(Written September 2009)
Bonds are fixed income investments. In other worldsbond (purchased individually or via ETF or mutual fuis a debt security. In effect, you are loaning money togovernment, a municipality or a company in the expectation of receiving monthly, quarterly or semi-annually interest payments, in addition to return of the principal.
Bonds are subject to their own set of investment risks including reinvestment risk, interest rate risk and purchasing power (inflation) risk. These risks affect all forms of corporate, government and municipal bond issues. Government bonds however are not subject to default risk, that is, the risk that a creditor may seize the underlying collateral of a bond (if any) and sell it to recoup the principal. Also, government bonds do not have credit risk which is the risk that the issuer cannot make interest and principal payments.
The credit risk of a bond issuer can be determined by reviewing the credit rating assigned by the bond rating agencies, most notably the private firms of Standard & Poor’s and Moody’s. Both firms rate a corporate bond issue as either Investment Grade or Non-Investment Grade (Speculative) grade. The grade assigned is a judgment call so it is recommend you (or your investment advisor) do your own due diligence on the issuer.
An alternative to individual bonds are bond ETF or mutual funds. A bond ETF/Mutual funds is a portfolio of individual bonds that have similar credit ratings. For example, the Dodge & Cox Income fund (DODIX) has an Average Credit Quality of AA (high grade) and Yield of 5.72%. On the other hand the Vanguard High-Yield Corporate mutual fund (VWEHX) has an Average Credit Quality of BB (Speculative) with a Yield of 8.40%.
You will notice with these two examples that the less the quality of the bond, the higher the yield. This is because for a lesser creditworthy company to sell its bonds, it must offer an interest rate high enough to attract a buyer. Contrast the two examples with the iShares Barclay 1-3 Year Treasury ETF (SHY) with a yield of 3.16% but no credit risk.
Bonds should be a portion of every investor’s portfolio regardless of age. The only variables being level of acceptable risk and percentage of portfolio. As the investor ages, shifting toward a larger allocation of bonds along with a move toward less risk in the bond allocation is necessary.
Bond Options
Municipals Bonds – Issued by state and city governments who use the money to build schools, sewers or other high ticket items. Most municipal bonds are free from federal income taxes and state tax (if the investor lives in the state that issued the bond. Because of the tax advantage, munis have historically offered much lower yields than Treasury bonds. The SPDR Barclays Capital Municipal Bond (TFI – 3.88%), Fidelity Municipal Income (FHIGX – 4.31%) and Vanguard Interm-Term Tx-Ex (VWITX – 4.00%) are three funds in this classification.
Government agency bonds – Ginnie Mae, Fannie Mae and Freddie Mac issue bonds backed by the payments from mortgages. Since the federal takeover of Fannie and Freddie, their bonds are effectively guaranteed. Ginnie Maes are also government backed. The yields tend to be higher than Treasurys. The Vanguard GNMA (VFIIX - 4.61%), Payden GNMA (PYGNX – 4.88%), Fidelity Ginnie Mae (FGMNX – 4.65%) and other funds can provide exposure.
Treasury bonds and TIPS – The interest and principal are guaranteed by the government. The downside is the safety is paid for with lower yields. The yields on Treasury Inflation Protected Securities (TIPS) are designed to float with the inflation rate. iShares Barclay TIPS Bond (TIP – 4.68%) and SPDR Barclays Capital TIPS (IPE – 3.38%) are two ETFs that invest in TIPS.
High-grade corporate bonds – Corporate bonds generally have higher yields when compared to Treasurys. They are not risk-free but the bondholders are ahead of stockholders if the company runs into financial trouble. RidgeWorth Investment Grade Bond (STGIX – 4.28%) and iShares Barclays MBS Bond (MBB – 3.85%) are two plays in these bonds.
High-yield bonds – Often called ‘junk bonds’, these riskier cousins of high-grade corporates are issued by companies that have to pay higher interest rates to attract investors. These funds can be tempting because of the high yields, but remember they are paying higher yields for a reason. Two funds in this agenda are SPDR Barclays Capital High Yiled Bond (JNK – 13.25%) and T. Rowe Price High-Yield (PRHYX – 8.32%).
As with any investment, always read the prospectus and make sure you understand all the fees and expenses associated with a bond or bond fund purchases. High fees may cut into your returns.
Written by David Snellen
© 2009 USA Living Financial Group
Disclosure:
David Snellen and/or his clients may have a position in one or more of the quoted funds/ETFs.
All stated yields are as of July 15, 2009
Due to the market volatility of the past year, the yields shown may not represent a true picture of the yields available with this class of bonds.
Thursday, November 5, 2009
Is the Worst Over?
(Written November 2009)
The stock and bond markets are indicating that we may have seen the bottom of this economic cycle. The markets are reacting to indication that the stimulus efforts may be working. Bad economic news comes less often and in many cases the numbers are improving. But is the worst over?
With the sharp rallies off the March 9th lows, the summer and fall seem to be giving way to a more somber view of a potential recovery.
Consumers continue to cope with near double digit unemployment and the ongoing recession while trying to salvage what they can of retirement and investment accounts. The U.S. auto industry operates as a former shell of itself, but manufacturing overall is showing some signs of stabilization. Banks and financial institutions still face pressures but posted substantial earnings recovery.
Economic data remains mixed and often contradictory. One must have faith in the ability of the U.S. economy to return to sustainable growth.
The tough part is the not knowing which way the economy and consequentially the stock market will move and over what length of time. No one has a crystal ball, but now being warier and wiser, we can look toward what’s on the horizon.
How It All Started
It’s hard to pinpoint the beginning of the financial crisis. The first signs appeared in late 2006 and 2007 when sub-prime mortgage lenders started going under. The government recognizes the problem and in 2007 began a series of moves to shortstop the growing number of mortgage defaults.
Through the fall of 2007 and into 2008, the government was actively injecting money into the banking system while simultaneously lowering the interest rate.
The Bank of America’s Jan 2008 purchase of Countrywide Financial, the country’s largest sub-prime lender, made BoA the nation’s largest mortgage lender. While mortgage defaults were in the news, this event put the issue on the front page and highlight for most Americans the seriousness of the mortgage defaults.
Then beginning in Jan 2008, banks began to fail. One in January, another one in March followed by two in May. JPMorgan Chase & Co. acquired The Bear Sterns Corporation in March 2008 at a fire sale price. And then the failure of Indymac Bank, on July 12th, 2008.
Many believe it was the failure of Indymac Bank that started the banking dominos to start falling. The failure of Indymac is widely blamed on Senator Chuck Schumer (D) New York who purposely leaked an internal memo on June 26th, 2008 calling into question Indymac Bank’s viability. The discloser resulted in an eleven day run on Indymac resulting in the withdraw of more than $1.3 billion dollars.
John Reich, the director of The Office of Thrift Supervision at that time directly placed the blame for the bank’s failure on the comments made in Senator Schumer’s letter. Indymac Bank was not a poster child of how to run a bank and may well have failed at a later date. And maybe not. We will never know. But at the time Indymac was the most expensive bank failure ever.
Blood was in the water and the Wall Street sharks began to circle Fannie Mae and Freddie Mac. Short sellers, who profit when the price of a stock falls, attacked these financial giants along with other large banks driving their stock price into the ground. One name that stands out is George Soro, the billionaire who broke the bank of England in late 1992 with his shorting the sterling. Soro takes major short positions in US and European stocks, the dollar and 10-year Treasuries. The book he published in April 2008 along with his many appearances on financial shows and written commentary help his positions become big winners.
And then came September 2008, the most harrowing month of all. Fannie Mae and Freddie Mac are placed under government control. Bank of America takes over Merrill Lynch and Lehman Brothers files for Chapter 11 bankruptcy. The consumer starts noticing things were not right and stopped spending which sent demand into a free fall. Washington Mutual Bank failed in September and twelve more would fail before the end of the year.
The U.S. stock market bottoms on March 9th, 2009 down 56.78% from the October 2007 high.
Getting Our Bearing
So where do we go from here? No one knows for sure except we do know that the business cycle and the economy move in a constant pattern of up and down cycles. If the pattern holds true then we should be looking at a gradual if uneven recovery. This will ultimately lead to yet another sump. Like waves on the ocean, you cannot prevent naturally occurring events.
But the one thing we did learn is that the world economies are much interwoven. The U.S. sells raw material and finished products to other countries who in turn sell us raw materials and their finished products. The U.S. is not likely to experience sustained consistent growth without the same occurring in other countries.
What we want to do is avoid overacting to the latest sentiment. Many investors now want a more actively managed portfolio which implies that somehow one can foresee which way the market will move. The best evidence that market timing is a bad idea is the market’s recent behavior. Very few people predicted the crisis. Of those who did, most have been predicting it for years. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.
The Road Ahead
There are investment strategies to consider going forward. The first step is to look at your overall investment portfolio within the context of a financial plan. We shouldn’t be focusing on individual investments or the hot sectors.
We do want to hedge the potential inflation risk by considering precious metals and high yield bonds. Diversification is a technique to help reduce risk, but there is no guarantee that diversification will protect against a loss. When the boat is sinking it doesn’t matter which seat you are in. You will still get wet.
We shouldn’t depend solely on the U.S. economy to drive our portfolio. Having a position in specialty sectors like emerging markets, consumer stables, science and technology in additional to the U.S. overall market will help to ensure your portfolio has a chance of growth.
In this era of American economy, investors chart their courses. Consumers set aside more savings. Workers value their jobs more than ever. The greatest cause for optimism may be that we’re grinding through this recession. This is a good thing.
Written by David Snellen.
© 2009 USA Living.com, Inc.
The stock and bond markets are indicating that we may have seen the bottom of this economic cycle. The markets are reacting to indication that the stimulus efforts may be working. Bad economic news comes less often and in many cases the numbers are improving. But is the worst over?
With the sharp rallies off the March 9th lows, the summer and fall seem to be giving way to a more somber view of a potential recovery.
Consumers continue to cope with near double digit unemployment and the ongoing recession while trying to salvage what they can of retirement and investment accounts. The U.S. auto industry operates as a former shell of itself, but manufacturing overall is showing some signs of stabilization. Banks and financial institutions still face pressures but posted substantial earnings recovery.
Economic data remains mixed and often contradictory. One must have faith in the ability of the U.S. economy to return to sustainable growth.
The tough part is the not knowing which way the economy and consequentially the stock market will move and over what length of time. No one has a crystal ball, but now being warier and wiser, we can look toward what’s on the horizon.
How It All Started
It’s hard to pinpoint the beginning of the financial crisis. The first signs appeared in late 2006 and 2007 when sub-prime mortgage lenders started going under. The government recognizes the problem and in 2007 began a series of moves to shortstop the growing number of mortgage defaults.
Through the fall of 2007 and into 2008, the government was actively injecting money into the banking system while simultaneously lowering the interest rate.
The Bank of America’s Jan 2008 purchase of Countrywide Financial, the country’s largest sub-prime lender, made BoA the nation’s largest mortgage lender. While mortgage defaults were in the news, this event put the issue on the front page and highlight for most Americans the seriousness of the mortgage defaults.
Then beginning in Jan 2008, banks began to fail. One in January, another one in March followed by two in May. JPMorgan Chase & Co. acquired The Bear Sterns Corporation in March 2008 at a fire sale price. And then the failure of Indymac Bank, on July 12th, 2008.
Many believe it was the failure of Indymac Bank that started the banking dominos to start falling. The failure of Indymac is widely blamed on Senator Chuck Schumer (D) New York who purposely leaked an internal memo on June 26th, 2008 calling into question Indymac Bank’s viability. The discloser resulted in an eleven day run on Indymac resulting in the withdraw of more than $1.3 billion dollars.
John Reich, the director of The Office of Thrift Supervision at that time directly placed the blame for the bank’s failure on the comments made in Senator Schumer’s letter. Indymac Bank was not a poster child of how to run a bank and may well have failed at a later date. And maybe not. We will never know. But at the time Indymac was the most expensive bank failure ever.
Blood was in the water and the Wall Street sharks began to circle Fannie Mae and Freddie Mac. Short sellers, who profit when the price of a stock falls, attacked these financial giants along with other large banks driving their stock price into the ground. One name that stands out is George Soro, the billionaire who broke the bank of England in late 1992 with his shorting the sterling. Soro takes major short positions in US and European stocks, the dollar and 10-year Treasuries. The book he published in April 2008 along with his many appearances on financial shows and written commentary help his positions become big winners.
And then came September 2008, the most harrowing month of all. Fannie Mae and Freddie Mac are placed under government control. Bank of America takes over Merrill Lynch and Lehman Brothers files for Chapter 11 bankruptcy. The consumer starts noticing things were not right and stopped spending which sent demand into a free fall. Washington Mutual Bank failed in September and twelve more would fail before the end of the year.
The U.S. stock market bottoms on March 9th, 2009 down 56.78% from the October 2007 high.
Getting Our Bearing
So where do we go from here? No one knows for sure except we do know that the business cycle and the economy move in a constant pattern of up and down cycles. If the pattern holds true then we should be looking at a gradual if uneven recovery. This will ultimately lead to yet another sump. Like waves on the ocean, you cannot prevent naturally occurring events.
But the one thing we did learn is that the world economies are much interwoven. The U.S. sells raw material and finished products to other countries who in turn sell us raw materials and their finished products. The U.S. is not likely to experience sustained consistent growth without the same occurring in other countries.
What we want to do is avoid overacting to the latest sentiment. Many investors now want a more actively managed portfolio which implies that somehow one can foresee which way the market will move. The best evidence that market timing is a bad idea is the market’s recent behavior. Very few people predicted the crisis. Of those who did, most have been predicting it for years. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.
The Road Ahead
There are investment strategies to consider going forward. The first step is to look at your overall investment portfolio within the context of a financial plan. We shouldn’t be focusing on individual investments or the hot sectors.
We do want to hedge the potential inflation risk by considering precious metals and high yield bonds. Diversification is a technique to help reduce risk, but there is no guarantee that diversification will protect against a loss. When the boat is sinking it doesn’t matter which seat you are in. You will still get wet.
We shouldn’t depend solely on the U.S. economy to drive our portfolio. Having a position in specialty sectors like emerging markets, consumer stables, science and technology in additional to the U.S. overall market will help to ensure your portfolio has a chance of growth.
In this era of American economy, investors chart their courses. Consumers set aside more savings. Workers value their jobs more than ever. The greatest cause for optimism may be that we’re grinding through this recession. This is a good thing.
Written by David Snellen.
© 2009 USA Living.com, Inc.
Managing Volatility with a Ladder
(Written October 2009)
During the past decade, income focused investors have faced a remarkable period of interest-rate volatility. In the past 10 years ending in 2008, the Federal Reserve adjusted the federal funds target rate, which influences the interest rates that consumers pay and bondholders earn, 41 times.
One way to help manage interest-rate risk and cash flow from income focused investment is to construct an investment ladder. This allows the investor to benefit when the rates are high and to help minimize the effect when rates are low. Implementing a ladder investment strategy is easy and can be done with bonds, CDs or annuities.
Step by Step Using Bonds
Bonds, which are debt obligations of the issuer, are issued with maturity dates ranging from a couple of years to 30 years or more. Interest payments are generally every six months with the face value of the bond due at maturity. The interest rate paid by bonds is established when the bond is issued. If interest rates later rise, the issuer will pay a below market interest rate. Conversely, if interest rates fall, the issuer is straddled with paying an above market rate interest rate.
Although the interest paid by the issuer will remain constant, the principal value of a bond may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investors seeking to achieve higher yields may also face a higher degree of risk. The interest earned may also be taxable at both the state and federal level.
To set up a six-year bond ladder, you would purchase five different bonds with maturity dates of two, three, four, five and six years, respectively. If these are new issue bonds, you will earn an interest rate close to the prevailing market rate. When the first bond matures after two years, you purchase a new six-year bond to keep the ladder intact. Each year when the bond matures, you simply purchase a new six year bond. If interest rates have risen, you benefit from having cash available to invest in a new bond at the higher rate. If interest rates have fallen, only a portion of the portfolio is subject to the lower rate.
An alternative to buying individual bonds is to invest in a bond mutual fund or ETF. Interest is paid monthly instead of semi-annually and you don’t have to worry about reinvestment interest rates.
Using Annuities
Annuities come is many flavors ranging from simple savings annuities to complex variable annuities. The ones we are interested in for an annuity ladder are the short term, no fee and no commission savings annuity. This type of annuity is available from several insurance companies. They can be purchased for various time periods ranging from two to ten years or more and generally have a minimum investment amount with $20,000 to $50,000 being common. These annuities offer a fixed rate of return for a fixed period and the purchaser has no market risk.
For example, in mid September 2009, a simple $100,000 2-year saving annuity contract can be purchased earning 1.75%. A $100,000 5-year saving annuity will earn 3.65%. You can buy this directly from the company with no fees, no commission or salesperson involved. You simply give them a check for $100,000 and in two years they give you back a check for about $103,560. The 5-year annuity would earn about $20,000. Unlike bonds and CDs, the tax on the interest earned on an annuity is deferred.
Constructing an annuity ladder is similar to that of a bond ladder, but you may be limited to the term lengths offered by a single company. For example, some companies offer 2, 5 and 10 year saving annuities. Others offer may offer 3, 5, 7 and 10 year terms.
The interest rate paid on an annuity contract is also influenced by the Federal Funds Target Rate. Like bonds, you will want to keep the ladder short with five to six years probably being the limit. To construct a two-year annuity ladder, purchase a two-year annuity this year and one year later purchase another two-year annuity. When the first one comes due, you may be able to do a 1031 exchange into another two-year annuity which may be paying a higher rate of guaranteed return. The 1031 exchange will allow you to defer the tax on the interest earned.
If a company allows for a three-year annuity contract, the ladder is constructed over a three year period. Or you could build a five year ladder by buying a five-year contract every year for five years. The longer the ladder the more stability the annuity ladder will offer but may subject you to interest rate risk.
Using CDs
Constructing a CD ladder is very similar to the bond and annuity ladder but with more choices. Term lengths on CDs range from three months to five years. In mid-September 2009, the highest rate available on a one-year CD is 2.15% APY.
To construct the CD ladder, buy five separate CDs with maturity dates of 1, 2, 3, 4 and 5 years. As the first one matures reinvest in a new five-year CD. Unlike annuities, you will pay the tax on the interest earned each year even if the money earned will not be received until the CD matures.
With CDs it pays to shop around. You may purchase the CD from practically any bank located anywhere within the USA. Interest rates vary widely between banks with a high today of 2.15% APY down to a low of 1.25% APY. You can find current rates on www.bankrate.com. It may also pay to call the bank directly to request quotes or check the bank’s Web site.
There is no trick to CD laddering. Only due diligence is required in order to minimize risks. You may pay a surrender charge if you cash in a CD before its maturity.
Income investing using a ladder strategy can help provide stability during periods of interest-rate volatility. Remember to read all the fine print before purchasing.
Where to Use a Ladder
All three ladders will create taxable income so it would be wise to consider which investment vehicle: a Traditional IRA, Roth IRA or Saving Account would be the most appropriate. The Roth IRA would by far be the best location because all income is receive tax free after you reach 59 ½. It would not make sense to place an annuity ladder in a Traditional IRA. An IRA already has deferred tax status. It’s a duplication of effort. Both the bond and CD ladder would fit nicely in any of the three investment vehicles.
Written by David Snellen
© 2009 USA Living Financial Group
During the past decade, income focused investors have faced a remarkable period of interest-rate volatility. In the past 10 years ending in 2008, the Federal Reserve adjusted the federal funds target rate, which influences the interest rates that consumers pay and bondholders earn, 41 times.
One way to help manage interest-rate risk and cash flow from income focused investment is to construct an investment ladder. This allows the investor to benefit when the rates are high and to help minimize the effect when rates are low. Implementing a ladder investment strategy is easy and can be done with bonds, CDs or annuities.
Step by Step Using Bonds
Bonds, which are debt obligations of the issuer, are issued with maturity dates ranging from a couple of years to 30 years or more. Interest payments are generally every six months with the face value of the bond due at maturity. The interest rate paid by bonds is established when the bond is issued. If interest rates later rise, the issuer will pay a below market interest rate. Conversely, if interest rates fall, the issuer is straddled with paying an above market rate interest rate.
Although the interest paid by the issuer will remain constant, the principal value of a bond may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investors seeking to achieve higher yields may also face a higher degree of risk. The interest earned may also be taxable at both the state and federal level.
To set up a six-year bond ladder, you would purchase five different bonds with maturity dates of two, three, four, five and six years, respectively. If these are new issue bonds, you will earn an interest rate close to the prevailing market rate. When the first bond matures after two years, you purchase a new six-year bond to keep the ladder intact. Each year when the bond matures, you simply purchase a new six year bond. If interest rates have risen, you benefit from having cash available to invest in a new bond at the higher rate. If interest rates have fallen, only a portion of the portfolio is subject to the lower rate.
An alternative to buying individual bonds is to invest in a bond mutual fund or ETF. Interest is paid monthly instead of semi-annually and you don’t have to worry about reinvestment interest rates.
Using Annuities
Annuities come is many flavors ranging from simple savings annuities to complex variable annuities. The ones we are interested in for an annuity ladder are the short term, no fee and no commission savings annuity. This type of annuity is available from several insurance companies. They can be purchased for various time periods ranging from two to ten years or more and generally have a minimum investment amount with $20,000 to $50,000 being common. These annuities offer a fixed rate of return for a fixed period and the purchaser has no market risk.
For example, in mid September 2009, a simple $100,000 2-year saving annuity contract can be purchased earning 1.75%. A $100,000 5-year saving annuity will earn 3.65%. You can buy this directly from the company with no fees, no commission or salesperson involved. You simply give them a check for $100,000 and in two years they give you back a check for about $103,560. The 5-year annuity would earn about $20,000. Unlike bonds and CDs, the tax on the interest earned on an annuity is deferred.
Constructing an annuity ladder is similar to that of a bond ladder, but you may be limited to the term lengths offered by a single company. For example, some companies offer 2, 5 and 10 year saving annuities. Others offer may offer 3, 5, 7 and 10 year terms.
The interest rate paid on an annuity contract is also influenced by the Federal Funds Target Rate. Like bonds, you will want to keep the ladder short with five to six years probably being the limit. To construct a two-year annuity ladder, purchase a two-year annuity this year and one year later purchase another two-year annuity. When the first one comes due, you may be able to do a 1031 exchange into another two-year annuity which may be paying a higher rate of guaranteed return. The 1031 exchange will allow you to defer the tax on the interest earned.
If a company allows for a three-year annuity contract, the ladder is constructed over a three year period. Or you could build a five year ladder by buying a five-year contract every year for five years. The longer the ladder the more stability the annuity ladder will offer but may subject you to interest rate risk.
Using CDs
Constructing a CD ladder is very similar to the bond and annuity ladder but with more choices. Term lengths on CDs range from three months to five years. In mid-September 2009, the highest rate available on a one-year CD is 2.15% APY.
To construct the CD ladder, buy five separate CDs with maturity dates of 1, 2, 3, 4 and 5 years. As the first one matures reinvest in a new five-year CD. Unlike annuities, you will pay the tax on the interest earned each year even if the money earned will not be received until the CD matures.
With CDs it pays to shop around. You may purchase the CD from practically any bank located anywhere within the USA. Interest rates vary widely between banks with a high today of 2.15% APY down to a low of 1.25% APY. You can find current rates on www.bankrate.com. It may also pay to call the bank directly to request quotes or check the bank’s Web site.
There is no trick to CD laddering. Only due diligence is required in order to minimize risks. You may pay a surrender charge if you cash in a CD before its maturity.
Income investing using a ladder strategy can help provide stability during periods of interest-rate volatility. Remember to read all the fine print before purchasing.
Where to Use a Ladder
All three ladders will create taxable income so it would be wise to consider which investment vehicle: a Traditional IRA, Roth IRA or Saving Account would be the most appropriate. The Roth IRA would by far be the best location because all income is receive tax free after you reach 59 ½. It would not make sense to place an annuity ladder in a Traditional IRA. An IRA already has deferred tax status. It’s a duplication of effort. Both the bond and CD ladder would fit nicely in any of the three investment vehicles.
Written by David Snellen
© 2009 USA Living Financial Group
Create a Personal Pension Plan
(Written August 2009)
“If you ask what is the single most important key to longevity, I would have to say it is avoiding worry, stress and tension. And if you didn’t ask me, I’d still have to say it.” – George Burns
A steady stream of income will go a long way toward eliminating worry, stress and tension in one’s life. The catch however, is how to create a no stress stream of income.
Many people have pensions earned while working for a larger corporation or a government entity. Others choose to buy an immediate annuity. This involves giving an insurance company a sum of money in exchange for a defined period of income. The defined period could be for a short term like 10 or 20 years or for life.
For those of us who do not have a pension and choose to not give up control of our money, one option is to create a personal pension plan. A personal pension is not something you buy, it’s an investing strategy. And if planned properly the income from the personal pension can be tax free!
An individual investor has three choices for saving money. They are tax deferred, tax free and taxable accounts. Tax deferred accounts include IRAs and deferred annuities. There are significant differences between an IRA and a deferred annuity. An IRA is funded with pretax money and the invested amount along with the earnings is taxed upon withdrawal. A deferred annuity is funded with post tax dollars, but the earnings are tax deferred until withdrawal. Tax free accounts are Roth IRAs. With a Roth IRA, the invested money is taxed in the year earned but the growth is not taxed. Both tax deferred and tax free accounts have age limitations and other withdrawal consideration. Consult with your tax professional. The taxable accounts include bank savings account, CDs, money markets, checking accounts and similar type accounts.
How to Create a Personal Pension Plan
During the working years maximize your savings in a 401(k), IRA or Roth account. If you have the 401(k) option, try to invest at least 10-15% of your income. At a minimum, invest at least enough to meet the company’s matching contribution.
If you don’t have the 401(k) option, then your saving choice should probably be a Roth account. You can invest up to $5,000 ($6,000 for 50 & older) this year. You pay tax on the money this year but future earnings can be withdrawn tax free after reaching the age of 59½.
The tax free earnings are significant. For example, a single $5,000 deposit growing at 8% a year for 20 years will create over $18,000 of tax free income. Another example. Investing $5,000/year for 20 years at an average annual growth of 8% will grow to over $205,500. Upon reaching age 59½, this $205,500 could be invested in a combination of government and corporate bonds earning an average return of 6%. This amounts to about $1,025 of tax free income each month. Not bad for a personal pension in which the principal isn’t touched and you don’t have to retire to get it.
Portfolio Organization
When creating a personal pension look at the tax deferred, tax free and taxable categories as a holistic portfolio with distinct parts but coordinated to work together. IRA assets can be withdrawn upon reaching the age of 59½ and reinvested in the Roth account. Or the IRAs asset can be re-characterized into the Roth IRA at any time. Both the withdrawal and re-characterization are taxable events. The Roth account is invested for growth and to create a tax free cash flow. See your tax professional to discuss the re-characterization option.
Portfolio Diversification
An investment portfolio should consist of three distinct allocations of stock funds, bond funds and cash. This applies to 401(k), IRAs, Roth IRA and investment saving accounts. This approach allows for growth and cash accumulation. Stock funds include investments in US and foreign stocks. Stock funds are volatile but over time will be the heavy lifers in a portfolio. Bond funds are the monthly income generators and investors have many choices from high yield corporate bond funds to Government issued bonds both foreign and domestic. Cash has a zero correlation with stocks and bonds and works very well to reduce the portfolio volatility. The allocation percentage is variable and should be discussed with your investment advisor.
Creating growth involves moving a portion of the stock equities capital appreciation into the bond allocation. The remaining portion and any dividends allow for growth in the stock equities. This is taking some of the profits and placing it in a lower risk investment while allowing for growth. Adding equity profits to the bond allocation will increase the monthly income generated by these funds. The bonds can retain the monthly dividends or put them in the cash account.
The cash can be used to adjust the portfolio allocation or possibly flow into another account. For example, the IRA cash could flow into the Roth IRA via re-characterization. Roth IRA cash account being fed by bond funds could create a tax free monthly cash deposit into a money market or checking account. See you tax professional to discuss the tax issues with IRA re-characterization
Creating a personal pension is possible but requires planning and a saving strategy. When is the best time to start planning for a personal pension plan? Today.
© 2009 David Snellen - USA Living Financial Group
“If you ask what is the single most important key to longevity, I would have to say it is avoiding worry, stress and tension. And if you didn’t ask me, I’d still have to say it.” – George Burns
A steady stream of income will go a long way toward eliminating worry, stress and tension in one’s life. The catch however, is how to create a no stress stream of income.
Many people have pensions earned while working for a larger corporation or a government entity. Others choose to buy an immediate annuity. This involves giving an insurance company a sum of money in exchange for a defined period of income. The defined period could be for a short term like 10 or 20 years or for life.
For those of us who do not have a pension and choose to not give up control of our money, one option is to create a personal pension plan. A personal pension is not something you buy, it’s an investing strategy. And if planned properly the income from the personal pension can be tax free!
An individual investor has three choices for saving money. They are tax deferred, tax free and taxable accounts. Tax deferred accounts include IRAs and deferred annuities. There are significant differences between an IRA and a deferred annuity. An IRA is funded with pretax money and the invested amount along with the earnings is taxed upon withdrawal. A deferred annuity is funded with post tax dollars, but the earnings are tax deferred until withdrawal. Tax free accounts are Roth IRAs. With a Roth IRA, the invested money is taxed in the year earned but the growth is not taxed. Both tax deferred and tax free accounts have age limitations and other withdrawal consideration. Consult with your tax professional. The taxable accounts include bank savings account, CDs, money markets, checking accounts and similar type accounts.
How to Create a Personal Pension Plan
During the working years maximize your savings in a 401(k), IRA or Roth account. If you have the 401(k) option, try to invest at least 10-15% of your income. At a minimum, invest at least enough to meet the company’s matching contribution.
If you don’t have the 401(k) option, then your saving choice should probably be a Roth account. You can invest up to $5,000 ($6,000 for 50 & older) this year. You pay tax on the money this year but future earnings can be withdrawn tax free after reaching the age of 59½.
The tax free earnings are significant. For example, a single $5,000 deposit growing at 8% a year for 20 years will create over $18,000 of tax free income. Another example. Investing $5,000/year for 20 years at an average annual growth of 8% will grow to over $205,500. Upon reaching age 59½, this $205,500 could be invested in a combination of government and corporate bonds earning an average return of 6%. This amounts to about $1,025 of tax free income each month. Not bad for a personal pension in which the principal isn’t touched and you don’t have to retire to get it.
Portfolio Organization
When creating a personal pension look at the tax deferred, tax free and taxable categories as a holistic portfolio with distinct parts but coordinated to work together. IRA assets can be withdrawn upon reaching the age of 59½ and reinvested in the Roth account. Or the IRAs asset can be re-characterized into the Roth IRA at any time. Both the withdrawal and re-characterization are taxable events. The Roth account is invested for growth and to create a tax free cash flow. See your tax professional to discuss the re-characterization option.
Portfolio Diversification
An investment portfolio should consist of three distinct allocations of stock funds, bond funds and cash. This applies to 401(k), IRAs, Roth IRA and investment saving accounts. This approach allows for growth and cash accumulation. Stock funds include investments in US and foreign stocks. Stock funds are volatile but over time will be the heavy lifers in a portfolio. Bond funds are the monthly income generators and investors have many choices from high yield corporate bond funds to Government issued bonds both foreign and domestic. Cash has a zero correlation with stocks and bonds and works very well to reduce the portfolio volatility. The allocation percentage is variable and should be discussed with your investment advisor.
Creating growth involves moving a portion of the stock equities capital appreciation into the bond allocation. The remaining portion and any dividends allow for growth in the stock equities. This is taking some of the profits and placing it in a lower risk investment while allowing for growth. Adding equity profits to the bond allocation will increase the monthly income generated by these funds. The bonds can retain the monthly dividends or put them in the cash account.
The cash can be used to adjust the portfolio allocation or possibly flow into another account. For example, the IRA cash could flow into the Roth IRA via re-characterization. Roth IRA cash account being fed by bond funds could create a tax free monthly cash deposit into a money market or checking account. See you tax professional to discuss the tax issues with IRA re-characterization
Creating a personal pension is possible but requires planning and a saving strategy. When is the best time to start planning for a personal pension plan? Today.
© 2009 David Snellen - USA Living Financial Group
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