Personal Finance Archives - Fee Only Financial Advisor San Francisco and Walnut Creek

May 23, 2023May 24, 2023

Tax-loss harvesting. How to maximize your after-tax returns.

What is tax-loss harvesting?

Tax-loss harvesting (TLH) is a strategy that you, as an investor, can use to reduce your capital gains taxes and potentially maximize your future after-tax returns. The TLH strategy involves selling an investment in a taxable account at a loss to offset the taxes on another investment sold for a gain in a different part of your investment portfolio. You can only use the strategy in taxable investment accounts.

For example, let’s say you own 1,000 shares of XYZ stock that you bought for $10 per share. The stock is now trading at $8 per share, so you have a loss of $2 per share. You will realize a $2,000 capital loss if you sell the stock.

Tax-loss harvesting can be a great tool to manage taxes and maximize long-term after-tax returns. It can help you reduce risk in your portfolio and turn losses into wins. According to studies, TLH can contribute up to 1% in after-tax portfolio returns.

A well-executed tax loss harvesting strategy can reduce your current tax bill through tax deferral. That means that you are not only saving money on their taxes in a given year, but you can reinvest those tax savings for potential growth in the future. And the longer your portfolio stays invested in the market, the more time it has to grow and compound.

Long-term capital gains versus short-term capital gains

To understand TLH, you also have to know how the US tax system treats long-term versus short-term capital gains

When you buy and sell an asset with appreciated value, you may have to pay capital gains taxes. The amount of tax you owe will depend on how long you hold the asset before selling it. The gain is considered short-term if you own the asset for one year or less. If you hold the investment for more than one year, the gain is taxable as long-term.

Short-term capital gains

Short-term capital gains are taxable at the same rate as your ordinary income. This means that the higher your income, the higher your capital gains tax rate will be. For example, if you are in the 32% tax bracket, you will pay a 32% capital gains tax on any short-term gains.

Long-term capital gains

Long-term capital gains, on the other hand, are taxable at a lower rate. The exact rate you pay will depend on your income and filing status.

All else equal, holding an appreciated asset for more than one year before selling it is more financially beneficial if you want to pay lower capital gains taxes.

Keep in mind that income levels to determine the tax rate for long-term capital gains include income from ALL sources, not just capital gains.

Example 1: You are single and earning $150,000 per year. Also, you have reported a long-term capital gain of $25,000. Your reported income is $175,000, which falls in the 15% tax bracket. Therefore, you must pay a long-term capital gain tax of $3,750 ($25,000 x 15%)

Example 2: You are a retired couple filing jointly. You don’t earn any income but have reported $70,000 in long-term capital gains from your investment portfolio. Since your total reportable income is below the 15% tax threshold, you don’t owe any taxes on your investment gains.

There are a few exceptions to the long-term capital gains tax rates. For example, collectibles such as art, antiques, and jewelry are taxed at a flat 28% rate regardless of how long you hold them.

State taxes

Another layer for the full impact of tax loss harvesting is your state taxes. Some states, like Texas and Florida, do not impose taxes on capital gains. California, New York, and New Jersey treat capital gains as ordinary income regardless of your holding period. A third group of states, like Connecticut and North Carolina, have a flat rate. While state income taxes are typically lower than federal ones, it’s essential to understand the full scope of your tax loss harvesting strategy before moving forward.

Net Investment Income tax

Net investment income tax (NIIT) is a 3.8% surcharge tax on certain types of investment income. It applies to individuals, estates, and trusts with modified adjusted gross income (MAGI) above certain thresholds.

The types of investment income that are subject to NIIT include Interest, Dividends, Capital gains, Rental income, Royalties, Passive income from businesses, and Non-qualified annuities. NIIT does not apply to distributions from retirement accounts, such as IRAs and 401(k)s. Additionally, NIIT does not apply to Social Security benefits, unemployment benefits, or veterans’ benefits.

The MAGI thresholds for NIIT are:

If your MAGI is above the threshold for your filing status, you will owe NIIT on the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.

What are some of the benefits of tax-loss harvesting?

You can reduce your taxes on capital gains in the current and future tax years.
Realized capital losses can offset realized capital gains from selling other investments in your portfolio, real estate, private equity, or a business.
Tax-loss harvesting can help you lower capital gain taxes from selling stocks from employer incentive stock options (ISOs), nonqualified stock options (NSOs), restricted stock units (RSUs), and restricted stock (RS)
You can unload bad investments
Turn a loss into a win
You can deduct up to $3,000 ($1,500 married filing separately) of capital losses per year against ordinary income.
Any residual losses that exceed $3,000 can be carried forward to future years.
You can use TLH to diversify your portfolio.
It can help you take advantage of market fluctuations and rebalance your investment portfolio.
You can use tax loss harvesting to reduce the risk of holding concentrated positions.

What are some of the risks of tax-loss harvesting?

You may miss out on future gains if you sell an investment at a loss.
You may have to repurchase the investment at a higher price in the future.
TLH may trigger a wash sale if you repurchase your investment too soon.
You may not be able to offset your losses with gains

Wash Sale Rule

The wash sale rule is an IRS rule that prevents investors from claiming a tax loss on the sale of an investment if they buy the same or substantially identical investment within 30 days before or after the sale. The wash sale rule is designed to prevent investors from artificially inflating their losses in order to reduce their tax liability.

Here is an example of a wash sale:

You sell 100 shares of ABC stock at a loss of $1,000.
Within 30 days of selling the ABC stock, you buy 100 shares of DEF, which is substantially identical to ABC.
You cannot claim the $1,000 loss on the sale of the ABC stock.
The loss from the sale of ABC shares is deferred for a later date.
The cost basis of DEF stock will adjust with the amount of the capital loss

The wash sale rule applies to a wide range of investments in a taxable account, including stocks, bonds, mutual funds, and ETFs. It also applies to options and futures contracts. The wash sale rule doesn’t currently apply to cryptocurrency, but that could change in the future.

How to make tax loss harvesting work for you

Here are some of the essential requirements and considerations of a successful tax-loss harvesting strategy

Stay invested. When you execute tax loss harvesting, you must continue to invest in the market. Replace the asset you sold at a loss with a similar (but not substantially identical) investment. Leaving the proceeds from the sale on the sidelines can lead to a substantial loss of potential future returns.
Know your goals – tax loss harvesting will be effective only if It is an essential element of your comprehensive financial plan. TLH must be integral to your strategy to achieve your long-term financial goals and milestones.
Avoid breaking the wash sale rule – Not complying with the wash sale rule can lead to confusion and errors. You may not be able to reach the goals of your TLH strategy if you don’t have a proper execution.
Know your investment time horizon – If you plan to hold an investment for the long run, it may not be in your best interest to sell it and harvest losses.
Track your tax bracket – If you are in a higher tax bracket, tax-loss harvesting can be a smart way to reduce your taxes.
Know the overall health of your portfolio. If your portfolio is well diversified, you may not need to use tax-loss harvesting. However, if your portfolio is concentrated in a few stocks or sectors, tax-loss harvesting can help you reduce your risk.
Don’t overdo it – too much TLH activity can draw the attention of the IRS or can prompt mistakes.

Final words

Tax-loss harvesting is a complex strategy. And it’s important to understand the risks and benefits before selling investments at a loss. If you are considering tax-loss harvesting, talking to a financial or tax advisor will ensure you know the full implications of the process. A fiduciary advisor can help you tailor a tax-loss harvesting strategy that is right for you and your financial plan.

April 25, 2023April 25, 2023

Successful strategies to manage your concentrated position

A concentrated position is an investment that makes an outsized share of your total net worth. As a rule of thumb, you should consider any investment that makes up more than 10% of your net worth as a concentrated position.

Why do concentrated positions matter?

Concentrated positions are a great way to build and grow your wealth. Holding shares in successful companies can be highly beneficial to your finances. There are many examples of stocks with phenomenal long-term returns, such as Apple, Tesla, Amazon, Nvidia, etc. Unfortunately, when a single stock makes up a disproportionate share of your portfolio, you expose yourself to unwanted idiosyncratic risks related to that particular investment.

Concentrated positions and risk

What can possibly go wrong with your stock? Well, pretty much everything from changes in consumer sentiments, economic recession, adoption of new technology, bankruptcy (Bath Bad and Beyond), accounting scandals (Enron), bank runs (SVB), management changes, competition threats, pandemic, supply chain disruptions, government policies, and war.

Take, for instance, Kodak and Motorola. Both companies were innovation leaders with great products and consumer brands at their peaks. Kodak invented the digital camera. Motorola had the RAZR phone. Everyone wanted their products until their competitors swept their markets with new gadgets. Technology evolves, and consumer sentiments change rapidly. Some companies drive these changes, others follow, and a third group never catches up.

How do you build a concentrated position?

You are a corporate executive or an employee who received employee stock options or restricted stock units from your current or previous employer. Through option exercise and RSU vesting, your company shares have grown significantly as part of your portfolio.
You were an early investor in a startup that successfully went public or a long-term investor in a stock with outsized performance. Your cost basis is low, and your shares have appreciated significantly over the years.
You inherited or received a significant number of shares from a relative as a gift.

Here are a couple of ideas on how you can manage your risk, earn additional income, and lower your tax impact. Ultimately the best strategy will depend on your individual circumstances.

Risk mitigation strategies for concentrated position

Sell stock and diversify your portfolio

Diversification is the bread and butter of investing. Building a diversified portfolio that matches your risk tolerance and investment horizon is crucial to wealth preservation and sustainable long-term capital growth.

When a single investment makes up more than 10% of your portfolio, the diversification process becomes more challenging. Furthermore, selling your stocks is not always an easy decision. If you own the stock for long, you probably sit on a significant gain and want to avoid paying taxes. Perhaps you have a sentimental attachment to that company. Lastly, your employer might be imposing trading restrictions on selling your shares.

10b5-1 Plan

A 10b5-1 plan is one that corporate executives and insiders can use to sell company shares under specific parameters like price, time, or other targets, as outlined in the predetermined plan.

Using the 10b5-1 plan forces you to follow a disciplined sales approach to reduce concentrated risk, taking the emotion out of your decisions. You must create your 10b5-1 plan at a time when you have no material non-public information. When your broker executes trades under the plan, you have a justification against any insider trading charges since the plan was put in place when you had no material non-public information.

Direct indexing

Directing indexing is a strategy that mirrors the performance of an index (S&P 500, Russell 1000) by investing in a basket of individual stocks. This strategy can be useful for reducing the risk of concentrated positions over time. Depending on the size and restrictions of your investment, we can incorporate it into the direct indexing strategy. You can determine how much you want to reduce your concentrated position every year until it reaches a more controllable percentage of the portfolio. Furthermore, the tax impact from selling your investment can be paired with tax-loss harvesting and other tax-saving strategies.

Protective put

Buying a put option is a popular hedging strategy. The put option is a contract where the owner has the right but not the obligation to sell a specified stock at a predetermined price on a particular date or during a specified period.

If your stock has appreciated significantly and you have concerns about locking your gains, you can use put options to limit future losses.

For instance, you bought XYZ at $5 per share a few years ago. Now the price is $100 per share. You are concerned about your gains and purchase a put option to sell your shares at $90. By doing that, you keep your upside if the stock continues to rally, but you also secure your gains if the price drops under $90.

The downside of this strategy is that selling appreciated stock can trigger unwanted large taxes because of the realized gains. Furthermore, if your put options expire worthless, you will lose the entire premium you paid.

Tax-saving strategies for concentrated position

Prioritize long-term capital gains

IRS views capital gains in two categories. Short-term capital gains are realized when buying and selling investments for less than one year. These gains are taxable at your ordinary income level.

Long-term capital gains are realized after holding a stock for over a year and one day. These gains are taxable at a favorably lower rate of 0%, 15%, or 20%, plus a 3.8% Medicare surcharge.

You will save the difference between ordinary income tax and the long-term capital gain rate by prioritizing long-term over short-term capital gains. Depending on your tax bracket, the difference between both rates can be up to 20%.

Tax-loss harvesting

Tax loss harvesting is a strategy that entails selling a stock or other investment that has lost value since you bought it. You can use the value of your realized losses to offset other capital gains from other parts of your portfolio in the same tax year.

Furthermore, you can use up to $3,000 annually to offset any ordinary income and carry over any residual amounts for future years.

If you want to purchase your security again, you must follow the wash sale rule. The rule does not allow you to buy back the stock for 30 calendar days.

Donate to charitable organizations

One of the most popular tax-saving strategies is giving appreciated assets directly to charitable organizations. This approach is subject to 30% of AGI for donations given to qualified public charities. Appreciated assets can include publicly traded stocks, restricted stocks, real estate, privately held companies, collectibles, and artwork. The main caveat to receiving the highest tax benefit is to transfer the appreciated asset directly to the charitable organization instead of selling it and gifting the residual cash amount. This way, you will avoid paying a capital gain tax on the sale and deduct the total fair value of your asset.

Set up a charitable trust for your concentrated position

Investors who want to keep some level of control over their charitable contributions can consider several advanced charitable strategies. The three most popular vehicles are utilizing donor-advised funds, charitable remainder trusts, and charitable foundations.

Give a gift to family members

You can gift appreciated stock from your investment account to family members with a lower tax bracket than yours. The gift and estate tax exemption is the amount you can transfer during your life or at your death without incurring gift or estate tax. You can use up to $17,000 a year to give to any number of people without tax consequences. The gift and estate tax exemption is $12.92 million ($25.84 million per married couple, for 2023. The receiver of your gift will inherit the original cost basis.

Stepped-up basis

A stepped-up basis is a strategy to transfer wealth between generations without incurring taxes. Your heirs will receive the appreciated asset in your investment account at a higher stepped-up basis, not at the original purchase price. If stocks are transferred as an inheritance directly (versus being sold and received in cash), they are not subject to taxes on any long-term or short-term capital gains at the date of the inheritance. The stepped-up cost basis transfer is subject to lifetime tax exemption limits.

Income Strategies for concentrated position

Sell call options for extra income

Selling covered calls is a popular strategy for earning additional income on large concentrated positions.

A call is the opposite of a put contract. The call option buyer receives the right but not the obligation to purchase stock at a predetermined price on a particular date or during a specified period. Call options allow investors to bet on increasing prices without buying the stock.

The call seller (you) has an obligation to sell the stock to the buyer if he or she decides to exercise their rights. The buyer pays the seller a premium for entering the contract.

Suppose you believe your concentrated position has limited upside potential. In that case, you can generate extra income by writing call options on all or portion of your shares at a higher level than the current price. If the option expires worthless, you keep your shares and the extra cash. The only downside of this strategy is that if your covered call option is exercised; you must sell your shares at the strike price level and generate a capital gain.

Collar

Often covered call and protective put are combined into a two-step trade called a collar. The combination decreases downside risk. The proceeds from the call sale provide extra cash to finance the premium of the protective put purchase.

Stock lending

Fully Paid Securities Lending is another opportunity to earn extra income from your concentrated position. During this process, the stock owner temporarily lends securities to a financial institution, such as a brokerage firm, bank, or hedge fund. The loan is usually facilitated by an intermediary, the lending agent, or the clearing broker. All parties enter into a loan agreement that covers the terms of the loan, loan fee, revenue sharing, and other provisions.

The main pitfalls of this strategy are the loss of proxy rights and the reclassification of dividends during the loan period. You cannot exercise voting rights. While you receive compensation for any dividends, the extra income will be reclassified for tax purposes.

Prepaid Variable Forwards

A prepaid variable forward (PVF) is a contract to sell a predetermined value of the concentrated position in the future. The number of shares varies depending on the stock price at the maturity of the contract. Specifically, you will have to give more shares if the price at maturity is lower than today’s price and fewer shares if the price is higher than the current price.

The PVF sale may be helpful for investors who wish to create tax-deferred liquidity from a concentrated stock position. Like collars, prepaid forward sales involve the purchase of a put and the sale of a call. The buyer of the PVF usually receives a loan equal to 70% to 90% of the value of the shares.

When a variable contract matures and you deliver your shares, the delivery of the shares will trigger a capital gain. The tax rate on the gain depends on the length of the holding period.

Like any tax strategy, the prepaid variable forward has its own limitations. A few years ago, the billionaire Philip Anschutz lost a lawsuit against IRS for using this technique. He was sentenced to pay $144 million in tax bills.

Take a security-based loan

Securities-based loans enable you to use your concentrated position as collateral to access a revolving line of credit. This strategy allows you to access funds and receive any potential price upside and dividends that accrue in your account without liquidating your concentrated position. However, if you have an outstanding loan balance and your concentrated position declines in value, you may have to post additional collateral or repay all or part of the loan. The lending party may also liquidate all or part of your portfolio to cover losses.

March 9, 2023April 20, 2023

Where is the stock market going in 2023?

The stock market posted impressive gains in the first two months of 2023. It’s fair to say that the strong market rally in January caught a lot of market experts and investors off guard. The general mood at the end of 2022 was quite negative. The overwhelming consensus expected a recession at the beginning of 2023. Despite that, I issued an article in early January titled “Why investors should cheer this bear market.” I discussed several reasons you should feel excited about the stock market in 2023. And my view hasn’t changed. Let’s dive deeper into what we should expect this year. One thing is for sure, the stock market in 2023 will keep us on our toes as usual.

“The market is a distribution mechanism to transfer wealth from the impatient to the patient.”

Analyst divergence

The current economic environment remains very challenging for analysts. You can see from the chart below that there is a 40% difference in S&P 500 year-end targets, the highest since 2009. A group of gloom and doom analysts calls for another 20% to 30% correction in the stock market. Another group of more optimistic investors believes that the worst is behind us and that the stock market in 2023 will have a strong performance. And there is a whole lot in between.

As usual, I remain cautiously optimistic. This is an excellent opportunity for long-term investors to build wealth and dollar cost averaging in the market.

Confusing environment

Most economists find this environment very challenging to predict. The issue is that the current generation of analysts has yet to live through a period of inflation. We last had over 6% inflation in the early 1980s. Not to mention that the current inflation has unique characteristics coming on the heels of a global pandemic, the war in Ukraine, China lockdowns, and supply chain bottlenecks and labor shortages.

Yours truly, born and raised in Bulgaria, remembers the uncontrolled inflation we had in the 1990s. Bulgaria is coming out of its communist era and making its first steps into the market economy. At some point, inflation hit hard, and the government was forced to implement a currency board, which is still active today.

Inflation is sticky.

There is no doubt in my mind that inflation will remain sticky for many years. However, I also think inflation will settle around 3%-4% annually and stay there for a while. Here is a 40-year view of the CPI index.

In the years since the GFC, the central banks around the world artificially kept zero interest rates. We had cheap labor from China, quickly becoming a global manufacturing hub. Cheap oil fueled consumer spending. The boom in technology – the internet, mobile phones, 3G, 5G, and cloud computing boosted productivity and created deflationary pressure on prices.

These conditions no longer exist. Central banks are racing with the clock to raise rates. China is burdened with its own debt. Oil is no longer cheap, and oil companies are more strategic in capital spending. While the technology factor remains strong, technology companies must reset their business models to the new economic environment.

The economy is resilient.

The U.S. economy remains strong despite negative views and overwhelming predictions of a recession. Last year, many experts called for a recession at the beginning of 2023, but here we are, still chugging along.

In the fourth quarter of 2022, the US GDP rose 2.7%. The unemployment rate is at a historic low of 3.5%. And the total nonfarm payroll employment rose by 517,000 in January 2023. The February payroll figures are also impressive, with employers adding another 244,000 workers.

As much as I respect Jamie Dimon, the CEO of JP Morgan, his recommendation in June 2022 to brace ourselves for an economic hurricane didn’t age well.

Even Elon Musk got pessimistic about the economy in October of 2022.

Where is the recession?

Soft or hard, no or delayed landing. Recession gets pushed forward?

You are probably wondering if everyone is expecting a recession; how come it’s not happening? Here is my view:

Diversified economy

The U.S. is the largest but also one of the most diversified economies. The consumer drives 70% of the economy. Unlike Europe, China, and Japan, we are energy independent.

Job onshoring

The U.S. is expanding its manufacturing footprint in semiconductors, electric vehicles, battery cell production, and hydrogen facilities. Even old-school industries like steel and lumber are making a comeback.

Tight labor market

The latest data shows over 10 million job openings in the U.S. versus only 5.7 million unemployed workers. Forty-seven million Americans left their jobs in 2021. For context, that was 23.5% of the U.S. workforce in 2021. Furthermore, the pandemic drove more than 3 million adults into early retirement.

Energy exports

The U.S. is on track to become a net exporter of crude oil with a record sale of 3.4 million barrels per day. The United States became the world’s largest exporter of liquefied natural gas during the first half of 2022, surpassing Qatar, and Australia, on the back of European demand and surging prices.

Technology leader

The U.S. is a technology and innovation leader in software engineering, A.I., cloud computing, E.V., clean energy, biotechnology, medical devices, and robotics. All these services remain in high demand even in a high inflationary environment.

Lagging effect of record stimulus

Nearly $ 5 trillion of the Covid pandemic and post-pandemic stimulus is still circulating in the economy. The money supply went from $15.3 trillion in 2019 to $21.7 trillion at its peak in March 2022.

The global picture is even more staggering. Over $10 trillion in the pandemic fiscal stimulus was distributed in two months, three times more than the 2008 – 2009 financial response.

The bottom line is that we are in unchartered territory. The economy has way too much stimulus, and its lagging effect may persist for several years.

The U.S. economy is less interest rate sensitive.

The U.S. economy is less susceptible to interest rate hikes. For several reasons, the Fed raising interest rates may have a meaningful short-term impact.

Mortgage Refinancing

Nearly 20% of all homeowners with a mortgage refinanced their mortgage in 2020, and another 25% did it in 2021. Many U.S. homeowners are sitting on a mortgage loan with a record-low fixed interest rate.

Excessive savings

During the pandemic, fiscal support more than replaced other income losses in the aggregate, propping up personal income even as spending fell. By the third quarter of 2021, the excess savings reached about $2.3 trillion, which began to decline as spending picked up and fiscal support dropped. Even so, by mid-2022, extra savings remained at about $1.7 trillion.

Housing inventory remains tight.

Single-family home inventory is still low. With more millennials forming a family and having children and existing homeowners willing to stay in their homes for longer, I don’t see an immediate solution to this problem.

Corporations’ balance sheets are healthy.

Most S&P 500 top 20 companies have healthy balance sheets with low debt levels. Corporations like Apple, Microsoft, Google, and Exxon Mobile operate with high free cash flows, allowing them to self-fund their business without borrowing excessively. Furthermore, many companies were also able to lock in lower borrowing costs as interest rates reached new lows in 2020 and 2021. Just 3% of junk bonds or those issued by companies below-investment-grade ratings, only 8% come due before 2025, according to Goldman Sachs.

Monetary policy is weakening.

The Fed Reserve of Kansas posted research in 2015 on the diminished impact of interest rates on the financial markets. Even though the report doesn’t arrive at a definite conclusion, they make three suggestions. “First, changes in the conduct of monetary policy do not appear to be responsible for the shift in interest sensitivity. Second, linkages between the short and the long end of the yield curve, along with linkages between financial markets and the overall economy, have become protracted. Third, structural shifts have altered how employment changes at the industry level feedback to the aggregate economy.”. Not all industries react the same way to interest rate changes, and many sectors move in the opposite direction.

The Fed doesn’t want the markets to go higher.

It’s clear to me that the current Fed regime is hostile to the stock market. Due to its weakened monetary policy, the Federal Reserve uses the stock market as a second derivative tool to control the money supply. Higher stock prices would lead to higher household net worth and improved ability to spend and borrow. I expect the Fed chair and all Fed representatives to continue their tough talk. After underestimating the inflation rise in 2021, the Fed has been playing catch-up for 2022. They want to appear determined to crush inflation. I don’t like that the Fed has become so reactive to backward-looking data while has shown clear signs of declaration. One of the biggest risks for the U.S. economy and stock market in 2023 is a Fed mistake to overtighten and bring the economy to a stall.

Where will the stock market go in 2023?

“Thousands of experts study overbought indicators, head-and-shoulder patterns, put-call ratios, the Fed’s policy on money supply…and they can’t predict markets with any useful consistency, any more than the gizzard squeezers could tell the Roman emperors when the Huns would attack.” – Peter Lynch.

The daily swings of the stock market remain challenging for day traders. Today’s market doesn’t give you too many chances in both directions. For long-term investors and those sitting on the sidelines, we see the current market conditions as an excellent opportunity to build a position and prepare for the next bull market.

This kind of headline makes me want to buy more stocks. Financial history has shown time and time again that the best time to buy stocks with the highest expected long-term returns is when they are out of favor. Imagine the returns of those investors who continued buying through the market bottom of the Global Financial Crisis. I was there. Nobody wanted to buy stocks then. Some people were even liquidating their 401ks.

S&P 500 price target for 2023

I believe we have a narrow path for the stock market to finish the year higher than where we started, But the ride will be bumpy. We may go a whole lot of nowhere for a while. 2023 is going to be a true test for patient investors. I don’t expect a sharp V-shape recovery back to the prior highs of 2021.

Furthermore, technology and other growth stocks, which took the poison pill in 2022 and dropped 30%, 50%, and even 80%, may fare better than slow growth slow-moving companies in the consumer staples industries.

My view is that inflation will moderate towards the second half of the year. And corporate earnings will accelerate in the third and fourth quarters of 2023.

This is an ideal environment for companies with solid balance sheets and adaptable management. After a decade of zero interest and low cost of capital., now the bar is higher. Those companies that can adapt to the new economic reality will gain market share and reap benefits in the future.

It’s a stock pickers market.

January 16, 2023January 14, 2023

10 Essential Money Saving Tips for 2023

10 Essential Money Saving Tips for 2023. It’s 2023. You turned a new chapter of your life. After experiencing once-in-a-lifetime events in 2022, here is an opportunity to make smart financial decisions and change your future. I have my list of ideas to help you care for your financial health in 2023.

Here are our 10 Essential Money Saving Tips for 2023

1. Set your financial goals

Your first Money Saving Tip for 2023 is to set your financial goals. Know where you are going. Build milestones of success. Be in control of your journey. Setting and tracking your financial goals will help you make smart financial decisions in the future. It will help you define what is best for you in the long run.

2. Pay off debt

Americans owe $16.5 trillion in debt. The average household owes $96,000 in total debt, $6,270 in credit cards, and $17,553 in auto loans. These figures are staggering. If you struggle to pay off your debts, 2023 is the year to change your life. Check out my article How to Pay off your debt before retirement. With interest rates on the rise, you can consider consolidating debt or prepaying your high-interest loans. Even a small percentage cut of your interest can lead to massive savings and reductions in your monthly debt payments.

3. Automate bill payments

Are you frequently late on your bills? Are you getting hefty late penalty fees? It’s time to switch on automatic bill payments. It will save you time, frustration, and money. You should still review your bills for unexpected extra charges. But no need to worry about making your payments manually. Let technology do the heavy lifting for you.

4. Build an emergency fund

Set up a certain percentage of your wage automatically in your savings account. Your rainy-day cash will hold you up if you lose your job or your ability to earn income. By maintaining an emergency fund, you could avoid taking debt and cover temporary gaps in your budget.

5. Monitor your credit score

In today’s world, everything is about data. Your credit score measures your financial health. It tells banks and other financial institutions your creditworthiness and ability to repay your debt. Often. The credit score methodology is not always perfect. That said, every lender and even some employers will check your credit score before extending a new line of credit or a job offer.

6. Review and budget your expense

Do you find yourself spending more than you earn? Would you like to save more for your financial goals? If you struggle to meet your milestones, 2023 will allow you to reshape your future. Budgeting is one of our most important Money Tips for 2023. Along with the old fashion pen-and-paper method, many mobile apps and online tools can help you track and monitor your expenses. Effective budgeting will help you understand your spending habits and control impulse purchases.

Here are some cost-cutting ideas for 2023:

Review your subscriptions
Cook at home
Make your own coffee/tea
Get a Costco membership
Shop around and negotiate for big purchases

7. Save more for retirement

Maximizing your retirement savings is one of your most Essential Money Saving Tips for 2023. I recommend saving at least 10% of your earnings every year. If you want to be more aggressive, you can set aside 20% or 25%. A lot depends on your overall income and spending lifestyle.

In 2023, you can contribute up to $22,500 in your 401k. If you are 50 and older, you can set an additional $7,500. Furthermore, you can add another $6,500 to your Roth IRA or Traditional IRA.

8. Plan your taxes

You probably heard the old phrase. It’s not about how much you earn but how much you keep. Taxes are the single highest expense that you pay every year. Whether you are a high-income earner or not, proper tax planning is always necessary to ensure that you keep your taxes in check and take advantage of tax savings opportunities. But remember, tax planning is not a daily race; it’s a multi-year marathon.

9. Review your investments

When was the last time you reviewed your investments? Have you recently checked your 401k plan? You will be shocked how many people keep their retirement savings in cash and conservative mutual fund strategies. Sadly, sitting in cash is a losing strategy, as inflation reduces the purchasing power of your money. A dollar today is not equal to a dollar 10 years from now. While investing is risky, it will help you grow your wealth and protect you from inflation. Remember that, repeatedly, long-term investors get rewarded for their patience and persistence.

10. Protect your family finances from unexpected events

The last three years taught us a big lesson. Life is unpredictable. Bad things can happen suddenly and unexpectedly. In 2023, take action to protect your family, your wealth, and yourself from abrupt events. Start with your estate plan. Make sure you write your will and assign your beneficiaries, trustees, and health directives.

Next, you need to review your insurance coverage. Ensure that your life, disability, umbrella, property, and other insurance are up to date and will protect your family in times of emergency.

May 15, 2020November 8, 2022

Charitable donations: 6 Tax Strategies – Updated for 2022

Charitable donations are an excellent way to help your favorite cause, church, foundation, school, or other registered charitable institution of your choice. Americans made $484.85 billion in charitable donations in 2021, which was 4% higher than 2020. The average annual household contribution was $2,534. In 2021, the majority of charitable dollars went to religion (27%), education (14%), human services (13%), grantmaking foundations (13%), and public-society benefit (11%).

Charitable donations are also a powerful tool to reduce your overall tax liability to the IRS. By carefully following the tax law and IRS rules, you can substantially increase the impact of donations. Here is what you can do.

1. Meet the requirements for charitable donations

You can receive tax deductions for your donations as long as they meet specific requirements. Some of the most important rules are:

You have to give to qualified charitable organizations approved by the IRS. The charity can be public or private. Usually, public charities receive more favorable tax treatment.
You need to have a receipt for your gift.
You need to itemize your tax return.
Donations apply for the same tax year when you make them. For most individuals, the tax year and calendar year are the same. For some companies, their tax year may end on a different date during the calendar year (for example, November 1 to October 31)
All gifts are valued at fair market value. Depending on your donation, the fair market value may not be equal to the initial cash value.
You have to transfer the actual economic benefit or ownership to the receiver of your gift.

There are many ways to give. Some are straightforward, and others are more complex and require professional help. Each has its rules, which you need to understand and follow strictly to receive the highest tax benefit.

2. Give cash

Giving money is the easiest way to help your favorite charitable cause. IRS allows for charitable donations for as much as 50% of your aggregated gross income. You can carry over in future years any amounts of more than 50%.s. However, you must keep a record of your cash donations.

3. Give Household goods

You can donate clothes, appliances, furniture, cars, and other household items in good condition. The items will be priced at fair value. In most cases, the value will be lower than what you paid for them. This category is also subject to the 50% limit of the AGI.

Donating household items is a perfect way to clean your closet of old clothes and shoes that you haven’t worn for years. You can even donate your old car collecting dust in the garage. Moreover, if you plan to remodel a kitchen, you can give your old cabinets and appliances to charities like the Salvation Army. Remember to keep the receipts of these items in case the IRS asks you for them.

4. Donate Appreciated assets

One of the most popular tax-saving strategies is donating appreciated assets directly to charitable organizations. This approach is subject to 30% of AGI for donations given to qualified public charities. Appreciated assets can include publicly traded stocks, restricted stocks, real estate, privately held companies, collectibles, and artwork. The main caveat to receiving the highest tax benefit is giving the appreciated asset directly to charitable donations instead of selling it and gifting the remaining cash. This way, you will avoid paying a capital gain tax on the sale of your asset and deduct the full fair value of your asset.

Let’s look at an example. An investor in a 28% tax bracket is considering donating an appreciating stock to her favorite charity. She can sell the stock and give the proceeds or donate the shares directly. The current market value of the stock is $100,000. She purchased it more than one year ago for $20,000. The total capital gain is $80,000.

The investor is achieving three essential goals by giving the stock directly to her favorite. First, she is not paying a capital gain tax on the proceeds of the sale. Second, she can use the entire fair value of the stock (instead of the proceeds from the sale) to reduce her tax liabilities. Third, the charitable organization receives an asset with a higher value, which they can sell tax-free.

5. Make direct IRA charitable rollover

Donations made directly from your IRA and 401k accounts are another way of reducing your tax bill. If you reached 72 (70 ½ if you turned 70 ½ in 2019), you could make up to $100,000 a year in gifts to a charity directly from your IRA or 401k accounts. Those contributions count towards the required annual minimum distributions you must take once you reach 72 or 70 ½, respectively. They also reduce your adjusted gross income. To be compliant, you have to follow two simple rules.

Your plan administrator has to issue a check payable to your charity of choice. Therefore the funds have to transfer directly to the charitable organization. If the check is payable to you, this will automatically trigger a tax event for IRS. In that case, your IRA distribution will be taxable as ordinary income, and you will owe taxes on them. The second rule, you have to complete the transfer by December 31 of the same calendar year.

6. Consolidate your donations

Tax Cuts and Jobs Act of 2017 increased the standard deduction for all individuals and families. Therefore relatively small charitable donations may not be tax-deductible at all.

Standard deduction amounts

	2021 tax year	2022 tax year
Individuals	$12,550	$12,950
Married couples filing jointly	$25,100	$25,900
Heads of households	$18,800	$19,400

If you want to increase the tax impact of your donations, you may have to consolidate the small annual contributions in a single year.

September 19, 2022November 7, 2022

Wise 401k moves to make in 2022

Six wise 401k moves to make in 2022 to boost your retirement saving. Do you have a 401k? These five 401k moves will help you grow your retirement savings and ensure that you take full advantage of your 401k benefits.

2022 has been a very choppy year for investors. Both stocks and bonds have experienced losses and large swings in both directions. As we approach the end of the year, you can take another look at your 401k, reassess your financial priorities and .revaluate your retirement strategy, Let’s make sure your 401k works for you.

Retirement Calculator

What is a 401k plan?

401k plan is a workplace retirement plan that allows employees to build and grow their retirement savings. It is one of the most convenient and effective ways to save for retirement, as both employees and employers can make retirement contributions. You can set up automatic deductions to your 401k account directly through your company payroll as an employee. You can choose the exact percentage of your salary towards your retirement savings. In 2022, most 401k will provide you with multiple investment options in stock, fixed-income mutual funds, and ETFs. Furthermore, most employers offer a 401k match for up to a certain percentage. In most cases, you must participate in the plan to receive the match.

1. Maximize your 401k contributions in 2022

The smart way to boost your retirement savings is to maximize your 401k contributions each year.

Did you know that in 2022 you can contribute up to $20,500 to your 401k plan? If you are 50 or over, you are eligible for an additional catch-up contribution of $6,500 in 2022. Traditional 401k contributions are tax-deductible and will lower your overall tax bill in the current tax year.

Many employers offer a 401k match, which is free money for you. The only way to receive the match is to participate in the plan. If you cannot max out your dollar amount, try to deduct the highest possible percentage so that you can capture the entire match from your employer. For example, if your company offers a 4% match on every dollar, at the very minimum, you should contribute 4% to get the entire match.

How to reach $1 million in your 401k by age 65?

Do you want to have $1 million in your 401k by retirement? The secret recipe is to start early. For example, if you are 25 years old today, you only need to set aside $387 per month for 40 years, assuming a 7% annual return. If you are 35, the saving rate goes up to $820 per month. If you start in your 50s, you need to save about $3,000 a month to get to a million dollars.

401k Contributions by Age

Age	\|	Monthly Contribution	Yearly Contribution	Lifetime Contribution
25		$387	$4,644	$190,404
30		$560	$6,720	$241,920
35		$820	$9,840	$305,040
40		$1,220	$14,640	$380,640
45		$1,860	$22,320	$468,720
50		$3,000	$36,000	$576,000
55		$5,300	$63,600	$699,600

2. Review your investment options

When was the last time you reviewed the investment options inside your 401k plan? When was the last time you made any changes to your fund selection? With automatic contributions and investing, it is easy to get things on autopilot. But remember, this is d your retirement savings. Now is the best time to get a grip on your 401k investments.

Look at your fund performance over the last 1, 3, 5, and 10 years and make sure the fund returns are near or higher than their benchmark. Review the fund fees. Check if there have been new funds added to the lineup recently.

What is a Target Date Fund?

A target-date fund is an age-based retirement fund that automatically adjusts your stock and bond investment allocation as you approach retirement. Young investors have a higher allocation to equities, considered more risky assets. In comparison, investors approaching retirement receive a bigger share in safer investments such as bonds. By design, plan participants should choose one target-date fund, set it, and forget until they retire. The fund will automatically change the asset allocation as you near your retirement age.

However, in a recent study, Vanguard concluded that nearly 33% of 401k plan participants misuse their target-date funds. A third of the people who own TDFs, combine them with another fund.

3. Change your asset allocation

Asset allocation tells you how your investments are spread between stocks, bonds, money markets, and other asset classes. Stocks typically are riskier but offer great earnings potential. Bonds are considered a safer investment but provide a limited annual return.

Your ideal asset allocation depends on your age, investment horizon, risk tolerance, and specific individual circumstances.

Typically, younger plan participants have a longer investment horizon and can withstand portfolio swings to achieve higher returns in the future. If you are one of these, investors can choose a higher allocation of stocks in your 401k.

However, if you are approaching retirement, you would have a much shorter investment horizon and probably lower tolerance to investment losses. In this case, you should consider adding more bonds and cash to your asset allocation.

4. Consider contributing to Roth 401k in 2022

Are you worried that you will pay higher taxes in the future? The Roth 401k allows you to make pretax contributions and avoid taxes on your future earnings. All Roth contributions are made after paying all federal and state income taxes. The advantage is that all your prospective earnings will grow tax-free. If you keep your money until retirement or reach the age of 59 ½, you will withdraw your gains tax-free. If you are a young professional or believe your tax rate will grow higher in the future, Roth 401k is an excellent alternative to your traditional tax-deferred 401k savings.

5. Do a Mega backdoor 401k conversion

Mega Backdoor 401k is an acronym for after-tax Roth conversion within your 401k plan. Many high-income earners cannot make direct Roth contributions. At the same time, they may prefer traditional tax-deferred 401k contributions, which reduce their current taxes. Mega backdoor 401k allows you to get the best of both worlds. There is one caveat — your 401k plan must allow for after-tax contributions and in-plan conversions.

For 2022, maximum 401k contributions of any kind (tax-deferred, Roth, after-tax, and employee match) is $61,000, up from $58,000 for 2021. If you’re 50 or older, the limit is $67,500, up from $64,500 in 2021. If you maximize your 401k allowance and receive an employee match, you can choose to make after-tax contributions up to the annual limit. Without any conversion, you will pay taxes on all your gains. The second step in the strategy requires an in-plan Roth conversion, which will move your after-tax money into Roth tax-exempt savings.

6. Rollover an old 401k plan

Do you have an old 401k plan stuck with your former employer? How often do you have a chance to review your balance? Unfortunately, many old 401k plans have been forgotten and ignored for years. Transferring an old 401k to a Rollover IRA can be a wise move.

The rollover is your chance to control your retirement savings. Furthermore, you will expand your investment options from the limited number of mutual funds to the entire universe of stocks, ETFs, and fund managers. Most importantly, you can manage your account according to your retirement goals.

September 7, 2022February 27, 2023

Maximizing Roth savings for high-income earners

Maximizing your Roth savings is a terrific way to save for retirement for both high-income earners and professionals at all levels. Roth IRA is a tax-free retirement savings account that allows you to make after-tax contributions to save towards retirement.

Key Roth benefits for high earners

Roth IRA offers tax-free retirement growth. All contributions are pre-tax. In other words, you pay taxes before you make them. Once your dollars hit your Roth IRA, they grow tax-free.
You won’t pay any taxes on future capital gains and dividends.
Roth IRA is not subject to required minimum distributions at age 72.
You can always withdraw your original contribution tax and penalty-free.
Maximizing your Roth savings, especially for high-income earners, is an effective way to diversify your future tax exposure
High earners can incorporate their Roth savings as part of their estate planning strategy

How much can I contribute to my Roth IRA?

You can contribute up to $6,000 to your Roth IRA in 2022 or $7,000 if you are 50 years or older. For 2023, you can contribute $6.500 or or $7,500 if you are 50 years or older

Income limits for Roth contributions

Roth IRA contribution limits for 2022 are based on your annual earnings. If you are single or a head of household and earn $129,000 or less, you can contribute up to the full amount of $6,000 per year. If your aggregated gross income is between $129,000 and $144,000, you can still make contributions with a lower value.

Married couples filing jointly can contribute up to $6,000 each if their combined income is less than $204,000. You can still make reduced contributions if your aggregated gross income is between $204,000 and $214,000.

If you are a high earner, you will not meet the income limits to make direct Roth contributions. However, you still have some options. Here are some ideas that can help you boost your Roth savings

Speak with a financial advisor to find out what Roth strategies make sense for you

Backdoor Roth IRA for high-income earners

The Backdoor Roth IRA is a multi-step process that allows high-income earners to bypass the Roth Income limits. The strategy comes with some conditions. While the IRS has kept the rules vague, it’s easy to make mistakes while following the process. I had seen more than one client who had made some mistakes when they followed the backdoor steps.

Here are the general guidelines. Remember that everyone’s circumstances are unique, and this article may not address all of them.

Backdoor Roth IRA steps

Contribute to a non-deductible IRA. Roth IRA and Traditional IRA have the same income limits. If you do not qualify to make direct Roth contributions, you don’t qualify for tax-deductible IRA savings. When you contribute to a non-deductible IRA, you are making an after-tax contribution to an IRA. Theoretically, you will pay taxes on your future gain but the original amount.
Convert your contribution to a Roth IRA. In the second step of the process, you must transfer your assets from the non-deductible IRA to your Roth IRA. Your IRA administrator or financial advisor will give you the instructions and paperwork. Every broker requires a slightly different process.
File your taxes and submit Form 8606. You must file form 8606 to report your non-deductible contributions to traditional IRAs. Please consult your CPA or tax accountant for the exact requirements for filling out and submitting the form. Pay attention to this form when you file your taxes using tax software.
The Pro-Rata Rule. The pro-rata rule has one of the biggest implications in the backdoor process. The rules stipulate that ALL Roth conversions must be made on a pro-rata basis. In other words, if you have an outstanding Traditional RA, SEP IRA, or Simple IRA, your Roth conversion must be pro-rated between all existing IRA accounts, not just the non-deductible IRA from which you want to make the transfer. In other words, the Backdoor Roth strategy could trigger a substantial taxable event for you if you own tax-deferred IRA savings.

Roth conversion from IRA and 401k

Roth conversion involves the transfer of the tax-deferred savings in your IRA or 401k accounts into tax-exempt investments in your Roth IRA. Roth conversion can be a brilliant move for high-income earners in the right circumstances.

Your current and future taxes are critical elements of any Roth conversion decision-making. The strategy becomes viable during low tax years or whenever you expect higher tax rates in the future. Higher future tax rates make a Roth IRA more appealing, while lower future tax rates would make a traditional IRA more attractive.

With some proactive planning, Roth IRA offers substantial tax-free benefits. Due to income limits, many high-income savers end up with significant amounts in tax-deferred accounts such as 401k and Traditional IRA. These plans give you initial tax relief to encourage retirement savings. However, all future distributions are fully taxable and subject to required minimum distributions.

Learn more about Roth conversion here

Roth 401k

Most corporate 401k plans allow you to make either traditional tax-deferred or Roth 401k contributions. Roth 401k is similar to Roth IRA as both accounts are funded with after-tax dollars.

The contribution limits for 2022 are $20,500 per person. All 401k participants over the age of 50 can add a catch-up contribution of $6,500.

Roth 401k vs. Roth IRA

Roth 401k and Roth IRA are very similar, but Roth 401k has major advantages for high-income earners

No income limits – Unlike Roth IRA, the Roth 401l doesn’t have income limits. Anyone eligible to participate in their company’s 401k plan can make Roth 401k contributions.
Higher Contribution limits – You can save a lot more in your company’s Roth 401k plan versus a personal Roth IRA. You can save up to $20,500 in your Roth 401k and $6,000 in your Roth IRA. If you are 50 or older, you can stash $27,000 vs. $7,000
Company match – You are eligible for a company match even if you make Roth 401k contributions. All employer matching contributions will be tax-deferred and placed in a separate account
Investment options – Roth IRA offers a broader range of investment options vs. 401k plans with a limited list of funds.
Distributions rules – Roth 401k savings are subject to required maximum distributions at age of 72. You can avoid this rule by rolling over your Roth 401k into a Roth IRA once you stop contributing to the plan.

What Is a Mega Backdoor Roth 401k?

For 2022, maximum 401k contributions of any kind (tax-deferred, Roth, after-tax, and employee match) is $61,000, up from $58,000 for 2021. If you’re 50 or older, the limit is $67,500, up from $64,500 in 2021. If you maximize your 401k allowance and receive an employee match, you can choose to make after-tax contributions up the annual limit. Without any conversion, you will pay taxes on all your gains. Since your original contribution was after-tax, you don’t pay taxes on that amount. Furthermore, the IRS limits the compensation eligible for 401k contributions to $305,000 or 2022. Depending on your specific circumstances, the final contribution amount to your 401k plan may vary,

Here is how Mega Backdoor Roth 401k works

Maximize your 401k contributions for the year
Opt-in for after-tax 401k contributions. Your plan must allow for this election
Convert your after-tax contributions into Roth 401k as soon as possible to avoid possible taxable gains. Some plans may allow you to choose automatic conversions versus manual.
Watch your Roth savings grow tax-free

Final words

Maximizing Roth savings can be highly advantageous for high-income earners and hard-working professionals. Since Roth IRAs have strict income limits, not everyone will qualify automatically for direct contributions. You will need careful planning to maneuver all the different rules and a long-term view to enjoy the benefits of your Roth savings.

March 28, 2022November 8, 2022

Inflation is a tax and how to combat it

Inflation is a tax. Let me explain. Inflation reduces the purchasing power of your cash and earnings while simultaneously redistributing wealth to the federal government.

When prices go up, we pay a higher sales tax at the grocery store, restaurants, or gas stations. Even if your employer adjusts your salary with Inflation, the IRS tax brackets may not go up at the same pace. Many critical tax deductions and thresholds are not adjusted for inflation.

For example, the SALT deduction remains at $10,000.

We have a $750,000 cap on total mortgage debt for which interest is tax-deductible. There is a $500,000 cap on tax-free home sales. We also have a $3,000 deduction of net capital losses against ordinary income such as wages.

The income thresholds at which 85% of Social Security payments become taxable aren’t inflation-adjusted and have been $44,000 for joint-filing couples and $34,000 for single filers since 1994

And lastly, even if interest rates on your savings account go up, you still have to pay taxes on your modest interest earnings.

Effectively we ALL will pay higher taxes on our future income

Here are some strategies that can help you combat Inflation.

(Not) keeping cash

Inflation is a tax on your cash. Keeping large amounts of cash is the worst way to protect yourself against Inflation. Inflation hurts savers. Your money automatically loses purchasing power with the rise of Inflation.

Roughly speaking, if this year’s Inflation is 8%, $100 worth of goods and services will be worth $108 in a year from now. Therefore, someone who kept their cash in the checking account will need an extra $8 to buy the same goods and services he could buy for $100 a year ago.

Here is another example. $1,000 in 2000 is worth $1,647 in 2022. If you kept your money in your pocket or a checking account, you could only buy goods and services worth $607 in 2000’s equivalent dollars

I recommend that you keep 6 to 12 months’ worth of emergency funds in your savings account, earning some interest. You can also set aside money for short-term financial goals such as buying a house or paying off debt. If you want to protect yourself from inflation, you need to find a different destination for your extra cash.

Investing in Stocks

Investing in stocks often provides some protection against Inflation. Stock ownership offers a tangible claim over the company’s assets, which will rise in value with Inflation. In inflationary environments, stocks have a distinct advantage over bonds and other investments. Companies that can adjust pricing, whereas bonds, and even rental properties, not so much

Historical data has shown that equities perform better with inflation rates under 0 and between 0 and 4%.

Historically, energy, staples, health care, and utility companies have performed relatively better during high inflation periods, while consumer discretionary and financials have underperformed.

While it might seem tempting to think specific sectors can cope with Inflation better than others, the success rate will come down to the individual companies’ business model. Firms with strong price power and inelastic product demand can pass the higher cost to their customers. Furthermore, companies with strong balance sheets, low debt, high-profit margins, and steady cash flows perform better in a high inflation environment.

You also need to remember that every economic regime is somewhat different. Today, we are less dependent on energy than we were in the 1970s. Corporate leadership is also different. Companies like Apple and Google have superiorly high cash flow margins, low debt, and a smaller physical footprint. Technology plays a more significant role in today’s economy than in the other four inflationary periods.

Investing in Real Estate

Real Estate very often comes up as a popular inflation hedge. In the long-run real estate prices tend to adjust with inflation depending on the location. Investors use real estate to protect against inflation by capitalizing on cheap mortgage interest rates, passing through rising costs to tenants.

However, historical data and research performed the Nobel laureate Robert Shiller show otherwise. Shiller says, “Housing traditionally is not a great investment. It takes maintenance, depreciates, and goes out of style”. On many occasions, it can be subject to climate risk – fires, tornados, floods, hurricanes, and even volcano eruptions if you live on the Big Island. The price of a single house also can be pretty volatile. Just ask the people who bought their homes in 2007, before the housing bubble.

Investors seeking inflation protection with Real Estate must consider their liquidity needs. Real Estate is not a liquid asset class. It takes a longer time to sell it than a stock. Every transaction involves paying fees to banks, lawyers, and real estate agents. Additionally, there are also maintenance costs and property taxes. Rising Inflation will lead to higher overhead and maintenance costs, potential renter delinquency, and high vacancy.

Investing in Gold and other commodities

Commodities and particularly gold, tend to provide some short-term protection against Inflation. However, this is a very volatile asset class. Gold’s volatility, measured by its 50-year standard deviation, is 27% higher than that of stocks and 3.5 times greater than the volatility of the 10-year treasury. Other non-market-related events and speculative trading often overshadow short-term inflation protection benefits.

Furthermore, gold and other commodities are not readily available to retail investors outside the form of ETFs, ETNs, and futures. Buying actual commodities can incur significant transaction and storage costs, making it almost prohibitive for individuals to own them physically.

In recent years the relationship between gold and Inflation has weakened. Gold has become less crucial for the global economy due to monetary policy expansion, benign economic growth, and low and negative interest rates in Japan and the EU.

Having a Roth IRA

If higher Inflation means higher taxes, there is no better tool to lower your future taxes than Roth IRA. I have written a lot about why you need to establish a Roth IRA. Roth IRA is a tax-exempt retirement savings account that allows you to make after-tax dollars. The investments in your Roth IRA grow tax-free, and all your earnings are tax=emept.

If you are a resident of California, the highest possible tax rate you can pay are

37% for Federal Income taxes
13.3% for State Income taxes
2% for Social Security Income tax for income up to $147,000 in 2022
35% for Medicare Taxes
20% Long-term capital gain tax
8% for Net Investment income tax (NIIT) for your MAGI is over $200,000 for singles and $250,000 for married filing jointly

Having a Roth IRA helps you reduce the tax noise on your earnings and improves the tax diversification of your investments

Here is how to increase your Roth contributions depending on your individual circumstances:

Roth IRA contributions
Backdoor Roth contributions
Roth 401k Contributions
Mega-back door 401k conversions
Roth conversions from your IRA

June 11, 2021November 7, 2022

Achieving tax alpha and higher after tax returns on your investments

What is tax alpha?

Tax Alpha is the ability to achieve an additional return on your investments by taking advantage of a wide range of tax strategies as part of your comprehensive wealth management and financial planning. As you know, it is not about how much you make but how much you keep. And tax alpha measures the efficiency of your tax strategy and the incremental benefit to your after-tax returns.

Retirement Calculator

Why is tax alpha important to you?

The US has one of the most complex tax systems in the world. Navigating through all the tax rules and changes can quickly turn into a full-time job. Furthermore, the US budget deficit is growing exponentially every year. The government expenses are rising. The only way to fund the budget gap is by increasing taxes, both for corporations and individuals.

Obviously, our taxes pay our teachers, police officers, and firefighters, fund essential services, build new schools and fix our infrastructure. Our taxes help the world around us humming. However, there will be times when taxes become a hurdle in your decision process. Taxes turn into a complex web of rules that is hard to understand and even harder to implement.

Achieving tax alpha is critical whether you are a novice or seasoned investor sitting on significant investment gains. Making intelligent and well-informed decisions can help you improve the after-tax return of your investment in the long run.

Assuming that you can generate 1% in excess annual after-tax returns over 30-year, your will investments can grow as much as 32% in total dollar amount.

1. Holistic Financial Planning

For our firm, achieving Tax Alpha is a process that starts on day 1. Making smart tax decisions is at the core of our service. Preparing you for your big day is not a race. It’s a marathon. It takes years of careful planning and patience. There will be uncertainty. Perhaps tax laws can change. Your circumstances may evolve. Whatever happens, It’s important to stay objective, disciplined, and proactive in preparing for different outcomes.

At our firm, we craft a comprehensive strategy that will maximize your financial outcome and lower your taxes in the long run. We start with taking a complete picture of financial life and offer a road map to optimize your tax outcome. Achieving higher tax alpha only works in combination with your holistic financial plan. Whether you are planning for your retirement, owning a large number of stock options, or expecting a small windfall, planning your future taxes is quintessential for your financial success.

2. Tax Loss Harvesting

Tax-loss harvesting is an investment strategy that allows you to sell off assets that have declined in value to offset current or future gains from other sources. You can then replace this asset with a similar but identical investment to position yourself for future price recovery. Furthermore, you can use up to $3,000 of capital losses as a tax deduction to your ordinary income. Finally, you can carry forward any remaining losses for future tax years.

The real economic value of tax-loss harvesting lies in your ability to defer taxes into the future. You can think of tax-loss harvesting as an interest-free loan by the government, which you will pay off only after realizing capital gains. Therefore, the ability to generate long-term compounding returns on TLH strategy can appeal to disciplined long-term investors with low to moderate trading practices.

How does tax-loss harvesting work?

Example: An investor owns 1,000 shares of company ABC, which she bought at $50 in her taxable account. The total cost of the purchase was $50,000. During a market sell-off a few months later, the stock drops to $40, and the initial investment is now worth $40,000.

Now the investor has two options. She can keep the stock and hope that the price will rebound. Alternatively, she could sell the stock and realize a loss of $10,000. After the sale, she will have two options. She can either buy another stock with a similar risk profile or wait 30 days and repurchase ABC stock with the proceeds. By selling the shares of ABC, the investor will realize a capital loss of $10,000. Assuming she is paying 15% tax on capital gains, the tax benefit of the loss is equal to $1,500. Furthermore, she can use the loss to offset future gains in her investment portfolio or other sources.

3. Direct Indexing

Direct indexing is a type of index investing. It combines the concepts of passive investing and tax-loss harvesting. The strategy relies on the purchase of a custom investment portfolio that mirrors the composition of an index.

Similar to buying an index fund or an ETF, direct indexing requires purchasing a broad basket of individual stocks that closely track the underlying index. For example, if you want to create a portfolio that tracks S&P 500, you can buy all or a smaller number of 500 stocks inside the benchmark.

Owning a basket of individual securities offers you greater flexibility to customize your portfolio. First, you can benefit from tax-loss harvesting opportunities by replacing stocks that have declined in value with other companies in the same category. Second, you can remove undesirable stocks or sectors you otherwise can’t do when buying an index fund or an ETF. Third, direct indexing can allow you to diversify your existing portfolio and defer realizing capital gains, especially when you hold significant holdings with a low-cost basis.

4. Tax Location

Tax location is a strategy that places your diversified investment portfolio according to each investment’s risk and tax profile. In the US, we have a wide range of investment and retirement accounts with various tax treatments. Individual investment accounts are fully taxable for capital gains and dividends. Employer 401k, SEP IRA and Traditional IRA are tax-differed savings vehicles. Your contributions are tax-deductible while your savings grow tax-free. You only pay taxes on your actual retirement withdrawals. Finally, Roth IRA, Roth 401k, and 529 require pre-tax contributions, but all your future earnings are tax-exempt. Most of our clients will have at least two or more of these different instrument vehicles.

Now, enter stocks, bonds, commodities, REITs, cryptocurrencies, hedge funds, private investments, stock options, etc. Each investment type has a different tax profile and carries a unique level of risk.

At our firm, we create a customized asset allocation for every client depending on their circumstances and goals. Considering the tax implications of each asset in each investment or retirement account, we carefully crate our tax location strategy to take advantage of any opportunities to achieve tax alpha.

5. Smart tax investing

Smart tax investing is a personalized investment strategy that combines various portfolio management techniques such as tax-loss harvesting, asset allocation and asset location, diversification, dollar-cost averaging, passive vs. active investing, and rebalancing. The main focus of tax mindful investing is achieving a higher after-tax return on your investment portfolio. Combined with your comprehensive financial planning, smart-tax investing can be a powerful tool to elevate your financial outcome.

May 1, 2021November 8, 2022

5 reasons to leave your robo-advisor and work with a real person

Robo-advisors have grown in popularity in the last 10 years, offering easy and inexpensive access to professional investment management with human interaction. Firms like Vanguard, Betterment, Personal Capital, and Wealth Front use online tools and algorithms to build and manage your investment. These digital advisors attract new customers with cutting-edge technology, attractive websites, interactive features, low fees, and cool mobile apps. The rising adoption of robo-advisors and various digital platforms allows the financial industry to become more accessible and consumer-friendly.

Unlike traditional portfolio management firms, most robo-advisors offer their automated investing service with low or no account minimums. You will answer an online questionnaire. Your answers will place you in a specific risk tier group. As a result, the robo-advisor will invest your assets according to your risk profile. The typical digital advisor offers automated portfolio rebalancing and tax loss harvesting. Some may even offer you financial planning advice for an additional fee.

If you have read one of my Investment Ideas articles (here and here), you know that I am a big believer in FinTech, mobile payments, and digitization of the financial industry. The covid outbreak created a massive tailwind for this trend to continue in the next decade. You will experience a complete digital transformation in all aspects of your financial life.

With all that in mind, why someone like yourself will decide to abandon their digital advisor service? So here we go.

Receive personalized advice

Life changes. Often you will be at crossroads in your life trying to make important financial decisions. You will need to talk to someone who understands your situation and can give you personalized advice with your best interest in mind. Unfortunately, digital advisor services rarely, if never offer personalized advice. Algorithms cannot understand your emotions and feelings.

Surely, you can do the research and the hard lifting yourself. There is nothing more rewarding than reaping the benefits from your hard work. However, there is nothing wrong with asking for help. You do not have to do it alone. Working with a fiduciary financial advisor who understands your circumstances will save you time and grievance. Moreover, it will save you and make you money in the long run. And most importantly, it allows you to enjoy what matters most to you.

Build a relationship

Finding a good financial advisor is like finding a personal doctor or a hairstylist who cuts your hair just the way you wanted. Would you ask a robot to cut your hair? Then, why would you leave your wealth and retirement savings to an algorithm? Having a trusted relationship with a fiduciary financial advisor will give you access to objective, unbiased, and reliable financial advice when you need it most. Your financial advisor can point your financial blind spots and recommendations on how to resolve them before they escalate.

I frequently work with clients coming from large robo-advisors. Almost always, their biggest complaint is that they were not able to get answers to their questions. They were calling customer service, waiting in line, and speaking with a complete stranger on the other side.

Building wealth is a marathon, not a race. Why not working with a trusted partner who understands your unique needs and has your best interest in mind.

Invest with purpose

Have you asked yourself, does your investment portfolio represent your philosophy and values?

For many of you, investing is a way to make a meaningful impact on your favorite causes.

Furthermore, most robo-advisors offer a limited number of generic ETFs in various asset classes. However, they do not provide a way to customize your investments according to your core values. The only you can achieve your purpose is through a customized investment portfolio that represents what you believe.

Impact Investing

Impact investing is about MAKING A DIFFERENCE. It is a philosophy that seeks to achieve sustainable long-term returns by investing in companies that create positive and measurable social, governance, and environmental impact. If you are an impact investor, your goal is to invest your money in areas that match your core beliefs and values. By choosing the path of impact investing, you will provide the necessary support to address the world’s most urgent challenges in areas such as sustainable agriculture, clean energy, gender equality, social justice, food conservation, microfinance, and affordable access to housing, healthcare, and education.

Thematic investing

Thematic investing is a path to achieve higher long-term returns by investing in specific economic and secular trends caused by structural shifts in our society. It is about CHANGE. The thematic investing strategy relies on megatrends that are changing the way we live. Several of my favorite trends include climate change and renewable energy, 5G and cybersecurity, digital payments and e-commerce, blockchain and digital revolution, the rising power of women, and population growth.

Have a plan

Life is complicated. As a result, your circumstances will change. You will start a new job, move to a new place. Start a family. Buy a new house. Exercise those stock options that you received when you started your last job. Above all, you must prepare for everything that life has to give.

Once you do the groundwork, it’s easier to update your plan than create a new one from scratch every time your life changes. Your plan will make you feel confident when making complex financial decisions about your future.

According to Vanguard itself, working with a financial advisor can bring you up to 3% average additional return. The advisor alpha comes from value-added services such as behavioral coaching, tax-smart investing, asset allocation, and rebalancing.

Get a customized tax strategy.

Let’s admit it. The US has one of the most complex tax systems in the world. We all get tangled with terms such as AMT, marginal tax bracket, capital gain tax, 401k, step-up basis, tax-deferred and exempt income. With the ever-rising budget deficit, there is no doubt that your taxes will only go higher. Paying taxes is part of life but managing your future tax bill is your responsibility.

One popular way to measure the efficiency of your tax strategy is your tax alpha. Tax Alpha is the ability to achieve an additional return on your investments by taking advantage of all available tax strategies as part of your comprehensive financial planning. Unlike robo-advisors, our firm can offer a wider range of tax planning tools that can help you realize higher long-term after-tax returns. For instance, for us, achieving Tax Alpha is a process that starts on day 1. As a result, we will craft a comprehensive strategy that will maximize your financial outcome and lower your taxes in the long run.

January 21, 2022January 11, 2023

New Year Financial Resolutions for 2022

New Year Financial Resolutions for 2022. It’s 2022. You turned a new chapter of your life. Here is an opportunity to make smart financial decisions and change your future. We have our list of ideas that can help you.

Here are your New Year Financial Resolutions for 2022

1. Set your financial goals

Your first New Year Financial Resolutions for 2022 is to set your financial goals. Know where you are going. Build milestones of success. Be in control of your journey. Setting and tracking your financial goals will help you make smart financial decisions in the future. It will help you define what is best for you in the long run.

2. Pay off debt

Americans owe $14.3 trillion in debt. The average household owes $145,000 in total debt, $6,270 in credit cards, and $17,553 in auto loans. These figures are insane. If you struggle to pay off your debts, 2022 is your year to change your life. Check out my article How to Pay off your debt before retirement. With interest rates staying at record low levels, you can look into consolidating debt or refinancing your mortgage. Take advantage of these low-interest options. Even a small percentage cut of your interest can lead to massive savings and reductions in your monthly debt payments.

3. Automate bill payments

4. Build an emergency fund

Life can be unpredictable. Economic conditions can change overnight. For that reason, you need to keep money on a rainy day. Your emergency fund should have enough cash to cover 6 to 12 months of essential expenses. Start with setting up a certain percentage of your wage automatically going to your savings account. Your rainy-day cash will hold you up if you lose your job or your ability to earn income. By maintaining an emergency fund, you could avoid taking debt and cover temporary gaps in your budget.

5. Monitor your credit score

6. Budget

Do you find yourself spending more than you earn? Would you like to save more for your financial goals? If you are struggling to meet your milestones, 2022 will give you a chance to reshape your future. Budgeting should be your top New Year Financial Resolutions for 2022. Many mobile apps and online tools alongside old fashion pen-and -aper to track and monitor your expenses. Effective budgeting will help you understand your spending habits and control impulse purchases.

7. Save more for retirement

One of your most important New Year Financial Resolutions for 2022 should be maximizing your retirement savings. I recommend saving at least 10% of your earnings every year. If you want to be more aggressive, you can set aside 20% or 25%. A lot depends on your overall income and spending lifestyle.

In 2022, you can contribute up to $20,500 in your 401k. If you are 50 and older, you can set an additional $6,500. Furthermore, you can add another $6,000 to your Roth IRA or Traditional IRA.

8. Plan your taxes

9. Review your investments

When was the last time you reviewed your investments? Have you recently checked your 401k plan? You will be shocked to know how many people keep their retirement savings in cash and low-interest earning mutual funds. Sadly, sitting in cash is a losing strategy as inflation reduces your purchasing power. A dollar today is not equal to a dollar 10 years from now. While investing is risky, it will help you grow your wealth and protect you from inflation. Remember that time and time again; long-term investors get rewarded for their patience and persistence.

10. Protect your family finances from unexpected events

The last two years taught us a big lesson. Life is unpredictable. Bad things can happen suddenly and unexpectedly. In 2022, take action to protect your family, your wealth, and yourself from abrupt events. Start with your estate plan. Make sure that you write your will and assign your beneficiaries, trustees, and health directives.

Lastly, you need to review your insurance coverage. Ensure that your life, disability, and other insurance will protect your family in times of emergency.

August 4, 2021November 7, 2022

5 smart 401k moves to make in 2021

5 smart 401k moves to make in 2021 to boost your retirement saving. Do you have a 401k? These five 401k moves will help you grow your retirement savings and ensure that you take full advantage of your 401k benefits.

After a very challenging 2020, 2021 allows you to take another look at your 401k, reassess your financial priorities and .revaluate your retirement strategy, Let’s make sure that your 401k works for you.

Retirement Calculator

What is a 401k plan?

401k plan is a workplace retirement plan that allows employees to build and grow their retirement savings. It is one of the most convenient and effective ways to save for retirement as both employees and employers can make retirement contributions. You can set up automatic deductions to your 401k account directly through your company payroll as an employee. You can choose the exact percentage of your salary that will go towards your retirement savings. In 2021, most 401k will provide you with multiple investment options in stocks, fixed-income mutual funds, and ETFs. Furthermore, most employers offer a 401k match up to a certain percentage. In most cases, you need to participate in the plan to receive the match.

1. Maximize your 401k contributions in 2021

The smart way to boost your retirement savings is to maximize your 401k contributions each year.

Did you know that in 2021, you can contribute up to $19,500 to your 401k plan? If you are 50 or over, you are eligible for an additional catch-up contribution of $6,500 in 2021. Traditional 401k contributions are tax-deductible and will lower your overall tax bill in the current tax year.

Many employers offer a 401k match, which is free money for you. The only way to receive it is to participate in the plan. If you cannot max out your dollar contributions, try to deduct the highest possible percentage so that you can capture the entire match from your employer. For example, if your company offers a 4% match on every dollar, at the very minimum, you should contribute 4% to get the full match.

How to reach $1 million in your 401k by age 65?

Do you want to have $1 million in your 401k by the time you retire? The secret recipe is to start early. For example, if you are 25 old today, you only need to set aside $387 per month for 40 years, assuming a 7% annual return. If you are 35, the saving rate goes up to $820 per month. If you have a late start, you need to save about $3,000 a month in your 50s to get to a million dollars at the age of 65.

401k Contributions by Age

Age	\|	Monthly Contribution	Yearly Contribution	Lifetime Contribution
25		$387	$4,644	$190,404
30		$560	$6,720	$241,920
35		$820	$9,840	$305,040
40		$1,220	$14,640	$380,640
45		$1,860	$22,320	$468,720
50		$3,000	$36,000	$576,000
55		$5,300	$63,600	$699,600

2. Review your investment options

When was the last time you reviewed the investment options inside your 401k plan? When is the last time you made any changes to your fund selection? With automatic contributions and investing, it is easy to get things on autopilot. But remember, this is d your retirement savings. Now is the best time to get a grip on your 401k investments.

Look at your fund performance over the last 1, 3, 5, and 10 years and make sure the fund returns are close or higher than their benchmark. Review the fund fees. Check if there have been new funds added to the lineup recently.

What is a Target Date Fund?

A target-date fund is an age-based retirement fund that automatically adjusts your stock and bond investments allocation as you approach retirement. Young investors have a higher allocation to equities which are considered more risky assets. In comparison, investors approaching retirement receive a bigger share in safer investments such as bonds. By design, plan participants should choose one target-date fund, set it, and forget until they retire. The fund will automatically change the asset allocation as you near your retirement age.

However, in a recent study, Vanguard concluded that nearly 33% percent of 401k plan participants misuse their target-date fund. A third of the people who own TDFs, combine them with another fund.

So if you own one or more target-date funds or combine them with other equity and bond funds, you need to take another look at your investment choices.

3. Change your asset allocation

Your ideal asset allocation depends on your age, investment horizon, risk tolerance, and specific individual circumstances.

4. Consider contributing to Roth 401k in 2021

Are you worried that you would pay higher taxes in the future? The Roth 401k allows you to make pretax contributions and avoid taxes on your future earnings. All Roth contributions are made after paying all federal and state income taxes now. The advantage is that all your prospective earnings will grow tax-free. If you keep your money until retirement or reaching the age of 59 ½, you will withdraw your gains tax-free. If you are a young professional or you believe that your tax rate will grow higher in the future, Roth 401k is an excellent alternative to your traditional tax-deferred 401k savings.

5. Rollover an old 401k plan

Do you have an old 401k plan stuck with your former employer? How often do you have a chance to review your balance? Unfortunately, many old 401k plans have become forgotten and ignored for many years.

It is a smart move to transfer an old 401k to a Rollover IRA.

The rollover is your chance to gain full control of your retirement savings. Furthermore, you will expand your investment options from the limited number of mutual funds to the entire universe of stocks, ETFs, and fund managers. Most importantly, you can manage your account according to your retirement goals.

October 6, 2020November 7, 2022

Benefits and drawbacks to buying Indexed Universal Life Insurance

Today, I am going off the beaten path for me and will discuss the pros and cons of buying Indexed Universal Life Insurance. As a fee-only advisor, I do not sell any insurance or commission-based products. However, on numerous occasions, I have received requests from clients to review their existing insurance coverage. I certainly do not know every IUL product out there. And I might be missing some of the nuances and differences between them. My observation is that IUL is not suitable for the average person due to its complexity and high cost. And yet, the IUL might be the right product for you if you can take advantage of the benefits that it offers.

Retirement Calculator

What is an Indexed Universal Life Insurance (IUL)?

Indexed Universal Life is a popular insurance product that promises protection coverage with stock market-like performance and a zero-downside risk. Like other universal life insurance, IUL offers a death benefit and a cash value. Your cash value account can earn interest based on the performance of a specific stock market index such as the S&P 500, Dow Jones Industrial Average, the Nasdaq 100, and Russell 2000.

IUL Illustration rate

IUL policies use an illustration rate for advertising and hypothetically projecting the policy values in their sales materials. The Illustration rate is the fixed rate derived from historical performance. Usually, the illustration rate ranges between 5% and 10%.

Is IUL right for me?

On the surface, Indexed Universal Life Insurance sounds like a great deal. You receive a stock market upside with zero risks for losses. Nevertheless, IUL comes with some severe caveats.

Let’s break down the main benefits and drawbacks of IUL.

Benefits of Indexed Universal Life Insurance

Tax-Deferred Accumulation

Index Universal Life Insurance allows you to grow your policy cash value and death benefit on a tax-deferred basis. Typically, you will not owe income taxes on the interest credited to your cash value and death benefit.

Tax-Free Distribution

Life Insurance, in general, is a lucrative tool for legacy planning. With IUL, your policy beneficiaries will receive the death benefit tax-free. As long as you maintain your insurance premiums and don’t take outsized loans, you can pass tax-free wealth to the next generation.

Access to a cash value

You can always withdraw your policy basis (original premiums paid) tax-free. In most cases, you can also access your cash value through tax-favorable policy loans or withdrawals. In case of emergency, you may borrow from your indexed universal life insurance policy. You can access your cash value without any penalty regardless of your age.

Supplemental Retirement Income

You can use the cash value from your policy as a source of supplemental retirement income. You can also use it to cover future medical expenses.

Limited downside risk

IUL offers protection against stock market volatility. An IUL delivers stock market-linked gains without the risks of losing principal due to the stock market declines. With the IUL’s principal-protection guarantee, your annual gains are locked in. Your principal cash value remains the same, even if the stock market goes down.

A guaranteed minimum rate

Many IUL policies come with a guaranteed minimum annual interest rate. This rate is a floor of how much you can earn every year. The guaranteed allows you to receive a certain percentage regardless of how the market performs. This floor rate depends on the specific insurance, and it could vary between 0% and 2%.

Drawbacks of Indexed Universal Life Insurance

IUL is complex

IUL is an extremely complex insurance product. There are many moving parts in your UIL policy, making it confusing and hard to understand. Most sales illustration packages portray an ideal scenario with non-guaranteed average market performance figures. In reality, between your annual premiums, cap rates, floors, fees, market returns, cash value accumulation, riders, and so on, it is tough to predict the outcome of your insurance benefits.

Upfront Commissions

The people who sell IUL are highly trained sales professionals who may not be qualified to provide fiduciary financial advice. The IUL comes with a hefty upfront commission, which is often buried in the fine print and gets subtracted from your first premium payment.

IUL has high fees

The policy fees will shock you and eat your lunch literally. I have personally seen charges in the neighborhood of 11% to 13% annually. These fees will always reduce the benefits of your annual premium and earned interest.

Limited earnings potential

IUL policies will typically limit your stock market returns and will exclude all dividends. Most IULs offer some combination of participation rate and capped rate in comparison to the illustration rate used in their marketing materials.

Participation Rate is the percentage of positive index movement credited to the policy. For example, if the S&P 500 increased 10% and the IUL has an annual participation rate of 50%, your policy would receive 5% interest on the anniversary date.

Cap Rate is the maximum rate that you can earn annually. The cap rate can vary significantly from policy to policy and from insurance provider to the next.

Why capped upside is an issue?

The problem with cap rates and participation rates is they limit your gains during, especially good years. Historically, the stock market returns are not linear and sequential, as the policy illustration rates suggest. In the 40 years between 1980 and 2019, the stock market earned an average of 11.27% per year. During this period, there were only eight years when the stock market had negative returns or 20% of that period. There were only seven years when the stock market posted returns between 0% and 10%. And there were 25 years when the stock market earned more than 10% per year. In 17 of those 25 periods, the stock market investors gained more than 20% or 42% of the time.

In other words, historically, the odds of outsized gains have been a lot higher than the odds of losses.

However, as humans, the pain of losing money is a lot stronger than the joy of gaining.

In effect, long-term IUL policyholders will give up the potential of earning these outsized profits to reduce their anxiety and stress of losing money.

Surrender charges

IULs have hefty surrender charges. If you change your mind in a couple of years and decide to cancel your policy, you may not be able to receive the full cash value. Before you get into a contract, please find out the surrender charges and when they expire.

Expensive Riders

Indexed Universal Life Insurance typically offers riders. The policy riders are contract add-ons that provide particular benefits in exchange for an additional fee. These provisions can include long-term care services, disability waivers, enhanced performance, children’s’ term insurance, no-lapse guarantee, and many more. The extra fee for each rider will reduce your cash value, similar to the regular policy fees. You need to assess each rider individually as the cumulative cost may outweigh your benefit and vice versa,

Cash value withdrawals reduce your death benefit

In most cases, you might be able to make a tax-free withdrawal from the cash value of your IUL policy. These withdrawals are often treated as loans. However, legacy-minded policyholders need to remember that withdrawing your cash value reduces your beneficiaries’ death benefit when you pass away.

Potential taxable income

There is still a chance to pay taxes on your IUL policy. If you let your policy lapse or decide to surrender it, the money you have withdrawn previously could be taxable. Withdrawals are treated as taxable when they exceed your original cost basis or paid premiums.

January 7, 2021November 8, 2022

New Year Financial Resolutions for 2021

New Year Financial Resolutions for 2021. Let’s kick off 2021 with a bang. It’s time to hit the refresh button. 2020 was very challenging. The covid pandemic brought enormous shifts to our daily lives. Social distancing. Working from home. Digital transformation. 5G. Many of these changes will stay with us permanently. It’s time to open a new chapter. Take control of your finances. Become financially independent

Here are your New Year Financial Resolutions for 2021

1. Set your financial goals

Your first New Year Financial Resolutions for 2021 is to set your financial goals. Know where you are going. Build milestones of success. Be in control of your journey. Setting and tracking your financial goals will help you make smart financial decisions in the future. It will help you define what is best for you in the long run.

2. Pay off debt

Americans owe $14.3 trillion in debt. The average household owes $145,000 in total debt, $6,270 in credit cards, and $17,553 in auto loans. These figures are insane. If you are struggling to pay off your debts, 2021 is your year to change your life. Check out my article How to Pay off your debt before retirement. With interest rates are record low today, you can look into consolidating debt or refinancing your mortgage. Take advantage of these low-interest options. Even a small percentage cut of your interest can lead to massive savings and reductions of your monthly debt payments.

3. Automate bill payments

4. Build an emergency fund

2020 taught us an important lesson. Life can be unpredictable. Economic conditions can change overnight. For that reason, you need to keep money on a rainy day. Your emergency fund should have enough cash to cover 6 to 12 months of essential expenses. Start with setting up a certain percentage of your wage that will automatically go to your savings account. Your rainy-day cash will hold you up if you lose your job or your ability to earn income. By maintaining an emergency fund, you could avoid taking debt and cover temporary gaps in your budget.

5. Monitor your credit score

6. Budget

Do you find yourself spending more than you earn? Would you like to save more for your financial goals? If you are struggling to meet your milestones, 2021 will give you a chance to reshape your future. Budgeting should be your top New Year Financial Resolutions for 2021. There are many mobile apps and online tools alongside old fashion pen-and -aper to track and monitor your expenses. Effective budgeting will help you understand your spending habits and control impulse purchases.

7. Save more for retirement

One of your most important New Year Financial Resolutions for 2021 should be maximizing your retirement savings. I recommend that you save at least 10% of your earnings every year. If you want to be more aggressive, you can set aside 20% or 25%. A lot depends on your overall income and spending lifestyle.

In 2021, you can contribute up to $19,500 in your 401k. If you are 50 and older, you can set an additional $6,500. Furthermore, you can add another $6,000 to your Roth IRA or Traditional IRA.

8. Plan your taxes

9. Review your investments

10. Protect your family finances from unexpected events

2020 taught us a big lesson. Life is unpredictable. Bad things can happen suddenly and unexpectedly. In 2021, take action to protect your family, your wealth, and yourself from abrupt events. Start with your estate plan. Make sure that you write your will and assign your beneficiaries, trustees, and health directives.

Laslly, you need to review your insurance coverage. Ensure that your life, disability, and other insurance will protect your family in times of emergency.

March 12, 2018November 8, 2022

The Benefits of using an Outsourced Chief Investment Officer

In today’s insights, we will discuss some of the key benefits of using an Outsourced Chief Investment Officer. Outsourced Chief Investment Officer (OCIO) is a growing service, where financial advisors, family offices, endowments, pension funds and other institutions seek an outside firm for help to manage their core assets. Employing an OCIO can be an essential step in improving the efficiency of the investment decision-making process by employing the resources and the expertise of an outside firm.

In fact, the 2016 NACUBO – Commonfund study of endowments revealed that 43 percent of the respondents had substantially outsourced their investment management function, up significantly from 2010’s report of 34 percent. Eighty-four percent of the study participants reported using a consultant for various services related to investment management

Managing growth

One of the most common reasons why clients seek our services is to manage their growing asset base. While fast growth is a good problem, it brings more responsibilities and higher investment and operational risk. For instance, one of our key clients increased their asset base 400% within 12 months. In that short period, we created an infrastructure to integrate new incoming accounts into the existing portfolio structure. While at the same time we worked on eliminating operational deficiencies and establishing an investment committee.

Asset complexity and customization

Organizations have unique investment goals and appetite for risk. We regularly observe customer portfolios with significant investment concentration and need for diversification. Additionally, we see that many organizations have specific tax or liquidity constraints that can hinder their investment decisions. There is also a growing need for socially responsible and faith-based investing. An outside CIOs can help clients efficiently navigate through the ever-growing complexity of customized investments and financial decisions.

Asset Liability management

As of December 31, 2017, the average endowment surveyed by NACUBO-Commondund Study has generated a 10-year return of +4.6%. This return is substantially lower than their long-term target rate of 7% which is necessary to support spending and operational cost. For a $10m foundation, this gap could result in a $3.9m asset shortfall in just 10 years and over $14m shortfall in 20-years.

Real-time oversight

Investment portfolios need real-time management. Financial markets are risky and often move very fast. Our customers know that their complex portfolios require continuous supervision from experts who can monitor investment risks and take advantage of tactical opportunities.

Performance pressure

The rise of ETFs and low-cost index investing created enormous pressure on organizations to improve their returns. Our team of experts can establish a dynamic process for evaluating external managers and passive investment strategies. We are a firm believer of risk-adjusted performance. Therefore we continuously scan the investment universe for managers with an outstanding history of achieving risk-adjusted returns and recommend them to our clients.

Risk management

Identifying and understanding the risks in our clients’ portfolios is a critical element in our investment management process. A robust risk and trading system can make a huge difference in a volatile market environment. As OCIO, we can implement ongoing risk management using daily monitoring, hedge strategies, portfolio stress testing, and risk modeling.

Free up internal resources

Our clients often rely on an investment committee and small internal staff to operate and manage their assets. Hiring a full-time portfolio manager can be a lengthy, challenging and often costly process. By engaging an external CIO, our clients can free up their already stretched internal resources and focus on their core services in a cost-effective way.

Accelerated investment process

In a dynamic market environment, many of our clients benefit massively from an accelerated investment process. Our OCIO service helps our clients make faster strategic and tactical investment decisions. We also assist in the timely implementation of portfolio infrastructure and operational tasks.

Fiduciary advice

Our clients highly appreciate the value of fiduciary advice aligned with their specific goals, needs, and objectives. As a fiduciary OCIO, we must provide advice, investment management and guidance in our clients’ best interest.

Open architecture

An outsourced CIO can implement an open architecture investment portfolio to allow for expanded investment options in all asset classes and categories. The open structure can lower cost and provide diversification. With our ongoing investment due-diligence process, our customers can choose from a broad pool of investment options including index funds, factor-based ETFs, and top-ranked portfolio managers.

Cost control

As OCIO, we can help clients reduce their overall investment management and administration cost. We often see clients locked-in expensive investment management agreements or using high-cost mutual funds and fee-loaded strategies with lackluster performance. Our fiduciary client commitment allows us to evaluate a wide range of investment strategies and recommend those with the lower cost and higher risk-adjusted return.

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

November 7, 2016May 23, 2020

MLP Investing – Risks and benefits

MLP investing is popular among retirees and income-seeking investors. In this article, we will break down the benefits, risks and tax implications of investing in MLPs.

What is an MLP?

Managed Limited Partnerships (MLPs) have grown in popularity in the past several years. Many U.S. energy firms have reorganized their slow-growing, but stable cash flow businesses, such as pipelines and storage terminals, into MLPs.

MLPs are very attractive to income-seeking investors. They must pass at least 90% of their income to their partners (investors). As a whole, the MLP sector offers on average 6% annual yield with some MLPs reaching over 15%.

Companies that operate as MLPs tend to be in very stable, slow-growing industries, such as pipelines and energy storage. The nature of their business offers few opportunities for price appreciation. On the other hand, cash distributions are relatively stable and predictable giving the MLPs features of both an equity and fixed income investment.

The number of public MLPs increased dramatically in the past 20 years. There were more than 18 IPOs in 2014 from almost zero in 1984.

MLP Legal structure

There are two types of MLP owners – general and limited partners. General partners manage the day-to-day operations of the partnership. All other investors are limited partners and have no involvement in the company’s activities. MLPs technically have no employees.

MLP investors buy units of the partnership. Unlike shareholders of a corporation, they are known as “unitholders.”

Each unitholder is responsible for paying their share of the partnership’s income taxes. Unitholders are required to file K-1 forms in each state where the MLP operates, regardless of the size of revenue generated from that state. This filing requirement makes the direct MLP ownership.

Additionally, open-end funds like traditional ETFs are restricted from investing more than 25% of their portfolio in MLPs. Therefore most ETFs choose a C-corporation or ETN structure in order to track the MLP market.

Distributions

MLPs provide generous income to their investors. The average yield is around 6% as some small MLPs pay up to 15%. The distributions from MLP consist of non-qualified dividends, return on capital, and capital gains.

Since MLPs pass through 90% of their income to unitholders, each type of distribution has different tax treatment.

Dividends are taxed at the ordinary income tax level, up to 39.6% plus 3.8% for Medicare surcharge.

Capital gains are taxable as either long-term or short-term. Long-term capital gains have favorable tax treatment with rates between 0, 15% and 20%. Short-term gains are taxed at the ordinary income level.

The largest portion of MLP distributions comes as a return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income. Return on capital distributions are tax deferred. Instead of being immediately taxable, distributions decrease the cost basis of the investment. Taxes are only due to these distributions when investors sell their units. In fact, investors can defer paying taxes indefinitely by keeping their shares.

Tax Impact

MLP distributions are not sheltered from taxes in retirement accounts. According to the Unrelated business taxable income (UBTI) rule, unitholders will owe taxes on partnership income over $1,000 even if the units are held in a retirement account.

Individual MLP holdings, ETFs, mutual funds and CEFs are most suitable for long-term buy and hold investors in their taxable investment accounts. Those investors can benefit from the tax-deferred nature of the cost of capital distributions, which will decrease their cost basis over time. They will pay taxes only when they sell their units. Investors can avoid paying taxes indefinitely or until cost basis reaches zero. In that case, they will owe taxes on the return of capital distributions at the long-term capital gain rate.

Short-term investors may consider ETNs for their better index tracking. All distributions from ETNs are taxable as an ordinary income level and do not provide any preferential tax treatment.

Risk considerations with MLP Investing

MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices compared to other oil & gas companies. Historically, MLPs as a group is less volatile than the broader energy sector. MLP price tends to have a direct correlation with the partnership distributions. Higher payouts drive higher prices while lowers distributions push the price down.

Between September 2010 and October 2016, the largest MLP ETF, AMLP had a standard deviation equal to 14.8%. As a comparison, the largest energy ETF, XLE, had a standard deviation of 19.61%.

MLPs are often treated as an alternative investment due to their considerable ownership of real assets. They also have a lower correlation with the broad equity and fixed income markets while simultaneously having characteristics of both. AMLP has 0.57 correlation with S&P 500 and -0.16 to the 20-year treasury.

MLP Investing options

Direct ownership

As of March 31, 2016, 118 energy MLPs were totaling $304 billion in market capitalization.

The most popular index tracking the MLP space is Alerian MLP. The index has 44 constituents and $298 billion market capitalization.

There are ten companies dominating the sector. They make up close to two-thirds of the Alerian MLP Index. The remainder consists of hundreds of small and mid-size partnerships.

Direct MLP ownership is a popular strategy for yield-seeking investors. The direct investing also provides the most beneficial tax treatment of MLP distributions – tax deferral.

However, the biggest drawbacks of direct investing are the large tax filing cost and exposure to a single company.

Investors interested in direct ownership in MLPs should consider buying a basket of partnerships to diversify their risk more efficiently. They should also weight the tax benefits of direct ownership versus the cost of year-end tax filing.

ETFs and ETNs

MLP ETFs and ETNs have the most complex legal and tax structure of any other ETFs. Due to these complexities, most funds are structured as ETNs.

There are 28 MLP ETFs and ETNs currently listed on the exchange. Their total Asset Under Management (AUM) is $17.7 billion with the top 4 ETFs dominating the space with total AUM equal to $15.9 billion.

AMLP

AMLP is the most popular and liquid MLP ETF. It tracks the Alerian MLP index. AMLP is the first ETF to address the complexity of direct MLP ownership. This ETF offers a broad diversification to the largest publicly traded MLPs.

AMLP offers simplified tax filing by issuing standard 1099 form. Because of its legal structure, AMLP can pass the tax-deferred treatment of MLP distributions to its investors.

To satisfy the legal restrictions on ownership, AMLP is structured as a corporation, not an actual ETF. AMLP pays taxes at the corporate level. The structure requires the fund to accrue the future tax liabilities of unrealized gains in its portfolio. Doing this is causing the fund to trail its underlying Alerian Index during bull markets and beat it during down periods.

AMJ

AMJ is the next most popular fund in this category. It is structured as an exchange-traded note.

ETNs are an unsecured debt instrument structured to track an underlying index’s return, minus management fees. Unlike exchange-traded funds, ETNs do not buy and hold any the underlying assets in the indexes they track. They represent a promise by the issuing bank to match the performance of the index.

AMJ is issued by JP Morgan and capped at the market value of $3.885 billion. Investors in AMJ have credit exposure to JP Morgan in case they are not able to pay the performance of the index.

Due to the lack of actual MLP ownership, AMJ can replicate the performance of the Alerian MLP index much closer than AMLP.

AMJ also issues single 1099 tax form. However, all its distributions are taxable as ordinary income, for up to 39.6% plus 3.8% of Medicare surcharge. AMJ distributions do not have the preferential tax treatment of AMLP and individual MLP ownership.

This ETF is suitable for short term investors willing to bet on the MLP sector and not interested in any potential income and tax benefits.

EMLP

EMLP is the only traditional ETF in this group. Because of the regulatory restrictions, EMLP holds only 25% stake in MLPs and the remaining 32% in Energy, 40% in Utilities and 2% in Basic Materials. Unlike the other funds, EMLP has a broader exposure to companies in the energy infrastructure sector. According to the prospectus, the fund invests in publicly traded master limited partnerships and limited liability Canadian income trusts,, pipeline companies, utilities, and other companies that derive at least 50% of their revenues from operating or providing services in support of infrastructure assets such as pipelines, power transmission and petroleum and natural gas storage in the petroleum, natural gas and power generation industries.

Mutual Funds

The three Oppenheimer mutual funds are dominating this niche. They manage almost 50% of the $20b AUM by MLP mutual funds.

The MLP mutual funds tend to have higher fees than most ETFs. They utilize the corporate structure which allows them to transfer the majority of the income and tax advantages to their shareholders.

Closed-End Funds

Closed-End funds (CEF) are another alternative for investing in the MLP sector. Similarly to mutual funds, CEFs are actively managed. The difference is that they only issue a limited number of publicly traded shares.

Most MLP closed-end funds use leverage between 24% to 40% to boost their income. These funds borrow money in order to increase their investments.

CEFs shares often trade at premium or discount from the NAV of their holdings. When purchased at a discount they can offer potential long-term gains to interested investors.

MLP CEFs also use the c-corp structure. They issue a 1099 form and pass current income and return on capital to their investors allowing for tax-deferral benefits on the distributions.

October 28, 2016May 16, 2020

Investing in Small Cap Stocks

Small cap stocks are an important part of a diversified investment portfolio. They had provided high historical return and diversification, which are key factors in the portfolio management process.

Many flagship companies started as small businesses in a local market and evolved to large multinational corporations. Some of these success stories include McDonalds, which opened its first restaurant in Des Plaines, Illinois to become one of the biggest food chains in the world.

Research has shown that small-cap stocks overperformed a large cap over an extended period.

The below chart shows 15-year performance between IWM, Russell 2000 Small Cap ETF and SPY, S&P 500 Large Cap ETF. For that period IWM surged by 164% while SPY rose by 67%.

Once we include dividends, the 15-year annualized return of a small cap blend strategy becomes 8.66% versus 6.71% for a large cap strategy.

If we extend our period to 40 years (1975 – 2015), the small cap generated 14.25% annualized return while large cap produced 11.66%.

Investing in small companies comes with many caveats. Even though they bring potentially high returns, they also impose high risk and uncertainty.

Small cap stocks market capitalization

Small cap companies have a market capitalization between $300 million and $2 billion dollars. Overall, the small size market is very fragmented. There are thousands of publicly traded small-size companies, but they only make 10-15% of the total market. The definition of a small-cap company varies widely among index providers and portfolio managers. Standard & Poor’s tracks their own S&P 600 Small Cap Index while FTSE Russell tracks the Russell 2000 Small Cap Index.

Very often, small companies are managed by their original founders. They are usually new and innovative companies with competitive strengths in a particular local market or a specific product. It is not uncommon for companies to go back and forth between small, mid and large-cap rankings depending on their business cycle.

Niche market

Small cap companies often operate in a niche market where they have a distinct competitive advantage. Small businesses have a unique product or service, which they offer on either national or local level. Unlike their bigger counterparts, which offer a variety of products in different geographies, small size companies tend to be more focused, with one or two flagship products. A particular example can be Coca Cola versus Red Bull. Coca-Cola offers hundreds of varieties of beverages worldwide while Red Bull offers only one type of energy drink.

Regularly small companies will start from a local market and grow nationwide. Starbucks is a great example of a local coffee shop that moved up the ranks and became one of the top 100 large company in the USA and the world.

Small businesses with a unique product will often become an acquisition target for a larger corporation that wants to gain a presence in a growing higher margin market. Great example for that is PepsiCo acquiring Gatorade. PepsiCo wanted to get access to the fast growing market of sports drinks and instead of developing their own line; they decided to purchase an already established brand.

Growth potential

Small cap companies often have higher revenue growth than large size ones. Their competitive advantages, innovative strategy, flexibility and market positioning allows them to grow faster. It is easier to increase 25% when you start at $10 million of revenue versus $25% at $ 1 billion of revenue. Many times small companies do not even have a competition in their market niche. Think of Facebook before they went public. It is common for small firms to grow their revenue between 25% and 50% annually for several consecutive years.

Volatile prices

Investing in small cap stocks is risky. The high potential return of small caps comes with greater risk. The share price of small companies is more volatile and subject to larger swings than those of bigger companies.

IWM, the biggest small-cap ETF, has a beta of 1.22 to the equity market. As the comparison, the beta of SPY, the most traded large-cap ETF, is equal to 1. Beta measures the volatility of a security compared to the market as a whole. IWM beta of 1.22 shows that the ETF is historically 22% more volatile than the overall market.

Another measure of volatility is a standard deviation. It illustrates how spread out are the historical returns compared to the average annualized return of the investments. In our case, the 15-year standard deviation of IWM is 19.73% versus 14.14% for SPY.

As I mentioned earlier, the average 15-year return for a small cap stock is 8.66%. With a standard deviation equal to 19.73%, an average annual return can go between -11.07% and 28.39%. For SPY the average range is between -7.43% and +20.85% with annualized return of 5.25%. Based on this historical data we can claim that the small cap market has a much wider probability of returns. The high upside comes with a bigger downside.

Limited access

Small cap stocks lack the liquidity and trading volume of the large public corporations. This makes them more vulnerable to large price swings in short periods.

In times of economic recession, small companies can take a bigger hit in their earnings and may take a longer time to recover. Ten or fifteen percent decline in revenues can have a much more adverse impact on a small company than a larger one.

Due to their limited access to equity markets and loan financing, small size companies have a higher risk to go into bankruptcy if they run out of money.

Many small firms are start-ups with one innovative product and untested business models. Their dependency on just one product or service puts them in a very high-risk category in cases when the product or service does not appeal to their target customer base.

Inefficient market

Traders and portfolio managers often ignore small-cap companies. The focus is usually on large size companies, which frequently have 5 to 10 analysts following their earnings. In fact, research analysts cover very few of the 2,000 stocks in the Russell 2000 index. Therefore, it is common that a small company does not have a full coverage by any industry analysts. This lack of interest and publicity produces conditions for inefficient pricing. Active investors with a focus on the small cap market can scan the universe for undervalued and mispriced stocks and generate higher returns based on their valuation techniques and knowledge of the market.

Diversification

Investing in small cap companies can significantly contribute to the diversification of your portfolio. Even though small stocks have a higher risk than larger ones, their correlation to the overall market is lower. A small blend strategy has 0.86 correlation to the overall US stock market and 0.56 to the broader international stock market.

A correlation equal to 1 shows the highest strength of the relationship between two asset categories. In the case of small cap, the correlation of 0.86 shows a weaker link with the overall market. Small cap prices does not fluctuate in the same magnitude and pace as the large cap companies. While there is some influence by S&P 500, they follow an independent path.

How to invest in small cap stocks

Individual stocks

You can invest in small size companies by buying them directly on the open market. There are over 2,000 listed small size companies in various industries and stages of their business cycle. Naturally, you cannot invest in all 2,000 stocks. You have to find a way to narrow down your criteria and select stocks based on certain factors. Very few small companies have analyst coverage. Therefore investing in small caps stocks will require doing your own research, analysis, and valuation.

When you invest in any company directly, being that a small or large size, you have to keep in mind that concentrated positions can adversely affect your portfolio performance if that company has a bad year or goes bankrupt. While everyone’s risk sensitivity is different, I would recommend limiting the range of each individual stock investment to 1% – 2% of your portfolio.

Tax Impact

For the best tax impact, I recommend putting small cap stocks either in taxable or Roth IRA accounts. Small cap companies have higher expected return combined with a higher expected volatility. If you hold your stocks in a taxable account, you can take advantage of tax loss harvesting opportunities if a particular stock in your portfolio is trading at lower levels than original purchase price. Tax loss harvesting is not available in Roth IRA, Traditional IRA, and 401k accounts. I

If you have small-cap stocks with solid long-term return prospects, keeping them in a taxable account will also allow you to pay the favorable long-term capital gain tax when you decide to sell them.

Having stocks in a Roth IRA account will have even better tax treatment – zero tax at the time of sale.

Passive indexing

ETFs and index mutual funds are the top choice for passive small cap investing. They provide a low-cost alternative for investors seeking a broader exposure to the small cap market. Small cap ETFs come in different shapes and forms. The table below shows a list of the most traded small cap ETFs with AUM above $500 million:

List of Small Cap ETFs

TICKER	FUND NAME	EXPENSE RATIO	AUM	SPREAD %	1 YEAR	5 YEAR	10 YEAR	SEGMENT	AS OF
IWM	iShares Russell 2000 ETF	0.20%	$27.79B	0.01%	5.69%	12.28%	6.01%	Equity: U.S. – Small Cap	10/26/2016
IJR	iShares Core S&P Small Cap ETF	0.07%	$20.83B	0.03%	7.35%	14.16%	7.56%	Equity: U.S. – Small Cap	10/26/2016
VB	Vanguard Small-Cap Index Fund	0.08%	$13.94B	0.03%	5.59%	13.14%	7.40%	Equity: U.S. – Small Cap	10/26/2016
VBR	Vanguard Small Cap Value Index Fund	0.08%	$8.16B	0.04%	7.31%	14.20%	6.77%	Equity: U.S. – Small Cap Value	10/26/2016
IWN	iShares Russell 2000 Value ETF	0.25%	$6.72B	0.01%	9.39%	12.17%	4.82%	Equity: U.S. – Small Cap Value	10/26/2016
IWO	iShares Russell 2000 Growth ETF	0.25%	$6.35B	0.02%	1.92%	12.31%	7.01%	Equity: U.S. – Small Cap Growth	10/26/2016
VBK	Vanguard Small-Cap Growth Index Fund	0.08%	$4.93B	0.04%	3.50%	11.36%	7.25%	Equity: U.S. – Small Cap Growth	10/26/2016
IJS	iShares S&P Small-Cap 600 Value ETF	0.25%	$3.85B	0.03%	10.26%	14.31%	6.57%	Equity: U.S. – Small Cap Value	10/26/2016
SCHA	Schwab U.S. Small-Cap ETF	0.06%	$3.78B	0.04%	5.46%	13.03%		Equity: U.S. – Small Cap	10/26/2016
IJT	iShares S&P Small-Cap 600 Growth ETF	0.25%	$3.47B	0.08%	4.41%	13.74%	8.42%	Equity: U.S. – Small Cap Growth	10/26/2016
DES	WisdomTree SmallCap Dividend Fund	0.38%	$1.59B	0.12%	11.96%	14.36%	6.35%	Equity: U.S. – Small Cap	10/26/2016
FNDA	Schwab Fundamental US Small Co. Index ETF	0.32%	$1.04B	0.06%	6.38%			Equity: U.S. – Small Cap	10/26/2016
SLYG	SPDR S&P 600 Small Cap Growth ETF	0.15%	$807.64M	0.27%	4.61%	13.74%	9.00%	Equity: U.S. – Small Cap Growth	10/26/2016
VTWO	Vanguard Russell 2000 Index Fund	0.15%	$675.74M	0.06%	5.67%	12.19%		Equity: U.S. – Small Cap	10/26/2016
XSLV	PowerShares S&P SmallCap Low Volatility Portfolio	0.25%	$651.46M	0.09%	12.43%			Equity: U.S. – Small Cap	10/26/2016
SLYV	SPDR S&P 600 Small Cap Value ETF	0.15%	$610.42M	0.21%	10.46%	14.43%	7.38%	Equity: U.S. – Small Cap Value	10/26/2016
SLY	SPDR S&P 600 Small Cap ETF	0.15%	$512.80M	0.25%	7.10%	13.99%	8.19%	Equity: U.S. – Small Cap	10/26/2016

Benchmark

One of the main differences between small-cap ETFs is the index they track. Each of the three main Small Cap Indexes is constructed differently.

Russell 2000 (IWM) includes the bottom 2,000 of the largest 3,000 publicly traded companies. The average market cap of the constituents of Russell 2000 is equal to $1.9 billion. The median is 698 million. And the largest stock has a market cap of $6 billion.

S&P 600 Index (IJR) tracks a smaller subset of the market. It includes only 600 companies. As of April 2016, the market capitalization of companies included in the Index ranged from US$ 400 million to US$ 1.8 billion. S&P 600 also sets additional requirements for liquidity, public float, sector and financial viability.

CRSP SmallCap index (VB) tracks the 2%-15% percentile of the total market. It has 1,462 companies. The smallest company has a market capitalization of $21 million; the largest has $7.9 billion. The average size is $1.85 billion. The median is $1.44 billion. It is worth noting that VB tracked Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; CRSP US Small Cap Index thereafter

Focus

Another big difference between Small Cap ETFs is their segment focus. There are three main segments – small cap blend, growth, and value. The blend strategy invests in the wide universe of small caps, which mechanically tracks the designated index. The value strategy tracks a specific group of companies that have a certain level of Price to Earnings, Price to Sales, Price to Book, dividend yield, and other fundamental ratios. Growth strategy invests in a group of stocks that meet certain criteria for price, revenue and earnings growth.

Tax Impact

ETFs and index funds have more favorable tax treatment than actively traded mutual funds. Due to their passive nature and legal structure, these funds rarely release capital gains and losses to their shareholders. Therefore, investors looking to optimize taxes in their investment portfolio should consider these type of funds.

Active investing

This strategy includes investing in actively managed mutual funds. These funds are run by management teams. They normally charge higher fees than comparable ETF to cover for the trading, administrative, marketing and research expenses. Mutual funds follow a benchmark, which is usually one of the three main indices described earlier – S&P 600, Russell 2000 or CSRP Small Cap Index. Because of their higher fees than comparable ETFs, fund managers are often expected to outperform their benchmark.

Active funds normally focus in one of the three main segments – blend, growth or value. The fund managers utilize a formal selection process that identifies a number of companies, which meet certain proprietary criteria. The end goal is to select those companies that will achieve a higher return than the undying benchmark. Since the characteristics of value vs. growth strategy can be subjective, it is not an unusual that the same company is owned by both value and growth oriented funds.

In the past 7-8 years, many of the active managers have been criticized for underperforming the market. Part of the reason is that we experienced a very long market rally driven by a small number of flagship companies.

Tax Impact

Actively managed mutual funds have a more complex tax structure. They must transfer most of their dividends and capital gains and losses to their shareholders. Mutual funds will often have large amounts of long or short-term gains and losses released in December regardless how long you had kept in your portfolio, to avoid paying additional taxes I recommend placing your actively managed mutual funds in tax deferred and tax exempt accounts. Another alternative is to look for tax-managed funds. They tend to have a low turnover ratio and tend to report long-term gain and losses less frequently.

October 12, 2016November 20, 2020

7 Proven practices to handle your credit card debt

The average US family owes $15,675 in credit card debt. An increasing number of Americans, many of which millennials are facing the unbearable burden of owing money. Hence, I would like to share some ideas on how to handle your credit card debt better. Whether you have maxed out on credit cards or planning to take on credit card debt, you may find the following steps critical in becoming debt-free.

1. Know your credit score

As a first step, you need to understand your credit score, also known as FICO. The FICO score is a measure between 300 and 850 points. Higher scores indicate lower credit risk. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, provides an individual FICO score. All three companies have a proprietary database, methodology, and scoring system. Many times you may find small or even substantial differences in your credit score issued by those agencies.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a general rule, your credit score depends mainly on the actual dollar amount of your debt, the debt to credit ratio, and your payment history. Being late on or missing your credit card payments, maximizing your credit limits, and applying for too many cards at once will hurt your credit score.

The good news is that you can get your score for free from each of the three agencies once a year. Additionally, many credit cards include the value of your credit score for free.

Keep in mind that the FICO score provided by your credit card will come from one of these three agencies. So if you have a second credit card from a different bank that also offers a free FICO score, it might be using a different agency, and the score most likely will be different.

2. Know the interest on your credit card

When you apply for a credit card, you should always verify the interest rate if you don’t pay off your dues at the end of the month. This interest rate can also change over time, and your credit card provider is required to notify you. However, the chance of you not paying attention to the mail notification is pretty high. If you are not sure, call your bank and verify it with them.

3, Know the due dates on your credit card

Make sure you know when your credit card monthly payments are due. Forgetting to pay the monthly minimum on time can cause you a lot of grief, high penalties, and a significant amount of time on the phone with your credit card provider. Most reputable banks will waive the penalty if this is your first late payment. However, doing it more than once will raise a big red flag in your relationship with them. At a very minimum, you can set up an automatic payment for the minimum amount due each month.

4. Set-up a budget

Before taking any further steps in managing your credit card debt, you need to have a balanced budget. To begin, make sure you know all your monthly income and paydays. List all your expenses in broad categories. If you spend more than you earn, you may have to decrease your discretionary costs until you balance out your budget. As a rule of thumb, try to leave 10-15% of your income aside for emergencies and unexpected expenses.

5. Open a savings account

In your pursuit of financial independence, one crucial step is opening a savings account. Most major banks will give you an extremely low, close to 0% saving rate. However, some of the online lenders like Discover Bank, Capital One, Ally Bank, and Synchrony Bank offer rates around 1%. Bankrate.com is an excellent source of various savings account options.

6. Consolidate your credit card debt

Consolidating credit card debt is most effective when it’s a part of your bigger financial strategy.

If you decide to continue on that route, pay very close attention to the fine print in your card offers. A lot of times, the small print will contain critical information about interest rates, promotional periods, credit limits, due dates, and penalties. Some banks offer credit cards with a promotional 0% rate for a specified period. Other banks will try to entice you with cashback or other rewards programs.

If you decide to transfer your debt, be aware that banks often charge upfront 3% to 5% fee on the transfer amount. In that case, you will have to do the math to see if it’s worth making the switch.

Also, keep in mind that opening too many credit cards can abruptly impact your credit score. The general rule is opening one credit card per 3 months.

Once you pay off a credit card, put it aside. Lock it away and keep it open. Closing a credit card lowers the amount of available credit and decreases your credit score.

7. Look for alternatives

Two of the main alternative options are taking a personal loan from local credit unions and a home equity line of credit if you own a house. A lot of times, local credit unions and banks can give you a much lower rate and will work with you to pay off your debt.

Conclusion

Having a solid plan where you monitor your monthly income and expenses is the best path to financial independence and debt free life. Be responsible with your finances and stay on top of your credit cards and loans. Many times you can do it on your own or ask a friend or a family member for help.

September 7, 2016November 8, 2022

4 Steps to determine your target asset allocation

One of the financial advisors’ primary responsibilities is to determine and document their clients’ target asset allocation. The target allocation serves as a starting point and guideline in diversifying the client portfolio and building future wealth. Clients’ unique financial goals, lifestyle, investment horizon, current and expected income, and emotional tolerance to market turbulence will impact their future asset allocation.

The target investment mix is not constant. It can shift from more aggressive to more conservative or vice versa with substantial changes in lifestyle, family status, personal wealth, employment, and age.

Assess your risk tolerance

Most advisors use questionnaires to evaluate their client’s risk tolerance. The length of these surveys varies from advisor to advisor. Furthermore, some assessments are available online for free. The idea behind all of them is to determine the investor’s tolerance to market volatility, and unpredictable macroeconomic and life events.

Individuals with high-risk tolerance have the emotional capacity to take on more risk. They can endure significant market swings in order to achieve a higher future return.

On the opposite side, investors with low-risk tolerance are willing to sacrifice higher returns for safer, low volatility assets which will have smaller swings during turbulent markets.

A free risk tolerance test is available here:

https://www.calcxml.com/calculators/inv01?skn=#top

Regardless of which test you take, if you answer all questions consistently, you should expect to get similar results.

Advisors, of course, should not rely solely on test results. They need to know and understand their clients. Advisors must have a holistic view of all aspects of client’s life and investment portfolio.

Set your financial goals

Your financial goals are another critical input to determine your target investment mix. Your goals can stretch anywhere from a couple of months to several decades. They can be anything from paying off your debt, buying a house, planning for a college fund, saving for a wedding, a trip or retirement, making a large charitable donation, and so on.

Each one of your goals will require a different amount of money for completion.

Having your goals in place will define how much money you need to save in order to reach them. The range of your goals versus your current wealth and saving habits will determine your target asset allocation.

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

Sometimes, investors can have a conflict between their financial goals and risk tolerance. An investor may have low to moderate risk tolerance but very aggressive financial goals. Such conflict will ultimately require certain sacrifices – either revising down the investor’s financial goals or adjusting his or her willingness to take on more risk.

Define your investment horizon

Your investment horizon and the time remaining to your next milestone will significantly impact your investment mix.

529 college fund plan is an excellent example of how the investment horizon changes the future asset mix. Traditional 529 plans offer age-based investment allocation. The fund is initially invested in a higher percentage of equity securities. This original investment relies on the equities’ higher expected return, which can potentially bring higher growth to the portfolio. Over time, as the primary beneficiary (the future student), approaches the first year in college, the money in the 529 plan will gradually be re-allocated to a broadly diversified portfolio with a large allocation to fixed income investments. The new target mix can provide more safety and predictable returns as the completion of the goal approaches.

The same example can apply for retirement and home purchase savings or any other time-sensitive goal. The further away in time is your goal; the stronger will be your ability to take on more risk. You will also have enough time to recover your losses in case of market turmoil. In that case, your portfolio will focus on capital growth.

As the completion time of your goal approaches, your affinity to risk will decrease substantially. You also won’t have enough time to recover your losses if the market goes down considerably. In this situation, you will need a broadly diversified portfolio with refocusing on capital preservation.

Know your tax bracket

The investors’ tax bracket is sometimes a secondary but often crucial factor in determining asset allocation. The US Federal tax rate ranges from 10% to 39.6% depending on income level and filing status. In addition to Federal taxes, individuals may have to pay state and city taxes.

Investors can aim to build a tax-efficient asset allocation. They can take advantage of the preferential tax treatment of different financial securities among various investment account types – taxable, tax-deferred, and tax-exempt accounts.

For instance, they may want to allocate tax-efficient investments like Municipal bonds, MLPs, ETFs and Index funds to taxable accounts and higher tax bearing investments like Gold, Bonds, and REITs into tax-advantaged accounts.

In any case, investors should attempt to achieve the highest possible return on an after-tax basis. Building a tax-efficient investment portfolio can add up to 1% or more in performance over an extended period.

August 24, 2016November 20, 2020

A Guide to Investing in REITs

On August 31, 2016, S&P 500 will introduce a new sector – Real Estate. Up until now real estate companies, also known as REITs, belonged to the Financial sector. They were in the company of large financial and insurance corporations. The new category will have 27 stocks, $567 billion of market capitalization and an approximate weight of 3% of the total S&P 500 market value.

With the addition of Real Estate as a separate sector in S&P indices, many active managers will have to aline their current portfolios with the new sector structure.

What is a REIT?

A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts.

REITs invest in all the main property types with approximately two-thirds of the properties in offices, apartments, shopping centers, regional malls, and industrial facilities. The remaining one-third is divided among hotels, self-storage facilities, health-care properties, prisons, theaters, golf courses and timber.

The total market capitalization of all publicly-traded REITs is equal to $993 billion. The majority of it, $933 billion belongs to Equity REITs and the remainder to Mortgage and other financing REITs.

There are 219 REITs in the FTSE NAREIT All REITs Index. 193 of them trade on the New York Stock Exchange

Legal Status

REITs are subject to several regulations. To qualify as a REIT, a real estate firm must pay out 90% of its taxable income to shareholders as dividends. The REIT can deduct the dividends paid to shareholders from its taxable income. Thus their income is exempt from corporate-level taxation and passes directly to investors. Other important regulations include:

Asset requirements: at least 75% of assets must be real estate, cash, and government securities.
Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.
Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders. Five or fewer individuals cannot (directly or indirectly) own more than 50% of the value of the REIT’s stock during the last half of the REIT’s taxable year.

Distributions

Dividend distributions for tax purposes are allocated to ordinary income, capital gains, and return on capital, each of them having different tax treatment. REITs must provide shareholders with guidance on how to treat their dividends for tax purposes. The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.

REITs distributions have grown substantially in the past 15 years. The total REIT distributions in 2000 were under $8 billion dollar. Just between 2012 and 2015, REITs distribution rose up from $28.8 billion to $44.9 billion, or 44%.

Tax implicationsThe majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6 percent, plus a separate 3.8 percent Medicare surtax on investment income.

Capital gains distributions are taxable at either 0, 15 or 20 percent tax rate, plus the 3.8 percent surtax.

Return-on-capital distributions are tax-deferred. They reduce the cost basis of the REIT investment.

When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation, those distributions are taxed at the qualified dividend rate of 0, 15, or 20 percent, plus the 3.8 percent surtax.

Timber REITs

One REIT sector makes an exception from the above rule. Timber REITs have a favorable tax treatment from the IRS. Distributions from timber REITs such as RYN, PCL, PCN & WY are considered long-term capital gains and therefore are taxable at the lower capital gain rate (0, 15% or 20% plus 3.8% Medicare surcharge).

Economic Cycle

Individual REIT sectors have different sensitivity to cyclical factors. Industrial, hotel, and retail REITs have the biggest exposure to economics cycles. Their occupancy and rental rates are extremely sensitive to economic conditions. Cyclical downturns in the economy, recession, and weak consumer spending, can significantly hurt the revenue stream of these REITs.

On the other hand, health care REITs tend to have long-term rental agreements and are more sheltered from market volatility.

Interest Rates

Since many REITs use bank loans and other external financings to expand their business, they have benefitted significantly from the current low-interest-rate environment. Furthermore, many yield-seeking investors turned to REITs for higher income. If low-interest rates remain, REITs will likely expand their base to a broader range of market participants.

Interest rates can impact REIT’s performance differently depending on two main factors – debt and lease duration.

Loan maturities

As a result of the current low rates, many REITs have increased their leverage and therefore have high sensitivity to interest changes. If interest rates rise, REITs with near-term loan maturities will need to refinance at higher rates. Thus their interest payments will go up, which will lead to less cash available for dividends. Therefore, REITs with higher levels of debt and short-term maturities will perform worse than REITs with less debt and long-dated maturity schedules.

At the same time, REITs with lower debt levels relative to their cash flows, all else equal, will perform better in a rising-rate environment.

Lease duration

While higher interest rates would affect all REITs, industry subsectors would be affected differently, depending on lease durations. REITs with shorter lease durations will perform relatively better in a rising-rate environment because they can seek higher rents from tenants as rates rise than could REITs with longer lease durations. The higher rents can offset the negative impact of higher interest expense. Hotel REITs usually have the shortest lease durations, followed by multifamily properties and self-storage.

Healthcare, office, and retail REITs usually sign long-term leases. Therefore rising interest rates will potentially hurt these REITs due to their inability to adjust rental contracts to offset rising costs.

Risk and return

Real Estate Investment Trusts historically have been more volatile than S&P 500. The 40-year standard deviation of the REIT’s sector is 17.16% versus 16.62% for the S&P 500 and 10.07% for the 10-year Treasury. During this 40-year period, REITs achieved a 13.66% cumulative annual return versus 11.66% for S&P 500 and 7.39% for the 10-year Treasury. (www.portfoliovisualizer.com)

Furthermore, the 10-year (2006-15) standard deviation of the REIT sector is 22.01% versus 18.02% for the S&P 500 and 9.54% for 10-year Treasury. For the same period, REITs reported 7.83% cumulative annual return versus 6.96% for S&P 500 and 4.57% for 10-year Treasury. (www.portfoliovisualizer.com)

Among the best five-year REIT sector performers were Retail, Self-Storage, and Industrial. For the same period, worst performers were Mortgage, Hotel and Office RETS.

Valuations

With respect to pricing, REITs are reaching high valuations levels. The current Price to Fund to Operations ratio is hovering around 18, which is slightly above the historical average of 16. While the P/FFO ratio remain reasonable compared to historical figures, further price rally in REITs not supported by the increase in cash flows may impose a significant risk for sector overheating.

Diversification

Even though REITs are publicly traded companies, very often they are considered an alternative asset due to their weak relationship with the other asset classes – equities and fixed income. US REITs have a relatively low correlation with the broader stock market. The 40-year correlation is equal to 0.51, while the 10-year correlation is 0.73. The correlation between REITs and 10-year Treasury is equal to -0.06, while that with Gold is 0.09.

This low correlation with other asset classes makes the REITs a solid candidate for a broadly diversified investment portfolio.

Investing Strategies

Directly

There are 219 publicly-traded REITs. 27 of them are included in the S&P 500 index. If you decide to invest in a single REIT or basket of REITs, you need to consider company-specific risk, management, sub-sector, regional or national market exposure, leverage, lease duration, history, and distribution payments.

Real Estate ETFs

VNQ

VNQ dominates the REITs ETF space as the largest and second-cheapest ETF. It includes a broad basket of 150 securities. The ETF tracks the MSCI US REIT Index, which includes all domestic REITs from the MSCI US Investable Market 2500 Index. This ETF doesn’t include any mortgage, timber, and tower REITs. It has an expense ratio of 0.12% (second lowest to SCHH). It has $32.4 billion of assets under management and Morningstar rating of 4. The fund holds a diversified portfolio across all property sectors. Retail REITs are the largest holding, at 25% of assets, Specialized REITs make up 16.50%, office, 12.6% residential, 15.7%, healthcare, 12.3%, diversified, 8%, hotel and resort, 5.3%, and industrial, 4.7% REITs.

IYR

IYR tracks the Dow Jones U.S. Real Estate Index. It is the most diversified REIT ETF. Unlike other ETFs which hold only equity REITs, IYR holds mortgage, timber, prison and tower REITs including companies like American Tower, Weyerhaeuser Co, Annaly Capital Management NLY and Crown Castle International Corp. IYR has three stars by Morningstar and has an expense ratio of 0.45%. IYR’s holdings are broken by Specialized REITs, (27.09%), Retail, 19.74%, Residential, 12.70%, Office, 10.00%, Health Care, 9.88%, Mortgage REITs, 4.90%, Industrial, 4.56%, Diversified, 4.51%, Hotel & Resort, 3.56%, Real Estate Services, 2.06%

ICF

ICF tracks an index of the 30 largest publicly traded REITs excluding mortgage and tower REITs. The design of this index capitalizes on the relative strength of the largest real estate firms and the conviction for consolidation in the real estate market. The ETF includes Retail REITs, 24.84%, Specialized REITs, 18.71%, Residential, 18.08%, Office, 15.23%, Health Care, 14.41%, Industrial, 5.79%, Hotel & Resort REITs, 2.56%.

RWR / SCHH

RWR / SCHH are the smallest of the five funds. They track Dow Jones US Select REIT Index. The index tracks US REITs with a minimum market cap of $200 million. The index also excludes mortgage REITs, timber REITs, net-lease REITs, real estate finance companies, mortgage brokers and bankers, commercial and residential real estate brokers and real estate agents, homebuilders, hybrid REITs, and large landowners of unimproved land. The funds’ portfolio holds a diversified range of REITs across property sectors similar to other ETFs.

SCHH has the lowest expense ratio of 0.07% all REITs ETFs while RWR has an expense ratio of 0.25%.

Performance

Comparing the performance of the top ETFs in the past ten years, we can see a clear winner. VNQ is leading by price return, total return, and Sharpe Ratio. Next in line are RWR and ICF. IYR takes the last spot.

Having the largest number of holdings, VNQ overweights small size REITs relative to the industry average. Hence it benefited from the smaller REITs outpacing the growth of their bigger competitors.

IYR did not benefit from being the most diversified REIT ETF. The mortgage and specialized REITs have lagged behind the performance of the traditional equity REITs.

Mutual Funds

Mutual funds are actively managed investment vehicles. They typically use an index as their benchmark. The goal of the fund manager is to outperform their benchmark either on a risk adjusted or absolute return basis. The fund manager can decide to overweight a particular REIT if he or she believes the company will outperform the benchmark. Many times the managers will look for mispricing opportunities of individual REITs.

Active funds usually charge higher fees than passively managed ETFs due to higher research, management, administrative and trading costs. However, many investors believe that after subtracting their fees, active managers cannot beat the market in the long run.

In my analysis, I selected a pool of five actively managed funds which are open to new investors and have an expense ratio less than 1% – VGSLX, DFREX, TRREX, CSRSX and FRESX.

All five funds have high ratings from Morningstar and robust historical performance.

VGSLX and DFREX have the largest number of holdings, 150 and 149 respectively, and maintain the lowest expense ratio. Both funds lean more towards small and micro-cap REITs relative to the average in the category.

The other three funds, TRREX, CSRSX and FRESX manage smaller pools of REITs. CSRSX and FRESX have the highest turnover: 58% and 34% respectively.

Performance

While the 1-year returns are quite variable, the long-term performance among the five funds is relatively consistent. Vanguard REIT Index Fund, VGSLX, has the lowest fee and the highest 10-year return of 7.6%. Cohen & Steers Realty Shares Fund, CSRSX, is second with 7.5% annual return. CSRSX has the lowest 10-year standard deviation of 25.2%. VGSLX edges slightly ahead with the highest Sharpe Ratio of 0.39. Vanguard and DFA funds benefitted from low expense ratio and larger exposure to mid and small size REITs, which had better 10-year performance than larger REITs.

It is worth noting that the 10-year Sharpe Ratio for all REITs sector is lower than the Sharpe Ratio of S&P 500. The Sharpe Ratio calculated the risk-adjusted returns of a particular investment. In this case, the risk-adjusted returns of REIT lag behind the overall equity market.

When you consider investing in REITs mutual funds, pay attention to management style, expense ratio, turnover, dividends, the number of holdings, and their benchmark.

Where to allocate REITs investments?

REITs are often attractive for their high dividend income. As I mentioned earlier, the majority of the REITs distributions are treated as ordinary income and therefore taxed at the investors’ tax rate. Investors in high tax brackets can pay up to 39.6% rate plus 3.8% Medicare surplus tax on the investment income.

Because of their unfavorable tax status, most REITs may not be suitable for taxable investment accounts. Tax-sensitive investors may want to consider placing REITs in Tax Advantage accounts like Roth IRA, Traditional IRA, and 401k.

Since timber REITs receive favorable tax treatment, they are an exception from the above rule. Investors may choose to hold them in taxable investment accounts.

There are two scenarios under which REITs could be an appropriate fit for a taxable account.

First, investors in the lower tax bracket will be less impacted by the tax treatment of the REITs income.

Second, investing in REITs with a history of making significant capital gain and return on capital distributions. These types of payments have more favorable tax treatment at the lower long-term capital gains tax rate.