I know… I know… this is a re-run, but we seem to be having unexpected disasters on a routine basis so a reminder of the value of Rainy Day Funds is once more in order. Where to start?
You’ve probably read or heard comments in the news media that most individuals/families would be hard pressed to meet an unanticipated $500 expense. I found that hard to believe until three years ago this month, when a major local disaster – the August 2017 Hurricane Harvey flood – damaged more than 200,000 homes in the Greater Houston area. This devastating event left thousands of gainfully employed people – young and old – in a major financial pickle. It compelled me to write an article that was published in my daughter’s informative website, You, Me and the Tree - “Harvey, Irma and the Importance of Rainy Day Funds”.
In the case of the Harvey flood, I recall the tens of thousands of individual Texas Gulf Coast citizens who, tragically, found themselves with flooded homes, soaked furniture, ruined automobiles, moldy clothing, and in some cases, an interrupted paycheck. Seventy-five percent of these folks were located outside the 100-year floodplain, not covered by flood insurance, and without a personal emergency fund to help restore their lives to normal. Now there are millions of folks whose jobs or businesses were disrupted because of the coronavirus that continues to devastate family incomes. The Texas state legislature has a multi-billion dollar “Economic Stabilization Fund”, a type of governmental Rainy Day Fund used for disaster relief, that helps during these times. That is helpful, but I want to talk about a different type of Rainy Day Fund over which you have total control.
You’re just out of school. You have a new job. You finally have a steady source of income. Perhaps it’s time to put some financial order in your life. When you’re flirting with financial insecurity – living from paycheck to paycheck as many young folks do – the first order of business you should tackle is to accumulate six or so months of liquidity (cash or near cash) to meet unexpected expenses. Despite steady income, most young people on the front end of their first good job with generous benefits often can’t meet medical plan or auto insurance deductibles much less the cost of unexpected emergencies. For this reason, they should start building a Rainy Day Fund… money that’s deposited in an easily retrievable but separate bank account.
According to a now bewhiskered Financial Industry Regulatory Authority (FINRA) Investor Education Foundation study, 56% of people nationally don’t have an emergency fund large enough to cover three months, much less six months of unexpected expenses – outlays such as major auto or home repairs, job loss, medical emergencies, unplanned travel expenses, etc. Sixty-four percent of Americans don't have enough cash on hand to handle a $1,000 emergency expense, let alone an uninsured flooded home (and pandemics), according to a survey by the National Foundation for Credit Counseling. Twenty-five percent of Americans don’t have a Rainy Day Fund at all. Many of these folks do, in fact, live from paycheck to paycheck, often by necessity, choosing to run the risk that no major financial disaster will uproot their lives. It’s a good bet that one week before Harvey struck, most southeast Texas citizens barely gave the tropical depression in the southern Gulf a second thought. I suspect the same held true nationally with regard to the pandemic. Its fury was slower in developing, but nastier in its endurance.
So, what happens when individuals or families without Rainy Day Funds suffer a financial setback? In the case of the pandemic, Uncle Sam came to the near-term rescue to one extent or another, but many people have been left short of funds. Then what? They borrow from family or friends. They neglect to pay other bills. They sell or pawn other assets. They get a cash advance from a credit card company. They mostly do things that simply exacerbate their financial woes. This is why I call a Rainy Day Fund a financial firewall. In addition to helping meet those unexpected expenses, a Rainy Day Fund helps avoid disruptions in meeting the goals of a long-term financial plan.
How does one begin the process of building a Rainy Day Fund? First, don’t set initial emergency fund goals so high that you soon deem them unrealistic or unattainable. A $100 or $1,000 fund is better than nothing, and when you hit that mark, strive for $200 or $2,000… then $300 or $3,000, etc.
To protect yourself against the possibility of a major emergency, develop a working relationship with your local banker and establish a meaningful line of credit. Money that could be borrowed in case of a financial emergency. And in that instance, use your smaller Rainy Day Fund to supplement the line of credit.
Where do you find the money to start your Rainy Day Fund? As potential sources, reduce or eliminate spending on non-essential goods and services while building your nest egg. Use spare change – dimes, quarters, and dollars – or an unexpected salary increase, a tax refund, or a few restaurant meals foregone (easier to do these days). You might even have that bank mentioned above automatically shift a small amount of money ($25-$100) from your checking to your emergency account each month. After a month or two of shifting, you might not notice the difference, and it adds up quickly!
In getting started, ensure that basic day-to-day needs are met to avoid discouragement during the accumulation process. And be wise, keep your emergency funds in a separate account – one less accessible than your regular checking or savings accounts. And DO NOT carry a debit card tied to that account. Make it a bit inconvenient to access these funds. In short, make the account accessible, but not too accessible. Force yourself to consider your actions before making a withdrawal. Accept the fact that all of us lack a bit of monetary self-discipline from time to time. In short, your Rainy Day Fund is a relatively accessible stash of cash for use only in case of emergency. Don’t use it to buy an automobile or computer. Don’t buy a new piece of furniture or remodel your kitchen with it, unless, of course, your home flooded in southeast Texas back in 2017.
America is well-stocked with numerous Fortune 500 companies and a population of folks with big hearts in times of great stress. In addition to friends and neighbors, companies large and small came to the aid of Harvey victims and are doing so as well with COVID-19 victims – supplying employees with temporary housing, food supplies, interest-free loans, grants, and volunteer cleanup crews, in addition to counseling and employee time off (or the opportunity to work from home) to take care of family needs.
To drive this need for a Rainy Day Fund home, in December 2018 the federal government halted the function of many of its agencies due to a budget impasse. Some 800,000 federal workers and service providers with very secure jobs missed a paycheck or two. As is typical of government shut-downs, those workers later received the missed paychecks, accrued sick and vacation time and their pensions were calculated as if they had been on the job during the shutdown. Still, according to news reports, many of those government workers quickly began to experience all kinds of financial chaos. In short, despite holding very secure positions with the federal government, many of them could not handle even this short-term financial disruption in their lives.
Simply put, major floods, government budget impasses and pandemics are not predictable events. A Rainy Day Fund is your first step toward both short- and long-term financial security. It also serves as a firewall protecting your long-term plan from short-term financial chaos.
"Your portfolio is like your face: Don't touch it! Market declines ultimately become market recoveries. Also, keep in mind that bear markets do not destroy wealth. The behavior of panic-prone investors during bear markets is what destroys wealth."
― Hugh F. WynnSights
Those who routinely read my blogs (both of you) know that I frequently encourage folks to optimize their 401(k) match opportunities. And I believe it’s incredibly good advice. Think of it this way. For those “specific” dollars your employer matches, you receive FREE MONEY - a 100% return on your investment. Yes, I know, a less than dollar-for-dollar match is the more standard match, reducing that 100% return, but I think you get the gist of what I’m saying.
Question is, why not?
If you qualify for an employer match, it provides a great retirement savings advantage over those employees who forego or aren’t blessed with the opportunity to participate in a matching program. But a lot of people do not participate for varying reasons. Quite a lot of folks work for companies that don’t offer a 401(k) plan. And many companies don’t allow new employees to participate during varying lengths of probation. Still other employees are eligible to participate but choose not to. In fact, studies indicate that a third or more of eligible employees simply opt not to contribute to their employer’s 401(k) plan.
For answers, I go to Vanguard, my low-cost investment advisor of choice that manages thousands of 401(k) plans for employers. They publish detailed information annually in their How America Saves report using data from millions of plans to provide an understanding of why certain employees don’t participate in available plans. By the way, Vanguard is low cost because the company is owned by its shareholder-owned funds (no outside investors other than those shareholders).
Most large employers offer a match to their plans. Only about a half of smaller employers do. The fact that some employers don’t offer a match is often misunderstood by new employees to mean “contribute only if the employer offers a match”. Don’t make this mistake. This can lead to valuable time lost NOT contributing to a retirement plan in the interim. And as you know, lost time equals money not compounding in future months and years. But as mentioned above, even when an employer offers a match, not all new employees are immediately eligible to participate. Many plans – up to 40% of both large and small employers – require a year of service (probation, if you will) before receiving the employer match opportunity. Mark your calendar. When probation ends, hop aboard the FREE MONEY train.
And there’s that other pickle. Even after an employee becomes eligible and chooses to match, employers frequently require that new hires remain with the company for a period of time before the match becomes the employee’s to keep… called vesting. That’s right, only around 40% of “large plan” employees are eligible to retain the match at the point of receipt. Those who depart the company within a particular timeframe stand to lose part or all of the match. Smaller companies are more generous. Competition, I suppose, dictates that upwards of 70% of employees in “small company plans” retain their match from the point of eligibility.
If a plan offers no match at all… or if there is a waiting period… or if all or some portion of the match might be forfeited, such factors DO impact the participation rate. In fact, they encourage many employees not to participate in their company’s 401(k) at all. Still, in many cases, these may not be the primary reasons for non-participation. Like so many other things in life, matching is a dollars and cents exercise. Consider for a moment an employee’s financial ability to participate in a plan.
With both large and small 401(k) plans, participation rates increase along with employees’ salaries. No surprise here. Conversely, the lower the income, the lower the participation rate. When a family breadwinner needs every penny of income to provide for life’s necessities, that employee simply can’t afford to contribute to a 401(k) even in the presence of generous matching rules. Under normal circumstances, higher-income workers go out of their way to collect every penny of an employer match. Lower-income folks, those with the greatest need for financial assistance, often leave this FREE MONEY on the table. Unfortunately, losing out on a 401(k) match is only one of many hurdles facing them. It’s expensive to be poor.
Failure to take advantage of matching plans makes sense only in the affordability instance. Otherwise, to not participate borders on imprudence. It truly is FREE MONEY… truly a 100% return on those “matched” dollars. And if affordable, eligible employees should start contributing to their employer’s 401(k) plan on day one of employment. Don’t wait until becoming eligible for matching (if a waiting period is involved). Those unmatched contributions add up and their yields compound, too.
You’ll be glad you did.
The enduring COVID-19 pandemic has retirees (or those nearing retirement) taking a second look at their “buckets of funds” – sources of cash for spending during the next 20-30 years. In all likelihood, folks will spend their more secure and predictable forms of income to pay for food, utilities, medical care, mortgage payments, etc. – and their less predictable streams of funds will be used to cover more discretionary types of outlays.
Retirees might view the secure bucket as paycheck replacements and the less secure bucket as holiday bonus replacements, or “sell-if-you-must” sources of cash. Nothing new here except, perhaps, a bit of belt-tightening until COVID-19’s dark cloud wanes. In short, a wise spending strategy in pre- or post-retirement necessarily includes two primary buckets of retirement income: (1) a sufficient amount of guaranteed income to cover life’s routine necessities, and (2) a cache of equities/bonds/real estate from which to draw funds to meet more occasional or unexpected outlays. Liquidity is the key element of the latter bucket; thus, it should include a “Rainy Day Fund” as a protective firewall against having to prematurely raid other portions of the second bucket stemming from unavoidable market decline.
IRAs, 401(k)s, and the like have made remarkable recoveries from the depths of the initial COVID-19 train wreck – as of July 22, 2020, the Dow was up 41% and the S&P 500 was up 49% from their March 23 lows. However, this rattling experience has planted seeds of worry in the minds of those in or near retirement. In previous blogs, I’ve nibbled around the edges of various cash sources, discussing how they might be viewed during an individual’s later years. Those “first bucket” sources of income (i.e., Social Security, annuities, and/or pension payments) provide familiar comfort in the form of regular bank deposits. That “second bucket” of retirement income – stocks, mutual funds, real estate, etc. – suggests a less regular flow of funds, impacted occasionally by an ever-volatile marketplace.
By the way, annuities provide protection against unusual longevity but come with significant inflation risk, reduced portfolio flexibility, and less “trickle down” for heirs. Delaying Social Security can provide similar protection with fewer negatives and offer those delightful inflation adjustments. In my rather biased view, an annuity makes sense only if a retiree is 70-plus and still seeks protection against longevity.
Let’s delve further into Social Security. A common recommendation retirees hear is to delay taking Social Security beyond normal retirement age. If a prospective retiree decides to follow this advice, another source of income should be set aside to fund the near-term income vacuum the delay creates. For example, if a delay to age 70 takes $100,000 out of an individual’s near-term income picture, $100,000 should be set aside from the remaining portfolio and placed in a safe account (perhaps a treasury bond fund) to replace those delayed Social Security checks. And for the resultant balance of the portfolio, a recalculation of the spending amount using a lower rate of annual spending (e.g., 3.5% vs 4%) based on one’s age should be considered. Adjustments to ANY spending strategy should be modified by expectations of a long or short longevity, high or low real interest rates and market value expectations, and how much (or little) a retirement portfolio holds of “market risk equities” versus “inflation-adjusted income”. Guestimates all, no doubt, but necessary.
A common question posed by my subscribers is, “In the few years before and then during retirement, what is the best allocation for a retirement portfolio?” I have an opinion, which is just that - an opinion. It first assumes setting aside funds to fill any Social Security delay until age 70. After age 60, I lean heavily toward an allocation much like Vanguard’s Target Retirement Income Fund (VTINX)… approximately 30% stock funds and 70% bond funds, which includes a 12% portion in international stocks and 16% in international bonds. It also includes roughly 17% of short-term inflation-protected securities that cozies up nicely with those inflation-adjusted Social Security checks, whether or not delayed. Folks who fret excessively about inflation (like me) might wish to go heavier on stock index funds. Those less concerned about Izzy The Inflation Monster might consider a higher percentage of bonds or a total bond fund (the latter would certainly not be my cup of tea). My own bottom line allocation reflects those oft-mentioned PDQ Principles: Quality (including equities with low annual operating expenses); Diversification (a fund of funds including international assets); and, of course, a big dab of Patience.
“What about insurance?” subscribers ask. If you are retired and without dependents, why keep paying for life insurance? One obvious situation might warrant it. If you’re married and most of your retirement income is pension-related with minimal survivor benefits, then yes, life insurance would be in order. And health insurance is absolutely necessary, particularly if retiring early (prior to Medicare eligibility). Liability insurance (perhaps an umbrella policy) seems appropriate given most retirees’ total dependency on their remaining assets. Disability insurance in retirement seems unnecessary. Long-term care insurance… who the hell knows. To NOT have it leaves one vulnerable to a catastrophic healthcare event. To have it exposes one to big premium adjustments. I’ll punt on that one.
I dug this week’s blog topic out of the archive because it focuses on important points of why passive investing is a good approach for smaller investors – particularly those who deliberately choose not to spend much time with their investment portfolios. There are compelling reasons for folks who dare to be average to consider index fund investing: simplicity, low-cost, good quality, diversification, and year-after-year yields approaching that of the broad market. The results speak for themselves compared to a more active management approach.
For years, I’ve been beating the drum about investing in index funds (called passive investing) and caterwauling about “daring to be average”. Well, in the last decade or so, it has become quite the rage… not because of my caterwauling, but because it simply makes sense to investors who wish not to spend much time fussing with their retirement accounts. Passive investing has stood the test of time by consistently outperforming most active fund managers who – bless ‘em – go to extraordinary lengths researching companies to determine where to place client dollars. Some are good at it… some are less proficient. In any case, extensive research is expensive to conduct and is a cost the investor ultimately absorbs.
A while back, I read a Wall Street Journal article about a fellow out in Nevada named Steve Edmundson, the investment chief of the Nevada Public Employees’ Retirement System who, all by his lonesome, out-performs many pension funds staffed by hundreds of employees. What’s his secret? He invests in low-cost funds that mimic indexes. A more recent WSJ article noted that Steve managed $35 billion or so in passive funds whose yields as of June 30, 2019, for one-year (8.5% vs 6.7%), five-year (7.1% vs 5.5%), and 10-year (9.9% vs 9.1%) periods beat one of the nation’s largest public pensions, Calpers, that hires hundreds of people to invest hundreds of billions of dollars. Edmundson’s minimalist approach is based on the simple concept of “reducing the complexity, risk, and costs of a portfolio”.
Another more well-known fellow, multi-billionaire Warren Buffett (often called the Oracle of Omaha… the so-called greatest living investor) is also an adherent of the passive investment approach despite his Berkshire Hathaway follies (humor). Rumor is that he instructed the executors of his sizable estate to “put 10% in short-term bonds and 90% in a low-cost S&P 500 index fund and "let ‘er ride.” In short, the Oracle advised his executors to avoid the high-cost financial geniuses (Wazoos, I call ‘em) and instead, dare to be average with his piddling (more humor) estate.
Of course, no single investment strategy is perfect – or without risk – but some tend to perform better than others over time. And there are some highly competent active managers out there. Take Will Danoff, the manager of Fidelity Investments’ huge Contrafund. Since 1990 and through October 2016, Danoff outperformed the S&P 500 Index by 2.9% per year (sources: Morningstar, Inc., and the WSJ). If you had hooked up with Danoff and invested $10,000 in 1990, you would have has around $230,000 in your account in 2016. For comparative purposes, the same $10,000 invested in an S&P 500 Index Fund would have topped out at $118,000 over the same period. During that period, Danoff was about as close to a sure thing as there was – but of course, there are no sure things. Problem is, locating the Danoffs of the world while they’re on a hot streak is a matter of good luck rather than skill.
Studies show that passive (index) funds do outperform most active fund managers, but it’s not the 90% outperformance stat you often hear. Sixty percent would be more like it on average… higher in good times, lower in bad times. In short, active managers seem to do a fairly good job of preserving capital in bad times while passive funds tend to outperform active managers in both bad and good times. Why is that? Well, passive funds give investors a jump start on actively-managed funds because they are cheaper to own (lower annual expense ratios) and are more tax efficient due to less trading.
Passive investing is not for everyone, but it sure fits this old duck. I like those low annual operating expense ratios and the tax advantages associated with less turnover versus active management costs. And like Steve Edmundson out there in Nevada, I don’t need co-workers. All I need on my desk is a uniball pen, a stapler, and a $3 calculator (okay, so I overpaid). Oh, by the way, I also avoid watching CNBC and those other frenzied cable news network programs. Used to watch Fox on Saturday morning until the network dropped those four consecutive 30-minute taking-head shows and turned the time over to Cavuto. Two hours of “thank you very, very much “ of Cavuto can wear on a man.
And to make my point about over-paid Wazoos, in a 2016 article by Nicholas Vardy titled “How The Nevada State Pension Fund Is Embarrassing Harvard," he noted that Edmundson earned $121,121 managing the Nevada fund in 2015 while Harvard Endowment’s ex-CEO knocked down $13.8 million… yep, $13.8 million… the year before. Edmundson’s Nevada Pension fund was roughly equivalent to Harvard’s endowment, then about $35 billion. Nine years after reaching its $35 billion peak in 2007, the Harvard endowment remained stuck in that same range. Yeah, we’re talking old news here, but it tells the tale.
In summary, I, like most index adherents, believe that the stock market is an extremely efficient mechanism for properly valuing the worth of index fund companies over time. Think of it this way. Millions of very smart folks collectively gather all the information there is to know about publicly-traded companies and their prospects. This consensus of opinions quickly adjusts valuations based on constantly changing variables.
This consensus of opinions isn’t perfect, but by golly is it hard to outwit! And by investing in index funds, I don’t have to pay for it.
Can your Social Security stream of income (let’s call it SSSI) be viewed as a bond in your asset allocation? One camp argues no because it cannot be sold. The other camp argues yes because it provides a predictable “bond-like” income stream. The way I see it, your SSSI is a valued asset regardless of its salability... with caveats, of course. Its fixed-income feature does in fact give it a very bond-like shine despite its inflation-adjusted attributes. Point is, why argue the point? What the hell difference does it make? Social Security is what it is – and admittedly, a rather valuable and unique asset. Many investors do, in fact, stick it on their balance sheet at some calculated present value as if it was a bond. But such a calculation has validity only so long as the individual is alive and is only as valid as the “rate of interest” applied to its income stream. You might conclude that it’s an individual sort of thing.
It is an individual thing because its meaningfulness to you depends a great deal upon what other assets you have in your retirement portfolio. A huge plus-factor is that your Social Security income stream is inflation-adjusted, meaning it will hold its value… its purchasing power… as long as you live. Another relevant – but in this case, negative – factor is that when you and your spouse depart this life, it, too, disappears, making it an inconsequential asset to heirs. And another negative is its susceptibility to political uncertainties, meaning that the Social Security Trust Fund is nearing depletion. But intense political pressure by the AARP crowd will likely resolve that issue. In my mind, to most SSSI recipients, these negatives are offset by some significant positives – that this stream of income is not subject to market risk, nor is it influenced by what is happening in the interest rate world – or by the quality of the issuer of bonds an investor might otherwise choose to own.
If you’re terribly concerned about viewing SSSI as a bond – or not – then set it aside when determining your “proper” asset allocation and net portfolio annual spending requirement. This will enable you to make portfolio-related decisions without cluttering up the “net required spending” (3%?… 4%?... 5%? per annum) from your portfolio. No doubt, there is a lot of difference between a stream of income with a calculated present value of say… $350,000… as opposed to having bonds with a collective redeemable value of $350,000 in your retirement account. If you should need to raise a large sum of money quickly, bonds would no doubt better fit that dilemma than your Social Security stream of income. Alternatively, if you need the comfort of knowing that a portion of your retirement portfolio is not being eroded by Izzy The Inflation Monster, your SSSI should provide a certain measure of such solace.
In the real world, SSSI is an inflation-adjusted, guaranteed stream of income that will continue throughout your life – but not beyond the life of you and your spouse (child benefits notwithstanding). Except for the most recent government check in hand, SSSI’s guaranteed revenue stream is essentially illiquid. It cannot be sold, and it is subject to political risk. Facts, all. But by viewing SSSI as simply a “bond” in your portfolio, you’re overlooking some of its unique and very comforting characteristics. In a nasty bear market like the current COVID-19 mess, families in retirement with one… often two… social security checks in their portfolio are much less exposed to the stock portion of their portfolio than those without inflation-adjusted income streams. Being reminded of this fact might bring you some peace of mind that, heretofore, you haven’t bothered to enjoy.
Folks nearing retirement are often advised to delay taking Social Security in an effort to enhance future benefits. Some calculate that this delay can increase benefits by an estimated 8% for each year a retiree waits past full retirement age (the age at which a person may first become entitled to full or unreduced retirement benefits) to take them. Such credits accumulated by waiting no longer accrue beyond age 70. In normal times, this well-intended advice will, in fact, result in a guaranteed balance-of-life benefit – one that can even carry over to a surviving spouse if that spouse isn't claiming benefits on his or her own work record.
Compared to today's anemic returns on cash and investment-grade bonds, that 8% is a tough yield to beat. But is the advice to delay taking Social Security is still sound amid the chaos of the current COVID-19 crisis and the accompanying market drop that has so devastated investor portfolios. Face it, most portfolios aren't as robust as they were three months ago (despite recent recoveries). Not surprisingly, investors on the verge of retirement likely find themselves with slimmer retirement assets. Those caught holding inadequate “rainy day” funds to meet current cash needs might wish not to delay taking Social Security, thus buying time for their portfolios to “heal”. Just a thought.
Everytime you blink our government is (temporarily) changing a rule or guideline in order to ease the financial burden on Americans during the COVID-19 pandemic. Don't get me wrong, I am happy they are making these moves, but you have to be paying attention to news sources 24/7 to keep up. Blink - and you might miss it.
Among the important provisions of the Coronavirus-related CARES Act were waivers for certain 2020 Required Minimum Distributions (RMDs). Retirees with withdrawals due in 2020 from their 401(k), 403(b) or an IRA all qualified for waivers (as did their beneficiaries). And, yes, the waiver included those who turned age 70½ in 2019 and had to take their first RMD by April 1, 2020.
UPDATE: On June 23, the Internal Revenue Service (IRS) issued a notice that folks who wished to return any or all Required Minimum Distributions (RMDs) taken in 2020 could do so by meeting an August 31 deadline. This is very important for those who blinked and did not know about the CARES waiver, and took an RMD in early 2020 before the pandemic wrought havoc on our country.
To rehash, many retirees contribute pre-tax income to tax-deferred 401(k), IRA, and other individual retirement accounts. The federal government REQUIRES these investors to begin withdrawing (and paying tax on) a set percentage of their account balance starting at age 70½ (for those born before July 1, 1949) or at age 72 (for those born after June 30, 1949). Such withdrawals are called Required Minimum Distributions. In April 2020, the IRS announced that folks who took RMDs between February 1 and May 15 of 2020 could put the money back in those accounts by July 15, but the option was off-limits to folks who withdrew RMDs in January 2020. That has since changed.
To illustrate, let’s assume an investor took a $10,000 RMD out in January 2020 and directed his/her custodian to withhold 20% or $2,000 for taxes. Under the second IRS action, the investor could return the net-of-tax $8,000 to his/her tax-deferred account and make up the $2,000 difference (the withheld taxes) out-of-pocket. To ultimately recover the taxes, the investor could reduce his/her 2020 quarterly estimated tax payments or await a refund on his/her 2020 return. A popular alternative considered by some is to let Uncle Sam keep the $2,000 tax portion and by the August 31 deadline convert the $8,000 balance to a Roth IRA… allowing this portion of RMDs to grow tax-free until death do you part. After conversion, Roth account owners are exempt from RMDs, but beneficiaries who inherit them are not.
By the way, if you had taken 2020 RMDs in monthly installments, you can return all of those net-of-tax distributions back into the tax-deferred account from which they came. In fact, you can even deposit the money in another tax-deferred account of your choosing. And this new relief covers everyone from account owners who had rolled over funds from one IRA to another within the past 365 days to beneficiaries (including spouses and children) to folks who turned 70½ in 2019 but who delayed taking their first RMD until 2020. But as mentioned above, the deadline to do a Roth conversion or to return RMDs taken in 2020 is August 31.
As you may recall, the purpose of the initial IRS action (as well as the revision) was to help older Americans avoid selling portions of their retirement account balances at vastly reduced values to meet 2020 RMDs – and hopefully buy time for their account balances to recover from the early 2020 COVID decimation. So far, the S&P 500 recovery has been remarkable… from a Feb. 19 high of 3,386 to a March 23 low of 2,237 (a loss of 33.93%) back to a July 6 close of 3,169 (a gain of 41.66%)… but still a net loss of 6.41% from the February low. In any event, a dramatic recovery from the nerve-wracking February to March decline of 33.93%.
That pesky COVID-19 virus has caused many folks, young and old, to take a second look at their investment plans. The resultant volatile, free-wheeling, bear market can create a lot of doubt in people’s minds about what to do or what not to do. But, by and large, people kept the faith.
In the first four month of 2020, less than 1% of Vanguard’s five million 401(k) and other retirement plan investors moved their money out of stocks. And almost 95% of those same patient investors didn’t make a single trade. T. Rowe Price revealed similar investor experiences from late February through March. Less than 3% of their 2.2 million retirement plan participants made any changes to their portfolios. So far, people have hung tough despite the pandemic, but it never hurts to review the basics of personal finance. And as usual, we’ll take dead aim at the youngsters among us.
Start saving early. The Amazing Power of Compounding is one of the most powerful long-term tools an investor has… a function of time and patience, given a reliable stream of investment dollars to deal with. The earlier an individual starts to save and invest, the easier it is to reach, say, a million-dollar goal. Start saving $500 per month at age 25. Invest for 42 years in assets yielding 6% per annum, compounded annually. Using a Bankrate investment calculator, after 42 years, your balance will be roughly $1,084,000 (before inflation and taxes). Change the starting age of investing to 35. All other things being equal, and your balance after 32 years would be approximately one-half…about $560,200…due to this unfortunate 10-year procrastination. Time is the key!
If possible, invest 15% of your paycheck (including any employer match) monthly to optimize your compound growth in later years.
Always… always… invest the amount necessary to snare the maximum employer match. Why? This FREE MONEY will greatly enhance the yield on your investment in a 401(k).
While young, be bold, invest for growth. Though riskier, equities (stocks and stock funds) traditionally outperform bonds or cash. Manage that higher risk by investing in highly diversified, low-cost index funds.
As retirement approaches, rebalance periodically. During those younger years, with a higher allocation in equities, an investor’s portfolio has more time to recover from an untimely market correction. As retirement approaches, rebalancing – perhaps annually – ensures a reallocation of stocks, bonds and cash that is in keeping with one’s more conservative investment plan.
It’s not uncommon for even the most conscientious among us to shy away from making our own investment decisions. This shyness includes what kinds of securities to buy and when and how often to rebalance portfolios. Consequently, more and more folks are shifting to index fund investing, and more specifically, to target-date “fund of funds” investing. The latter simply involves allowing a team of professionals decide for you what diversified array of securities to buy and when. Specifically, the fund managers select your overall mix of stocks, bonds, and cash – a mixture that increasingly shifts to bonds (i.e., becomes more conservative… less volatile) in retirement or as retirement nears.