Archives for December 2011

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Playing Catch-Up with Retirement Savings

I sometimes receive emails from investors describing themselves as “behind schedule” with regard to retirement savings. They’re nearing the age at which they’d like to retire, but their portfolios just aren’t where they’d need to be to get the job done.

The truth is, if you’re in such a situation, there are things you can do to improve your chances of retiring comfortably, but they’re not magic bullets — they involve sacrifices and have imperfect success rates. Nor are they top secret tips — these are the same types of things we discuss here on the blog all the time.

Retire Later

Whether it’s sticking it out for an extra couple years at your current job or picking up part-time work in a more enjoyable field after leaving your job, retiring later is often the highest-impact thing you can do for your retirement finances. Each additional year of work is one more year to accumulate savings and one fewer year of spending from your savings.

Improve the Return from Your Investments

Many investors who find themselves behind schedule with their savings attempt to make up for lost time by ratcheting their stock allocation upward. Sometimes it works. Other times it backfires.

Rather than crossing your fingers and taking on more risk, my best suggestion for improving returns is to cut costs. While even this is not a sure thing, low-cost index funds (or ETFs) tend to outperform the majority of actively managed funds, and I have yet to hear of anyone finding a better predictor of mutual fund performance (within a given asset class) than fund expense ratios.

Annuitize Part of Your Portfolio (by Delaying Social Security)

Finally, the safest way to increase the amount you can spend from your portfolio per year is to annuitize a part of that portfolio via an immediate inflation-adjusted lifetime annuity. In exchange for giving up liquidity and the ability to leave the money to your heirs when you die, such annuities offer a higher level of income than you can safely take from a typical stock/bond portfolio.

Remember though, that delaying Social Security is akin to buying just such an annuity — one that’s a significantly better deal than what you could actually buy from an insurance company. So before using a part of your portfolio to purchase an actual annuity, it usually makes sense to use that part of your portfolio to satisfy your regular spending needs while you delay claiming Social Security benefits for as long as possible.

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What are Muni Bonds? And Should I Own Any?

A reader writes in to ask:

“I use Vanguard’s Total Bond Market Index Fund for my bond allocation, but I noticed that it doesn’t include any municipal bonds. Can you walk us through municipal bonds — how they work, who should own them, where you should put them (taxable account? IRA?), and which ones should you own (e.g. a general fund or a state-specific fund)?”

Bonds issued by U.S. states or municipalities are exempt from federal income tax. These bonds are referred to interchangeably as tax-exempt bonds, municipal bonds, muni bonds, or even just “munis.”

Because of their tax-exempt status, the market typically prices muni bonds so that they have lower yields than taxable bonds of a similar credit quality.

Who Should Use Muni Bonds?

Tax-exempt bonds only make sense when investing in taxable accounts. In other words, if all of your investments are in tax-sheltered accounts — 401(k), IRA, etc. — your investments are already protected from taxes, so there’s no reason to accept municipal bonds’ lower yields.

But even for investors who can’t tax-shelter all of their investments, muni bonds still aren’t necessarily the best bet.

Because of stocks’ built-in tax-efficiency (due to the maximum 15% tax rate on dividends and long-term capital gains), it generally makes sense to tax-shelter all of your bonds before tax-sheltering any of your stocks. As a result, municipal bonds typically only make sense if:

  1. Your desired bond allocation is larger than the amount of tax-advantaged space you have, and
  2. You’re in a high enough tax bracket that your after-tax yield on taxable bonds would be less than the yield on muni bonds of similar credit quality.

Example: James has $300,000 in a taxable account and $100,000 in an IRA. His desired allocation is 60% stock, 40% bond (that is, $240,000 stocks, $160,000 bonds for his $400,000 portfolio).

Even after James invests his entire IRA in bonds, he still needs to own $60,000 of bonds in his taxable account in order to satisfy his desired bond allocation. If James’ marginal tax rate is high enough, muni bonds could provide a higher yield than the after-tax yield on similarly-rated taxable bonds.

Of course, as with all broad investing guidelines, there will be exceptions. For example, an investor in a high tax bracket might want to own muni bonds in a taxable account and stocks in her retirement plan at work if the retirement plan has inexpensive stock funds but only super-high-cost bond funds.

Should You Own a State-Specific Muni Bond Fund?

While municipal bonds are exempt from federal income tax, they’re usually subject to state income tax. However, if you buy a bond issued by your own state or by a governmental body within your state, the bond will usually be free from state income tax as well.

State-specific muni funds (e.g., Vanguard California Intermediate-Term Tax-Exempt Fund) exist in order to invest in bonds within a particular state to take advantage of this exemption from state income taxes.

So, if you have a high state income tax rate, there’s a significant tax advantage to sticking with muni bonds from your own state. The downside is that you’d be sacrificing some degree of diversification.

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