Archives for July 2012

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Building a CD Ladder (And a CD Ladder Alternative)

With interest rates as low as they are, I’ve been getting questions recently about using CDs (specifically, CD ladders) to try to squeeze a little bit more yield from savings.

When to Use (and How to Build) a CD Ladder

CD ladders are typically best used for sums of money that you want to keep fairly liquid, but that you don’t expect to spend at any specific date in the future. For example, if your emergency fund is $24,000, you could build a CD ladder with the following purchases:

  • $4,000 in a 6-month CD,
  • $4,000 in a 1-year CD,
  • $4,000 in an 18-month CD,
  • $4,000 in a 2-year CD,
  • $4,000 in a 30-month CD and
  • $4,000 in a 3-year CD.

Then, six months later (when the 3-year CD has become a 30-month CD, the 2-year CD has become an 18-month CD, and so on), you buy another 3-year CD. The benefits of building such a CD ladder are that:

  1. You’ll always have a part of the ladder that’s coming due relatively soon (thereby giving you some degree of liquidity), and
  2. After 2.5 years, the CD ladder will be comprised entirely of CDs that were purchased as higher-yielding 3-year CDs.

Implementation note: Depending on the offerings of your favorite bank, you might not be able to get a 30-month CD. In that case, you can simply buy the other 5 CDs, and after 6 months, buy both a 3-year CD and another 2-year CD, thereby completing your ladder. (This completes the ladder because the gap that was previously at 30 months has now, after 6 months, become a gap at 24 months, which you’ll fill with the purchase of a 2-year CD.)

When Not to Use a CD Ladder

If you’re saving for a specific expense at a specific date (or even a semi-specific date) in the future, it probably makes more sense to just buy CDs of the appropriate maturity, rather than building a CD ladder. For example, if you want to use CDs to save for a home downpayment roughly 4 years from now, you probably want to purchase 4-year CDs rather than building a CD ladder that extends to 4 years.

It’s often wise, however, to use “parallel CDs” for such purposes. That is, instead of buying a single 4-year CD, you would buy multiple (smaller) 4-year CDs. That way, if you end up needing to spend some of the money prior to maturity, you’ll only have to pay an early redemption fee on a portion of the money rather than paying the penalty on the whole sum.

Low-Penalty CDs as a CD Ladder Alternative

Sometimes, even in the case of an emergency fund, it can make sense to simply purchase longer-term CDs with low early redemption penalties rather than building an entire ladder. For example, Ally Bank currently offers 5-year CDs with an early redemption penalty of just 60 days worth of interest. With a penalty that low, it might make sense to put the entire emergency fund into 5-year CDs right away (thereby getting the higher yield that comes with the longer maturity) rather than building a ladder.

It would still probably be a good idea, however, to purchase parallel 5-year CDs to minimize any early redemption penalties. This is especially true with Ally Bank because, unlike some banks, Ally offers the same rate regardless of CD size.

How is a Sole Proprietor Taxed?

I recently received the following question from a reader:

“I’ve earned a significant amount this year so far in self-employed income. Is there anything special I need to be doing taxwise before actually doing my taxes next April?”

I know many of you earn self-employment income, so I thought it’d be worth addressing as a blog post. In brief, yes, there are a few things you should be doing. Specifically:

  1. Keeping records,
  2. Making estimated tax payments (maybe), and
  3. Saving money (maybe).

Keeping Records for Your Sole Proprietorship

It’s important to track your business transactions if you want to be able to claim every possible deduction come tax season. An easy way to do this is to set up a spreadsheet with columns for the date, description, and amount of each transaction. This way, when tax time rolls around, you’ll have all the necessary information in one place.

If you have more than a handful of business-related transactions each year, your best bet is to open a separate checking account for your business. That way, you won’t need to bother with recording every transaction, because the bank statements from your business checking account will have all the necessary information already.

Note: For the purposes of protecting yourself against an audit, you’ll actually need to do a little more recordkeeping — in addition to keeping bank statements (and/or credit card statements), you’ll have to keep receipts for your business expenses.

Making Estimated Tax Payments

Unlike salary or wages from a normal job, payments made to your business will not have anything withheld for taxes. As a result, you may end up needing to make estimated tax payments throughout the year.

In order to avoid interest or penalty, over the course of the year, the sum of your withholding (if any) plus your estimated tax payments must equal the smaller of:

  1. 90% of your tax for this year, or
  2. 100% of your tax from last year (Line 60 from Form 1040).

For many people who start a business in addition to their normal job, no estimated tax payments will be required in the first year, because the withholdings from their normal job are sufficient to meet requirement #2.

Saving Money to Pay Taxes

Even if you don’t have to make estimated tax payments (because the withholding from your or your spouse’s “real job” will be equal to your total tax from last year), you’ll still probably want to start saving now for next tax season. It’s likely that instead of getting a refund this year, you’ll be writing a check to the US Treasury.

When attempting to estimate how much you need to save, be sure to remember that income from a sole proprietorship is also subject to self-employment tax (calculated as roughly 15% of the net profit from your business) in addition to being subject to income tax at your current tax rate.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
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Which One Fund Would You Recommend to Anyone?

A reader writes in, asking:

“There are many types of investors, from those who like to micromanage, to those who don’t know and don’t care about investments. Most are in the middle: they know they have to save, have some vague notion of how stocks and bonds work, but have more important things to do, such as living their lives.

What would you recommend for investors who want to buy one fund, hold it and forget it for years, and why?”

The two primary criteria I’d use for trying to pick such a fund would be:

  1. Low costs, and
  2. A middle-of-the-road sort of asset allocation that could be at least reasonably suitable for anybody.

Unfortunately, the low-cost criteria rules out most all-in-one funds available to retail investors. Aside from a selection of funds from Vanguard, the pickings are quite slim.

Vanguard Target Retirement Funds

While I do like Vanguard’s Target Retirement Funds, there isn’t one that I’d be comfortable recommending to investors of every age and risk tolerance. Most are too aggressive for many investors, and the target date funds that currently hold moderate allocations will soon be shifting to very conservative allocations that wouldn’t make sense for many young investors.

Nor would I feel comfortable recommending that investors pick a Vanguard target fund based solely on their age. If investors did that, many would end up with a 90% stock allocation (which Vanguard’s target funds hold until 25 years from retirement). In my opinion, there are plenty of investors for whom a 90% stock allocation would not be appropriate, even if they are young.

Vanguard Balanced Index Fund

While Vanguard’s Balanced Index Fund has low costs and a reasonable 60% stock, 40% bond allocation, it’s not a fund I find myself suggesting very often, because it has no allocation to international stocks. Given how inexpensive it is to get international diversification, I don’t see a lot of reason for choosing not to do so.

Low-Cost Actively Managed Funds

While I prefer index funds to actively managed funds, the primary reason for my preference is costs. Two of Vanguard’s actively managed balanced funds (Wellington and Wellesley Income) are approximately as inexpensive as Vanguard’s Target Retirement funds and LifeStrategy funds, so they at least merit consideration.

Still, like Vanguard Balanced Index Fund, they would not be my first choice due to the fact that they both have very low international allocations — approximately 88% of their respective stock allocations are allocated to U.S. stocks.

Vanguard LifeStrategy Funds

Most likely, the one fund I’d feel most comfortable recommending to anyone would be Vanguard’s LifeStrategy Moderate Growth Fund. It has an allocation of 42% U.S. stocks, 17.5% international stocks, and 40.5% bonds.

A 60% stock, 40% bond allocation is something that I think most people have the risk tolerance to handle, and it should still provide for a decent degree of growth for young investors. In addition, studies have showed that, historically, a 60/40 allocation has done approximately as well as more conservative allocations (e.g., 40% stock, 60% bond) at supporting low withdrawal rates (i.e., 4% or less) in retirement.

One Size Doesn’t Fit All

Of course, anything that tries to be a one-size-fits-all solution is bound to have shortcomings. And this is no different.

As we’ve discussed before, in many cases, using all-in-one funds means passing up on cost-saving opportunities.

For example, if you have investments in a retirement plan at work, rather than using all-in-one funds to implement the same asset allocation in each of your accounts (e.g., 401(k), Roth IRA, traditional IRA), you can often reduce costs by choosing the lowest-cost one or two funds in your work retirement plan, then picking up low-cost funds in your other accounts in order to fill in the gaps in your desired overall asset allocation.

In addition, with something as straightforward as Vanguard’s LifeStrategy funds, there’s no reason to recommend the same fund to everybody. It doesn’t take much work (and it isn’t very confusing, even to rookie investors) to explain that the LifeStrategy lineup includes four different options — Growth, Moderate Growth, Conservative Growth, and Income — each with its own level of risk and hoped-for return.

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