How to Add Tax Diversification to Your Retirement Investments

US News and World Report, By Emily Brandon Sept. 15, 2014

Saving in accounts with different tax treatments can help you minimize taxes in retirement. If you do all of your saving for retirement in traditional 401(k)s and individual retirement accounts, you could face hefty required withdrawals in retirement that bump you into a higher tax bracket. However, saving for retirement in accounts with different types of tax treatments including traditional retirement accounts, Roth accounts and taxable investment or savings accounts, adds tax diversification and flexibility to your portfolio. Maintaining a balance in taxable, tax-deferred and tax-free accounts can help to decrease your tax bill in retirement. Here’s how to control your tax bills:

Traditional 401(k)s and IRAs: Contributions to traditional 401(k)s and IRAs are excluded from your current income, and you don’t have to pay tax on that money until you take it out, presumably in retirement. However, once you turn age 70 1/2, annual withdrawals become required and the tax bill is due on each distribution.

Roth 401(k)s and Roth IRAs: Roth account contributions are made with after-tax dollars, but withdrawals in retirement from accounts that are at least five years old are tax-free. Withdrawals from Roth accounts aren’t required at any age, so you have the flexibility to take the money out when you need it without tax consequences or leave the money in the account for later in retirement or even leave it to heirs. “If their tax rate is higher now than it will be in the future, we will have them mostly contribute to a traditional account, but if a young person comes in and we are pretty sure that their tax rate is going to be the same or greater in retirement, then we are going to have them do a Roth,” says Eric Mancini, a certified financial planner for Traphagen Financial Group in Oradell, New Jersey. “As a general rule, the younger the client, the more they should be tilted to Roth 401(k)s or Roth IRAs.”

Taxable Accounts: Regular savings and investment accounts typically require you to pay taxes on the gains in the account each year, and there are no tax perks for contributing. However, these accounts are also the most accessible for spending or emergencies, and there aren’t penalties for withdrawing your money before a certain age. “Don’t forget to start stockpiling a taxable account, because that gives you so much flexibility in your 60s,” says Bryan Clintsman, a certified financial planner and principal of Clintsman Financial Planning in Southlake, Texas. “The more you get in there, the more years you are going to be able to live on that and defer access to the tax-advantaged account.”

The Order of Saving: The highest return you are likely to receive on an investment is a 401(k) match, so getting that should be your first priority. After that, there is room to diversify your saving. “First, you get your match from your company, and then I would say the Roth type of account is next, and then the tax deduction type accounts are after that,” says Joe Franklin, a certified financial planner and president of Franklin Wealth Management in Hixson, Tennessee. But he cautions: “If you don’t have anything outside of retirement accounts, an emergency can be a problem. You always want to have your emergency fund set aside. “

The Order of Spending: In retirement, you can draw from all three types of accounts in a way that minimizes your tax bill. “For most people, generally the order of withdrawals in retirement is taxable first, and then tax-deferred and then tax-free,” Clintsman says. “You want to save the Roth for last because every single dollar of earnings is tax-free.” However, there is also an exception to this order of spending. If you have a very large traditional 401(k) or IRA balance and you’re going to need to pay a high tax rate on the withdrawals, it can make sense to start taking distributions before you are required to so you can space them out over more years and perhaps pay a lower tax rate on at least some of the distributions. “If they are in a low tax bracket – 15 percent or less – we look to actively convert traditional IRAs to a Roth,” Mancini says. “In retirement, there are a lot of advantages to having amounts in taxable, Roth and traditional accounts. It brings the required minimum distribution down when they get to 70 1/2.”

Maintaining a balance in accounts with different tax treatments heading into retirement gives you options to minimize your tax bill each year. “You want to keep some balance in all three types of accounts: the taxable, the tax-deferred and the tax-free,” Clintsman says. “There might be some years that taking a disproportionate amount from one of them is important.”

 To Your Successful Retirement!

Michael Ginsberg, JD, CFP® 


Gen Y Rejects the School-Work-Family-Retirement Cookie-Cutter Mold?

Hal M. Bundrick, MainStreet.com, Sep 15, 2014

NEW YORK (MainStreet) — Compared to those in older generations, Gen Y investors are more hands-on and less focused on traditional life stage planning, according to new reports out of Vanguard, the venerable index investment firm. As a result, financial advisors must change their behavior to attract business from this cohort of Millennials, those born between the early 1980s and the early 2000s.

For Baby Boomers the generation gap meant “don’t trust anyone over 30.” That revolutionary rally cry against the establishment in the ‘60s quickly morphed into a population absorbed into a corporate culture: work hard for your employer, “pay your dues” and plan for retirement.

Today, youthful adults are living the “peace and love” lifestyle more than Boomers ever did. The school-work-family-retirement life path has been replaced by a generation seeking self-expression, personal fulfillment at work and a life built on experiences rather than possessions.

Vanguard’s series of position papers guiding financial advisors in the best practices of connecting with younger investors serve as a roadmap any industry could find valuable in developing marketing and products targeting Gen X – and particularly Gen Y. The refusal to follow a traditional life path is a fundamental component to understanding today’s young adults.

“Instead, they tend to wait longer to start a family, and are more apt to experience multiple career changes, hold more than one job at once, and engage in contract employment,” the Vanguard report says. “They’re also more willing to dip into savings for things such as additional schooling, a start-up business, or an artistic pursuit. “Millennials really hold a world view and place a priority on charitable and social causes. Vanguard cites a 2013 Pew research survey that found Gen Y placed a higher priority on “helping others in need” than “owning a home” and “having a high-paying career.”

This focus also impacts investing behavior too, with Gen Y admitting that social causes influence their investment decisions — to a significant degree more than their older peers. “Younger clients tend to see themselves as hands-on investors,” the report says. “Yet studies show that although they display confidence, they also seem to lack thorough investment knowledge.”

2013 Fidelity study of high-net-worth Generation X and Y investors found that nearly 75% said they enjoyed investing, felt reasonably knowledgeable and were active in the management of their money. However, these same investors averaged 30 trades per month — suggesting they could benefit from education on factors such as risk and the long-term effects of cost.”

For financial advisors, or anyone looking to do business with Gen Y, here are relevant points to consider, according to the research:

  • Brevity and relevance are vital. Rather than launching a lengthy pitch that focuses on accomplishments or accolades, focus on asking probing questions that “leave younger prospects feeling understood and valued.”
  • Take a partnership approach, rather than proclaiming authority. Vanguard says younger investors “are looking for education, collaboration and validation of their choices.”
  • Streamline and modernize communications. “Advisors who don’t keep pace risk being seen as outdated and out of touch, especially to Millennials,” Vanguard says. “In other words, if your default communication is a phone call, it’s time to rethink your strategy.” Young adults often prefer e-mail, texts and social media.
  • Update your website. “Your website alone has the potential to make or break a deal — and possibly before you’ve even spoken to the prospect,” the report claims. Consider highlighting your community involvement or charitable projects.

With more than $41 trillion in inheritance assets in motion during the next four decades, it’s wise for all facets of the financial services industry to reevaluate how Gen Y does business.

 To Your Successful Retirement!

Michael Ginsberg, JD, CFP® 


401(k) Allocation Mistakes: Why Investors Need to be More Proactive

  • Ellen Chang, MainStreet.com, Sep 11, 2014 3:55 PM EDT

NEW YORK (Main Street) — Investors need to be more proactive and reallocate their retirement portfolio to mirror the changes in their life.

A recent TIAA CREF survey found that 25% of workers have never made changes to how their money is invested and an additional 28% have not made changes to how their money is invested in more than one year. This strategy changes drastically with younger investors. Millennials were significantly more likely to have changed how their money was invested in the past year with 59% who did so compared to those 35 years or older with only 42% who participated. Of those age 55 or older, 34% say they have never made a change to the way their money is invested.

Investors who have adopted the “set it and forget it” approach to investing their 401(k) can find it to be a “recipe for disaster,” said ReKeithen Miller, a certified financial planner with Palisades Hudson Financial Group in Atlanta. Although investments in a 401(k) are meant for the long term, investors still need to monitor them at least annually.

By reallocate or re-balancing periodically to a target asset allocation, investors will benefit from selling high and buying low since they will be “selling their best performing investments and buying those who have not performed as well recently,” he said. This strategy helps investors limit the amount of risk and control it. Since stocks tend to outperform bonds, if a portfolio is never rebalanced, stocks will eventually make up a larger portion of the portfolio, leading to higher volatility in the portfolio, Miller said.

“Revisiting the investments in your 401(k) will allow you to assess whether an investment option still makes sense,” he said. “Perhaps you picked a fund because it was managed by a very successful manager. If that manager is no longer around, the fund may not make sense for you to invest in going forward especially if the new manager plans to follow a strategy that you are not comfortable with.”Investors who rarely make changes to their retirement portfolio are pursuing the right strategy because there is no need for individuals who are over 20 years from retirement to reallocate frequently, said Robert Johnson, professor of finance at Heider College of Business at Creighton University.

“If you are young and retirement is many years off, the optimal allocation for most individuals is either 100% stocks or the vast majority in stocks,” he said. “One’s asset allocation should not change significantly from year to year. The fact that the majority of individuals haven’t changed how their money is invested in the past year is actually quite encouraging.”

Although many Millennials are making more changes to their portfolio, some of them could be “chasing returns” or “running scared,” Johnson said. “They increase their allocation to stocks after stocks have performed well and lower their allocations to stocks when they have recently fared badly,” he said. “In essence, they are doing the opposite of the old adage ‘buy low and sell high.’”

Millennials need to build their portfolios instead by having a very large allocation to stocks and to leave that allocation untouched each year, he said. “They have the benefit of having many years to go until retirement and can afford to assume the short-term volatility of the stock market,” Johnson added. “Unfortunately, many people get the idea that ‘investing’ is about actively buying and selling. Building wealth is about developing a plan and sticking to it, ignoring all of the ‘noise’ coming from many of the financial news networks.”

Without rebalancing a 401(k), a consumer may be invested like a 25-year-old when he is actually 65 and ready to retire, said Martin Buchanan, private wealth advisor for Buchanan Capital Management in Oklahoma City. “If the economy were to go south and this individual was taking on the same amount of investment risk as when they were at 25 years old, they would not have the same luxury of time to recover their investments that their younger self would have,” he said. “All too often investors are emotional with their assets. In a market downturn, participants may sell out of their investments for fear they will fall lower and in turn miss the recovery.”

Investors need to review their investments “when they have the greatest need for liquidity” such as paying for college, said Terry Dunne, managing director at Millennium Trust in Oak Brook, Ill. “The secret to making money over time is to invest money regularly and stay invested,” he said.


To Your Successful Retirement!

Michael Ginsberg, JD, CFP® 


Retirement Comes Early, Plans to Work Aside

People know they need more money to pay for retirement, so they plan to work longer and retire later.

However, a new research paper published by the Pension Research Council at the Wharton School says that there’s a substantial disconnect between what people say they’re going to do and what they actually end up doing — and that they should plan for their plans to be thwarted.

According to “The Changing Nature of Retirement,” by Julia Coronado of Graham Capital Management, although many survey respondents say they intend to postpone retirement past age 65 and two-thirds intend to work for pay after retirement, in actuality statistics reveal a different picture. 

What they show is that many retire earlier than planned (nearly half) and fewer (only about 25 percent) work for pay.  According to Coronado’s paper, while that could improbably be chalked up to “individuals (who) are so cautious that they over save and find themselves in a surplus position at older ages (a view refuted by a large body of data and research),” Coronado wrote, “There is something else afoot.”

That something else includes a job market that is distinctly unfriendly to older workers, forcing them out earlier than they had planned and reluctant to hire them for anything but part-time jobs. It also includes other unforeseen circumstances, such as ill health and the need to care for a relative. And people are not planning for these contingencies.

The author cites numbers from the Retirement Confidence Survey conducted by the Employee Benefit Research Institute that indicate a steady rise in the number of people who plan to retire after age 65. In 1991, only a little more than 10 percent planned to linger in the workplace past 65; now that number has risen to approximately a third. People are retiring earlier rather than later; only about 15 percent stay past age 65.

Those who retired earlier than they’d intended gave reasons that implied their standards of living in retirement took a hit. Twenty-two percent cited downsizing or firm closure, while 61 percent said they left due to health issues or disability, and another 18 percent said they had to care for a family member.

Coronado wrote, “The implication is that workers must factor considerable uncertainty about their ability to work later in life into their planning process, rather than assume they can work as long as they want.”

To Your Successful Retirement!

Michael Ginsberg, JD, CFP® 


Why Low Volatility Produces High Returns

Research Affiliates analysts examine the research that explains the persistence of outperformance by lower-risk stocks


They say there’s no such thing as a free lunch in economics. But investing in low volatility stocks appears to make a gourmet banquet available at diner prices — with most of the tab picked up by investors eager to pay up for higher-priced high-volatility stocks. That is the implication of an analysis by Research Affiliates’ Feifei Li and Philip Lawton in the smart beta firm’s latest newsletter.  While investors generally believe that one must take on higher risk to achieve higher returns, Li and Lawton show that, to the contrary, the outperformance of low-volatility stocks has persisted both over time periods and across global markets.

U.S. low-volatility stocks — colloquially, the value stocks that tend to trade at a discount to the broad market (and even more so to high-volatility stocks) — exceeded the performance of cap-weighted benchmarks by more than 2 percentage points from 1967 to 2012, though the benchmark was more than 3 percentage points more volatile.

Looking at all developed markets from 1987 to 2012, low-vol’s premium was over 3 percentage points, though the benchmark was, again, over 3 percentage points more volatile. In emerging markets between 2002 and 2012, low volume trounced the benchmark by between 7 and 9 percentage points (using two different low-vol formulations), though the cap-weighted benchmark was more than 7 percentage points more volatile.

Despite the persistence and seeming universality of the low-volume effect, the Research Affiliates duo prefer not to assume as an article of faith that the anomaly will continue without seeking to understand why it exists—i.e., why investors don’t “eradicate the return premium once and for all” by scooping up these stocks.

Since researchers have all but given up on resolving the anomaly within the “traditional framework of rational, utility-maximizing decision-making,” Li and Lawton cite behavioral finance studies to explain why investors would make “self-defeating investment decisions.” One such explanation describes the attractiveness of “lottery-like risk” in pursuit of high returns. “Investors with a strong penchant for gambling are likely to choose high-risk stocks with large potential payoffs over low-risk stocks with unexciting expected returns,” the authors write, noting that such a behavior pattern “would tend to produce the low volatility effect.”

Li and Lawton provide a subtler version of this gambling thesis by citing research theorizing that some investors are unwilling or unable to use leverage — they follow investment guidelines prohibiting borrowing, they lack access to low-cost credit or they consider borrowing too risky. For investors such as these, risky stocks provide an outlet for the possibility of achieving high returns.

Another behavioral explanation involves the incentives of investment professionals subject to benchmark risk, business risk or career risk should they accumulate “loser stocks” that have recently fallen in price. The benchmark risk occurs because the cap-weighted indexes that serve as benchmarks inherently favor popular stocks. And since “clients typically ‘de-select’ managers who underperform the benchmark for three years,” the authors write, investment professionals risk “losing clients, bonuses, and ultimately their job” if they do not cling to their benchmark. This sort of closet-indexing, like the penchant for gambling, would tend to reinforce the low -volatility effect.

Conversely, Li and Lawton cite empirical evidence that sell-side analysts exaggerate the virtues of growth stocks, which would contribute to the market’s overvaluing high-volatility stocks. Citing the success of smart-beta low volatility since the global financial crisis, the Research Affiliates duo add that investors have mechanisms by which they reaffirm their false faith in their failed approaches rather than avail themselves of the excess returns of low-volatility. They cite research indicating that “managers characteristically tell stories to explain their successes and failures,” the former using the “epic genre,” the latter using the “tragic genre.”

The plausibility of these rationalizations has the effect of protecting their investment beliefs and keeping them from learning from their mistakes. For all these reasons, Li and Lawton “expect low-volatility investing to persist in producing excess returns,” noting research suggesting that gambling (i.e., “chasing outlier returns”) is considered a behavioral addiction.

Similarly, activities that go hand in hand with the quest for high returns such as active management and its attendant high fees aren’t going away, either, thus leaving ample room for contrarian investors to benefit from low volatility and high returns. 

To Your Successful Retirement!

Michael Ginsberg, JD, CFP®