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Safe Money
Concepts
( Click the links
on the chalkboard below to jump to the different
sections on this webpage. )
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Liquidity Cost
Say that your
choices were a money market account offering a
yield of 1.5% with access to your money at any
time without penalty, or a one-year certificate
of deposit offering a yield of 2.0% but with a
six-month interest penalty if you cashed in
before the year was up. What is the liquidity
cost of buying the CD if you cashed it in on the
364th day?
Your immediate answer would
probably be 1% because if the CD yield is 2.0%
and the penalty is six-months interest, or half
a year’s interest, to calculate it you would
simply multiply 2.0% by one half and come up
with 1.0%. But that does not accurately reflect
the liquidity cost.
The CD yield is 2.0%. After
subtracting the 1% penalty the net after-penalty
yield of the CD is 1.0%. The money market
account had a net yield of 1.5%. If we surrender
the CD early we do not make 1% less than the
money market account. We make 0.5% less. The
liquidity cost of cashing in the CD is not 1% -
the penalty, it is 0.5% - the difference between
what we would have earned with the other choice.
Behind the concept of
Liquidity Cost is the realization that financial
decisions are not made in a vacuum, but are
always a choice between alternatives and you
need to compare the net after-penalty yields to
determine the true liquidity cost.
What if our choices were a
five-year certificate of deposit with a
six-month interest penalty or the money market
account? The traditional answer would be the CD
must have a greater liquidity cost because the
penalty goes on for 5 years. But what if the CD
yielded 4% and the money market yielded 1.5% and
we cashed in the CD after one year? The
surrender penalty for the CD would be six months
interest, or 2%, leaving us with a net
after-penalty yield of 2.0%. The money market
yield is 1.5%, a half percent less than the net
CD yield. In this situation it is not the CD
that has a liquidity cost but the money market!
Owning the money market has cost us 0.5% after
one year.
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Saving Too Conservatively
Many people keep
too many of their retirement dollars invested in
cash and low interest accounts even though other
places offer higher potential yields. Saving too
conservatively may translate into having
inadequate funds during retirement. This chart
shows the growth of $100,000 at different rates
of returns.
Even a 2% increase in
the average annual return can mean
hundreds of thousand of dollars more
during retirement. It can mean the
difference between spending retirement
years in comfort or asking many people a
day “Do you want fries with that”
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Growth
Of $100,000
| Years |
at 4% |
at 6% |
at 8% |
| 10 |
148,024 |
179,085 |
215,892 |
| 20 |
219,112 |
320,714 |
466,096 |
| 30 |
324,340 |
574,349 |
1,006,266 |
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Split Funding ...
is a safe money
technique that can be used to provide a variety
of financial solutions. The
purpose of split funding is to generate stable
tax-advantaged monthly income while preserving
principal.
Split Funding could be used
to:
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Possibly reduce or
eliminate Social Security Benefit Taxation
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Pay long-term-care premiums or other expenses
while maintaining control of the asset
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Create an income stream to
bridge the gap between early retirement and
Social Security
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Pay college costs on a tax-advantaged basis
The
Basic Premise:
Let’s say you were age 57, had $100,000 and
wanted to receive additional monthly income for
5 years until you were eligible for Social
Security. Perhaps you could put that money into
a 5-year fixed annuity or CD earning around
4.5%, but the income would be fully taxable.
Here's the split-funded idea:
Put $80,000 into the five
year multi-year fixed annuity. If we can earn
4.56% a year the $80,000 will grow back to
$100,000 in five years and we'll still have our
nest egg. The reason an annuity is used is
because the interest growth is not taxed as long
as it remains inside the annuity (you could also
use Savings Bonds for the tax-deferred growth,
but the rate on the bonds changes every six
months leaving uncertainty about how much the
bonds would be worth in five years).
Take the remaining $20,000 and buy an immediate
annuity (aka income annuity) that will pay a
monthly income for five years (technically
called a 5-Year Period Certain), and then it the
immediate annuity is used up. When I last looked
at rates this produced around $345 for 60 months
or five years.
The Results:
For every month from age 57 until age 62 the
immediate annuity will produce an income of $345
and $333 of that amount is
Income Tax Free. Almost 97% of the
income is free from federal, state and Social
Security benefit taxation. At the end of five
years the multi-year fixed annuity has a value
if $100,000. It should be noted that if
the fixed annuity is cashed in taxes would be
owed on the growth over the original $80,000.
Split funding provides stable
income for the period needed and protection of
principal. Although the concept may be used with
a variety of safe money places, the tax
advantages and guarantees of annuities make
these places the usual choice.
Tax Deferral
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"One way
Warren E. Buffet became the world's
most successful investor was by
understanding how putting off tax
payments can build wealth."
Learning to Think
Like Warren Buffett,
Business Week, February 14, 2004, p.2
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Money that remains inside a savings
bond or fixed annuity grows free from current
income taxes. Not only does the principal earn
interest (simple interest at work), and the
interest earns interest (compound interest at
work), but the money that would have gone to
Uncle Sam also earns interest (tax-advantaged
interest at work)
Tax Deferral Means
Triple Interest Crediting
Suppose you had $50,000 and were in a combined
federal and state tax bracket of 33%. Say both a
taxable account and the annuity or savings bond
are earning 6%. The annuity and bond benefit
from triple interest crediting and work with the
full 6% interest. However, the taxable account
produces a Form 1099 every year which says that
part of the interest must be paid in taxes,
whether it is being used or left for later. If
you are earning 6%, but have a 33% tax rate, a
third of that 6% - or 2% - goes for taxes. This
means there is only 4% working in the taxable
account. Here is what the accumulated values of
the taxable account and the tax-deferred account
look like down the road.
More Interest Income
The tax-deferred advantage continues growing
with each passing year. Tax-deferred growth
means more money is available for future needs.
If you kept earning 6% here’s the interest
earned.
Comparison - Interest Earned
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After Year |
Taxable Account Interest |
Tax Deferred Interest |
Tax Deferred Advantage |
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1 |
3,120 |
3,180 |
2% |
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5 |
3,650 |
4,015 |
10% |
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10 |
4,441 |
5,372 |
21% |
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20 |
6,573 |
9,621 |
46% |
Tax-deferral translates into over 20% more
interest available to spend in 10 years and an
amazing 46% more interest more than the taxable
account provides in 20 years. One of the fears
in retirement is outliving our money; an annuity
can help overcome this fear. Tax-deferral means
a higher accumulated value from which to
draw.
Tax-deferred doesn’t mean tax free. Taxes have
to be paid on the interest when withdrawn or
paid out at death.. However, tax-deferral still
means more dollars. Let’s look at the previous
example and assume the annuity is cashed in and
taxes paid. Here’s what we’d have in our hands.*
*In addition to regular income taxes there is a
10% penalty on withdrawals from an annuity
before age 59 1/2. The penalty only applies to
interest earned and doesn’t affect the premium,
but withdrawals are taxed on an “interest out
first” basis. The penalty does not apply upon
the death or disability of the owner, or if
substantially equal payments are made. Consult
your tax advisor.
There are other ways to look
at the power of tax-deferral.
Interest Free Loan
If someone said they would loan you $10,000
and that you didn’t have to pay it back for 10,
20 or 30 years and you wouldn’t have to pay any
interest on the loan, but you could earn
interest on the money Would you be
interested?
Tax deferral this means you are getting to use
money that should have gone to pay taxes.
Someday, that money has to be paid back.
However, you get to keep the after-tax portion
of the interest you earned from those tax
dollars and, if you’re in a lower tax bracket
when you do repay the “loan”, you could pay back
fewer of them.
Finally, there’s no limit on the amount of taxes
or the length of time you can defer, but
interest is taxable when withdrawn or at death
of the owner.
Tax Control
If you have a taxable account every January
you receive a Form 1099 that says you must pay
taxes on any interest earned, even if that
interest is being saved for future use. An
annuity or savings bond gives you tax control.
You decide when to take the interest and pay the
taxes - not the IRS.
Avoiding SSBT
If your pension, taxable interest income,
tax-free municipal bond interest and social
security income is over a threshold amount you
can be forced to pay taxes on your social
security benefits. However, interest compounding
within an annuity is not counted in the
calculation. If you move dollars generating
compounding interest from a taxable account to
an annuity you may lower or avoid SSBT (Social
Security Benefit Taxation).
Missouri Bucket
Having your money in a taxable account is
kind of like putting it in a bucket. The problem
is every year the IRS punches a hole in your
bucket and drains off some of that interest in
taxes. However, placing your money in a savings
bond or annuity is like adding a faucet to the
bucket. The only time you pay taxes is when you
decide to open the faucet and take out some of
that interest.
Yield Ladders
Yield
ladders are a safe money yield
enhancement technique based on the premise that
yields tend to be higher as length of maturity
increases. Yield ladders may be built using
certificates of deposit, fixed annuities, or
bonds. Laddering is designed to maximize yields
without trying to guess where interest rates
might go.
How Ladders Work
Yield ladders place equal
parts of the principal into the different
maturities, or maturity buckets, so that you
always have a part of your money available to
earn new rates or meet liquidity needs.
As an example, Let’s say we
have $30,000. Although a yield ladder may be for
any length of time we will use a three-year
period and split the money into three parts –
one year, two year, three year – placing $10,000
in each segment.
We will assume the yields
remain the same and are: 1 year – 2.5%, 2 year –
3.5%, 3 year – 4.5%, Now let’s see what happens
over the next three years.
How to read the chart:
The first column shows the years remaining until
the money is liquid; the second column shows the
initial maturity of the bucket, and the third
shows the interest rate earned. The remaining
columns multiply the money in each bucket by the
interest rate earned.
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Interest Rates |
Year 1 |
Year 2 |
Year 3 |
TOTAL |
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The First Year |
$10,000 |
$10,000 |
$10,000 |
$30,000 |
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Year
1
2.5% |
$250 |
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Year
2
3.5% |
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$350 |
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Year
3
4.5% |
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$450 |
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TOTAL |
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$1,050 |
We are earning 2.5% (or $250)
on a maturity bucket that will be liquid in one
year with an original term of one year. We are
earning 3.5% (or $350) on a bucket that will be
liquid in two years with an original term of two
years and 4.5% (or $450) on a bucket that will
be liquid in three years with an original term
of three years. The total interest earned is
$1,050 this is equal to 3.5% or the same rate
earned on the two year maturity, and our average
maturity is also two years.
At the end of the first year
the 1-year ladder bucket becomes liquid. Since a
year has passed the original 2-year bucket now
comes due in 1 year, and the 3-year bucket comes
due in 2. The fresh liquid money is placed in a
new 3-year bucket, so we now have two buckets
earning a 3-year rate (the original and the new
one).
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Interest Rates |
Year 1 |
Year 2 |
Year 3 |
TOTAL |
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The Second Year |
$10,000 |
$10,000 |
$10,000 |
$30,000 |
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Year
1
3.5% |
$350 |
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Year
2
4.5% |
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$450 |
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Year
3
4.5% |
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$450 |
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TOTAL |
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$1,250 |
In the second year the yield
is 4.17% ($1,250/$30,000), over half percent
higher than the two year rate, but our average
liquidity has stayed at two years.
At the end of the second year
what originally was the 2-year rate bucket
becomes liquid, all of the other buckets are one
year closer to liquidity, and the fresh money is
again placed in a new 3-year bucket earning the
3-year rate.
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Interest Rates |
Year 1 |
Year 2 |
Year 3 |
TOTAL |
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The Third Year |
$10,000 |
$10,000 |
$10,000 |
$30,000 |
|
Year
1
4.5% |
$450 |
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Year
2
4.5% |
|
$450 |
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Year
3
4.5% |
|
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$450 |
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TOTAL |
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$1,350 |
By the fifth year the average
yield is 4.5%, the equivalent of the 3-year
period, but the average liquidity is still two
years and a third of our money is liquid in one
year.
What Has Happened
By using laddering we are
earning the equivalent of 3-year rates on all of
our money even though the average liquidity wait
has stayed at 2 years. The power of laddering is
it permits you to get the higher yields
associated with longer terms, while maintaining
your liquidity.
Rising Rate Environment
But what happens if rates go
up? There is a tendency for individuals to not
use laddering because of fears they will lock in
today’s rates when tomorrow’s rates may be
higher. However, laddering can still provide an
advantage because longer terms may offset most
or all the increase.
Yield Ladders Work
Yield ladders work when
higher yields are paid as maturity lengthens.
They work very well in stable interest rate
environments and falling ones.
Yield ladders do
not work as well when rates are steadily rising,
but they reduce volatility of interest income.
Many people sacrifice yield
by keeping money in short maturity instruments
because they don’t want to miss out if rates
rise. A yield ladder means you always have money
coming due that will earn the new rate, and you
will be able to take advantage of any yield
curve benefits of the longer rate term. Even
though I used a three year timetable with three
annual buckets a yield ladder may be any length
and have any number of maturity buckets. The key
to success is having the discipline to keep the
ladder going.
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