The Bogleheads' Guide to Retirement Planning (10 page)

Holding international equity funds in a taxable account also has added advantages. There are three benefits to holding international equity funds in taxable accounts:

Vanguard’s FTSE All-World ex-US (Ticker: VFWIX) and Vanguard’s Total International Stock Market (Ticker: VGTSX) funds are two of the best options if you’re going to hold an international stock fund in your taxable account. Both funds hold individual stocks, which qualifies them for the foreign tax credit. The FTSE All-World ex-US includes Canada, while Total International and Tax-Managed International do not. More information is available at
www.bogleheads.org/wiki
.

Investors in higher tax brackets should avoid holding taxable bonds and bond funds in a taxable account. The interest those bonds pay is taxable at your marginal tax rate. Consider holding municipal bond funds in a taxable account if you are in a high marginal tax rate. For investors in lower tax brackets, the after-tax return may be higher by using a taxable bond fund and paying the tax each year. You can determine whether regular taxable bonds or municipal bonds are a better choice for your taxable account by using Vanguard’s Tax Equivalent Yield Calculator at
www.Vanguard.com
.

Low-cost target retirement funds such as those from Vanguard are an excellent way to create an extremely simple portfolio that is well diversified and low cost and that automatically becomes more conservative over time. But if some of your retirement savings are in a tax-advantaged account and some in a taxable account, then target retirement funds may not be the best choice for the taxable account. That’s because all target retirement funds hold bonds, and holding bonds in a taxable account can create an unnecessary tax bill.

Generally, you should hold target retirement funds in a taxable account only if you are in one of the lower tax brackets or are spending (rather than reinvesting) all dividends. Other balanced funds that hold a combination of stocks and bonds have the same problem.

Saving more money than will fit in your tax-advantaged accounts is a classic good problem in that it is a sign that you are serious about saving. Many investors hold all of their retirement savings in tax-advantaged accounts. These investors can often hold the same target retirement fund in different IRAs and 401(k)s, thus putting their investing decisions on autopilot.

If you also have retirement savings in a taxable account, you may need to hold a slightly more complex portfolio than the appropriate target retirement fund. When your retirement savings will be mixed between taxable and tax-advantaged accounts, it is generally best to keep your bonds in your tax-advantaged accounts and your tax-efficient equities in your taxable account. If you can fit all of your bonds and some of your equities in your tax-advantaged accounts, put your international equity funds in your taxable account. If you don’t have enough room in your tax-advantaged accounts for your desired bond allocation, you should first fill your tax-advantaged accounts with as many bonds as will fit. Unless you are in a very low tax bracket, you would then want to hold municipal bonds in your taxable account to fill out your bond allocation.

In the first part of this chapter, we’ve discussed taxable retirement accounts. But even if all of your retirement savings are in tax-advantaged accounts like 401(k)s and IRAs, you will probably still want to have at least one taxable account for holding your emergency fund and for transferring money into and out of your retirement accounts.

If you intend to access your money in less than two years, it is important to invest it only in safe investments where the principal is not at risk, such as high-interest savings accounts, money markets, and certificates of deposit. If you have a two- to five-year time horizon for this money, short-term bond funds might also be suitable, but you may experience small fluctuations in principal. For money needed in five to ten years, investing in intermediate-term bonds should work. Only for longer term investments should you consider holding equities. And the sooner you need the money, the larger the percentage of cash and bonds you should hold.

It’s essential that all investors have access to an emergency fund for dealing with issues like layoffs, a car breakdown, or the need for sudden travel. The main issues to consider when selecting where to keep your emergency fund is safety, liquidity (how easily you can get your money), taxation, and return. Because you may need access at any time, it could be a mistake to hold anything other than cash-equivalent securities as an emergency fund.

The safest place to keep your money is an FDIC-insured bank, as long as you don’t exceed the maximum FDIC-insured amount. These funds are insured by the full faith and credit of the U.S. government. When a bank fails, the FDIC has consistently made funds available the next business day. Unfortunately, most FDIC-insured banks do not pay overly generous interest rates.

Since inflation averages around 3 percent a year, a checking account that pays a lower interest rate loses spending power over time. However, checking and saving accounts are safe and liquid. Although you owe taxes on any interest earned, the returns are relatively low and the tax is normally not very much.

An alternative to the lower rates offered by your local bank is using the Web to find an FDIC-insured bank that is offering higher rates on savings or checking accounts. Many of these accounts can be set up entirely online. The best site for finding these deals is bankdeals.blogspot .com. Unfortunately, most of these offers last for only six months or so and then revert to an uncompetitive rate. Internet savings accounts may make sense only if you are willing to repeatedly move your money around to chase the highest rates.

The second safest place to save your money is a money market fund that invests in high-quality securities. Money market funds invest in high-quality, short-term securities and are designed to provide a higher return than a bank account, while never losing principal. Unfortunately, a major retail money market fund lost money in 2008, which tarnished this fund class for some people.

Vanguard money market funds have never lost money and are managed much more conservatively than the fund that did lose money. Vanguard runs some of the largest money market funds in the industry and is able to take advantage of its economies of scale to offer the lowest expense ratios available to individual investors. This also means that they don’t need to chase yield by taking on riskier investments to compensate for their expense ratio. A money market fund from Vanguard provides safety, although it is not insured by the FDIC. It has excellent liquidity (you can get your money immediately) and has historically offered the highest return for a generally safe asset. You can choose whether to use taxable or tax-exempt funds, based on your situation.

Many Bogleheads use Vanguard money markets to hold their emergency fund. If you are in the 25 percent or lower tax bracket, the Vanguard Prime Money Market is generally the best choice. For those in higher tax brackets, a state-specific fund such Vanguard New York Tax Exempt Money Market or the national tax-exempt fund may provide higher after-tax returns. Given your tax rate, you can figure out which is the better choice by using Vanguard’s Tax Equivalent calculator at
www.vanguard.com
. If the yield of the Prime Money Market is higher than your tax-equivalent yield for the appropriate tax-exempt money market, you are better off using prime. Otherwise, use a tax-exempt fund.

Certificates of deposit (CDs) provide a higher return in exchange for losing access to your money for a set period. CD rates are higher than a checking account, and CDs often offer a higher return than Vanguard money markets, particularly for longer terms. As long as you have less than the maximum amount insured by the FDIC in each bank, CDs are perfectly safe.

Most CDs are not suitable for an emergency fund because you do not have immediate access to the money. An exception could be made for some CDs that allow you to get your money back early for a small fee, such as forgoing three months of interest. If you’re certain that you will not need access to this money for a year or more, a CD can be a good option.

If you need to save more than the FDIC insurance limit in CDs, be careful to hold the CDs in different banks to avoid exceeding the FDIC insurance limit. There are a number of ways that you can title multiple accounts to increase your FDIC coverage, including payable on death (POD) designations. For example, a husband and wife with two children could set up nine differently titled accounts to increase their FDIC insurance coverage to 10 times the standard limit at a single bank. More information on this titling process is available at
http://bankdeals.blogspot.com
. You can determine the level of insurance available on your accounts, based on how they’re organized and titled, directly with the FDIC at
www.fdic.gov/edie
.

Taxable investing is the most straightforward way of holding investments, although often not the best way. You should first take advantage of all of your tax-advantaged options before investing in a taxable account. Tax loss harvesting is a cost-free way of taking advantage of the losses that will inevitably occur in your investments to help lower current taxes. It is important to place your most tax-efficient assets in your taxable account—particularly international equity funds, but also domestic equity and municipal bond funds. Taxable accounts are also typically used to hold emergency funds and nonretirement investments, like savings for a house down payment. Savings accounts, money market funds, and CDs are good savings options that avoid putting your principal at risk. They offer different trade-offs of safety, liquidity, and return.

An individual retirement arrangement (IRA), commonly referred to as Individual Retirement Accounts is one of the best ways an investor can save for retirement. The advantage over a taxable investment account (see Chapter 3) is that the assets in an IRA grow without being taxed each year, leaving more money to compound for your benefit. The advantages over an employer-sponsored retirement savings account (see Chapters 5 and 6) include lower fees and more investment choices.

An IRA allows the individual investor to minimize the two biggest drags on investment returns: taxes and expenses. Jack Bogle has said, “In investing, you get what you don’t pay for. Whatever future returns the stock and bond markets are generous enough to deliver, few investors will succeed in capturing 100 percent of those returns, simply because of the high costs of investing—all those commissions, management fees, investment expenses and taxes.”

IRAs are so attractive that the U.S. government has set maximum limits for annual contributions. As recently as 2001, the contribution limit was a mere $2,000 per person. This limit has been raised in recent years, and if possible, investors should take advantage of the higher limits.

If there was an investment account where you could invest in nearly anything you want, pay no fees or taxes when you change your investments, pay no taxes on the annual returns, and get an up-front tax break on contributions, would you be interested? Of course you would. In fact, you’d probably be wondering what the catch was. There is no catch. Washington wants people to put money away for retirement, and Congress created tax incentives to help. Instead of individual retirement accounts, they could be called tax savings accounts.

Before we get into IRA nitty-gritty, you should understand the difference between an investment account and an investment. An account is nothing more than an empty box for holding your investments. Examples of accounts are trusts, personal, joint, 401(k), traditional IRA, and Roth IRA. Investments are held in an account. Examples of investments include certificates of deposits (CDs), mutual funds, stocks, and bonds. Think of an investment account as a piece of luggage and investments as your clothes. Your clothes go in the luggage.

The luggage might be a backpack, useful for carrying a load through the woods; a nice big rolling suitcase, useful for a week at Aunt Betsy’s; or a small carry-on. They all serve the same function of holding your stuff, but each type of luggage has different advantages and disadvantages. In this chapter, you’ll learn how to better use your luggage to get your stuff safely to your destination and back.