these three bad years, you might have been okay, because your portfolio would have grown for a number of years.

Because a retiree does not know the short-term performance of the stock market, we have to take much smaller withdrawals than the historical averages. It’s not just the long-term average which matters. Losses early in your retirement can wreck your income plan.

Longevity Risk

The next big risk for retirement income is longevity. We don’t know how long to plan for. Some people will have a short retirement of less than 10 years. Others will retire at 60 and live for another 40 years. If we take out too much, too early, we risk running out of funds at the worst possible time. There is tremendous poverty in Americans over the age of 80. They didn’t have enough assets and ran out of money. Then they end up having to spend down all their assets to qualify for Medicaid. It’s not a pretty picture.

And for you macho men who intend to die with your boots on – Great. You may wipe out all your money with your final expenses and leave your spouse impoverished. She will probably outlive you by 5-10 years. That’s why 80% of the residents in nursing homes are women. You need to plan better – not for you, but for her.

Read more: 7 Ways for Women to Not Outlive Their Money

We plan for a retirement of 30 years for couples. There’s a good chance that one or both of you will live for 25-30 years if you are retiring by age 65. There are different approaches to dealing with longevity risk, and we will be talking about this more in the upcoming articles.

Inflation Risk

Longevity brings up a related problem, Inflation Risk. At 3% inflation, your cost of living will double in 24 years. If you need $50,000 a year now, you might need $100,000 later, to maintain the same standard of living.

A good retirement income plan will address inflation, as this is a reality. Luckily, we have not had much inflation in recent decades, so retirees have not been feeling much pressure. In fact, most of my clients who start a monthly withdrawal plan, have not increased their payments even after 5 or 10 years. They get used to their budget and make it work. Retirement spending often follows a “smile” pattern. It starts high at the beginning of retirement, as you finally have time for the travel and hobbies you’ve always wanted. Spending typically slows in your later seventies and into your eighties, but increases towards the end of retirement with increased health care and assistance costs.

When we talk about a 4% Real Rate, that means that you would start at 4% but then increase it every year for inflation. A first year withdrawal of $40,000 would step up to $41,200 in year two, with 3% inflation. After 30 years (at 3% inflation), your withdrawal rate would be over $94,000. So, when we talk about a 4% withdrawal rate, realize that it is not as conservative as it sounds. Even at a low 3% inflation rate, that works out to $1,903,016 in withdrawals over 30 years. It’s a lot more than if you just were thinking $40,000 times 30 years ($1.2 million).

Periods with high inflation require starting with a lower withdrawal rate. Periods with low inflation enable retirees to take a higher initial withdrawal amount. Since we don’t know future inflation, most safe withdrawal approaches are built based on the worst historical case.

Invest for Total Return

There is one thing which all of our retirement income approaches agree upon: Invest for Total Return, not Income. This is counter-intuitive for many retirees. They want to find high yielding bonds, stocks, and funds. Then, they can generate withdrawal income and avoid selling shares.

It sounds like it would be a rational approach. If you want a 5% withdrawal rate, just buy stocks, bonds, and funds that have a 5% or higher dividend yield. Unfortunately, this often doesn’t work as planned or hoped!

Over the years, I’ve invested in everything high yield: dividend stocks, preferred stocks, high yield bonds, Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), Closed End Funds, etc. They can have a small place in a portfolio, but they are no magic bullet.

Problems with Income Investing

  • Value Trap. Some stocks have high yields because they have no growth. Then if they cut their dividends, shares plummet. Buy the highest dividend payouts and your overall return is often less than the yield and the share price goes no where. (Ask me about the AT&T shares I’ve held since 2009 and are down 14%.)
  • Default risk. Many high yield investments are from highly levered companies with substantial risk of bankruptcy. Having 5% upside and 100% downside on a high yield bond or preferred stock is a lousy scenario. When you do have the occasional loss, it will be greater than many years of your income.
  • Poor diversification. High yield investments are not equally present in all sectors of the economy. Often, an income portfolio ends up looking like a bunch of the worst banks, energy companies, and odd-ball entities. These are often very low quality investments.

Instead of getting the steady paycheck you wanted, an income portfolio often does poorly. When your income portfolio is down in a year when the S&P is up 10-20%, believe me, you will be ready to throw in the towel on this approach. Save yourself this agony and invest for total return. Total return means you want capital gains (price appreciation) and income.

For investors in retirement accounts, there is no tax difference between taking a distribution from dividends versus selling your shares. So, stop thinking that you need to only take income from your portfolio. What you want is to have a diversified portfolio and a good long-term rate of return. Then, just make sure you are able to weather market volatility along the way.

Read more: Avoiding The High Yield Trap

Ahead in the Series

Each of the retirement income approaches we will discuss have their own Pros and Cons. We will address each through looking at how they address the risks facing retirees: Sequence of Returns Risk, Longevity Risk, and Inflation Risk. And I’ll have recommendations for which may make the most sense for you. In the next four posts, I’ll be explaining SPIAs, the 4% Rule, a Guardrail Approach, and 5-Year Buckets.

Even if you aren’t near retirement, I think it’s vitally important to understand creating retirement income. Retirement income establishes your finish line and therefore your savings goals. If you are planning on a 4% withdrawal rate, you need $1 million for every $40,000 a year in retirement spending. Looking at your monthly budget, you can calculate how much you will need in your nest egg. Then we can have a concrete plan for how much to invest and how we will get there. Thanks for reading!

Read More
maximize FAFSA financial aid

Maximize FAFSA Financial Aid

Posted On October 25, 2020 By Scott Stratton, CFP(R), CFA In College Savings /  

We are going to discuss three specific strategies:

  • Moving Assets from reportable sources to non-reportable locations
  • Reducing cash by paying down debt
  • Avoiding assets in the child’s name

Before we get to the details, a few caveats. First, some of the expected family contribution is based on the parent’s income. If you have a high income, your reported assets may not make a big difference in financial aid. Second, it’s possible that the college’s solution to your financial need will be to offer more loans, rather than a scholarship. We want to be careful about taking large loans for college, as these are increasingly becoming a significant burden for students and parents. Some schools have a generous amount of need-based financial aid available and at those schools, these strategies may increase the scholarships your student receives.

Non-Reportable Assets on the FAFSA

Non-reportable assets include:

  • All Qualified Retirement Accounts, such as 401(k), 403(b), IRA, Roth, SEP, and SIMPLE plans
  • Your home
  • Small businesses
  • Household items and personal possessions

If you are planning on a child going to college in a few years, you may want to put as much as you can into your non-reportable assets, such as retirement accounts, and not into a savings account or taxable investment account. If you have a lot of cash, look at maximizing your 401(k) and IRAs to shift your investments into retirement accounts.

Paying Down Debt

If you have credit cards, car loans, or a home mortgage, that debt does not get considered on the FAFSA. Your cash, however, will be counted towards your expected Family Contribution. If you want to maximize your eligibility for student aid, you could pay down debt. This will reduce the cash you have as a reportable asset. And your home, cars, and personal assets are not considered on the FAFSA.

Obviously, you want to make any changes well in advance of applying for financial aid and make sure you keep enough cash for your emergency fund.

Avoid Assets in the Child’s Name

Assets of the child will have an expected contribution of 20% a year, whereas an asset of the parent has a maximum contribution of 5.64%. Having a lot of money in the name of a college kid will reduce their financial aid eligibility. This is a problem with the UGMA account for minors – colleges expect that this account will be fully available for tuition and expenses.

If your pre-college student has earned income, it may be preferable to put their assets into a Roth IRA than into a savings account. In the year of the FAFSA application, a retirement contribution is typically counted as eligible income, but not as a reportable asset. The assets in a Roth IRA accumulated before college are not a reported asset. This way, the money your child earns before college can start to grow for them and not get sucked into college expenses.

College funding is an important part of financial planning. A lot of people think college planning means getting a 529 plan. There is more to it than just 529 plans. By managing your reportable assets, you can maximize your FAFSA financial aid.

Read More
Questions to Ask a Financial Advisor

Questions To Ask A Financial Advisor

Posted On October 20, 2020 By Scott Stratton, CFP(R), CFA In Financial Planning /  

I recently saw an article on 10 Questions to Ask a Financial Advisor, as a way to interview prospective advisors. The article is on point, and I hope that future clients will ask me these questions. Doing so will enable them to understand my process and recognize the value I can provide. Let me save you the time by providing my answers here.

1. Are you a Fiduciary?

Yes, I am a Fiduciary. I am legally required to place client interests ahead of my own. As an independent Registered Investment Advisor, I am not tied to any single company or product. My goal is to do the best I can to help every client.

2. How do you get paid?

On portfolios above $250,000, the asset fee is 1% a year. This is charged at the beginning of each quarter, at 0.25%. For clients who just want a financial planning engagement (without $250,000 in investments), the quarterly cost is $2500. My clients know exactly how much they pay me and have the right to leave at any time if they are unsatisfied. By charging an annual fee on the value of your portfolio, our incentives are aligned. If your account goes up, I get paid a bit more. And if your account goes down, I make less. I think this is mutually beneficial and creates accountability. My goal is to have a long-term relationship with each client.

Read more: The Price of Financial Advice

3. What are my all-in costs?

Aside from the fee described above, I do not charge any other fees, planning charges, or receive investment commissions. The core of our portfolios are low-cost funds from companies like Vanguard, iShares, and SPDRs. We build portfolio models in-house, so you will never be charged an outside management fee or “wrap” fee. Some other firms will charge you $2,000 for an initial plan, followed by a 1 to 1.5% management fee, and then outsource your portfolio to someone else who will ding you another 1% to manage your investments! Our focus is on keeping your investment costs low.

4. What are your qualifications?

I hold the Certified Financial Planner (CFP) and Chartered Financial Analyst (CFA) designations. I received a Certificate in Financial Planning from Boston University. Since 2004, I have been a full-time financial advisor. Before that, I taught at several colleges and approach my practice as an educator. My academic background includes a Bachelors degree from Oberlin College, and a Masters degree and Doctorate in music from the University of Rochester.

You should also look up an advisor on the SEC’s Investment Advisor Public Disclosure website to check if they have any disciplinary record, bankruptcies, or legal settlements. I do not.

5. How will our relationship work?

Planning comes first. A financial plan can help you see your goals clearly and develop concrete steps to achieve them. Investment policy is the product of financial planning so it has to be second. I work with a small group of families so I can do my best work and provide a high level of service. Financial planning is a long-term process, not a once and done event.

We begin with an in-depth Discovery Meeting to learn both the quantitative details about your financial situation as well as the qualitative goals, needs, and preferences you have for your money and your life. We will gather statements, tax returns, and other documents to analyze. All clients will complete a Finametrica Risk Profile and we will go over the results together. Based on your objectives, we use a modular planning process to address the areas which are most important and relevant to your situation.

In the first year, we have a lot of work to do in establishing your plan. Starting in year two, we will meet twice a year for monitoring and ongoing planning. I encourage clients to reach out to me whenever they have questions about financial topics or if their situation changes.

6. What’s your investment philosophy?

Investors are best served by a passive, long-term investment strategy. Our role is to manage a diversified, target asset allocation for buy and hold investors. We create and manage a series of Portfolio Models to meet the differing needs and risk preferences of our clients.

Within each Portfolio Model, we employ a Core + Satellite investment strategy. Core holdings are low-cost Exchange Traded Funds, in primary categories such as US Large Cap Stocks, US Small Cap Stocks, International Developed Equities, Investment Grade Bonds, and Cash. Satellite holdings are more tactical and may vary from year to year depending on their relative value and attractiveness. Satellite positions may include ETFs, mutual funds, or alternative investments, such as Emerging Markets, Real Estate, Commodities, Preferred Stocks, Convertible Bonds, Floating Rate Income, or other categories or strategies.

We do not believe that we can add value through market timing, picking individual stocks, sector rotation, or speculative strategies. We see little evidence that such strategies are beneficial for investors, especially when we consider the additional risks associated with them.

7. What asset allocation will you use?

Our models include the target allocations below, to be determined by your situation. Each model typically has 10-15 Exchange Traded Funds or Mutual Funds and is diversified across thousands of securities.  

  • Ultra-Equity: 100% Equity / 0% Fixed Income
  • Aggressive: 85% Equity / 15% Fixed Income
  • Growth: 70% Equity / 30% Fixed Income
  • Moderate: 60% Equity / 40% Fixed Income
  • Balanced: 50% Equity / 50% Fixed Income
  • Conservative: 35% Equity / 65% Fixed Income

8. What investment benchmarks do you use?

We use two benchmarks: for stocks, the MSCI World Index Total Return, and for fixed income, the Barclays US Aggregate Bond Index.

Read more: How a Benchmark Can Reduce Home Bias

9. Who is your custodian?

Charles Schwab & Co. will hold your accounts. We think it is a beneficial arrangement where you can work with an independent fiduciary advisor, and also have the strength, low-cost, and technology from one of the largest financial institutions in the world.

10. What tax hit do I face if I invest with you?

We will look at your individual situation and carefully consider taxes in our transfers, trades, and investment strategy. Working with high-net worth families, we aim for tax‐efficiency through the implementation of asset location, low‐turnover funds, tax loss harvesting, and tax‐favorable investment vehicles. We rebalance portfolios typically once a year, to avoid creating short-term capital gains.

Read More: 9 Ways to Manage Capital Gains

Have other questions for me? Drop me a note! I’m happy to chat.

Read More
Tax Strategies Under Biden

Tax Strategies Under Biden

Posted On October 2, 2020 By Scott Stratton, CFP(R), CFA In Tax Strategies /  

With the Presidential election next month, investors may be wondering about what might happen to their taxes if Joe Biden were to win. Let’s take a look at his tax plan and discuss strategies which may make sense for high income investors to consider. I am sharing this now because we might consider steps to take before year end, which is a short window of time.

Let’s start with a few caveats. I am not endorsing one candidate or the other. I am not predicting Biden will win, nor am I bashing his proposals. This is not a political newsletter. Even if he is elected, it is uncertain that he will be able to enact any of these proposals and get them passed through the Senate. The discussion below is purely hypothetical at this point.

My job as a financial planner is to educate and advise my clients to navigate tax laws for their maximum legal benefit. I create value which can can save many thousands of dollars. Some of Biden’s proposals have the potential to raise taxes significantly on certain investors. If he does win, we may want to take steps before December 31, if we think his proposals could be enacted in 2021. I would do nothing now. I expect no significant changes under a continued Trump administration, but I will also be looking for tax strategies for that scenario.

Other Biden proposals will lower taxes for many people. For example, he proposes a $15,000 tax credit for first-time home buyers. I am largely ignoring the beneficial parts of his tax plan in this article, because those likely will not require advance planning.

Tax Changes Proposed by Biden

1. Tax increases on high earners. Biden proposes to increase the top tax rate from 37% back to 39.6%. He would eliminate the Qualified Business Income (QBI) Deduction, which would penalize most self-employed business owners. He would limit the value of itemized deductions to a 28% benefit. For those with incomes over $1 million, he proposes to increase the long-term capital gains and qualified dividend rate to the ordinary income rate, an increase from 20% to 39.6%, plus the 3.8% Medicare surtax. He proposes to add 12.4% in Social Security payroll taxes on income over $400,000.

Strategies:

  • Accelerate earnings, capital gains, and Roth Conversions into 2020 to take advantage of current rates.
  • Accelerate tax deductions into 2020, such as charitable donations or property taxes. Establish a Donor Advised Fund in 2020.
  • Increase use of tax-free municipal bonds, and use ETFs for lower taxable distributions. Shift dividend strategies into retirement accounts.
  • Use Annuities for tax deferral if you anticipate being in a lower bracket in retirement.

2. 26% retirement contribution benefit. Presently, your 401(k) contribution is pre-tax, so the tax benefit of a $10,000 contribution depends on your tax bracket. If you are in the 12% bracket, you would save $1,200 on your federal income taxes. If you’re in the 37% bracket, you’d save $3,700. Biden wants to replace tax deductibility with a flat 26% tax credit for everyone. On a $10,000 contribution to a 401(k), everyone would get the same $2,600 tax credit (reduction). This should incentivize lower income folks to put more into their retirement accounts, because their tax savings would go up, if they are in the 24% or lower bracket. For higher earners, however, this proposal is problematic. What if you only get a 26% benefit today, but will be in the 35% bracket in retirement? That would make a 401(k) contribution a guaranteed loss.

Strategies:

3. End the step-up in cost basis on inherited assets. Currently, when you inherit a house or a stock, the cost basis is reset to its value as of the date of death. Under Biden’s plan, the original cost basis will carry over upon inheritance.

Strategies:

  • If parents are in a lower tax bracket than their heirs, they may want to harvest long-term capital gains to prepay those taxes.
  • Life Insurance would become more valuable as death benefits are tax-free. Or Life Insurance proceeds could be used to pay the taxes that would eventually be due on an inherited business or asset. Read more: The Rate of Return of Life Insurance.

4. Cut the Estate Tax Exemption in half. Presently, the Estate/Gift Tax only applies on Estates over $11.58 million (2020). Biden wants to cut this in half to $5.79 million (per spouse).

Strategies:

  • If your Estate will be over $5.79 million, you may want to gift the maximum amount possible in 2020. Alternatively, strategies such as a Trust could be used to reduce estate taxes. (For example, the Intentionally Defective Grantor Trust (IDGT) or Grantor Retained Annuity Trust (GRAT).)
  • Be sure to use all of your annual gift tax exclusion, presently $15,000 per person.
  • Establish 529 Plans, which will be excluded from your estate.
  • Shift Life Insurance out of your Estate, using an Irrevocable Life Insurance Trust (ILIT).

While we don’t know the outcome of the election, there could be valuable tax strategies under Biden. We will continue to analyze economic proposals from both candidates to develop planning strategies for our clients. When there are significant changes in tax laws, we want to be ahead of the curve to take advantage wherever possible.

Read More
When To Sell A Fund

When to Sell a Fund

Posted On September 27, 2020 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

As part of monitoring your investments, you should have defined reasons when to sell a fund. It is important to distinguish between market timing and valid reasons for selling. Don’t sell an index fund and buy an actively managed fund just because the active fund has outperformed recently. That is performance chasing – and you need to guard against this.

There are a couple of scenarios when you might want to sell a fund, primarily if it is to fix your portfolio. There is probably not a bad time to do this, although investors often agonize over the timing of moves. We cannot predict the future. If you know your portfolio has problems, make those changes and move on.

Three Sales to Fix Your Portfolio

First, if you have narrow funds, such as a sector fund, I would suggest you sell those and get into a broader index fund. If you are up, and have a nice gain, go ahead and sell. Don’t wait until the fund or stock has tanked. If it has tanked, take your loss and learn a lesson. You may hope that it will come back, but hope is not a good investment rationale. While you are waiting for it to come back, perhaps you could be growing your portfolio in an index fund.

I’m not going to recommend that you try to own individual stocks in your portfolio. That is speculative and a distraction for most investors to growing your wealth. I know many millionaires who invest in funds, but not many who got there with individual stocks. The majority of people who are trading stocks have tiny accounts. According to the NY Times, the popular trading app, Robinhood has only an average account of $4,800. Focus on your accumulation and being a market participant, not a speculator. If you’ve had good luck with individual stocks, take your gains and get into index funds. 

Second, if you are invested in a fund or product that has high expenses, switch to a low-cost index fund. For example, if you have an actively managed fund, an A-share mutual fund with 12b-1 fees, or a fund in a Variable Insurance product, your expense ratio might be 0.75%, 1.00% or more a year. An index fund might be one-tenth of that, 0.10% or less for many categories. When your goal is long-term growth through market participation, costs are a direct drag on your performance. That’s a good reason to sell.

Interestingly, the average active manager often (slightly) beats their benchmark before fees. It’s just that the drag of a 1% expense ratio, in a market that returns 5% or 10%, eats up all the benefits the managers can create. Over time, low expenses are correlated with better performance.

Third, you may want to sell some of your funds to establish your target asset allocation. Most of your performance is based on your overall asset allocation. I see many younger investors who start out 100% in stocks and as they grow their wealth, eventually realize that they need some bonds. Other investors have some bonds, but no target allocation to use for rebalancing. So, start with your recipe first and adjust your funds to fulfill your target allocation. Otherwise, you end up with a poorly diversified portfolio.

Staying Invested

If you are already invested in a low cost, diversified index fund, why sell it ever? I can think of two good reasons: rebalancing and tax loss harvesting. Outside of that, investors can do quite well by having little or no turnover and sticking with low cost Index funds for not just years, but decades.

What aren’t reasons for a long-term investor to sell? Coronavirus. Elections. Business cycles. News.

Sure, those things can impact stock prices in the short-term. But staying the course in an Index Fund seems to work better than any other strategy. So, yes to selling sector funds, single stocks, and high-expense funds to replace them with an Index Fund. Yes to the occasional sale for rebalancing or tax loss harvesting. Outside of those reasons, try to keep your diversified allocation and stick with your index funds. Now, if you are within five years of retirement and are concerned about risks to your retirement income, let’s talk about how to make sure you are on the right path.

I am posting this because right now volatility seems to be picking up into the election. And over the next two months, I worry that a lot of investors are going to feel spooked. You’re going to hear a lot of opinions about what is going to happen. And markets could, indeed, go down. That’s always a possibility. That’s the inescapable reality of being an investor. But, our approach is to stay the course in turbulent times and be patient. As unique as today’s challenges are, there were unique challenges before. Markets prevailed.

Read More
Retirement Withdrawals Without Penalty

Retirement Withdrawals Without Penalty

Posted On September 16, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

If you have multiple retirement accounts, when can you start withdrawals without penalty? This is very important if you want to retire before age 59 ½ and be able to access your money. The rules vary by the type of account, so advance preparation can make it easier to plan your withdrawals.

In our retirement income planning, we carefully choose the order of withdrawals. This can make a big difference in your tax bills. It’s also helpful to have multiple types of accounts so you can select from capital gains, tax-deferred accounts, and tax-free accounts. Let’s start with the early retirement penalties, by account type.

Five Retirement Plans with Different Rules

  1. 401(k) and 403(b): 10% penalty on distributions prior to age 59 ½.
  2. A 457 Plan can be accessed after you retire without penalty, regardless of your age. This is the easiest plan for accessing your money.
  3. Traditional IRA: 10% penalty for distributions prior to age 59 ½. This also applies to a SEP-IRA.
  4. SIMPLE IRA: 10% penalty prior to age 59 ½. Additionally, any distributions within the first two year of participation are subject to a 25% Penalty. Ouch. Don’t do that.
  5. Roth IRA. 10% penalty on earnings before age 59 ½, AND the five-year rule. You must have had a Roth open for five years before taking penalty-free withdrawals. So, if you open your first Roth at age 57, you’d have to wait until age 62 to get the tax-free benefit. However, you can access your principal at any time without tax or penalty. It is only when you start drawing down your earnings that the tax and penalty might apply. To withdraw tax-free and penalty-free, you must be over 59 ½ and have had a Roth for at least five years.

Read more: The Secret Way to Contribute $35,000 to a Roth IRA

Exceptions to the Penalty

  1. For 401(k) and 403(b) Plans: if you are at least age 55 and have separated from service, the penalty is waived. This means that if you retire between 55 and 59 ½, you can access your account without penalty. You would lose this exception if you roll your money into an IRA.
  2. 72(t) / Substantially Equal Periodic Payments (SEPP). If you are before age 55 and want to access your 401(k), 403(b), or Traditional IRA, you can take Substantially Equal Periodic Payments and waive the penalty. This means that you commit to taking the same amount from your account, annually, for at least five years or until age 59 ½, whichever is longer. Even if you later don’t want or need the distribution, you must continue to withdraw the same amount.  
  3. You may be able to avoid the 10% Penalty on an IRA or 401(k)/403(b) distribution if you qualify for these exceptions:
    • Total and Permanent Disability
    • An IRS Levy
    • Unreimbursed Medical Expenses in excess of 10% of AGI
    • Qualified Military Reservists called to Active Duty
  4. There are some exceptions which are available to IRAs (including SEP and SIMPLE), but not allowed from a 401(k) or 403(b). For these exceptions, you may want to roll your 401(k) into an IRA to qualify.
    • Qualified higher educational expenses
    • Qualified first-time homebuyers, up to $10,000
    • Health insurance premiums paid while unemployed

Full List from IRS: Exceptions to Tax on Early Distributions

Using Exceptions and Planning Your Income

I’m happy to let people know about these exceptions for retirement withdrawals without penalty before age 59 1/2. However, you should be very careful about tapping into your retirement accounts in your 30’s, 40’s or 50’s. This money needs to last a lifetime. I sometimes hear of people who take from their 401(k) accounts to buy a car or build a pool. And they have no idea that taking $50,000 now is stealing $400,000 from their future. Here’s the math: At 8%, your money will double every 9 years. That’s the Rule of 72. $50k will become $100k in 9 years, then $200k in 18 years, and $400k in 27 years. (Yes, this is a hypothetical rate of return, not a guarantee.)

The order of withdrawals does matter when planning your retirement income. While we can work to avoid the 10% penalty before age 59 ½, distributions from “Traditional” retirement accounts are still taxable as ordinary income. It’s often better to access your taxable accounts first. When eligible for long-term capital gains rate, that will be lower than IRA distributions which are taxed as ordinary income. And you have a cost basis on a taxable position, so only a portion of your sale ends up as a taxable gain.

Many retirees avoid touching their retirement accounts until they have to take Required Minimum Distributions. RMDs used to be at age 70 ½, but now are age 72. If there are years when you are in a low tax bracket (sabbatical, retired, year off, etc.), it may make sense to do a partial Roth Conversion. Start shifting money from a tax-deferred account into a tax-free account and save yourself on future taxes.

Once you reach age 72, you could be subject to a lot of taxes from RMDs. That’s the problem with being too good at waiting to start distributions from your retirement accounts. You’re creating a bigger tax bill for yourself later. While you are accumulating assets, it pays to plan ahead and know when and how you will be able to actually access your accounts. Have a question about retirement withdrawals without penalty? Let me know how I can help.

Read More
457 403b Plan

Choosing a 457 or a 403(b) Plan

Posted On September 13, 2020 By Scott Stratton, CFP(R), CFA In Retirement Planning /  

Does your employer offer both a 403(b) and a 457 Plan? What should you do and what is a 457 anyways? A 457(b) Plan is an employer sponsored retirement plan for state or local government employees. It is a pre-tax, salary deferral plan, with an annual contribution limit of $19,500. Sounds just like a 401(k) or 403(b), right? Yes, but with one very interesting difference.

If you have more than one 401(k) or 403(b), your combined contribution to all 401(k) and 403(b) accounts cannot exceed $19,500 a year. 457 Plans are not included in this rule. That means that if you work for a government employer who offers both a 403(b) and a 457, you can contribute the maximum to both!

IRS Publication 4484: Choose a Retirement Plan for Employees of a Tax-Exempt Government Entity

457 Versus 403(b)

Besides the amazing tax-savings of doubling your contributions, there are a couple of other unique features of 457 plans.

The 457 has the same catch-up feature as a 403(b). Participants age 50 and higher can contribute an extra $6,500 a year. Additionally, if you are within three years of normal retirement age, you may be able to contribute up to two times the usual limit. Instead of $19,500, you could contribute up to $39,000 to a 457. Eligibility for this catch-up is limited by your previous contributions, so check with your HR to calculate your actual amount.

Most employers do not contribute to a 457 Plan. If they do, their contribution is counted towards your $19,500 limit. That’s a difference from a 403(b), where an employer contribution is on top of your individual limit.

There is no 10% penalty on distributions before age 59 ½. At whatever age you retire, you can access your 457 Plan without penalty. This is a big advantage compared to a 403(b) or IRA for people who want to retire early. And it’s a good reason to not rollover a 457 into an IRA. Once it’s in the IRA you would have to wait until after 59 ½ to avoid the penalty.

Let’s Evaluate Your Options

If your employer offers a 457 in addition to a 403(b), look into the 457. Want to contribute the maximum to both plans? That would be $39,000 for 2020, or $52,000 if you are age 50 or above. And potentially even higher if you are within three years of normal retirement age. Of course, you will also want to compare both plans being offered to you. Consider if any match is available, as well as the investment options and expenses of each plan.

You’d love to do both, but not sure you can contribute more than $19,500? Start here: 5 Steps to Boost Your Savings

Whatever type of retirement plan you have, let’s make sure you are taking full advantage of the benefits available to you. Not sure where to begin? I’m here to help, just send me a note.

Read More
Do You Need Bonds?

Do You Need Bonds?

Posted On September 6, 2020 By Scott Stratton, CFP(R), CFA In Portfolio Management /  

With ultra low yields today, more investors are asking if you really need to have bonds in your portfolio. It’s going to depend on your objectives for your overall plan. First, let’s take a look at expected returns and how this impacts your allocation.

The primary role of bonds is to reduce the risk of a stock portfolio. Bonds fluctuate a lot less and most are relatively low risk. The trade-off is that they have a lot lower return than stocks. Of course, the stock market has a negative return in approximately one of every five or so years. From 1950 through 2019, 15 of 70 years had a negative return in the S&P 500 Index. Bonds are more consistent, and they can help smooth out your overall returns. In years when stocks are down, you can rebalance by selling some bonds and buying stocks.

The more bonds you have, the more you reduce stock risk, but also the more you probably lower your long-term returns. With the 10-year Treasury bond yielding only 0.721% this week, bonds offer almost no return on their own. Bonds used to offer safety and income, but today, you are really only owning them just for safety.

Portfolio Asset Allocation

We describe a portfolio by the percentage it has in stocks versus bonds. A 70/30 portfolio, for example, has 70% stocks and 30% bonds. Our asset allocation models target different levels of stock and bond exposure:

  • Ultra Equity (100% Equity)
  • Aggressive (85/15)
  • Growth (70/30)
  • Moderate (60/40)
  • Balanced (50/50)
  • Conservative (35/65)  

Expected Returns

Next, let’s consider what Vanguard projects for the next 10 years for annualized asset returns, as of June 2020: 

  • US Equities: 5.5% to 7.5%
  • International Equities: 8.5% to 10.5%
  • US Aggregate Bond Market: 0.9% to 1.9%

Let’s calculate hypothetical portfolio returns using these assumptions. If we take the midpoint of stock projected returns, we have 6.5% for US Stocks and 9.5% for International Stocks. If we invest equally in both, we’d have an 8% return. For our bond return, we will take the midpoint of 1.4%. Now, here’s a simple blend of those expected returns when we combine them in a portfolio.

PortfolioProjected 10 Year Return
100% Equities8.00%
90% Equities / 10% Bonds7.34%
80% Equities / 20% Bonds6.68%
70% Equities / 30% Bonds6.02%
60% Equities / 40% Bonds5.36%
50% Equities / 50% Bonds4.70%
40% Equities / 60% Bonds4.04%
30% Equities / 70% Bonds3.38%
20% Equities / 80% Bonds2.72%
10% Equities / 90% Bonds2.06%
100% Bonds1.40%

If you simply want the highest return without regard to volatility in a portfolio, you could invest 100% into stocks. Moreover, any addition of bonds should reduce your long-term returns. Of course, this assumes that returns are simply linear. In a real portfolio, there would be up years and down years in stocks. That’s when you would rebalance, which could be beneficial.

For young investors, in their 20’s, 30’s, or 40’s, you probably should be more aggressive in your asset allocation. For some, it may even make sense to be 100% in stocks. If you have 20 or more years to retirement, and aren’t scared of stock market fluctuations, being aggressive is likely going to offer the highest return.

The 10-year expected return of stocks is not bad, 8% combined today. That’s a little bit lower than the historical averages, but still an attractive return. Bond returns, however, are expected to be very weak. Consequently, 60/40, 50/50, and more conservative portfolios, are expected to have much lower projected returns.

Retirement Planning and Your Need for Bonds

For those closer to retirement, low yields are a challenge. You want to have less volatility but also want good returns. If you are within five years of retirement, you probably want to reduce the risk of a stock market crash hurting your retirement income. Now, if the hypothetical 8% stock returns were guaranteed, our decision would be easy. But getting out of bonds today, with the market at an all time high, seems too risky. This week has certainly been a reminder that stocks are volatile.

I think most pre-retirees will want to keep their current allocation through their retirement date. After that, they may want to consider gradually reducing their bond exposure by selling bonds. There is evidence that this strategy, The Rising Equity Glidepath, is a beneficial way to access retirement withdrawals. It allows retirees to benefit from the higher expected return of stocks, while reducing their risks in the crucial 5-10 years right before and at the beginning of retirement.

Some retirees have a high risk capacity if they have ample sources of income and significant assets. If their time horizon is focused on their children or grandchildren, they can also consider a more aggressive allocation.

We want to calculate your asset mix individually. I wanted to show you what the blend of stocks and bonds is projected to return over the next decade. We’ve had strong returns from fixed income in recent years because falling interest rates push up bond prices. Going forward, it looks like bond returns are going to be quite low. We do have to consider these projected returns when making allocation decisions.

If you’re looking for advice on managing your investment portfolio today, let’s talk. Our planning process will help you address these questions and have a better understanding of your options.

Read More
How to Save More Money

How to Save More Money

Posted On August 29, 2020 By Scott Stratton, CFP(R), CFA In Financial Planning /  

Growing your net worth is the product of saving and investing. Sometimes, we assume this means we have to slash our spending to be able to save more. Sure, you want to have awareness and planning regarding your spending. But it’s not much fun to give up coffee or never take a vacation. There has to be a balance between sensible spending and your saving goals.

Luckily, there is another way to increase your savings rate: earn more. Especially for younger investors, as your income grows you will find that you can easily save more. This may take a number of years. But, as your career takes off, your income may increase at a double digit rate during your twenties and thirties.

So, don’t despair if you cannot save as much as you would like today! Focus on growing your career and increasing your income. Saving will get easier.

Hold Your Spending Steady

As you get promotions and raises, avoid the temptation to keep up with the Joneses. You will see friends and classmates who are buying fancy cars and huge houses. Good for them! But what you might not see is how much debt they have, how little they save, or their net worth. You won’t know how stressed they are about their finances. They may be two paychecks away from being broke.

Hopefully, your current lifestyle is enjoyable and you find happiness in your relationships and the things you do. Getting more expensive things is not likely to create lasting satisfaction. The temporary, but fleeting, pleasure from consumption is known as The Hedonic Treadmill. If your priority is becoming financially independent, using a raise or bonus to save more is a better choice than spending it.

Put Your Savings On Autopilot

As your income grows, save your raises. Establish recurring deposits to your retirement plans and other accounts, and increase them annually. If take this step when you receive a raise, you will not miss the extra money. Skip increasing your monthly savings, and you probably aren’t going to have extra money leftover at the end of the year. If it’s in your checking account, you will spend it!

For couples, a joint income is a tremendous opportunity. If you can live off of one salary and save the second salary, you will grow your wealth at an amazing rate. In some cases, this could literally be saving one of your paychecks. Or, it may make more sense to participate in both of your 401(k) plans, and save the equivalent of one salary.

Multiple Sources of Income

Given the economic fallout from Coronavirus, many people aren’t getting a raise this year. A lot of us are seeing that our 2020 income will be lower than 2019. Hopefully, this will be temporary, but there are lessons to be learned. It is a risk to have all your eggs in one basket with one job. If you lose that job, you’re really in trouble.

As an entrepreneur, I have always had multiple sources of income. My financial planning business is diversified across a number of clients. I also sell insurance. I make music in a couple of orchestras and teach a few lessons on the side. Some of it is small, but having multiple sources of income gives me flexibility and safety.

Have you considered finding a side hustle, second income, part-time business, or online gig? Find something you enjoy and make it into a business. Find something people need and provide that service. You never know where that part-time work might take you. Maybe someday it will allow you to retire early or be your own boss! In the mean time, use your additional income to save more and build up your investment portfolio. Don’t give up your time just for the sake of buying more things.

How and Where to Save More

How much should you save? If you are saving 15% of your income, you’re doing way better than most people in America. Start at a young age, and a 15% savings rate will likely put you in a very comfortable position by retirement age. For those who are more ambitious, or just impatient like me, aim to save more than 15%. You could be putting $19,500 into your 401(k) each year ($26,000 if over age 50).

And you might be eligible for an IRA, too, depending on your income. Or, consider a taxable account, Health Savings Account (HSA), or 529 College Savings Plan. There are lots of places you could be saving! Put your savings on autopilot with recurring deposits to your retirement plans and other accounts. If take this step when you receive a raise, you will not miss the extra money, but you will be growing your wealth faster.

Do you need a reason to save more? The sooner you save, the faster you can achieve financial freedom. Even if you enjoy your work, it’s great to have the means to not have to worry about your job.

You can save more by spending less. That’s true, but you can only eliminate an expense once. Most people will have some tolerance for cutting costs, but austerity is no fun. Focus on increasing your income, hold your expenses steady, and increase your monthly savings. Put your energy into building your career, and aim for a high income. Couples have a great ability to save, if they can aim to live off one income. Look for creating a second or third income stream. A lot of the wealthy people I know have an entrepreneurial mindset. They have multiple income streams.

As your earnings grow, you will be able to save more and invest more. Most of my newsletters deal with investing, tax, or planning questions. But those benefits only accrue after you’ve done the first step of saving that money. It’s not how much you make that matters, but how much you keep!

Read More
Do You Have a College Fund?

Do You Have a College Fund?

Posted On August 21, 2020 By Scott Stratton, CFP(R), CFA In College Savings /  

Do you have a college fund set up for your children or grandchildren? It is back to school time and that’s a little bit different this year. No one knows if the online classes will permanently change the process of education in the world. Still, I think there will be no substitute for the career benefits of having a degree in an in-demand field from a top notch school. Not everyone needs college, but overall, a higher education is strongly correlated to future earnings and career satisfaction.

The cost of a college education continue to climb. Student debt has become a crippling problem for many young adults I meet. They were told it would be worth it to get their degree, regardless the expense or their future earnings potential. Every parent wants the best for their kids, for them to have the opportunities we did not have. We want for them to be able to pursue their dreams and find their own unique greatness. Helping to pay for college goes a long way to setting up your kids to find their own Good Life.

Like most big financial goals, I think the best way to create a successful college fund is by making it automatic. Establish a 529 college savings account and make automatic contributions each month. If you can only start with $100 a month, great, just get started. Later, you can gradually bump that up to $200 or $300 a month or more.

How Much Should You Save?

A 529 plan will allow you to invest into a diversified allocation. The 529 Plan I use has Vanguard, iShares, and State Street index funds, just like I recommend in our Premiere Wealth Management portfolios. While no one knows future returns, let’s consider how your money might grow at 1%, 3%, or 6%. And then let’s also consider if you start at age zero, 5, and 10 for your kids. This would equate to 18, 13, and 8 years of growth to age 18 and the start of college.

Here is how $250 a month would grow:

There are two main points I think this chart makes. First, it pays to start your college fund early for compound interest. If you wait until your kids are 10, you might have only one-third the amount saved, compared to starting at birth. Second, you aren’t going to grow much if your money is in a bank account earning one percent. (By the way, at $250 a month, or $3,000 a year, you would have contributed a cumulative $54,000 over 18 years, $39,000 over 13 years, or $24,000 over 8 years.)

How to Get Started

A 529 College Savings Plan is an efficient way to create a College Fund, as distributions for qualified education expenses are tax-free. You can even start a 529 for an unborn child and change it to their name once they are born. The important thing is to get started early. Each state sponsors their own 529 Plan. If your state has income taxes, there may be a benefit for using the In-State plan. For Texas, since we don’t have an income tax, there is no inducement to use the Texas plan versus one from any other state. You can use any plan at any college in the country.

While you could save in a regular account for college, there are valuable tax benefits in 529 Plans. Most investors prefer to have different buckets for different goals. This helps address savings goals. Even if your kids are 10 or older, it’s not too late to start your college fund. We are accepting new clients and want to help you get started.

If you’d like an estimate what it might cost to send your kid to a specific University, send me that information. I’m happy to prepare a report for you. We will estimate future costs and calculate a saving and investing plan. (Be prepared to be shocked if you plan to pay for 100% of four years at a private university.)

Learn More About 529s

Looking for details on how a 529 Plan works? Here’s what you need to know.

Want to compare different 529 Plans? Check out SavingForCollege.com

529 Plans are a way for Wealthy Families to create an inter-generational transfer of millions of dollars, potentially tax-free. This linked article calculates that parents who fund $1 million dollars into 529 Plans could be able to cover the college educations of four grandchildren, eight great-grandchildren, and 16 great-great-grandchildren. That’s because when you over-fund a 529 plan, you can always change the beneficiary to a younger generation later. The successor owners of your 529 Plans can keep the accounts open and change beneficiaries, even after you are gone.

Read More