Conservative Portfolio With Gold

1. Reader Question

I have developed a portfolio which I call the Wesley consisting of: 10% S&P/ 10% small cap value /10% EFA/ 15% gold/ 5% cash and 50% 5 year treasuries. It seems to have a more consistent performance than the classic 50/50 portfolio with lower drawdowns. Moreover, during periods like the 1970's it gives more reliable returns. Of course I have tinkered with the Permanent Portfolio to come up with this. What is your take on this? Many thanks for your great website.

[Similar question from, I believe, same reader: Many thanks for your superb site. I came to it from bogleheads. I would like your comment on a portfolio I use: 10% S&P/ 10% US small cap value/ 10% EFA/ 15% gold/ 55% intermediate bonds. This is for a $6 milliom portfolio. Using your historical calculator it returns 10% per annum average without the big drawdowns of the 60/40 or 50/50 portfolio. I am glad to see that you don't badmouth gold. For me it appears to be an effective hedge that is easy to buy and sell.]

My Reply

Thank you for writing. Yours is a perfectly good conservative asset allocation portfolio. I took the liberty of comparing it to the "classical" 50/50 portfolio, consisting of only S&P 500 and 5-year treasuries, for the time period you quoted:

Blue line ("Custom Portfolio A") is your Wesley portfolio while the red line ("Custom Portfolio B") is the 50/50. Here's a live link to the same chart.

Backdoor Roth IRA

1. Reader Question

What do you think about yearly contributions to a non-deductible Traditional IRA? I currently max out my 401k without other tax shelters available and I am in the highest income tax bracket. Would I be better off using that cash for investments in my taxable accounts? Would I be better off purchasing I-bonds (I don't currently) given their inherent tax deferral properties?

My Reply

Very good question. Most likely you are doing the right thing, provided your plan is to then convert your non-deductible Traditional IRA to Roth IRA -- the so-called "backdoor Roth IRA" conversion. The net result of this is more or less equivalent to being able to contribute to a Roth IRA directly without the income limit. Unfortunately there is a gotcha in that process in case you have other Traditional IRA holdings which you do not mean to convert to Roth. The rule is that the Roth conversion takes place across all of your Traditional IRAs. So if you have a deductible Traditional IRA which you do not (and should not, in highest tax bracket) want to convert to Roth you would be forced to do so (at least partially) anyway, as opposed to being able to designate just the non-deductible contribution for conversion to Roth. And getting even more complex, the way to avoid this last problem is to roll your existing deductible Traditional IRAs into a 401k, should you happen to have one that accepts incoming IRA rollovers, thereby eliminating other deductible Traditional IRAs and allowing you to backdoor-covert just the new non-deductible Traditional IRA contribution. This whole subject is relatively tricky, so do make sure you understand the steps and rules involved, especially if you are doing the "reverse" 401k rollover to eliminate existing Traditional IRA before Roth IRA conversion. Do your research, maybe talk to an accountant, google "backdoor Roth IRA", the Finance Buff's explanation at http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html, and Bogleheads' wiki at: http://www.bogleheads.org/wiki/Backdoor_Roth_IRA

Adaptive Asset Allocation

1. Reader Question

Love your blog. I have been reading up on a form of portfolio management which you are no doubt aware of, "adaptive asset allocation." As I understand it--Basically rather than a static portfolio (e.g. 60/40 equities/fixed) which is periodically rebalanced within tolerance bands to maintain the static AA, adaptive asset allocation attempts to take account of momentum effects and co-variance among asset classes to minimize variance and maximum drawdown while maximizing CAGR of the portfolio. Could you please discuss this concept on your blog and more importantly is there any effective way an individual DIY investor could effectively implement such a strategy? Thanks.

My Reply

Thank you for writing. I'm going to be harsh in my reply. I feel that these adaptive or tactical or otherwise-named drifting asset allocations are some of the worst ideas floating around in the generally lousy pool of active investing strategies. And to be clear, when I say "lousy", I mean lousy for the investors who sign on to them. For the wealth managers who come up with, sell, and implement these ideas in customer portfolios they are absolute golden geese which is why all these strategies are here to stay.

The story goes, as you outlined, that by examining past correlations and returns one can build a multi-asset portfolio that minimizes volatility and maximizes returns. This examination of past correlations and returns is colloquially known as "backtesting". Having done extensive backtesting myself for more "strategies" than I can remember and having read or analyzed plenty of others, I can tell you a number of facts about it:

Dow Jones To Hit 20,000

1. Reader Question

http://www.nytimes.com/2013/05/12/your-money/forecast-for-a-20000-dow-still-holds.html?pagewanted=1 . Dont know if NYT "ahead of the curve" on this story (the facts speak, at least Fed rates do) or looking for a some sensationalism. Either way, certainly gases the market.

My Reply

Calling for Dow Jones Industrial Average to hit 20,000 by end of this decade is one of the more reasonable forecasts I've seen. Let's do a bit of math...

The Dow is at about 15,300 today, so it would need to rise by about 31% to reach 20,000. The article you linked does not state the exact year for the Dow 20,000 forecast, but instead calls for it by "the end of the decade". Depending on your personal philosophy the end of the decade will be either December 31, 2019 or December 31, 2020 (personally I'm strongly in the 2020 camp, but am not dogmatic about it). That  gives the Dow either about 6.6 or 7.6 years to run. To reach the 20,000 level in 6.6 years the Dow would have to appreciate in price by about 4.1% annually. To get there in 7.6 years, it would have to appreciate in price by about 3.6% annually.

Taking A Short Break

I already have a few reader questions to answer, but won't be able to get to them till the weekend after next at the earliest. Remember to rebalance from equities to fixed income (at least in tax-advantaged accounts where you won't be on hook for capital gains taxes) if the recent stock market gains pushed your stock allocation much higher than its intended percentage of your portfolio. That aside, keep writing in with questions and comments and I'll do my best to get to them when I get back.

4 Percent Portfolio Withdrawals

1. Reader Question

I am 64 this year and retired at 62 to care for my husband who has passed away. I am drawing about 4% from my investments but they are not paying that in dividends. They are only paying between $300 and $400 a month and I need $1200. The difference is coming from cash in the account but it is going down each month. I had this money with Amerprise but left due to concerns about growth and earnings. I currently let a Professor friend (Business and Economics) take care of my investments with Etrade. I have about $290,000 with Etrade and around $40,000 in a RET. The $290,000 is mostly in stocks and bonds paying dividends. Etrade is going to give me their idea of how to increase my ability to draw what I need for my income. Do you have any feeling for Etrade and their approach to giving me income? Would you take all of the $290,000 and go with Vanguard?

My Reply

Sorry to hear about your husband's passing. From what you outlined your investments are likely to be enough for you to live on. Obviously, no guarantees, but for the past nearly 100 years any reasonable (more on what "reasonable" means later), diversified portfolio of stocks and bonds at rock bottom cost would have supported at least 30 years of 4% annual withdrawals that grew with inflation. If you are interested, here is the original study that popularized the notion of "safe" 4% withdrawals: http://www.afcpe.org/assets/pdf/vol1014.pdf -- it's often referred to as "Trinity Study" after the university of the paper's authors. If you had started with a $300,000 portfolio and had withdrawn (including dividends and interest) 4% or $12,000 in the first year and inflation had been 3% in that year, then for the next year you would have withdrawn 3% more -- around $12,360 -- and so on. Depending on the luck of the draw (namely, the year when you started withdrawals and subsequent market returns) at certain times in the 20th century the ending portfolio after those 30 years of 4% inflation-adjusted withdrawals wound up to be much bigger than the starting portfolio! But sometimes it went the other way and the portfolio came perilously close to zero. There is nothing carved in stone about this 4% rule but it has held for most of the 20th century, sometimes with a lot of room to spare.

Are Mutual Funds Safer Than ETFs?

1. Reader Question

Is it safer to invest in mutual funds vs ETFs? With a fund I get the underlying net asset value as the price of the fund, but with an ETF the share price is whatever someone will pay for it...so couldn't it go lower than net asset value?

My Reply

That's a very good question. In normal times and with reasonably established ETFs (more on that later) there is no material difference between pricing of mutual funds and ETFs. The reason for this is that if ETF ever deviates significantly from its underlying asset value market participants can arbitrage away (meaning pocket) the difference. If an ETF dips below its fair value, a market participant can buy it and redeem the shares for underlying individual securities which can then be sold at fair value. If an ETF exceeds its fair value then a market participant can buy its individual underlying securities in proper quantities and redeem them for ETF shares which it can then sell at a profit. The actual mechanisms involved in such arbitrage are fairly complicated. But at the high level it's a very simple concept: if the price dips too low or rises too high somebody will step in to profit from this aberration. The same thing happens thousands of times a day on eBay and Craigslist: professional dealers and resellers look for underpriced items for sale that they can buy and flip for a quick profit.

But once in a while the market simply breaks down. Something unusual happens to start the chain, leading many of all those market participants who might otherwise be arbitraging ETFs to shut down and withdraw from uncertainty, leading to still larger price aberrations, leading still more market participants to shut down, and so on... You may remember the so-called Flash Crash of just about three years ago. That lasted only a few minutes. The same basic effect was in place for days during the turmoil of 2008. Consider the following chart:

This is a chart of three identical (in normal times) investments: Vanguard Total Bond Market Index mutual fund VBMFX, Vanguard Total Bond Market Index ETF BND, and iShares Total Bond Market Index ETF AGG. To prove to yourself that these truly are identical investments look here. But as you can tell from the above chart they behaved anything but identically in those crazy days of 2008 as liquidity (meaning all those participants looking to buy below fair value or sell above it) disappeared from the markets.

Global Portfolio of VTI and VXUS or VT

This grew out of reader questions and my answers to one of my older posts, but I think it's relevant enough to be a standalone post...

Reader Question

I noticed the expense ratio for VT (the Vanguard Total World Stock ETF) is now down to 0.19%. When investing in a taxable account and limited to ETFs (which is my situation), I wondered if you would still strongly prefer holding VXUS and VTI instead of just VT? Obviously a substantial difference in expense ratio remains, but it is less than it was and wouldn't you be likely to have significantly less turnover through rebalancing (beneficial in a taxable account) and, of course, the greater simplicity of a two-fund portfolio (when VT is paired with a bond fund)?

My Reply

I think with new lower expense ratio VT is a reasonable alternative to the combination of VXUS and VTI, provided you have decided that you are OK with global market weightings and really like the simplicity of one-fund equities solution. The expense gap is under 0.1% now and will likely keep shrinking. VTI and VXUS do provide greater diversification (about twice as many individual stocks) but I'll go out on a limb and say that once you get into thousands of stocks (which VT does) it is highly unlikely to matter if you have X or 2X of them. Going with VT will also half your commissions costs (if you are paying commissions, of course -- at Vanguard you can buy these ETFs commission-free).

I haven't checked bid-ask spreads on VXUS and VT but I'm assuming they are not much higher than 1 cent and they are not of much concern to a long-term buy-and-holder anyway -- you would only sell for rebalancing (from or to bonds) and presumably that won't happen more often than once a year or so and only on a relatively small portion of your holdings. Simply directing new contributions as well as dividends and interest towards the "lagging" component of the portfolio may well prevent any need for active rebalancing until your portfolio is quite large.

Municipal Bonds or CDs

1. Reader Question

Hi LTR, I'm struggling to understand bonds and know you can help. This year I will begin taking RMD's from an inherited non-spousal IRA. I'm 50 and want a place to deposit the RMD's in a taxable account. Don't currently need the money but if something comes up, I would like easy access. Seems like the default choice are I-Bonds but dealing with Treasury Direct, interest penalty for early withdrawal and 1.76% i'm wondering if Muni's could be a better option for me? I also know you recommend PenFed. I'm looking at VWAHX and the taxable equivalent yield is 3.31% for my 25% bracket according to their calculator. I don't understand the downside to this option. Thank you!

My Reply

There is not much of a downside. I have basically been recommending this very strategy for months in my posts like http://www.longtermreturns.com/2013/01/optimizing-investment-portfolio-with-municipal-bonds.html. The main thing you have to keep in mind is that even high-quality muni bonds, while (in my opinion) pretty darn safe from defaults, can fluctuate in value quite a bit, both because of interest rates moves and -- the more scary variety -- because of occasional panics, such as what happened in late 2008 (for almost all investments) and late 2010 (specifically for munis). You can soften the impact of these occasional panics by going with higher credit quality of VWLTX/VWLUX over VWAHX/VWALX.

Either of those funds will still fluctuate with interest rate changes, but tolerably so -- on par with how much the total bond market fund fluctuates. You should be prepared to ride out prolonged, if not overly steep, declines in value of these funds -- or any bond funds -- if and when interest rates start to rise. Probably prudent to expect to see a 5% slide over the course of a year or two at some point. It could conceivably get to be even 10%. The main thing to do is to stay the course, not sell low, and fully realize that rising interest rates are actually highly desirable for you as a bond investor. Just that first you'll have to put up with some pain of falling bond values. But a year or three or five down the road, you will start seeing the benefit of new higher rates.

Quick Note

I got a few emails from readers regarding the ads that started appearing on my blog. Terms and conditions to which I agreed do not allow me to say much about these, but:
1) let me assure you that the content, tone, and the message of my blog will not change in the least, and 2) please scroll all the way to the bottom on the page to read a short disclaimer and privacy policy related to these ads.

I hope to find time this weekend to make a new post -- I do apologize for my posts coming fewer and further between.

Managing 25 Million Dollar Portfolio

1. Reader Question

HI. Thanks for the always interesting read. This is a somewhat different question. I have just sold my company. I received USD 25 million in consideration for the sale. A life changing amount of money. I am 40. I've visited several wealth advisers and private banks who simply want to sell me expensive mutual funds and set up "discretionary accounts" with large fees for AUM. Given I don't really have "target retirement age or required amount" - How would you approach portfolio creation in this situation? Thanks so much.

My Reply

First off, congratulations on building such a successful business! Now on to your question... I assume that you wish to retire at this point -- or at least not feel obligated to work for money. That means you will be relying on your portfolio to provide all or nearly all your living expenses going forward. Here is what I would do if I were in such a situation...

1. Roughly estimate my total annual living expenses, including averaging out big-ticket items like kids college costs. I would err on the side of larger numbers for safety. Let's say I estimated my actual living expenses at between $300,000 and $400,000. I would then use the $400,000 figure going forward. Call this number E (for Expenses).

2. Calculate my total investable net worth, after all the taxes on the sale of business are paid. Let's say it's $15 million. Call this number W (for Worth).

3. Calculate my net worth to living expenses ratio R = W / E. In my case, R = 15,000,000 / 400,000 = 37.5.

I-Bonds Taxes And Other Fun Math

1. Reader Question

LTR: Really enjoy your blog and have a question on I Bonds. My wife and I have over $50K in I Bonds and plan on purchasing more. I understand I Bond interest can be tax-deferred for federal income tax purposes. That is, I have the choice of reporting the interest each year as it accrues, or reporting all of the interest earned in the year in which I redeem the bond. I've never reported annual interest and I remained in the 25% tax bracket upon retirement so I wouldn't ever have the opportunity for income shifting. Wondered if you might consider addressing this subject and recommending a strategy between the two approaches. Thanks for your time and keep up the great work!

My Reply

As long as the marginal tax brackets in the possible scenarios are the same, it is always in your interest to postpone taxes as long as possible (as you have been doing).

If postponing taxes till redemption ends up pushing you into the higher marginal bracket for the year of redemption, then it may makes sense to pay taxes as you go. Let's do a bit of math and a whole lot of assuming, which is unfortunately unavoidable when talking about future returns and taxes. Assume 25% tax bracket in "normal" years, 2% inflation, 2.5% return from I-Bonds (in other words, 0.5% above inflation), and 20-year holding period.

Pay-taxes-every-year result in 45% return after taxes [Math: (1+0.025 * (1 - 25%)) ^ 20 = 1.45]. Postponing taxes results 64% return before taxes [Math: (1+0.025) ^ 20 = 1.64]. So the only way postponing taxes will harm you is if your marginal tax bracket jumps from 25% to above 30% [Math: 64% * (1 - N) < 45%, where N > 30%). Jump from 25% bracket to 30+% seems unlikely under today's tax code since the next marginal bracket above 25% for married filing jointly is 28%.

LifeStrategy And Buckets Investing

1. Reader Question

LTR....excellent ideas, well written. How would investing in VSMGX work with using the bucket approach to retirement spending? Years 1-3 using cash/short term bond funds for expenses. Should I invest in VSMGX with all my funds except for the VFSTX (short term bond)/MMF retirement portion of my assets? How would I continue funding that portion…bucket 1 in the future? Thanks for your opinion.

My Reply

Thank you, glad you liked my blog. I am not a big fan of the bucket approach. Not that it's going to lead to any kind of financial disaster but it makes things unnecessarily complicated while providing a false sense of extra security (probably because that complexity fools us into thinking that we must doing something useful). Whether you think of your portfolio as a short-term bucket of 5 years of living expenses in cash, intermediate-term bucket of 10 years in bonds, and long-term bucket of 10 years in stocks or as one "bucket" of 40% stocks and 60% fixed income (which happens to be available in convenient one-fund format in Conservative Growth LifeStrategy fund, VSCGX), the future returns, future risk, future volatility, future you-name-it are identical. (Actually they're be a little higher for the 40/60 since cash has lower expected return than bonds, but that's a minor point.) If you try to be clever by riding out inevitable bear markets by dipping exclusive into your cash and/or bond buckets, then you will be running the risk of running out of those safe assets and having to sell from the stock bucket at the lows of the stock market (see Japan 1990-now). On the other hand if you have the single-bucket approach then you will always be buying into (during working years) or selling from (during retirement years) the same 40/60 portfolio, always maintaining the same relative risk level.

In other words, the safety of the bucket approach relies on the unstated assumption that if you wait long enough stocks will recover and grow ever higher, so it's OK to spend down the cash/bond buckets during the bear markets because you can later "refill" them from the grown stock bucket (and, incidentally, little is usually said about exactly when and how these refills would happen). While this assumption is not entirely unreasonable, it is no way guaranteed. If it was guaranteed then there would be no reason to ever invest more than a small portion of the portfolio into bonds -- buckets or not. Since the bucket approach usually calls for substantial amounts in bond/cash buckets, it's clear that it does not explicitly make the assumption that stocks will always outperform. But by advocating spending down cash/bonds in bad times, it still makes that assumption implicitly.

Savings And CDs For House Down Payment

1. Reader Question

My wife and I are setting about $20k aside per year, starting this year, to save for a down payment on a house. We're looking to buy a house in 2 to 3 years. We're putting our emergency fund in a high-yield savings account or a CD. Should we do the same with our down payment fund? Or perhaps something like VISPX?

My Reply

Yes, with the need to liquidate in 2-3 years, I would be investing these funds exclusively in "high-yield" savings  and CDs (and I-Bonds for the first 1-2 years so you can liquidate at a small penalty when the time comes). VIPSX and virtually every other marketable US Treasury bond or bond fund, whether nominal or inflation-adjusted, is currently priced to deliver returns below those of high-yield savings or CDs -- quite possibly by a lot if interest rates spike unexpectedly. So I absolutely would ignore the US treasuries market for short-term safe investments. Go straight to places like ally.com, personalsavings.americanexpress.com, and others like them for high-yield savings and CDs. The best deals in that area are constantly changing but even the above-average deals will likely net you more than VIPSX or virtually any other treasuries bond fund, and with less risk.

Timing The Market With International Stocks

1. Reader Question

Dear LTR, I'd greatly appreciate your thoughts on Increasing International Stock allocation and reducing U.S. REIT allocation. And I think potential shifts among these 2 asset classes would be of broad interest to your readers. Here's the situation: For the stock side of my asset allocation, I'm currently at 40% US Total Stock Mkt (VTSAX) 20% US Small Cap Value (VSIAX) 10% US REIT (VGSLX) 30% Total International Stock Mkt (VTIAX)

I'm thinking hard about increasing International from 30 to 33% (baby steps...I know) in what I think is the right direction long-term; which would require me to reduce something else. I'm thinking reduce REIT from 10% to 7%. This would of course result in: 40% US Total Stock Mkt (VTSAX) 20% US Small Cap Value (VSIAX) 7% US REIT (VGSLX) 33% Total International Stock Mkt (VTIAX) Thoughts? I'm telling myself this is a long-term directional shift to start increasing International toward 40%, that also factors in P/E of REIT & International, but maybe I'm just rationalizing an attempt to time the market?...I hope not. Many thanks for all your helpful guidance so far!

My Reply

Well, it is timing the market. But considering that it's just 3% of the portfolio you'll need a magnifying glass to notice the difference in performance -- regardless of whether the change proves to be brilliant or terrible!

On a more serious note, yes, I would be very open to that sort of change as well. I don't quite know what to make of US REIT valuations these days -- can bubbles really form this obviously even after we've gone through several in the past 15 years? But one thing I'm sure of is that today's REITs are nothing remotely like a bargain. International stocks, especially developed international in my view, have at least a plausible claim to being cheap (see another question/answer below). So if you are going to time the market, this is the kind of move that makes sense.

Another option is to exchange US REITs for international REITs which appear to be much more reasonably priced -- see Vanguard ETF VNQI.

Investment Tracking Spreadsheet

Reader Question

Hello: I discovered your blog from the bogleheads forum. I am already recommending it to others. Anyway, my question, which I have not seen addressed elsewhere and which puzzles me: My retirement funds are multiple places, and I don't see how I can combine them into a simple 2 or 3 fund strategy. They are in a) in a profit-sharing plan for a small company where I work, and where I have don't have control over the allotment of funds (they seem to be mostly funds like Fidelity Contrafund or Spartan 500 etc.), b) in TIAA CREF (I am a former professor), where I have them in TIAA Traditional (a kind of bond fund I think) and some stock funds, c) and in IRAs where they are spread into different funds. I am 62. I'm assuming that I should just wait until I retire to unify things? But even then I don't know that I can get a simple rollover from TIAA... I'm not even clear whether all this represents a problem, but I'd like your reaction if you have time and find this of sufficient interest. Thanks!!

My Reply

Glad you liked my blog and thank you for spreading the word about it! Your problem is a universal one. It is simply impossible to combine many different types of accounts -- either because they have different tax treatment (e.g. taxable versus IRA) or because regulations are simply written that way (e.g. active 401k with an IRA).

Some accounts can be combined, but usually only after you've changed jobs. Your old 401k and 403b can be rolled into a Traditional Rollover IRA. Brokers seem to like to distinguish Rollover IRAs from regular Traditional IRAs for reasons that I confess I do not understand -- probably having to do with some fringe scenarios. For myself I have rolled over/combined all my Traditional (meaning tax-deferred) IRAs and 401ks into a single Traditional/Rollover IRA and have had not any issues with that. A new Roth 401k account can be rolled into a Roth IRA. You didn't mention what kind of account you have with TIAA CREF, but it's likely a 403b which can be rolled into a Traditional IRA (though that "bond fund" you have in TIAA CREF is actually a very nice fixed income investment compared to alternatives, so you may want to keep it with TIAA CREF just for that reason). You should be able to call TIAA CREF to verify your account type and that it can be rolled over.

Exclusive Investment Opportunity!

Dear Friend,

I trust you are doing well. I will like to begin by way of introduction. My name is Mr. Richard Hedge a native of Greenwich, Connecticut of the United States of America and a senior employee of Strategic Wealth Accumulating Nebulous Capital who is currently in London on an important trade mission.

I am written to solicit your co-operation in order to bring you into a highly exclusive investing with large profits are enjoyed by many wealthy individuals of Great Britain. The said investment was originally purchase by Mr. Wilbur Manfred and lease to the East India Mining corporation 1968. Since the maturity of this contract in September 1988, several attempts has been made without success to contact Mr. Wilbur Manfred and his close relatives in whose favour the investment cash can be repay. My partner who is the Investment Director at Strategic Wealth Accumulating Nebulous Capital and two of our colleagues have initiate the process of filling a claim for this monies. We have look for suitably intelligent and interested individual such as yourself to share in this incredible opportunity. In order to participated we ask that you transfer a sum of no less than US$100,000 (United States One Hundred Thousand Dollars) to our bank account number enclosed.

In return my colleague and I will direct your capital to recover Mr. Wilbur Manfred investment and enjoy profits of up to 5341.67% (Five Thousand Forty-One Point Sixty-Seven Percent) in no more than 4 (Four) years time. For this service we charge you modest fee of 2% (Two Percent) of your assets under our management and 20% (Twenty Percent) of said large profits.

I want to assure you that my partners are in unique position to participate in this exclusive investing provided you can give us a very strong guarantee that your funds are transfer to our bank account in the next two weeks. Be assured that there is absolutely nothing to worry about in view of this claim. It is perfectly save with no risk involved and it is not subject to any inquiry since my partner will be handling the investment directly on our behalf. Large profits is all but assured. Thank you for your anticipated co-operation while I wait your urgent response.

April Fools',

Mr. Richard Hedge

HSA As A Retirement Account

1. Reader Question

Hi LTR. Your blog has been very helpful to me as I've been learning more about investing. It's also been a great resource to share with friends / family who ask me investing questions since you have explained so many concepts so well. I've recently incurred some larger medical expenses and have some questions about the optimal place to draw the money from to pay for them. I'm fairly young and keep a roughly 75 stocks / 25 bonds portfolio spread amongst accounts in a 401k, IRA, HSA, and taxable accounts. I was leaning towards paying my medical expenses from my taxable accounts to maximize my tax advantage space rather than withdrawing money from the HSA which has access to fairly good low cost bond index fund. As a follow up, what would happen if I'm blessed enough to in the future not have enough medical bills to completely drawdown my HSA? I know I can withdraw funds post age 65 without a penalty at which point I could no longer contribute, but you still have to pay taxes, but I'm having trouble finding information on how these distributions are taxed. Are the capital gains of these withdraws taxed as income? I ask because I max my HSA contributions every year, and if I keep paying all my medical bills from taxable funds, I can see my HSA growing to a significant amount of money by the time I'm 65. I'm debating if this is the optimal strategy. Thanks for your time!

My Reply

You are absolutely right to pay your medical expenses out of pocket while maximizing your HSA as another retirement account. What happens after age of 65 is you become eligible to withdraw funds from your HSA without a penalty and subject to regular income taxes. That means that at that point your HSA effectively becomes an equivalent of a Traditional IRA -- fully tax-deductible at the time of contribution and subject only to regular income taxes (on the amount withdrawn) at the time of withdrawals. Hopefully you already know what great deal Traditional IRAs are (as well as Roth IRAs and all sorts of flavors of 401k, 403b, and other tax-advantaged retirement plans) -- HSA is just as good, just kicking in a few years later (at 65 instead of 59.5 years of age).

But wait, there's more!

Answering Bond Questions

I have one hour to answer 7 reader questions. Go!

1. Reader Question

Dear LTR, I have just read an article regarding increased investment risks with bonds and bond funds. The author suggested reducing allocation in bonds now and replacing longer term bond funds with shorter terms (e.g. replacing TIP with VTIP, shorting VFIIX). Do you share similar view points and recommend significant reduction of investment in bonds? Thanks.

My Reply

No, I do not share those view points. There is zero reason to believe that you or I or whoever wrote that article can time interest rate increases any better than the whole of the bond market. The bond market is already pricing in significant rate increases in the near future -- that's why longer and longer maturities are offering higher and higher yields. The chances of your guess when exactly these rate increases will kick in being better than the market's guess are exactly the same as the chances of it being worse. Where the bond market is much more obviously skewed is in its exceedingly low yields on treasuries relative to I/EE-bonds/CDs/corporates/municipals (as I've been writing about for over a year by now, I think -- though the gap has narrowed a bit lately). That's where I think you have a pretty good shot at "outsmarting" the market by passing over pricey treasuries and TIPS in favor of those other choices. If you look through my prior blog entries you will find many that talk about this.

Benefit Of Tax-Advantaged Accounts

1. Reader Question

This is an embarrassingly basic question... apparently too basic to even show up in a quick google search. You emphasize putting as much money in tax-advantaged accounts as possible. But what's the point of a traditional IRA? I get that 401(k)'s (401(a)'s, 403(b)'s) generally have some matching from the employer, clear benefit. For Roth IRAs, earnings are tax free, clear benefit. But what's the advantage of a traditional IRA over a taxable account? If you have a chunk of money x, an expected total return of a, and a tax loss of b (e.g., b=0.75 for the 25% bracket), then the taxable account gives (x*b)*a, while the tax-deferred account gives (x*a)*b. (I'm assuming the marginal rate is the same in both cases, not an unreasonable assumption since the 25% bracket covers most of the middle class, likely before and after retirement.) Multiplication is commutative. So... why would you tie up money in a tax-deferred account that you couldn't touch for decades, for zero benefit? By the way, I'm looking forward to April 1, when I assume you'll post of list of individual stocks and commodities that are must-buy immediately ;) ... I just wrote in about "why traditional IRAs". While washing dishes, I think the answer came to me. The point is that although your _marginal_ tax rate might be the same while working and in retirement, there are still two different rates to consider. You are tax advantaged based on the marginal rate (IRA contribution coming off the top), but you pay taxes in retirement at your effective rate. Hence lower taxes overall. It's a pity traditional IRA deductions phase out with incomes, making a person more likely to be ineligible for them precisely when traditional might start looking better than Roth (later in life = higher marginal rate and less time to accrue return). Thanks for the site. You may just be giving good basic advice, but it's packaged well and all very clear. An invaluable resource for a beginning investor like me.