Jonathan Clements's Blog, page 416

Unheard Of

TALKING TO A BROKER or insurance salesman? Here are 10 things you’ll likely never hear:

“Wow, your 401(k) has great low-cost institutional funds. There’s no way you should roll that money into an IRA.”
“Do you know that you could buy these funds outside a variable annuity and pay a fraction of the price?”
“Sure, you could make that trade—but probably the only person who will get richer is me.”
“My hunch is, this closed-end fund you’re buying will be at discount within a few months of the IPO.”
“Given the markup on that bond you just bought, I hate to think how much you’d lose if you sold right away.”
“Of course, unlike a 401(k), you won’t get a tax deduction or matching contribution when you buy this cash-value policy.”
“I know the B shares look like a no-load fund, but the annual expenses will eat you alive—and the back-end commission will nail you if you try to escape.”
“Actually, I’m not required to act in your best interest.”
“So you pay 1.5% a year for the fee-based account and 1% for the funds you’ll be buying. Meanwhile, the stock market will probably earn 6% a year over the next decade, while inflation runs at 2% and taxes take maybe 1 percentage point out of your gain. Let me know if you need any help with the math.”
“I doubt you’ll make much with this indexed annuity, but things look pretty great from my perspective.”

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Investment Taxes: 10 Questions to Ask

WANT TO BOOST your after-tax wealth? Grab copies of your latest tax return and investment statements—and ask yourself these 10 questions:

What’s your marginal tax rate? That’s the tax rate on the last dollar of income you earn each year. It’s a crucial piece of information as you decide which retirement accounts to fund and how to invest your taxable account. You can get a quick estimate using Dinkytown’s calculator.
Do you expect your marginal tax rate to be higher or lower once you’re retired? If you expect your marginal rate to fall, you should probably favor tax-deductible retirement accounts. If not, go for Roth accounts.
Are you making the most of tax-sheltered accounts? You can get tax-free growth not only from Roth retirement accounts, but also from tax-deductible accounts—because the initial tax deduction often ends up paying the final tax bill. On top of that, you may get the big bonus: a matching employer contribution.
If you don’t qualify for a tax-deductible or Roth IRA, have you considered making nondeductible contributions? You could then convert the account to a Roth—but you need to be careful or the tax bill could be far bigger than you hoped.
Do you hold tax-inefficient investments in your taxable account? We’re talking about things like taxable bonds, real estate investment trusts and actively managed stock funds. You could trim your annual tax bill by confining these investments to your retirement account.
Does it really make sense to own municipal bonds? Munis are often recommended for those taxed at a high marginal rate. But even if your tax bracket justifies owning munis, you might be better off owning taxable bonds in your retirement account—and using your taxable account to own stock-index funds instead.
Got a year with relatively little taxable income? That might be the case if you’re out of work or just retired. To take advantage, look into converting part of your traditional IRA to a Roth. Alternatively, you might sell stocks in your taxable account with large unrealized capital gains that you’ve been looking to unload.
Do you have losing investments in your taxable account? If you sell, you can use the losses to offset realized capital gains and up to $3,000 in ordinary income.
Did you report short-term capital gains on your last tax return? Those gains would have been taxed at the higher ordinary income tax rate—a tax hit you could have avoided if you’d held the investments involved for more than a year or, better still, confined any short-term trading to your retirement accounts.
Is your income taxed at a federal rate of 15% or less? You may be able to sell winning investments in your taxable account—and pay nothing in capital gains taxes.

This is the eighth blog in a series. Be sure to check out the earlier articles.  Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Late? That’ll Cost You 50%

EVERY YEAR, MANY SENIORS needlessly incur hefty penalties or overpay their taxes. The reason: They don’t understand the strict rules that govern removing money from their tax-deferred retirement accounts.

The IRS sets the year you turn age 70½ as the deadline to begin taking RMDs, short for required minimum distributions. The feds allow some leeway for the first of your RMDs. But this is a tricky exception.

Yes, you can postpone the reckoning until April 1 of the year after you attain 70½. (No, it isn’t the April 15 due date for filing returns, as many seniors mistakenly believe.) But delaying the first RMD until the year after you turn 70½ can prove costly, as you still must take your second RMD by Dec. 31 of the same year.

Aside from the exception for the first RMD, the IRS is insistent on getting its share of at least the minimum amount each year, though you can always remove funds faster than required without incurring any penalty.

Just how expensive can indifference to the calendar be? Say you reach age 70½ before the close of 2017 and postpone the first RMD beyond April 1, 2018. The law empowers the IRS to exact a late-withdrawal penalty equal to a horrendous 50% of the difference between what should have been distributed (a set amount based on your life expectancy) and what was actually distributed.

Suppose you should have withdrawn $20,000 and only remove $12,000. The $8,000 difference is subject to a 50% penalty of $4,000. Completely ignore the calendar, don’t withdraw any of the $20,000 and the penalty soars to $10,000.

The penalty’s purpose is to compel you to begin shelling out for taxes. It’s immaterial that you’re fortunate to have more than enough other income from pensions, dividends and Social Security to cover your foreseeable retirement needs and would just as soon postpone RMDs for at least several years beyond 2017, so the money continues growing tax-deferred inside your IRA.

Penalties aside, it could prove costly to delay the first RMD until early 2018 and then also have to make a second RMD later that year. Even if you make that first RMD before the April 1 deadline and thus avoid the 50% tax penalty, the boost to income for 2018 from two payouts could push you into a higher bracket and cause more to be siphoned off for taxes than if you had made your first RMD during 2017.

Moreover, more of your Social Security benefits for 2018 could be lost to taxes and you might find yourself paying higher Medicare Part B and D premiums. Another drawback: Doubling up in 2018 might cause you to forfeit a valuable tax benefit. Many states authorize an exemption for a sizable part of money removed from IRAs and other retirement plans. For instance, New York exempts as much as $20,000 for each spouse. But such exemptions are on the basis of per year, not per distribution.

Julian Block writes and practices law in Larchmont, NY, and was formerly with the IRS as a special agent (criminal investigator). His previous blogs were Hitting Home and Sell or Sweat? This article is excerpted from Julian Block’s Year-Round Tax Savings, available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.

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Getting Sued

LIKE MOST PEOPLE, I don’t spend a lot of time thinking about my car insurance. And like most people, the only time I do think about insurance is when I need to use it. Four years ago, I was involved in a collision. My car was totaled and my insurance company processed my claim quickly. Because I was deemed to be not at fault by my insurance company, I didn’t have to pay my deductible or any other expense related to the collision. I purchased a used car with the funds from my claim and thought nothing more about it.

Until a year ago.

Sitting at home one day last summer, I heard a knock on my front door. I opened it and saw a young man standing there with a large envelope in his hand. After verifying who I was, he proceeded to hand me a summons. I was being sued by the other person involved in the collision.

I had no idea how to deal with being sued. Fortunately, through a series of friendships developed in the competitive shooting community I’m part of, I was able to talk to someone knowledgeable about auto insurance litigation. I found out my insurer would provide a lawyer to represent me. I also learned several other valuable lessons related to my insurance coverage:

Keep comprehensive notes about any accident you’re involved in. Get copies of any police reports that were filed. Take photos of any damage that occurred. Spend time writing down the details—weather, road conditions, specific location of the accident—as soon as you can.
Don’t be in a hurry to throw away any documents you collect. I almost discarded all the records related to my collision just a couple of months before I received the summons. I assumed that since the accident had happened more than two years earlier—and my claims had all been resolved—there was no reason to keep my records. As it turned out, the lawsuit was filed just one month before the three-year statute of limitations expired, so I was glad I had hung on to the documentation.
If you receive a summons related to a car accident, contact your insurance company immediately. You have a limited number of days to respond to a complaint filed against you, so it’s imperative to get the insurance company involved immediately.
Be aware of your insurance coverage limits and consider increasing them if you have substantial assets. I was happy to discover I had more bodily injury (BI) liability coverage than the minimum my state requires. Subsequently, it was recommended that I increase my BI coverage to at least $100,000 per person, to adequately protect my financial assets. With a net worth now exceeding $400,000, I’m also considering purchasing a separate umbrella policy to further protect me from any future litigation.

I recently gave my deposition about the accident and the case should go in front of an arbitrator soon. Being sued was both a surprise and a wakeup call. Spending time reviewing insurance policies and contemplating litigation isn’t the way I like to spend my time. But knowing I’ve done what I can to protect my financial future helps me sleep better at night.

Kristine Hayes is a departmental manager at a small, liberal arts college in Portland, Ore. Her previous blogs include College, Then and Now ,  Growing Up (Part I) and To Buy or Not to Buy .

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This Week/Sept. 3-9

TALK TO YOUR CHILDREN ABOUT MONEY. Forget lectures—and instead teach your kids by telling family stories, setting a good example and sharing your financial life. Show them your account statements. Detail where your paycheck goes. Talk about your goals. Tell them about your financial struggles when you first entered the workforce.

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September’s Newsletter

DO FINANCIAL GIFTS inevitably undermine our children’s ambition? What’s the best way to rein in our hardwired instincts? After the huge stock market rally of the past eight years, is it time to throttle back risk? In September’s newsletter, I tackle seven ideas that have lately been rattling around my brain.

The newsletter also includes an updated list of recently popular blogs. Want to get HumbleDollar’s free monthly newsletter via email, rather than reading it here? Be sure to subscribe, which you can do from the site’s home page or the main newsletter page.

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Out of My Mind

IF WE HAVE DINNER with half-a-dozen others, we might all share the same meal and yet each of us will have a different experience—sometimes radically different. Even as we talk politics, crack jokes and swap gossip, we’ll each have our own thoughts whirling in the background: errands we can’t forget, work issues we need to resolve, incidents from the day we keep replaying, worries we can’t put behind us.

For me, those whirling background thoughts often concern financial notions I want to write about. I get stuck on ideas, mulling them over again and again. Here are seven topics that have lately captured my attention:

1. Taming instincts. If financial education was all it took to make us better savers and smarter investors, we’d have solved those problems long ago. We are awash with great books, articles and videos on money management, and yet there’s scant evidence any of this has made much difference.

Why is change so difficult? Improving behavior is toughest when it means bucking our hardwired instincts. Intellectually, we may know we should exercise more, lose weight and save more—and yet our instincts keep telling us to stay on the couch, eat Cheez Doodles and shop online.

Sometimes, the contemplative side of our brain can sway the instinctual part. But only a minority of individuals seem able to discipline themselves—and only in some situations: We might persuade ourselves to eat less, but we still struggle to save more.

What to do? To change our financial behavior, we could try automating our regular savings (payroll deduction into 401(k) plans, automatic investment plans), removing temptation (stay away from stores, get excess cash out of our checking account, leave credit cards at home) and raising our own awareness (set calendar alerts, post notes on the refrigerator, write down every dollar we spend).

But I have come to believe that the key to success is social pressure. If I tell myself I need to sock away more money, it’s so easy to break that promise. But if I announce to friends that I’m going to save enough to make a house down payment within 12 months, I’ll feel truly committed.

2. Missing ambition. It’s a story I hear again and again: Children of comfortable middle-class families make it through college, but then drift. They might travel, work as au pairs, teach English abroad or spend time working clerical jobs for which they’re overqualified.

Should we be alarmed by this lack of drive? Or is this gentle launch into the adult world a luxury that we—as an affluent society—can now afford and which we should embrace? I’m torn. I tend to withhold judgment when I hear of other people’s children doing this. But I’m sure glad my kids didn’t.

Often, adult children of affluent households are able to launch slowly because they have their parents’ financial backing. Are parents killing their children’s ambition with kindness, so their kids miss out on the great pleasure that comes from working hard at something they care deeply about?

I have written many times about the financial assistance I’ve provided my children. By helping them to save for retirement and for a house down payment, I’ve taught them about money, emphasized the financial goals I think are most important and taken advantage of investment compounding. But in retrospect, I wonder whether I was lucky—and whether the money I provided could just as easily have killed their ambition, rather than speeding their financial journey into the adult world.

“What’s prudent for the long haul often generates mediocre results, or worse, in any given year.”

3. Recognizing luck. We often make two unconscious assumptions: that people with greater wealth are somehow superior—and that their financial success is the result of talent. Yet all it takes is a moment’s reflection to realize this is nonsense. There are many rich people who don’t deserve our admiration and who acquired their wealth more through luck than skill.

It’s especially important to recognize this in the financial markets. In the short-term, the market’s biggest winners are often the lucky and maybe even the foolish—those who made big bets on a few stocks or a single sector of the market. We should be careful not to learn the wrong lesson from their success. In all likelihood, their luck won’t hold, and nor will ours if we mimic what they do.

Instead, the long-term spoils are most likely to go to those who hold down investment costs, minimize taxes and diversify broadly. The problem: What’s prudent for the long haul often generates mediocre results, or worse, in any given year.

4. Falling costs. For those inclined to waste money, Wall Street continues to offer plenty of overpriced merchandise, everything from variable annuities to cash-value life insurance to hedge funds.

But if you’re like me and want to keep costs to a minimum, it’s astonishing how cheap investing has become. We can now build globally diversified portfolios of stock and bond index funds, and pay less than 6 cents a year for every $100 we have invested. Meanwhile, our neighbors might be forking over $3 a year for every $100 they have in their variable annuity. How could their results possibly rival ours? It’s almost inconceivable.

5. Emerging markets. Even as my enthusiasm for U.S. shares wanes amid soaring valuations, I remain a huge fan of emerging market stocks. Quantitatively driven money managers often look for a combination of low valuations and upward price momentum—and developing markets offer both.

There have been early signs of a rebound, with emerging markets posting double-digits gains in both 2016 and 2017. Those gains followed a miserable five-year stretch during which developing markets broke even in one calendar year and lost money in three others. Despite the recent revival, emerging markets’ valuations remain cheap by global standards.

6. Looking wide. I have long advocated taking a broad view of our financial lives. For instance, when settling on a portfolio’s split between stocks and more conservative investments, we should factor in our Social Security benefits, any traditional pension plan we have—and, most important, our paycheck or lack thereof.

Indeed, as I can attest, the investment world looks quite different when you no longer have a regular salary and you’re no longer regularly adding fresh savings to your portfolio. That got me to thinking: When calculating our asset allocation, perhaps we should count any future savings as part of our portfolio’s conservative investments. I explored that notion in a recent blog.

7. Declaring victory. The overriding financial goal isn’t to beat the market, prove how clever we are or become the richest family in town. Rather, the goal is to have enough to lead the life we want.

After the amazing stock market run of the past eight-plus years, many of us are much closer to that point—and certainly far closer than we could possibly have hoped during the dismal winter of 2008-09. Should we keep gunning for growth? Or is the rational response to reduce risk? I’ll have more on that topic in next month’s newsletter, which will go out on Saturday, Oct. 7.

August’s Greatest Hits

HERE ARE THE SEVEN most popular blogs that HumbleDollar published last month:

Measure for Measure
Protection Money
Safety Net: 10 Questions to Ask
Happiness: 10 Questions to Ask
Savings: 10 Questions to Ask
By the Book
Who Needs Munis?

Meanwhile, three blogs from July continued to garner a healthy amount of traffic during August: Growing Up (Part II), Bad Old Days and Retirement: 10 Questions to Ask.

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Investing: 10 Questions to Ask

REVIEWING YOUR INVESTMENT strategy? To get you started, here are 10 questions to wrestle with:

How much cash you will need from your portfolio over the next five years? That money should be out of stocks and riskier bonds—and invested in nothing more adventurous than short-term bonds.
What’s the total sum you expect to save between now and retirement? If you look at that future savings as a cash holding and count it as part of your portfolio’s conservative investments, you may find your portfolio is far less aggressively positioned than its current investment mix suggests.
What market bets are you making? You might see how your portfolio compares to the global market portfolio—the world’s investments weighted by their market capitalization—and then ponder the risks you’re taking by overweighting, say, U.S. or foreign shares, large or small companies, and growth or value stocks.
Do any individual stock positions account for more than 5% of your stock portfolio’s value? It’s dangerous to bet that heavily on any individual stock—and doubly dangerous if it is your employer’s stock.
How much are you paying every year to invest? Even if you actively manage part of your money, consider anchoring your portfolio with index funds, so your weighted average annual expenses are below 0.4% of assets. Not sure how much you’re paying? That’s a bad sign—and probably means you need to simplify your strategy and have a tough conversation with any financial salespeople you use.
How did your stock funds perform in 2008 and your bond funds in 2013? Are you mentally prepared for losses like that? If not, you might adjust your portfolio now, before you find yourself panicking and selling in the midst of a market decline.
Would you be better off with market-tracking index funds? Take a hard look at how your actively managed mutual funds and individual stocks have performed since you bought them—and also consider the performance of the investments you’ve sold and would like to forget about.
Should you allocate more to foreign stocks? The amount recommended by experts has increased over the years, with good reason: Adding foreign shares can reduce a stock portfolio’s overall volatility—plus foreign markets today are much better value than U.S. shares.
Are you using strategies that are either widely discredited or unlikely to succeed? At issue are things like market timing, day trading, technical analysis, options trading and short selling.
When did you last rebalance? If it’s been more than a year, it’s been too long.

This is the seventh blog in a series. The earlier articles were devoted to retirement, housing, college, your family’s safety net, money and happiness, and saving money. Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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August’s Updates

HOW SHOULD WE DESIGN our portfolios? It’s one of the most fundamental personal finance questions. Thinking about goals, time horizon and risk tolerance isn’t enough. We also need to ponder our broader financial lives.

To reflect that, I beefed up the beginning of HumbleDollar’s chapter on investing—the parts devoted to setting goals and asset allocation. Along the way, I added a new section on the many bond lookalikes in our financial lives, and rewrote the chapter’s asset allocation guidelines and the section on human capital.

This month, I also added a page to the money guide’s big picture chapter that includes links to all the 10 Questions to Ask blogs that the site has run in recent months. There will be more of these articles in the weeks ahead. I view them as an alternative way for readers to discover relevant parts of the money guide. One reason they’re helpful: As we tackle financial issues, we often stray into other subject areas. For instance, when hunting for the right home, we also need to ponder whether we’re sufficiently creditworthy to get a mortgage—and whether we can get that mortgage paid off by retirement.

In 2017, HumbleDollar has run a large number of articles on kids and money, including pieces on what we learned from our parents, how to help kids with college and other costs, and what should be the financial priorities for young adults when they first enter the workforce. I pulled together links to all these articles in a new section that’s located at the end of the money guide’s chapter on saving money.

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Not So Fast

TOWARD THE END OF HIGH SCHOOL, I landed in some predictably adolescent legal trouble: I purchased alcohol underage and had to shamefully explain what happened to my parents. As I dejectedly declared that I would pay the fine and admit guilt, my parents—concerned about potential career implications—instead insisted that I hire a lawyer with my own money. I had to work for more than a year as a busboy and caterer to reimburse my parents for the cost, but my permanent record was eventually completely cleared.

I used to tell this was a story to prove I was a reckless kid who didn’t always follow the rules. But as I reflect on the episode today, I’m struck by two thoughts.

First, my own privilege—and my relative unawareness of it—was startling. If I hadn’t had access to a lawyer who I’m sure discounted his rate (my parents were close friends with partners at the firm), or the money to pay him (loaned to me by my parents) or the knowledge that I should contest the charges (under pressure from my parents), I would’ve had a criminal record before my freshman year of college.

Everything was lined up for me, simply because of who my parents were and, let’s be honest, the color of my skin. It wasn’t until I recently replayed this experience that it crystallized into a comprehensive microcosm of what it means to be privileged and how my own privilege benefitted me.

Second, when faced with a choice, either personal or financial, the best long-term decision is often disregarded, because it conflicts with immediate needs. I wanted the quick, easy solution—pay the fine, admit guilt, walk away—without considering the potential long-term impact that my parents immediately grasped. It’s the same impulse that can lead 20-somethings to forgo health insurance because they’re “healthy,” not realizing the cost of one emergency room visit could quickly land them in six-digit debt. Similarly, many recent graduates make a shortsighted decision to postpone saving for retirement, even though basic investing principles and the power of compounding suggest the opposite approach.

To be sure, true financial hardship can prevent people from buying health insurance, contributing to a 401(k) or paying for needed legal advice. But there are also situations where we, as millennials, decide something more tangible and immediate is a better use of our time and money. We make the quick, easy choice—but we also risk making a major mistake.

Looking back, I realize that my own privileged upbringing—captured in that crucial moment of parental good advice and financial help—has much to do with my own personal and financial success. I’ve grown increasingly aware of my instinct to go for the quick fix—and that awareness has ultimately saved me money, as I’ve become less impulsive about financial and other life decisions, and more thoughtful about the consequences.

Zach Blattner’s previous blogs include Growing Up (Part II),   Seller’s Remorse  and  Too Trusting . Zach lives in Cambridge, MA, and is a former teacher and school leader who now teaches English teachers as a faculty member at Relay GSE. He is a self-taught finance nerd who dispenses advice to his wife, friends, family and anyone else willing to listen.

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