Merriman

I recently had the pleasure of sitting down with a client’s daughter. She’s in her twenties, just finished up her nursing degree six months ago and is working the night shift at a local hospital. She is living with a couple of roommates and is finally in a position to save some money after being a very broke college student. She now faces the question posed by many young people who are starting their first “real” jobs.

Now what?

Michelle (as we will call her) wanted to know what to do with the money she’s now able to save. She had no idea where to start getting her finances in order. To get her started on the right track, I suggested she focus on a few key areas.

Live within your means

She’s already years ahead of many twenty-somethings in that she is living on less money than she earns. She wasn’t sure how much money she would be able to save on a monthly basis so I suggested she set up a rough budget. I didn’t encourage her to be terribly rigid with the budget but to use it to get a sense of where she is spending her money so she’s aware of her spending habits. This will help her decide what she wants to spend money on and what is less important to her.

Create an emergency fund

While she enjoys her job and has no plans to quit anytime soon, you never know what life will throw your way. So I recommended she save three to six months of income and have it very liquid (money market, for example), which will enable her to have a safety net in place.

Understand your insurance policies

Michelle wasn’t sure exactly what her benefits were at work. She knew she had medical but wasn’t sure of the deductible. She also didn’t know if she had dental or vision coverage. As a young woman in her twenties, the likelihood of an expensive surgery or illness is very low, but injuries can still happen.

She also had no idea whether her employer provided disability insurance. I recommended she read through her employee materials again as things are typically a blur when starting a new job. I also encouraged her to ask the HR department about any questions she may still have after reading the policy information.

I checked to make sure she has car and renter’s insurance and that the policies are up to date. When you’re just getting started financially, you don’t want to find out after an accident that your $10,000 car is only covered up to $5,000, or regret not having renter’s insurance after your upstairs neighbors leaves a faucet on, flooding your apartment and ruining your new laptop, couch and clothing.

Pay off your debt

This is typically the ball and chain around many people’s ankles when they first start their careers. I recommended that Michelle pay off the money she owes by attacking the debt with the highest interest rates first. She has about $10,000 in student loans and another $1,500 in credit card debt. The credit card debt has a much higher interest rate than the student loans, so she’ll pay the minimum on the student loans until she pays off the credit cards. Then she’ll pay down the student loans. A good way for her to keep debt in check moving forward is to use primarily cash for all purchases or to use a credit card and pay it off monthly.

I also recommended she compare her local credit union fees and programs to that of her bank. She’ll likely save money on ATM transactions, credit card interest and loans in the future by using a credit union.

Identify short-term and long-term goals

Michelle’s short-term goals include a trip with college friends to Hawaii later in the year. Her longer-term goals include retirement and buying a house. It was important to identify these goals so she can budget for the trip and start down the road to home ownership and retirement. While retirement is probably 40 to 50 years off for Michelle, she will not have to save nearly as much towards her future as friends who start saving in their thirties. She’s fortunate to have a 401k plan and the hospital provides her with some matching as well. The matching is basically free money to her so she would be wise to take advantage of it. By contributing to her 401k plan, she’ll pay less in taxes and benefit from the employer match, which is a win-win. She may not be able to add as much as she’d like to her retirement plan right now, but she can always increase that after building up her emergency fund and paying off debt.

Get organized

Michelle is well on her way to a successful future just by addressing her finances at such a young age. She’ll have a good handle on her spending habits, her debt level and goals.

My final piece of advice, which Michelle has already followed, is to talk to your parents’ financial advisor. The advisor may not be in a position to take you on as a client, but they should be happy to meet with you and get you headed in the right direction.

The return-centric environment in which we live too often gives little credence to an equally important measure – risk. Professionals and individual investors alike can often quote the return of a given stock or index, followed by silence when asked to recite its relative measure of risk. The financial crisis shouted to us the importance of understanding and controlling risk. If you did not hear the call – and hopefully you did before the fall – it’s not too late to answer it.

Two quantifiable means of controlling risk are diversification and asset allocation.

Proper diversification stretches well beyond your region and your country of residence. It has little to do with individual stock positions or individual sectors. It consists of all types of stocks – large, small, value, growth, etc., which are located all over the world. Global diversification is the goal.

Diversification is equally important for bond allocations. A bond portfolio consisting of high-yield bonds differs from one invested in U.S. treasury bonds. Obtaining an adequate amount of diversification on both sides of your portfolio is essential in controlling your risk.

Asset allocation speaks to the percentage of stocks and the percentage of bonds in your portfolio. While the specific mix has many variables, age and retirement goals are often large factors. Each investor’s situation is unique and there is no “one size fits all” solution. A good place to start is by answering the following questions:

• At what age do I begin adding bonds? 40? 45?
• How often do I add bonds and how much do I add?
• What is an appropriate allocation once I am retired?

If you are struggling to answer these questions, it may be time to seek professional guidance. The answers are essential to your long-term investment success.

Investor discipline is a less tangible but equally important component of risk mitigation.

As stocks outpace bonds, a portfolio’s risk increases. At some point, there will be a need to sell the stocks to buy bonds and maintain the target allocation. In essence, this follows the golden rule of investing – that is to sell high and buy low. The same logic holds within each asset class of the portfolio, such as when international stocks outpace domestic stocks or small cap stocks outpace large cap stocks.

I can almost guarantee that when the time comes, rebalancing will not feel like the natural thing to do. Why, for example, would you want to buy into an underperforming asset class? Despite our rational brain, loading up on the winners will feel like the right thing to do at that moment. There are two questions you must ask yourself:

• Do I have the discipline to rebalance my portfolio?
• What mechanical process will I use to rebalance?

Your long-term investment success hinges on your answers to these questions. If you do not know how to answer them, seek guidance.

Investing is about risk and return. Understanding how much risk you can afford to take and how much risk you’re willing to take is the key. Quantitatively, two ways in which we control risk for clients is through diversification and asset allocation. Keeping clients disciplined in their goals and executing on a well thought out rebalancing process is another, less tangible means of controlling risk.

As Warren Buffet famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.”

Industry specific jargon can be intimidating. Fortunately, you can leave most of it to the experts. The six terms listed below are the exceptions – understanding them is crucial to your long term investment success.

Fiduciary. Someone who is legally obligated to put your interests ahead of theirs. In the investment world, Registered Investment Advisors (RIAs) have a Fiduciary responsibility. Stockbrokers do not. The difference is dramatic. Do yourself a favor and make sure you work with someone who is legally obligated to put your interests first so that you can prosper.

Market index. Indices are measuring sticks for different sections of the market. A good example is the S&P 500, which represents the 500 largest companies in the United States. Understanding the indices allows you to track your relative performance. To do so, it’s important to understand which indices are fair representations of your portfolio. Using the S&P as a barometer against a portfolio of international stocks, for instance, does not make sense. In this case, using the EAFE Index (Europe, Asia and Far East) would be suitable.

Personal risk tolerance. In its simplest sense, how much of your portfolio should be allocated to stocks and how much to bonds? The answer depends upon your unique set of goals and circumstances. Remember – it is a personal risk tolerance. Speak with a Certified Financial Planner™ to guide you to an answer.

Stock risk. Ever heard the saying “don’t put all your eggs in one basket?” While some companies may seem like a sure thing, remember this – the S&P 500 of 1960 looked much different than the S&P 500 of today. Times change, companies grow and others fail to meet changing demands of the world. Eastman Kodak and Enron come to mind. Successful investors use diversification to increase their long-term risk adjusted return.

Loaded mutual funds. A front-end load is recognized when you purchase a mutual fund. A back-end load is recognized when you sell one. Choose their no-load counterpart. You will save the fee and the performance is more often than not just as good. After all, a no-load fund has a head start in the amount of the load, which can be upwards of 4% in some instances.

Pundit. Someone who prognosticates, in this case, about the financial markets. Their pedigree may be impressive and their intellect alluring, but do not follow their advice. No doubt they made a few good calls in their day. Chances are they made more bad ones. Your best bet is to develop a long-term strategy with your financial advisor that you can stick to. One that is tailored to your specific needs and goals.

The article “All in the Family” by Barron’s ranks mutual fund families across several asset classes and time periods. A stellar 2012 for the DFA Value Portfolio helped it earn first place for the US equity fund category. Its three year performance was also very respectable. DFA took 16^th place overall for 2012 and 33^rd for five-year performance. This article substantiates our use of DFA in client portfolios. The funds served clients well in the short term, but more importantly for the long term. Investing is, after all, a marathon, not a sprint.

Every year, we update some of our core articles.

The 2013 update of The ultimate buy-and-hold strategy, which includes performance information through 2012, is now available in our Best of Merriman library.

For many Merriman clients, getting investments right is only part of achieving their financial goals. I am often asked what else people can do to help improve their financial outlook, and I always answer that being financially disciplined is just as important as investing wisely.

Here are five things I think everyone should do to simplify their financial situation and become more disciplined with their finances:

1. Consolidate your accounts. If you have an inactive 401(k) with an old employer, transfer it into an IRA. Often, 401(k)s have limited investment options, and you can take advantage of diversification and management benefits by moving your old 401(k) into an IRA account held elsewhere.  Likewise, if you have several IRAs in your name, consider consolidating them into one. There is no real benefit to maintaining multiple accounts, and it can be a headache to manage them all.
2. Get a handle on what you are spending. There are dozens of apps and websites that can simplify the process of tracking expenses. Mint.com is a great example – it is free and anyone can use it. If you own an Apple device, go the App Store and search for “budget.” Find the app with the highest ratings and download it. Knowing how much money you spend and what you are spending it on is important, both before and after retirement.  You cannot, for instance, know how much you are going to need in retirement unless you know how much you typically spend.
3. Put your savings on auto-pilot. If your employer matches contributions to your 401(k), you should contribute at least enough to max out that matching and take advantage of that “free money.” If you can afford more, all the better. Don’t forget that saving is not limited to company-sponsored retirement accounts. Saving toward your emergency fund in a bank account or your child’s education in a 529 college savings plan is just as important.  As with your 401(k), you can set these types of accounts up for automatic contributions. Ideally, you would work with a Certified Financial Planner™ to figure out the exact percentage you need to contribute based upon your specific set of circumstances.
4. Limit the number of credit cards you own.  The more cards you own, the more complicated it becomes to manage them. If you have several cards with outstanding balances, consider transferring balances to consolidate your credit card debt at a lower interest rate and save yourself a substantial amount in interest payments.
5. Use an auto-pay service to manage and pay your bills. I have a Schwab checking account that allows me to pay thousands of vendors directly from my account. It also alerts me when I have a bill due. If you do not bank with Schwab, don’t worry – most banks now offer a similar service. Ask your local branch for help in getting this set up.

Some of these steps may sound daunting, but are actually quite easy to complete. I know you’ll be glad you did it. Ultimately, these steps will allow you more time to focus on the things that matter most to you.

The American Taxpayer Relief Act, passed by Congress on January 1, 2013, contains many far-reaching tax provisions. In addition to extending many tax items that had expired or were due to expire, the act also made permanent many provisions of previous tax acts. The tax features of this act are too numerous to list here, but the most comprehensive description of these changes I have found is this Journal of Accountancy article.

I highly recommend you read this article or consult a qualified tax professional to assess the impact of this act on your personal situation.

As we near the end of 2012, it’s time to start thinking about your finances for 2013. While some year-end planning might still be needed, it’s not too early to start thinking about next year. Many employers will start having their open enrollment periods over the next few weeks, and this is a great time to review your retirement plan contributions.

The new 2013 retirement contribution limits are as follows:

• The elective deferral contribution limit for 401(k), 403(b) and most 457 plans increased to $17,500 from $17,000 in 2012.
• The catch-up contribution limit for employees aged 50 and older into those same plans remains unchanged at $5,500 for 2013.
• The maximum total contributions into a defined contribution plan rise to $51,000 for 2013 compared to $50,000 for 2012. For those aged 50 and older, the limit is $56,500.
• If you participate in a Simple IRA plan, the salary reduction contribution limit increases to $12,000 in 2013, up from $11,500 in 2012. The catch-up contribution remains at $2,500.
• The limit for IRA and Roth contributions increased to $5,500 from $5,000 in 2012. The catch-up contribution remains at $1,000 for 2013.
• For traditional IRAs, there are a few different scenarios where different income limitations apply. These income limits increased from years prior and need to be looked at in more detail for each specific situation.
• For Roth IRAs, the AGI phase out range is $178k-$188k for married couples filing jointly. For single and heads of households, the phase-out range is $112,000-$127,000.

If you’d like to learn more, you can read the IRS press release here.

With the Bush-era tax cuts set to expire at the end of 2012, many investors are seeking ways to hedge against a potential increase in tax rates for 2013 and beyond. One option that should not be overlooked is the use of Roth conversions.

A Roth conversion allows you to pay tax on the converted IRA assets now, with those assets then growing tax-free for the rest of your life. It is generally preferable to defer taxes for as long as possible, but in a situation where tax rates may increase in the future, it may be worth locking in the taxes at today’s rates. For example, the top tax rate in 2012 is 35%; In 2013, the top tax rate may be as high as 43.4% (39.6% top marginal rate plus the 3.8% “Medicare surtax”). If tax rates don’t increase, you can always undo the conversion by recharacterizing the Roth back to a traditional IRA. As long as a recharacterization is done by the extended due date of the tax return (October 15^th), you’ll just be back to where you started.

It is also important to recognize that a Roth conversion may bump you up into a higher tax bracket in the year of the conversion, depending on the amount converted. In that case, you should consider a partial conversion, where you only convert enough to stay within your current tax bracket. This is where the assistance of a tax professional can be invaluable.

Everyone’s situation is different, and whether a Roth conversion makes sense for you will depend on your particular circumstances and desires. Your financial advisor and CPA can help you weigh the costs and benefits of such a strategy to determine if it is right for you.

The RMD is the amount that Traditional, SEP, SIMPLE IRA owners and qualified plan participants must begin distributing from their retirement accounts in the year in which they reach 70.5.  The RMD must then be distributed each subsequent year.

The standard deadline for taking your RMD is December 31^st.  However, you can use a one time exemption for your first RMD and delay until April 1^st of the following year.  If you choose to utilize this deferral you will have to take both your first and second year distributions that year.

The amount of your RMD is calculated by dividing the year end value of all of your IRAs by your distribution factor.  Your distribution factor can be found using the IRA Uniform Lifetime Tables which are prepared by the IRS.