The Money Class

by Suze Orman

  Now, if you are many years into retirement, you may well be able to pull out more each year. If you manage to wait until your 70s to begin to make withdrawals, you can consider starting with a 5% withdrawal rate. And of course, if you have other reliable income sources such as a bountiful pension, you may indeed be fine with a higher withdrawal rate. But again I would caution you to be careful. I appreciate that with interest rates so low, the yield you can earn on your bond and cash investments has made it hard, if not impossible, to generate enough income to pay your bills. But the answer is not to withdraw big sums from your account. If you eat into that principal too much and you are fortunate enough to enjoy a long life, I am sorry to tell you that you very well may run out of money.

  In the next two lessons I explain how to invest in today’s environment so that you can earn 4% to 5% interest on your retirement money. Can it be done? You bet, but it is not as easy as just walking into a bank or credit union and asking for a CD or leaving your money in a money market fund. To create your New American Dream you are going to have to be involved with your money, to know what to do and what not to do. And believe it or not, we are going back to the future. We just may have to do it the way our grandparents did, years ago.

  HOW TO MAKE TAX-SMART WITHDRAWALS

  When you make withdrawals from your retirement accounts, the tax you owe will be based on the type of account. In these times when you want to maximize every penny of your retirement income, you need to devise a withdrawal strategy that allows you to keep your tax bill as low as possible.

  • Traditional 401(k)s and traditional IRAs are subject to a required minimum distribution (RMD) by April 1 of the year after you turn 70½. The firm that holds your retirement accounts can tell you what your RMD must be, or you can use the online calculator at apps.finra.org/Calcs/1/RMD. (If your spouse is the beneficiary of your accounts and is 10 years younger than you, your RMD will be lower than the amount shown in the calculator. I recommend you consult with your tax advisor.)

  The tax you owe on RMDs is based on your individual income tax rate.

  It is very important to follow the RMD rules; there is a 50% penalty (of the amount that should have been withdrawn) if you fail to make your annual withdrawal. That 50% is in addition to the income tax you owe on all withdrawals.

  RMD Tip: If you have multiple tax-deferred accounts, you do not have to take an RMD from each one. You can calculate the total amount due across all the accounts, but then make your withdrawal from just one account. That can cut down on administrative headaches. It also gives you more control over which assets you want to sell.

  While you must take your annual RMD from your traditional 401(k) and IRA, I recommend you do not take out more than the RMD if you have other money you can access first. It is always smart to leave money that is sheltered from tax growing for as long as possible. If you have other savings you can tap, that is preferable, especially when those other accounts will bring a less painful tax bill.

  • Roth IRAs: Withdrawals of money you contributed to a Roth IRA are always tax-free. To withdraw earnings from your account tax-free you must be at least 59½ or have had the account for at least five years.

  • Regular taxable accounts: Money you withdraw from regular accounts will be taxed only if you have a gain, that is, if you are selling the asset for more than you paid. If you have owned that asset for less than one year, you pay the tax at your ordinary income tax rate. But if you have owned the asset for at least one year it is eligible for the long-term capital gains tax rate. The long-term capital gains rate is either 10% or 15%, depending on your income. Those rates are in effect through 2012. A maximum long-term capital gains tax rate of 15% is a lot better than what you might pay on ordinary income; the top income tax rate is 35%.

  Another important consideration is that any loss you have in a taxable investment can be used to reduce your tax bill. (You cannot claim losses from 401(k) and IRA investments.) You can use any loss to offset any capital gains for a given tax year. If you don’t have any tax gains, you can claim up to $3,000 of your losses as a deduction. If your loss is more than $3,000 you can keep claiming more losses in subsequent years—either to offset gains in those years, or as a deduction.

  Here is how I want you to think strategically about which accounts you withdraw money from to support yourself in retirement:

  1. If you are at least 70½: Fulfill your RMD on traditional IRA and 401(k)s but do not withdraw more than the RMD.

  2. If you are under 70½ or you need more income than is generated by your RMDs: Withdraw money tax-free from a Roth IRA.

  3. If you don’t have a Roth IRA: Withdraw money from taxable accounts.

  4. If you don’t have a taxable account: Make additional withdrawals from your traditional 401(k) and IRA accounts.

  LESSON 4. AVOID LONG-TERM BONDS AND BOND FUNDS

  One of the biggest mistakes I see retirees making today is investing in long-term bonds (and bond funds) because they offer the highest current yields. That is an especially risky move to be making right now. Going forward it is likely we will see interest rates begin to rise and when that happens, the value of long-term bonds will fall. This hasn’t really been an issue for nearly 25 years, as we have been living in an extended period where interest rates have been falling. That cycle is coming to an end, and I fear that an entire generation of retirees is about to get a very costly lesson in how rising interest rates can hurt them.

  Please read the next section carefully. If your retirement dream relies on income from long-term bonds that you are purchasing today, you may in fact be putting your dream at great risk.

  WHAT YOU MUST UNDERSTAND ABOUT BONDS

  The longer the maturity of a bond, the more its price will fall when rates rise. Since 1983 we have been in a long cycle of falling interest rates, and that has been great for long-term bonds. But now we are at the end of that falling-rate cycle. So going forward, it is the long-term bonds with the highest yields that will suffer the biggest price declines. Sure, if you buy a 20-year Treasury bond at 4% and you hold it until maturity you are indeed guaranteed to get 100% of your principal back. But during that 20 years your 4% yield will not budge, and it will be less than what you could earn if you invested in new debt. While you are stuck with your 4% yield, new debt in a rising rate environment could yield 5%, 6%, etc. Now when that happens, you could decide to sell your 4% bond so you could reinvest at the higher rates. But remember, the price you will get when you sell a bond before it matures, and with a below-market yield, will be less than what you paid for it. And here is what is also so very important. When interest rates rise so does inflation. Therefore, as your cost of living goes up, your retirement income should also increase. If you are stuck with 20-year bonds paying only 4% when you could be getting 5% or 6% or more you will not be very happy as you struggle to pay your bills or are frustrated your money isn’t earning more.

  Because we will eventually be seeing interest rates rise, my recommendation is that you invest in bonds with maturities of less than 3 to 5 years. If you own shorter-term issues, when they mature you will have the ability to reinvest at what I expect will be higher rates.

  HOW TO BUILD A BOND LADDER

  A smart way to deal with the prospect of higher interest rates in the future is to construct your bond portfolio so you have some bonds maturing every year or so. This will allow you to reinvest that money in a higher-yielding bond. It’s what is known as bond laddering. I’ll give you an example. Let’s say you have $50,000 to invest. Rather than taking all $50,000 and investing it in a 5-year bond you could divide up the money among different maturities. For example:

  $10,000 in a 1-year bond

  $10,000 in a 2-year bond

  $10,000 in a 3-year bond

  $10,000 in a 4-year bond

  $10,000 in a 5-year bond

  That way every year you have $10,000 that will mature and you can reinvest it in a higher-yielding bond, assuming rates do rise. Even if rates
don’t rise, your laddering strategy gives you more income than if you stuck with super-short maturities, and also protects you from the very real risk of rising rates. Given where we are with historically low rates, the important fact to stay focused on is that at some point rates will indeed rise. Bond laddering is a strategy I want you to keep handy for the future; once we see rates rise, you should think about staggering your maturities in order to have money available every year to reinvest at those potentially higher rates.

  But I have to tell you that bond laddering is not the best move for right now. As I write this in early 2011, we have a very abnormal situation given how Federal Reserve policy is keeping all short-term Treasury issues very low. The yield of a 1-year Treasury bill (the technical term for Treasury bonds with shorter maturities) is 0.29% and the yield on a 5-year Treasury is 2%. At the same time you may be able to earn 1% in a 1-year bank or credit union certificate of deposit.

  It does not make sense to invest in a longer-term security with a lower yield. My recommendation: Rather than ladder your portfolio as long as Treasury yields are so low, stick with a safe and simple bank or credit union CD. (Remember, up to $250,000—and potentially more depending on your mix of different accounts—is 100% safe if it is deposited at a federally insured bank or credit union.) You should be able to earn 1% or more. You can shop for the best deals at Bankrate.com.

  Beware of Long-Term Bond Funds

  I always prefer direct investments in individual bonds rather than investing through a bond mutual fund. There is no set single maturity date with a bond fund because the fund owns dozens or hundreds of different bonds that are being bought and sold. I think that’s a huge disadvantage when interest rates rise—as I expect them to in the near future. At least with a high-quality individual bond you know that if you hold it until it reaches maturity you will be repaid your principal. There is no such guarantee with a bond fund.

  That is one reason why I always recommend that once you leave a job (or turn 59½) that you move money out of a 401(k) and into a rollover IRA. Most 401(k)s only offer bond funds, whereas with an IRA at a discount brokerage you have the flexibility to invest directly in individual bonds.

  And the big lesson here is that bond funds that own long-term issues will be the most vulnerable if interest rates rise. Remember, when rates rise the price of bonds declines. The longer the maturity, the bigger the decline. If you want to have your money in short-term bond funds (maturities of 3 years or less), that’s okay; given the very short maturity, your potential loss will be much less in a rising rate environment. But I have to point out that in early 2011 the yield on a supersafe 1-year bank or credit union CD looks a lot smarter to me. Any money you don’t expect to need for a year or more just might be better off in a bank account.

  BEYOND TREASURY BONDS: OTHER BOND INVESTMENTS

  Investing in Treasury bonds offers important safety: The bond is backed by the full faith and credit of the United States Treasury. No matter what you may think of our current state of affairs, that promise is rock-solid. But there is an obvious trade-off: Typically the interest you can earn on Treasuries is lower than other types of bonds. Here is what you need to know if you want to venture beyond Treasury issues:

  Municipal Bonds

  I have made no secret of the fact that since 2007 I have been in love with municipal bonds. But investing in municipal bonds is indeed tricky today. Not only have bond values already risen sharply, but we now must consider the troubling finances of states and municipalities that could impact their ability to pay their bond interest. I want to stress that to date, muni bond defaults have been extremely rare. But the fiscal straits of many states and cities are very real. That just increases the need to be extra careful and smart in how you invest in municipal bonds.

  Municipal bonds are issued by state and local governments and public agencies to help finance public projects. There is no federal income tax on the interest you earn on a municipal bond. If you live in a state that levies a state income tax, interest from a bond issued by an entity within your state can also be free of state tax. If your retirement income is still high enough that you are in the 35% federal tax bracket, the tax-free yield can be a good advantage. There is of course the risk that if the state or municipality that has issued a bond falls into dire financial shape it could have trouble making all its interest payments. To date this has been extremely rare. Still, I would only recommend you invest in municipal bonds if you have a trusted advisor who specializes in building a well-diversified portfolio of high-quality municipal issues.

  Trusting most of the rating agencies and buying bonds with safe ratings is not good enough today. Nor is buying general obligation bonds in certain states. I myself have switched from buying general obligation bonds to general revenue bonds that are tied to an essential public service, such as water service. I think general revenue bonds for essential services can be a smarter investment in this environment. People tend to keep paying their bills for essential services, so bonds whose own payments are made from that revenue flow are likely to have a steady source of money to keep paying their bond interest. As I write this, the states that currently are in the biggest financial trouble are California, Illinois, New York, New Jersey, and Florida. That is not to say all the other states are healthy, mind you; you have to do your homework here. You have to know what backs the bonds, the condition of the state, and the risk you can afford to take. So if you are going to invest in municipal bonds at this point in time, you really have to know what you are doing. Again, I would encourage you to seek out the help of an expert in municipal bonds and make sure you are thoroughly diversified among various states—and be aware that you might end up owing state taxes on some of those.

  Corporate Bonds

  Please be very careful if you are buying corporate bonds. I recommend sticking with high-quality bonds rated above BBB. And the same maturity rule applies; I don’t think you want to own corporate bonds that mature in more than 5 years. Now, I know many of you may be investing in high-yield corporate bonds, which are also called junk bonds. They definitely pay much higher yields; in early 2011 the average yield for an index of junk bonds was near 8%. I want you to understand, however, that junk bonds are nothing at all like regular bonds. They pay that higher yield because there is a higher risk that the company that issued the debt could run into financial trouble and not be able to honor its payments. Even if that doesn’t come to pass, when the markets are volatile, junk bonds will resemble stocks more than bonds. Consider that in October 2008, as the financial crisis was deepening, an index of junk bonds fell 20%! My recommendation is that if you want to invest in junk bonds, you think of them as part of your stock portfolio, not your bond portfolio, because of the risk factor.

  Okay, I bet you’re getting a little frustrated with me as I tell you not to chase higher yields in the bond market. Stick with me. I actually have a plan that will allow you to earn yields of 3% to 5% or higher without investing in long-term bonds.

  LESSON 5. EARN HIGHER YIELDS BY INVESTING IN DIVIDEND-PAYING ETFS AND STOCKS

  Yes, as I write this in early 2011, I am recommending ETFs and stocks over bonds for generating income to help you meet your living expenses.

  Stocks belong in most every retiree’s portfolio. From a pure planning perspective, if your retirement spans 20 or 30 years, having a small portion of your assets invested in the stock market, with its history of providing inflation-beating gains, makes a lot of sense. And for those of you who intend to leave assets to your heirs, your time horizon is even longer. You need to consider the life span of your beneficiaries—your children and grandchildren.

  There is also a timely reason to consider investing in stocks. As I explained in the prior lesson, it is likely that we will see interest rates rise in the coming years and that will present challenges for bond investors. As tempting as it is to think that bonds are the best place to be right now, that is only using the rearview mirror as your guide. And you must lo
ok at the road ahead. In an economy where interest rates are rising, bond returns will not be as great as they have been over the past 20 years.

  Let’s be clear: I am not telling you to sell all your bonds and invest everything in the market. What I am recommending is that you take time to consider seriously what the proper mix of stocks and bonds would be for you to meet your goals. As a retiree, most of your money absolutely belongs in bonds and cash. Most, but not all. Let’s go back to that very good rule of thumb: Subtract your age from 100. That is how much you might consider investing in stocks. So if you are 75 I am recommending you consider keeping 25% of your investments in stocks. That is just a guideline; if you have lots of other retirement income—pensions, etc.—and you don’t think you need stocks, that’s fine. Or if you want to focus on a longer-term strategy for your heirs and keep 30% in stocks, that’s also fine. You must stand in the truth of what is best for your life, right now and in the years ahead.

  THE CASE FOR DIVIDEND-PAYING ETFS AND STOCKS

  Not all companies pay a dividend, but many do. Dividends are a retiree’s best friend. Actually, they are great for investors of all ages, but they are especially smart for retirees in search of income. To start this lesson I want to review a point I made earlier: As I write this in early 2011, a six-month certificate of deposit (CD) has a yield of less than 1%. In 2008, before the financial crisis, that same CD was yielding 5%. Let’s say you had $250,000 that you kept safe and sound in CDs. Three years ago that portfolio might have generated $12,500 in interest. In late 2010 the same account would be earning just $2,000.

  I mentioned all of that at the start of this class, but I think that is shocking enough that it deserved to be written twice.