Among the important provisions of the Coronavirus-related CARES Act are waivers for 2020 Required Minimum Distributions (RMDs). Retirees with withdrawals due in 2020 from their 401(k), 403(b) or an IRA all qualify (as do their beneficiaries). And, yes, the waiver includes those who turned age 70½ in 2019 and had to take their first RMD by April 1, 2020.
Why is this waiver helpful? Most 2020 RMDs are based on retirement account values at year-end 2019. At that point in time, the Dow Jones Industrial Average (DOW) stood at 28,538, near its historical high. Today’s DOW opened at 20,820… over 7,700 points below the 2019 close. Without this timely waiver, in all likelihood, retirees would have to sell a greater percentage of their 401(k), 403(b) or IRA balance to meet the 2020 RMD threshold. The result would be the payment of taxes based on year-end 2019 values that have since significantly declined. With this waiver, Congress gave retirees more time to – hopefully – recover a portion or all of those losses. That, of course, may or may not happen, but hope springs eternal.
Is there a downside to the waiver? Not really. Accepting the waiver is a choice, not a requirement. RMDs are the minimum retirees must take out in a given year. And, of course, they can always take out more than was initially required if need be. In fact, many retirees do just that. Fact is, the RMD suspension puts retirees in total control during the 2020 waiver period. They can withdraw some or none depending on their specific needs.
Unfortunately, about 80% of IRA owners will not benefit from this waiver. These retirees depend heavily on RMDs for annual retirement income. They will withdraw the required amount… and more… regardless (source: the U. S. Treasury). For the other 20%, it raises the question of whether or not to withdraw even if they don’t have a current need for the money. Why pay tax on withdrawals in 2020 if the income is not needed to make ends meet? There are other considerations, so read on.
It never hurts to carefully review ones 2020 tax situation before deciding yeah or nay. For whatever reason, you may find yourself in a lower tax bracket situation, offering the opportunity to take advantage of lower tax rates versus later years of “anticipated” higher tax rates. Another thing to consider, because market values are now lower, 2020 might be a good time for a Roth IRA conversion. With the federal government taking on multi-trillion dollars of debt to battle the virus, it’s likely that both market values and tax rates are going to increase in the future.
As you know, RMDs cannot be converted to Roth IRAs (remember, you took a tax deduction when you contributed to that traditional IRA and by requiring RMDs if how Uncle Sam finally gets his cut). But under the waiver, there are no RMDs (in 2020). So, you can withdraw funds from the traditional IRA at the currently reduced value, pay the resultant lower amount of tax and then deposit those funds into a Roth IRA. Yes, I know, you pay taxes on the conversion (just like you would have on non-waived RMDs). But your RMD could not have been converted to a Roth. And even though you paid the tax on non-waived RMDs, you lost out on the conversion benefit. Now, during this 2020 RMD waiver period, you can get more for the taxes paid simply by being able to convert the withdrawn funds to a Roth IRA. In short, RMDs due for 2020 are waived, but you can take them if needed or simply to take advantage of the aforementioned tax planning opportunities.
I’m not a financial adviser, nor am I a professional tax adviser. But this seems to be an excellent opportunity to consider a Roth conversion. If you happen to be in that 20% category that doesn’t need the money, consult the experts and take a hard look at the conversion. But remember, once you convert to a Roth, it cannot be undone. The conversion is permanent, and the tax must be paid. The key factor in making a conversion decision is your own prediction of tax rates. If you expect your future tax rate in retirement to be the same or higher, a conversion should be to your advantage.
While we’re on the subject, let me remind you of potential other benefits. Obviously, the amount converted to a Roth removes those dollars from your Traditional IRA, which decreases future amounts of taxable RMDs. And lowering your future taxable income might also lower the taxable percentage of your Social Security benefits as well as the amount taken out of your Social Security check for Medicare purposes. By the way, those Roth funds will also pass tax-free to your beneficiaries. And by converting to Roth funds when the market value is 20-30% (or more) lower, means that any future rebound will accumulate tax-free; whereas, had you not converted, rebound gains in your traditional IRA will eventually be taxed at personal rates.
"If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. Money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility."
― Niall Ferguson
If not by now, you will soon be fully aware of my devotion to the simplicity of index fund investment portfolios. Many of my examples focus on the “early-in-life” saving for retirement by investing in a single index fund to achieve a modicum of financial comfort thirty… 40… 50 years hence. But, of course, there are more ways than one to skin a cat, while maintaining an allegiance to those PDQ Principles I mention so frequently. Let’s consider another increasingly popular approach.
Target-date funds (TDFs) are offered to investors that seek to grow assets over a specified period of time, usually for retirement. Often named for the year in which an individual plans to retire, the fund’s asset allocation becomes a function of the time available to meet the investment objective.
The notion behind TGFs is something that, not surprisingly, has a great deal of appeal to me – their simplicity and diversity. Generally speaking, most of us accept the idea that stocks are riskier than bonds; that as we grow older, it makes sense to reduce market risk by holding more bonds in our investment portfolio than stock; and that rebalancing a portfolio to properly weight the stock/bond ratio makes sense along the way. Therein lies the appeal of TGFs. By design they radically adjust to a less risky (more conservative) investment mix as the so-called “target date” of an investor’s retirement looms.
This simplicity makes TDFs increasingly popular vehicles for 401(k) plans – and attractive to investors prone to putting their investing activities on autopilot. Particularly when the fund’s portfolio is allocated to various index funds. Take the case of a young man hoping to retire in 2065. He would likely choose a more aggressive target-date 2065 fund. An older individual nearing retirement (say in 2025) might choose a more conservative target-date 2025 fund. My fund company of choice, Vanguard, offers a comprehensive series of target-date funds¹, using several index funds as underlying securities for the investment. Let’s compare a couple of their funds to illustrate those target-date characteristics:
Vanguard Target Retirement 2065 Fund (VLXVX)
The Vanguard Target Retirement 2065 Fund (formed 7/12/2017) has a low-cost annual operating expense ratio of 0.15%. The Fund’s portfolio percentage allocation as of January 31, 2020, stood at 54.2% of assets invested in VG: Total Stock Market Index Fund, 35.6% in VG: Total International Stock Index Fund, 7.1% in VG: Total Bond Market II Index Fun, and 3.1% in VG: Total International Bond Index Fund. In short, a more aggressive 90% in equities and a conservative 10% in bonds and cash equivalents because of its long-term horizon.
Vanguard Target Retirement 2025 Fund (VTTVX)
The Vanguard Target Retirement 2025 Fund (10/27/2003) has a low expense ratio of 0.13%. The fund’s portfolio percentage allocation as of January 31, 2019, stood at 36.2% invested in VG: Total Stock Market Index Fund, 23.5% in VG: Total International Stock Index Fund, 28.4% in VG: Total Bond Market II Index Fund, and 11.9% in VG: Total International Bond Index Fund. This is a less volatile, shorter-term mixture of 60% in equities and a more conservative 40% in bonds and cash equivalents.
Beyond the target date¹ – for folks already in retirement – the Vanguard Target Retirement Income Fund (VTINX) gravitates to an even more conservative, less volatile asset allocation (roughly 18% in domestic equities, 12% in international equities, 37% in domestic bonds, 16% in international bonds, and approximately 17% in short-term TIPS (Treasury Inflation Protected Securities). Its annual expense ratio is a very low .12%. Although I used Vanguard funds in my hypothetical example, a wide variety of marketplace target-date options await the investor – funds with various asset allocation strategies to fit differing risk and management preferences.
The Great Recession of 2008-09 reminded many investors that even for folks close to retirement, TDF’s have their own shortcomings. With all of the talk of their conservative mix of highly diversified investments as retirement nears, they still hold a certain percentage of investments in stock, and they do take a one-size-fits-all approach to investing. In short, the funds simply can’t consider each individual investor’s unique portfolio needs. And the automatic approach to investing strategy simply ignores changing market conditions. Therefore, it’s important that investors consider the caveats of their risk profile when considering TDFs, including the cost and performance of a particular company’s TDF portfolio. It’s always essential to compare fees, and it goes without saying that any conscientious investor should continue to pay attention to changing market conditions. No approach to investing should relieve us of that duty.
For inexperienced investors dealing with an array of confusing choices offered by their employer’s 401(k) program, TDFs can be a relatively low risk starting point in the saving and investment cycle. But there are no panaceas out there. As conditions change in one’s financial life, the types of investment suitable to those changed circumstances might also change.
According to Morningstar Direct, in 2008, target-date fund portfolios for folks planning to retire in 2010 took a nose-dive of 36% from the market’s October 9, 2007 peak, on average, during the Great Recession (the broad index fell 55% during that crisis). Compared to the current coronavirus scare, from the February 20, 2020 market high through last Thursday, TDF portfolios of folks who planned to retire in 2020 dropped by about 13%, on average. During the Great Recession, the 36% loss by near-retirees in TDFs represented more than two-thirds of the 53% decline suffered by those planning to retire in 30 years. By comparison, losses by today’s investors close to retirement represent about half of the 24% market decline.
Hopefully, lessons were learned from the bitter Great Recession experience. We’ll soon find out.
I practice this philosophy every day… obsessively, according to my Gen-X daughters. It’s the underpinnings of everything I have to say about saving and investing. Face it, if you don’t save, you have nothing to invest – unless you’re a debt-leveraging dude. And a critical ingredient of saving is watching those pennies…every single one. Recently, while wandering around Lowe’s tool department, I spotted a penny on the floor. Out of sheer habit, I bent over, picked it up, and stuck it in my pocket. Was it worth the effort? No, but the ingrained habit of watching those pennies is what’s important. (Watch the video below.)
Watching your pennies is a very important factor in making quality investment decisions. In fact, it is crucial to optimizing return on investment. Focus for a moment on the simple act of deciding which of three investments to make. Mutual fund companies charge an “annual operating expense ratio” for managing money in their funds (there are no free lunches, but Vanguard’s John Bogle certainly made the Wazoo crowd more honest than it was prior to the mid-1970s).
Let’s assume that you’re investigating a possible $10,000 investment in three funds of relatively equal quality: 1) a Total Stock Market Index fund that charges an expense ratio of 0.04%; 2) a fund that charges 0.25%; and 3) a third that charges 0.90%.
How does your final choice impact the value of your retirement portfolio 40 years hence, given a theoretical market yield of 7% on each, compounded annually? Per the results in the table, with the first fund, you accumulate approximately $147,400 of value, in the second case $135,500, and in the third case $104,300.
The significant variable in our example is the annual operating expense ratio. In short, a fraction of a single percent (i.e., the .86% difference in Case One and Case Three) could ultimately reduce the value of your retirement portfolio by as much as $43,000 after 40 years on a relatively small initial investment of $10,000. SO, WATCH THOSE PENNIES! Make this mistake enough times while waltzing toward retirement and dog food might be in your future. (By the way, the $43,000 difference is comprised of $14,200 in additional fees and $28,800 in opportunity cost associated with paying those additional fees.) That’s the money the late John Bogle spoke of when he said, “You get what you don’t pay for.”
The scenario I paint above is, of course, hypothetical. Future investment rates of return aren’t predictable with any certainty. Investments that yield higher rates are generally subject to higher risk and volatility. Rates of return vary widely over time, especially for long-term investments, including the potential loss of principal. However, paying a higher annual operating expense has little to do with market risk and more to do with watching your pennies. And if you don’t avoid those tiny fee differentials (i.e., watch those pennies), the down-the-road impact on your lifestyle in retirement can be significant.
With dizzying speed, the Coronavirus has moved the market index from its recent all-time high to bear market territory in just 19 sessions! Amazing. In previous downturns, it has taken the index, on average, 136 trading days to enter bear market status from its most recent high (Source: Dow Jones Market Data). The combination of this new virus and the ridiculous Saudi/Russian kerfuffle regarding crude oil production has been particularly unsettling to investors.
This, too, shall pass, folks. Just keep the faith.
During this endless political season – I’m fine with about six months of campaigning instead of two years – there have been some behind-the-scenes mutterings about how to address America’s extremely low non-retirement household savings. A solution to this dilemma, partial or otherwise, might help stem the ballooning dependence of many of our citizens on so-called government entitlements. Could such a solution be accomplished through the tax code without feathering the nest of those big birds in the upper branches of our national tree? Perhaps. In addition to encouraging non-retirement household savings, such a program might also address the income disparity between those upper branch big birds and the many smaller birds in the middle and lower branches.
According to a 2018 Federal Reserve study, the average American family has less than $11,000 in non-retirement household savings… few readily available financial resources to deal with an emergency. Why? Do they lack the ability... the motivation... the whatever… to create a “rainy day” fund? Yeah, I know, I blogged about rainy day funds back in July 2019, so let’s not cover old ground. But I would like to discuss one idea that is making the rounds among Trump economic advisers should his administration serve a second term.
Who might be the target of these non-retirement household savings accounts? Perhaps those American families who occupy the lower- and middle-income branches earning as much as $200,000 a year. How’s that for attempting to reduce the usual clamor of “tax cuts for the millionayes and billionayes”? So, how is this proposition different from existing retirement plans, you ask? It has some similarities and some distinct differences. The non-retirement household savings account would allow eligible families to sock away up to $10,000 per year pre-tax in a savings fund. A popular suggestion is that the money be invested in low-cost stock index funds, which would minimize risk through diversification. Sound familiar? These features would expand ownership of stock to all participants, allowing millions more folks to share in future stock market gains. These features would not only help reduce the wealth inequality between the big and small birds, they would also enable many more of the smaller birds to enjoy The Amazing Power of Compounding.
This non-retirement household savings account would, of course, be voluntary in nature and employers would be encouraged to match employee contributions. After an accumulation period of five years, funds in the plan could be used for virtually any purpose: to supplement income in the event of job loss; for all emergencies; to buy or improve homes; to start a new business; to send kids to college and/or to private or tech schools; and yes, even for retirement. In short, this type of plan is not meant to be restrictive of use; rather, it’s purpose is to encourage non-retirement household savings.
There would be one very familiar feature. It’s well-known that Uncle Grabby (IRS) gets grumpy when he loses revenue. As with distributions from pre-tax contribution retirement accounts, Grabby would recapture tax revenue delayed by contributions to these household funds when the money is finally withdrawn and spent. In short, and as usual, Grabby would get his pound of flesh by taxing those pre-tax contributions – and the dividends and capital gains they earn – when the money is finally withdrawn. But withdrawal is not a requirement.
These tax-affected non-retirement household savings could well be a major step toward replacing the entitlement culture with incentives to save for broad-based wealth creation – I call ‘em fat and sassy, tax-advantaged rainy day funds. And they would certainly be better than another proposition being circulated by certain “Deep State” forces – a plan to eliminate the existing pre-tax contributions to retirement plans and go “all in” on Roth-type plans. In short, under this troubling proposition, all monies contributed to retirement plans would be after-tax dollars. No pre-tax dollars allowed. I’m a firm believer in Roth plans, but it’s sure nice to have the choice of paying taxes now or paying them later.
Since 1994, 10 major health issues – Zika, SARS, avian flu, etc. – have significantly impacted global markets. In eight of those cases, stocks climbed more than 10% after 12 months once investors properly evaluated the threat. Since 1946, there have been 26 market corrections of at least 13%. On average, it has taken about four months to recover to pre-correction levels¹. Panic if you must, but patience might serve you best. Just remember, big market declines are unsettling. Usually they’re linked to some totally unexpected global event – a time, perhaps, to re-assess your “true” risk tolerance. If you’re very uncomfortable with today’s events, you might want to consider a different asset allocation once the market recovers…and it will. We just don’t know when.
How often do you play the lottery? It’s not uncommon for routine lotto participants to spend $1,000 or so per year chasing this “get-rich-quick” gambit. Buy a ticket and win $100, a $1000, perhaps $1,000,000+ against overwhelming odds. Recall the incredible $1.537 billion drawing won by a single South Carolinian. The odds of winning that prize exceeded 1:302,000,000, roughly the same odds as one citizen in the United States (population 333,000,000+) being selected in a drawing to win the big prize. It happened, but it wasn’t you… or me… or all the other 333,000,000+ Americans. Watch the video below.
How about reducing your odds from 1:302,000,000+ to a more believable 1:1 depending on how patient you are over the next 45 years? Here’s the deal. For those of you in the early stages of a career (say 22 years of age), instead of buying $100/month of lottery tickets, contribute an initial $3,000 (the initial minimum contribution in after-tax dollars) to a Roth IRA and deposit the $100/month (again, after-tax dollars) of “lottery savings” into the Roth for 45 years. Invest every penny of it in Vanguard’s Total Stock Market Index Fund, Admiral shares, compounded quarterly (which has earned a return on investment (ROI) of 7.14% since its 2000 inception – and Voila! you wake up on retirement morning with a $466,000 balance in your Roth account. This is in addition to Social Security, your work-related 401(k) or 403(b), your home, and all the other assets and retirement savings you’ve accumulated during that same period.
Because folks purchase lottery tickets with after-tax dollars, I assumed a $3,000 initial investment (the required minimum) and the $100 monthly contributions would fund a Roth IRA. In retirement, Roth IRA withdrawals are tax-free. The VG Index Fund’s 7.14% ROI is based on the fund’s returns since its 2000 inception. I made no inflation adjustments. By the way, the Total Stock Market Index Fund has earned, on average, 13.82% over the last 10 years, so using 7.14% in my hypothetical example doesn’t seem overly optimistic… but who knows?
Okay, so it doesn’t sound like much compared to $1.537 billion, but think about that $466,000 every time you walk into a convenience store during the next 45 years and throw down a few loose “after-tax” dollars for a lottery ticket. I’ll take the 1:1 chance of ending up with $466,000 upon retirement versus those long odds of being extremely lucky. But remember, to gain these improved odds, you have to be very disciplined… and very patient.
Speaking of the lotto, a quizzical subscriber asked me the following question: If you became a lucky winner and had the choice of taking $50,000 today or $80,000 spread evenly over 30 years, what would you do? And how would you invest the money in either case? In responding to these questions, I assumed that in both cases the money was invested in taxable accounts to avoid muddying the water about who might be eligible to place those winnings in retirement fund vehicles.
As usual, in both cases, my investment choice would be the aforementioned index fund. As to the cash, I would invest the lump sum assuming an annual return of 7.14%, compounded quarterly, which mathematically would grow to $418,000 before taxes and inflation after 30 years. In the second case, I would invest the larger sum evenly over 30 years (assuming the same yield of 7.14%, compounded quarterly), which mathematically would grow to approximately $312,000. Granted, my approach is very simplistic, but it certainly reaffirms the value of “a bird in hand” even when it’s a smaller bird².
A couple of subscribers I’ve chatted with recently seem to think that if they retire with a million bucks in their retirement account, they’ll be in hog heaven. No doubt, it’s a very comforting figure. But should it be? I ran a hypothetical calculation for myself assuming I was 28 years of age. Hey, don’t giggle, I’m only about twice that age (if you’ll permit me to use the term “about twice” quite loosely). I simply want to present an example that at age 28, with a good job, and already having saved $10,000, how much more money would have to be tucked away monthly, invested at 7%, compounded annually, to achieve millionaire status at age 68 (40 years hence).
I grabbed my abacas (Source: Bankrate’s Investing & CD Calculator - Save a Million Dollars Calculator), slapped around a few beads, and Voila! I had my answer. In addition to the $10,000 seed money, I’ll need to invest another $343 per month to reach that million-dollar goal. Seems doable – particularly if I have a generous employer who matches some of my contributions. And there should be nice raises in this mythical future even as my family grows and requires a bigger house, dependable cars and college or trade school educations.
But then I realized that there is more to the calculation than first meets the eye. I forgot to allow for Izzy The Inflation Monster! So, I threw in a 2.5% per year inflation factor to feed that hungry beast who will gobble up as much of my purchasing power as it can during those intervening 40 years.
Using that 2.5% inflation factor, here are the numbers. Beginning with the $10,000 initial investment and adding $343 each month for 40 years, I do end up with roughly $1 million in my retirement account at age 68. Unfortunately, those “gray bearded” million bucks will only purchase $373,300 worth of goods in today’s dollars.
So, I go back to the abacas and bean-count how much more I must save to end up with $1 million in purchasing power at age 68. And boy is that a Zebra of a different stripe! To have $1 million in today’s purchasing power 40 years hence, I will need almost $2.7 million in my retirement account, not just $1 million.
To achieve this new goal, it will require a monthly savings of… gasp… $1,020 instead of the $343 I mentioned earlier. But being a “glass-half-full” chap, I desperately try to see the silver lining of this cloudy dilemma. By saving at the $1,020 clip per month, I’ll have about a million bucks sitting in my retirement account by age 55 – a “fat-cat” millionaire 13 years ahead of the original schedule… for whatever that’s worth.
Still, take heart in the fact that although inflation steals an individual’s purchasing power, it also tends to exert upward pressure on paychecks. In short, the higher $1,000 per month savings requirement might be more achievable than one might imagine. Inflation tends to lift all boats… income as well as expenses.
But don’t forget, this scenario is hypothetical. Future rates of return aren’t predictable with any certainty (they can vary widely over time, especially for long-term investments like I assumed here). Investments that pay higher rates of return invariably come with higher degrees of risks and more volatility. And to really brighten your day, the loss of investment principal is also a possibility. So, immerse yourself in a bowl of Blue Bell® ice cream and hope that the (also mythical) Social Security trust fund (like so much of the other money we send to politicians) doesn’t soon disappear into that fetid, alligator-infested, Washington D. C. swamp – and for goodness sake, start saving!
By the way, there’s stirrings among political investment advisers about tax-free investment accounts for lower and middle-income families – and they’re not retirement accounts. These accounts would accumulate funds that, after five years, could be used to buy or improve homes, start new businesses, send kids to college or private schools, supplement income after job loss, or yes, even for retirement. It’s an interesting idea. We’ll talk more about it in a week or so.