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Advice to the Masses May Not Apply to Individuals

5bnlOa3Last week on my ride home from a meeting I had the opportunity to tune into a nationally syndicated talk show regarding personal finance. The host is very popular among listeners and has written several best sellers. Many churches and schools follow the financial program designed to educate individuals on how to set a budget, get out of debt and save for retirement. Generally, the advice given is applicable to many individuals.

Sometimes it’s not.

A listener called into the show and explained that she had approximately $100,000 in an annuity in an IRA. The annuity paid an interest rate of 2% and had a current surrender charge of 4% – just over $4,000. The caller was asking the host whether or not she should surrender the annuity and roll it over to a non-annuity IRA invested in mutual funds.

In a matter of seconds the recommendation was to surrender the annuity, pay the surrender charges of over $4,000 and find one of the host’s endorsed providers and find a mutual fund that pays 6%. The reasoning was that if the annuity was paying 2% and the surrender charge was 4%, the caller would need to find a fund that makes 6% to “break even.”

There are a few things not necessarily ideal in this situation. First, why wouldn’t the advice be to wait out the surrender period and still receive 2% interest? This was a guaranteed 2% rate! Second, why pay 4% in surrender charges to move from a guaranteed rate to a vehicle (mutual fund) that is not guaranteed? Admittedly, if the caller was looking for a higher potential rate of return, moving to a riskier investment makes sense. However, the host could have advised the caller to wait until the surrender period was over to make the move.

Finally, the caller doesn’t realize that moving their money to one of the endorsed providers ensures they’ll get a commissioned salesperson offering them front-loaded mutual funds. For many popular mutual fund companies a common break point (the point at which front end loads are reduced) for $100,000 in assets is 3.5%. This means that when the investor moves out of her annuity, they’re losing the 2% guarantee, 4% in surrender charges and another 3.5% in front end loads (commissions).

In other words, the investor would need to find a fund that would make them 9.5% in the first year just to break even. The advice on finding a mutual fund that pays 6% was not only inaccurate (mutual funds don’t have guaranteed rates) but the advice on only needing 6% to break even was erroneous!

I do agree that the annuity should be rolled over to a non-annuity IRA. Generally, an IRA annuity is overkill. You have a tax-deferred vehicle (the IRA) in a tax-deferred wrapper (the annuity)*. However, perhaps the advice would have been better if the host would have told the client to wait until the surrender charges were done (about a year or two) and then roll it over. On the host’s recommendation she’ll be out approximately $9,400 (9.5% based off of 6% lost in total from surrendering the annuity, and another 3.5% on the approximately $96,000 rolled over to the endorsed provider) and will need to make that in 1 year just to get into the black.

Generally, the advice on the host’s radio show is good for individuals needing to get out from under credit card debt or get control of their personal finances. However, this particular situation identifies an area of concern for listeners who otherwise wouldn’t know the true cost of the advice they’re receiving.

 

*Special thank you to David Hultstrom at Financial Architects for this terminology.

Traveling for Charitable Purposes

a horse named charitySometimes charitable work involves travel – such as for the Red Cross, for example. Did you know that your travel expenses for charitable work can be a tax deduction? Recently the IRS sent out a Summertime Tax Tip (2015-12) that outlines some valuable information about this deduction.

Tips on Travel While Giving Your Services to Charity

Do you plan to donate your services to charity this summer? Will you travel as part of the service? If so, some travel expenses may help lower your taxes when you file your tax return next year. Here are several tax tips that you should know if you travel while giving your services to charity:

  • Qualified Charities.  In order to deduct your costs, your volunteer work must be for a qualified charity. Most groups must apply to the IRS to become qualified. Churches and governments are qualified, and do not need to apply to the IRS. Ask the group about its IRS status before you donate. You can also use the Select Check tool on IRS.gov to check the group’s status.
  • Out-of-Pocket Expenses.  You may be able to deduct some costs you pay to give your services. This can include the cost of travel. The costs must be necessary while you are away from home giving your services for a qualified charity. All  costs must be:
    • Unreimbursed,
    • Directly connected with the services,
    • Expenses you had only because of the services you gave, and
    • Not personal, living or family expenses.
  • Genuine and Substantial Duty.  Your charity work has to be real and substantial throughout the trip. You can’t deduct expenses if you only have nominal duties or do not have any duties for significant parts of the trip.
  • Value of Time or Service.  You can’t deduct the value of your services that you give to charity. This includes income lost while you work as an unpaid volunteer for a qualified charity.
  • Deductible travel.  The types of expenses that you may be able to deduct include:
    • Air, rail and bus transportation,
    • Car expenses,
    • Lodging costs,
    • The cost of meals, and
    • Taxi or other transportation costs between the airport or station and your hotel.
  • Nondeductible Travel.  Some types of travel do not qualify for a tax deduction. For example, you can’t deduct your costs if a significant part of the trip involves recreation or a vacation.

For more on these rules, see Publication 526, Charitable Contributions. You can get it on IRS.gov/forms at any time.

IRS YouTube Videos:

IRS Podcasts:

Personality Influences Financial Decisions

The recent volatility in the stock market has everyone a bit uneasy – even folks who have worked with a trusted financial adviser for years. But if you’ve never worked with an adviser before, you may be surprised to find that one of the first things he or she will do is ask you to fill out a risk analysis questionnaire. This questionnaire is designed to help you understand your financial decisionsdecisions and the process of making decisions. It’s all tied to your personality, your own unique world-view.

Why is risk analysis important before you make decisions with your money? Risk tolerance is an important part of investing – that should be understood at the outset. But the real value of answering a lot of questions about your risk tolerance is to tell you what you don’t know – how the sources of your money, the way you made it, how outside forces have shaped your view of it and how you’re handling it now will help shape every decision you make about money now and in the future.

The most important thing a risk analysis questionnaire can tell is what’s important about money to you. Trained financial advisers can determine your money personality through a process of questioning discovery. Planners can then guide investors within their money personality. Do you want certainty? Are you willing to take a little risk or let it roll because long-term results are more important than short-term volatility? Or will you take more risks with your money because you can always make more of it?

A financial planner tries to see through the static to find out what you really need to create a solid financial life. But it might make sense to ask yourself a few questions before you and your planner sit down:

  1. What’s important about money to me?
  2. What do I do with my money? What do I plan to do with my savings?
  3. If money was absolutely not an issue, what would I do with my life?
  4. Has the way I’ve made my money – through work, marriage, windfall – affected the way I think about money in a particular way?
  5. How much debt do I have, what kinds of debt, and how do I feel about it?
  6. Am I more concerned about maintaining the value of my initial investment or making a profit from it?
  7. Am I willing to give up that stability for the chance at long-term growth?
  8. What am I most likely to enjoy spending money on?
  9. How would I feel if the value of my investment dropped minimally for several months? How about significantly over several months? What is a significant drop in value to me?
  10. How would I feel if the value of my investment dropped minimally or stayed constant (no growth) for several years?
  11. If I had to list three things I really wanted to do with my money, what would they be?
  12. What does retirement mean to me? Does it mean quitting work entirely and doing whatever I want to do or working in a new career full- or part-time? Or would I take on volunteer work in retirement?
  13. Do I want kids? Do I understand the financial commitment?
  14. If I have kids, do I expect them to pay their own way through college or will I pay all or part of it? What kind of shape am I in to help with paying for their college education?
  15. How’s my health and my health insurance coverage?
  16. What kind of physical and financial shape are my parents in? Are they enjoying retirement, and what does retirement look like for them?

One of the toughest aspects of getting a financial plan going is recognizing how your personal style, mindset, and life situation affect your investment decisions. A financial professional will understand this challenge and can help you think through your choices. Your resulting plan – from investments to insurance, savings to estate plans – should feel like a perfect fit for you.

Everything But The Retirement Plan!

drawing retirementConventional wisdom says that when you leave a job, whether you’ve been “downsized” or you’ve just decided to take the leap, you should always move your retirement plan to a self-directed IRA. (Note: when referring to retirement plans in this article, this could be a 401(k) plan, a 403(b), a 457, or any other qualified savings deferral-type plan).

But there are a few instances when it makes sense to leave the money in the former employer’s plan.  You have several options of what to do with the money in your former employer’s plan, such as leaving it, rolling it over into a new employer’s plan, rolling it over to an IRA, or just taking the cash.

The last option is usually the worst. If you’re under age 55 you’ll automatically lose 10% via penalty from the IRS (unless you meet one of the exceptions, including first home purchase, healthcare costs, and a few others), plus you’re taxed on the funds as if it were ordinary income. For the highest bracket, this can amount to losing nearly 50% or more of the account balance to taxes and penalties.

In addition, by cashing out you’re derailing the retirement fund that you’ve put so much effort into setting aside. If you cash it out, you’ve got to start over from scratch and you’ve got less time to build the account back up. A 2005 change in the tax law requires your old employer to automatically roll over your account into an IRA if it is between $1,000 and $5,000 (if you don’t choose another option), to keep folks from cashing out. If your account balance is more than $5,000, the old employer is required to maintain your account in the old plan until you choose what you’re going to do with it.

Another option has become available for your old account: you can roll these funds over into a new employer’s retirement plan, as long as the new plan allows it. In many cases this may make good sense, especially if the new plan has good investment choices and is cost-effective.

If the new plan doesn’t suit you or you’d like more control over your investment choices, you can always roll the funds from your old employer’s plan into an IRA. You’ll then be able to decide just how you want to allocate the investments, choosing from the entire universe of available investment options, rather than the limited list that many plans have available. Caution is necessary when doing this type of rollover, as a misstep could cause the IRS to treat your attempted rollover as a complete distribution, having the same tax effect as cashing out. Always choose a direct transfer to the IRA (rather than a 60-day rollover) and seek the help of a professional if you are unsure about how to deal with this situation.

But when would you leave the funds at the old employer? If the old employer’s plan is a well-managed, low-cost plan, and you’re happy with how your investments have done, then you might just want to leave it where it is. In addition, if you happen to be over age 55, you have the option available to access the funds immediately without penalty, rather than waiting until age 59 1/2 – but only if you leave the funds in the original employer’s plan. Plus, if your plan is a 457 plan (generally only available to governmental employees, such as with a state or local government), you may be able to tap the plan upon your ending employment without penalty as well.

Another good reason to leave the fund at the old employer is if you believe that there is a high probability that you may return to employment with this same employer. Especially in the case of working for a governmental unit, it probably makes sense to leave those funds in the old plan when you think there is a better than average possibility that you may return to work with the government (even another agency). This is because there are benefits available in some governmental plans that you would be giving up if you moved your account to an IRA, and you’re not likely to be able to move those funds back when you return.

So – hopefully this quick conversation has helped to clear up some questions, and perhaps it has brought up some new questions for you.

Social Security Trustees Report – 2015

truss-teesEvery year, the Trustees of the Social Security and Medicare trust funds release reports to Congress on the current financial condition and projected financial outlook of these programs. The 2015 reports, released on July 22, 2015, show that, despite some encouraging signs, both programs continue to face financial challenges that should be addressed as soon as possible, with the Disability Insurance Trust Fund needing the most urgent attention.

What are the Social Security trust funds?

The Social Security program consists of two parts. Retired workers, their families, and survivors of workers receive monthly benefits under the Old-Age and Survivors Insurance (OASI) program; disabled workers and their families receive monthly benefits under the Disability Insurance (DI) program. The combined programs are referred to as OASDI. Each program has a financial account (a trust fund) that holds the Social Security payroll taxes that are collected to pay Social Security benefits. Other income (reimbursements from the General Fund of the Treasury and income tax revenue from benefit taxation) is also deposited in these accounts. Money that is not needed in the current year to pay benefits and administrative costs is invested (by law) in special Treasury bonds that are guaranteed by the U.S. government and earn interest. As a result, the Social Security trust funds have built up reserves that can be used to cover benefit obligations if payroll tax income is insufficient to pay full benefits.

(Note that the Trustees provide certain projections based on the combined OASI and DI (OASDI) trust funds. However, these projections are theoretical, because the trusts are separate, and one program’s taxes and reserves cannot be used to fund the other program.)

Trustees report highlights: Social Security

  • The combined trust fund reserves (OASDI) are still increasing and will continue to do so through 2019 (asset reserves increased by $25 billion in 2014, with year-end reserves totaling $2.8 trillion). Not until 2020, when annual program costs are projected to exceed total income, will the U.S. Treasury need to start withdrawing from reserves to help pay benefits. Absent congressional action, the combined trust fund reserves will be depleted in 2034, one year later than projected in last year’s report.
  • Once the combined trust fund reserves are depleted, payroll tax revenue alone should still be sufficient to pay about 79% of scheduled benefits in 2034, with the percentage falling gradually to 73% by 2089. This means that 20 years from now, if no changes are made, beneficiaries could receive a benefit that is about 21% less than expected.
  • The OASI Trust Fund, when considered separately, is projected to be depleted in 2035 (one year later than projected in last year’s report). At that time, payroll tax revenue alone would be sufficient to pay 77% of scheduled OASI benefits.
  • The DI Trust Fund is in worse shape and will be depleted in late 2016 (the same as projected last year). The Trustees noted that the DI Trust Fund “now faces an urgent threat of reserve depletion, requiring prompt corrective action by lawmakers if sudden reductions or interruptions in benefit payments are to be avoided.” Once the DI Trust Fund is depleted, payroll tax revenue alone would be sufficient to pay just 81% of scheduled benefits.
  • Based on the “intermediate” assumptions in this year’s Trustees report, the Social Security Administration is projecting that there will be no cost-of-living adjustment (COLA) for calendar year 2016.

What are the Medicare trust funds?

There are two Medicare trust funds. The Hospital Insurance (HI) Trust Fund pays for inpatient and hospital care (Medicare Part A costs). The Supplementary Medical Insurance (SMI) Trust Fund comprises two separate accounts, one covering Medicare Part B (which helps pay for physician and outpatient costs) and one covering Medicare Part D (which helps cover the prescription drug benefit).

Trustees report highlights: Medicare

  • Annual costs for the Medicare program have exceeded tax income annually since 2008, and will continue to do so this year and next, before turning positive for four years (2017-2020) and then turning negative again in 2021.
  • The HI Trust Fund is projected to be depleted in 2030 (unchanged from last year, but with an improved long-term outlook from last year’s report). Once the HI Trust Fund is depleted, tax and premium income would still cover 86% of program costs under current law. The Centers for Medicare & Medicaid Services (CMS) has noted that, under this year’s projection, the HI Trust Fund will remain solvent 13 years longer than the Trustees predicted in 2009, before passage of the Affordable Care Act.
  • Due to increasing costs, a Part B premium increase is likely in 2016. However, about 70% of Medicare beneficiaries will escape the increase because of a so-called “hold harmless” provision in the law that prohibits a premium increase for certain beneficiaries if there is no corresponding cost-of-living increase in Social Security benefits. If there is no COLA for 2016, the increased costs may be passed along only to the remaining 30% not eligible for this hold-harmless provision–generally, new enrollees, wealthier beneficiaries, and those who choose not to have their premiums deducted from their Social Security benefit. If so, these individuals could see the base premium rise to $159.30 in 2016, up sharply from $104.90 in 2015.

Why are Social Security and Medicare facing financial challenges?

Social Security and Medicare accounted for 42% of federal program expenditures in fiscal year 2014. These programs are funded primarily through the collection of payroll taxes. Partly because of demographics and partly because of economic factors, fewer workers are paying into Social Security and Medicare than in the past, resulting in decreasing income from the payroll tax. The strain on the trust funds is also worsening as large numbers of baby boomers reach retirement age, Americans live longer, and health-care costs rise.

What is being done to address these challenges?

Both reports urge Congress to address the financial challenges facing these programs in the near future, so that solutions will be less drastic and may be implemented gradually, lessening the impact on the public. As the Social Security Board of Trustees report states, “Social Security’s and Medicare’s projected long-range costs are not sustainable with currently scheduled financing and will require legislative action to avoid disruptive consequences for beneficiaries and taxpayers.”

Some long-term Social Security reform proposals on the table are:

  • Raising the current Social Security payroll tax rate (according to this year’s report, an immediate and permanent payroll tax increase of 2.62 percentage points would be necessary to address the revenue shortfall)
  • Raising the ceiling on wages currently subject to Social Security payroll taxes ($118,500 in 2015)
  • Raising the full retirement age beyond the currently scheduled age of 67 (for anyone born in 1960 or later)
  • Reducing future benefits, especially for wealthier beneficiaries
  • Changing the benefit formula that is used to calculate benefits
  • Changing how the annual cost-of-living adjustment for benefits is calculated

Regardless of the long-term solutions, Congress needs to act quickly to address the DI program’s imminent reserve depletion. According to this year’s report, in the short term, lawmakers may reallocate the payroll tax rate between OASI and DI (as they did in 1994). However, this may only serve to delay DI and OASI reforms.

You can view a combined summary of the 2015 Social Security and Medicare Trustees reports at www.socialsecurity.gov/OACT/TRSUM/. You can also access a full copy of the Social Security report from that page. You can find the full Medicare report at www.cms.gov.

Selling your home? Here’s the income tax facts

home for saleSummer is a time when many folks choose to move to a new home. It makes a lot of sense, especially if you have children in school – this way if the move is to a new school district, the children will not have to switch schools during the academic year.

Selling your home can have consequences for your income taxes. Recently the IRS issued their Summertime Tax Tip 2015-13, which details ten key tax facts about home sales. The text of the Tip is below:

Ten Key Tax Facts about Home Sales

In most cases, gains from sales are taxable. But did you know that if you sell your home, you may not have to pay taxes? Here are ten facts to keep in mind if you sell your home this year.

  1. Exclusion of Gain.  You may be able to exclude part or all of the gain from the sale of your home. This rule may apply if you meet the eligibility test. Parts of the test involve your ownership and use of the home. You must have owned and used it as your main home for at least two out of the five years before the date of sale.
  2. Exceptions May Apply.  There are exceptions to the ownership, use and other rules. One exception applies to persons with a disability. Another applies to certain members of the military. That rule includes certain government and Peace Corps workers. For more on this topic, see Publication 523, Selling Your Home.
  3. Exclusion Limit.  The most gain you can exclude from tax is $250,000. This limit is $500,000 for joint returns. The Net Investment Income Tax will not apply to the excluded gain.
  4. May Not Need to Report Sale.  If the gain is not taxable, you may not need to report the sale to the IRS on your tax return.
  5. When You Must Report the Sale.  You must report the sale on your tax return if you can’t exclude all or part of the gain. You must report the sale if you choose not to claim the exclusion. That’s also true if you get Form 1099-S, Proceeds From Real Estate Transactions. If you report the sale, you should review the Questions and Answers on the Net Investment Income Tax on IRS.gov.
  6. Exclusion Frequency Limit.  Generally, you may exclude the gain from the sale of your main home only once every two years. Some exceptions may apply to this rule.
  7. Only a Main Home Qualifies.  If you own more than one home, you may only exclude the gain on the sale of your main home. Your main home usually is the home that you live in most of the time.
  8. First-time Homebuyer Credit.  If you claimed the first-time homebuyer credit when you bought the home, special rules apply to the sale. For more on those rules, see Publication 523.
  9. Home Sold at a Loss.  If you sell your main home at a loss, you can’t deduct the loss on your tax return.
  10. Report Your Address Change.  After you sell your home and move, update your address with the IRS. To do this, file Form 8822, Change of Address. You can find the address to send it to in the form’s instructions on page two. If you purchase health insurance through the Health Insurance Marketplace, you should also notify the Marketplace when you move out of the area covered by your current Marketplace plan.

401(k) Mistakes (also applies to other Retirement Plans!)

mistakeThese days you’re pretty much on your own when it comes to planning for your retirement. Granted, many state and local governments have a pension plan, but beyond that, precious few employers provide a pension these days. Typically retirement benefits only include a 401(k) or other deferred retirement plan, which means it’s up to you! For the purpose of brevity, I’ll refer to 401(k) plans throughout this article; please understand that most of the information applies to 403(b) plans, 401(a) plans, and 457 plans as well as Keogh, SIMPLE, and SEP IRA plans.

For most of us, the 401(k) is the default account that must take on the role that the pension plan did for previous generations. Paying attention to and avoiding the following mistakes can help you to ensure that you have a financially-secure future.

#1 – Choosing Not to Participate
It’s amazing how many folks, young or old, don’t participate in their company’s 401(k) plan. If your employer matches your contributions, you’re effectively giving money away. You wouldn’t do that with a raise or a tax cut, would you? And even if your employer doesn’t match your contributions, the tax savings should be enough to spark your interest… If you’re not presently participating in your company-offered 401(k) plan, bear in mind that time is your greatest ally when it comes to building up your savings. Starting early and making regular contributions to your account will have an enormous impact on the results when you’re ready to begin using these funds in retirement.

For example, if you only put $1,000 into your account at age 25, with a compound rate of return of 6%, by age 65 your account would be worth over $10,000. By the same token, if you’d waited until age 30 to make that $1,000 deposit, by age 65 it would only have grown to $7,600. That’s roughly a 30% difference only because you delayed for 5 years!

If you put $1,000 aside each year beginning at age 25, at the example 6% return when you reach age 65 this would have grown to $154,000+. And if you delay 5 years, the result is $111,000, a difference of $43,000 for your extra $5,000 of deposits.

#2 Not Having a Plan
Blindly allocating your investments can have significant consequences as well. I have reviewed retirement plans where the participant believed that they were doing the right thing by “diversifying” across every fund choice in their plan. This results in diversification all right, but doesn’t take into account the time horizon for the investment, your own risk tolerance, and other factors. And most importantly, the diversification is not necessarily among different types of assets, only among different funds in most cases.

An acquaintance, age 26, had a conservative portfolio of investments in his account – amounting to more than 80% in bonds and fixed instruments. At that age, even the most conservative of investment plans should have you above a 50% ratio in equities, in order to take advantage of long-term stock market returns. Granted, stocks are more volatile than bonds and fixed income investments, but with a longer time horizon, bonds and fixed income investments can barely keep up with inflation, let alone provide any measure of growth. In addition, the longer time horizon provides the time to ride out any “bumps” in the market that may take place.

It makes good sense to analyze your potential investment choices, consider your time horizon, your risk tolerance, and ultimately your investment “mix”, in order to create a plan for your investments that will carry you toward that holy grail of investment success – a fruitful retirement.

#3 Set It and Forget It
While we shouldn’t obsess over every single market move every single day, we also shouldn’t make our investment and contribution decisions once and then leave them for 20, 30 or 40 years. Over time, your various investments are going to grow at different rates, eventually causing one or more of your holdings to become overweighted (with regard to your planned “mix”).

I generally recommend reviewing your quarterly statements just to see how things are going in your account, and choose one of the quarters to make rebalancing moves annually as needed. These rebalancing moves don’t need to be done until one or more of your investments gets to a 5% or more variance from your plan.

#4 Taking Out a Loan
This falls into the category of things you *can* do but shouldn’t. Kinda like jumping off a cliff. What happens here is that your contribution program goes on hold as you pay back the loan, and if you don’t pay it back, you’ll owe tax and penalties. In addition, you’re paying back your tax-deferred fund with after-tax dollars, which will eventually be taxed again when you withdraw the funds at retirement. In only the most extreme of circumstances should you consider this kind of loan – honestly, you’ll regret it if you do it in most cases.

Strategies of Successful Investors

successFor a golfer looking to improve his game, it can be useful to study the top golfers’ strategies and methods. Investors can, in much the same way, learn from the “money masters”, the top group of the most successful investors. You might not have their resources or years of experience, but understanding their philosophies can help you in your own approach to investing.

Think Like an Owner, Not Like a Trader
This philosophy is as commonsense as the investor who is so famous for following it: Warren Buffett. Any list of the most successful investors of all time has to include the chairman of Berkshire Hathaway, and he’s typically at the top of the list. The Oracle of Omaha is well-known for his down-to-earth approach to sizing up investment opportunities.

Buffett invests in businesses however (not stocks), and prefers those with consistent earning power and little or no debt. He also looks at whether a company has an outstanding management team. Buffett attaches little importance to the market’s day-to-day fluctuations; he has been quoted as saying that he wouldn’t care if the market shut down completely for several years. However, he does pay attention to what he pays for a business; as a value investor, he may watch a company for years before deciding to buy. And when he buys, he makes a big play and plans to hang on to his investment for a long time.

Don’t Forget That Markets Can Be Irrational
George Soros feels that markets can be irrational. However, rather than dismissing the ups and downs, the founder of the legendary Quantum Fund made his reputation by exploiting macroeconomic movements. He once made more than $1 billion overnight when his hedge fund speculated on the devaluation of the British pound.

Soros believes in capitalizing on investing bubbles that occur when investors feed off one another’s emotions. He is known for making big bets on global investments, attempting to profit from both upward and downward market movements. Such a strategy can be tricky for an individual investor to follow. However, even a buy-and-hold investor should remember that market events may have as much to do with investor psychology as with fundamentals, and use that information to your advantage. You probably wouldn’t apply Soros’s philosophy in the same way he does, but nonetheless it can be a valuable lesson to remember.

Use What You know; Know What You Buy
During his 13-year tenure at Fidelity Investments’ Magellan Fund, Peter Lynch was one of the most successful mutual fund portfolio managers in history. He subsequently wrote two best-selling books for individual investors.

If you want to follow Lynch’s approach, stay on the alert for investing ideas drawn from your own experiences. His books contend that because of your job, your acquaintances, your shopping habits, your hobbies, or your geographic location, you may be able to spot up-and-coming companies before they attract attention from Wall Street. However, simply identifying a company you feel has great potential is only the first step. Lynch did thorough research into a company’s fundamentals and market to decide whether it was just a good idea or a good investment.

Lynch is a believer in finding unknown companies with the potential to become what he called “ten baggers” (companies that grow to 10 times their original price), preferably businesses that are fairly easy to understand.

Make Sure the Reward is Worth the Risk
Perhaps the best-known bond fund manager in history, the co-founder of PIMCO Bill Gross makes sure that if he takes greater risk – for example, by buying longer-term or emerging-market bounds – the return he expects is high enough to justify that additional risk. If it isn’t, he says, stick with lower returns from a more reliable investment. Because bonds have historically returned less than stocks and therefore suffer more from high inflation, he also focuses on maximizing real return (an investment’s return after inflation is taken into account).

Choose a Sound Strategy and Stick To It
Even though all these investors seem to have different approaches, in practice they’re more similar than they might appear. Each of their investing decisions has specific, well-thought-out reasons behind it. They rely on their own strategic thinking rather than blindly following market trends. And they understand their chosen investing disciplines well enough to apply them through good times and bad.

Work with your financial planner to determine a strategy that matches your financial goals, time horizon, and investing style.

Book Review: The Opposite of Spoiled

51C1MmoNHOL._SY344_BO1,204,203,200_Last week I had the opportunity to read Ron Lieber’s book, The Opposite of Spoiled. The book centers on raising kids that are well-rounded and responsible when it comes to money.

As a father of two kids myself (and supposedly a financial planner), the book offered many insights to me as a father and as a planner. After all, even I have questions about how to get my kids to think about the way money works and the family finances.

Mr. Lieber’s book does an excellent job of how to answer the money questions kids ask. Naturally, kids see the world through different lenses and it’s in their nature to ask question. Such questions about money Mr. Lieber covers range from the “Are we rich?” to handling what kids see their friends have that they do not.

Taken right from the cover is Mr. Lieber’s take on how to teach kids to allocate their money. On the cover can be seen three clear jars. One is labeled Give, another Save, and the last, Spend. The book teaches how to allocate these amounts and to which jars. The wisdom from this idea alone is arguably one many adults can use as well.

Although geared mainly toward parents it’s also a book that I would recommend to grandparents. One of the main reasons why is to help grandparents understand the lessons their children are trying to teach the grandkids. This especially hits home when Mr. Lieber talks about how grandparents can overindulge their grandkids on birthdays and holidays which may contradict and impede the lessons parents are trying to convey. Granted, this can be a touchy issue. But it’s one the book may help parents and grandparents who deal with this matter on special occasions.

The Opposite of Spoiled is a fun, enjoyable book that will be read again as my kids continue to grow. The book’s guidance for parents is a wonderful asset to help us with teaching and encouraging our kids to think and talk about finances openly; rather than ignoring their curiosity or worse, raising kids who are afraid of money.

How to Interview Your (Potential) Financial Adviser

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

As individuals need help with their finances and investments they will likely turn to the help of a qualified professional. Their future financial adviser may come via referral from a trusted friend or family member, or through an extensive Internet search. The following is a list of questions (and answers to look for) that individuals can ask their potential adviser to see if he or she is likely to be a good fit and more importantly, act in the client’s best interest.

  1. Are you a fiduciary?

If yes, move to question 2. If no, thank them for their time and move to the next adviser on your list.

Advisers that are fiduciaries are legally bound to put their clients’ best interests first. In other words, regardless of compensation, products offered or company affiliation, fiduciary advisers must act in the best interest of their clients. Everything else is secondary.

  1. How do you get paid?

This answer may vary but will generally be answered that he gets paid via commission (by selling a product), fee (hourly rate or a percent of money managed), or a combination of both. If they say salary, ask how the firm gets paid. Generally, fee-only advisers will have less conflicts of interest, however it doesn’t mean there aren’t any.

  1. Are there any conflicts of interest I need to be aware of?

Depending on the answer to question 2 will determine what, if any conflicts are prevalent. Conflicts aren’t necessarily bad, but they should be disclosed. Potential conflicts are that the adviser can only get paid if they sell you something (it may bias their advice), or if they refer you to another professional they get a kick-back. Additionally, conflicts arise if an adviser can only sell their company’s products. Also, see how they limit and reduce potential conflicts.

  1. How much experience do you have?

Every adviser needs to start somewhere and it doesn’t mean that an adviser with one year experience is worse than one with 20 years. It depends on the experience. If they have limited experience, ask if they work with other experienced advisors. What did their experience consist of?

  1. Will I be working with you or a team?

This may tie into question 4 or may be how the firm operates. For example, the firm may have an investment team, tax team, estate team, etc. It’s important to know whom you’ll be working with and your level of comfort with that individual. Some individuals prefer teams, while others prefer only one individual. Along these lines, you may ask how much turnover the firm experiences. High turnover means it’s likely you’ll have a new adviser every 6 months to a year.

  1. Do you follow your own advice?

This is a fair question to ask and will often tell you whether or not you’re working with a professional or salesperson. Granted, not all advice is going to be followed by the person giving it (i.e. I’m not planning on taking Social Security for quite some time, but I can give advice on filing strategies). But if the advice is a specific stock, annuity, life insurance, or mutual fund, ask if they own it or if they would be comfortable having a family member own it. Their reply (and their facial expression) will tell you a lot.

  1. What type of advising/planning do you do?

Some advisers call themselves advisers or planners but they really only sell one or two products or are strictly asset gatherers. By asking this question you can determine if all they care about is applying their fee to your investments or if they’re truly interested in helping you plan financially and comprehensively. If all you’re looking for is investment management, then a firm that only does investment management may be a good fit. If you’re looking for more comprehensive advice, then you may want to find a firm that does both.

  1. What are your fees?

Not only is it important to know how the adviser gets paid, but it’s just as important to know what you’re paying them. For a fee-only adviser you can ask how much they charge per hour or what percent they charge for managing your money. If they work on commission, ask what percent commission they receive on the product(s) they sell. In addition, it’s important to ask what the fees (expense ratios) are for investing in their recommended mutual funds, annuities, ETFs, and other vehicles. Higher fees generally mean lower returns.

  1. What products do you generally recommend?

This can tell you a lot on what their philosophies lay on compensation, products, and your best interests. Generally, the answer should lead to the lowest costs products for the best coverage. For life insurance this generally means term (although there are a few times permanent makes sense) and for investing it generally means low-cost passively managed mutual funds and/or ETFs such as index funds.

  1. What designations do you hold?

Generally, the first designation to look for regarding competence in financial planning is the CFP® designation. Considered the gold standard for financial planners, holders must have met an experience requirement, an exam requirement (6 hours, 175 questions), an education requirement (college-level courses in financial planning), and an ethics requirement. Additionally, CFP® professionals must complete continuing education to remain certified. Other designations may indicate specializations in an area of planning, but the CFP® requires their holders to be fiduciaries in financial planning engagements.

IRAs: Roth or Traditional?

compareThe question comes up pretty often: when contributing to an IRA, should you choose the Roth or Traditional? I often approach this question in general with my recommended “Order of Contributions”:

  1. Contribute enough to your employer-provided retirement plan to get the company matching funds. So if your employer matches, for example, 50% of your first 5% of contributions to the plan, you should at least contribute 5% of your income to the plan in order to receive the matching funds.
  2. Maximize your contribution to a Roth IRA. For 2015 that is $5,500, or $6,500 if you are age 50 or older.
  3. Continue increasing your contribution to your employer-provided plan up to the annual maximum. So if you have more capacity to save after you’ve put 5% into your employer plan to get the matching dollars, and you’ve also contributed $5,500 (or $6,500) to your Roth IRA, you should increase the amount going into your employer plan. Increase this amount up to the annual limit if possible. For 2015 the annual limit for employee contributions to an employer plan like a 401(k) is $18,000 (plus a catch-up amount of $6,000 if you’re age 50 or older).

Beyond those three items if you have more capacity to save, you may want to consider college savings accounts or tax-efficient mutual funds in a taxable account among other choices.

But the question I was referring to is this: Which is better – a Roth or Traditional IRA?

The answer, as you might expect, is a fully-qualified “It depends”. The are several important factors to take into consideration.

If you were to compare the two types of accounts side-by-side, at first glance you’d think that it doesn’t make any difference which one you contribute to – especially if you assume that the tax rate will be the same in retirement (or distribution phase) as it was before retirement (or accumulation phase). This is because you’d be paying the same tax on the distribution of the Traditional IRA after the investment period, simply delayed, that you would pay on the Roth contribution, only this part is paid up-front.

Clear as mud, right? Let’s look at the following table to illustrate. I have purposely not included any increases in value, as we’ll get to that a bit later. In the example, we’re using a 20% ordinary income tax rate.


Each year we had $1,250 available to contribute to either a Traditional or a Roth. We had to pay tax on the Roth contribution each year, but we were able to make the whole contribution of $1,250, tax-deducted on our Traditional account.

What happens when we factor in growth in the account? The following table reflects the next step in our analysis, with each account growing at 10% per year, and the values are as of the end of the year:


If you subtract the tax from the Traditional balance, you come up with the same number as the Roth account, since there is no tax on the Roth account at distribution. So, although you pay more in taxes, you had more contributions to your account, so it all comes out in the wash.

So far, I’ve not come up with a convincing argument for a Roth or Traditional IRA. Let’s make another change to our table, by assuming that the tax rate in distribution increased to 25%, and that we remain at a 20% rate during accumulation. The following results come from that change:


As you can see, this results in a nearly $1,100 increase in taxes at distribution, making the Roth IRA the preferred option. Conversely, if the ordinary income tax rate is lower in distribution, the Traditional IRA is a better option.

There are some other factors that we could consider and run calculations on, but for the most part we’ve covered the important bases. Depending upon your own situation, one might be better than the other, and the reverse could be true in slightly different circumstances.

However, strictly going by the numbers the Roth IRA is preferred when the income tax rate is higher in retirement, and it’s at least as good as the Traditional IRA if the rates remain the same. If the numbers were the only differences between the two accounts, this is not a strong argument for the Roth, because you’re just making a gamble as to what will happen with tax rates in the future.

Thankfully, there are more factors to bear on the decision. In my book An IRA Owner’s Manual I point out three very good reasons to choose the Roth IRA over the Traditional IRA (excerpt below). With those factors in mind, and given that most folks have a generally pessimistic view of tax rate futures in the US, it seems that the Roth IRA is the better choice in nearly all situations.

Three Very Good Reasons to Choose
The Roth IRA Over the Trad IRA

  1. Roth IRA proceeds (when you are eligible to withdraw them, at or after age 59½) are tax free. That’s right, there is no tax on the contributions you put into the account and no tax on the earnings of the account. You paid tax on the contributions when you earned them, so in actuality there is no additional tax on these monies.
  2. There is no Required Minimum Distribution (RMD) rule for the Roth IRA during your lifetime. With the Trad IRA, at age 70½ you must begin withdrawing funds from the account, whether you need them or not. For some folks, this could be the biggest benefit of all with the Roth IRA.
  3. Funds contributed to your Roth IRA may be withdrawn at any time, for any reason, with no tax or penalty. Note that this only applies to annual contributions, not converted funds, and not the earnings on the funds. But the point is, you have access to your contributions as a sort of “emergency fund of last resort”. While this benefit could work against your long-term goals, it may come in handy at some point in the future.
  4. (a bonus!) A Roth IRA provides a method to maximize the money you pass along to your heirs: Since there’s never a tax on withdrawals, even by your heirs, the amount of money you have in your Roth IRA is passed on in full to your beneficiaries, without income taxation to reduce the amount they will eventually receive – estate tax could still apply though.

As illustrated, if you believe ordinary income tax rates will remain the same or increase in the future, the calculations work in favor of the Roth IRA.

529 Plan vs. Student Loan

college 529 years agoWhen planning for the cost of college for your children, often parents and grandparents think of the 529 plan due to the tax benefits. Almost ten years ago the 2006 Pension Protection Act made the tax treatment of 529 plan college savings instruments permanent.  This will be familiar ground for most, but perhaps parents of future college students need to a refresher.

It will always be cheaper to save for college than to pay for loans. If you’re in the position of most folks – with enough assets that you figure your child won’t be considered for financial aid – then it pays in spades to save now. If you saved $150 a month into a 529 plan for 10 years at 4% rate of return, you’d have just over $22,000 saved up. If, on the other hand, you didn’t save that money and had to borrow $22,000, paying it back over the same 10 year period at 6% interest would require monthly payments of $245 – $95 dollars a month more. If you got lucky and the rate on the loan was the same 4%, the payments would still be $224 a month, almost 50% more than the amount you could have been saving.

The best time to start is yesterday, so the best thing to do is don’t delay. If you started putting money into a 529 plan when your child was first born, accumulating $22,000 by the time the child is 18 only requires $70 per month, assuming 4% rate of return. Wait just five years (until the child is 5), that payment increases to $108 per month. Wait until your child is 13, when you have only five years left in order to accumulate $22,000, you’d need to make 529 plan contributions of more than $333 each month.

Choose the right plan. The differences between your choices for a 529 plan alone are mind-boggling. You can choose a 529 plan that is specific to your state, or one of a myriad of other choices. You can choose a pre-paid tuition plan, or a savings 529 plan (my choice is always the savings type of 529 plan). In addition you need to consider other options for savings as well, such as a Roth IRA. Some options may provide tax benefits, others may not, but this is a critical choice to make as you make your savings plan work for you.

Book Review – Stumbling On Happiness

Stumbling_on_HappinessDaniel Gilbert does a fine job educating the reader on how to think about happiness. A great example is when he gives some rather positive and happy quotes like the ones you’d read from a satisfied customer’s testimonial. When you turn the page, you find out the quotes come from people you’d least expect. In other words, one of our perceptions of happiness is derived from looking at a person from our perspective, not theirs.

A few examples of this are given throughout the book. One in particular is the example of being a conjoined twin. Most of us would think that particular situation would be a horrible outcome in our lives. But we are looking at it from the perspective of not being a conjoined twin. In fact, conjoined twins would have it no other way. They are happy. We would argue that they’re really not happy because they don’t know what it feels like to not be conjoined.

Mr. Gilbert also talks a bit about diminishing marginal utility which is the economic concept that as we get more of something, we feel happier at a decreasing rate. For example, if you have two people; person A makes $30,000 annually and person B makes $300,000 annually. A raise of $10,000 annually will likely increase person A’s happiness quite a bit while person B will feel only slightly happier. The $10,000 has more of an impact on person A as it’s 33% of his annual income while person B receives a raise of only 3%.

This concept (any many others) from the book can help individuals realize that more money doesn’t mean more happiness. Once a person is receiving enough to be secure, often more money may bring more happiness, but at a decreasing rate.

Stumbling on Happiness is written by an academic (he’s a professor at Harvard) and cites plenty of academic evidence. The beauty of this book is it’s not written academically. Mr. Gilbert’s sense of humor and clever examples will keep the reader interested while knowing the information is backed by research.

How to Prioritize Your Time and Money

minimize taxesSometime ago I wrote about needs versus wants. Along those lines I’d like to talk about priorities. It’s pretty common that we heard our friends or family say “I don’t have the time” or “I don’t have the money” (of course, we’ve never said these words). And periodically, I’ll hear these words uttered by my students (no time to study), generally after a not-so-good exam score. But what these folks are really saying is “It’s not a priority right now.”

For many of us, it’s not about having more time or more money. It’s really about prioritizing the time and money we have. When we reprioritize what’s important to us, it’s amazing the things we can accomplish and the money we can save. Here are some tips to prioritize your time and money. In fact, for many folks time is money.

Prioritize your savings. This can be done by paying yourself first through automatic payroll deduction to your 401(k) or other employer sponsored. Do the same thing with automatic deposits into your IRA from your bank account.

Determine needs from wants. This is tough for some folks, but doable. Make a list of everything you spend money on monthly and force yourself to eliminate unnecessary things (wants) from necessary expenditures such as retirement savings, emergency funds or mortgage payment (needs). One you’ve made the list, allocate your money accordingly and stick with it.

Don’t procrastinate. This is easier said than done. But I would argue that eliminating certain wants (such as cable TV or your smartphone) can free up more time to do things that “you never have time for” such as going back to school, reading or writing a great book, or spending time with family.

Another neat trick to get more time I learned in college was to set my alarm 1 minute earlier each day than the day before. By doing do, I was able to free up an extra 30 minutes in my day over a month without shocking my body. Eventually, this led to 60 minutes. Now, I have almost two hours to get work done, exercise, and study before my day starts with my wife and kids.

Set goals. Write down specific goals you’d like to achieve and give them a timeline for accomplishment. For example, you could set baby steps for retirement amounts. This can be done by coming up with an annual savings goal say, $5,500 into an IRA. Give yourself a year (or tax deadline) to accomplish this goal. From there, you can simply divide $5,500 by 12 to get a monthly amount of $458.33. Use the $458.33 as a “mini-goal” and try to free up that money from the needs and wants step mentioned above. Once the money’s freed up, put it on autopilot as recommended in the first step.

Try it, and let me know how it works for you.

 

 

The SEP IRA

canoeOne of the more unique types of retirement accounts is the Simplified Employee Pension IRA, or SEP IRA for short.  This plan is designed for self-employed folks, as well as for small businesses of any tax organization, whether a corporation (S corp or C corp), sole proprietorship, LLC, LLP, or partnership.

The primary benefit of this plan is that it’s simplified (as the name implies) and very little expense or paperwork is involved in the setup and administration of the plan.  The SEP becomes less beneficial when more employees are added. There are additional options available in other plans (such as a 401(k)) that may be more desirable to the business owner with more employees.

SEP IRAs have a completely different set of contribution limits from the other kinds of IRAs and retirement plans.  For example, in 2015, you can contribute up to $53,000 to a SEP IRA. That amount is limited to 20% of the net self-employment income, or 25% of wage income if the individual is an employee of the business.

The account for each participant is an IRA, just like any other IRA (other than the contribution limits mentioned above).  You’re allowed to invest in any valid investment security offered by the custodian, rollover the plan (upon termination of employment) and direct the plan to your heirs however you wish, just like any other IRA.

Money contributed to the plan is excluded from the income of the employee/participant upon contribution, and any growth in the account is tax-deferred until distribution.  At the distribution of the funds, the funds will be taxed as ordinary income.  Upon reaching age 59½ you can access the funds without penalty – otherwise, unless you meet one of the early distribution exceptions, there is a 10% penalty imposed in addition to the income tax on the distribution.  At age 70½ you will be required to begin taking minimum distributions from the account, just like any other IRA.

Additionally, a SEP IRA can be established up to the filing date for your business entity – as late as April 15 of the following year if you like.  This is different from a 401(k), for example, which must be established during the tax year.

Correlation, Risk and Diversification

prepping peppersMany investors understand the importance of asset allocation and diversification. They choose among various assets to invest in such as stocks, bonds, real estate and commodities. Without getting too technical, the reason why investors choose different asset allocation is due to their correlation (often signified by the Greek letter rho ρ) to the overall stock market. Assets with a correlation of +1 (perfect positive), move identically to each other. That is, when one asset moves in a particular direction, the other moves in the exact same fashion. Assets with a correlation of -1 (perfect negative), move exactly opposite of each other. That is, when one asset zigs, the other asset zags.

Generally, the benefits of diversification begin anytime correlation is less than +1. For example, a portfolio with two securities with a correlation of .89 will move similar to each other, but not exactly the same. Thus there is a diversification benefit. In other words, both securities may fall in a market downturn, but one may fall further than the other. The other security dropped, but not as bad as its counterpart.

The reason correlation among securities is important is it allows investors to create portfolios with different assets, while lowering risk. This is why diversification works. One of the caveats of diversification is that the more diversified we are, we can eliminate certain risks. We can improve our risk adjusted returns. This is one of the finer points discovered by Dr. Harry Markowitz in his work developing Modern Portfolio Theory.

Investors are subject to two broad categories of risk when investing; systematic risk and unsystematic risk. Systematic risk is undiversifiable. In other words, systematic risk cannot be eliminated no matter how much an investor diversifies. This risk is also called economy-based risk, market risk, reinvestment rate risk, exchange rate risk, and interest rate risk.

Unsystematic risk is risk that can be eliminated through proper diversification. Unsystematic risk includes accounting risk, business risk, country risk, default risk, financial risk and government risk. We don’t have to invest in only one business (Enron), or one country (Greece). This Risk Chart illustrates the more securities we add to a portfolio the lower the risk becomes – up to a certain point. That point is when the curved line nearly touches, but never does, the market risk line. This asymptotic relationship means that we can get very close to the market risk line, but never eliminate market risk. Market risk is always present.

A key point for investors to understand is that diversification reduces but does not eliminate risk. Investors (as well as financial planners) should understand that there will always be risk and that there’s no such thing as a riskless asset.

Another consideration that investors must understand is that if they are properly diversified, they will not perform exactly the same as the market in a bull market. In other words, if the S&P 500 increases 30% in any given year, the investor’s portfolio should not do the same. The same is true in a bear market. A 30% decline in the S&P 500 should not mirror the investor’s portfolio. If all of an investor’s investments go up together and down together, they’re not properly diversified. A well-diversified portfolio will have some assets increase while others decrease.

This can be a tough pill to swallow when the market is seeing record gains and our portfolios seem to be struggling to keep up. Well-diversified investors are (somewhat) comforted when the market drops heavily and don’t see their own portfolios suffer as greatly.

Have You Saved Enough for Retirement?

winding roadOne of the reasons that retirement funding is a mystery to most folks is the uncertainty that comes with trying to determine how much is enough – enough savings set aside so that we don’t run out of money during retirement.

The answer to this question begins with an understanding of your day-to-day living expenses, and how those expenses may change in retirement. This is a simple enough process, although it does take some effort.

The difficult part is to determine what the funding requirement is in order to provide the income you’ll need to cover your living expenses – for as much as forty years or more!

There is a rule of thumb (more on this later) that you can use to come up with a rough guess – but without using sophisticated computer modeling and analysis, your level of assuredness is limited.

According to a recent survey by the Employee Benefits Research Institute, 84% of future retirees believe that they will have plenty of savings to cover their needs in retirement. At the same time, less than one-third of those surveyed had gone through the effort to calculate how much they will need.

When looking at the actual savings numbers, only around 20% of the survey respondents had in excess of $100,000 set aside for retirement, and more than 10% indicated that they had nothing at all saved for retirement.

The rule of thumb that I mentioned before indicates that you should plan to withdraw no more than 3% to 5% each year from your retirement savings in order to not run out of money. This is what we refer to as a “sustainable rate of withdrawal”. (There are many opinions about what exactly is the appropriate sustainable withdrawal rate – at one time it was suggested that 4% is the right number, but this has been under considerable scrutiny of late. Working with the range of 3 to 5% will get you in the ballpark, nonetheless.) This equates to a requirement of $1 million in retirement funds in order to be able to withdraw $30,000 to $50,000 each year.

Don’t despair over these estimates, though. The rule of thumb is based upon 100 percent certainty, and if you happen to have that luxury, that’s fantastic. There are ways to increase your sustainable rate of withdrawal, while still maintaining a relatively high degree of certainty.

Improving the Level of Certainty

The first and possibly most important factor is to have a plan, and to monitor your plan closely. You can do this on your own, or in conjunction with a financial pro. Paying close attention to your plan and staying with it will provide you with the information in order to make certain that your plan stays on track.

Your plan should include some sort of projections or modeling to show what your future income could be based upon your sources of income – retirement savings, pensions, Social Security, and the like. This will help you to plan for your expenses in retirement – developing a budget in reverse, if you will.

Making adjustments to your portfolio holdings can have a positive impact on the level of sustainable withdrawal. It may seem to run counter to your intuition, but more risk in your holdings is good for your long-term holdings. It is important to maintain significant positions in the stock market in order to achieve a higher level of withdrawals over time. Without some exposure to risk, your funds will fall behind when compared to inflation of day-to-day expenses, not to mention high-inflation items like healthcare costs.

The third factor that can have an impact on your savings’ sustainability is the pattern of income that you’ll need in retirement. As you probably realize, over the span of the potential forty-plus year retirement, your income needs will likely change. During your first several years, you’re likely to spend considerably more than the overall average, as you travel more, take on new hobbies, and the like. Or, on the other hand you may continue to save during this time of your life.

Later on in your retirement, many folks take on lower expenses as they become more sedentary, not traveling as much and having fewer extraneous expenses. Declining health and lower energy level makes staying closer to home more attractive. In later years, health care costs can cause those expenses to increase. It is also important to maintain a realistic view of your own life span. It’s not at all unreasonable to project your retirement plan out to your late 90’s.

There are more factors that can have a positive impact on your sustainable withdrawal rate, but these are the primary ones. I want to reiterate that the most important factor is to make a plan, monitor it closely, and make the appropriate adjustments throughout your life.

What you’ll find is that, by putting some effort into developing a plan, you’ll have much more confidence in your ability to make your savings last. At the same time, if you find that you haven’t yet done enough, you have time to make adjustments in your efforts that will increase your odds.

Having made a plan, it’s also important to review and update it, on average once a year or so. This kind of review will leave you with the peace of mind that, in fact, you’re on track.

How to Invest

Eggs in a basket

Photo courtesy of sraskie

Occasionally, someone will ask me a question in the following different ways: “Did you see what the market did today?” or “How did the market do today?” To be honest, I’d love to use the line that Charley Ellis has used from the movie Gone with the Wind; “Frankly my dear, I don’t give a damn.”

Professionally, my response is more in line with “I couldn’t tell you.” or “I don’t follow the market really.”

The response is not meant to be rude or abrupt, but more to simply say that for most investors (myself included); they shouldn’t be worried about what the market is doing on a day to day basis. This is especially true for the Dow Jones Industrial Average. A price weighted index of 30 stocks is hardly representative of the market, yet it’s what most people think and refer to as “the market” when they ask the questions above or read the news.

The other reason is when you think of it, do we really have control over the market? In other words, what’s the sense in worrying about something that’s beyond our control? Instead, we can focus on what we can control. One of those is expenses. The other is diversification. The good news is that both are easy to control and easy to implement.

As the title says, this is how most individuals can and should invest. Leave worrying about market fluctuations to individuals who think they can beat the market, but very rarely do consistently.

How to control expenses

Generally, one of the best ways to control expenses is to find passively managed funds such as index funds. Index funds simply buy the market basket of securities and since they represent a market index (such as the S&P 500, the bond market, real estate market, etc.) they generally don’t have a manager actively buying and selling securities in order to beat the market. The more a manager actively trades, the more expenses increase – and lower investors’ returns. To quote Dr. Burton Malkiel, Princeton professor and author of the seminal book on investing A Random Walk Down Wall Street, “You get what you don’t pay for.”

Not all index funds are created equal. This is something I wrote about in the past. Investors should look for index funds that are no-load (do not pay the broker an up-front commission) and with expense ratios of .5% (1/2 of 1%) or less. Two companies that offer very inexpensive index fund options are Vanguard and Fidelity. Once you’ve selected which company you’re going to use it’s now time the next step.

How to diversify

When it comes to diversification, investors should first consider which assets classes they will select to invest and diversify into. Asset allocation and diversification are different. Asset allocation means selection from asset classes such as stocks, bonds, REITs, commodities, etc. Diversification means spreading your investment selection among a particular asset class. Once an investor has picked their asset classes the choice of funds from the above two providers becomes easy.

An investor can have excellent asset allocation and diversification with only a few funds in their portfolio. For example, an investor could choose a total stock market index fund, total bond market index fund, an international index fund and a REIT index fund and arguably never have to look at it again except to re-balance occasionally. The weights of the funds (percent of the portfolio dedicated to each fund) needs to be determine by the investor and may solicit the help of a competent financial planner. Financial planning professionals can assist the client with understanding their appetite for risk, goals, time horizon, and tax implications of their investments.

It’s been said that diversification is the only free lunch in investing. That is, according to Modern Portfolio Theory investors can combine individually risky assets while lowering the overall risk in the portfolio.

I’d love to tell you that investing is rocket surgery, but it really isn’t. The industry can make it complicated and I would argue that the more complicated the less benefit it is to investors. Investors should focus on what they can control; expenses and diversification, and get competent professional advice when necessary.

Delayed Retirement Credits for Social Security

these two dudes are delayingWhen you delay filing for your Social Security retirement benefit until after your Full Retirement Age (FRA), your future benefit increases due to a factor known as Delayed Retirement Credits, or DRCs. These credits accrue at the rate of 2/3% for each month of delay, which equates to 8% for every full year of delay.

It’s important to know a few facts about DRCs. For one – the delayed retirement credits are accumulative, not compounding. If your Full Retirement Age is 66 (if you were born between 1943 and 1954), you can accrue a full 32% in DRCs. This means that the amount of benefit that you would normally receive at FRA (which is your Primary Insurance Amount, or PIA) would be multiplied by 132% at your age 70. If your FRA is above age 66, your maximum delayed retirement credit is something less than 32% – as little as 24% if your FRA is 67.

Delayed retirement credits stop once you reach age 70, no matter when your Full Retirement Age is.

If you are delaying your benefit to achieve the delayed retirement credits and you die before reaching age 70, your DRCs stop at your death. Your surviving spouse will be eligible for a Survivor Benefit with delayed retirement credits as of the date of your death. Even if your spouse delays receiving the Survivor Benefit after your death, no more delayed retirement credits will accrue to that benefit.

For example, if you died at the age of 68 years and 6 months, your surviving spouse will be eligible for a Survivor Benefit that is 120% of your Primary Insurance Amount (PIA). If your PIA is $1,500 that means your surviving spouse is eligible for a benefit equal to $1,800.

The same is true if you decide at some point before your own age 70 to go ahead and file. I get this question every once in a while, since most examples of File & Suspend illustrate the individual doing a file & suspend at Full Retirement Age and then delaying benefits until age 70. But it’s not a requirement that you delay until age 70 – if you delay until, for example, age 67, you’ll achieve an increase of 8% since you waited a year before filing for your benefit.

You can file at any time after you’ve reached Full Retirement Age to achieve this 2/3% increase for each month. There’s no requirement to File & Suspend before filing for the delay credits either. It might be part of your strategy to File & Suspend if you’re delaying your own benefit but want to provide a Spousal Benefit for your better half. On the other hand, you might not want to File & Suspend if you plan to file a restricted application for Spousal Benefits based upon your spouse’s record.

Lastly, DRCs only affect your own retirement benefit. There are no delayed retirement credits for Spousal or Survivor benefits by delaying past FRA.