Objective information about financial planning, investments, and retirement plans

Small Business Retirement Plans – SEP-IRA vs. Solo 401(k)

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One of the best tax deductions for a small business owner is funding a retirement plan.  Beyond any tax deduction you are saving for your own retirement.  As a fellow small business person, I know how hard you work.  You deserve a comfortable retirement.  If you don’t plan for your own retirement who will? Two popular small business retirement plans are the SEP-IRA and Solo 401(k).

Small Business Retirement Plans – SEP-IRA vs. Solo 401(k)

SEP-IRA vs. Solo 401(k)

SEP-IRA Solo 401(k)
Who can contribute? Employer contributions only. Employer contributions and employee deferrals.
Employer contribution limits For 2016, up to 25% of the participant’s compensation or $53,000 whichever is less. Contributions are deductible as a business expense and are not required every year. For 2016, employer plus employee combined contribution limit is 25% of compensation or $53,000 ($59,000 if the employee is age 50 or older) whichever is higher. Contributions are deductible as a business expense and are not required every year.
Employee contribution limits A SEP-IRA only allows employer contributions. Employees can contribute to an IRA (Traditional, Roth, or Non-Deductible based upon their individual circumstances). $18,000 for 2016. An additional $6,000 for participants 50 and over. In no case can this exceed 100% of their compensation.
Eligibility Typically, employees must be allowed to participate if they are over age 21, earn at least $600 annually, and have worked for the same employer in at least three of the past five years. No age or income restrictions. Business owners, partners and spouses working in the business. Common-law employees are not eligible.

Note the Solo 401(k) is also referred to as an Individual 401(k).

  • While a SEP-IRA can be used with employees in reality this can become an expensive proposition as you will need to contribute the same percentage for your employees as you defer for yourself.  I generally consider this a plan for the self-employed.
  • Both plans allow for contributions up your tax filing date, including extensions for the prior tax year. Consult with your tax professional to determine when your employee contributions must be made. The Solo 401(k) plan must be established by the end of the calendar year.
  • Note that the SEP-IRA contribution is calculated as a percentage of compensation.  If your compensation is variable so will the amount that you can contribute to plan year-to year. Even if you have the cash to do so, your contribution will be limited by your income for a given year.
  • By contrast you can defer the lesser of $18,000 ($24,000 if 50 or over) or 100% of your income for 2016 into a Solo 401(k) plus the profit sharing contribution. This might be the better alternative for those with plenty of cash and a variable income.
  • Loans are possible from Solo 401(k)s, but not with SEP-IRAs.
  • Roth feature is available for a Solo 401(k) if allowed by your plan document. There is no Roth feature for a SEP-IRA.
  • Both plans require minimal administrative work, though once the balance in your Solo 401(k) account tops $250,000, the level of annual government paperwork increases a bit.
  • Both plans can be opened at custodians such as Charles Schwab, Fidelity, Vanguard, T. Rowe Price, and others. For the Solo 401(k) you will generally use a prototype plan. If you want to contribute to a Roth account, for example, ensure that this is possible through the custodian you choose.
  • Investment options for both plans generally run the full gamut of typical investment options available at your custodian such as mutual funds, individual stocks, ETFs, bonds, closed-end funds, etc. There are some statutory restrictions so check with your custodian.

Both plans can offer a great way for you to save for retirement and to realize some tax savings in the process.  Whether you go this route or with some other option I urge to start saving for your retirement today 

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

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Avoid these 9 Investing Mistakes

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Investing is at best a risky proposition and sometimes even the best investment ideas don’t work out. However avoiding these 9 mistakes can help improve your investing outcomes.

Avoid these 9 Investing Mistakes

Inability to take a loss and move on 

It’s difficult for many investors to sell an investment at a loss. Often they prefer to wait until the investment at least gets back to a break-even level. I think its part of our competitive nature. Investing is not a competitive sport, leave that for our Olympians.  When reviewing your investments ask yourself “Would I buy this holding today?” If the answer is no, it’s time to sell and invest the proceeds elsewhere.

Not selling winners

I’ve seen many investors over the years refuse to sell highly appreciated holdings, all or in part. There is always the risk that you’ll sell and the price will keep going up. But sometimes it’s best to protect your gains and sell while you’re ahead or at least consider selling a portion of the holding and reinvesting the proceeds elsewhere. The latter can be part of your portfolio rebalancing process.

Investing without a plan

When you take a road trip in your car you generally have a map to help you to get to your destination. Investing is a means to an end, a road map to achieve your goals such as providing a college education for your children or funding your retirement.

Without a financial plan how will you know how much you need to accumulate to achieve your goals?  How much risk should you take?  What types of returns do you need to shoot for? Are on track toward your goals?  Essentially investing without a plan is much like hopping in the car without any idea where you are headed. 

Trying to time the market

It’s difficult to predict when the market will rise and fall. Even if the stock market is following a general trend, there will be up and down trading days. Trying to buy and sell based on those daily fluctuations is difficult. While there are professional traders who do this for a living, for most of us this is a losing proposition.

Worrying too much about taxes

Taxes can consume a significant portion of your investment gains for holdings in a taxable account. While nobody wants to pay more tax than needed, in my opinion paying taxes on a gain is almost always better than dealing with an investment loss.

Not paying attention to your investments

Your portfolio needs to be evaluated and monitored on a periodic basis.  You should reevaluate a stock when the company changes management, when the company is acquired by or merges with another company, when a strong competitor enters the market, or when several top executives sell large blocks of stock.

This applies to mutual funds as well. Manager changes, a dramatic increase or decrease in assets under management or a deviation from its stated style should all be red flags that cause you to evaluate whether it may be time to sell the fund.

Failure to rebalance your holdings  

This goes hand in hand with having a financial plan. Ideally you have an investment policy for your portfolio that defines the percentage allocations of your investments by type and style (stocks, bonds, cash, large stocks, international stocks, etc.).  A typical investment policy will set a target percentage with upper and lower percentage ranges for each style. It is important that you look at your overall portfolio in terms of these percentages at least annually.

Different investment styles will perform differently at various times.  This can cause your portfolio to be out of balance. The idea behind rebalancing is to control risk. If stocks rally and your equity allocation has grown to 75% vs. your target of 60% your portfolio is now taking more risk than you had planned. Should stocks reverse course, you could be exposed to over-sized losses.

Assuming recent events will continue into the future  

The first 15 plus years of this century have been tough on investors. The market tumbled during the 2000-2002 time frame and then again in 2008-2009. More recently the stock market dropped steeply and suddenly in the wake of the Bexit vote in the U.K. These events have instilled fear into many investors. It’s hard to blame them.

However this fear and the assumption that recent events will continue into the future might also be keeping you from investing in the fashion needed to achieve your financial goals. Taking the events of recent years into account is healthy, however letting these events paralyze you can be destructive to your financial future. This holds true for stock market drops as well as protracted bull markets.

Building a collection of investments instead of a well-crafted portfolio

Are you investing with a plan or do you simply own a collection of investments?  Great football teams like my beloved Green Bay Packers have a better chance of winning when everyone embraces and executes their role in the game plan for that week.  In my experience you will increase your chances for investment success when all of the holdings in your portfolio fulfill their role as well.

Nothing guarantees investment success.  Avoiding these 9 investing mistakes as well as others can help you increase your odds of being a successful investor.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner . Please check out our Resources page for links to some additional tools and services that might be beneficial to you. 

 

401(k) Fee Disclosure and the American Funds

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With the release of the Department of Labor’s fiduciary rules for financial advisors dealing with client retirement accounts, much of the focus has been on the impact on advisors who provide advice to clients on their IRA accounts. Long before these new rules were unveiled, financial advisors serving 401(k) plan sponsors have had a fiduciary responsibility to act in the best interests of the plan’s participants under the DOL’s ERISA rules.

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Starting in 2012, retirement plan sponsors have been required to disclose the costs associated with the investment options offered in 401(k) plans annually.

As an illustration, here’s how the various share classes offered by the American Funds for retirement plans stack up under the portion of the required disclosures that deal with the costs and performance of the plan’s investment options.

American Funds EuroPacific Growth

The one American Funds option that I’ve used over the years in 401(k) plans is the EuroPacific Growth fund.  This fund is a core large cap foreign stock fund.  It generally has some emerging markets holdings, but most of the fund is comprised of foreign equities from developed countries.  The R6 share class is the least expensive of the retirement plan share classes.  Let’s look at how the various share classes stack up in the disclosure format:

Share Class Ticker Expense Ratio Expenses per $1,000 invested Trailing 1 year return Trailing 3 year return Trailing 5 year return
R1 RERAX 1.59% $15.90 -10.54% 1.77% 0.89%
R2 RERBX 1.57% $15.70 -10.55% 1.79% 0.90%
R3 RERCX 1.13% $11.30 -10.13% 2.24% 1.37%
R4 REREX 0.84% $8.40 -9.89% 2.55% 1.66%
R5 RERFX 0.53% $5.30 -9.60% 2.86% 1.97%
R6 RERGX 0.50% $5.00 -9.56% 2.90% 2.01%

3 and 5 year returns are annualized.  Source:  Morningstar   Data as of 4/30/2016

While the chart above pertains only to the EuroPacific Growth fund, looking at the six retirement plan share classes for any of the American Funds products would offer similar relative results.   

The underlying portfolios and the management team are identical for each share class.  The difference lies in the expense ratio of each share class.  This is driven by the 12b-1 fees associated with the different share classes.  This fee is part of the expense ratio and is generally used all or in part to compensate the advisor on the plan.  In this case these would generally be registered reps, brokers, and insurance agents.  The 12b-1 fee can also revert to the plan to lower expenses. The 12b-1 fees by share class are:

R1                   1.00%

R2                   0.74%

R3                   0.50%

R4                   0.25%

R5 and R6 have no 12b-1 fees.

Share classes matter

The R1 and R2 shares have traditionally been used in plans where the 12b-1 fees are used to compensate a financial sales person.  This is fine as long as that sales person is providing a real service for their compensation and is not just being paid to place the business.

With all of the publicity generated by the new DOL fiduciary rules one has to wonder if the expensive R1 and R2 share classes might go by the wayside at some point

If you are a plan participant and you notice that your plan has one or more American Funds choices in the R1 or R2 share classes in my opinion you probably have a lousy plan and you are overpaying for funds that are often mediocre to poor performers.  It is incumbent upon you to ask your employer if the plan can move to lower cost shares or even a different provider. The R3 shares are a bit of an improvement but still pricey for a retirement plan in my opinion. That evaluation has to be made in the context of the plan’s size and other factors.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

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Reverse Churning Are You a Victim?

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One of the best things about being a freelance financial writer and blogger is that I often learn new things in the course of my writing. A reader recently left a comment on a post here on the blog and mentioned reverse churning. Until that time, I had never heard this term, but after a bit of research its’s one more thing that clients of stock brokers and registered reps need to be aware of.

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What is churning?

Investopedia defines churning as “Excessive trading by a broker in a client’s account largely to generate commissions. Churning is an illegal and unethical practice that violates SEC rules and securities laws.”

Churning conjures images such as the boiler room in the movie Glengarry Glen Ross (actually they sold real estate) or the iconic 2002 ad by Charles Schwab (SCHW) in which a brokerage house manager is depicted as telling the brokers, “Let’s put some lipstick on this pig” in reference to a sub-par stock he wants them to pitch to clients.

What is reverse churning?

A 2014 piece by Daisy Maxey in The Wall Street Journal describes reverse churning as follows:

“The Securities and Exchange Commission says the practice of so-called “reverse churning”–putting investors in accounts that pay a fixed fee but generate little or no activity to justify that fee–is on its radar. Regulators will be watching for signs of double-dipping by advisers who generate significant commissions within a client’s brokerage account, then move that client into an advisory account and collect additional fees.”

Evidently this occurs in brokerage accounts that at one point generated significant commissions for the broker from the purchase and sale of individual stocks or other commission generating transactions. If the activity in the account tails off the broker makes little or nothing from this client.

As a way to generate continual fees from this type of client the broker may suggest moving to a fee-based advisory account, often called a wrap account.

Under this arrangement there is an ongoing fee based upon the assets in the account plus often trailing commissions in the form of 12b-1 fees from the mutual funds usually offered in this type of account. These generally include proprietary mutual funds offered by the brokerage firm or at the very least costly actively managed funds in share classes geared to offering broker compensation.

Fee-based is not fee-only

Fee-based is often confused with fee-only. I suspect the brokerage industry likes it this way.

Fee-only compensation, which I wholeheartedly support, means that the financial advisor earns no compensation from the sale of financial products including trailing fees and commissions. Their fees come from their clients. These can be hourly, a flat-fee or as a percentage of the assets under management.

Fee-based compensation, also called fee and commission by some, is a mix of the two forms of advisor compensation. A common form of the fee-based model entails the client paying the advisor to do a financial plan and then if the client chooses to have the financial advisor implement their recommendations this will often be via the sale of commission-based products.

The version with fee-based advisory accounts associated with reverse churning by brokers and registered reps arose out of a 2007 rule that prohibits the charging of fees in brokerage accounts. Many broker-dealers have a registered investment advisor (RIA) arm which runs these accounts.

Buyer beware 

If you are working with a stock broker or registered rep and they propose moving to a fee-based or wrap account, you should take a hard look at what you are being offered. What is the wrap fee? What types of investments are used in the account? Are they expensive actively managed mutual funds that throw off 12b-1 fees in addition to wrap fees? What is the track record of the manager of the account that the advisor is proposing?

The Bottom Line 

I can’t recall hearing about a case of churning in recent years. Reverse churning is a new term to me, but from the perspective of a broker or registered rep fee-based advisory accounts make a ton of sense. They provide ongoing fee income and frankly require little attention from them. If your broker proposes a wrap account to you make sure you understand how this arrangement benefits you the client.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

6 Investment Expenses You Need to Understand

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Investment expenses reduce your investment returns. While nobody should expect investment managers, financial advisors or other service providers to offer their services for free, investors should understand all costs and fees involved and work to reduce investment expenses to the greatest extent possible.

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Here are 6 investment expenses you need to understand in order to maximize your returns.

Mutual fund and ETF expense ratios

All mutual fund and ETFs have expense ratios. These fees cover such things as trading costs, compensation for fund managers and support staff and the fund firm’s profit. Expense ratios matter and investors shouldn’t pay more than they need to.

Vanguard’s site, as you might expect, deals with this topic at length. In one example, it shows the impact of differing levels of fees on a hypothetical $100,000 initial account balance over 30 years with a yearly return of 6%. After 30 years the balance in the account would be:

$574,349 with no investment cost

$532,899 with an investment cost of 25 basis points

$438,976 with an investment cost of 90 basis points

These numbers clearly illustrate the impact of fund fees on an investor’s returns and their ability to accumulate assets for financial goals like retirement and funding their children’s college educations.

Mutual fund expense ratios are an example of where paying more doesn’t get you more. Case in point, Vanguard Growth Index Adm (VIGAX) has an expense ratio of 0.09%. The Morningstar category average for the large cap growth asset class is 1.21%. For the three years ending January 31, 2016 the fund ranked in the top 32% of all of the funds in the category; for the trailing five years the fund placed in the 19% and for the trailing ten years the top 17% in terms of investment performance.

Sales loads and 12b-1 fees

Front-end sales loads are an upfront payment to a financial advisor or registered rep. Front-end sales loads reduce the amount of your initial investment that actually goes to work for you. For example, if a rep suggests investing in a mutual fund like the American Funds EuroPacific Growth A (AEPGX) for every $10,000 the investor wants to invest, $575 or 5.75% will be deducted from their initial investment balance to cover the sales load. Over time this will reduce the investor’s return versus another version of the same fund with a similar expense ratio that doesn’t charge a sales load.

Some will argue that this load is a one-time payment to the advisor and their firm for their advice. This strikes me as dubious at best, but investors need to decide for themselves whether the advice received in exchange for paying a sales load warrants this drain on their initial and subsequent investments. This share class has an expense ratio of 0.89% which includes a 12b-1 fee of 0.21% (see more on 12b-1 fees below).

Deferred sales loads associated with B shares are largely a thing of the past. Carrying the American Funds example forward, the EuroPacific Growth B (AEGBX) which has been closed to new investors since 2009, was purchased at NAV with a deferred sales charge of 5%. The fund carried a surrender charge over a period of years whereby if the investor sold the fund during this time they would be assessed a surrender charge (see below for more on surrender charges) on a declining basis. In order to compensate the advisor for not receiving an upfront sales commission the fund’s expense ratio is 1.69% which includes a 0.99% 12b-1 fee which compensates the advisor. After a set period of time B shares are supposed to convert to the lower cost A shares. If you are still in a B share of any fund you should aggressively ask why this is and demand to have the shares converted to A shares if eligible.

Level loads are associated with C shares. The American Funds EuroPacific Growth C (AEPCX) fund has a level load of 1% in the form of a 12b-1 fee and an overall expense ratio of 1.61%. Brokers and registered reps love these as the level load stays in place for eight years until the funds convert to a no load share class of the fund. There is a 1% surrender charge if the fund is redeemed within the first year of ownership.

12b-1 fees are a part of the mutual fund’s expense ratio and were originally designated to be marketing costs. They are now used as trialing compensation for financial advisors and reps who earn compensation from selling investment products. They can also be used to provide revenue-sharing in a 401(k) plan. While 12b-1 fees don’t increase expenses as they are part of the fund’s expense ratio, typically funds with a 12b-1 fee will have a higher expense ratio than those that don’t in my experience.

401(k) expenses

For many of us our 401(k) plan is our primary retirement savings vehicle. Beyond the expense ratios of the mutual funds or other investments offered, there are costs for an outside investment advisor (or perhaps a registered rep or broker who sold the plan) plus recordkeeping and administration among other things. If your employer has these costs paid by the plan they are coming out of your account and reducing the return on your investment.

Add to this mutual funds that may be more expensive than needed to compensate a brokerage firm or insurance company and all of a sudden the expenses associated with your 401(k) plan are a real drag on your investment returns.

Financial advice fees

Fees for financial advice will vary depending upon the type of financial advisor you work with.

Fee-only financial advisors will charge fees for their advice only and not tied to any financial products they recommend. Fees might be charged on an hourly basis, on a project basis for a specific task like a financial plan, based on assets under management or a flat retainer fee. The latter two options would generally pertain to an ongoing relationship with the financial advisor.

Fee-based or fee and commission financial advisors will typically charge a fee for and initial financial plan and then sell you financial products from which they earn some sort of commission if you choose to implement their recommendations. Another version of this model might have the advisor charging a fee for investment management services, perhaps via a brokerage wrap account, and receiving commissions for selling any insurance or annuity products. They also would likely receive any trailing 12b-1 fees from the mutual funds used in the wrap account or from the sale of loaded mutual funds.

Commissions arise from the sale of financial and insurance products including mutual funds, annuities, life insurance policies and others. The financial advisor is compensated from the sale of the product and in one way or another you pay for this in the form of higher expenses and/or a lower net return on your investment. Additionally, financial sales types are incented to sell you products for which they are compensated, it is highly unlikely they will push a low-cost Vanguard index fund.

Investors need to understand these fees and what they are getting in return. In fact, a great question to ask any prospective financial advisor is to have them disclose all sources of compensation that they will receive from their relationship with you.

Surrender charges

Surrender charges are common with annuities and some mutual funds. There will be a period of time where if the investor tries to sell the contract or the fund they will be hit with a surrender charge. I’ve seen surrender periods on some annuities that range out to ten years or more. If you decide the annuity is not for you or you find a better annuity the penalty to leave is onerous and costly.

Taxes 

Taxes are a fact of life and come into play with your investments. Investments held in taxable accounts will be taxed as either long or short-term when capital gains are realized. You may also be subject to taxes from distributions from mutual funds and ETF for dividends and capital gains as well.

Investments held in a tax-deferred account such as a 401(k) or an IRA will not be taxed while held in the account but will be subject to taxes when distributions are taken.

Tax planning to minimize the impact of taxes on your investment returns can help, but investment decisions should not be made solely for tax reasons.

The Bottom Line

Fees and expanses can take a big bite out of your investment returns and your ability to accumulate a sufficient amount to achieve your financial goals. Investors should understand the expenses listed above and others and take steps to minimize these costs.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

4 Things To Do When The Stock Market Drops

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The stock market has started out the new year with some hefty declines. We are seeing firsthand the impact that China has on our markets. CNBC is calling this the worst start to a new year in almost a century. What should you do now? Here are 4 things to do when the stock market drops.

4 Things to do When the Stock Market Drops

Breathe 

Cable news networks like CNBC have a field day during steep, sudden stock market corrections like we are seeing this week. It’s easy to get caught up in all of this hype. Don’t let yourself be sucked in.

Step back, take a deep breath and relax.

Take stock of where you are 

Review your accounts and see the extent of the damage that has been done. Depending upon how you are invested it may be minor or a bit more significant. Investors who are well-diversified have probably been hurt but not to the extent of those with a heavy allocation to equities and other areas that have been hit.

Review your asset allocation 

Has your portfolio weathered this storm and the declines of this past summer as you would have expected? If so your allocation is likely appropriate. If not, then perhaps it is time to review your asset allocation and make some adjustments. Proper diversification is great way to reduce investment risk.

Go shopping 

Market declines can create buying opportunities. If you have some individual stocks, ETFs or mutual funds on your “wish list” this is the time to start looking at them with an eye towards buying at some point. It is unrealistic to assume you will be able to buy at the very bottom so don’t worry about that.

Before making any investment be sure that it fits your strategy and your financial plan. Also make sure the investment is still a solid long-term holding and that it is not cheap for reasons other than general market conditions.

The Bottom Line 

The stock market declines we’ve seen since the start of 2016 have been steep and unnerving. Don’t panic and don’t let yourself get caught up in all of the media hype. Stick to your plan, review your holdings and make some adjustments if needed. Nobody knows where the markets are headed but those who make investment decisions driven by fear usually regret it.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.

My Top 10 Most Read Posts of 2015

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I hope that 2015 was a good year for you and your families and that you’ve had a wonderful holiday season. For us it has been great to have our three adult children home and to be able to spend time together as a family. We saw the movie Sisters on Christmas day and I highly recommend it.

My Top 10 Most Read Posts of 2015

Hopefully you find many of the posts here at The Chicago Financial Planner useful and informative as you chart your financial course. Whether you do your own financial planning and investing or you work with a financial advisor my goal is to educate and provide some food for thought.

In the spirit of all of the top 10 lists we see at this time of year, here are my top 10 most read posts during 2015:

Life Insurance as a Retirement Savings Vehicle – A Good Idea?

7 Tips to Become a 401(k) Millionaire

4 Signs of a Lousy 401(k) Plan

Is a $100,000 a Year Retirement Doable?

4 Reasons to Accept Your Company’s Buyout Offer

401(k) Fee Disclosure and the American Funds

Is My Pension Safe?

My Thoughts on PBS Frontline The Retirement Gamble

7 Reasons to Avoid 401(k) Loans

YOU RECEIVED A PINK SLIP AND SEPARATION AGREEMENT – NOW WHAT?

I continued to write elsewhere as well, most notably Investopedia and Go Banking Rates.

I want to thank you again for your readership.  I invite you to contact me ( or thechicagofinancialplanner at gmail dot com) to ask any questions that you might have, to tell me what you like or don’t like about the site and to suggest topics that you would like to see covered here in the future. Don’t miss any future posts, please subscribe via email.

I wish you and your families a happy, healthy and prosperous 2016.

8 Portfolio Rebalancing Tips

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My last post discussed 4 Benefits of Portfolio Rebalancing. This post continues on the rebalancing theme and looks at some ways to implement a rebalancing strategy. Here are 8 portfolio rebalancing tips that you can use.

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Set a target asset allocation 

Your asset allocation should be an outgrowth of a target asset allocation from your financial plan and/or a written investment policy. This is the target asset allocation that should be used when rebalancing your portfolio. 

Establish a time frame to rebalance 

Ideally you are reviewing your portfolio and your investments on a regular basis. As part of this process you should incorporate a review of your asset allocation at a set interval. This might be semi-annually for example. I generally suggest no more frequently than quarterly. An exception would be after a precipitous move up or down in the markets.

Take a total portfolio view 

When rebalancing your portfolio take a total portfolio view. This includes taxable accounts as well as retirement accounts like an IRA or your 401(k). This approach allows you to be strategic and tax-efficient when rebalancing and ensures that you are not taking too little or too much risk on an overall basis.

Incorporate new money 

If you have new money to invest take a look at your asset allocation first and use these funds to shore up portions of your asset allocation that may be below their target allocation. A twist on this is to direct new 401(k) contributions to one or two funds in order to get your overall asset allocation back in balance. In this case your will need to take any use of your plan’s auto rebalance feature into account as well. 

Use auto pilot 

For those with an employer sponsored retirement plan such as a 401(k), 403(b) or similar defined contribution plan many plans offer an auto-rebalancing feature. This allows you to select a time interval at which your account will be rebalanced back to the allocation that you select.

This serves two purposes. First it saves you from having to remember to do it. Second it takes the emotion and potential hesitation out of the decision to pare back on your winners and redistribute these funds to other holdings in your account.

I generally suggest using a six-month time frame and no more frequently than quarterly and no less than annually. Remember you can opt out or change the interval at any time you wish and you can rebalance your account between the set intervals if needed.

Make charitable contributions with appreciated assets 

If you are charitably inclined consider gifting shares of appreciated holdings in taxable accounts such as individual stocks, mutual funds and ETFs to charity as part of the rebalancing process. This allows you to forgo paying taxes on the capital gains and provides a charitable tax deduction on the market value of the securities donated.

Most major custodians can help facilitate this and many charities are set-up to accept donations on this type. Make sure that you have held the security for at least a year and a day in order to get the maximum benefit. This is often associated with year-end planning but this is something that you can do at any point during the year.

Incorporate tax-loss harvesting

This is another tactic that is often associated with year-end planning but one that can be implemented throughout the year. Tax-loss harvesting involves selling holdings with an unrealized loss in order to realize that loss for tax purposes.

You might periodically look at holdings with an unrealized loss and sell some of them off as part of the rebalancing process. Note I only suggest taking a tax loss if makes sense from an investment standpoint, it is not a good idea to “let the tax tail wag the investment dog.”

Be sure that you are aware of and abide by the wash sale rules that pertain to realizing and deducting tax losses.

Don’t think you are smarter than the market 

It’s tough to sell winners and then invest that money back into portions of your portfolio that haven’t done as well. However, portfolio rebalancing is part of a disciplined investment process.  It can be tempting to let your winners run, but too much of this can skew your allocation too far in the direction of stocks and increase your downside risk.

If you think you can outsmart the market, trust me you can’t. How devastating can the impact of being wrong be? Just ask those who bought into the mantra “…it’s different this time…” before the Dot Com bubble burst or just before the stock market debacle of the last recession.

The Bottom Line 

Portfolio rebalancing is a key strategy to control the risk of your investment portfolio. It is important that you review your portfolio for potential rebalancing at set intervals and that you have the discipline to follow through and execute if needed.

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4 Benefits of Portfolio Rebalancing

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As we move into the last month of the year and look forward to the new year many of us look to get our financial situation in order. One of the most important things you can do is to ensure that your investments are properly allocated. Portfolio rebalancing is something that all investors should do periodically. Here are 4 benefits of portfolio rebalancing.

4 Benefits of Portfolio Rebalancing

Balancing risk and reward

Asset allocation is about balancing risk and reward. Invariably some asset classes will perform better than others. This can cause your portfolio to be skewed towards an allocation that takes too much risk or too little risk based on your financial objectives.

During robust periods in the stock market equities will outperform asset classes such as fixed income. Perhaps your target allocation was 65% stocks and 35% bonds and cash. A stock market rally might leave your portfolio at 75% stocks and 25% fixed income and cash. This is great if the market continues to rise but you would likely see a more pronounced decline in your portfolio should the market experience a sharp correction.

Portfolio rebalancing enforces a level of discipline

Rebalancing imposes a level of discipline in terms of selling a portion of your winners and putting that money back into asset classes that have underperformed.

This may seem counter intuitive but market leadership rotates over time. During the first decade of this century emerging markets equities were often among the top performing asset classes. Fast forward to today and they are on track for their third year of losses.

Rebalancing can help save investors from their own worst instincts. It is often tempting to let top performing holdings and asset classes run when the markets seem to keep going up. Investors heavy in large caps, especially those with heavy tech holdings, found out the risk of this approach when the Dot Com bubble burst in early 2000.

Ideally investors should have a written investment policy that outlines their target asset allocation with upper and lower percentage ranges. Violating these ranges should trigger a review for potential portfolio rebalancing.

A good reason to review your portfolio

When considering portfolio rebalancing investors should also incorporate a full review of their portfolio that includes a review of their individual holdings and the continued validity of their investment strategy. Some questions you should ask yourself:

  • Have individual stock holdings hit my growth target for that stock?
  • How do my mutual funds and ETFs stack up compared to their peers?
    • Relative performance?
    • Expense ratios?
    • Style consistency?
  • Have my mutual funds or ETFs experienced significant inflows or outflows of dollars?
  • Have there been any recent changes in the key personnel managing the fund?

These are some of the factors that financial advisors (hopefully) review as they review client portfolios.

This type of review should be done at least annually and I generally suggest that investors review their allocation no more often than quarterly so perhaps the full-blown portfolio review would not be done each time you do a rebalancing review.

Helps you stay on track with your financial plan 

Investing success is not a goal unto itself but rather a tool to help ensure that you meet your financial goals and objectives. Regular readers of The Chicago Financial Planner know that I am a big proponent of having a financial plan in place.

A properly constructed financial plan will contain a target asset allocation and an investment strategy tied to your goals, your timeframe for the money and your risk tolerance. Periodic portfolio rebalancing is vital to maintaining an appropriate asset allocation that is in line with your financial plan.

The Bottom Line 

Regular portfolio rebalancing helps reduce downside investment risk and ensures that your investments are allocated in line with your financial plan. It also can help investors impose an important level of discipline on themselves.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.