Archives for July 2011

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Do You Need an Emergency Fund?

Conventional personal finance wisdom says that it’s essential to have a designated emergency fund. The typical suggestion is that your emergency fund should be a checking, savings, or money market account with 3-12 months of living expenses in it.

But is there a point at which there’s no need to keep a separate emergency fund? That is, is there a point at which your retirement portfolio (and other assets) can do double duty as your emergency fund?

I think there is. If your retirement portfolio is large enough, liquid enough, and accessible without adverse tax consequences, you don’t necessarily need a separate emergency fund.

Is Your Portfolio Large Enough?

In order to be able to safely do away with your emergency fund, you have to know that, in the event of an emergency, your portfolio would be large enough to satisfy any immediate, short-term spending needs.

Whether or not it can do that depends on the size of your portfolio, your asset allocation, and the size of any potential unplanned spending needs.

For example, if your stock holdings declined by 50% over the next year, and at the end of that year you got laid off or found out you needed a major home repair, how problematic would it be? The more problematic such a scenario would be, the greater your need for an emergency fund.

Are Your Assets Liquid Enough?

In order to live safely without an emergency fund, you also have to know that you can turn your assets into spendable cash in a short period of time.

For example, if you place a sell order for one of the holdings in your brokerage account, you should be able to have the money in your bank account within just a few business days. For most unexpected spending needs, that should be just fine.

In contrast, if most of your net worth is tied up in something significantly less liquid (real estate or a lifetime annuity, for example), you probably need an emergency fund.

Tax Considerations

Finally, in order for it to make sense to do away with your emergency fund, you need to be able to get to your money without adverse tax consequences. If you’re under age 59½, you would want to make sure you have sufficient Roth IRA contributions (which can be withdrawn free from tax or penalty at any time) or sufficient holdings in taxable accounts (without large unrealized capital gains) to satisfy any unexpected spending needs.

Obvious Exception

As with most personal finance concepts, the above discussion comes with some exceptions. Most importantly, if you know you’re not going to be able to sleep at night without a certain-size pile of cash in your checking account, the question of whether or not you need an emergency fund pretty much settles itself.

Types of Income Tax Deductions

Most people understand that reducing their tax burden is an easy way to improve their finances. And most people understand that a significant part of reducing their taxes is claiming every deduction for which they’re eligible.

Unfortunately, many people don’t fully understand that there are multiple types of deductions and that, depending on the circumstances, some deductions may be of limited value–or no value at all!

“Above the Line” Deductions

The first type of deduction is the “above the line deduction.” These deductions are particularly valuable because (assuming you meet the applicable requirements) you can claim them regardless of whether you itemize or use the standard deduction (which we’ll discuss in just a minute).

One easy way to know that something is an above the line deduction is that it appears on the first page of Form 1040. Some of the more common above the line deductions include:

Itemized Deductions

The next primary group of deductions are itemized deductions. Every year, you have the choice to claim either a) the standard deduction or b) your itemized deductions. In other words, itemized deductions are only valuable if they–in total–exceed the standard deduction.

The standard deduction amount changes per year, and it depends on your filing status, your age, and whether or not you are blind. (See here for 2011 standard deduction amounts.)

Some of the more common itemized deductions include:

  • Home mortgage interest,
  • State and local income taxes,
  • Real estate taxes, and
  • Charitable contributions.

2% Floor, Miscellaneous Itemized Deductions

Next, there’s a sub-category of itemized deductions known as “miscellaneous itemized deductions, subject to the 2% AGI floor.” This means that they’re only deductible to the extent that they–in total–exceed 2% of your adjusted gross income. (Your adjusted gross income is the last line on the first page of your Form 1040.)

In other words, it’s possible that you won’t be able to deduct these at all–even if you do itemize your deductions.

Common miscellaneous itemized deductions, subject to the 2% AGI floor include:

Other Assorted Deduction Limitations

Finally, many deductions have limits on the amount that you can deduct and/or limits on the amount of income you can earn before you become ineligible for the deduction. For example, student loan interest is deductible as an above the line deduction, subject to two limitations:

  • The total amount of the deduction cannot exceed $2,500, and
  • If your modified adjusted gross income exceeds $60,000 ($120,000 if married filing jointly), the amount of the deduction you can claim is reduced. Once your MAGI exceeds $75,000 ($150,000 if married filing jointly), you cannot claim the deduction at all.

Other deductions have their own completely unique rules. For example, medical expenses are an itemized deduction that you can only claim to the extent that they exceed 7.5% of of your adjusted gross income.

What to Know About a Deduction

In order to determine whether or not a deduction will save you money on taxes, you first need to know:

  • Is it an above the line deduction or an itemized deduction? (Or is it a different type of deduction entirely–a deduction you’d claim on Schedule C as a sole proprietor, for instance?)
  • If it’s an itemized deduction, do you have enough itemized deductions to exceed your standard deduction?
  • Does the expense/loss have to exceed a certain amount (a “floor”) before you can deduct it?
  • Is there a limit to the amount you can deduct? (And is that limit affected by your income?)
  • And, if you’re subject to the Alternative Minimum Tax, is the deduction allowed for AMT purposes as well?

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!"

Risk Means Different Things to Different People

In a recent guest post, the author (Neal) argued that an investment in real estate becomes less risky the longer it’s held. In the comments, two readers (Dylan and The Finance Buff) disagreed. One even argued that such an investment becomes more risky the longer it’s held.

So who was right?

As far as I can tell, they all were. They were just using different definitions of risk.

Traditional Risk Measurement

In traditional finance literature, variability (specifically, standard deviation) of annualized returns has often been used as a measurement of risk.

Perhaps the most famous example of someone using this definition is Jeremy Siegel in his mega-selling Stocks for the Long Run in which he argued that stocks become less risky the longer you hold them because (historically in the U.S.), the standard deviation of inflation-adjusted annualized stock returns has been smaller over longer periods than over shorter periods.

Variation in Total Ending Value

Others argue that risk is better measured as variability of total ending values. This definition turns the “stocks become less risky with time” idea on its head. When measured in terms of ending value, stocks (and other investments with highly variable returns) become more risky the longer you hold them because, when compounded over a few decades, even a slight difference in annual returns leads to a dramatic difference in total ending value.

Probability & Magnitude of Shortfall

Still others argue that the best definition of risk involves probability and magnitude of a shortfall–that is, the risk of not having the amount of money you need when you need it.

Using this definition, the riskiness of an investment depends on your expectations for it and on how you plan to use it. For example, even if an investment steadily delivers 4% inflation-adjusted returns every single year, it’s going to be a problem if your financial plan was relying on 7% returns.

Probability & Magnitude of Loss

Finally, it can be helpful to consider risk as probability and magnitude of loss. But, as with the previous definition, this one varies from person to person. For example:

  • Are you going to experience significant stress any time you sign into your brokerage account and see that the portfolio value is lower than last time you checked?
  • Or, for instance, would you be OK as long as the value is higher than it was, say, three years ago?
  • Or would you be OK as long as the decline is smaller than a given percentage?
  • Or would you be OK as long as the decline is smaller than a given dollar value?

Why Is This Important?

I think there are two useful takeaways here.

First, when you hear writers, financial advisors, or anyone else use the term “risk,” be aware that they could mean any of several different things. If the meaning isn’t clear, ask.

And more importantly: When assessing your risk tolerance, put some thought into what type(s) of risk you care most about. This information will play an important role in selecting an appropriate asset allocation.

Long-Term Care Insurance: Should You Buy It? And If So, When?

In the last few days, I’ve gotten a couple emails asking for my thoughts on long-term care insurance, specifically:

  • Is it a good idea to buy it?
  • If it is a good idea, are there people who should not buy it?
  • If you should buy it, when is the best time to buy it?

According to the U.S. Department of Health and Human Services:

“At least 70 percent of people over age 65 will require some long-term care services at some point in their lives.  And, contrary to what many people believe, Medicare and private health insurance programs do not pay for the majority of long-term care services that most people need.”

That information, combined with the expensive cost of long-term care, leads me to think that long-term care insurance is a good idea for many people.

But it’s not for everyone. There are (at least) two scenarios in which it makes sense not to buy LTC insurance:

  1. You can’t afford it. It’s not exactly cheap, and it should be a much lower priority than saving for retirement.
  2. You can afford to self-insure. That is, you expect to have a large enough portfolio to be able to cover the cost of long-term care while using a sustainable withdrawal rate (usually considered to be 4% per year or less) for the rest of your expenses.

In other words, LTC insurance makes most sense for people whose savings are in the “able to afford it, but not able to afford long-term care without it” range.

So How Much Does Long-Term Care Cost?

It depends who you ask.

Insurance companies are fond of quoting the eye-popping average cost of a stay in a nursing home: $219 per day for a private room.

But much of what qualifies as long-term care services (and, therefore, much of what makes up that “70% chance of needing long-term care” figure quoted above) is less expensive than a stay in a nursing home.

For instance, one study on the topic estimated that, of people who turned 65 in 2005, 94% would end up with out-of-pocket long-term care costs below $100,000 during their lifetime, and 82% would have out-of-pocket long-term care costs below $25,000 during their lifetime. (Important caveat: These are 2005 costs, and things have gotten more expensive in the last 6 years.)

In short: You probably won’t have to pay an astronomical sum of money for long-term care during your life. But the possibility is there, and I would argue that it’s worth planning for.

When Should You Buy Long-Term Care Insurance?

The majority of long-term care needs arise after age 65, but the longer you wait, the greater your premiums, and the greater your chance of being denied coverage. As a result, most of the analyses I’ve seen indicate that the best time to buy long-term care insurance is usually sometime between age 50 and 60.

It seems to me that a big part of this decision comes down to the likelihood of needing long-term care prior to age 65. Unfortunately, I’ve tried several times to find such information, and I haven’t had much success. (If any readers have that information, please pass it along!)

Also, to some extent, it’s simply a question of personal preference. The more risk-averse you are, the more sense it makes to insure earlier rather than later.

Shopping for Long-Term Care Insurance

Finally, it’s important to understand that all long-term care policies are not created equal. If you’re not careful, it’s entirely possible to buy a policy, only to find out that it doesn’t pay a dime toward the type of care you were hoping to receive.

For a few tips on what to look for in a long-term care insurance policy, I’ll direct you to two of my favorite resources:

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

What’s My Cost Basis for Inherited Property?

A reader writes in to ask:

“Some time in the next month or so, I’m going to be inheriting about $45,000 worth of various stocks from an uncle of mine who passed away earlier this year.

I don’t have a clue what to do with a portfolio of individual stocks, so I’d like to sell them and allocate the money to my normal index fund portfolio. But I’m a bit worried to sell them, because I don’t know how to calculate the applicable capital gains taxes.

Inherited Cost Basis = Fair Market Value (Usually)

In most cases, if you sell the property soon after inheriting it, your capital gains should be fairly small. This is a result of the fact that, in general, when you inherit property, your cost basis is equal to the fair market value (FMV) of the property at the time of the decedent’s death.

Alternatively, if the administrator of the estate elects to use the “alternate valuation date” for the estate (and if this is the case, you should be informed of such an election), then your cost basis will be equal to the fair market value of the property on the earlier of:

  • 6 months after the date of death, or
  • The date that the property was distributed to you.

(Though again, this will usually result in any capital gains being small-to-nonexistent if you sell the property soon after receiving it.)

Note: Exceptions may apply for inherited property that was used in a closely held business or for farming

Holding Period for Inherited Property

Inherited property is considered to have a holding period of greater than one year, regardless of how long you’ve held the property or how long the decedent held the property. As such, any capital gains or losses will be considered long-term capital gains/losses.

Takeaway: Based on current tax law, the gains will be taxed at a maximum rate of 15%.

Special 2010 Cost Basis Rules

While we’re on the topic, it’s worth pointing out that if the person in question had died in 2010, the applicable rules would have been different. Specifically, administrators of estates of decedents who died in 2010 were allowed to choose between the rules that had originally been in place for 2010, or the rules that were scheduled to be in effect for 2011.

  • If the administrator elected to use the 2010 rules (under which there was no estate tax), the recipients of the inherited property would have received the decedent’s cost basis in the property as their cost basis.
  • If the administrator elected to use the 2011 rules (35% estate tax, but with a $5 million exemption), the recipients’ cost basis would be the FMV at the date of death (or FMV using the alternate valuation date, as described above).

As you might imagine, most estates were well below the $5 million exemption, so using the 2011 rules was usually best because it allowed the recipients to use the fair market value as their cost basis rather than having to use the (usually lower) cost basis of the decedent.

(Note: The above discussion relates to inherited taxable property. See here for inherited IRA rules.)

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!"

Spending Strategies in Retirement

“Consumption smoothing” means going out of your way to have the same standard of living throughout your life–as opposed to, for instance, a standard of living that climbs throughout your working years and declines throughout your retirement years.

Economists love consumption smoothing.

But for most people, real life doesn’t work out that way. For most people, there are some higher-earning years and some lower-earning years, and spending is generally allowed to fluctuate (to some degree) along with income.

And, for the most part, that’s OK, despite not being ideal from an economic textbook standpoint.

Consumption Smoothing and Retirement Spending

When it comes to retirement planning, the most commonly-discussed spending plan is one based on the idea of consumption smoothing: Withdraw a given percentage of the initial portfolio value (usually around 4%), and adjust the withdrawal upward each year in keeping with inflation.

Of course, in real life, that 4% withdrawal plan isn’t perfect. If you never stray from that original plan, you face two undesirable possibilities:

  1. Running out of money completely (at which point spending drops rather precipitously), or
  2. Accumulating a huge pile of money without ever increasing your standard of living.

What if, instead of using such a rigid plan, we did the same thing in retirement that most of us do throughout our working lives? That is, what if we incorporated a bit of flexibility into our level of spending from year to year?

Same Portfolio, Flexible Spending

One alternative approach would be to keep the same type of portfolio we usually discuss here on the blog (that is, a diversified portfolio of low-cost index funds) but change the way in which you go about liquidating it. For example, Vanguard published a paper last year proposing a strategy in which the investor:

  • Starts with a certain withdrawal rate, and
  • Tentatively adjusts the spending upward each year in keeping with inflation, but
  • Limits that spending using both a ceiling and a floor (for example, annual spending cannot drop below 2.5% of the current portfolio value or exceed 5% of the current portfolio value).

Without being able to see the inputs they used for their simulations, it’s difficult to know how much confidence to have in the specific quantitative results of their study, but I don’t think that changes the fact that the proposed strategy is worthy of further consideration. Just from a common sense standpoint, it seems like it could do a good job of minimizing the probability of either of the two undesirable outcomes discussed above for the typical consumption smoothing strategy.

Safe Income for Basic Needs

Another alternative approach (one that, at this point, I anticipate using myself) is to ensure that your most basic spending needs are satisfied with very safe, inflation-adjusted sources of income–Social Security, TIPS, and inflation-adjusted lifetime annuities.

After that, because your most basic needs are covered, you’re left with a great deal of flexibility with the remainder of your portfolio. (Though admittedly, this remainder may not be very large.)

  • You can invest the remainder conservatively or aggressively,
  • You can use whatever starting withdrawal rate you feel comfortable with–the less you mind the possibility of living exclusively on the safe income stream, the higher withdrawal rate you can use–and
  • You can adjust that withdrawal rate freely over time based on the performance of this part of your portfolio.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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