Show Notes

• (00:58) The Megatron: Mega Backdoor Roth IRA vs. Roth 401(k) (Jim, NJ)
• (14:42) 5-Year Rule on Roth Conversions: How Does January First Default Start Date Apply? (Nancy, WI)
• (19:43) 5-Year Rule on Roth Conversions vs. Tax-Efficient Investments, Bond Funds Vs. Bonds Vs. CDs (Johnny Mercer, Savannah, GA)
• (32:42) What’s the Best Strategy for Incorporating Bonds into Our Retirement Portfolio? (Brad, St. Louis)
• (40:09) The Derails

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Transcription

Andi: Joe and Big Al spitball on the mega backdoor Roth, the 5 year rules for Roth conversions, and investing in bonds, today on Your Money, Your Wealth® podcast 451. Should Jim in New Jersey do the YMYW-infamous Megatron (the Mega Backdoor Roth IRA) or use his Roth 401(k) – and how can he keep bonds out of his Roth accounts? The fellas discuss the January first start date when it comes to the 5-year rule on Roth conversions for Nancy in Wisconsin, and they spitball on those Roth clocks and tax-efficient investments for Johnny Mercer in Savannah, GA, who also wants to know the pros and cons of bonds vs. bond funds vs. CDs. Should Brad in St. Louis incorporate bonds into his investment portfolio, given the fact that he will have pensions and Social Security providing 5 streams of fixed income in retirement? I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA.

The Megatron: Mega Backdoor Roth IRA vs. Roth 401(k) (Jim, NJ)

Joe: Got Jim from New Jersey. “Hey, Joe, Big Al, Andi. Longtime listener, first time spitball requester. Now to the important stuff. I drive a 2017 Jeep Grand Cherokee. Enjoy a little bourbon Old-Fashioned.

Al: There you go. Your Old Fashioned.

Joe: Everyone loves these Old Fashioned drinks.

Al: Apparently so.

Joe: “No pets. Too much of a clean freak. Apologies in advance. I actually don’t need an elaborate spitball here. But have a mega garage back door technical question that I have never heard addressed or found reliable in all of my searching.”

Al: Oh, here we go.

Joe: Pressure’s on.

Al: Does Jim think we’re gonna be reliable?

Joe: I don’t know.

Al: This is 50/50.

Joe: Well, we are pretty good at the old Megatron.

Al: Yeah, that’s true.

Joe: Beef brief

Andi: Beef demographics.

Joe: We’ve got some demographics that are a little beefy over here.

Al: That’s good. I like that better than brief. Beef demographics.

Joe: Yeah, we got some beef ones. Beefy here. “If I’m married in my early fifties, we’re five years from retirement in the hyper accumulation phase.

Al: Oh, look at you. The big word. The word we joke about

Joe: I bet Jim was trying to

Al: You know what? Because it’s two words, you know how to pronounce it.

Andi: And there’s not a minus sign between them.

Joe: There’s not a minus sign anywhere. Okay, “we got via Roth contributions up to allowable limits plus,

Al: yeah a plus is usually a plus. It doesn’t mean anything else.

Joe: We got a plus, we got a minus, “HSA contributions after tax accumulation from vesting RSUs specific to Roth contributions, which I achieved via my company 401(k). I’ve been taking full advantage of the Megatron for several years up to the limits. Topping up at $7,300 this year, including an employer match. While I know most answers to 401(k) questions end up referring me back to the plan doc, I’ve already read it intensively. Extensively.

Al: Both are good words.

Joe: Thank you.

Al: I would have said intensively and extensively.

Joe: You just get a little added boost there.

Al: And I liked it so much, I read it again.

Joe: Who reads the plan?

Al: This time only extensively.

Joe: Oh Jim, you gotta find some hobbies there. Okay.

Al: Have you read our plan document in 401(k)?

Joe: No, I have not.

Al: Me neither.

Joe: No, I have not. All right. So here’s the details. My 401(k) plan allows the Megatron. So for those of you taking the score here, that means you can place after-tax dollars into the 401(k) plan. If you’re over 50, the maximum allowable defined contribution is $73,500. Some of that is pre-tax. Some of that could be Roth. The additional, after the 401(k) limits is going to be an after-tax component that you can put in. You don’t pay tax on it. It would either sit in a plan, After tax, so you never pay tax on those contributions again, or you could convert those dollars into Roths and have everything grow 100% tax-free.

Al: Yeah, better yet because the growth will be tax-free. And so that’s like a giant Roth contribution for those keeping score.

Andi: And if you take this to any other financial planner and say, I want to do a Megatron, they’re not going to understand unless they listen to YMYW. It’s like a mega backdoor Roth.

Al: Oh, did we make that up?

Joe: The Megatron?

Andi: That basically came from this show. Yeah. It was actually Marcus in Tennessee/Alabama that came up with that one, and we’ve been using it ever since.

Al: Maybe it’s going to catch on.

Andi: I think so.

Joe: All right. Okay. “Additionally, any combinations of pre-tax Roth and after-tax contributions are eligible for employee match. My current band in the 401(k) plan is made up of about a half pre-tax, from the employer match and half Roth, from his contributions. I typically jam in the after-tax contributions up to the limit toward the end of the year to ensure Congress doesn’t pull the plug on the beloved Megatron, or to limit earnings that also come out, and then I pull it out in December and transfer it to my Roth IRA.

Al: Okay, good.

Joe: One other important detail behind my question. My 401(k) plan only allows investment choices to be made uniformly across tax buckets. In other words, I cannot allocate my Roth dollars to one fund and pre-tax dollars to another fund. Fund allocations apply across buckets. While I’m heavily weighted into stocks, I do have some allocations to bonds given my proximity to retirement and also have a small allocation of my company stock with a low basis to take advantage of NUA.
Is this guy an advisor?

Al: I think so.

Joe: NUA folks is Net Unrealized Appreciation. That means that you can take company stock out of your 401(k) plan, you pay ordinary income tax only on the basis. And then you could sell the stock at a capital gains rate. So it’s another kind of cool tax little trick if you do have your own company stock inside your 401(k) plan.

Al: You have to be 59 ½ or terminated from service or separated from service. Something like that.

Joe: All right. Given the 401(k) plan construction. Do you ever talk about 401(k) plan construction?

Al: All the time.

Joe: What’s in a 401(k) plan construction? Well, let me tell you, I read my plan extensively.

Al: I was thinking of doing a different construction. Here’s what I’m thinking.

Joe: I hate continuing to add Roth dollars in the plan that are then partially allocated to bonds and company stock, as I believe any Roth dollars for my situation should be in 100% equities as it is for my Roth IRA. That brings me to my question.

Al: All right.

Joe: This is good.

Al: Are you on the edge of your seat?

Joe: Yes. I had an idea. This reminds me of a question of the guy that asked if he should take Social Security right away and he’s worth like $400 million.

Al: That’s right. What was that last week or the week before?

Andi: Yes

Joe: I had an idea to begin next year foregoing my annual 401(k) contributions, which currently goes 100% Roth. Instead, replacing those dollars with after-tax contributions. Still maxing out the total allowable limit. Since I get the employer match on any contributions, including after-tax contributions, I see no difference between directing these dollars into a Roth 401(k) contribution versus directing them to a Roth IRA via the Megatron. The clear advantage is it would be better able to direct the investment allocation to my goal forward contributions, which would end up in my Roth IRA. Appreciate all you do via Your Money, Your Wealth®, and hoping you can spitball whether my planning strategy makes sense, or you see any pitfalls based on the facts I laid out.

Alright, so the problem is this. If I understand it correctly, he’s contributing $70,000 roughly into the plan. And out of that $70,000, he’s got some money going into stock funds. He’s got a little bit going into bond funds and he’s got a little bit going into company stock. What he’s stating is that he’s got a Roth component in his 401(k) plan. And then he’s got a pre-tax component in his 401(k) plan because all of the other dollars that are after-tax he converts out into his Roth IRA. But it appears that the allocation that he’s selecting Is saying that he’s got, let’s say 50% in stocks, 10% or 20% in bonds, and 30% in company stock. It’s pro rata across all different accounts. So he can’t just select, I want stocks to go on my Roth, I want bonds just to go on the pre-tax, and I want my company stock to go wherever. So… He’s upset about this because he’s getting bonds in his Roth.

Al: Yeah, and he wants growth in his Roth.

Joe: And he doesn’t want bonds in his Roth. He just wants to have a little high flier.

Al: Yeah, sure. Because you get rewarded for high flyers in the Roth because you pay no taxes on the growth.

Joe: He’s saying, you know what? I’m not going to go into Roth. I’m going to go all after tax and then convert everything into my Roth. So let’s say he does that. And then, because he can buy and sell, I guess, within the Roth IRA, he can do whatever he wants, so maybe when the money comes into the Roth, there’s some bonds there, but then he just sells the bonds out of his Roth IRA, and then he has the allocation that he wants?

Al: Although he still has, in his current balance in the 401(k), about half is pre-tax, and half are Roth contributions. So he can’t pull that out until…

Joe: No, what he’s saying is future contributions…

Al: No, I understand. Yeah. Future. In other words, don’t add to the problem anymore.

Joe: No, he wants the $70,000 contributions not to go to the Roth, everything to after tax.

Al: Right, right. No, I understand. I’m just, and the backdoor Roth part comes out, I mean, or the Megatron backdoor, whatever you call it. So that still comes out, that goes to Roth, that can be invested aggressively. I guess what he’s saying is maybe I don’t want to add more Roth contributions to the account because I end up with bonds in Roth and I don’t really want to do that.

Joe: Right. So is his strategy viable? He wants to put $70,000 in after-tax and convert the $70,000 out in December.

Al: Yeah. Can you do that?

Joe: I don’t see why not.

Al: I guess it depends upon the plan.

Joe: That’s why you said no one can give him the right answer. And he says, I don’t want to hear you guys saying it’s up to the plan doc.

Al: Yeah. That’s what he said.

Joe: But if it’s an after tax contribution. I’ve never seen a plan that allows you to go either Roth, pre-tax or just straight after tax. Because no one would ever do straight after tax, would you if you had the option to do a Roth?

Al: Well, I mean, straight after tax means you’re going to put it in a Roth, right?

Joe: But not necessarily with him, he’s going to convert it to a Roth. Because it’s not going into the Roth 401(k). He’s not taking advantage of the Roth provision of the 401(k) plan.

Al: Right.

Joe: Are you just saying, right, or are you following me?

Al: I’m about 75%. I got lost in this one. You answer it. You answer the question.

Joe: How do I know that? You’re like, yeah, right. Right. And then I’m like, okay, you son of a…

Al: And then I’m going, what if I get there? See if I can bluff him. Alright, well then you answered.

Joe: I’m trying to. I’m just, I’m trying to get your opinion.

Al: What I asked you was, can you do 100% after tax?

Joe: I don’t know, I would have to look at the plan.

Al: I know, I think that’s the answer.

Andi: So, Jim, look at your plan Doc, and see if you can do a 100% after tax.

Joe: I don’t see why he wouldn’t be able to.

Al: So, let’s just answer it this way. If you can… Sure, it’s a great idea.

Joe: Sure.

Al: Why not?

Joe: Because then you can control the whole $70,000 that goes into the Roth IRA.

Al: But the employer match part?

Joe: No.

Al: So part of it is pre-taxed.

Joe: Yeah. But then what he’s saying is that instead of the money that he’s contributing to the Roth component of the 401(k) plan, that just doesn’t seem right to me. He can’t rebalance. He can’t reallocate. But I suppose when he reallocates or when he rebalances, it just rebalances across the whole thing.

Al: That’s what he’s saying. It’s pro-rata on…

Joe: So if he wants 20% in bonds, 20% is going to be in the Roth.

Al: Right.

Joe: I would say, you know what, you’re going to retire in a couple of years? I think this is a lot of nonsense for nothing.

Al: Well, that actually was going to be my final conclusion is it probably works if the plan document lets you.

Joe: But who cares?

Al: It sounds like you got a lot of money already in the Roth IRA. So this is a little bit of bond money. I’m not too worried.

Joe: Right. Let’s say he has 100% equities, he gets 8% versus 7.8?

Al: Yeah. True. I mean it doesn’t move the needle that much.

Joe: It doesn’t move, yeah. It’s not going to push you over the finish line here, I don’t think.

Al: I would agree with that statement.

Joe: I think he just loves this stuff so much.

Al: Oh, big time. That’s why he’s constructing the portfolio.

Joe: Exactly. All right. Well, I love the question, Jim. Good luck with everything. Appreciate it.

Andi: Lifetime tax-free growth on investments – that’s the big draw of Roth accounts, and now with the SECURE Act 2.0, there are even more Roth options available. Make sure you understand how Roth accounts work so you can take full advantage of their tax-saving benefits! Visit the podcast show notes to download The Complete Roth Papers Package – you’ll receive the Roth Basics Guide, the 5-Year Rules for Roth IRA Withdrawals, and the Ultimate Guide to Roth IRAs. You’ll get valuable details about Roth IRA contributions and conversions, and the Backdoor Roth strategy for when you make too much money to contribute directly to a Roth. Plus, learn the differences and pros and cons of saving in a traditional IRA vs. a Roth IRA vs. a Roth 401(k), the rules for taking money from your Roth account, and much more. Click the link in the description of today’s episode in your favorite podcast app, go to the show notes, download the Complete Roth Papers Package, and share the show and all these free financial resources – all yours, all from Your Money, Your Wealth®.

5-Year Rule on Roth Conversions: How Does January First Default Start Date Apply? (Nancy, WI)

Joe: Nancy from Wisconsin writes in. “Hey, Andi, Joe, and Al. A little background on me. I retired a couple of years ago. I have no mortgage ongoing debt. No more critters in my house.

Al: Okay. No more pets or kids. I assume pests.

Joe: My drink of choice is unsweetened iced tea. Ugh.

Al: I don’t even like sweetened iced tea myself.

Joe: My only adult beverage is a Christmas gift of a bottle of wine from my neighbor every year. Sorry, Joe. No drinking excitement here. I knew that was coming.

Al: Do you still love her?

Joe: I do. I do live near Milwaukee, Wisconsin, but I can’t stand the taste of beer. And I don’t like football. Wow. That’s crazy.

Al: Yeah. From Wisconsin?

Joe: Yes. I have been accused of not really being from Wisconsin.

Al: There you go.

Joe: So Nancy drinks unsweetened iced tea, doesn’t like beer, can’t stand the taste of it or the smell of it.

Al: And no football.

Joe: Oh, no football.

Al: And where you from, Wisconsin

Joe: Like those Packers? Okay. No. That is sacrilegious. I ask for a clarification of the Roth IRA conversion and the five year rules related to dates. I read that Roth conversion dates default back to January 1st of the year the conversion is done. True.

Al: That is true.

Joe: Based on this, my understanding is that if I do a Roth conversion in September, it really defaults back to January 1st of the year, the five year rule start date. Correct. Can you clarify how the January 1st default start date applies to the five year rule?

Al: Didn’t we answer that already? Didn’t we just do that? I think she answered that.

Joe: Yeah. So you are correct. You understand the rules quite well.

Al: You do the conversion or the Roth contribution in October, it goes back to January 1st. That’s your start date for the five year plan.

Joe: How this really comes into play is that if I’m doing a contribution, you have until April the following year to do the contribution for the year, right? You have until your tax filing deadline. So if I do a Roth contribution in 2024 for the 2023 tax year, it reverts back to January 1st of 2023.

Al: Sure. But you have to be able to qualify.

Joe: You have to be qualified. Yes. If I do a conversion in April of 2024, well, that start date is January 1st of 2024. Is that clear enough?

Al: I think so.

Joe: Andi, are you with me?

Andi: I think so. Yes.

Al: Yeah. All right. Is there anything else?

Joe: I don’t know. I’m still shocked that she doesn’t even like the smell of beer.

Al: You can’t get past that.

Joe: I can’t. All right.

Al: I wonder if she likes cheese.

Joe: I doubt it. Let’s say I’ll be 59 ½ next month. If I do a Roth conversion this month, before I turn 59 ½, will the five year rule be different than if I do Roth conversions next month, after I turn 59 ½ ? What is she really getting at?

Al: What she’s getting at, if I do the conversion after I’m 59 ½, is there different rules than before 59 ½. So it sounds like she’s right there.

Joe: Or, will they both technically fall under the same five year rule? Do I need to wait until next year to have a post 59½ year rule apply if the date defaults to January 1st? Thanks for the clarification.

Al: Yeah. No, do it this year. Because the five year clock starts the longer of 59 ½ and five years. So once you hit 59 ½, and as long as you had it five years, you’re good, right? So do it now. Get January 1st of 2023 and you’re golden. Now the five year clock, realize what that means. It just means

Joe: Five years or 59 ½, whichever is longer.

Al: That’s right. So if you do it now, maybe you won’t get to pull out the income or growth until 64 or whatever age, probably 64. Right. But it also means. And this is true of any conversion. Once you’re over 59 ½, you can pull out those conversion funds tax free. No problem. You just can’t pull out the growth. If you’re under 59 ½ and you’re trying to pull out the growth, you’ve got a five year clock for every conversion. That’s what changes at 59 ½.

Joe: Yeah. The second five year clock is almost irrelevant once you turn 59 ½ .

Al: Correct.

Joe: You’re playing these weird things, January 1st or non January, just do the conversion and then once you turn 59 ½, you’ve got different rules.

Al: Yeah, but in her defense, this is confusing. I mean, you read the IRS publication on this? Good luck.

Joe: Yeah. Did I seem like an ass or something to her?

Al: No

Joe: You’re sticking up for Nancy.

Al: I am.

Joe: You’re going to sit down and have a little unsweetened tea?

Al: I’m going to have a bowl of cheese with it.

5-Year Rule on Roth Conversions vs. Tax-Efficient Investments, Bond Funds Vs. Bonds Vs. CDs (Johnny Mercer, Savannah, GA)

Joe: Let’s go. “Choose a name for me, Andi.”

Andi: I chose Johnny Mercer because this emailer is from Savannah, Georgia. Johnny Mercer is a very famous lyricist, songwriter, and the co-founder of Capitol Records. He was also born in Savannah, Georgia.

Joe: All right. “Andi, Joe, and Al. Thank you for taking my questions.” Oh questions. “I have been absorbing your wit and wisdom for about two years now. As your podcast was recommended by David Graham.

Andi: That’s FIphysician. com

Joe: FI physician.

Andi: He’s the guy that voted us the best retirement podcast with humor. Like four years in a row.

Joe: Wow.

Al: I didn’t know the name, but I remember that.

Joe: Thank you, David Graham. I’m 67 and drive a 2015 Honda CRV, which like me is still in its prime.

Al: Oh, I like it.

Joe: I like Johnny Mercer. Coming out blazing, throwing heat, a little high heat at us here. “My lovely and insightful wife is 64 and drives a 2018 Lexus RX 350. Her drink of choice is Napa Valley Pinot Noir.

Andi: Noir.

Joe: Noir. Pinot. Don’t people just kind of say Pinot?

Al: They say Pinot.

Joe: Pinot.

Andi: But there’s also Pinot Grigio.

Al: That’s true. You have to know which one.

Joe: Got it. “And I’m a sucker for a good lager beer, either draught or in a dark glass bottle. That makes it look expensive.

Al: Yeah, you gotta have the look.

Joe: My dad drank red, white, and blue, and that came in a dark bottle, and that was like really cheap ass beer.

Al: He fooled a lot of people, didn’t he?

Joe: Like, the returnable bottles?

Al: Oh yeah, I remember those.

Joe: Remember those? That’s what he would drink.

Al: Okay. Another, like, $0.02 or something to return or $0.05.

Joe: I don’t know. All right, well, she’s already retired. I plan to work until age 70. We have no debt and typically spend about $200,000 a year. I don’t expect our expenses to change much in retirement. I’ve recently cut back at work, but expect my income will still cover expenses until retirement. I’ve decreased contributions to only the amount required to qualify for matching funds. So we’ll only be adding about $2,000 a month to our retirement accounts until retirement. Social Security will yield $72,000 a year and I’ll have a government pension of about $35,000. We currently have $4 million in qualified retirement accounts that are roughly 50/50 split between stocks and bonds. $4 mil. That’s a big account.

Al: I like it.

Joe: We have $250,000 in our brokerage account, currently in our money market fund, making 5%. I started a Roth IRA conversion account about two years ago, but have not yet contributed much to it. Primarily because I’ve been in the 32% tax bracket until this year. Well, I’ll cut back. Unless there is some Malthusian. What the hell does that mean?

Andi: It’s a reference to, what was the guy’s name? Malthus. Come on.

Joe: Something really bad. I’m guessing.

Al: I actually have seen that term.

Ani: His theory that population tends to increase at a faster rate than its means of subsistence and unless it is checked by moral restraint or disaster, widespread poverty and degradation inevitably result.

Joe: A Malthusian economic collapse in our lifetime. I think we’ll be okay in terms of retirement income, but I do have two questions. I plan to take money out of our qualified accounts at the top of the 24% tax bracket. A little tickle in my throat here.

Al: Can you get it?

Joe: Yeah. I plan to take out money in our qualified accounts up to the top of the 24 % tax bracket or whatever it may be after 2026. I’d like to hear your spitball regarding Roth conversion IRA versus brokerage account using tax efficient funds. So he wants to take money out of the big $4 million retirement account and he’s asking us to put it into a Roth or tax efficient fund.

Al: Sure.

Joe: Okay.

Al: Yep.

Joe: All right. I was originally planning on Roth, but recently found out from you guys, the five year rule for accessing the money applies to each conversion rather than when the account was open. I’m concerned that if I box early, this money won’t be available to my wife without penalties. If I box early. Oh my God. I’d love that saying.

Al: That’s a great saying.

Joe: I mean, you’re just going to go in a wood box.

Al: Just going to box it out. So it’s different.

Joe: Yeah, babe, if I box early, I just want to make sure that Roth IRA is available to you because we only have $4 million bucks. So ironically, one of the reasons I like the idea of Roth was it to protect her from at least somewhat from a widow’s penalty of higher taxes because she would eventually be filing as a single person. I also like the idea of being able to put money into tax inefficient investments in the Roth if I choose to. My other question is about fixed income. Alright, let’s just get this out of the way.

Al: Yeah, the five year rule.

Joe: Yeah, the five year rule.

Al: Oh boy, here we go.

Joe: How old is Johnny?

Al: 67.

Joe: Johnny, don’t worry about the five year rule on every conversion, because that’s only if you’re under 59.5. So the five year rule, if you already have a Roth, which you opened two years ago, you can convert money into that Roth IRA in your five year clock started two years ago.

Al: Correct. And by the way, you can always take your contribution or conversion out of it tax free without penalty. It’s just the growth.

Joe: Right. So if he boxes out, his wife can take any money that he converted. She just can’t touch the earnings for another three years.

Al: Let’s say over time you convert $400,000, right? And the $400,000 of the Roth grows to $475,000, right? She can take out the $400,000 dollar for dollar because the growth part doesn’t come out till after the principal. So the $75,000, she’d have to wait five years. Now, if you live another three, then you’re golden.

Joe: Yeah, it’s all good.

Al: If you don’t, if you live, if you die prematurely, like right away, she’s got to wait three years to get that extra $75,000, but she can take the $400,000.

Joe: But the conversion on the five year clock on each conversion only applies to people that are under 59.5. Because If they didn’t have that rule, people would be able to take their conversion out and avoid the 10% penalty. Because they paid taxes on the conversion, then they could take it out the next day or the next year. If they were under 59.5 that was just a bypass rule for them to get away from the 10% early withdrawal penalty. They created that rule to… Put a stop to that loophole.

Al: Yep, exactly.

Joe: All right. My other question is about fixed income. I’ve been using bond funds in my qualifying accounts, thinking that they’re a good stabilizer. It could probably provide me income for my expenses, RMDs, et cetera. The last couple of years though, have shown how wrong that thinking was. My Vanguard total bond fund is still 15% below what I paid for it. I’m leaning towards ladder CDs and or individual bonds at this point, at least for now, since they are paying well, I would love to hear your thoughts on this. Thanks again. Okay, Johnny. We answered the Roth, now bond funds.

Al: Yeah, what are your thoughts?

Joe: I have a lot of thoughts.

Al: Okay, I got all day.

Joe: He bought the Vanguard Total Bond Fund Index, and I’m guessing… I don’t own that fund. I’m guessing it mirrors the index, because it’s an index fund. And he’s going to have all sorts of different maturities, all sorts of different types of bonds within that overall index fund,

Al: Total bond index fund probably means short, midterm and long term.

Joe: Mid, short, treasuries.

Al: Right. Right. Everything corporate.

Joe: Yeah corporate, mortgage back, whatever. And so a bond is a loan, first off, it’s not a stock. So when you purchase a bond. Let’s say I’d lend my good friend Alan $100,000.

Al: Okay. Are we talking now?

Joe: Yes. And he pays me 5% interest. Okay. And so I’m going to receive that $5,000 per year, and at the end of the term of the loan, I receive my $ 100,000 back.

Al: If I have it.

Joe: Hopefully you have it. If you don’t have it, then that’s called a default.

Al: That’s the problem. Right.

Joe: Yes. But if I look at the amount of defaults that happen, it’s a pretty minimal amount.

Al: Correct.

Joe: So when he’s seen the bond fund go down. He might be thinking oh this is not good. Is there a default? If a stock fund goes down, that means maybe the company is not in favor anymore, right? Something happened. They’re not meeting expectations of what the market anticipated them to do for the stock price to go up. But with a bond fund, it’s a loan. It’s a note. So let’s say if interest rates go up. What happens to bond prices?

Al: They go down.

Joe: They go down. Only if you redeem the bond or if you wanna sell the bond to a second party.

Al: So you loaned me $100,000 at 5%. You wanna get out of it. So you go to the secondary market and interest rates are now 8%. You’re gonna have to get a discount, right?

Joe: Because no one will buy it, right?

Al: Because they can get 8% on a new bond. Why would they pay you the full price for 5%? So you just do the math to figure out what 8% equivalent is and it’s a reduced bond price.

Joe: If I hold that bond to maturity, I’m going to get the $100,000 back. But if I’m looking to redeem it early, right, well, 8% is the going market, so the bond price is going to go down. You’re going to see bond prices and these bond funds have done just that. So if I buy an individual bond, I have a little bit more predictability or certainty if avoiding defaults, that I know that I’m going to get tha par value back at maturity, a bond fund is going to be a little bit different, but there’s thousands and thousands of bonds within that bond fund. I don’t even know, I’m guessing probably 10,000 different types of bonds. So all of these different bonds are going to come to maturity at different times. And then as interest rates stabilize or go up or down, you’re going to see some of that par value come back. So for me, what I sell the bond today and get into an equivalent security when I already bought the risk. You already bought the risk. You’re just paying for it right now. Because a bond fund with a 30 year maturity is going to be more risky than a treasury bond that has a 30 day maturity. I’m going to get more yield on that 30 year bond because I’m taking on more risk. He’s already bought the risk. Should I sell onto the bond fund and buy individual bonds? I don’t know. I don’t think I would.

Al: I wouldn’t either. Because here’s the thing, if the interest rates start to come down again, and they probably will after we get inflation under control. Then what you’re going to see is the bond funds increase and they will, you’ll earn a lot more than a CD and that, see, that’s your protection. As interest rates come down, it basically means the economy is sputtering, right? So interest rates come down to try to spur that on. And that’s typically at the same time stocks are down, their interest rates come down, bonds go up. It’s a good counterbalance to stocks.

Joe: I guarantee within the fund that he’s buying, they’re buying those bonds today that have high yields

Al: Oh, for sure. It all turns around.

Joe: Right.

Joe: In fact, if you look at long term studies. Because there’s been trends, long term trends, the interest rates going up and going down. Yeah. Certainly when interest rates go down, bond funds do better because interest rates are lower. And vice versa, when interest rates go up. Interestingly enough, when you look at long term trends of that, it’s not that far apart. And the reason it’s not that far apart is because over time you get higher interest rate bonds in your portfolio and you do almost as well, really. So the last two years, if we had a crystal ball, we probably wouldn’t have done that, right? Or you wouldn’t have done that. But the point is you’ve already paid for the risk. Interest rates come down. You’re going to be glad to have it.

Joe: I would just hold tight. I like this strategy. It’s a very low cost fund. It’s a good fund.

Al: It’s a great fund.

Joe: Don’t buy yesterday’s winners today.

Andi: Download 10 Steps to Improve Investing Success and the Investing Basics Guide for free from the podcast show notes to learn more about all kinds of asset classes, including stocks, mutual funds, target date funds, and fixed income from bonds. You’ll also find out how asset allocation and capital gains can impact your investment choices, and you’ll see how controlling your emotions and your risk can lead to higher returns in your investment portfolio – so you can retire with more wealth. Take your investing skills to the next level. Click the link in the description of today’s episode in your favorite podcast app, go to the show notes, and download 10 Steps to Improve Investing Success and the Investing Basics Guide for free – you’ll find them right before the episode transcript. 

What’s the Best Strategy for Incorporating Bonds into Our Retirement Portfolio? (Brad, St. Louis)

Joe: “Good morning, Big Al and little Joe.” Oh, right off the bat, we got a little funny guy.

Al: Yeah, we do.

Joe: This is Brad coming to you from sunny St. Louis.” Didn’t know St. Louis was The Sunshine State.

Al: Well, apparently it can be.

Andi: It is for Brad.

Joe: “My wife and I are both 37 and are currently maxing out my 401(k) and 403(b), two Roth IRAs, and we have a brokerage account. We have $550,000 in investment accounts, $30,000 in iBonds, $25,000 in cash, and one paid off rental property.

Al: Wow. Another big wallet here.

Joe: Look at the big wallet and a big Brad.

Al: It’s coming up I can tell.

Joe: “We’re invested in almost all stocks with a very small portion in a REIT fund. My question is what is the best strategy for starting to incorporate bonds into the portfolio? Do we convert a large portion into bonds in addition to increasing the percentages of bonds with paycheck deductions or just start increasing with our paycheck deductions?

Andi: That was the same thing twice.

Joe: No, he’s like, hey, do I reallocate? And then with the deductions that are going in from his paycheck, does he change the allocation?

Al: Yeah, so that it gets to where he wants to be.

Andi: Ah, I got it.

Joe: Retirement always seems so far away, so I’m always willing to take more risk, but I’m hoping to retire at 57. How old’s Big Brad?

Al: 37.

Joe: Okay, he’s got 20 years. “So I wanted to start thinking about a strategy to balance the portfolio. We will also have five streams of fixed income. Five, not four, nor three.

Al: Five. Wow. And he lists them, too.

Joe: We got a little military pension

Al: My pension, her pension.

Joe: Oh, my pension, her pension, a military reserve pension.” Thank you for your service, Brad, “and two Social Security annuities.

Al: That’s five.

Joe: There’s five.

Al: Plus the rental property, that’d be six.

Joe: Does having this fixed income change our strategy to balance our accounts and take on a little bit more risk? I drive a 2010 Camry, she drives a 2017 Pacifica. We both drink high-noons and Coors, and we don’t have any animals other than our four boys. Thanks. Love the show.”
All right, Brad. Thanks. This is an interesting strategy. Someone that has high fixed income, they have high pensions, they have high fixed income. Some experts in our field say, you know what, that could be a component of your bond or fixed income component of the portfolio, so you could take on more risk in your liquid assets.

Al: Right. And particularly if your fixed income is going to cover your expenses anyway, who cares?

Joe: Might as well take on more

Al: Be more aggressive. And it sounds like Brad, you’re okay being all in the market because that’s what you’re doing right now.

Joe: Most people don’t have pensions. That’s why bonds are such a key component of a portfolio. If you have three pensions and you have your social security benefits and that’s covering a lion’s share of your overall fixed income. Yeah. Then I would probably not invest a ton of money in bonds.

Al: Even if you didn’t have all these pensions, you’re 20 years away from retirement, you’re okay being all in. I mean, me personally, I would stay put for a while.

Joe: I would not touch a thing. He’s retiring in 20 years, I think he’s probably 10 years from retirement, probably even five years from retirement. That’s really where you want to start allocating your portfolio appropriately? You don’t want to do it the year before retirement, just because if the market takes a dump and you know, you’re kind of, you could get left holding the bag there.

Al: So the great recession, which is the worst market we’ve had in our lifetime, right? That the market was off for 18 months. It wasn’t five years, right? If you think about this five years before, then you can sort of, even if there’s another great recession, you’ll probably be okay.

Joe: So I would not do anything different than what he’s currently doing, but as he gets probably five years from retirement, then that’s when I would want to make the switch.

Al: Me too. And even still, with all this fixed income, you might not even need to. It’s up to you what your goals are with the money.

Joe: Yep. What you look at is that you need to place the portfolio of what the portfolio needs to do when you need it. You don’t want to try to time things. If I’m five or four years from retirement, I’m like, okay, well, how much income needs to be produced or how much, what’s my distribution rate from the portfolio? That’s when I would reconstruct the overall portfolio at that point. Versus saying, well, markets are up, maybe I can’t continue to ride this thing, or markets are down a little bit, maybe I try to ride it back up, because you don’t know what directions it’s going to go. You just want to make sure that you’re diligent in your overall planning. Five years is probably the right amount of time, you know, I would just sell and get it in the right portfolio right now, if I was, let’s say, five years from retirement.

Al: Right.

Joe: But he’s got 15 years, right? And the right portfolio for you see, this is the problem with reading an article on how you should position your portfolio. It’s different for everybody. I mean there’s guidelines, right? But I mean, and we’ve said this before, I’ll say it again. We have clients in our eighties that are 100% in the stock market. Why? Because they don’t need it. It’s for the kids and grandkids. So why do they want bonds, right? They’ve got so much other income. They have way more income, fixed income, or rental property income, or whatever it may be, that they don’t know what else to do with it, right? It depends upon your own situation and your own goals. The fact that you have five retirement income streams plus the rental, I’m going to call it six, plus you’ve already saved half a million dollars by 37. What’s that going to be in another 20 years? It’s going to be a big number.

Joe: He’s got a big wallet.

Al: You’re in good shape. I wouldn’t worry too much about it. Just say I’m blessed.

Joe: All right. Is that it?

Andi: That’s it.

Al: That’s it.

Joe: Okay. Awesome. Well, thank you all for your questions. You make the show really appreciate it. Andi, thanks for producing such a wonderful program.

Andi: Awe, thank you, Joe.

Al: Yes, we value you for sure. I appreciate that.

Joe: Wow. Look at you kiss ass.

Al: I am trying to improve our employee culture by complimenting.

Joe: All right. That’s it for us. We’ll see you next week. The show is called Your Money Your Wealth®.

Andi: Drinking Old Fashioneds and Twisted Tea and boxing early with Johnny Mercer in the Derails, so stick around. Help new listeners find YMYW by telling your friends about the show, and by leaving your honest reviews and ratings for Your Money, Your Wealth in Apple Podcasts, and any other podcast app that accepts them.

Your Money, Your Wealth® is presented by Pure Financial Advisors. Click the “Get An Assessment” button in the podcast show notes at YourMoneyYourWealth.com or call 888-994-6257 to schedule your free financial assessment, in person at one of our seven offices around the country or online, a time and date convenient for you, no matter where you are. Chances are, one of the experienced financial professionals at Pure will be able to identify strategies to help you create a more successful retirement.

Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.

The Derails

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