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Social Security Planning Approaches: Insurance Approach vs. Maximizing Expected Outcome

When it comes to Social Security planning, people often take one of two approaches:

  • The insurance approach: Social Security is meant to be longevity insurance, so in order to get the most protection from it, I will delay until age 70.
  • The maximizing approach: I want to get the most total dollars (or present value of dollars) from Social Security over my lifetime, so I will file at whatever age results in the highest expected sum. (Note: this second approach is what calculators such as Open Social Security are doing — recommending the filing age(s) that maximize the expected present value of dollars collected.)

In short, most people should be accounting for both perspectives in their planning.

Taking only the maximizing approach fails to account for the fact that a reduction in risk is valuable. Waiting to file for Social Security generally reduces longevity risk, because it makes you less likely to deplete your savings in a live-a-long-time scenario, and it means that you would be left with a greater monthly income in the undesirable event that you do deplete your portfolio.

Conversely, taking only the insurance approach makes no sense either. Yes, Social Security does function as longevity insurance. And when you delay Social Security you are, essentially, buying more of that insurance. But just because a type of insurance is available doesn’t mean that you need it or that it’s a good deal. (I’m sure you can come up with several examples of this concept on your own.)

For some people, the risk reduction that comes from delaying Social Security isn’t really important, because they’ve already reached a point where their level of savings relative to their desired level of spending is such that there’s very little chance of running out of money, regardless of what decisions are made with regard to Social Security.

Similarly, for some couples (most especially, married couples in which one person is in very poor health or the higher earner is much older than the lower earner), having the spouse with the lower earnings history delay filing doesn’t necessarily even reduce risk. It makes the “we both live a long time” scenario better. But it makes the “one of us lives a long time” scenario worse. And for such couples, it’s that second scenario that’s far more likely.

“Delay until 70” happens to be a respectable rule of thumb for an unmarried person, because:

  1. It does happen to be a pretty good deal (not astonishingly good, but good) for most unmarried people, and
  2. If you choose to delay, then you die at an early age, it’s not as if you’ll be upset about having waited to file for your benefits.

But once we look at married couples, it’s more complicated because:

  1. It’s often not a good deal (for the lower earner to delay). In some cases (again, if one person is in very poor health or if the higher earner is much older than the lower earner), it can be quite a bad deal.
  2. And if you’re the lower earner and you choose to delay, then one spouse dies soon thereafter, the surviving spouse will still be alive and will be in a worse position as a result of you not having filed for benefits early.

Point being, Social Security planning should be treated much like any other personal financial planning topic in that:

  • It’s helpful to actually do an analysis that looks at your personal facts and circumstances, and
  • When performing that analysis, the evaluation of any particular strategy should account for both the effect that that particular strategy would have on the risk(s) to which you are exposed and the effect that that strategy would have on the expected (i.e., probable) outcome.

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Investing Blog Roundup: Morningstar Fund Fee Study

Morningstar recently released their annual fund fee study. Mutual fund investors continue to pay lower and lower fees per year, and it’s largely due to the fact that we’re choosing less expensive funds:

“Investors deserve most of the credit for putting the squeeze on fees. […] In nine of the last 10 years, the cheapest 20% of funds across all Morningstar Categories have, as a group, accounted for 100% of the net inflows into all funds. Meanwhile, money has poured out of the remaining 80% in all but one year over the past decade.”

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Roth Conversion Rules FAQ

After the recent article “Roth Conversion Planning, a Step-by-Step Approach,” it has become clear through emails from readers that lots of people have questions — not just about the decision making process, but about the rules themselves. So what follows is a brief FAQ about the rules surrounding Roth conversions.

Is there an income limit for Roth conversions?

No. There used to be a limit. (Prior to 2010, you could not do a Roth conversion if your modified adjusted gross income exceeded $100,000.) But there is no longer an income limit.

Is there an income requirement for a Roth conversion?

No. While you (or your spouse) must have earned income in order to make a Roth IRA contribution, you do not have to have any earned income in order to do a Roth conversion.

Is there a maximum amount you can convert per year?

No. There is no maximum conversion — other than the fact that you can’t convert more than you have in tax-deferred accounts.

Can you do a partial conversion, or do you have to convert the whole account at once?

You can do a partial conversion of a traditional IRA. For example, converting $20,000 of a $100,000 account is perfectly allowed.

And in most cases in which conversions make sense, doing partial conversions over a period of years is in fact what’s most desirable — converting only enough to put your income up to a particular threshold each year, rather then converting the whole account at once. Converting the whole account at once would often mean paying a high tax rate on the conversion, as it would mean having a very high level of income that year. (Of course, this depends on the size of the account.)

Note that the same is true for a 401(k). If your 401(k) allows for in-plan conversions, you can do a partial conversion to Roth 401(k).

How is a Roth conversion (from a traditional IRA) taxed?

Generally, a Roth conversion will be taxable as ordinary income.

If, however, you have made nondeductible contributions, a portion of the conversion will not be taxable. Specifically, the percentage of the conversion that is not taxable is calculated as:

  • Your basis in traditional IRAs, divided by
  • The sum of your traditional IRA balances on 12/31 of the year of the conversion and any distributions and conversions from traditional IRAs that occurred that year.

Your basis in traditional IRAs is the sum of your nondeductible contributions, minus any portions of those amounts that have been distributed or converted.

For example, if you have made $20,000 of nondeductible contributions over the years (and none of those amounts have been distributed or converted), you have $20,000 of basis in your traditional IRAs. If you do a $100,000 conversion, and at the end of the year your traditional IRAs are in total worth $400,000, then 4% of your $100,000 conversion would be nontaxable.

That is, $20,000 (basis in traditional IRAs) divided by $500,000 (i.e., the sum of the conversions/distributions for the year and the sum of your traditional IRA balances at the end of the year) equals 4%. So you would have $96,000 of gross income as a result of the $100,000 conversion.

Something that surprises many people is that if, for example, you do a Roth conversion in March and then in November of the same year you roll a 401(k) into a traditional IRA, that rollover is going to affect the portion of the conversion that’s taxable (because it will increase your traditional IRA balance on 12/31 of that year).

Another key point here is that all of your traditional IRAs (including SEP and SIMPLE IRAs) are considered to be a single IRA for the purpose of this calculation. (See: “When are IRAs Aggregated?”)

How is an in-plan Roth conversion (e.g., a conversion within a 401(k)) taxed?

As with a conversion of a traditional IRA, the conversion will generally be taxable. Also similarly, if you have made nondeductible, non-Roth (i.e., “after-tax”) contributions to the plan, a portion of the conversion will be nontaxable. And again, it’s a pro-rata calculation.

However for this calculation, unlike with IRAs, the 401(k) is not aggregated with other 401(k) plans.

Also, if the plan separately accounts for the after-tax contributions and their earnings, then it’s possible to largely avoid the pro-rata rule, because you can have just those amounts (i.e., the after-tax contributions and their earnings) converted. In such a case you would only have to pay tax on the earnings on the after-tax contributions.

Can a Roth conversion trigger the 10% penalty?

If you are under age 59.5, any money that comes out of the traditional IRA and does not end up going into the Roth IRA may be subject to the 10% penalty. For instance, if you take $100,000 out of your traditional IRA, $75,000 goes into your Roth IRA, and $25,000 is withheld to pay the tax on the conversion/distribution, the $25,000 would be subject to the 10% penalty if you’re under age 59.5 and don’t meet one of the other exceptions to the penalty.

When is a Roth conversion taxed?

A Roth conversion is taxable in the year in which it occurs. That is, conversions work on a calendar-year basis. There’s no “I’m doing this in March of 2022, and I want it to count for 2021” option as there is for contributions to an IRA.

How are distributions from a Roth IRA treated, after a conversion?

When amounts that were converted to a Roth IRA are distributed from the Roth IRA, they will not be subject to ordinary income tax. They might be subject to a 10% penalty. But that penalty will not apply if you’re at least age 59.5, or if the conversion was at least 5 years ago, if the conversion itself wasn’t taxable, or if one of several other exceptions applies. For more details, see “Roth IRA Distribution Rules” or the Roth IRA Distribution Tool.

Can I do a Roth conversion of an inherited IRA?

No — unless you inherited it from your spouse, in which case you’re allowed to treat the account as your own, which allows you to do a conversion into your own Roth IRA.

Can I recharacterize (undo) a Roth conversion?

No. As a result of a change made by the Tax Cuts and Jobs Act of 2017, you can no longer recharacterize a Roth conversion.

Does a Roth conversion satisfy my RMD for the year?

No. If you have to take a required minimum distribution (RMD) in a given year, a Roth conversion does not count toward that RMD.

Investing Blog Roundup: Guaranteed Income as a “License to Spend”

This week I encountered a recent paper by David Blanchett and Michael Finke in which they found that, among retiree households with similar levels of wealth, the greater the percentage of that wealth that is held in the form of guaranteed income (i.e., Social Security, pension, or annuity income), the more the household spends.

To an extent, this makes perfect sense, as a household whose wealth is overwhelmingly in the form of stocks and bonds must pick a conservative spending rate to protect against the possibility of poor investment returns, a very long retirement, or a combination of the two, while a household with a high level of pension (or similar) income can generally feel pretty safe spending all of that income. Blanchett and Finke found though that the size of the difference indicates that retirees with a low percentage of guaranteed income are likely being even more conservative than they need to be, in terms of spending rate.

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How Much Cash Should a Retirement Savings Portfolio Include?

A reader writes in, asking:

“What do you think is an appropriate level of cash allocation in a portfolio for retirement savings?”

Let me begin with my standard disclaimer for any asset allocation question: there’s a broad range of what is reasonable. There is no one perfect allocation, and it’s a waste of time to try to find such.

For any particular investor, there’s an approximate overall level of risk that is appropriate, and there are countless different ways to get to that level of risk. So, for example, if you like to use cash instead of bonds because doing so allows you to feel comfortable with a slightly higher stock allocation, that’s perfectly reasonable.

But, in most cases, a retirement portfolio will not require a cash allocation at all.

As for our household (still in the accumulation stage), our retirement portfolio has no intentional cash allocation. It’s all stocks or bonds. (More specifically, it’s 100% Vanguard LifeStrategy Growth Fund and has been for ~10 years.)

That said, we do keep a few months of expenses in checking accounts. In part, that’s because my own income has a high degree of variation from one month to the next. That’s just the nature of self-employment. If we were both paid a predictable monthly salary, we would probably keep a smaller amount in checking accounts.

Similarly, if we were retired and our Social Security/pension/annuity income were sufficient to pay the bills, I’d be comfortable with a very small amount in checking. Assets from investment accounts can be tapped pretty quickly. Even for an unexpected large expense, you can use a credit card to pay the expense, then liquidate some assets from investment accounts to be able to pay off the credit card promptly (i.e., before paying any interest).

As far as cash as an asset class, it does what you would expect it to do: it reduces the overall volatility of the portfolio, but it earns almost no return, even before inflation.

Some people hope to use cash holdings to actually improve returns by deploying it at opportune times, but that’s harder than it might appear. For instance, by January of 2009, the market had spent the last several months moving dramatically downward. So it was clearly a better time to buy than it was several months ago. But was this the bottom? Or would it be better to continue to wait? (If you wait, it might turn out that this was the bottom, and you end up having to buy at a higher price.)

I certainly had no idea at the time. I never have any idea where the market is heading next, so I have no interest in holding cash just to hope to take advantage of such opportunities.

And for all of the years in which the stock market doesn’t provide any crash-fueled, obvious buying opportunity, the money that you have sitting in cash is just missing out on returns.

For instance, over the last 10 years, Vanguard Short-Term Treasury Index Fund (which we can use as a stand-in for cash) went up in value by about 12%. By contrast,

  • Vanguard Total Bond Market Index Fund has increased in value by about 39%, and
  • Vanguard Intermediate-Term Treasury Index Fund increased in value by about 30%.

Depending on which comparison fund we’re looking at, that’s a cumulative 18-27% return shortfall by having the money sit in cash. That’s not massive, but it’s not nothing. And it’s not as if a total bond fund or intermediate-term Treasury fund is any sort of terrifying roller coaster ride.

So, again, cash is a perfectly reasonable thing to include in almost any asset allocation, because it’s one tool that you can use to adjust the portfolio’s overall risk level to where you want it. But it’s uncommon for a portfolio to need any cash allocation at all.

There is one specific case in which I do think cash can play a critical role. If you’re retired and you’re temporarily spending from your portfolio at a high rate until Social Security (or a pension) kicks in, it’s important to use something very safe like cash or CDs for satisfying that extra-high level of spending, because, for that money, you can’t afford to take on much risk at all.

Investing Blog Roundup: Roth IRA Distribution Tool

After recently writing about Roth IRA distribution rules, I was asked to create a tool, so you can just answer a few questions and get the answer as to how your distributions will be treated. So, here it is:

It’s nothing fancy — just a basic tool that guides you to the applicable outcome from the rules we discussed recently.

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My new Social Security calculator (beta): Open Social Security