You’re recovering from Thanksgiving and preparing for the holidays, so investing is not high on your list of activities. However, I’ve found it’s best to set aside a little bit of time to review where things stand financially and make a few decisions. Before we get to a couple of important decisions, let’s set a few expectations.
If you use active money management, don’t expect your manager to beat his benchmark in 2014. While some managers will achieve the feat, most will not. Throughout 2014, I’ve heard that we’re entering a period when active management will shine. It hasn’t happened yet. The relatively few managers who excelled in 2014, are getting to market their recent achievements. I urge you to resist their entreaties, because the evidence against active management keeps piling up, especially in liquid securities like stocks and bonds. Nonetheless, trillions of dollars are still pursuing the dream of beating the benchmark.
You can also anticipate a sizable tax bill if you utilize active management in your taxable accounts. As the market has appreciated and more investors have turned toward indexing, some active mutual fund managers have been forced to sell a great deal of low-basis stock. In addition, portfolio managers who trade a lot will also be passing along hefty tax bills which will find their way onto your tax returns next April. By the time you’ve paid your taxes, as much as half of your return may wind up in the coffers of the IRS and the N.C. Department of Revenue. By contrast, you should expect that most index funds will have relatively small tax bills. The tax bill shouldn’t depress you too much. After all, 2014 looks like it’s going to have been a good year for stocks and even a decent year for bonds. Moreover, all this discussion of taxes doesn’t apply to your 401(k), IRA or College Savings Account.
Power of deductions
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I’m hoping you didn’t exhaust all your extra cash on Black Friday, because it’s time to talk about savings. As the year comes to an end, there’s still time to give your spouse, your children, your grandchildren, or even yourself a gift without having to endure the stampede at the mall. Admittedly, the gift I have in mind isn’t going to evoke any immediate pleasure or shouts of joy from the recipient. However, as a savvy shopper you ought to be excited by the big government savings attached to retirement and college savings plans. In other word, the IRS (and to a lesser extent North Carolina) is offering you some awesome discounts.
I know you have a lot to do between now and year-end, but there’s probably nothing more important to your long-term economic well-being than saving for retirement or preparing for your child’s or grandchild’s higher education. I’m not going to attempt to give you all the ins and outs of IRAs, Roth IRAs, and 529 Plans. There are plenty of excellent websites and publications that spell out the maximum contributions, allowable deductions, age limitations, and deadlines for contributing to retirement or educational accounts.
If you are like me, you haven’t made a retirement or education saving contribution yet for 2014. This is a basic investment mistake. We ought to make contributions to these types of accounts at the beginning of year, instead of at the end of the year, or before April 15 of the following year in the case of retirement accounts. As a result of our procrastination, we’re losing 12 to 15 months of investment returns. Since we can’t turn back the clock, we might as well get the 2014 contribution invested in December (it is the deadline for 529 College Savings Plans) and make a New Year’s resolution to fund our 2015 contributions early next year.
Let’s turn to the question of tax deductions. A tax deduction is much like that 30 percent discount on a 55-inch flat panel television that catches your eye at Best Buy. Unfortunately, we tend to overreact to Black Friday specials and tax deductions. If a tax deduction is available, we get an urge to make the investment so we can take the deduction. Conversely, if the deduction isn’t available, we’re very likely to pass on making an investment or buying that television set.
I have two excellent examples of the blinding power of deductions. Many of us are attracted to the traditional IRA. Why? The contribution is deductible. For instance, if you are entitled to make the maximum contribution of $5,500 (it’s $6,500 if you are over age 50) and your federal tax rate is 28 percent, the U.S. government is offering you over $1,500 in savings, and North Carolina is kicking in another $230. In other words, there’s a 32 percent discount available for investing in an IRA.
Before you write a check or wire funds to your brokerage account, you might want to consider the Roth IRA. While the contribution isn’t tax deductible, the withdrawals at age 70½ and beyond are likely to be tax-free and not subject to the mandatory withdrawals of a conventional IRA. If you believe that your tax rate in retirement is going to be relatively high, you might want to have at least some of your money in a Roth IRA. So while the deduction for a traditional IRA is mighty tempting, it may not be the best strategy. For many investors, it makes perfect sense to have both a traditional and Roth IRA, since no one knows with any real certainty what tax rates will look like in 20 or 30 years.
Beware of tax changes
Last year, many of you may have contributed to a North Carolina 529 College Saving Plan. You were probably lured by a $5,000 state tax deduction, which was repealed when our state legislature cut the top state tax rate from 7.5 percent in 2013 to 5.8 percent in 2014. Without the tax deduction, you might be thinking that it’s no longer worth contributing to the 529 plan. Unlike federal deductions, which are reasonably valuable because federal tax rates are much higher than state tax rates, the $5,000 deduction isn’t really much of a discount, since there is no deduction at the federal level. Under the old state tax rate, the deduction was worth about $280 in actual savings on a $5,000 investment. If the deduction hadn’t been repealed, it would only have been worth about $210 in 2014 because of the state’s lower tax rate.
The two most important parts of the 529 College Saving Plan are unchanged and remain extremely valuable, because a 529 Plan operates much like a Roth IRA. The capital gains, dividends, and income aren’t taxed at the federal or state level, and the eventual distributions for college expenses aren’t taxed either. While the old deduction was a nice teaser, the value of the 529 Plan hasn’t changed materially. Nonetheless, I’ll bet that many folks will forgo contributing because the deduction was repealed. (A quick disclosure; I still provide occasional consulting services to the North Carolina 529 Plan.)
Only 24 more shopping days remain before Christmas. Set aside part of one of those days to being a long-term investor. Consider making a contribution toward your spouse’s or your retirement as well as toward the education of your children and grandchildren. It doesn’t require any gift-wrapping, and there are no shipping charges.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/