Concepts

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 364^th 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.

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.

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:
Possibly reduce or eliminate Social Security Benefit Taxation
Pay long-term-care premiums or other expenses while maintaining control of the asset
Create an income stream to bridge the gap between early retirement and Social Security
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.

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
After Year	Taxable Account Interest	Tax Deferred Interest	Tax Deferred Advantage
1	$3,120	$3,180	2%
5	$3,650	$4,015	10%
10	$4,441	$5,372	21%
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.

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.

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.

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.

The First Year			$10,000	$10,000	$10,000	$30,000
1	1	2.5%	$250
2	2	3.5%		$350
3	3	4.5%			$450
Total						$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).

The Second Year			$10,000	$10,000	$10,000	$30,000
1	2	3.5%	$350
2	3	4.5%		$450
3	3	4.5%			$450
Total						$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.

The Third Year			$10,000	$10,000	$10,000	$30,000
1	3	4.5%	$450
2	3	4.5%		$450
3	3	4.5%			$450
Total						$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.

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.

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 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.