MONEY exchange-traded funds

Why Index Funds Are Like Cheap TVs at Walmart

"Why are you window shopping?" Sale inside sign on store window
jaminwell—Getty Images

You can get a great deal on exchange-traded funds tracking large stock indexes. But watch out for the extra spending that can pile up.

Every industry has its loss leaders, and the investment world is no different. The theory is that you will go to the store for the $12 turkey and stick around to buy dressing, cranberries, juice, pies and two kinds of potatoes.

In the investment world, the role of the cheap turkey is played by broad stock index exchange traded funds. While investment firms say they make money on even low-fee funds, their profit margins on these products have been narrowing.

There’s been a bidding war among issuers of exchange traded funds that mimic large stock indexes like the Standard & Poor’s 500 or the Wilshire 5000 stock index. Companies including Blackrock, Vanguard, and Charles Schwab have been competing to offer investors the lowest cost shares possible on these products. Right now, Schwab — which will begin offering pre-mixed portfolios of ultra-low-cost ETFs early in 2015 — is winning.

Their theory? You’ll come in the door for the index ETF and stay for the more expensive funds, the alternative investments, the retirement advice.

“We believe we will keep that client for a long time,” said John Sturiale, senior vice president of product management for Charles Schwab Investment Management.

Investors, of course, are free to come in and buy the cheap TV and nothing more. Here are some points to consider if you want to squeeze the most out of low-cost exchange traded funds.

A few points don’t matter, but a lot of points do.

“Over the long term, cost is one of the biggest determinants of portfolio performance,” said Michael Rawson, a Morningstar analyst.

If you have a TD Ameritrade brokerage account, you can buy the Vanguard Total Stock Market Index Fund ETF for no cost beyond annual expenses of 0.05% of your assets in the fund. At Schwab, you can buy the Schwab U.S. Broad Market ETF for an annual expense of 0.04%. That 0.01 percentage point difference is negligible.

But compare that low-cost index fund with an actively managed fund carrying 1.3% in expenses. Invest $50,000 at the long-term stock market average return of 10% and you’ll end up with $859,477 after 30 years of having that 0.05% deducted annually. Pay 1.3% a year in expenses instead (not unusual for a high-profile actively managed mutual fund) and you’ll end up with $589,203. You’ll have given up $270,274 in fees, according to calculations performed at Buyupside.com.

Don’t pay for advice you don’t need.

The latest trend in investment advice is to charge clients roughly 1% of all of their assets to come up with a broad and diversified portfolio — with index funds at their core. Why not just buy your own core of index funds and exchange traded funds directly, and then get advice on the trickier parts of your portfolio? Or pay an adviser a onetime fee to develop a mostly index portfolio that you can buy on your own?

You won’t give up performance.

High-priced actively managed large stock funds as a group do not typically beat their indexes over time. Even those star managers who do outperform almost never do so year after year after year.

Build a broad portfolio.

Not every category of investment lends itself to low-cost indexing. You may do better with a seasoned stock picker if you’re taking aim at small-growth stocks, for example. But you can make the core of your plan a diversified and cheap portfolio of ETFs at any of the aforementioned companies, and save your fees for those extras that will really add value — the gravy, if you will.

MONEY retirement income

Retirement Withdrawal Strategies That Can Pay Off Big

To figure out the right pace for your retirement withdrawals—and to avoid ending up in higher tax brackets—start planning before you stop working.

Having your own tax-deferred retirement account is a bit like having one of those self-titrating morphine buttons that hospitals use: Press it whenever you need quick relief.

But once you’re retired and able to tap your 401(k) or individual retirement account (IRA), it’s not easy to titrate your own doses of cash. Withdraw too much, and you use up your nest egg too quickly; too little, and you might unnecessarily crimp your retirement lifestyle.

Overlaying the how-much-is-enough question are several finer points of tax planning. Because you can decide how much money to pull out of a 401(k) or individual retirement account, and because those withdrawals are added to your taxable income, there are strategies that can help or hurt your bottom line.

That’s especially true for early retirees trying to decide when to start Social Security, how to pay for health care and more. Here are some money-saving withdrawal tips.

CURB TAXABLE INCOME

If you are buying your own health insurance via the Obamacare exchanges, keep your taxable income low to qualify for big subsidies, advises Neil Krishnaswamy, financial planner with Exencial Wealth Advisors in Plano, Texas.

“It’s a pretty substantial savings on premiums,” said Krishnaswamy.

Here’s an example using national averages from the calculator on the Kaiser Family Foundation web page. Two 62-year-old spouses with annual taxable income of $62,000 would receive a subsidy of $8,677 a year, against a national average premium of $14,567. If they took another $1,000 out of their tax-deferred account and raised their taxable income to $63,000, they would be disqualified from receiving a subsidy.

Not every case may be that dramatic, but it’s worth checking the income limits and available subsidies in your own state.

DELAY BENEFITS

If you retired early, consider taking out extra money to live on and delaying Social Security benefits until you are older. Withdrawing money from retirement savings hurts. You not only lose the savings, you lose future earnings on those savings. And in most cases, you have to pay income taxes on withdrawals from those tax-deferred accounts.

But Social Security benefits go up roughly 8% a year for every year you don’t claim them. And even after you claim them, they rise with the cost of living and are guaranteed for life. When you draw down your own savings to protect a bigger Social Security payment, tell yourself you are buying the cheapest and best annuity you can get.

PLAN IN ADVANCE

Plan ahead for mandatory withdrawals. In the year you turn 70 1/2, you have to begin drawing down your tax-deferred IRAs and 401(k) accounts and paying income taxes on those withdrawals. Unless you expect to be in the lowest tax bracket at the time, it makes sense to start withdrawing at least enough every year before then to “use up” the lower tax brackets.

For single people in 2014, you’re in a 10% or 15% marginal tax bracket until you make more than $36,000 a year. For married people filing jointly, that 15% bracket goes up to $73,800. It’s a lot better to pull out that money in your 60s and use up other savings to live on, than it is to save it all until you are 70 and then withdraw large chunks at higher interest rates.

GET A GOOD ACCOUNTANT

You may want to use early years of retirement to take the tax hit required to move money from a traditional IRA into a Roth IRA that will free you of future taxes on that money and its earnings.

You may pull a lot of money out of your account in one year and spend it over two or three years, to keep yourself qualified for subsidies in most years.

You may titrate your withdrawals to keep your Medicare premiums (also income linked) as low as possible.

The best way to optimize it all? Get an adviser or accountant who is comfortable with a spreadsheet and can pull all of these different considerations together.

Related:

When do I have to take money out of my 401(k)?

How will my IRA withdrawals be taxed in retirement?

Are my Social Security payouts taxed?

MONEY mutual funds

Big Tax Bill Looms for Mutual Fund Investors

Even if you don't sell any mutual fund shares this year, you might owe big taxes on capital gains. Here's why — and here's how you can avoid the problem.

If you are the kind of steadfast investor who buys a mutual fund and holds it forever, prepare to pay for your loyalty next April, when you settle up your 2014 tax bill.

At the end of this year, many mutual funds are expected to distribute sizeable capital gains to shareholders who will have to pay taxes on them.

That is true of stock mutual funds that sold off last week after carrying forward big gains from 2013, and also may be true of the popular Pimco Total Return Fund, which was thrown a curve when star manager Bill Gross left Pacific Investment Management Co. in late September and the Pimco Total Return Fund was forced to sell appreciated bonds to pay off shareholders who left in his wake.

Here is why: Mutual funds must distribute realized gains to their shareholders every calendar year. Managers of both bond and stock funds have seen sizeable gains for several years running, but have not had to sell shares and realize those gains. This year, there have been some big selloffs that may have forced the managers to sell winning securities and realize those gains for tax purposes.

For individual investors, those gains might hurt more than they would have over the last few years, because a lot of investors have been offsetting their taxable gains for years with losses they carried over from the 2008-2009 rout. Now, with most of their losses used up, they will have full exposure to the gains. Long-term gains are typically taxed at 15%; those in the top tax bracket face a capital gains tax rate of 20%.

The Pimco Total Return Fund, for example, saw $48.4 billion in outflows through September, according to data from Morningstar and Pimco, and some analysts believe that could result in unusually high taxable gains.

“If Pimco sold bonds to meet redemptions at a gain, the remaining shareholders could suffer an inordinately large tax consequence,” said Tom Roseen, an analyst with Lipper, a Thomson Reuters company.

Through September, research firm Morningstar was estimating that Pimco Total Return Fund would pay out 2% of its net asset value in taxable gains, a high figure but one not out of the fund’s long-term historical range.

That means a person with $50,000 in that fund would see a $1,000 taxable gain, and — at the most common 15% capital gains tax rate — owe $150 in federal taxes on it.

Last year, the Total Return fund distributed 0.66% net asset value in gains. The year before, it distributed 2.31%, Roseen said.

Stock fund investors could be harder-hit, said Morningstar analyst Russel Kinnel. He estimates that U.S. domestic stock funds might be sitting on gains of around 20% and could end up paying 16% or 17% of their value to shareholders as gains. (When that happens, fund shareholders do not actually cash in the gain; they end up with more shares at lower prices.)

Note that none of this affects investors who hold mutual funds through tax-favored retirement accounts. They do not have to pay annual taxes on fund earnings.

For everyone else, there are very few ways to minimize the impact of those taxable gains. Here are some strategies that might help.

  • If you bought recently, you might consider selling quickly. If you have not seen much of a gain in a fund you bought, or if you have actually sustained a loss, you can sell shares and either use your capital loss to offset other gains, or at least get out before the gain is distributed. That strategy will not work if you have been in the fund long enough to rack up your own gains – then you will just have to pay taxes on them when you sell.
  • Think before you buy. The people who will get hardest-hit by these year-end mutual fund taxes are people who have not owned the funds for long. They buy in just before the distribution, miss out on the actual gains, but get hit with the taxable distribution anyway. Do not buy any funds this year until you have checked with the fund company to find out when it is distributing 2014 gains. If you think it is a fund that is sitting on big gains, wait until that date passes before making your purchase.
  • Take losses. If you own any stocks or funds that have lost money since you have held them, sell and reap the loss. It can offset those fund gains.
  • Relax. At 15% for most people (20% for top tax bracketeers), the capital gains tax is still much lower than regular income taxes. And there are worse things than having to pay taxes because you made money.

 

MONEY Taxes

5 Things to Do Now To Cut Your Tax Bill Next April

If you want to owe less for 2014, start your year-end tax planning today.

When everyone else starts loading their backpacks and shopping the back-to-school sales, I know it is time for me to dive back into TurboTax.

That’s because fall is the perfect time to plan my approach to the tax forms I won’t file until next April. By using the next four months strategically, I may be able to reduce the amount I have to pay then.

This is a particularly easy year to do tax planning, because the rules haven’t changed much from 2013. If you do your own taxes on a program like Intuit’s TurboTax or TaxAct, you can use last year’s version to create a new return using this year’s numbers, and play some what-if games to see how different actions will affect your tax bill.

If you use a tax professional, it’s a good time to ask for a fall review and some advice.

Here are some of the actions to take now and through the end of the year to minimize your 2014 taxes.

1. Feed the tax-advantaged plans. Start by making sure you’re putting the maximum amount possible into your own health savings account, if you have one associated with a high-deductible health plan. That conveys maximum tax advantage for the long term. Also boost the amount you are contributing to your 401(k) plan and your own individual retirement account if you’re not already contributing the maximum.

2. Plan your year-end charitable giving. You probably have decent gains in some stocks or mutual funds. If you give your favorite charity shares of an investment, you can save taxes and help the charity. Instead of selling the shares, paying capital gains taxes on your profits and giving the remainder to your charity, you can transfer the shares, get a charitable deduction for their full value and let the charity—which is not required to pay income taxes—sell the shares. Start early in the year to identify the right shares and the right charity.

3. Take losses, and some gains. If you have any investment losses, you can sell the shares now and lock in the losses. They can help you offset any taxable gains as well as some ordinary income. You can re-buy the same security after 31 days, or buy something different immediately. In some cases, you may want to lock in gains, too. You might sell winners now if you want to make changes to your holdings and have the losses to offset them.

4. Be strategic about the alternative minimum tax. Did you pay it last year? Do you have a lot of children, medical expenses and mortgage interest payments? If so, you may end up subject to the alternative minimum tax, which taxes more of your income (by disallowing some deductions) at a lower tax rate. Robert Weiss, global head of J.P. Morgan Private Bank’s Advice Lab—a personal finance strategy group—says there are planning opportunities here. If you expect to be in the alternative minimum tax group, you can pull some income into this year—by exercising stock options or taking a bonus before the year ends—and have it taxed at the lower AMT rate. It’s good to get professional advice on this tactic, though. If you pull in too much money you could get kicked out of the AMT and the strategy would backfire.

5. Look at the list of deductible items and plan your approach. Many items, such as union dues, work uniforms, investment management fees and more are deductible once they surpass 2% of your adjusted gross income. Tax advisers often suggest taxpayers “bunch” those deductions into every other year to capture more of them. Check out the Internal Revenue Service’s Publication 529 to view the list, and try to determine if you want to amass your deductions this year or next. Then shop accordingly.

Do you have a personal finance question for our experts? Write to AskTheExpert@moneymail.com.

MONEY financial advice

Where to Go for the Best Financial Advice

Wall of paint chips
Carolyn Hebbard—Getty Images/Flickr Open

Seeking help with investments or retirement planning? Here's how to sort through the overwhelming number of options you face.

The financial advice business is changing dramatically in every aspect, from how advisers spend their time, to what they charge, to how they label and promote themselves.

The result? Further confusion for consumers who probably sought help to find clarity in the first place.

“Brokers” who used to pick stocks and sell mutual funds at firms like Morgan Stanley and Bank of America Merrill Lynch are now more likely now to call themselves “financial advisers” and manage portfolios for fees instead of (or in addition to) commissions.

Independents who used to offer comprehensive advice are now more likely to focus on investment management and call themselves “wealth managers.”

Charles Schwab, the online brokerage that made its name catering to do-it-yourself investors, now is pushing its own stable of are “financial consultants” and preaching the value of face-to-face (or at least Skype-to-Skype) connections.

New to the scene are “robo-advisers” — algorithmically driven online money management firms that will automate your investment decisions.

Further complicating consumer choice is the fact that most firms have a variety of ways in which they offer financial advice to clients.

At Vanguard, for example, a firm which promotes simplicity in investing, there are nine different advice platforms. They vary, based on whether a client is investing through a retirement account or directly, how much advice a client needs or wants, and how much money the client has to invest.

How can someone seeking financial advice navigate their way through this complex field and make sure they get the right advice? Here are a few things you should know now:

Needs Assessment

Assess your own needs. The first step is to figure out what you want a financial professional to do for you. Do you want comprehensive investment management? A whole-life plan that includes everything from how to pay for college to tax reduction to retirement planning? Just a reality check on your retirement readiness?

Pay for What You Eat

Once you know what you want, it’s easier to find the right adviser. For a spot check or limited amount of planning, consider hiring a by-the-hour adviser — you can find one through the Garrett Planning Network (www.garrettplanningnetwork.com).

Want a comprehensive soup-to-nuts life financial plan? Look for a fee-only certified financial planner through the CFP Board of Standards (www.cfp.net) or the National Association of Personal Financial Advisors (www.napfa.org).

Learn the Lingo

“Fee only” means that the adviser is not paid to sell products and, if that person is a certified financial planner, it also means she doesn’t even own a small share in a financial company that does sell products.

“Fee-based” is a meaningless term of art, typically used by advisers who charge fees and reap commissions.

Watch Your Wallet

There’s a huge discrepancy in the amount of fees advisers charge.

At Vanguard, investors willing to stick with Vanguard funds can get basic fund choice advice for free and a comprehensive financial plan for 0.3% of the assets they invest with Vanguard.

Traditional brokerage firms will offer broader portfolios and go fee-only but at costs that can top 2% a year.

In the middle are most independent financial advisers, who tend to charge fees near 1% of assets, more for small accounts and less for bigger ones.

An extra percent or two, pulled from an account every year, can cost a long-term investor hundreds of thousands of dollars at the end of the day, so fees do matter.

Consider Generic Advice

A lot of lip service is given to selling the idea that everyone needs personalized and customized financial advice.

That’s true for people who have ultra-high net worth, with businesses, estates, tax issues and the like to manage. It’s also true of people who have very special situations, such as handicapped children who will need lifelong care.

But it may not be true of the average Joe and Jane, who simply need tips on how to invest their 401(k) or IRA fund.

Companies like T. Rowe Price, Vanguard and Fidelity will give you basic fund guidance for free, or close to it.

Remember the Robots

Companies like Wealthfront, Betterment and Hedgeable will invest your money for you in diversified portfolios regularly rebalanced and managed, if you need that, to minimize taxes.

They will charge pennies on the dollar of what a face-to-face individualized money manager will charge, and in some cases offer that for free.

They offer a reasonable solution for investors who know how much they have to invest, don’t need hand-holding, and are comfortable turning their finances over to an algorithm and sticking with passive index-linnked investing.

Here’s encouragement: Over long swaths of time, those passively-managed portfolios tend to beat the active investment managers.

MONEY women and investing

Why Wall Street Is Wooing Women and Their Future Wealth

Businesswomen in a black car
Riccardo Savi—Getty Images

Women will receive 70% of inherited wealth over the next two generations, and Wall Street wants their business. Here's what you—and the advisers wooing you—need to know.

Is there a target on the back of my dress? Because it feels like there is a target on the back of my dress.

It was painted there by the financial services industry, which has grown hyper-aware of the fact that women have a lot of money and are about to have a lot more.

According to a 2009 study from the Boston College’s Center on Wealth and Philanthropy, women will inherit 70% of the money that gets passed down over the next two generations, and that excludes the increasing amounts they earn on their own. Women already own more than half of the investable assets in the United States.

Companies like Bank of America’s Merrill Lynch, Prudential Financial, and TD Ameritrade are studying the investing behavior of women, in the hopes of winning more of our dollars.

They know that when a husband dies, his widow often switches money managers.

Indeed, the Certified Financial Planning Board of Standards is trying to lure more women to the business of financial advice.

Sallie Krawcheck, who ran Merrill at Bank of America, recently bought a women’s network and started a mutual fund that seeks to invest in companies led or heavily influenced by women.

Last week, Barclay’s Bank moved in the same direction, creating a Women in Leadership index and related investments.

It’s great to be wooed, but it’s also scary to be the focus of a great marketing effort. It could all end badly if the industry simply pink-washes inferior financial products.

Here are a few bits of advice for women and Wall Street, as they circle each other warily:

Questions

There will be questions. Women are infamous in some financial advisory circles because we ask so many more questions than men. That is good. Do not invest in something you don’t understand. Advisers who want us to invest in complex products and services need to be willing to explain them clearly and simply.

Female Advisers Not Necessary

We don’t need our advisers to be women. It’s not like going to a gynecologist. A male financial adviser is fine with me, as long as he’s competent, straightforward and good with my money.

We also don’t need pink folders for our statements or ladies’ investment products. We like green, and want the products and services that will secure our money and make it grow.

Funds that invest in women-led companies may do well in the future; there’s some research that diverse boards govern winning companies. But women and men should be cautioned not to be over-dependent on niche funds and not to overpay for them.

Keep Costs Low

Women control most household income and tend to be price and budget conscious. So don’t try to win us with high-priced mutual funds when there are less expensive ones that do the job.

Don’t charge us a lot to recommend a generic plain-vanilla index fund portfolio we could find on our own.

Women, Worry Less

Survey after survey reveal that women are more afraid of managing money than men (which is not the same thing as being worse at it) and they are more afraid of market risks than are men.

Women keep a lower proportion of their money in stocks than men do, even though women live longer and the stock market has long proven itself to be the best place for long-term investors to keep money.

Advisers, Worry More

A good adviser won’t prey on those fears; she or he will help female clients overcome their worries and invest in low-cost products that balance risks and rewards.

And if they don’t? There’s another new company out there that is explicitly targeting women investors. It’s called FireMyAdvisor.com.

MONEY 401(k)s

The New 401(k) Income Option That Kicks In When You’re Old

The U.S. Treasury allows savers to buy deferred annuities in their retirement plans. But no need to rush in now.

The U.S. Treasury Department has just given a tax break and its blessings to retirement savers who want to buy long-term deferred annuities in their 401(k) and individual retirement accounts.

The new rule focuses on a particular kind of annuity. These so-called deferred “longevity” plans kick in with guaranteed income when the buyer turns, say, 80 or 85 years old. For example, a 60-year-old man who spent $50,000 on a longevity annuity from New York Life could lock in $17,614 in annual benefits when he turned 80, the company said.

Like most insurance policies and traditional pension plans, these “longevity” plans take advantage of the pooling of many lives. Not everyone will live beyond 80 or 85, so those who do so can collect more income than they would have been able to produce on their own.

That takes the worry of outliving your money off the table. It also lets you take bigger retirement withdrawals in the years between 60 and 80. A saver who put 10% of her nest egg into one of these policies could withdraw as much as 6% of her retirement account in the first year instead of the safer and more traditional amount of 4 percent, estimates Christopher Van Slyke, an Austin, Texas, financial adviser.

A fee-only planner who tends to view many insurance products with some skepticism, Van Slyke likes these longevity plans for those reasons and because they convey a tax break, too: IRA and 401(k) money spent on these policies—up to 25% of the account’s value or $125,000, whichever is less—is exempt from the required minimum distribution rules that force savers over 70 1/2 to make withdrawals that count as taxable income.

The insurance industry loves this new rule, too, so consumers can be excused for taking some time to consider all the costs and angles. Treasury official J. Mark Iwry announced the new rule—declared effective immediately— at an annuities industry conference on Tuesday, and it was a crowd pleaser.

Related: Where are you on the Road to Wealth?

For retirement savers, the math just got harder. Should you buy such a plan? If so, when and how? What should you look for? Here are some considerations.

* You don’t have to rush. The younger you are, the cheaper these annuities are. A 40-year-old male putting down that same $50,000 with New York Life would get $31,414 in monthly benefits—almost twice the payout of the 60-year-old. But there’s a downside to that: Most do not have built-in inflation protection, points out David Hultstrom, a Woodstock, Georgia, financial adviser. So if you’re buying a $1,200-a-month benefit now but not collecting it for 20 years, you’ll be disappointed with its buying power. At a moderate 3% annual inflation rate, in 20 years that $1,200 would cover what $664 buys now.

* There are other reasons to wait. These policies are relatively new, and the Treasury’s rule “will open the floodgates,” Van Slyke says. Expect heightened competition to improve the policies. Furthermore, annuity payouts are always calculated on the basis of current interest rates, which remain near historic lows. A policy bought in a few years, in a (presumably) higher interest-rate environment probably would provide higher levels of income.

* Age 70 might be a good time to jump for those with lots of assets. Those required taxable distributions start the year you turn 70 1/2, so if you’re worried about the tax hit of taking big mandatory distributions, you could pull some money out of the taxable equation by buying one of these policies with it. Your benefits would be taxable as income in the year you receive them.

* Social Security is the best annuity. Before you spend money to buy an annuity, use money you have to defer starting your Social Security benefits as long as possible. Your monthly benefit check will go up by roughly 8% a year for every year after 62 that you defer starting your benefits. Social Security benefits are inflation protected, unlike these annuities.

* Think of your heirs. Money spent to buy an annuity is gone, baby, gone, so you can’t leave it to your kids. Some of these annuities will offer “return of premium” provisions. That means that if you die before you’ve received your purchase price back in monthly checks, your heirs can get the rest back. But that will probably cost you something in the first place. New York Life, for example, shaves almost $4,000 a year of annual payout for the 60-year-old who wants to add that protection to his policy. The heirs would get only cash that has been falling in value for all the years you’ve held the policy, not any income on that cash.

* This won’t solve your long-term care problems. The more money you have tied up in an annuity when you need round-the-clock nursing care, the less you have available to pay for that care. So if you want to use a longevity annuity to give yourself some income in those later years, you should also assure you have the big bad expenses covered. That means setting aside enough other money to pay the $7,000 to $10,000 a month it can cost for full-time nursing care, or buying a long-term care insurance policy you have faith in and can afford.

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