Year End Capital Gains Distributions How to Avoid Getting Slammed

Year-End Capital Gains Distributions: How to Avoid Getting Slammed

With tax season now in the rear view mirror, many of us are licking our wounds after a shellacking from Uncle Sam.  I heard from a lot of people this year that they owed far more to the IRS than they expected to.  Come to find out, the IRS changed the withholding tables with the new tax bill.  Rather than overwithholding throughout the year and getting a refund in April, thousands across the country underwitheld & had to pay out of pocket.

Another item factoring into last year’s fat tax bills was capital gains.  Mutual funds and ETFs distribute capital gains back to shareholders, which are taxable based on the amount of time the fund owned the holding.  As an investor, receiving an unwanted taxable distribution can be inconvenient.

As a reader recently put it: “For the second year in a row I’ve gotten killed with large capital gains from my mutual funds, resulting in a large tax bill.  Aside from owning stocks on my own, how can I eliminate or minimize these capital gains?”

Today’s post will answer this exact question.  For those of you who’ve seen the adverse tax consequences of capital gains distributions, read on to learn a few strategies you could use to minimize the bite.

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What's an Appropriate Cash Reserve in Retirement?

What’s an Appropriate Cash Reserve in Retirement?

Cash flow is one of the first topics I like to cover when working with new financial planning clients.  Cash flow is so fundamental to the rest of your household finances that it’s really helpful to understand how much money is coming in every month and how much is going out.  With this in place we can begin to wrap our heads around concepts like your capacity to take risk, disability insurance needs, and other components of a typical financial plan.

We can also use this information to determine how big your cash reserve should be.  There are many different names for a cash reserve: cash buffer, cash safety net, emergency fund, and so on.  Regardless of what you might call it, the objective is to keep enough cash on hand so that no matter what happens in your life, you don’t need to sell investments at an inconvenient time (i.e. during corrections or market crashes).

The easiest way to view your cash reserve is as a function of monthly living expenses.  Simply multiply your monthly living expenses by the number of months you feel comfortable with and voila!  That’s how big your cash reserve should be.

During your “accumulation” or working years, most financial planners recommend a cash reserve of somewhere between 6 and 24 months’ worth of living expenses.  Where you fall on that spectrum depends on a several different factors:

  • Your capacity and willingness to take risk
  • How many incomes you have in your household
  • How consistent your income is
  • How many dependents rely on your income
  • What your disability insurance situation looks like

In retirement the situation is quite a bit different.  You’ve already amassed the amount you need to quit working, and are obviously not concerned with the possibility of being laid off.  Instead, the biggest issue is avoiding having to sell assets at an inconvenient time.

It’s a challenging line to walk.  You want to keep enough cash on hand to cover unexpected expenses and avoid selling stocks in periods of market turmoil.  But you also don’t want to keep more in cash than you need to.  Keeping too much is a drag on your portfolio, and inflation will slowly eat it away over time.  The right amount of cash for you in retirement depends on a different set of factors, which I’ll cover in this post.

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How to Take Advantage of Your Retirement "Gap Years"

How to Take Advantage of Your Retirement “Gap Years”

Often when I bring up the idea of retirement “gap years” in meetings, my clients’ minds wander toward a family member who’s decided to take a year off between high school and college.  Then they shake their head in disbelief about how millenials are often encouraged to backpack around for a year to mature and “find themselves”.  Another moment of reflection about how the world’s changed, and that’s about when their attention snaps back to refocus on our meeting.

No, retirement gap years don’t have anything do with finding yourself or maturing.  They have to do with the years between retirement and age 70.  Many people will see their taxable income fall to lower levels once they stop working, and spike once they turn 70.  Thus, the retirement income “gap”.

Here’s why.  For those of us with assets in qualified retirement accounts like 401(k) plans or IRAs, 70.5 is the age when the IRS begins imposing mandatory distributions, which will be added to your taxable income.  Once you begin collecting Social Security you’ll also be taxed on either 50% or 85% of the benefits, depending on where that taxable income falls.  If you’re one of the many people waiting until age 70 to collect, that’s two extra sources of taxable income added simultaneously, and recurring every year thereafter.

Thanks to our progressive tax system, the years you find yourself in a lower tax bracket can be a great opportunity to reduce taxes over the rest of your life.  This post will explore how.

How to Take Advantage of Your Retirement "Gap Years"

 

The Opportunity

As you know, we have a progressive tax system here in the U.S.  The higher your taxable income, the higher the rate you pay.  As I write this, the tax brackets for single & married people filing jointly are:

How to Take Advantage of Your Retirement "Gap Years"

Notice the big jumps here – our marginal tax rates don’t increase evenly.  10% & 12%, 22% & 24%, and then 32% and higher.  The increases from 12% to 22%, and again from 24% to 32% are significant, and present a convenient opportunity when planning for retirement.

Think of a typical retirement timeline.  If you plan to stop working at 65 years of age, chances are your taxable income will be higher at age 64 than it will be at age 66.  Then a few years later at age 70.5, you’ll enter RMD territory.  The IRS will force you to take a certain amount of money out of your tax deferred retirement accounts every year, or face a stiff 50% penalty.

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Dollar Cost Averaging: Are You Really Better Off?

Dollar Cost Averaging: Are You Really Better Off?

As I write this post the S&P 500 is about 100 points off it’s all time high of 2922, and climbing fast.  We’ve seen an incredible bull market over the last ten years since the last financial crisis, and many people are wondering whether the next crash is around the corner.

So if you’ve just come into some money that you’d like to invest, is now a good time?  What if you invest everything right before the market crashes again?  Should you wait?

One popular strategy used in this situation is dollar cost averaging.  Rather than invest everything at once or keeping your cash on the sidelines, dollar cost averaging parses out what you’d like to invest over time.  The idea is that stretching out your investing over a longer period protects your savings against crashes.  Basically, if the market does crash tomorrow you have less at risk.

For example, I have a client who just sold her business last year.  She’s expecting to live off the proceeds raised from the sale for the rest of her life.  We have a plan in place to help her accomplish this.

One of the big psychological hurdles we had to work through was how to go about investing this cash.  While my client needs portfolio growth to ensure she doesn’t run out of money, the proceeds from her business sale account for over 70% of her net worth.  Investing all of it at once was a nerve wracking idea!  So we decided to dollar cost average the funds over the subsequent 12 months instead.

 

Dollar Cost Averaging vs Lump Sum

After studying this stuff for a while, I know that my client is likely to have a better outcome by investing everything at once.  But that doesn’t help her sleep at night.  The idea that the years of toil in her business could be washed away in an instant by neurotic Mr. Market was unacceptable.  And even though she’s more likely to leave money on the table by holding back the cash during a growth period, this route made more sense for her.

Since then I’ve had probably half a dozen clients in similar situations.  They have cash, but are reluctant to put it all at risk at once.  While dollar cost averaging helps, I know intuitively that we’re more likely to miss out on potential returns than successfully avoid a crash.

But how much more likely?

There have been a few studies on this subject over the years (like Vanguard’s in 2012).  But with the research tools I use in my practice, I figured I’d run the analysis myself out of curiosity.  Especially since market returns since 2012 have been so strong.

I should also note that I grabbed the data for this post (and began writing it) back in December.  Business got in the way, and it’s taken me a couple months to finish it up.  Last month Nick Maggiulli of Ritholtz Wealth wrote a great post on the same topic.  Ordinarily I don’t like to write posts that are similar to others I’ve recently read, but here we are.  If you’re interested in the topic you should definitely read Nick’s post.

 

The Data

To start, I used the Morningstar US Market Index as a proxy for stocks and the Barclays U.S. Aggregate bond index for bonds.  I chose the Morningstar index because didn’t want to omit small & mid cap stocks by using the S&P 500.  I pulled monthly returns going back 20 years for both indices, including dividends & distributions.  20 years isn’t a tremendously long time, but it does capture the dot com bubble & bust, the mortgage crisis, and the last 10 years of market strength we’ve enjoyed.

Then I went to work calculating the returns of a 60/40 portfolio invested all at once, versus the same portfolio invested over a 12 month period using dollar cost averaging.  I ran the exercise using rolling 3 year, 5 year, and 10 year periods.

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Market Volatility Survival Guide

Free Online Training: Market Volatility Survival Guide

If you’ve been paying any kind of attention to the markets over the last two months, you’ve probably noticed a new trend: volatility.  Consistent market volatility isn’t something we’ve seen in quite some time.  Other than the market’s brief reaction to the Brexit, we really haven’t seen much upheaval since the depths of the financial crisis.

With tighter monetary policy from the Federal Reserve and both feet on the gas of our fiscal policy here in the U.S., there’s a good chance the choppy waters are here to stay.

Since I’ve been getting a ton of questions recently about how to handle market volatility, I figured it’d be a good subject for an online training.  So, this Tuesday, March 6th, from 10-11am PST / 1-2pm EST, I’ll be hosting a free online training on how to protect your retirement accounts during market corrections.  Here’s the link to register.

Topics We’ll Cover:

  • The single BEST strategy to protect your retirement portfolio when markets crash
  • The secret to surviving the next bear market
  • The top 5  mistakes you should avoid when saving in workplace retirement accounts
  • How to tune out the noise and identify what news you should actually pay attention to

This will be a free online event, but seating is strictly limited to 100 attendees.  Feel free to spread the word to your friends/family members/colleagues who might be interested, but make sure you reserve your spot before the spaces are filled.

Click Here to Register

I look forward to seeing you there!

Backdoor Roth Conversion: How to Contribute to a Roth IRA When You Make Too Much Money

Backdoor Roth IRA Conversion: How to Contribute to a Roth IRA When You Make Too Much Money

If you asked me to choose my FAVORITE type of account to invest in, it would definitely be the Roth IRA.  Roth IRAs allow you to save money tax free for the rest of your life.  They’re not subject to mandatory withdrawals in your 70’s, and your kids won’t even owe taxes on their withdrawals if they inherit the account from you down the road.  In my opinion the Roth IRA is just about the best deal out there.

Problem is, they’re not accessible to everyone.  The IRS considers Roth IRAs such a good deal that they won’t let you contribute to one if you make too much money.  Fortunately, there’s a work around: the backdoor Roth IRA conversion.  The backdoor Roth conversion allows you to get money into the Roth IRA by making non-deductible contributions to a traditional IRA.  Don’t worry if this sounds complicated.  We’ll go over the strategy step by step in this post.  Read on to learn more.

 

The Backdoor Roth IRA Conversion Strategy

So here’s how it works.  I’ll break it down into two-distinct steps.  But to start, let’s review the income limitations for direct contributions to a Roth IRA.  If your modified adjusted gross income on the year (MAGI) falls below the “Full Contribution” threshold, you can contribute to a Roth IRA directly.  If your MAGI falls into the phaseout region your contribution limit for the year begins to fall.  When it reaches the “Ineligible” threshold, you’ll be prevented from contributing to a Roth IRA altogether (at least in 2018).  If this is you, the backdoor Roth conversion might be a good fit.  (Here’s a review of how to calculate modified adjusted gross income).

Backdoor Roth Conversion: How to Contribute to a Roth IRA When You Make Too Much Money

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Bloodletting and Evidence Based Investing

Bloodletting and Evidence Based Investing

Have you ever heard the term “bloodletting”?  Bloodletting was a tactic used by the medical community to prevent or cure illness.  In the old days, the collective wisdom was that our blood was one of many systems in our body that must remain in balance at all times.  If you walked into a doctor’s office with a common affliction like the flu or a cold, the doctor might determine that you simply had too much much blood in your body.  A common prescription was to apply leeches to your skin to bring relief.

Why did they believe this craziness worked?  Their anecdotal experience, speculation, and conjecture.

So how did we figure out that bloodletting was probably doing more harm than good?  Researchers began applying science to the practice of medicine in the late 1800s.  The scientific method of hypothesizing, gathering data, testing, and using analysis to come to a reasonable conclusion helped us figure out that our problems were not because we had too much blood.  They came from other things like viruses, bacteria, and our genetics.

 

Evolution of Investing

This revolution in western medicine is similar to what we’re seeing in investing today.  For years and years the investment process has been driven by anecdotal observation and conjecture.

For example, how many times have you read an article in Forbes or The Wall Street Journal that profiles the “next big stock to pop”?  In the 90’s it was tech stocks, in the 2000’s it was banking and pharmaceuticals, and since then it’s been social media and tech stocks.  Buying a stock that you think is about to pop, or is undervalued, has been one of the preeminent investment strategies since the early 1900s.

The same goes for “tactical” asset allocation.  Boosting your portfolio’s allocation to oil stocks because you think OPEC is about to cut their production quotas, or selling bonds because you think interest rates are about to rise are strategies based on speculation about the future.

Why do so many people invest this way?  Because of our life experience & anecdotal observations.  Everyone I’ve ever met has at least one person they know who invested early in Facebook or Microsoft and made a fortune.  We believe this type of investing can work because of our anecdotal experience.

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How to Use Strategic Asset Allocation to Reduce Your Tax Bill

How to Use Strategic Asset Location to Reduce Your Tax Bill

I’m a believer that the biggest factor contributing to the returns in your portfolio is asset allocation.  The amount of your portfolio you choose to invest in stocks, bonds, real estate, or anything else will ultimately have the biggest effect on how your portfolio does over the long run.

In other words, the decision of whether to buy Lowe’s or Home Depot isn’t nearly as important than the decision to be in large cap stocks or international bonds.

If you’re being strategic about your saving, you’ll probably try to utilize tax advantaged accounts like IRAs, Roth IRAs, and 401(k)s as much as you can.  If you’re using them (like most people), after a while your total portfolio will probably be spread across several different types of these accounts.

Today’s post covers asset location.  Rather than replicate the exact same asset allocation in each of your individual accounts, placing your investments across them strategically can work to reduce your tax bill and enhance your after tax returns.

Since some asset classes are more likely to distribute taxable income & capital gains, parking them in the accounts you don’t pay tax on (like a Roth IRA), only seems logical.  When done thoughtfully, asset location can as much as 0.25%-0.75% per year to your portfolio’s returns.

Read on to learn how it works.

 

 
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Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax

The Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax

Taxes are frustrating to nearly every small business owner I speak with.  Most people agree that we should all pay our fair share.  But after working countless thousands of hours to build a viable business, it’s easy to feel like Uncle Sam’s reaching into our pockets too far.  That’s why I focus on helping my clients who own businesses make sure they’re not paying more in taxes than they need to.  One great tool we can use in this endeavor is a defined benefit retirement plan.  Whatever you want to call it, DB plan, defined benefits pension plan, etc., it can be a killer way to defer a huge portion of your income from taxation.

I realize you might cringe when you read the words “pension” or “defined benefit”.  The idea of promising employees a monthly check throughout their retirement may not foster warm and fuzzies.  But if you don’t have employees, or only have a few, a defined benefit plan can offer some pretty major tax advantages.

Read on to learn how you might take advantage of them.

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How to Tell Whether You Have Enough Money to Retire

How to Tell Whether You Have Enough Money to Retire

“I’m not sure I have enough saved up to retire.”

“How can I know for sure my savings will last after I stop working?”

“I”m concerned I’ll spend through my savings too fast and run out of money when I’m 80.”

These are a few common phrases I hear from people who are approaching retirement.  Many people I speak with in the their mid 50s and early 60s these days have saved diligently for years for their own retirement.  But now as they approach the transition from accumulating wealth to spending their savings, the question of whether they’ve saved enough becomes extremely important.

Plus, when you mix in longer life expectancies, rising health care costs, and expensive stock and bond markets, there’s a lot of uncertainty surrounding the issue.

So in today’s post, I’ll cover some of the leading ways you can determine whether you have enough saved up to stop working.  Without putting you and your family’s future at risk, that is.

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