Financial Frontlines®

When a market bubble pops, everyone knows. The news is full of stories about the doomed economy, trying to find someone to blame, and citizens interviewed as victims because their retirement account values took a dive.

A bubble occurs when the market places a value on an investment that is higher than the investment is actually worth. There are numerous reasons behind bubbles. At their core, they are caused by greed or fear which creates an artificially high demand.

How can you prevent bubble victimhood? It’s not really about the bubble, it’s about account management. Watch and listen closely and the bubble warning signs are obvious.

Listen to the news, family, friends and acquaintances. The media will overwhelm you with stories about the investment because now it’s newsworthy. There was no peep when it was actually a good opportunity because it wasn’t newsworthy. Everyone will be talking about it. Everyone wants some of it. People who know nothing about investing are buying it. Examples? Gold recently. How about housing prices in the mid-2000s—house flipping anyone? How about dot-com/internet/tech firms in the 1990s? Remember tulips in the 17th century?…maybe not.

Another sign…salespeople. People pitching the investment will multiply. Why? Because the investment is getting free advertising in the media. People are worked into a lather thinking they are being left out of a big score. Salespeople in the financial world know that you have two buttons; one for greed and one for fear. All they have to do is figure out which button motivates you and that’s how the product will be pitched. Think how easily gold can be pitched to press your greed or fear button. It’s like shooting fish in a barrel.

Finally, experts start to speculate whether it’s time to jump into or out of the investment. Remember the phrase “irrational exuberance” used by Alan Greenspan in the 1990s? Emotion (read greed) took over and drove market prices above their true values. When stock funds in 401ks, IRAs and investment accounts of everyday investors start to show large net inflows of money, your warning sensors should light up.

What do you do?

• Don’t buy into the fever.
• Don’t own too much of one thing (real estate, gold, oil, banks, etc.).
• Diversify your portfolio allocation; stocks, bonds, cash, international, alternatives…
• Select investments by objective (growth, income, protection…).
• Select investments to meet a time period (short-, mid-, long-term).
• Run when you hear “This time it’s different” or “It’s a new era.”

P.S. If you are “averaging down” (AKA “dollar cost averaging”) in your investment accounts and the market takes a dive after a bubble pops, congratulations!…assuming you are still years away from retirement. You are raking in shares of ownership!

It’s interesting. It is always the right time to do estate planning, but we never get around to doing it.  But, it is especially important to think about estate planning when you go through a life transition, such as retiring from the military or moving to a new state.  This can be especially true for military officers who may have relatively complicated probate estates.  A simple thing anyone can do to reduce probate costs and hassles is to reconfigure their non-retirement accounts as PODs or TODs.  What are PODs and TODs?  Let me explain.  I’ll start with explaining probate estates.

Your probate estate includes anything that transfers from you to your heirs via your will (or by state law if you don’t have a will).  Your estate pays the county courthouse fees to probate your estate.  The fees are usually based on the value of the estate.  So, the more that transfers via will, the more your estate pays in probate fees (and the more time and effort it will take to settle the estate).

Many of your assets automatically avoid probate.  Retirement accounts are one.  Life Insurance proceeds are another.  These assets pass via contract to the designated beneficiaries.

Warning:  If you designate “My Estate” as a beneficiary you’ve put the accounts into your probate estate and opened a whole new can of worms.

However, most taxable accounts (checking, savings, brokerage accounts) do not pass via contract unless you take action.  That is where TOD and POD comes in.  TOD stands for “Transfer on Death”, POD stands for “Pay on Death” and in effect if you make the effort to convert your accounts to POD or TOD accounts they  function just like a retirement account and the assets pass outside probate (saving you money and time…my two favorite things to save).

How do you set up a POD or TOD account.  Normally it is as simple as filling out a form.  At one major financial institution that caters to military members you can change your brokerage account or mutual fund to TOD by filling out a form… and it is free.  A Credit Union that serves military members has a similar capability for POD accounts.  It’s free too.

Your estate situation may be such that you don’t need this (You have everything in a Living Trust, for example).  But, there really isn’t a good reason to skip doing it.  All it takes is time (and not that much) and it will make things significantly easier and less expensive for your heirs.

It is the second week of April, so all minds naturally turn to taxes.  And one of the things that often comes up is Roth (both IRA and 401(k)).  The decision on whether to use a Roth versus a Traditional retirement account is never as straight-forward as it seems.  It can be especially difficult for a transitioning military officer to make the decision while developing a financial plan.  So here are some thoughts that I have when I do the comparison, either for contributions or conversions.

Pay Me Now or Pay Me Later

The IRS will eventually get its money from you.  You will either pay taxes when you put the money in (Roth) or when you take the money out (Traditional).  At the first level the math is simple.  If your tax rate is lower now than it will be in the future chose the Roth.  Make the opposite decision if you tax rate will be lower in retirement.  But, determining your tax rate now may be harder than you think.  Will contributing to a deductible Traditional IRA/401(k) now lower your Adjusted Gross Income (AGI) and make you eligible for credits or deductions you wouldn’t normally get?  If so, the effective reduction in your taxes will be higher than your marginal rate.  You need to do the second and third level analysis.

It Is All About Maximizing Income In Retirement

Distributions from Roth accounts are not considered income for tax purposes.  Distributions from Traditional accounts, on the other hand, are.  If you will not have a Pension in retirement and only have your savings and Social Security then a Roth may make more sense.  That is because if you have “too much” income (and it is not that much), your Social Security Income will be taxable.  However, if the other major portion of your income comes from a Roth account, you won’t have that much “income” and your Social Security will not be taxable…more money in your pocket.

You Also Want As Much Matching As Possible

If you invest through a Traditional 401(k) it is possible to get $1 of matching for less than $1 of income ($1 of income contributed to a Traditional 401(k) reduces taxes by some amount resulting in less than $1 in income for $1 in matching).  On the other hand, you need earn more than $1 in income to get $1 of matching in a Roth 401(k).  You can think of it this way:  Income – Taxes = $1 = $1 matching.  By the way, employer matching goes into a Traditional 410(k) not a Roth  (Uncle Sam is going to get his cut eventually).

You Should Think About Your Legacy Plans.

Roth IRAs do not have Minimum Required Distributions.  All 401(k) and its cousins 403(b) and TSP (including Roth) accounts and Traditional IRAs have Minimum Required Distributions.  Therefore a Roth IRA can be an extremely effective, tax efficient way to pass on assets to the next generation.

There are obviously other factors in the decision (eligibility for Roth IRAs as one example), but these are some of the things I think about when it comes to Roth IRA/401(k)/403(b)/TSP versus Traditional decisions.

by Col. Bob Norton, USA (Ret)

The plug was pulled on military tuition assistance recently, but thanks to two Senators it’s been re-booted at least until September 30.

Even so, it may take time for the Services to re-start the program. And, TA monies will still be pared back by about 7.8% to match “sequestration” rules. That’s a Latin word for “stupid,” but at least some lawmakers are trying to craft ways to restore some of the more draconian cuts to military programs.

After this year, all bets may be off the table on TA. TA could be restricted by skill, dollar amount or the ubiquitous “needs of the Service.” What if you’re forced to use your Post-9/11 GI Bill benefits on active duty or are considering doing that now?

The new GI Bill pays up to the full-cost of attendance at any public college or university for full-time study, or up to $18,077.50 for study at a private school. The good news is that if you choose to go to college off-duty and pick the right school, you may not have to pay a dime for your courses.

You can also get up to $1,000 per year for books. Less if you take just one or two courses.

There’s a housing allowance, too, but sorry, you can’t draw your current housing benefit plus the GI Bill housing allowance at the same time.

There are some things to think about in planning to use your new GI Bill while still serving on active duty.

Part-time study
Given the pace of operations today, most servicemembers only have time to take 3-6 credits – one or two courses – at a time. Here’s how the “burn rate” works using your new GI Bill on a part-time basis. First, everyone gets 36 months of benefits under the new GI Bill. Public college tuition is fully paid based on 3 years’ active duty; lower rates for less active service.

The Dept. of Veterans Affairs (VA) charges entitlement based on the ratio of the student’s course load to the number of credits required for full-time training. For example, if a soldier pursues 12 credit hours (where 12 hours is full time) for a four-month long semester, VA will charge the individual one day for each day in the enrollment period (4 months of entitlement). However, if the same troop was only enrolled in seven hours, VA would charge the individual seven-twelfths of a day for each day in the enrollment (2 months and 10 days of entitlement).

In plain language, if a servicemember averages two 3-credit courses per semester, the burn rate would be two months per semester or four months for the year. At the end of the year, the military member would have 32 months of benefits remaining: 36-4 = 32 months of new GI Bill left.

Non-degree training
Let’s say you want to take non-degree courses towards a civilian license as an Emergency Medical Technician (EMT) or Microsoft Certified Engineer. In those situations, benefits are capped at an annual dollar amount by law. VA charges entitlement based on the amount of benefits paid divided by one-twelfth of the cap amount. For example, if the annual cap was $12,000, an individual would be charged one month of entitlement for every $1,000 received.

Transferred Benefits
If TA is suspended again and you’ve already transferred some or all of your GI Bill months of entitlement, are you stuck? Once a Transfer Account is set up, you can move around your entitlement or cancel it. If you transferred 18 months to a spouse and another 18 to a child, you can re-arrange the accounts; e.g., you want to be more competitive for promotion by finishing a degree, in this example you could take back 6 months each from your dependents. If you don’t have a Transfer Account, keep in mind that your Service owns ‘transferability’ as a carrot to induce you to serve longer, and you must have completed 6 years’ service and agree to serve 4 more years to have the right to transfer new GI Bill benefits.

Picking a School
Choose your college program very carefully. Avoid diploma mills and schools whose credits won’t easily transfer – think of your next PCS. Talk with your post/base education counselor, but then do your own homework. The American Council on Education has good tips on ‘student-vet friendly’ schools. For many, the best place to start is a community college. Many states allow students who earn an Associates degree at a community college to enroll automatically at the next level in a participating four-year state college or university.

Student Veterans of America
Your former battle buddies have banded together at over 700 college and university campuses for camaraderie, mutual support and to advocate for their needs with college administrators. Link up with an SVA Chapter and get some first-person advice on how to get in and get going in a good college program.

Getting Ready to Get Out
If you are wrapping up your service obligation, retiring, or in the crosshairs for being RIF’d, your options for transferring your GI Bill benefits can be tricky. The key thing to remember is, once you separate — voluntarily or otherwise — you’re once and done and can no longer transfer your benefits, if eligible to do so. For those who expect to be caught up in the draw down, you should consider transferring your benefits if you have no plans to use them. If you get RIF’d, you won’t have to serve the extra four years’ service after completing the required six years’ service.

Once you separate or retire, you’ll have 15 years to use your remaining GI Bill benefits. And once you’re enrolled in a program, the housing allowance will kick in if you served three years’ active duty. The housing rate is pegged to the E-5 With Dependents rate at the zip code where the college or university is located.

For more information, go to the VA GI Bill homepage or check out the Frequently Asked Questions page there.

Never spend principal.  Like “don’t eat the seed corn” it warns against consuming the permanent assets (principal) that produce earnings.  But a common misunderstanding can make this safe policy rather risky.

Some investors consider securities to be principal and all dividends or interest to be spendable income.  They believe that only income can be spent and selling securities to create cash flow is “spending principal.”

But what really matters is “total return” which is income plus appreciation.  Appreciation, particularly the amount in excess of inflation, can be spent without diminishing productive capital.

Income securities, including high dividend stocks, have little growth potential. Overweighting income securities raises risk by reducing diversification and spending all of the income can shrink the inflation-adjusted value of the portfolio.  Unless income is reinvested to compensate for inflation, the result can be the same as spending principal.

Chasing high yields can be worse.  Some products that artificially increase income actually…pay out principal!

Appreciation is unreliable (and in some years nonexistent) so projected “spendable” appreciation must be averaged.  A reserve fund (sometimes called a “bucket”) should be established to hold 3 to 5 years’ worth of income so securities need not be sold in a depressed market.

Even with these drawbacks, spending the total return (in excess of inflation) from a diversified portfolio is wiser than overweighting bonds and only spending income.