Motley Fool Money - Mailbag! Accounts for Early Retirement, Roth Conversions, Closed-End Funds, and More

Starting point is 00:00:02 De-bills, closed-end funds, the best accounts for early retirees, and more. This week on a financial planning mailbag episode of the Motley Fool Hidden Gems Investing podcast. I'm Robert Brokamp, aka Bro, and it's time for our second personal finance mailbag episode. And like the last time, I'm joined by longtime Motley Fool contributor, Dan Kaplaner, who is a former financial planner and trust attorney. Dan, welcome back to the show. Thanks again for having me.

Starting point is 00:00:34 Always glad to be here. So like our last mailbag episode, we have chosen six questions that we've receive from our wonderful listeners. I'll read each one. Dan and I will take turns taking a first crack at it, and then the other one of us will add some thoughts. So with all that said, here's the first question, and it comes from Anonymous, who asked recently the team mentioned buying treasury bills directly through Treasury Direct or Vanguard. Could you guys expand on how doing that compares to holding other short-term options like the I-share's zero-to-three-month Treasury bond ETF, ticker SGOV, the Vanguard zero to three month treasury bill

Starting point is 00:01:09 ETF, ticker VBIL, or Vanguard Treasury Money Market Fund, ticker VUSXX. So anonymous, I would say that the do-it-yourself buy treasury bills directly, either through your broker or from the government's own treasury direct.gov website, it's kind of the,

Starting point is 00:01:28 whether you decide that you want to pay the fees to an ETF that will do that for you, if you feel like saving that, depends on how much money you are investing. If you only have a couple hundred dollars, probably is not going to make that much of a difference. If you've got a couple hundred thousand dollars, then suddenly even a tenth of a percentage point can make enough of a difference that, you know, take you out for a nice dinner once a year or something like that. But with treasury bills that you buy, you are responsible for monitoring when you buy them by participating at auction or by buying them in the secondary market. you are responsible for knowing when they mature,

Starting point is 00:02:07 and then when they mature, either if you need the money, you withdraw it. If you don't need the money, then you're responsible for then reinvesting that matured T bill into another T bill or if you want a stock or another investment, whatever that may be. With the ETFs that you're talking about, they handle most of that for you. Once the money is in the ETF, you essentially own a piece. of many different treasury bills with many different maturities. All of the ETFs that you were talking about as well as the money market mutual fund, all of those have maturities that are come and do probably every day, at the very least several

Starting point is 00:02:50 times a week. And so they are handling, their management team is responsible for jumping in, reinvesting that they'll charge a modest expense ratio. It's not that much, but it is something that if you are doing the self-surve, option, then you can avoid that while also customizing to your particular needs with the ETF. It's all on them to decide what they're buying when. I'll just point out a few stats about these. So both SGOV and V-Bill are yielding about 3.6%. The Vanguard Money Market Fund is yielding 3.8%. But if you go and buy a three-month T-bill straight from the government, it's yielding 4.2% right now.

Starting point is 00:03:30 and you'll see that in a situation where interest rates are rising, what you get from the money market funds and the ETFs will lag what happens. So, because they have older T bills. Now, the opposite will happen when interest rates go down. You know, so if you're buying a new T bill, it's going to be lower than what you're getting from these ETFs. So that's just something else to think about. And I'll also point out that because these are treasuries,

Starting point is 00:03:54 they are free of state income taxes. So that's always something to consider. All right. Let's move on to our second question from Ben. I am 38 and hope to retire well before age 59.5. I have consistently maximized my available tax advantage retirement accounts, but this has left me with less that I would like in my taxable brokerage account to fund the years before traditional retirement age.

Starting point is 00:04:16 Should I continue maximizing my tax advantage accounts and plan to use Rule 72T substantially equal periodic payments for early retirement income, or should I redirect some future contributions into my taxable brokerage account for greater flexibility? So Ben's concern here is obviously the 10% early distribution penalty when you take money out of a tax advantage retirement account before age 59.5. Now, there are many exceptions to this. You can get a way around that 10% penalty. So you should certainly know those if you're going to retire early. The IRS website has a whole page of them. One of them is this substantially equal periodic payments. And it can get very complicated, so I'm just going to highlight it very quickly,

Starting point is 00:05:00 that you're basically committing to a series of payments for at least five years or until you reach age 59.5, whichever is longer. Once you start it, you cannot stop or change the payment amount outside of some approved modifications without facing not only a penalty in that year, but retroactively. So you've got to make sure you stick with it. And you have to choose from among the IRS's approved three methods of calculating the substantially equal periodic payment. So it's all very complicated, but many people in the financial independence retire early community follow this. So it is doable. I'll just add some other thoughts. So first of all, you certainly want to at least contribute to your 401k or employer account to get the employer match. You definitely want to do that. Another option is to

Starting point is 00:05:46 contribute to Roth accounts, because with Roths, the contributions come out tax the penalty free. It's the earnings, you have to worry about being taxed and penalized before age 59.5. Now, it gets a little complicated with the difference between Roth IRAs and 401ks. With the Roth IRA, the contributions always come out first, so that's easier. With the Roth 401K, every distribution is a proportional mix of contributions and earnings. So it's messier with the Roth 401K. Final thing to think about is a health savings account if you have access to it and you have money in it, because the interesting thing about the HSA is the money at the company

Starting point is 00:06:21 out tax-free for qualified expenses, but they don't have to come out in that year. So what many people do is over many years, they keep the receipts for their qualified medical expenses, but they don't take the money out until they retire, and then they get the tax-free distributions. They just have to have to have all of all those receipts ready in case the IRS comes knocking with an audit. So those are some thoughts. You could also do the taxable brokerage account as well, and that would definitely give you a lot of flexibility. Dan, do you have any thoughts on that? I'll just add on that last point.

Starting point is 00:06:55 One of the things that using that taxable brokerage account allows that people don't necessarily think about is that in a taxable brokerage account, if you have a stock that goes up in value quite a bit, then you're going to have long-term capital gains treatment. The tax treatment on that is more favorable than a withdrawal from a traditional IRA or a traditional 401k account. And so if you are indeed planning to use that money before you reach age 59 and a half, that tax advantage in a taxable brokerage account might be a factor airing towards going ahead and putting some money in that taxable brokerage.

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Starting point is 00:08:41 Sign up for exclusive access today, rippling.a.I slash fool. All right, let's move on to question number three. It comes from Scott. Why is there seemingly no love in the professional community for closed-end funds? I know they're a bit esoteric, but the yields are usually fabulous, and the risk seems to lie somewhere between bonds and equities. It seems like a decent strategy might be holding close-end funds over bonds in your 30s to 40s and then transitioning to bonds in your 50s and 60s, if one is using the traditional 60-40 portfolio. But this idea seems foreign to boast. I have held close-in

Starting point is 00:09:17 funds since the early 2000s and have found them to be wonderful. for income generation, and I'm just wondering, what am I missing that keeps others from singing their praises? Maybe you fools can help me out as to why. Well, Scott, I have been following closed end funds for a long time. I dabbled in them from time to time, and I share your confusion about why they get so little attention, because in many ways they combine, sort of the predecessors to modern exchange traded funds, but you always have that lovely premium or discount question because with these closed-end funds, what we're referring to here are funds that, unlike most ETFs and mutual funds, you cannot just go to the fund and not even an institutional investor

Starting point is 00:10:05 can go to the fund and say, you know what, I've got these shares. I want the actual assets that are held in the fund in exchange. That's why with traditional mutual funds, you almost always get net asset value with ETFs. The price generally stays pretty close to net asset value, but with closed-end funds, they can vary widely. You can have some funds that trade at a discount to their actual value of the assets that they hold. You can have others that trade at a premium. I think that that may be one of the reasons why professionals have so much difficulty with them. There are certainly very popular closed-end funds that trade at huge premiums until whatever it is that they hold of falls out of favor. And when those fall, when those assets fall out of favor, suddenly the

Starting point is 00:10:55 closed end fund declines. It loses the premium. And some investors may face losses, even though, even if the net asset value of the shares goes up. The fact that you bought at a huge premium suddenly means that when that premium disappears, you could have a loss, even when the underlying investment is doing well. The other thing that I would caution folks with a lot of closed end funds use leverage. They borrow money in order to take leverage positions in the assets that they hold. That can be very favorable with bond closed-end funds. That was a winning argument for much of the first 20 years of the 21st century as interest rates were gradually coming down. You got kind of highlighted exposure to a positive bond market. That has not been the case over the past three,

Starting point is 00:11:45 four, five years, and that is something to take a look at. Always be careful with closed-end funds. Look at the nature of the distribution. Is it actually coming from income, or is it a return of your own capital? Just because it looks like a dividend payment doesn't mean that the fund actually generated the income that you are getting back. I'll just add that if your interest is piqued. The best source on the internet for information about close-ed-funds is c-efconnect.com, which is owned by Duvine, but they have great information on all providers of closed-in funds, screening tools, some education. So check that out.

Starting point is 00:12:24 And as I often say, when you are considering any kind of ETF, especially if it's a new asset class to you, look back at past returns, both good years and bad years, just to get a sense of how the fund or asset class will perform in different environments. All right. Let's move on to question number four, and it comes from Tony. For retirees with a relatively secure funding source, such as a pension in my case, or adequate Social Security, would a more aggressive investment strategy be appropriate for a discretionary fund?

Starting point is 00:12:53 I am contemplating a 90% stock's 10% bonds portfolio for by deferred in Roth funds to be used for travel and experiences. I stress tested it on a year 2000 through 2020 time period and it did well. Better even than a glide path scenario from 30% to 60% equities over the cost of the cost to 60% equities over the first 15 years. What I learned is that opportunity cost is a real thing. So I would say that I think Tony is on to something, and he points out a few things that I want to highlight.

Starting point is 00:13:22 So first of all, you know, pension and Social Security income or really any other source of secure income like that, maybe an annuity or a business group, really be considered like a big holding in bonds. And the more of you get of that income, the more risk you could take with the rest of your portfolio. And you can actually even value that as a holding of bonds. by doing some sort of present value calculation.

Starting point is 00:13:44 If you don't know or don't want to know how to do that, visit value your pension.com. It was created by Professor Benjamin Bailey, who wanted to basically create a present value calculation for his pension. He couldn't find one online, so he created the website. And Tony's also says he's going to be more aggressive with his discretionary funds for his travel and experiences. And I think that makes a lot of sense.

Starting point is 00:14:07 We've had several guests on the show recommend that you break your retirement spending into essential and discretionary expenses. You try to cover your essential expenses with a very secure sources of income, hedge and social security, bond ladder, maybe annuity, something like that. But then you can take more risk with your non-essential expenses. And that sounds like that's what Sony's doing. Now, 90% stocks is pretty aggressive. But there have been studies that have looked at it, I think inspired often by Warren Buffett, who wrote in his 2013 annual letter that in his will, he advised the person who's going to manage. his wife's assets to invest 90% of it in an S&B 500 index fund and 10% in short-term government bonds.

Starting point is 00:14:46 And the studies have found that it could definitely pay off, assuming you can stand the ups and downs of such an aggressive portfolio, and it does mean that you're going to have to cut back on your discretionary spending during bare markets. And then my final point is I'll just add that Tony's reference to the glide path increasing from 30% to 60% over the first 15 years, I think he's referring to studies that have found it very beneficial to play it really safe around what's often called the retirement danger zone. It's like five to ten years before retirement, five to ten years after retirement, but then it's okay to let your stock allocation rise once you've survived that first 10 years or so of retirement. So that's what is referring to those

Starting point is 00:15:25 studies. I think I find compelling. I personally want to play it probably pretty safe in those first few to several years of retirement, but then getting more aggressive, it turns out, is perfectly fine. Dan, what do you think? I agree 100%. I'll just add that if Tony or any listener in this situation, if you have this sort of excess money above and beyond what your necessities are. One question always to ask is, do you have plans, hopes to leave a legacy for future generations? In that case, taking a more aggressive portfolio stance, essentially borrows that extended time horizon of the person that you're getting. So you may be retired and have a relatively short time horizon, but if you're hoping to leave that money for

Starting point is 00:16:09 kids or grandkids, their time horizons much longer justifying a more aggressive asset allocation for that portion of the portfolio above and beyond those necessities. All right. Moving on to question number five, and it comes from Ben. I am considering going back to grad school and could cover all the tuition by selling about a third of my portfolio. I've been debating this versus taking out student loans. While current market valuations do play a role in my consideration, I'm also thinking that this type of of life move is exactly what an investment portfolio can be intended to pay for. Did you help make it over my anxiety of pulling back from the market a bit to invest in my future career goals?

Starting point is 00:16:49 I will only be penalized via taxes for selling from this account. So Ben, let me applaud you for having the flexible mindset of an investor who understands the value of investing early, who understands the value of time in the market, but who also is willing to be able to. willing to think twice before just sticking with a single-minded way of approaching money. Because I'm just going to say this. One of the best investments that you can make, especially early in a career, is building your human capital. It's your human capital that is going to be the source of the salary income, of the business opportunities, of so many of the things that are going to affect your financial security for the rest of your life,

Starting point is 00:17:43 that making an investment in that makes a lot of sense. The question often comes up, okay, yeah, well, there's student loans available. Why would you take money out of the market when you have potentially good debt available? And there is some validity to that. But one thing to keep in mind is that there's been big shifts in the way that the student loans work in recent years. You have sometimes had a federal government that seemed committed to making that funding available. At other times, now you're starting to see the federal government pull back from being as committed to making that funding available. And so it leaves borrowers who kind of got

Starting point is 00:18:26 in in one period of time questioning, okay, well, things have changed. I don't have as much flexibility as I thought that I would. And so you are in a fortunate situation, you have the flexibility of having these assets to say, you know what, I don't even want to deal with that. I just want to take some money and invest in my immediate future to generate more of more career earnings over the rest of your lifetime. I applaud that. I think that that's a worthy goal. Yes, there is going to be potentially some opportunity cost to not being in the market as long, but hopefully your investment in grad school more than pays off enough to make up for that over the course of your lifetime. I would imagine that the rates you pay on these loans could be a factor. The rates on

Starting point is 00:19:14 federal loans for grad school are ranging between 8, 9% nowadays. For private loans, it could be as low as 3% and as high as 17%. So obviously, the higher the loan interest rate, the more I would be inclined to sell some of my portfolio to pay that off. And, you know, if you're going to sell some of your investments, you could always do some things to try to manage the tax consequences, maybe you know, offset losses with gains and identify shares with lower embedded capital gains. So you can manage that. The final point I would make of this is just understand that selling and realizing some taxable income may reduce any need-based aid that you could be eligible for.

Starting point is 00:19:50 So keep that in mind if you're, you know, also counting on getting some need-based aid. All right, let's move on to our sixth and last question, and it comes from Tom. I'm 61 years old and planning to retire in the first half of 2027. Congrats, Tom. My wife is 62 and has chosen to continue to work for a few more years. When I retire, we will lose my income and need to start pulling from my retirement accounts. Unfortunately, about 95% of our assets are in pre-tax 401k accounts, so traditional accounts here. So not only do I want to withdraw enough to replace my income, but I'd also like to withdraw enough to start some Roth conversions, add to my cash account.

Starting point is 00:20:35 and pay the income taxes required for these withdrawals. Is this a reasonable plan? And what else do I need to consider as I make these changes? So, Tom, I'll just say that there's this sort of rough rule of thumb when you are taking money from your accounts after you retire. It's that you drain your taxable accounts first, then traditional tax deferred, and then Roth. In your situation, it doesn't sound like you have too many options, though, right?

Starting point is 00:21:00 But you might start with that 5% that it seems that you might have in a taxable brokerage account. but then you're going to have to do the tritical counts. It does seem that really the crux of your question is whether you should do the Roth conversions. So I would say, first of all, there are two main reasons to do Roth conversions, and one is that you expect to be in a higher tax bracket in the future.

Starting point is 00:21:19 When you do the conversion, the amount you convert will be added to your taxable income. So you have to pay taxes on it today, but it's going to grow tax-free after that if you follow the rules. So if you're going to be in a higher tax bracket in the future, then it makes sense to do the Roth conversions. That said, most people are actually in a lower tax bracket once they retire, especially since your wife is still working. This is generally because

Starting point is 00:21:40 people spend less in retirement, but plus after age 65, there's a higher standard deduction. There's the new bonus senior deduction. It is due to expire in 2028, but we'll see what happens. But the bottom line is most people are not in a higher tax bracket in retirement versus when they're working, and your wife is still working. But of course, it depends on your situation. But you still might want to do Roth conversions for the second reason. And that is, if you don't, the required minimum distributions from your traditional accounts at age 75 are going to be much higher than you need, and it will result in a much bigger tax bill. Ross, on the other hand, aren't subject to RMDs. You can just let them keep growing. So that's another reason to consider doing that, and you actually

Starting point is 00:22:20 can find calculators on the internet that can help you project your RMDs. So that's another consideration. Just know that those conversions, if you do some Roth conversions, they're going to increase your adjusted gross income, which could reduce your eligibility for various tax breaks, you know, advanced deductions and credits, and it could eventually require you to pay those income-related monthly adjustment amount surcharges on Medicare. You don't take Medicare, at least aren't eligible for Medicare until age 65, but those Irma surchargers are based on your tax return from two years prior. So once your wife starts hitting age 63, then you have to start thinking about that. So your strategy, the bottom line here is, could make sense, but it really depends a lot on

Starting point is 00:23:06 your situation. Dan, what do you think? I agree. And I highly recommend, Tom, that you do kind of a multi-year analysis. Look at what happens if you do it the way that you do it right now when you're 61. Then also look at what if you do it that you decide to put off doing the Roth conversions until you're, your wife decides to retire. Maybe that's at 65. Maybe it's a couple of years, one side or the other of that. But see what happens. There's a lot of daylight between age 65 and when you need to start taking required minimum distributions at age 73 or 75, depending on what your birth year is. That may make a difference in your calculation. It's worth taking a little bit of extra effort to run the numbers and see what it comes out with. And with that final answer to our final question,

Starting point is 00:23:55 We've come to the end of our show. Thank you, Dan, for joining us once again, and thanks to Bart Shannon, the engineer for this episode. As always, people on the program may have interest in the investments they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell investments by solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes. I'm Robert Brokamp. Pull on, everybody.

Motley Fool Money - Mailbag! Accounts for Early Retirement, Roth Conversions, Closed-End Funds, and More

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