Everything you need to know about your Target Retirement Fund

Everything you need to know about your Target Retirement Fund

Target Retirement Funds are a popular investment option in many workplace retirement plans such as 401k, 403b, 457, and TSP. They offer a relatively simple and straightforward way to invest your retirement savings as their investment approach is based on the individual target retirement dates.

Nowadays, almost all employers and 401k providers offer target retirement funds – from Fidelity to Vanguard, American Funds, Blackrock, and Schwab. Although employers and advisors have a choice amongst several fund families, they will typically select one of them for their plan. Multiple target fund families are readily available in individual brokerage accounts or self-directed IRAs.

Workplace plan participants typically have to choose one fund from a single family with target retirement dates in 5-year increments – 2025, 2030, 2035, 2040, 2045, and 2050. Often, plans with auto-enrollment features will automatically assign a target retirement fund based on the estimated year of retirement. Manual enrollment programs will have the fund series in their fund line-up, which could consist of a mix of index, actively managed and target retirement funds.

The base assumption of the target retirement funds is that younger investors have a long investment horizon and higher risk tolerance, therefore, they should have their target retirement assets in more risky investments such as stocks. Inversely, older investors will have a shorter investment horizon and lower risk tolerance. Therefore, the majority of their target retirement money will be in more low-risk investments such as bonds.

Despite their growing popularity, target retirement funds have some limitations and are not identical.  They have substantial differences that may not always appeal to everybody. In this post, I would like to explain some of those nuances.

Style

Target funds utilize two main investment styles – passive indexing and active management. Passive Target Retirement Funds like Vanguard and BlackRock LifePath primarily invest in a mix of index funds. The second groups including T. Rowe Price, Fidelity, American Century, and American Funds pursue an active strategy where investments are allocated in a mix of active mutual funds typically managed by the same firm.

Fees

The fund investment style will often impact the management fees charged by each fund. Passive funds tend to charge lower fees, usually around 0.15% – 0.20%. On the other hand, active funds typically range between 0.40% – 1%.

NameTickerMorningstar RatingMorningstar Analyst RatingAUMExpense
Vanguard Target Retirement 2045VTIVX4-starGold$18.1 bil0.16%
T. Rowe Price Retirement 2045TRRKX5-StarSilver$10.2 bil0.76%
American Funds 2045 Trgt Date Retire R6RFHTX5-StarSilver$4.8 bil0.43%
Fidelity Freedom® 2045FFFGX3-StarSilver$3.5 bil0.77%
American Century One Choice 2045AROIX4-starBronze$1.7 bil0.97%

If you have any doubts about how much you pay for your fund, double-check with your plan administrator or Human Resource. Not to sound alarming but I recently read about a case where a 401k plan contained a fund listed as “Vngd Tgt Retrmt 2045 Fund.” whose sole investment was Vanguard Target Retirement 2045 Fund. However, instead of charging an expense ratio of 0.16%, the fund was taking a whopping 0.92%.  The only purpose of this sham is to deceive participants into believing they are investing in the real Vanguard fund and marking up the expense ratio exponentially.

Asset allocation

The asset allocation is the most critical factor for investment performance. According to numerous studies, it contributes to more than 90% of the portfolio return.  As a factor of such significance, it is essential to understand the asset allocation of your target retirement fund.

While comparing five of the largest target retirement families, we see some considerable variations between them. Vanguard has the highest allocation to Foreign Equity, while T. Rowe has the largest investment in US Equity. Fidelity has the highest allocation to Cash and Cash Equivalents while American Century has the biggest exposure to Bonds. And lastly, American Funds has the largest distribution to Other, which includes Preferred Stocks and Convertible Bonds.

 

2045 Series 

NameTickerCashUS StockNon-US StockBondOther
Vanguard Target Retirement 2045VTIVX  1.11     52.98        34.91    9.77  1.23
T. Rowe Price Retirement 2045TRRKX  2.87     58.98        28.48    9.05  0.62
American Funds 2045 Trgt Date Retire R6RFHTX  3.66     53.21        29.02    9.77  4.34
Fidelity Freedom® 2045FFFGX  5.79     57.58        32.07    3.93  0.63
American Century One Choice 2045AROIX  2.04     55.38        20.32  21.36  0.90

It is also important to understand how the target asset allocation changes over time as investors approach retirement. This change is known as the glide path. In the below table you can see the asset allocation of the 2025 target fund series. All of them have a higher allocation to Bonds, Cash and Cash Equivalents, and a lower allocation of US and Foreign Equity.

2025 Series

NameTickerCashUS StockNon-US StockBondOther
Vanguard Target Retirement 2025VTIVX  1.44     38.05        25.09  34.30  1.12
T. Rowe Price Retirement 2025 FundTRRHX  3.35     45.64        22.06  28.23  0.72
American Funds 2025 Trgt Date Retire R6RFDTX  4.12     39.60        19.36  33.65  3.27
Fidelity Freedom® 2025FFTWX  8.99     41.70        24.31  24.46  0.54
American Century One Choice 2025ARWIX  7.18     40.01        11.88  40.01  0.92

 

 Keep in mind that the target Asset Allocation is not static. Moreover, the fund managers can change the fund allocation according to their view of the market and economic conditions.

Performance

After all said and done, the performance is what matters for most investors and retirees. However, comparing performance between different target funds can be a little tricky. As you saw in the previous paragraph, they are not the same.

So let’s first look at a comparison between different target-date funds from the same family. The return figures represent a net-of-fees performance for 3, 5 and 10 years. Standard Deviation (St. Dev) measures the volatility (risk) of returns.  As expected, the long-dated funds posted higher returns over the near-dated funds. However, the long-dated funds come with higher volatility due to their higher allocation to equities.

 

Target Date Performance Comparison by Target Year

ReturnStandard Deviation
NameTicker3-Year5-Year10-Year3-Year5-Year10-Year
American Funds 2025 Trgt Date Retire R6RFDTX   5.71    9.36     5.88   6.78    7.48   12.83
American Funds 2035 Trgt Date Retire R6RFFTX   6.73  10.43     6.44   8.70    8.84   13.81
American Funds 2045 Trgt Date Retire R6RFHTX   6.99  10.67     6.56   9.09    9.10   13.96
American Funds 2055 Trgt Date Retire R6RFKTX   7.33  11.32   9.13    9.15

 

The comparison between different fund families also reveals significant variations in performance. The majority of these differences can be attributed to their asset allocation, investment selection, and management fees.

Target Date Performance Comparison by Fund Family

Return  Standard Deviation
NameTicker3-Year5-Year10-Year3-Year5-Year10-Year
Vanguard Target Retirement 2045VTIVX   6.24    9.50     5.70   9.42    9.51   14.63
T. Rowe Price Retirement 2045TRRKX   6.54    9.92     6.20   9.68    9.80   15.80
American Funds 2045 Trgt Date Retire R6RFHTX   6.99  10.67     6.56   9.09    9.10   13.96
Fidelity Freedom® 2045FFFGX   6.50    8.95     4.82   9.83    9.64   15.25
American Century One Choice 2045AROIX   5.79    8.63     5.73   8.38    8.41   13.50

How they fit with your financial goals

How the target retirement fund fit within your financial goals is an important nuance that often gets underestimated by many. Target retirement funds assume the investors’ risk tolerance based on their age and the estimated year of retirement. Older investors will automatically be assigned as conservative while they could be quite aggressive if this is a part of their inter-generational estate planning. Further, young investors default to an aggressive allocation while they could be more conservative due to significant short-term financial goals. So keep in mind that the extra layer of personal financial planning is not a factor in target retirement funds.

 

Final words

Target retirement funds come with many benefits. They offer an easy way to invest for retirement without the need for in-depth financial knowledge. Target funds come in different shapes and forms and bring certain caveats which may appeal to some investors and not to others. If you plan to invest in a target retirements fund, the five questions above will help you decide if this is the right investment for you.

14 Effective ways to take control of your taxes

In this blog post, I will go over several popular and some not so obvious tax deductions and strategies that can help you decrease your annual tax burden. Let’s be honest.  Nobody wants to pay taxes. However, taxes are necessary to pay for pensions, social services, Medicaid, roads, police, law enforcement and so on. Most people will earn a higher income and grow their investments portfolios as their approach retirement. Thus they will gradually move to higher tax brackets and face a higher tax bill at the end of the year. IRS provides many tax deductions and breaks that can help you manage your tax burden. Taking advantage of these tax rules can help you reduce your current or future your tax bill.

These are general rules. I realize that we all face different circumstances. Use them as a broad guideline. Your particular situation may require a second opinion by an accountant, a tax lawyer or an investment advisor.

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1. Primary residence mortgage deductions

Buying a first home is a big decision. Your new neighborhood, school district, nearby services are all critical factors you need to consider before making your choice. If you own a primary residence (sorry, a vacation home in Hawaii doesn’t count), you can deduct the interest on your mortgage loan from your taxable income for the year. Your property taxes are also deductible. These incentives are provided by the Federal and state governments to encourage more families to buy their home.

There are two additional benefits of having a mortgage and being a responsible borrower. First, your credit score will increase. Making regular payments on your mortgage (or any loan) improves your credit history, increases your FICO score and boosts your creditworthiness. Your ability to take future loans at a lower rate will significantly improve. Second, your personal equity (wealth) will increase as you pay off your mortgage loan. Your personal equity is a measure of assets minus your liabilities.  Higher equity will boost your credit score. It is also a significant factor in your retirement planning.

Buying a home and applying for a mortgage is a long and tedious process. It requires a lot of legwork and documentation. After the financial crisis in 2008 banks became a lot stricter in their requirements for providing mortgage loans to first buyers. Nevertheless, mortgage interest on a primary residence is one of the biggest tax breaks available to taxpayers.

 

2. Home office deductions

Owning a home versus renting is a dilemma for many young professionals. While paying rent offers flexibility and lower monthly cash payments it doesn’t allow you to deduct your rent from your taxes. Rent is usually the highest expense in your monthly budget. It makes up between 25% and 35% of your total income. The only time you can apply your rent as a tax deduction is if you have a home office.

A home office is a dedicated space in your apartment or house to use for the sole purpose of conduction your private business. It’s usually a separate room, basement or attic designated for your business purposes.

The portion of your office to the total size of your home can be deductible for business purposes. If your office takes 20% of your home, you can deduct 20% of the rent and utility bills for business expense purposes.

 

3. Charitable donations

Monetary and non-monetary contributions to religious, educational or charitable organization approved by IRS are tax deductible. The annual limit is 50% of your AGI (aggregate gross income) for most donations and 30% of AGI for appreciated assets.

Most often people choose to give money. However, you can also donate household items, clothes, cars, and airline miles. The fair value of the donated items decreases your taxable income and therefore will reduce the amount of taxes due to IRS.

Another alternative is giving appreciated assets including stocks and real estate. This is one of the best ways to avoid paying significant capital gain tax on low-cost investments. For one, you are supporting a noble cause. Second, you are not paying taxes for the difference between the market value and purchase cost of your stock. Also, the fair market value of the stock at the time of donation will reduce your taxable income, subject to 30% of AGI rule. If you were to sell your appreciated assets and donate the proceeds to your charity of choice, you would have to pay a capital gain tax on the difference between market value and acquisition cost at the time of sale. However, if you donate the investments directly to the charity, you avoid paying the tax and use the market value of the investment to reduce your taxable income.

 

4. Gifts

Making a gift is not a standard tax deduction. However, making gifts can be a way to manage your future tax payments and pass on the tax bill to family members who pay a lower tax rate. You can give up to $14,000 to any number of people every year without any tax implications. Amounts over $14,000 are subject to the combined gift and estate tax exemption of $5.49 million for 2017.  You can give your child or any person within the annual limits without creating create any tax implications.

Another great opportunity is giving appreciated assets as a gift. If you want to give your children or grandchildren a gift, it is always wise to consider between giving them cash or an appreciated asset directly.  Giving appreciated assets to family members who pay a lower tax rate doesn’t create an immediate tax event. It transfers the tax burden from the higher rate tax giver to the lower tax rate receiver.

 

5. 529 Plans

One of the best examples of how gifts can minimize future tax payments is the 529 college tuition plan. Parents and grandparents can contribute up to $14,000 annually per person, $28,000 per married couple into their child college education fund. The plan even allows a one–time lump sum payment of $70,000 (5 years x $14,000).

529 contributions are not tax deductible on a federal level. However, many states like New York, Massachusetts, Illinois, etc. allow for state tax deductions up to a certain amount. The plan allows your contributions (gifts) to grow tax-free. Withdrawals are also tax-free when using the money to pay qualified college expenses.

 

6. Tax-deferred contributions to 401k, 403b, and IRA

One of my favorite tax deductions is the tax-deferred contribution to 401k and 403b plans. In 2017 the allowed maximum contribution per person is $18,000 plus an additional $6,000 catch-up for investors at age 50 and older. In addition to that, your employer can contribute up to $36,000 for a total annual contribution of $54,000 or $60,000 if you are older than 50.

Most companies offer a matching contribution of 5%-6% of your salary and dollar limit of $4,000 – $5,000. At a very minimum, you should contribute enough to take advantage of your company matching plan. However, I strongly recommend you to set aside the entire allowed annual contribution.

The contributions to your retirement plan are tax deductible. They decrease your taxable income if you use itemized deductions on your tax filing form. Not only that, the investments in your 401k portfolio grow tax-free. You will owe taxes upon withdrawal at your current tax rate at that time.

If you invest $18,000 for 30 years, a total of $540,000 contributions, your portfolio can potentially rise to $1.5m in 30 years at 6% growth rate. You will benefit from the accumulative return on your assets year after year.  Your investments will grow depending on your risk tolerance and asset allocation. You will be able to withdraw your money at once or periodically when you retire.

 

7. Commuter benefits

You are allowed to use tax-free dollars to pay for transit commuting and parking costs through your employer-sponsored program.  For 2017, you can save up to $255 per month per person for transit expenses and up to $255 per month for qualified parking. Qualified parking is defined as parking at or near an employer’s worksite, or at a facility from which employee commutes via transit, vanpool or carpool. You can receive both the transit and parking benefits.

If you regularly commute to work by a bike you are eligible for $20 of tax-free reimbursement per month.

By maximizing the monthly limit for both transportation and parking expenses, your annual cost will be $6,120 ($255*2*12). If you are in the 28% tax bracket, by using the commuter benefits program, you will save $1,714 per year. Your total out of pocket expenses will be $ 4,406 annually and $367 per month.

 

8. Employer-sponsored health insurance premiums

The medical insurance plan sponsored by your employer offers discounted premiums for one or several health plans.  If you are self-employed and not eligible for an employer-sponsored health plan through your spouse or domestic partner, you may be able to deduct your health insurance premiums.  With the rising costs of health care having a health insurance is almost mandatory.  Employer-sponsored health insurance premiums can average between $2,000 for a single person and 5,000 for a family per year. At a 28% tax rate, this is equal to savings between $560 and $1,400. Apart from the tax savings, having a health insurance allows you to have medical services at discounted prices, previously negotiated by your health insurance company. In the case of emergency, the benefits can significantly outweigh the cost of your insurance premium.

 

9. Flexible Spending Account

Flexible Spending Account (FSA) is a special tax-advantaged account where you put money aside to pay for certain out-of-pocket health care costs. You don’t pay taxes on these contributions. This means you will save an amount equal to the taxes you would have paid on the money you set aside. The annual limit per person is $2,600. For a married couple, the amount can double to $5,200. The money in this account can be used for copayments, new glasses, prescription medications and other medical and dental expenses not covered by your insurance.  FSA accounts are arranged and managed by your employer and subtracted from your paycheck.

Let’s assume that you are contributing the full amount of $2,600 per year and your tax rate is 28%. You effectively save $728 from taxes, $2,550 * 28%. Your actual out-of-pocket expense is $1,872.

One drawback of the FSA is that you must use the entire amount in the same tax year. Otherwise, you can lose your savings. Some employers may allow up to 2.5 months of grace period or $500 of rollover in the next year. With that in mind, if you plan for significant medical expenses, medication purchases or surgery, the FSA is a great way to make some savings.

 

10. Health Spending Account

A health savings account (HSA) is a tax-exempt medical savings account available to taxpayers who are enrolled in a high-deductible health plan (HDHP) The funds contributed to this account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year over year if not spent. HSA owners can use the funds to pay for qualified medical expenses at any time without tax liability or penalty. The annual contribution limits are $3,350 per person, $6,750 per family and an additional $1,000 if 55 or older. The owner of HSA can invest the funds similarly to IRA account and withdraw without penalty when used for medical expenses.

 

11. Disability  insurance

Disability premiums are generally not deductible from your tax return. They are paid with after-tax dollars. Therefore, any proceeds received as a result of disability are tax-free. The only time your benefits are taxable is when your employer pays your disability insurance and does not include it in your gross income.


12. Life insurance

Life insurance premiums are typically not deductible from your tax return if you are using after-tax dollars. Therefore, any proceeds received by your beneficiaries are tax-free.

Life insurance benefits can be tax deductible under an employer-provided group term life insurance plan. In that case, the company pays fully or partially life insurance premiums for its employees.  In that scenario, amounts more than $50,000 paid by your employer will trigger a taxable income for the “economic value” of the coverage provided to you.

If you are the owner of your insurance policy, you should make sure your life insurance policy won’t have an impact on your estate’s tax liability. In order to avoid having your life insurance policy affecting your taxes, you can either transfer the policy to someone else or put it into a trust.

13. Student Loan interest

If you have student loans and you can deduct up to $2,500 of loan interest.  To use this deduction, you must earn up to $80,000 for a single person or $165,000 for a couple filing jointly. This rule includes you,  your spouse or a dependent. You must use the loan money for qualified education expenses such as tuition and fees, room and board, books, supplies, and equipment and other necessary expenses (such as transportation)

14. Accounting and Investment advice expenses

You may deduct your investment advisory fees associated with your taxable account on your tax return.  You can list them on Schedule A under the section “Job Expenses and Certain Miscellaneous Deductions.” Other expenditures in this category are unreimbursed employee expenses, tax preparation fees, safe deposit boxes and other qualifying expenses like professional dues, required uniforms, subscriptions to professional journals, safety equipment, tools, and supplies. They may also include the business use of part of your home and certain educational expenses. Investment advisory fees are a part of the miscellaneous deduction.  The entire category is tax deductible if they exceed 2% of your adjusted gross income for the amount in excess.

 

About the Author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

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,  Image Copyright: www.123rf.com

Financial planning for physicians

Financial planning for physicians

Introduction to Financial planning for physicians

Being married to a physician has allowed me to obtain an understanding of the unique challenges of financial planning for physicians.   In this post, I will discuss several practices that can help physicians and other healthcare professionals achieve financial prosperity.

What sets financial planning for physicians apart?

Doctors begin their careers and start earning an income much later than the average person.  If a physician is accepted to a medical school immediately following completion of an undergraduate degree, she will be in her mid-20s when she graduates from medical school.   After medical school, physicians must continue clinical training in their chosen specialty.  The residency training period ranges from 3 to 7 years depending on the specialty.  During this time, new doctors make a modest salary, work long hours, and cover overnight on-call shifts in exchange for clinical training.

Once launching their career, doctors receive above-average compensation and have almost zero risks of unemployment. These privileges, however, come with some serious caveats.

As of 2015, graduating physicians start their careers with an average student loan of $183,000. This is equal to $1,897 of monthly payments over ten years or $927 over thirty years, at 4.5% interest. If I remove the lowest 20% of the medical students that come out of school with zero or small loan amounts, the average debt figure jumps to $230,000. Which is a total of $286,000 due on principal and interest on a 10-year loan and 420,000 on a 30-year one. Student loans become repayable after medical school graduation.

1. Start saving for retirement early.

Doctors have a shorter working life than the average person. They start their careers ten years after most people. During these ten years, doctors don’t earn a significant salary and accumulate a large amount of education-related debt.

It is critical that young doctors start saving for retirement while they are in residency. During residency, the new doctors receive a salary between $40,000 and $70,000. Many employers offer both tax-deferred 401k and Roth 401k accounts. Depending on your financial situation you should consider maximizing both plans with priority on your Roth over tax-deferred contributions.

2. Maximize your retirement contributions.  

You have to maximize their retirement contributions to compensate for the extra ten years of school and residency.

Physicians working in hospitals and large healthcare systems will very likely have the option to open a tax-deferred 401k plan. As of 2020, these programs allow their participants to contribute up to $19,500 a year. Most employers offer matching contributions for up to a certain amount.

Some health systems offer pension plans, which guarantee a pension after certain years of service. These plans are a great addition to your retirement savings if you are willing to commit to your employer for 10 or 20 years.

Additionally, some government and state-run hospitals even offer 457 plans in conjunction with a 401k plan, allowing participants to super save and defer a double

Doctors who run a private practice should consider investing in solo 401k plans. These plans allow for the maximum pretax contributions, once as an employee and once as an employer.

Doctors earning significant cash flow in private practice should also consider adding a defined benefit plan to their 401k. This combination is a powerful saving tool. However, it requires the help of an accredited actuary. Contact your financial advisor if you want to learn about this option.

In addition to contributing to employer-sponsored retirement plans, doctors should consider setting aside a portion of their earnings to taxable (brokerage or saving) accounts. The contributions to these accounts are made on an after taxes basis. Taxes are due on all dividends, interest, and capital gains.   The most significant benefit of these funds will be their liquidity and flexibility with no income restrictions.

 3. Manage your taxes.

High earning doctors need to consider managing their tax bill as one of their top priorities. Tax implication can vary depending on income level, family size, and property ownership. Hiring a CPA, a tax attorney or a financial planner may help you reduce or optimize some of your tax dues.

A successful tax planning strategy will include a combination of retirement savings, asset allocation, tax deductions, and estate planning.

4. Balance your budget.

After ten years of vigorous study, sleepless nights, and no personal life, doctors are thrown back in the normal life where they can enjoy the perks of freedom and money. As much you are excited about your new life, do not start it with buying a Lamborghini or an expensive condo on South Beach. In other words, do not overspend. Even if you got a great job with an excellent salary and benefits, you need to remain disciplined in your spending habits. Stay focused on your long-term financial goals. Leave enough money aside for retirement savings, rent or mortgage payments, loan payments, living expenses, college savings for your children and an emergency fund.

5. Manage your student loans

The cost of a medical degree is one of the highest amonsgt other professions. For that reason many dpctors graduate with massive student loans. 0How to best manage your student debt depends on a combination of factors including your credit score, federal or private loan, loan maturity, interest rates, monthly payments, and current income. Stay on top of your student debt. Do not lose track of due dates and interest rates.

For those looking for help reducing their debt, here are some options:

  • Loan repayment options from employers. Many private, federal, state and city health care organizations offer loan repayment options as an incentive to retain their doctors. Those options are frequently dependent on years of service and commitment to work for a certain number of years. These programs vary from employer to employer.
  • Loan forgiveness. Under the Public service loan forgiveness program (PSLF) launched in 2007, full-time employees at federal, state or local government agencies, as well as nonprofit workers at an organization with a 501(c)(3) designation, are eligible for loan forgiveness after paying 120 monthly payments. The first applicants will be able to benefit from this program in 2017.
  • Working in underserved areas. Some states offer loans forgiveness for doctors working in underserved areas. The conditions and benefits vary state by state but in essence, works similar to the PLSF program.
  • Loan consolidation and refinancing. If you have two or more private student loans, you may want to consider loan consolidation. If you pay high interest on your current loans, think about refinancing it at a lower rate. Your new loan availability depends on your credit history, income, and general macroeconomic factors.

Under the current tax law, all forgiven loans are subject to taxes as ordinary income. Take it into consideration when applying for loan forgiveness.

6. Watch your credit score.

Physicians need to monitor and understand their credit score. Known also as the FICO score, it is a measure that goes between 300 and 850 points. Higher scores indicate lower credit risk. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, has a proprietary database, methodology, and scoring system. It is not uncommon to find small or even substantial differences in credit scores issued by three agencies. Many times, creditors will use the average of the three value to assess your creditworthiness.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a general rule, your FICO score depends mostly on the actual dollar amount of your debt, the debt to credit ratio and your payment history. Being late on or missing your loan payments and maximizing your credit limits can negatively impact your credit score.

You can get your score for free from each one of the bureaus once a year. Additionally, many credit cards provide it for free. Keep in mind that their FICO score will come from one of these three agencies. Don’t be surprised if your second credit card shows a different value.  Your other bank is probably using a different credit agency.

7. Take calculated risks.

Doctors are notorious for their high-risk tolerance and attitude toward investing in very uncertain endeavors. While this is not always a bad thing, make sure that your investments fit into your overall long-term financial plan. Do not bet all your savings on one risky venture. Use your best judgment in evaluating any risky investments presented to you. High returns always come with high risk for a loss.

8. Get insurance.

Having insurance should be your top priority to take care of yourself and your family in case of unforeseen events. There is an extensive list of risks you have to consider,  for instance – health, disability, life, unemployment, personal umbrella, and malpractice insurance.

Fortunately, some of them might be covered by your employer. A lot of organizations offer a basic package at no cost and premium package at added subsidized price. Take advantage of these insurance packages to buy yourself protection in times of emergency.

For instance, if you are a surgeon or dentist and get a hand injury, you may not be able to work for a long time. Having disability insurance can help you have an additional income while you recover.

If you run your practice, having malpractice insurance will help cover the cost if you get sued by your patients.

Final words

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

A Guide to Investing in REITs

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.

How to build your 401k plan

How to build your 401k plan

401k plans are a powerful savings tool for retirement

With total assets reaching $4.8 trillion dollars 401k plans are the most popular retirement vehicle and are increasingly used by employers to recruit and retain key talent.  401k accounts allow employees to build their retirement savings by investing a portion of their salary. Contributions to the plan are tax-deductible, thus reducing your taxable income,  and the money allocated grows tax-free. Taxes are due upon withdrawal of funds during retirement years. In this article, I will discuss how to build your 401k plan.

Does your employer offer a 401k plan?

If you recently joined a new company, find out whether they offer a 401k plan. Some employers offer automatic enrollment, and others require individual registration.

Many companies offer a matching contribution up to a set dollar amount or percentage.

Contributions are usually deducted from each paycheck, but employees can also opt to contribute a lump sum.  The 2016 limit is $18,000 plus a $6,000 “catch-up” contribution for people age 50 and above.

How to decide on your investment choices

Employers must provide ongoing education and training materials about retirement savings plans.

401k plans can offer anywhere between 5 and 20 different mutual funds which invest in various asset classes and strategies.  Your choice will be limited to the funds in your plan. Hence you can not invest in stocks or other financial instruments.

The fundamental goal is to build a diversified and disciplined portfolio with your investment choices. Markets will go up and down, but your diversified portfolio will moderate your risk in times of market turmoil.

Index Funds

Index Funds are passively managed mutual funds. They track a particular index by mirroring its performance. The index funds hold the same proportion of underlying stocks as the index they follow. Many indexes are tracking large-cap, mid-cap, small-cap, international and bond indices. One of the most popular categories is the S&P 500 Index funds.

Due to their passive nature index funds are usually offered at a lower cost compared to actively managed funds. They provide broad diversification with low portfolio turnover. Index funds do not actively trade in and out of their positions and only replace stocks when their benchmark changes. Index funds are easy to buy, sell and rebalance.

Actively Managed Mutual Funds

Actively managed mutual funds are the complete opposite of index funds. A management team usually runs each fund. The mutual funds have a designated benchmark, such as the S & P 500, Russell 2000,  and MSI World. Often the management team aims to beat the benchmark either by a greater absolute or risk-adjusted return. Overall active funds trade more often than index funds. Their portfolio turnover (frequency of trading) is bigger because managers take an active approach and invest in companies or bonds with the goal of beating their benchmark.

There is a broad range of funds with different strategies and asset classes. Some funds trade more actively than others. Even funds that follow the same benchmark can gravitate towards a particular sector, country or niche. For instance, a total bond fund might be more concentrated into government bonds, while another fund may invest heavily in corporate bonds.

Active funds charge higher fees than comparable index funds. These fees cover salaries, management, administrative, research, marketing, and trading costs. Funds investing in niche markets like small-cap and emerging market will have higher costs. Fees are also dependent on the size of the fund and its turnover strategy.

It’s critical to do at least a basic research before you decide which fund to purchase. Morningstar.com is a great website for mutual fund information and stats.

Target Retirement funds

These are mutual funds that invest your retirement assets according to a target allocation based on your expected year of retirement. The further away you are from retirement, the more your target fund asset allocation will lean toward equity investments. As you get closer to retirement, the portion of equity will go down and will be replaced by fixed income investments. The reason behind target retirement funds is to maintain a disciplined investment approach over time without being impacted by market trends.

One significant drawback of the retirement funds is that they assume your risk tolerance is based on your age. If you are a risk taker or risk averse, these funds may not represent your actual financial goals and willingness to take the risk.

In addition to that, investors also need to consider how target retirement funds fit within their overall investment portfolio in both taxable and tax-advantaged accounts.

Most large fund managers offer target retirement funds. However, there are some large differences between fund families. Some of the discrepancies come from the choice of active versus passive investment strategies and fees.

Without endorsing any of the two providers below I will illustrate some of the fundamental differences between Vanguard and T. Rowe Price Target Retirement funds.

Vanguard Target Retirement funds

Vanguard Target Retirement funds offer low-cost retirement fund at an expense ratio of 0.15%. All funds allocate holdings into five passively managed broadly diversified Vanguard index fund.

Vanguard Target Retirement2015202520352045
Total Stock Market Index28.4439.8648.7554.07
Total Intl Stock Index19.0126.5632.4535.9
Total Bond Market II Index30.3223.6613.237.05
Total Intl Bond Index13.379.925.572.98
Short-Term Infl-Protected Sec Index8.86
% Assets100.00100.00100.00100.00
By asset class
Equity47.4566.4281.289.97
Fixed Income52.5533.5818.810.03

T. Rowe Target Retirement funds

On the other spectrum are T. Rowe retirement funds. Their funds have a higher expense ratio. They charge between 0.65% and 0.75%. All target funds invest in active T. Rowe mutual funds in 18 different categories. T. Rowe target funds are a bit more aggressive. They have a higher allocation to equity and offer a wider range of investment strategies.

T. Rowe Target Retirement Fund2015202520352045
New Income24.3817.3410.646.74
Equity Index 50022.1514.859.317.41
Ltd Dur Infl Focus Bd11.013.530.540.53
International Gr & Inc5.046.687.858.35
Overseas Stock5.016.647.828.3
International Stock4.425.786.87.26
Emerging Markets Bond3.552.471.431.01
Growth Stock3.4311.7417.8420.26
International Bond3.422.441.510.98
High Yield3.262.321.420.91
Value3.111.3117.3619.75
Emerging Markets Stock2.883.874.494.71
Real Assets2.12.783.283.5
Mid-Cap Value1.852.462.953.12
Mid-Cap Growth1.782.352.732.9
Small-Cap Value0.931.231.481.55
Small-Cap Stock0.881.151.411.53
New Horizons0.720.941.11.12
% Assets100100100100
By Asset Class
Equity54.2971.7884.4289.76
Fixed Income45.6228.115.5410.17

Which approach is better? There is no distinctive winner. It depends on your risk tolerance.

Vanguard funds have lower expense ratio and a lower 10-year return. However, they have a lower risk.

T. Rowe funds have higher absolute and risk-adjusted return but also carry more risk.

10-year Performance Analysis, 2045 Target Retirement Fund

 Standard10-yearSharpe
FundNameDeviationReturn Ratio
VTIVXVanguard Target 204514.655.480.36
TRRKXT. Rowe Target 204515.825.890.38

 *** Data provided by Morningstar

Most 401k plans will offer only one family of target funds, so you don’t have to decide between Vanguard, T. Rowe or another manager. You will have to decide whether to invest in any of them at all or put your money in the index or active funds. For further information, check out our dedicated article on target date funds

ETFs

ETFs are a great alternative to index and active mutual funds. They are liquid and actively trade on the exchange throughout the day.

As of now, very few plans offer ETFs. One of the main concerns for adding them to retirement plans is the timeliness of trade execution. Right now this problem is shifted to the fund managers who only issue end of day price once all trades are complete.

I expect that ETFs will become a more common choice as they grow in popularity and liquidity. Many small and mid-size companies that look for low-cost solutions can use them for them as an alternative to their for their workplace retirement plans.

Company stock

Many companies offer their stock as a matching contribution or profit sharing incentive in their employee 401k plan. Doing so aligns employees’ objectives with the company’s success.  While this may have positive intentions, current or former employees run the risk of having a large concentrated position in their portfolios.  Even if your company has a record of high returns, holding significant amounts of company stock creates substantial financial risk during periods of crisis because one is both employee and shareholder.  Enron and Lehman Brothers are great examples of this danger.  Being overinvested in your company shares can lead to simultaneous unemployment and depletion of retirement savings if the business fails.

Allocation mix

You will most likely have a choice between a family of target retirement funds and a group of large-cap, mid-cap, small-cap, international developed, emerging markets stocks, a REIT, US government, corporate, high yield and international bond funds.

Your final selection should reflect your risk tolerance and financial goals. You should consider your age, family size, years to retirement, risk sensitivity, total wealth, saving and spending habits, significant future spending and so on.

You can use the table below as a high-level guidance.

401k asset allocation mix

Data source: Ibbotson Associates, 2016, (1926-2015). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only. It is not possible to invest directly in an index. For information on the indexes used to construct this table, see footnote 1. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet an investor’s goals. You should choose your investments based on your particular objectives and situation. Be sure to review your decisions periodically to make sure they are still consistent with your goals.
Source: https://www.fidelity.com/viewpoints/retirement/ira-portfolio?ccsource=email_monthly

Final recommendations

Here are some finals ideas how to make the best out of your 401k savings:

  • At a minimum, you should set aside enough money in your 401k plan to take advantage of your employer’s matching contribution. It’s free money after all. However, the vesting usually comes with certain conditions. So definitely pay attention to these rules. They can be tricky.
  • 2016 maximum contribution to 401k is $18,000 plus $6,000 for individuals over 50. If you can afford to set aside this amount, you will maximize the full potential of retirement savings.
  • If your 401k plan is your only retirement saving, you need to have a broad diversification of your assets. Invest in a target retirement fund or mix of individual mutual funds to avoid concentration of your investments in one asset class or security.
  • If your 401k plan is one of many retirement saving options – taxable account, real estate, saving accounts, annuity, Roth IRA, SEP-IRA, Rollover IRA or a prior employer’s 401k plan, you will need to have a holistic view of your assets in order to achieve a comprehensive and tax optimized asset allocation.
  • Beware of hidden trading costs in your plan choices. Most no-load mutual funds will charge anywhere between 0.15% and 1.5% to manage your money. This fee will cover their management, administrative, research and trading costs. Some funds also charge upfront and backload fees. As you invest in those funds your purchase cost will be higher compared to no-load funds.
  • If you hold large concentrated positions of your current or former employer’s stock, you need to mitigate your risk by diversifying the remainder of your portfolio.

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans, and other institutional clients. To find out 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,

A beginner’s guide to retirement planning

uide to retirement planning

Many professionals feel overwhelmed by the prospect of managing their finances. Often, this results in avoidance and procrastination– it is easy to prioritize career or family obligations over money management.  Doing so puts off decision making until retirement looms.  While it is never too late to start saving for retirement,  the earlier you start, the more time your retirement assets have to grow.  There are several things you can do to start maximizing your retirement benefits.  In this posting, I will present my beginner’s guide to retirement planning.

Start Early 

It is critical to start saving early for retirement. An early start will lay the foundation for a healthy savings growth.

With 7% average annual stock return, $100,000 invested today can turn into almost $1.5m in 40 years. The power of compounding allows your investments to grow over time.

The table below shows you how the initial saving of $100,000 increases over 40 years:

Year 0       100,000
Year 10       196,715
Year 20       386,968
Year 30       761,226
Year 40    1,497,446

Not all of us have $100k to put away now. However, every little bit counts. Building a disciplined long-term approach towards saving and investing is the first and most essential requirement for stable retirement.

Know your tax rate

Knowing your tax bracket is crucial to setting your financial goals. Your tax rate is based on your gross annual income subtracted by allowable deductions (ex: primary residence mortgage deductions, charitable donations, and more).

See below table for 2016 tax brackets.

Guide to retirement planning

 

Jumping from a lower to a higher tax bracket while certainly helpful for your budget will increase your tax liabilities to IRS.

Why is important?  Understanding your tax bracket will help you optimize your savings for retirement.

Knowing your tax bracket will help you make better financial decisions in the future. Income tax brackets impact many aspects of retirement planning including choice of an investment plan, asset allocation mix, risk tolerance, tax level on capital gains and dividends.

As you can see in the above table, taxpayers in the 10% and 15% bracket (individuals making up to 37,650k and married couples filing jointly making up to $75,300) are exempt from paying taxes on long-term capital gains and qualified dividends.

Example: You are single. Your total income is $35,000 per year. You sold a stock that generated $4,000 long-term capital gain. You don’t owe taxes for the first $2,650 of your gain and only pay 15% of the remaining balance of $1,350 or $202.5

Conversely, taxpayers in the 39.6% tax bracket will pay 20% on their long-term capital gains and qualified dividends. A long-term capital gain or qualified dividend of $4,000 will create $800 tax liability to IRS.

Tax bracket becomes even more important when it comes to short-term capital gains. If you buy and sell securities within the same year, you will owe taxes at your ordinary income tax rate according to the chart above.

Example: You make $100,000 a year. You just sold company shares and made a short-term capital gain of $2,000. In this case, your tax bracket is 28%, and you will owe $560 to IRS. On the other hand, if you waited a little longer and sold your shares after one year you will pay only $300 to IRS.

Know your  State and City Income Tax

If you live in the following nine states, you are exempt from paying state income tax:  Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire and Tennessee.

For those living in other states, the state income tax rates vary by state and income level.  I’ve listed state income tax rates for California and New York for comparison.

California income tax rates for 2016:

1% on the first $7,850 of taxable income.

2% on taxable income between $7,851 and $18,610.

4% on taxable income between $18,611 and $29,372.

6% on taxable income between $29,373 and $40,773.

8% on taxable income between $40,774 and $51,530.

9.3% on taxable income between $51,531 and $263,222.

10.3% on taxable income between $263,223 and 315,866.

11.3% on taxable income between $315,867 and $526,443.

12.3% on taxable income of $526,444 and above.

 

New York State tax rates for 2016:

4% on the first $8,400 of taxable income.

4.5% on taxable income between $8,401 and $11,600.

5.25% on taxable income between $11,601 and $13,750.

5.9% on taxable income between $13,751 and $21,150.

6.45% on taxable income between $21,151 and $79,600.

6.65% on taxable income between $79,601 and $212,500.

6.85% on taxable income between $212,501 and $1,062,650.

8.82% on taxable income of more than $1,062,651.

 

City Tax

Although New York state income tax rates are lower than California, those who live in NYC will pay an additional city tax. As of this writing, the cities that maintain city taxes include New York City, Baltimore, Detroit, Kansas City, St. Louis, Portland, OR, Columbus, Cincinnati, and Cleveland. If you live in one of these cities, your paycheck will be lower as a result of this added tax.  The city tax rate varies from 1% and 3.65%.

Create an emergency fund

I recommend setting up an emergency fund that will cover six to 12 months of unexpected expenses. You can build your “rainy day” fund overtime by setting up automatic monthly withdrawals from your checking account. Unfortunately, in the current interest environment, most brick and mortar banks offer 0.1% to 0.2% interest on saving accounts.

Some of the other options to consider are saving account in FDIC-accredited online banks like Discover or Allied Bank, money market account, short term CD, short-term treasuries and municipal bonds.

Maximize your 401k contributions

Many companies now offer 401k plans to their employees as a means to boost employee satisfaction and retention rate. They also provide a matching contribution for up to a certain amount or percentage.

The 401k account contributions are tax deductible and thus decrease your taxable income.  Investments grow tax-free. Taxes are due during retirement when money is withdrawn from the account.

Hence, the 401k plan is an excellent platform to set aside money for retirement. The maximum employee contribution for 2016 is $18,000.  Your employer can potentially match up to $35,000 for a total joint contribution of $53,000. Companies usually match up to 3% to 5% of your salary.

401K withdrawals

Under certain circumstances, you can take a loan against your 401k or even withdraw the entire amount.  Plan participants may decide to take a loan to finance their first home purchase. You can use the funds as last resort income during economic hardship.

In general, I advise against liquidating your 401k unless all other financial options are exhausted.  If you withdraw money from your 401k, you will likely pay a penalty.  Even if you don’t pay a penalty, you miss out on potential growth through compounded returns.

Read the fine print

Most 401k plans will give you the option to rollover your investments to a tax-deferred IRA account once you leave your employer. You will probably have the opportunity to keep your investments in the current plan. While there are more good reasons to rollover your old 401k to IRA than keep it (a topic worth a separate article), knowing that you have options is half the battle.

Always read the fine print of your employer 401k package. The fact that your company promises to match up to a certain amount of money every year does not mean that the entire match is entirely vested to you.  The actual amount that you will take may depend on the number of years of service. For example, some employers will only allow their matching contribution to be fully vested after up to 5 years of service.   If you don’t know these details, ask your manager or call HR. It’s a good idea to understand your 401k vesting policy, particularly if you just joined or if you are planning to leave your employer.

In summary, having a 401k is a great way to save for retirement even if your employer doesn’t match or imposes restrictions on the matching contributions. Whatever amount you decide to invest, it is yours to keep. Your money will grow tax-free.

Maximize your Roth IRA

Often neglected, a Roth IRA is another great way to save money for retirement.  Roth IRA contributions are made after taxes. The main benefit is that investments inside the account grow tax-free. Therefore there are no taxes due after retirement withdrawals. The Roth IRA does not have any age restrictions, minimum contributions or withdrawal requirements.

The only catch is that you can only invest $5,500 each year and only if your modified adjusted gross income is under $117,000 for single and $184,000 for a couple filing jointly. If you make between $117,000 and $132,000 for an individual or $184,000 and $194,000 for a family filing jointly, the contribution to Roth IRA is possible at a reduced amount.

 

How to decide between Roth IRA and 401k

Ideally, you want to maximize contributions to both plans.

As a rule of thumb, if you expect to be in a higher tax bracket when you retire then prioritizing Roth IRA contributions is a good move.  This allows you to pay taxes on retirement savings now (at your lower taxable income) rather than later.

If you expect to retire at a lower rate (make less money), then invest more in a 401k plan.

Nobody can predict with absolute certainty their income and tax bracket in 20 or 40 years.  Life sometimes takes unexpected turns. Therefore the safe approach is to utilize all saving channels. Having a diverse stream of retirement income will help achieve higher security, lower risk and balanced after tax income.

I suggest prioritizing retirement contributions in the following order:

  1. Contribute in your 401k up to the maximum matching contribution by your employer. The match is free money.
  2. Gradually build your emergency fund by setting up an automatic withdrawal plan
  3. Maximize Roth IRA contributions every year, $5,500
  4. Any additional money that you want to save can go into your 401k plan. You can contribute up to $ 18,000 annually plus $6,000 for individuals over 50.
  5. Invest all extra residual income in your saving and taxable investment account

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

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.