Q&A: When to merge 401(k) accounts

Dear Liz: I have $640,000 in a previous employer’s 401(k) and $100,000 in my new employer’s plan. Do you recommend I merge the two? Both funds offer similar investment options. My only motivation is based on simplifying paperwork during retirement, although there may be other advantages I am not aware of.

Answer: The choice of investment options matters less than what you pay for them. If your current plan offers cheaper choices, rolling your previous account into your current one makes sense if your employer allows that.

If the previous employer’s plan is cheaper, though, leaving the money where it is can make more sense. Once you actually reach retirement age you can decide whether to consolidate the plans or roll them into an IRA.

IRAs give you a wider array of investment options, but keeping the money in 401(k) accounts has other advantages. Larger 401(k)s often offer access to cheaper, institutional funds that aren’t available to retail investors in their IRAs. A 401(k) may offer more asset protection, depending on your state’s laws, plus you can begin withdrawals as early as age 55 without penalty if you no longer work for that employer.

Q&A: Here’s why timeshares are a bad investment

Dear Liz: About two years ago, I lost my timeshare because of financial hardship. I paid off the mortgage but after my divorce I missed paying the annual fees. Is there any way I can regain it, or can the company just take it like they did? Also, is it worth it to try to get it back? I think so because it is the only thing I own.

Answer: Please consider investing your money in an asset that can gain value over time. Timeshares don’t.

Timeshares give you the right to use a vacation property for one week each year. They aren’t an investment. In most cases, timeshare owners are lucky to get 10 cents on the dollar when they try to sell their interests.

Sites such as Timeshare Users Group and RedWeek are filled with ads from people trying to sell their timeshares for $1, and some will even pay others to take timeshares off their hands, perhaps by prepaying a year or two of maintenance fees. Those fees average about $900 a year but can top $3,000 on high-end properties. Resorts damaged by natural disasters or older properties that are being improved also may charge “special assessments” that can be hundreds or thousands of dollars more.

As you discovered, timeshare resorts can take back your interest if you don’t keep up with those fees. You also could have lost your timeshare if you hadn’t been able to pay the mortgage. (In general, it’s not a good idea to borrow money to pay for vacations or other luxuries, and that includes timeshares. The high interest rates charged by most timeshare resort developers make borrowing an even worse idea.)

In addition to taking your timeshare, the developers may have sold your delinquent account to a collection agency that reports to the credit bureaus. Those collections could damage your credit scores.

You could ask the resort developer if you can get the timeshare back, but you could just face the same problem again down the road. One of the biggest problems with timeshares is that there typically is no easy exit. Those annual fees and special assessments are due as long as you own the timeshare. You may not be able to find a buyer if money is tight or you’re no longer able to use it.

If you really loved vacationing at that particular resort, you probably still can. Owners who can’t use or trade their timeshare weeks often rent them out on the sites mentioned above, sometimes for less than the annual maintenance fee. Renting could be a much better deal than tying yourself to a timeshare that could become unaffordable.

Q&A: Rebalancing your portfolio can trigger tax bills

Dear Liz: Is there a tax aspect to rebalancing your portfolio? You’ve mentioned the importance of rebalancing regularly to reduce risk.

Answer: Rebalancing is basically the process of adjusting your portfolio back to a target asset allocation, or mix of stocks, bonds and cash. When stocks have been climbing, you can wind up with too high an exposure to the stock market, which means any downturn can hurt you disproportionately.

There definitely can be tax consequences to rebalancing, depending on whether the money is invested in retirement plans.

Rebalancing inside an IRA, 401(k) or other tax-deferred account won’t trigger a tax bill. Rebalancing in a regular account could. Investments held longer than a year may qualify for lower capital gains tax rates, but those held less than a year are typically taxed at regular income tax rates when they’re sold.

Tax experts often recommend selling some losers to offset winners’ gains, and “robo advisor” services that invest according to computer algorithms may offer automated “tax loss harvesting” to reduce tax bills.

Q&A: If you’re putting money in a 401(k) and an IRA at the same time, be ready for the taxes

Dear Liz: I recently returned to a regular 9-to-5 job after freelancing for several years. I contributed the maximum amount to an IRA while self-employed and continued to do so after starting my new job. I was surprised to learn when doing my taxes this year that I could not deduct my IRA contributions because I was also contributing to my company’s 401(k) plan.

Other than increase my 401(k) contributions at the expense of future IRA funding, are there any actions I can take?

Answer: The ability to deduct IRA contributions when contributing to a workplace retirement plan phases out once your modified adjusted gross income reaches certain limits. For single filers, the deduction starts to phase out at $63,000 and disappears at $73,000. For married couples filing jointly, the phase-out is from $101,000 to $121,000.

Your next move depends on your goals and situation. If you’re primarily concerned with reducing your current tax bill and you’re likely to be in a lower tax bracket in retirement, as most people will, then you should funnel more money into your 401(k) rather than funding your IRA.

If, however, you expect to be in the same or higher bracket in retirement, or if you want more flexibility to control your tax bill in your later years, consider contributing to a Roth IRA in addition to your 401(k). Roths don’t offer an up-front deduction, but withdrawals in retirement are tax free. Also, unlike 401(k)s and traditional IRAs, there are no minimum required withdrawals in retirement.

There are income limits on the ability to contribute to a Roth IRA. For single people, the ability to contribute phases out between modified adjusted gross incomes of $120,000 to $135,000 in 2018. For married couples filing jointly, the phase-out is between $189,000 and $199,000.

Q&A: There’s a big difference in various kinds of bonds

Dear Liz: My mutual funds and IRA are mostly in stocks with very little in bonds. I’m thinking I should have more in bonds, but just don’t know how much I should transfer from the stock funds and which bond fund to pick. Are they all the same?

Answer: Just as with stock funds, bond funds have different compositions, fees and investment philosophies. There’s a fairly big difference, for example, between a rock-solid U.S. Treasury bond and a “junk” or low-rated bond.

There’s also a difference in fees between funds that are trying to beat the market (active management, which is more expensive) versus merely matching the market (passive management, which is less expensive and typically offers better results).

The ideal asset allocation, or mix of stocks, bonds and cash, also varies depending on your age and risk tolerance. There are a variety of asset allocation calculators on the web you can try, or you can consult a fee-only planner.

Another option is turn the task over to a target date retirement fund, which manages the mix for you, or a robo-advisor, which invests according to computer algorithms.

Whatever you do, keep a sharp eye on the fees you’re charged. The average bond fund had an expense ratio of 0.51% in 2016, according to the Investment Company Institute. There’s little reason to pay much more than that, and ideally you’d try to pay less.

Q&A: Deferred compensation plans

Dear Liz: I’m 54 and plan on retiring at 55 with a government pension. I have about $450,000 in a 457(b) deferred compensation plan. I owe about $220,000 on my home. I would like to pay off my 15-year, 2.5% interest mortgage. This would free up $1,900 a month and leave us debt-free. Everyone I’ve spoken to says this is a bad idea since I’d lose my mortgage interest deduction and I’d be “investing” in a low-interest vehicle (my mortgage). My only other obligation is my daughter’s college education, and I’m paying that in cash. Am I crazy to pay off this mortgage?

Answer: You’re not crazy, but you probably haven’t thought this all the way through.

The money in your deferred compensation plan hasn’t been taxed. Withdrawing enough to pay off your mortgage in one lump sum would shove you into a higher tax bracket and require you to take out considerably more than $220,000 to pay the tax bill. You could easily end up paying a marginal federal tax rate of 33% plus any applicable state tax — all to pay off a 2.5% loan.

There are a few scenarios where using tax-deferred money to pay off a mortgage can make sense. Some people have so much saved in retirement plans that the required minimum distributions at age 70½ would push them into high tax brackets and cause more of their Social Security to be taxed. They also may have paid down their mortgage to the point where they’re no longer getting a tax break.

In those instances, it may be worth withdrawing some money earlier than required to ease the later tax bill. The math involved can be complex, though, and the decisions are irreversible, so anyone contemplating such a move should have it reviewed by a fee-only financial advisor who is familiar with these calculations.

In fact, it’s a good idea to get an objective second opinion from a fiduciary any time you’re considering tapping a retirement fund. (Fiduciaries are advisors who pledge to put your interests ahead of your own.)

During your meeting, you also should review the other aspects of your retirement plan. How will you pay for health insurance in the decade before you qualify for Medicare? If you’re a federal employee, you should be eligible for retiree health insurance but your premiums may rise once you quit work. If you’re planning to buy individual coverage through a healthcare exchange, what will you do if that’s yanked away or becomes unaffordable? How will you pay for long-term care if you need it, since that’s not covered by health insurance or Medicare?

You can get referrals to fee-only financial planners from the National Assn. of Personal Financial Advisors at napfa.org. You can find fee-only planners who charge by the hour at Garrett Planning Network, garrettplanningnetwork.com.

Q&A: Money in the bank isn’t safe from inflation

Dear Liz: I am 68 and not in very good health due to heart disease. I’m not sure what do with my savings of over $1 million, which sits in online bank accounts, earning 1.25% to 1.35% in 18-month certificates of deposit. (No account contains more than $250,000 to remain under the FDIC insurance limits.) The money will eventually go to my daughter, though I could use it for my retirement. I don’t have the appetite for market swings. What should I do with my money?

Answer: Your money currently is safe from just about everything except inflation. If you want to keep your nest egg away from market swings, you’ll have to accept that its buying power will shrink. There is no investment that can keep your principal safe while still offering inflation-beating growth.

If you do want a shot at some growth, you could keep most of your savings in cash but also invest a portion in stocks — preferably using low-cost index mutual funds or ultra-low-cost exchange-traded funds.

Before you know how to invest, though, you’ll need to think about your goals for this money. A fee-only financial planner could help you discuss the possibilities and come up with a plan. You can find fee-only planners who charge by the hour through the Garrett Planning Network, www.garrettplanningnetwork.com.

Q&A: How to find the right balance when investing

Dear Liz: My brokerage wanted me to start moving from stocks that paid me steady dividends into bonds as I got older. If I’d followed that advice, I wouldn’t be nearly where I am today. I sleep just fine with my dividends. Things can change, of course, but until I see solid evidence otherwise, I am sticking with my plan. I have no idea why the brokerage is still pushing the “more bonds with advancing age” idea.

Answer: Presumably you were invested during the financial crisis and saw the value of your stocks cut in half. If you can withstand that level of decline, then your risk tolerance is a good match for a portfolio that’s heavily invested in stocks.

The problem once you retire is that another big drop could have you siphoning money for living expenses from a shrinking pool. The money you spend won’t be in the market to benefit from the rebound. This is what financial planners call sequence risk or sequence-of-return risk, and it can dramatically increase the odds of running out of money.

Perhaps you plan to live solely off your dividends, but there’s no guarantee your buying power will keep up with inflation. Most people, unless they’re quite wealthy, wind up having to tap their principal at some point, which leaves them vulnerable to sequence risk.

There’s another risk you should know about: recency bias. That’s an illogical behavior common to humans that makes us think what happened in the recent past will continue to happen in the future, even when there’s no evidence that’s true and plenty of evidence to the contrary. During the real estate boom, for example, home buyers and pundits insisted that prices could only go up. We saw how that turned out.

Bonds and cash can provide some cushion against events we can’t foresee. The right allocation varies by investor, but consider discussing your situation with a fee-only financial planner to see how it aligns with your brokerage’s advice.

Q&A: Investment advisor’s fees

Dear Liz: Two years ago I rolled my 401(k) into an IRA at the suggestion of an advisor after I lost my job. The rollover was $383,000, and a secondary amount of $63,000 was transferred from my after-tax savings to a second account. All the fees for the advisor are taken from my small account and are 1.5% annually. My IRA is now at $408,000. Assuming an average earnings of 3% annually ($12,000), and with the advisor taking 1.5% ($6,000), I’m thinking this is not beneficial to me financially and that can I do better. Also, why is the advisor taking his fee out of my small (after-tax) account? I am 67 and filed for full Social Security in January.

Answer: You should ask your advisor to confirm this, but withdrawals from the smaller account are likely to trigger a smaller tax bill since most of the money there has already been taxed. A withdrawal from your larger account, which is presumably all pre-tax money, would result in a larger tax bill for you.

That’s the end of the good news. Given your age, with perhaps decades of retirement ahead, a good benchmark for you to use to compare your returns would be Vanguard’s Balanced Composite Index, which tracks the performance of funds that have 60% of their portfolios in stocks and 40% in bonds. The index returned 8.89% in 2016 and has a three-year average of 6.49%. Even a portfolio with a much lower proportion of stocks would have gotten better results than you did. Vanguard’s Target Retirement 2015 fund, with a stock exposure of less than 30%, earned 6.16% last year and 4.04% on average over the last three years.

Investment performance shouldn’t be the only way you judge an advisor, but giving up half your returns to fees could dramatically reduce the amount you have to live on in retirement.

Fortunately, you have options. You could hire a fee-only planner who charges by the hour to design a portfolio for you, and implement it yourself at one of the discount brokerage firms such as Schwab, Vanguard, Fidelity or T. Rowe Price.

Or you could explore the digital investment options known as robo-advisors, which invest and rebalance your money using computer algorithms. Some of the pioneers in this field include Betterment, Wealthfront and Personal Capital. Schwab, Vanguard and T. Rowe Price also offer digital investment services directly to consumers, while Fidelity offers it to advisors.

If you still want the human touch, some of the services — including Betterment, Personal Capital, Vanguard and T. Rowe Price — combine digital investment with access to advisors.

Q&A: Annuities and fees

Dear Liz: I must object to a point you made in a recent column. You wrote: “…Also, annuities often have high fees, so you’d need to shop carefully and understand how the surrender charges work.” To write “…annuities often have high fees” is misleading, because there are annuities that don’t have fees, such as fixed annuities and indexed annuities. Coupling that phrase about fees with the admonition “you’d need to shop carefully and understand how the surrender charges work” is also a disservice to the public. Of course, an investor has to understand surrender charges! Just like if they try to end a bank CD too soon, there’s a penalty, or if they try to get out of a real estate deal incorrectly, or if they commit some other kind of breach of contract. That doesn’t mean that annuities are bad investments, especially when their principal is guaranteed, and no fees to pay.

Answer: Thanks for bringing up two areas of confusion that are actually linked.

All investments have costs. Many, including mutual funds and variable annuities, explicitly state their fees. With fixed and indexed annuities, the cost isn’t disclosed. Instead, it’s built into the interest rate spread — the difference between what the insurer earns on your money and what it pays into your account, said financial planner Michael Kitces, partner and director of financial planning research at Pinnacle Advisory Group in Columbia, Md.

“In other words, if the annuity company pays 2.5% on its annuity, it likely earned closer to 3% or 3.5% in the first place,” Kitces said. The insurer keeps the remainder to recover commissions paid to the insurance agent and the annuity’s own profit margins, he said.

Indexed annuities are a little more complicated. These promise investors they will get a certain portion of the return earned by some market benchmark while protecting them from market losses. The insurers use the spread to cover their overhead costs, profits and commissions. But instead of paying the remaining yield into your account, insurers use the money to purchase options that provide the promised participation rate in the index, said Kitces, who writes the Nerd’s Eye View blog at kitces.com.

Either way, surrender charges encourage people to stay invested long enough for the insurance company to get back enough money from the interest rate spread to cover the cost of commissions. If people need their money during the first few years, the surrender charge they pay is designed to make up the difference between what the insurer paid out and what it has received from the yield spread. Surrender charges are typically around 7% to 9% and may persist for seven or more years, although the penalty declines over time.

You’ve heard that “there’s no such thing as a free lunch.” Investors need to understand that they’re paying a price for their investments, even if they can’t see the money directly coming out of their pockets. Costs are a drag on investor returns and how big their portfolios can grow. That’s why it’s important to minimize those costs. When insurers don’t disclose the costs, it’s hard to know how much you’re giving up compared to what you could earn from another investment.