Advanced Personal Finance

For some reason, I find getting my friends to actually act and get a will to be one of the toughest sells I try to make. Maybe it’s me and I’m just not a terribly persuasive person. People I talk to about this agree that having a will is a great idea and it’s something they should do. Getting them to do it is something else altogether.

Whenever I mention having a will to friends, I also tell them it’s important to have a power of attorney. A power of attorney is a legal document that allows someone to act on your behalf. You can make the powers conferred on this person as broad or narrow as you like.

A power of attorney is not scary, but not having one is. If you cannot act on your own behalf for any reason (commonly, the reason is medical), your bills still need to be paid. You need a trusted person to take care of things if you can’t.

Here are the 4 bad reasons for not having a will and power of attorney.

“I don’t want to focus on death.”

You know what, neither do I, but we’re all going to die. When you do, you need to know your loved ones and your affairs are taken care of. It’s not really that painful an exercise. Plus, once it’s done, you can stop ‘focusing on death’ unless you have a major change to your life (e.g. birth of a child).

“I don’t have much in the way of assets anyway.”

Maybe not, but you have an opinion on how your money is spent before you die. You should also have an opinion on where it goes afterward.

“I don’t have kids. If I die, my wealth will all go to my spouse by default.”

Absolutely incorrect in many cases. In many states, if you’re survived by a spouse and your parent(s), they share your property equally. You may want your spouse to get everything, but that might not be the case. Note that any assets that are Joint Tenant With Right of Survivorship (JTWRS) do automatically go to the other person. But I’ll bet you have plenty of assets not in that category.

“It’s too expensive.”

It’s really not. A basic will drawn up by an attorney (not a piece of software) might cost between $200-$300. I don’t think that’s too expensive to make sure your wishes are fulfilled when you die.

So getting a will is not hard, not expensive, yet it’s valuable both practically and for piece of mind. You really have no good excuse for not having one. As for us, we have to get ours updated since we have a new child. I’m waiting for the SSN to come in the mail before we go, though.

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As if you needed another reason to invest in index funds, consider just how much doing so saves you in taxes. It’s capital gains season. Late in the year, mutual funds must distribute their taxable capital gains amongst their investors. Index funds, by their nature, have very little in the way of capital gains.

Unlike an actively managed mutual fund, index funds change their stock holdings very infrequently. As a result, they rarely take any capital gains (or losses for that matter). What that means to you is, assuming you hold the fund in a taxable account, you can save hundreds or thousands of dollars in taxes every year, year after year, compared to an actively managed fund.

According to Lipper Inc., the average actively managed stock fund gave up 1.4% in returns because of taxes. As an investor in an actively managed fund, you’re already behind.

This year might be particularly hard on active funds. According to this Wall Street Journal article, many funds will likely make dramatically higher capital gains distributions this year. It seems many of them have burned through the capital losses they carried forward from earlier in the decade.

Incidentally, year-end distributions mean you should probably not invest in an actively managed fund late in the year. If you do, you’ll just be handed back part of your investment in the form of capital gains. You’ll be paying taxes on gains you didn’t get the benefit of earning. That’s what is known as a sucky deal.

I keep it simple. In our taxable investment account, we hold only an S&P 500 index fund. Last year, we had no capital gains (we did have taxable dividends, however). I’m a big believer in index funds; I recommend them highly.

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IRS rules dictate that some tax credits and deductions have income limits. Make too much money, and it’s no tax credit for you. Here are the major tax credits and deduction with their associated income limits. Where appropriate, numbers reflect the point at which phase-out begins. All numbers are for 2006. I’ll update after 2007 numbers are published.

Child tax credit ($1,000 credit per dependent child)

• Married filing jointly: $110,000
• Married filing singly: $55,000
• All others: $70,000

Lifetime learning credit (up to $2,000 credit per tax return)

• Married filing jointly: $90,000
• All others: $45,000

Hope scholarship credit (up to $1,650 credit per student)

• Married filing jointly: $90,000
• All others: $45,000

Student loan interest deduction (up to $2,500 deduction)

• Married filing jointly: $100,000
• All others: $50,000

Traditional IRA (deduction up to yearly maximum contribution - currently $4,000)

• Married filing jointly: $75,000
• Single: $50,000

Roth IRA (informational only - no deduction or credit)

• Married filing jointly: $156,000; cannot contribute to Roth IRA if over this amount
• Single: $ 99,000
• Married filing single: Cannot contribute to Roth IRA

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Here’s a topic I’m sure to never face - inheriting an IRA. But for those people who might find it of some use, here’s a run-down on how to inherit an IRA.

Step 1: Have a relative wealthy enough to leave money to you.
Step 2: Help that relative set up an IRA naming you as beneficiary.
Step 3: Wait until relative dies.
Step 4: Decide what to do with inherited IRA.

Inherited IRAs really fall into two categories - spousal and non-spousal. Non-spouses can take all the cash out of the IRA immediately, establish a beneficiary IRA and begin taking annual distributions, or wait up to five years and then take the lump sum. Spouses have the additional option of making the IRA their own.

Cash-out option. Any beneficiary can use the cash-out option. This simply involves taking a lump sum and paying the tax on it as ordinary income.

Establish a beneficiary IRA. Going this route means taking annual distributions. The IRS publishes tables with life expectancy based on sex and age. Your annual distribution is based on how much longer the IRS says you’ll live. Since the IRS is always right, these tables come in handy for all sorts of things. I myself base my borrowing decisions on them. I try to arrange repayment beginning the year after the IRS says I’ll die. At any time, you can also take a lump sum.

Deferral cash-out. You can also do nothing for up to five years, then take the lump sum.

Roll-over option (spouses only). Spouses have the additional option of rolling over the IRA into one with their name. This also allows them to continue making contributions. Using this option, the spouse doesn’t have to begin distributions right away. Deferring taxes is nearly always preferable to paying them right now, so this is most likely the smartest move for the surviving spouse.

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Most of the time when you read about 401(k)s, it’s something like, “contribute at least up to the company match,” or, “don’t put too much in company stock.” But what do you do when your company’s 401(k) sucks?

Problem: Your company doesn’t offer a match.

Solution: Contribute as much as you can to a Roth IRA, then contribute to your 401(k).

I recommend maxing out a Roth IRA before contributing to a Traditional 401(k). The reason is that Roths are funded on an after-tax basis, but you withdraw the money at retirement tax free. I believe most people will be paying more taxes in the future, so a Roth is usually the best solution.

I also recommend contributing to a Roth IRA even if your plan offers a Roth 401(k). The reason is because you can always withdraw your contribution to a Roth IRA without penalty before retirement if disaster strikes and you need the money.

After you max out the Roth IRA, go back to your 401(k) plan. A 401(k) has great tax benefits. It reduces your current taxable income. Your contributions compound tax-deferred or tax-free, depending on with type you use (Traditional or Roth). It’s also an easy, automatic way to save for retirement. A company match is nice, but it’s not the best reason to use a 401(k) to save for retirement.

Problem: Most or all of the funds offered in your plan suck.

Solution: Figure out just how bad the funds are and decide if saving outside a 401(k) makes more sense.

Great, so how do you do that?

I’d consider a fund ‘bad’ if it has higher-than-average fees for its type and middling or below returns compared to its peers over many different time periods. If just some of the funds in your plan fit that description, invest instead in the ones that are good, even if it means overweighting your asset allocation. That is, if you’re offered a good stock fund in your plan, but no good bond funds, go ahead and invest in the stock fund. Outside your 401(k), say in an IRA, you can overweight bonds to compensate.

If truly all of the funds are bad, you have to consider not contributing to the 401(k) at all. Before you do, though, consider any employer match. If you’re offered a match, you’re almost certainly better off contributing to the match maximum and investing in bad funds. That’s because the immediate 50% or 25% return a company match gives you counteracts the general suckiness of the fund you invest in. For example, if you’re offered a 50% match on contributions up to 6%, go ahead and contribute the 6%. Even if your fund returns -20%, you’re still netting a positive 30% return - great by any standard.

So what if you have the worst situation of all - the funds suck and there’s no company match? In that case, there’s a very good chance you’d be better off not contributing to the 401(k) at all. Instead, invest in an IRA. I recommend a Roth IRA, but Traditional is good, too. That way, you can choose any fund you want.

Problem: Your match is in company stock and the stock is going nowhere.

Solution: Sell your company stock as soon as you can.

In 2006, Congress passed the Pension Reform Act that allows 401(k) participants to sell company matching stock. For stock given before the law was passed, you can sell 1/3 of the total each year over three years. For future matches, you can sell immediately. I advocate selling matching stock as soon as you can anyway, but this is especially true if the stock is declining or flat.

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