The performance of the Financial Place Online balanced portfolio

The Financial Place Online balanced 401k portfolio example was developed based on a grouping of common Vanguard funds available to various 401k plans.  The asset allocation is as follows:

As compiled from Vanguard’s website, the performance record for each of these assets is impressive.

VanguardThe first thing to note here is the omission of the Developed Markets fund.  That fund has been recently established.  In its place, the MSCI EAFE index has been used, which is a more than reasonable assumption.  Each of the four funds have experienced strong performance in the past.  It is important to remember that past performance is just that; past performance.  What is important is what each of these funds represent.  As a combination, this portfolio covers ownership of the U.S. S&P 500 index, a stong mix of Real Estate Investment Trusts, the U.S. aggregate bond market (high credit rated bonds) and developed markets in Europe and Asia.  There will be profitability in the future.  You can be sure of that.  Businesses are all about increasing shareholder value, though some are better at it that others.  This portfolio is geared towards capturing as much of the total market profits as you can in as cost effective of a method as possible.

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Tax planning to make the 401k into your own retirement pension

The 401k is a retirement plan which is employer sponsored.  In 2013, an employee may contribute up to their qualifying income or $17,500 (whichever is greater) to this account.  Many employers will match your contributions up to to several percent of your salary, but not all will.  The benefit of this plan is that your contributions are deferred from present taxes and gains within the account are sheltered from taxes.  This means that if you earn $75,000 per year and are $3,000 into the 25% marginal tax bracket, then contributing $3,000 to your 401k over the year will reduce your taxable income by $3,000 and knock you back down to the %15 marginal tax bracket.  This equals a tax savings of $750 in that year!  That’s $750 that you get to keep and don’t have to give to the government.

There’s other options for retirement accounts.  The term Roth comes up often, and points to the one downside of a 401k.  That is, for a 401k, the amount withdrawn at age 59 1/2 is subject to taxes.  Any amount withdrawn before age 59 1/2 is subject to taxes and a 10% penalty.  In the case of a Roth 401K, the principle can be withdrawn from the account, and withdrawals after age 59 1/2 are tax free.  The same penalty rules apply.

The fact that taxes aren’t paid on Roth 401k withdrawals sounds like a good deal, and it is.  However, contributions are made with “after tax” dollars.  This means no $750 savings in 2013.  The conventional financial wisdom suggests a bias towards Roth contributions for all except those in the higher tax brackets, usually 28% and higher.  The reasoning is that if you’re below this bracket, your present tax rates are low and will likely be higher in retirement since you will have multiple sources of income.  If your tax rate is 28% or above, the standard advice to to contribute to a traditional 401k.

Does the conventional wisdom work?  Is the bias towards Roth contributions valid?  Not so much.  Here’s why:

  • The above advice for Roth contributions make the fatal mistake that anyone has an idea what U.S. income taxes will look like in a decade or more.
  • The advice also ignores all elements of tax planning; where proper planning has multiple options for deferring taxes.
  • Roth contributions serve the government better as it brings in more tax revenues in the present.  Wouldn’t you rather have that money in hand?
  • The 10% bracket for Married Filing Jointly is about the same size of the maximum contribution limit of $17,500.  Even if all of your 401K contribution is in this bracket, you will get back $1750 if you max out your contribution.
  • 401k contributions lower your AGI.  They’re an “Above the line” deduction, one of the sweetest tax deals available.  This can open the door to the retirement tax contribution credit (or even a higher credit multiplier) and the earned income credit; which if you have kids you should at this point expect the additional child tax credit.

Based on this, the best strategy at any time is to defer taxes the most that you can in the current year.  The only exception to this rule exists for those who are in or near the 1% category.  Even in the case of a 0% tax rate, your best bet may not be the Roth contribution because of working your way out of the “phase out” of the earned income credit which is 16% with 1 child and 21% with 2 children.  Also worth considering is that the additional child tax credit is refundable.

>>>Taxes are complicated.  They are built to be that way.  It is not reasonable to expect mastery based on one read.  Financial Place Online will continue to provide only the best in tax guidance to make sure that you can maximize your own wealth development.

Fund expense ratios explained

The expense ratio is a fee that occurs in all mutual and index funds.  In fact, it is even nested inside of exchange traded funds, though in this case the fee is generally lower than it’s index fund or mutual fund counter part.  The options that present themselves in your 401k, IRA, TSP, or non-retirement index fund and mutual fund accounts will have fees that the honest brokers will explain and less than honest brokers will try to obfuscate.

The expense ratio is this:

The annual fee expressed as a percentage of the assets under management charged directly against those very assets.  The expense ratio is paid internally to the account, so many do not realize that this fee exists at all.  However, this fee, if substatial can become a redistributor of wealth from the account to the managing institution.  It is money that is forfeited in exchange for management and operating expenses, reagardless of profits or even losses.

Take a $10,000 portfolio for example.  The value of which did not change through out 2012.  A 1% expense ratio means that $100 is paid out of this fund to the manager/broker, leaving a balance of $9,900.  If the value went up 10% in 2012 instead, the manager would still recieve 1%, or $110, leaving $10,890.  This will effect compound interest and the Time Value of Money over time.  What was a 10% return is now a 9% return.  This will carry on for as long as you are invested in this fund.  It is in your best interest to minimize this fee.  Below are some expectations for what this fee should be.  If your investments fall within this range, there is no real concern.  Even if you can find a lower rate, there may be other benefits with your current institution, such as multiple account discounts, loyalty programs, or the convenience of one stop shop banking.

  • Expect to pay more for an “actively managed” fund.  Fees here range from 0.5% to 1.5%.  They’re not necessarily better.  Remember the manager is not really accountable for your losses and can always explain them away by blaming the market.  Good active fund managers are exceedingly rare to find, and as their funds grow in size, they tend to under perform the overall market, as it is more difficult to move larger amounts of money without being noticed.
  • The index fund is your friend.  The cheaper, the better.  These funds track a computer generated index portfolio of stocks based on a pre established rule set.  All personal bias and emotion driven mistakes are removed here.  The S&P 500 is an example index.  Index fund expense ratios should be below 0.5% and can reach close to no cost.  The Thrift Savings Plan available to federal employees and military service members offers some of the lowest rates possible at 0.025%.  That’s right, $2.5o for each $10,000 invested.  Now that’s a good deal!
  • Fund houses that specialize in funds, particularly actively managed funds, may have front-end and back-end load fees.  These are fees to buy into and then sell out of the fund.  In the past, these fees could be up to 5% on either side.  This fee in general has been done away with as consumer champion Vanguard has driven this fee out of the fund industry.
  • In addition, certain funds have fees if sold within a certain period, commonly 2 to 12 months.  If you plan on being long term in these funds, this is not necessarily a bad deal.  The reason for these fees is to reduce turnover; which is the rate of buying and then selling assets within the fund.  The action of turnover has negative tax consequences and reduces that ability of a fund to achieve target performance.  Early termination fees should be 2% or less.

For reading additional information of stocks, bonds, index funds, and other investment opportunities, please visit the FPO investment page.

 

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