Retirement Financials In One Chapter

Critical Stuff: Your biggest risk to retirement may be an advisor working in their own interest.

In This Chapter: Paying for lousy advice. Why retirees are lousy tippers.  Betting on death. Why taxes really suck when you’re unemployed. Borrowing from Gino the Shark.

Hate reading financial crap? This chapter is the shortest version of everything important about the financial aspects of retirement that I could think of. I could have edited out the explanations of the thumb rules. but I hate rules without explanations, so I left some in.

I can actually shorten this chapter and the basic subject of retirement financials into one set of bullet points

  • If you have a financial advisor of any sort, look very hard at what he is costing you in direct fees as well as indirect costs like commissions, back-channel payments, and conflicts of interest. If you have a broker or any other advisor other than a CFP who is willing to sign a fiduciary statement, can them. If you need financial advice use someone who charges an hourly or fixed fee. No long term charges, and absolutely not a percentage of funds under management. A CPA may be more useful than a financial planner.
  • Invest ONLY in index funds, for stocks, bonds, and alternative investments. Don’t buy individual stocks, actively managed mutual funds, alternative investments, or any risky investment.
  • Keep sufficient liquid, low-risk funds to last you two years.
  • Allocate your investment assets to suit your age and your appetite for risk.
  • You can’t owe anything. No loans, no mortgages, no credit card balances. It makes no sense to have loans at rates that exceed the return on your investments. The only exception could be a locked-in mortgage at a low rate.
  • Get healthy–exercise, control your weight, stop smoking (Really? Still?). Medical expenses can devastate your retirement funds.
  • Delay taking your social security payments as long as possible.
  • Your total draw on your savings can’t be more than 3% per year. This includes the expenses of investment but not taxes. If your financial advisor is charging you 1.5% to manage your money and they invest it in mutual funds that have an average expense ratio of 1.5%, then there’s no money for you.
  • Be smart about how you handle 401(k) and IRA choices.
  • Funds should be held by an independent custodian. If you use a financial manager, never write checks directly to them.
  • Your fund family must be reputable and low cost. I like Vanguard, but any company with a similar size and operating principles may suit.


That’s it. But that’s a lot.

The critical things you need to do are:

  • Create a portfolio of investments that will provide enough income to satisfy your needs, keep up with inflation, and recover from market changes over what could be a very long retirement.
  • Allocate your assets to manage risk and minimize taxes. Continue to manage that allocation for rebalancing or strategy changes.
  • Distribute the money you need to live from your investments and other fund sources in the most advantageous ways

To accomplish this you need to know:

  • How asset allocation works
  • How to deal with inflation eating away at your nest egg
  • How annuities work and which ones to consider
  • How IRAs work and how to minimize the tax consequences of distributions
  • How social security works and the tax consequences of other income on social security taxes
  • How the investment markets work.

Getting Help–Or Not

I assume that seems pretty daunting. If it doesn’t, you aren’t paying attention. You might think it would be ever so much easier to just pay someone to do this for you, but the professional advice business is a minefield. Yes, you can find a Certified Financial Planner who has to be knowledgeable about taxation and investment. But like every profession, there are good CFPs and there are terrible ones. Many CFPs suggest that they can provide investment gains for you that outperform the market. That is so unlikely that you would be well served to assume the advisor is lying, stupid, or crazy. They may have managed to do that for someone else at some random moment in time, but they simply cannot promise to do it for you.  It’s impossible.

There are hordes of “retirement advisors” with various titles and letters after their names. If the letters aren’t Phd or Mba then you can safely assume they are a meaningless sales tactic intended to bullshit you. There is a lot of money to be made by screwing a lot of people out of some of the money they saved for retirement–total USA retirement assets are $21 trillion. Even if you only have a few hundred thousand saved, there are lots of people who would love to take some of that from you. Be wary. Be SUPER wary. Seminars, lunches, meetings in beautiful mahogany conference rooms, radio or TV “guest” appearances–those are ALL being paid for by their current clients. Don’t become one of the guppies supporting the growing business of a charlatan in a three-piece suit.

I’m going to suggest some simple investment strategies that don’t require much in the way of handholding. I still use a financial advisor, but my advisor is a low-cost, fee-only specialist. I’ll cover all that later, but first, let’s look at the typical kinds of wealth and financial planners and how they can cause more harm than good.

If you are preparing to hire an advisor, take your time, don’t decide that Mr. Smiley is your guy while you’re sitting in his office. Investigate. Interview. Verify. Don’t decide based on your gut feeling of someone being a nice, honest guy. I’ve done that myself–it didn’t work out well for me. Scam artists are great at appearing to be honest.  A major part of deciding that an advisor is a good fit for you is looking at how they are compensated. There are always conflicts of interest in how your advisor is compensated. Some conflicts are huge, some small. Here are some examples:

  • The most common way to pay an advisor is by some percentage of assets under management.  The conflict is that they always want as much of your assets under their management as possible. They don’t want you working with someone else, don’t want you to buy fixed annuities, pay off your mortgage, and don’t want you to invest in a business or buy real estate–even if any of those alternatives would be good for your circumstances. They’re cool about it, they won’t come out and say “bad idea, that means less for me”, but having an advisor whose incentives work against your interests is a big problem that only gets worse with time.
  • Advisors are also commonly “fee-based”, waffle words for “you pay and I get a commission as well”. You won’t wind up with index-based investments, you’ll have a nice set of very expensive mutual funds and alternative investments to maximize their commissions. Your advisor will also be incented to trade frequently, collecting commissions and causing tax problems. They might be willing to sell you a wildly inappropriate and expensive variable annuity, but only if they get a huge commission for it.
  • Fee-only advisors are relatively rare, but there are some very good ones, and there are probably some useless ones. First, you need to find which is which. One measure is the number of clients and the assets under management. Fee-only advisors need a lot more clients to make a living. A fee-based advisor with 20 clients and $40 million under management might be grossing $600,000 per year (yes, that means you are paying somewhere in the neighborhood of $30,000 to manage a million bucks for you, and you probably think you’re paying them much less). A fee-only advisor with 20 clients might be grossing something more like $100,000.  Successful fee-only advisers necessarily have a lot more clients and often manage a lot more money.  If you find a good one their only conflict of interest is that they want you to keep paying them every year. That’s OK if you don’t want to learn enough to manage the investments and planning yourself. If you need pro help, then this is almost certainly the best way to go. But it won’t necessarily be a learning experience. They didn’t sign up to teach you how to manage your money, so you can’t expect that. Your advisor has a reason to keep everything appearing complex and difficult. That’s pretty easy since it actually is.

Don’t misunderstand this warning–I’m not condemning financial advisors, even the one’s whose practices I consider sleazy. They are in business to make money, and it’s incumbent on the buyer of services to ensure those services meet their needs. Unfortunately, the financial industry in general trades on the simple fact that most people don’t pay much attention to their finances–and don’t want to start doing so. Most people pay little attention to what their advisor is doing with hard-earned savings, even if the conflicts of interest are obvious and the advisor fully discloses their inflated fees, commissions, and back-channel payments. Most people don’t read the contracts they sign, and if they read them, they don’t necessarily understand or act on the information received. Don’t be one of those people.

But the deck really is stacked against you in these encounters. There has been talk about reforming the financial industry and requiring greater fiduciary responsibility (meaning a legal duty to act solely in your interests). So far the effort has produced more noise than results. If you had any notion that congress is not bought and paid for, read the sleazy bill sponsored by Rep. Ann Wagner of Missouri that aimed at stopping the Department of Labor from moving forward on its rule to amend the definition of “fiduciary” for retirement advice. Wagner’s bill, in blatant new-speak titled the Retail Investor Protection Act, passed in the house, but apparently died in committee in the senate after President Obama threatened veto.  the Department of Labor wrote a new rule defining and regulating fiduciary responsibility, but it does not take effect until mid-2017. I listened to Ann Wagner’s speech about the bill. She just about made me puke. But even if the Department of Labor ruling stands under the new administration (unlikely), there’s no guarantee that the advice you are given will be effective, worthwhile, or honest.

In theory, registered financial advisers have a fiduciary responsibility, but Bernie Madoff was a financial adviser and that didn’t stop his Ponzi schemes. It’s up to you to make sure any financial adviser you hire manages your account in your best interest. To do that you need to know how they are compensated–what all compensations sources are. Get that in writing, and confirm it as best you can. Request a Form ADV from any adviser you are considering. It discloses conflicts and complaints. You should also request client references. Call the references and talk to them, but don’t make those conversations the core of a positive decision–it’s more of a disqualifier. Dig a little, ask if they feel they understand what the adviser is doing for them. Ask if they feel their investments have been growing properly compared to the general market, if they consider their investment to be safe, and if they think the adviser charges too much. You aren’t likely to hear outright criticism, but tune your ear for hints.

If you do decide to use a financial advisor, require them to give you a list of the investment vehicles they plan to use before they commit your money. Take a look at the expense ratios of any mutual funds they intend to invest in, google any of the investment services firms they plan to use and the “platform” they propose. Look at what people are saying about the firms and their practices. If you see a mutual fund with an investment ratio over 1 percent, ask for the justification for choosing that fund.

For example, one of my advisors put a substantial amount of our savings into Matson Money.  Google “Matson Money complaints” and you can see why I was so pissed off once I understood why. He also decided to switch platforms to a company called LPL. Again, google “LPL complaints”. Both organizations serve to benefit advisors, not their clients. Beyond managing investments and handling the nuts and bolts of financial transactions, these companies are popular with fee-based advisors because they increase the commissions they receive. Their marketing is aimed at assuring the advisors that they can make more money while doing less work by using their services. Who pays for that? You do. You are the only source of income in these transactions.

With, or without an adviser it’s time to start formulating a plan. Understand that your plan may need to change. Everything regarding the money you plan to use to live on can change–tax laws, inflation, global economic shifts, market crashes, bond interest changes. Everything and anything. The aim of your plan is not just to have a recipe, it’s to understand the fundamentals of managing your money, and to have the confidence you need to make good decisions. When you panic, you sell low and buy high. Let’s not do that.

You also need a solid tax strategy that keeps you from wasting money on taxes you wouldn’t have paid if you had done the right steps in the dance. That’s beyond the scope of this chapter. We’ll cover the basics later, but anyone looking to me for tax advice is delusional. Invest in either professional advice or some good books on tax planning.

How much money?

If you’re going to have a plan that works, you need to know how much you need.

Expenses: List your current expenses–you need to go back at least one year to get a good idea of what that is. Come on, do the work! Don’t just guess. Then take that list and adjust for retirement. You won’t be commuting anymore, you won’t be paying a mortgage payment (hopefully), you might move to a less expensive location, your insurance picture might change, and you won’t be saving for retirement. If you plan to travel, you need to estimate that. If you are close to retirement, your list needs to be pretty good. If you have a long way to go then revisit the list every few years and tweak it. You need an updated picture to guide your efforts. Don’t forget that you’ll still be paying taxes–even on your social security, and long-term capital gains on any investments you sell.

Income: Add up all the sources of income you expect to receive once you retire. Pension, social security, etc..  The difference between your income and your expenses is what you need to make up from your savings.

Save all this in your notebook. we’ll be using it later for budgeting. You know, that notebook you got that has the tabs in it?

If the amount you need to draw from your savings is more than 4 percent (including all the fees you pay to advisers, brokers, etc.) then you’re in trouble and you need to fix your plan. Four percent is a thumb rule, but it’s an important one. The number comes from solid research, but there’s a rational explanation behind the raw number. Over the last 80 years the general stock market averaged a 7 percent return. The raw historic numbers are higher, but they include full reinvestment of dividends and changes in price to earning ratios. You might think 7 percent would make a good number, but if you spend at that rate you will almost certainly run out of money well short of 20 years. The prime culprit is market volatility. When the market is low you’ll be selling more shares to make up your 7 percent.  You won’t be buying shares when the market is high, but still you’ll be on the most destructive side of a sell low, buy high portfolio ratchet. If that volatility happens in the early years of your retirement your portfolio will suffer even more from an effect called Sequence Of Returns risk. Volatility is generally not damaging to portfolios when you are accumulating them if you take advantage of dollar cost averaging (there will be more about that later or you can Google Dollar Cost Averaging) but when you’re selling your portfolio over many years, that same cost averaging effect works against you to deplete your savings faster. Historically the net effect of volatility and the Sequence Of Returns risk is about 3%. Subtract 3 percent from 7 percent and Presto–4 percent.

I really recommend three percent as a more useful thumb rule, but a lot of people have trouble making it to four. If you have the option, cut your costs early so your portfolio has a better chance of recovery. Otherwise, Sequence of Returns risk means the gain you should see over time will be against a much smaller base. There are numerous sources on the web that graphically show this set of issues. Google “market volatility in retirement” and “sequence of returns risk” to see examples and graphs.

So here’s the math so far. George is 65, and after calculating his current and estimated future expenses he expects he’ll need $45,000 per year to retire. His social security and a pension (who gets a pension these days? People in government jobs, that’s who) give him $25K, so he needs $20K from his savings. If he’s going to spend 4% per year he just multiplies that $20K times 25 (the inverse of 4 percent) to get $500K in savings.

Unfortunately, George only has $400K saved. and he plans on retiring soon. He has only a few potential solutions:

1. Retire later. He can not only continue to save, but he’ll shorten the number of years he needs to plan for. And the longer he defers claiming social security, the bigger the annual payment is. In fact, Social Security payout grows about 8% per year after 65, which is probably more than any of George’s investments deliver, including annuities.

2. Cut expenses now and save more. That’s going to have limited effect for George since time is short, but it might be practical for you.

3. Reduce your planned expenses in retirement. That’s always an option though it might be unpalatable.

4. Work part time in retirement

5. Put part of your portfolio into an annuity.

George might thrash around and try some whacky ideas to make his portfolio grow. He might fall prey to one of the many sleazebags that take advantage of George’s panic to screw him out of some money and make his problem even worse. But George and you need to understand something very simple–there is no free lunch, no easy path to suddenly increase his holdings. Most of the extreme measures you take to try to fix a problem like this simply make it much worse. Don’t panic, be smart, be prudent, and understand that the only person that can solve this kind of problem is you. The five approaches above are really all that’s available to you–but it’s enough.

Other than number five, I think most of those options are self-explanatory, though some people are surprisingly resistant to reducing expenses. People living in an expensive house in an expensive location might hate the thought of moving into something affordable. But if you run out of money you won’t be able to keep that McMansion anyway. Better to get out in front of the situation. Simplifying your life also frees time and effort. Eliminating maintenance and taxes while being able to put some more money into your retirement savings helps you in multiple ways.

Saving and Investing for Retirement

Just to be clear, we are talking here and throughout this book about retirement savings. The money you need or may need in a year, two years, or even five years, does NOT belong in retirement savings and it absolutely does not belong in mutual funds or the stock market in general. What is the point of putting short-term money in a place where it might be substantially less than what you invested, right when you need it most. If you can’t wait out a downturn and continue building your portfolio with dollar cost averaging, then your money shouldn’t be in stocks. In the short term the stock market looks like a roller coaster, in the long term, it looks like a long, gentle slope.  This is also the reason that as you approach retirement age your asset allocation for your savings should move steadily towards bonds–because it takes time for the dips and bumps to smooth out, and if you need your retirement money today, you can’t afford to pull your investments out in the dips.

So stash your short-term money in highly liquid, boring, insured, savings accounts, Money Market funds, CDs, bond funds, and don’t get fancy. You aren’t going to outsmart the market.

And now you also know why financial advisers–at least all the good ones–say you need two years of liquidity. Without that liquidity, you can’t wait out the dips. But now let’s leave the short term behind and get into your retirement savings.

Workplace 401K

Hopefully your employer offers a  401(k), 403(b), or 457 plan. If your company offers matching funds–full or partial–max it out. I don’t care it that means you eat oatmeal and beans, it’s free money that you contribute pre-tax and that grows without tax. Your contributions to the 401(k) lowers your taxable income, so if money gets tight, talk to your HR people about decreasing the withholding on your paycheck.  Most years 85 percent of Americans get a tax refund–which means they loaned Uncle Sugar money interest-free. Your Uncle won’t do that for you, so don’t do it for him.

The only problem with 401(k) plans is that some of them have lousy investment choices with load funds or high management fees. It’s a structural problem that seems inherent with the way 401(k) plans have been implemented. I’m not sure what the government had in mind with the original legislation, but the benefits of 401(K) plans accrue to workers last and least. The big beneficiaries of 401(k) plans have been employers–because they no longer have to offer potentially ruinous retirement plans to attract employees. The second set of beneficiaries are insurance companies and the securities industry–they got a huge windfall in management fees and expensive investment vehicles. And then finally there’s you.

At the bottom of the 2008 market crash, 401(k)’s suffered paper losses of $2 trillion. That’s a pretty tough punch, but unless you did something dramatic like yanking out what was left of your money (and paying stiff penalties) a lot of that downturn has reversed. But you’re still probably losing money even with the market rebounding because most funds are burdened with high fees, high plan costs, and ridiculous asset allocation.

In theory, investors in 401(k)s are supposed to make good choices about how their money is invested. Most don’t. If you are a long way from retirement–ten years or more–the simplest choice is to put all your 401(k) contributions into index funds. Most plans have indexes as an option. The result of that choice is that your fund management cost will probably decline by as much as 1 percent.  You’ll have to manage your own asset allocation, and rebalance once a year to maintain the allocation you choose, but that’s not difficult.

Your other general choices are specific mutual funds and Target Date Funds. Target date sounds like a great idea–they change your investment strategy and asset allocations over time, so you aren’t maintaining a risky portfolio that could take a big hit just before you retire. Unfortunately, they often have exorbitant fees that will eat up the lion’s share of the gain. One percent might not sound like much, but it’s compounded–you pay it every year. It’s deadly for your retirement. Mutual funds simply suck. We’ll cover why later in this chapter, but the problem is mostly fees and poor long-term performance.

One quick aside–you can borrow from your 401(k), but that’s a last ditch choice. Better you should borrow from Gino the Shark. If you leave your job you have to repay the loan plus interest immediately. If you don’t repay it, then it’s called a deemed distribution and it will be taxed as ordinary income, and if you’re younger than 59.5 you pay a ten percent penalty. Even if you repay the loan and interest, the interest you’ve paid for with earnings that have already been taxed is counted as untaxed earnings, so you’ll pay tax on it when you retire. Gino is looking better already.

Once you’ve maxed out your workplace retirement account (or, if it’s an atrocious plan, invested enough to get your employer match), divert your next retirement dollars into an IRA. And once you retire or leave your employer, don’t make the mistake of leaving your nest egg in your former employer’s 401(k). You can roll it into a new employer’s 401(k) if you consider the available investment options to be worthwhile, or roll it into an IRA.

Rolling over your IRA is almost always the best choice. A rollover simplifies and consolidates your savings from multiple employers, offers the widest range of investment choices and the lowest fees (if you choose wisely) and it’s easy, as long as you don’t make any mistakes. Most importantly–don’t request a check from your former employer. If you do, you have to move the money into an IRA within sixty days. If something untoward happens and you wait 61 days, you owe taxes on the full amount and if you don’t meet early withdrawal criteria you’ll be hit with a ten percent penalty. You can lose nearly half your savings. Instead, do a trustee-to-trustee transfer which moves the money to the investment company you designate.

You might be tempted to pull your money out of a crappy and expensive 401(k) while you are still employed, but Uncle Sam won’t let you contribute as much money to IRA accounts each year (again, check with the IRS for this year’s limits). And, depending on your income, you may not be eligible to contribute to one fully — or at all.

Furthermore, if there is a chance you might need to use your savings early, the 10% early withdawal limit is 55 for 401(k) with some useful exceptions, while it’s 59 for an IRA with less wiggle room.

IRAs come in two garden varieties — Roth and traditional — and they offer different tax advantages:

  • Traditional IRA: Tax-wise, this account works just like a 401(k) — the money you put into it is not taxed until you make withdrawals during retirement. Also, like a 401(k), you can deduct the money you contribute from your income, lowering your tax bill in the year you make the contribution.
  • Roth IRA: This account gives you a future tax break only. The money you sock away in a Roth is never deductible. However, come retirement, you get off scot-free — you pay no taxes on the gains or the principal when you withdraw the money. A Roth IRA also allows you to withdraw your contributions tax-free at any time for certain things, such as a first-time home purchase or education expenses, whereas with a traditional IRA (and 401(k)), you’d not only pay taxes, but you’d also get hit with penalties. The Roth IRA is also a fantastic vehicle for providing an inheritance. If you can convince your heirs to behave, a relatively small Roth IRA can provide lifelong benefits and substantial wealth. We’ll cover the details later.

Which one is right for you? I like the flexibility of the Roth — and the fact that the earnings grow tax-free. That said, the Roth is not necessarily the best choice for everyone. The Motley Fool article  “Roth vs. Traditional IRA” gives a great explanation of the choices, and provides calculators to crunch the numbers. They also offer a three-step article will show you how to get one set up. The Motley Fool is a great source of advice though they are constantly trying to sell you their investment advice. I’ve never followed advice like theirs, and probably never will, but their newsletters are highly regarded by people who make a hobby out of the stock market.

Taxable accounts
If you are aggressively saving for retirement you will probably max out the limits for tax-advantaged retirement accounts. The most important consideration in taxable accounts, other than keeping the accounts at a trustworthy custodian, is the tax aspects of the investments. Tax-inefficient investments will have to produce huge gains to overcome taxes, and that means very risky investments.  Your taxable account should be in long-term, buy-and-hold index funds. Since the taxes you pay on these investments is minimal until you sell, they grow like tax-deferred savings. When you cash them in you pay only long-term capital gains.

Some advisers might take me to task for not recommending ETFs. I’m not all that excited about ETF’s compared to index funds, but that’s me. I’ll cover the differences in detail in the appropriate chapters.

All of your long-term retirement accounts should take advantage of dollar cost averaging. If you save a fixed amount of money each month, the number of any given shares you buy is a function of market swings. When the shares are expensive you’re buying less, when they’re cheap, you’re buying more. If your contributions to your tax-deferred accounts is automatic then you’re already doing dollar cost averaging. If you’re maxed out and contributing to a taxable account, do it the same way, either with an automatic withdrawal to your custodian along with instructions on what to do with it, or a manual but consistent contribution, or a Robo-advisor account. That makes volatility work for you instead of against you.

Annuitize! Is that really a word?

Most annuities are a terrible idea. If your advisor is pushing you into a complex indexed, deferred, or variable annuity you can be certain that the reason he’s doing it is because he’s getting a big commission. And one way or another you’re paying that commission.  Fire the bastard, right now. It’s certainly not the only way he’s putting his interests before yours.

There is a flavor of annuity that can make sense for people who don’t have enough savings to fund the lifestyle they want for their retirement. It’s variously called a Single Premium Immediate Annuity, Immediate Annuity, or Simple Annuity. But it’s only simple by comparison. We’ll cover the ins and outs of other annuities, mostly for the benefit of people that have already been hosed by their financial advisor into committing to something hideously complex. Understand this–there are LOTS of drawbacks to SPIA annuities, and every device that insurance companies add to respond to those drawbacks decrease the periodic payout of the annuity and increases the fees the insurance company collects. There’s no free lunch, and insurance companies not only charge you too much for the lunch, they charge you for eating it.

Here’s how SPIA’s work at their simplest. You pay the insurance company a lump sum of money up front. They pay you a monthly sum for the rest of your life. There are lots of tweaks here about how much they pay, adjustments for inflation, adjustments for your spouse surviving you, and providing some kind of inheritance. What’s the problem with those? You’ll pay for every tweak, and you’ll pay too much. You’re also betting that the insurance company will stay in business for 30 years, which is never a certainty. But you can hedge that inexpensively.

The big benefits are that you know how much money you’re getting every month, and it’s more than you could safely withdraw from your portfolio. The reason they can do that and you can’t is that they’re betting that people are going to die, and they have a big pool of people for that bet to work with. You’re getting a mortality benefit because some of the people who are buying annuities die the next day, and some live to be a hundred. The people who die early are paying for your mortality benefit. Just recognize that it could be you doing the paying. But you’ll be dead, so that’s cool.

The question of how much mortality benefit you can collect is easily answered online. Find a company that offers Single Premium Immediate Annuities (Google it!) and use the calculator they all provide to figure what your monthly paycheck could be for the particular amount you could pay for the annuity. You probably want to select inflation adjustments and if you’re married you probably want your spouse to keep getting payments when you kick. The rates wander all over the place, depending on what the treasury and the stock and bond market are doing and how long the insurance company gets to play with your money before they have to start paying you. But you can expect it to be somewhere between the 7 percent average gain of the market and the 4 percent average safe withdrawal rate.

The downside is that your heirs don’t get anything from the annuity when you (and perhaps your spouse) kick the bucket. If you need more money than your portfolio can safely provide but leaving an inheritance is  important to you, you have two choices. Cut your retirement expenses or change your mind about leaving those particular bucks for the kids. You’re likely to have other inheritable funds and properties. Personally, I think leaving a big chunk of cash to my relatives would result in a lot of really unwise spending and would probably leave them in a worse financial condition than they were when the spree started. But that’s me.

You should also recognize that trying to leave a substantial portfolio to your kids could have a worse result than “screwing them” with annuities. If you run out of money you’re likely to be a burden to them. My Dad used to say “I think my money and my life will run out at the same time. If I die before the money runs out there might be a little for you, if I live longer than my money lasts, I might have to hit you up”. He died regrettably young, but I wound up helping my mother financially for thirty years after he passed.

Spread Out The Risk

It makes sense to have your SPIA at multiple insurance companies, and they need to be very solid. Fred’s Insurance and Storm Door Corp doesn’t qualify. And you should have a clear idea of what protections the insurance regulations in your state provide. Some states require the insurance company to provide a substantial guarantee pool so even if the company becomes insolvent you’re covered up to the guaranteed amount. The pools all have a residency requirement, but in some cases the residency requirement is for when you bought the insurance, in others, if you move you are only covered by the pool requirements of the state you moved to. So if you live in a state with a pool covering $300K and you move to one with a $100K guarantee, it’s prudent to ensure your prior residency covers you.

Once you know what the pool is, you can decide how many companies to have an annuity with. If you’re covered for $200K and you want Annuities for $400K you choose two companies. Recognize that the company you buy an annuity from may not be the actual annuity holder. For example, Vanguard offers SIPAs, but they actually place the insurance at Transamerica. Splitting your annuity to half Vanguard and half Transamerica may not offer the protection you expect.

This may feel a little complex, but it’s much simpler than the purposely intricate piles of crap that variable annuities offer. The prospectus from just one of the variable annuity my sleazebag advisor stuck me with is a book the size of an urban telephone directory, and it’s just as readable. I spent many hours digging through it to figure out how to unwind myself from that mess. It was simply good luck on my part that I was able to transfer to a more rationally priced annuity at Vanguard. Exiting the annuities completely would have incurred a big tax bill. More on that later in the Exiting Bad Investments With Your Ass Intact chapter.

Is This For Me?

If you don’t need an annuity to fill the void between what you need and what you have, then don’t go there. A rational investment approach will suit you better in most cases. At most you might consider an annuity as a filler, annuitizing just enough to make up the difference between what you need and what you can safely withdraw. In almost all cases, a SPIA should be a Plan B, something you plug in if Plan A doesn’t work at all, or fails at some point. You don’t need an annuity the day you retire, unless you find that your portfolio just won’t support your life. When that sad day comes, you can give your bucks to the insurance company and explain to Junior why he’s not going to be able to buy a new monster truck when you move on to that big mud bog in the sky.

Understand though, that buying an annuity when you think Plan A has failed is not an easy proposition emotionally. You’ll be selling off a big chunk–maybe all–of your invested assets at a low price. Generally people decide they have to take this step after a big market decline. There’s a good chance that after a big market decline the annuities you can buy will offer a much smaller return than they did previously. If you view an annuity as a potential Plan B it’s a good idea to keep an eye on the annuity market. Get quotes every so often and watch your portfolio. You might find a point when interest rates are up and the market is a little spooky where a SPIA looks really good. You might be very happy annuitizing enough of your portfolio to ensure you have the income you need, even if it’s not the income you want. That’s a much nicer place to be than finding yourself at the bottom of a big market dip, with annuity offerings that won’t meet your income needs.

If you are particularly conservative, or you think that you will be emotionally unprepared to live with big fluctuations in your portfolio, then annuitize a larger percentage, and do it sooner. It’s not the best strategy, you’ll be forgoing the typical market gains, but you’ll sleep better and you won’t freak out and sell low.

Delaying Social Security

With just a little math you can treat Social Security like a SPIA. I know that sounds whacky, but your Social Security payout increases by 8 percent per year after age 65. Holding off on Social Security and living off your portfolio is a lot like buying an annuity with the $20K or so that you’ll receive each year. Say you’d get $18,000 in benefits at age 65. If you wait a year that increases to $20,000 (I’m using round numbers, the government never does). Delaying a year is essentially the same as paying $18,000 for an annuity that pays $2000 per year. That’s an 11.1 percent payout. Where are you going to find an annuity that pays that much? Of course you need to use your own numbers, and it’s unlikely that $2k per year is going to change your life, but it certainly makes sense to deduct that amount from any annuity that you might be planning to buy and just defer as long as is prudent considering both your and your spouse’s likely lifespan. You can only delay Social Security until you are 70.5, but your spouse can delay too, and there are some complex but useful Social Security strategies that we’ll cover lightly later, or just Google it now.

It’s generally a crappy idea to annuitize everything. Life has a way of handing out surprises that might not be covered by a monthly payment. You need some liquidity to cover that–the general advice is two years of expenses in liquid form. That doesn’t mean stick two years of expenses into gold coins in your sock drawer. Your portfolio is partly liquid, you can get at some of the money in a day or so. Treat that as part of your emergency funds and add some money market or just an interest-bearing checking account for the rest. FDIC insured for any banked cash of course.

One investment you can look at as generally safe and highly liquid is bond indexes. You can get your money in a day, and the better indexes have a low correlation to market risk.

You won’t find any solutions in this book for when the monetary system collapses and we’re reduced to trading cowrie shells for coconuts. I’m not saying it won’t happen, I just don’t have any good ideas for how to sell the world economy short.

Asset Allocations and Life After Annuities

So now you have some idea where the difference in income between pensions and social security and your expense level is coming from. If you need an annuity you know what kind to get. What do you do with the rest of your portfolio? Stocks, bonds, gold coins buried in the back yard? The most common answer and the only thing I’m going to cover in this chapter is index funds of stocks, bonds, and bond-like investments. The question of how much of each (your asset allocations) is really up to you and your tolerance for risk. We’ve already talked about volatility and its effect on your stock portfolio. What should be obvious to anyone looking at a historic chart of market value is that the market goes up and down–it recovers, but it takes time. If you simply held onto all your stock, the value should reappear. But how long will that take, and what will you be doing in the meantime? If you’re no longer working and you need to sell stocks to pay expenses while the market is down, you won’t be fully participating in the recovery. So logically the closer you are to retirement, the less money you should have in volatile investments. Bonds and bond-like investments tend to fluctuate independently from the stock market and in a generally opposite direction. Bond values are also driven by interest rates and inflation, but when the market goes sour, panicked investors sell off and put their money in bonds.

So how much in bonds, how much in stocks? The thumb rule is to have your age in bonds. Not a bad rule, but there are better ways to determine asset allocation. There are a host of online calculators that will take into consideration the ages of you and your spouse, the size of your portfolio, the amount of money you need to draw, and perhaps your shoe size and calculate an asset allocation. Which ones you believe are up to you, we cover them in the chapter “Will It Last”.  For completeness sake here’s a link to a catalog of calculators that seems to be well-maintained on Bogleheads:  I like the Monte Carlo calculators, because I think that method is most useful for modeling complex situations with a lot of unknowns.

But a real answer to the question of asset allocation lies in your attitudes and your understanding of your needs and emotional makeup. It also has to do with how rigid your schedule for retirement is. If you’re nearing your planned retirement age a market downturn can put you in a situation where you might need to defer retirement. If you retire as scheduled you might have to sell a substantial part of your portfolio at depressed prices to cover your expenses. Once you are in retirement this becomes even more challenging. Your ability to handle the outcome of risky or volatile investments is probably less. Of course if you have a substantial part of your expenses covered with a pension, social security, or annuities, then you can probably accept more risk in the rest of your portfolio. For example, say you’re recently retired and you are relying on your portfolio to provide 20 percent of your expenses. Let’s say you’re 50/50 stocks and bonds for a 100,000 portfolio. You want the portfolio to grow at something close to market rate, so you’re taking that higher risk. If the market declines by 20 percent, your bonds stay at $50,000 and your stock declines to $40,000 so your total portfolio is now $90,000 meaning the value declined by 10%. If that’s tolerable for the length of time it takes for the market to recover, then you might be fine. But prudent asset allocation strategy demands that you rebalance your portfolio. You’re going to sell bonds and buy stock to get back to 50/50 so you’ll be at $45k bonds and $45K stock. In essence, it’s the holding version of a dollar cost averaging approach. But your allocation ratio really determines the risk you face in the future, so even if it wasn’t forcing you to buy low and sell high (a good thing), it would still be important to rebalance.  If you can’t stomach that, you shouldn’t be in that risky a position.

If your ratio was  70 percent bonds and 30 percent stock, and the market declined by 20 percent your $30,000 in stock becomes $24,000 and your portfolio declines by 6 percent. You rebalance at $28.2K stocks and $65.8K bonds for a total portfolio value of $94K. That sounds nicer, but recognize that bond portfolios don’t appreciate much beyond their interest rate, which has been very low in recent years. With a market growth rate of 7 percent and the current bond interest a 70/30 bond/stock portfolio will struggle to earn 4 percent. But if your living expenses are covered, and seeing your portfolio turned upside down scares the crap out of you, then you might not care about the upside potential of a more risky option.


What Flavor Of Bonds?

The easiest way to buy a diverse set of bonds is in an index fund. But it might be a mediocre idea. Stock Indexes operate with some kind of rule that determines what kind of stocks comprise it and what percentage of the whole each stock represents. In the stock markets it’s often something like market cap. meaning you’ll have a larger percentage of the money invested in the larger company stocks that meet the other criteria for inclusion. That might suit your investment ideas, or you might be more interested in things like value, so there are a variety of index funds that slice the market in different ways.

The same is true for bond index funds, but their concentration is different. Big debtors wind up being over-represented in many index funds. The amount of debt owed is probably not an indication of the quality of a bond and only a secondary indication of company size and importance. And if you try to diversify by buying different fund designs, you might wind up with the same kind of concentration in each fund just because of the number of bonds available. In other words, you could have a lot of overlap and what stock market investors would call “creep” of the criteria that you are trying to apply. While I’m a big proponent of index funds for stocks, I’m more inclined to favor actively managed funds for bonds. There may actually be expertise available that can make a difference. Bonds seem to have a less transparent market with factors influencing return and risk that might not be obvious in reading a prospectus.  Expert knowledge seems more important. Of course you don’t want to overpay for this expertise, so you need to take a close look at what the expertise is costing you. But I’ve found some actively managed bond funds with expense ratios similar to rule-based indexes. They seem to be worth considering.

Another way is to buy individual bonds, but this exposes you to some risks you might not anticipate. Individual bonds expose you to credit risk (the risk of default), inflation risk and duration risk. The current value of a bond is affected by the interest rate multiplied by the remaining duration of  the bond. So if you have a 10 year bond and the interest rate increases by 1% the value of your bond will fall about 1% times 10 years, or 10%. Bond funds are similarly affected, but they fluctuate as the average of the duration and the average of the interest rate of the bonds held. This multiplier means long term bonds swing in value a lot more than short term bonds. You can buy inflation adjusted bonds, such as the US Treasury TIPS (Treasury Inflation Protected Securities), but you’ll pay a premium for protection you might never need. Risk is a factor to manage, not a factor to avoid. You can’t get a return in any market without accepting risk. The trick is to make sure the risk you are accepting is compensated appropriately, and that a greater risk taken in one place is balanced by reduced risk, or at least uncorrelated risk elsewhere (meaning the cause of the risk is not related, so the two investments will not decline in value because of the same change in the market).

Bond Ladders

If your portfolio is modest, say less than $1 million, you are probably better off sticking with bond funds to manage the concentration risk. But there are some advantages to holding a ladder of bonds. For one thing, in states with high taxes, tax-free municipal bonds can be very attractive. You need to look at the bonds carefully and understand the creditworthiness of your state. In general, a state bond for some entity with revenue-generating ability is preferable over something amorphous like General Obligations. So a sewer bond in an area that collects fees for sewage is perhaps a safer bond than one that provides a service that is supported by general taxation.  Bonds have some strange complications regarding their coupon rates, face value, maturity date, and purchase price. If you buy a bond at the wrong time the next coupon payment might go to the previous owner. Conversely, if you buy a bond that immediately delivers a coupon payment, the price inevitably includes “buying the coupon” which is like buying money with someone collecting a fee for the transaction. Bound to be a losing proposition.  You may be able to get inexpensive advice by finding a bond broker to do your buying and selling for you. They can at least outline current bonds available and tell you about pitfalls, but they won’t hold your hand a lot. No one makes money just by giving small investors advice about bonds.

Credit Risk

Treasury bonds have almost no credit risk, and almost no yield. At the other end of the spectrum, corporate junk bonds have higher risk and more yield. Which should you invest in? That’s up to you and your tolerance for risk. You can certainly use junk bonds in a well designed portfolio to balance out risk levels. It takes more work, and more knowledge, but while credit risk might seem like some different kind of risk than inflation or duration risk, it’s really all quantifiable–it’s just emotionally scarier. Higher risk bonds with a short maturity might actually hold value better when interest rates rise.

FDIC-insured certificates of deposit and other interest bearing holdings have a place in your portfolio as well. There’s no magic in bonds. If CDs are doing as well, the much easier redemption might make them a lot more attractive. and money market funds can be even more attractive and more liquid.

Stocks, mutual funds, ETFs, and Indexes

Investing in singles stocks is mostly just gambling. The exception is stock in a company you work for where you get either options, stock grants, or some kind of discounting. There are tax issues with stock you get from your company that are beyond the scope of this book, and you need specific tax advice to deal with them. Most people hold stock in their portfolio in the form of mutual funds, and in most cases the mutual funds are doing very little good. The reason is that the fees for many mutual funds eat up much too much of the gain. If you haven’t been paying attention to the fees you’re paying for the funds you hold it’s time to change that.

The story you’ll hear from advisors and brokers is that smart mutual fund managers are worth the difference in cost. And study after study over the last decades have proven that to be at best nonsense, and more baldly, a complete lie.  In general, the cheapest funds outperform the more expensive ones in every asset class. Yes, you can google that. Morningstar has several recent reports and some historic ones that categorically state that, but it’s been the topic of research for decades. The reason is mostly expense deducted from gain, but it’s also true that expensive funds tend to be the ones that were most successful in the previous year, so investors pile in, and the manager has to reach further to place all that money and take more risks to try to meet or beat his previous performance. And then there’s the simple statistical principle called Regression to the Mean, which we’ll cover a little later. And finally, the frantic management means two things–lots of trading, which means more short term capital gains recognized, and uninvested money sitting in the fund when a losing position is sold. The taxes aren’t part of the performance reported, but they’ll bite you right in the ass. All of that means that “hot” funds and star fund managers is just marketing bullshit.

Mutual Funds can be defined as funds where an active manager tries to beat a given index, while Index Funds are funds that aim to duplicate the performance of an index. The expense of executing a set of rules that follow an index are much lower (typically 0.1 percent or less) than the expense of an active manager (typically 1 percent or more). One percent doesn’t seem like much until you compound that cost over the years you hold an investment. And once you retire you’ll be living on three percent of your total investments. Add in 1 percent for the fund manager and your likelihood of depleting your savings too quickly increases drastically. Add another 1 percent for your investment advisor and you’re really in trouble.

ETFs are varied forms of index funds that are traded as stock instead of as a fund, as index funds are. You can generally only buy an index fund from the provider–like Vanguard–but you can buy ETFs anywhere you can buy stock. It used to be that you paid brokerage fees to buy ETFs, but most low cost brokerages like Vanguard, Schwab, etc. will buy and sell many ETFs without a fee. The fundamental difference between an ETF and an Index Fund is that you are not buying the shares that make up the ETF, you’re buying the ETF. In theory it shouldn’t make much difference except for certain capital gains tweaks that have to do with redemption (covered later) but in fact ETFs may not precisely follow their index in value, and a few have lost most of their value for one reason or another. We’ll cover the pitfalls in the ETF chapter, but for now lets just say that ETFs from larger companies have numerous trading benefits and only a few downsides. But lots of companies have jumped on the ETF bandwagon, creating all kinds of exotic indexes. A lot of care is recommended in playing with these toys.

Risk and Low Cost Funds

Low cost funds like ETFs and Indexes offer several other benefits and reduced risk. The biggest benefit is diversification and simplification. If you wanted to hold thousands of US and International stocks as well as a broadly diversified bond portfolio, you could do so with as little as three index funds. In fact you could do it roughly and with a little less control with just two funds. There are all kinds of portfolio suggestions on the web for radically simplified and very inexpensive portfolios that have only a few components. You might consider this oversimplification, and wonder how much return you would be sacrificing if you held such a simple portfolio. The answer is, compared to the average investor, an average three, five, or seven element portfolio would blow the socks of their return.  Most individual investors, and investors using traditional high-expense financial advisors, gain substantially less than market returns, year after year. A simplified and highly diverse index portfolio will return almost exactly what the market returns. With portfolios like this the asset allocation becomes much more important than the particular funds chosen. Asset Allocation manages the general risk level, which determines how close to market returns the portfolio generates.

This all might seem mechanical. That’s because it is, and that’s why it works. There are even “ROBO Advisors” that manage these kind of portfolios for you with automated processes. Most do the asset allocation and rebalancing automatically, and some do more advanced and generally painful tax loss harvesting, selling losing positions and buying similar stocks automatically to harvest losses and avoid “wash sale” tax consequences.

This isn’t to say that there are not people with sufficient knowledge of the markets and understanding of the fundamentals of particular companies and markets who can make money with targeted investments. But those people probably are not you, and unless you have many millions of dollars to attract their attention, they probably won’t be offering to manage your money. You’re going to get some frat boy named Bubba. If you’re investing in Index Funds and ETFs you don’t need Bubbas help. And you don’t bear the irrational market risk of high cost funds where the superstar moves to another firms and the fund falls out of favor. And you don’t bear the risk that your fund manager puts a big bet on a particular stock, or segment, or market, or country that doesn’t work out. Indexes have basic rules that get executed with boring regularity, which means you won’t wake up some morning and read about the implosion of one of your holdings in the Wall Street Journal. That’s a form of excitement I can do without.

Sacking Your Adviser: Switching Costs

Switching advisors is easy and doesn’t cost much, unless they have you wrapped up in some proprietary junk that’s hard to transfer. That, by the way, is an important issue. Don’t let your advisor put your investments in a proprietary “platform” that can’t be traded in the general market. Outfits like Matson Money take standard DFA index funds and clump them together into their own proprietary form. You might think that any DFA-approved advisor could unravel and trade them, or move them to a custodian “in kind”. But you’d be wrong. You’re stuck with their ridiculously expensive management fees, holding ordinary DFA funds that should cost a fraction of what you’ll pay. The only way out is to sell them, and pay capital gains for any increase over basis. This is a fine way though to tell if your advisor is screwing you–if they want to put your money into Matson funds, or a platform like LPL, or into some complex alternative investment with limited liquidity you should stop right there and ensure you know what you’re getting into. Outfits like Matson sell their services to financial advisors on the premise that the advisor can make millions without effort. Where do you suppose those millions come from? LPL kicks back as much as 80 percent of the fees it charges to brokers, and is constantly dealing with lawsuits, investigation, and consumer complaints. Google it.

For the most part you can move custodians, or just leave the funds where they are if the custodian permits it, and change the advisor’s ability to access it. Most custodians will be glad to help you through the steps of either eliminating the advisor or transferring to another who isn’t screwing you. And of course, if you’re switching to a fee-only advisor they can and should hold your hand through all the steps.

If your current investments are in high-cost funds you will want to move to low-cost. But don’t just pull the plug. You’ll almost certainly be paying long term capital gains on any increase. You can transfer the funds “in kind” to a new custodian if they can hold those particular funds, but while you will have eliminated the advisor’s fee, you won’t have eliminated the fund managers fee (expense ratio). If the funds are in non-taxable accounts then you’re in good shape, you can sell them and buy low-cost funds without tax of any kind. If they are in a taxable account then you need a strategy.

The first thing to do is to look at the change in value of all the funds since the time you purchased them. Any losing positions can be sold immediately, and you can use those losses to offset selling some winners. Look at the management fees for all the funds you own, and decide which you want to get rid of first. If you are like most investors, you’ll probably be shocked to find that the high-fee funds are often modest performers or losers. You don’t need to do anything quickly, rushing into changes often leads to unintended tax consequences. This is a good time to spend a little money on tax advice. Make sure that whoever you hire for that can communicate with you well. Tax code is arcane, and there are some great practitioners who only make sense when they are talking to other experts. In my experience tax advisors make a lot of mistakes. They’re often rushed, especially during the heavy workload times around quarterly tax times and April 15. Plan to double check and ask if something looks wrong–and keep asking until you understand the numbers and know they are correct. Try to avoid those crunch times.

We’ll cover how to get out of annuities in a later chapter, but understand that you have to proceed carefully, and at the right times. Many annuities have substantial penalties for withdrawal.

You might also be interested in rolling over your 401(k) into an IRA or doing a conversion to a Roth IRA. Pro advice is worthwhile, though I’ll lay out the basics in the IRA’s, 401(K) and the Grapes of Roth chapter.

Taxes In Retirement

Who would have thought that taxes become so much more important in retirement than when you are working. It’s true for nearly everyone. For most people’s working life, taxes and social security are generally automatically deducted from their paycheck–they don’t really feel the pain. It’s only if you are self-employed, or have some major windfall or loss that you pay much attention to taxes other than filling out a yearly form to see if you owe more or get a refund. And since eighty percent of Americans get a refund, taxes just aren’t all that apparent in your daily life. But when most of your spending money comes from retirement savings, every dollar of taxes that you pay is one less dollar you can spend–and you have to plan for it. Uncle Sam wants everything that’s coming to him. It’s rare for retirees to get a refund at tax time, and if you do, it’s because you screwed up and paid too much.

Most retirement tax strategy has to do with deciding which accounts you should use to take the distributions that constitute your paycheck. Your tax bracket during the year you take distributions and your current age plays a big part in the answer to that question. When you reach 70.5 you have to start taking Required Minimum Distributions (RMD) from your tax-deferred accounts (except Roth IRAs). The basic strategy is to treat your tax brackets as buckets. You take distributions from your tax-deferred accounts to “fill up” the lower tax brackets.  If you’re over 70.5, take the RMD (the penalties for not doing so are large enough to outweigh any tax issues) and then fill the buckets up to the tax bracket you expect to be in for the next few years. If the total amount withdrawn is more than you need, probably the best use for it is to transfer it to a Roth IRA. More on that later or google for the five brazillion* articles on Roth conversion. Your tax-deferred account distributions will be taxed as ordinary income, but if you expect to be in a higher bracket in following years (for example, when you start taking Social security Payments and Required Minimum Distributions) then it makes sense to take the hit now. If your prognostication skills are good enough, you might want to fill the buckets up to the bracket below your expected future rate and put any excess into a Roth IRA. That means you’ll be paying tax on the distributions now at your current low tax rate, and taking the money out of your Roth tax-free in the future.

Otherwise, fill up the lowest tax buckets and take the rest from your taxable accounts. If you are married filing jointly, then roughly the first $20,000 of your income is not subject to tax (because of the standard deductions of about 12K plus two exemptions of 4K).

Surprise Taxes

One of the main reasons to avoid high cost, managed mutual funds is the turnover rate of the shares they hold. The crappy performance of high-cost mutual funds relative to indexes is well known, successful managers rarely repeat success, and the big fees eat up the gain. But that’s just the tip of the iceberg–the returns get worse when you factor in the taxes that the fund managers blithely distribute to fund holders and never deduct from published gains.  On average, managed funds replace 80-85% of their holdings yearly. That’s kind of the definition of actively managed, and any manager who doesn’t trade a lot is going to look very skanky if his funds don’t do well. But all those trades cost money, and on average, active trading reduces returns by as much as one percent–and that’s before you pay the manager for his brilliant strategy. It also creates taxable gains which are distributed to the shareholder. It’s really fun to get socked with a substantial tax on an underperforming fund. You can buy tax-managed funds, where the manager tries to offset gains with losses in the shares he trades, but they generally have fees to keep you from selling shares, because large exits mean the tax strategy blows up when shares need to be sold to pay those exiting.

The best solution, in my opinion, is don’t buy actively managed mutual funds. Index funds and ETFs are the polar opposite of active trading. There still will be occasional capital gains distributions if a stock is bumped from the index and must be sold according to the rules of the fund. But that’s comparatively rare. Smaller index funds may also need to sell shares if a lot of investors exit the fund. But the magnitude of turnover-generated taxes for Index Funds is historically tiny.

There is an additional benefit of the low turnover and rule-based trades of index funds over actively managed fund–index funds can keep 99% of the money invested, whereas the uninvested cash position of the average mutual fund with it’s 85% churn is much higher. If a smaller percentage of the money is invested at all times, then the mutual fund has to beat the index before it can even break even.  One more factor that fund managers need to overcome. And that’s before they make up for transaction fees, management fees, and finally capital gains distributions that make most of the gains taxable.

But wait, there’s more. You are also taxed on dividends, but the tax rate on qualified dividends is much lower than on stocks that have been held for less than a year. With mutual funds turning over at 85 percent, most dividends are unqualified. Qualified dividends are currently tax-free for those in the 10% and 15% brackets if the dividend income does not exceed the bracket. They’re taxed at 15% rate for those in the 25% up to 35% tax brackets and max out at 20%. Nonqualified dividends are taxed as ordinary income.

All this talk of taxes might seem terminally boring, but here’s a statistic that will send a little sizzle up your spine. As much as 25% of the returns from mutual funds is consumed by taxes on turnover gain and dividends. That happens every year, so the effect is compounded. Over a thirty year period, a 25% reduction in returns of $10,000 is nearly $200,000. If the mutual funds in your portfolio are providing $50,000 per year for you to live on, the thirty year compounded cost of all that trading, fees, and advisor fees can easily exceed a million bucks.  

Plan your tax strategy well, my friend. 

So that’s the basics. Now on to the detail and equally important, some advice on health and fitness as well as some ideas about how to spend your retirement well.

Here’s the two paragraph version of the health and fitness chapters.

There are five things that are likely to shorten your life:

  • cancer
  • heart disease
  • stroke
  • respiratory disease
  • liver disease

You control most of the risk factors for all five. Diet, exercise, what you eat, how fat you are, and whether you smoke and/or drink too much alcohol. Clean up those factors and you’ll save a lot of money, because the best way to manage health care costs is to not need it. If you suffer from any of those diseases and they don’t kill you, the out of pocket medical expenses for  30 years of your retirement will rise from an average of $250,000 to at least double that.

I other words, the second worse thing that can happen to you if you don’t clean up your act is that you’ll die young. The worst thing is that you won’t, you’ll just be chronically ill and a miserable burden for the next thirty years. At least that’s how I see it.



*I use Brazillion occasionally to denote a big number because it makes me grin. Old joke. Insert the president you like least.

At the morning briefing:

“Mr. President, five Brazillian men were killed last night in a terror attack.”

The president is visibly shaken. “My god, that’s horrible. Remind me–how many is in a Brazillion?”

Homework Assignment

Since we haven’t given detail, we’re going to minimize the homework for this chapter.

If you currently use an advisor, contact them and ask for a full accounting of last year’s fees, including all commissions and trading costs–if they are a Registered Investment Advisor (RIA) you can ask specifically for a form ADV part 2. Be prepared for pushback and foot-dragging, but insist on a full accounting, even if they are not a RIA. There is no question that they already know that number–they couldn’t run their business without it. If they refuse to provide that to you, then you know what you need to know.

Gather copies of your retirement savings account year-end statements, and asset values for other investments (home, vacation home, rental properties, collections and other valued assets). We’re going to need that soon. Put it in the Retirement Fiance section of your notebook.

Follow-up to Previous Chapter

Did you get the notebook and write down those two simple numbers?








The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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