Uncommon Cents

While I realize the government is running such a deficit that it needs as many of my tax dollars as I can give it, I don’t agree this is best for me, so a lot of my financial planning has to do with tax efficiency.

This comes down to just a few things:

1) Use all the tax advantages I can. This means 403(b)s (in my case, anyway, since I work for a non-profit), Roth IRAs (I qualify), and flexible spending accounts. If I needed it and I could I’d also use a dependent care account. Anything to reduce the tax sting, which is substantial for someone like me with a marginal tax rate of about 30%. It also means claiming mortgage interest and student loan interest if you’re in those positions.

2) Invest in a tax efficient manner. This means not only to use the 403(b)s and Roth IRAs but to invest outside those accounts in ways that make sense for taxes. Index funds (or, actually, in my case, an index fund exchange traded fund) which spin off little to nothing in capital gains helps. Right now, dividend paying stocks or funds are fine in taxable accounts since they get a preferred rate, but that could change soon. Stocks which pay no dividends are even better in taxable accounts. And hold onto your stocks long enough to avoid short term capital gains.

3) Don’t overpay! Despite all the many, many friends of mine who brag about their tax returns, I don’t believe for a second getting a return is financially wise. In the exchange between yourself and the government regarding your income, someone owes someone, and I’d rather I owe them at the end of the year rather than they owe me. Why? Because someone’s giving the other an interest free loan, and I’d rather get the interest free loan and pay it back in the end than give the interest free loan and get the money back later–sometimes much later. This is why I was kicking myself so much over getting a refund recently because I overpaid on April 15.

These three things are the core of my tax strategy. Do you have any other ideas?

I love dividends. In fact, one of the things I look for when I buy a stock is whether or not it pays a dividend and how much it is in comparison to the stock price (it’s not the only thing, of course, but I like to see a nice dividend). There’s been even more to like about dividends in the last few years since qualified dividends have gotten a better tax rate than ordinary income on the federal level.

Unfortunately, that special treatment is due to expire in 2011. With record deficits going on in Washington it’s quite possible that it won’t be extended and dividend tax rates might be back to regular income levels.

If that’s the case, while I will still own dividend paying stocks, I will restrict them to my tax sheltered accounts (Roth IRA, regular IRA, and 401(k)/403(b), etc.).

I agree taxes are needed, but I won’t pay more than I have to.

After having it on my action list for a few weeks, today I finally got around to looking at the stocks in my Roth IRA. I did some calculations, I reviewed some numbers, and I made up my mind about selling a few positions, adding a few others, and adding on a few shares to some of my existing stocks.

Selling: Bank of America (BAC), AT&T (T), Wells Fargo (WFC) (sadly, I didn’t really want to, but since they cut their dividend it’s not been one of my better performers).

Buying: Verizon (VZ) and Kraft (KFT)

Adding to: DuPont (DD) and Pfizer (PFE)

These are, with the exception of Wells Fargo, all stocks that I buy for the short term, meaning from year to year. After a year I look at them and decide if I still want them and/or if there is something more appealing out there for the same short term period. For instance, if a stock did really well while I had it for that year but it’s not a company I really believe in, I may sell it. That’s the case with Bank of America–I bought in at $7.23 a share; now it’s $16.82 about a year later, so I’ll take my more than 100% profit and go look for something else.

In addition to that, I have new money coming into the Roth, since I just sent off my 2009 contribution of $5,000. That’ll help me add to this portfolio.

I’m hoping a year from now I can say that at least one of my stocks did just as well over that year as BAC has done over this one!

This is a guest post from the National Endowment for Financial Education (NEFE), a non-profit dedicated to improving the financial literacy of all Americans. NEFE operates the site Smart About Money and have developed a series of articles filled with tips to help you make 2010 the year of financial freedom. You can also find Economic Survival Tips, worksheets and articles focused on financial education related to housing, spending, credit and job change. Please look at Smart About Money’s other articles to help to make 2010 a great financial year for yourself, and you can follow NEFE on Twitter at @nefe_org

1.      Control spending: If you spend less you’ll have more money available to pay down debt and save for the future. Write down your expenses for a month to see where your money is going. You might be surprised by how easy it is to find places to scale back.

2.      Create a debt repayment plan: If you carry credit card debt, write down everything you owe and make a plan to pay it off. Start with small items you can act on right away–it will make tackling the bigger debt easier. Also, try buying with cash only. It’s a sure-fire way to prevent increases in your credit card debt.

3.      Set up auto-savings plans: Arrange with your bank or another financial institution to have a set amount deducted from your checking account to a savings account each pay period. Of the Americans who have been able to contribute to emergency savings funds, automatic withdrawal is the most popular method, according to the Consumer Federation of America.

4.      Boost retirement savings: If your employer offers a 401(k) plan, increase your contributions. If you don’t have an employer plan, open an Individual Retirement Account (IRA) and arrange for contributions to be made automatically from your checking or savings account.

5.      Create a long-term plan: Write a list of your long-term goals, such as buying a home or saving for college or retirement. Visit the Life Events section of Smart About Money for concrete tips on accomplishing those goals.

6.      Protect Yourself: Be prepared for the unexpected by making sure you, your family, your assets and investments are insured and fully covered. If you do not have a will, make 2010 the year you establish a life plan.

7.      Find a financial buddy: Share your financial resolutions with a friend, colleague, or family member, and you’ll be more likely to keep them. Find someone else who wants to turn around their debt or cut their spending, and establish a mutual support system.

Welcome to our September 20, 2009 Link Payday! As the seasons change over, in this episode we will once again look at some of the best personal finance blog posts from all over the Internet in the past few weeks:

One of my favorite bloggers and Twitterers, Mrs. Micah discovers there are No More Paper Paychecks at Walmart. As the nation’s largest employer this is a huge step–there are lots of positives and some negatives, and her opinion seems to be this is a move for the best.

A post on Get Rich Slowly asks Should You Buy it? It also gives a flowchart to help people evaluate potential purchases. If you’re someone who likes flowcharts (some days I do, but not all that often), this might help you.

The Online Savings Blog asks Should You Keep Multiple Investment Accounts? It’s an interesting question. I have several, but they’re that way because they have to be–my 403(b) is separate from my Roth IRA is separate from my traditional IRA is separate from my taxable brokerage account–although I guess I could combine that and my Sharebuilder account. But one of their points is that there are some advantages to having multiple accounts. Definitely worth a read.

Beks at Blogging Away Debt discusses Stretching to New Goals. As a guy who is constantly finding new challenges, I’m interested in learning about the goals others are interested in. One of hers right now: learning to swim.

Finally, Lynnae over at Being Frugal shares Lessons From a Little Forced Frugality where she (re)learns what’s really important in light of a check that was bounced to her.

And that’s your September 20, 2009 Link Payday!

I received what I call my yearly “fake raise” this week: I hit the maximum contribution for my 403(b).

It makes me feel better to know I’ve contributed all I can, but it disappoints me that I can’t save more in this tax deferred way. As we’ve covered before, the advantages of regular investing are great, so even though I can’t put more money into my 403(b) for this year, my Roth IRA and regular brokerage account will continue to be filled as the months go on.

While it’s not really best in terms of building wealth, it’s really nice psychologically if in no other way to have more money in my paycheck at the end of the pay period.

How are you doing with your 403(b) or 401(k) or 457 contributions?

A while back I wrote about a DRIP that one of my friends was interested in investing in for her 1 year old baby, presumably for a college fund. I researched the company, looked at performance, discussed different investment vehicles, and gave my opinions.

And in the end I think I failed miserably in assisting my friend.

Not for lack of effort, but for lack of relating.

I understand DRIPs. I understand to a lesser extent Coverdale ESAs and 529s (I certainly don’t understand them as well as I do Roth IRAs, regular brokerage accounts, and 401(k)s). I understand the tax advantages of dividends (the ones that exist right now). I understand diversification, stocks, index funds, and ETFs, all of which were part of that blog post.

What I failed to remember was that my friend doesn’t understand those, at least not the way I do.

I’m going to take another stab at that discussion in a bit. In the meantime, let’s review this statement (and blog post) at the heart of this matter: invest in what you know.

Here it is: the final part of my portfolio (wow, this has taken a long time!). This is another exchange traded fund and it’s an index that follows the S&P 500, but it’s not from Vanguard and it’s not what you might expect: it’s the Rydex ETF Trust S&P 500 Equal Weighted Index (RSP).

Most indices are “weighted”, meaning that even though they own a little of all of the stocks in the index, it owns more of some than others based on market cap. Equal weight indices vary from the weighting system. Sometimes it does better than others; this year it’s not doing better (down 10.31% year to date versus the close to breakeven performance of the S&P 500). It’s held in my Roth IRA so I’m not concerned about taxes at this point; it pays a small 2.07% dividend yield as well. It has a decent but not great 0.4% expense ratio.

I’m not sure how long I’m keeping this fund; it only makes up 0.2% of my total portfolio so I’m not concerned about exposure. However, compared to the index, the costs are higher and the current performance pales badly in comparison. There’s no way I would suggest this fund over a plain and simple index fund, although it could be an adjunct.

And that’s the final part of my portfolio! Thanks for letting me do this series for you!

Here’s a mutual fund in my Roth IRA which is atypical (for me, anyway)–it’s not an index fund, it’s not an ETF, and it’s not from Vanguard. It’s the Dodge & Cox Funds International Stock Fund (DODFX), which is a (surprise) international stock fund that is actively managed.

This fund has been a winner for me in the years I’ve owned it, and this year it’s up 13.07% vs. the 9.99% that the Vanguard Total International Stock Fund (VGTSX) that my much larger holding in the international stock arena has returned this year.

Fortunately, since it’s held in a Roth IRA, I don’t have to worry about the capital gains taxes resulting from the turnover of its active management. It has a decent but not fantastic expense ratio of 0.64% and it pays a yield of 3.45%. It makes up just 0.42% of my total portfolio so there is no chance of overexposure.

While I would always choose the passively managed index over this fund, the Dodge & Cox has done quite well for me and I would not hesitate to buy it again. I’ve held it for a few years and I plan on holding it for quite some time.

Yes, here’s yet another ETF from Vanguard in my Roth IRA (I have a few of these)–the Vanguard Value Exchange Traded Fund (VTV), not to be confused with the Vanguard Index Funds Small Cap Value Exchange Traded Fund (VBR). This is the ETF equivalent of the Vanguard Value Index Fund (VIVAX).

This ETF tracks the index of large cap “value” stocks–value investing being the kind of investing where someone seeks out stocks that are undervalued and buying them. This fund pays a nice 4.19% yield; unfortunately, it is down considerably for the year (16.82%). It has a rather high turnover for an “index” type fund of 27%, meaning that it’s the kind of ETF best held in a tax sheltered account unless you like paying capital gains taxes. This ETF also makes up a miniscule part of my portfolio–far under one percent–so I am definitely in no danger of being overexposed.

If you are interested in following a value index, this is definitely one to consider. While it’s not performed well recently, its low costs (hey, it’s Vanguard) and yield are likely to help it stay in my portfolio for a long, long time.