8 Financial planning tips for doctors

Introduction

Being married to a physician has allowed me to obtain a unique understanding of the costs and benefits of achieving a medical degree.   In this post, we will discuss several practices that can help physicians and other healthcare professionals achieve financial prosperity.

What sets physicians apart from other professions?

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

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

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

1. Start saving for retirement early.

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

It is critical that young doctors start saving for retirement while they are in residency. During residency, the new doctors receive a salary between $40,000 and $60,000. Many employers offer both tax-deferred 401k and after-tax Roth accounts. Depending on their financial situation physicians should consider maximizing both plans with priority on their After Tax Roth contributions first before adding money to their 401k account. As of 2019, Roth IRA contributions are limited to $6,000 per year at $122,000 of income. The amount phases out as the income reaches $137,000. Almost certainly this option won’t be available once they start their career and move to higher income levels.

2. Maximize your retirement contributions.

Doctors have to maximize their retirement contributions to catch up for the extra ten years of school and residency.

Physicians working in hospitals and large healthcare systems will very likely have the option to open a tax-deferred 401k plan. As of 2019, these programs allow their participants to contribute up to $19,000 a year. Most employers offer matching contributions for up to a certain amount.

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

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

Doctors who are self-employed, own a corporation or run a private practice should consider investing in solo 401k plans. These plans allow for up to $56,000 of pretax contributions, $19,000 as an employee and $37,000 as profit sharing by an employer.

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

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

 3. Manage your taxes.

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

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

Feel free to check some of my previous postings about tax optimized financial planning.

4. Balance your budget.

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

5. Manage your student loans. 

How to best manage your student debt depends on a combination of factors including your credit score, federal or private loan, loan maturity, interest rates, monthly payments, and current income. Stay on top of your student debt. Do not lose track of due dates and interest rates.

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

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

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

6. Watch your credit score.

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

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

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

7. Take calculated risks.

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

8. Get insurance.

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

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

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

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

Final words

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

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

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) 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,  Image copyright: 123RF.com

4 Steps to determine your target asset allocation

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

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

Assess your risk tolerance

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

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

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

A free risk tolerance test is available here:

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

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

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

 

Set your financial goals

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

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

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

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

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

Define your investment horizon

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

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

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

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

 

 Know your tax bracket

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

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

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

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

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

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com

Мaximize the benefits of Roth IRA

Roth IRA is a tax-exempt investment account that allows the owner to make after-tax contributions to save for retirement.  The plan has a tax free status. All investments grow tax-free. The Roth IRA offers a lot of flexibility and few constraints.  There are numerous ways to maximize the benefits of the Roth IRA.

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Save for the future. Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those with who have 401k plans with their employer can open a Roth IRA.

Flexibility. There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well.

No investment restrictions. There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes. There are no taxes on the distributions from this account once the owner reaches the age of 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either. 

No penalties if you withdraw your original investment. While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Roth IRA helps you diversify your future tax exposure. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Naturally, nobody can predict what will happen in several years or decades. Nobody knows how the tax laws will change by the time they need to take out money from the account. That is why I highly recommend devitrifying your mix of investment accounts and take full advantage of your Roth IRA.

Roth IRA is ideal for investors who are in a lower tax bracket but expect to jump in a higher one when they retire. Naturally, nobody can predict what will happen in several years or decades. Nobody knows how the tax laws will change by the time they need to take out money from the account. That is why I highly recommend devitrifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions.  Unlike 401k plans, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Roth IRA has two main restrictions. First, you can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.

Second, you can only contribute up to $5,500 plus a catch-up $1,000 per year if you make $117,000 and under for 2016 tax year.

Since Roth IRA enjoys a special tax status, there are several ways to capitalize on these benefits.

1. Maximize your contribution

If you earn $117,000 or less, you can contribute up to $5,500 per year. Individuals 50 years old and above can add a catch-up contribution of $1,000.

If your aggregated gross income is between $117,000 and $131,999 you can still make contributions but with decreasing value. The chart below will help you determine how much you can add if your income falls within this range.

AGILimitCatch-UpTotal
 117,000 and under 5,500 1,000 6,500
 118,000 5,133 1,000 6,133
 119,000 4,767 1,000 5,767
 120,000 4,400 1,000 5,400
 121,000 4,033 1,000 5,033
 122,000 3,667 1,000 4,667
 123,000 3,300 1,000 4,300
 124,000 2,933 1,000 3,933
 125,000 2,567 1,000 3,567
 126,000 2,200 1,000 3,200
 127,000 1,833 1,000 2,833
 128,000 1,467 1,000 2,467
 129,000 1,100 1,000 2,100
 130,000 733 1,000 1,733
 131,000 367 1,000 1,367
 132,000 – –

2. Start early

To maximize the full potential of Roth IRA, you need to start saving early. With an average historical growth rate of 7%, your investment of $5,500 today can bring you $41,867 in 30 years completely tax-free. The cumulative effect of your return and the tax status of the account will help your investments grow faster.

Roth IRA is an excellent starting point for young professionals who just start their career. If you make under $117k, you are in your full right to invest the full amount of $5,500.

Minors who earn income can also invest in Roth IRA. While youngsters have fewer opportunities to make money, there are some that will count – babysitting, garden cleaning, child acting, modeling, selling lemonade, distributing papers, etc.

If you can only afford to save $5,500 this year, put them in Roth IRA.

3. Rollover from Traditional IRA and 401k plans

Under certain circumstances, it makes sense to rollover assets from your Traditional IRA and old 401k  accounts to Roth IRA. If you expect to earn less income or pay lower taxes in a particular year, it could be beneficial to consider Roth IRA rollover. Your rollover amount will be taxable at your current ordinary income tax level.

Another strategy is to consider annual rollovers in amounts that will keep you within your tax bracket.

4. Do a Backdoor rollover

Due to recent legal changes investors who do not satisfy the requirements for direct Roth IRA contributions, can still make investments to it. The process starts with taxable contributions, up to the annual limit, into a Traditional IRA. Eventually, the contributions are rolled from the Traditional IRA to the Roth IRA.

5. Best way to manage your Roth IRA

If the Roth IRA holds the bulk of your retirement savings, you have to maintain a diversified portfolio that is in line with your risk tolerance and financial goals.

However, due to the set contribution limits, Roth IRA accounts tend to be smaller relative to other investment accounts. In this case, you can take a more holistic approach and overweight certain assets in the Roth IRA, by maintaining your overall assets allocation within your risk tolerance level and financial targets.

How to invest 

Growth investments

The favorable tax status of the Roth IRA gives the advantage to high growth investments. Large-cap and small-cap growth and emerging market stocks are one of the most fittings investments for Roth IRA accounts. These investments have a common characteristic. They have higher than average expected future returns.

When you overweight these investments in your Roth IRA, you will avoid paying significant capital gain taxes if your investments were in the regular taxable account or high-income taxes if your investments were in a tax-deferred account like 401k.

High-yielding securities

Investments paying large distributions like high yield bonds, emerging market bonds, and REITs are also a good match for the Roth IRA. These investments generate above-average distributions taxable at the ordinary income rate. Placing them in your Roth IRA will shelter their income from taxes and let them grow tax-free.

Commodities

Commodities investments including Gold have complex taxation rules. Gold ETFs like GLD and IAU are taxed as collectibles with 28% for long-term capital gains. Commodity ETFs are taxed at the 60/40 rule, 60% long-term, 40% short term (20% max/39.6% max) regardless of holding period. Commodity ETNs are taxed at 20% max for the long-term capital gain and 39.6% for short-term gains. Having commodity investments in your Roth IRA account will let you protect their return from these complex taxation rules.

Active mutual funds

Active mutual funds have higher turnover than ETFs and index funds. Therefore they often release capital gains to their shareholders. The short-term capital gains are taxable as ordinary income plus 3.8% Medicare surcharge. While long-term gains are taxed at the lower long-term capital gain rate of 0%, 15% or 20% plus 3.8% Medicare surcharge.

When these funds sit in your Roth IRA account, they will not trigger any taxes when the management releases the gains.

What to avoid

Tax-Exempt Municipal Bonds

The interest on tax-exempt municipal bonds is free from Federal and in some cases state taxes. These instruments are most suitable for taxable accounts where investors can take advantage of the favorable tax treatment. The benefit is not available if the municipal bonds sit in a Roth IRA account.

Investors interested in Municipal bond exposure in their Roth IRA may consider taxable municipal bonds. Their distributions are taxable at the ordinary income level. Hence you will avoid paying taxes on those investments.

MLPs

Managed Limited Partnerships (MLPs) distribute at least 90% of their income to their partners. MLPs are attractive for their dividends. Also, on average 80% of the income payout is in the form of a tax-deferred return of capital. These type of distributions reduce the cost basis of the owenership and create a huge tax benefit for buy-and-hold investors. They will pay capital gain taxes on their shares only at the time of sale. However, this tax benefit will disappear if the MLP holdings sit in a Roth IRA account. They will lose their tax advantage status.

Furthermore, distributions that exceed $1,000 for each unitholder are considered unrelated business taxable income, or UBTI, and are subject to taxes even while in Roth IRA account.

Investors interested in MLPs for their Roth IRA should consider buying exchange-traded funds and mutual funds. They provide diversified exposure to MLPs and are not subject to the UBTI rule.

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

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions.  Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com
Sources:

http://www.rothira.com/how-convert-to-a-roth-ira

How to build your 401k plan

How to build your 401k plan

401k plans are a powerful savings tool for retirement

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

Does your employer offer a 401k plan?

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

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

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

How to decide on your investment choices

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

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

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

Index Funds

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

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

Actively Managed Mutual Funds

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

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

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

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

Target Retirement funds

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

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

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

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

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

Vanguard Target Retirement funds

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

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

T. Rowe Target Retirement funds

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

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

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

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

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

10-year Performance Analysis, 2045 Target Retirement Fund

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

 *** Data provided by Morningstar

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

ETFs

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

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

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

Company stock

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

Allocation mix

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

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

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

401k asset allocation mix

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

Final recommendations

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

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

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

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

About the author:

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

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

A beginner’s guide to retirement planning

uide to retirement planning

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

Start Early 

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

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

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

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

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

Know your tax rate

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

See below table for 2016 tax brackets.

Guide to retirement planning

 

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

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

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

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

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

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

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

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

Know your  State and City Income Tax

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

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

California income tax rates for 2016:

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

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

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

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

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

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

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

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

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

 

New York State tax rates for 2016:

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

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

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

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

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

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

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

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

 

City Tax

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

Create an emergency fund

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

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

Maximize your 401k contributions

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

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

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

401K withdrawals

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

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

Read the fine print

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

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

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

Maximize your Roth IRA

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

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

 

How to decide between Roth IRA and 401k

Ideally, you want to maximize contributions to both plans.

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

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

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

I suggest prioritizing retirement contributions in the following order:

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

 

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

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

A beginner’s guide to ETFs

Guide to ETFs

A beginner’s guide to ETFs. The ETF industry was born as a result of the market crash in October 1987. The initial goal behind ETFs was to provide liquidity and mitigate volatility for market participants. Over the last 20 years, ETFs became a favorite investment vehicle for individual investors and asset managers. Today, globally there are 6,870 ETF products on 60 exchanges and over $3 trillion of assets under management.

ETF stands for an exchange-traded fund. ETF is a passively managed marketable security that tracks an index, a commodity, or pool of bonds. ETFs trade on the stock exchange and their price fluctuates throughout the day.

The media and investors often compare ETFs with mutual funds.  In contrast with ETFs, the mutual fund managers actively look for securities in an attempt to beat their designated benchmark.

ETFs typically have higher daily liquidity and lower fees than most mutual funds.  This makes them an attractive alternative for individual investors.

By design, ETFs do not produce positive alpha. Alpha is the difference between the fund and the benchmark performance.  ETFs strictly follow their index, and as a result, their alpha is always zero.

ETFs popularity spiked in the past five years due to the rise of robo-advisers and lowering management fees. At the same time, many emblematic active managers underperformed their benchmarks and saw significant fund outflows.

To illustrate this, in 2015 Morningstar reported a $206.7 billion outflow from active funds and a $412.8 billion inflow in passive strategies.

 

Underlying Index

There are significant variations in the index composition between indices tracking the same asset class.  The ETFs structure and performance reflect these differences.

In the small-cap space, for example, IJR tracks the S&P 600 Small-Cap index, and IWM follows Russell 2000 Small Cap index. As the name suggests, the S&P index has 600 constituents, while Russell index has 2,000 members. While there are many similarities and overlaps between the two, there are also significant variations in their returns, risk and sector exposure.

In the Emerging market space, indices provided by MSCI include South Korea in their list of emerging market countries. At the same time, indices run by FTSE exclude South Korea and have it in their developed country list.

Investors seeking to manage their exposure to a particular asset class through ETFs need to consider the index differences and suitability against their overall portfolio.

 Fees

The fees are the cost associated with managing the fund – transaction cost, exchange fees, administrative, legal and accounting expenses. They are subtracted from the fund performance. The costs are reported in the fund prospectus as an expense ratio. They can be as low as 0.08% and as high as 2% and more. The percentage represents the total amount of management fees over the value of assets under management.

Consider two ETFs that follow the same index.  All else equal the ETF with the lower fee will always outperform the ETF with the higher one.

Liquidity

The ETF liquidity is critical in volatile markets and flash-sales when investors want to exit their position.

Asset under management, daily volume, and bid/ask spread drive the ETF liquidity. Larger funds offer better liquidity and lower spread.

The liquidity and the spread will impact the cost to buy or sell the fund. The spread will determine the premium you will pay to buy the ETFs on the stocks exchange. The discount is what you will need to give up to sell the ETFs. The lower the spread, the smaller difference between purchase and sale price will be. Funds with less spread will have lower exit costs.

ETF varieties

Exchange Traded Notes are an offshoot of the ETFs products. ETNs are structured debt instruments that promise to pay the return on the tracking assets. This structure is very popular for Oil, Commodity and Volatility trading. They offer flexibility and easy access for investors to trade in and out of the products.

I believe that long-term investors should avoid Exchange Traded Notes (ETNs), volatility (VIX) ETFs, inverse and leveraged (2x and 3x Index) ETFs and ETNs products. While increasing in popularity and liquidity, they are not appropriate for long-term investing and retirement planning. These types of funds are more suitable for daily and short-term trading. They incur a higher cost and have higher risk profile.

Smart Beta ETFs are also increasing in popularity. While the name was given for marketing purposes, this particular breed of ETFs uses a single or multi-factor approach to select securities from a pre-defined pool – S&P 500, Russell 2000, MSCI world index or others.

The Single Factor ETFs like Low Volatility or High Dividend are strictly focusing on one particular characteristic. They offer a low-cost alternative to investing in a portfolio of income generating or less volatile stocks.

The multi-factor ETFs are a hybrid of active management and ETFs. ETF providers have established an in-house index that will follow the rules of their multi-factor model. The model will select securities from an index following specific parameters with the intention of outperforming the index. The ETF will buy only the securities provided by the model. The multi-factor ETFs are competing directly with the actively managed mutual funds, which are using similar techniques to select securities. Their advantage is the lower cost and easy entry point.

Will smart beta ETFs succeed? Only time will tell. For now, we don’t have enough historical data to confirm their ability to outperform their index consistently.

Currency Hedged International ETFs is another newcomer in the ETF space. Their goal is to track a foreign equity index by neutralizing the currency exposure. They can be attractive to investors with interest in international markets who are concerned about their FX risk.  Some of the more popular ETFs in this category include HEDJ, which tracks Europe developed markets, and DXJ, which follows Japan exporting companies.

Where to place ETFs?

ETFs are a great alternative to all investment accounts.

Due to their passive management, low turnover and tax-advantaged structure ETFs are a great option for taxable and brokerage accounts.

For now, ETFs have not made their way to corporate 401k plans, where mutual funds are still dominating. I am expecting this to change as more small and mid-size companies are looking for low-cost solutions for their workplace retirement plans.

Tax-sensitive investors, however, need to consider all circumstances before adding ETF holdings to their portfolio. The ETF tax treatment follows the tax treatment of their underlying assets. Qualified dividends paid by your ETF will trigger a favorable rate of 0%, 15% or 20%. The interest from bond ETFs and dividends from REITs are taxed at the ordinary tax income rate of up to 39.6%.

Higher-yielding ETFs like those tracking REITs, High Yield, and Emerging Markets Bonds are suitable for the tax-advantaged accounts like 401k, IRA and Roth IRA where their income will be sheltered from taxes.

Equity Growth, Municipal, and MLP ETFs have favorable tax treatment, which makes them a great fit for taxable investment accounts.

 

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 the 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.
Resources:
Great Bloomberg article about the history of ETFs:
http://www.bloomberg.com/features/2016-etf-files/
2015 Morningstar Direct U.S. Asset Flows:
http://corporate.morningstar.com/US/documents/AssetFlows/AssetFlowsJan2016.pdf