Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we discuss when to open a taxable investment account and how to strategize the location of your investment vehicles based on account taxability characteristics.
Once you’ve filled up all your tax-deferred and tax-free investment accounts, it’s time to start paying Uncle Same (now) to invest. The 9th Financial Commandment for Millennials is to open a taxable investment account, while keeping tax management a key feature of this aspect of your portfolio.
Investors need not worry about dividends, interest, or gains in a 401k, 403b, 457, SEP or Traditional IRAs because those will be taxed when you decide to have them taxed (or an annual portion is taxed when the government says so via Required Minimum Distributions at age 70 ½). Gains, dividends and interest in Roth IRAs are tax-free if you meet certain qualifications. For this reason, its best to have growth, dividend, and other income producing investment held inside these accounts.
Now that you’re opening a taxable investment account, any growth, dividend, interest or other income is taxed in the year the gains are realized or the dividend and interest is paid (usually…i.e. phantom income). While you can use long-term capital gains tax rates to your advantage on investments held over a year, the ideal goal for a taxable account is to participate in investment growth while also not being taxed left and right for gains and income produced.
To accomplish this, we recommend using a portfolio made up of Exchange Traded Funds (ETFs). ETFs offer broad diversification that reduce the need for trading, minimize taxable distributions, and provide the long-term growth you want in a tax-efficient manner. Here’s an example of Oak Street Advisors’ FatPitch ETF Portfolio investments:
Even better-- our clients experience $0 trading cost because of our relationship with TD Ameritrade as custodian. However, any DIYer can implement a similar ETF strategy on their own for a minimal $5-$8 per trade.
In general, investors can see less return drag from investment and tax expenses by utilizing this strategy in their taxable investment accounts. The relationship of the taxability of an investment and the taxability of the account it is held matters, and can keep dollars in your pocket. As with any investment, making sure you’re sticking to your strategy via rebalancing and reacting to market conditions, or paying someone to do so on your behalf, is crucial.
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we go through the advantages of paying down common and often necessary consumer debts such as car loans, mortgages, and student loan obligations.
If you’ve made it to the 8th Commandment congrats, you have established a strong financial foundation; we also know you’ve paid off your high interest credit card debt—but now it’s time to start pecking away at the larger consumer debts weighing down your net worth.
I’m referring to debt typically considered “necessary” for most Americans—student loans, your mortgage, car loans, business loans etc. These are loans with normally reasonable interest rates and longer payoff schedules. Paying them down may seem almost unattainable but be assured, if you commit to doing so you will save a lot of money.
For example: adding $100/month to a $500,000 mortgage at 4.5% interest will save $36,240 over 30 years. That seems abstract, like you will never really see that savings—but your net worth doesn’t lie.
What Should You Start Paying Down First?
We discuss the two different debt payoff methods in Getting Out of Credit Card Debt: The 2nd Financial Commandment for Millennials. Our advisors tend to favor the Snowball Method, so we’d recommend starting with the smallest loan first.
The thinking is as follows; Paying off a car note early not only saves interest but also increases monthly cash flow by eliminating the monthly car payment. The money that would have been allocated to the car payment can now be used to pay down student loans or add monthly principle additions to the mortgage.
Paying down your mortgage or student loans is not sexy financial planning advice—but doesn’t saving tens of thousands of dollars and eliminating all debt down sounds pretty awesome?
Over the course of my thirty-year career in the financial services industry I have seen and continue to hear many investment theses. Some brilliant, some not so much so. I have also witnessed a number of changes that in retrospect were obvious and inevitable. The personal computer revolution was one of the first. I recall there were many would be winners that vanished into dust, but some of the early players like Intel, Microsoft, and Cisco became the next generation of mega-cap companies. Likewise, with the internet boom. Companies came and went, but some like Amazon and Google became behemoths. Cell phones were the stuff of dreams in my youth, but the ability to access people and information, no matter where you are, was inevitable and although early participants like Nokia and Motorola have become footnotes, Apple and Samsung have had explosive growth and rewarded investors many times over.
Recognizing inevitable change is only half of the battle for successfully profiting in new industries and market opportunities. Diversification and patience are more important long-term ingredients to financial success. If you put all your eggs in the Commodore computers basket you were a loser. The same for eToys.com or Lycos, or Palm Inc. Even if you recognized the inevitable, it was still much too easy to lose all or most of your investment.
Perhaps, though you were bright enough or lucky enough to pick the winners. On 3/24/1980 you could have bought Intel for just $0.32 adjusted for splits. By 10/20/1980 it had already soared 56% to $0.50. A year later, the price had fallen about 48% to just $0.26 per share. Would you have held on? Would you still have faith that this was inevitable? It wasn’t until the second quarter of 1983 that Intel reached that $0.50 peak again. Today, no one gets very excited about Intel, but the stock price has reached $51 per share netting those long-term patient investors $100,000 for every $1,000 they invested nearly 40 years ago.
So, although you can find inevitable investment opportunities, today the rush of the quick pop in price per share will not always be there. Sometimes, it is just waiting, and waiting, and waiting.
With those words of warning, we will share with you four inevitable investment opportunities we feel all investors should be considering right now.
In January of 2012, marijuana became legal for medicinal and recreational use in Colorado. In 2018, it became legal for the entire country of Canada. Around the world attitudes toward “pot” are changing rapidly. We are now witnessing the birth of an entirely new industry. We believe the opportunity is akin to the liquor industry at the end of prohibition, and we are not alone. On November 1, 2018, Constellations Brands (STZ) closed a $5 billion investment in Canadian cannabis producer Canopy Growth (CGC). On August 1, 2018, Molson-Coors (TAP) announced a joint venture with Canadian cannabis company HEXO Corp. (HEXO) to develop non-alcoholic cannabis infused beverages. Additionally, in December of 2018, Philip Morris (PM) invested $2.4 billion in the Canadian cannabis company Cronos (CRON). What do these large multi-national companies see in the future of the cannabis market?
Take a look at some of the numbers.
In four and a half years, total sales of cannabis have more than doubled in the state of Colorado, jumping from $683 million to over $1.5 billion. Colorado ranks 21st in the US by population with about 5.7 million residents. That works out to sales of about $263 per year per person.
There are now ten states in the US where cannabis is legal for both medicinal and recreational use. This includes California, ranked number 1 by population and Michigan ranked number 10. These states in aggregate have a population of about 80 million. Throw in New Jersey and New York who are likely to follow suit and that means about one third of American’s live in states where cannabis is legal.
Even if Colorado is an outlier and sales in other states are only say 70% as high (haha) or $184 per person that works out to a market of $14 billion. Maybe Constellation Brands and Molson-Coors envision a day when you stop by your local pub for a cannabis infused drink rather than a beer. For comparison, the US market for beer topped $35 billion in 2018. Like the acceptance of the lottery, there will be many states reluctant to join the party for moral reasons, but sooner or later acceptance is inevitable.
No, you don’t have to be a tree hugger to realize that renewable energy is inevitable. Take a look at this chart from Yahoo Finance showing the fastest growing jobs in every state.
In eight states, the fastest growing job is solar panel installer. In four states, the fastest growing job is wind turbine service technician.
Climate change concerns aside, it is obvious renewable energy is becoming a much bigger deal both in the US and abroad. Although, starting from a low base the following chart from the Yale School of Forestry illustrates the beginnings of an explosive growth in solar energy production worldwide.
Much like the tipping point in software adoption, we believe solar installation will reach a critical mass that will one day lead to a distributed production model for energy use. With a large installed base of photovoltaic solar panels, today’s electric utility could evolve into a sort of common carrier like the Telcos, moving electricity from areas of high production to areas of high consumption. Your rooftop solar array and the arrays across the nation would provide power for homes and factories across the country. Rather than spending most of their capital on new power generation assets, they might spend more on upgrading and improving the efficiency of our electric grid instead.
Both utility scale solar and wind systems currently provide the lowest power costs available. As photovoltaic systems improve, and manufacturing systems evolve, the price will head only one way – down, as illustrated in this chart from Lazard on levelized energy costs.
You have likely heard about the Tesla (TSLA) cars with autopilot, or maybe Google’s Waymo division. The first generation of self-driving vehicles is nearly here, and it means big change for the entire transportation industry. It will change the way automobiles are used, change the ways roads are built, and change the way freight is shipped.
Like most people in America, you own a car that sits parked in your garage or at your place of employment 90% of the time. Cars are expensive. There was a time when the average family could buy a vehicle and pay for that vehicle with three-year financing. Today dealers are stretching that financing out to six or even seven years to make ownership possible.
Imagine getting up in the morning and using a smartphone app, you summon your ride to work. On the way you are free to check your email, read the news, or even just nap because you are not driving the vehicle - it is driving itself. In 2018, the average payment for a new car in the US was $523 per month. That doesn’t include insurance, fuel, or maintenance. It is easy to guess that the total cost of car ownership to be around $700 per month. With autonomous vehicles, you would pay only for the time you are using the vehicle and various companies would own fleets of vehicles around the country. They would pay for the maintenance and insurance, you would just rent a ride. Again, once critical mass is reached with autonomous vehicle adoption, our roads would become safer, parking garages would go the way of payphones, and travel becomes less frustrating. How many traffic jams would be eliminated if crashes were rare and rubbernecking were eliminated?
Shipping freight will change radically as well. Without the need for human drivers, shipping companies would program their trucks for fuel efficiency rather than speed. Trucks would travel the highways 24/7. If you have ever been on an interstate highway in the wee hours of the morning, you know there is almost no one using the highway. This becomes prime time for shippers, resulting in less congested roads and decreased need for new road construction.
For all these reasons and more, we see autonomous vehicles as an inevitable change.
The Wilshire 5000
Yep, it’s as simple as that. History has shown that investing is common stocks for the long run inevitably creates wealth. Markets go down but they do not stay down. You don’t have to be a genius or a prognosticator to participate and profit from the inevitable growth generated by a group of great American companies.
Back to our question about Intel. Did you buy it? Did you hold it? The Wilshire Index did. Same for Apple, Netflix, Tesla, and many other great and not so great companies. Some companies that were in the index disappeared, but the growth of market value marched on anyway.
The Wilshire 5000 Index is a market cap weighted index of all the actively traded stock on all the US exchanges. Originally named the 5000 because when the index was first constructed in 1977, there were about 5,000 companies actively traded in the US. As of June 30, 2018, there were 3,486 companies in the index. You will find the components of all the inevitable trends we covered here, and some that we may not be aware of included in the index. If new companies come to market in the future, they will be added too. The companies in the index are updated monthly to include IPOs and corporate spinoffs and also to remove companies that move to the pink sheets or cease to trade actively.
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we discuss the advantages a Roth IRA presents for young investors. From tax-free compound growth to backdoor Roth IRA contributions— we explain why young investors need to use Roth IRAs regardless of their income level.
The 7th Financial Commandments for Millennials is to max our Roth IRA contributions. Roth IRA accounts have been available since 1997. Unlike a Traditional IRA, Roth IRA contributions are taxed in the year of the contribution but never taxed again if certain requirements are met.
The magic of compounding means, the earlier you start, the greater the tax-free growth within the account. If you are 20 when you start making contributions, you could be looking at four doubles of your original contribution by the time you retire at age 60. That means a $6,000 contribution this year could grow to $96,000, creating $90,000 of tax-free income for your retirement years.
With today’s historically low income-tax rates, it would be prudent to put as much money as one can into a Roth IRA. Always consult your CPA before making this decision, but one could argue the tax-free growth and withdrawals outweigh the hurt of paying today’s top tax rates.
The 5 Year Rule
Another reason to open a Roth IRA is the flexibility it can provide to fund emergencies that may arise over your life.
You can always withdraw any Roth IRA contributions without taxes, after all, you paid income tax on the money prior to making the contribution. However, if you haven’t had the Roth IRA open for at least five years, your distribution could still be subject to a 10% tax penalty, similar to the early withdrawal penalty for Traditional IRAs.
The five years for withdrawals begins when you open the account, not when you make subsequent contributions. There is also a five-year rule for Roth IRA conversions that start in January of the year you make a conversion; this prevents someone from using a Roth IRA conversion to avoid early distribution penalties from early Traditional IRA withdrawals.
Who Qualifies for a Roth IRA
If you have a modified adjusted gross income of less than $122,000 if single, or less than $193,000 if married filing jointly, you can make Roth IRA contributions of 100% of your income up to $6,000 if younger than age 50 or $7,000 if age 50 or older.
Back-Door Roth IRA Contributions
Without income limitations for converting assets in a Traditional IRA to a Roth IRA, many who are disqualified for income resort to the back-door method for funding a Roth IRA. This works because anyone may open and contribute to a non-deductible Traditional IRA, even if you are covered by a qualified retirement plan.
Once the funds are deposited into the non-deductible Traditional IRA, they can then be converted to a Roth IRA. This has the same net income-tax effect as contributing directly to a Roth IRA. The IRS recently loosened the back-door conversion rules and allow for immediate conversions, where in the past investors were recommended to wait a few months before converting to satisfy the IRS.
The Younger, The Better
Tax-free growth and tax-free distributions are very enticing, especially for young investors. The more time your account grows tax-free, the better. Another point to make is that the more of your nest egg you have in a Roth IRA, the less your Required Minimum Distributions (RMDs) will be during retirement. Which inherently leads to you and your financial advisor having more ability to control/minimize income taxes during retirement years.
A health savings account is a tax-deductible savings plan for individuals covered by a qualified High-Deductible Health Plan (HDHP). This program allows for tax deductible contributions to a special account that allows you to pay for expenses your insurance plan does not cover with pretax and tax-free dollars.
A high deductible plan for 2019 requires a minimum deductible of $1,350 for individuals and/or $2,700 for a family. These plans must have a maximum out-of-pocket expense of at least $6,750 for an individual and $13,500 for a family.
If you are covered by a spouse’s workplace policy, Tricare, the Veterans Administration, or Medicare you are not eligible. If you are a dependent on someone else’s tax return or covered by a Flexible spending account or Health reimbursement account, you are not eligible.
How an HSA Works
The beauty of an HSA is you make contributions that are deducted from your taxable income, yet when you spend the money for qualified expenses, the distribution is tax-free as well. Any growth within the HSA account is also tax-free. So, the contributions are deductible like a traditional IRA, but earnings and distributions are tax-free, like a Roth IRA – you get the best of both worlds!
Contributions to an HSA are deductible from your taxable income in the years you contribute, and like an IRA, you can make contributions up until April the 15th or your normal tax filing deadline of the following year. For 2019 the maximum HSA contribution is $3,500 for and individual and $7,000 for a family, with an additional $1,000 per year “catch-up” contribution for those over age 55. It is important to know that for married couples the $1,000 catch-up provision applies to each spouse. If you and your spouse are each over 55 your HSA contribution limit for 2019 would be $9,000.
If you contribute to an HSA plan through your employer, your annual contributions are reduced dollar for dollar by any contributions your employer makes on your behalf. For example, if you and your spouse are under age 55 and your employer makes a $1,200 annual contribution on your behalf, you would only be allowed to contribute and deduct from your taxable income $5,800 for 2019 ($7,000 contribution limit minus $1,200 employer contribution).
If you drop out of a high deductible plan before the end of any calendar year, say you become eligible for Medicare, or you change employers and the new coverage does not qualify as a high deductible plan, your contributions for that year are simply pro-rated. Meaning if you participate for three months then changed to a plan that is not eligible for HSA contributions, you would be eligible for a 3/12ths deduction in that calendar year.
On the other hand, if you become eligible for HSA contributions during a calendar year, you can make contributions as if you were covered by a high-deductible plan for the full year. So, if you moved from an employer plan that was not HSA compliant to another employer plan that was HSA eligible in October you would be allowed to contribute as if you were eligible for the entire year. This is known as the last month rule.
The contribution rules for HSA accounts also allow others to contribute to the account on your behalf. For example, if you have a working child who is covered by an HSA compliant insurance policy, you can contribute directly to the account for them. The contribution is considered a gift so you will not receive an income tax deduction, but it may be an important step to helping your child become financially stable.
Qualified HSA Funding Distribution
An important funding technique is the ability to make a trustee to trustee transfer from an IRA into your HSA account. Each taxpayer may only do one qualified transfer in their lifetime and the amount of your HSA contribution will be reduced dollar for dollar in the year you make a conversion. But this is an outstanding opportunity to convert dollars that are potentially taxable in the future to dollars that can be tax free. If you are young and make a conversion, the potential for tax free growth can’t be beat. Even if you are just shy of Medicare eligibility, the income tax savings of this strategy make it worthy of consideration.
An important note for couples is that only one person can own an HSA account. To maximize the Qualified HSA funding distribution benefit, one spouse will open a family HSA for a calendar year and use their qualified finding distribution. In the following year the other spouse will open a separate HSA account and use their own once in a lifetime qualified funding distribution to fund that account. This would allow a couple to convert up to $18,000 from IRA where distributions are likely to be taxable into HSA accounts that compound tax free and provide tax free future benefits.
You are allowed to rollover funds, via a trustee-to-trustee transfer, from one HSA account to another without triggering a taxable event. This means if you leave an employer’s plan and wish to establish an HSA account through a different provider, you can consolidate your account with the new provider and simplify your financial life. Or if you wish you can change HSA account custodians anytime you wish.
If you name your spouse as the beneficiary of your HSA account, the account will be treated as the spouse’s HSA upon your death. For other beneficiaries the fair market value becomes a taxable distribution to the beneficiary.
Funds from your HSA account can be used for qualified medical expenses for you and your family. The IRS is a bit liberal in their definition of family. Anyone who qualifies as a dependent on your income tax return can have medical expenses paid from your HSA account. You, your spouse, your children under age 19 or under age 24 if a full-time student, grandchildren, parents, and foster children are all included.
Medically necessary expenses not covered by insurance can be paid from your HSA account without taxation. Even things like drug and alcohol rehab, home modifications for disabilities, acupuncture, dental and vision care, and over the counter drugs prescribed by your doctor, are all allowed expenses.
Although your current insurance premiums cannot be paid from you HSA account, you can use those funds to pay for Long-term care insurance and Medicare Part B and Part D premiums.
For a complete listing of eligible expenses see IRS publication 502.
Look Back Provision
If you have an HSA account open during any tax year and do not have enough money contributed to cover all the allowed reimbursements, you can use future years contributions to pay yourself back. For example; In 2018 you had an HSA balance of $4,000 but in December you had a large unexpected $5,000 medical expense. You would be able to make 2019 contributions and then reimburse yourself for the extra $1,000 expense you incurred in 2018.
Like IRA accounts, there are certain transactions that are prohibited inside your HSA account. You cannot have any self-dealing transactions such as sale leasing or exchange of property between yourself and your HSA account, you cannot charge your HSA account for services you provide, and you cannot use your HSA account as collateral for any loans. A violation of these rules will trigger a deemed distribution from your HSA account and subject all the funds to taxation in the year the violation occurs. For more information on prohibited transactions see section 4975 of the tax code.
For the full IRS guidance on Health Savings Accounts see Publication 969.
The 6th Financial Commandment for Millennials: When it's (Not) Smart to Max Out Your Retirement Plan
Whether you’re enrolled in an employer retirement plan like a 401k, are self-employed and can utilize a SEP or Solo 401k, or are forced to brave it alone and contribute to a personal IRA – and you’ve completed the previous Financial Commandments for Millennials it's time to start making the maximum contributions to these plans.
First things first, regardless of how your 401k or other employer plan’s investments and fees are structured, investors should always contribute enough to their employer retirement plans to receive the full employer matching…aka the free money.
After that, don’t max out your contributions blindly. There are a number of factors that should be considered when determining where your savings should be invested, and an employer retirement plan should be analyzed just as thoroughly as any other investment vehicle.
For example, a low earner with access to a poorly constructed and expensive 401k plan may find it more advantageous to only contribute enough to receive the full employer matching (free money), while making the remainder of their contributions to a Traditional or Roth IRA that offers full diversification with lower fees; at least until they reach maximum IRA contributions.
If the same investor is a high earner, eating those high expenses might be worth it. Inherently, these investors have more excess income to be deferred in the first place. If they’re in the 32% tax bracket currently, they may want to defer income until they retire in a few years and their tax bracket drops to 22%. In this scenario, the tax savings may outweigh the high costs of the 401k plan.
The bottom line is that everyone’s circumstances are different and investors need to be aware that just because they have access to a 401k plan doesn’t mean it’s always the best investment option.
If you’re not sure if you’re 401k or other employer retirement plan is serving your best interest, download our 401k Like A Boss workbook. We walk you through selecting the best investments in your plan, as well as guidance on how to allocate your portfolio as well.
Ideally, you’d want to see total expenses equal to or less than 1%; anything near or above 1.5% should give you cause for concern. You can also reach out to a fee-only financial advisor who can help you determine your plan’s fees and the best investment strategy for your personal situation.
You could also ask for a copy of your plan’s 408(b)(2) and 405(a)5 fee disclosures and fund expense breakdown to find out.
Once you determine the best vehicle(s) to make your contributions, how should you invest it? You can refer to last month’s article Asset Allocation and Risk Tolerance or you can access Oak Street Advisors’ 401k Like a Boss employer plan investment strategy workbook as a starting point.
Wow! 2018 went out with a huge rise in volatility as stocks swung from a small gain for the year to nearly reaching bear market territory, before rebounding yet again to end the year down 4.38% as measured by the S&P 500 index
For 2019, you should expect volatility to remain high. Markets will continue to gyrate as we face increasing political uncertainty. The government shutdown will likely become an extended event, as neither side is likely to move much, and negotiating with the executive branch is like trying to eat Jell-O with chopsticks; it wiggles all over the place. While some may find these tactics a refreshing change to the way our government usually works, the markets are likely to be confused by the new normal and react with wild swings based on the latest news cycle. The unpredictability of the current administration will continue to promote volatility as markets react to a constant barrage of headlines and unconventional political tactics.
The Federal Reserve raised rates 4 times in 2018, moving the benchmark short-term rate from 1.25% to 2.25%. This resulted in a difficult year for bond investors as fixed income indices fell for the first time since 2013.
There is also concern about the yield curve. While the yield curve has not inverted yet, it is dangerously close to doing so. The chart below shows the 10-year treasury yield minus the 2-year treasury yield, going back to the 1970s. The shaded areas represent recessions. Historically, an inverted yield curve has presaged recessions and Fed economist David Andolfatto recently argued that an inverted yield curve could actually cause recessions. Regardless of whether an inverted yield curve is a leading indicator or a contributing factor to recessions, being on the cliff’s edge as we are now adds to the uncertainty surrounding markets going into 2019.
With worries about a possible recession on investors minds, credit quality spreads are finally normalizing after years of compression following the credit crunch of 2008-2009.
2019 may be the year we finally find some value in high-yield bonds after nearly a decade of tightened credit quality spreads.
Rising interest rates also leads to a stronger dollar. This makes US produced goods more expensive for foreign buyers and can dampen the earnings of US exporters.
After a fast start in early 2018, the equity markets fell hard in the 4th quarter of the year. Nearly every subcategory of the market ended 2018 in the red.
But compared to one year ago, equity valuations have fallen, based on many metrics.
Have equity valuations fallen enough to make stocks a compelling value? No one knows for sure, but investors should keep in mind that their default position should always be to remain fully invested. Remember, the price of the long-term gains historically inherent in the equity markets is the short-term pain caused by corrections along the way.
Investor sentiment remains muted, offering more good news for contrarian investors.
Earnings among the companies in the S&P 500 continues to grow at a torrid pace. Lower corporate tax rates have fueled stock buyback programs that allow corporate earnings per share to grow faster than the economic growth generated by normal business operations. I would expect to see a slowdown in the rate of earnings growth later in 2019, as year over year comparisons get tougher, and interest rate increases continue to take a toll on earnings growth. That does not mean we expect earnings to fall, just that the rate of growth will moderate as 2019 progresses.
2018 was also something of a dud for foreign stock investors. Developed markets produced even lower returns for US investors than did the domestic market.
And emerging markets were equally as disappointing.
For 2019, we expect both trends to continue. Higher interest rates will generally lead to a stronger dollar and a stronger headwind for non-dollar denominated investments. In 2018, the dollar rose by about 3.5% versus the Euro and about 5% versus the Chinese Yuan. That means investors in the Eurozone needed a 3.5% gain to remain even when they convert their Euro based investments back to US dollars and investors in Chinese companies had a 5% hurdle to clear.
At this point we believe investors should focus on US based companies and remain fully invested. Bond durations should remain short, at least for the first half of 2019, as Fed policy is still unclear. If the yield curve does invert, we would take that as a sign to lengthen bond maturities and perhaps reduce our equity holding a bit. You should expect volatility to remain elevated and look at dips as an opportunity.
Important: This is not intended as investment advice. We share this so that our clients and prospective clients can understand some of the factors we consider as we implement their investment strategy. Any predictions of future events should be viewed with a skeptical eye.
The 5th Financial Commandment for Millennials: Implementing the Right Asset Allocation for Your Risk Tolerance
Asset Allocation & Risk Tolerance
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, understanding risk tolerance, asset allocation, and their relationship, is the foundation of modern portfolio theory. Implementing the proper asset allocation to minimize risk, while still achieving your long-term goals, is crucial to your success and peace of mind.
Asset allocation means: how much…of what asset.
What are Asset Classes?
There are 3 basic Asset Classes
You could add real estate, commodities, alternatives, and other investments to this list, but for simplicity we’ll stick with these main 3 classes.
Asset allocation refers to the weight of each of these asset classes in a portfolio. Here’s a generic look at how we currently allocate the different asset classes:
For example, at Oak Street Advisors we use the following asset allocation for someone who has a Moderate Risk Tolerance:
Stocks = 60%
Bonds = 30%
Cash = 10%
This asset allocation leaves a good portion of weight to bonds and cash; which is less risky than an Aggressive Risk Tolerance:
Stocks = 95%
Bonds = 0%
Cash = 5%
As you can see, with 95% stocks, and stocks being riskier than bonds and cash positions, the latter allocation is much riskier than the former.
The reason for using asset allocation is to manage risk inside your portfolio. The more stocks you own, the more volatility your portfolio will experience. The more stock you own, the higher your return has historically been. We add bonds and cash to the mix to make the short-term swings in the overall portfolio value smaller, but in doing this we also reduce the potential returns provided by the portfolio as well.
We use asset allocation to allow ourselves to stay invested for the long-term gains while sleeping well at night during times when stocks temporarily fall. Your personal asset allocation will reflect your Risk Tolerance, which can be viewed as the point where you can stay invested for the long-term gains, without making the big mistake of selling in a panic.
For some of our clients, we provide them with a short Risk Tolerance Scorecard. While brief and simplified, it gives investors a start on their comfort with investment risk. Once a risk tolerance score is determined, investors can select the appropriate asset allocation based on their individual or combined familial results. While you’re here, why don’t you determine a base-line risk tolerance by answering the following:
Grading Your Risk Tolerance:
Starting from the top down, assign the number of points from 5 to 1.
What is your current age?
Less Than 45 = 5 Points
45 to 55 = 4 Points
56 to 65 = 3 Points
66 to 75 = 2 Points
Older than 75 = 1 Point
Each question is graded the same, 5 points for the first answer, 4 points for the second answer, 3 points for the third, 2 points for the fourth, and 1 point for the last.
Write all your points down, then add them together.
An idea of your risk tolerance is estimated from the sum of your points as follows:
1-14 = Conservative
15-21 = Moderate
22-28 = Moderately Aggressive
29-35 = Aggressive
Remembering the asset allocations from above, you can select the corresponding allocation.
Inside those asset classes is an investment manager’s secret sauce, but any investor can achieve these general allocations via indexed ETFs.
One last point I want to present is the fact that yes, you can determine a proper asset allocation based on your personal risk tolerance; however, is that level of risk going to produce the returns necessary to meet your long-term goals? Sometimes investors must take more risk than they may be quantifiably comfortable with in order to achieve the desired outcome.
The Emergency Fund: Why, How Much, & Where
Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, determining the correct amount, picking a high-yield account, and saving for an Emergency Fund is critical in establishing a solid financial foundation for millennial investors.
Before you start investing, you still need to complete one other, vital, step; and that’s saving enough for a properly funded emergency fund. An emergency fund is a savings account dedicated to bailing you out when unforeseen financial troubles arise. This fund is for repairing your HVAC unit, fixing your car, unexpected medical bills, and loss of wages.
Your emergency fund shouldn’t be so small that you aren’t able to cover a financial crisis without going into debt; but not so large that you have too much capital allocated in cash.
General savings guidelines call for 3 months of expenses for two incomes, 6 months of expenses with one income- for both single and married investors. This is a baseline, but your Emergency Fund should be dictated by your individual circumstances. You and your financial planner should collaborate to determine the amount that is right for you. Or, you can head back over to our Personal Budget Template to calculate a personal number.
Once the proper amount is determined, your emergency fund should be moved into a high yield savings account. Most of us keep our savings at a big bank and receive terrible interest rates for parking our money there. While it may not seem like a lot of extra money, going from an account producing 0.01% interest vs. 2.0% interest just makes sense. Why not let your money earn the most it can for you?
For example, say you have $10,000 in your Emergency Fund:
Bank A Bank B
Interest Rate 0.01% 2.0%
Amount You Earn/Year $10 $200
Mistakenly, many believe that they do not have enough assets to worry about estate planning. With today’s $5.6 million exclusion per individual and simplified portability that raises a couple’s exclusion to $11.2 million, estate taxes may not be an overbearing concern. But there are many estate planning steps everyone with heirs and assets should take. A financial plan would be incomplete without a review of the basics of estate planning. As a fiduciary, your advisor should cover this important topic. Just be sure to work with a fee-only advisor to avoid being sold high commission and high expense insurance products you might not need under the guise of estate planning.
How Assets Transfer After Your Death
Transfer by Will
Assets that transfer by will are assets you specifically list in your will to any designated beneficiary. If you don’t have a will, the state you reside in has one for you. While the state's method of distributing your assets may not be what you would wish for and could lead to serious problems for your heirs, your assets will be distributed to someone.
Without a will an asset could be passed under state law to your heirs as an undivided interest in a home or other real estate. This presents a problem if the asset needs to be liquidated to evenly divide and title the property. Because all parties must agree to the terms of any sale and beneficiaries may have differing opinions as to the value, holding an undivided interest can make final disposition very difficult. Sometimes sentiment will stand in the way of liquidating the asset, causing friction among family members and leaving some susceptible to emotional blackmail or simply leaving all with a claim to property that in essence has no remainder value.
Another common mistake in drafting a will is to misunderstand how some assets transfer and the hierarchy of the transfer. If an asset transfers by contract, that is, if there is a named beneficiary of an IRA or insurance product, the contract takes precedent and that asset will not be available to transfer through your will.
It is inappropriate to transfer certain retirement plan assets through your will. IRA and 401k type assets lose their tax advantaged status and result in needless income tax leakage for your estate.
Items transferred through your will are also subject to the delays and costs of probate. Probate costs vary from state to state but it is the delay that is often the problem. If there is not enough liquidity in the estate, heirs could be hard pressed to carry the expenses of maintenance and taxes while the probate process proceeds.
Another drawback to transferring assets through your will is that wills are all a matter of public record and must be filed with the county where the decedent last lived. That means your estate and its’ disposition is not a private matter. Anyone who is curious can learn about matters that you may have preferred to be private.
Transfer by Contract
You can also transfer assets to your heirs via contract. Contracts are private agreements and thus can preserve privacy. Assets that transfer by contract also will avoid the delays of the probate process. For example, the beneficiary of a life insurance contract will receive any funds soon after the required paperwork is completed and processed. IRA and other retirement accounts may also have a named beneficiary. Once the death certificate is presented to the custodian the distribution of those assets will begin. For this reason, it is important that you keep the beneficiary designations on assets that transfer by contract up to date. You should review your beneficiary forms regularly and any time there is a life changing event.
A revocable living trust is another type of contract often used to transfer assets. Investment accounts, real estate, collectibles, and many other items can be owned by a revocable living trust. RLCs are a very popular alternative to wills. These trusts protect the privacy of your estate and your heirs and avoid the delays of probate. A common mistake in the use of a revocable living trust is forgetting to title assets in the trust name. Maybe you buy a vacation home, or you open a new investment account and forget to have it titled to the trust. You should regularly review your estate assets and be sure they are titled correctly.
If you do not want to go to the expense and trouble of setting up a revocable living trust there are other tolls you can use to transfer assets via contract rather than through your will.
An often-overlooked tool is called Transfer on Death (TOD). Many states have adopted laws that enable individuals to transfer assets by contract rather than by will, which greatly simplifies final distributions for heirs.
For investment accounts the TOD designation allows you to specify beneficiaries for each account you may have that is registered in your name. You may specify a different percentage ownership for each beneficiary. Upon your death the assets in the TOD account will transfer to the named beneficiaries without the delay of probate and separate from other items in your will. You can make changes to the beneficiaries and their percentage participation whenever you choose. There is usually no additional charge for having the TOD designation added to your account, but not all institutions may offer this type of account, so be sure to ask.
For banking accounts you should know about the Pay on Death designation which works in a similar fashion, and also avoids probate. Ask your banking institution if they offer this type of account.
Per Stirpes is a Latin term meaning "per branch". It indicates how property should be distributed in the event of a named beneficiary is deceased.
For example let's say you have a son and daughter who each have two children of their own. You have an IRA which you wish to leave to your children in equal shares. If you have indicated this on the IRA beneficiary form you may think all is well. However, suppose your daughter is traveling with you when you both die in an automobile accident. What will happen to the assets in the IRA?
Without the per stirpes indication the IRA will transfer Per Capita, meaning your son will inherit all the assets in the IRA, leaving your grandchildren from you daughter with no share. If, however, you included the per stirpes designation on the beneficiary form, your surviving son would inherit his half of the IRA, and your daughter’s heirs (the branch) would inherit the other half of the assets. This dramatic difference is due to those two small words - per stirpes.
Durable Power of Attorney
A Durable Power of Attorney is another estate planning must have. Many of us worry, with good reason, that we might one day become incapacitated and unable to attend to our own affairs. How can we be sure our bills are paid, our investments are managed, or our property sold if the need arises?
A power of attorney is a document that delegates legal authority to another person. You may be familiar with a limited non-durable power of attorney from attending a property closing when one of the parties is absent. The Power of Attorney allows the principal (person granting the Power of Attorney) to name an Attorney in fact (the person to whom the legal authority is being delegated) to sign documents to effect a property closing on their behalf.
Non-Durable Powers of Attorney can be granted for a wide variety of tasks, and they remain in effect until canceled by the Principal or until the Principal becomes incompetent or dies.
A durable Power of Attorney is often granted between spouses or between a parent and a trusted child or other relative. The durable Power of Attorney as the name implies enables the Agent to act on the Principals behalf even if the Principal becomes mentally or physically incompetent. This is an important distinction. Should the Principal become incompetent through disease such as Alzheimer's or as the result of an accident or illness, there is someone in place who can make legal decisions, access funds, and pay bills on behalf of the Principal. As with non-durable POAs a durable Power of Attorney ends when revoked by the Principal or when the Principal dies.
If you have not executed a Durable Power of Attorney and you become unable to handle your own affairs your family will probably have to go to court to have you declared incompetent - a very public airing of a very private matter. The court must then appoint someone, maybe not the person you would choose to handle your affairs. Sometimes a bond must be posted, an attorney or CPA hired to prepare detailed financial reports that must be filed with the court, and the court must give permission for certain transactions like the sale of real estate. All of this can be a long and expensive undertaking that can easily be avoided with proper planning.
Healthcare Power of Attorney
The healthcare power of attorney, sometimes called a healthcare proxy, is another estate planning necessity. It names an individual to make healthcare decisions on your behalf when you are incapable of making those decisions for yourself. Not to be confused with a healthcare directive, this document works much like a durable power of attorney except it is for medical care rather than financial assets. Usually it is granted to a spouse or close relative to grant them the authority to make healthcare decisions on your behalf.
While not a legal document a healthcare directive does inform your family of your wishes for end of life care. You should not subject your family to the agony of having to guess under what circumstances you would like medical care withheld. You should spell out the conditions under which you would like to not be revived or the treatments you would not want to be subjected to. If you do not want to be kept alive by feeding tubes or respirators at some point, you should spell out those circumstances and spare your family any potential guilt or heartache of having to make such hard decisions at what will be for them a very horrible time.
Letter of Instruction
Another non-legal document you should prepare is a simple letter telling your heirs who they should contact if you die and where they can find documents they will need as they close out your estate. Some of the items you should include are: