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Investing Blog Roundup: Treasury Interest from Mutual Funds and ETFs (Avoiding Unnecessary State Income Tax)

Interest from Treasury bonds is exempt from state income tax, and thatís just as true for interest from Treasury bonds held by mutual funds that you own. But as Harry Sit points out this week, the 1099-DIV the brokerage firm sends you doesnít tell you how much of the dividend distribution from a fund is from Treasury bond interest. If you donít go look it up yourself, you can end up paying unnecessary state income tax.

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Social Security and Safe Spending Rates

A reader writes in, asking

ďIím a big fan of Morningstar and the stuff theyíve released recently on Ďsafe withdrawal rates.í My question is how I should be thinking about future Social Security payments, when I calculate my Ďsafe withdrawal rate.í

To me, it makes sense to add the NPV (calculated conservatively) of the future Social Security payments that I expect my wife and I to receive to our current portfolio, before I do the math on what our starting annual withdrawal number looks like.

Have you published anything on how to think about that question?Ē

Thatís a great question, and it gets directly to the limitations of safe spending rate research. That is, such research is very helpful for determining approximately how much a person should have saved before retiring, but when trying to use it as an actual spending plan, it comes up somewhat short.

The biggest issue isnít that the strategy of spending a fixed (inflation-adjusted) amount from the portfolio every year is necessarily a bad strategy (though it does have some drawbacks). Rather, the issue is that such an idea is simply not applicable for most real-life households.

That is, in most households, itís rare that (inflation-adjusted) spending from the portfolio will be kept constant from one year to the next, because the amount of non-portfolio income changes meaningfully over time ó for example as the person semi-retires, then fully retires, then Social Security begins. And for a couple, there are even more distinct phases, because there are twice as many retirement dates and twice as many Social Security start dates.

As far as considering the expected present value of your lifetime Social Security benefit to be a part of the portfolio, and then calculating an initial spending amount accordingly, the issue I see with that is that it depends significantly on what real interest rates are at the time of the calculation. And the higher that real interest rates are (i.e., the higher the discount rate used in the PV calculation), the lower the PV will be, which would indicate spending a lower dollar amount. And thatís rather backwards (i.e., higher real interest rates should indicate that you can spend at a higher rate).

My preferred way to incorporate Social Security into the analysis is to consider it a reduction in spending, for the years in question.

You can do this manually. Calculate what your non-portfolio income will be, year-by-year (including Social Security, earned income, and anything else). Then you can carve out a piece of the portfolio to ďreplaceĒ that income in the years in which it wonít exist. And then you can spend at a fixed (inflation-adjusted) rate from the rest of the portfolio. (In the context of Social Security, this is often referred to as creating a ďSocial Security bridge.Ē)

Very basic example: Bob is single. Heís 65, just retired. He plans to file for Social Security at age 70, at which point heíll get $36,000 per year. He could allocate 5 x $36,000 = $180,000 to something safe (e.g., a short-term bond fund or a 5-year CD ladder). And he could spend from that chunk of money at a rate of $36,000 per year. And he would spend from the rest of his portfolio at a fixed (inflation-adjusted) rate, which would lead to a fixed (inflation-adjusted) total spending rate also.

As mentioned above though, a real implementation of this idea is likely to be more complicated than this simple example, because there may be a phased retirement ó or perhaps a pension or annuity that starts on some particular future date. And there may be two people involved, which would mean even more dates at which the level of non-portfolio income will shift.

Also, ideally, the above calculation would be done on an after-tax basis.

And, admittedly, all of that can get rather cumbersome when taking a DIY approach.

If you want, you can use financial planning software for this, because it can do all of this math (including the taxes) very quickly. The software I use for retirement spending analysis is RightCapital. Itís great, but itís priced for advisors. The only reason I mention it is that, because Iím happy with the software that Iím using, Iím not also spending time test-driving a whole bunch of other software packages. So I canít confidently recommend one software package or another for individual users. I have heard good things about the following, but I have not tested them myself.

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Investing Blog Roundup: I Bond Interest Confusion

A reader wrote in, wanting to share this experience in case itís helpful to anybody else who has recently purchased I Bonds for the first time.

ďI purchased $10K worth of I-Bonds for the first time in 2022, specifically on July 1st, when the annualized interest rate was 9.62%. Funds left my bank account on that same day, July 1st. Fast forward to mid-January; using straight-line logic, Iím expecting to see $481 posted into the account, perhaps a few bucks less, but only associated with timing issues. I didnít expect to see only $236 posted (???) Could not work the math, any which way.

Called the Treasury Department, waited almost two hours on hold before talking to a human being. The Rep was fabulous to deal with Ė polite, professional, and knowledgeable Ė but the two hours on hold was brutal. He assured me that I HAD earned the full interest, but shared with me that Treasury does not actually post the interest accrued into the account, even if only for viewing purposes, due to the Ď3 month penaltyí rule for holding the security for less than 5 years. According to the Rep, this is on a rolling calendar basis and the most current 3 months of interest will NEVER show in the account, until the Ďheld for 5 yearsí criteria is met. The owner will never see the full interest accrual until year 5.Ē

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Whatís the Best Time of Year for a Roth Conversion?

A reader writes in, asking:

ďI do not believe in market timing and my approach of regular investing over the years without selling has been very successful. However, when you make a Roth conversion, within the year you are market timing.

From what I understand, I can tell my broker whatever date I desire to have my Roth conversion be effective. They will then send me a 1099 indicating the market value on the conversion date. The market value is then treated as taxable income on my federal and state returns.

However, within the year when I will be making my conversion, the market value of my retirement account could fluctuate materially. Should I do the conversion as early in the year as possible to give the longest time for tax free growth? Should I watch interest rates and make the conversion when rates come down? Or should I try to convert in portions throughout the year?

The additional tax caused by poor timing could be significant. I have not seen any discussion of this issue and I thought, in addition to me, it might be of interest to other readers.Ē

If the dollars that would be used to pay the tax would be coming out of the IRA itself, and the tax rate would be the same at different points during the year, then it doesnít matter at all when during the year the conversion is done. Returns, whether positive or negative, as well as the payment of tax, are both multiplication functions. And the commutative property of multiplication tells us that we can do those multiplications in any order and end up with the same result. (Thatís the rule from grade school math that tells us that A x B x C is the same as C x B x A.)

The tax rate might not be the same though, at different points during the year. For example, imagine that, on January 1, you have $50,000 in an IRA that consists of 1,000 shares of a particular mutual fund. If you convert the whole IRA on January 1, it would be $50,000 of income. Now imagine that, on March 1, those same 1,000 shares happen to be worth only $35,000. Itís possible that the actual tax rate would be different on an additional $50,000 of income rather than an additional $35,000 of income.

If the dollars that would be used to pay the tax on the conversion would be coming out of taxable accounts, then youíre effectively using taxable dollars to ďbuy moreĒ Roth dollars. And the lower the share price on the date of conversion, the more effectively you are using your taxable dollars.

Overall point being, if you somehow knew in advance which day of the year would have the very lowest market value, that would be the best day to convert, because a) you might be able to pay a lower rate on the conversion (or a portion of the conversion), and b) if youíre using taxable dollars to pay the tax, those taxable dollars will go further, in terms of being able to pay for a larger number of shares being converted.

But, of course, thereís no reliable way to do that.  No way to know when weíll see the lowest market levels in a given year.

On average ó because investments generally go up in value over time ó earlier in the year will likely be a better ďdealĒ than later in the year. Conceptually, this is the same as the question of lump-sum vs dollar cost averaging. That is, the earlier in the year you do it, the more growth you would be expected to take advantage of. Though whether it actually plays out that way in any particular year has a large chunk of randomness involved.

There is an important counterpoint though, with regard to conversions. Early in the year, many of the other numbers on your tax return may not yet be known. For instance, in January, you may find that itís very hard to predict how much earned income, interest income, dividend income, or capital gain distributions from mutual funds youíll have over the course of the year. Waiting until later in the year can make it much easier to try to target a specific income threshold with the conversion (e.g., staying just below a given IMRAA threshold or staying within a given tax bracket).

On the whole, I think for most people it makes most sense to wait until later in the year, given the uncertainty about all the tax planning inputs.

If, however, you find that you can pretty reliably predict most of the inputs on your tax return (e.g., youíre retired, so you know your earned income will be zero, and you find that your dividend income is pretty reliable each year), converting earlier in the year can make sense. Or, if at some point during the year you happen to notice a major market decline, you could go ahead and do a conversion at that time. (Though of course youíd have to accept the fact that you may be missing out on an even better opportunity that could arise a few days/weeks/months later. Thereís just no way to know.)

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Investing Blog Roundup: Monte Carlo Simulations

Monte Carlo simulations are a popular way to determine how risky a given level of spending is, for a particular set of household circumstances (i.e., assets, age, other sources of income, etc.). Different software will do such simulations differently ó and provide different output as well. But the most common form out output is to show a probability of success/failure ó that is, in what percentage of the simulations did the household end up depleting the portfolio before the desired length of time had elapsed.

As David Blanchett discusses in a recent article, many ďfailureĒ scenarios wouldnít even occur in real life. In part, thatís because people tend to cut their spending, if they see that it doesnít look like things are going according to plan. Second, Monte Carlo simulations are often run using a conservative time horizon estimate (e.g., to age 100). If a ďfailureĒ scenario shows the portfolio being depleted at, for example, age 97, thereís a good chance that the original owners of the portfolio would no longer be alive and spending from it.

In another recent article, Massimo Young and Wade Pfau point out a danger of Monte Carlo simulations, which people might not recognize. Namely, while such software randomizes the results, it does so using constraints/assumptions set by the user (or set by the software developer, if the user doesnít have options to adjust). And the results of the simulations are very sensitive to the assumptions used.

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Financial Planning at an Early Stage: Is It Just Guessing?

A reader writes in, asking:

ďIím 26, single, with a good job. I have been saving 10% of each paycheck since I started working. Iím starting to read more about investing, and Iím using calculators online but one thing I canít wrap my head around is isnít all of this just a wild guess? Like, Iím supposed to input a return and an age when Iíll retire. ButÖI donít know? And when people talk about Roth and Traditional accounts, they always talk about tax rates. Iím not even sure what my tax rate is this year, but somehow Iím supposed to know what it will be when Iím 70??Ē

You are absolutely right.

You donít know what investment returns youíll get. You donít know how much youíll earn each year through your career. You may not, right now, even be able to predict what career youíll be in 10 years from now ó much less the specific position and income. We donít now whatís going to happen with Social Security. We donít know whatís going to happen with tax law. You, likely, donít know if youíre going to get married or what that personís career will be like. Or how many kids youíll have, if any.

So, if youíre trying to do projections out to age 65 to see how much youíll be able to spend based on your current plan, yes, itís just a wild guess.

But thatís okay!

As you get closer and closer to retirement age, more of those things will become known. You donít need to know them right now.

Right now, early in your career, the focus of financial planning is mostly about building good habits.

Make a habit of periodically checking that you have proper insurance: health, disability, auto, and renters (or homeowners if/when then becomes applicable). If anybody else is dependent on you financially, you should have life insurance as well.

Get in the habit of tracking your spending so that you know how much youíre spending and on what. For many people, when they do that for the first time, they find that theyíre spending a lot on some things that really arenít that important to them. Whenever you find that to be the case, you have identified an easy area for improvement.

Build an emergency fund of safe, accessible assets. At least a few months of living expenses. Gradually, seek to build that up to 6 months of living expenses. (The primary purpose of an emergency fund isnít for an unexpected spending need, though those do arise. The primary purpose is to make sure you donít have an absolute disaster if you lose your job unexpectedly and it takes a while to find a new one.)

Youíre already saving a significant part of your income each year, which is great. Admittedly, thereís no way to know how much is ďenoughĒ this early. We can make some reasonable guesses (see Wade Pfauís ďSafe Savings RateĒ research, for example), but itís still a guess. The critical thing at this stage is that you have started a habit of saving. Whenever your income goes up, save more.

Get in the habit of investing those savings (other than your emergency fund), in a low-cost and diversified way. Most often this means a single target-date fund or a simple portfolio of 2-3 index funds/ETFs.

And get in the habit of investing in that same simple portfolio, every paycheck, regardless of what the market has done recently. A market downturn isnít a problem for you ó itís a bargain-buying opportunity.

With regard to accounts, if your employer offers a matching contribution to a 401(k)/403(b), make sure that youíre contributing enough to get the maximum match. And, if you can, contribute to a Roth IRA, rather than just saving in a taxable brokerage account.

Itís true that you canít predict the future 30, 40, 50 years from now. But thatís OK. There are still a lot of things you can do right now that will improve your future, even if thereís no way to know precisely how that future will look.

(For further related reading, see A Basic Financial Planning Checklist or What is Comprehensive Financial Planning?)

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