Protect yourself from Uncle Sam!

Uncle Sam wants his money, and who can blame him? The government tells you that some of your money actually belongs to them. However they are willing to give you a break here or there if you are smart enough to utilize these benefits. You can defer taxes, reduce taxes, and even avoid some taxes…and in the long run this will save you literally thousands and thousands of dollars for your retirement. Last week I talked about qualified accounts being one of the 5 “buckets” of money; qualified accounts are simply accounts that hold certain tax-incentives in them, such as 401k’s and IRAs. Often retirement accounts will be sponsored by your employer, but accounts can be opened individually as well. When it comes to retirement accounts, or “qualified” accounts there are literally thousands of rules and regulations, but to keep things simple there is really only two types of accounts you need to know and understand. One is the tax-deductible account, these accounts allow you to put away money before it is taxed as income, and the other is a tax-free account, which is simply taxed up-front to avoid the taxes down the road. To demonstrate how effective this can be let us look at an example:

Joe makes $100,000 a year and wants to put away 5% for retirement. Joe can utilize his 401k at work, or an individual retirement account (IRA). In doing so Joe is able to deduct his 5% savings from his gross income. This means that not only is he putting away $5,000 but he is being taxed on only $95,000 rather than the full $100,000. How does this translate into savings? Well if Joe has a 20% income tax liability he would save $1,000. Think of all the things you can do with an extra $1,000!

Income	$100,000		Income	$100,000
Deduction	$5,000	Vs.	Taxable Income	$100,000
Taxable Income	$95,000		Tax Rate	20%
Tax Rate	20%		Taxes Paid	$20,000
Taxes Paid	$19,000

Extra benefits of qualified plans are that these accounts grow tax-deferred, which means that any capital gains that are experienced aren’t taxed until they are withdrawn. This is a huge benefit, imagine a snowball rolling down a hill, as it gets bigger it rolls faster, and as it rolls faster it gets bigger. (That is my analogy to compounding interest) Now, if you were to constantly take out little chucks of snow every couple of feet or so, you would be slowing down the process…this is what taxes do to a portfolio and that is why it is important to protect yourself from taxes.

Another popular qualified account is the Roth IRA or Roth 401k. These differ from the previously mentioned accounts in the fact that these are post-tax savings rather than pre-tax savings. Instead of deducting your savings and being taxed down the road (saving extra money today) you can pay the taxes now, and not be taxed on any withdrawals. Take a look at the photo below to help understand how it works.

As always if you have any questions let me know!

Take advantage of your buckets...don't end up like this guy in the photo!



Buckets of Money

There are thousands of articles on the web about personal finance, hundreds of books written on the subject, and even classes taught on college campuses. In my opinion it shouldn’t be that complicated. Someone once explained to me that there are five buckets of money for personal finance and I was amazed at how simple he made it. The idea is to fill each bucket up first in order and then as the bucket starts to fill up and overflow the funds will then spill into the next bucket.

Each week I plan on going into more detail about each "bucket"

1.       Cash – Liquid investments that you can use for your day-to-day living expenses.

a.       Checking Account – typically have 1-2 month’s worth of expenses in here as this is used for your everyday transactions.

b.      Savings Account – typically have 3-6 month’s worth of expenses in here as this is your emergency/opportunity fund.

2.       Insurance – Illiquid investments that you use for protection

a.       Disability Insurance – typically replaces income in the event that you become sick or injured beyond a 3-month period. Benefits typically don’t start until 3 months after the incident first occurs, hence the reason for the 3-6 months emergency fund in your savings

b.      Life Insurance – in case you pass away this typically is used for three things; cover any existing debt or obligations you might have i.e. cars, mortgages, credit etc. replace any income to dependents, and lastly to leave a legacy whether it is your kids college education, a charity you wish to support, or anything you were passionate about

c.       Health Insurance – to cover the costs of diagnostic tests, surgeries, medicine, etc.

d.      Property Insurance – to cover the costs of any damages done to expensive property i.e. cars, homes, equipment, etc.

3.       Qualified Retirement Accounts – Tax favorable savings for retirement. Typically you’ll want to put away 5-10% of your income into each account. Deferring taxes, lowering taxes, or avoiding taxes all together saves you tons of money in the long run.

a.       Pre-tax savings – 401k’s and IRA’s offer a way to put money away while lowering your current year tax liability.

b.      Post-tax savings – Roth IRA’s offer a way to put money away while lowering your future year’s tax liability

4.       Real Estate – you have to have a place to live with a roof over your head, why not make it profitable for you?

a.       Most buyers will put anywhere between 10-20% down on a home

b.      The idea is to own a home so that each month you are paying for housing you’ll see that money back in the form of equity, where as with renting it simply is an expense you’ll never see again

5.       Non-Qualified Investments – Typically your last bucket to fill, which I like to call your “strike it rich” bucket

a.       Non-Qualified Investments can be anything you want, whether it is a small business you want to start up, or a business you want to invest in there are little restrictions. Typically this bucket is the bucket in which we use “other people’s money” and leverage our investments and take slightly more of a risk. We are allowed to take bigger risks here since all the other buckets are filled and secure.

Why is diversification so important?

Let’s face it, in today’s environment the world of finance has gotten so overly complicated and convoluted that the majority of us have no clue what to expect. It is a gamble out there. Even the professionals who claim to be prophets are contradicting each other’s statements. If you just spend 5 minutes on yahoo finance or any other finance website you’ll see 2 articles written by two different professionals with completely opposite predictions albeit each of them having years of education and experience. Just take a look at my last post to see how the “professionals” have performed in recent history…it doesn’t take long to realize that you as an individual investor with little to no experience can do just as well.

What exactly is diversification?

In my first article I discussed taking away specific risk by holding more than one stock and illustrated a graph showing the effect of holding multiple stocks. Essentially what occurs is the risk of one company failing is dampened by the success of others…but it doesn’t mitigate the risk of all the companies failing at once -- that is called market risk. It isn’t that easy though, if you read the fine print (as you should learn to do in the finance world) and learn the assumptions made in the graph you’ll notice the word “uncorrelated”. Correlation is the biggest determinant in the success or failure of your attempt to diversify. Simply holding 20 stocks doesn’t necessarily mean you are better diversified than holding 10 stocks. Correlation is a statistical measure of how two securities, or asset classes, move in relation to each other. Say for instance every single time the S&P 500 goes up 5%, your stock also goes up 5%...well then you have a correlation of 1.00 (which means you aren’t diversified at all). The whole point of diversifying your portfolio is so that when the market crashes it doesn’t take your portfolio down with it. The opposite though can be true too, you don’t want a -1 correlation because then every time the market booms you’ll be losing money. The ideal situation would be to have no correlation at all to the market and yet still have positive returns. Take a look at the chart below comparing the correlations to the S&P 500 and each asset class return and risk. – Source: Morningstar

	Correlation	Return	Std Dev.
Large Cap	1	3.14	15.65
Mid Cap	0.97	7.5	18.38
Small Cap	0.96	7.4	20.72
International	0.9	6.62	19.58
Emerging Market	0.86	15.36	24.52
REIT	0.81	9.86	25.5
High Yield Bond	0.73	6.75	9.12
TIPS	0.25	6.93	6.92
Total Bond	0.08	5.25	3.79
Gold	0.07	21.9	20.29

As you can see Bonds and Gold do not have any relationship to the stock market. Correlation has no relationship to return or individual risk. So what is my suggestion? Why not just spread your bets evenly across the board and keep your life simple and safe. By spreading your bet evenly you’d have returned a little over 9% with half the amount of risk…not bad if you ask me.