August 2009

The topic of “emergency funds” is popular in the realm of personal finance. The general idea is that things come up (car repairs, medical bills, job losses, etc.), and you need some accessible funds (savings account or money market most likely) so that you’re prepared for such scenarios.

Typically, the discussion is focused on avoiding debt. And that makes sense. You certainly don’t want to have to use a credit card to pay for a several-thousand-dollar expense.

But having an emergency fund isn’t essential just for the purpose of avoiding debt. It’s also essential if you want to be a successful investor.

Emergency Funds and Investing

If you have a decent amount accumulated in your retirement accounts, you’ll likely be able to withdraw from them (rather than use a credit card) to pay for large, unexpected expenses. But ideally, of course, you’d never have to tap into your 401(k) or IRA to fund current spending.

In fact, you don’t want to have to even think about having to do so. If, somewhere in the back of your mind, you know there’s a chance that you’ll have to withdraw money from your 401(k) or IRA to pay for current expenses, you’ll always be worrying about fluctuations in your account value.

And if you can’t stop yourself from worrying about your account value, you’ll never be able to invest in a manner that’s appropriate for long-term savings. You’ll have to invest extremely conservatively. (Either that, or you’ll invest aggressively, only to panic and sell immediately after a market downturn someday.)

My Own Emergency Fund

For me, the size of emergency fund that allows me to sleep well at night (no matter how wildly my IRA value happens to be fluctuating) is 6 months of living expenses. For you it could well be different.

My wife and I use ING Direct for our emergency fund. It’s not always the highest rate, but it tends to be pretty respectable, and I’ve been very happy with their customer service and website. (Also, I’m not the type to spend time swapping between accounts for half a percent here or there.)

If you don’t have one yet…

Get moving. Just open the account somewhere (As long as there are no fees, it doesn’t matter too much where you open it.), and get started building your savings up.

Then you can move on to all the exciting stuff–opening an IRA, maxing out your 401k, and so on.

August 25, 2009 12 comments

Readers often email me to ask what to do when you have asset that you’d like to sell, but which has a large unrealized capital gain. The two most common examples being:

1. Shares of a given stock which now make up far too high a percentage of their overall net worth, or
2. An actively managed mutual fund with unreasonably high costs.

Generally, my suggestion is as follows:

First, calculate precisely how much you would owe if you were to sell the asset. If we assume you’ve held the asset for greater than one year, the Long-Term Capital Gain would be taxed at a rate of 15% (unless you’re in a tax bracket of 15% or lower, in which case LTCGs are taxed at a rate of 5%).

Next, weigh the cost of that taxation against the benefits of having an appropriately-balanced portfolio.

Holding Too Much of One Stock

For example, let’s say you own shares of a stock and (in total) they’re currently valued at $100,000. You purchased them (all at the same time, at the same price) for $30,000.

If you were to sell all of your shares, you’d be realizing a LTCG of $70,000. Assuming you’re in the 25% (or greater) tax bracket, the gain will be taxed at a rate of 15%, meaning you’d be paying $10,500 in tax.

Is that too high a price to pay for diversification? If this $100,000 makes up a significant portion of your net worth, it may be wise to accept that 10.5% decline in value now rather than expose yourself to the much larger potential losses that can come from having so much money invested in one company.

It’s also important to note that, assuming you plan on selling the shares at some point in the future (and assuming they don’t decrease in price), you’re going to be paying this tax eventually.

Selling Actively Managed Funds

Alternatively, let’s imagine that you own an actively managed fund and would like to sell it (having been convinced of the benefits of index funds), but your cost basis is significantly below the current value. (Again, let’s use $30,000 and $100,000.)

Again, if you sell, you incur a cost of 10.5%. Essentially the question comes down to how long it will take for the reduced expenses to recoup the tax paid. Often, it’s a much shorter time than you’d think.

For example, it wouldn’t be unheard of for your total costs to decrease by 2% per year or more:

• 0.75% via a lower published expense ratio
• 0.50% via lower turnover
• 0.75% via increased tax efficiency (which is relevant given that we’re obviously dealing with a taxable account here).

At that rate, it would take barely 5 years before your savings more than outweighed the cost of paying the tax. (And you’d now have a higher cost basis in your holding as well, meaning that when you sell the index fund at a later date, you won’t be paying as much tax as you would had you held the original fund.)

In Summary…

Obviously, this sort of situation is something that must be considered on a case-by-case basis. That said, in my own experience, I find that investors tend to overestimate the cost of selling and underestimate the benefits of having an appropriately constructed portfolio.

One final note: In the above analysis, I assume that you don’t have any investments which a) you’d like to sell, and which b) have unrealized capital losses. If you do have such investments, the solution sometimes becomes a no-brainer: Sell both, use the capital losses to offset the capital gains, and invest the cash as you choose.

August 24, 2009 2 comments