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Early retirement for physicians

Early retirement for physicians

Early retirement for physicians….As someone married to a physician and surrounded by many friends in the medical field, I know that early retirement is on the minds of many physicians. If you are reading this article, you have probably put some serious thoughts about it as well.

Retiring early is a very personal decision. And it is not an easy decision to make. It would be best if you considered many financial and personal factors before you make the final call. Retirement will change your lifestyle dramatically. Your salary and healthcare benefits will be different. You might experience an unexpected change of pace. You may lose touch with colleagues and friends. On the bright side, you can travel and do things that matter most to you. Your stress level will decrease, and you will spend more time with your family and loved ones.

Physician Burnout

Many physicians decide to leave the profession due to physical and emotional stress. A 2019 study by the AMA, the Mayo Clinic, and Stanford University School of Medicine found that 44% of US physicians presented at least one symptom of burnout. For comparison, the overall burnout among US workers is 28%.

Among the specialties with the highest burnout rate are Urology (54%), Neurology (53%), Physical Medicine and Rehabilitation (52%), Internal Medicine (49%), and Emergency Medicine (48%).

The peer pressure for early retirement

Be prepared to encounter some resistance from colleagues and patients when you announce your early retirement. There is this unspoken public “belief” that doctors owe society their skills and knowledge. Many patients don’t want to look for another doctor. And some of your colleagues may feel that you are abandoning the profession. You need to ignore the noise and focus on your personal goals.

I compiled a list of suggestions that will help you prepare for your journey to early retirement. Don’t wait until the last moment. Get ahead of the curve so that you can take the financial stress out of your retirement plans.

Study your benefits

The first step to early retirement for physicians is to know your employee benefits in full detail. Most public and private healthcare systems offer competitive benefits packages with a wide range of perks, including pension, 401k match, profit sharing, healthcare coverage, life insurance, disability insurance, and loan repayment. Many employers even offer an early retirement option at 55.

These benefit packages vary significantly from one employer to the next. Take some time to learn and understand your options. If your goal is to retire early, consider an employer that will give you the highest chance to achieve this goal.

Become debt-free

The US student debt has skyrocketed to $1.6 trillion. Seventy-five percent of medical students graduated in their class of 2018 with student debt. The average loan per student is $196,520. Furthermore, many medical students graduate with more than $300,000 in debt. It’s not uncommon that some physician couples owe over half a million dollars in student debt.

A crucial step in your journey to early retirement for physicians is paying off ALL YOUR DEBT, including student loans, credit cards, and mortgages. It might seem like an uphill battle, but it’s not impossible.

There are several options you can consider when tackling your student loans – loan forgiveness, refinancing with low-interest rates, and income-driven repayment.

Maximize your retirement savings

When you retire early, assuming before the age of 66, you will not have full access to your social security benefits, pension, and Medicare benefits. In many cases, you may want to delay taking your pension and social security to maximize the amount you will receive annually.

One way to cover the gap while you are waiting is through your retirement savings. Most employers nowadays offer either a 401k, a 403b, or a 457-retirement plan. When you join your employer’s retirement plan, you can save up to $19,000 per year as of 2019. If you are 50 or older, you can save an additional $6,000 for a total of $25,000 per year. An additional benefit to you is that these contributions are tax-deductible and will lower your tax bill. Many employers also offer a match that can further boost your retirement savings. For more information about how to increase your 401k savings, read my article about “The Secret to becoming a 401k millionaire.“

Save outside your retirement plan

if you plan to retire early, you need to make additional savings outside of your retirement plan.

First, you need an emergency fund. It would help if you had at least six months’ worth of living expenses in cash or a savings account. This emergency fund will serve you as a buffer in case of sudden and unexpected expenses.

Second, save in a taxable investment account. The main benefit of using an investment account is liquidity. You can access these funds at any point in time without any restrictions.

If you retire in your 40s or 50s, you may not be able to access your retirement accounts before reaching 59 ½. Some legal exemptions, including poor health, disability, and economic hardship, allow withdrawing your retirement savings without a penalty. However, these exceptions may not apply to you. And ideally, you should let your tax-deferred retirement savings grow for as long as possible.

Investing outside of your retirement accounts does not provide immediate tax benefits. All investments will be after-taxes. You may also incur taxes on dividends and capital gains. To make the most out of your investment account, make sure to use low-cost, tax-efficient ETFs and index funds.

Have an exit strategy if you own a medical practice

If you own a medical practice and want to retire early, you need a good exit and succession plan. You will have to find a suitable buyer or someone who will manage the day-to-operations on your behalf. Many business owners have a significant portion of their wealth locked in their business. If selling your practice is the primary source of your retirement income, you will need to consider tax implications from any potential realized capital gains.

Consider moving to a low-cost location.

If you currently work and live in an expensive area like San Francisco or New York City, you may want to consider retiring in a different state or even another country. The cost of living differential between Mississippi or Arkansas versus New York and California could make a big difference in your retirement lifestyle, especially when working on a tight budget.

Look for healthcare coverage.

One of the main challenges when you plan for early retirement for physicians will be healthcare coverage. Depending on your employer, some doctors have excellent medical and dental benefits. In some cases, these benefits are completely free or heavily subsidized by your employer.  Some hospitals that offer an early retirement option could have healthcare benefits included. In other cases, when you retire early, you could lose these perks. Since you won’t have access to Medicare until you reach 65, you need to find a reasonably priced healthcare insurance policy.

Do not underestimate healthcare costs. According to Fidelity, a 65-year old couple retiring in 2019 can expect to spend $285,000 in health care and medical expenses throughout retirement. For single retirees, the health care cost could reach $150,000 for women and $135,000 for men.

Consider working per diem

If you are short of retirement savings or bored of staying at home, you may consider working per diem or locum tenens. You can work on an hourly basis at your own pace. The extra work will boost your early retirement income and will keep your knowledge up to date.

Stick to a budget

You must adhere to a budget before and after your retirement. Before retirement, you need to pay off your debt and save for retirement aggressively. Depending on your income, these payments can cut through your family budget. You may have to make some tough choices to avoid or delay large purchases and curb discretionary spending.

Once you retire, your income may go down. True, you don’t have to drive to work, but some of your expenses might still be the same.

Here are some ideas about how to save money—Cook instead of going to a restaurant. Make your coffee. Drive your old car instead of buying a new one—travel off-season.

Have a plan

A happy retirement comes with a good plan. It may require some self-discovery but ultimately will lead to finding a purpose and fulfilling your life dreams. You can travel and volunteer. Write a book. Teach. Learn a new hobby or language. Find out what makes you happy outside of your daily routine and make the most out of your free time.

The bottom line on early retirement

Early retirement for physicians is not an illusion. It’s an achievable mission that requires a great deal of planning and some personal sacrifice. If you want to retire early, you need to start planning now. Some hospital systems offer early retirement packages. Unfortunately, your guaranteed retirement income or pension will be a lot less than what you would get if you retire ten years later.

Your family can be a big influencer for or against your decision to retire early.  You might have a partner who wants to stay active. Perhaps, you have children who are going to college soon. Every family is different, and every situation is unique. Do the number crunching and see what makes the most sense to you.

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10 Behavioral biases that can ruin your investments

10 Behavioral biases that can ruin your investments

As a financial advisor, I often speak with my clients about behavioral biases. Our emotions can put a heavy load on our investment decisions. In this article, I would like to discuss ten behavioral biases that I encounter every day. It’s not a complete list, but it’s a good starting point to understand your behavioral biases and how to deal with them.

We have to make choices every day. Often our decisions are based on limited information or constrained by time. We want to make the right call every single time. But sometimes we are wrong. Sometimes we can be our worst enemy. Stress, distraction, media, and market craziness could get the worst of us.

Behavioral finance

In 2018 Richard Thaler won the Nobel prize for his work in behavioral economics. In his 2009 book “Nudge” and later on in his 2015 book “Misbehaving: The Making of Behavioral Economics,” Thaler reveals the architecture of the human decision-making process. He talks about behavioral biases, anomalies, and impulses that drive our daily choices.

In another study about the value of the financial advisor or the advisor alpha, Vanguard concluded that clients using a financial advisor have the potential to add 1.5% of additional annual returns as a result of behavioral coaching. Further on, Vanguard concludes that because investing evokes emotion, advisors need to help their clients maintain a long-term perspective and a disciplined approach.

 

Afraid to start investing 

Social Security is going into deficit by 2035. And most employers moving toward Defined Contribution Plans (401k, 403b, SEP-IRA). It will be up to you and me to secure our retirement by increasing our savings and investments. However, not everybody is in tune. For many people, investing is hard. It’s too complicated. Not all employers provide adequate training about retirement and investment options. And I don’t blame anyone. As much as I try to educate my blog readers, as well as many colleagues, we are outnumbered by the media and all kinds of financial gurus without proper training and credentials. If you are on the boat and want to start investing, talk to a fiduciary financial advisor, or ask your employer for educational and training literature. Don’t be afraid to ask hard questions and educate yourself.

“This time is different.”

How many times have you heard “This time is different” from a family member or the next financial guru, who is trying to sell you something? Very likely, it’s not going to be any different. As a matter, it could be worse. As humans, we tend to repeat our mistake over and over. It’s not that we don’t learn from our mistakes. But sometimes it’s just more comforting staying on your turf, not trying something new, and hoping that things will change. So, when you hear “This time is different,” you should be on high alert. Try to read between the lines and assess all your options.

Falling for “guaranteed income” or “can’t lose money” sales pitch

As many people are falling behind their retirement savings, they get tempted to a wide range of “guaranteed income” and “can’t lose money” financial products. The long list includes but not limited to annuities, life insurance products, private real estate, cryptocurrency, and reverse mortgage. Many of these products come with sky-high commissions and less than transparent fees, costly riders, and complex restrictions and high breakup fees. The sales pitch is often at an expensive steakhouse or a golf club following a meeting in the salesperson’s office where the deals are closed. If someone is offering you a free steak dinner to buy a financial product that you do not fully understand, please trust me on it – you will be the one picking the tab in the end.

Selling after a market crash

One of the most prominent behavioral biases people make in investing is selling their investments after a market crash. As painful as it could be, it’s one of the worst decisions you could make. Yes, markets are volatile. Yes, markets crash sometimes. But nobody has made any money panicking. You need to control your impulses to sell at the bottom. I know it’s not easy because I have been there myself. What really helps is thinking long-term. You can ask yourself, do you need this money right away. If you are going to retire in another 10 or 20 years, you don’t need to touch your portfolio, period. Market swings are an essential part of the economic cycle. Recessions help clean up the bad companies with a poor business model and ineffective management and let the winners take over.

You may remember that the rise of Apple coincided with the biggest recession in our lifetime, 2008 – 2009. Does anyone still remember Blackberry, Nokia, or Motorola, who were the pioneers of mobile phones?

Keeping your investments in cash

Another common behavioral bias is keeping your investments in cash…..indefinitely. People who keep their 401k or IRA in cash almost always miss the market recovery. At that point, they either have to chase the rally or must wait for a market correction and try to get in again. As a financial advisor, I would like to tell you that it is impossible to time exactly any market rally. By the time you realize it. It’s already too late.

To understand why timing the markets and avoiding risk by keeping cash can be harmful, see what happens if an investor misses the biggest up days in the market. The hypothetical table below looks at the performance of $10,000 invested in the S&P 500 between January 4, 1988, and December 31, 2018. It’s important to note this hypothetical investment occurred during two of the biggest bear markets in history, the 2000 tech bubble crash and the 2008 global financial crisis.

10 Behavioral biases that can ruin your investments - Keeping Cash

As you can see, missing the ten best days over between 1998 and 2018 meant earning nearly 2.5% less on an annual basis and leaving half of the potential absolute gains on the table. Here’s the kicker: Six of the 10 “best days” in the market were within weeks of the worst days in the market. In other words, some of the best days often happen as “v-shaped” bounces off the worst days. Going to cash on a big negative day means increasing the risk of missing a big positive day which, as can be seen from the table above, can have a substantial impact on your returns over time.

Chasing hot investments

One of the most common behavioral biases is chasing hot investments. People generally like to be with the winners. It feels good. It pumps your ego. There is a whole theory of momentum investing based on findings that investors buy recent winners and continue to buy their stock for another 6 to 12 months. We have seen it time and time again – from the tech bubble in 2000, through the mortgage-backed securities in 2008, to cryptocurrency and cannabis stocks in 2018. People like highflyers. Some prior hot stocks like Apple, Google, and Amazon dominate the stock markets today. Others like Motorola, Nokia, and GE dwindle in obscureness. If an investment had a considerable run, sometimes it’s better to let it go. Don’t chase it.

Holding your losers too long

“The most important thing to do if you find yourself in a hole is to stop digging.” – Warren Buffett. 

In a research conducted in the 1990s by professor Terrance Odean, he concluded that investors tend to hold to their losers a lot longer than their winners. A result of this approach, those investors continue to incur losses in the near future. Professor Odean offers a few explanations for his findings. One reason is that investors rationally or irrationally believe that their current losers will outperform. A second explanation comes from the Prospect Theory by Kahneman and Tversky (1979). According to them, investors become risk-averse about their winners and risk-seeking to their losers.

When it comes to losing bets, they are willing to take a higher gamble and seek to recover their original purchase price. A third theory that I support and observed is based on emotions. The pain from selling your losers is twice as high as the joy from selling your winners. We don’t like to be wrong. We want to hold on to the hope that we made the right decision. After all, it is a gamble, and the odds will be against you. At some point, we just need to make peace with your losses and move on. It’s not easy, but it’s the right thing to do.

Holding your winners too long

There is a quote by the famous financier Bernard Baruch – “I made my money by selling too soon.” Many people, however, often hold on to their winners for very long. Psychologically, it’s comforting to see your winners and feel great about your investment choices. There is nothing wrong with being a winner. But at some point, you must ask yourself, is it worth it. How long this run can go for and should you cash in some of your profits. What if your winners are making up a large part of your investment portfolio? Wouldn’t this put your entire retirement savings at risk if something were to happen to that investment?

There is no one-size-fits-all answer when it comes to selling your winners. Furthermore, there could be tax implications if you realize the gains in your brokerage account. However, it’s prudent to have an exit strategy. As much as it hurts (stops the joy) to sell the winners, it could lower the risk of your portfolio and allow you to diversify amongst other investments and asset classes.

Checking your portfolio every day

The stock market is volatile. Your investments will change every day. There will be large swings in both directions. So, checking your portfolio every single day can only drive crazy and will not move the needle. It could lead to irrational and emotional decisions that could have serious long-term repercussions. Be patient, disciplined, and follow your long-term plan.

Not seeking advice

Seeking advice from a complete stranger can be scary. You must reveal some of your biggest secrets to a person you never met before. It’s s big step. I wish the media spends more time talking about the thousands of fiduciary advisors out there who honestly and trustworthy look for your best interest.

My financial advisory service is based on trust between you as a client and me as the advisor . So, do not be afraid to seek advice, but you also need to do your homework. Find an advisor who will represent you and your family and will care about your personal goal and financial priorities. Don’t be afraid to interview several advisors before you find the best match for you.

Final words

“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.” – Warren Buffet.

Investing is an emotional act. We put our chips on the table and wish for a great outcome. We win, or we lose. Understanding your emotions and behavioral biases will help you become a better investor. It doesn’t mean that we will always make the right decisions. It doesn’t mean that we will never make a mistake again. We are humans, not robots. Behavioral biases are part of our system. Knowing how we feel and why feel a certain way, can help us when the markets are volatile, when things get ugly or the “next big thing” is offered to us. Look at the big picture. Know your goals and financial priorities. Try to block the noise and keep a long-term view.

Reach out

If you have questions about your investments and retirement savings, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit my 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, founder of Babylon Wealth Management

Stoyan Panayotov, CFA, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families, physicians, and successful business owners.

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The biggest risks for your retirement savings

Biggest risks to your retirement savings

Whether you are just starting your career or about to retire, you need to understand the risks you are facing when you plan for your future retirement.

Most experts recommend that you should aim to replace about 80% of work income during your retirement. Part of your retirement income will come from Social Security. Other sources could be a public pension, IRAs, 401k, rental income, sale of real estate or business, royalties, or a part-time job. However, the 80% is not a definite number. The amount you need in retirement could vary substantially depending on your lifestyle, family size, number of dependents, health issues, and so on.

Social Security benefits

The maximum Social Security benefit in 2019:

  • $3,770 for someone who files at age 70.
  • $2,861 for someone at a full retirement age of 66
  • $2,209 for someone aged 62

For reference, very few people reach these upper limits. The average Social Security retirement benefit in 2019 is $1,461 a month. The average disability benefit is $1,234.

Unfortunately, the Social Security trust is already running a deficit. Currently, the Social Security is paying more benefits than all the proceed its receiving from the payroll taxes. Its reserve will be depleted by 2035. After that point, social security recipients will have to receive only a portion of their actual benefit. The current estimate is around 75%.

Pension Shortfall

Similarly to Social Security, most of the public and private pension plans nationwide have an enormous shortfall between assets and their future liabilities. According to a recent study by Pew Charitable Trust and Pension Tracker, US public pension shortfall is over $1 trillion. States like Alaska, California, Illinois, Ohio, Hawaii, and New Jersey have one of the highest pension burdens in the nation. Even after ten years of economic recovery and bull market, most state pension plans are not prepared to face another downturn. Policymakers must take urgent measures to close the pension funding gap, which remains at historically high levels as a share of GDP.

Low savings rate

With social security benefits expected to shrink, I advise my clients that they need to increase their savings in order to supplement their income in the future. Retirement savings in IRA, 401k and even a brokerage account will provide you with the necessary income during your retirement years.

Unfortunately, not everyone is forward-looking. The average 401k balance, according to Fidelity, is $106,000 in 2019, while the average IRA is $110,000. The sad reality is that most Americans do not save enough for retirement and we are facing a retirement crisis.

Not saving enough for retirement is the highest risk of enjoying your retirement years.

Relying on a single source

Many people make the mistake of relying on a single source of income for their retirement.  

Imagine that you were planning to retire in 2009 upon selling a piece of real estate. Or you had all your retirement savings in a 401k plan and the market just crashed 50%.  Many of these folks had to delay their retirement for several years to make up for the lost income. Similarly, selling your business can be risky too. With technology advancements, many businesses are becoming obsolete. You may not always be able to find buyers or get the highest price for your business.

We always recommend to our clients to have a diversified stream of retirement income. Diversifying your source will create a natural safety net and potentially could increase the predictability of your income in retirement.

Market risk

We all would like to retire when the market is up and our retirement account balance is high. However, the income from these retirement accounts like IRA, Roth IRA and 401k are not guaranteed. As more people relying on them for retirement, their savings become subject to market turbulence and the wellbeing of the economy.  Today, prospective retirees must confront with high equity valuations, volatile markets, and ultra-low and even negative yields.

In my practice, I use my clients’ risk tolerance as an indicator of their comfort level during market volatility. With market risk in mind, I craft well-diversified individual retirement strategies based on my clients’ risk tolerance and long-term and short-term financial goals.

Sequence of returns

The sequence of returns is the order of how your portfolio returns happen over time. If you are in your accumulation phase, the sequence of return doesn’t impact your final outcome. You will end up with the same amount regardless of the order of your annual returns.  

However, if you are in your withdrawal phase, the sequence of returns can have a dramatic impact on your retirement income. Most retires with a 401k or IRAs have to periodically sell a portion of their portfolios to supplement their income. Most financial planning software uses an average annual return rate to project future account balance. However, these average estimates become meaningless if you experience a large loss at the start of your retirement.

Our retirement strategies take the sequence of returns very seriously. Some of the tools we use involve maintaining cash buffers, building bond ladders and keeping a flexible budget.

Taxes

Your IRA balance might be comforting but not all of it is yours. You will owe income taxes on every dollar you take out of any tax-deferred account (IRA, 401k, 403b). You will pay capital gain taxes on all realized gains in your brokerage accounts. Even Social Security is taxable.

With skyrocketing deficits in the treasury budget, social security and public pensions will guarantee one thing – higher taxes. There is no doubt that someone will have to pick up the check. And that someone is the US taxpayer – me and you.

Managing your taxes is a core function of our wealth management practice. Obviously, we all must pay taxes. And we can not predict what politicians will decide in the future. However, managing your investments in a tax-efficient manner will ensure that you keep more money in your pocket.

Inflation risk

Most retirees have a significant portion of their portfolios in fixed income. Modern portfolio managers use fixed income instruments to reduce investment risk for their clients. At the time of this article, we are seeing negative and near-zero interest rates around the world. However, with inflation going at around 2% a year, the income from fixed-income investments will not cover the cost of living adjustments. Retirees will effectively lose purchasing power on their dollars.

Interest risk

Bonds lose value when interest rates go up and make gains when interest rates go down. For over a decade, we have seen rock bottom interest rates. We had a small blip in 2018 when the Fed raised rates 4 times and 1 year’s CDs reached 2.5%. At that point in time, many investors were worried that higher interest rates will hurt bond investors, consumers and even companies who use a lot of debt to finance their business. Even though these fears are subdued for now, interest rates remain a viable threat. Negative interest rates are as bad for fixed income investors as the high rates are. Unfortunately, traditional bond portfolios may not be sufficient to provide income and protect investors for market swings. Investors will need to seek alternatives or take higher risks to generate income.

Unexpected expenses

Most financial planning software will lay out a financial plan including your projected costs during retirement. While most financial planning software these days is quite sophisticated, the plan remains a plan. We can not predict the unexpected. In my practice, I regularly see clients withdrawing large sums from their retirement savings to finance a new home, renovation, a new car, college fees, legal fees, unexpectedly high taxes and so on. Reducing your retirement savings can be a bad idea on many levels. I typically recommend building an emergency fund worth at least 6 months of living expenses to cover any unexpected expenses that may occur. That way, you don’t have to touch your retirement savings.

Healthcare cost

The average health care cost of a retired couple is $260,000. This estimate could vary significantly depending on your health. Unless you have full health insurance from your previous employer, you will need to budget a portion of your retirement savings to cover health-related expenses. Keep in mind that Medicare part A covers only part of your health cost. The remaining, parts B, C, and D, will be paid out of pocket or through private insurance.

Furthermore, as CNBC reported, the cost of long-term care insurance has gone up by more than 60% between 2013 and 2018 and continues to go higher. The annual national median cost of a private room in a nursing home was $100,375 in 2018.

For future retirees, even those in good shape, healthcare costs will be one of the largest expenses during retirement. In my practice, I take this risk very seriously and work with my clients to cover all bases of their health care coverage during retirement.

Longevity

Longevity risk is the risk of running out of money during retirement. Running out of money depends on an array of factors including your health, lifestyle, family support and the size and sources of retirement income.  My goal as a financial advisor is to ensure that your money lasts you through the rest of your life.

Legacy risk

For many of my clients leaving a legacy is an important part of their personal goal. Whether funding college expenses, taking care of loved ones or donating to a charitable cause, legacy planning is a cornerstone of our financial plan. Having a robust estate plan will reduce the risks to your assets when you are gone or incapacitated to make decisions. 

Liquidity Risk

Liquidity risk is the risk that you will not be able to find buyers for your investments and other assets that you are ready to sell. Often times, during an economic downturn, the liquidity shrinks. There will be more sellers than buyers. The banks are not willing to extend loans to finance riskier deals. In many cases, the sellers will have to sell their assets at a significant discount to facilitate the transaction.

Behavioral risk

Typically, investors are willing to take more risk when the economy is good and the equity markets are high. Investors become more conservative and risk-averse when markets drop significantly. As humans, we have behavioral biases, Sometimes, we let our emotions get the worst of us. We spend frivolously. We chase hot stocks. Or keep all investments in cash. Or sell after a market crash. Working with a fiduciary advisor will help you understand these biases. Together, we can find a way to make unbiased decisions looking after your top financial priorities.

Final Words

Preparing for retirement is a long process. It involves a wide range of obstacles. With proper long-term planning, you can avoid or minimize some of these risks. You can focus on reaching your financial goals and enjoying what matters most to you.

Reach out

If you need help growing your retirement savings, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit my 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, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families, physicians, and successful business owners.

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Why negative interest rates are bad for your portfolio

Why negative interest rates are bad for your portfolio

Quantitative Easing

Ever since the financial crisis of 2008-2009, central banks around the world have been using lower interest rates and Quantitative Easing (QE) to combat to slow growth and recession fears. In the aftermath of the Great Recession, all major central banks cut their funding interest rate to nearly zero.

The QE policy led to the longest US economic expansion in history. As the US economy improved, the Federal Reserve started hiking rates in late 2015 and continued hiking until December of 2018. The Fen fund rate reached 2.4% in the early months of 2019. In the meantime, the European and Japan Central Banks hovered their interest rates near zero. In 2016, for the first time, we registered negative interest rates in Europe and Japan.

The trade wars

Escalating fears for slowing global growth and trade war threats had forced the Fed to announce its first rate cut since the financial crisis. While widely expected, the rate cut triggered a chain of events. First, President Trump imposed an additional 10% import tax on $300 billion of Chinese good. In return, the Chinese central bank lowered the target exchange rate between US dollars and yuan to 7.0039, the lowest level since April 2008. Losing confidence for a quick trade resolution the equity markets sold off by 3%. The 10-year Treasury fell to 1.7%, one of the lowest levels since the financial crisis.

Negative interest rates

Fearing that the intensifying trade war between the US and China could adversely impact the global economy, many Central banks around the world cut their funding rates to zero or even negative levels. Most recently the Reserve Bank of New Zealand lowered its rate from 1.5% to 1%. Furthermore, the New Zealand Governor said, “It’s easily within the realms of possibility that we might have to use negative interest rates,”

In Germany, the 30-year government bond turned negative for the first time last week. In Japan, the 10-year government bond yields -0.2%.

As we stand today, there is $15 trillion in government bonds that offer negative interest rates, according to Deutsche Bank. In short, European investors are paying to own EU government bonds. 

In addition, there are 14 European below investment grade bond issuers trading at negatives rates. Conventionally, the junk bonds are issued by risky borrowers with weaker balance sheets that may struggle to pay back their loans. The typical junk-bond offers a higher income to compensate investors for taking the higher risk of not getting paid at all.

So why negative interest rates are bad for your portfolio

Traditionally, retired and conservative investors have used government bonds as a safe-haven investment. Historically, US treasuries have had a negative correlation with stocks. When the equity markets are volatile, many investors move to US government bonds to wait out the storm. Therefore, many portfolio managers around the world use government bonds as a diversification to lower the risk of your investment portfolio.

So, let’s imagine a conservative investor whose portfolio is invested in about 40% in Equities and 60% in Fixed Income. This person has a low-risk tolerance and would like to use some the extra income to supplement her social security benefits and pension. With ultra-low or negative interest rates, 60% of the portfolio is practically earning nothing and potentially losing money. Let’s break it down.

Lending free money

Investors in negative-yielding bonds are effectively giving the government free money and receiving nothing in return. With $15 trillion worth of negative-yielding bonds, many institutional investors might be willing to take the “deal” since they have legal restrictions on a target amount of fixed income instruments they must own.

No risk-reward premium

The interest rate is the risk-reward premium that the lender is willing to take to provide a loan to a borrower. The higher the risk, the higher the interest rate. Simple. If the risk-reward relationship is broken, many creditors will choose not to lend any money and have the risk of going out of business. Why would a bank give you a negative interest mortgage on your home?

Can’t supplement income

Going back to our imaginary investor with 60% in negative-yielding bonds. This portfolio will not be able to provide additional income that she will need to supplement their pension or social security benefits. What if our investors could not rely on guaranteed benefits, and her portfolio was the sole generator of income? In that case, she will have to spend down the portfolio over time. She would have to adjust her lifestyle and lower her cost so she can stretch the portfolio as long as she could.

Need to take more risk to generate higher income

What if our investor wants to protect her principal? To generate higher income, our conservative investor will ultimately have to consider higher-risk investments that offer a higher positive yield. She will have to be willing to take more risk to receive a higher income from her portfolio.    

Subject to inflation risk

The inflation risk is the risk of lower purchasing power of your money due to rising prices. In a simple example, if you own $100 today and the annual inflation is 2%, the real value of your money will be $98 in a year. You are essentially losing money.

With the US inflation rate at around 1.6% as of June of 2019 and Eurozone inflation rate hovering about 1.2%, there is a real risk that the ultra-low and negative rates will reduce the real value of your investments. Investments in negative-yielding bonds will end up with lower purchasing power over time 

Subject to interest rate risk

In the fixed-income world, rising interest rates lead to a lower value of your bonds. The reason is that older bonds will have to sell at a lower price to match the yield of the newly issued bonds with a higher interest. Just about a year ago when the Fed was hiking rates by 0.25% every quarter, fixed income investors were rightly worried that their bond holdings would lose value. Many bonds funds ended up in the negative in 2018. Even with lower or negative interests, this risk is looming out there.

Promote frivolous spending and cheap debt

It’s not a secret that lower interest rates allow more individuals, corporations, and governments alike to borrow cheap credit. While everybody’s situation is unique, cheap credit often leads to frivolous and irresponsible spending. With US consumer debt reaching $13.51 trillion, total US corporate debt at $15.5 trillion, and Federal debt pushing above $22 trillion, the last thing we need is banks and politicians writing blank checks.

Create asset bubbles

Cheap credit leads to asset bubbles. Artificially low interests allow phantom companies with negative earnings and weak balance sheet to borrow cheap credit and stay afloat. 

The financial crisis of 2008 – 2009 was caused by lower interest rates, which increased the value of US real estate. Many borrowers who otherwise couldn’t afford a mortgage took on cheap loans to buy properties around the country. This led to a real estate bubble which burst soon after the Fed started hiking the interest rates.

One bright spot

The lower interest rate will allow millions of Americans to refinance their mortgage, student debt, or personal loan. If you have borrowed money in the last three year, you might be eligible for refinancing. Be diligent, talk to your banker, and assess all options before taking the next step.

Reach out

If you need help with your investment portfolio or have questions about generating income from your investments, reach out to me at stoyan@babylonwealth.com or 925-448-9880.

You can also visit my 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, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families and successful business owners.

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The Secret to becoming a 401k millionaire

401k millionaire

How to become a 401k millionaire? Today, 401k plans are one of the most popular employee benefits. Companies use 401k plans to attract top talent. 401k plan is a powerful vehicle to save for retirement and become financially independent. According to Fidelity, there are 180,000 Fidelity 401(k) plans with a $1 million or more balance. Congratulations to you If you are one of them. There are still many helpful tips that can get you to reach your financial goals while keeping your investments safe.

You hear stories about people with a million dollars in their 401k plan. Then you look at your 401k balance, and it doesn’t look as high as you would like it to be.

The path to becoming a 401k millionaire

I hope this article will guide you on your path to become a 401k millionaire.

Many variables can impact your 401k account – age, salary, debt, tax rate, risk tolerance, plan fees, employee match.

Becoming a 401k millionaire is not as hard as it might seem. However, you need to follow a few simple rules that can get you on the right path.

“The best time to plant a tree was 20 years ago. The second-best time is now.”

Start saving early in your 401k

Saving early in your 401k will guarantee you the highest chance to become a 401k millionaire at the lowest cost.

I did the math for how much you need to contribute if you start fresh at any age. These numbers are based on assumptions for continuous monthly 401k contributions until reaching 65 with a 7% average annual market return for a 60/40 portfolio and 2% annual inflation.  Keep in mind that these assumptions are just assumptions and only for illustration purposes.  Your situation could be unique and could change the math dramatically.

401k Contributions by Age if you start fresh

 

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

 

What drives the growth of your 401k is the power of compounding. It’s the snowball effect of accumulating earnings-generating more earnings over time. The longer you wait, the larger you will need to contribute to reaching your 1-million goal.

If you are 25-years old and just starting your career, you need to save approximately $390 per month or $4,644 annually to reach the $1-million goal by the age of 65. Your lifetime contribution between the age of 25 and 65 will be $190,000.

When you start saving in your 30s, this target number goes to $560 per month. Your lifetime contribution between the age of 30 and 65 will be $241,920.

Your saving rate goes up to 1,220 per month if you start saving actively in your 40s and increases to $5,330 at the age of 55.

Take advantage of your employer match.

If my recommended monthly contribution looks like an uphill battle, don’t forget about your employer match. Many employers offer a 401k match to attract and keep top talent. The match could be a percentage of your salary, a one-to-one match, or an absolute dollar amount. If your employer offers a 4% match, at a minimum, you should contribute 4% to your 401k plan. Take full advantage of this opportunity to get free money.

Max out your 401k

In 2020, you can make up to a $19,500 contribution to your 401k plan. If you can afford it, always try to max out your contributions.

Catch-up contributions when 50 and older

If you are 50 years or older, you can make an additional $6,500 contribution to your plan. Combined with the $19,500 limit, that is a maximum of $26,000 in 2020.

Save aggressively

Obviously, owning $1 million is a big accomplishment. However, it may not be enough to sustain your lifestyle during retirement.  As a financial advisor, I recommend that my clients replace at least 80% of their income before retirement. If you are a high earner or plan to retire early, you need to save more aggressively to reach your goals.

Be consistent

An important part of the formula of becoming a 401k millionaire is consistency.  Saving every month and every year is a critical part of achieving your financial goals. On the contrary, large gaps could hurt your chances of reaching your financial goals.

Don’t panic during market turbulence.

The market can be volatile. Don’t let your emotions get the worst of you. Nobody has made any money panicking. During 2008-2009, many people stopped contributing to their 401k plans or moved their investments into cash. These folks never participated in the market recovery and the longest bull market in history. Stay invested. And think of this way. If the market goes down, your plan will invest your automatic monthly contributions at lower prices. You are already getting a deal.

Watch your fees

Higher fees can erode your returns and slow down the pursuit of your financial goals. I recently advised a 401k plan, where the average fund’s fees were 1.5%. In the age of ETFs and index investing, it is mind-blowing that some 401k plan still charges exuberantly high fees. If your 401k plan charges high fees, talk to your manager or HR representative, and demand lower fee options.

Be mindful of your taxes.

Taxes play a big role in 401k planning. Most 401k contributions are tax-deferred. Meaning that your contributions will reduce your current taxable income. Your investments will grow tax-free until you reach retirement age. You start paying taxes on your withdrawals. There are a couple of strategies you can implement to make your withdrawals to make more tax-efficient. You can reach out to me if you have any questions on that topic, as every situation is unique and could require a unique solution.

Roth 401k

Currently, some employers offer a Roth 401k contribution as an additional option to their plan. Unlike the tax-deferred option, Roth 401k contributions are made on an after-tax basis. Roth 401k contributions don’t have an immediate financial impact. However, if planned well, Roth contributions could help you immensely to reach your financial goals. For example, let’s assume that you are in a low tax bracket and your employers offer both tax-deferred and Roth 401k contributions. The tax-deferred option is usually the default. But if you are in a low tax bracket, your tax benefit will be minimal. In that case, maybe it’s worth selecting the Roth 401k.

Don’t take a loan

Under no circumstances you should take a loan from your 401k plan. No matter how dire the situation is, try to find an alternative.  Taking a loan from your 401k can set you back many years in achieving your financial goal of becoming a 401k millionaire. Obviously, all rules have exceptions, but before you take a loan from your 401k, talk to your financial advisor first for alternatives.

Keep a long-term view.

Life happens. Markets go up and down. You can lose your job or change employers. You need to pay off a big loan. Your car breaks down. You need money for a down payment on your first house. Something always happens. Circumstances change. Whatever happens, keep a long-term view. Your 401k plan could be the answer to your financial independence. Don’t make rash decisions.

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The Smart Way to Manage Your Sudden Wealth

The Smart Way to Manage Your Sudden Wealth

Getting rich is the dream of many people. When your sudden wealth becomes a reality, you need to be ready for the new responsibilities and challenges. As someone experienced in helping my clients manage their sudden wealth, I want to share some of my experience.

Sources of sudden wealth

Your sudden windfall can come from many different sources – receiving an Inheritance, winning the lottery, selling your business or a real estate property, signing a new sport or music contract, royalties from a bestselling book or a hit song, or selling shares after your company finally goes public. Whatever the source is, your life is about to change. Being rich brings a unique level of issues.  Your new wealth can have a variety of financial, legal and core repercussions to your life.

Avoid making any immediate changes to your life

Don’t make big and hasty changes to your lifestyle. I recommend that you wait at least six months. Let the big news sink in your mind.  Let things settle down before quitting your job, moving to another city or making a large purchase. Keep it quiet. The next six month will give you a chance to reassess your life, control your emotions and set your priorities.

Figure out what you own

This is the moment you have been waiting for all your life.
You are probably very excited, and you deserve it. There are tons of things you want to do with your money. But before you do anything.  Take a deep breath. Figure out exactly what you own. Gather all necessary information about your assets. Maybe your sudden
windfall is in cash. However, your new wealth could be in real estate, land, stocks, art, gold, rare wines, luxury cars and so on. Not always your new fortunate can easily be converted into cash. Each wealth source is unique on its own and has specific legal and financial rules.

Build your team

Your financial life is about to become a lot more complicated. You will need a team of trusted experts who will help you navigate through these changes. Your financial team can help you understand your wealth.   They watch your back and flag any blind spots. Talk to your team and figure what are your options.

Hire a CPA

You are rich. And that’s a great news for the IRS and your state. There is a very good chance you will pay more taxes that you ever imagined. Start assembling your financial team by hiring a reputable CPA who
understands your situation and can steer you through the complex world of taxes.  Each source of wealth has unique tax rules. Find out what rules apply to you.

Hire a financial advisor

Look for a trusted fiduciary financial advisor with experience managing sudden wealth. A fiduciary advisor will look after your best interest and guide you in your new journey. Talk to your new advisors about your personal and financial goals and how to reach them with the help of your new wealth.

Have a financial plan

Ask your advisor to craft a financial plan that is tailored to your unique situation, specific needs and financial objectives. Figure out how
your sudden wealth can help you reach your goals – retire early, send your kids to college, buy a new house, become self-employed. The list is endless. Talk to your advisor about your risk tolerance. Many of my clients who earned a windfall have a low risk appetite. An important part of our conversation is how to reach their goals without taking on too much risk.

Protect your new
wealth

You need to take steps to protect your sudden windfall.  For a starter, try to keep

If your new money is sitting in your checking account, make sure you allocate it among several different banks and account types. Remember that FDIC insurance covers up to 250k per person per bank in each account category.

If you inherited real estate or art or some other type of physical
property make sure to have solid Insurance to protect you from unexpected events.  

In case you received stocks or other investments, speak to
your financial advisor how to hedge them from market volatility and losing value.

Have an estate plan

No matter how well you plan, life can be unpredictable. Getting a windfall is a great opportunity to update your estate plan or craft a new one. The estate plan will protect your loved ones and ensure your legacy in the face of the unknown. If something happens to you, your fortune will be used and divided per your own wish. The alternative is going through a lengthy and expensive probate process that may
not have the same outcome.

Pay off your debts

If you owe money, you have a chance to pay off your debts.  Credit cards debts and any personal loans with high interest should be your priority. Your new wealth can help your live a debt-free life. This is one area where working with a financial advisor will make a big difference in your life.  

Beware that many people who receive sudden windfall end up
borrowing more money and sometimes filing for bankruptcy.  Don’t be that person. You still need to live within
your means.

Plan your taxes

Depending on the source of sudden wealth you may owe taxes to the IRS and your state either immediately or sometime in the near future. Don’t underestimate your tax bill. Your CPA and financial advisor should help you understand and prepare for your current and future tax bills.

Don’t overspend

Many lottery winners and former athletes file for bankruptcy
due to poor spending habits, lending money to family and friends and money mismanagement.
The fact that you are rich doesn’t mean that you can’t lose your money. You need to be responsible. Talk to your advisor about your monthly budget and what you can afford.  

Be philanthropic

Making a donation is an excellent way to give back to the society and leave a legacy.  If you have a charitable cause close to your heart, you make a difference. Often time, charitable contributions can be tax-deductible and lower your tax bill. Talk to your CPA and financial advisors how you can achieve that.

Conclusion

Sudden Wealth can come in all shapes and forms – cash, real estate, land, ongoing business, royalties, stocks, and many others. Even though it might not be completely unexpected, the way you feel about after the fact might be shocking to you. Don’t let your emotions get the worst of you. Getting windfall is a great life accomplishment. And you should make the best out of it.  Work with your team of trusted professionals and build a long-term plan with milestones and objectives.

Reach out

If you are expecting a windfall or recently received a sudden wealth, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

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

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8 reasons to open a solo 401k plan

8 reasons why entrepreneurs should open a solo 401k plan

What is a solo 401k plan

The solo 401k plan is a powerful tool for entrepreneurs to save money for retirement and reduce their current tax bill. These plans are often ignored and overshadowed by the more popular corporate 401k and SEP IRA plans.  In fact, there is a lack of widely available public information about them. Simply put, not many people know about it. In this article, I will discuss 8 reasons why entrepreneurs should open a solo 401k plan.

Solo or one participant 401k plans are available to solo entrepreneurs who do not have any personnel on staff. If a business owner employs seasonal workers who register less than 1,000 hours a year, then he or she may be eligible for the solo 401k plans as well. The solo plans have most of the characteristics of the traditional 401k plan without any of the restrictions.

Learn more about our Private Client Services

What are some of the most significant benefits of the self-employed 401k?

Maximize your retirement savings with a solo 401k

Self-employed 401k allows a business owner to save up to $56,000 a year for retirement, plus an additional $6,000 if age 50 and over. How does the math work exactly?

Solo entrepreneurs play a dual role in their business – an employee and an employer. As an employee, they can contribute up to $19,000 a year plus catch-up of $6,000 if over the age of 50. Further, the business owner can add up to $37,000 of contribution as an employer match. The employee’s side of the contribution is subject to 25% of the total compensation, which the business owner must pay herself.

Example: Jessica, age 52, has a solo practice. She earns a W2 salary of $100,000 from her S-corporation. Jessica set-up a solo 401k plan. In 2017 she can contribute $18,000 plus $6,000 catch-up, for a total of $24,000 as an employee of her company. Additionally, Jessica can add up to $25,000 (25% x $100,000) as an employer. All-n-all, she can save up to $49,000 in her solo 401k plan.

One important side note, if a business owner works for another company and participates in their 401(k), the above limits are applicable per person, not per plan. Therefore, the entrepreneur has to deduct any contributions from the second plan to stay within the allowed limits.

Add your spouse

A business owner can add his or her spouse to the 401k plan subject to the same limits discussed above. To be eligible for these contributions, the spouse has to earn income from the business. The spouse must report a wage from the company on a W2 form for tax purposes.

Reduce your current tax bill

The solo 401k plans contributions will reduce your tax bill at year-end. The wage contributions will lower your ordinary income tax. The company contributions will decrease your corporate tax.

This is a very significant benefit for all business owners and in particular for those who fall into higher income tax brackets. If an entrepreneur believes that her tax rate will go down in the future, maximizing her current solo 401k contributions now, can deliver substantial tax benefits in the long run.

Opt for Roth contributions

Most solo 401k plans allow for Roth contributions. These contributions are after taxes. Therefore, they do not lower current taxes. However, the long-term benefit is that all investments from Roth contributions grow tax-free. No taxes will be due at withdrawal during retirement.

Only the employee contributions are eligible for the Roth status. So solo entrepreneur can add up to $19,000 plus $6,000 in post-tax Roth contributions and $37,000 as tax-deductible employer contributions.

The Roth contributions are especially beneficial for young entrepreneurs or those in a lower tax bracket who expect that their income and taxes will be higher when they retire. By paying taxes now at a lower rate, plan owners avoid paying much larger tax bill later when they retire, assuming their tax rate will be higher.

No annual test

Solo 401k plans are not subject to the same strict regulations as their corporate rivals. Self-employed plans do not require a discrimination test as long as the only participants are the business owner and the spouse.

If the company employs workers who meet the eligibility requirements, they must be included in the plan.  To be eligible for the 401k plan, the worker must be a salaried full-time employee working more than 1,000 hours a year. In those cases, the plan administrator must conduct annual discrimination test which assesses the employee participation in the 401k plan. As long as solo entrepreneurs do not hire any full-time workers, they can avoid the discrimination test in their 401k plan.

No annual filing

Another benefit of the 401k plans is the exemption from annual filing a form 5500-EZ, as long as the year-end plan assets do not exceed $250,000. If plan assets exceed that amount, the plan administrator or the owner himself must do the annual filing. To learn more about the annual filing process, visit this page.

Asset protection

401k plans offer one of the highest bankruptcy protection than any other retirement accounts including IRA. The assets in 401k are safe from creditors as long as they remain there.

In general, all ERISA eligible retirement plans like 401k plan are sheltered from creditors. Non-ERISA plans like IRAs are also protected up to $1,283,025 (in aggregate) under federal law plus any additional state law protection.

Flexibility

You can open a self-employed 401k plan at nearly any broker like Fidelity, Schwab or Vanguard. The process is relatively straightforward. It requires filling out a form, company name, Tax ID, etc. Most brokers will act as your plan administrator. As long as, the business owner remain self-employed, doesn’t hire any full-time workers and plan assets do not exceed $250,000, plan administration will be relatively straightforward.

As a sponsor of your 401k plan, you can choose to manage it yourself or hire an investment advisor. Either way, most solo 401k plans offer a broader range of investments than comparable corporate 401k plans. Depending on your provider you may have access to a more extensive selection of investment choices including ETFs, low-cost mutual funds, stocks, and REITs. Always verify your investment selection and trading costs before opening an account with any financial provider.

About the author:

Stoyan Panayotov, CFA, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families, physicians, and successful business owners.

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All you need to know about Restricted Stock Units (RSUs)

Restricted Stock Units (RSU)

Restricted Stock Units are a popular equity compensation for both start-up and public companies. Employers, especially many startups, use a variety of compensation options to attract and keep top-performing employees. Receiving RSUs allows employees to share in the ownership and the profits of the company. Equity compensation takes different forms such as stock options, restricted stock units, and deferred compensation. If you are fortunate to receive RSU from your employer, you should understand the basics of this corporate perk. Here are some essential tips on how to manage them.

What are RSUs?

A restricted stock unit is a type of equity compensation by companies to employees in the form of company stock. Employees receive RSUs through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. RSUs give an employee interest in company stock but they have no tangible value until vesting is complete.

Vesting Schedule

Companies issue restricted stock units according to a vesting schedule.
The vesting schedule outlines the rules by which employees receive full ownership of their company stock. The restricted stock units are assigned a fair market value when they vest. Upon vesting, they are considered income, and often a portion of the shares is withheld to pay income taxes. The employees receive the remaining shares and can sell them at their discretion.

As an employee, you should keep track of these essential dates and figures.

Grant Date

The grant date is the date when the company pledges the shares to you. You will be able to see them in your corporate account.

Vesting Date

You only own the shares when the granted RSUs are fully ‘vested’.  On the vesting date, your employer will transfer the full ownership of the shares to you. Upon vesting, you will become the owner of the shares.

Fair Market Value

When vesting is complete, the restricted stock units are valued according to the fair market value (FMV)  at that time. Your employer will provide you with the FMV based on public price or private assessment.

Selling your RSU

Once the RSUs are converted to company stock, you become a shareholder in your firm. You will be able to sell all or some of these shares subject to companies’ holding period restrictions. Many firms impose trading windows and limits for employees and senior executives.

How are RSUs taxed?

You do not pay taxes on your restricted stock units when you first receive them.  Typically you will owe ordinary income tax on the fair market value of your shares as soon as they vest.

The fair market value of your vested RSUs is taxable as personal income in the year of vesting. This is a compensation income and will be subject to federal and local taxes as well as Social Security and Medicare charges.

Typically, companies withhold part of the shares to cover all taxes. They will give employees the remaining shares. At this point, you can decide to keep or sell them at your wish. If your employer doesn’t withhold taxes for your vested shares, you will be responsible for paying these taxes during the tax season.

Double Trigger RSUs

Many private Pre-IPO companies would offer double-trigger RSUs. These types of RSUs become taxable under two conditions:
1. Your RSU are vested
2. You experience a liquidity event such as an IPO, tender offer, or acquisition.

You will not owe taxes on any double-trigger RSUs at your vesting date. However, you will all taxes on ALL your vested shares in the day of your liquidity event.

Capital gain taxes

When you decide to sell your shares, you will pay capital gain taxes on the difference between the current market price and the original purchase price.

You will need to pay short-term capital gain taxes for shares held less than a year from the vesting date.  Short-term capital gains are taxable as ordinary income.

You will owe long-term capital gains taxes for shares that you held for longer than one year. Long-term capital gains have a preferential tax treatment with rates between 0%, 15%, and 20% depending on your income.

Investment risk with RSUs

Being a shareholder in your firm could be very exciting. If your company is in great health and growing solidly, this could be an enormous boost to your personal finances.

However, here is the other side of the story. Owning too much of your company stock could impose significant risks to your investment portfolio and retirement goals. You are already earning a salary from your employer. Concentrating your entire wealth and income from the same source could jeopardize your financial health if your employer fails to succeed in its business ventures. Many of you remember the fall of Enron and Lehman Brothers. Many of their employees lost not only their jobs but a significant portion of their retirement savings.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your employer and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Key takeaways

Receiving RSUs is an excellent way to acquire company stock and become part of your company’s future. While risky owning RSUs often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, they can help you achieve your financial goals, whether they are buying a home, taking your kids to college, or early retirement.

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A financial checklist for young families

A financial checklist for young families

A financial checklist for young families…..Many of my clients are young families looking for help to build their wealth and improve their finances. We typically discuss a broad range of topics from buying a house, saving for retirement, savings for their kids’ college, budgeting and building legacy. As a financial advisor in the early 40s, I have personally gone through many of these questions and was happy to share my experience.

Some of my clients already had young children. Others are expecting a new family member. Being a dad of a nine-month-old boy, I could relate to many of their concerns. My experience helped me guide them through the web of financial and investment questions.  

While each family is unique, there are many common themes amongst all couples. While each topic of them deserves a separate post, I will try to summarize them for you.

Communicate

Successful couples always find a way to communicate effectively. I always advise my clients to discuss their financial priorities and concerns. When partners talk to each other, they often discover that they have entirely different objectives.  Having differences is normal as long as you have common goals. By building a strong partnership you will pursue your common goals while finding a common ground for your differences

Talking to each other will help you address any of the topics in this article.

If it helps, talk to an independent fiduciary financial advisor. We can help you get a more comprehensive and objective view of your finances. We often see blind spots that you haven’t recognized before.

Set your financial goals

Most life coaches will tell you that setting up specific goals is crucial in achieving success in life. It’s the same when it comes to your finances. Set specific short-term and long-term financial goals and stick to them. These milestones will guide you and help you make better financial decisions in the future.

Budget

There is nothing more important to any family wellbeing than budgeting. Many apps can help you budget your income and spending. You can also use an excel spreadsheet or an old fashion piece of paper. You can break down your expenses in various categories and groups similar to what I have below. Balance your budget and live within your means.

Sample budget

Gross Income ?????
Taxes ???
401k Contributions ??
Net Income ????
Fixed Expenses
Mortgage ?
Property Taxes ?
Utilities (Phone, Cable, Gas, Electric) ?
Insurance ?
Healthcare/Medical ?
Car payment ?
529 savings ?
Daycare ?
Non-Discretionary Flexible Expenses
Groceries ?
Automotive (Fuel, Parking, Tolls) ?
Home Improvement/Maintenance ?
Personal Care ?
Dues & Subscriptions ?
Discretionary Expenses
Restaurants ?
General Merchandise ?
Travel ?
Clothing/Shoes ?
Gifts ?
Entertainment ?
Other Expenses ?
Net Savings ???

Consolidate your assets

One common issue I see amongst young couples is the dispersion of their assets. It’s very common for spouses to have multiple 401k, IRAs and savings accounts in various financial institutions and former employers. Consolidating your assets will help you get a more comprehensive view of your finances and manage them more efficiently.

Manage your debt

The US consumer debt has grown to record high levels. The relatively low-interest rates, rising real estate prices and the ever-growing college cost have pushed the total value of US household debt to $13.25 trillion. According to the New York Fed, here is how much Americans owe by age group.

  • Under 35: $67,400
  • 35–44: $133,100
  • 45–54: $134,600
  • 55–64: $108,300
  • 65–74: $66,000
  • 75 and up: $34,500

For many young families who are combining their finances, managing their debt becomes a key priority in achieving financial independence.

Manage your credit score

One way to lower your debt is having a high credit score. I always advise my clients to find out how much their credit score is.  The credit score, also known as the FICO score, is a measure between 300 and 850 points. Higher scores indicate lower credit risk and often help you get a lower interest rate on your mortgage or personal loan. 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. You can sometimes see 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 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.

Own a house or rent

Owning your first home is a common theme among my clients. However, the price of real estate in the Bay area, where I live, has skyrocketed in the past 10 years. The average home price in San Francisco according to Zillow is $1.3 million. The average home price in Palo Alto is $3.1 million. While not at this magnitude, home prices have risen in all major metropolitan areas around the country. Buying a home has become an impossible dream for many young families. Not surprisingly a recent survey by the Bank of the West has revealed that 46% of millennials have chosen to rent over buying a home, while another 11% are staying with their parents.  

Buying a home in today’s market conditions is a big commitment and a highly personal decision. It depends on a range of factors including how long you are planning to live in the new home, available cash for a downpayment, job prospects, willingness to maintain your property, size of your family and so on.

Maximize your retirement contributions

Did you know that in 2019 you can contribute up to $19,000 in your 401k? If you are in your 50s or older, you can add another $6,000 as a catch-up contribution. Maximizing your retirement savings will help you grow your wealth and build a cushion of solid retirement savings. Not to mention the fact that 401k contributions are tax-deferred and lower your current tax bill.

Unfortunately, many Americans are not saving aggressively for retirement. According to Fidelity, the average person in their 30’s have $42.7k in their 401k plan. people in their 40s own on average 103k.

If your 401k balance is higher than your age group you are already better off than the average American.

Here is how much Americans own in their 401 plan by age group

  • 20 to 29 age: $11,500
  • 30 to 39 age: $42,700
  • 40 to 49 age: $103,500
  • 50 to 59 age: $174,200
  • 60 to 69 age: $192,800

For those serious about their retirement goals, Fidelity recommends having ten times your final salary in savings if you want to retire by age 67. They are also suggesting how to achieve this goal by age group.

  • By the age of 30: Have the equivalent of your starting salary saved
  • 35 years old: Have two times your salary saved
  • 40 years old: Have three times your salary saved
  • 45 years old: Have four times your salary saved
  • 50 years old: Have six times your salary saved
  • 55 years old: Have seven times your salary saved
  • 60 years old: Have eight times your salary saved
  • By age 67: Have 10 times your salary saved

Keep in mind that these are general guidelines. Everybody is different. Your family retirement goal is highly dependent on your individual circumstances, your lifestyle, spending habits, family size and alternative sources of income.

Know your risk tolerance level

One common issue I see with young families is the substantial gap between their risk tolerance and the actual risk they take in their retirement and investment accounts.  Risk tolerance is your emotional ability to accept risk as an investor.

I have seen clients who are conservative by nature but have a very aggressive portfolio. Or the opposite, there are aggressive investors with a large amount of cash or a large bond portfolio. Talking to a fiduciary financial advisor can help you understand your risk tolerance. You will be able to narrow that gap between your emotions and real-life needs and then connect them to your financial goals and milestones.

Diversify your investments

Diversification is the only free lunch you will get in investing. Diversifying your investments can reduce the overall risk of your portfolio. Without going into detail, owning a mix of uncorrelated assets will lower the long-term risk of your portfolio. I always recommend that you have a portion of your portfolio in US Large Cap Blue Chip Stocks and add some exposure to Small Cap, International, and Emerging Market Stocks, Bonds and Alternative Assets such as Gold and Real Estate.

Invest your idle cash

One common issue I have seen amongst some of my clients is holding a significant amount of cash in their investment and retirement accounts. The way I explain it is that most millennials are conservative investors. Many of them observed their parents’ negative experience during the financial crisis of 2008 and 2009. As a result, they became more risk-averse than their parents.  

However, keeping ample cash in your retirement account in your 30s will not boost your wealth in the long run. You are probably losing money as inflation is deteriorating the purchasing power of your idle cash. Even if you are a very conservative investor, there are ways to invest in your retirement portfolio without taking on too much risk.

Early retirement

I talk about early retirement a lot often than one might imagine. The media and online bloggers have boosted the image of retiring early and made it sound a lot easier than it is. I am not saying that early retirement is an illusion, but it requires a great deal of personal and financial sacrifice. Unless you are born rich or rely on a huge payout, most people who retire early are very frugal and highly resourceful. If your goal is to retire early, you need to pay off your debt now, cut down spending and save, save and save.

Build-in tax diversification

While most of the time we talk about our 401k plans, there are other investment and retirement vehicles out there such as Roth IRA, Traditional IRA and even your brokerage account. They all have their own tax advantages and disadvantages. Even if you save a million bucks in your 401k plan, not all of it is yours. You must pay a cut to the IRS and your state treasury. Not to mention the fact that you can only withdraw your savings penalty-free after reaching 59 ½. Roth IRA and brokerage account do not lower your taxes when you make contributions, but they offer a lot more flexibility, liquidity, and some significant future tax advantages. In the case of Roth IRA, all your withdrawals can be tax-free when you retire. Your brokerage account provides you with immediate liquidity and lower long-term capital gains tax on realized gains.

Plan for child’s expenses

Most parents will do anything for their children. But having kids is expensive. Whether a parent will stay at home and not earn a salary, or you decide to hire a nanny or pay for daycare, children will add an extra burden to your budget. Not to mention the extra money for clothes, food, entertainment (Disneyland) and even another seat on the plane.

Plan for college with a 529 Plan

Many parents want to help their children pay for college or at least cover some of the expenses. 529 plan is a convenient, relatively inexpensive and tax-advantageous way to save for qualified college expenses. Sadly, only 29% of US families are familiar with the plan. Most states have their own state-run 529 plan. Some states even allow state tax deductions for 529 contributions. Most 529 plans have various active, passive and age-based investment options. You can link your checking account to your 529 plan and set-up regular monthly contributions. There are plentiful resources about 529 plans in your state. I am happy to answer questions if you contact me directly.  

Protect your legacy

Many young families want to protect their children in case of sudden death or a medical emergency. However, many others don’t want to talk about it at all. I agree it’s not a pleasant conversation. Here in California, unless you have an established estate, in case of your death all your assets will go to probate and will have to be distributed by the court. The probate is a public, lengthy and expensive process. When my son was born my wife and I set up an estate, created our wills and assigned guardians, and trustees to our newly established trust.  

The process of protecting your legacy is called estate planning. Like everything else, it’s highly personalized depending on the size of your family, the variety of assets you own, your income sources, your charitable aptitude, and so on. Talking to an experienced estate attorney can help you find the best decision for yourself and your family.

I never sell insurance to my clients. However, if you are in a situation where you are the sole bread earner in the household, it makes a lot of sense to consider term life and disability insurance, which can cover your loved ones if something were to happen to you.

Plan ahead

I realize that this is a very general, kind of catch-all checkpoint but let me give it a try. No matter what happens in your life right now, I guarantee you a year or two from now things will be different. Life changes all the time – you get a new job, you have a baby, you need to buy a new car, or your company goes public, and your stock options make you a millionaire. Whatever that is, think ahead. Proper planning could save you a lot of money and frustration in the long run.

Conclusion

I realize that this checklist is not complete. Every family is unique. Each one of you has very different circumstances, financial priorities, and life goals. There is never a one-size-fits-all solution for any family out there. If you contact me directly, I will be happy to address your questions.

 
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The recent market volatility – the tale of the perfect storm

The recent market volatility – the tale of the perfect storm

The recent market volatility – the tale of the perfect storm

October is traditionally a rough month for stocks. And October 2018 proved it.

S&P 500 went down -6.9% in October after gaining as much as 10.37% in the first nine months of the year. Despite recouping some of its losses in early November, the market continues to be volatile, with large daily swings in both directions. On top of that, Small Cap stocks, which were leading the way till late September, went down almost 10% in the span of a few weeks.

So, what led to this rout?

The market outlook in September was very positive. Consumer sentiment and business optimism were at a record high. Unemployment hit a record low. And the market didn’t really worry about tariffs.

I compiled a list of factors that had a meaningful impact on the recent market volatility. As the headline suggested, I don’t believe there was a single catalyst that drove the market down but a sequence of events creating a perfect storm for the equities to go down.

Index Q1 2018 Q2 2018 Q3 2018 Q3 YTD 2018 Oct – Nov 2018 Nov 2018 YTD
S&P 500 Large-Cap (SPY) -1.00% 3.55% 7.65% 10.37% -4.91% 5.45%
S&P 600 Small-Cap (IJR) 0.57% 8.69% 4.87% 14.64% -9.54% 5.09%
MSCI EAFE (VEA) -0.90% -1.96% 1.23% -1.62% -7.06% -8.68%
Barclays US Aggregate Bond (AGG) -1.47% -0.18% -0.08% -1.73% -0.81% -2.54%
Gold (GLD) 1.73% -5.68% -4.96% -8.81% 1.39% -7.42%
Source: Morningstar

1. Share buybacks

The month of October is earnings season. Companies are not allowed to buy back shares as they announce their earnings. The rationale is that they possess significant insider information that could influence the market in each direction. As it turned out, 2018 was a big year for share buybacks. Earlier in the year, S&P estimated $1 trillion worth of share buybacks to be returned to shareholders. So, in October, the market lost a big buyer – the companies who were buying their own shares. And no one stepped in to take their place.

The explosion of share buyback was prompted by the TCJA law last year which lowered the tax rate of US companies from 35% to 21%. Additionally, the new law imposed a one-time tax on pre-2018 profits of foreign affiliates at rates of 15.5% for cash and 8% for non-cash assets. Within a few months, many US mega-cap corporations brought billions of cash from overseas and became buyers of their stock.

2. High valuations

With the bull market is going on its ninth year, equity valuations remain high even after the October market selloff.

Currently, the S&P 500 is trading at 22.2, above the average level of 15.7. Its dividend yield is 1.9%, well below the historical average of 4.34%.

Furthermore, the current Shiller PE Ratio stands at 30.73, one of the highest levels in history. While the traditional Price to Earnings ratio is calculated based on current or estimated earning levels, the Schiller ratio calculates average inflation-adjusted earnings from the previous ten years. The ratio is also known as the Cyclically Adjusted PE Ratio (CAPE Ratio) or PE10.

While a coordinated global growth and low-interest rate environment had previously supported the thesis that high valuation ratios were justified, this may not be the case for much longer.

3. The divergence between US and international stocks

The performance of International Developed and Emerging Market remains disappointing. While the US markets are still in positive territory, International Developed and EM stocks have plunged by -8% and -15% respectively so far in 2018.  Higher tariffs imposed by the US, negative Brexit news, growing domestic debt in China, and slower GDP growth in both the Eurozone and China have spurred fears of an upcoming recession. Despite attractive valuations, international markets remain in correction territory, The dividend yield of MSCI EAFE is 3.34%, while MSCI EM is paying 2.5%, both higher than 1.9% for S&P 500.

4. The gap between growth and value stocks

The performance gap between growth and value stocks is still huge. Growths stocks like Apple, Amazon, Google, Visa, MasterCard, UnitedHealth, Boeing, Nvidia, Adobe, Salesforce, and Netflix have delivered 10% return so far this year. At the same time value strategies dominated by Financials, Consumer Staples and Energy companies are barely breaking even.

Index Q1 2018 Q2 2018 Q3 2018 Q3 YTD 2018 Oct – Nov 2018 Nov 2018 YTD  P/E Ratio
S&P 500 Large Cap Growth (IVW) 1.81% 5.17% 9.25% 16.97% -6.95% 10.01% 29.90
S&P 500 Large Cap Value (IVE) -3.53% 1.38% 5.80% 3.26% -2.59% 0.67% 19.44

 

5. Tempering earnings growth

So far in Q3 2018, 90% of the companies have announced earnings. 78% of them have reported better than expected actual earnings with an average earnings growth rate of 25.2%. 61% of the companies have reported a positive sales surprise. However, 58 companies in the S&P 500 (12%) have issued negative earnings guidance for Q4 2018. And the list of stocks that tumbled due to cautious outlook keeps growing – JP Morgan, Facebook, Home Depot, Sysco, DR Horton, United Rentals, Texas Instruments, Carvana, Zillow, Shake Shack, Skyworks Solutions, Michael Kors, Oracle, GE, Cerner, Activision, etc.

Despite the high consumer optimism and growing earnings, most companies’ CFOs are taking a defensive approach. Business investment grew at a 0.8% annual rate in the third quarter, down from 8.7% in the second quarter. This was the slowest pace since the fourth quarter of 2016.

The investment bank Nomura also came out with the forecast expecting global growth to slow down. Their economists predicted that global growth in 2019 would hit 3.7% and temper to 3.5% in 2020 from 3.9% in 2018. According to Nomura, the drivers for the slowdown include waning fiscal stimulus in the U.S., tighter monetary policy from the Federal Reserve, increased supply constraints and elevated risk of a partial government shutdown.

 

6. Inflation is creeping up

Almost a decade since the Credit Crisis in 2008-2009, inflation has been hovering below 2%. However, in 2018, the inflation has finally made a comeback. In September 2018, monthly inflation was 2.3% down from 2.9% in July and 2.7% in August.

One winner of the higher prices is the consumer staples like Procter & Gamble, Unilever, and Kimberly-Clark. Most of these companies took advantage of higher consumer confidence and rising wages to pass the cost of higher commodity prices to their customers.

7. Higher interests are starting to bite

After years of near-zero levels, interest rates are starting to go higher. 10-year treasury rate reached 3.2%, while the 2-year rate is slowly approaching the 3% level. While savers are finally beginning to receive a decent interest on their cash, CDs and saving accounts, higher interest rates will hurt other areas of the economy.

 

With household debt approaching $13.4 trillion, borrowers will pay higher interest for home, auto and student loans and credit card debt. At the same time, US government debt is approaching $1.4 trillion. Soon, the US government will pay more for interest than it is spending on the military.  The total annual interest payment will hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.

The higher interest rates are hurting the Financial sectors. Most big banks have enjoyed a long period of paying almost nothing on their client deposits and savings accounts. The rising interest rates though have increased the competition from smaller banks and online competitors offering attractive rates to their customers.

We are also monitoring the spread between 2 and 10-year treasury note, which is coming very close together. The scenario when two-year interest rates go above ten-year rates causes an inverted yield curve, which has often signaled an upcoming recession.

8. The housing market is slowing down

Both existing and new home sales have come down this year.  Rising interest rates, higher cost of materials, labor shortage and high real estate prices in major urban areas have led to a housing market slow down.  Existing home sales dropped 3.4% in September coming down for six months in a row this year. New building permits are down 5.5% over 2017.

Markets have taken a negative view on the housing market. As a result, most homebuilders are trading at a 52-week low.

9. Fear of trade war

Some 33% of the public companies have mentioned tariffs in their earnings announcements in Q3.  9% of them have negatively mentioned tariffs. According to the chart below, Industrials, Information Technology, Consumer Dictionary, and Materials are the leading sectors showing some level of concern about tariffs.

10. Strong dollar

Fed’s hiking of interest rates in the US has not been matched by its counterparts in the Eurozone, the UK, and Japan. The German 10-year bund now yields 0.4%, while Japanese 10-year government bond pays 0.11%. Combining the higher rates with negative Brexit talks, Italian budget crisis and trade war fears have led to a strong US dollar reaching a 17-month high versus other major currencies.

Given that 40% of S&P 500 companies’ revenue comes from foreign countries, the strong dollar is making Americans goods and services more expensive and less competitive abroad. Furthermore, US companies generating earnings in foreign currency will report lower US-dollar denominated numbers.

11. Consumer debt is at a record high

The US consumer debt is reaching 4 trillion dollars. Consumer debt includes non-mortgage debts such as credit cards, personal loans, auto loans, and student loans. Student loans are equal to $1.5 trillion while auto debt is $1.1 trillion and credit card debt is close to $1.05 trillion. Furthermore, the US housing dent also hit a record high. In June, the combined mortgage and home equity debt were equal to $9.43 trillion, according to the NY Fed.

The rising debt has been supported by low delinquencies, high property values, rising wages, and low unemployment. However, a slowdown in the economy and the increasing inflation and interest rates can hurt US consumer spending.

12. High Yield and BBB-rated debt is growing

The size of the US corporate debt market has reached $7.5 trillion. The size of the BBB rated debt now exceeds 50% of the entire investment grade market. The BBB-rated debt is just one notch above junk status. Bloomberg explains that, in 2000, when BBB bonds were a mere third of the market, net leverage (total debt minus cash and short-term investments divided by earnings before interest, taxes, depreciation, and amortization) was 1.7 times. By the end of last year, the ratio had ballooned to 2.9 times.

Further on, the bond powerhouse PIMCO commented: “This suggests a greater tolerance from the credit rating agencies for higher leverage, which in turn warrants extra caution when investing in lower-rated IG names, especially in sectors where earnings are more closely tied to the business cycle.”

13. Oil remains volatile

After reaching $74.15 per barrel in October, US crude oil tumbled to $55, a 24% drop. While lower crude prices are pushing down on inflation, they are hurting energy companies, which are already trading in value territory.

According to WSJ, the oil’s rapid decline is fueling fears for global oversupply and slowing economic growth. Furthermore, the outlook for supply and demand shifted last month as top oil producers, began ramping up output to offset the expected drop in Iranian exports. However, earlier this month Washington decided to soften its sanctions on Iran and grant waivers to some buyers of Iranian crude—driving oil prices down. Another factor pushing down on oil was the strong dollar.

14. Global political uncertainty

The Brexit negotiations, Italian budget crisis, Trump’s threats to pull out of WTO, the EU immigrant crisis, higher tariffs, new elections in Brazil, Malaysian corruption scandal and alleged Saudi Arabia killing of a journalist have kept the global markets on their toes. Foreign markets have underperformed the US since the beginning of the year with no sign of hope coming soon.

15. The US Election results

A lot has been said about the US elections results, so I will not dig in further. In the next two year, we will have a divided Congress. The Democrats will control the house, while the Republicans will control the Senate and the executive branch. The initial market reaction was positive. Most investors are predicting a gridlock with no major legislature until 2020. Furthermore, we could have intense budget negotiations and even another government shutdown. Few potential areas where parties could try to work together are infrastructure and healthcare. However, any bi-partisan efforts might be clouded by the upcoming presidential elections and Mueller investigation results.

In Conclusion

There is never a right time to get in the market, start investing and saving for retirement. While market volatility will continue to prevail the news, there is also an opportunity for diligent investors to capitalize on their long-term view and patience. For these investors, it is essential to diversify and rebalance your portfolio.

In the near term, consumer confidence in the economy remains strong. Rising wages and low unemployment will drive consumer spending. My prediction is that we will see a record high shopping season. Many of these fifteen headwinds will remain. Some will soften while others will stay in the headlines.

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,
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9 Smart Tax Saving Strategies for High Net Worth Individuals

9 Smart Tax Saving Strategies for High Net Worth Individuals

The Tax Cuts and Jobs Act (TCJA) voted by Congress in late 2017 introduced significant changes to the way high net worth individuals and families file and pay their taxes. The key changes included the doubling of the standard deduction to $12,000 for singles and $24,000 for married couples filing jointly, the elimination of personal exemptions, limiting the SALT deduction to $10,000, limiting the home mortgage interest deduction to loans of up to $750,000 versus $1,000,000 as well as comprehensive changes to itemized deductions and Alternative Minimum Tax.

Many high net worth individuals and families, especially from high tax states like California, New York, and New Jersey, will see substantial changes in their tax returns. The real impact won’t be completely revealed until the first tax filing in 2019. Many areas remain ambiguous and will require further clarification by the IRS.

Most strategies discussed in this article were popular even before the TCJA. However, their use will vary significantly from person to person.  I strongly encourage you to speak with your accountant, tax advisor, or investment advisor to better address your concerns.

1. Home mortgage deduction

While a mortgage tax deduction is rarely the primary reason to buy a home, many new home buyers will have to be mindful of the new tax rule limiting mortgage deductions to loans of up to $750,000. The interest on second home mortgages is no longer tax-deductible.  The interest on Home Equity Loans or HELOCs could be tax-deductible in some instances where proceeds are utilized to acquire or improve a property

2. Get Incorporated

If you own a business, you may qualify for a 20 percent deduction for qualified business income. This break is available to pass-through entities, including S-corporations and limited liability companies. In general, to qualify for the full deduction, your taxable income must be below $157,500 if you’re single or $315,000 if you’re married and file jointly. Beyond those thresholds, the TJLA sets limits on what professions can qualify for this deduction. Entrepreneurs with service businesses — including doctors, attorneys, and financial advisors — may not be able to take advantage of the deduction if their income is too high.

Furthermore, if you own a second home, you may want to convert it to a rental and run it as a side business. This could allow you to use certain tax deductions that are otherwise not available.

Running your business from home is another way to deduct certain expenses (internet, rent, phone, etc.). In our digital age, technology makes it easy to reach out to potential customers and run a successful business out of your home office.

3. Charitable donations

All contributions to religious, educational, or charitable organizations approved by the 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.

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

The TCJA made the tax planning for donations a little bit trickier. The new tax rules raised the standard deduction to $12,000 for singles and $24,000 for married couples filing jointly. In effect, the rule will reduce the number of people who are itemizing their taxes and make charitable donations a less attractive tax strategy.

For philanthropic high net worth individuals making charitable donations could require a little more planning to achieve the highest possible tax benefit. One viable strategy is to consolidate annual contributions into a single large payment. This strategy will ensure that your donations will go above the yearly standard deduction threshold.

Another approach is to donate appreciated investments, including stocks and real estate. This strategy allows philanthropic investors to avoid paying significant capital gain tax on low-cost basis investments. To learn more about the benefits of charitable donations, check out my prior post here.

4. Gifts

The TCJA doubled the gift and estate tax exemption to almost $11.18 million per person and $22.36 per married couple. Furthermore, you can give up to $15,000 to any number of people every year without any tax implications. Amounts over $15,000 are subject to the combined gift and estate tax exemption of $11 million.  You can give your child or any person within the annual limits without creating create any tax implications.

Making a gift will not reduce your current year taxes. However, making gifts of appreciated assets with a lower cost basis 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.

5. 529 Plans

The TCJA of 2017 expanded the use of 529 plans to cover qualifying expenses for private, public, and religious kindergarten through 12th grade. Previously parents and grandparents could only use 529 funds for qualified college expenses.

The use of 529 plans is one of the best examples of how gifts can minimize your future tax burden. Parents and grandparents can contribute up to $15,000 annually per person, $30,000 per married couple into their child college education fund. The plan even allows a one–time lump-sum payment of $75,000 (5 years x $15,000).

Parents can choose to invest their contributions through a variety of investment vehicles.  While 529 contributions are not tax-deductible on a federal level, many states like New York, Massachusetts, Illinois, etc. allow for state tax deductions for up to a certain amount. The 529 investments grow tax-free. Withdrawals are also tax-free when used to pay cover qualified college and educational expenses. 

6. 401k Contributions

One of the most popular tax deductions is the tax-deferred contribution to 401k and 403b plans. In 2020 the allowed maximum contribution per person is $19,500 plus an additional $6,500 catch-up for investors at age 50 and older. Also, your employer can contribute up to $36,500 for a maximum annual contribution of $57,000 or $63,500 if you are older than 50.

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, but the investments in your 401k portfolio also grow tax-free. You will owe taxes upon withdrawal at your current tax rate at that time.

7. Roth IRA

Roth IRA is a great investment vehicle. Investors can contribute up to $6,000 per year. All contributions to the account are after-tax.  The investments in the Roth IRA can grow tax-free. And the withdrawals will be tax-exempt if held till retirement. IRS has limited the direct contributions to individuals making up to $124,000 per year with a phase-out at $139,000. Married couples can make contributions if their income is up to $196,000 per year with a phase-out at $206,000.

Fortunately, recent IRS rulings made it possible for high net worth individuals to make Roth Contributions.  Using the two-step process known as backdoor Roth you can take advantage of the long-term tax-exempt benefits of Roth IRA. Learn more about Roth IRA in our previous post here. 

8. Health Spending Account

A health savings account (HSA) is a tax-exempt saving account available to taxpayers who are enrolled in a high-deductible health plan (HDHP) The funds contributed to this account are tax-deductible. 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 for 2018 are $3,450 per person, $6,900 per family, and an additional $1,000 if 55 or older. The owner of HSA can invest the funds similar to the IRA account.

In effect, HSAs have a triple tax benefit. All contributions are tax-deductible. Investments grow tax-free and. HSA owners can make tax-free withdrawals for qualified medical expenses.

9. Municipal bonds

Old fashioned municipal bonds continue to be an attractive investment choice of high net worth individuals. The interest income from municipal bonds is still tax-exempt on a federal level. When the bondholders reside in the same state as the bond issuer, they can be exempted from state income taxes as well.

Final words

If you have any questions about your existing investment portfolio, 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.

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Market Outlook December 2017

Market Outlook December 2017

Market Outlook December 2017

As we approach 2018, it‘s time to reconcile the past 365 days of 2017. We are sending off a very exciting and tempestuous year. The stock market is at an all-time high. Volatility is at a record low. Consumer spending and confidence have passed pre-recession levels.

I would like to wish all my readers and friends a happy and prosperous 2018. I guarantee you that the coming year will be as electrifying and eventful as the previous one.

 

The new tax plan

The new tax plan is finally here. After heated debates and speculations, president Trump and the GOP achieved their biggest win of 2017. In late December, they introduced the largest tax overhaul in 30 years. The new plan will reduce the corporate tax rate to 21% and add significant deductions to pass-through entities. It is also estimated to add $1.5 trillion to the budget deficit in 10 years before accounting for economic growth.

The impact on the individual taxes, however, remains to be seen. The new law reduces the State and Local Tax (SALT) deductions to $10,000. Also, it limits the deductible mortgage interest for loans up to $750,000 (from $1m). The plan introduces new tax brackets and softens the marriage penalty for couples making less than $500k a year. The exact scale of changes will depend on a blend of factors including marital status, the number of dependents, state of residency, homeownership, employment versus self-employment status. While most people are expected to receive a tax-break, certain families and individuals from high tax states such as New York, New Jersey, Massachusetts, and California may see their taxes higher.

 

Affordable Care Act

The future of Obamacare remains uncertain. The new GOP tax bill removes the individual mandate, which is at the core of the Affordable Care Act. We hope to see a bi-partisan agreement that will address the flaws of ACA and the ever-rising cost of healthcare. However, political battles between republicans and democrats and various fractions can lead to another year of chaos in the healthcare system.

 

Equity Markets

The euphoria around the new corporate tax cuts will continue to drive the markets in 2018. Many US-based firms with domestic revenue will see a boost in their earnings per share due to lower taxes.

We expect the impact of the new tax law to unfold fully in the next two years. However, in the long run, the primary driver for returns will continue to be a robust business model, revenue growth, and a strong balance sheet.

Momentum

Momentum was the king of the markets in 2017. The strategy brought +38% gain in one of its best years ever. While we still believe in the merits of momentum investing, we are expecting more modest returns in 2018.

Value

Value stocks were the big laggard in 2017 with a return of 15%. While their gain is still above average historical rates, it’s substantially lower than other equity strategies.  Value investing tends to come back with a big bang. In the light of the new tax bill, we believe that many value stocks will benefit from the lower corporate rate of 21%. And as S&P 500 P/E continues to hover above historical levels, we could see investors’ attention shifting to stocks with more attractive valuations.

Small Cap

With a return of 14%, small-cap stocks trailed the large and mega-cap stocks by a substantial margin. We think that their performance was negatively impacted by the instability in Washington. As most small-cap stocks derive their revenue domestically, many of them will see a boost in earnings from the lower corporate tax rate and the higher consumer income.

International Stocks

It was the first time since 2012 when International stocks (+25%) outperformed US stocks. After years of sluggish growth, bank crisis, Grexit (which did not happen), Brexit (which will probably happen), quantitative easing, and negative interest rates, the EU region and Japan are finally reporting healthy GDP growth.

It is also the first time in more than a decade that we experienced a coordinated global growth and synchronization between central banks. We hope to continue to see this trend and remain bullish on foreign markets.

Emerging Markets

If you had invested in Emerging Markets 10-years ago, you would have essentially earned zero return on your investments. Unfortunately, the last ten years were a lost decade for EM stocks. We believe that the tide is finally turning. This year emerging markets stocks brought a hefty 30% return and passed the zero mark. With their massive population under 30, growing middle class, and almost 5% annual GDP growth, EM will be the main driver of global consumption.

 

Fixed Income

It was a turbulent year for fixed income markets. The Fed increased its short-term interest rate three times in 2017 and promised to hike it three more times in 2018. The markets, however, did not respond positively to the higher rates. The yield curve continued to flatten in 2017. And inflation remained under the Fed target of 2%.

After a decade of low interest, the consumer and corporate indebtedness has reached record levels. While the Dodd-Frank Act imposed strict regulations on the mortgage market, there are many areas such as student and auto loans that have hit alarming levels. Our concern is that high-interest rates can trigger high default rates in those areas which can subsequently drive down the market.

 

Gold

2017 was the best year for gold since 2010. Gold reported 11% return and reached its lowest volatility in 10 years.  The shiny metal lost its momentum in Q4 as investors and speculators shifted their attention to Bitcoin and other cryptocurrencies. In our view gold continues to be a solid long-term investment with its low correlation to equities and fixed income assets.

 

Real Estate

It was a tough year for REITs and real estate in general. While demand for residential housing continues to climb at a modest pace, the retail-linked real estate is suffering permanent losses due to the bankruptcies of several major retailers. This trend is driven on one side by the growing digital economy and another side by the rising interest rates and the struggle of highly-leveraged retailers to refinance their debt. Many small and mid-size retail chains were acquired by Private Equity firms in the aftermath of the 2008-2009 credit crisis. Those acquisitions were financed with low-interest rate debt, which will gradually start to mature in 2019 and peak in 2023 as the credit market continues to tighten.

Market Outlook December 2017

In the long-run, we expect that most public retail REITs will expand and reposition themselves into the experiential economy by replacing poor performing retailers with restaurants and other forms of entertainment.

On a positive note, we believe that the new tax bill will boost the performance of many US-based real estate and pass-through entities.  Under the new law, investors in pass-through entities will benefit from a further 20% deduction and a shortened depreciation schedule.

 

What to expect in 2018

  • After passing the new tax bill, the Congress will turn its attention to other topics of its agenda – improving infrastructure, and amending entitlements. Further, we will continue to see more congressional budget deficit battles.
  • Talk to your CPA and find out how the new bill will impact your taxes.
  • With markets at a record high, we recommend that you take in some of your capital gains and look into diversifying your portfolio between major asset classes.
  • We might see a rotation into value and small-cap. However, the market is always unpredictable and can remain such for extended periods.
  • We will monitor the Treasury Yield curve. In December 2017 the spread between 10-year and 2-year treasury bonds reached a decade low at 50 bps. While not always a flattening yield has often predicted an upcoming recession.
  • Index and passive investing will continue to dominate as investment talent is evermore scarce. Mega large investment managers like iShares and Vanguard will continue to drop their fees.

 

Happy New Year!

 

Final words

If you have any questions about your existing investment portfolio, 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.

 

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6 Saving & Investment Practices All Business Owners Should Follow

6 Saving & Investment Practices All Business Owners Should Follow

In my practice, I often meet with small business owners who have the entire life savings and family fortune tied up to their company. For many of them, their business is the only way out to retirement. With this post, I would like to offer 6 saving & investment practices all business owners should follow.

Having all your eggs in one basket, however, may not be the best way to manage your finances and family fortune. Think about bookstores. If you owned one 20-30 years ago, you probably earned a decent living. Now, bookstores are luxuries even in major cities like New York and San Francisco. Technology, markets, consumer sentiments, and laws change all the time. And that is why it is vital that you build healthy saving and investment routines to grow your wealth, protect your loved ones, and prepare yourself for the years during retirement.

Start Early

I always advise my clients to start saving early and make it a habit. Saving 10-20 percent of your monthly income will help you build and grow your wealth. For instance, by starting with $20,000 today, with an average stock market return of 6 percent, your investments can potentially accumulate to $115,000 in 30 years or even $205,000 in 40 years.

Saving and investing early in your career can build a buffer to correct for any sidesteps or slip-ups. Starting to build your wealth early will provide the necessary protection against market drops and economic recessions and prepare you for large purchases like a new home, college tuition, a new car or even expanding your business.

Build a Safety Net

Life can often be unpredictable in good and bad ways. Having an emergency fund is the best way to guard your wealth and maintain liquidity for your business. I typically recommend keeping 6 to 12 months of basic living expenses in your savings account.

Even though my firm does not offer insurance, I often advise my clients especially those who are sole bread earners or work in industries prone to accidents to consider getting life and disability insurance. Good insurance will guarantee protection and supplemental income for yourself and your loved ones in case of unexpected work or life events.

Manage Your Debt

The last eight years of a friendly interest environment has brought record levels of debt in almost every single category. Americans now owe more than $8.26 trillion in mortgages, $1.14 trillion in auto loans, and $747 billion in credit cards debt. If you are like me, you probably don’t like owing money to anyone.

That’s great, however, taking loans is an essential part of any enterprise. Expanding your business, building a new facility or buying a competitor will often require external financing. Keeping track of your loans and prioritizing on paying off your high-interest debt can save you and your business a lot of money. It may also boost your credit score.

Set-up a Company Retirement Plan

The US Government provides a variety of options for businesses to create retirement plans for both employees and owners. Some of the most popular ones are employer-sponsored 401k, self-employed 401k, profit-sharing, SIMPLE IRA, and SEP IRA.

Having a company retirement plan is an excellent way to save money in the long run. Plan contributions could reduce current taxes and boost your employees’ loyalty and morale.

Of the many alternatives, I am a big supporter of 401(k) plans. Although they are a little more expensive to establish and run, they provide the highest contribution allowance over all other options.

The maximum employee contribution to 401(k) plans for 2017 is $18,000. The employer can match up to $36,000 for a total of $54,000. Individuals over 50 can add a catch-up contribution of $6,000. Also, 401k and other ERISA Plans offer an added benefit. They have the highest protection to creditors.

Even if you already have an up-and-running 401k plan, your job is not done. Have your plan administrator or an independent advisor regularly review your investment options.

I frequently see old 401k plans that have been ignored and forgotten since they were first established. Some of these plans often contain high-fee mutual funds that have consistently underperformed their benchmarks for many consecutive years. I typically recommend replacing some of these funds with low-fee alternatives like index funds and ETFs. Paying low fees will keep more money in your pocket.

Diversify

Many business owners hold a substantial amount of their wealth locked in their business. By doing so, they expose themselves to what we call a concentrated risk. Any economic, legal and market developments that can adversely impact your industry can also hurt your personal wealth.

The best way to protect yourself is by diversification. Investing in uncorrelated assets can decrease the overall risk of your portfolio. A typical diversified portfolio may include large-, mid-, small-cap, and international stocks, real estate, gold, government, and corporate fixed income.

Plan Your Exit

Whether you are planning to transfer your business to the next generation in your family or cash it in, this can have serious tax and legal consequences. Sometimes it pays off to speak to a pro.

Partnering with someone who understands your industry and your particular needs and circumstances, can offer substantial value to your business and build a robust plan to execute your future financial strategy.

 

The article was previously published in HVACR Business Magazine on March 1, 2017

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End of Summer Market Review

End of Summer Market Review

Happy Labor Day!

Our hearts are with the people of Texas! I wish them to remain strong and resilient against the catastrophic damages of Hurricane Harvey. As someone who experienced Sandy, I can emphasize with their struggles and hope for a swift recovery.

 

I know that this newsletter has been long past due. However, as wise people say, it is better late than never.

It has been a wild year so far. Both Main and Wall Street kept us occupied in an electrifying thriller of election meddling scandals, health reforms, political battles, tax cuts, interest rate hikes and debt ceiling fights (that one still to unfold).

Between all that, the stock market is at an all-time high. S&P 500 is up 11.7% year-to-date. Dow Jones is up 12.8%, and NASDAQ is up to the whopping 24%. GDP growth went up by 3% in the second quarter of 2017. Unemployment is at a 10-year low. 4.3%.

Moreover, despite record levels, very few Americans are feeling the joy of the market gains and feel optimistic about the future. US families are steadily sitting on the sideline and continuing to pile cash. As of June 2007, the amount of money in cash and time deposits (M2) was 70.1% of the GDP, an upward trend that has continued since the credit crisis in 2008.

End of Summer Market Review

Source: US Fed, https://fred.stlouisfed.org/graph/?g=dZn

Given that the same ratio of M2 as % of GDP is 251% in Japan, 193% in China, 91% in Germany, and 89% in the UK, US is still on the low end of the developed world. However, this is a persistent trend that can reshape the US economy for the years to come.

 

The Winners

This year’s rally was all about mega-cap and tech stocks. Among the biggest winners so far this year we have Apple (AAPL), up 42%, Amazon (AMZN), 27%, NVIDIA (NVDA), 54%, Adobe, 48%, PayPal, 55%. Netflix, 36%, and Visa (V), 33%,

Probably the biggest story out there is Amazon and its quest to disrupt the way Americans buy things. Despite years of fluctuating earnings, Amazon is still getting full support from its shareholders who believe in its long-term strategy. The recent acquisition of Whole Foods and announcement of price drops, only shows that Amazon is here to stay, and all the key retail players from Costco, Wall-Mart, Target, and Walgreens to Kroger’s, Home Depot, Blue Apron and AutoZone will have to adjust to the new reality and learn how to compete with Amazon.

The Laggards

Costco, Walgreens, and Target are bleeding from the Amazon effect as they reported- 0.49%, -0.74% and -21% year-to-date respectively. Their investors are become increasingly unresponsive to earnings surprises and massively punishing to earnings disappointments.

Starbucks, -0.74%, is still reviving itself after the departure of its long-time CEO, Howard Shultz, and will have to discover new revenue channels and jump-start its growth.

The energy giants, Chevron, -5%, Exxon, -12%, and Occidental Petroleum, -14.5% are still suffering from the low oil prices. With OPEC maintaining current production levels and surge in renewable energy, there is no light at the end of the tunnel. If these low levels continue, I will expect to see a wave of mergers and acquisitions in the sector. Those with a higher risk and yield appetite may want to look at some of the companies as they are paying a juicy dividend – Chevron, 4%, Exxon, 4%, and Occidental Petroleum, 5.4%

AT&T, -7% and Verizon, -5%, are coming out of big acquisitions, which down-the-road can potentially create new revenue channels and diversify away from the otherwise slow growing telecom business. In the near-term, they will continue to struggle in their effort to impress their investors. Currently, both companies are paying above average dividends, 5.15%, and 4.76%, respectively.

And finally, Wells Fargo, -4%. The bank is suffering from the account opening scandals last year and the departure of its CEO.  The stock has lagged its peers, which reported on average, 8% gains this year. While the long-term outlook remains positive, the short-term prospect remains uncertain.

 

Small Caps

Small Cap stocks as an asset class have not participated in this year’s market rally. Despite spectacular 2016 returns, small cap stocks have remained in the shadow of the uncertainty of the expected tax cuts and infrastructure program expansion. While I believe the Congress will come out with some tax reductions in the near term, the exact magnitude is still unclear. My long-term view of US small caps remains bullish with some near-term headwinds.

 

International Stocks

After several years of lagging behind US equity markets, international stocks are finally starting to catch up. The Eurozone reported 2% growth in GDP. MSCI EAFE is up 17.5% YTD, and MSCI Emerging Markets is up 28% YTD.

Despite the recent growth, International Developed and Emerging Market stocks remain cheap on a relative basis compared to US Stocks.  I maintain a long-term bullish view on international and EM stocks with some caution in the short-term.

Even though European Central Bank has kept the interest rates unchanged, I believe that its quantitative easing program will slow down towards the end of 2017 and beginning of 2018. The German bund rates will gradually rise above the negative levels. The EUR / USD will breach and remain above 1.20, a level not seen since 2014.

Interest Rates

I am expecting maximum one or may be even zero additional rate hikes this year. Under Janet Yellen, the Fed will continue to make extremely cautious and well-measured steps in raising short term rates and slowing down of its Quantitative Easing program. Bear in mind that the Fed has not achieved its 2% inflation target and any sharp rate hikes can ruin the already fragile balance in the fixed income space.

Real Estate

After eight years of undisrupted growth, US Real Estate has finally shown some signs of slow down. While demand for Real Estate in the primary markets like California and New York is still high, I expect to see some cooling off and normalization of year-over-year price growth

US REITs have reported 3.5% total return year-to-date, which is roughly the equivalent of -0.5% in price return and 4% in dividend yield.

Some retail REITs will continue to struggle in the near-term due to store closures and pressure from online retailers. I encourage investors to maintain a diversified REIT portfolio with a focus on strong management, sustainability of dividends and long-term growth prospects.

Gold

After several years of underperformance, Gold is making a quiet comeback. Gold was up 8% in 2016 and 14% year-to-date. Increasing market and political uncertainty and fear of inflation are driving many investors to safe havens such as gold. Traditionally, as an asset class, Gold has a minimal correlation to equities and fixed income. As such, I support a 1% to 5% exposure to Gold in a broadly diversified portfolio as a way to reduce long-term risk.

 

About the author: Stoyan Panayotov, CFA is a fee-only investment 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,

 

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10 ways to grow your savings during medical residency

Grow your savings during medical residency

As someone married to a physician, I happen to have many friends in the medical field. Most doctors have to go through a brutal residency program. The medical residency takes between three and five years. Residents have a hectic working schedule, aggressive learning plan and spend long hours in the hospital. They shift every 3 to 6 months between different subjects and medical practices. Their salaries are usually in the 40-60k range, while their student loan balance is still growing with compounding interest. As a financial advisor, I would like to suggest ten ways to grow your savings during medical residency.  Naturally, I have to give credit to my wife for contributing to this article.

Learn more about our Private Client Services

1. Consider a location with low cost of living

When you apply for medical residency, one way to save money is to pick an area with a low cost of living. If you decide on a residency in New York City or San Francisco, you can expect your living expenses like rent and food to be much higher than if you are in Charlotte or Denver for example. $10 bucks don’t go a long way in the Big Apple but might fit your daily budget in a smaller town.

2. Find out if your hospital provides subsidized housing

Many hospitals offer subsidized housing. A lot of these apartments are conveniently located near your hospital, and you will save money on rent and transportation. Also, you might be able to get an extra 15-20 minutes of sleep just because you are right next door.

Often these spots are limited. Check if you qualify and apply early. Don’t wait until the last minute.

3. Get a roomy

If you spend six out of seven days in the hospital, you might as well have a roommate. You can split the bills. If you are on good terms with your roommate, you can even shop together at Costco or Sam’s club. They sell in bulk at very competitive prices. If you have a buddy to split the large packages, you can save a lot of money on your meals and other necessities.

4. Set up a budget

This is an important one. Medical residents get an average salary for the number of hours spent in the job.  Since you won’t have much time later on, before you start your residency, do your budget. Go over your salary from the hospital and your necessary expenses. Make sure that all numbers add up. Also, start setting up an emergency fund. You never know what life will present.

5. Manage your student loans

Do not ignore your student loans. If you are not required to pay them during residency the interest on the loan will still accrue and add to the amount you have to pay later. Try to refinance your high-interest loan with a lower rate one. If you can’t refinance it, try to pay the interest regularly.

Not paying your interest will have a huge compounding effect on your loan balance, which will substantially increase the amount you owe once you leave residency.

6. Manage your credit card debt

Now when you finally started making some money, you can look at your credit card debt. Credit cards are a convenient way to pay for things, but they often carry a huge interest. I hope you don’t carry any credit card debt, but if you do, now is an excellent opportunity to start refinancing or repaying the high-interest balances.

7. Maintain a good credit

A good FICO score will save you a lot of money in the long run. People with high credit score get lower interest on their personal, car loans, and mortgages. A lousy credit score can even hurt your job search. Yes, many employers check that.

8. Don’t splurge on expensive furniture. Go to Ikea or Craigslist

If you must buy new furniture, do not splurge on expensive ones. Remember, you will spend the next four years in the hospital. You don’t need expensive furniture to collect dust. If you want to have something decent go to Ikea, look on Craigslist or ask other senior residents, who are graduating soon.

9. Start retirement savings

This recommendation is critical. Doctors launch their career at least ten years after the average person. Therefore they start saving for retirement much later. The new physicians miss ten years of potential retirement savings. You don’t have to be that person.

401k / 403b

Most health systems offer some variation of a 401k or 403b plans. Take full advantage of them. Your contributions are tax deductible. You won’t owe any taxes on your savings until you start withdrawing money from the plan.

Roth IRA

If your hospital does not offer any retirement saving plans (very unlikely but possible), you can always open a Roth IRA account. Roth IRA allows you to invest up to $5,500 every year which will grow tax-free until retirement. You will never pay any taxes on your gains and dividends as long as you keep the money in the account until you retire. Roth IRA has one caveat. You can only contribute the maximum amount if you make less than $117,000 per year. The chances are high that you will make a lot more after leaving residency and starting your practice. Therefore, you won’t qualify for Roth IRA later in your career.

 

10. Find freebies

Look for free stuff. There is no shame in that. There are many local free concerts, free museum nights, restaurant specials and happy hours. Look for them in your area or local newspaper or website.

Your hospital will regularly offer sponsored programs with free lunches or dinners. Go to some of them. You may learn something new, meet interesting people and get a free meal.

Find out if your hospital has a gym. Regular workouts will keep you in shape and help you get through the long hours.

 

Final words

If you have any questions about how to grow your savings during medical residency 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 married to a physician. He 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 healthcare professionals and their families.  To learn more about our Private Client Services and how to grow your savings during medical residency visit out page here. 

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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%.

Name Ticker Morningstar Rating Morningstar Analyst Rating AUM Expense
Vanguard Target Retirement 2045 VTIVX 4-star Gold $18.1 bil 0.16%
T. Rowe Price Retirement 2045 TRRKX 5-Star Silver $10.2 bil 0.76%
American Funds 2045 Trgt Date Retire R6 RFHTX 5-Star Silver $4.8 bil 0.43%
Fidelity Freedom® 2045 FFFGX 3-Star Silver $3.5 bil 0.77%
American Century One Choice 2045 AROIX 4-star Bronze $1.7 bil 0.97%

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 

Name Ticker Cash US Stock Non-US Stock Bond Other
Vanguard Target Retirement 2045 VTIVX   1.11      52.98         34.91     9.77   1.23
T. Rowe Price Retirement 2045 TRRKX   2.87      58.98         28.48     9.05   0.62
American Funds 2045 Trgt Date Retire R6 RFHTX   3.66      53.21         29.02     9.77   4.34
Fidelity Freedom® 2045 FFFGX   5.79      57.58         32.07     3.93   0.63
American Century One Choice 2045 AROIX   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

Name Ticker Cash US Stock Non-US Stock Bond Other
Vanguard Target Retirement 2025 VTIVX   1.44      38.05         25.09   34.30   1.12
T. Rowe Price Retirement 2025 Fund TRRHX   3.35      45.64         22.06   28.23   0.72
American Funds 2025 Trgt Date Retire R6 RFDTX   4.12      39.60         19.36   33.65   3.27
Fidelity Freedom® 2025 FFTWX   8.99      41.70         24.31   24.46   0.54
American Century One Choice 2025 ARWIX   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

Return Standard Deviation
Name Ticker 3-Year 5-Year 10-Year 3-Year 5-Year 10-Year
American Funds 2025 Trgt Date Retire R6 RFDTX    5.71     9.36      5.88    6.78     7.48    12.83
American Funds 2035 Trgt Date Retire R6 RFFTX    6.73   10.43      6.44    8.70     8.84    13.81
American Funds 2045 Trgt Date Retire R6 RFHTX    6.99   10.67      6.56    9.09     9.10    13.96
American Funds 2055 Trgt Date Retire R6 RFKTX    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
Name Ticker 3-Year 5-Year 10-Year 3-Year 5-Year 10-Year
Vanguard Target Retirement 2045 VTIVX    6.24     9.50      5.70    9.42     9.51    14.63
T. Rowe Price Retirement 2045 TRRKX    6.54     9.92      6.20    9.68     9.80    15.80
American Funds 2045 Trgt Date Retire R6 RFHTX    6.99   10.67      6.56    9.09     9.10    13.96
Fidelity Freedom® 2045 FFFGX    6.50     8.95      4.82    9.83     9.64    15.25
American Century One Choice 2045 AROIX    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.

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6 Essential steps to diversify your portfolio

6 Essential steps to diversify your portfolio

Diversification is often considered the only free lunch in investing. In one of my earlier blog posts, I talked about the practical benefits of diversification. I explained the concept of investing in uncorrelated asset classes and how it reduces the overall risk of the investments.  In this article, I will walk you through 6 essential steps to diversify your portfolio.

1. Know your risk tolerance

Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional and spur of the moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.

Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.

2. Understand your risk capacity

Often your willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. And inversely, you could be away too conservative while you need to be a bit more aggressive.

Factors like the size of savings and investment assets, investment horizon, and financial goals will determine the individual risk capacity.

3. Set a target asset allocation

Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.

These asset classes often include small-cap, deep value, and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors will lower risk tolerance will look for safer investments like government and corporate bonds, dividends and low volatility stocks.

In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historical low dependence on each other’s returns.

The US Large Cap stocks and US Treasury Bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. Therefore, the pairs tend to move in opposite direction over time. US Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets.

See the table below for correlation examples between various asset classes.

Asset Correlation Chart
Source: Portfoliovisualizer.com

4. Reduce your concentrated positions

There is a high chance that you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account.

If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401k plan matching, stock awards, stock options, inheritance, gifts or just personal investing.

The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a substantial portion of your investments and retirement savings.

Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they sit on significant capital gains that can trigger large tax dues to IRS if sold.

5. Rebalance regularly

Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at a different rate, they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.

Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon, and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.

6. Focus on your long-term goals

When managing a client portfolio, I apply a balanced, disciplined, long-term approach that focuses on the client’s long-term financial goals.

Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy ignoring the fact that they may not fit with our financial goals and risk tolerance.

If you are about to retire, you probably don’t want to put all your investments in a new biotech company or tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And so regularly, taking a risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.

Keeping your portfolio well diversified will let you endure through turbulent times and help your investments grow over time by reducing the overall risk of your investments.

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, Copyright: www.123rf.com
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Top 5 Strategies to Protect Your Portfolio from Inflation

Top 5 Strategies to Protect Your Portfolio from Inflation

Protecting Your Portfolio from Inflation

The 2016 election revived the hopes of some market participants for higher interest rates and higher inflation. Indeed, the 10-year Treasury rate went from 1.45% in July to 2.5% in December before settling at around 2.35-2.40% at the end of February 2017. Simultaneously, the Consumer Price Index, which is one of the leading inflation indicators, hit a five-year high level at 2.5% in January 2017. As many investors are becoming more concerned, we will discuss our top 5 strategies to protect your portfolio from inflation.

Higher interest and inflation rates can hurt the ability of fixed-income investors to finance their retirement. Bonds and other fixed-income instruments lose value when interest rates go up and gain value when interest rates come down.

There were numerous articles in popular media about the “great rotation” and how investors will switch from fixed to equity investments in the search for a higher return. None of that has happened yet, and the related news has seemed to disappear.

However, the prospects for higher inflation are still present. So, in this article, I would like to discuss several asset classes that are popular among individual investors. I will explain see how they perform in the environment of rising inflation.

Cash

Cash is by far one of the worst vehicles to offer protection against inflation. Money automatically loses purchasing power with the rise of inflation. Roughly speaking, if this year’s inflation is 3%, $100 worth of goods and services will be worth $103 in a year from now. Therefore, someone who kept cash in the checking account or at home will need extra $3 to buy the same goods and services he could buy for $100 a year ago.

A better way to protect from inflation, while not ideal, is using saving accounts and CDs. Some online banks and credit unions offer rates above 1%. This rate is still less than the CPI but at least preserves some of the purchasing power.

Equities

Stocks are often considered protection tools against inflation. They offer a tangible claim over company’s assets, which will rise in value with inflation. However, historical data has shown that equities perform better only when inflation rates are around 2-3%. To understand this relationship, we have to look at both Real and Nominal Inflation-Adjusted Returns. As you can see from the chart below, both real and nominal stock returns have suffered during periods of inflation that is over 5% annually. Moreover, stocks performed very well in real and nominal terms when inflation rates were between 0% and 3%.

High inflation deteriorates firms’ earnings by increasing the cost of goods and services, labor and overhead expenses. Elevated levels of inflation have the function to suppress demand as consumers are adjusting to the new price levels.

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

Real estate

Real Estate very often comes up as a popular inflation protection vehicle. However, historical data and research performed the Nobel laureate Robert Shiller show otherwise.

According to Shiller “Housing traditionally is not viewed as a great investment. It takes maintenance, it depreciates, it goes out of style. All of those are problems. And there’s technical progress in housing. So, the new ones are better….So, why was it considered an investment? That was a fad. That was an idea that took hold in the early 2000s. And I don’t expect it to come back. Not with the same force. So people might just decide, ‘yeah, I’ll diversify my portfolio. I’ll live in a rental.’ That is a very sensible thing for many people to do”.

Shiller continues “…From 1890 to 1990 the appreciation in US housing was just about zero.  That amazes people, but it shouldn’t be so amazing because the cost of construction and labor has been going down.”  Rising inflation will lead to higher overhead and maintenance costs, potential renter delinquency, and high vacancy rates.

To continue Shiller’s argument, investors seeking an 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. “Every transaction involves paying fees to banks, lawyers, and real estate agents. There are also maintenance costs and property taxes. The price of a single house also can be quite volatile.”  Just ask the people who bought their homes in 2007, just before the housing bubble.

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 42-year standard deviation is 33% higher than that of stocks and 3.5 times greater than the volatility of the 10-year treasury.  Short-term inflation protection benefits are often overshadowed by other market-related events and speculative trading.

Not to mention the fact that gold and other commodities are not easily available to retail investors outside the form of ETFs, ETNs, and futures. Buying actual commodities can incur significant transaction and storage cost which makes it almost prohibitive for individuals to physically own them.

Bonds

According to many industry “experts” bonds are a terrible tool to protect for inflation. The last several years after the great recession were very good to bonds since rates gradually went down and the 10-year treasury rate reached 1.47% in July 2017.  The low rates were supported by quantitative easing at home and abroad and higher demand from foreign entities due to near zero or negative rates in several developed economies. As the rates went up in the second half of 2016, bonds, bonds ETFs and mutual funds lost value. While bonds may have some short-term volatility with rising inflation, they have shown a strong long-term resilience. The 42-year annualized return of the 10-year Treasury is 7.21% versus 10.11% for large Cap Stocks. The Inflation adjusted rate of return narrows the gap between two asset groups, 3.07% for bonds and 5.85% for stocks.

For bond investors seeking inflation protection, there are several tools available in the arsenal. As seen in the first chart, corporate bonds due to their stronger correlation to the equities market have reported much higher real returns compared to treasuries. Moving to short-term duration bonds, inflation-protected bonds (TIPS), floating-rate bonds, are banks loan are some of the other sub-classes to consider

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Municipal Bond Investing

Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many Americans.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities, and related businesses. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals, and sewer systems. The size of the muni bond market has reached 3.7 trillion dollars. There are about $350 billion of Muni bond issuance available every year.

To encourage Americans to invest in Municipal Bonds, US authorities had exempted the muni bonds’ interest (coupon income) from Federal taxes. In some cases, when the bondholders reside in the same state where the bond was issued, they can also be exempted from state taxes.

Types of Municipal Bonds

Municipal entities issue general obligation bonds to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of borrowers such as water and sewer services, toll bridges, non-profit colleges, or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not significantly benefit the general public. Investor-led housing, local sports facilities, refunding of a refunded issue, and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields than those of other taxable sectors, such as corporate or government agency bonds.

Investment and Tax Considerations

Tax-Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why are certain investors flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering an AA-rated corporate bond offering a 4% annual yield and an AA-rated municipal bond offering a 3% annual yield. All else equal, which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax-adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax-adjusted interest, which is higher than the 4% offered by the corporate bond.

 The effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes, while out-of-state bonds are taxable at the state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal, she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. The most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included in the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be taxable. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

Diversification

Muni bonds are a good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Like the corporate world, municipal bonds and bond issuers receive a credit rating from major credit agencies like Moody’s, S&P 500, and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C, with AAA being the highest possible and C the lowest. BBB is the lowest investment-grade rating, while all issuance under BBB is known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014, there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances are a lot smaller than those for comparable corporate bonds.

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy-and-hold strategy as most investors seek their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF, holds 2,852 muni bonds with the highest individual bond weight at.45%. The top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, a 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. The top 5% make up 38.14% of the assets under management.

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11 Effective financial strategies for business owners

Financial strategies for business owners

Eleven ways to boost and protect your wealth

Small and mid-size businesses are the backbone of the US economy. Entrepreneurship and creativity have been moving the American economy for centuries. In fact, the US has one of the best grooming environments for start-ups and small businesses.  Many flagship consumer brands like McDonald’s, Starbucks, and Apple started very small with one restaurant, a coffee shop, and a garage workshop to become international leaders in their industry.

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Business owners spend several years building up their business. They invest a significant amount of personal time and capital to grow their companies.  Almost always these entrepreneurs will have their family fortune locked in their business. Those who succeed can go public or pass their wealth to the next generation.

Entrepreneurs are a special breed. Many have a vision or a single idea that that drives their pursuit for success. Others have unique skills or talent that make them stand out from their competitors. They are independent, self-driven, and bold.

Focused on their business, more often than not entrepreneurs ignore or delay their personal financial planning.  In this post, I would like to discuss several practical steps that business owners can follow to establish their successful financial plan.

Balance your business and personal goals

The first and most crucial step in the personal financial planning process is setting your short and long-term financial goals. In many cases, the business goals can interfere and clash over personal financial goals. Business goals to expand into a new market or purchase a new factory can negatively interfere with your personal goals such as saving for retirement or college education for your children. Striking the right balance between your business and personal goals is key to achieving them.  Prioritizing one over the other may hurt your long-term financial success.

 

Explore different financing alternatives

Every new business idea requires capital to start. The success of the venture depends on the owner’s ability to secure financing. Sometimes, the funding comes from personal savings or the sale of a property. Other times, the owner needs to look for external funding within his or her social circle or even approach a financial institution. The external financing can be in the form of a loan or equity stake.

Both debt and equity financing come with embedded costs. The cost can vary depending on the company’s size, industry, history, economic conditions, etc. One of the main advantages of debt financing is that the interest on the loan is tax deductible. One the other hand equity financing may allow for more flexibility.

Another great way of financing your idea is your customers. Indeed, your clients are one of the best and inexpensive sources of financing. If your customers love your product, they will be willing to give you an advance payment, subscribe to your platform or consider a product/service exchange.

In any case, the entrepreneurs should seek to minimize the overall cost of capital of its business by exploring multiple financing channels.

Control cost

Even the best idea can fail if it doesn’t generate profit. In simple numerical terms, the company revenue should be higher than its expenses. Many ventures do not succeed because the company cannot generate enough revenue to cover all costs. Clearly, the first answer will be to generate more revenue. However, many successful companies are notorious with their focus on cost control. Business owners must stay on top of their expenses. They must track and analyze your cost. Owners should look for operational deficiencies and overlaps, result-based compensation, economies of scale and ways to increase productivity.

 

Manage liquidity

Businesses need cash to maintain healthy growth. Not surprisingly, the prominent investor Warrant Buffet prefers to invest in companies generating significant cash flows. The capacity to produce cash from its operations will determine the company’s ability to pay its employees, creditors, and vendors. Building a disciplined system of managing receivables and payables and maintaining a cash buffer for emergencies are keys for effective cash flow management.

 

Manage your taxes

Filing and paying taxes is a long and painful process. Tax law is very complex. Many hidden threats can trigger tax events for you. There are also many opportunities to save on taxes. Often, your tax bill depends on your company’s legal status. Sole proprietors have different taxation rules from c-corporation. Speak to an accountant or tax lawyer to find out what legal status works best for you. To avoid missed opportunities and last-minute mistakes, you have to prepare for the filing process in advance. Start early. Keep a clean record of all your expenses. Track all tax filing dates. Remember to pay all federal and state taxes, social security, Medicare, local permits, and fees. Consider using professional bookkeeping software and working with a CPA.

 

Manage risk

Risk comes in all shapes and forms – business risk, operational risk, financial risk, disability risk and so on. Managing the risk from different sources is a mandatory skill for any successful business owner and executive.  External threats can impose significant obstacles to profitability and expansion but if managed successfully can create substantial opportunities for long-term growth.

Business threats can come from new competitors, new technology, changes in consumer demand, new regulatory requirements, and so on. Business owners have to be on top of these changes and often even drive the change.

Operational risk impacts the companies’ ability to serve their customers.

Financial risk can come from interest rates, volatile stock markets, and liquidity crunches. Macroeconomic factors can affect your clients’ ability to pay off their debt. Having a solid financial strategy, building buffers and managing cash will allow the business to withstand unexpected financial turbulence.

Short-term and long-term disability will prohibit the owners and key employees to perform their duties. Injuries and sickness of key personnel can significantly hurt any business. Prolonged disability can limit owners’ ability to make a living, support their families, and grow their business. Having disability insurance can help bridge the financial gap during a time of recovery. Moreover, having a disaster plan can save your business at times of emergencies and unforeseen circumstances.

 

Establish a retirement plan

Having a company retirement plan is an excellent way to save money in the long run. A pension plan contributions could reduce current taxes and boost employee’s loyalty.

While there are few alternatives – 401k, SEP IRA, and SIMPLE IRA. I am a big supporter of 401k plans. Although they are a little more expensive to establish and run, they provide the highest contribution allowance over all other options.

The maximum employee contribution for 2016 is  $18,000. The employer can match up to $35,000 for a total of $53,000. Individuals over 50 can add a catch-up contribution of $6,000 for a total of $59,000 annual contribution.

Self-employed individuals can also take advantage of this option by setting up a solo 401k plan. Moreover, they can contribute up to $53,000, $18,000 as an employee of your company, and $35,000 as an employer.

 

Build a safety net

Creating a safety net is a critical step to protecting your wealth. Many business owners hold a substantial amount of their assets tied up to their personal business. By doing it, they expose themselves to a concentrated risk in one company or industry. Any economic developments that can adversely impact that particular sector can also hurt their personal wealth.

The best way to build a strong safety net is asset diversification. Owners can significantly decrease the overall risk of their portfolio when investing in a broad and uncorrelated range of assets, sectors, and regions.

 

Start your estate planning

Estate planning is the process of arranging the disposal of your assets after your passing. It further involves your family members, other individuals, and charitable organizations. Estate planning starts with setting up a family trust and personal will and can also affect financial, tax, medical and business planning. Additionally, you can use estate planning to eliminate uncertainties over the administration of a probate and to maximize the value of the estate by reducing taxes and other expenses. The ultimate goal of estate planning can be determined by your specific goals and may be as simple or complex as your needs dictate.

 

Plan for business succession

A successful business can impact various parties such as owners, employees, contractors, vendors, clients, landlords, and suppliers. Therefore, creating a business succession plan will ensure that all parties’ interests are met in the event you decide to discontinue your business or pass it to another person.  Moreover, a robust plan will address numerous tax and financial issues that will result from the succession. The complexity of the succession plan will depend on the size, industry, and legal status of your business.

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