Your Personal Finance Questions, Answered – Motley Fool

In this episode of Motley Fool Answers: Mailbag, Alison Southwick is joined by Motley Fool personal finance expert Robert Brokamp and Motley Fool Wealth Management Certified Financial Planner Ross Anderson to answer listeners’ questions. This week they answer questions about contributing to nondeductible IRAs, spending safely in retirement, when to do tax-loss harvesting, starting a stock account for kids, and so much more.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on November 24, 2020.

Alison Southwick: This is Motley Fool Answers. I’m Alison Southwick, and I’m joined, as always, by Robert Brokamp, Personal Finance Expert here at The Motley Fool. Hello, Mr. Brokamp.

Robert Brokamp: Hello, Mrs. Southwick.

Southwick: It’s the mailbag episode, and with the help of Ross Anderson from Motley Fool Wealth Management, we’ll answer your questions about tax-loss harvesting, if you really need life insurance, bonds versus bond funds, and more, so much more on this week’s episode of Motley Fool Answers.

So, Ross, how have you been?

Ross Anderson: I am fantastic. Thanks for asking, and thank you for having me.

Southwick: Man! We are always happy to have you on the show, and it’s always nice to see your face, even if it’s just over Zoom. So, for the folks out there who aren’t familiar, Ross, why don’t you introduce yourself?

Anderson: My name is Ross Anderson, I’m a Certified Financial Planner with Motley Fool Wealth Management …

Southwick: … a sister company of The Motley Fool.

Anderson: [laughs] Correct. We are a sister company; and come visit us, FoolWealth.com.

Brokamp: And DJ, and drummer; and is it you or your wife who is the tuba player?

Anderson: That is my wife that’s the tuba player.

Brokamp: Got you. Fun household to be in.

Anderson: Yeah.

Southwick: I don’t know if Ross is also always that proud of talking about his extracurricular activities? Do you feel that that undermines your seriousness as a financial planner?

Anderson: You know, it’s funny, early on in my career, I definitely had nerves about that, because it was like, who wants to take financial advice from the drummer in a bad rock band? So, at this point, I’ve come to peace with it and I’m much more comfortable sharing that piece of my life.

Southwick: [laughs] Well, I trust your advice, even if you are a drummer in a bad rock band. Are you still a drummer in a bad rock band?

Anderson: I mean, we haven’t played out in a long time, but I had a band with Dan Boyd, and Dan Messeca, and myself, and Mike Shade, another Motley Fool guy, so.

Brokamp: I’ve heard you perform and I think you’re fantastic.

Anderson: Oh, yeah! Thank you.

Southwick: Well, then, who doesn’t want advice from a guy who’s in a band, let’s get to it, shall we? The first one comes from… what?

Brokamp: Yeah, I don’t know either, but just give it a try.

Southwick: Okay, UNBULLSUE. It’s all in caps, so I thought you were … so just some behind the scenes fun, I’ll take you back behind the scenes of Motley Fool Answers. Bro goes through every question and kind of edits it down, so I don’t have to. And so, I assumed that he was putting UNBULLSUE in there as an acronym. And there’s lots of acronyms I don’t know about, and that could have been another one in financial planning. All right, let’s …

Brokamp: … that’s just what he or she put in, so we’ll see what happens.

Southwick: Let’s get to it. “I started making contributions to an IRA immediately out of dental school in 1989 and continued until today. I was quickly out of the income limit for tax deductions, yet continued to contribute both to my own and my wife’s traditional IRAs. Is there a point where contributing to a traditional nondeductible IRA no longer makes sense? Should I just put that money in a brokerage account? I hope to retire in 10 years.”

I hope you do retire in 10 years, as well.

Brokamp: Absolutely. And good for you for saving for retirement over the last few decades. So, you know, even though you cannot deduct the contributions to a nondeductible traditional IRA, they still have the benefits of being tax deferred, which means you don’t pay taxes on the interest and dividends and capital gains from year-to-year. But when you take the money out in retirement, you are taxed at ordinary income rates. So, the alternative would be just to contribute to a regular taxable brokerage account. In that situation, you will pay taxes on any dividends or interest but you won’t pay capital gains taxes until you sell, and then you’ll pay long-term capital gains rates, which are lower than ordinary income tax rates, at least according to current law. Also, with a brokerage account, you don’t have to worry about making required minimum distributions at age 72, like you would with a traditional IRA.

So, really, to answer the question, I start by just thinking about what kind of investor you are. If you’re the type who buys a stock and holds onto it for several years, perhaps even more than a decade, then the taxable brokerage account may actually be the better option, especially for stocks that pay little to no dividends. But if you’re the type who does a fair bit of buying and selling, you know, you intend to hold on to a stock for many years, but you actually find yourself buying and selling after three to five years, paying those capital gains tax, if it’s outside the IRA, then maybe it’s best to stick with the traditional IRA.

Southwick: Our next question comes from Dave. “A couple of years ago, you pointed us to the spend safely in retirement strategy. I think I’ll be using this plan as a guide for my retirement.”

Bro, look! People are taking your advice.

Brokamp: I know, I’m so sorry; I mean, that’s great.

Southwick: [laughs] That’s so good. “Among other things, it recommends waiting until age 70 to take social security and RMDs. [Required Minimum Distribution] For those of us that want to ramp down or even stop working in our early 60s, it suggests using some of your retirement savings to bridge the gap between not working so much and age 70. Great idea. But now it seems I have two retirements to consider. One, ages 62 through 70; and two, older than 70. Any thoughts on how to think about this 62 to 70 retirement? There’s a wide solution space, for example, using Roth versus pre-tax savings, how to de-risk savings, do I shore up my +70 retirement funding first and then see when it makes sense to stop working at 60-something?”

Anderson: Okay. So, there’s a lot to unpack in this question, but let’s get into it. So, I think Dave is asking a lot of the right questions, which is, you know, ultimately, what is your portfolio going to have to support in retirement, right; your portfolio-supported spending versus what you have other income sources to cover? So, if you’re thinking about it in just those two terms, social security is going to kick on and your portfolio-supported spend after age 70, if you’re delaying social security, is actually going to be much lower. And so, if you’re retiring early, you’re probably leaning on those assets much heavier, especially if you’re planning to delay.

Now, I’ve kind of changed my own thinking on this over the past few years, because I also used to be in the get the most from social security camp and definitely delayed till 70, but this very question I think is presenting a challenge. And I’m going to go to a little bit of an extreme to share how this could be problematic, which is that social security doesn’t have a beneficiary, right. So, if you’ve got legacy goals and people that you want to pass money to after retirement, social security is not going to transfer to them and your assets will. And so, if you chew up all of your assets waiting for social security, and then there’s nothing left for the family, right — again, that’s an extreme example, but I do think you need to be looking at your portfolio and understanding, is it calibrated to support the spending need.

So, the other thing that’s going to happen here is that your portfolio-supported spend ends up being pretty high in the early years and then coming down, which is ultimately going to affect your risk tolerance too, right. Not necessarily your tolerance, but how much risk you should have in the portfolio. So, when you’re drawing heavily off the portfolio, I think you need less risk, more safe assets, whether that’s cash, bonds, etc., and then once your social security kicks on, you could probably ramp that back up to where you’re most comfortable. So, yes.

And then the final thing is, absolutely, whether you choose pre-tax savings to draw the money from versus Roth versus just a taxable account, I think is going to have a big impact and it’s tough to analyze it from here not really knowing all of the details, but one of the things that I would give you as an exercise to look at, Dave, is, look if your RMD, if you hold off on all of the pre-tax money, does your RMD start forcing more money out of your IRAs and 401(k)s than what you’re going to need, because it might be pushing you into an extra tax bracket. When those RMDs kick in, you could jump from a 12% tax bracket to 24% tax bracket, you might want to get some of that money out early and accelerate some of those distributions, either through Roth conversions or pulling some of that money in that, you know, age 60 to 72 bracket, really.

So, I mean, it’s a super-complicated question, I don’t know that I’ve given you clear things to do, but hopefully, you know, those are the considerations, and I hope that helps you in, kind of, your thought process there.

Brokamp: I’ll just add that, for people who didn’t hear previous discussions about this strategy, that the spend safely and retirement strategy was actually developed by the Stanford Center on Longevity in conjunction with the Society of Actuaries. Just Google it, and you’ll find that it’s a pretty extensive report, and then they did a follow-up a couple of years later. But you’ll see the numbers behind why they think you should delay social security and then use RMDs as, sort of, a guide from your withdrawal rate.

But Ross makes a good point, in that, everyone’s situation is different, and in some people, it might be better to claim social security, or at least if you’re married, for one spouse to claim social security earlier.

Anderson: I mean, Bro, you’ve probably read more on this than I have, but defining a successful retirement could be a couple of different things. Does that mean the one that protects you most from longevity, does that mean the one with the highest possible standard of living, does it mean the one that leaves the most to families and heirs, right? So, if you’re framing it from a longevity standpoint, which it sounds like maybe they were in that study, absolutely, right? You want to create that guaranteed income for as long as possible, as high as possible, but that’s not necessarily everybody’s goal, and that’s why we do have to, kind of, step back from it and look at what’s going on with each individual.

Brokamp: Yup, totally agree.

Southwick: Next question comes from Boon. “How often should I do some tax-loss harvesting? Now that trades are free, the only impediment to harvesting losses is the 30-day wash-sale rule. There is a possible fear of missed opportunity if you are out of that stock for 30 days, but what if you’re not out of the stock market entirely? For example, I harvested a bunch of losses in early April. These were all stocks recommended by Motley Fool Stock Advisor, and I wanted to keep them long-term, but wanted the benefit of the loss for this year’s taxes. I sold about 20 individual stocks with a loss in a taxable account, I put all that money into an S&P 500 ETF for 30 days, then sold the fund and rebought the stock back a month later. I think this is a good idea. I get the tax benefit and a stepdown basis for the stocks, but my money is still in the market, so I didn’t miss out on the rebound under way. Not without risk, but the benefits seem to outweigh the risk. So, how frequently do you recommend harvesting losses? Is it a once-a-year occurrence for all losses for you, or if the stock has fallen X% from the purchase price, or only long-term capital losses?”

Brokamp: So, Boon, let’s make sure everyone is aware of the benefits of tax-loss harvesting. So, if you sell an investment at a price below what you paid for it, and this is in a regular taxable brokerage account, not a 401(k) or not an IRA, then the capital loss can offset capital gains on your tax return. And if your losses exceed your gain, then you can offset up to $3,000 of ordinary income in one year and then if you have losses left over, you can carry them forward indefinitely to future years.

So, in April the market was down, so that actually was a great time to harvest losses, but as Boon points out, you take those losses on your tax return, if you want to take them on your tax return, you can’t buy back that investment for 30 days, and just because you’re curious, those are 30 calendar days, not 30 trading days, and the 30-day clock starts the day after the trade. If you do buy it back before those 30 days, you won’t be able to use that on your tax return, you violate the wash-sale rule. And, of course, by selling that stock and being out of it for 30 days, you run the risk of missing out on any performance over those next 30 days.

So, Boon did something smart, he sold those stocks in the parked the proceeds in an S&P 500 index fund, then 30 days later, he sold the index fund and rebought the stocks. It’s all perfectly fine and dandy. But I will say that this does have its drawbacks, right. So, because Boon held on to that S&P 500 ETF for just 30 days, his gains will be taxed as ordinary income, and that’s a higher rate than long-term capital gains. And as he points out, he’s now lowered his cost basis. In other words, he’ll pay a higher capital gain when he sells in the future then if he had just held on to the stock through the downturn.

In the end, he still may come out ahead, depending on how much in taxes he saves this year, and what he does with that savings. If he invests it, rather than spends it, then tax-loss harvesting is much more likely to pay off.

Now, to get to his original question, which is basically, how often to consider tax-loss harvesting. People have different opinions on this, but I would say, at least once-a-year, as part of, sort of, your overall portfolio review, when you look at all your investments and consider whether you still want to hold them. And I would say, anytime a stock or the overall market experiences a significant sell-off, say, maybe 20% or more, certainly, a time to consider doing some tax-loss harvesting.

But it also depends on your tax circumstances. Tax-loss harvesting makes more sense in years when you’re in a particularly high tax bracket or in years when you realize a lot of capital gains that you’re looking to offset. In years when you’re in a lower tax bracket and you expect to be in a higher tax bracket in the future than tax-loss harvesting makes less sense.

Ross, I’d be curious, in Motley Fool Wealth Management, how often do you folks consider tax-loss harvesting?

Anderson: So, we will do it, basically, by request, but it’s not part of our typical process. And it’s not for a couple of reasons. No. 1 is a little bit of the risk that the position that your exiting does well. Everything that’s in a strategy for us, everything that’s in one of our portfolios, is there for a purpose, it’s because we like the company and we want that investment as part of our portfolio. And I don’t think that we have any sense of when are the good days for an individual company. [laughs] Any investment we’re making, we’re saying this is a company I want to be an investor in, I want to own a piece of, and I’m along for the ride, not that I think it’s going to have a good week or month or whatever. And so, that’s why we don’t necessarily do it, but we can do it.

It would typically be at the end of the year for me, just in terms of when I’d be looking at it, but I also am even now, I’m a little burned by some experiences doing this for people that have asked for it. And I believe it was the end of 2018, you know, the third or the fourth quarter of 2018, we saw pretty nasty stock market slide, people that tax-loss harvested in December, then January of 2019 was the best month out of the year, if I recall, and people missed some of that rebound. And so, even if you’re using a replacement position, you do run the risk of missing out.

So, I’m not a huge tax-loss harvesting proponent. Certainly, if you’ve got losses, at some point you’re going to realize them or at some point you’re going to offset another gain elsewhere, but I don’t necessarily for myself — or recommend — going through systematically and just doing that all the time.

Brokamp: Yeah, I would agree. In many cases, it is oversold, and you’re going to read more about it, because it’s often part of those like, what to do at the end of the year articles, do some tax-loss harvesting. The problem is that you are going to be out of the market, assuming you want to buy back. And December and January are among the best months, generally, for the stock market. So, generally, it’s not a great time to be out of it.

Southwick: Our next question comes from Robert. “Now that I’m in my 40s and earning a good paycheck, I’ve decided that I’m going to start paying cash for all future car purchases instead of financing them. To accomplish this, I’ve been saving $1,500/month for the past few years and now have nearly $50,000 saved, which is about how much the car I intend to buy costs. The problem is that it’s a large amount sitting in a savings account earning almost no interest, 0.1% or so. I’m wondering if I should invest this money into stocks? I know that Bro will say that any money you plan to use in the next three to five years should be in cash, but this isn’t money that I really need. If the market is down, I could just drive the car longer, or I could always finance the car and use that invested money on the next car, while paying $1,500/month on the loan. I know there are other options like CDs, but those don’t pay much better, and I feel like the stock market is going to net me more, though with the short-term risk. I don’t see vehicle purchases going away any time soon, so in a way, my time horizon is decades, sort of, maybe, right?”

Anderson: Robert, great question. And first of all, congratulations on the discipline to be saving that way and to be getting out in front of things that you’re hoping to purchase. So, I’m also going to [laughs] start with just a shameless plug here for, on The Motley Fool site, there’s a Personal Finance tab, and The Ascent service ranks bank accounts. So, if your bank account is paying 0.1%, I think you can do better, and there’s a list on there. It looks like, currently, the worst one is yielding 0.5%, and so there may be some savings that you’re leaving on the table. So, I would at least check that out.

Now, on to the question. I really like this question, because this gets into a concept that I think about a lot, which is, the time horizon is one of the things we talk about most in terms of investing risk, but flexibility can really impact it, and that’s really what you’re saying here, Robert, is that you can be flexible, and not necessarily buy a car this year. So, if you go to pull the trigger, and you put that money in stocks, and you have the ability to choose not to. And so, just expanding from a little bit away from the car, but if you had a very inflexible goal, if you’ve got a kid that’s going to college in the Fall, there’s a pretty high likelihood that you know, probably within a couple of weeks of when you’re going to spend that money, it should be pretty safe, because you’re not necessarily flexible on when you’re going to have that spend.

In your case, there are several other options, you could borrow the money, you could choose to defer. You know, you could choose to buy a cheaper car, right? There’s all sorts of things that you could do, if it’s not a good time to pull the trigger on selling those investments. And so, while I do think there’s a little bit of a reach for yield here, kind of underlying the question, but I’m pretty comfortable with your thought process. And if you do choose to invest some of those savings, maybe not every dollar of it, but if you do choose to invest it, I think you’ve got a lot of options in terms of how you would deal with any poor market performance in the short-term.

Brokamp: And I’ll just add, you know, with many of these discussions, it’s not an either/or situation, right. If you’re socking away $1,500/month, you could put most of it in the stock market, if you’re comfortable, but it’s perfectly fine to put $250 of it in cash, just so that you’re building up a little bit of a safety margin.

Southwick: Our next question comes from Aaron. “I’ll preface this by saying that I’m sure I’m not your average listener, lower middleclass at best, but I’m trying to make good decisions. My question is regarding life insurance. My gut, and experience from my parents tell me that it’s really a waste of money. I’m treating my 401(k) and my house as my legacy that will pass on to my family, and I’m trying to pay down my mortgage and build up my retirement accounts rather than pay monthly fees for insurance. We don’t carry credit card debt and have only small student and car loans, which are also being paid off quickly. Is this a reasonable thing to do or is my thinking flawed?”

Brokamp: Well, Aaron, it sounds actually like you’re making a lot of good decisions, so kudos to you. The question about life insurance is, what kind of financial circumstances would your family be in, if you, your spouse, or both of you passed away in the near future? Financially, would the rest of your family be devastated or would they be OK? If they’d be in really difficult circumstances, then you should consider term life insurance for as long as other people are relying on your income. And you already have some in the form of social security benefits for survivors, and you can use the tools on the Social Security Administration website to see how much your family would receive and for how long. Also, your employer may provide some life insurance, so ask your HR department.

And then considering those sources, get term life insurance to fill the gap. And the good news is that life insurance proceeds are generally tax-free, so every dollar will go to supporting your family. And term life insurance is actually not that expensive if you’re in decent health. So, I would certainly consider at least getting some of it if you don’t think social security and any life insurance provided by an employer would cover the gap.

Southwick: So, you’re saying not a waste of money?

Brokamp: Not a waste of money. It’s one of those situations where it’s — I can see why Aaron thinks it could be a waste, because it’s a low probability event. Aaron didn’t mention his age, but he says he has a family, I’m going to assume he’s in his 30s or 40s raising a family. The likelihood of someone that age passing away is low, but it does happen. And I know people, actually we all know people who died much younger than anyone would have expected. So, it’s really a question of, when it comes to insurance, risk, how much risk are you willing to take? And in this case, how much are you willing to risk that your family would be in very difficult financial circumstances, and how much are you willing to pay for someone else to take on that risk by buying insurance?

Southwick: Our next question comes from Mark. “I am on the cusp of retiring early and would really like to do some good with my free time.” Aw! That’s awesome! “While I made all of the typical financial mistakes when I was a young man, I learned to effectively manage my finances and think that I might be good at helping other people get their finances under control as well. I’m not interested in years of study to become a CFA or anything like that, I’m thinking along the lines of volunteering in community groups to teach people how to put together a budget or help them find a path to get out of debt. What would be a basic certification that I could work toward that would best put me in a position to pursue this modest goal?”

Mark, this sounds like a man after your own heart, huh! Bro?

Brokamp: I admire it; I think that’s outstanding.

Anderson: I love Mark’s question as well. I appreciate that he’s interested in volunteering his time, and so I’m going to take from that word that you’re not necessarily interested in becoming a professional advisor or doing this for profit-seeking endeavors. So, there’s really no licensing required to become a financial advisor. If you want to advise on securities or help people with investing, there are licenses required, but in order to help people with budgeting and, kind of, financial counseling, absolutely nothing required there.

So, I went down the rabbit hole a little bit to look at what designations are out there. I’m a Certified Financial Planner. I also have another one that I had achieved, but it’s dormant because I’m not paying the renewal fees on it. And, you know, there’s a handful that are fairly well-respected designations. I do think the CFP is one of them. CFA, [Chartered Financial Analyst] which is more of an analyst designation. CPA, [Certified Public Accountant] obviously, for the tax side. Turns out there’s 214 different designations that FINRA [Financial Industry Regulatory Authority] recognizes. [laughs] FINRA is the regulatory body for financial services and brokers. 214.

Now, they’re not endorsing any of those, but holy cow! That’s a lot of professional designations. I was shocked by it.

Brokamp: Did you pick out a few of your favorites; because Ross sent me a link to this, and I picked out a few of my favs?

Anderson: Oh, man! I mean, there’s just so many, and some of them are really niche areas that you could practice in, some of them just look like nonsense.

Brokamp: All right. So, here are some of my favorites. 3 Dimensional Wealth Practitioner, Asset Protection Planner, Behavioral Financial Advisor, Certified Anti-Money Laundering Specialist, Certified Financial Transitionist, and my favorite, Certified Kingdom Advisor.

Southwick: Oh! What’s that one?

Brokamp: Well, I thought that might be for, you know, people in the Middle East, but it’s actually, it’s a religious thing. So, it’s the Kingdom of God I think that they’re talking about and you have to sign a faith pledge.

Southwick: And what about 3 Dimensions; there’s three dimensions?

Brokamp: Yeah, I don’t know what that one is.

Southwick: They only go height, length, depth, but not time, we’re not going into the dimension of time here with our financial planning. [laughs]

Anderson: So, you know, with all of these, I would, honestly, scan this list. And the link to it, if you search “FINRA professional designations” it should come up. But it’s FINRA.org/Investors/Professional-Designations. I would go through this and find, first of all, few that look like [laughs] they’re in the right space. So, there’s like a Financial Counselor one, there is, you know, Behavioral Financial Advisor might be something that you’re looking for. And again, I haven’t really gone down the rabbit hole deep enough to know exactly what the education requirements are, what the testing requirements are, if they have experience requirements.

And I think whenever you’re talking about designations and some sort of education program, you’ve got to define the goal. Are you doing this because you want the people that sit across the table from you to understand that you’ve taken this seriously and that you know something about it or are you looking to shore up your own knowledge in order just to feel more comfortable giving that advice? And I think that’s going to, kind of, take you down the path of finding one that might be appropriate for you, but certainly love the idea. And good luck to you and I hope that you’re able to help some people out.

Brokamp: Yeah. And I’ll just add another possible helpful tip, is that, find an organization that you’d like to help and that is doing what you’d like to do and ask how you can help. So, there might be organizations that are doing something along the lines of what you’re looking to do and you can reach out to them and say, how can I join your team, how can I help you out?

Anderson: Absolutely. That’s great advice. Yeah. And they may have a minimum requirement or a designation that they require as well or a list of some that they approve of.

Southwick: Yeah, because I think even at The Motley Fool there’s a local organization, like, Together We Bake. It isn’t The Motley Fool. And that it’s an organization that helps women who are in rough positions and teaches them how to make money in this bakery and gives them a chance to support themselves. But we volunteer with them and every now-and-then meet with the women as part of this program. So, it doesn’t even necessarily need to be a financial program, it could be any sort of charity that helps people, and then maybe financial advice is one aspect of it.

Brokamp: Right. Especially if — in many of these situations, the people you’re trying to help are not looking for, you know, analysis on whether you should invest in Tesla or not, they’re looking for basic budgeting, basic retirement planning, basic debt strategies that someone who’s led a life of, generally, learning about these things can probably help out with.

Southwick: Next question comes from Michelle. “In 2013, I opened up a Roth IRA and started contributing a small amount each month, $50. I retired at the end of 2016 and continued the contribution for two more years until I discovered I had to have earned income, which I didn’t, in order to contribute to a Roth. The money, now about $10,000, is still sitting in this Roth account. I’m not sure what I should do or what tax penalties there are.”

Brokamp: So, Michelle, you’ve done something that’s known as an excess contribution, so you contributed more than was allowed to. And she’s right, if you don’t earn a paycheck, you can’t contribute to an IRA, with one exception, if you’re married and your spouse has earned income. So, Michelle, if you are married and your spouse is working, that might take care of all this. If not, then the penalty for an excess contribution is somewhat steep, it’s 6% every year it’s left in the account. Generally, there’s no 6% penalty if you correct the mistake by withdrawing the contributions and any earnings on that contribution before the tax filing deadline, including extensions, for the year you made the contribution. However, of the gains part, you owe taxes at 10% penalty if you’re not 59.5.

Unfortunately, Michelle’s situation is more complicated, because she’s now beyond the tax filing deadline. She’s going to have to actually use a very complicated formula to determine how much she should withdraw and what the penalties would be. For those who want to see it, it’s found on page 32 of IRS Publication 590-A, or you can just do an online search for calculating tax on excess IRA contributions.

But if I were Michelle, I’d start by contacting the discount broker and seeing if they can help with the calculations, because chances are, they’ve handled this before and hopefully they can give you some aid in figuring out how much you have to take out, what the consequences would be? And if not, contact an accountant. By the way, another way that people accidentally make excess contributions to a Roth is when they think that they are below the income eligibility limits, but they’re not, maybe because they just didn’t understand the limits or, you know, they made a contribution in the first half of the year, and in the second half of the year they got a raise and a bonus and all of a sudden they’re beyond that.

So, the bottom-line for anyone making any kind of excess contribution is, solve it as soon as you can to avoid that 6% penalty each year you leave it in the account.

Southwick: All right. Our next question comes from Neil. “I was surfing the tube last weekend and landed on PBS for a few minutes. [laughs] I love how that’s worded, as if you’re embarrassed to be like, oh, no, no, no, I don’t know what was, it’s just I was …

Anderson: … I wasn’t PBS.

Southwick: I wasn’t watching PBS.

Brokamp: [laughs] I wasn’t watching Sesame Street, and then this other show came on …

Southwick: … the cat stepped on the [laughs] remote, I don’t know, I wasn’t paying attention to that. Anyway. Be proud of PBS, come on! “When a certain female celebrity financial advisor was discussing bonds and bond funds and how she saw investing in bond funds as much less advantageous than investing in individual bonds, because unlike bonds, bond funds never have a maturity date. So, they are more susceptible to lowering interest rates and not as much upside potential. So, is there a fundamental difference between investing in bonds versus bond funds?”

I feel like I used to know this answer.

Anderson: Well, so I don’t know that there’s a super-simple one or the other answer here. So, certainly, if you’re buying individual bonds, the beauty of that is that you can hold it to maturity, and on the day that you buy a bond, assuming we’re talking about a fixed rate bond, or not like a floater, but if you’re talking about buying a bond, you know on the day you buy it, how much you’re going to get. There’s a yield to maturity that you’re going to get on the day that you buy it, and as long as they don’t go out of business or default on the debt, you know exactly what you’re going to get returned. And so even though bonds price up-and-down in the market, you’ve got certainty there, that again, as long as they don’t go out of business, I know I’m going to get X number of dollars back.

The thing that makes this a little bit tricky, is that buying bonds as a retail investor is a pretty cloudy experience. Bonds don’t trade on an exchange like stocks do. So, there’s no open market where you can just, kind of, go swap bonds back-and-forth, you’re typically dealing with a broker that may be showing you their inventory or maybe they’ve got access to other bond desks and they’re showing some other inventory of bonds. But when you’re buying them, they’ve generally been marked up a couple of times. So, the bond desk is marking up the price to the customer. And that may have happened at a couple different stages along the way, and it’s not like you understand that as a commission, where you used to pay, you know, X number of dollars for a stock trading and you knew exactly what you were paying, it’s being baked into the bond pricing for you. And so, as a retail investor, you’re likely not getting very attractive pricing, you’re probably getting much worse pricing than somebody that’s an institutional buyer that’s buying big blocks, can go get.

And so, as a big mutual fund or asset manager, they’ve got the buying power. And you know, simple example, just think of Costco versus going to 7-Eleven, right? If you’re going to go buy [laughs] a single snickers bar at 7-Eleven, you’re going to pay the retail investor rate for that, or the retail buyer rate versus buying a box of snickers bars at Costco, where you get 40 of them or something, and you’re getting [laughs] much better pricing on a per snicker basis.

So, yes, if you’re in a bond fund and interest rates go up, you can see prices come down, but the underlying product still has the same characteristics, right. You’re assuming that if you’re investing in a fund that that bond manager is also paying attention, and isn’t just going to kneejerk sell out of all of those bonds, because they price down. So, they have the ability to wait on it just like you do.

I’m going to throw one final thing at you on this, because this is actually what The Motley Fool Wealth Management bond strategy is built on, which is called a Target Maturity ETF. I believe the ones we’re using are all bullet shares from Invesco now, but basically what they are, is it’s a basket of bonds that all mature in a single year. And so, you’re spreading risk across a ton of different bonds, it’s not just one single bond that you’re holding, but you do have a maturity date. And so, it’s a little bit of the best of both worlds in terms of being able to have that certainty of when you think you’re getting your money back without necessarily having to go and figure out an individual, which bond do I buy and does my broker have decent inventory and all of that.

So, maybe look at that. Again, I don’t think there’s anything wrong with bond funds inherently, but if you’re worried about that price volatility, sure, go buy some individual bonds.

Southwick: Our next question comes from Naross. “I am a retired 65-year-old, my withdrawal rate is less than 0.5%. I follow a bucket philosophy. I have enough cash for +10 years of expenses, including medical and inflation. I have a high tolerance for risk. I have more than 90% of my portfolio in equities. Is there anything wrong with it? I keep hearing about 60-40, 70-30, etc. Given that equities have outperformed bonds and cash over a long period of time, and that I’m fairly certain I don’t need to sell stocks anytime soon, why not go all in?”

Brokamp: Well, Naross, I would say, you’re probably in pretty good shape. So, you’ve done a couple of solid things. First of all, you have protected any money you need in the next +10 years by having it in cash. So, you can ride out any stock market decline that takes more than 10 years to recover. Also, your withdrawal [laughs] rate is just 0.5%. I mean, if you have a portfolio that’s all stocks, you’re at least getting 1%, 1.5%, maybe 2%, depending on which stocks you have, just from the dividend, which means you can live off the dividends and then some. You still have excess cash coming in that I assume you’re reinvesting.

We’ve mentioned in the past that in his 2012 annual letter, Warren Buffett said that he’s directed the administrator of his estate for his wife’s account, when he passes away, to invest 90% of it in the S&P and 10% in short-term treasuries. Which a lot of people felt, well, that’s very aggressive. But when your wealth is so high and your withdrawal rate and the amount you need is so low, the market could drop 50% and you’re still in good shape. So, generally speaking, Naross, as long as you have the risk tolerance for all the ups-and-downs of such a stock-heavy portfolio, I think you’re going to be in good shape.

Southwick: Next question comes from Ryan. “I’ve been looking at the performance of my stocks. If I look at my broker, it shows my cost basis, then I get 1% gain based on current market value versus the cost basis. If I look at Vanguard’s site, where I have some ETFs and mutual funds, I can also look at cost basis, but they have a few articles about how cost basis is not the whole story and you have to look at personal performance. However, I can’t get the math to work out like they do. The questions are, how do you measure performance? And how the heck does Vanguard measure performance? Is it a cost basis just for taxes? I’m sure both of these ways are correct, but which one is The Foolish way and which one is the foolish way?”

Anderson: All right, Ryan. So, I think in last month’s Mailbag episode, Jim Mueller tackled a performance question. I’m also going to take this performance question, because I can see how it gets so confusing for people. And I’m going to go through an example of why it becomes confusing for people. So, if you have a mutual fund that pays any sort of income in the form of a dividend or a bond that’s paying income out, you have a couple choices on how they treat that income. You can have it reinvested into the mutual fund again, it might pay to cash, either way, you’re going to have a different situation on how your cost basis eventually looks as a result of that and how your cost basis is no longer going to be an accurate representation of what your pure performance is.

So, if you invest $100 into a mutual fund, and six months into owning it, it pays out $1, it buys back into the fund at that new rate. So, it’s establishing another $1 into the fund at a potentially new cost basis, unless the price hasn’t moved at all in that six-month period. So, if you’re reinvesting dividends, you’re constantly adding to your cost basis, but that dividend that’s being paid out is also part of your return, right, so that when that cash comes out of the fund it’s not showing that as part of your gain and loss reporting.

So, here’s what I would do, I would look at a single period, right, so figure out what time period you want to measure, might be just a calendar year, might be a month, you know, whatever, you’re going to look at the ending value and you’re going to divide by your beginning value to see what your total performance over that period was. If you’ve been adding money along the way, that’s what makes these calculations so complicated, you, in theory, to do it completely accurately, would have to do a different return calculation for every time you’ve added money.

So, over the course of the year, if you get paid every two weeks, and you add 26 times to your portfolio to get a perfectly accurate performance calculation, [laughs] you’d have to basically do 26 different period returns to really break this down. Most people don’t need to do that, if you just want to understand how you’re doing. Again, I would do the ending value, in this case, divided by beginning value, and then net out whatever you’ve added or subtracted from the portfolio to understand what that performance is. So, if you’ve been taking money out, or if you’ve been adding money to it.

Again, I think that’s going to be the much easier way to do it, there’s a lot of math that goes into time-weighted return versus money-weighted return. At the end of the day, I think what most investors want to know is, am I moving in the right direction and am I moving at a rate that is similar to what my benchmark is. So, you know, that’s the S&P 500 or whatever you’re using to measure success.

Southwick: Our last question comes from Ross. “I want to start a stock account for my two-year-old with $1,000 from a CD that will be maturing this month. He already has a 529 college fund going, but I was thinking of buying a few shares a futuristic fun stocks, such as, Virgin Galactic, Apple, Chewy, Disney, etc., that he could take ownership of when he’s older, rather than leaving his grandparents’ checks in a CD or savings account. How is this done? Can I just open a Robinhood account in his name or would it be more advisable to use a more mainstream brokerage account? Finally, are there yearly tax implications for the stock account of a toddler? I feel uncomfortable attaching my son’s bank account to a brokerage account, but maybe that must be done?”

Brokamp: Well, Ross, I think it’s a great idea; always good to get kids learning about investing sooner. Of course, it’s two-year-old, I don’t know how much your kid is going to figure it out at this point, but certainly at some point you’ll be able to show your kid the stocks, and hopefully they’ll grow over the years.

What you’ll need to do is open up a custodial account. So, a custodial account is for the kid, it’s owned by the kid, but the kid can’t take control of it until they reach the age of majority; and that changes, it depends on which state you live in. I looked very briefly at Robinhood, by the way, and I didn’t see that they had a custodial account, and I found just some other articles that said they don’t. So, you probably will have to go to another brokerage, but you’ll have control of the account until your kid reaches the age of majority, and then the money is all his or hers.

In terms of the tax implications, generally speaking it goes like this, with unearned income, and unearned income means dividends, interest, capital gains. The first $1,100 will be tax-free, the next $1,100 will be taxed at the kid’s tax bracket, which is probably 10%, and then beyond that, money is taxed at the parents’ tax rate, it’s known as the kiddie tax.

I’ll just mention, since you mentioned the 529, if you want this money to go toward college, you could consider the Coverdell, which has most of the benefits of the 529, in the sense that the money can be withdrawn tax-free as long as it’s used for qualified education expenses, but unlike the 529, you actually can buy stocks in the Coverdell. So, I would say that’s something else to consider.

Southwick: Any reason, benefits to doing the custodial account versus just having another account yourself as an adult and just in your mind knowing it’s your child’s?

Brokamp: Right. So, the benefit of having the kid’s account is that, that first $1,100 of interest and all that is tax-free, and then the next $1,100 is in the kid’s bracket. So, there’s those tax benefits. The benefit of having it as basically your account, but just saying it’s the kid’s account, is that you maintain control. So, if the kid reaches age 18 or 21, whatever it is in your state, and it turns out that the kid is actually pretty irresponsible and you wouldn’t want them to have control of that, you maintain control.

And the other downside of having any money in the kid’s name, it’s the kid’s asset, and that has a bigger effect on financial aid eligibility versus assets that are owned by the parent.

Southwick: Wonderful. Well, that’s it for this month. Ross, thank you so much for joining us, it’s always just a joy to have you on the show and help us answer our listeners’ questions.

Anderson: It’s my pleasure, I love getting to be a part of it, and thank you for having me.

Southwick: All right. Well, drum on, buddy!

[…]

Southwick: So, Bro, funny story.

Brokamp: Yeah.

Southwick: Rick and I had to go into the office for the first time since March and we discovered two things. One of those things was that we have this wonderful wall where we hung all of the postcards. [laughs] All of the postcards fell off the wall and so there’re hundreds of postcards on the ground and we took one look at it and we said, well, we’ll come back and deal with this after the coronavirus. So, that’s just a mess.

But we also discovered that our listeners were still sending us postcards. Look at these.

Brokamp: Whoa!

Southwick: I know.

Brokamp: For people at home listening to this podcast, those are a lot of postcards, lots and lots of postcards.

Southwick: Yeah, there are. Oh, man! Like, Rick, do you remember what noise I made when I saw them? I’m pretty sure I made a pretty ridiculous noise.

Rick Engdahl: The word “squeal” comes to mind.

Southwick: Squeal, yeah, I probably squealed. A joyful squeal. Yeah. So, PT is the big winner, who sent us cards from the Alamo, Independence Hall, South Carolina, John Pennekamp Coral Reef State Park, the Dry Tortugas and Fort Lauderdale in Florida, Cumberland Gap and Mammoth Cave in Kentucky. PT! I hope you’re staying safe out there, but it was fun to go to all these places via a postcard.

Francois sent a postcard from Quebec. Drew learned about money laundering in the Caymans. Boon — hey, you just answered the question from Boon. Boon earned — it could be the same Boon — Boon earned some hubby points by taking his wife to the Blomquist Garden of Native Plants in Durham. Ben is drinking rum punch and eating conch fritters in Belize. Allen and Roxanne got a trip under the wire to England back in March. [laughs] So, we got that postcard. Neu from Birmingham invited us to his new spanking house with a card from China. [laughs] Rudd sent a card from the Palouse, one of my favorite places in the world. 50 Billion Cent, sent a card from seaside, Oregon with the family. Monica sent a lovely card from Belarus. Bill and Bonnie let us know they are sipping scotch and surveying the Salish Sea. And then the remaining cards I grabbed were actually intended for other Fools, from Peter Bartoli, but I accidentally took them. So, sorry, Joan and Marico, but I’ve got your postcards.

So, anyway. Yeah, look at the — I mean, I know our listeners can’t look at them, but, Bro, look at them! Look at them!

Brokamp: Very cool, very cool.

Southwick: Oh! It’s so cool and so nice to know that our listeners are still out there, and to see these lovely postcards of parts of the world that someday I will hope to one day go to someday. Someday.

So, all right. Well, that’s the show. It’s edited collapsing-ly, I don’t know, my mind is still on our sad postcard wall, by Rick Engdahl. Our email is [email protected] For Robert Brokamp, I’m Alison Southwick, stay Foolish everybody.

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