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Published On
November 22, 2022

Joe and Big Al discuss LIRPs, or life insurance retirement plans, they spitball whether to take full pension survivor benefits or buy a life insurance policy, and whether to sell losing stocks for even bigger losers to take advantage of the 0% capital gains tax bracket. Plus, zero coupon municipal bonds and the de minimis rule, and target date funds as part of Paul Merriman’s Two Funds for Life strategy. Finally, how do dividends figure into the 4% rule for retirement withdrawals, and should that 4% come from stocks or bonds?

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Show Notes

  • (00:54) LIRP: Life Insurance Retirement Plan (John, Abilene, TX – voice)
  • (09:13) Full Pension Survivor Benefits or Life Insurance? Retirement Spitball Analysis (Tom, Chicago)
  • (18:26) Should I Sell Losing Stocks and Buy Even Bigger Losers? (Brian, Albany, NY)
  • (25:39) Should We Buy Zero Coupon Municipal Bonds? (Jimmy, Northern California)
  • (33:24) Paul Merriman’s Two Funds for Life and Target Date Funds (Alfred)
  • (39:17) Dividends and the 4% Rule: Where Should Withdrawals Come From? (Daniel, Whittier, CA)

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Transcription

Today on Your Money, Your Wealth® podcast 405 we’ll find out what Joe and Big Al think about LIRPs, or life insurance retirement plans. Plus they’ll spitball whether to take full pension survivor benefits or buy a life insurance policy, whether to sell losing stocks for even bigger losers to take advantage of the 0% capital gains tax bracket. They’ll also discuss zero coupon municipal bonds and the de minimis rule, and target date funds as part of Paul Merriman’s Two Funds for Life strategy. Finally, how do dividends figure into the 4% rule for retirement withdrawals, and should that 4% come from stocks or bonds? I’m producer Andi Last, and with the hosts of Your Money, Your Wealth®, Joe Anderson CFP®, and Big Al Clopine, CPA. Visit YourMoneyYourWealth.com and click Ask Joe and Big Al On Air to send in your money questions as an email or a priority voice message like this one:

LIRP: Life Insurance Retirement Plan (John, Abilene, TX – voice)

“Hey, guys. This is John from Abilene, Texas. I drive a 2021 Nissan Armada. My favorite drink is a margarita with some Mexican food on a Friday night. And my question is, I want to get you-, I want to hear your’all’s thoughts on a LIRP, a life insurance retirement plan. Basically it’s a variable universal life insurance policy most suited for younger high earners that are not eligible to contribute to Roth IRAs. So they put, call it $1000 a month into this life insurance policy. The cash value accumulates and it’s invested. Do that for 10 to 15 years and then let it grow. And then when they become retirement age, 65, 70, whatever the policy is designed, then they can take the distributions tax-free because it’s return of premiums and then you’re taking loans from the gains. So obviously the counter argument is that $1000 a month could just go into a taxable account, but then you’re going to deal with the tax implications later whenever you sell the investments, whereas the LIRP strategy kind of guarantees that it will be tax-free. So I wanted- anxious to hear y’all’s thoughts. Enjoy the podcast. Keep it up. Bye.”

Joe: LIRP.

Al: Yeah, I never heard that acronym, but sounds good.

Joe: Yeah, or crap.

Al: That’s another one. Well, we should say- so this is a permanent life insurance policy that you over fund, and so you got extra money in there that you can invest, it grows over time. And then what happens later on, and this works tax-wise, there’s some issues here, but tax-wise it does work, it does grow. And if you pull the money out at the appropriate time, you can pull the money out tax-free. But there’s a lot of potential issues here, Joe, I think, on this kind of product.

Joe: All right. So we can break this down and get really deep if we wanted to. But if you need life insurance, that’s one thing, right? So life insurance is not an investment. First important, foremost, life insurance should be used for death benefit. So if you have children, if you have a special needs child, if you have a legacy, when you pass, you want cash to go to the next generation tax-free. That’s what life insurance is all about. So then they get creative and say, hey, well, we can build cash value inside these policies. So there’s whole life, universal life and what our buddy John from Texas is talking about, he’s like, well, there’s a variable universal life. So you can buy in mutual fund like investments inside the chassis or a shell of a life insurance contract. And some people might be listening to this and go, why on earth would you want to do that? Because it’s an after-tax contribution. It grows 100% tax-deferred. And then in some cases when you pull the money out, you can have that tax-free treatment just like you said, AL. Because it works as like FIFO tax treatment, first in, first out. So you pull out all your premiums and then whatever is left, you can pull out as a loan. So you’re just taking a loan from yourself, from the gains of whatever your principal performed over the last 10, 15, 20 years. But the problem with that is twofold. One, if you don’t need the life insurance, never do this, ever. It doesn’t make any sense whatsoever, in my humble opinion, and I’ve been doing this 25 years. Is because the cost of insurance- now with Roth IRAs and Roth conversions, it doesn’t hardly make any sense at all because it’s an after-tax contribution that you’re funding a life insurance contract with. I don’t care what your income is, you can do a backdoor Roth. I mean, our listeners love the backdoor. They could do that. If they have any type of retirement account, they could convert that retirement account into a Roth. It has the same tax treatment because the life insurance is after-tax. If you want to take money out of retirement account, pay the tax and put it into a Roth IRA, isn’t that after-tax?

Al: Yeah it is.

Joe: That grows tax-free. So the whole pitch of this was the tax implications. Because once you take the money out of the life insurance contract, it’s tax-free. So you take your principal out or your contributions, and then you take a loan from yourself on the earnings. But if you take too much out, you still have to fund the policy for the rest of your life. And the cost of insurance is going to continue to increase as you get older, especially if you’re taking money out. The whole reason why they have a permanent policy was that, alright, you pay a bunch of premiums and then the premiums will pay for the life insurance as you age. As those premiums get a lot more expensive, you’ve accumulated a lot more cash within the policy, so it kind of evens out the overall premiums. So then now I’m taking money out of it- if it lapsed, so I took too much money out and it doesn’t fund the actual insurance, it lapsed on me, then it’s all ordinary income. So the tax-free component is dead. So you have to look at what is the true cost of insurance versus the taxes you otherwise would have paid on any other type of investment. And in most cases, unless you’re super, super healthy like Big Al that’s a vegan that runs marathons, the cost of insurance is going to be way too expensive. That’s just my two cents.

Al: Yeah, I think, Joe, you’ll also find that it’s rare to find a fiduciary financial adviser that recommends this. Because what happens is, just like you described Joe, later on, if the investments perform, which is a big if right off the bat. Because a lot of times the insurance agents give you an illustration that’s not necessarily realistic based upon the rate of return that they show. But let’s just say you get the rate of return that you’re hoping for and you do pull it out tax-free. That’s great. But let’s say you live a nice long life, you gotta keep the policy in force. Otherwise, all the income that you took out of it, which you thought was tax-free, is now fully taxable at the time the policy lapses. Right? So at the time when you have no money to either fund the insurance policy or pay the tax, it’s all fully taxable. And we’ve seen some pretty big horror stories on this. It’s not something that we would ever recommend. I would never do it myself personally. But Joe, it’s been a pitch for insurance agents for quite some time.

Joe: Decades. Right. Bank on yourself is like another one. You’re putting all this money in a life insurance contract. The super Roth, I’ve heard that.

Al: Private insurance plan, because there’s no limit, you can put whatever you want to in it.

Joe: Right. Why would you want to do a Roth? You can only do $6000 or $7000, but the super Roth, you could put in hundreds of thousands of dollars. And then now you’re confined by the rules of the life insurance contract. With how tax efficient I think that you can go in a non-qualified account. So let’s say you did have $100,000 that you wanted to invest per year. So you have a choice. You could put it into a life insurance contract, or you could put it into a non-qualified portfolio. You could still look at super tax efficient ETFs, and if you tax manage it in volatile markets like tax loss harvesting, tax gain harvesting, things like that, you’re probably going to be a lot better off. We could run the numbers and run a bunch of analysis. But you’re right, what I’ve seen with these policies is very rarely do they work out because they’re sold wrong. But if you’re going to fully fund it, max fund the hell out of it for years, maybe it might work.

Full Pension Survivor Benefits or Life Insurance? Retirement Spitball Analysis (Tom, Chicago)

Joe: We got Tom from Chicago. He goes, “Andi, Joe and Bigger Than Life Al.”

Al: Wow.

Joe: Wow, “Greetings from the frozen tundra of Chicago in winter.”

Al: I was just there at a conference.

Joe: Yeah, ChiTown.

Al: It wasn’t frozen, but it was definitely cooler than San Diego.

Joe: “Been listening with rapt attention since the beginning of the pandemic.” What is rapt attention?

Al: Never heard that word.

Joe: Am I saying that right?

Andi: Yes, it is rapt.

Joe: R A P T Rapt.

Andi: And it means completely fascinated by what one is seeing or hearing.

Al: Rapt, it’s like, couldn’t pull himself away from the podcast.

Joe: I wonder if he- he probably knew that there was no way I would know what that-

Andi: Luckily, it’s a short word. Looks easy to pronounce.

Al: I don’t even know what it means.

Joe: “Still running daily through all the seasons of ChicagoLand, what locals call the Greater Chicago area. And look forward to Wednesday morning so I can catch up on the latest edition of Your Money, Your Wealth®. Sadly, the new episodes don’t drop in time for me to listen to it on Tuesday mornings.”

Al: So you got to wait till the next morning.

Andi: That’s impressive because we drop at 6:00 a.m. Chicago time, so apparently it’s not early enough for Tom.

Al: He’s running at 5:00.

Joe: “My drink of choice is Coke Zero to get me through the day. I’m a married 62 year old dude and hope to retire in the next two years based on market conditions.” I like Tom.

Al: Yeah, me too. 62 year old dude. I bet he was a surfer once, so he’s got that lingo.

Joe: Just like he’s the dude. “When I retire, I’ll have nonCOLA monthly pension of $6000 based on a single life annuity. If I opt to get full Survivor benefits for my smoking hot 60-year-old wife-“ Tom “-I’ll get about $500 a month less in pension payments. It seems like another option would be to take the higher single life pension payment and get some type of life insurance policy for myself that would provide the financial benefits for my wife if I were to pass first. From a cursy look at insurance options-”

Al: Cursory.

Joe: That’s what I said. You weren’t listening. “-it would appear that life insurance would cost less than the reduction in the monthly pension payments. Would you please discuss the pros and cons of this strategy? Or a little spit balling on the topic. Basic breakdown, $1,500,000 in IRAs, $300,000 in brokerage account. I have the pension already mentioned and plan on a healthy Social Security payment starting in 66. Thank you for the fantastic show. And if I could figure out how to give you 5 stars in the Google podcast app, I certainly would. Tom.” That means all the world, Tom, because most people give us one star.

Al: That’d be cool to get a 5 star, right?

Joe: From Tom from Chicago? With the smoking hot wife. You know what I would do, Tom? She’s going to probably re up if you die. Don’t worry about it. She’s smoking hot. She won’t have any issues.

Al: You go for the single life? Or you go for the survivors?

Joe: Well, here’s the math. Let’s do the math for him. We’re financial planners, Al. So you said $6000 is the delta per year.
$6000 is what the difference is in benefits. And so Tom is going to collect at what age? 62 he said?

Al: He says when he retires and that’s in the next two years, so call it 64.

Joe: Okay. So let’s call it 30 years.

Al: Yeah, could be.

Joe: Or more. $200,000 is what he’s leaving on the table. So he’s like, should I buy a life insurance policy? You get a $200,000 policy because it reduces the benefit for $500.
That’s $6000 a year over 30 years, that’s $200,000 that the pension company is taking from him so his wife can continue to have a pension. So he’s trying to say, well, why don’t I take the $6000 a month? Can I buy a life insurance policy that’s going to cover the entire $6000 for 30 years?

Al: For 30 years, sure.

Joe: So if I take a look at $6000 times twelve times 30 is a big number. And at 62 years old, you have to take a look at what is the cost of insurance going to be. And you’re going to need to have a permanent policy. I don’t have any rate sheets up here. But I would imagine the $500 delta or $6000 a year, that seems like a pretty good deal to me.

Al: Yeah, but you got to do the present value of that. So let’s try that.

Joe: What’s $72,000 times 30?

Al: Now I’m going to do present value at 6%. Present value is $87,000. So that’s really your number. That’s the present value of $6000 a year over 30 years. In other words, if your life insurance policy, if it costs less than that, you agree?

Joe: No. No, because he needs $2,000,000, in a sense, because his pension is going to pay him $2,100,000. So he dies tomorrow, he takes a single life.

Al: Oh, I see. Yeah, I got it. You’re talking about if he dies early, so it wouldn’t be 30 years probably. Unless she’s going to live 35 years.

Joe: Well, what I’m saying, if his normal life expectancy, what is that pension worth? Okay. Over that, 30 years. And I guess I could take the present value of that, right? So over 30 years, what’s your discount rate? 3.5%?

Al: I just use 6% investment rate.

Joe: Okay, well, 6% is $376,000. So what would you do, given those numbers? Would you take the pension of single life and buy life insurance? Let’s say you could buy a policy, and how big of a policy would you buy?

Al: Well, you’d need a higher life insurance policy because- well, I guess not. I guess it’s the $400,000 would be your life insurance policy, right. Is that the right way to think about it?

Joe: No, because let’s say if he dies tomorrow, his wife is expecting $6000 a month-

Al: – and getting nothing.

Joe: – and getting nothing, or she’s going to get $200,000 when she should have gotten $2,000,000 over her lifetime.

Al: Yeah, that’s true. So maybe it’s a $2,000,000 policy.

Joe: Probably.

Al: Permanent, which would be pretty expensive.

Joe: Very expensive. It would cost more than $6000 a year is what my point is.

Al: Yeah, I agree with that.

Joe: Unless he’s going to roll the dice and say, you know what, okay, if I can buy a policy for $200 a month, because then I’m not getting $6000 or $5500. I’m getting now, what, $57,000- or $5700 a month, because instead of the $500 that I’m buying a life insurance policy from my company, I’m going to go shop a policy on the secondary market. And if I could get a policy for less than $500 a month, it would behoove me to do that. But then how big of a policy are you going to buy? You don’t know when you’re going to die.

Al: Right. That’s the problem.

Joe: And you need the policy probably permanent.

Al: Well, you do need permanent, but you could potentially reduce the benefit each year to reduce the premiums.

Joe: Or you could gamble and you could say, you know what?

Al: I’m going to do a $1,000,000 policy.

Joe: I’m going to do $1,000,000 policy for 20 years. And hopefully I die before the 20 years, and if I make it past the 20 years- because the insurance premiums are going to be too expensive.

Al: I know at that point.

Joe: But that’s how he has to look at it. He looks at, can I buy a life insurance policy that’s going to cover the need for my hot wife when I die that’s going to be less than what I’m paying my company to give me a survivor benefit of $5500.

Al: Yeah, okay. I agree. That’s right. What would I do? I would take the survivor benefit. I don’t even care what the math is. I think that’s easier. It’s a sure thing.

Joe: Yeah. $500. Yeah.

Al: That’s what I would do. I would do the same.

Financial decisions like these impact your entire retirement future – they deserve more than a spitball analysis on YMYW. The best plan for you and your family is highly individualized – it depends on your current circumstances, your risk tolerance, and your goals for retirement. If you don’t have a financial plan, get one. Click the link in the description of today’s episode in your favorite podcast app to go to the show notes, then click Free Financial Assessment to schedule a no cost, no obligation, one on one, personalized deep dive into your entire financial situation with an experienced professional on Joe and Big Al’s team at Pure Financial Advisors. Do it soon, because the end of the year is coming up fast and the calendar is getting full. Pure is a fee only fiduciary financial planning firm, which means they’re not going to sell you any investments of any kind, and they’re required by law to act in the clients’ best interes. Click that link in your favorite podcast app, go to the show notes, then schedule your Free Financial Assessment now.

Should I Sell Losing Stocks and Buy Even Bigger Losers? (Brian, Albany, NY)

Joe: Brian from Albany, New York writes in “Hey Andi, Big Al, Joe. Due to recent retirement, is it to my advantage to take some capital gains this year to take advantage of the 0% tax bracket? I also wanted to get out of some managed funds and do index funds. I like to sell mid cap growth fund, it’s down 30%. Maybe a large cap growth fund, it’s down 37%. And then reinvest those money in a total US stock market fund. I’ve been holding off as the growth funds were down much more than the total stock market fund, and I expected that gap to narrow as the market improves. As we get near year-end however, I’ll need to make a move. I’m thinking about selling-“

Andi: the mid cap growth-

Joe: “-the mid cap fund and buying-“

Andi: the large cap growth-

Joe: “- as it seems to be a bargain right now. I can eventually sell that too to buy the total US stock market fund when the market has settled down, hopefully in a year or two. I know this is a bit of a market timing question, but I think it may be an opportunity to sell the winners and buy the losers. I suspect–

Andi: the large cap growth-

Joe: “-large cap growth will stabilize in time. His major holdings are big tech companies, Apple, Microsoft, Amazon, Tesla, et cetera. Appreciate your spitball. You guys are the best.” All right, Brian, so he wants to sell, mid cap is down 30%. Large cap growth is down 37%. So those are losers. And he’s like, you know what, I want to buy the total US stock market fund. It’s down 21%. So they’re all down. But he wants to sell the mid cap that’s down 30% and buy a little bit more of the large cap growth that’s down 40%. So he’s selling his losers to buy losers-

Andi: – to buy bigger losers.

Al: Yeah, right, bigger losers under the theory that the bigger loser has more room to recover. Right? So it’s a fine idea. The market doesn’t always work that way though, right? Especially when you think about like large company stocks, which Joe, has had such a good run for the last 10 years, who’s to say it’s going to come roaring back to how it was? Maybe it’s already done its thing. On the other hand, maybe it will. But see, that’s- you just don’t know that. We will know in a year or two or 5 what the right strategy is. But that’s why we recommend staying globally diversified. And don’t try to pick which ones you think are going to do better because I would say more often than not, you make the wrong choice.

Joe: So if this is a tax strategy, Brian, so let’s say he’s down 30% of one mutual fund, you could sell that and just buy something similar, it can’t be identical because you got the wash sale rule there. You could buy the total US stock market fund and take the losses, or you could buy something similar as well. So depending on what you’re trying to do, I like where his head’s at. He’s like, okay, well, I have some losses here, I could sell them. But he’s all in Vanguard, so the fees are cheap. He’s got some managed funds at Vanguard, like Wellington and I forget the others that they have, but they’re still decent funds. They’re really low cost, not diversified. So is he looking to sell some of these managed funds to get more into index funds? And is that to save money in fees and costs? He doesn’t believe in the managers or doesn’t believe in active management? Then if that’s your belief, they’re always going to trail, right? They’re always going to lag the overall index. So get out of the managed funds right now, sell them and buy the index fund. So if you have these managed funds that are down 31%, sell those managed funds and buy the index funds in the same asset class.

Al: I do like that. I guess one caveat, we don’t know how long he’s owned these. Like if he owned it for 5 years, there might be a 200% gain, right? And so now there’s down 37%, it’s still a huge gain. So maybe there’s a big tax consequence. Because originally, I think the first thing you talked about was taking advantage of the 0% tax bracket. So I think there’s probably some gains in here. So you just have to be careful. We don’t know enough about Brian’s overall portfolio or situation to have any kind of analysis on what’s appropriate. But I would say if you’re trying to save fees, go from managed funds to index funds. I like that, as long as it’s not too much of a tax consequence to get there.

Joe: I guess you sell up to the 0% tax bracket, which is- for single taxpayers, if you’re in the 10% or 12% tax bracket, your capital gains is tax-free up to that bracket. And if you’re married, it’s the 10% or 12% bracket. So if you’re married, I believe it’s what, let’s call it $80,000 and you’re single, it’s $40,000. I know it’s a little bit more than that.

Al: A little bit more, but that’s good. It’s $41,000 and- $41,500 and $83,000-ish.

Joe: So at $80,000 single- I mean, $80,000 married, I’m not sure if Brian’s single or married, but let’s say Brian’s taxable income is $40,000 as a married man, he’s got $40,000 of room in the 12% tax bracket because the top of the 12% tax bracket is roughly $80,000. So he could sell $40,000 of gain in mutual funds, stocks, bonds, whatever, and pay zero tax on that. So he’s looking, now I have gains here. Which one should I sell? Should I sell the ones even though I have gains? They’re getting murdered this year, and I want to get out of these managed funds. And so the first step of the exercise is to look at how much room that you have in that 0% tax bracket. And then I would go to your highest fee managed fund and sell that and go into the same asset class index fund or the total US. Stock market fund.

Al: Yeah, that makes sense to me. And by the way, so if you find out you got $40,000 in that 12% bracket and you’re trying to have $40,000 of capital gain, if you do $50,000, it’s okay. The first $40,000 would be tax-free. The last $10,000, you’ll pay the 15% capital gains tax. I just realized that’s how that works, because Joe, sometimes we get the question, I’m in the 12% bracket. So that means I can sell a $1,000,000 of gain and have it be tax-free. No, it’s just up to the $80,000 figure.

Should We Buy Zero Coupon Municipal Bonds? (Jimmy, Northern California)

Joe: “Hey, Joe, Big Al, and Andi. This is Jimmy from North California. Northern California.”

Al: Northern, yeah. Usually you say Northern, but you could say north if you want.

Joe: Okay, thank you. “Such a great show. I’m a long time listener and have really learned a lot from you guys over the years. I have a few municipal bond questions. My wife and are both 56 and are planning to retire in 10 years. We file joint returns and are currently in the 32% tax bracket and 9.3% California tax rate.” OK, now you ready for some municipal bond action?

Al: Okay, I guess so.

Joe: Okay, he’s got 3 questions. They’re quite lengthy. “Number one, given we don’t have the need for current income, we are thinking about buying zero coupon bonds so that the interest can accrue and we collect the full amount only at maturity. Timed used a 10-year bond ladder, so 1/10 of them mature each year with the first rung to mature when we are age 65.
However, I’m concerned about the de minimis rules on deeply discounted Muni bonds. Does that rule apply to zero coupon Muni bonds? And if so, how do you calculate it for the zero coupon bond? Is that a rule? Good reason for individual investors to totally ignore bonds that are penalized under this rule.” All right, so he’s talking zero coupon de minimis-

Al: Yeah. So first of all, let me explain what the de minimis rule is. And that’s if you buy a bond at a discount, and if it’s too big of a discount, by the time it matures, you’re going to have an ordinary income part, for the discount-

Joe: Discount?

Al:- the deeper discount. And if it’s below a certain threshold, it’s a capital gain. So that’s what this is. And the threshold is a .25% times the number of years the bond is. Like, for example, let’s say you’ve got a 10-year bond, times .25 is 2.5%. So in other words, if the bond discount was less than 2.5%, then you’ve got a capital gain when either you sell, or it gets redeemed. Otherwise, if it’s more than that, even if it’s a dollar more than that, the whole thing is ordinary income at the time of redemption.

Joe: So let’s talk about discount for a second, because I think a lot of people, including myself, are a little confused. So let’s say a bond is issued at par, right? So $1000. And so they issue it at par, $1000. I pay $1000. Now, I lent my money to the organization. In return, I’m going to receive an interest rate, let’s just say 5%. So I’m receiving $5 of interest on that $1000 loan. In a zero coupon bond, what Jimmy wants to do, is he doesn’t want to get that 5% per year. He wants to say, you know what, just pay me at the end because I don’t need the income now. But I’m going to buy the bond and when it matures, I’m going to accrue all of the interest. And because of the way that bond is structured, I’m guessing there’s a deeper discount on the zero coupon bond in the municipal bond market. So he’s wondering, what is it going to pay out? Because I’m buying it at such a deep discount. So I’m not buying it at $1000, I’m buying it at $700. And it’s still going to pay me that 5% interest, but I’m going to get the $300 plus the 5% interest when it matures in 10 years from now.

Al: Yeah, that’s accurate. Well, first of all, 5% of $1000 is $50.

Joe: I’m sorry.

Al: So you said $5. So just for our listeners, $50 is your income.

Joe: Thank you.

Al: But if you buy it when it’s issued, there’s no problem. It’s a par. It’s only when you buy it in the secondary market, it could be, it could be a discount or there could be a premium, depending upon if the interest rate’s gone up or gone down.
And it hasn’t been much of a problem lately because interest rates have been going down. But when interest rates go up now, it’s like, I got a discount my bond, because the interest rate is too low compared to what you could get in the primary market. So you got to discount the bond to do it. So we’re going to see more of this. Now, zero coupon bonds are different animals, just like you described. You basically just buy a $10,000 bond for $5000 or whatever it is, and at the end of the term, you get the full $10,000 back. So the nice thing about a Muni bond, Muni zero coupon bond, is it’s not taxable, because it’s tax-free. So these rules, the de minimis rule, doesn’t really apply-

Joe: -to the interest.

Al: – to the interest part, which is all of it. Unless you buy it in the secondary market, then there might be a little bit of that, and then you’ve got to determine, is there a premium or discount? If there’s a discount, you might run into this rule.
But I think by and large, Jimmy, it’s not that big of a deal. Because even if there’s a little bit, in other words, it’s not the entire discount that is subject to this rule. It’s just that what you paid for it in secondary market versus kind of what the real-

Joe: – what the par would be.

Al: – what the par would be better way to say it.

Joe: So the discount part of it is going to be subject to ordinary income or capital gains. The interest is still tax-free. So if you buy like a municipal bond mutual fund. And you buy that mutual fund at $100,000 and it’s worth $150,000 and you never sold it, but you received tax-free income from it, and you decide to sell the mutual fund, you’re still going to have a capital gain on the $50,000 of gain.

Al: Yeah. Well, that’s right. I think a lot of people don’t realize that Muni bonds are always tax-free. Well, not necessarily. If you buy it at one price and sell it for a greater price or lower price, there’s a capital gain or capital loss, which actually could be even ordinary if you don’t meet the de minimis rule.

Joe: Did we answer two and 3 during this little conversation? I didn’t read any of the stuff.

Al: No, I don’t think so.

Joe: Okay, let’s go. “We do not plan on collecting Social Security until age 70. Our annual expenses is $100,000 a year. Therefore, we expect once we retire in 10 years, our annual portfolio withdrawal will be about $120,000 a year, pretax. Currently 40% of our portfolio is Roth, 30% is a brokerage account, 30% is 401(k). So the pre age 70 distribution can be managed quite tax efficiently. Given our post retirement tax rates could be very low, would zero coupon Muni bonds that mature in 10 years still be a good idea? A related question- if we do buy Muni bonds that are subject to de minimis rules, is that ordinary tax stream and apply each year we hold the bond or only at maturity? If it’s the latter, and we plan to hold the Muni bonds until maturity when our tax rates are low, should we even care about this?”

Al: All right, to minimize rule is only when you sell or you redeem, so you don’t have to worry about it ongoing.

Joe: And then if the tax rates are pretty low-

Al: Doesn’t matter.

Joe: Don’t matter.

Al: In fact, if he buys it on issuance and holds it to redemption, there’s no gain, right? Except for if you bought at a discount. But you wouldn’t have that if you buy an original issue.

Joe: I’m sure he’s buying on the market.

Al: I would think so.

Joe: “Given we are planning to stay in California after retirement, we should only focus on California municipal bonds.” Well yeah, if you want the state tax-free. The federal- you could buy a municipal bond in Texas. You’re going to get federal tax-free, but you’re going to have to pay the franchise tax board.

Al: Correct.

Joe: All right, we answered all of Jimmy’s questions on de minimis. Hopefully that was not as de minimis as it sounded.

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Paul Merriman’s Two Funds for Life and Target Date Funds (Alfred)

Joe: Let’s go back to the questions. Here he goes. “Hi. Would you be able to break down the two Fund for Life approaches, the specific allocations of small cap international and target date funds? Thanks, Alfred.” Alfred. All right. So this is our buddy Paul Merriman.

Al: Yeah, we’ve had him on the show before.

Andi: Alfred is actually asking about the 3 two Funds for Life approaches. So there’s different versions?

Al: Yeah, there’s 3 different versions. Three different- well, there’s a small cap, there’s the international, and there’s a target date, and I think those are the 3.

Andi: All right.

Joe: The two Funds for Life approach of my limited understanding of this, a lot of this stuff is just marketing, you know what I mean? So Paul Merriman, God bless him, he’s one of the best. He’s been on the show many times, and he does so much for the industry in regards to education. But he’s a big fan of the target date fund. I’m not a big fan of the target date fund. Did we have, like, a kind of a conversation about that, Andi?

Andi: Episode 209 with Paul Merriman talked about the two Funds for Life episode. Yeah.

Joe: On our show.

Andi: On our show, yeah.

Al: There ya go.

Joe: Oh wow, you knew just right off the cuff there.

Al: Okay.

Andi: I do my show prep.

Joe: Got it.

Al: Okay, so if we do a poor answer, just go to show 209, you’ll get the real skinny.

Andi: There ya go.

Joe: I disagree with the target date funds. For people that don’t know what a target date fund is, I think it’s a fund that will go certain amount of stocks, certain amount of bonds as you age. So let’s say you want to retire in 2060. So you pick a target date of 2060. It’s going to have more stocks and bonds, and as you get closer to that 2060 date, there’s a glide path that will change from stocks to bonds. So it’s managing the risk for you. But then he’s got a little kicker on it. If you have a target date fund, you don’t add any other funds. That’s the whole purpose of a target date fund.

Al: It’s already doing it.

Joe: Exactly.

Al: Yeah. The idea is you’re more aggressive when you’re younger. So the fund, you pick your target date of retirement, 2030, 2050. Right. Let’s just say you were young, you picked 2050. Cool. So then it’s going to be pretty much equities for a long time. And then as it gets closer to 2050, they’re going to sell some of your equities or stock funds- I should say- mutual funds, ETFs, whatever. And they’re going to buy more bond funds that are safer because now you’re getting to the point where you’re going to need to withdraw the funds. And you don’t necessarily want to withdraw funds from an all stock portfolio when the market is down. It’s hard to recover that way, so that’s why they do that. So I agree with you, Joe. It’s like if you have a target date fund, isn’t that enough?

Joe: Your whole portfolio should be the target date.

Al: Yes. Or maybe, I don’t know, maybe some target date funds are solely international, some are solely domestic. You might want to have two in that case, right? To kind of have a balance.

Joe: I don’t think so. I don’t think they have those. I don’t think so.

Al: Well, we don’t know, so we’re just guessing.

Joe: But what Paul Merriman is stating is that you add a booster to this thing, give a little steroid to the fund if you will.

Al: Got it. A little boost. Vitamin boost.

Joe: Yeah, a little boost, maybe a little Celsius. You ever had Celsius?

Andi: Give it the shakes.

Al: Is that what you’re on now? Celsius?

Joe: No. I can’t drink that stuff anymore. I’m off.

Al: Oh, you can’t. You outgrew it.

Joe: Man that stuff gives me some crazy heart-

Al: I hear ya. I’ll pass on that myself.

Joe: So it’s a decent strategy. Paul Merriman likes small cap value, and it’s like, all right, well, that’s the highest performing asset class because it’s the most volatile. It’s going to give you the highest expected return. So you can kind of have a buffer here with your target date fund just to get it some added juice, if you will, to get a little bit higher expected rate of return in the overall strategy. I’m totally fine with that from an accumulation standpoint, you know what I mean? But once you’re retired, I don’t think that strategy works at all because now you’ve got to create income from the portfolio. How are you going to sell? What are you going to do? Because it’s pro rata in the target date fund. Let’s say it’s now 80% bonds and 20% stocks, or 70/30 and the market’s down. And you’re selling shares of that mutual fund. It’s going to be pro rata from the fund. So you’re selling stocks and bonds. I don’t know if I want to do that.

Al: Yeah, when you should be selling bonds in that particular case. Or when the stock market is zooming, you might want to take some profits off the table and sell some of your stocks. And that doesn’t happen in a target plan.

Joe: No. So I like the strategy. If you want super simple, this is going to give you a higher expected return than a standard target date fund because there’s more risk. But from a distribution strategy, if I’m looking to take income, I’m not a huge fan. Not a huge fan. Alright. Thank you, Alfred, for that.

Dividends and the 4% Rule: Where Should Withdrawals Come From? (Daniel, Whittier, CA

Joe: Daniel from Whittier, California. “Hey, guys, thanks for the great show. A long time listener. I enjoy Joe’s jokes and Big Al’s wisdom.” Joe’s jokes.

Al: You got jokes. You’re the funny man.

Joe: You’re the straight guy.

Al: I’m the wisdom guy.

Joe: “I won’t bore you with cars or drinks. Whoa, whoa, whoa..

Al: That’s the only part Joe likes.

Joe: I know. You’re boring me with all your financial garbage.

Andi: That means he probably drinks water or soda.

Joe: Yeah, I want to enjoy just visualizing what these people look like, what they like to drive, what they like to drink, feel like they’re right there with us, Al.

Al: Right. Well, and by the way, this happened, this phenomena happened on this show because people would say I listen to you in the car. And Joe would say, well, what kind of car do you drive? Or I listen to you while I’m walking my dog. What’s your dog? What’s your name? I listen to you during happy hour. Okay. What are you drinking? That’s why these questions came about. Just if you’re wondering what the genesis of this is.

Joe: Yeah, it’s been awhile.

Al: Because you said I need to be able to picture you, where you’re at.

Joe: Right. Because you want to be in the moment. We take pride in this. It’s not like just off the shelf advice. There’s zero advice here.

Al: There’s no shelf that can take what we talk about.

Joe: I won’t bore you with cars or drinks. I bet when Daniel listens to this, he’s like-

Al: He turns the volume down.

Joe: I don’t really care about what they drive. Ford Bronco. Jack on the rocks.

Al: Coors Lite.

Joe: “Here’s my financial info.” Okay, here’s for the really exciting stuff. “67 years old and still working, but I’m on my last year.” All right, congrats. “I have traditional IRA plus company stocks totaling $825,000. I receive $36,000 from Social Security. I still have a mortgage, which is my only debt. My questions are about the 4% rule in retirement. Not sure if I’ll do this strategy, but have a few questions. I know it’s based on a 60/40 split of stocks and bonds. My question is, how do dividends figure into the equation? Are dividends reinvested, then pulled out for the 4%? Or are dividends removed, paid, and the 4% pulled from only the principal? I really like dividend stocks. You currently get about $25,000 per year, which are reinvested. Last question. When pulling out the 4%, where does it come from? Stocks, bonds, mix of both? And I’ll assume after the 4% is removed, the portfolio should be rebalanced. Hope all this makes sense, and thanks for all the informative shows.” Okay. You wanna-

Al: Sure, I’ll go for it.

Joe: You wanna take a little stab at that?

Al: First of all, Danny, the 4% rule is, I would say more of a guideline.

Joe: Rule of thumb.

Al: This is not gospel.

Joe: Yes. Not even close. Not a strategy.

Al: It came from an analysis done by- what was his name?

Joe: Bill Bengen.

Al: Bill Bengen here in San Diego area. So he did all this research to show that if you only take 4% out of your portfolio at age 65, there’s a high likelihood it will last you till 90. So, in other words, 25 years with a 60/40 portfolio. But that’s just a guideline. But if you want to use that rule, the way I would think about it is even if you take the dividends that’s part of your 4%. If you reinvest them, you take out 4%. If you’re receiving them, then just subtract that from your 4%.
Because we think of this in terms of total return, whether you have high dividends or low dividends, it doesn’t make much difference to us. So I would subtract them from the 4%. Secondly, where do you take the money from? Well, you kind of answered your own question. You take it whatever is out of balance. Instead of taking it 50/50 or 60/40 or whatever, and then doing a rebalance, if your stocks are overweight, to take it from your stocks. If your bonds are overweight, to take it from your bonds. If they’re both equal, then take 60% from stocks, 40% from bonds, and then you don’t have to rebalance.

Joe: Here’s how I would want you to use the 4% rule, is first you don’t want to take out any more than 4%. So I don’t care if it comes from dividends. I don’t care if it comes from interest. I don’t care- whatever that you have. You just kind of take a look at that and say, hey, if I’m getting whatever, what did he say, $25,000 in let’s say dividends. Well, $25,000 into $825,000 is roughly 3%.

Al: Yeah. So you can take one more percent out.

Joe: You can take one more percent out.

Al: That’s how we think about it.

Joe: I don’t care where it comes from. You just don’t want to pull out any more than that. If you do, you’re in jeopardy of running out of money. But let’s say you don’t need the full 4%. You’re not going to pull 4%. If you only need $10,000 of income, pull $10,000. If you need $50,000 of income, that’s going to tell you I’m picking up more than I probably should because I only have $825,000. So use that as a guideline to see what is the stress test of your portfolio. I think where you want to look at- if you like dividend paying stocks and saying, hey, I like these dividends, we’ll keep your dividend paying stocks. And then just find another distribution program or strategy to take out whatever additional that you need, no more than 1%. But I think more importantly, what Daniel has to look at is a lot more than this. Is like, how much money does he need to accumulate over the next year? He’s got $36,000 of Social Security. How much does he need from the overall portfolio? And then where is he going to be pulling it from, from a tax perspective. So is it all in a retirement account? Is he going to pull it from a Roth account? Is he going to pull it from his brokerage account? I think that is your second step of this, because it all depends on what your tax bracket is. Because I think doesn’t he have a little mixture of- no, he says he’s-

Al: Well, he’s got $36,000 from Social Security. He didn’t really say if he has pension or not.

Joe: He doesn’t tell us how much money that he needs. He’s 67, but he’s got a traditional IRA, some stocks, it’s $825,000. So if it’s all in an IRA, okay, just know that you’re all taxed at ordinary income rates. So do you have Roth money? Do you have brokerage money? So that is, I think, a bigger strategy of what you want to start penciling out. Stop picking investments that sound good today, given a dividend. Right? Because that could get you into trouble. Like, we had a guy last week was, oh, I’m in these BDCs and they’re paying me like 14%.

Al: Right. For how long?

Joe: It’s gonna be great.

Al: So here’s one other quick thought, and that is the 4%, as we said, it’s just a guideline. If you’re retiring 60 instead of 65, now you got, say, 30 years at least. So maybe it’s 3% or 3.5%. If you retire at 70, maybe it’s 5%. So these are just guidelines, depending upon how much time you have left based upon a 60/40 portfolio.

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