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Financial Planning for Emergencies

You’ve probably been told before to prepare for the unexpected, and that’s good advice.  And being prepared for the unexpected includes your finances as well. In the event of a job loss, medical expense, or other form of unexpected financial damage, it’s important to have an emergency fund. So once you’ve asked yourself what’s the worst thing that could happen to you financially, you’ll need to figure out what you’d need should disaster strike.

First, ask yourself several questions:

  • Do you have some form of income continuation in the event that you lose your job?
  • Do you have untapped credit that you could use to tide you over?

If the answer to both of these questions is “yes”, you may not need a whole lot of emergency savings (your checking account alone may be sufficient). This, of course, varies on a case-by-case basis.

However, if the answer to one or both of the questions is “no”, you should probably be putting together some extra savings in case of a financial emergency. Typically these funds contain between three to six months wages, although your individual circumstances could necessitate that that number be higher or lower.

Medical emergencies are just one of the situations that can cause serious financial strain if you're unprepared
Medical emergencies are just one of the situations that can cause serious financial strain if you’re unprepared

Because in an emergency your money would need to be easily accessible, it limits the options that you’d otherwise have for investing. Your first option is bank deposits. Whether its checking, savings, or money market, the investment will be both safe, secure, and readily accessible. The downside is that you won’t likely make much in terms of interest.

A second option that you have is short term treasuries. The federal government offers short term treasuries every week that pay a set rate of interest. What’s more, there’s no set penalty on the sale of treasury bills before they reach maturity (aside from simply not receiving the interest that you’d otherwise get). Treasury yields vary based on the market interest rates at the time they’re sold and the duration of time your money is invested.

Your third option is to invest in money market mutual funds. With this investment, you are for all intents and purposes buying into a pool of Treasury bills, corporate lOUs, and short-term bank deposits. The rate of return will vary, but will generally correspond to the current yield on treasury bills and bank deposits. Accessing your funds is usually as simple as writing a check, although there may be a limit on how often you can access your funds. Be sure to read the prospectus (which spells out rules and other important information) before investing in money market mutual funds.

This little guide is by no means comprehensive, and you may want to seek out the advice of a financial planner first before making any decisions. But the important thing is that you have a fallback set of funds in case some sort of tragedy happens to you and/or your family. It’s also important to keep track of these funds properly.

Estate Planning and the Estate Tax Exclusion Amount

The “estate tax exclusion amount” refers to the amount of assets that a decedent can shelter from estate tax upon their death.  The estate tax exclusion amount has been steadily rising for years.  Many people who die in 2013 will not use their entire $5,250,000 estate tax exclusion amount.  For example, if a married person dies and simply leaves their entire estate outright to their spouse without taking any further action, the decedent’s entire estate tax exclusion amount is wasted.

window-arch-front-door-ranch-1282181-mIf a married couple has a combined estate worth $10,000,000 and the husband dies and gives his half of the estate directly to his wife, then his wife’s estate would be $10,000,000.  No estate tax would be due upon the husband’s death because of the unlimited estate tax marital deduction that allows a married person to give an unlimited amount of assets to their spouse estate tax free.  However, if the wife dies when the estate tax exclusion amount is $5,500,000, the wife’s $5,500,000 estate tax exclusion amount will not be sufficient to shelter her entire $10,000,000 estate from estate tax.  $5,500,000 of her estate could be sheltered by her estate tax exclusion amount, but the remaining $4,500,000 in her estate would be subject to estate tax.  The estate tax rate is currently 40% (although this rate is likely to change in future years).  Estate tax on $4,500,000 at an estimated 40% rate would result in an estate tax bill of $1,800,000 due within 9 months of the surviving spouse’s death.

With proper planning, there are at least two ways to avoid this estate tax bill under current law.  One way is by making a timely Portability Election on an estate tax return for the first spouse to die, and another way is to establish a Credit Shelter Trust upon the death of the first spouse.  It is also possible to combine these two techniques. The decision of whether to make a portability election, fund a Credit Shelter Trust, or both, is complicated and should be discussed with an estate planning attorney.  It is never too early to start planning.  If you have any questions regarding the issues discussed in this article, please contact the Willms, S.C. Law Firm.

Mutual Fund Sales Loads

Those who deal in mutual funds, much like the clients investing with them, are out to make money. There are a variety of different ways they do this, and one of them is through something called a sales load. Sales loads aren’t applicable to all mutual funds, as no-load funds do exist (as we shall discuss later), but when a broker recommends a fund for clients to buy, chances are it will be a load fund since it would be in their interest to recommend one. Sales loads essentially function as a commission, and are valued at a certain percentage of the actual investment amount.

Sales loads come in several varieties. The first is the front-end load. This type of load is quite easy to understand. The way that it works is to have a given percentage charged immediately upon purchase. The maximum sales load allowable by law is 8.5%, although most sales loads are smaller than that.

mutual-funds-glasses-newspaperAnother type of sale load is the back-end sales load. These are also sometimes known as deferred loads. Back end sales loads are fees that are charged upon the sale of the investment rather than when you buy it. This let’s all of the money work for you and benefit from compounding from the very beginning. Some of these back end sales loads have provisions in them which either reduce or completely eliminate the fees if you keep it for a certain length.

Finally, there’s something known as a level load. Level loads are ongoing management fees instead of having a fee upon buying or selling. By law, these are capped at 1% annually, but will typically be around .25%. These allow those who manage the fund to benefit from the effect of compounding. This makes level loads potentially the most costly, depending on how long it’s held.

A very important piece of information to keep in mind is that you should vastly prefer no-load mutual funds to funds with a load attached. Historically, no-load funds outperform load funds, especially when adjusted for the fee itself. Keep in min that your losses are not only limited to the 5% or so load itself, but the opportunity cost of all the lost compounding on that investment. So unless you have a particularly strong reason to opt for a fund with a load, stick with no-load mutual funds.

The Impact of Expense Ratios on Investment Performance

The basic idea behind investing is to grow your assets, of course. However, there are certain factors involved in the entire investment process that can take a chunk out of your expected investment returns. Investment fees are one notorious factor, so we decided that we’d look through some of the basics on expense ratios and their potential impact on investment performance.

With a vast array of mutual funds and ETFs to choose from, one of the most important things to consider in terms of long-term gains is the expense ratio. This is separate from the load, which some funds charge and when the investment is made in order to compensate brokers.

Compounding is one of the most important aspects to investing, and it’s also why investing early in retirement is important. A good way to think about expense ratios is to picture them as compounding in reverse. If you lose even 1 percent every year, that adds up significantly. Expense ratios are so important that Russel Kinnel, Morningstar’s director of mutual fund research, said that “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

To illustrate just how impactful it is to be selective with expense ratios, I ran them through a calculator (those of you wishing to do your own calculations can do so here). Let’s say you invested $50,000 in a fund that gives a return of 8%. Disregarding any other sales loads, fees, taxes, etc, this chart illustrates precisely what your investment will look like at various points in time.


As you can see, the numbers are quite significant. A difference of half a percentage point, over time, could reduce your ending value equal to your entire original investment amount (or even more if this chart went beyond 30 years)! This just further sends home the message that, in the long run, the expense ratio of your funds is one of the most important things to consider.

Investing for Education 101

In an increasingly competitive and technical world, a proper post-secondary education of some sort is more important than ever before. It’s also more expensive than ever before, so being able to invest wisely for education is an extraordinarily important thing. Here, we’ll be covering just the basics of investing for college.

First, generally speaking, stocks are the ideal investment for college savings. The reason for this is that tuition costs are raising faster than inflation, and bonds/cash simply don’t have the growth potential stocks do.

Second, consider special savings plans known as 529s. 529s (named after their section of the tax code), are essentially, IRAs for college. Your savings here are tax free. However, if you use them for non-approved purposes, you will end up paying ordinary income tax plus a 10% penalty on top of that.

529s come in two varieties: college savings plans and prepaid tuition plans:

Prepaid tuition plans essentially allow you to pay for tuition for a future student now, at today’s prices. Different plans allow you to pay for a certain number of years of school, or a certain number of credit/hour units. With prepaid tuition plans, it’s important to read the contract carefully, as some of them contain some fine print.

College savings plans are the other type of 529. These function essentially like a 401K or an IRA. You get different options on what type of investment to choose, and then your investments’ performance determines if your account grows or not.

If you choose to invest for education, keep in mind that you don’t necessarily need to cover all 4 years of college. Financial aid and student loans can help to make up the cost difference as well.

4 Major Stock Market Myths

Like many aspects of society, Wall Street has bred its own mythology. Some of these myths about the stock market are quite harmless, but some can have deep financial consequences for those who subscribe to them.

One of the biggest myths of the stock market is that what goes down, must go back up (and its corollary, what goes up, must come down). Considering that the markets fluctuate on a daily basis, it’s not at all difficult to see how this myth originated. But in reality, the laws of physics do not apply to the stock market, and there’s a reason that the saying “those who try to catch a falling knife will only get hurt” developed. There also exist many examples of rising stock prices which continued to rise and investors, if they subscribed to this myth, would have lost out on potential gains.

The myth that investing in the markets is like gambling is another myth with easy-to-spot origins. It’s simply a fact that people make and lose money in the markets every day, and sometimes it’s a lot of money. Some industry professionals further this myth with language about “betting.” But the truth of the matter is that informed investing is fundamentally very different from gambling. Gambling is a zero-sum game; money is transferred directly from one party to another while creating no additional value. Investing helps to create value in the markets that never existed before. Not to mention, investing smartly has a positive expected value.

A third major myth about the stock markets is that a typical rate of return on stocks is 10% yearly. This has a little more complicated origin, since the numbers come from the 1800s. It turns out that that 3 of those 10 percentage points came from inflation, and the rest of the data is still suspect. The fact of the matter is that you generally can expect a 7-8% average return, assuming that you purchase stocks at average valuations.

A fourth myth about the stock market is that you must necessarily assume high risk in order to make money. Once again, it’s easy to see where this myth came from since investments with particularly high risk typically provide a higher reward in order to offset said risk. However, this myth is simply mathematically untrue. Investors with a smaller amount of money invested make money every day. Investors with smaller amounts of money can save on expensive brokerage fees and costs by engaging in do-it-yourself investing, which is growing in popularity as investors seek to become more involved with their portfolio after the recent economic crisis.

Portfolio Rebalancing

Piechart1Once you understand portfolio allocation and have decided upon the correct mix of investments for you, you will of course go ahead and make your investments. However, it is important to keep in mind that your investments will not grow and fall at a uniform rate. Growth and loss within your portfolio will be distributed, and a practice called “rebalancing” is the key to getting your portfolio back to the target mix you had before.

To take a very simple example, let’s say that you decided that the optimal target mix for your portfolio would consist of 50% stocks and 50% bonds. One year later, some of your assets have performed spectacularly, and others not quite as well. As a result, your portfolio, while having grown in total value, is now 65% stocks and 35% bonds (bonds usually grow at a slower rate than stocks do). At this point, you would engage in rebalancing, which is essentially selling part of your portfolio’s winning assets to purchase more of those lagging behind in order to get back to your target mix. So in this case, you would sell a portion of your stocks in order to purchase bonds. Putting excess gains into lower return assets in rebalancing creates a sort of fixed-income ‘lockbox’ for liquidity or emergency needs.

2013-06-26-graphThe purpose of rebalancing is to manage risk. Remember that the purpose of finding your target mix pecentages in the first place was to find the least amount of risk to accomplish whatever goals you’re looking for. Without rebalancing, it’s possible to get a portfiolio mix more overly dependent on one asset class than you intended if your more volatile assets have a hot streak.

Generally speaking, it is wise to rebalance once a year, and many people do this in January after the year end statements are released. Others rebalance more often, ether semi annually or quarterly, although the latter makes up a small minority.

Rebalancing does take discipline. It’s not always easy to sell some of the better performers to purchase those who lagged behind last year. For example, after the 2008 crash, stocks were cheap, but of course they had cost people a great deal of money over the last year. Remembering that, in the long run, rebalancing is a calculated decision meant to managing portfolio risk can help overcome cold feet towards the process. Don’t just take our word for it, though. According to Financial Planning Magazine, annually rebalanced portfolios had higher ending account value in 14 out of 20 twenty-year rolling periods than the buy-and-hold portfolio.

The Expansion of DIY Investing

“Do it yourself” investing is nothing new. Amateurs have been grinding away and managing their own portfolios for years now. But new tools and services have fueled tremendous growth in the DIY investing area. Studies indicate that anywhere between one and two thirds of investors are investing independently. And emerging from the economic downturn, more and more investors are seeking to be personally involved with their portfolio while many financial advisers have suffered a loss in the degree of trust that others hold for them.

Independent investors are also privy to better information than ever before. This is, of course, due to the expansion of the internet and the enterprising companies that have taken advantage of it. Add to the traditional internet the advent of smartphones and apps, and much of the data and analysis that would otherwise be difficult to obtain is now at a consumer’s fingertips.  Along with this new access to information, there are also more and more ways for people to use this information themselves. Portfolio tracking software and asset management programs are becoming both more advanced and more popular since they make it easy for the DIY investor to manage their portfolios effectively.


The explosion in popularity of ETFs is another reason for the boom in do it yourself investing. Almost every serious investor already knows about the importance of diversification, and ETFs provide a low-cost way to diversify a portfolio without having to micromanage a varied basket of stocks individually.

Finally, the expansion of social media communities has made DIY investing bigger than ever. This isn’t simply referring to Facebook or Twitter, either. Discount brokers and investment software companies often have forums and communities built into their own websites. This allows for peer-to-peer investment communication in ways never seen before.

While many people are still most comfortable with the traditional broker-based methods of portfolio management, with so many new tools and options, it doesn’t look like the DIY investing trend will be reversing any time soon. And we think that’s a good thing.

Understanding Portfolio Allocation

Two of the most important decisions an investor must make when constructing portfolios are the 1) allocation of the portfolio assets between stocks, bonds, cash and other investments and 2) the diversification of securities within those asset classes. These decisions will not only determine the risk character of the portfolio, they will also provide the major explanation for the portfolio’s return. In order to better understand the relationship between allocation and diversification, four concepts must be defined: the strategic asset allocation of the portfolio, the tactical asset allocation of the portfolio, portfolio rebalancing, and portfolio diversification.

Strategic vs. Tactical Allocation
Strategic Asset Allocation
Strategic asset allocation refers to the long-term plan to combine portfolio assets in a manner that is suitable for an investor’s risk tolerance. In other words, strategic allocation answers the question: as a general rule, how much of the portfolio should be invested in bonds vs. stocks vs. cash.

Since investors strive to the achieve the highest rate of return for the level of risk assumed, there are several important risk factors that must be considered when forming strategic allocation decisions.   These include the investor’s appetite for risk: market volatility risk (beta), the estimated inflationary risk (purchasing power risk) and the investor’s liquidity risk (unanticipated need for cash). Once identified, then the portfolio’s normal “target” balances of each asset class can be assigned. These targets serve as the portfolios long-term “preferred” asset mix, and are therefore infrequently changed. To summarize then, strategic asset allocation refers to the asset mix – i.e., % stocks, bonds, cash, etc. It should be based on current market conditions and the investors’ objectives, needs and risk tolerance. Many studies have shown strategic asset allocation is the predominant determinant of an investor’s return.

Tactical Asset Allocation
Tactical allocation on the other hand refers to the short-term allocation decisions made in order to take advantage of current market conditions. Tactically, an actively managed portfolio will be constantly adjusted so as to take advantage of perceived relative values between the assets classes. So, if the investor believes that stocks are undervalued relative to bonds, funds would be shifted from bonds into stocks to take advantage of those current market conditions.

Tactical asset allocation decisions are driven by judgments of relative values between asset classes and are based on mean reversion: i.e., asset classes that are under or overvalued will move toward normal value so opportunity to profit exists.


Portfolio Diversification
Equally important is adequate portfolio diversification. Diversification not only relates to the asset mix of the portfolio, but also relates to the individual securities held within each asset class. In other words, a portfolio with a strategic allocation mix of 30% bonds, 60% stocks, and 10% cash may seem adequately diversified. However, if the common stock percentage is overly concentrated in large cap stocks, or high technology companies, the overall risk of the portfolio will be greater than it if more widely diversified by company size (small, medium, large) and industry sectors (energy, healthcare, industrial, etc.).  Successful investors keep a close eye on the diversification of their investments within their portfolio allocations. The goal is to maximize return for the risk assumed.

Portfolio Rebalancing
Finally, once the allocation and diversification targets are set, investors need to monitor their portfolio to gauge how current market valuations are impacting goals and to identify if rebalancing is required.  Portfolio rebalancing refers to the shifting of portfolio funds between the portfolio assets due to the relative performance between the portfolio assets. Investment funds may be reallocated from over-performing assets into under-performing assets to better align the long-term strategic target portfolio weights.  If an investor is pursuing short-term tactical allocation, rebalancing enables the investor to take advantage of current market conditions.

The benefits of sound portfolio allocation planning are many. Focusing on these important concepts of portfolio management not only helps to prevent overly concentrated portfolios and to reduce overall portfolio risk, it also adds discipline to the management process and helps to avoid emotional decision making.

Planning for Tax Law Changes with GRATs and SLATs

President Obama’s 2014 budget proposal would reduce the lifetime gift tax exemption from the current $5.25 million (indexed for inflation) to $1,000,000 (not indexed for inflation).  As a result, individuals who are hoping to give or bequeath large amounts to children and more remote descendants may be able to save taxes through use of the gift tax exemption amount before the President’s proposals have a chance to become law.

Notwithstanding the foregoing, there are several reasons why many of us are reluctant to make large gifts during our lifetimes, including:

  • Concern about our personal financial security;
  • Loss of control over the gifted funds;
  • Fears about the way the gifted funds will be used by the recipient;
  • The loss of the step up in basis at death; and
  • Uncertainty about future law changes.

Fortunately, Spousal Limited Access Trusts (“SLATs”) and Grantor Retained Annuity Trusts (“GRATs”) can be used to overcome these concerns.

A Grantor Retained Annuity Trust is a special type of gift trust whereby the person establishing the trust is entitled to receive an annuity payment from the GRAT each year for a period of years (the “Term Period”).

The tax code allows the value of this annuity to be deducted when determining the amount of the gift for tax purposes.  As a result, if the value of the annuity equals the value of the initial gift, then the creation of the GRAT does not result in a taxable gift.  If the person who creates the GRAT outlives the Term Period, the assets that remain in the GRAT (if any) when the annuity ends will pass to the ultimate beneficiaries of the GRAT tax free.  However, if the person who creates the trust dies before the Term Period expires, then all of the assets held in the GRAT are estate taxable.  Often, this risk can be covered by a term insurance policy.

The President’s budget proposal would amend the rules governing Grantor Retained Annuity Trusts so as to require GRATs to have a term period of at least 10 years.  This change would increase the odds of the grantor dying during the Term Period which would undo the estate and gift tax savings created by using a GRAT.  In addition, the amount of the annuity payment could not decline during the Term Period.  This change would also reduce the effectiveness of a GRAT with respect to assets that are expected to appreciate rapidly.

The President also proposes to add a requirement that the creation of a GRAT results in a taxable gift upon formation, thereby precluding so called zeroed-out GRATs.  The minimum required gift upon formation is yet to be determined, but it is likely to be no less than a minimum percentage (e.g. 10%) of the amount initially transferred to the GRAT.

Married couples who wish to take advantage of the current gift tax exemption without significantly changing their current economic situation may want to consider establishing a Spousal Limited Access Trust.

This type of planning involves one spouse using his or her gift tax exemption to fund an irrevocable trust for the benefit of the other spouse.  The donee spouse would be the beneficiary of the SLAT, and as such could receive income and principal as needed.  When the donee spouse dies, assets that remain in the SLAT could be given to the couple’s descendants, free of the federal estate tax.  It should also be possible for the person who funds the SLAT to become the beneficiary of the SLAT if the donee spouse dies first, without triggering estate taxes.

In summary, GRATs and SLATs make it possible to enjoy the tax benefits of a significant lifetime gift without reducing your personal financial security.