Money, Money, Money, It’s A Rich Man’s World*
A year end checklist for your retirement and investments
When I was a kid, I did not realize that we were poor (financially speaking). I knew our 800 square foot house overlooking the town trailer park was not as nice as some of my friend’s houses (especially the ones with pools), and I ate government cheese from time to time (I still crave that delicious Velveeta type cheese with a very distinct orange color). Other than that, I felt like I had everything I needed and wanted, including the original Nike leather court shoes and a clicker controlled Land Speeder.
What did not happen in our household? Any sort of discussion about money. It was considered rude to talk about money, no one ever wanted to know how much money anyone else had or was paid, and I had no understanding of how my parents managed their finances or paid bills. We barely even talked about how I spent my allowance!1
But money shouldn’t be taboo. For me, money discussions became more transparent when I got my first job out of college. It was at a mutual fund administration company, which required me to get Series 6 and 63 investment licenses. In this job I trained salespeople and wrote A LOT of articles about retirement planning, investing, alternative investment vehicles like derivatives, and financial risk management. I think one of the best ways to learn is by teaching, and all the educational materials I wrote allowed me to develop my own thoughts about how to prepare for future financial needs. Then, as I invested more, I realized that no advisor was going to be around when I actually retired. Thus I was the only one who was going to have to live with the consequences of my investment decisions - and I needed to get serious about my own knowledge.
I do not typically discuss money in professional settings. However, my friends (the ones who know that I love to talk about investing strategy and other financial planning tools)2 do frequently ask me questions that they are too embarrassed to ask other people. And, just like nagging people to get colonoscopies because they are easy and painless and can save your life, I often nag people about various financial deadlines and opportunities that I know apply to them.
So, with just a few weeks of 2022 left, it’s a great time to assess your investment/retirement situation in a few key areas.
Do you have the right amount invested in stocks (equities) and bonds (fixed income)? Asset allocation and you.
Any time you meet with an investment advisor, they will probably pull out a chart about historical equity returns and asset allocation to give you comfort that your money will grow enough to outpace inflation and allow you to retire before you are older than Gandalf. When I worked in investments many years ago, most people followed a 60/40 portfolio target asset allocation, meaning 60% of their portfolio was invested in stocks, and 40% in bonds.
Now might be a good time to pause and explain the difference between a stock and a bond. I say this because I myself didn’t know the difference when I interviewed for that first job at the mutual fund company mentioned above. A stock is “a security that represents the ownership of a fraction of the issuing corporation.” Conversely, a bond is a “a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). When you talk about asset allocation, stocks might be in individual stocks, or a mutual fund or exchange traded fund (ETF) that includes a number of different stocks in the fund (allowing you to diversify without trying to make individual stock purchases yourself). Same with bonds, your asset allocation percentage may include individual bonds, or a mutual fund or exchange traded fund that includes a number of different bonds for “instant” diversification.
As the world changed and people started living longer, the thinking changed and many advisors quickly realized that a 60/40 portfolio might be too conservative for their clients. Many advisors moved to a new formula that said that to determine asset allocation, you should take the individual’s age, subtract it from 100, and that should be the percentage invested in stocks, with the remaining percentage invested in bonds. But as you can imagine, when someone a bit over 40 was already below 60% of their portfolio invested in stocks, it was unlikely that their portfolio would perform in a manner that would enable retirement and retain the purchasing power that it had when they started saving. The new thinking moved to a slightly different rule, where the percentage invested in stocks should equal the individual’s age subtracted from 110 or 120, again with the remaining percentage invested in bonds. But none of these rules may be right for an individual investor.
While the rules of thumb are great to give you a general idea of asset allocation, your time horizon for when you might need to withdraw the funds and your risk tolerance are usually the most critical aspects in determining your own asset allocation. For example, regardless of your age, if you have a pretty healthy risk tolerance, are in good health, and are not going to need the funds for at least 7-10 years, an asset allocation of 70% stocks/30% bonds may make sense even if you are 65. This is because the amount of time you can comfortably allow the investments to sit untouched and your risk tolerance matter a lot more than an arbitrary age. Historically, even the most heinous market downturns corrected themselves in a lot less than seven years, so if you believe in the predictive value of the past, leaving investments untouched for a longer period of time may cushion volatility and allows you to comfortably keep more money in stocks (which is pretty much the only vehicle that consistently outpaces inflation).
Further asset allocation within your stock portfolio
There is a second, more complicated part of asset allocation as it relates to stocks. This is the philosophy that your stock portfolio should include a mix of investments similar to that of the Dow Jones U.S. Total Market Index (DWCF) or comparable broad index in order for the historical performance of the stock market to be extrapolated to the future and your individual portfolio. Though if you’ve ever read investment literature, you will see statements very prominently that say something like “past performance is not indicative of future results.” (We all know nothing is guaranteed, otherwise everyone would be rich.) Historical performance, while not guaranteed on a go-forward basis, provides insights that you can use to make investment decisions when that performance is based on the larger overall market and not just a single investment.
So, how do you ensure the stock/equity portion of your portfolio aligns with an index like the DWCF? Most large brokerages (like Fidelity, Schwab, Vanguard, etc) offer a vast array of online tools to assess your investment distribution and verify that it (1) aligns with the broad indexes, (2) isn’t creating risk outside your tolerance, and (3) is appropriately weighted between things like large capitalization stocks (companies with market capitalization of greater than $10 billion - and where most advisors agree the largest portion of your investable money should be) and small capitalization stocks (companies with market capitalizations of about $300 million to $2 billion) which can be much riskier. Many of the online tools available also will let you review your portfolio by “sector” to ensure that you aren’t too heavily weighted (meaning more heavily invested in a single sector that is not comparable to that sector’s percentage of the broader market) in a category like technology, financial services, healthcare, consumer staples or real estate, among other categories.
Have you made all of your 401k or other deferred retirement vehicle deposits?
Your individual contributions to your 401k reduce your current year income by the amount of the contribution (reducing your tax liability) up to the current tax year limits as established by the Internal Revenue Service (IRS).
Most employers provide great information and easy payroll deduction vehicles to deposit funds into a 401k or other retirement plan, and some employers even create opportunities to expand the value of your contributions through company matches.
401k and other deferred retirement plans allow your investments to grow without having to pay tax on that growth, including capital gains and dividends. Those funds continue to grow tax free until they are withdrawn, usually after retirement. When you withdraw funds from these types of retirement plans, you owe income tax only on the amounts withdrawn.3
The 401k account is founded on the principle that when you retire and do not have regular income, you will be in a lower tax bracket. This may not be true for individuals with a lot of passive income or side hustles that don’t end when they retire from their employment, but for most people, it’s pretty likely to be the case.
Are you turning 50 this year? Don’t forget your catch up contributions.
One area that many people forget is that you are eligible to contribute an additional “catch up” amount in the calendar year that you will turn 50 (even if you aren’t 50 when you start making them) and each year thereafter. For example, my birthday is in October. So the year I turned 50, I started making catch up contributions on January 1 of that year. For tax year 2022, the “catch up” amount was $7,500, meaning you can make additional contributions to reduce your current year taxable income by up to $7,500, and the additional money also grows on a tax deferred basis.
IRA Contributions in excess of other contributions
Did you know that you can contribute to an IRA or Rollover IRA, up to the IRS defined limit, even if you’ve maxed out your 401k contributions? The rub here is that your contribution will not reduce your current year taxable income and you cannot take a deduction on your “excess” IRA contribution. However, money deposited into an IRA can grow on a tax deferred basis, giving you a great place to park your dividend producing, high potential gain, or high turnover fund investments (see below for more on this).
When you contribute to an IRA or Rollover IRA with after tax income (up to the annual contribution limits) recordkeeping becomes critical. If you make a non-deductible contribution, make sure that you include the information on your tax return (even though it isn’t deductible) and include your Form 5498 (an informational statement from your broker) and IRS Form 8606 with your tax return.
By being diligent in your documentation, you are taking steps to ensure these contributions will not be deemed taxable by the IRS because you cannot prove, sometimes years or decades later, that you made the contribution with “after tax” money. With a good paper trail, you can ensure that your withdrawals can be properly prorated as taxable or nontaxable depending on the source of funds. Otherwise, you may get stuck paying tax twice on the same money (when you made it as income and deposited it into the IRA, then later when you withdraw it from the tax deferred vehicle).
Keep in mind that a Roth IRA is a different animal entirely, and not covered by the general rules above. However, really rich people, like Peter Thiel, use both traditional IRAs and Roth IRAs creatively to avoid taxes on their vast wealth. For the rest of us, there are a lot of tax lessons you can learn from ProPublica’s coverage of the tricks of the 1%.
Tax deferred v. after tax investments? Does it matter what account I make certain investments in?
The higher your tax bracket, the more impact placing the right types of investments in the right place can have on your taxes (and ultimately how well your investments perform on an after tax basis).
For example, if you have invested in a balanced or income producing mutual fund that kicks off a lot of dividends, or a fund with high turnover (meaning they make frequent trades, including sales of individual stock investments that create capital gains), those “income creators” are better served in a tax deferred account (think IRA, 401K, etc.) where the taxes on the gains and dividends will be deferred until you withdraw the money in retirement. In addition, bond and other fixed income vehicles that produce a lot of taxable yield (like corporate bonds) are more valuable in your tax deferred account. Why do these “income producing” equity and fixed income investments belong in a tax deferred account? Because if they are in a tax deferred account, you will not owe any current year taxes on that investment income. Plus, if you pay taxes every year on investment income instead of deferring it until retirement, it reduces the overall performance of the investment on an after tax basis.
Conversely, how do you use after tax accounts most effectively? If you need more fixed income/bond investments to keep your asset allocation in line, vehicles like municipal bonds, expected to have a great 2023, can live in “after tax” accounts because their returns are exempt from federal and often state taxes already, so there is no added benefit to parking them in a tax deferred account. And for your stock/equity investments in after tax accounts, make sure that your investments are less likely to pay dividends (if possible), are more focused on long term growth, and if investing in mutual funds or ETFs, make sure the turnover rate is low so that less capital gains are generated by the fund (I typically target a turnover percentage below 15% for after tax accounts).
WARNING: Before we go on, trust me, get a second cup of coffee, or a third. The next topic is both valuable and ridiculously complicated (but in a fun way, like this crazy domino run).
Harvesting isn’t just for farmers.** Tax loss harvesting can help reduce your tax liability now. Want to learn more? Click here if you dare.
Regardless of whether you were brave enough to click the link above…..
With all things money related, the most important thing is to understand what you have, why you are utilizing it in the manner that you are, and how it will work for you in the future. It’s also helpful to consider the philosophy behind certain strategies, and whether you believe those philosophies apply to your individual situation. For example, if you think capital gains and income tax rates will be a lot higher when you retire, it might change your views on the value of tax deferred vehicles today. However, don’t be afraid to talk about money, ask questions about what other people are doing or what advice they receive from their advisors (do not even get me started on the terrible quality of financial advice available through some institutions - please trust but verify), and take a bit of time to read more about key areas like the ones here. The one failure when it comes to money is to ignore it and hope it will work for you anyway. Not even ostriches bury their heads in the sand, so neither should you!
For the record, I spent it on Noxema, Dr. Pepper Lip Smackers, Tiger Beat magazine, and music like Rick Springfield’s Success Hasn’t Spoiled Me Yet.
I am not a Certified Financial Planner, but folks there is still a lot of time for me to try yet another career!
Things like Required Minimum Distributions (RMDs) are too complicated for this article, but something to be aware of related to tax planning.
Again with Substack footnote limitations!
*Have I mentioned that in addition to all of the guilty pleasures previously shared here, I also adore Abba? When I wasn’t watching Corvette Summer of repeat, I was watching a documentary on The Movie Channel (TMC) almost daily in the 1970s about Abba and their tour. This is of course borrowed from Money, Money, Money.
**In the 1970s, when I wasn’t busy planning my impending nuptials to Shaun Cassidy, I was watching Hee Haw with my dad.