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Investing Blog Roundup: Retirement Savings Contribution Credit

There are a handful of tax-planning topics that get quite a bit of coverage (e.g., Roth conversions, whether to contribute to Roth or tax-deferred accounts, backdoor Roth strategies). Morningstar’s Christine Benz recently took a look at two important topics that don’t get very much attention.

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Spending from a Portfolio in Retirement

I was recently asked to share my thoughts on how to spend from a portfolio in retirement. In my view (without getting into the topic of whether part of the portfolio should be annuitized) there are three broad questions you have to answer:

  1. Which account(s) to spend from each year (i.e., Roth, tax-deferred, taxable),
  2. Which assets to spend from (i.e., stocks first, bonds first, or both at the same time), and
  3. How much to spend per year.

Which Account(s) to Spend From?

While tax planning is very case-by-case, there is broad consensus on the strategy that most often makes sense. (See this paper or this article from Colleen Jaconetti and Maria Bruno of Vanguard, or my book Can I Retire, for a more thorough discussion of this topic.)

Most often, the overall strategy is to spend in the following order:

  1. Spend RMDs,
  2. Spend from taxable accounts,
  3. Spend from Roth accounts if your current marginal tax rate exceeds the marginal tax rate you expect to face in the future, or spend from tax-deferred accounts if your current marginal tax rate is lower than the marginal tax rate you expect to face in the future.

Of note, #3 isn’t just about tax brackets. It’s about marginal tax rates, which include the effect of various tax breaks phasing out over specific income levels or various taxes kicking in at specific income levels. Also, it’s a dollar-by-dollar decision. For example, in a given year it may make sense to spend from tax-deferred up to a certain point, then switch to Roth spending once, for example, you reach the point where additional income would be taxed at a higher rate (e.g., because you’ve hit the top of your tax bracket).

A tax professional can be very helpful here. Alternatively, if you’re doing the analysis yourself, software such as TurboTax can be useful for running “what if” scenarios (e.g., how much would my overall tax bill go up if I took out an additional $1,000 from my traditional IRA this year?).

Which Assets to Spend From?

With regard to which assets to spend from first, there’s still ongoing debate on the topic.

Most target-date fund providers assume that stock allocation should decline in early retirement, then stay level for the rest of retirement (i.e., spend first from stocks, then spend from both stocks and bonds).

But Michael Kitces and Wade Pfau made an interesting case a few years back that retirees’ stock allocation should actually be lowest in the years immediately before and after retiring, when their finances are most exposed to years of bad returns. That is, your bond allocation should be at its highest point when you retire, and you should be reducing your allocation to bonds gradually from there.

How Much to Spend Each Year?

As far as how much to spend per year, that’s also a topic where there’s a lot of discussion/debate. It mostly centers around whether or not the “4% rule” — in which you spend 4% of your portfolio in the first year of retirement, then increase that level of spending each year in keeping with inflation, regardless of how your portfolio performs — is actually safe.

For instance, Wade Pfau took a look at how a 4% inflation-adjusted withdrawal rate would have worked if used in other countries, and the answer is that it would have been quite risky. That is, it may just be a historical fluke that such a strategy happened to be pretty safe in the U.S. in the 20th century.

In addition, the low interest rates we face today strongly suggest that a 4% withdrawal rate is riskier today than it would have been in the past (in the U.S.), because we can be pretty confident that the bond portion of the portfolio will provide less total return than in most historical cases in the U.S.

A counterpoint, however, is that if you are flexible with how much you spend (i.e., you could easily cut spending if your portfolio experiences poor returns early in retirement), you can start with a higher withdrawal rate. (For a good discussion of this topic, see the second video in this article in which financial planner Jonathan Guyton explains his applicable research.)

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Can I Retire Cover

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  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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Investing Blog Roundup: Fiduciary Duty Rule

With the GOP now in control of the executive and legislative branches, the Department of Labor “fiduciary rule” is in peril of being eliminated before it goes into effect. This week Michael Kitces provides an update on what, exactly, is going on with the rule right now. And Jack Bogle makes the case that elimination of the fiduciary rule would be “a step backward for our nation.”

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Re-evaluating Betterment After Their Price and Service Change

Most readers of this blog are passive investors of some form or another, whether via Target Retirement/LifeStrategy funds, robo-advisors, or just simple index-fund/ETF portfolios.

A few readers have asked for my thoughts on the changes that robo-advisor Betterment recently made to their fees and offerings.

Previously, Betterment’s cost was 0.35% pear year for accounts up to $10,000, 0.25% for accounts from $10,000-$100,000, and 0.15% per year for portfolios of at least $100,000. And for that price, the customer received automated portfolio management, including tax-loss harvesting for taxable accounts.

Now, they will be offering three different levels of service, two of which include ongoing human advice along with the portfolio management:

  • For 0.25% per year you get the same portfolio management service as before.
  • For 0.40% per year you get portfolio management, plus an annual call with their CFP team.
  • For 0.50% per year you get portfolio management, plus unlimited calls with their CFP team.

In other words, it’s a price increase for people who have at least $100,000 with Betterment, and a price decrease for people who have less than $10,000 invested with them. And now there are two additional options to choose from (for people who meet the applicable minimum account sizes).

The price change makes Betterment’s portfolio management price nearly identical to that of their closest competitor, Wealthfront, which also charges a flat 0.25% per year for portfolio management (with the exception of the fact that Wealthfront will manage the first $10,000 of assets for free).

Compared to Target Date Funds

I’ve always found it instructive to compare robo-advisors to an alternative hands-off portfolio solution: all-in-one funds, such as target-date funds, balanced funds, or LifeStrategy funds.

In my view, relative to all-in-one funds, the primary advantage of Betterment’s portfolio management service has been the fact that it is more tax-efficient when there’s a taxable account in the mix, because it includes tax-loss harvesting, offers asset location planning, and uses muni bonds rather than taxable bonds when appropriate.

As a result, the situation in which Betterment always seemed most appealing to me was for investors who:

  • Have at least $100,000 to invest (such that they’d qualify for the lowest cost),
  • Want a hands-off portfolio management solution, and
  • Have a large part of their assets in taxable accounts (such that the improved tax-efficiency would provide significant value).

I think the same holds true today, except for the fact that there’s no longer a need to hit the $100,000 threshold for lower pricing. (Of course, for people who do have more than $100,000 to invest, the price just went up by 0.1%, thereby meaning that the value of the tax-efficiency must overcome an additional 0.1% annual hurdle in order to provide a net benefit to the customer.)

Compared to other Human/Robo-Advisors

Vanguard’s Personal Advisor Services costs 0.30% per year. For that cost you get portfolio management, plus phone/email/Skype contact with a Vanguard advisor whenever you want. The service does not, however, include tax-loss harvesting.

Similarly, Schwab recently announced that they’ll be launching a human/robo service later this year. The cost for that service is supposed to be 0.28% per year (with an annual maximum of $3,600). And what you get for that cost looks very similar to Vanguard’s service — portfolio management, plus as-needed contact with a Schwab advisor. One noteworthy difference: for accounts of at least $50,000, they will also provide automated tax-loss harvesting.

Schwab’s upcoming service and Vanguard’s Personal Advisor Services seem most comparable to Betterment’s 0.5% service level, because they each include unlimited access to human advisors.

The Betterment platform would be preferable to the Vanguard platform if you think that tax-loss harvesting will be worth at least 0.2% per year (in order to justify the additional cost). But I’m not really sure how it would be better in any way than Schwab’s new service once that is released, as the Schwab service appears to offer all of the same things, at a lower cost (0.28% annually rather than 0.5%).

(Of course, it’s possible that the Schwab service will have some “catch” that we have yet to learn about. Presumably we’ll get more information when the service is actually released and people try it out and report back on their experiences.)

Investing Blog Roundup: Hierarchy of Retirement Needs

It’s common for retirees — even well informed retirees — to make financial decisions that, from a purely economic perspective, don’t make sense. People like to hold much more cash than they actually need. People with no bequest motive and long life expectancies still tend to claim Social Security early and avoid annuitizing their portfolios. People prefer variable annuities to basic immediate lifetime annuities, even though they’re usually an inferior tool for satisfying an income need. The list goes on and on.

This week, Michael Kitces provides an interesting discussion of a psychological “hierarchy of retirement needs” that seems to be informing these decisions.

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Should I Prepare My Own Tax Return?

A reader writes in, asking:

“This is my first time having to file a tax return since getting a ‘real job’ and my head is spinning. Should I hire a CPA to do my taxes or is it better to use software for it myself? I’ve read that Turbotax guarantees the highest refund possible. Is it really better than hiring a CPA?”

Without a doubt, using a tax professional is the most reliable way to get the lowest tax bill. A key point here is that tax professionals use tax preparation software too, so using such software yourself does not provide you with any advantage over a professional.

That said, there are valid reasons for taking a DIY approach. Most obviously, you save on fees. Buying a download of TurboTax or other similar software certainly costs less than hiring a professional.

More importantly in my opinion though is that by preparing your own return for the first time, you’ll learn quite a bit about how income taxes work.

In my work, I frequently come across people who have been paying income taxes for decades, yet they don’t understand even the most basic income tax concepts (e.g., they misunderstand how tax brackets work, or they don’t know the difference between a deduction and a credit). Every year, they simply turn over all of their documents to somebody else who prepares their return, and so they go years without learning these things. Naturally, it’s impossible to make very good decisions about tax planning when you don’t understand the fundamental concepts.

In addition to allowing you to make smarter financial decisions, having a better understanding of income taxes allows you to be a more well-informed voter. It’s very common for politicians to propose various changes to our tax code (e.g., creating a new deduction or credit, or eliminating/changing an existing deduction or credit). If you don’t understand how the system works now, you can’t really understand the impact of proposed changes.

My point here isn’t that everybody should be preparing their own tax returns. It depends on your goals, and it depends on how complicated your return is. (If you’re already at the point where you have investments in taxable accounts, you itemize your deductions, and you have income from a rental property, then it’s going to be quite a challenge to prepare your own tax return if you’ve never prepared a return before.)

In summary, if you want to learn more about income taxes, you want to save on tax prep fees, and/or your return isn’t too complicated, those are all points in favor of preparing your own return. But it’s unlikely that your tax bill will be lower as a result of taking a DIY approach rather than hiring a professional. In most cases, the outcome that you’re hoping for with a DIY approach is that your return will turn out exactly the same as it would have if a professional had prepared it.


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