Jonathan Clements's Blog, page 433

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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A Tale of Two Assets

HOW SHOULD YOU DIVVY UP your nest egg between stocks and bonds once you’re retired? There’s a host of factors to consider, including Social Security, any pension plan, any debt you still have and any lump sum payments you expect, such as the proceeds from trading down to a smaller home.

Perhaps the most important consideration: How much income do you need relative to your portfolio’s size? I discuss that topic in my latest client letter for Creative Planning, where I sit on the advisory board and investment committee.

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This Week/Aug. 27-Sept. 2

TAKE ADVANTAGE OF YOUR GROWING WEALTH. You might avoid interest charges by paying cash for your next car, rather than borrowing. You could minimize financial account fees by always keeping the required minimum. You might save on insurance premiums by raising deductibles and lengthening elimination periods, and perhaps even opting to self-insure.

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Who Needs Munis?

IT’S A COMMON PLOY among columnists: You start with the provocative statement—and then spend the rest of the article dancing like crazy, trying to defend it. Today’s provocative statement: Except in a few rare instances, I’m not sure why anybody would ever own municipal bonds.

At first blush, this sounds not just provocative, but downright stupid. If you’re in a high income-tax bracket and investing money through a regular taxable account, it would be foolish to buy taxable bonds and then pay income taxes on the interest you earn. You would be better off sidestepping that tax bill and instead purchasing lower-yielding but tax-free municipal bonds.

That’s correct, except for one small issue: Why would you buy bonds in a taxable account? Why not use your taxable account to pursue a tax-efficient stock strategy, such as investing in broad stock market index funds, so you take advantage of the special low rates on long-term capital gains and qualified dividends? Meanwhile, to the extent you want to own bonds, why not purchase taxable bonds in your retirement account and reap the benefit of the higher yield?

This suggestion would not be helpful for two groups of high-income investors. First, there might be folks who have little or no money in tax-favored retirement accounts, so there’s no way they could buy all the bonds that their portfolio requires in a retirement account. Second, there may be high-income earners who want nothing to do with the stock market, so their entire portfolio is in bonds. For these investors, I graciously concede that owning municipal bonds in their taxable account makes sense.

But not for anybody else.

“Wrong,” you cry. “I’m worried about a financial catastrophe, such as losing my job or a huge medical bill. That means I need easy access to cash—and the right strategy, at my lofty tax bracket, is to own munis in my taxable account.”

Maybe not. Imagine you have $100,000 in stock-index funds in your taxable account and $100,000 in taxable bonds held in your retirement account. Your world then implodes. Not only do you lose your job, but also the stock market plunges 30%.

Now, you have $70,000 in stocks in your taxable account, which you are loath to sell at such depressed prices. Meanwhile, your bonds have rallied to $105,000, but you can’t get access to that money without paying tax penalties, because it’s sitting in a retirement account and you’re under age 59½.

Game over? Not at all. Let’s say you need $20,000 to cover your living expenses for the months ahead. You cash in part of your stock-index fund holdings, perhaps realizing a tax loss in the process. Even with a tax loss, that doesn’t seem so smart, because you just sold stocks at fire-sale prices.

But the damage is easily repaired. Within your retirement account, you shift $20,000 from bonds to stocks. Result: You still have the same amount in stocks. Indeed, you have effectively sold bonds to cover your financial emergency.

And, no, this isn’t some crazy pie-in-the-sky strategy: It’s how I handle my own portfolio—with my taxable account entirely in stock-index funds and all my bonds held in my retirement account.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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Savings: 10 Questions to Ask

IF YOU DON’T SAVE DILIGENTLY, you are highly unlikely to amass a decent-size nest egg. Time to make amends? Here are 10 questions to ponder:

Do you regularly spend more than planned? Try writing down every purchase you make. That’ll tell you where your dollars are going—and make you think twice before spending.
How much of your income goes toward fixed living costs? We’re talking about items such as mortgage or rent, car payments, utilities, groceries and insurance premiums. If your fixed living costs are too high, you’ll find it tough to save, no matter how determined you are.
If you have goals other than retirement, are you saving more than 12% of income? That 12% is probably the minimum you should be socking away each year for retirement. If you’re looking to make a house down payment or fund the kids’ college, that will require additional savings.
Is 12% enough? With long-run stock and bond returns expected to be modest, it might be safer to sock away more than 12% for retirement.
Should you force yourself to save—by automating your savings? Many folks use payroll deduction to fund their employer’s 401(k) or 403(b) plan. But you could also automate other savings, such as automatically moving money every month from your checking account to a high-yield savings account or to your favorite mutual funds.
To save even more, how about cutting living costs—and then upping your automatic investments by an equal amount? Let’s say you save $150 a month by downgrading your cable package, cancelling magazine subscriptions, using a cheaper gym, and raising the deductibles on your home and auto insurance. To ensure those savings don’t get squandered, you might immediately increase your automatic monthly investments by $150.
Could you turn debt payments into savings? Suppose you’re about to pay off a student loan or car loan. You’re used to living without the money, so it shouldn’t be any great sacrifice to redirect the sum involved to your favorite mutual fund.
Do you have excess cash in your checking account? Move it to a high-yield savings account or a low-cost money market mutual fund. If you leave the money in your checking account, it’ll earn little or no interest—plus you may be tempted to spend it.
Could your savings be working harder? If you favor lower-cost investments, take advantage of tax-deductible and tax-free retirement accounts, and ensure you collect the full matching contribution offered by your employer’s 401(k) plan, your savings will almost certainly grow faster.
Should you create a wish list for major expenses? By keeping a running list of potential major expenditures—things like remodeling projects, new furniture, new cars and vacations—you’ll give yourself extra time to ponder whether these are good uses for your money.

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

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Sell or Sweat?

DON’T GIVE INVESTMENT ADVICE to clients. That’s something I’ve repeatedly learned as a tax lawyer. Still, when financial markets gyrate, many clients want advice about taxes, especially the seemingly simple rules for capital gains—and I have a long-standing fondness for eating three times a day.

Let’s start with the basics. Take an individual who sells an investment that she has owned for more than 12 months. Any increase in its value from its cost basis is taxed at her long-term capital gains rate—15% for most individuals, but as high as 23.8% for those who are in the top ordinary income-tax bracket of 39.6% and subject to the 3.8% Medicare surtax on investment income.

It can get worse. She surrenders more to the IRS when her profit is from the sale of an asset held for 12 months or less. Her short-term capital gain is taxed at higher ordinary income-tax rates—the same rates that apply to income sources like salaries and pensions.

The dilemma: Should savvy investors opt to realize short-term gains, so as to nail down profits, albeit causing them to be nicked for taxes at the same rates as ordinary income? Or is the wiser strategy to stand pat until those profits become long-term, meanwhile hazarding declining prices that could more than offset the lower taxes?

Consider an example. Let’s say Norma Bates’s regular income-tax bracket is 25%. (In 2017, that rate applies to taxable income between $37,950 and $91,900 for singles and between $75,900 and $153,100 for joint filers.) Norma has a sizable unrealized gain on shares of Beefsteak Uranium, a volatile stock she has owned for fewer than 12 months.

She’s considering selling her BU shares for fear of plummeting prices, perhaps caused by terrorist attacks or world instability (cue countries like North Korea, Iran and Russia). Norma’s worst fear: photos of BU’s top execs being booked on charges of securities fraud and larceny, a result of cooking the books, spending company funds on personal indulgences or some other kind of corporate chicanery.

Her first option: Unload the shares now and secure the short-term gain, but lose 25% of her profit to the IRS. Depending on where she lives, she may also owe state and even city taxes.

Her other option: Hold off on a sale until the gain becomes long-term, and forfeit no more than 15% of it to the IRS, plus local levies.

How much of a drop can Norma endure while waiting until she qualifies for that lower rate and still be no worse off after taxes? For the answer, she can use this three-step calculation:

Figure her after-tax short-term profit from her BU shares.
Divide this amount by her after-tax profit on the same amount of long-term gain.
Multiply the short-term gain by the resulting decimal.

To see how the math work, let’s plug in some numbers. Suppose Norma’s paper profit is $10,000. Her combined federal and state bracket is 30% for short-term gains. For long-term gains, it’s 20%.

A $10,000 gain taxed at 30% entitles the tax collectors to $3,000, leaving Norma with $7,000.
The same $10,000 taxed at 20% leaves her with $8,000. Divide $7,000 by $8,000 and you get 0.875.
Multiply $10,000 by 0.875 and the result is $8,750. A smaller long-term profit of $8,750 taxed at 20% leaves Norma with $7,000—the same profit she would have received were she to sell for a $10,000 gain and be taxed at 30%.

When does a decision to sweat out the 12-month holding period leave Norma worse off after taxes? Not until her paper profit drops from its present $10,000 to below $8,750—that is, by more than $1,250. Is it worth waiting? Clients have to decide that one for themselves.

Julian Block writes and practices law in Larchmont, NY, and was formerly with the IRS as a special agent (criminal investigator). His previous blog was Hitting Home. 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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On Our Own

IT ALL BEGAN WITH AN AFTERNOON phone call between Andrew, my twin brother, and me. I made an off-the-cuff comment about starting our own company. For the previous eight years, both of us had worked at a large lawn care company and then, for a few brief months, at a medium-sized landscaper.

Neither of us doubted we would be successful. But we were taking a large financial risk: Starting our own company meant leaving the security of a regular paycheck, health insurance, a workplace retirement plan, a company vehicle and more. We both had mortgages and, of course, utility bills to pay and groceries to buy. I was single at the time, but Andrew had a family to provide for, so it was important for him to have a salary from our new company.

Meanwhile, I drew on savings to cover personal expenses. In earlier blogs, I have mentioned that I am frugal. Not only did I know how to keep my expenses to a minimum, but also being careful with my money had allowed me to accumulate a healthy amount of savings, so I was well prepared for the lean months that lay ahead. I wouldn’t take a salary for the entire first year. Fortunately, health insurance was a relatively modest expense, because of my young age, and I never considered going without. To do so would, in my opinion, be penny wise and pound foolish.

At our previous employer, we both had a company vehicle. Rather than buy a new vehicle, I gave Andrew my car to make sales calls, while I used our new company’s first truck not only to perform the fall work that we had been contracted to do, but also for my personal use.

Ensuring that we had sufficient work during the fall months was important, so we would have enough money going into the following spring. There would be large upfront costs, such as trucks, trailers, equipment and materials.

Thankfully, there was a lot of work that first fall, most of it coming from a company whose owner we knew from the lawn care company that had previously employed us. I worked 12- to 14-hour days to get all the work done. It was an exhausting time. Over those fall months, we were able to bring in sufficient money to pay cash for the trailers and equipment needed for the spring, though we borrowed to buy the trucks. We also asked each of our parents for a $10,000 loan, which we repaid within a year.

The short-term personal financial sacrifices that we both made allowed us to avoid having to take out bank loans, which benefitted the company in the long run. In that first year, we had a very small loss. But there was never another year when we weren’t profitable.

Nicholas Clements is one of Jonathan’s older brothers. He is retired and lives just outside Washington, DC. His previous blogs include Growing Up (Part III),  Less Green and  Not a Good Time . Follow him on Twitter @MDScaper .

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This Week/Aug. 20-26

GIVE AWAY MONEY NOW? You might be considering a large financial gift to your favorite charity or to your children. Charitable contributions aren’t limited, though their tax-deductibility can be. Meanwhile, with our kids, we might take advantage of the $14,000 annual gift-tax exclusion. But before we do, we should check we have plenty for own retirement.

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Protection Money

VANGUARD GROUP has long been my favorite fund company—and the place where I now keep all my investment dollars. There’s no mystery why: Among mutual fund companies, Vanguard has long been not only the biggest champion of index funds, but also the firm with the lowest annual fund expenses.

Except that’s no longer the case.

Fidelity Investments, BlackRock’s iShares and Charles Schwab have all muscled onto Vanguard’s turf, offering index funds with lower annual expenses. This is obviously a marketing ploy: By offering cut-rate deals on select index funds, they hope investors will also buy some of their pricier merchandise.

Still, this is a potential bonanza for investors, who can now invest at extraordinarily low cost. Suppose you were aiming to build a global balanced portfolio, with 40% bonds and 60% in stocks. The 60% stock portion is split so you have 40% in the U.S. and 20% overseas, including a 4% allocation to emerging markets. Here’s how much you would pay at four major fund companies:

Fidelity Investments

40% Fidelity Total Market Index Premium Class (0.035%)
20% Fidelity Global ex U.S. Index Premium Class (0.1%)
40% Fidelity U.S. Bond Index Premium Class (0.045%)
Portfolio’s weighted expenses: 0.052%
Annual cost: $52 per $100,000

iShares

40% iShares Core S&P Total U.S. Stock Market ETF (0.03%)
20% iShares Core MSCI Total International Stock ETF (0.11%)
40% iShares Core U.S. Aggregate Bond ETF (0.05%)
Portfolio’s weighted expenses: 0.054%
Annual cost: $54 per $100,000

Charles Schwab

40% Schwab U.S. Broad Market ETF (0.03%)
16% Schwab International Equity ETF (0.06%)
4% Schwab Emerging Markets Equity ETF (0.13%)
40% Schwab U.S. Aggregate Bond ETF (0.04%)
Portfolio’s weighted expenses: 0.0428%
Annual cost: $42.80 per $100,000

Vanguard Group

40% Vanguard Total Stock Market ETF (0.04%)
20% Vanguard Total International Stock ETF (0.11%)
40% Vanguard Total Bond Market ETF (0.05%)
Portfolio’s weighted expenses: 0.058%
Annual cost: $58 per $100,000

The three Fidelity funds are mutual funds, which means you can buy them directly from Fidelity, with no additional cost. All three funds require a $10,000 minimum investment. The other funds listed are exchange-traded index funds, so buyers would likely lose a little to trading spreads and perhaps commissions. In the case of the three Vanguard funds and three of the four Schwab funds, there are corresponding mutual funds with the same annual expenses. The similar-cost Vanguard funds have $10,000 investment minimums, while the Schwab funds have no required minimum.

Keep in mind that expenses aren’t the sole driver of differences in index fund performance. Funds can also help performance by skillfully replicating their target index or by making money from securities lending.

But forget those issues. Based solely on expenses, it looks like Vanguard wouldn’t be anybody’s first choice. And yet I’m not about to move my money elsewhere.

Why not? Vanguard is effectively owned by the shareholders of its funds, and it benefits those shareholders by operating its funds at cost. If Vanguard is operating at cost, all of these other firms are either barely breaking even and possibly losing money. How long will these firms—which, unlike Vanguard, are profit-making entities—be willing to operate that way?

Maybe it’s forever. But maybe it’s only until the investment dollars stop pouring in, at which point these firms might decide its time to make a little money off the assets they’ve gathered. At that juncture, shareholders will face a tough choice: They can either stick with funds that are no longer dirt cheap—or they can move to lower-cost funds. The problem: Selling could trigger capital gains taxes if investors own their index funds in a regular taxable account. By contrast, selling in a retirement account wouldn’t trigger taxes, but it would be a hassle—and investors could incur modest transaction costs and perhaps find themselves out of the market for a few days.

Or these investors could just stick with Vanguard, where there shouldn’t be any sudden price hikes. Right now, on our hypothetical balanced portfolio, that would mean paying as much as $15 a year extra for every $100,000 invested. I think of it as protection money—and it strikes me as small price to pay.

Follow Jonathan on Twitter @ClementsMoney and on Facebook.

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