Understanding Retirement Account Distribution Rules

When it’s time to take a distribution from your employer-sponsored retirement plan, you have several options.

1. Leave the money in the plan. Depending on your employer’s retirement plan rules, you may be able to leave your savings in your employer’s plan until you reach age 70 1/2 or retire. Why choose this option? This makes sense if you have other sources of retirement income such as a taxable account or a working spouse, and you want to continue to obtain tax-deferred compounding interest on your investments.

2. Move your money to another tax-qualified retirement account. You can roll the money in your employer-sponsored retirement plan over to another retirement account, such as an IRA. This can be done as a direct rollover or by taking a cash distribution and depositing it in another tax-qualified retirement plan within 60 days. Why choose this option? This route works well if you have other sources of retirement income and want to continue to obtain tax-deferred compounding interest on your investments, but you are seeking more varied investment options.

3. Take a distribution. You can also receive a lump-sum payment or take distributions in installments. Why choose this option? You may simply want your money, or you may want to invest it in a taxable account. Remember, however, that you will have to pay income taxes on the money withdrawn, and if you are under age 59 1/2, you will have to pay an additional 10 percent penalty.

Whatever you choose, the tax regulations around distributions of retirement accounts are complex, so it is best to consult a financial professional.

Retirement Spending and the 4 Percent Rule

The 4 percent rule, which is used to determine how much you should withdraw from your retirement account each year so you don’t outlive your savings, is much loved by some and much hated by others. How effective is it, really?

How it works is simple but often misunderstood. You don’t withdraw 4 percent of your retirement savings each year in retirement; you withdraw 4 percent in the first year of retirement. In subsequent years, you increase the value of your annual withdrawal by the inflation rate.

So, as an example, if you have $2 million in retirement savings, you would withdraw $80,000 in the first year (4 percent of $2 million). Then, in the second year, when the inflation rate is 2 percent, you would withdraw $81,600 (the original $80,000 plus 2 percent).

But the 4 percent rule is more of a guideline than an absolute. The rule is intended to provide a schedule of withdrawals that will ensure that your retirement savings will last at least 30 years. When William Bengen developed it in the 1990s, that seemed to be the case. But some financial planners now argue that the 4 percent rule might not provide the same margin of safety as it did in the past, since stock returns and bond yields have declined since the 1990s.

The fact is, it has always been impossible to know with absolute certainty that the 4 percent rule will prevent you from outliving your retirement savings. Even the most careful planning cannot account for every scenario and surprise.

So how do you choose a withdrawal rate? It may be more art than science. Start with the 4 percent rule; but if you seem to be running through your savings too quickly, withdraw less. If you seem to have some wiggle room, withdraw more. Continue to monitor your investments and make adjustments as needed.

It’s certainly a conversation worth having with a financial professional who knows your individual financial circumstances and goals. This expert can help you fine-tune your retirement withdrawals to achieve a healthy balance between spending and saving.

Revisiting Yield in a Rising Rate Environment

Interest rates are rising, but rates are still relatively low, and many investors are looking for conservative investments – such as bond funds – that will generate a suitable level of income.

How can you find one?

The U.S. Federal Reserve raised the federal funds rate target in June for the second time this year and the seventh time since the end of the financial crisis. The last time the rate topped its current level – 2% – was late in the summer of 2008, when the Fed was cutting rates. They would remain near 0% for years.

But that’s still low. The federal funds rate topped 20% in 1981 and was around 5% leading up to the financial crisis. So if you are looking for a bond fund that will generate a suitable level of income, you may want to look at one of two commonly quoted yield figures.

The first, dividend rate (also called distribution yield), indicates what a bond fund pays in distributions. The figure is typically calculated by taking a bond fund’s income in the most recent month, multiplying by 12, and dividing by a recent fund share price.

Because that number assumes that a fund’s distributions remain constant for a year, which may not be the case, you may want to consider SEC yield.

This seeks to accurately reflect a bond fund’s income-producing potential over time by looking at the “yield to worst” of all the individual holdings in the fund’s portfolio.

Both figures provide useful information, but which is a better indicator of a fund’s actual yield depends.

SEC yield takes into account the eventual decline of a higher-trading bond. However, it includes some worst-case assumptions, so some investors prefer dividend rate.

Which figures you rely on can depend on personal preference and your individual portfolio. A financial professional can help you understand what kind of yield you should look at and help you accurately compare and contrast the figures.

529 Plans: How to Leverage Them to Your Advantage

529 savings plans offer a compelling means of tax-advantaged savings – but are they right for you? Named after a section of the U.S. tax code, 529 plans allow you to save money before it is taxed, with earnings that are also free from taxes.

What’s the catch? The money you save must be used to pay for qualified educational expenses, which include tuition and room and board at an accredited educational institution (and supplies and approved equipment the student needs in order to study at the college).

That may be compelling, given that the average annual cost of college tuition, fees, and room and board for the 2017-2018 school year was $20,770 for a four-year in-state public college and $46,950 for a four-year private college, according to the College Board Advocacy and Policy Center.

Typically, a parent or grandparent will open a 529 account and name a child or grandchild as the beneficiary. Unlike a custodial account, which eventually transfers ownership to the child, a 529 plan gives the account owner (not the child) control.

The IRS doesn’t specify annual contribution limits to 529 plans, but the annual gift-tax exclusion applies. In 2018, up to $15,000 gifted per person qualifies for the tax exclusion. So if you and your spouse have two grandchildren, you can gift a total of $60,000 without tax consequences.

If this piques your interest in 529 plans, ask a financial professional about these options. He or she can guide you through your state-specific 529 plans and help you set up a winning strategy to cover future education costs.

The Emergence of Emerging Markets

Given their potential volatility, emerging markets aren’t for fainthearted investors, and many people avoid them. But emerging markets aren’t the vast unknown they used to be.

What are they? Emerging markets are countries that are still developing, usually by means of rapid industrialization. It may surprise you to hear that some economic powerhouses – such as China – fall into this category. Others, such as Thailand and Indonesia, are less surprising.

The primary reasons to consider emerging markets are diversification and growth potential. Emerging-market stocks may perform well when developed-market stocks are performing poorly. And in some cases, emerging markets offer unique growth opportunities. For example, China is transitioning from an industrial economy into a digitally led economy, with a high number of graduates in technology fields, significant venture-capital funding, and tax credits that support innovation.

Of course, emerging markets aren’t for everyone. The main risk is volatility. Any political- or currency-related crisis in an emerging market could devastate its stocks. Another concern is the potential impact of US interest-rate hikes, which can lead to a stronger US dollar. In such an environment, conventional wisdom holds: emerging markets underperform. Others point out that emerging markets have outperformed developed markets during most rate-tightening cycles since 1969, with exceptions occurring only when the rate increases came sooner than the market anticipated or were stronger than the market anticipated.

That said, a bout of volatility in the first quarter of 2018 stress-tested emerging markets, and they held up fairly well, as evidenced by flows. In other words, investors kept investing.

If you would like to discover the potential for portfolio diversification and growth through emerging markets, schedule a conversation with your financial professional. He or she can point you in the right direction based on your individual financial circumstances and goals.

Five Healthy Finance Habits to Fortify Your Future

Financial advice is often directed at the very young or very old: spend less than you earn every month, and don’t put too much of your retirement savings in stocks as your retirement progresses. But what about the rest of us – those of us in our working years who are approaching retirement? Here are five tips to keep us on track.

Track your income and expenses. Do it while you’re working. Do it in retirement. Knowing what you earn and what you spend is the key to financial freedom.

Save part of your income every month. In your working years, save for retirement. In your retirement, save for a rainy day. Take advantage of automatic paycheck deductions, if they’re available.

Take advantage of your employer’s tax-savings plans. If you have a 401(k) plan, a pretax transportation plan, or a health savings account, use them. Every little bit of tax savings helps.

Be diligent. Open bills when you get them. Review your bank and credit card statements for errors. Pay your bills on time (and online when possible; it can help keep you on track). Pay attention to interest rates on mortgages and other loans. Plan your dinner menus in advance, and shop accordingly. Read all contracts before signing.

Don’t overspend. Keep the money in your wallet to a minimum. Avoid buying on impulse by making a shopping list and sticking with it. Gifts are no exception. They may seem like they don’t count, but your generosity shouldn’t threaten your financial security.

Unraveling the Mystery of Dividend Stocks

As you approach retirement, you may hear more about dividend-paying stocks. That’s because they provide income, which many retirees seek. What are dividend-paying stocks, and what role can they play in your portfolio?

When a company earns profits, it can either invest those profits back in the business or pay those profits to its shareholders. When paid to shareholders, these profits are called dividends.

A dividend-paying stock is the stock of a company that generates consistent dividends. Such companies are usually well-established, mature, and stable, and their stock prices tend to be less volatile than those of fast-growing companies in new industries, such as technology. Those newer companies seldom pay dividends; instead, they invest their profits in ways that will allow for future growth. How much income can you realize from dividends? As of April 2018, the average dividend yield of the Standard & Poor’s (S&P) 500 Index was around 1.90%. It has ranged from 1.11% (in August 2000) to 13.84% (in June 1932).

Dividend-paying stocks present a double benefit: Because many dividend-paying stocks are less volatile and generate income, they appeal to investors seeking to generate steady growth as well as investors who want to build a steady income flow during retirement. Additionally, even though they provide income, dividend-paying stocks do not necessarily provide low returns. Dividend-paying stocks are particularly appealing when purchased in tax-deferred accounts, such as 401(k) plans and individual retirement accounts (IRAs). In a non-tax-deferred account, the dividends would be taxed as ordinary income. In a tax-deferred account, the dividends are not immediately taxed. They compound over time until they are taxed at withdrawal. According to a 2016 white paper from Hartford Funds, 81% of the total return of the S&P 500 Index going back to 1960 can be attributed to reinvested dividends and the power of compounding interest.

Consult with your financial adviser to determine how these stocks will work best in your portfolio.

How to Search for Quality Stocks

When stock markets are volatile, many investors turn to high-quality stocks. What are they, and how might they be used in your portfolio? High-quality stocks are stocks of companies with outstanding characteristics based on a set of clearly defined criteria, such as balance-sheet strength and good management.

Because finding a high-quality stock among the thousands that trade on exchanges can be a daunting undertaking, high-quality investors often focus on certain criteria. These criteria may include return on equity (ROE), return on assets (ROA), and return on capital employed (ROCE).

As complicated as these criteria sound, they essentially speak to a company’s ability to generate earnings from its investments. ROE indicates how much profit a company has earned relative to shareholder capital. ROA indicates how efficient a company’s management is at using assets to generate earnings. Finally, ROCE indicates how efficiently a company is using its capital investments, which include all long-term funds used by the company. An increase in these three measures suggests that a company is growing.

That said, these measures may not be the only indicators of a company’s prospects. Other criteria – such as growth of the industry in which a company operates – can also affect a stock’s performance, and thus merit close scrutiny.

How important is quality in a stock? Very. Benjamin Graham, who is often called the founding father of value investing, has said that the greatest investment losses result not from buying high-quality stocks at high prices, but from buying low-quality stocks at low prices.

Should You Look Overseas for Equities?

You can probably achieve your financial goals while sticking to US stocks, but exposure to international stocks might be desirable as well, depending on your individual financial circumstances. Here are three reasons why.

Diversification: First, academic research shows that investors have better outcomes over the long term when they spread their money around-among asset classes, market capitalizations, and even countries. Indeed, some academics believe you should have no more than half of your equity portfolio in stocks from any one country. That may not be right for everyone, but it’s a viewpoint worth considering.

Performance: In addition, the United States has a strong economy and stock market, but history tells many stories of strong stock markets that encountered problems. And there have been long periods in which international stocks have outperformed US stocks. From 2000 through 2009, for example, the S&P 500 Index lost 0.9%. International stocks generally performed much better, from 1.2% to 12.8%, according to MarketWatch.

Opportunity: Finally, more than half of the world’s market capitalization is outside the United States, and many international markets are growing rapidly. China and India are just two examples. There were 4.7 million science, technology, engineering, and mathematics (STEM) graduates in China in 2016, and 2.6 million in India, according to McKinsey Global Institute. There were just 568,000 in the United States. And ample venture-capital funding is available to innovative Chinese companies. So there is good reason to believe that, over the long term, international stocks have significant potential.

Of course, international equities have risks that US stocks don’t, including lessened trading transparency and heightened volatility, so it is important to consider your risk tolerance when investing in them. Your financial advisor can help you decide if they are right for you, and, if so, what role they should play in your portfolio.

IRA Recharacterization Rules

In 2018, American investors said goodbye to a key retirement-saving strategy: the ability to “recharacterize” Roth IRA conversions.

That’s a mouthful, so let’s start with the basics by reviewing the two types of IRAs. Traditional IRA contributions are tax-deductible (in the year in which you make the contribution), but any withdrawals you make in retirement are taxed at your ordinary income-tax rate.

The Roth IRA, meanwhile, does not provide any tax breaks for contributions; however, earnings on the account and withdrawals are generally tax-free.

There are pros and cons for each type of IRA, and sometimes people change their minds about which is best. In the past, you’ve been able to convert funds in a pre-tax IRA to a post-tax Roth IRA simply by paying tax on the converted money. Your money then grows and is not taxed at withdrawal.

Sometimes, however, people change their minds about that conversion, and the old US tax law allowed them to undo that transaction anytime up until Oct. 15 of the year following the conversion. This is called a “recharacterization.” But under current tax rules, recharacterization is not allowed.

This may make Roth conversions less attractive for many individuals. If there’s no possibility of undoing a conversion, some people may hesitate to convert.

If you are thinking of converting a traditional IRA to a Roth IRA, you may want to speak with a financial professional to determine that the conversion is right for you (or come up with another plan if it is not).