Tax-Free Investing for Those Fearing a Tax Hike

 

A recent article in the Wall Street Journal described a new investment trend: “Wealthy Americans eyeing potential tax increases are helping drive record amounts of money into municipal bond funds.” 

It also went on to state that tax-free U.S. municipal (muni) bonds attracted an estimated $56.9 billion in net new money during the first six months of 2021 and that financial advisors are increasingly fielding questions about muni bonds and bond funds.

With these trends in mind, now is a good time to review some basics about tax-free (a.k.a., tax-exempt) investing.

¨     Reciprocal Immunity- For over 100 years, government entities do not tax each other’s investors. This means that the federal government does not tax earnings on debt securities issued by states and cities (e.g., muni bonds and bond funds) and states do not tax earnings on federal debt (e.g., Treasury securities).

¨     Tax Benefit- Tax-free investing means that investment earnings are exempt from federal income taxes. Muni bond and bond fund earnings are exempt from federal income taxes as are earnings from Roth IRAs (if specific rules are followed). In addition, most states and cities with income taxes waive taxes on investment earnings on their own muni securities (e.g., no tax for New Jersey residents with a New Jersey-issued bond).

¨     Roth IRA Rules- You can withdraw the earnings from a Roth IRA tax free if you have reached the age of 59½, and at least five years have passed since your Roth IRA account was opened. Investors can also consider converting a traditional IRA to a Roth IRA to avoid paying tax on withdrawals made in retirement. The amount that is converted is taxed as ordinary income, however, in the year that the conversion is made.

¨     It’s Not What You Earn, But What You Keep- Knowing how investments are taxed is an important factor when making investment decisions. Investors need to compare tax-free investment yields (e.g., muni bonds) to returns on similar, taxable investments (e.g., corporate or U.S. Treasury bonds) to determine which provides the greatest after-tax return after subtracting federal and/or state income taxes.

¨     Default Risk- Investors need to consider the risk involved with tax-free securities. The governing body that issues a muni bond can default just like any other debtor. Investors risk losing all or part of their of their principal and should always check the ratings of a bond for financial stability. Fortunately, federal aid has helped many states and cities with outstanding bonds weather the pandemic easier than originally thought.

¨     Marginal Tax Rates Matter- The term “marginal tax rate” refers to the tax rate paid on a person’s last dollar of income. Federal income tax rates currently range from 10% to 37%. Tax-free securities are especially beneficial for high marginal tax bracket investors because they allow them to keep more of an investment’s return versus having to pay federal and state taxes on taxable investments.

¨     There is an Easy Formula- Investors can easily compare tax-free and taxable investment yields by using the formula, below, to calculate the taxable equivalent yield for a tax-free investment. Once you have “done the math”, the next step is to compare formula-based yields to those currently available on fixed-income securities.

Taxable equivalent yield = tax-free yield ÷ (100% - marginal tax bracket %)

Example: Assume you are in the 22% tax bracket, and have an investment with a 4.0% tax-free yield. To get the equivalent taxable yield, divide 4.0% by .78 (100% - 22%). The taxable yield is 5.13%. 

In the 24% tax bracket, the taxable equivalent of a 4% tax-free yield is 5.26% (4 ÷ (100% -24%) or .76).

In the 37% tax bracket, the taxable equivalent of a 4% tax-free yield is 6.06% (4 ÷ (100% -37%) or .63).

You can also use the What is My Tax-Equivalent Yield? calculator or the Bankrate Tax Equivalent Yield Calculator which use both federal and state income tax rates to calculate the tax-equivalent on tax-free securities.

Portfolio Rebalancing in Later Life

 

One of my favorite “niche” areas of content development work, in addition to personal finance topics for military families and financial educators, is financial transitions in later life. Especially since publishing my latest book, Flipping a Switch, I spend a fair amount of time teaching and writing about financial topics that affect older adults.

Full disclosure: I count myself in this category. I have found that I have more “street cred” with older adults now that I am one of them versus presentations I made in my 30s and 40s. Not surprising. People often relate better to “people like them.”

Portfolio Rebalancing Basics

Like some of my blog posts, this one is informed by personal experience. First, some background information on the topic of portfolio rebalancing, which is the process of getting back to target asset allocation percentages (e.g., 60% stock, 30% bonds, 10% cash) when the mix of assets in your portfolio shifts over time due to market conditions and gets out of whack.

The purpose of rebalancing is to maintain desired asset allocation weightings consistent with your age, goals, and risk tolerance. Without it, stock weightings, especially, would continue to rise, increasing an investor’s exposure to risk of loss of capital. Rebalancing forces investors to “sell high and buy low” which is a proven key to investment success.

When to Rebalance

There is no clear consensus about exactly when and how to rebalance a portfolio. Some sources recommend annual or semi-annual reviews (and, if necessary, revisions) of asset allocation percentages on dates of your choosing. This is typically done in a two-step process: 1. Prepare a net worth statement with the current value of savings and investments and 2. Classify your accounts into asset classes (e.g., money market funds as cash equivalent assets and growth mutual funds as equity assets).

Other sources recommend rebalancing when your asset mix shifts by a certain percentage from target weights based on market conditions. However, there are a variety of percentage shifts suggested; e.g., 3%, 5%, or 10% from your targets. Excel spreadsheets to keep track of asset weightings are available to download on the Rutgers Cooperative Extension web site.

How to Rebalance

Once you determine a “when” to rebalance, the next step is to figure out how to do it. There are basically three options: withdraw money from (sell) the overweighted class(es), add money to (buy) the underweighted classes(es), or do both. According to research, variations in results of various rebalancing techniques are surprisingly small. In other words, if you have any type of rebalancing process and stick with it, it will likely provide some benefit versus no rebalancing at all.

Personal Experience

Now, my personal rebalancing story. For decades, I  have calculated my net worth and asset allocation using the two-step process (net worth followed by asset allocation analysis) and Excel spreadsheet templates described above. I started doing this in July when I took much of my vacation time, so I still do these calculations in July today. The process takes about three hours, mostly to look up current asset values online or from statements. Lots of passwords and text message security codes!

In July 2020, however, I skipped the asset allocation spreadsheet step. Maybe it was the pandemic or getting ready to launch my book or a multitude of freelance writing assignments last summer. In any case, I did not do it. So, in July 2021, it had been two years since my last asset allocation analysis. 

Needless to say, I was surprised how much the asset class weightings had shifted. While recent market trends had worked in my favor, it was time to dial back my stock asset class weighting. I then used the Rutgers Excel spreadsheet to create several hypothetical asset shifting scenarios until I reached my target level.

My Take-Aways 

Below are seven “Barbservations” about the rebalancing process through the “lens” of  an older adult’s portfolio:

¨     Larger Dollar Amounts- Compared to younger investors, older adults often have larger portfolio sums to rebalance.

¨     Weighting Change Challenges- Reallocation of larger amounts of money is needed to shift the asset weights of larger portfolios.

¨     Periodic Review Benefits- Especially in active markets, it is useful to address asset weighting shifts in a timely manner.

¨      “New Money” Limitations- Non-working older adults may not have “new money” (e.g., from a paycheck) to put into underweighted assets to rebalance their portfolio.

¨     Automatic Rebalancing?- If only some assets are set to rebalance automatically, consider doing manual “total-portfolio” rebalancing instead.

¨     Tax Implications- To avoid capital gains taxes by selling assets in taxable accounts, shift money in tax-deferred account assets.

¨     Portfolio Guidelines- “One-size-fits all” percentages for stock weights (e.g., 100, 110, or 120 minus your age) are not for everyone.

We are all getting older. It happens. Consider this fact when you rebalance your portfolio. A lifetime of investing is at stake.

Beyond Legal Documents: Planning Strategies for a “Good Ending”

 

When people hear the words “estate planning,” their first thought usually turns to legal documents: wills, living wills, powers of attorney, trusts, and the like. These documents are very important and all adults should have at least the first three prepared with the assistance of an experienced estate planning attorney.

 

There is more to settling a person’s financial affairs, however, than legal documents. There are many steps that people can take on their own to distribute property and simplify decision-making for themselves and their heirs. Below are 12 strategies to increase the odds of having what I refer to in my book, Flipping a Switch, as a “good ending.”

 

¨     Simplification and Downsizing- Many people have “asset sprawl.” Estate planning will always be easier when there are fewer items to manage and dispose of. Consider selling, gifting, and/or donating unneeded possessions and consolidating similar types of financial accounts (e.g., growth mutual funds and traditional or Roth IRAs).

 

¨     Net Worth Calculation- Annual updates of net worth (assets minus debts) provide a status check for your finances and can make it easy for the executor named in your will to begin the process of tallying up the value of your estate. Be sure to share updated calculations with your executor and trusted loved ones.

 

¨     Emergency Contact Cards- The American Red Cross, health departments, and law enforcement issue emergency contact cards to carry around with you in the event of an emergency or disaster. The cards include a person’s name, address, and phone number and emergency contact people to call or text, if needed.

 

¨     Financial “Notebook”-  This does not have to be an actual binder or notebook. It could be available digitally in the cloud or on a flash drive. The point is to have one “go to” place for all of your financial information such as these worksheets from Rutgers Cooperative Extension and Schwab.

 

¨     Digital Asset Inventory- You will find it useful and your survivors will thank you if you prepare a written inventory of your digital accounts (e.g., computer passwords, financial and shopping accounts and social media). Another option is to use a password manager account and share the password with your executor and trusted loved ones.

 

¨     Beneficiary Designations List- It is wise to regularly review the beneficiaries and personal representatives listed in your financial and legal documents such as tax-deferred retirement savings plans, life insurance policies, and wills. Use this worksheet to record all of your beneficiary designations in one place.

 

¨     Untitled Property Planning- Untitled property (a.k.a., your “stuff”) must be sold, gifted, donated, and/or disposed of when you pass away. This process can be greatly simplified by performing some of these tasks during your lifetime. The Cooperative Extension program Who Gets Grandma’s Yellow Pie Plate? has many helpful ideas.

 

¨     Task List for Survivors- Survivors will appreciate a list of people and businesses to call (e.g., Social Security, pension plan, final employer, credit cards) and things to do (e.g., memorial service songs/prayers, personal property transfers, disposition of ashes) when a loved one passes. This list from AARP provides some helpful suggestions.

 

¨     Written Obituary- If you want certain things said about your life achievements and one less stressful task for heirs, write your own obituary. Some people write two: a short version for local newspapers and a longer version for placement on memorial websites. Obituary templates, sample obituaries, and writing tips are available online.

 

¨     Pre-Planned Funeral- Some people pre-plan and pre-pay funeral expenses to decide the arrangements that they want and spare survivors the stress and expense of decisions made at a time of grief and anguish. State laws govern funeral pre-planning and more information can be found in this Federal Trade Commission publication

 

¨     Gifting and Philanthropy- Advantages of lifetime gifting of cash and/or property include decreasing taxable estate value, downsizing, and watching gift recipients enjoy their gifts. The 2021 gift tax exclusion is $15,000 per recipient.

 

¨     Communication with Surrogates and Heirs- Legal documents and lists are of no use if nobody knows that they exist or where to find them. Share this information and the thinking behind them in face-to-face conversations.

 

Who Knew? Ten Lesser-Known Money-Saving Tips

 

Each summer, AARP Bulletin publishes a 99 Great Ways to Save article with money-saving ideas. As a financial educator who has taught budgeting and frugal living for decades, I often find these lists full of strategies that I already know such as:

Traveling with an empty water bottle to fill beyond TSA checkpoints, keeping refrigerator settings slightly below 40 degrees, senior discounts, seasonal sales, digital coupons and promo codes, bartering, supermarket “loss leaders,” unit pricing, meatless meals, YouTube video tutorials, insulating hot water pipes, and warm water clothes washing.

Also, sealing windows, fee-free National Park days, reviewing medical bills for errors, home gardening, shopping apps, online travel alerts, thrift store and estate sale shopping deals, property insurance “bundling, fixing leaky toilets, online banks, and AARP/AAA discounts.

Also, cash-back and low-interest credit cards, pre-tax employer flexible spending accounts, negotiating (a.k.a., haggling) for price discounts, LED light bulbs, city “restaurant week” deals, telecommuting, drinking home/office coffee, cleaning dryer lint, airline travel date flexibility, “round-up” savings apps, raising insurance deductibles, cancelling collision/comprehensive coverage (old cars), and GasBuddy (to find cheap gas).

Also, MOOCs (low-cost online courses), mortgage principal prepayment, automatic bill payment (to save on postage), online banks, skipping beverages/drinking water at restaurants, changing furnace filters, insulating attic hatches, store/restaurant/airline loyalty programs, birthday freebies from retailers, and more.

Nevertheless, I also continue to find money savings tips that are new to me. I call them my “Who Knews?” Below is a list of 10 of my “Who Knews?” from the several recent annual AARP 99 Great Ways to Save articles. If these money-saving tips are new to me, they might also be for you, too. Happy saving! All of these small steps add up over time.

¨     Ink Jet Cartridge Fix- Printer cartridges may still have ink in them but it could be blocked by dried up ink. Take them out, heat them with a hair dryer, and gently shake them to see if any remaining ink can be saved.

¨     Ink-Conserving Printer Fonts- Select light versions of fonts before printing out documents. In addition, a Times New Roman font uses less ink than Arial and Calibri because the letters are thinner. Over time, this adds up.

¨     Car Oil Change Sensors- On many newer cars, it is best to wait for sensors to notify you when oil needs changing instead of changing still-good oil at a pre-determined number of miles such as 3,000 miles, 5,000 miles, or longer.

¨     Discounted Gift Cards- There are a number of websites that buy back unused gift cards and sell them at a discount from their face value. Be sure to check their fine print about shipping costs and possible online use only.

¨     Generic Pet Medications- Pet owners can search online for sources of generic alternatives to popular “name brand” medications to keep their pets healthy (e.g., protect against heartworms and treat arthritic pain).

¨     Pill Splitting for Prescription Drugs- If it makes financial sense and only if your doctor agrees, consider splitting a double-strength medication in half (to create two single doses) so it lasts longer (e.g., 180 days instead of 90 days).

¨     Online Comparison Shopping- AARP recommended an app called ShopSavvy. Simply go to a store, scan the bar code for an item that you are interested in buying, and the app will tell you if it is being sold elsewhere for less.

¨     Cell Phone Data Pruning- The objective here is to turn off cell apps that use data even when you are not using them. As one of the “Settings” commands on smart phones, data use for apps that you rarely use can be toggled off.

¨     Gas Purchase Timing- According to data gathered by GasBuddy, Monday is the cheapest day to buy gas in most states and Friday is the worst. Depending on where you live and how much you drive, savings on cheaper gas can add up.

¨     Non-Member Warehouse Club Discounts- The AARP article noted that certain products (e.g., prescription drugs and alcohol) and services (e.g., hearing tests) are available to non-members of Sam’s Club and/or Costco. In addition, non-members can make purchases at Costco if they have a gift card.

Think of all of the above suggestions as a “Jersey Diner Menu” from which you can pick a meal. In other words, select those money-savings strategies that are relevant for you and your lifestyle. Next, identify the potential savings from the strategies that you select using the CFPB worksheet Cutting Expenses.