by Donna Gordon on September 7th, 2016

​Tips From Donna Gordon
September 2016 Wesban Monthly


Politics and Investment Performance

With President Obama's time in office coming to a close, here's the result of an investigation into the relationship between the composition of the legislative and executive branches of the U.S. government and market performance. The 'unified' situation refers to years when the Senate, the House of Representatives, and the White House were all controlled by the same party. The 'partially divided' situation represents years when the House and Senate were controlled by the same party, but the White House was held by a different party. The 'completely divided' situation uses data from years in which the two houses of Congress were divided. Both the S&P 500 and the diversified portfolio (60% stock/40% bond) averaged the highest returns during unified years, lower returns during partially divided years, and the lowest under completely divided years.



Retirement Planning in Your 20s and 30s

Is it too early to start planning for retirement in your 20s? The answer is no. As life expectancy continues to increase, planning early can ensure a comfortable retirement. While planning for retirement at this age may be the last thing on your mind, the earlier you start the better chance you have of achieving your retirement goal. An early start also allows more time for your investment to grow through compound interest. In addition to starting early, here are some steps you should consider when planning for retirement in your 20s and early 30s.
Maximize your employer match: Young investors should consider maximizing their employer 401(k) match, since failure to take advantage of this benefit means missing out on free money. Typically employers match 50 cents per dollar invested by an employee, up to a predetermined maximum contribution percentage. If your employer provides this, make sure to put enough money in your 401(k) plan to maximize your employer match.
Consider a Roth investment: Much like a company-sponsored retirement plan, traditional IRAs are a common investment vehicle. Traditional IRA contributions are not taxed, but withdrawals are taxed. A Roth IRA or Roth 401(k) gives you the option of taxing your contribution up front at the time of investment while the account grows in value tax-free thereafter. This means that withdrawals during retirement are not subject to income tax, provided you are at least 59 1/2 and the account is held for five years or more. This is a great way for younger investors to take advantage of lower tax rates, especially if they expect to be in a higher tax bracket closer to retirement.
Manage your risk: One mistake young investors make is selecting a less-than-optimal stock/bond allocation based on their age. Typically, investors in their 20s or 30s are best advised to select a stock-heavy portfolio with a minimal allocation to bonds. For investors who feel less comfortable with selecting their own investments, target-date funds can serve as a convenient alternative. Target-date funds start out with heavier allocations to stocks and become more income-oriented depending on the participant's age. If you are in your 20s or 30s, it might make sense to choose an aggressive portfolio allocation and limit your investment in bonds.
Avoid market-timing: A look back in time suggests that some of the biggest gains in the stock market have followed periods of poor market returns. Investors can make the mistake of timing the market by pulling out of their investments during market losses and buying back when the market has rebounded. Investors who attempt to time the market run the risk of missing periods of exceptional returns. With time on your side, it is best to adopt a long-term approach to investing. 
Keep in mind that you should first determine how much money you may need in retirement as well as determine your annual expenses such as living, healthcare, and miscellaneous spending before considering the options outlined above. It is always a good practice to track your spending in addition to identifying your savings and investments.
This is for informational purposes only and should not be considered tax or financial planning advice.
401(k) and IRA plans are long-term retirement-savings vehicles. Funds grow tax-deferred. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Direct contributions to a Roth IRA are not tax-deductible but may be withdrawn free of tax at any time. Earnings may be withdrawn tax and penalty free after a five-year holding period if the age of 59 1/2 (or other qualifying condition) is met. Otherwise, a 10% federal tax penalty may apply. Please consult with a financial or tax professional for advice specific to your situation.


A Risk Drill for Foreign Stocks

While the past several years haven't rewarded global investors, there will be market environments when foreign stocks do better than U.S. (The year 2012 was the most recent example.) More important, investors who diversify globally gain exposure to some world-class companies that just happen to be domiciled overseas.
Yet as much as diversifying overseas makes sense, it's also worth bearing in mind the risks of doing so. Many of the same risk factors that apply for U.S. stocks, such as valuation and concentration risk, apply for foreign-stock investors, too. But foreign-stock investors confront a few other risk factors that are specific to investing in the asset class. As you survey your foreign-stock holdings today, here are some of the key questions to focus on, as well as details on how to find the answers.
Question 1: Is the investor's time horizon long enough to regroup from bad currency movements?
As with foreign bonds, this is the risk that currency losses will reduce any gains, or magnify any losses, associated with the underlying investments. While foreign-currency fluctuations can have a meaningful impact on the returns that U.S. investors earn by investing in foreign bonds, currency fluctuations generally play a smaller, but still significant, role in foreign stock returns.
Not speculating on foreign currencies is the best way to avoid getting burned by a bad currency move. Because currency fluctuations tend to wash each other out over longer time frames, investors with a similarly long-term approach would do well to opt for products that take a consistent stance on currencies (either hedged or unhedged) and call it a day.
But investors with shorter time horizons should be more mindful of foreign-currency risk; the shorter the time horizon, the more likely it is that the investor would encounter a bum foreign-currency move that could dampen gains over his holding period. That's important because U.S. investors usually spend their portfolios in dollars, not in foreign currencies. Because currency risk is such a wild card, it's one of the key reasons the asset-allocation experts at Morningstar reduce foreign equities as a percentage of a portfolio's total equity allocation as retirement approaches.
Question 2: Is the portfolio overly exposed to geopolitical risks?
Geopolitical risk can take a toll on foreign equities, as investors will tend to jettison the securities from countries where there's military action or economic or political unrest. For example, Russian equities dropped sharply in 2014, owing to sanctions related to its actions in the Ukraine, as well as falling energy prices. Of course, crazy stuff can happen anywhere. But investors can mitigate geopolitical risk by not gorging on emerging markets, which tend to be particularly vulnerable to geopolitical shocks, as well as avoiding hefty bets on any single region or country.
Question 3: Is the portfolio overloaded on emerging markets?
The extent to which a foreign portfolio is exposed to emerging markets will be a key determinant of how volatile it is. That volatility can translate into real losses in certain periods: The typical emerging-markets funds lost more than 54% in 2008, whereas broad foreign large-blend funds lost 10 percentage points less that year, on average. Of course, there will be time periods when emerging markets far outperform developed, so investors will want to be careful about shunning them altogether. A broad foreign stock index fund that buys both can serve as a good benchmark for your own emerging-markets exposure: Many have between 15% and 20% of assets in emerging markets today. But risk-averse investors, especially those approaching retirement, may want to downplay emerging-markets-heavy investments.
Question 4: Does the foreign-stock position exacerbate economic sensitivity?
The U.S. market generally is well-diversified across sectors. But foreign markets tend to skew more heavily to certain industries—for example, broad foreign stock index funds hold more in basic materials and financials than broad U.S. index funds, and smaller weightings in healthcare and technology. The net effect of these sector tilts, assuming an investor buys a broad foreign stock index fund, is a bigger weighting in cyclically and economically sensitive industries. That, as well as the relative strength of the U.S. dollar in times of turmoil, helps explain why foreign markets have often performed worse than U.S. in global economic downturns like 2008’s.
Question 5: Will high costs erode a big share of the portfolio's return?
Owing to both convention and small differences in the actual costs of management, foreign large-blend funds typically charge more than U.S. ones. For example, the typical large-blend fund in Morningstar's database has a 1.06% expense ratio in 2016, while the average domestic large-blend fund charges 0.91. Specialized foreign funds, such as those that invest exclusively in small caps, emerging markets, or a specific region, often charge fees that exceed 1.5%. Those levies can drag on investors' take-home returns and exacerbate losses in down markets.
This is for informational purposes only and should not be considered financial planning advice.
Diversification does not eliminate the risk of experiencing investment losses. Holding a portfolio of securities for the long term does not ensure a profitable outcome, and investing in securities always involves risk of loss.
Stocks are not guaranteed and have been more volatile than the other asset classes. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards.
The investment return and principal value of mutual funds will fluctuate and shares, when sold, may be worth more or less than their original cost. Mutual funds are sold by prospectus, which can be obtained from your financial professional or the company and which contains complete information, including investment objectives, risks, charges and expenses. Investors should read the prospectus and consider this information carefully before investing or sending money.




Wesban Financial Consultants P.C.1800 Providence Park
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by Donna Gordon on August 3rd, 2016

​How Your Investment Income Is Taxed

This article provides a quick rundown of how the income produced by different investment types is treated at tax time. While this is by no means an exhaustive list, it covers some of the main categories of income-producing investments and how the income they produce is generally treated by the IRS at tax time. Please note, though, that because every investor's tax situation is unique, you should consult your accountant for verification of your tax status and tax treatment of any investment product mentioned below.
Also, we won't go into capital gains taxes in this article because the tax treatment of them is largely the same regardless of asset class.
Stocks
Stocks With Qualified Dividends
For most stocks that pay qualified dividends, the tax treatment is pretty straightforward: Investors would report the income on a 1099-DIV in the Qualified Dividends box. Investors in the 10% and 15% brackets will have a zero tax rate on dividends. For individuals in income tax brackets greater than 15% but less than 39.6%, qualified dividends are taxed at 15%. Individuals in the 39.6% tax bracket are subject to a 20% tax on dividends. Higher-income taxpayers are also subject to a 3.8% Medicare surtax on investment income.
In order to be a 'qualified dividend,' the dividend must be issued by a U.S. corporation or a foreign company that either trades on a U.S. exchange, such as an ADR, or is eligible for benefits under a U.S. tax treaty.
Note that in order for the dividend to be 'qualified,' you must have owned the investment for at least 60 days of the 121-day period that begins 60 days before the ex-dividend date, or the day the stock trades without the dividend priced in.
Foreign Stocks With Nonqualified Dividends 
If you're considering a foreign stock for a taxable account, do your homework on whether the company's dividends are qualified. You can find out more about this by consulting IRS Publication 17.
Preferred Stock 
In many (but not all) cases, preferred-stock dividends are treated as qualified dividend income for tax purposes, even though they have many bondlike characteristics such as a stated par value and fixed coupon.
Some dividends paid by U.S. companies are not eligible for lower tax rates, however. Here are a few examples:
REITs
Real estate investment trusts do not pay income taxes at the corporate level, but they are required to pay annually at least 90% of their taxable income in the form of shareholder dividends, which is one reason they pay out such large dividends.
Different types of REIT payments are taxed at different rates. In the majority of cases, REIT dividends are considered nonqualified and taxed at ordinary income rates; therefore, they are probably best held in a tax-advantaged account. But there are other types of income payments, such as those distributed from taxable REIT subsidiaries or out of long-term capital gains, which could be subject to lower tax rates; investors should consult with their tax advisors in these cases.
MLPs 
Master limited partnerships are partnerships that trade on a public exchange. They may offer certain tax benefits but also some tax complexity. Unlike with REITs, however, it's best to hold MLPs in a taxable account, because owning them in a tax-deferred account can result in something called unrelated business taxable income, which then requires the account to pay taxes.
MLPs pass through their taxable income to unitholders, who then pay taxes on that income at their own marginal tax rates, often only when the units are sold. These can be a little complicated at tax time, owing to the fact that you don't use a 1099 form to report the distributions but instead have to use a K-1.
Another interesting feature of MLPs is that cash distributions are not directly taxable: The IRS looks at them as returns of capital, so it reduces the investor's cost basis in the MLP. In practical terms, that means that the investor will have to pay taxes on the spread between a lower cost basis and the MLP's price at the time of the sale, but most of the income the MLP distributes from year to year is effectively tax-deferred.
Exchange-traded products can sometimes sidestep tax-reporting complexities, but oftentimes at the expense of the tax benefits one would get if the MLPs were held directly.
Bonds
Taxable Bonds 
Bond income is generally taxed at investors' ordinary income tax rates in the year it was received. The income is taxable at the federal level in all cases, but Treasury bonds are not subject to state and local income taxes.
TIPS 
As with Treasury bonds, interest payments from Treasury Inflation-Protected Securities, and increases in the principal of TIPS, are subject to federal tax but exempt from state and local income taxes. One additional thing to remember about TIPS, however, is that the amount by which the principal of your TIPS increased because of inflation is taxable for the year in which it occurs, even if your TIPS hasn't matured (in other words, before you would receive an actual payment of principal).
Municipal Bonds 
Muni bonds are issued by state and local governments to finance public projects. In the vast majority of cases, the income paid out by these bonds is not taxed at the federal level. In some instances (particularly if the bond is issued by a state or municipality in which you reside), muni income is not taxed at the state or local level, either. It's also worth noting that income from private-active munis is subject to the Alternative Minimum Tax.
Other
Commodities
There are typically no dividend or interest payments paid to investors who get exposure to commodities through exchange-traded note (which is an unsecured debt obligation) or grantor trust (which often holds physical commodities) structures. However, if you bought a commodity-futures-based ETN, you might have to report income using a Schedule K-1.
This is for informational purposes only and should not be considered tax or financial planning advice.
Stocks are not guaranteed and have been more volatile than the other asset classes.
Holders of preferred stock are usually guaranteed a dividend payment and their dividends are always paid out before dividends on common stock. In event that the company fails, there's a priority list for a company's obligations, and obligations to preferred stockholders must be met before those to common stockholders. On the other hand, preferred stockholders are lower on the list of investors to be reimbursed than bondholders are.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Bonds in a portfolio are typically intended to provide income and/or diversification. U.S. government bonds may be exempt from state taxes, and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government.
A municipal bond investor is a creditor of the issuing municipality, and the bond is subject to default risk. Only insured municipal bonds are guaranteed as to the timely payment of principal and interest by issuer. However, insurance does not eliminate market risk. Municipal bonds may be subject to the Alternative Minimum Tax and state and local taxes, and federal taxes would apply to any capital gains distributions.
Returns and principal invested in REITs are not guaranteed. REITs typically provide high dividends plus the potential for moderate, long-term capital appreciation. A REIT must distribute at least 90% of its taxable income to shareholders annually. Real estate investment options are subject to certain risks, such as risks associated with general and local economic conditions, interest rate fluctuation, credit risks, liquidity risks and corporate structure. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards.
Transactions in commodities carry a high degree of risk and a substantial potential for loss. In light of the risks, you should undertake commodities transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk. Trading in commodities is not suitable for many members of the public. You should carefully consider whether this type of trading is appropriate for you in light of your experience, objectives, financial resources, and other relevant circumstances.




A Risk Drill for Your Portfolio

As of early May 2016, the yield on a three-month Treasury bill—often called 'the risk-free rate'—is about 0.22%. Assuming rates remain that low, $10,000 saved today will be worth ... wait for it ... $10,681 in 30 years.
Risk is a fact of life for investors. Yes, it can punish--sometimes severely. And it can surprise, when misunderstood. But risk also can reward, sometimes generously, if managed well, with patience and perspective. The point with risk is not to avoid it--because you can't. But you don't have to blindly submit to it, either. The point with risk is to take it. Actively take it. Deliberately take it. Take it with purpose, in the right balance and for the right reasons.
That can mean owning plenty of equities—even later in your investment years—and embracing securities that entail plenty of volatility on a stand-alone basis. What matters most is your total portfolio's risk level. Do the constituent holdings counterbalance one another, performing well (or poorly) in different market environments? Is the portfolio sufficiently diversified so problems in one security or sector don't bring down the whole ship? And finally, is the total portfolio well-positioned to confront the mother of all risks, falling short?
As you assess whether your portfolio's risk level is appropriate given your goals and life stage, here are some of the key questions, as well as details on how to find the answers. 
Question 1: Is there a risk of falling short?
This is the worst of all risks: not having enough money to fund your goal (retirement, for most people), or perhaps even worse, retiring and then running out of money. Because the risk of falling short carries such enormous repercussions, the centerpiece of any portfolio checkup should be a 'wellness check'—an assessment of whether you're on track to reach your goals given your current investment mix, your current and future savings, and your time horizon. A basic savings calculator like Morningstar's can help you see if you're in the right ballpark; just be sure to use a realistic rate of return (most experts recommend 4% for a balanced portfolio). If it turns out you have a looming shortfall, a combination of portfolio shifts and lifestyle decisions (such as being willing to retire a few years later) can help you bridge the gap. And the earlier you realize you may fall short, the more flexibility you'll have to make a save.
Question 2: Is the asset mix appropriate given life stage?
Is your asset allocation too risky? Because stocks will tend to return more than other asset classes over long periods of time, investors might naturally assume that loading up on them is the way to go. And it's true that younger investors with steady incomes should generally employ the highest equity weightings they can tolerate; over long periods of time, they'll tend to be rewarded for being willing to put up with day-to-day and year-to-year fluctuations, and those fluctuations shouldn't bother them too much given that they don't have an imminent need for their money. 
But there are two key reasons a portfolio's asset allocation can be too risky. The first is if the portfolio is so volatile that the investor could be inclined to retreat to a more defensive position at an inopportune time. The second is if the portfolio's asset mix exposes it to violent swings in value (especially downward) when the investor is getting close to needing the money. Circumventing that risk is the key reason that most retirement portfolio 'glide paths' begin to skew more bond- and cash-heavy for people in their 50s, 60s, and beyond.
Question 3: Will inflation take a big bite out of returns?
This risk factor goes hand-in-hand with the portfolio's asset allocation. Inflation isn't generally a big deal for portfolios with high equity weightings; over long periods of time, stocks will usually deliver a return that's comfortably above inflation, and when inflation is on the move, stocks are often trending up, too. But inflation risk looms large for portfolios with sizable allocations to bonds. Because bonds' income is what it is, regardless of inflation, it will buy less and less if the costs of goods and services trend up. Thus, bond-heavy investors should work hard to ensure that their portfolios include ample exposure to investments with the ability to keep up with, if not out-earn inflation, including stocks and Treasury Inflation-Protected Securities, which have a built-in hedge against inflation.
Question 4: Is the portfolio riding on a single outcome?
Stocks? Check. Bonds? Check. All-weather portfolio? Not so fast. Even portfolios that are dispersed across these two major asset classes may not be all that well-balanced. That's because lower-quality bond types respond to the same forces that stocks do—specifically, the overall health of the economy. That's fine as long as gross domestic product growth is increasing and unemployment is on the decline. But when investors are feeling skittish about the economy, they tend to dump credit-sensitive bond types right along with their stocks. During the financial crisis, for example, categories like high-yield, bank-loan, and emerging-markets bonds all tumbled because investors worried about the creditworthiness of their issuers in a weakening economy. These bonds' losses weren't as high as equities, but nor did they provide any ballast for investors' depressed equity holdings. Thus, another check on your portfolio's overall risk level is the complexion of your fixed-income holdings. Even though credit-sensitive bonds typically provide better yields, high-quality bonds are the better way to diversify stock-heavy portfolios.
Question 5: Is the portfolio overly concentrated?
Packing too much into an individual holding won't be a big risk for most for most mutual fund or exchange-traded fund investors, assuming they don't go overboard with a single concentrated fund or two. Rather, it's more of a risk factor for investors who own at least some individual securities. Newer investors often start out with just a small handful of stocks; sometimes they get lucky, but oftentimes they learn the hard way about the dangers of underdiversification. Concentration risk can be particularly problematic for holders of company stock.
Question 6: Are you a risk factor?
Last but not least, one of the biggest risk factors for many portfolios doesn't lurk inside. Rather, it's the chance that despite your well-laid plans, you'll undermine your results by falling into the fear-greed cycle, or one of the many other behavioral traps that investors face. Such mistimed buying and selling can exact an even bigger toll than investment fees over time. We're all wired differently as investors, so unfortunately there's no one-size-fits-all way to short-circuit behavioral risk factors. However, a few simple steps can help. First, don’t peek at your portfolio or its value; assuming the plan you started with was reasonable, a policy of benign neglect will tend to beat one that's overly busy. Second, consider an all-in-one investment type that allows you to be truly hands-off. While it's still early days for target-date funds, Morningstar's investor return data paint a promising picture of investors' propensity to use such funds well—that is, they tend not to jump in and out of them so they're able to take home a good share of their returns. Last but not least, put as much of your plan on autopilot as possible, automating your ongoing IRA and taxable account contributions, just as is the case with the money going into your 401(k) plan. Not only does such a program instill discipline in your saving and investment habits, but it creates barriers that you'll need to jump over if you decide you want to stop investing when the market gets rough.
This is for informational purposes only and should not be considered financial planning advice.
Diversification does not eliminate the risk of experiencing investment losses. Holding a portfolio of securities for the long term does not ensure a profitable outcome, and investing in securities always involves risk of loss.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes.
401(k) and IRA plans are long-term retirement-savings vehicles. Funds grow tax-deferred. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Direct contributions to a Roth IRA are not tax-deductible but may be withdrawn free of tax at any time. Earnings may be withdrawn tax and penalty free after a 5 year holding period if the age of 59 1/2 (or other qualifying condition) is met. Otherwise, a 10% federal tax penalty may apply. Please consult with a financial or tax professional for advice specific to your situation.








Don’t Get Caught by These 10 Behavioral Pitfalls

Successful investing is hard, but it doesn't require genius. As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one's own psychological weaknesses.
Over the past several decades, psychology has permeated our culture in many ways. In more recent times, its influences have taken hold in the field of behavioral finance, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests.
Experts in the field of behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market. In this article, we focus on how the insights from the field of behavioral finance can benefit individual investors. Primarily, we're interested in how we can learn to spot and correct investing mistakes in order to yield greater profits. Following are 10 of the biggest psychological pitfalls.
1. Overconfidence 
Overconfidence refers to our boundless ability as human beings to think that we're smarter or more capable than we really are. It's what leads 82% of people to say that they are in the top 30% of safe drivers, for example. Moreover, when people say that they're 90% sure of something, studies show that they're right only about 70% of the time. Such optimism isn't always bad. Certainly we'd have a difficult time dealing with life's many setbacks if we were diehard pessimists.
However, overconfidence hurts us as investors when we believe that we're better able to spot the next miracle stock than another investor is. Odds are, we're not. (Nothing personal.) Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Trading rapidly costs plenty and rarely rewards the effort. Trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns. These frictional costs will always drag returns down.
One of the things that drives rapid trading, in addition to overconfidence in our abilities, is the illusion of control. Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.
2. Selective Memory
Another danger that overconfident behavior might lead to is selective memory. Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing. In terms of investments, we certainly don't want to remember those stock calls that we missed much less those that proved to be mistakes that ended in losses.
The more confident we are, the more such memories threaten our self-image. How can we be such good investors if we made those mistakes in the past? Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.
Incorporating information in this way is a form of correcting for cognitive dissonance, a well-known theory in psychology. Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviors, at once, and our psyche will somehow need to correct for this.
Correcting for a poor investment choice of the past, particularly if we see ourselves as skilled traders now, warrants selectively adjusting our memory of that poor investment choice. 'Perhaps it really wasn't such a bad decision selling that stock?' Or, 'Perhaps we didn't lose as much money as we thought?' Over time our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.
Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence—such as short-term performance numbers—and too little weight to the evidence from the more distant past. As a result, we'll give too little weight to the real odds of an event happening.
3. Self-Handicapping
Researchers have also observed a behavior that could be considered the opposite of overconfidence. Self-handicapping bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true.
An example of self-handicapping is when we say we're not feeling good prior to a presentation, so if the presentation doesn't go well, we'll have an explanation. Or it's when we confess to our ankle being sore just before running on the field for a big game. If we don't quite play well, maybe it's because our ankle was hurting.
As investors, we may also succumb to self-handicapping, perhaps by admitting that we didn't spend as much time researching a stock as we normally had done in the past, just in case the investment doesn't turn out quite as well as expected. Both overconfidence and self-handicapping behaviors are common among investors, but they aren't the only negative tendencies that can impact our overall investing success.
4. Loss Aversion
It's no secret, for example, that many investors will focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black. This behavior is called loss aversion. Investors have been shown to be more likely to sell winning stocks in an effort to 'take some profits,' while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, 'More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason.'
Regret also comes into play with loss aversion. It may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons. In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more. It also doesn't help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It's this unwillingness to accept the pain early that might cause us to 'ride losers too long' in the vain hope that they'll turn around and won't make us face the consequences of our decisions.
5. Sunk Costs
Another factor driving loss aversion is the sunk-cost fallacy. This theory states that we are unable to ignore the 'sunk costs' of a decision, even when those costs are unlikely to be recovered.
One example of this would be if we purchased expensive theater tickets only to learn before attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us by a friend. Rational behavior would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible, we would choose to go or not go based on our interest. Instead, our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits. Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses. Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.
6. Anchoring
Ask New Yorkers to estimate the population of Chicago, and they'll anchor on the number they know—the population of the Big Apple—and adjust down, but not enough. Ask people in Milwaukee to guess the number of people in Chicago and they'll anchor on the number they know and go up, but not enough. When estimating the unknown, we cleave to what we know.
Investors often fall prey to anchoring. They get anchored on their own estimates of a company's earnings or on last year's earnings. For investors, anchoring behavior manifests itself in placing undue emphasis on recent performance as this may be what instigated the investment decision in the first place.When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to 'break even' or get back to what we paid for it. We may cling to subpar companies for years rather than dumping them and getting on with our investment life. It's costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.
7. Confirmation Bias
Another risk that stems from both overconfidence and anchoring involves how we look at information. Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favorably.
For instance, if we've had luck owning a certain brand’s cars, we will likely be more inclined to believe information that supports our own good experience owning them, rather than information to the contrary. If we've purchased a mutual fund concentrated in healthcare stocks, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.
Hindsight bias also plays off of overconfidence and anchoring behavior. This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome. Our judgment of a previous decision becomes biased to accommodate the new information. For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. This type of 'knowledge updating' can keep us from viewing past decisions as objectively as we should.
8. Mental Accounting
If you've ever heard friends say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Most of us separate our money into buckets—this money is for the kids' college education, this money is for our retirement, this money is for the house. Heaven forbid that we spend the house money on a vacation.
Investors derive some benefits from this behavior. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we categorize our funds without looking at the bigger picture. One example of this would be how we view a tax refund. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as 'found money' to be spent more frivolously. Since tax refunds are in fact our earned income, they should not be considered this way.
For gambling aficionados this effect can be referred to as 'house money.' We're much more likely to take risks with house money than with our own. For example, if we go to the roulette table with $100 and win another $200, we're more likely to take a bigger risk with that $200 in winnings than we would if the money was our own to begin with. There's a perception that the money isn't really ours and wasn't earned, so it's OK to take more risk with it. This is risk we'd be unlikely to take if we'd spent time working for that $200 ourselves.
Similarly, if our taxes were correctly adjusted so that we received that refund in portions all year long as part of our regular paycheck, we might be less inclined to go out and impulsively purchase that Caribbean cruise or new television.
In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance, or realized capital gains.
9. Framing Effect
The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision. Let's assume, for example, that we decide to buy that television after all. But just before paying $500 for it, we realize it's $100 cheaper at a store down the street. In this case, we are quite likely to make that trip down the street and buy the less expensive television. If, however, we're buying a new set of living room furniture and the price tag is $5,000, we are unlikely to go down the street to the store selling it for $4,900. Why? Aren't we still saving $100?
Unfortunately, we tend to view the discount in relative, rather than absolute terms. When we were buying the television, we were saving 20% by going to the second shop, but when we were buying the living room furniture, we were saving only 2%. So it looks like $100 isn't always worth $100 depending on the situation.
The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, and to take care not to think of your 'budget buckets' so discretely that you fail to see how some seemingly small decisions can make a big impact.
10. Herding
There are thousands and thousands of stocks out there. Investors cannot know them all. In fact, it's a major endeavor to really know even a few of them. But people are bombarded with stock ideas from brokers, television, magazines, websites, and other places. Inevitably, some decide that the latest idea they've heard is a better idea than a stock they own (preferably one that's up, at least), and they make a trade.
Unfortunately, in many cases the stock has come to the public's attention because of its strong previous performance, not because of an improvement in the underlying business. Following a stock tip, under the assumption that others have more information, is a form of herding behavior.
This is not to say that investors should necessarily hold whatever investments they currently own. Some stocks should be sold, either because the underlying businesses have declined or their stock prices greatly exceed their intrinsic value. But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons.
We can all be much better investors when we learn to select stocks carefully and for the right reasons, and then actively block out the noise. Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.
This is for informational purposes only and should not be considered financial planning advice.
Diversification does not eliminate the risk of experiencing investment losses. Holding a portfolio of securities for the long-term does not ensure a profitable outcome, and investing in securities always involves risk of loss.
Returns and principal invested in stocks are not guaranteed, and stocks have been more volatile than other asset classes.

by Donna Gordon on July 21st, 2016

​Investors Missed the Boat After the Financial Crisis

Looking at where people invest their money on an annual basis can offer some insight into investor behavior. The chart below shows worldwide fund flows into mutual funds and exchange-traded funds by asset class. Historically, the best predictor of future flows is recent past performance. Asset classes with good performance over the last year tend to get strong flows in the following year.
Generally speaking, this is not the best way to invest. For example, in 2009, after the financial crisis and at the beginning of a strong bull market in stocks, the largest flowing category was fixed income. Actually, fixed income received the highest flows from 2009 to 2012. The traumatic experience of the financial crisis scared investors out of investing in U.S. equities all the way until 2013. By waiting so long to invest the average investor missed out on the best returns of the bull market.
Another trend is the strong flows into international stocks. This trend goes against the pattern of flows following performance because international-stock returns have been much lower than U.S. stock returns in the last several years. So, despite their lower recent returns, investors are allocating more money into international stocks. It seems that investors are doing everything they can to avoid buying U.S. equities.
In conclusion, the patterns in this chart show the behavior of the average investor. It is generally not a good idea to follow the crowd in investing. Instead, the more prudent choice is to look to invest in unpopular categories. The best example of this is the fantastic returns you could have received in U.S. stocks over the last seven years.
​What History Says About Safe Retirement-Withdrawal Rates

When approaching retirement, the first question many investors ask is how much money can they safely take from their portfolio each year. A simplistic way of looking at this is a withdrawal rate, expressed as a percentage of your investment assets. To help you make that decision, it may be helpful to look at what previous retirees could have withdrawn over a long retirement.
The chart shows the historical maximum sustainable inflation-adjusted withdrawal rate over rolling 30-year periods for three hypothetical stock and bond portfolios from 1926 to 2015. In the portfolios, stocks are represented by the S&P 500 and bonds by an index of five-year U.S. Treasury bonds. Initial starting values for the three portfolios are assumed to be $500,000. Rolling-period returns are a series of overlapping, contiguous periods. For example, the first point on the chart represents the rolling period of January 1926 to December 1955, the second point moves one month forward to the period February 1926 to January 1956, and so on.
As shown, the amount that could have been withdrawn over each 30-year period varied greatly. If you retired right after the stock market crash of 1929 or in the early 1980s at the beginning of a long 20-year bull market, you could have withdrawn over 10% and still not run out of money after 30 years.
On the other end of the spectrum, if you retired at the beginning of a bear market, the maximum withdrawal rate was as low as 3.5%.
Obviously, you don't know when you start retirement whether market returns will be good or bad, so most people pick a withdrawal rate near 4%, because it works most of the time. While the chart models a fixed withdrawal rate for the entire period, we would advise people to use a more flexible strategy in practice.
When choosing the allocation of stocks and bonds, a portfolio with a higher stock allocation may make the most sense. The chart illustrates that a portfolio invested in 75% stocks has been more volatile but has almost always paid off through higher maximum withdrawal rates.
In conclusion, investors should start retirement with a conservative withdrawal rate near 4% and make adjustments over time based on their income needs and portfolio performance. And investors should consider a portfolio with at least a 50% equity allocation in retirement.




3 Tricks for Getting the Most Out of Your HSA


According to a survey by America's Health Insurance Plans the number of Americans covered by high-deductible health plans (HDHPs)--and who are, in turn, eligible for HSAs--rose by two million between 2014 and 2015, a more than 10% growth rate.


Many workers who are eligible to contribute to HSAs don't take full advantage of them. Even though HSAs offer the best tax treatment of any savings vehicle--pretax contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenses--only 4% of HSA holders choose to invest their funds, according to research from HelloWallet, a Morningstar company.


Of course, not everyone has the wherewithal to use an HSA as an investing vehicle; most people need to spend the amounts they've accumulated in their HSAs to cover out-of-pocket healthcare costs. But even those where workers who use a 'spend as you go' approach probably aren't saving enough: The HelloWallet study found that the average HSA deferral was $1,600; the median deferral was $700. Families, especially, are apt to blow through that amount in a hurry in a given year.


If you're considering using your HSA as an investment vehicle, here are three strategies to help get the most mileage out of this valuable account type.


Trick 1: Obtain a payroll deduction while also getting away from a lousy employer-provided HSA.


High-deductible healthcare-plan participants are free to use any HSA custodian they choose, not just the one their employers have chosen. To do so, they would simply steer their contributions into their own HSA, then deduct the contribution on their tax return. (Note that HSA contributions don't fall under the heading of qualified medical expenses, the latter of which can only be deducted to the extent they exceed 10% of adjusted gross income. Rather, HSA contributions are an 'above-the-line' deduction, so they help reduce your adjusted gross income directly, thereby reducing your income to enable Roth contributions and the like.)


But from a practical standpoint, that can be cumbersome and won't likely yield exactly the same tax benefits as having your contribution extracted from your payroll. For one thing, using the payroll deduction enables you to get the tax break right away versus waiting to reap the benefit of the deduction on your tax return. Additionally, HSA dollars extracted via payroll deduction are not subject to Social Security and Medicare taxes, provided the plan is a Section 125 or cafeteria plan.


A workaround is to contribute to your employer's chosen HSA for convenience and tax benefits, then annually roll over or transfer that money to the HSA of your choice. (A rollover, which is allowed once a year, means that you get a check from the first HSA custodian and must get it over to the second HSA custodian within 60 days. A transfer means the two custodians deal with one another on the transaction; you don't receive a check. You can complete multiple transfers per year.) That strategy lets you enjoy the best of both worlds: You get the tax benefit of payroll deductions as well as the long-term benefits of steering your HSA investments to a custodian with better and/or lower-cost options.


A couple of caveats: You can have more than one HSA going at one time, but like IRAs, your combined HSA contribution for a given year cannot exceed the limits--in 2016, that's $3,350 for individuals and $6,750 for families. And if you're employing the two-part strategy I outlined above, it's worth thinking through your investment approach to the employer-provided HSA. Because it's essentially a short-term parking place under the two-part strategy, you'd either want to keep your money liquid while you hold it there or make sure that your hand-chosen HSA includes analogous investment products that you hold in your employer-provided HSA. That way, if one of the investment choices in your employer-provided HSA happens to be in the dumps at the time you plan to transfer your money, you can swap into a similar investment option to maintain like-minded market exposure.


Trick 2: Take a hybrid 'spend/invest' approach.


HSAs offer prodigious tax features--tax-free contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenditures. That explains why HSA-eligible investors are often advised to let their HSA assets ride while using non-HSA assets to defray their healthcare costs as they arise. (Doing so has the salutary effect of not triggering point-of-purchase fees that some HSA debit cards carry.)


Yet, even as that makes all the sense in the world by the numbers, from a practical standpoint, paying healthcare expenses with non-HSA assets can be disruptive to a household's budget. For employees who have spent most of their careers covered by traditional healthcare plans like PPOs, it's disconcerting to be suddenly on the hook for hundreds or even thousands of dollars of out-of-pocket healthcare costs.


In that instance, it can be comforting to split the difference: Contribute the maximum to your HSA if you can swing it, park enough in the savings-account option to cover your expected healthcare outlays and pay for them from that account, and invest the rest in long-term investments. If you have had an HDHP for the past few years, your previous out-of-pocket outlays can help you figure out how much to hold in cash.


Trick 3: Use your HSA to cover emergency non-healthcare costs later on.


Despite the very good case to be made for paying healthcare expenses with aftertax assets and letting the assets build inside an HSA, some investors might demur. The HSA is, after all, a single-purpose vehicle--that is, you only enjoy the full range of tax benefits if you earmark your withdrawals for healthcare expenditures.


That's mostly true, but there's actually a workaround in case you need to crack into your HSA for non-healthcare expenses later on. Even if you paid out of pocket (using non-HSA assets) for healthcare expenses in previous years, you can still make a tax-free withdrawal later on for non-healthcare expenses, provided you hung on to receipts for the earlier healthcare costs. An unlimited amount of time can elapse between when you actually incurred the healthcare cost and when you reimburse yourself; the withdrawal will be tax-free as long as you have the proper documentation of the prior expense.


To use a simple example, let's say a person paid $5,000 out of her taxable monies to cover healthcare expenses incurred at the end of 2015. Throughout 2015, she racked up the maximum family contribution of $6,650 in her HSA, letting the money build up rather than spending from it. If she needed a new roof in 2016, she could pull $5,000 from her HSA to steer toward that expense, and that withdrawal would be tax-free provided she could document the 2015 out-of-pocket healthcare costs.


That's not ideal, of course, because she's better off letting the money grow. But a tax-free HSA withdrawal beats other forms of emergency funding, such as credit cards, HELOCs, or 401(k) loans.


The key to preserving this escape hatch, as noted above, is to maintain scrupulous documentation of healthcare expenditures. It's also worth noting that the HSA participant must have established the HSA and made the contribution before she incurred the healthcare cost.



 

by Donna Gordon on July 21st, 2016

Asset Flows Into Passive Bond Strategies Pick Up

Indexing or passive investing started out and is more predominant in equity funds.  Equities trade on an exchange, they're very liquid, and therefore they are relatively easy to index. On the other hand, bonds are traded over the counter, are not as liquid, trade less frequently, have higher trading costs, and there are also many more bonds out there than stocks. For these reasons, indexing fixed income is more difficult; however, fixed-income indexing has been growing rapidly in the last few years.
Looking back to 2008, passive fixed-income funds held 13% of assets. From 2008 to 2013, the category enjoyed steady positive flows as investors remained in flight-to-safety mode even after the financial crisis ended. Most of these flows went into active funds until the so-called 'taper tantrum' of 2013 caused a sudden reversal.
As investors began to plan for lower bond returns due to the Fed's tapering of the QE program, they became particularly sensitive to cost. Before, when an active manager had the potential to bring in higher returns, investors were willing to pay a larger fee. Now, however, if they know they have to settle for lower bond returns, investors started looking for less expensive options. So, in this context, the passive share of fixed-income assets doubled, from 13% in 2008 to 26% in 2015.
In conclusion, fixed-income flows are very sensitive to interest-rate movements, and investors are positioning themselves for a low-return world while trying to control costs. This will continue to be an interesting story going forward because there is still uncertainty about when and by how much rates will increase, and that is likely to keep flows volatile for most fixed-income categories.
​Low-Volatility ETFs

One trend we've been observing recently is increasing flows into low-volatility exchange-traded funds. Currently there are 18 low-volatility ETFs in Morningstar's database, with $23 billion in assets as of May 13, 2016. The largest funds in this category are iShares MSCI USA Minimum Volatility and PowerShares S&P 500 Low Volatility.
These ETFs aim to provide similar returns to the U.S. stock market, while at the same time taking on less risk than the overall market. Obviously, that's an appealing concept for investors, especially after the January sell-off. Investors are still seeking exposure to U.S. equities but are less and less willing to put up with the market's erratic ups and downs.
Looking at monthly organic growth rates (that's flows over beginning assets), we can see that low-volatility ETFs grew at a peak rate of 17% in February and continued to grow at a robust pace since. In contrast, the organic growth rate for SPDR S&P 500 SPY was a negative 1% in February and remained close to zero for the next two months. Flows tend to follow performance, and low-volatility ETFs significantly outperformed SPY, on average, both year to date and during the past year.
A word of caution, however. Like any rapidly accelerating trend, the growing popularity of low-volatility ETFs carries some concerns. These ETFs are more expensive; their average expense ratio is 29 basis points, as opposed to only 9 for SPY. Also, there are concerns that low-volatility ETFs may now be overvalued after such large inflows and will not able to maintain such high returns in the future. Investors should carefully consider the potential downsides, as well as the benefits, before jumping in on this trend.
Investor Return Versus Total Return

The average investor return can diverge widely from a fund's posted total return, illustrating the dangers of performance chasing. The Morningstar Investor Return data point measures how the typical investor in a fund fared over time, incorporating the impact of cash inflows and outflows. It is not one specific investor's experience, but rather a measure of the return earned collectively by all investors in the fund. Conversely, total return measures the percentage change in price for a fund, assuming the investor buys and holds the fund over the entire time period, reinvests distributions, and does not make any additional purchases or sales.
The image illustrates the divergence in total return and investor return for a mutual fund selected from Morningstar's mutual fund database. The fund's 10-year total return was 3.9%, but its 10-year investor return was a terrible negative 15.4%, which is quite a big difference. The fund's net cash flow tells the story of the discrepancy. Investors piled into the fund during its runup between 2006 and mid-2007, with most inflows occurring near the fund's peak value. Investors then fled as the fund's returns plummeted, with most outflows occurring near the fund's bottom. This type of behavior is not uncommon as investors tend to chase performance, buying high and selling low.
In conclusion, performance-chasing is one of the biggest reasons investors underperform over the long term. By being aware of this behavioral bias, you can be better prepared to counteract it, by learning to stick to a long-term asset allocation plan through the market's ups and downs.

by Donna Gordon on July 21st, 2016

​A Guide to College-Savings Options

Is setting up a college-savings account for a child or grandchild an item on your to-do list? You know you should get it done; that matriculation date just keeps creeping closer. But finding the right vehicle to save for college can be daunting. There are many choices, and it can be difficult to discern the differences between each type of account.
Below, we've outlined a few salient features of a few of the most common college-savings vehicles, including the tax treatment for each, how much you can contribute, who can contribute, the rules governing distributions, and a summary of the types of individuals who will tend to benefit most from each investment vehicle.
529 College-Savings Plan
Tax Treatment: Contributions not deductible on federal income tax. Contributions may receive a state tax break (either a deduction or a credit). Money compounds on a tax-free basis and withdrawals to pay for qualified college expenses are tax-free, too.
Tax Benefit: Possible state tax break; tax-free compounding; tax-free withdrawals. Contributions treated as completed gifts; apply $14,000 annual gift-tax exclusion (per person, so $28,000 per married couple) or up to $70,000 ($140,000 per married couple) with five-year election (click here to read the IRS rules on this).
Contribution Limit: Per IRS guidelines, lifetime contributions cannot exceed the amount necessary to provide education for beneficiary. What this actually means varies widely by state and by plan--anywhere from $235,000 to $425,000 for non-prepaid tuition plans. Deduction amounts vary by state, and gift tax may apply to very high contribution amounts.
Income Limit: None.
Withdrawal Flexibility: Medium. Investors can withdraw contributions at any time without taxes or penalty. Withdrawals of investment earnings must be used for qualified college expenditures or will incur taxes and a 10% penalty. Those withdrawing funds for noncollege expenses may also be required to pay back any state tax deduction they've received on contributions. They can, however, change the beneficiary of a plan, as long as the new beneficiary is a family member of the former beneficiary.
Investment Flexibility: Low. Investors in 529 plans must choose their investments from a preset menu offered by the plan.
Required Distributions: None.
Pros: High allowable contribution amounts, state tax breaks on contributions, and tax-free compounding and withdrawals. The plans reduce the financial-aid impact compared with money held in the student's name.
Cons: States may impose an extra layer of administrative costs, and investment choices may be costly and/or subpar.
Best for: Individuals who are aiming to stash a significant sum for college while also enjoying tax benefits.
Coverdell Education Savings Account
Tax Treatment: Contributions not deductible on federal or state income tax. Money compounds on a tax-free basis, and withdrawals to pay for qualified educational expenses are tax-free, too. Contributions don't have to be made with earned income, meaning grandparents can contribute even if parents are ineligible due to income limits.
Tax Benefit: Tax-free compounding; tax-free withdrawals for qualified educational expenses.
Contribution Limit and Time Frame: $2,000 per beneficiary, per year; must make contributions by the time beneficiary is age 18. (Any amount exceeding $2,000 per year per beneficiary is subject to a 6% excise tax penalty.)
Income Limit: For 2016, single income tax filers with modified adjusted gross incomes of more than $110,000 and married couples filing jointly with incomes greater than $220,000 cannot make contributions to a Coverdell.
Withdrawal Flexibility: Medium. Withdrawals of contributions are tax- and penalty-free. And in contrast with 529 assets, in which withdrawals will incur taxes and a penalty unless used for qualified college expenses, Coverdell assets may be used for elementary and high school expenses, too. You can also change the beneficiary of a plan, as long as the new beneficiary is a family member of the former beneficiary.
Investment Flexibility: Medium. Coverdell ESA investors can, in theory, invest in a broad swath of assets, but fewer and fewer investment providers offer the accounts.
Required Distributions: Funds must generally be distributed from an account by the time the student reaches age 30, though they may be rolled over into a Coverdell ESA for another eligible family member.
Pros: Ability to use funds for elementary and high school expenses; flexibility to invest in a broad variety of securities, including mutual funds and individual stocks.
Cons: Limited contribution amounts and lower MAGI thresholds; investment providers may not offer this account type.
Best for: Individuals aiming to invest relatively smaller sums for education--including elementary, high school, and college--who are seeking more investment flexibility than 529s afford.
UGMA/UTMA
Tax Treatment: Aftertax contributions. Earnings and gains taxed to minor; for children under age 19 and full-time students under age 24 (whose unearned income does not provide half their support), first $1,050 of unearned income is tax-exempt, the next $1,050 is taxed at the child's rate, and over $2,100 is taxed at parents' rate.
Tax Benefit: First $2,100 of earnings and gains subject to lower tax rates. Transfers treated as completed gifts; apply $14,000 annual gift tax exclusion.
Contribution Limit: None. Gift tax may apply to contribution amounts above $14,000 per child for single filers; $28,000 for married couples.
Income Limit: None.
Withdrawal Flexibility: Greater. There is no penalty for using assets to pay for non-educational expenses, regardless of the child's age. However, even though custodian retains control of assets until beneficiary reaches 18 or 21 (depending on the state and type of account), the assets may be used only for the child's benefit (that is, not to cover basic parental obligations such as food and shelter). When the minor in whose name the UGMA/UTMA account is established reaches age of termination, he or she assumes control of all the assets.
Investment Flexibility: Greater. UGMA/UTMA investors can invest in a broad swath of assets.
Required Distributions: Minor takes custodial ownership of assets at age of termination (18-21)--varies by state and account type.
Pros: No penalty for not using earnings for educational expenses; can be used for any purpose that benefits beneficiary.
Cons: Counted as student's assets, heavier impact on financial aid eligibility. Cannot transfer beneficiary. Contributions are irrevocable. At age of majority, beneficiary is entitled to account assets.
Best for: Individuals who may not attend college.
Roth IRA
Tax Treatment: Aftertax contributions; tax-free compounding and withdrawals after five years, at age 59 1/2.
Tax Benefit: Tax-free compounding and withdrawals.
Contribution Limit: $5,500 (under 50); $6,500 (over 50).
Income Limit: Single filers with modified adjusted gross incomes below $132,000 can make at least a partial contribution for 2016. Married couples filing jointly can make at least a partial contribution if their modified adjusted gross incomes are less than $194,000. Investors of all income level can contribute to a Roth with the 'backdoor' maneuver.
Withdrawal Flexibility: Medium. Roth IRA contributions can be withdrawn tax-free for any purpose. And while you'll typically face taxes and a 10% early withdrawal penalty if you take out investment earnings from your Roth before age 59 1/2, the 10% penalty usually assessed for early withdrawals from an IRA is waived if funds are used to pay for college tuition, books, fees, and other qualified expenses.
Investment Flexibility: High. Most investment types can be held inside an IRA, with a few exceptions.
Required Distributions: None.
Pros: Investors can choose low-cost and best-of-breed investments with limited administrative costs. For financial aid: not counted as asset in need-based calculations. Money not spent on college can be used for retirement instead.
Cons: Limited contribution amounts. If you are depending on the Roth IRA to help fund your retirement you may be depriving yourself of years of tax-free growth and distributions by removing funds from the account to pay for college. For financial aid: Distributions taken from Roth IRA (even if contributions only) are counted as income the year after they are taken.
Best for: Savers aiming to invest relatively smaller sums and who desire more flexibility in terms of investment options and use of assets (can be used to pay for college and to fund retirement).


Disclosure: 529 plans are tax-deferred college-savings vehicles. Any unqualified distribution of earnings will be subject to ordinary income tax and subject to a 10% federal penalty tax. 

A Crash Course in Long-Term Care

If you've helped an elderly friend or relative find and figure out how to pay for long-term care, or you've done so yourself, you likely confronted a bewildering maze of unfamiliar terms as well as extreme financial complexity.


What's the right type of care given the person's needs? What type of care is covered by Medicare? When does your private insurance--either health or long-term care insurance--pick up the slack? And what expenses must be paid out of your own coffers? Can a spouse hang on to any assets before Medicaid kicks in and provides coverage for long-term care needs?


Unfortunately, many people are navigating the long-term care maze at times when they're contending with other major challenges. Older individuals may be confronting declining physical health and/or mental faculties at the same time they're attempting to make important long-term care decisions. And because long-term care may also bring a loss of independence, contemplating it can cause emotional distress for both older individuals and their loved ones.


Rather than having to sort out long-term care on the fly, it helps to be pre-emptive. Get familiar with the various types of care, as well as the financial ramifications, before you actually need to put the information to use. This article explains the key terms and variables that consumers should be aware of when navigating long-term care.


Activities of Daily Living (ADLs): Basic activities that are used to measure a disabled or elderly individual's level of functioning. The key ADLs are bathing, dressing, eating, ambulating/transferring (moving from place to place, or from standing position to chair), grooming, and toileting.


Skilled Nursing Facility (sometimes called a SNF or 'Sniff'): A type of facility that provides skilled nursing care, usually medical care and/or rehabilitation services. Medicare covers, in full, the first 20 days of care in a skilled nursing facility following a qualifying hospital stay (defined as three days in a row in the hospital as an inpatient). For days 21-100 in a skilled nursing facility (again, following release from a qualifying hospital stay), you must pay a copayment (often covered by your supplemental health-insurance policy) while Medicare covers the remainder of the cost. For days 101 and beyond, Medicare does not cover the costs of care in a skilled nursing facility.


Nursing Home: A facility that helps individuals with the activities of daily living, including eating, bathing, and getting dressed. Nursing homes are also likely to coordinate and/or provide medical care for individuals who need it, but their central focus is to help residents with their daily lives. In contrast to care provided in a skilled nursing facility to people who have had a qualifying hospital stay, nursing-home care (sometimes called 'custodial care') is not covered by Medicare. Instead, costs are covered out of pocket, by long-term care insurance (for those who have such policies), or Medicaid for individuals with limited assets.


Assisted Living Facility (ALF): A type of facility geared toward people who need assistance with the activities of daily living but who do not need the type of extensive care provided in a nursing home. Most assisted living facilities, like nursing homes, help patients coordinate medical care, but providing medical care to sick individuals is not the central focus. Many ALFs now have locked 'memory care' units geared toward people with Alzheimer's disease or dementia. As with nursing homes, stays in ALFs are not covered by Medicare; instead, such care is covered out of pocket, by long-term care insurance (for those who have it), or Medicaid.


Continuous Care Retirement Community (CCRC): A type of community geared toward providing a gradation of care to older adults--from independent living to assisted living to nursing-home care. The goal of the CCRC is to help older individuals reside in the same community for the remainder of their lives. Such communities tend to be the most costly of all elder-care options, often requiring an upfront sum as well as monthly charges that will vary depending on the level of care the individual is receiving. As with nursing homes and assisted living facilities, most of the care provided within CCRCs is not covered by Medicare, unless it's medical care or skilled nursing care that is normally covered by Medicare (see 'Skilled Nursing Facility,' above). The financial arrangements of CCRCs can be devilishly complicated; this article delves into some of the particulars.


Custodial Care: Non-medical care provided to assist older adults with the activities of daily living. As a rule, custodial care alone is not covered by Medicare; instead, such costs must be covered out of pocket with long-term care insurance, or by Medicaid for eligible individuals.


Hospice Care: Care provided to individuals at the end of their lives; the focus is on keeping the patient comfortable rather than extending life. Such care may be provided at home, in the hospital, or in a skilled nursing facility. Hospice care is covered by Medicare if your doctor and the hospice director certify that you're terminally ill and have less than six months to live. To be covered by Medicare, hospice care cannot be delivered in conjunction with any curative treatment. This document provides more details on the interaction between hospice and Medicare.


Palliative Care: Care geared toward providing pain relief and emotional support to individuals with serious illnesses. In contrast to hospice care, which is for terminally ill patients, palliative care can be provided to individuals undergoing curative treatment. Medicare Part B may cover some of the prescriptions and treatments offered under the umbrella of palliative care.


Adult Day Services: Services, including social activities and assistance with activities of daily living, provided during the day to individuals who otherwise reside at home. Approximately half of the individuals who take part in adult day services have some form of dementia, according to the National Adult Day Services Association; thus, adult day services frequently focus on cognitive stimulation and memory training. Medicare may cover adult day services in certain limited instances, but generally does not.


Institutionalized Spouse: A spouse who has moved into a nursing home or other long-term care setting.


Community Spouse: A healthy spouse who remains in the community even after the other spouse has moved into a nursing home and requires Medicaid benefits.


Exempt (or Noncountable) Assets: Assets that can be owned by the institutionalized person without affecting Medicaid eligibility. Specific parameters depend on the state where you live, but exempt assets typically include $2,000 in cash, a vehicle, personal belongings, and household goods. In most states, a primary residence is also considered an exempt asset, even if an individual ends up moving into a nursing home, so long as a spouse or child lives there. The individual's equity in the home cannot exceed certain limits, usually $552,000 in most states. Moreover, the state can attempt to recover any money paid out through Medicaid when the owner dies and the home is sold.


Countable Assets: Assets that are counted when determining Medicaid eligibility. The specific parameters depend on the state in which you reside, but countable assets usually include checking and savings accounts, retirement-plan assets, and additional vehicles (in addition to the one vehicle that is considered exempt).


Community Spouse Resource Allowance (CSRA): The amount of assets that the community (in other words, healthy) spouse can retain, even as the institutionalized spouse qualifies for Medicaid. Those assets typically include a house, a car, and financial assets equal to one half of the couple's assets, subject to minimum and maximum thresholds. (The maximum allowable figure was recently $119,220.)


Lookback Period: The five-year period prior to an individual's application for Medicaid benefits. If assets were transferred to children or any other individuals during this five-year period, it will trigger a period of ineligibility for Medicaid benefits. The length of the penalty period is calculated by dividing the amount of the transfer by the average monthly nursing-home costs in the region or state where the individual resides. The goal of this provision is to keep otherwise-wealthy individuals from transferring assets to qualify for long-term care coverage under Medicaid.


Elimination Period: Similar to a deductible for other types of insurance, this is the amount of time during which one must pay long-term care costs out of pocket before insurance kicks in. The longer the elimination period, the lower the premiums will be.


Benefit Triggers: Triggers used by insurers to determine whether a long-term care policy will begin paying benefits. These triggers typically depend on the individual's ability to complete a certain number of activities of daily living.

3 Tricks for Getting the Most Out of Your HSA

According to a survey by America's Health Insurance Plans the number of Americans covered by high-deductible health plans (HDHPs)--and who are, in turn, eligible for HSAs--rose by two million between 2014 and 2015, a more than 10% growth rate.


Many workers who are eligible to contribute to HSAs don't take full advantage of them. Even though HSAs offer the best tax treatment of any savings vehicle--pretax contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenses--only 4% of HSA holders choose to invest their funds, according to research from HelloWallet, a Morningstar company.


Of course, not everyone has the wherewithal to use an HSA as an investing vehicle; most people need to spend the amounts they've accumulated in their HSAs to cover out-of-pocket healthcare costs. But even those where workers who use a 'spend as you go' approach probably aren't saving enough: The HelloWallet study found that the average HSA deferral was $1,600; the median deferral was $700. Families, especially, are apt to blow through that amount in a hurry in a given year.


If you're considering using your HSA as an investment vehicle, here are three strategies to help get the most mileage out of this valuable account type.


Trick 1: Obtain a payroll deduction while also getting away from a lousy employer-provided HSA.


High-deductible healthcare-plan participants are free to use any HSA custodian they choose, not just the one their employers have chosen. To do so, they would simply steer their contributions into their own HSA, then deduct the contribution on their tax return. (Note that HSA contributions don't fall under the heading of qualified medical expenses, the latter of which can only be deducted to the extent they exceed 10% of adjusted gross income. Rather, HSA contributions are an 'above-the-line' deduction, so they help reduce your adjusted gross income directly, thereby reducing your income to enable Roth contributions and the like.)


But from a practical standpoint, that can be cumbersome and won't likely yield exactly the same tax benefits as having your contribution extracted from your payroll. For one thing, using the payroll deduction enables you to get the tax break right away versus waiting to reap the benefit of the deduction on your tax return. Additionally, HSA dollars extracted via payroll deduction are not subject to Social Security and Medicare taxes, provided the plan is a Section 125 or cafeteria plan.


A workaround is to contribute to your employer's chosen HSA for convenience and tax benefits, then annually roll over or transfer that money to the HSA of your choice. (A rollover, which is allowed once a year, means that you get a check from the first HSA custodian and must get it over to the second HSA custodian within 60 days. A transfer means the two custodians deal with one another on the transaction; you don't receive a check. You can complete multiple transfers per year.) That strategy lets you enjoy the best of both worlds: You get the tax benefit of payroll deductions as well as the long-term benefits of steering your HSA investments to a custodian with better and/or lower-cost options.


A couple of caveats: You can have more than one HSA going at one time, but like IRAs, your combined HSA contribution for a given year cannot exceed the limits--in 2016, that's $3,350 for individuals and $6,750 for families. And if you're employing the two-part strategy I outlined above, it's worth thinking through your investment approach to the employer-provided HSA. Because it's essentially a short-term parking place under the two-part strategy, you'd either want to keep your money liquid while you hold it there or make sure that your hand-chosen HSA includes analogous investment products that you hold in your employer-provided HSA. That way, if one of the investment choices in your employer-provided HSA happens to be in the dumps at the time you plan to transfer your money, you can swap into a similar investment option to maintain like-minded market exposure.


Trick 2: Take a hybrid 'spend/invest' approach.


HSAs offer prodigious tax features--tax-free contributions, tax-free compounding, and tax-free withdrawals for qualified healthcare expenditures. That explains why HSA-eligible investors are often advised to let their HSA assets ride while using non-HSA assets to defray their healthcare costs as they arise. (Doing so has the salutary effect of not triggering point-of-purchase fees that some HSA debit cards carry.)


Yet, even as that makes all the sense in the world by the numbers, from a practical standpoint, paying healthcare expenses with non-HSA assets can be disruptive to a household's budget. For employees who have spent most of their careers covered by traditional healthcare plans like PPOs, it's disconcerting to be suddenly on the hook for hundreds or even thousands of dollars of out-of-pocket healthcare costs.


In that instance, it can be comforting to split the difference: Contribute the maximum to your HSA if you can swing it, park enough in the savings-account option to cover your expected healthcare outlays and pay for them from that account, and invest the rest in long-term investments. If you have had an HDHP for the past few years, your previous out-of-pocket outlays can help you figure out how much to hold in cash.


Trick 3: Use your HSA to cover emergency non-healthcare costs later on.


Despite the very good case to be made for paying healthcare expenses with aftertax assets and letting the assets build inside an HSA, some investors might demur. The HSA is, after all, a single-purpose vehicle--that is, you only enjoy the full range of tax benefits if you earmark your withdrawals for healthcare expenditures.


That's mostly true, but there's actually a workaround in case you need to crack into your HSA for non-healthcare expenses later on. Even if you paid out of pocket (using non-HSA assets) for healthcare expenses in previous years, you can still make a tax-free withdrawal later on for non-healthcare expenses, provided you hung on to receipts for the earlier healthcare costs. An unlimited amount of time can elapse between when you actually incurred the healthcare cost and when you reimburse yourself; the withdrawal will be tax-free as long as you have the proper documentation of the prior expense.


To use a simple example, let's say a person paid $5,000 out of her taxable monies to cover healthcare expenses incurred at the end of 2015. Throughout 2015, she racked up the maximum family contribution of $6,650 in her HSA, letting the money build up rather than spending from it. If she needed a new roof in 2016, she could pull $5,000 from her HSA to steer toward that expense, and that withdrawal would be tax-free provided she could document the 2015 out-of-pocket healthcare costs.


That's not ideal, of course, because she's better off letting the money grow. But a tax-free HSA withdrawal beats other forms of emergency funding, such as credit cards, HELOCs, or 401(k) loans.


The key to preserving this escape hatch, as noted above, is to maintain scrupulous documentation of healthcare expenditures. It's also worth noting that the HSA participant must have established the HSA and made the contribution before she incurred the healthcare cost.





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