Greed

I’m amazed how we tend to forget the pain of 2000-2002 and 2008-2009.  While we sit at record highs, the pains of yesterday seem to be a distant memory.  Greed is now peeking its ugly head around the corner once again.  I am hearing some discussions from average investors stating they want to buy a stock a friend turned them on to.

The thought of picking a winning stock and doubling your money is intoxicating for some.  Wanting the best bang for the buck, the most return on investment,  and doing the best you can are all certainly understandable. But, putting your future at risk by over indulging in the market because a friend or a talking head on the TV says “this rally has legs” is not a wise move.

Fear

At the other side of the spectrum is fear.  Some folks are still scarred from the pain the market inflicted over the last 13 or so years.  I have seen many folks who are fearful to invest because the market is just too “risky.”  This path can also lead to financial disaster.

Staying out of the market can also be painful over the long term. Of course, we sometimes have money sitting in cash for short periods of time as we wait to put it to work. That is okay, but having large amounts of cash sitting idle for extended periods can certainly be a financial pitfall.

What to do?

While fear and greed fall at the edges of our investment psychology, balance lands us right in the middle and proves the answer we need for overall portfolio health.  Developing a portfolio that can handle the three economic environments our economy can produce (Prosperous, Inflationary, and Deflationary) is the ticket.

The keystone to investment health is understanding how much risk is appropriate.  Not how much risk your stomach can handle (the typical broker based risk profile), but how much risk is appropriate for your situation based on endogenous (specific to you) factors.  Unfortunately, many folks end up with portfolio allocations based on risk factors determined from exogenous (outside) factors.   These factors include things like market conditions, outside information (investment tips from friends and talking heads), and other economic factors.  These outside factors are usually issues we can’t control.

The path to financial success is one led by controlling the things you can control (spending, savings, and managing taxes).  Trying to time the market or an individual stock is very difficult and very risky.  This points us back to the comprehensive planning approach.  We should continue to plan and do the things we normally do: contribute to retirement accounts, maintain tax efficiency, and keep the big picture in mind.

I have no idea what the market will do today, tomorrow, or the rest of the year.  Anyone who tells you otherwise is speculating.  Our job is to maintain a disciplined approach to investing based on endogenous factors and not fall prey to fear and greed.

Yahoo! published an article entitled “13 Money Lies You Should Stop Telling Yourself by Age 30″ and it gives some good food for thought about the ways you can fool yourself into financial neglect.

“If I turn a blind eye, somehow my finances will figure themselves out.”

The writer mentions ignoring bank account statements “for fear of how low the number would be,” not checking credit reports, and being in ignorance about the matching 401(k) offered at her first job.

It can seem scary to examine your finances…but this discomfort is nothing compared to what can happen in you ignore financial matters. If you are too afraid to face your finances on your own, seek the expert advice of a Fee-Only Financial Planner.

“I should buy a home because that’s what grown-ups do”

You have likely seen a number of reports or read many articles on renting vs. owning. In the end, this decision is an individual one. You need to do what will work best for your situation and make sure your housing costs don’t get out of hand, no matter what you hear about the housing market.

“I’m too inexperienced to start investing.”

You may feel as if you don’t know enough, but you have time on your side. As a young adult, you have time for your money to grow: “According to personal finance expert Kimberly Palmer, someone who begins investing at age 25 will only have to save $4,830 annually to reach $1 million by age 65…”

Plenty is wrong with it, let’s take a look.

You distrust Wall Street but you trust the housing market?  Really? 

The article cites the distrust that some of these investors have of Wall Street and a desire to own hard assets.  I get the distrust of Wall Street in the wake of the 2008-2009 market drop.  These same folks must have short memories regarding the role that the drop in housing values played in the recession and the lingering effects of on many families.  Yes prices are low, but they are rising.  Are you knowledgeable enough to know if the property that you are buying is really a good deal?  Distrust Wall Street all you want, but the fact of the matter is that investors who hold a reasonably diversified portfolio saw their 401(k) and other investments recover within a couple of years of the 2009 market bottom.

Are you getting in too late? 

According to the article, Wall Street Investors are also entering this market and in some cases have bid up the price of homes in many of these hot markets.  Much like the John Hancock TV commercial touting the idea of getting back into the stock market now that it is at new highs, is this an ideal time to be taking your retirement funds and investing them into a “hot” housing market?

Are you smarter than the professional investors? 

As mentioned above this opportunity has come to the attention of Wall Street investors.  Think what you want about Wall Street, these firms have the resources in terms of capital and research that you don’t.  I’m not saying that individual investors can’t outdo the professionals, but ask yourself are you one of these real estate investors who can?  Do you want to risk your retirement savings to find out?

Understand the potential costs and risks 

In order to get at your money in a 401(k) plan you will likely need to take a loan from the plan.  There are no tax consequences of doing this and as long as you repay the loan there won’t be any.  Understand, however, that if you leave your job before fully repaying the loan, any remaining loan balance could end up becoming a distribution which would trigger income taxes and a 10% penalty if you are under 59 ½.

Further there is a potential opportunity cost.  Are you convinced that your real estate investment will outperform what you might have gained in your 401(k) plan?  Additionally, if your investment goes south you might end up with a property that is worth less than you paid for it, you are paying back your loan on the 401(k), and the house might be underwater if there is a mortgage involved.

Look before you leap 

Let’s be clear, I’m not against investing in real estate, in fact many have made their fortunes from doing just that.  What I am against is a novice who has read about the opportunities in the housing market taking funds from their 401(k) and investing in something they barely understand.

Will this always end badly?  No.  This might be a successful route to take for someone who understands real estate investing and who understands the risks.  If this doesn’t describe you ask yourself is this a good use of my retirement funds?

The Social Security retirement earnings test affects those who earn income while claiming Social Security benefits before age 66, which is full retirement age (FRA) for those born before 1955. It impacts equally those who are claiming personal retirement benefits, spousal benefits and survivor benefits. Those who delay claiming their benefit until FRA or later will not be impacted. For example, after age 66, you can earn $1 million (or more) a year without cutting into your Social Security checks.

Even if you are under age 66, going back to work has a double benefit. For starters, this additional income can raise your 35-year income average, which is the basis of your Social Security benefit. Second, going back to work is treated as if you had delayed taking your retirement benefit to an older age and you begin receiving this higher benefit at FRA.

Here’s how the earnings limit works: Only wages count towards this earnings test, not your investment earnings or pension payments. For 2013, the general limit is $15,120. For every $2 over this limit, you will see your Social Security benefit reduced by $1. For example, if you are 63 and your wages are expected to be $24,000, this puts you $8,880 over the earnings limit and will reduce your benefit by $4,440.

If your Social Security benefit happens to be $2,220 per month, Social Security will withhold payments for the first two months to cover the $4,440 excess amount and then resume your normal payment in the third month. At FRA, your benefit is increased to account for the two-month delay. This means that you will be repaid the benefits that you deferred with interest over your lifetime. Those who die prematurely may receive a negative return on this deferral but those who live to life expectancy or beyond will receive a healthy inflation-adjusted payback.

If you reach full FRA during 2013, you will only have $1 withheld for every $3 earned over $40,080. However, these rules don’t affect you in the year you retire that protects you from both earnings limits. You can earn an unlimited amount for the first part of the year, retire, and immediately begin receiving your full benefits.

The earnings test in not a penalty but rather a deferral of retirement benefits. In fact, some retirees who now understand that claiming early Social Security benefits was a poor decision could go back to work and have the earnings test give them a do-over.

Because the earnings test is not a penalty, retirees should not hesitate to go back to work. In fact, since so many are confused by this topic, we should wonder why the test exists at all. In fact, the Social Security Earnings Test Repeal Act of 2013 aims to strike this option from the records. The problem with repealing this law is that too many people already claim benefits at age 62. Removing the illusion of a penalty might incentivize more people to claim early. And delaying your Social Security benefit is almost always the correct answer.]]> http://www.figuide.com/social-security-earnings-penalty.html/feed 0 http://www.figuide.com/the-big-pension-decision-should-you-choose-a-lump-sum-or-monthly-annuity-payments.html http://www.figuide.com/the-big-pension-decision-should-you-choose-a-lump-sum-or-monthly-annuity-payments.html#comments Thu, 23 May 2013 10:00:16 +0000 Mike Helveston, CFP® http://www.figuide.com/?guid=f8bb055607f6ab9775b5480a7d78cdb8 If you are fortunate enough to have this decision in front of you, you may be seeing some obvious reasons to take each of these options. Maybe you want to grab the cash now while it is available and invest in an IRA. Or maybe the idea of ‘guaranteed’ income for life sounds better.

Here are the key factors to consider:

Age & Health – Pension benefits are generally calculated based on a combination of years of service and final average salary. Also, life expectancy is used in determining lump-sum amounts. Therefore, typically women and those in good health may favor a monthly pension for life. In contrast, a lump sum could be attractive for someone in poor health because the whole remaining amount could be passed to beneficiaries.

Spouse’s Resources – If your spouse already has a pension and you don’t have much saved in a 401(k), you might like having money to invest with a lump-sum. However, if your spouse has no assets, it might be comforting to have a fixed pension income for the rest of both of your lives by electing a joint and survivor annuity option.

Risk Tolerance – Generally, I have observed that risk-averse investors prefer a monthly annuity and those with greater investing experience and risk tolerance like the lump-sum. Another big factor is when you need the money. For example, if you can take a lump-sum 10 years or more before it is needed, this might be a good fit.

Other Income & Taxes – Probably the most often missed – yet key factor – is other sources of income and the rate of tax paid on the pension funds. In the example above, would it make sense to pay tax on monthly annuity payments if you don’t need the money for 10 years? A pension would be stacked on top of your other income from wages (etc.) and could end up costing you a big chunk in taxes to the IRS each year. So if you have time before the money is needed to live on, a lump-sum may work for you.

Make sure you carefully review the pros and cons of each pension option before making this important – and irrevocable – decision.

The Big Pension Decision – Should You Choose a Lump-Sum or Monthly Annuity Payments? appeared on http://rodgers-associates.com/blog/

Work Longer: Working longer is one of the easier solutions for those facing retirement shortfalls, allowing you to contribute to your savings for a few more years.

Reduce Spending During Accumulation Years: One of the best ways to save more is to spend less. Setting explicit goals with a financial advisor, having a clear understanding of your net worth, and carefully tracking expenses are essential to reducing your spending.

Reduce Planned Expenses in Retirement: Your retirement nest egg may last longer if expenses, such as home costs during retirement years, are reduced.

Optimize Your Asset Allocation: As you near retirement, a portfolio that is too conservative can be just as risky as one that is too aggressive. Retirement can be a 30-year prospect, long enough to consider a specific allocation to stocks, which, although they are more volatile, offer higher return potential over time.

Delay Taking Social Security: If you’re healthy and expect to live long, waiting until age 70 to receive Social Security benefits can result in a higher payout.

Returns and principal invested in stocks are not guaranteed. Please keep in mind that diversification does not eliminate the risk of experiencing investment losses, and that investing in securities always involves risk of loss. Please consult with a financial professional for advice specific to your situation.

If you’re concerned about running out of money during retirement, you need to be realistic and conservative with your assumptions. Here are 8 conservative assumptions for you to consider:

Assume you will need 100 percent of your current income in retirement  

Many rules of thumb suggest you’ll need between 70 and 100 percent of your pre-retirement income in retirement, but plan on at least 100 percent to be safe. Today’s retirees are active, they want to travel, pursue hobbies, and live a generally active lifestyle.  This costs money.  Even though you will likely slow down a bit as you age, medical costs later in retirement will likely rise and may replace what you were spending on activities and travel earlier in retirement.

Add extra years to your life expectancy  

We are all living longer with advances in medicine and the like.  Many factors come into play here including the history of longevity in your family.

Reduce your estimates of Social Security benefits  

The youngest of the Baby Boomers can likely count on Social Security as we know it but I’m guessing that those younger than 50 may see reduced benefits.  In the interest of being conservative, I suggest that you take your current estimate from Social Security and reduce it by say 25%.  If things work out better that’s great, if not then you’ve planned and saved accordingly.

Cut back on your living expenses now  

This not only frees up money to set aside for your retirement, but it helps you adjust to a potentially lower standard of living in retirement.

Be conservative with your investment expectations

We are four plus years into a stock rally and the stock market is at record levels.  For investors nearing retirement it is a good idea to adjust your portfolio and expectations regarding investment returns accordingly. 

Rethink early retirement  

Saving enough to last from age 65 to age 85 or 90 is a difficult task. Trying to retire at age 55 or 60 is just not practical for most individuals, unless you’re willing to significantly change your lifestyle. Working a few more years can go a long way in helping fund your retirement. Those years are typically your highest earning years, so hopefully you’ll be able to save significant sums during that period. Also, every year you work is one year you don’t have to support yourself with your retirement savings.

Consider working during retirement 

Especially during the early years of retirement, you should consider having at least a part-time job. Even modest earnings can help significantly with current retirement expenses help delay the need to withdraw money from your retirement accounts at least to some extent.  Additionally this can be a great way to transition to “full retirement” especially for those retiring early.

Take conservative withdrawals from your retirement accounts  

Don’t plan on taking out more than 3 to 4 percent of your balance annually.  The “four percent rule” is a handy rule of thumb, but it is just that.  Everyone’s situation is different.  It is best to start with a detailed retirement expense budget and then determine what your investments and other sources of income can support.

The best retirement planning strategy is to have a financial plan in place. Monitor your retirement accumulation progress against the plan’s benchmark and make adjustments as needed in areas such as the amount you are saving, your investment allocation, and the lifestyle that your resources will support.  Always be conservative in your planning, it’s much better to have more than you planned on than to hit age 80 and realize that you are out of money.

To resolve the situation, let’s consider the following IRA: John, the decedent, designated April (his daughter) as the primary beneficiary of his IRA.  It isn’t known why John only designated April as the beneficiary, as he has three other children – Bill, Chuck, and Dale – and John had only his IRA as an asset to pass along to the children.  April could choose to take the entire IRA as her own and receive payments over her lifetime using the stretch rules, but she sees the inherent lack of fairness in the situation, so she wants to make the IRA available to her brothers as well.

One way to accomplish this would be for April to withdraw 75% of the IRA and split that amount with her brothers.  She would then be able to stretch out the payments on the remaining 25% over her lifetime.  Mission accomplished, right?

The problem with this option is that April would have to pay tax on the 75% distribution – and since the IRA is sizeable, this is a significant cost.  Naturally she could just pass along this tax cost to her brothers in the form of a reduced payment, but this isn’t a very efficient way to distribute the money.

On the other hand, April could maintain the account in her name and stretch out payments over her lifetime, splitting each payment (after tax) among herself and her brothers.  Again, this accomplishes what she had set out to do, but she’s still paying tax on the entire amount and since our tax system works on a graduated scale, the tax on 100% received by one person is likely to be much higher than the tax would be for four persons each receiving 25% from the account.  In addition, the three brothers would be required to wait until April decides to take a distribution before they would have access to the account.  Bill for example, would prefer to withdraw a large sum right away as he’s building a home and could use the funds for the construction.  This would be very inefficient (tax-wise) if April had to make the withdrawal for him and pay the tax at her higher rate.

So – what else could be done?  It would be great if there was a way for April to re-write the beneficiary designation so that all four children were considered to be the beneficiaries, but that’s not possible.  What is possible is to re-direct a portion of the inheritance, by way of a method called disclaiming.

It’s important to know how to properly disclaim the inheritance of an IRA.  The person disclaiming all or a portion of an IRA must not be an eventual beneficiary as a result of the disclaimer.   Plus, the person disclaiming must not be in a position to direct who are the new beneficiaries; the natural course of the law must be followed.  If either of these rules is broken, the disclaimer is considered to be nonqualified, and any distribution would be considered to have been done by April.  Any amount transferred to her brothers would be considered a gift, subject to gift taxes.

So, if April disclaims the entire IRA, the new beneficiary would be John’s estate.  Since John’s will dictates that the four children will split all of his assets equally, this would accomplish the desired result, right?  No, not really.

The problem is that, when April disclaims the entire IRA, she is still an eventual beneficiary of the IRA since the estate becomes the de facto beneficiary, breaking the first rule above.  In addition, since the estate isn’t a “person”, the stretch rules can’t be used for this IRA at all.  When there is no real person as a beneficiary of an IRA, the entire account must be paid out within five years, rather than stretched out over a beneficiary’s lifetime.

What April should do is to disclaim 75% of the IRA, and also disclaim rights to the IRA portion of the estate that results from her first disclaimer.  This gives her 25% of the original IRA with the stretch benefits still intact.  In addition, since she’s disclaimed her right to the estate portion of the IRA asset, her brothers each have right to 25% of the IRA – 1/3 each of the 75% that April disclaimed.  This portion passes through the estate to the brothers.

The brothers will not be allowed to stretch out their payments from the account for more than five years – this is one unfortunate circumstance that can’t be avoided.  But otherwise, the eventual distribution is much more “fair” – even if it’s not what John had planned.  And each brother has control over his portion of the funds, at least for distribution purposes.  Bill can take the large distribution right away, and Chuck and Dale can delay up to five years before taking a distribution.  And each of the four siblings will only pay tax on the distribution that he or she takes.

Ross: “I’d probably get some municipal bonds, and then put the rest of the money in the bank and live off the interest.” 

Joey: “Well, we’ve heard from Dr. Fun.” 

-        From Friends, Season 3 Episode 18: “The One with the Hypnosis Tape”

A bond is an investment to receive the repayment of a “loan” at a certain interest rate. The way you invest in bonds matters now more than ever because of low interest rates.

Bond mutual funds are attractive for ease of use, but purchasing individual bonds insulates you from swings in their market price. Following are some key points for investing in individual bonds.

Create a laddered portfolio

The beauty of this strategy is that it can achieve several goals. First, it provides a predictable income source. Second, it gives a bond portfolio a shorter average maturity, but with almost the same yield as a longer maturity one.

To create a ladder, determine how much you have to invest and what time period you would like to invest it over.  Divide the total investment into relatively equal parts and choose investments with different maturities equally weighted over your time horizon.  For example, $100,000 invested in a five year ladder would have $20,000 invested each in bonds with maturities of one, two, three, four, and five years.  As each bond matures, you replace it by purchasing the longest maturity bond in the ladder – in this case five years. The average maturity works out to be about three years.

The rationale behind laddering isn’t complicated. When you buy bonds with short-term maturities, you have stability – but you have to accept a lower yield. When you buy bonds with long-term maturities, you receive a higher yield, but you must also accept the risk that the prices of the bonds might change. With a laddered portfolio, you would realize greater returns than from holding only short-term bonds, but with lower risk than holding only long-term bonds.

Laddering like this gives you the flexibility to redirect funds if needed for withdrawals, and reduce interest-rate risk because if rates rise, you are reinvesting at the higher rates.

Armed with this knowledge, you can begin building yourself a bond portfolio that, while hardly immune to rising rates, at least won’t get pummeled by them.

Understand Interest Rate Risk or Market Risk

Bond prices move inversely with interest rates. So when rates rise, your bonds drop in value. The longer the maturity, the greater the degree of price volatility. This isn’t a problem if you buy individual bonds and hold them until maturity. But it’s a major risk for investors in bond mutual funds, which price their shares according to the market each day. By way of example, the price of a bond fund with a duration of five years would be expected to fall approximately 5% if interest rates rose by only 1% point!

By having individual bonds, you receive the par, or face, value of your bond at maturity. 

• When interest rates rise, new bonds come to market with higher yields than older securities, making the older ones worth less. Hence, their prices go down.
• When interest rates fall, new bonds come to market with lower yields than older one. Hence, their prices go up.

As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.

When interest rates increase, take steps to minimize the negative effect it will have on your bonds. Longer maturity bonds get hit more by rising rates than shorter maturity bonds.  Also, bonds with higher coupon rates tend to do a bit better than bonds with lower coupon rates in periods of rising rates. During times of rising interest rates invest in individual bonds and not mutual fund bonds for better return, protection against interest rate risk, and liquidity.

The rating of individual bonds is very important.

A bond is unsafe when it defaults its interest or principal payments. Interest coverage ratio must be solid. Investment grade bonds have the highest quality possible A-AAA.  Maintain investment-grade whenever possible.

Look at the yield-to-maturity not coupon. Hold the bonds to maturity; this way fluctuation in interest rates doesn’t affect your bonds. Buy premium bonds. Never buy long-term bonds, too much risk for not much more return. You seldom earn much extra income from tying up your money for longer than 10 years.

Only interest on certain private purpose (private activity) municipals may trigger something ugly, the alternative minimum tax (AMT), yuck.

Bond ladders are usually better than CD ladders because:

• They are more liquid
• There is no penalty for early withdrawal
• You receive a better rate further out

Because bond values move in the opposite direction of interest rates, the value of most bonds or bond funds will go  down (you will lose principal) when interest rates rise. But it still makes sense to hold bonds as rates rise.

Well, we’ve heard from Dr. Fun.

Here in Illinois, the current law exempts retirement income from being taxed at the state level. What this means, is that any contributions to a 401(k), 403(b), SEP, SIMPLE and 457 avoid state income taxation. Qualified distributions at retirement are only taxed at the federal level, and then only as income.

If you contribute directly to a Roth IRA that money is after-tax money going in. After-tax in this case meaning it’s been already taxed at the federal and state level. So in this case the money going into the Roth IRA has been “hit twice” with federal and state taxes.

One possible way to avoid this double whammy (going by current Illinois law) is to contribute to your employer’s plan and then at retirement or whenever you leave your job, convert that money to a Roth IRA. In this case the money from your paycheck is already deferred from state taxation and then when it’s converted to a Roth IRA, avoids state income taxation again – since it’s income from a retirement plan and considered retirement income – which Illinois does not tax. This is evidenced by the 1099-R you’ll receive at the time of conversion.

Another way to avoid this is if your employer’s plan allows, convert your 401(k) to a Roth 401(k) while you’re still employed. Again, you’ll pay federal income tax but avoid the state taxation if your state excludes retirement income for tax purposes. If you’re in a higher tax bracket, you may consider staging your conversions up to the point where you maintain low tax costs (converting small amounts over many years). Or you may just want to wait to convert the whole amount when you know you’ll be in a lower tax bracket.