MONEY Ask the Expert

When It Comes to Muni Funds, Does Location Matter?

Investing illustration
Robert A. Di Ieso, Jr.

Q: I live in New York state and currently invest in a high-yield municipal bond fund. Should I switch to a tax-exempt New York muni fund? — Connie

A: There are lots of considerations when weighing the pros and cons of a high-yield bond fund that invests nationally versus a state-specific municipal bond fund.

The three big ones: “You want to think about taxes, volatility and credit quality,” says Stephen DeCesare, as certified financial planner and president of DeCesare Retirement Specialists in Marlton, NJ.

Let’s start with taxes, since that is the primary perk of investing in municipal bonds, which are issued by local and state government entities to cover general expenses or fund specific projects. Most, but not all, municipal bonds are exempt from federal income taxes, which is a selling point in and of itself.

If you’re in the 28% tax bracket, for example, a 3% yield on a tax-exempt muni is the equivalent of a 4.17% taxable bond. You can run your own numbers using this simple Vanguard calculator.

There are, of course, caveats, such as if you owe the alternative minimum tax. Also, gains on principal are subject to capital gains tax. Likewise, it generally doesn’t make sense to own tax-exempt municipal bonds in a tax-deferred retirement account.

That said, because you live in a state with high-income taxes – New York’s top rate is 8.8% — narrowing your focus to New York can further sweeten the tax side of the deal.

If you lived in a state with low income taxes, however, you might be better off in a national tax-exempt municipal bond fund. Managers of those funds typically have more leeway to find opportunities without necessarily ramping up risk.

It’s always important to weigh the breadth and health of your state’s muni market against any tax break. New York has a relatively robust municipal bond market, says DeCesare, which is another reason why a state-specific muni bond fund could make sense in your case.

Once you’ve looked at all the variables, the decision will ultimately hinge on your risk tolerance and income needs. Remember that high-yield municipal bond funds invest the majority of their assets in bonds that are rated below-investment grade or aren’t rated. These funds can put up higher total returns – even after taxes – but with that comes more credit risk and in turn more volatility.

MONEY Ask the Expert

When Investment Growth, Income, and Safety Are All Priorities

Investing illustration
Robert A. Di Ieso, Jr.

Q: I’m 64 and retired. My wife is 54 and still working, but I’m asking her to join me in retirement. We have about $1 million in savings, with about half in an IRA and the rest in CDs. How can try I try to preserve the principal, generate about $2,000 in monthly income until I collect Social Security at age 70, and somehow double my investment? — Rajen in Iowa

A: The first thing you need to ask yourself is what’s really more important: Growth, income, or safety? You say you want to preserve your principal – and your large cash position suggests that you are risk averse – but you also say you want to double your investment.

“Why do you need to double your investment?” asks Larry Rosenthal, a certified financial planner and president of Rosenthal Wealth Management Group in Manassas, VA. “Everybody likes the idea of doubling their investment, but there’s a high cost if it doesn’t work out.”

Given that you’re already retired, doubling your investment is a tall order. You probably don’t have that kind of time. At a 5% annual return, it would take you more than 14 years, and that’s without tapping your funds for income along the way. Nor can you afford to take on too much additional risk.

Either way, you do need to rethink how you have your assets allocated.

A 50% cash position is likely far too much, especially with interest rates as low as they are. “You’re effectively earning a negative return,” factoring in inflation, says Rosenthal.

And while cash is a great buffer for down markets, the value is lost in the extreme: The portion of your portfolio that is invested in longer-term assets such as stocks and bonds needs to do double duty to earn the same overall return.

If generating growth and income are both priorities, “look at shifting some of that cash into dividend paying stocks, a bond ladder, an annuity, or possibly a combination of the three,” says Rosenthal, who gives the critical caveat that the decision of how to invest some of this cash will depend on how your IRA money is invested.

Meanwhile, you should take a closer look at the pros and cons of claiming Social Security at full retirement age, which is 66 in your case, or waiting until you’re 70 years old.

The current conventional wisdom is to hold off taking Social Security as long as possible in order to maximize the monthly benefit. While that advice still holds true for many people, you need to look at the specifics of your situation – as well as that of your wife. The best way to know is to run the numbers, which you can do at Social Security Timing or AARP.

The tradeoff of waiting to claim your benefit, says Rosenthal, is spending down more of your savings for six years. You may in fact do better by keeping that money invested.

What’s more, “if you die, you can pass along your savings,” adds Rosenthal. But you don’t have that type of flexibility with Social Security benefits.

MONEY Ask the Expert

Even if Rates Rise, the Sky Won’t Fall

Investing illustration
Robert A. Di Ieso, Jr.

Q: With interest rates predicted to rise in 2015, what should I consider doing with my mutual fund bond holdings now? About 35% of my retirement portfolio is in bonds as part of a target date retirement fund. — Alan in Orland Park, Ill.

A: No doubt this is a common concern for many investors today. Economists have for years been saying that interest rates can only go higher from here, and yet interest rates are still near historic lows. The yield on the 10-year Treasury note has been hovering around just 2% — and that’s down from 3% at the start of last year.

Why the worry? Market interest rates and bond prices move in the opposite direction. So a rise in interest rates would likely translate to a drop in the value of older bonds held by your bond funds. Trouble is, exactly when rates will rise and to what degree is still anyone’s guess.

“We all know the elephant in the room is that rates will go up,” says Jason Jenkins, an investment advisor and CEO of portfolio monitoring software company AssetLock. “But I don’t think they will respond as violently as everyone thinks.”

Jenkins isn’t alone in that view that interest rates won’t shoot up over night. While it’s true that the end of the Federal Reserve’s stimulative bond-buying program reduces domestic demand for Treasuries — which lowers prices and in turn raises rates — foreign investors have been flocking to U.S. bonds of late amid worries of another global slowdown.

Regardless of what happens in the big picture, it’s important to view this in the context of what role bonds play in your overall portfolio.

If you’re in or near retirement, odds are that you’re looking to bonds for steady income. In that case, rising rates will ultimately be to your benefit. “Investors need to remember there are two sides to the coin,” says Jenkins. “If rates go up, prices go down but payments go up.” In 1999, for example, the Barclays U.S. Aggregate index fell 7%, but the yield was 6.7%. Investors, adds Jenkins, need to think not just about price and yield but total return.

Meanwhile, bonds bring something else to the table – diversification. Historically, when stocks are at their worst, bonds have still managed a positive return. In one study, Vanguard looked at periods of bottom-decile returns for U.S. stocks from 1988 through 2012. During those times, the median monthly return bonds — including Treasuries, U.S. corporate bonds and international corporate bonds — was still positive.

That said, Jenkins and bond strategists aren’t advocating investing in bonds indiscriminately. Because long-term bonds are most vulnerable to rising rates, he recommends sticking with short-term and intermediate-term bonds.

Now, your question of what to do with bond holdings raises a couple of other points: Should you be in a target date fund, and if so, are you in the right target date fund?

Target-date funds are a handy solution for investors who would otherwise make poor investment decisions, try to time the market, or not invest at all. In theory, you could choose such a fund pegged to the year you think you’ll retire and never worry about where to invest or when to rebalance. The managers of these funds will make those decisions for you.

Yet as many investors in these funds learned after the financial crisis, one-stop-shopping isn’t a perfect solution. Two funds with the same target date may take two very different approaches — one risky, one conservative. Moreover, your own propensity for risk is as much of a factor as the date you expect to retire.

If you’re concerned, at the very least do look under the hood (sounds like you have) and see what percent of your portfolio is in bonds and the maturity of those bonds. You can use some of the free tools at Morningstar.com to see how your fund did relative to similar portfolios in 2008 and get a closer look at where it’s invested today.

MONEY Ask the Expert

How to Turn Your Tax Loss Into a Gain

Investing illustration
Robert A. Di Ieso, Jr.

Q: I have a substantial amount of tax-loss carry forwards, but all of my net worth is now in tax-deferred accounts, such as my 401(k). I am 68 years old and don’t expect any large capital gains to offset these losses. Is there any way to recover these losses before I die?

A: The silver lining of investment losses is that you can use them to offset future capital gains—and you can carry them forward indefinitely. In other words, if you lose $10,000 on a stock in a taxable account, you can sell other stocks at a $10,000 gain and not owe taxes, even if those gains come years down the road. (Remember that to claim any loss you need to have actually sold the dud investment, and of course you’ll need to fill out the proper IRS paperwork to get that loss on record.)

Unfortunately, as you noted, these losses aren’t as useful if most of your savings is in tax-sheltered retirement vehicles, which aren’t subject to capital gains taxes. “Anything you take out of a 401(k) or other tax-deferred vehicle is taxed as ordinary income,” says Barbara Steinmetz, a certified financial planner and enrolled agent in San Mateo, Calif.

Uncle Sam does offer some consolation. Each year, you can use up to $3,000 of your losses to offset your ordinary income, says Steinmetz. But you need to first use your losses against any capital gains that year.

Moreover, upon death, your spouse effectively inherits those losses. A spouse can then use those losses to offset capital gains or, if there are no gains or excess losses, up to $3,000 a year against ordinary income. Once your spouse passes away, however, those losses are gone.

If you sell your home and make more than $250,000 on the sale ($500,000 if you’re married) you can apply your carry-forward losses toward any gains above those exclusion limits, says Steinmetz.

Likewise, you could open a taxable brokerage account knowing that you’ve banked some losses toward future appreciation and harvest your winners from there. But whatever you do, don’t let the proverbial tax tail wag the dog. Better to forgo the write off than make bad investment choices.

MONEY Ask the Expert

When Putting Most of Your Eggs in One Basket Can Make Sense

Investing illustration
Robert A. Di Ieso, Jr.

Q: A recent Money issue recommends consolidating accounts at a single brokerage. I’d like to do that, but we worry about having all of our eggs in one basket. What if the company’s systems are hacked, my password gets compromised, or the company gets managed like Enron or the big banks in 2008? – Shirley in North Carolina

A: These are valid concerns, no doubt, but you are still better off consolidating your accounts to the extent you can, says Michael Garry, a certified financial planner and chief compliance officer at Yardley Wealth Management in Newtown, Penn.

For starters, most brokerage firms offer protection should someone gain unauthorized access to your account. (If you share your password with your unscrupulous cousin or are otherwise negligent, it’s a different story.)

Check your firm’s brokerage account agreement to understand exactly who’s liable when and for what.

To make sure you’re covered in the event that your firm goes belly up, see if accounts are protected by the Securities Investor Protection Corporation (SIPC). This insurance, which is not unlike Federal Deposit Insurance Corporation protection offered at banks, covers up to $500,000 per account type at each firm. “Most big firms also have insurance on top of that,” notes Garry.

Those safeguards are important, but here’s the thing: The best way to protect your nest egg is to regularly check your account for suspicious activity and routinely change your passwords. “It’s a lot harder to be vigilant if you have six or seven different accounts,” says Garry.

More importantly, having too many accounts poses an even bigger risk than a security breach or bankruptcy – mismanaging your savings. “Remember that your asset allocation can account for 90% of your performance,” Garry adds. When your accounts are spread out, he says, it’s much harder to gauge how you’re invested, measure your performance and make necessary changes to your allocation.

Of course, if you are going to put most of your eggs in one basket, make sure it’s the right basket.

In addition to the right insurance and security measures, look for a firm that offers the right mix of investment products, tools and research. Fees should be a big part of your equation. Just keep in mind that the costs associated with long-term investing may be very different than those of, say, trading stock.

It may very well be that no single firm offers exactly everything you need. In that case, it may make sense to do business with more than one firm.

You may, for example, keep most of your assets with the brokerage that offers the best retirement-planning tools and broadest selection of no-transaction-fee mutual funds, but then designate a discount broker for buying and selling individual stocks. Under that scenario, a little distance doesn’t hurt.

MONEY Ask the Expert

How to Secure Your Finances When Reality Doesn’t Bite

Investing illustration
Robert A. Di Ieso, Jr.

Q: I am a 22-year-old college grad with a six-figure income and minimal student debt. I have no car and live with my parents. Is there something I should do now to lead a secure and fiscally responsible life? My father gave me the name of his planner but he was of little help — Timothy

A: Given your age, healthy salary, low expenses, and minimal debt, you’re financial situation is pretty straight forward. “There is a time and a place to work with a financial planner, and now may not be one of them,” says Maggie Kirchhoff, a certified financial planner with Wisdom Wealth Strategies in Denver.

If you still want some guidance, you may have better luck getting referrals from friends or colleagues. “A planner who’s a good fit for your parents may not be a good match for you,” she adds.

In the meantime, there are plenty of things you can be doing to improve your financial security. The biggest one: “Save systematically,” says Kirchhoff. If you start saving $5,500 a year, even with a conservative 5% annual return, you’ll have nearly $600,000 when you turn 60. “That assumes you never increase contributions,” she says.

It sounds like you’re in a position to save several times that amount now that your expenses are still low. Make use of your current economic sweet spot by taking full advantage of tax-friendly retirement vehicles, such as an employer-sponsored 401(k) plan. You can sock away up to $18,000 a year in such a plan, and any contributions are exempt from federal and state taxes. If your employer offers matching benefits, contribute at least enough to get the most you can from that benefit.

Your 401(k) plan likely offers an allocation tool to help you figure out the best mix of stocks and bonds for your time horizon and risk tolerance. Based on that recommendation, you’ll want to choose a handful of low-cost mutual funds or index funds that invest in companies of different sizes, in the United States and abroad. “You can make it as complicated or simple as you like,” says Kirchhoff.

If you want to keep things simple, look at whether your plan offers any target-date funds, which allocate assets based on the year you expect to retire (a bit of a guess at this point) and automatically make changes to that mix as that date nears. Caveat: Don’t overpay to put your retirement plan on autopilot; ideally the expense ratio should be less than 1%.

Now, just as important as investing for retirement is making sure you protect that nest egg from its biggest threat: you. Build an emergency fund so you won’t be tempted to dip into your long-term savings — and owe taxes and penalties — if you lose your job or face unexpected expenses.

“A general rule is three to six months of expenses, but since his expense are already so low, he should aim to eventually save three to six months of his take-home pay,” says Kirchhoff, who recommends keeping your rainy-day fund in a money market account that isn’t tied directly to your checking account.

With the extreme ends of your financial situation covered, you’ll then want to think about what you have planned for the next five or 10 years.

Is graduate school in your future? What about buying or renting a place of your own? Once you get up to speed on your retirement savings and emergency fund, you can turn your attention to saving up for any near-term goals.

You might also consider eventually opening a Roth IRA. You’ll make after-tax contributions, but the money will grow sans tax, and you won’t owe taxes when you withdraw for retirement down the road. (Note: You can save up to $5,500 a year in a Roth, but contributions phase out once your modified gross adjusted income reaches $116,000 to $131,000.)

A Roth may not only save you more in taxes down the road, it also offers a little more flexibility that most retirement accounts. For example, you can withdraw up to $10,000 for a first-time home purchase, without tax or penalty, if you’ve had the account at least five years. Likewise, you can withdraw contributions at any point, for any purpose.

What about the student debt? Depending on the interest rate and whether you qualify for a tax deduction (in your case probably not), you could hang onto it and focus on other financial priorities.

That said, if you can make large contributions to your 401(k) plan, build your emergency fund and pay off your student debt at a quicker pace, says Kirchhoff, so much the better.

Your browser, Internet Explorer 8 or below, is out of date. It has known security flaws and may not display all features of this and other websites.

Learn how to update your browser