Archives for August 2013

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Should Spouses Make Asset Allocation Decisions Separately?

As we’ve discussed previously, it’s often possible to save on fund expenses and/or taxes by making investing decisions at the overall portfolio level rather than at the account level — making sure, for example, that your portfolio’s overall asset allocation is in line with your risk tolerance rather than trying to achieve a diversified allocation in each individual account.

I recently came across a discussion on the Bogleheads forum in which an investor asked whether, in cases in which the spouses in a married couple have very different ages, it makes sense to implement separate asset allocation plans for each of the spouses. That is, should the spouses’ respective accounts be looked at as separate portfolios?

In my opinion, no, a large difference in ages is not, in itself, a reason to break from the “it’s all one portfolio” concept.

What’s the Goal?

In most cases, when it comes to retirement savings, the primary goal is simply to provide a certain standard of living during retirement. And that’s the case whether we’re talking about his IRA, her IRA, their joint account, etc. And to the extent that a collection of accounts are all intended for the same financial goal, it makes sense to consider them as one overall portfolio intended to meet that goal.

Said differently, tax planning aside, with regard to retirement savings, it’s the overall portfolio value (rather than the value of a given account or a given holding) that matters. And, critically, that’s true:

  1. From the perspective of either spouse, and
  2. Regardless of the age of either spouse.

So decisions — whether asset allocation decisions, savings rate decisions, or spending rate decisions — should be made with regard to how they will affect the overall portfolio value.

Possible Exceptions

While the overwhelming majority of most married couples’ accumulated assets are devoted to the goal of financing spending in retirement, there certainly are cases in which a specific account is designated as the source of funds for some other specific goal. In such cases, I think those accounts should be treated separately for the purpose of making asset allocation decisions.

Example: Bob and Jane got married at age 60. Bob has three children from his prior marriage. Bob and Jane’s combined assets exceed the amount they expect to spend during their lifetime, so they have decided to treat their Roth IRAs as “bequest money.” They have agreed to list Bob’s children as the beneficiaries of Bob’s Roth IRA and Jane’s sister as the beneficiary of Jane’s Roth IRA.

Because Bob’s IRA and Jane’s IRA are intended for different goals rather than a combined “financing our spending in retirement” goal, it makes sense to make asset allocation decisions separately for each IRA.

Tax-Efficient Ways to Make Charitable Donations

In many cases, there is a more tax-efficient way to do your charitable giving than simply writing a check for the desired amount to the desired charity. Two primary strategies to consider are:

  • Donating appreciated securities from a taxable account, or
  • Making qualified charitable distributions from an IRA.

Donating Appreciated Securities

When you make a donation, to a qualified charitable organization, of assets that, if you sold them, would qualify for a long-term capital gain, you (in most cases) not only get to claim a deduction for the fair market value of the assets, you also get to avoid paying tax on the capital gain.

The benefit here is straightforward: Because you get to completely avoid paying tax on the gain, using long-term-capital-gain assets for charitable contributions typically makes more sense than using such assets to pay for living expenses (and paying tax on the gains when you liquidate them) and using other assets to fund charitable contributions.

Qualified Charitable Distributions

If you’re age 70.5 or older, you have another option: Do your giving this year via a “qualified charitable distribution.” A qualified charitable distribution is a distribution from a traditional IRA made directly to a qualified charitable organization. Unlike most distributions from an IRA, qualified charitable distributions are excluded from your gross income. (You do not, however, get an additional deduction for the donation.)

In addition to the age restriction — you must be 70.5 or older — there is a limitation in that the exclusion from gross income is limited to $100,000 per year.

The big benefit here relative to simply writing a check to the charity of your choosing is that you get to use the full pre-tax value of the IRA assets for your donation.

An additional benefit is that this is an exclusion from gross income rather than an itemized deduction (which is what you would ordinarily get for a charitable donation). This is relevant because it means that:

  • This income will not be included in your adjusted gross income (which plays a role in determining many things such as how much of your Social Security benefits will be taxable and whether you qualify for numerous credits/deductions), and
  • You can take advantage of this tax break even if you use the standard deduction.

A final benefit is that qualified charitable distributions can count toward your RMD for the year.

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How Bad Does a 401(k) Have to Be Before It Makes Sense to Skip It?

A reader writes in, asking:

“The 401K at my new job doesn’t have a single fund with an expense ratio below 1.4%. How bad does a 401K have to be before it makes sense to skip it entirely?”

As you might expect, the answer is, “it depends.” In addition to looking at the costs of the funds (and to what extent you can minimize the costs you pay by sticking to the cheapest options and picking up other parts of your allocation elsewhere), you have to consider:

  • Whether or not there is a matching contribution,
  • What you would do with the money if you did not put it into your 401(k),
  • How long you plan to stay with the employer in question, and
  • Your current and future marginal tax rates.

Is There a Match?

If your employer offers a matching contribution, that weighs very heavily in favor of contributing to the 401(k) — though perhaps contributing no more than necessary in order to get the maximum match offered — even if the investment options are very poor. It takes many years of subpar investment performance to overwhelm a risk-free 100% return right off the bat.

What’s the Alternative?

If there is no matching contribution being offered (or you have already gotten the maximum match), then it’s time to consider what you would be doing with this money if you don’t put it into your 401(k).

  • Do you have any high-interest debt to pay down?
  • Can you contribute the money to an IRA, or have you already maxed out IRA contributions for the year?
  • Is there available room for contributions in your spouse’s retirement plan at work? And if so, are the investment options in that plan better than the options in your plan?

If any of the three options above are available to you, it’s often a good idea take advantage of them rather than investing in an especially crummy 401(k).

If none of those options are available, however, the decision typically comes down to contributing to the high-cost 401(k) as opposed to investing in low-cost funds in a taxable brokerage account. If that’s the case, there are two more factors to consider.

How Long Will You Work There?

The reason high-cost mutual funds are so undesirable is that they typically lead to a lower rate of compounding for your savings, which, over a long period of time, causes you to accumulate a much smaller sum than you would otherwise accumulate.

But the expense ratios of the funds in your 401(k) are only relevant for as long as you have the money in the plan. And once you leave your job, you can roll your 401(k) assets into an IRA, where you can choose low-cost funds. In other words, you’ll only have to pay the high costs of the funds in your 401(k) for as long as you’re with the employer in question.

As a result, if you anticipate leaving the employer within the next several years, even an absurdly high expense ratio is likely to be overwhelmed by the tax savings you get from investing in a tax-sheltered account.

Looking at Tax Rates

But what if there is no employer match, you have nothing else especially attractive to do with the money (such as pay down high-interest debt), and you expect to stay with your employer for many years? Then does it make sense to invest in a taxable brokerage account rather than contribute to a 401(k) with high-cost funds?

In this case, the question comes down to weighing:

  • The improvement in performance you expect to obtain from using less expensive funds (in a taxable account) against
  • The additional taxes you would have to pay because your money is in a taxable account rather than a tax-sheltered account.

Unfortunately, this is one of those things that’s not so much a simple math problem as it is a set of several guesses, which you can then use to do a math problem if you so choose.

But, generally speaking, the lower your current tax rate (for ordinary income), the lower the tax rate you expect to pay on qualified dividends and long-term capital gains, the higher the costs of the funds in the 401(k), and the longer you expect to be with your employer, the more likely it is that the taxable brokerage account makes sense.

Waiting to Invest Doesn’t Make Things Any Easier

A reader writes in, asking:

“We have an undesirably large sum in cash at the moment, nearly a third of our total financial assets. Interest rates can go nowhere but up, but who knows when? Is it best to invest this money right away, or given the current situation, should we wait until we know better what’s happening with the market and interest rates?”

To start with, I think it’s a mistake to think that interest rates have nowhere to go but up. Right now, interest rates are significantly higher than they were at the beginning of this year. (For example, as I write this, the yield on 10-year TIPS is a full 1.3% higher than it was on January 1, 2013.) Given that rates were lower just a handful of months ago, I don’t see why they couldn’t go that low again.

Unfortunately, with interest rates, we’ll never know where they’re headed next.* For example, imagine a scenario in which interest rates rise by 2% over the next year. That would put them at a more historically normal level, but there would be no reason they couldn’t rise further. In other words, no matter how long you wait to see what interest rates do, there’s no knowing what they’ll do next.

And, as it turns out, the same goes for the stock market — waiting doesn’t really give us any useful information about what the market will do in the future.

That is, neither stocks nor bonds become any more predictable (i.e., less risky) simply as a result of waiting to buy them. So, in my opinion, the primary question is simply: How much risk are you comfortable taking right now with this money? (And, for reference, I think it’s perfectly reasonable for investors with a low risk tolerance to include cash as a significant part of their long-term allocation.)

Once you have decided on the allocation you want to use for the long-haul, there tends to be little to gain from delaying your move toward that allocation — with, of course, the exception of situations in which the delay results in a predictable advantage, such as allowing you to make the switch at a lower cost due to a short-term capital gain becoming a long-term capital gain.

*Even the market as a whole tends to be unable to successfully predict interest rate movements. (See Figure 7 from this Vanguard research paper for a striking visual representation of just how often the market gets it wrong.)

Intentionally Increasing Income to Increase Social Security Benefits?

A reader writes in, asking:

“I have been unemployed for two years and don’t know that I will work again. I am considering converting part of my IRA to a Roth IRA, in part to increase the number of earning years that go into the calculation of my future SS benefits. If the only ‘earned income’ I have in a year is related to such a conversion, will that increase my years of service included in my SS benefit calculation?”

Over the last month or so, I’ve received a handful of questions like this — people wondering about realizing capital gains or doing a Roth conversion in order to increase their Social Security benefits.

To be as clear as possible: This doesn’t work. Neither capital gains nor income from a Roth conversion is included in the calculation of your “average indexed monthly earnings” upon which your Social Security retirement benefit is based.

Section 713 of the Social Security Handbook (or, alternatively, Section 404.211 of the Code of Federal Regulations) outlines the types of income that are included:

“In computing your AIME, we include the following as total earnings (subject to the yearly limits in §714):

  1. Wages covered by Social Security and paid during the computation period;
  2. Self-employment income covered by Social Security and allocated to this period;
  3. Military service wage credits;
  4. Railroad compensation creditable for Social Security purposes; and
  5. Deemed wages if you were interned in the U.S. during World War II.

We may not count earnings from employment or self-employment not covered by Social Security in computing your AIME.”

In other words, Roth conversions, other distributions from tax-deferred accounts, capital gains, dividends, and interest are all excluded from this calculation. Or said yet another way, there’s nothing you can do with your portfolio that would increase your earnings for the purpose of calculating your Social Security retirement benefit.

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How Should Annuitizing Affect Asset Allocation?

A reader writes in, asking:

“If I buy a lifetime annuity after retiring, should that money come out of my bond allocation, stock allocation, or equally from all of my holdings?”

Any of those approaches can make perfect sense, depending on the situation. In short, after annuitizing, you should ask exactly the same questions you would have asked before annuitizing in order to set your asset allocation:

  • How much risk can I afford to take?
  • How much risk do I want to take?

In other words, just like always, you want to figure out what risk level is appropriate for you, then choose an asset allocation that meets that risk level. Once you know the allocation that you want to have after you’ve purchased the annuity, it will be easy to figure out which holdings to sell in order to meet that allocation.

If you were comfortable with your risk level before annuitizing, it’s likely that it makes sense for the annuity to come from the bond allocation. But that won’t always be the case. After all, for many people, the whole point of annuitizing is that they want to reduce the level of risk in their portfolio.

Example #1: Shortly after she retires, Glenda buys an inflation-adjusted lifetime annuity. Between the annuity and her Social Security benefits, she has about $30,000 of safe annual income — enough to satisfy her basic needs, given that she owns her home and has paid off her mortgage. She would like to be able to spend more than $30,000 per year, but she knows she can get by on that amount, if she has to.

Because Glenda can afford to take on a good deal of risk with the rest of her portfolio, because she has always been fairly comfortable with volatility, and because she wants to shoot for high returns, Glenda decides to use a high stock allocation with the remainder of her portfolio. (That is, she uses bond holdings to fund the annuity purchase.)

Example #2: Glenda’s twin sister Gail is in the exact same position as Glenda, but she has always been less comfortable with seeing the value of her holdings bounce around. So, despite having a high economic tolerance for risk, Gail decides to use the same conservative allocation for her portfolio after annuitizing that she used prior to annuitizing — that is, she uses both stock and bond holdings to fund the annuity purchase — thereby resulting in an overall reduction of risk, given that she has transferred a significant portion of her wealth from stocks to fixed income (i.e., the annuity).

Example #3: Tom found himself unintentionally retired at age 62. He held off on claiming Social Security all the way until age 70, but because of a modest earnings history, he still only receives about $15,000 of Social Security per year. He also purchased a fixed lifetime annuity that pays another $8,000 per year. While Tom would have liked to be able to lock in a higher amount of safe income, he felt that he couldn’t afford to allocate any more money to an annuity because doing so would have left him with very little in the way of liquid assets.

Because Tom has a level of safe income that doesn’t quite meet his needs, and because he doesn’t have a very large remaining portfolio, Tom has a low economic risk tolerance. That is, regardless of his emotional comfort level with volatility, Tom cannot afford to take on a great deal of risk with the non-annuitized portion of his portfolio — meaning the annuity should probably come out of his stock holdings or a combination of his stock and bond holdings.

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