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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.

Recommended Reading

Thanks for reading!

Prepay the Mortgage or Buy I-Bonds?

A reader writes in, asking:

“I have been making sure to make my mortgage a priority the last few months because I realized that is the highest paying fixed income investment I could invest in at the moment because I understand how to compare it to the yield on typical bonds. But when I compare to I bonds, how do I perform this comparison? For example, on the I bonds issued between May and November of this year…is it better to pay my 3.125% mortgage or invest in these I bond issues with composite rate 3.54%, fixed 0%?”

Comparing Risk

As a bit of background information for readers not familiar with I Bonds, their interest rate is made up of two components: a fixed rate and a variable rate.

The fixed rate stays the same through the life of the bond. For I Bonds purchased right now, the fixed rate is 0%.

The second component is a a variable rate that gets recalculated every 6 months, based on the rate of inflation over the prior 6 months (specifically, the change in the Consumer Price Index for all Urban Consumers). For I Bonds purchased right now, the variable rate is 3.54%.

So, today, when we see a 3.54% composite rate, made up of a 0% fixed rate and 3.54% variable rate, we only know that that variable rate will be applicable for 6 months. After that, it could be lower or higher, depending on inflation.

In contrast, if the mortgage is a regular fixed-rate mortgage, we know what the rate of return will be (i.e., the after-tax rate of interest that you no longer have to pay).

Of course, that’s in nominal terms. In real (i.e., inflation-adjusted) terms, it’s the I Bonds that have the predictable rate of return (in this case, 0%, minus any tax you would have to pay on the variable rate), whereas the mortgage has an unpredictable rate of return (i.e., the rate on the mortgage, tax-adjusted, minus whatever inflation turns out to be).*

Comparing Returns

In both cases, we want to look at the after-tax rate of return.

If your mortgage interest is fully deductible, we would multiply the interest rate by 1 minus your marginal tax rate (federal + state, if you can deduct the interest at the state level as well). For example with a 30% marginal tax rate, paying down a 3.125% mortgage would provide a nominal after-tax rate of return of 2.1875% (i.e., 3.125% x 0.7).

And you would also want to adjust the interest rate on the I Bonds accordingly. I Bonds are generally taxable at the federal level. But they are exempt from state income tax. In addition, if the bonds are ultimately used to pay higher education expenses, the interest will be federally tax free as well.**

In short, there’s going to be a break-even rate of inflation at which you are indifferent to prepaying the mortgage as opposed to buying I Bonds.

If taxes were not a consideration, that would be 3.125%. (That is, if inflation is 3.125% over the period in question, both I Bonds with a 0% fixed rate and prepaying a 3.125% mortgage would have a 3.125% nominal return or a 0% real rate of return.)

Considering taxes, we’d want to do some algebra in which we set the real rate of return on the mortgage equal to the real rate of return on the I bonds, and solve for inflation.

That is:

  • mortgage real rate of return = I Bonds real rate of return

The mortgage real rate of return can be written as:

  • after-tax mortgage interest rate inflation.

And the real return for the I Bonds can be written as:

  • fixed rate taxes paid on fixed rate + variable rate taxes paid on variable rate inflation

For I Bonds purchased today, the fixed rate is 0%. And the variable rate will always be equal to inflation. So we can rewrite the real rate of return for I bonds purchased today as:

  • 0 0 + inflation (inflation * marginal tax rate) inflation

Or simply:

  • (inflation * marginal tax rate)

For example, if the mortgage has a rate of 3.125% and you expect a 30% tax rate on the mortgage and a 22% tax rate on the I Bonds, the break-even rate of inflation would be 2.804%.

  • mortgage real rate of return = I Bonds real rate of return
  • 3.125% * 0.7 inflation = 0.22 * inflation
  • 2.1875% inflation = 0.22 * inflation
  • 2.1875% = 0.78 * inflation
  • inflation = 2.804%

That is, with inflation of 2.804% and a 30% tax rate on the mortgage and 22% tax rate on the I Bonds, they each provide the same after-inflation, after-tax rate of return.

Mortgage real rate of return = 3.125% * (1 0.3) 2.804% = 0.617%

I Bonds real rate of return = 0.22 * 2.804% = 0.617%

If you expected inflation greater than 2.8%, I Bonds would be expected to provide a greater after-tax return. If you expected inflation less than 2.8%, the mortgage would be expected to provide a greater after-tax return.

Liquidity

Another important difference between using cash to buy I Bonds and using cash to pay down a mortgage is that buying I Bonds would preserve a greater degree of liquidity. You can cash I Bonds after one year. (If you cash them before five years, you lose the previous three months of interest.) Whereas when you pay down a mortgage, that cash is gone, and there is no cashflow benefit until the mortgage is paid off.

*Throughout this article I am using the simplifying convention of subtracting inflation from the nominal return in order to find the real return. The more precise math is to divide (1 + nominal return) by (1 + inflation), then subtract 1.

**For simplicity’s sake, I am ignoring the fact that with I Bonds you have the choice to pay tax on the interest each year or defer taxation until the year in which you cash the bond or the bond matures. In theory, deferral is an advantage. But the specifics will depend on how your marginal tax rate changes over time.

Investing Blog Roundup: Which Bond Fund?

This week Jim Dahle did a great job answering the question of which bond fund you should use in a portfolio. Perhaps my favorite thing about the article though is the introduction, in which he makes it clear that this isn’t a critically important question.

Which bond fund to use is an important question in the sense that, when constructing a portfolio, you do have to pick something(s) to use for fixed-income (unless you’re going with an all-stock allocation). But your likelihood of meeting your financial goals is extremely unlikely to be significantly affected by whether you use a Total Bond fund or, for example, an intermediate-term Treasury fund. It’s not even close to one of the most important financial planning decisions.

Recommended Reading

Thanks for reading!

Roth IRA Withdrawal Rules

Mike’s note: In talking to people about Roth conversions, it has become clear to me that people have a lot of misunderstandings about the general rules for Roth IRA distributions. So today’s article is something of a back-to-basics post.

Types of Roth IRA Distributions

Withdrawals from a retirement account are known as “distributions.” The way a distribution from a Roth IRA is taxed depends on what type of money is being distributed. Specifically, a Roth IRA can consist of (up to) three types of money:

  1. Contributions,
  2. Amounts converted from a traditional IRA or other retirement plan, and
  3. Earnings.

An important point to note here is that earnings are not considered to be “earnings on contributions” or “earnings on converted amounts.” They’re simply earnings.

Example: In Year 1 Kevin contributes $6,000 to a Roth IRA. In Year 2 Kevin contributes another $6,000 to the Roth IRA. He also converts $30,000 from his traditional IRA to his Roth IRA. At the end of Year 2, Kevin’s Roth IRA is worth $50,000. That $50,000 is considered to be a) $12,000 of contributions, b) $30,000 from conversions, and c) $8,000 of earnings. It does not matter whether the earnings are the result of growth from the converted amounts or growth from the contributed amounts. Earnings are simply earnings.

Another important point here is that distributions from a Roth IRA are considered to happen in the order listed above. That is, distributions are considered to first come from contributions, then from converted amounts, then from earnings.

Distributions of Contributions

The tax treatment of distributions of contributions is simple: contributions can come out at any time, tax-free and penalty-free.

Example: Kelly is 24 years old. She opens her first Roth IRA and contributes $3,000. Two weeks later, she takes the $3,000 back out. Kelly does not owe any tax or penalty.

Distributions of Converted Amounts

Distributions of converted amounts are not subject to ordinary income tax.

Distributions of converted amounts are subject to a 10% penalty, unless (at least) one of the following is true:

  • The distribution is occurring at least 5 years from January 1 of the year in which the conversion occurred,
  • The distribution is of a converted amount that was not taxable in the year of the conversion,
  • The distribution is for a “qualifying reason” (listed below), or
  • One of the “other exceptions” to the 10% penalty (also listed below) applies.

Distributions of converted amounts are considered to occur on a first-in-first-out basis. That is, if you do a Roth conversion in Year 1 and another in Year 2, distributions will be considered to come from the Year 1 conversion first. And for a given conversion, if it was partially taxable and partially nontaxable, the taxable portion (i.e., the portion of the conversion that was taxable in the year of conversion) is considered to be distributed before the nontaxable portion.

Qualifying Reasons

The following are the “qualifying reasons” for a distribution from a Roth IRA:

  • You have reached age 59½.
  • The distribution was made to your beneficiary after your death.
  • You are disabled.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.

Other Exceptions to 10% Penalty

The following are the “other exceptions” to the 10% penalty:

  • The distributions are part of a “series of substantially equal payments.”
  • You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
  • You are paying medical insurance premiums during a period of unemployment.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the account.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified birth or adoption distribution (up to $5,000 per parent per birth/adoption).
  • The distribution was a “qualified coronavirus-related distribution.”

Distributions of Earnings

Distributions of earnings will be subject to ordinary income tax unless they are “qualified distributions.” In order for a distribution to be a qualified distribution:

  • It must be for a “qualifying reason” (listed above), and
  • The distribution must not occur any earlier than 5 years from January 1 of the year in which you first established and contributed to a Roth IRA. (For example, if you first opened and contributed to a Roth IRA on May 18, 2019, this 5-year rule would be satisfied as of January 1, 2024.)

And distributions of earnings will be subject to a 10% penalty unless:

  • The distribution is for a “qualifying reason” (listed above), or
  • You meet one of the “other exceptions” to the 10% penalty (also listed above).

The following flowchart summarizes tax treatments of distributions of earnings from a Roth IRA:

All Roth IRAs Are Viewed as One

When applying the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, distributions from a Roth IRA will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2018, you contributed $2,000 to a Roth. In 2019, you opened a Roth IRA with a different brokerage firm and contributed $3,000 to it. By 2021, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA for these purposes.

What if You Have Rolled a Roth 401(k) or 403(b) into Your Roth IRA?

If you have rolled assets from a designated Roth account in an employer plan (i.e., what we would typically refer to as a Roth 401(k) or Roth 403(b)) into your Roth IRA, those rollover amounts are separated into contributions and earnings — and then lumped into the appropriate category along with regular Roth IRA contributions and earnings.

Of note: at least in theory, this information should be transmitted from the administrator of the employer plan to the administrator of the Roth IRA. But it’s best if you keep records of your own, to be able to demonstrate the portion of the rollover that is attributable to contributions.

Example: Over the course of a few years, you contribute $50,000 to your Roth 401(k). After leaving that employer, you roll the entire Roth 401(k), which is worth $80,000 at the time of the rollover, into your Roth IRA. For the sake of applying the distribution rules discussed above, the $50,000 is treated as if it were regular Roth IRA contributions (i.e., it can be withdrawn from the Roth IRA tax-free and penalty-free at any time). And the additional $30,000 will be treated just like any other earnings in the Roth IRA (i.e., it will be treated in keeping with the rules shown in the flowchart above).

Investing Blog Roundup: Long-Term Care Needs

Long-term care is one of the trickiest topics in financial planning. The potential costs are quite high, yet the available insurance products leave something to be desired.

Three researchers with the Center for Retirement Research at Boston College recently sought to answer a few of the questions that you have likely asked yourself: how likely are you to need long-term care? And how likely are you to need a severe level of care as opposed to a more minor level of care? And how long is your need for care likely to last?

Recommended Reading

Thanks for reading!

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