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2020 Personal Finance: A Year in Review
I think I can safely say that most of us are happy to see 2020 in our rearview mirror. Between the onset of Covid, a crashing economy that led to many people losing jobs, personal lives being turned upside down with kids taking classes from home, parents working from home, sports canceled, political/social upheaval, and the elimination or scaling down of many of the things that bring us joy (travel, eating out, being with friends, etc..) it will not go down as a fondly remembered time. But when things seem at their worst there is always an opportunity to reflect and learn lessons that can be valuable to us in the future and 2020 certainly provided us with many of those. As a financial planner, I would like to take this time to reflect back on the year and see what 2020 taught us about personal finance and what you can use moving forward. 1. Focus on financial fundamentals If you have read my previous posts you may know that I put a big emphasis on financial fundamentals. I like to think of your finances as a pyramid and each level of that pyramid represents a different area of your finances. The concept is that you can’t build a solid structure without having a strong base. In the case of your finances that base is the financial fundamentals which consist of your budget, debt management, and emergency savings. Unfortunately, this year saw a big spike in people losing jobs, being temporarily furloughed, seeing reduced hours, or taking a big income hit due to the Covid impact. Having strong financial fundamentals will help you stay afloat during hard times. Budget: If you are aware of where your money is being spent you are in a better position to react quickly and cut costs in certain areas helping you stretch your dollar during a period of reduced income. Debt management: The major drag with debt is that it comes with mandatory monthly payments. When your income takes a hit this means less income for living expenses because you are still having to make those fixed debt payments. I am not here to say all debt is bad and you should never have any. The key is to keep your debt manageable so that if you have reduced income you still have money left for living expenses. Emergency savings: This is having the 3-6 month of living expenses rule of thumb you always hear about. And you hear about it because it is a really good rule. This protects you from job loss or reduced income. Likely you will still cut back on certain expenses but you can use these savings to still pay for your necessities and not lose sleep at night about keeping a roof over head or food on the table. In general, having sound financial fundamentals keeps you in the position of saying “that sucks”, because you know you may have to cut back or cancel some plans in bad times instead of saying “oh sh*t, now what do I do?” That is not a position any of us want to be in. 2. Have a long term investment strategy While we have been living with some periodic volatile markets over recent history, 2020 presented with the biggest drop in the markets we have encountered since the financial crisis. Fortunately, this drop didn’t last very long and the markets came back with a vengeance and ended the year at all-time highs. For those of you looking at your investments for a long term goal like retirement, 2020 reinforced that the best thing to do is hang in there even when things get dicey and stick to your plan. The long term returns of the market have a very good track record. You might take a short term hit every now and then but over the long haul you will come out ahead. Those that stayed the course were rewarded with a tremendous rally and even a positive return on the year while those that panicked and sold likely missed out on a good portion of the recovery waiting for things to feel safe again. Now, I am not here to advocate that everyone should be all in no matter what. You need to have a portfolio that is constructed to contain the appropriate amount of risk for you and your circumstances. 3. Don’t try to time the market This one is closely related to the previous point. Financial planners give a lot of advice in a lot of different areas but we are pretty consistent with talking about long term investment strategies. We don’t recommend you check your 401k balance on a daily basis because the up and down swings will be too stressful for many people. The key is to make sure that over time you are making the progress you need to reach your goals. Many people though get caught up in the moment and either buy or sell their investments in an attempt to protect against further losses or take advantage of cheap asset prices. As a financial planner, I pay more attention to the workings of the economy and the markets than the average person but none of us know which day will see things turn a certain direction. That is why we advocate patience and to ride out the good and bad as history is your favor for good results. 2020 saw 8 of the 9 single biggest daily gains in the history of the Dow Jones and 8 of the 10 largest single day losses. In every one of these cases, the market moved at least 1,000 points to the good or bad. All but 2 of these 16 days occurred between February 24 and March 26th, a window of just 24 trading days. Had you lost hope after an almost 3,000 point loss on March 16th and gotten out of the market you would have missed out on the 1,050 point gain the following day. While that certainly didn’t get you back to even it was a 5% gain that you would have missed. If you could have guessed right on a daily basis over the course of that month you would have made a fortune but had you guessed wrong you would have lost one too. 4. Be flexible When I create a financial plan for a client that plan reflects data, analysis and recommendations for that specific moment in time. While the initial financial plan is an important document as it provides guidance it is just as important, if not more so, to provide ongoing analysis and recommendations as clients continue through their lives and deal with all the changes that occur as time passes by. The financial plan needs to be thought of as a living document that will change along with the changes in a client’s life. 2020 presented us with change on many fronts. Whether it was how we worked, how we schooled, ate, visited with family. You name it, life was different. Our finances were different too. As a result of Covid related restrictions and lockdowns, we didn’t have as many options for spending money. Instead, we were able to pivot and invest in our health with home gym equipment, make overdue home improvements or set aside money for other long term goals. People’s long term goals may also have changed as a result of what they lived through in 2020. Maybe you decided to live closer to family, came to the conclusion life is too short and want to retire earlier, travel more in the future, or deemed that some other goal is now more important. Your plan and goals are subject to change and that is okay. You just need to know it will have an impact and you will need to adjust accordingly. 5. Be opportunistic This goes hand in hand with being flexible. When hard times hit opportunities are often created. In February and March our markets were in free fall. To help prop up the economy the Fed lowered interest rates. This created multiple opportunities. With lower interest rates, it made financing a new home or refinancing an existing home more attractive. As people were looking to move out of urban areas and into suburbs it resulted in sharply rising home prices in the now in-demand suburban areas and falling prices where people were leaving. For those who have thought about downtown living, it created an opportunity to sell high and buy an urban home at a discounted price. Maybe you were thinking this was a move you would make five years from now but the opportunity was too good to pass up. With the markets dropping by thousands of points at a time it created an opportunity for those that stayed calm and had the strength to buy when things looked dire. They were rewarded with a massive rebound. I previously mentioned not trying to time the market. Being opportunistic is not about trying to find the date when those assets were at their cheapest, that is market timing. Being opportunistic is about identifying an asset you feel is undervalued and you are comfortable getting in at that price. The price may go down further from there and you are okay with knowing in the long run you made a good deal. While I don’t like to promote the purchase of individual stocks, companies like Microsoft, Google, Amazon and Apple which were well positioned to survive the pandemic and whose business wasn’t really hurt by it either saw their value drop by as much as 40%. By mid-June, some of these stocks were at new all-time highs. Those who had the foresight to invest in companies like Zoom, Peloton and other work from home/stay at home companies saw values go up by over 300% in the year. Again, this is not about waiting for Apple to drop 40% before your pounce. You might have looked at Apple dropping 25% and thinking to yourself this is a good price to buy this stock because I am sure it will bounce back. With many of our usual outlets for discretionary spending limited we were able to find other uses for that money. Whether it was shoring up emergency savings, paying down debt, propping up your kids' college fund, adding an extra percent or two to your 401k fund there was a way to make positive strides towards financial goals. I am not calling for taking advantage of other's misfortune here but simply being on the lookout for opportunities that arise when a situation results in either bargain priced assets or a chance for you to make bigger contributions to your own financial goals. 2020 sucked, but if we take the time to reflect we can learn some of our most valuable life lessons coming out of dark times including your financial life. Let’s hope 2021 provides a smoother ride. I’ll be okay taking a year off from learning hard lessons. The foregoing content reflects the opinions of 7th St. Financial, Inc. and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
What Rate of Return Should Your Portofilo Deliver?
As investors, many of us watch to see how the stock market is doing on some sort of regular basis. We have seen the big market collapses of the dot com bubble, financial crisis and more recently this spring due to Covid. We have seen massive market recoveries in recent history such as 2009 and this summer/fall as the economy tries to recover from Covid shutdowns. As financial advisors, we often speak to clients about their investments with projections in the 6-8% range. The truth is only three times since 1930 has the annual rate of return actually been in that range for a given year. A look at the chart below shows that actual returns tend to be much more volatile than that. So what should you be looking for as a proper rate of return for your portfolio? How many of you have heard someone you know saying they made a killing on a particular stock and found yourself feeling a little jealous that you weren’t in on that action as you can’t help but think this person just fast tracked their retirement by five years. This might make you think that if you’re not getting 35% plus in returns you’re missing out. The truth, as with most matters in personal finance, is that it depends on your situation. The ‘market’ may be up 15% in a given year and you may find yourself looking at your own returns and it is only up 10%. Should you be upset about this? Maybe, maybe not. If you are 26 and invested fully in a growth portfolio you may want to look at things. For the rest of us, remember to get that 15% return you would have to be 100% invested in that particular index. In this case, if we are talking about the S&P 500, you would need 100% of your investments in the IVV ETF (iShares Core S&P 500 fund) for example. Now don’t get me wrong. This is a good fund (or another S&P 500 index fund) and absolutely has a place as one of your core holdings, but I don’t think anyone would ever feel comfortable having every penny they have invested in a single fund even if that was a fairly diverse fund. The moment you add another fund into the mix you will get away from that specific 15% market return. Say you add an International fund as 20% of your portfolio and that space doesn’t perform as well this year and is only up 5%. Now your portfolio has an overall return of 13%. Again, should we be upset because our portfolio didn’t match ‘market’ returns? Now say we make 30% of your portfolio bond/fixed income holdings and they return just 3%. Now our overall portfolio return drops to 9.4%. We are nowhere close to the 15% ‘market’ return. Time to be upset yet? Before you react, take a look at the thought that went into creating your portfolio. First, was an analysis done to determine your risk tolerance? As an advisor, we should work with our clients to determine this so we know the mental comfort level you have to ride out the ups and downs of the market (again, see chart above). Was analysis done to determine your risk capacity? We need to understand how long to expose your investments to risk before you need the funds. The longer you can leave them invested the more risk you can take because you have time on your side for any losses to recover. But, if you need the funds in a few years then the mindset switches more to preservation than focused on growth. The combination of these two items will help determine the proper allocation of your portfolio and how much risk you can take on (i.e. stocks vs fixed income). You might match market returns but if you lose sleep every time the market goes down 1% in a day then being 100% invested in that index is probably not a good thing for you. Next, is your portfolio well diversified? In our example above we talked about having your entire portfolio in one S&P 500 index fund. Again, no one is going to advocate being all in on a single fund. We want to spread our investments around to different sectors and segments of the overall market. As a result, we add in some mid and small cap funds, throw in some International and Emerging Markets. Maybe you even dedicate a little chunk to a dedicated area (tech, healthcare, ESG, etc..). We do this to cover our bases. In our example, the S&P 500 was up 15% and International was only up 5%. But how would you have felt in 2016 when the S&P returned 9.5% but the small caps returned 18.2% and small value returned 24.6%? Bet you wished you would have been invested in something other than just large cap that year. Nobody really knows what exact date a particular segment of the market will take off or when it will cool down so by being in a little bit of everything at all times you are always participating in what is working, and on the flipside, what isn’t as hot. This works to smooth out the average portfolio return. The fact is that once you construct your portfolio to be diversified and have the proper allocation there is no way you can compare your rate of return to a single market index. You’re just not comparing apples to apples at that point. Instead, try thinking of your returns in a different way. Instead of comparing your rate of return to a certain benchmark try tracking the progress you are making towards your goals. As an advisor, I never work with a client and have a stated goal of returning 12% on investments. Instead, the goal the client might really care about is to retire at a certain age. When I meet with a client we review how we are tracking towards that goal, what possible challenges could prevent them from achieving that goal, and are there any changes we need to make to the plan. Over time we track the progress towards achieving this goal and make sure we are heading in the right direction and course correct if we are not. For example, if the client is at age 48 and we show a 70% chance of success in achieving that goal, assuming a 6% average return in a portfolio that is 60% equities and 40% fixed income, it would appear we have some work to do here to meet our goal. To increase our chance of success we may need to bump up the portion of the portfolio that is in equities to say 70% which will increase our chances of having higher overall returns. Maybe we can see if they can increase the amount they are saving for retirement. Maybe the answer is a combination of the two. There are a lot of different levers we can pull to get to that goal. The best solution will depend on what makes sense given the client's specific situation and comfort level. As time moves on, let’s say at age 58, they now are at a 97% chance of achieving their goal. Obviously, the client is in a very good position now and there is no reason to take unnecessary risks that might result in missing a goal we are so close to achieving. Here, we might be perfectly happy with that 6% return even if the market returns 20%. Why? Because the risk to get the extra return isn’t worth the downside of screwing up obtaining their goal. Sure, maybe we could have added an extra $50,000 in returns by having 75% of the portfolio in equities but if the market took a downturn that year we would have increased losses and now retirement at age 64 could be a challenge. The bottom line is there is no magic number you should be tracking against for your portfolio returns. Don’t worry about your brother, co-worker, or friends and what they are doing. As we mentioned earlier, they may mention a specific move they made that gets you doubting yourself but you don’t know how many times a similar move went against them or how they are tracking towards their long term goals. Your portfolio needs to do what you need it to do to meet your goals. There is an obvious emphasis on focusing on you here. If you are on track to achieve what you want to financially out of life that is all that really matters. You can go to bed and rest easy dreaming of the life you want. Thanks for reading and hopefully you found this informational. As always, I love to hear any thoughts or questions you might have. Please email and let me know what is on your mind.
It is October which means the beginning of the financial aid season for college bound students. The FAFSA, short for Free Application for Federal Student Aid is the first step in the process for financial aid. The FAFSA form became available for families to fill out on October 1 and must be filled out in order to be considered for financial aid. Each year the US Department of Education doles out almost $30 billion in grants and another $100 billion in loans. Here are 10 things you need to know about the FAFSA. 1. The goal of the FAFSA is to determine your EFC (Expected Family Contribution). The output of the FAFSA is your EFC which is the amount the US Dept. of Education calculates you should be able to contribute towards the cost of college for your family in the upcoming school year. This does not mean you have to pay that much towards the cost of college just that this will be the number used to determine your eligibility for various forms of need-based aid. Here is how it works. Say your EFC comes back at $30,000. This amount will be the same for each school. School one has a cost of attendance (COA) of $28,000. Since the formula indicates you should have the resources to pay the full amount and will not be a candidate for need based aid. But at school two, which has a COA of $55,000, you have a demonstrated need of $25,000 which leaves you as a candidate for need based aid. 2. The FAFSA information is shared with individual schools so they can prepare your financial award package. On the online FAFSA form, there is a section where you can provide the code of the various schools you want the FAFSA information to be sent. The Dept. of Education will share this data with those schools allowing them to prepare a financial award package specific for you. 3. The primary drivers of the EFC calculation are income and certain assets. Both the parents and the student’s data is taken into consideration. For most people, their income will the primary driver. Retirement funds and home equity are not considered which for most people are their two largest assets. Non-retirement investment accounts, vacation or rental properties, and the value of a business are considered though. In general, assets in the parent’s name are considered at a rate of 5.6% while those belonging to the student are considered at 20%. So the general rule of thumb is that an advantage to have assets in the parent’s name than the child’s. 4. In the case of divorced parents, the only parent who needs to report income and assets is the custodial parent. Even if the non-custodial parent provides more than 50% of the financial support and/or claims the child as a dependent for taxes, only the custodial parent needs to report data for the FAFSA. In addition, if the custodial parent has remarried, it is still only the custodial parent who needs to report data and not the step parent. 5. 529 plans are treated as an asset of whoever is listed as the account owner. In most cases, these belong to the parents and are assessed at the 5.6% rate. If a 529 plan is owned by a grandparent it is not counted as an asset on the FAFSA but once funds are taken out and used for the student then that will be treated as income for the student and will be assessed at 20%. 6. When filling out the FAFSA you will use the income reported on your prior, prior year tax return. This can be a bit confusing but here is how it works. If you are applying for financial aid for the 2021-22 school year you will use the data from your 2019 tax return so at the time the aid will be received it will be based on the prior, prior year. If you file the form this fall the 2019 return will be your most recent return. 7. During the process of filling out the online form you will have the option to use a data retrieval tool to get your IRS tax return information. This will greatly reduce the amount of time required to fill out the form. You can expect the process to take 1-2 hours depending upon the complexity of your information if you use data retrieval. 8. You may need to file a separate form depending upon the schools you are interested in applying to. FAFSA is widely used by most public schools but many private schools use a form called CSS that has a slightly different formula it uses and some of the assets that are not considered by FAFSA will be considered on the CSS. 9. You will need to refile the FAFSA every year you want financial aid. This is not something you do prior to your freshman year and have the totals carry over each subsequent year. Your financial details will vary year by year so might your ability to qualify for needs based aid. 10. Everyone should be urged to fill out the form regardless of whether you think you are a need based candidate or not. The FAFSA is the basis for determining other types of aid as well including some non-need based aid. For instance, to qualify for the Unsubsidized Federal Direct Loan you will need to have filled out the FAFSA and this is a loan that is available to everyone regardless of your financial situation. So even if you are sure you won’t get grants that is no reason to not fill out the form. If you are unsure of how to complete the form or have questions please reach out to info@7thstfinancial to get the guidance you need. Make sure you have the correct information so you are in position to get financial aid you have coming to you.
In my last entry, we began discussing the topic of portfolio risk management, specifically discussing portfolio allocation or the amount of risk within a portfolio. In this installment, we will continue the risk management discussion but the focus here will be on portfolio diversification. Many people are familiar with the term diversified portfolio but for those of you who aren’t it is basically the concept of spreading your investments around. For those of you who have been around long enough to remember the classic case is Enron, which was a huge and very successful energy company in the late 1990s and early 2000s. The problem with Enron was that they committed fraud with their accounting and the profits they were reporting were non-existent. The employees of Enron received their pension all in Enron stock so when the fraud was exposed, the company filed for bankruptcy and the stock went to zero. All of the employees lost their pension which was all tied to Enron stock. While Enron might be an extreme example, it certainly highlights the risk of having a concentrated position in any single asset. There is more to diversification though then just making sure you invest in more than one company. The goal of having a diversified portfolio is that no one event leaves you’re a major portion of your portfolio at risk. Now the truth is you can’t diversify away all risk. There are some things that happen that are on such a scale that they impact everything. The financial crisis is a prime example of this as it took down the value of every major asset class. Natural disasters, wars, and other acts of God are examples of other things where it is hard to diversify away risk. As an investor, you must understand that things change within the economy, world politics, consumer tastes, and technological advancements that can impact the fortunes of a company, an entire industry, or even a country. The key goal with diversification is to not have one of these changes put too much of your investment portfolio at risk. Below are the different ways you want to try and diversify your portfolio to help manage these risks as they occur. Security diversification This is basically the Enron scenario I laid out above. Any single company can experience a significant downturn due to poor management decisions, financial mismanagement, scandal, or one of the other reasons listed above. Blockbuster Video is another good example of this. We all used to go to Blockbuster to rent our videos but then along came a little upstart called Netflix which changed the way we consumed this content. Blockbuster failed to adjust to this new technology and consumer tastes and now has one remaining store while Netflix is worth over $200 billion. A study by the University of Michigan concluded that it takes 25-50 individual holdings to have a diversified portfolio. In addition to spreading out your investments between multiple companies the other rule is to try and not have any single holding be more than 5% of your total portfolio. This can be a challenge for those that work for a company where the 401k match is company stock, offer an employee stock purchase plan (ESPP) that allows workers to purchase the stock at a reduced price or receive company stock as part of their total compensation. In these cases check your company rules on when they allow you to sell the stock. These rules were put into place as a result of the Enron scandal. Be aware of how concentrated you are getting and do the best you can to keep this in check. Sector diversification The S&P 500 is made up of 11 unique sectors. Think of these as different areas of business. The five biggest sectors are Technology, Health Care, Consumer Discretionary, Communication Services, and Financials. Each sector contains companies that are related by the broad type of business they conduct. For instance, the Consumer Discretionary sector includes Amazon, Home Depot, McDonald’s, Nike, and Starbucks. These companies would most likely take a hit in a recession as people would likely look to spend less money on home improvement, eating out and new clothing but would tend to do well if the economy is going strong. Another sector such as Technology or Consumer Staples might still perform fine in a recession as they are less reliant on individuals having discretionary income. Industry diversification This is just a deeper dive into the sector diversification. Say for example you have investments in Facebook, Twitter, and Snap. These are all part of the much broader Technology sector but largely all play specifically in the social media space. The risk here is that something could come along that could change the outlook of all social media companies. For instance, in the past couple of years, Congress has had several issues with various social media companies. If they were to pass a law that hindered their business models the stock prices of all social media companies could take a hit. This new law though may not have any impact on other tech companies like Apple, Salesforce, Nvidia and Adobe that don’t have a social media component. Capitalization diversification Companies that you can invest in come in all sizes. While they are big enough companies to have issued stock and be listed on a public market they run a vast range in their market size (number of shares x stock price). Within the S&P 500 alone which is home to ‘large’ companies, Apple currently has a market cap of over $2 trillion while Macy’s comes in at roughly $1.5 billion which is less than 1% the size of Apple. Different forces can be beneficial or harmful to companies of different sizes. Coronavirus, which was generally hard on all companies has widely been viewed as being much harder on smaller companies in general than large companies. On the other hand, Congress could pass a tax law that could target large companies by having them pay a higher corporate tax rate. The market has classifications of mega cap, large cap, mid cap, and small cap. Spreading your investments out between the various market cap classifications is key to having a diversified portfolio. Geographic diversification This concept involves spreading your investments across different geographies around the world. Different countries will go through economic ups and downs at different times. The common geographic classifications are domestic, international, and emerging markets. In the early to mid-2000s the US stock market was returning an average of 14% from 2003-2007 but Emerging Markets returned an average of 37% over that same time. Spreading your investments around and not just being focused on US investments only would have let you participate in those explosive Emerging Markets returns. Now had you thought you needed to go all-in on this Emerging Markets trend you would have been rudely greeted with a 53% loss in 2008 which was the worst performing segment of that year. Investment style diversification Another way companies are classified is where they are in their lifecycle. The common designations here are growth and value. Growth companies (current examples include Amazon, Google and Facebook) tend to be earlier in the lifecycle and are experiencing rapid growth in sales and/or income. Value companies (think Coca Cola, McDonald's, and Verizon) tend to be more well established and with more stable revenue and income or can be companies that have experienced a downturn and whose stock can be purchased at a relative bargain. Growth companies have enjoyed superior investment performance since the mid-2010s, but in the early 2000s value stocks outperformed growth by a good margin. Bonds In the last post, I talked about how mixing in bonds or other fixed income assets help an advisor with portfolio allocation. Well, there is also diversification within fixed income investments. Fixed income assets come in different maturity lengths. Bonds or Treasury securities, for example, can range from 1 to 30 years before they mature. Longer term debt pays higher interest rates but is more vulnerable to changes in interest rates. Another way to diversify your fixed income holdings is by credit quality. Many fixed income instruments are debt that has been issued and you are receiving interest payments and then eventually your principal. The higher the credit quality of the debtor the lower interest rates you will receive. Lower quality debtors need to pay a higher rate of interest but are more susceptible to default if there is an economic downturn. Summary A well diversified portfolio will have a little bit of everything. This may keep the portfolio returns from achieving the peak numbers one could reach if they were in the hot segment of the moment but that would require being invested 100% in that segment of the market and we have just discussed the risks of doing that. This approach will tend to smooth out your returns as even if part of your portfolio is encountering issues you should have plenty of other areas doing just fine. Most of us achieve this diversification by investing in mutual funds or ETFs in our investment accounts. For example, an S&P 500 index fund alone will give you access to a pretty well diversified portfolio all by itself. This gives you access to a wide variety of companies, sectors, industries and many of these large companies have an international presence. In addition, most of us have access to an international fund in a 401k account to help get better access to non-US based companies. Some plans may have access to a total market fund which would have holdings in all categories. Diversification along with allocation goes a long way to managing the risks of your investment portfolio. Hopefully, you found this informative and helpful. If you are wondering if your investments are properly aligned to manage risk and would like help I would love to hear from you. Feel free to reach out to or schedule a conversation here.
Welcome to the latest blog from 7th Street Financial where I discuss various topics related to personal finance with the goal of providing insight you can use for yourself or at the very least get you thinking about certain topics and how they might impact you. In this first of two installments on the topic, I will discuss risk management within your investment portfolio. The two primary key concepts covered here will be Risk Tolerance and Risk Capacity. These two items combined help us determine the proper allocation of one’s portfolio. The second installment will cover the risk elements that drive to having proper diversification within the portfolio. One of the primary tenants of investing is risk vs. reward. In order for us to get larger returns on our investments we need to take larger risks. Historically, the larger share of your investments that are in equities the better your long term return. Equities though tend to be more risky than fixed income investments from the perspective that they are more prone to sharp declines. This risk of holding equities smooths out over the long term as short term ups and down tend to result in a long term upward trajectory. The following two charts show year by year returns for the S&P 500 which highlights that there is occasional downside risk while most years are positive and the second chart is the historical long term trend which reflects long term growth. Managing the risk of short term declines can be critical depending upon where you are at in your investing lifecycle. Many of us are at least somewhat familiar with the concept of Risk Tolerance which is basically a measure of how much risk are you comfortable having in your portfolio. As an advisor, I use a series of questions that I pose to clients to determine their appetite for incurring risk. These questions are geared to help an advisor understand how comfortable someone is with investments, their mindset with investing, and how you would react to several potential investment return scenarios. For example, a question might be “if the stock market is down 25%, what would you do?” and the options would be something like 1. Buy more; 2. Stay the course; 3. Sell some of the investments; 4. Sell all of the investments. The person who sees this as an opportunity to buy more is demonstrating a high risk tolerance where the person inclined to sell is not. This is something that needs be continually monitored. Life experiences and situations may change the way an investor feels about risk. It is one thing to answer a theoretical situation on paper but it is another to see you IRA drop by 30%. People have a tendency to be slightly more conservative in real life than on paper. The goal with this series of questions is to have the information needed to construct a portfolio for the investor that they can be comfortable with. One key to know as the investor is that the most important thing is to just be truthful in your responses. Advisors shouldn’t care if you profile out as more conservative or aggressive. There is no right or wrong on that scale. The advisor should just want to do what is right for you. If an advisor pressures you into a portfolio you are not comfortable with that is a warning sign you and the advisor are probably not a good fit. The last thing I want is for a client to be losing sleep at night because they can’t handle the ups and downs of a turbulent market. Risk tolerance is a measure of an investor’s ability psychological ability to handle risk. There are no neat categories that groups of people fit in. Younger investors can be just as conservative with risk as older investors and vice versa. In addition to Risk Tolerance, advisors also consider a lesser known concept known as Risk Capacity. This is a measure of the amount of risk an investor can take on to achieve their goals and may or may not line up with your Risk Tolerance. Also, you may have different Risk Capacities for different financial goals. The basic measurement of one’s Risk Capacity is time. The longer you have before you need the money for a given goal the higher your Risk Capacity is and as your time horizon shortens before you need money the lower your Risk Capacity becomes. For example, when you are age 30 and saving for retirement you have a very high Risk Capacity as you have potentially 30 plus years to grow your investments and plenty of time to ride out any ups and downs in your returns. Compare that to when you are three years away from retirement and you no longer have time to recover from a major market downturn which results in you having a very low Risk Capacity. As I stated earlier, you might have different Risk Capacities for different financial goals. I found myself in this position this past year. Take a couple who is 50 years old planning to retire at age 62 with a 16 year old child. Since they have 12 years to go to retirement they still have a fairy high risk capacity in terms of retirement but if they have been saving for their child to go to college they have a very low risk capacity for those funds as they would have almost no time to recover from a market downturn. As a result, I left my retirement funds alone but moved the funds in our 529 plan to a much more conservative investment in 2019 when we were two years out from needing the funds. At that point I was less concerned with trying to get substantial growth than protecting what we had already saved and was willing to take a much lower return in exchange. When Covid-19 hit my retirement funds certainly took a hit but they have time to recover but our 529 plan just took a minor dip which, thankfully, was not enough to alter our plans. Events like Covid-19, the Financial Crisis of 2008 are why we make these moves to get more conservative as our time horizon gets closer. Next, what do you do if your risk capacity and risk tolerance are at odds with each other? Take the situation I discussed above with our college savings. My risk tolerance is fairly high but our risk capacity was low due to our short time horizon. When it comes to risk management with your investments choose the more conservative option in a case like this so even though risk tolerance is high the low risk capacity wins out. The same holds true in the case of a low risk tolerance and high risk capacity. This might happen if there is a 30 year old who has decades to save for retirement but gets nervous when there is volatility in the market. Even though there is plenty of time to recover from any downturns I don’t want the client to be uncomfortable watching the daily ups and downs if that makes them uncomfortable. A slightly more conservative portfolio makes sense in this case. The combination of Risk Tolerance and Risk Capacity drives the proper allocation in an investor’s portfolio. You are probably familiar with people talking about a 70/30 or 60/40 mix or something similar. That is in reference to the allocation of equity versus fixed income holdings in a portfolio with a 70/30 meaning 70% of the portfolio is in equities and 30% in fixed income. The higher the equity holdings the riskier the portfolio. So, let’s put everything together and walk through a couple of examples. Say we have our 30 year old and their retirement savings. They have moderate risk tolerance and high rick capacity at this stage of their life which might put them in a 70/30 portfolio for now. As they get within 10 years of retirement they can start to gradually become more conservative. By the time they hit retirement a 50/50 portfolio may be appropriate. This is similar to the approach I took with the 529 plan I mentioned earlier. When our daughter was born the portfolio was nearly 100% equities. Since the entire life of the investment is only 18 years we moved through the stages much quicker. By age 10, the portfolio mix was closer to 70/30, by age 13 it was closer to 60/40 and at age 16 it was 40/60. Remember that as an investor there is no right or wrong answer for where you land on the spectrum. Over the long term a higher equity allocation historically has resulted in higher returns but that may not be worth the mental anxiety or the risk of short term downturns for you. If your allocation isn’t the same as your family, friends or that is okay. You need your portfolio to work for you and your goals which are unique to you. That wraps up this first installment on portfolio risk management. I hope you found this informative and maybe learned something you can use for yourself. Look for the next installment portfolio risk management where I will cover diversification. If you have any questions about where you should be from an allocation standpoint and if your portfolio is properly matched feel free to reach out to or visit our website at to schedule a no cost 30 minute discussion on your situation. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
Financial Planning 101 - Mega Backdoor Roth Conversions
Want to hear about a way to make the largest contribution to a Roth plan on an annual basis regardless of your income? Welcome to the latest in the Financial Planning 101 series where I cover various topics related to personal finance and try to educate you about how these items could be relevant to you. I have been focusing lately on all things Roth including the basics of Roth plans and the different types of Roth conversions. The last installment was on Backdoor Roth conversions. Today’s topic is the Mega Backdoor Roth Conversion. The Basics Most workplace retirement plans today are defined contribution plans. This means that the plan allows for certain contributions but has no guaranteed return or payout on the back end. In other words, the employee takes on the risk of return. Compare that to a defined benefit plan (think pension plan) where it is the payout that is guaranteed and the employer has to figure out how much to contribute to meet their obligation. Under a defined contribution plan there is a maximum of $57,000 that can be contributed to the plan during the year. This amount covers all contributions including the employee and employer contributions. Very few employees will ever hit this cap based on their normal contributions. Even someone making $300,000 may max out their 401k contributions of $26,000 (assuming age 50 or over), add in a 5% employee match of $15,000 and that still leaves $16,000 remaining before hitting that cap. Some plans allow for additional after-tax contributions to be made into the plan beyond the $26,000 maximum for 401k as long as you are under the overall $57,000 cap. And that is where the Mega Backdoor Roth comes into play. The Conversion These additional contributions aren’t part of a Roth even though they are after-tax contributions. Usually, these additional contributions will still be part of your 401k plan but will be segregated and identified as after-tax. To make the conversion you would select a rollover of just these after-tax funds directly to a Roth account. Ideally, you would do this on an annual basis if possible. To do this you would need a Roth account already established with an outside financial institution. Alternatively, you can wait until you leave the company and roll over the funds then. Tax Handling Unlike other Roth conversions where you recognize the amount being converted as income and have to pay income taxes on that amount, this type of conversion is handled much differently. Since the amount being converted is already after-tax contributions the amount being converted is not recognized as income and therefore no additional taxes are owed. Once the funds are in the Roth account they are treated the same as any other funds in a Roth. That means tax-free growth and tax-free distributions later on assuming you meet the criteria for qualified distributions. Since the contributions are made after-tax, they retain Roth like status even while not being in a Roth account. The earnings on these contributions are a different story though. The earnings will be treated like 401k earnings and will be taxed at the time of conversion. That is why ideally you can make the conversions prior to leaving the job so the contributions won’t have time to accumulate much in gains. Remember, that once the funds are converted to a Roth all gains are tax-free. The Benefits 1. Allows high income earners a chance to make Roth contributions despite being above the income limits. 2. Being able to make these after-tax contributions is preferable to investing funds in a taxable brokerage account. A taxable account has both after-tax contributions and the gains are taxed as well. With these after-tax contributions, the gains will be tax-free once in the Roth account. The Limitations Much like the traditional Backdoor Roth Conversion discussed in my previous post, there are some big caveats with this type of conversion that can make this a difficult option for many to participate in. 1. You need to have the financial means to make this high level of contributions. Before doing non-Roth after-tax contributions you would need to first max out your annual 401k contributions. I would also recommend making contributions to a traditional IRA or Roth IRA before choosing this option. It can be difficult for many people to have additional funds for retirement savings once they have maxed out these other accounts. 2. Your 401k plan must allow for these after-tax contributions to be made and not many plans do (43% according to a 2017 survey). This is the biggest impediment to most people being able to take advantage of this because without this provision in your workplace plan it is a deal breaker. To see if your plan allows these contributions you will need to look at the Summary Plan Description (SPD) for your employer’s plan. 3. To get the maximum benefit from this you will want to be able to make in-service distributions so that you can do the rollovers on whatever time schedule you please. Again, this is not an option that many plans offer and you will need to refer to your SPD to see what your plan allows. If in-service distributions are not offered in your plan then you can still do the conversion when you leave that employer. Conclusion The Mega Backdoor Roth Conversion is not something that many people can take advantage of, but for those that can, it can be another powerful tool in your financial planning toolkit. Max out your other retirement contributions first and if you have the remaining capacity to set aside retirement savings check with your employers SPD to see if they allow for extra after-tax contributions. That puts a wrap on my series on Roth related items. I hope you found this series informative as Roths are an under utilized yet extremely beneficial investing option for many people. The next installments will focus on other areas of investing. As always, if you have any questions about your finances and you want to understand if any given topic is appropriate for you please reach out to to have a free discussion regarding your situation. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
In my previous post, I wrote about Roth conversions. The focus there was on the traditional type of conversion where an investor moves funds from a traditional IRA to a Roth IRA. Today, I will discuss a different type of Roth conversion called the backdoor Roth conversion. The traditional Roth conversion is suitable and even advisable for a large number of people. The backdoor conversion serves a more narrow audience but can still be a very powerful tool for those in position to take advantage of it. If you try and google a backdoor Roth conversion you will find varying definitions and descriptions. Some will refer to the ‘backdoor’ component as simply converting traditional IRA funds to a Roth which is really just a straight forward Roth conversion that is available to everyone. The backdoor Roth conversion I will discuss here is a way for high income investors to bypass the income limits on making annual Roth conversions. In my post on Roth IRAs, we discussed the annual limit of contributions of $6,000 for people under age 50 as long as their income is under certain limits, currently $206,000 at the highest, depending upon tax filing status. So while traditional Roth conversions are usually made in bulk sums they don’t address the ability to make annual contributions to a Roth plan for high earners. That’s where the backdoor Roth conversion comes into play. Why would someone want to do this? While contributing to a Roth in high earning years may not seem to make much sense due to the high taxes you will have paid on the money contributed, think about what your other options are for investments. Assuming you have maxed out your 401k first, where else do you go? A Roth is a better option than a taxable account which has after tax contributions and capital gains taxes on the back end. I also prefer a Roth to any of the tax sheltered insurance related options such as forms of permanent life insurance and annuities. Here is how it works. Assume your family AGI puts you over the $206,000 threshold for being able to make contributions to a Roth plan. You probably also make too much to make a tax deductible contribution to a traditional IRA. But, you can always make a non-tax deductible to an IRA regardless of your income. So step one is to make that non-deductible IRA contribution. Note, this will be after tax money. Step two, convert this non-deductible IRA amount to your Roth account. So, what are the benefits? This allows a high earner to make annual Roth contributions. No tax owed on the conversion since it was taxed before entering the IRA. Enjoy tax free growth on the converted amount. Provides tax flexibility by allowing a high earner to have not just tax deferred income in retirement. Sounds great, let’s do it! To quote the great Lee Corso, “Not so fast my friend.” There are some major strings tied to the backdoor conversion you need to be aware of before trying one and they are significant. Annual limit on the contribution limit. IRA contributions are limited to $6,000 per year for people under age 50 and $7,000 for those 50 and above. So, for a high earner this can be a somewhat complicated process to go through for a $6,000 contribution. But, that tax free growth can be worth it. Pro-rata rule. This is the big one and can frankly make this a non-starter for some people. The pro-rata rule states that when making a Roth conversion you must make the conversion in the same ratio as what you have in pre-tax vs after-tax money in your IRA. For example, let’s say you have $54,000 in an IRA from a 401k rollover. You now have added you $6,000 after tax contribution and try to do a $6,000 Roth conversion. That leaves you with an IRA balance of $60,000 (90% of which is pre-tax and 10% after tax). The pro-rata rule prohibits you from cherry picking that specific after tax $6,000 for conversion. Instead, your $6,000 conversion is going to be made up of $5,400 pre-tax and just $600 of that after tax contribution. Since 10% of your IRA balance is made up of after tax contributions you are limited to 10% of the converted amount to be after tax. This can be a deal breaker for those that already have large established IRA balances as you will have to recognize the income and pay taxes on the non after tax amount and may only be able to convert a small potion of your after tax contribution. Taxes owed on gains. If there is a lag between the time the after tax contribution is made and the conversion takes place, the principal that was contributed may have gains associated with it. These gains will be considered ordinary income when converted along with their principal. So who should be trying to take advantage of the backdoor Roth conversion? This conversion makes sense for people meeting the following criteria: High income earners Maxed out their 401k and still have funds to invest No previous IRA balance The limitations due to the smaller amounts that are converted and the specific criteria needed to be met for the conversion to be beneficial make this an option that a limited number of people can take advantage of. While the backdoor conversion may not be quite as powerful a tool as traditional Roth conversions due to these limitations, it is still an option for high earners that allows access to annual Roth contributions they would otherwise be prohibited from making and there can be significant value in that. That wraps up our overview of backdoor Roth conversions. I hope you found this informative and helpful for your understanding of personal finances. As always, if you are wondering if this makes sense for you and your specific circumstances please reach out to me at or check out our website at and provide your contact information. Thank you for reading and I hope you check out our next topic which will be on one final type of Roth conversion, the Mega Backdoor Roth Conversion. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
In the previous post, I discussed the key facts you need to know about Roth investment accounts. In this installment, we’ll switch to discussing Roth conversions. Specifically, what they are, the benefits of doing one, and when they make sense to do. A Roth conversion is a great tool that savers have at their disposal to take advantage of different tax rates throughout their life. In the previous posts covering traditional IRAs and Roths, we specifically discussed the tax treatment of both contributions and withdrawals. Understanding this is critical to knowing why Roth conversions are a valuable option for you. First, let’s start with understanding what a Roth conversion is. A Roth conversion is the process of moving funds from a traditional IRA account into a Roth IRA and in the process recharacterizing the funds from a tax standpoint. To do this you need to have opened both a traditional IRA account that is funded and a Roth IRA account (this account does not have to be funded). As we learned about traditional IRA accounts, withdrawals are treated as taxable income, and the same applies when doing Roth conversions. Any amount that you convert from a traditional IRA to a Roth will be added to your taxable income for the year and be taxed at your marginal tax rate. For example, if a married couple with a taxable income of $100,000 does a Roth conversion in the amount of $25,000, their taxable income increases to $125,000. As this income is in the 22% range, they would owe $5,512 in income tax on the amount that was converted. So why would someone want to do this if you have to pay $5,500? The reason is that the $25,000 now in the Roth account will grow tax-free and won’t be taxed a t the time of withdrawal either (assuming rules are followed for qualified distributions). That can be a very compelling reason. This $25,000 growing at 6% over 20 years will grow to just over $80,000. This $80,000 is now tax-free for the couple when they need it in retirement. There are other advantages as well to doing Roth conversions: Reduces amount in IRA which in turn reduces future RMDs and the corresponding taxes Roth IRAs are not subject to RMDs so provide flexibility with an option for tax-free retirement income planning Roth IRAs provide a way to pass assets to your heirs without them owing taxes Provides a workaround for IRS income limits on being able to contribute to a Roth This chart below shows the financial benefit of doing a series of Roth conversions and how it shifts the balance over time from the IRA to Roth account and how that will reduce future RMDs and related tax liability. So why wouldn’t everyone do this? One, you need to pay those pesky taxes in the year of the conversion and you may not have the cash to do that. Second, it may not make financial sense, believe it or not, given your current circumstances. Ideally, you can take advantage of Roth reconversions when you are in periods of paying low tax rates. Let’s walk through a few scenarios using our same couple from before. 1. Let’s adjust the couple’s income to $50,000 which is in the middle of the 12% tax rate. Converting $25,000 still keeps them in the 12% tax bracket. Let’s assume they are both 35 years old and that as time goes on their income increases and prior to retirement their income grows to $200,000. Between what they were able to save and Social Security, their retirement income projects to be $175,000 which is in the 24% tax bracket. By doing a Roth conversion when they did they were able to pay 12% in taxes on the conversion to later avoid 24% on the withdrawals. That is a great scenario for doing a Roth conversion. 2. Now let’s assume our same couple is age 50 and are in their peak earning years. Their income has grown to a combined $350,000 which puts them in the 32% tax bracket. They now have an expected $225,000 retirement income. Doing a Roth conversion at this point and paying 32% on the conversion to avoid paying 24% later does not make much sense. 3. Our couple is now making $170,000 and expects to have $125,000 in retirement income. The $170,000 current income is in the 22% tax bracket as is $125,000 retirement income. But, the $25,000 Roth conversion is additional income which pushes their current income to $195,000 and the incremental $25,000 is almost all in the 24% tax bracket. In this case, they would pay the higher rate on almost the entire conversion amount. The basic premise boils down to taking advantage of lower tax rates now compared to projected future higher rates. The best way to do this is when you are in a lower tax paying year to try and fill up the lower tax bracket with Roth conversions. In our first scenario listed above, the couple has $100,000 of taxable income. The 22% bracket goes all the way up $171,500 in 2020 meaning if possible they could convert $71,500 and still be in the 22% tax bracket. Here is a list of times in life that a Roth conversion might make sense: Early retirement. Say you retire at age 60. You are not yet eligible for Social Security and do not have to start taking disbursements from your IRA/401k accounts. This can be a period of lower income and can be a perfect time for Roth conversions. Take a couple that retires at age 62 and is planning to live off money in their savings account and investments from a joint taxable account. The savings money can be used tax free and the taxable account will only result in income to the extent of the capital gains. Say this results in $25,000 in taxable income. That still leaves $55,000 of room to do Roth conversions and stay in the 12% tax bracket. Early career. When starting your career your salary tends to be lower than it will be later in your career and as a result likely puts you in a lower tax bracket. Economic hardship. This one can be tough because at a time when your income is lower due to a job loss or other economic conditions, volunteering to pay additional taxes for a Roth conversion may not seem like a smart thing to do. If other areas of your finances are intact though and you can ride out the temporary dip, the timing might be right. Expected tax increases. In 2018 Congress passed the law to reduce our tax rates. One thing many people may not know is these lower rates are set to expire after 2025. That means all rates across the board may go up at all income levels. Income is at the lower end of the tax bracket. This is especially important when there is a large increase in the rate of the next tax bracket. There isn’t a huge difference between $80,250 up to $326,600 which covers both the 22% and 24% tax brackets. Contrast that with $80,250 which is the tipping point between 12% and 22% brackets. Likewise $326,600 is the tipping point between the 24% and 32% brackets. If your income is at $200,000 you have $126,600 remaining in the 24% bracket to take advantage of conversions. Compare that to if your income is at $315,000 which only leaves $11,600 in the 24% bracket. Any conversion amount greater than $11,600 will be taxed at the much higher 32%. There is one important caveat to know with Roth conversions and it is called the 5 year rule. Any amount converted to a Roth must be in the Roth account for a period of five calendar years in order to avoid the early withdrawal penalty and have earnings taxed. Five calendar years only means that the funds have to be in the account covering five different years not five full years. For instance, a conversion made in December of 2020 covers all of 2020 meaning a withdrawal in January of 2024 counts as year 5. This holds true for each conversion performed. Once an individual turns 59 ½ the five year rule no longer applies. The Roth conversion can be a very powerful option in your financial planning toolkit. If used correctly you can pay a lower income tax rate on your contributions and get to take advantage of the huge benefit of tax free growth. You just need to know when to do the conversion so you can take advantage of the benefits it can provide. If you are interested in understanding if you are a good candidate for a Roth conversion drop us a line at firstname.lastname@example.org. I hope you found this helpful and informative. Look for the next post where I will continue discussing additional forms of Roth conversions, the backdoor Roth conversion, and the Mega backdoor Roth conversion.
Financial Planning 101 - What You Need to Know About Roth Accounts
It has been a while since my last blog post on traditional IRA accounts. There have been quite a few changes in the world since then and I have put a focus on trying to deal with issues related to COVID-19 and its fallout. As a result, the blog activity was put on the back burner. While COVID continues to dominate our national discussion and there is much uncertainty on how and when we can get back to a sense of normalcy, there are planning opportunities that have been created as a result, and those need to be discussed. One of the biggest financial planning opportunities that has been created is the increased potential benefit of Roth conversions. Before getting into conversions, though, let’s understand what a Roth account is first. To do that we’ll discuss how Roth accounts are different from other accounts and the pros/cons of this type of account. Remember that the 401k and IRA account contributions are pre-tax, meaning that the contributions are removed from your income before they figure out the income tax calculation. On the back end though all distributions, including both contributions and earnings, are all fully taxable. With a Roth plan it is just the opposite. Contributions are post-tax but all distributions, including both contributions and earnings, are tax-free. Here is an example of how this works using simple math (actual tax rates and amounts would be different due to tiered tax rates). Say your salary is $100,000 and you want to contribute 10% ($10,000 in this case) to a Roth and are in a 22% tax bracket. Your $100,000 is taxed at 22%, or $22,000, leaving you with an after tax amount of $78,000. The $10,000 Roth contribution then comes out of the $78,000 leaving you with a net of $68,000. In comparison, a 401k would take the $10,000 contribution from the $100,000 leaving $90,000 to be taxed. At 22% this would be $19,800 leaving a net of $70,200. So while the 401k might leave more money in your pocket right away the Roth makes up the difference when you withdraw the funds by not paying taxes at that time. Here’s how it works on the back end. Let’s say in retirement you withdraw $50,000 and are in the 12% tax bracket. If you withdraw the funds from an IRA or 401k you would have to pay 12% in taxes on that $50,000, leaving you with a net of $44,000. If instead the funds were a qualified withdrawal from a Roth IRA or Roth 401k the entire $50,000 would be tax-free leaving a net of $50,000. Qualified Distributions One key thing to note with Roth accounts is that your contributions can always be withdrawn tax-free as you have already paid income taxes on the money used for contributions, but the earnings need to meet certain criteria to be withdrawn tax-free. The Roth account must have been open for at least five years and the individual must be at least age 59 ½. There are exceptions to this which include distributions for the following: certain health insurance and medical expenses; higher education expenses, up to $10,000 towards a first home or to meet an IRS levy. Non-Qualified Distributions Any distributions not meeting the criteria listed above or for one of the exceptions incurs the same penalty as an early distribution from an IRA/401k which is a 10% penalty in addition to the distribution being considered taxable income. Important things to know If your employer offers a 401k plan with a Roth option you can split your contributions between the traditional 401k and the Roth however you choose. One thing to note is that your employer match will be placed in the traditional 401k account. So if you are looking for a specific split between the two types of accounts you will want to take the match into consideration as well. Contribution limits are the same with a Roth 401k as they are a traditional 401k, $19,500 for 2020 plus an additional $6,500 catch up if over the age of 50. This contribution limit can be split between the traditional and Roth accounts. They are also the same for a Roth IRA and a traditional IRA which is $6,000 plus an additional $1,000 if over age 50. There are income limits for being able to contribute to a Roth IRA account. Phaseout ranges are $0-$10,000 if married filing separately, $196,000-$206,000 if married filing jointly and $124,000-$139,000 for everyone else. There are no income limits for contributing to a Roth 401k. When does a Roth make sense compared to other investments? The decision to use a Roth account compared to a traditional IRA/401k account really comes down to current vs. future tax rates. Ideally what you want to do is use whatever type of account today that will help you avoid the higher tax rate you will experience in working years compared to retirement. If your income is lower, and are therefore in a lower tax bracket, it makes sense to pay the tax now on your income, invest in a Roth, and then enjoy the tax free growth. This is usually the case for people earlier in their career or maybe in a down economic cycle like we are in now. For example, a young worker is making $50,000 and is in a 15% tax bracket. They anticipate growth in their career and earnings, which should hopefully result in a nice sized nest egg for retirement. As a result of their various savings and income sources they may find themselves in a 24% tax bracket in retirement. In this case, it would be smart to be in a Roth, pay the 15% taxes now, and then enjoy tax free distributions that would avoid the 24%. Likewise, the traditional IRA/401k makes more sense when your income is higher. Someone in their peak earning years might be making $350,000 per year which puts them in a 32% tax bracket and upon retirement is anticipating $150,000 of income from various retirement sources which places them in the 22% bracket. In this case, it makes sense to avoid paying the 34% today and, instead pay the 22% in retirement. Finally, a Roth makes sense in general as a future tax rate hedge. While we don’t know what future rates will be we do know that the current tax rates which were introduced in 2016 are set to expire in 2026. Those expiring lower rates combined with a concern that our growing debt will require higher future tax rates might make all current tax rates attractive to what may await us in the future. This wraps up the basics of Roth accounts. I hope this helps explain the basics of the plan to you. If you have questions on whether a Roth is right for you reach out to us at email@example.com. I’ll try to get back on a regular schedule with the blog. Look for the next installment on Roth conversions. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
Financial Planning 101 - What You Need To Know About IRAs
Last post we talked about 401k plans. In this edition, we will focus on IRA (Individual Retirement Account) accounts which are the next most popular type of retirement account. There are over 36 million of these accounts in the U.S. according to the IRS containing $9.8 trillion which is nearly one-third of all retirement assets. For the most part, the key attributes of IRA accounts are very similar to 401k plans. I won’t get into the details of explaining again the various terms, for that you can refer to the previous post. There are some differences though and I will highlight both the key similarities and differences here. IRAs are typically funded in one of several ways. It can either be someone’s primary retirement savings account if they don’t have access to one from an employer, as a supplement to their 401k or as a result of a 401k rollover. Key Similarities · Like the 401k, the IRA is a retirement plan where people can contribute pre-tax dollars that grow tax-deferred. · Withdrawals before the age 59 ½ (with a few exceptions) incur a 10% penalty. · RMDs are mandatory starting at age 72. · All withdrawals are considered taxable income. · Both 401k and IRA accounts may have a Roth option. Key Differences · As the title states the IRA is an individual account. This is not an employer sponsored account. These are accounts you can open on your own at a brokerage firm like Schwab, Vanguard or Fidelity or with an advisor through their firm. · The contribution limits for an IRA are much lower than those for an IRA. For 2020 the contribution limit is $6,000 and the catch-up amount is an additional $1,000 compared to the $19,500 and $6,500 for the 401k. · The $6,000 contribution limit is tied to that amount or your earned income whichever is less. · Unlike a 401k there are income limits for being able to make tax deductible contributions to an IRA. For those who are participating in a workplace retirement plan the ability to deduct your contributions phase out between $104,000 and $124,000 for those filing taxes as married joint. The phase-out is 0-$10,000 for those filing married separately. For those individuals who are don’t have access to a workplace plan but are married to someone who does, the phase out is $196,000 - $206,000. If neither spouse has access to a workplace plan then there is no income limit. · Since an IRA is not an employer plan the contributions do not come directly from your paycheck and do not need to be consistent. Contributions can be made periodically or even in one lump sum. · Contributions can be made by April 15th of the following year and still be used a deduction for income tax purposes for the previous year. · For a traditional IRA account there is no employer match since, again, it is an individual account. This combined with the lower contribution limits can make it difficult to accumulate a larger balance as quickly as one can with a 401k. · There are no vesting timetables for IRA accounts. Since all of the contributions came from you all of the funds are yours immediately. · One major upside for an IRA is the amount of investment options that are available. Whereas a 401k has a limited number of mutual funds to select from, an IRA can have an almost unlimited number of investment options. Almost any investment option that is available through your custodian are fair game in an IRA. This includes a choice of thousands of mutual funds, ETFs and individual stocks and bonds. Rollover of 401k to IRA When workers leave their job they have several options on what they can do with their 401k plans. 1. Choose to leave it with your former employer 2. Cash it out – If you select this option be aware that the entire amount will be taxable income to you and if you are under age 59 ½ there will be an additional 10% penalty. 3. Roll it over to an IRA. The best way to do this is via a direct rollover. This is where the funds from your 401k plan are sent directly to your new IRA custodian. This way you avoid the rollover being considered a withdrawal and subject to income taxes and penalties. If the funds are sent to the account holder there is a 60-day window to forward on to the new custodian to avoid taxes and penalties. Otherwise, the entire transfer amount will be considered the same as a cash-out. Changes with SECURE Act Right before the end of 2019 Congress passed and the President signed into law the SECURE Act which contains some rule changes to how these plans are used. Here is a summary of the key updates: · The age cap for contributions was previously 70 and is now unlimited as long as there is earned income · The previous age for beginning to take RMD from the account was 70 ½, it is now 72 That completes our overview of IRA accounts. If you are one of the 36 million IRA account holders in the United States I hope this helps explain the basics of the plan to you. If you have any additional questions you can request a copy of your plan’s SPD (summary plan description) from your employer which will have all of the rules for your specific plan. As always, if you have any questions regarding this topic or anything else with your personal finances please let us know at firstname.lastname@example.org. Look for the next blog post in the coming weeks on Roth accounts. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
Financial Planning 101 - What you need to know about 401k plans
Probably the most popular type of investment account in the United States today is the 401k account. According to a 2019 document from the American Benefits Council there are 100 million 401k accounts in the United States holding over $6 trillion. That is almost one account for every two people over the age of 18. What exactly is a 401k account? It is an employer sponsored retirement account that allows you to contribute pre-tax dollars into an investment account. In many cases the employer will contribute funds into the account as well. The funds in the account will continue to grow tax deferred until the funds are withdrawn. At the time of withdrawl the funds are treated as taxable income. Most people are aware of these basic facts so let’s dig a little more into the details of the plan. Contributions As stated above, the employee makes pre-tax contributions into the account. The annual limit for contributions an employee can make in a year is $19,500. If you are age 50 or older you can make catch up contributions up to an additional $6,500 for a total of $26,000. In most 401k plans you can choose to make these contributions as either a percentage of your income or a flat dollar amount. What does pre-tax mean? Pre-tax contributions means that the income you direct into the 401k plan avoids income tax. For example, if you have a salary of $50,000 and you contribute 10%, or $5000, your state and federal income tax is based on the remaining $45,000 of salary. Income used for 401k contributions are still subject to Social Security and Medicare taxes though. Tax deferred growth Different types of investment accounts have different tax treatments. The 401k, as we’ve mentioned is funded with pre-tax income. The other key tax treatment is tax deferred growth. This means that during the time assets are accumulating in the account that individual assets within the account can be bought and sold and there is no tax on the gains realized for any of those transactions. There is no tax due at all until funds are withdrawn. Employer match While the whole tax deferral and pre-tax contribution things are great, the employer match is the truly powerful component of the 401k plan. Depending upon how the plan is structured the employer typically will contribute a certain percentage of your income to the plan depending upon how much you contribute. Typical plans will have rules such as the employer contributing .5% for every 1% you contribute up to 6% or a dollar for dollar match on the first 4% or something to that effect. That is a 50 or 100% immediate return on the amounts you are putting into the plan. That is the best return you will find and contributing at least to the point where you get the full match is considered one of the bigger no brainers in personal finance. Each plan may have slightly different matching rules so refer to your Summary Plan Description (SPD) to get the details on your plan. Vesting Vesting is the concept of obtaining rights to the funds within a 401k over time. Funds that you contribute from your paycheck into the plan are 100% vested immediately as that is your money. Matching funds contributed from the employer are a different story though. Many plans will have a defined schedule, for example 25% each year so that after four years you are fully vested. Again, look to your SPD for the specifics on your plan’s vesting information. Withdrawls Since the 401k is a retirement account there are rules around when and how you can take money out. Withdrawls can begin at age 59 ½ penalty free (there are a few exceptions where you can take penalty free withdrawls earlier). Remember the funds in these accounts have never been taxed so the entire amount you withdraw is considered taxable income for federal and state income tax purposes. And while most of us are aware about the penalty for early withdrawls there is also a provision on the backend dictating when you have to start taking money out of the 401k. Why? Again, the government has never received tax revenue from any of the money in this account and they want to begin getting their share. This concept is known as Required Minimum Distribution (RMD). At the age of 72 you have to begin taking withdrawls from the account based on an IRS life expectancy table. If you are over age 59 ½ you can begin withdrawing funds from a 401k plan penalty free from a previous employers plan. You will have to refer to your SPD about making withdrawls from your current employers plan if over age 59 ½. Investments A typical 401k plan has a limited number of investment options but most will include a fund choice from each of the following categories: domestic stock fund, international stock fund, bond fund, money market fund and target date options. This will allow you to build a basic diversified portfolio at a minimum. Many funds are now setup to automatically enroll people in the appropriate target date fund as a default option. Costs Many people don’t consider the costs involved in a 401k plan but they do exist. Each fund that you invest in within the 401k plan has what’s called an expense ratio. This is shown as a percentage and that percentage is charged based on the amount you have invested in that particular fund. These fees can range from 2% to almost zero. Be aware of funds with high fees. Anything over 1% can be deemed high given the amount of low cost funds that are available. The second cost is the one paid to the company who is managing the 401k plan on behalf of the employer. This should be a very low fee but can vary based on the size of the plan and the level of provider the employer can afford. Similar Plans The 401k is the most popular of these type of workplace plans but there are others that function in the same way. A 403b plan is very similar but is used by people in the education and medical fields. A 457b plan is similar and is used by state and local government employees as well as some medical professionals. Changes with SECURE Act Right before the end of 2019 Congress passed and the President signed into law the SECURE Act which contains some rule changes to how these plans are used. Here is a summary of the key updates: · The cap on the percent an employee can contribute thru automatic annual increases from 10 to 15% · Part time employees that have worked at least 1000 hours or 500 hours for at least three years are now eligible to participate in the plan. · The previous age for beginning to take RMD from the account was 70 ½, it is now 72 That completes our overview of 401k plans. If you are one of the 100 million 401k account holders in the United States I hope this helps explain the basics of the plan to you. If you have any additional questions you can request a copy of your plan’s SPD from your employer which will have all of the rules for your specific plan. As always, if you have any questions regarding your personal finances please let us know at email@example.com. Look for the next blog post in the coming weeks on IRA plans. 7th St. Financial Inc. (“7th St. Financial”) is a registered investment adviser offering advisory services in the State of Minnesota and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by 7th St. Financial in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
In my last installment I started getting into the details of investment vehicles with a focus on stocks. With this installment the focus shifts to bonds and the fixed income category. When constructing a portfolio it is best to have a mix of different asset classes including bonds so it is important to understand what value they provide to your overall investment mix. When an entity needs extra money they have a few options: they can sell stock, borrow money from a bank or sell debt to the public. Bonds are what corporations and governments use to sell debt to the public. Bonds are issued for a specific period of time with a stated interest rate paid to the purchaser. Bonds are usually sold in $1000 face amounts with interest paid semi-annually and then the face amount is repaid when the bond matures. There are three primary types of bonds. The most common are those issued by the U.S. government. These bonds are sold by the government primarily to fund budget deficits. As you see news stories about annual deficits or the mounting government debt this has been funded by the selling of bonds. The government then is responsible for paying the interest to the bondholders. U.S. government bonds are considered the safest investment available because they are backed by the full faith and credit of the government. In theory there is no risk of these bonds not being paid because the government can always print more money. These bonds are available in a variety of term lengths from 1 month to 30 years. The second type of bond is also issued by government entities but instead of the federal government these are issued by state and local governments and are better known as municipal bonds. These are often issued to fund items such as schools, infrastructure or other special projects. The final type of commonly issued bond are those issued by corporations. Companies may issue bonds because they want to raise money but don’t want to dilute equity. Pricing of a bond Bonds can be purchased on an individual basis or a mix of bonds may be purchased together within an ETF or mutual fund. Since mutual funds and ETFs hold a mix of bonds their pricing is completely different than individual bonds. As stated earlier, individual bonds have a face value of $1000 but are rarely sold at this price once issued. The reason for this is because interest rates change over time and that changes the value of the bond. Think about a bond selling for $1000 when it is issued and paying 6% interest. This would provide the bondholder with $60 interest per year. But if interest rates go down to 5% and new bonds are paying $50 per year to the bondholder a bond paying $60 per year becomes more valuable. A bond paying 6% at that point is worth $1200 as at that price a new bondholder would still be receiving a 5% interest payment. On the flip side if the interest rates go up to 7% and a new bondholder would be in line to receive $70 of interest per year from new bond why would they pay $1000 for a bond paying $60 per year? They wouldn’t and the 6% bond would then sell at a discount. To still get a 7% return on the $60 interest the 6% bond would have to sell for about $850. What this shows is that as interest rates go up the price for existing bonds goes down and as interest rates go down the price for existing bonds goes up. This is only a factor if a bond is sold on the secondary market. If you hold a bond until maturity the interest rate fluctuations are irrelevant and you would get your $1000 back. Prices for bond mutual funds or ETFs has nothing to do with the $1000 face value. Instead they package a group of different bonds and sell slices for something that is more reflective of an individual stock price or mutual fund. What determines the interest rate? Like with any investment the rate of return is going to be driven by the risk of that investment. If you hold a bond to maturity the primary risk is that the entity issuing the debt will not be able to repay the principal or make the ongoing interest payments. As stated previously the US Treasury bonds are considered a risk free investment so in turn they have lower interest rates. There are rating agencies like Fitch, Moody’s and Standard & Poor’s who assess the ability of the bond issuer to repay the debt. The higher rating the entity gets the less risk there is determined to be with their ability to make payments which leads to lower interest rates. Entities that are deemed more risky have to pay a higher interest rate to make the investment worthwhile since there is a greater likelihood of them defaulting. This is really no different than an individual having to pay higher interest rates on a loan because they have a lower credit score. Another risk with bonds is interest rate risk. This is the risk that as time goes by interest rates will change and you may be left with an investment that is paying less than current market rates. The longer the maturity of the bond the more risk there is of interest rate changes during the life of the bond and therefore they will tend to pay a higher interest rate. Why hold bonds in your portfolio As discussed in the previous installment, stocks are known for their volatility and historically produce high returns which comes with a higher amount of risk. Bonds historically are a much more conservative investment asset. The returns tend to be much lower but this comes with much less risk. That’s not to say bonds aren’t subject to loss. As noted earlier if interest rates go up sharply an individual bond may lose a lot of its value. But, if like most investors, you are purchasing a bond fund that risk tends to go way down. Over the last ten years the largest bond fund, Vanguard Total Bond Market Index (VBMFX), has lost money in just two of those years and the worst single year performance was -2.26% while the best year has so far been 2019 which has seen a 7.61% gain. Note that over ten years the entire range of returns is right about 10%. On the other hand, the largest stock fund, Vanguard 500 Index (VFIAX), has had its worst year of -4.43% and a best year of 32.33% for a total range of return of 36%. This has been during a historically strong stock market period. In 2008 the VFIAX was down 37% while our bond returned 5.05%. Having bonds in your portfolio provides diversification in your overall holdings. One way to achieve diversification is by having multiple asset classes in your portfolio. This helps smooth things out in your portfolio so if one asset class, say stocks, goes down sharply your entire portfolio isn’t at risk as illustrated in the paragraph above. In addition, bonds produce income. Earlier I mentioned that bonds pay interest twice per year. This interest income can be helpful especially in retirement as it is steady and reliable even if the price of the bond itself is fluctuating. Combining this interest income along with Social Security and dividends from stocks can help inflate your income and help you not have to draw down as much of your retirement assets. When you are younger, this interest can be reinvested to help purchase additional bonds and grow the overall portfolio. Downside of Bonds The main downside to bonds is the smaller rate of return when compared to stocks historically. That said, you shouldn’t be buying bonds with the thought they will give you the best return. Over the long run stocks will provide the best return but in a short term scenario bonds may do better if it is a volatile stock market. One other downside is related to the interest income I mentioned earlier. While it is nice to get the income from bonds, this income is taxed as regular income. Dividends from stocks on the other hand are usually taxed at the same rate as long term capital gains or 15% for most tax payers. Depending on what your income is level bond interest can end up being taxed at a much higher rate. While bonds are generally thought of as being a safer investment than stocks, that really depends on who is issuing the bond. As mentioned earlier, bonds from the US Government are considered risk free but depending on the financial health of a particular company or other government entity there can absolutely be risk that that entity may not be able to pay back the bonds or make the interest payments. Again, bonds are rated so something in the AAA or AA class is very safe. When getting down to the BBB rated bonds you should be aware of the increased risk. This risk should come with a greater interest payout buy but a greater chance the issue could default. How to purchase bonds Very few regular investors go out and purchase individual bonds. Instead most people buy bonds through a mutual fund or ETF. These larger holdings will put together a mix of bonds and you are just buying a small piece of whatever is in the fund. This gives you access to bonds from different issuers, bond durations and interest rates. Examples of the most popular bond funds are Vanguard Total Bond Market (VBMFX), Vanguard Total International Bond Fund (VTABX) and PIMCO Income Fund (PONAX). These and similar bond funds are available in your IRA, 401k plan or your brokerage account. Individual bonds are available via a brokerage such as Vanguard, Fidelity, Schwab or TD Ameritrade. What types of accounts should you use for holding bonds? So you want to go ahead and make bonds a part of your portfolio. Great. But where is the best place to hold them? Bonds can be placed in any of three main types of accounts, 401k/IRA, Roth and taxable brokerage account. That said, in my opinion, bonds make the most sense in a 401k plan or a Traditional IRA. This is because the interest income being generated while the account is growing before retirement isn’t taxed and instead is used to purchase additional bonds. A Roth account on the other hand has its assets grow tax free so it makes sense to put more aggressive assets in that type of account so you can take advantage of tax free growth. In a taxable account, it depends on the type of bond holding. Since interest income is taxed as regular income on bonds in this type of account that is makes holding bonds in a taxable account much less appealing. But, if you hold onto municipal bonds, which are tax free, then they can be a great fit and provide tax free income from a taxable account. Summary Bonds are a great way to add diversification to your portfolio and smooth out some of the risk you take on from the stock market. Just don’t expect the same type of returns you get from stocks and understand this may cause your portfolio to have an overall return of less than “the market” for a given period of time. That’s okay. Remember, you are not always trying to maximize every dollar of return. Instead, your focus should be on having your portfolio do what it needs to do for you and your individual situation. As with other parts of your portfolio look for diversification within your bond holdings by buying bond funds containing different maturities. If you have any questions about how bonds fit into your portfolio please contact a financial advisor. We would love to hear from you at 7th Street Financial. Until next time, I hope you enjoyed the read and learned a little something you can use in your own life. All written content on this site is for information purposes only. Opinions expressed herein are solely those of 7th St. Financial, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful. #personalfinance #investments #financialplanning #bonds