Q&A: Riding the market waves

Dear Liz: Today’s stock market is one of the most volatile of all time. So many issues affect it, and there seems to be no end in sight to war in Ukraine, inflation, high fuel prices, the pandemic, China conflict concerns and more. Any one of these would cause the market pain, but together it’s scary. I have a broker who’s used to riding ups and downs, and says to me to be patient. In the meantime I’ve lost 25% of a portfolio that was extremely fruitful until January of this year. Please give me guidance on working with a broker, finding one who knows how to navigate this market and isn’t mired in some tradition of riding waves. I need one who sees opportunity and knows how to take advantage and get out appropriately.

Answer: The reason your broker is “mired in some tradition of riding waves” is because that’s the one approach that consistently works. It’s the advisors who promise you that they can “see opportunity” and “get out appropriately” that can cost you big time. Advisors who try to time the market — which is what you’re asking them to do — inevitably fail. They might get out in time to avoid the crash but rebounds happen so swiftly that they’ll miss a good chunk of the recovery before they get back in.

There is no reward without risk, and riding out inevitable downturns is how investors get ahead over time. Trying to outsmart the market just leads to extra costs that lower your ultimate returns.

Q&A: When a full-service brokerage doesn’t want your business anymore

Dear Liz: Can a brokerage firm drop a 26-year customer because their account falls below $200,000? I have been told that they don’t normally have accounts under that limit. Of course, my balance is lower because of the market slide. This policy doesn’t seem very ethical. Ten years ago, I had another account with them and it fell below $100,000 and nothing was said about that.

Answer: Your full-service brokerage may have just done you a favor. After charging you high fees for years, it has set you loose to find an alternative that will cost you much less.

Discount brokerages such as Vanguard, Fidelity, Charles Schwab and T. Rowe Price will welcome your business. You also could explore robo-advisory options that manage your money for a fraction of what you’re paying now.

Q&A: The ins and outs of I-bonds

Dear Liz: As you know, interest rates on certificates of deposit are extremely low. I was thinking of investing in government I-bonds. Can you discuss the pros and cons?

Answer: I-bonds are guaranteed by the U.S. government and currently pay an interest rate of 7.12%. But they do have some downsides.

The rate on Series I savings bonds is a composite of two rates: a fixed rate, which is currently zero, and an inflation rate, which changes every six months. The semiannual inflation rate is currently 3.56%, which translates into a 7.12% annual rate. This rate applies for I-bonds issued November 2021 through April 2022 and is good for the first six months you own the bond, according to Treasury Direct, the financial services site that allows you to buy securities including I-bonds directly from the U.S. government.

Although the rate can change, it can’t go below zero, so you can’t lose your principal. However, you also can’t cash in I-bonds for the first year, and if you cash them in before five years, you’ll lose the previous three months’ worth of interest.

Also, the bonds don’t pay interest to you directly. Every six months, the interest earned is added to the bond’s principal. That creates a new principal value, and interest is then earned on that value.

The bonds are exempt from state and local taxes but subject to federal taxes. You can opt to pay federal tax on the interest each year, but most people defer reporting the interest until they cash in the bond or it stops earning interest at 30 years, in which case it’s automatically cashed out and the interest reported to the IRS.

You can buy up to $10,000 in I-bonds electronically each calendar year. You can buy another $5,000 in paper bonds, but only if you use your tax refund to do so.

Q&A: What is the capital gains tax, and how big a bite does it take?

Dear Liz: We own stocks with enormous capital gains — as in, six figures or more. The tax would be a lot. Any advice on how to limit the tax bite? Our income consists of Social Security and a teacher’s pension.

Answer: Capital gains taxes may be less of a problem than you fear. If your taxable income as a married couple is less than $83,350 in 2022, your federal tax rate on long-term capital gains is zero. (Long-term capital gains apply to profits on stocks held one year or more.) If your taxable income is between $83,350 and $517,200, your federal capital gains tax rate is 15%.

In addition, you may owe state taxes. California, for example, doesn’t have a capital gains tax rate and instead taxes capital gains at the same rate as ordinary income.

Capital gains aren’t included when determining your taxable income, by the way, but they are included in your adjusted gross income, which can affect other aspects of your finances. A big capital gain could determine whether you can qualify for certain tax breaks, for example, and could inflate your Medicare premiums. That’s why it’s important to get good tax advice before selling stocks with big gains.

A tax pro can discuss strategies that might reduce a tax bill, such as offsetting gains with capital losses by selling any stocks that have lost value since you purchased them. You also could consider donating appreciated shares to qualifying charities. If you itemize your deductions, you can deduct the fair market value of these shares. The write-off is typically limited to 30% of your adjusted gross income for the year, although if you donate more you can carry forward the excess deduction for up to five years.

All this assumes that these shares aren’t held in retirement accounts. Withdrawals from retirement accounts are typically taxed as ordinary income and don’t benefit from the more favorable capital gains rates. If the stocks are in an IRA and you’re at least 70½, however, you could make qualified charitable distributions directly to nonprofits and the distributions wouldn’t be included in your income. Again, this is something to discuss with a tax pro before taking action.

Q&A: All investments involve risk

Dear Liz: I want to protect principal in my modest retirement savings account for future needs. I’ve been in cash and money market funds, but if the recent surge in inflation continues, purchasing power could decrease 25% or more over the next five years. Certificates of deposit and Treasury Inflation-Protected Securities (TIPS) tie money up for long periods and emergency use would result in significant loss. I’ve examined diversifying into real estate, commodities, foreign currencies, gold, but they all go up and down. Can principal be protected from loss and inflation?

Answer: No.

Investments that protect your principal typically have returns that trail inflation. Even though your principal is protected from one kind of loss, you’re all but guaranteed the loss of buying power over time. For inflation-beating returns, you need to take some risk.

Young people with decades until retirement should keep most of their retirement savings in stocks, but even those in retirement typically need to have some exposure to the stock market to preserve growth and buying power. A fee-only, fiduciary financial planner could give you individualized advice about how much risk is appropriate for you to take.

Q&A: How a fee-only financial planner differs from a fee-based one

Dear Liz: What is the difference between a fee-based financial planner and a fee-only financial planner? I have had a few complimentary meetings with a fee-based financial planner regarding retirement planning and income-generating strategy. I am 61 and currently have $325,000 in a traditional IRA and a 401(k) from a former employer, with 70% of both accounts held in stocks. The planner suggests that I put the whole $325,000 into a fixed indexed annuity, which he says is no risk. Is this a good idea?

Answer: Someone who is “fee based” typically accepts commissions or other incentives for selling certain investments in addition to charging fees. “Fee only” advisors accept money only from their clients.

Another important word that starts with f: fiduciary. Fiduciary advisors promise to put your interests ahead of their own. A fiduciary advisor, for example, typically wouldn’t recommend putting all your money in a single investment since having all your eggs in one basket is rarely in your best interest.

Most advisors are not fiduciaries, however, and may recommend poorly performing or expensive products to you when better options are available because those lesser options pay them more. Indexed annuities can pay high commissions to the people selling them, for example, and that can be a powerful incentive for your advisor to gloss over their potential disadvantages.

Indexed annuities are sold as a way to benefit from some of the upside of the stock market without the risk of loss if the market falls. But these annuities are complex and insurers can typically change the rules that govern your returns. In addition, you may face surrender charges if you need to take your money out.

The Securities and Exchange Commission has issued investor alerts about indexed annuities. These alerts urge potential investors to thoroughly investigate how the contracts are structured, how returns are figured and how the calculations can change. Anyone who is considering an indexed annuity would be smart to run the purchase past a fee-only, fiduciary financial planner to see whether it really makes sense for their situation.

By the way, there’s no such thing as a no-risk investment. Every investment poses some kind of risk, and a fiduciary advisor will take the time to explain those to you so you can make an informed judgment.

Q&A: What’s the difference between ETFs, mutual funds and index funds?

Dear Liz: What is the difference between ETFs, mutual funds and index funds?

Answer: Index funds are a type of mutual fund. Mutual funds and ETFs both allow you to buy a diversified mix of investments, but they’re structured differently.

Mutual fund shares are usually priced once a day, based on the value of their underlying assets minus liabilities. Investors buy and sell without knowing precisely what the share price will be, since that’s calculated after they place their orders with the mutual fund company. ETFs, or exchange-traded funds, by contrast, trade throughout the day on stock exchanges and can be worth more or less than the underlying investments, depending on demand.

Most mutual funds are actively managed. That means the underlying investments may frequently change as the fund manager tries to “beat the market” and get a better return than a market index or benchmark such as the Standard & Poor’s 500. All that trading increases a fund’s costs and usually doesn’t result in a higher return.

By contrast, index mutual funds just try to match the market benchmark. This is known as passive management. Less trading leads to lower costs and typically better returns.

Most ETFs are passively managed and have even lower costs than typical index mutual funds. ETFs are the investment of choice for robo-advisors, which offer automated investment management, but they also can be an inexpensive way for individuals to invest. Also, ETFs don’t have the investment minimums that can sometimes be a barrier to start investment with mutual funds.

Q&A: Investing a windfall

Dear Liz: My husband and I are retired and recently inherited a large sum of money. We already have money of our own invested and have a good income. Would a whole-life insurance policy based on an index account be a good place to put this money?

Answer: The insurance agent trying to sell you that policy certainly thinks so, because it’s an expensive product that would generate a substantial commission. You’d be smart to get a second opinion from a fee-only financial planner that doesn’t profit from the investments they recommend.

Q&A: Why you might want a Roth IRA

Dear Liz: I never understood Roth IRAs. They don’t offer a tax break for contributions, so they cause you to pay taxes on your money when you’re working and in a higher tax bracket. With a regular IRA, you get a tax break upfront when you’re in the higher tax bracket and then you pay taxes on withdrawals when you’re retired and in a lower tax bracket. What am I missing?

Answer: Not everyone will be in a lower tax bracket in retirement. Some will be in the same bracket or a higher one when it’s time to withdraw the money. People in their 20s, for example, may be in the lowest tax bracket they’ll ever see. People who expect tax rates in general to rise also may wish to hedge their bets by having at least some money in a Roth.

A Roth also can make more sense if you don’t get a tax break for your IRA contributions. That could be the case if you have access to a workplace plan and your income is above certain limits, or if your income is so low that you owe little or no income tax.

Roth IRAs have a few other advantages. Having a pot of tax-free money in retirement can give you some flexibility in managing your tax bill. If a big bill comes up, for example, a withdrawal from your IRA could push you into a higher tax bracket while a withdrawal from your Roth would not.

Roths also don’t require you to take withdrawals in retirement, unlike regular IRAs. You can hang on to the money until you need it, perhaps to pay for late-in-life costs such as long-term care, or you can pass it on to your heirs.

Roths are more flexible in another way: You can always withdraw the amount you contributed to a Roth without tax consequences. Withdrawals from IRAs before retirement typically incur both taxes and penalties.

Q&A: Where to find the most bang for your savings buck. Spoiler: On Wall Street

Dear Liz: I recently sold my home and want to put away funds for my daughters. I want to place $130,000 each in an account that will earn 7% to 10% interest for 30 years or so, providing them with a comfortable retirement fund. I’m thinking of having them start with a low-cost index mutual fund. What are the drawbacks to placing all of the funds in one mutual fund account?

What are the tax implications?

Answer: Stock market index funds mimic a benchmark, such as the Standard & Poor’s 500. That means you’re typically getting at least some diversification, which can help reduce the volatility of your investment.

You could reduce volatility even more by including bond market index funds, or opting for a target date fund that spreads the money across a mix of investments — stocks, bonds, cash. Target date funds are labeled with a specific year in the future and gradually reduce risk as that date approaches. Or you could consider a robo-advisor, which uses computer algorithms and ultra-low-cost exchange-traded funds to create and manage a portfolio.

These investments typically will generate taxable returns, so you’ll want to discuss the implications with a tax pro.

Also, you mentioned earning interest, but interest is what is paid on bonds and savings accounts. Returns are what investors earn on stocks and other higher-risk investments. No investment currently pays 7% to 10% interest. Over time, stocks typically generate average annual returns of 8% or so, but returns aren’t guaranteed and some years your stocks may lose money.