Finance 101: A basic plan

(Since my previous posts, quite a few people asked me a basic plan which can be followed, here it is)

The items are ordered from first thing to be done to the last thing which can be done (assuming money is still left).

  1. Emergency savings
    Put 6 months worth of expenses in a Series I-Bonds (sold by treasurydirect.gov) – they try to match inflation rates (but nothing more than that) and can be sold after holding them for at least a year. The idea behind this is to minimize downsides in case of a major market crash. Also, I-Bonds are not counted towards state taxes and a max of 10, 000$ can be purchased in a single year (per SSN).
    Another simpler approach is to put money in high yield savings account like Barclays Savings or American Express Savings, of course, there is no rate guarantee and rate do fluctuate (usually go down) over time.
  2. Max out pre-tax 401K
    Assuming there is an employer match or if the person can convert it into Roth IRA.
    Otherwise, don’t do it.
  3. Backdoor Roth IRA
    Invest 5, 500 $ in traditional IRA, hold that for a few weeks and then convert it into Roth IRA and let the money grow tax-free.
  4. REITs and Preferred’s
    Investing in dividend paying (or “fixed income” as they are called) equities is not the optimal strategy for someone who is working full time but I think its psychologically beneficial to get regular dividends especially when market tanks down.
    An approach for that is to first figure out the amount of monthly dividend one wants to receive and then invest accordingly. For example, to get 100$ pre-tax a month in dividends from saying HSBC preferred shares (HCS) which has an 8% annual yield, the total investment has to be 15, 000 $.
    A caveat here, dividends coming from preferred are qualified and taxed at a lower rate while dividends from REITs are not, they are considered a regular income. The trick is to hold REIT in Roth IRA account where the income becomes tax-free.
  5. Municipal Bonds
    (Disclaimer: I have not tried these)
    Municipal bonds are usually issued for long-term (30 years) and the dividends they pay are tax-free (no state or federal taxes) provided the person is resident of that state. Rich people love these especially because the dividends are tax-free and there is no risk (except for municipality filing bankruptcy) if they are held till maturity.
    If they are not held till maturity there is in interest rate risk where bonds can go down in value if the interest rate goes up. So, the current market value of the bond will go down and vice-versa.
    In the current scenario (2013), interest rates are low enough that they can only go up, so, investing in these does not make sense unless the person is planning to hold them till maturity.
  6. Three-fund portfolio
    Rest of the money should go into a three fund portfolio (discussed earlier).

Finance 101: Cheatsheet

(Based on what I have seen financial savvy people doing and makes sense to me. Disclaimer: These are my opinions.)

  1. Should a person contribute to pre-tax 401K?
    Only if the company has a matching policy, else wise, its money trapped till the person reaches retirement age.
  2. Should a person contribute to post-tax 401K?
    Only if the company has a matching policy, else wise, its money trapped till the person reaches retirement age.
  3. What about pre-tax 401K vs post-tax 401K?
    Post-tax  401K is better than pre-tax only if

    1. The person decides to immediately convert to Roth IRA (since in Roth earnings will be tax-free while in post-tax, they are tax-deferred, this depends on whether the employee permits it or not.
    2. If the employer does not permit Roth conversion but still the person is either on a really low tax rate for that year (eg. not working for a full year or had added dependents to the family etc.) or expects the future tax rates to be much higher.
  4. What about traditional IRA?
    Same as pre-tax 401K, contributions are tax-deductible (if the income is below certain limits which are relatively low), earnings are tax-deferred either ways.
    The only case where this makes sense is to contribute and then immediately convert to Roth IRA where earnings will grow tax-free.  This technique is popular enough to acquire a name of its own “Backdoor Roth IRA“.
  5. What about Indexed Universal Life Insurance?
    The solution of guaranteed no-money-loss in a single year sounds really promising but its stupid to be told that I have to pay interest to borrow my own money and will be charged a premium for someone else to make money off of the money, not to ignore the fact that this insurers itself can be at the brink of bankruptcy.
  6. What about tax efficiency?
    Long-term stock gains and qualified dividends receive favorable tax treatment, that is, lower tax rates.
    Bonds, interest from bonds, short-term stocks, interest from bank accounts(yeah that pesky tenth of a penny) are treated as regular income, so, these things should be better held in either tax-deferred account or tax-free (retirement) accounts.
    International stocks should be held in taxable (normal) account since they are taxed by foreign countries and one can receive a foreign tax credit by holding them in a taxable account. All other stocks should be held first in taxable and then left over in tax-free and then tax-deferred account.
    Do note that stocks held in a taxable account will be taxed at a lower rate than in tax-deferred account where they are taxed as normal income upon retirement.
    More details on Bogleheads.
  7. What about tax loss harvesting?
    Complicated topic, I will write a blog post some other day.
  8. What would be a basic allocation?
    Go for Bogleheads three fund portfolio.
    Invest in three things

    1. Total US stock market (VTI or VTSAX)
    2. Total world stock market excluding US (VEU or VXUS or VFWIX)
    3. Total bond market (BND) ~ %age allocation should be almost the person’s age (conservative rule – reduce this %age to be more aggressive)
      Split between (1) and (2) should be roughly 80:20 or 70:30.
  9. What about rebalancing?
    As the person invests more, s/he should put more money in a manner to ensure that the above allocation ratio is maintained.
  10. Should the person go all in or slowly move money into the market (Dollar cost averaging)?
    Dollar cost averaging outperformsone-timee all-in in only 33% of cases (Vanguard study) but I think it makes one feel psychologically safer, IMHO, first timers should go for DCA.
  11. What about exotic stuff like commodities, precious metals and rare earth metals?
    The only time people think about buying these is when everyone else is talking about them, these have already peaked in prices and its an even worse time to buy them – paraphrased from The only investment guide you will ever need.
  12. What about P2P lending?
    Income  from P2P lending is considered regular income and losses are not tax-deductible, therefore, from a financial perspective, it makes sense to invest only via Roth IRA. Apart from that, I believe its too much hassle in terms of time (see my previous post on Peer to Peer lending).

Finance 101: References

Books

  1. One up on Wall Street by Peter Lynch – a good book on stock picking
  2. A random walk down the wall street by Burton Malkiel – a good book on why not to pick stocks
  3. The only investment guide you will ever need by Andrew Tobias – a hilarious summary of investing/saving and many other random money related topics
  4. The retirement miracle – For people who believe in indexed universal life insurance plans (I don’t)
  5. Where are customer’s yachts – hilarious read on wall street trader who profit on the expense of customers (won’t help in investing though).

Blogs

  1. fairmark.com – There only guides are thorough and amazing but requires some effort to grasp (only recommended for advanced and the curious)
  2. bogleheads – Interesting forum of people who believes in Jack Bogle’s philosophy of index investing (Jack Bogle is founder of Vanguard), definitely read three-fund portfolio
  3.  Twenty Common Sense Investing rules
  4. 401(k) Guide

Good portfolio checker sites

  1. sigfig.com
  2. personalcapital.com
  3. futureadvisor.com
  4. feex.com

Finance 101: Type of money holding accounts

Money has to be held in some form or the other. It could be cash, physical gold, land or more conveniently accounts. The blog post is only about the last one.

Normal accounts (or non-retirement accounts) – held at banks

  1. Checking account –
    1. Post-tax contributions
    2. Earnings are realized immediately and taxed as ordinary income
    3. Account will never down in value (insured by FDIC for upto first 250K $)
    4. money is highly liquid – can be deposited/withdrawn any time (and absolute limits on deposit/withdrawal are usually of order of 10, 000$ per day)
  2. Savings account
    1. Post-tax contributions
    2. Earnings are realized immediately and taxed as ordinary income
    3. Account will never down in value (insured by FDIC for upto first 250K $)
    4. Money can be deposited anytime but can only be withdrawn six times per month

Investment accounts (for lack of better term) – held at stock brokers
These can be held as retirement or non-retirement accounts. Tax treatment of contributions/earnings/withdrawals depends on the type of parent account they are part of.

  1. Money market account
    1. Post/Pre tax contributions (depending on whether its pre-tax account or post-tax contribution account)
    2. Earnings are realized and taxed as ordinary income
    3. Primarily used for holding money temporarily before it is used for stocks or bonds (or more exotic things like options)
    4. Account can go down in value, though it happens rarely
  2. Brokerage account
    1. Account which holds holdings in stocks/bonds
    2. Earnings are not realized till a sale happens and then taxed as ordinary income or capital gains/losses depending on the holding period

Retirement accounts – held at stock brokers

Retirement accounts provide certain tax advantage (like tax-free or tax-deferred growth), usually, these accounts come with a restriction like money cannot be withdrawn at all till age of 59.5 years or can be withdrawn before that by paying a penalty (account specific details are given below).

IRA = Individual retirement account, just like a bank account, anyone can open it at pretty much any broker.
401K = employer-sponsored account, can be opened only by employer and contributions can only be made directly via paycheck [and employer contributions], the choice of funds to invest is also controlled by employer, sometimes, employers provide a match to encourage employees.

  1. Traditional IRA
    1. Direct contributions have a maximum limit (5,500$ annual limit in 2013 for people below age 50).
    2. Contributions are tax-deductible if income is less than a certain limit (limits are pretty low, though).
    3. Earnings are tax-deferred but taxed as ordinary income on withdrawal.
    4. Money can be withdrawn after age of 59.5 (or before with 10% penalty unless it’s a case of financial hardship).
    5. On leaving an employer, its 401K plan can be converted to traditional IRA account.
    6. See more gory details at Wikipedia page.
  2. Roth IRA
    1. Direct contributions have maximum limit same as traditional IRA but income limit to make contributions is much lower.
    2. Indirect contributions can be done via rolling over 401K money (if employer allows) or backdoor Roth IRA (contribute to Traditional and convert to Roth).
    3. Earnings are tax-free.
    4. Contributions can be withdrawn after a seasoning period (5 years) with no penalties (provided there is a reason – like financial hardship).
    5. Earnings can be withdrawn after age of 59.5 tax-free or by paying both tax and penalty (10%) before that age.
    6. Roth IRA is the only retirement account with no RMD (required minimum distribution clause).
    7. See more gory details at Wikipedia page.
  3. Pre-tax 401K
    1. Contributions are pre-tax (max employee annual contribution limit $17.5K – must come directly from paycheck), employer contributions are not counted towards this limit (they are subject to a total retirement contribution limit which hovers around $50K).
    2. Earnings are tax-deferred.
    3. Withdrawals taxed at ordinary income tax at the time of withdrawal.
    4. Some 401K plans don’t allow any withdrawal (even for financial hardship) till age of 59.5
    5. An employer decides which funds will be available for 401K plan.
    6. See more gory details at wikipedia page.
  4. post-tax 401K
    1. Contributions are post-tax. (same limit at pre-tax 401K)
    2. Earnings are tax-deferred.
    3. Contributions are withdrawn tax-free, earnings are taxed at ordinary income tax at the time of withdrawal.
    4. Some people prefer post-tax since they can effectively contribute more money into the account.
  5. Roth 401K
    1. Similar to Roth IRA in the sense that contributions are post-tax (for most people) and earnings are tax-free.
    2. Withdrawal though, is controlled by employer and might not be possible without leaving the employer or attaining the age of 59.5.
    3. Usually, it’s a good idea to convert post-tax 401K to Roth 401K (or Roth IRA) if that choice is available in employer’s plan.
  6. Some other exotic options like SEP IRA, 403(b) plan – I don’t know these and they won’t be covered here
Retirement accounts (contributions vs earnings chart)

Retirement accounts (summary)

Which plan should a person go for?
See my next blog post for the same.

Finance 101: Terminology

  1. Contributions – Money being put into an account is called a “contribution” to that account.
  2. Earnings – Money “earned” in an account. Usually, as an interest or dividend on the money contributed but can also include things like bank bonuses.
    As a concrete example, a person opened a new bank account and “contributed” 1000$ in the account, the bank gave him a 150$ bonus and by the end of 31 Dec, the account earned and interest of 35$, the “earnings” will be 185$ (150 + 35).
  3. Withdrawal – Money “withdrawn” from an account of one type into an account of a different type. Movement of money between accounts of the same type is not withdrawal.
  4. Realized and Unrealized gains – Suppose a person buys stocks worth of 1000$ and it gains 5% in one month, the gain of 50$ in this case would be “unrealized” till the person decides to sell the stocks, at which point, the gain is “realized”.
    Why does this matter? As per the contemporary IRS rules, gains are taxed on realization based on tax laws at the time of the realization.
    Note: In the case of bank accounts, earnings are realized as soon as the bank pays interest at the end of the month.
  5. Pre-tax contribution – A contribution made from the pre-tax money, the money from which state and federal income tax have not been deducted.
  6. Post-tax contribution – A contribution made from post-tax money. Such a contribution won’t be taxed again (provided the person is careful), the earnings on it might/might not be taxed depending on the type of account earnings were generated in.
  7. Tax-deferred growth – An account where earnings are not taxed till a withdrawal is made from the account (what if 10% money is withdrawn from the account? well, that is account specific and will be covered in a different blog post)
  8. Tax-free growth – An account where earnings are not taxed ever – usually these accounts have certain constraints like age at the time of withdrawal should be more than 59.5 or money should be held in the account for a certain period of time or both. Trivia: Mitt Romney holds money in one such account.
  9. Equity – A piece of ownership of land or company
  10. Share/Stock – A piece of ownership of a company
  11. Bond – A piece of ownership of a debt given to a company. Safer than stock but yields lower return.
  12. Options/Futures/Currencies/Shorting/Margin trading – A collection of exotic complicated financial instruments which I don’t fully understand. Please refer to one of the references if you are interested.
  13. Municipal Bonds (munis) – The earnings on these bonds are not subjected to federal and state taxes as long as they are from the same state as the buyer’s state of residence. High earners love these.
  14. Ordinary income tax – A tax which applies to regular income  like salary and interest paid by the banks. This tax has both state and federal tax components.
  15. Capital gains tax – A tax which is applied to the appreciation in value of an equity (like stock or house), this tax is either short term (if holding period of equity is less than 365 days) – where it is counted as part of ordinary income or long-term – where it gets a preferred treatment and is taxed on a lower rate (more on this in another blog post).
  16. Required Minimum Distribution (RMD) – A lot of retirement accounts mandate that the owner must start withdrawing a certain amount of money from the age of 70.5, the minimum withdrawal limit is controlled by IRS [source].
  17. Expense Ratio – A percentage of money which a mutual fund eats into every year. Eg. if expense ratio is 1% than a contribution of 1000$ with 10% gain will become 1090$ at the end of the year.

Trivia: Reason being 59.5 being the retirement age is detailed here.

Personal Finance: Thoughts on peer to peer lending

A year back I decided to try peer to peer(P2P) lending (out of curiosity) will a small sum of money.
My net conclusion is that peer to peer lending is not a sensible form of investing.
My money is still stuck (and that’s not the only reason why I would recommend people to stay away from it).

How it works

A lender with say 1000$ will go to a site like lendingclub.com or prosper.com and will loan money directly to people in units of say, 25$ notes. The loan (with interest)  will be paid back in fixed period of time (36 or 60 months).

Reasons why I dislike P2P lending

  1. Income counted as regular income
    The income counts as ordinary income and is treated at marginal income tax rates which is usually much higher rate then long terms capital gains and dividends. Not to ignore that if a person is living in high tax state like California, the state tax applies as well. So, the after tax rate of P2P lending is approx. 20% lower than equities.
    Note: This does not apply if you are using Roth IRA account for investment.
  2. Tax inefficient
    The lender will get a fixed amount of money every month (except for defaulted loans) unlike capital gains, there is no way to keep it unrealized and timing it (Eg. postponing gains for a year). Even worse sometimes the creditors will pay back well in advance.
    Note: This does not apply if you are using Roth IRA account for investment.
  3. Too much of work
    Unless the lender is ready to put in a minimum sum (~25, 000 $), the task cannot be automated.
    In my opinion, investing one’s savings in chunks of 25$ units is not the best investment of one’s time.
    Also, from time to time some creditors will pay back earlier forcing lender to spend time reinvesting that money.
  4. No liquidity
    While equities and bonds can be sold at will (Eg. in case of a better opportunity or emergency), that’s not the case with P2P lending. The notes can be sold though (through trading platform provided by P2P sites), but only at a loss.
  5. Money is not always invested
    While one can buy equities/bonds anytime in open market, P2P lending will not begin till the funding is finished. Eg. As a lender, you saw someone requesting a loan of 10, 000$ and decided to buy notes worth 1000$, but the rest of 9000$ did not arrive for next one week then the investing period won’t begin till then (even worse, all the loan requests have deadline and if requests is not 100% fulfilled then the loan will not be granted and you will get the money back after one week of lock-in and no gains). Therefore, the net annualized returns are misleading.

 

The bottom line is simple: If you want to try out P2P lending for fun then go ahead and try with small amount of money. Serious investors should probably stay away from it.

Malkiel’s Timeless lessons for Investors

(Notes from Burton Malkiel’s talk at Google in 2010)

Lesson #1: Buy-and-hold is still the best strategy
Not only timing the market is tough but people who are trying to time the market loose more often than not.

Lesson #2: Dollar-cost Averaging
Since it is impossible to guess whether the market is going to go bull or a bear, it is better to invest over a period rather than in one-shot.

Lesson #3: Rebalance yearly
It guarantees minimum volatility and unless the market is going monotonically upwards, it guarantees best returns as well.

Lesson #4: Diversifying helps
Even though markets across the world are correlated, gains in emerging markets are usually higher.

Lesson #5: Costs matter
Always judge the mutual funds by the expense ratio, lower the expense ratio, usually better the fund.

Lesson #6: Indexing helps
Roughly 2/3rd (actively managed) mutual funds are beaten by (unmanaged) S&P 500 every year.
Core portfolio must be held in low-cost index funds, small proportions can then be invested in risker investments for seeking higher alpha.

Good chinese ETFs (He was personally managing some of these funds at that time).
FXI – only 25 companies
YAO – 150 companies (recommended)
HAO – small private companies