Archives for September 2013

New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 17,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

When Does a 100%-Stock Portfolio Make Sense?

Administrative note: I’m thrilled to be back to working on articles after an enjoyable and productive break. At the same time, having had two weeks to reflect on it, I’ve decided to change the schedule to just two articles per week — basically the same as for the last few years, minus the Wednesday article. The point of the change is to free up more time to work on updating existing books and creating new ones — something that I haven’t been able to spend a sufficient amount of time on so far in 2013, as readership (and therefore volume of reader emails) has increased.

A reader writes in, asking:

“I recently inherited nearly $200,000. I’m 25 and am new to investing, but I’m reading everything I can to make sure I don’t squander this opportunity by investing it poorly. Based on what I’ve read, because I’m young and because I now have plenty of ‘cushion’ I can use a risky asset allocation. Is there any reason I shouldn’t go 100% in stocks?”

An all-stock allocation can make sense in the right circumstances:

  1. You want to take on lots of risk in the hope of higher returns,
  2. You can afford a large decline in the market, even if that decline is not followed by an immediate comeback, and
  3. You have good evidence that you won’t panic and sell during a sharp market decline (or, the size of your retirement portfolio relative to your total economic assets is small enough that it’s no big deal if you do end up panicking and selling at the bottom of a bear market).

Stated differently, you must want to have a high-risk portfolio and you must have the economic and emotional risk tolerance to handle such a thing.

In addition to being able to satisfy requirements #1 and #2, many young investors can satisfy requirement #3 because their portfolios are small enough that even if they do capitulate and sell during the next bear market, it’s no big deal for their long-term financial success. They (permanently) lose a little money, but in the process they gain valuable information about their risk tolerance — not a wholly bad experience.

But for anybody with a significant amount of assets on the line, it doesn’t make sense to use a high-risk allocation unless you have evidence that you can handle such a level of risk. And the only way to have such evidence is to have actually made it through a real-life bear market without selling. (And this is why, if I were in the above reader’s shoes, I would not personally want to have an all-stock portfolio.)

Further, for that previous bear market experience to be particularly meaningful, it must have been under economic circumstances that are at least roughly similar to your current circumstances. In other words, if your portfolio is now many-times larger than it was before the last bear market or if you’re now retired whereas you were still working during the last bear market, knowing that you didn’t panic and sell last time doesn’t necessarily tell you very much about what you’ll do this time.

Tax Planning for the Retirement Savings Contribution Credit

A reader writes in, asking:

“Based on my gross income, I don’t quite qualify for the retirement savings credit. But I’m not maxing out my 401k. If I contributed more to the 401k would it reduce my income so that I *would* qualify for the credit?”

In short, yes, it could.

How the Retirement Savings Contribution Credit Works

For those unfamiliar with the Retirement Savings Contribution Credit, it’s calculated as a percentage (either 10%, 20%, or 50%) of the first $2,000 of contributions you make to a retirement account per year. (If married filing jointly, the first $2,000 of contributions for each spouse can be counted.) As your adjusted gross income increases, however, the percentage used to calculate the credit decreases. The income ranges for 2013 are as follows:

Married filing jointly:

  • Up to $35,500: credit = 50% of contribution
  • $35,501-$38,500: credit = 20% of contribution
  • $38,501-$59,000: credit = 10% of contribution
  • Above $59,000: Not eligible for credit

Single:

  • Up to $17,750: credit = 50% of contribution
  • $17,751-$19,250: credit = 20% of contribution
  • $19,251-$29,500: credit = 10% of contribution
  • Above $29,500: Not eligible for credit

Head of household

  • Up to $26,625: credit = 50% of contribution
  • $26,626-$28,875: credit = 20% of contribution
  • $28,876-$44,250: credit = 10% of contribution
  • Above $44,251: Not eligible for credit

Taking Control of Your Adjusted Gross Income (AGI)

The key point from a planning perspective is that the credit is based on your adjusted gross income (that is, the bottom line from the first page of your Form 1040), which you have some degree of control over. As the reader surmised above, pre-tax contributions to a 401(k) would reduce this figure, as would deductible traditional IRA contributions and HSA contributions. In fact, any of the deductions listed on lines 23-35 of Form 1040 reduce your adjusted gross income, though retirement plan contributions and HSA contributions are typically the ones over which you have most control.

So, if your AGI is anywhere just above one of the applicable threshold points, taking action to reduce your AGI such that it falls below the threshold in question could increase the amount of your credit — either by making you eligible when you otherwise wouldn’t be or, for example, by moving your income to the range where the credit is calculated as 20% of your eligible contributions rather than 10%.

For more information about the credit (such as the requirements to claim the credit other than having an adjusted gross income below the applicable threshold levels), see Form 8880 and its instructions or IRC Section 25B.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Misconceptions About Delaying Social Security

There are many common misconceptions about Social Security planning, but two that I see pop up very often are the ideas that:

  1. Delaying Social Security is like buying a bond that pays 8% interest, and
  2. Delaying Social Security gets you an 8% return.

Social Security: Not a Bond

I’ve seen several writers make the case that delaying Social Security is a good deal, because it’s like buying a bond that pays 8% interest per year, adjusted for inflation. But Social Security makes for a very strange bond, doesn’t it? You cannot sell it. It pays nothing at maturity. And it matures at an unknown date in the future (i.e., when you die, or, in some cases, when your spouse dies).

In other words, delaying Social Security is not like buying a bond at all. It is, however, exactly like buying an inflation-adjusted lifetime annuity (or, if you prefer to think of this way, like buying a pension).

An inflation-adjusted lifetime annuity that pays 8% per year (or more precisely, 6.5%-8%, depending on which year of delaying we’re talking about) is still a good deal relative to what you can get on an annuity from an insurance company. But it’s not even close to the screaming-hot, nobody-should-ever-pass-it-up bargain that an inflation-adjusted Treasury bond with an 8% yield would be.

Delaying Social Security Gives an Unknown Return

A similar misconception about Social Security is the idea that delaying your retirement benefit gets you an 8% rate of return. In reality, the rate of return you get from delaying Social Security will depend upon how long you live (and, perhaps, how long your spouse lives).

As an obvious example, consider an unmarried person who chooses to delay Social Security all the way until 70, but who dies shortly before his 70th birthday. This unlucky fellow does not get an 8% return on the money he gives up in order to delay his benefits. In fact, every dollar he “invests” in this manner gets a -100% return, because he never gets any of it back.

The point here is not that it’s a bad idea to hold off on claiming Social Security. For many people, delaying benefits is quite advantageous. The point is simply that there’s no way to calculate your rate of return in advance, because there’s no way to know exactly how many Social Security checks you will collect — unless you somehow know exactly when you will die.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Roth 401(k) Distribution Rules

While many investors understand that a Roth 401(k) is basically a hybrid of a regular 401(k) and a Roth IRA, if my email correspondence is any indication, many people are somewhat confused about the details. Specifically, many people have misunderstandings about either of two points:

  • When you can take money out of the plan, and
  • How withdrawals (technically referred to as “distributions”) are treated for tax purposes.*

When Can You Take Money Out?

With an IRA (whether Roth or traditional), you can take your money out of the account at any time. The only question is whether the money will be taxable and/or subject to the 10% penalty. In contrast, with a 401(k), you have to meet certain requirements before you’re even allowed to take money out of the account.

In this regard, a Roth 401(k) works like a regular 401(k). That is, if you are still working for the employer in question, you might not be able to take money out of the plan at all. (Possible options to look into would include a financial hardship distribution, an in-service distribution, or a 401(k) loan.)

Is the Distribution “Qualified”?

When trying to figure out how a distribution will be treated, the first thing to determine is whether or not the distribution will count as a “qualified distribution.” If a distribution is qualified, it will be free from tax and penalty. For a Roth 401(k) distribution to be qualified, it must occur:

  1. After you have reached age 59.5 (or died or become disabled), and
  2. At least 5 years after the first day of the calendar year in which you first made a Roth contribution to the retirement plan.

Note that this 5-year rule is on a per-Roth-401(k) basis. (In contrast, the 5-year rule that applies to Roth IRA distributions is not on a per-IRA basis — once you have met it for one Roth IRA, you have met it for all Roth IRAs.)

Example: Bob is employed by Employer A and has been making Roth contributions to Employer A’s retirement plan since 2010. In October of 2013, however, Bob takes a new position with Employer B and begins making Roth contributions to Employer B’s retirement plan. Bob will now have to satisfy a new 5-year period (in this case, he must wait until January 1, 2018) until Roth distributions from Employer B’s retirement plan can be considered qualified.

If, however, you roll money over from a prior Roth 401(k) into your new Roth 401(k), the 5-year rule for your new Roth 401(k) is considered to have started on January 1 of the year in which you first made a Roth contribution to the prior plan. (So, if Bob in our previous example rolled over his Roth 401(k) from Employer A into his Roth 401(k) with Employer B, his 5-year period with regard to Employer B’s plan would be satisfied as of January 1, 2015.)

How Are Nonqualified Distributions Treated?

If your distribution is a nonqualified distribution:

  • The portion of the distribution that represents your contributions to the account will be nontaxable (and not subject to the 10% penalty), and
  • The portion of the distribution that represents earnings (i.e., growth) will be taxable and potentially subject to the 10% penalty.

In determining what portion of the distribution is considered to come from contributions as opposed to earnings, each distribution is simply treated on a pro-rata basis. For example, if you currently have $10,000 in your Roth 401(k), of which $8,000 is from contributions and $2,000 is from earnings, any distribution will be considered to come 80% from contributions and 20% from earnings — meaning that 80% of the distribution will be nontaxable, and 20% will be taxable and possibly subject to a 10% penalty.

Any portion of a nonqualified distribution that comes from earnings will be subject to the 10% penalty unless one of the following requirements is met. (Note that these are the same requirements as for regular 401(k) distributions.)

  • You are age 59.5 or older,
  • You are disabled,
  • You have died and the distribution is being made to your estate or your designated beneficiary,
  • The distribution is part of a series of “substantially equal periodic payments” made based on the appropriate life expectancy table,
  • The distribution is made after you have separated from service with your employer and that separation from service occurred in or after the year in which you reached age 55,
  • The distribution is the result of an IRS levy on the plan,
  • The distribution does not exceed the amount of medical expenses that you can claim as an itemized deduction for the year,
  • The distribution is made pursuant to a qualified domestic relations order (e.g., in the event of a divorce), or
  • The distribution is a qualified reservist distribution for a military reserve member called to active duty.

*For those interested in reading the actual reference material, Internal Revenue Code section 402A contains the rules for designated Roth contributions (i.e., what we typically refer to as Roth 401(k) contributions).

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2017 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy