We just can't get enough of Motley Fool contributor Dan Caplinger. In this episode of Motley Fool Answers, he helps us answer your questions about SPACs, variable universal life insurance, maximizing accounts, hopes for Gen X, and more.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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This video was recorded on May 25, 2021.
Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick, joined as always by Robbie Brokamp, personal finance expert here at The Motley Fool. Hey, it's the mailbag for May and joining us this week, it's Dan Caplinger. He's a long term contributor to The Motley Fool and he is going to help answer your questions about SPACs, inheriting an IRA, which accounts to maximize and a bunch of other stuff. Yeah, all that and more on this week's episode of Motley Fool Answers. Hey, Dan is back. Welcome to the show. I feel like it's probably been a while.
Dan Caplinger: It's been a whole pandemic. Hasn't it, Alison?
Southwick: I think so. I think we had you on the show back when we were still feeling this whole remoteness out. Now we got our act together. We are this well-oiled machine. What's new with you?
Caplinger: You know how that goes. It's a whole lot of the same old stuff put on another way, so I've been doing a bunch of the video stuff, now I'm back with you guys. It's like a whole high school reunion thing going on.
Robert Brokamp: Here is the fun fact about Dan. When he's bored, he just gets in his plane and he flies around for a while, which is not something most of us do.
Southwick: Oh, really?
Caplinger: It's highly recommended. I enjoy it a lot.
Southwick: That's wonderful. Well, I always forget what state you're coming to us from, because I always want to say something like Vermont, but that's totally wrong, isn't it?
Caplinger: I'm two miles from Vermont, so it's not totally wrong, but I'm in Massachusetts, which means that Bernie is not my senator and I don't have cows in my backyard or anything like that.
Southwick: There you go.
Brokamp: Is there a problem when you're flying from one state to the other? Like, do you have to do any certain clearance like I'm flying into New Hampshire aerospace or anything like that?
Caplinger: No. I talk to air traffic control all the time, so it works just fine. I mean, you got to be worried about the state-by-state restrictions, but as long as I don't get out of the plane, I figured out it was OK. From 5,000 feet, I don't think anybody is catching anything.
Brokamp: Got it. Very interesting.
Southwick: Well, let's get into it, shall we? Our first question comes from Dwayne. "My wife and I are in our early 50s and I feel like Gen Xers are really heading for rough times in our golden years. The boomers ran up the nation's credit card, spent all the social security and were planning to take it all with them. The millennials are all on fire, living out of vans and blogging about work-life balance, darn lazy kids, which leaves even though those of us in Gen X that worked hard and saved a little out of luck. Where should Gen X keep their hard-earned money to deal with the massive inflation and tax increases that are coming, even if it turns out not to be that dire? Where does a smart investor keep his money during inflationary times: stocks, bonds, mattresses?
Brokamp: Well, Dwayne, a full disclosure, Dan and I, and Rick, the producer, are Gen X. Alison, do you consider yourself Gen X? You're kind of on the cusp.
Southwick: I'm right on the cusp, but yeah, I think I identify more with Gen X than I do with millennials. I don't know.
Brokamp: Well, so we are fortunate to have had the best movies and the best music growing up and I would agree with Dwayne that the boomers will have it better than the rest of us, at least in terms of things like if you think of like America's retirement infrastructure like social security, Medicare, pensions, not to mention good returns on their homes, stocks, and bonds. I think younger generations will end up having essentially pay more to get less, which is not very exciting. I would say that the millennials might even have a tougher time especially when you consider those who had to borrow lots of money to go to college. As for the FIRE folks, FIRE of course standing for Financial Independence, Retire Early, next week, our next episode actually is going to cover myths of the FIRE movement. As we discussed last week with Brian Feroldi, I think actually the FIRE movement has a lot to teach people. Namely, that keeping expenses low and saving like mad is a great formula for financial success. That said, I get Dwayne's point, although he might have been making it sarcastically, not sure, but if a bunch of young folk stop working, that's less money going into the tax base and into entitlement programs, and that would definitely make them much more unsustainable.
To address Dwayne's concern specifically, here are some thoughts. No. 1, I think we're all in the younger generations, Gen X and below, are going to have to save more to make up for entitlements that may be reduced. Just as an example, Social Security is still going to be there for future beneficiaries, but around the 2030s, payroll taxes are only going to be enough to cover about 75% of benefits, so I think people in their 50s and younger should expect a 25% benefit cut. It may not happen, but that's a prudent assumption. Regarding inflation, the only investment that has historically outpaced inflation over the long term is the stock market. Not cash, not bonds, not your mattress. Assuming Dwayne is going to work for another 15 years or so, he is much more likely to outpace inflation if you invest in stocks and maybe real estate. I personally feel like the U.S. stock market is very expensive, so I'm a big fan of putting some in international stocks, but I've been saying that for a few years and U.S. stock just keep winning, so take what I say with a grain of salt about that one.
As for taxes, the best way to hedge against high tax rates and retirement is a Roth account. We're going to talk about that a few times in today's mail backs. I won't get into the details, but finally, I will just say make sure you don't retire until you're absolutely sure that you have enough money to do so. For most folks, that does mean probably working into their late 60s or 70s. That sounds like really bad news to you and you want to retire sooner, then just follow the example of the FIRE folks and save like mad.
Southwick: I love that Dwayne is so on brand with being Gen X in this question. It's like, "Everything sucks, everything hates me and it's out to get me. I'm just going to listen to Depeche Mode in my room." I mean, that's what I did in the '80s. I don't know about you, but I was only like --
Brokamp: You have?
Southwick: nine years old and listening to Depeche Mode. I was very advanced. Next question comes from Collin. "I recently started a new job. Yay! From this job, I will have access to a 401(k) with both a traditional and Roth option and an HSA. I also have a Roth IRA, a taxable brokerage account and a simple IRA from a previous job. I'm 28 years old and as I understand it, Roth contributions are generally more favorable for young professionals that expect to be in a higher tax bracket in the future. Hopefully. With all of these different accounts, where do I start?"
Caplinger: Collin boy, you've already started. Not only have you already started, you have the menu of golden opportunity in front of you. You got all these accounts at 28. Wow, that is amazing that you are so well put together at this point, so you already get the green check-mark of success in my book, but to answer your question with all of these different accounts, there's two of the accounts that I would push above and beyond the others. The first is that health savings account, that HSA that you've got. Most of the time when you get a tax favored account, you got to choose. Either you get a nice upfront tax break in the form of a deduction or at the end you get tax-free treatment on the income and gains that your investments make, but HSAs give you both. You get both the upfront deduction when you put the money in and the tax-free treatment when you spend that money on your healthcare needs and so if you have money, that's usually the first place that I'm going to suggest that people put their money with one exception.
Here's the deal, because when you've got a 401(k) account whether it's a Roth or whether it's a traditional, you've got both. Not everybody has both, but when you've got that 401(k), the first question you're asking is, is my employer going to be matching my contribution with some of my employers on money? Because I love free money from other people that could come from you. It could come from Bro, it can come from Alison.
Southwick: It's going to be from me.
Caplinger: Wherever it's coming from, bring it on. That means if you have a matching contribution in a 401(k), go ahead and make sure that you put at least enough money into that 401(k) to get the match. After that, you can decide, "Okay, hey, yeah. All right then I'll put some of the HSA, then I'll put some more in the 401(k) and we will take it from there." As far as your comment about Roth being good for young professionals over traditional, I agree 100% and here's the deal why. When you're a young professional, you are just getting started unless you hit the career lottery and make the big bucks right out of the gate. You are going to be in that low tax bracket or relatively low tax bracket right now, and that means that when you have a choice between the traditional and the Roth, between getting an upfront tax break that's based on your current tax bracket versus tax-free treatment for the future when you might be in a higher tax bracket, the younger you are generally, the more you're going to get out of that Roth option. Yeah, two accounts out of that group. I like the HSA and the Roth 401(k), making sure you get that match. That's a winner. Anything else that you've got extra, you can divvy it up across IRAs and regular accounts depending on what the goals you've got, but you are starting out great, you are in great shape, and keep up that positive momentum because it's impressive what you've done already Collin.
Brokamp: Yeah, I agree with Dan. The only thing I'll add is with the simple IRA with a former employer, if it's not a good plan, not a good account, not great options, high expenses, you go ahead and transfer to that just to a traditional IRA and save yourself some money.
Southwick: Next question comes from Phil. "I'm 41 and in the highest tax bracket now. We've prioritized saving and investing and have done well, seven-figures. My current mix of accounts is skewed to traditional IRA and taxable brokerages. Even though we are in the highest tax bracket, I have a nagging suspicion that increased government spending, coupled with demographic shifts that could lead more progressive, will result in taxes going up, but then I wonder what income will I have then. Will our MDs really be enough to put me in the highest bracket in the future if I stopped working? Should I pay the known high rate now via the Roth and balance my taxable, non-taxable mix? It seems like it at least gives me optionality later."
Brokamp: Well, as Dan suggested in the previous answer to the previous question, the rule of thumb is, if you're in a lower tax bracket today, go with a Roth. If you're in a higher tax bracket today and you expect to be in a lower tax bracket in the future, go with the traditional. Here we have Phil who is in the highest tax bracket which this year is 37%. He says, "We," so I assume he's married. To be in that tax bracket, you have to be earning over $630,000 a year, so Phil is doing pretty well. The rule of thumb would say he probably should stick with the traditional. It's always important as I've mentioned before, that if you go with the traditional, you're going to realize some tax savings that you invest that tax savings. That's really the way to make the traditional pay off. Contributing to its traditional allows them to save even more, but it's also right to be concerned about higher tax rates. The 2017 tax cuts will expire after 2025, so rates are going to go up automatically. Then there's all the government deficits, unfunded entitlements, and you'd think that at some point we're going to have to pay for this eventually.
Brokamp: So tax rates, I think, are definitely going to be higher in the future. The thing is, when people retire, one of the biggest expenses that drop off for retirees is taxes. That's because, first of all, they don't need as much income and when you have less income you don't pay as much as taxes. There are few other reasons people who are 65 and older get a higher standard reduction, social security isn't fully taxed. A lot of states give good tax breaks for retirees. A study by the Center for Retirement Research at Boston College looked at people who retired between 2010 and 2018 and estimated that the top 1% of retirees, in terms of income, paid a tax rate of 22.7%. Overall, retirees paid a tax rate of 6% on their income. If tax rates were going to save roughly the same, I'd say someone in the top tax bracket sticks with the traditional. Phil's concern is, "Well, tax rates in the future are going to be so high, they're going to be higher than 30%." I think that's certainly a possibility. If Phil were to say, "You know what? I want to put some of my money in the Roth," I think that makes sense. He's hedging out against extremely high tax rates and plus as he suggests, he won't have to worry about required minimum distributions from a Roth account either. But I wouldn't go overboard because generally speaking, people do pay much lower taxes in retirement. Plus when you retire, you have so much control over when you recognize income, that you add that to having some assets in a Roth, I think he'll be OK.
Caplinger: Bro, I'll just add into that that he talks about RMDs, but sometimes the ideal tax strategy when you are retired, assuming you retire before that RMD age which is now 72, is to take some of that money out before you hit 72 if by doing so, you're using up some of the lower tax brackets that you're talking about. That's an essential component of what gets baked into that lower average taxes for retirees versus especially somebody top bracket earner with seven figures.
Southwick: Next question comes from Terry, "SPACs have grabbed my interest. I know SPACs are not doing well right now, bubble yadda, yadda, yadda, but I feel like that might make for some good opportunities. Seems like companies are staying around $10 even after announcing a target, so that gives me the opportunity to shop. But I'm confused about a couple of things. Why do the SPACs sometimes trade below $10? I'm not worried about this from a loss perspective. I'm worried that since $10 apparently isn't the absolute bottom, is there something fundamentally potentially important that I don't understand? I also have a question about warrants. As I understand it, if I buy 100 SPAC shares with a one-fifth warrant per share, then I have the right to redeem the full warrants for 20 more shares at a price of $11.50 a share at some point in the future. When in the future? Is it fairly standard or do I have to dig for that information somewhere for each SPAC? How would I that?" Wow, this is the next-level SPAC 200-level class here. We did not talk about much of this at all in our SPACs episode. All right, Dan, educate me.
Caplinger: That's what you get for bringing me on. I have to go with the SPAC craziness here. SPACs, special purpose acquisition companies, are also known as shell companies, and basically, they're set up before you know what they're going to be. They just collect a bunch of money and then they go out and they try to find a privately held company that sparks their interest. If they find a good one, they try to make a deal to merge with them. It's basically an alternative to the traditional IPO process. A lot of privately held companies say, hey, I don't want to deal with Wall Street, I don't want to deal with this IPO stuff, let's do a SPAC instead. That's what the appeal is to the private company involved. Investors get a chance to get in on an IPO a lot more easily than they usually do.
Usually, with an IPO, ordinary investors don't get to get that preferential treatment that those Wall Street institutional investors get, they have to buy in on the first day, pay a big popped-up price and it goes through the roof on the first day, then who the heck knows what happens next. So this is a good alternative to it that's why SPACs got so much attention especially toward the end of 2020. But they had a day of reckoning here this year. They came back down to earth and Terry is absolutely right. Some SPACs are even trading below that $10 magic price. Now, you might be wondering if you don't know what a SPAC is, why is $10 such a magic deal? Well, the deal is most SPACs, when they do their initial public offerings and they do offerings of their own SPAC shares, those offerings usually go at $10 a share. Why? They just decided that was what they were going to do. The interesting thing about the SPAC is usually SPACs have two years, 24 months, to figure out who they want to merge with. If they can find a merger candidate in two years, then the jig is up and all the money goes back to the shareholders. Ideally, in a perfect world, if the SPAC collected the $10 a share from the investors on day one and two years goes by, yeah, sure, there's some expenses. But for the most part, most of that $10 a share is still there, and so a lot of investors say, well, hey, worst I could do is get my $10 a share back. Best I could do is get shares of a company I really like that I think is worth more than $10 a share, sounds like a win-win.
Well, it turns out it's not quite that simple. Now, first of all, I read a study from, I think it was in the Harvard Business Review, that said that on average, these SPACs, they will actually spend some money along the period where they are looking for companies. Where they're trying to negotiate, doing research, so reaching out to folks. It may not be $10 a share in cash that's left at the end of two years, it might be $9.50, it might be $9. If you see a SPAC trading at $9.95 or $9.90 or something like that, don't suddenly think that this is payday central because it's not necessarily. There can be some disparities in the value there. Then the other thing that sometimes happens is just that you get some, I want to call consternation about a target that the SPAC has chosen.
Now, one thing to keep in mind is that before a SPAC merger gets completed, an existing SPAC shareholder has the right to redeem their shares with the SPAC. Basically, you can tell the SPAC, "Hey, you picked this company, you made a bad choice. I don't like it, I want my money back," and you'll get what you get back. Sometimes it's $10, sometimes it's going to be $9.95. It's whatever it is. But that's one reason why these things are happening. Then, the other thing you have to keep in mind is that there's usually a time period between when a SPAC merger gets approved by shareholders and when the ticker changes over to the name of the new company. If that happens and if the public didn't like that company, then at that point, everything is fair game, stock price can drop below $10 a share, you no longer have that right to redeem because you lost that as soon as the shareholder vote was complete. Just keep that in mind. In general, Terry, your thinking is right. Usually that $10 is a rough underpinning. It's not usually going to go much below that, but there are a couple of cases just to keep in mind. It may not be an aberration, it may be a specific case that you need to look into.
With respect to the warrants question, here's how everything is getting even more complicated. When you buy SPAC shares when the SPAC first offers its shares, it doesn't offer shares, it offers what's called units. A unit has a share plus usually a fraction of a warrant. Sometimes like Terry says, sometimes it's a fifth, sometimes it's a fourth, sometimes it's a third, whatever it is, it gives you the right within a certain time period in the future to buy additional shares. Usually, just like the magic price for the initial offering is $10 a share, usually, the magic price for the warrant is $11.50. Where do we get that? I don't know, somebody added a tip. 15%, kind of stingy, but maybe at New York City it'd be 20% or 18%, I don't know. But here, it's 15% usually. $11.50 a share is where that warrant kicks in and Terry asked, "How long do you usually have?" Usually, you have five years from the day that the SPAC went public, not when the merger happened. You have to go back and look and see. There are also some provisions that will accelerate that and basically force you to exercise that warrant sooner than the five-year period. Where do you go for that? You can go back to the S-1 prospectus for the SPAC when it was issued. Not when the merger happens, but when the SPAC itself was formed. You can search that on the SEC website, sec.gov. Just put in the SPAC's name it will give you a list of filings, look for S-1 and that will tell you what you need to know. But yes, the world of SPACs is very confusing. Very exciting, but lots of traps for the unaware. Be careful out there, Terry, but good for you for giving it a shot.
Southwick: Thank you, Professor Caplinger. Let's move on to the next one that comes from Sean. Sean writes, "Over the past couple of years, I have been struggling to come to a solid plan as to what sort of investments should be held in what types of accounts. For the Roth IRA, I've heard all kinds of recommendations, dividend stocks, high growth stocks, actively traded strategies, since short-term capital gains need not apply, even options trading. I understand all of these different ideas at face value, but does it make sense to place riskier stocks in these accounts hoping they'll grow tax-free while realizing the contribution limits still apply if the company goes bust? For taxable accounts, is the rule of thumb basically just try to hold onto things for a year to enjoy a slightly smaller capital gains tax? I know, I should hold for three to five years, but if the original thesis blows up how long would you wait to get out just to try to make it to the 12 months? I'm going back and forth and the one thing I am 100% sure of is that there is no one answer to rule them all, but would love to hear your opinions."
Brokamp: What Sean is asking about is the asset allocation, which is basically which type of investments should go in which accounts. He's right that to a certain degree it is more art than science. I think one way to approach it is to just rank your investments and investment strategies from the most tax-inefficient, meaning the ones that generate the most taxes, down to the ones that are the most tax-efficient. At the top would be something like real estate investment trusts because they're high yielding, they pay out income every year that's taxed if it's not held in a retirement account. Plus, much of the income from a REIT does not qualify for the qualified dividend lower tax rates, so it's taxed is ordinary income. You would also place at the top there an active trading strategy. Maybe you're a day trader, or maybe you invest in an actively traded mutual fund that has a lot of turnover that generates a lot of tax consequences. Even if you just hold on to the fund, you're still responsible for the tax consequences which goes on to the fund, then you move down to the list. You just move down to higher-yielding stocks.
Brokamp: Further down the list might be index funds which are generally tax-efficient but still pay dividends and will sometimes distribute capital gains distributions. Then at the very bottom, would be a stock that doesn't pay a dividend and that you plan to hold on for many, many, many years, and at the very bottom, would be municipal bonds because you don't pay taxes on those at all. Basically, you start at the top of that list, the most tax-inefficient, and you put those into your tax-advantaged accounts and you fill those up first. One point that Sean is making is that people often recommend that you use your Roth for your investments that you believe will have the most growth potential, because that's the tax-free account, that's the one you want to grow the most. You might come across a stock and you feel like, "You know what, I think this might be the next, whatever, next Google [Alphabet], next Amazon, next Apple." You put that in your Roth because you want that one to grow the most, but then, it's a dud. It turns out to go out of business or just not doing very well and that account didn't grow very much at all. I think that's an interesting point. You definitely want to balance your expectations for a stock with which account you put it into to a certain degree. You didn't say anything about employer-sponsored accounts, but that's also important. I think your asset location is somewhat dictated by what's available within your 401(k) or your simple IRA or whatever you have at work. You would want to look at and choose the investments that are good there and then balance it out with your other accounts. The final thing I'll say is, Sean suggested that, do you hold on to a stock for just a little bit longer just to have a lower capital gains rate? We generally don't think that you should make too many investment decisions based on taxes, but if I were close to that one-year mark, I might hold on just a little bit longer.
Southwick: Next question comes from Eric. "I just heard the March Mailbag episode and noticed a question about options. The question was about Foolish options being part of the Foolish mindset. The response was to look at cash-secured puts on investments you like, so you get them at a better price, and covered calls on stocks you're unhappy with to sell at a better price. I have shares in the stock that I really like and have been using covered calls for three months now and collecting about $650 a month in premium. My plan is that if my shares are called away, I'll start selling cash-secured puts to also make between $450-$600 each month until I buy them back, and continuing this cycle indefinitely since it's been paying for half of my daughter's tuition each month. Are there downsides to this strategy?
Caplinger: Eric, it's an awesome strategy as long as it works and that is a current answer to a complicated question, but basically what you're doing here is you are hoping that your stock does well but not too well, essentially. Because what you're doing is, when you own the stock you really like, you want it to go up. That's what everybody wants when they own a stock. But when you use a covered call, you're trading away some of that upside in exchange for that monthly payment that you're getting every time you write one of those monthly options. If the stock price goes up too far, depending on where your strike price is on the covered call, then you're going to lose those shares. Those shares are going to get sold. Whoever you sold that option to, is going to exercise that option and then buy your shares at what will then look like a bargain price and you will have no more stock.
Now, you correctly point out, "Hey, no problem there. I'm just going to start selling some cash-secured puts," which means that basically, you will agree, you write a put option. You will agree that if the stock comes back down to whatever price you pick as your strike price, you're going to agree to buy that back. You'd be happy to buy it back. By the way, thank you very much for the option premium that you're going to give me in exchange for me writing that put option. Now, as long as the stock comes back down, you're golden. You end up you've made a round trip, basically. You started out on the stock, you wrote a covered call, that covered call get exercised, you had to sell the stock, but then you wrote a cash-secured put, the stock price conveniently went back down, and then suddenly, that option gets exercised, you bought back the stock. You have exactly the same stock position as when you started and you got some monthly income from it. That sounds great. Now the problem though, is what happens when that stock goes from $100 to $200? Then suddenly, it's like, "If I'm going to write a cash-secured put, well, I'm not going to get that $450-$600 a month unless I write a cash-secured put that's pretty close to that $200 a share mark." Now, in that case, I'm buying back stock for $200 a share when I wrote that covered call back when it was closer to $100. That's real money out the door. If that happens, then suddenly, you're in a situation where either you're buying high after you sold low, or alternatively, that income from the covered call and cash-secured put, it evaporates because you can't get as much income once that stock has changed in price by a lot. That's the downside. It may be worth it to you. I'm not saying don't do it. But it is a downside, especially with the stock that you really like.
The worst thing in the world is, really, love a stock, hope that it goes up, and then suddenly, it goes up, but it went up without you, and then you're on the sidelines and you're saying, boy, I was right, I'm not getting rich. What the heck happened here? Just be careful with it. Understand this is something with options. There's no such thing as free money. It can be a benefit to you, but there is always that trade-off and, here, it's the possibility that stock takes off without you. They can end up doing you more harm than good. Good luck with it.
Southwick: Next question comes from Justin. "Many years ago, a former financial advisor recommended my wife and I invest in a variable universal life policy as a way to invest in a tax-advantaged way and get life insurance at the same time. He recommended my wife get a $2 million policy and myself a $1 million policy." Do we say VULs?
Brokamp: Sure. V-U-Ls.
Southwick: We say it out or do we just spell out the acronym?
Brokamp: You do whatever you want.
Southwick: How am I supposed to know whether I'm supposed to say V-U-Ls or VULs? Who makes the rules here? Who decides it's SPACs for $10 a share? Not me, no one asked me.
Southwick: "VULs were too expensive and probably had hidden fees. I went along with this plan because he kept on pushing my wife and I had to do so. Fast forward six years, and we still have these VULs and I'm still not sure that they are the best way to invest or to pay for life insurance. My VUL has about $12,000 cash in the account and my yearly payment for the VUL is around $3,200, with about $1,800 of that amount going to the cash investment. In other words, I'm spending about $1,400 a year for a $1 million life insurance policy. My surrender value is $20,000, so if I stop paying on the policy, I lose my $12,000 cash. But as you know, there are better investments out there with lower fees. Should I just lose my $12,000 of cash in the account and start a term policy for $600 or so a year on a different million-dollar policy or keep paying the $3,200 per year?
Brokamp: Well Justin, every Wednesday, Dan and I answer financial planning questions on Fool Live, which is like this big Zoom call for Motley Fool premium subscribers and we hear a lot of stories like this. People who have bought or people are being pushed to buy life insurance products for investment purposes. The numbers in this example show why it's generally not a good idea. The money is a liquid, the returns aren't so great and the insurance is expensive. If you already found yourself in this situation, what can Justin do? Well, first of all, he can exchange this policy for something else. It's called a 1035 exchange, it's tax-free, you can exchange it into another life insurance policy that's cheaper. He could go to other agents, other brokers or other big companies that offer life insurance and say, can you offer me something that is cheaper than this, and then you do the exchange? He also could exchange it for just a plain old variable annuity. You can get those at very low cost from companies like Fidelity and Vanguard or TIAA CREF. That way, you would just have the cash value invested in a tax-advantaged account and let that grow and then go out and buy the term policy for much cheaper. Now, you say $600 or so a year, I'm assuming that you've done some research on this. But if that's true, then you're paying a third of what you're currently paying for that insurance.
The one thing I would just say is, you are older than you were when you first took it out, so your insurance is probably going to be a little higher. The one reason I would reconsider it is if you had any significant health changes since you last got life insurance, that will impact how much you pay for a new policy. But if you've recently looked and found that it's just $600 a year, I would certainly go that route. Get the life insurance through a term and then move this policy to something else that is cheaper and that is just a pure investment like a variable annuity.
Southwick: Next question comes from Joan. "I have an inherited IRA and an inherited Roth IRA from which I take required minimum distributions each year. I did not make an RMD in 2020 for either of these accounts as allowed by the CARES Act. I'm wondering if the life expectancy factor I used for calculating my RMD for 2021 should be the 2020 figure, or should I subtract one from what would have been the factor used to calculate my 2020 distribution as I would normally do as if I had actually taken the deduction?" Thanks, Joan.
Caplinger: There's probably a group of people out here who are wondering, what is this life expectancy factor that we're talking about here? The reason they might be wondering that is that for a lot of people, the need to do these sophisticated calculations unfortunately went away because the change in laws on us, and so, most non-spouse beneficiaries who inherent IRAs no longer have the ability to take money out over their expected life span. Instead, they have just a squat 10-year period that they have to figure out what they're going to do, get it all out within that first 10 years. But for folks who inherited IRAs prior to the beginning of 2020, the rules that Joan's talking about here apply.
Basically, what you did was when you inherited your IRA, you figured out what the IRS thought your life expectancy was, and then, you had to take out the fraction of that, that corresponded to that year. If your life expectancy was 40 years say, when you inherited that IRA, that first year you had to take a required minimum distribution, IRS made you take one-40th of the balance at the beginning of the year, you had to take that out as your required minimum distribution. Next year, IRS said, hey, it was 40 last year, we're one year closer to death, that means 39, and so they make you take one-39th out and so on and so forth until by the end of 40 years, even if you were still around, you had to take it all out that you didn't recalculate. You just said, hey, that's 40 years and you get 40 years to take it out. The question here was, what happened when in 2020, the federal government said, hey, you don't have to take an RMD this year, you get basically a one-year timeout and we got to sit here and you basically get to do in 2021 what you would have done in 2020, or did time move on and we just said, well, we're going to skip it for 2020, but we're going to keep playing by the same rules in 2021. It's the second version of that. Basically what you will do Joan, is you will take that life expectancy factor that you would have used in 2020, even though you didn't do it, even though you didn't have to take anything out, you will still use that, and then you will subtract one just like you have every year when there have been RMDs, you'll subtract another year for 2021 and you will take out that fraction.
When you compare what you did in 2019, which was the last time that you had to take one, and what you did in 2021, that life expectancy factor, it will go down by two years, which is what you expect because two years went by. No real time out there, it's just a one-time break. We saw this happen once in the early 2010s. That's how the rules work then, that's how the rules work now. You'll have to take a little bit more. It's not a huge amount more, but just a little bit more than you would have if you'd gotten the timeout, but that's how the ball bounces this time around.
Southwick: Next question comes from Jim. "In 2020, I took Bro's advice." When you hear words like that, do you just hold your breath?
Brokamp: Well, my first reaction is, I don't give anyone advice because I'm not allowed to give personalized advice, I am just providing information and some things that you should consider, but you should always consult your own professional before you make any major decisions.
Southwick: Right. Anytime you hear, "I took Bro's advice," it's basically a punch to your gut. You're like, I think I'm going to be sick.
Brokamp: It just shows how effective all the disclosures and disclaimers that we make are. It's just like a wink, wink, nudge, nudge advice.
Southwick: In 2020, I took Bro's very specific and personal advice for my situation.
Southwick: Jim, you're giving Brokamp an arrhythmia, but that's fine. Here we go, "In 2020 I took Bro's general advice that he delivers across this podcast to thousands and thousands of people every week, and I did the mega backdoor 401(k) thing. I maxed out my 401(k) all the way up to the all-in 401(c) limit, of $63,500 with deferrals, company matching and after tax contribution. To my surprise, my employer then made a true-up contribution in mid-January 2021 to account for the fact that my monthly income fluctuated quite a bit throughout the year. To make matters worse, both my HR department and Fidelity said that they don't monitor our contributions against the 415(c) limit and they give conflicting answers as to what year accounts to what. What contribution year does that true-up count against, if it counts toward 2021, then I will just reduce my plan contributions this year and account for it now. But if it accounts against the previous year then I have exceeded the 415(c) limit, I presume that unless I get it fixed, I'll owe the 6% excise tax on it when I start to withdraw that money in retirement quite a few years from now; correct?
Brokamp: Well, Jim, I have to say I went down a bit of a rabbit hole trying to find the exact answer for your question, and I couldn't find it. But I'm going to give you some thoughts here. First of all, when it comes to HR folks, we all love them, but they are very knowledgeable generally about benefits. Most of them are not real experts about the 401(k), unless you have a company that has someone who is just dedicated to the 401(k). If I'm in a situation where the HR person is telling me one thing and Fidelity is telling me another thing, I'm probably inclined to go with Fidelity. That said, I've had experience calling big financial services firms and being on the phone with someone and they tell me something that's not true. I would maybe call Fidelity a few times, get different people or maybe even get the answer in writing. I would also say there are probably a couple of other ways to determine when that contribution, what year that is being counted toward.
First of all, you could just log into Fidelity online. It should indicate how much money has been contributed to your account this year. I'd be surprised if it doesn't say whether it's in this year or not, that extra money that you got. What also might happen, and we do this, we have this at The Motley Fool, you're very last paycheck, will indicate how much money was contributed to your 401(k) account and it's a mixture of your contributions as well as the employer contributions, so I would look at those two things to look for the answer. If you can't find the answer, I would default to that it happened this year because that's the general rule. Like when money goes into a 401(k) it accounts for the calendar year in which it went in the account. The only other thing that I will say is that you said that if you over contributed that you'll pay a 6% excise tax on that when you start to withdraw that money in retirement. That's not true, it's a 6% excise tax assessed every year until you fix it. You definitely want to put in the effort to make sure you get it right, and if you did make an excess contribution, there's all these steps you have to take to take that money out, you owe some taxes on any money that that earned. But it's definitely better to take care of that sooner rather than later.
Southwick: Next question comes from Joseph. "If I have a traditional IRA 401(k) and Roth IRA and want to make withdrawal of principal from the Roth, am I subject to the pro rata rules making some of that withdrawal taxable?"
Caplinger: Now, it's funny because Joseph, on the financial planning power hour Bro and I do every week, there's always these questions about the rules. It's the five-year rules and it's the pro rata rules, and we're always like, oh boy am I going to take this question? Because am I going to get the rules mixed up, am I going to get confused but, as it goes, this one's actually pretty simple because the fun thing about Roth IRAs is that pretty much, I can't really think of a situation where this is not the case. When you put money into that Roth IRA, if you're eligible to make direct contributions in, I'm not talking about backdoor Roth, I'm not talking about any of that stuff. I'm just talking about actual vanilla contributions, to a Roth IRA, if you can put that money in, then you can take it out, and that's it. No pro rata, no nothing. You can take it out. You just say, "Hey, this money was in the Roth, I'm taking it out. It's the money that I put in, and so because I put it in, no taxable income on any of the income that it generated because I'm not touching those earnings, I'm just taken my contribution." No 10% penalty, because no 10% penalty applies on the amount that you contributed, and this is why Roth IRAs are as popular as they are, not just for retirement savings, but a lot of folks use them for other types of savings, things like saving for a kid's college, saving for down payment on a house, all kinds of things.
This is a big part of it because of this ability to tap into these accounts, their retirement accounts. We've all been trained, "Hey, retirement account, don't touch it, don't touch it." Are you 59 1/2 yet? Don't even think about it. But with the Roth, you actually do get to think about this and you get to say, "Hey, I want my contribution money out, I need it, I can get it." No tax consequences, no penalties, nothing like that. Now, of course, once it's out, it's out and it's no longer working for your retirement savings. So you don't like to use this rule if you don't have to, by any means. But it is there, no pro rata rule, no complication. As long as you don't go above the amount that you've contributed, just take it out and you're done. It's one of the simplest things you'll find in this very complicated Roth IRA domain.
Brokamp: But just to complicate things further, I will point out that that is different for the Roth 401(k), Roth 401(k) is not as easy when you take that money out it is pro rata, so it's the Roth IRA is the one that has all the flexibility.
Caplinger: Well of course it's more complicated, Bro, because it's retirement accounts, so it couldn't be simple, could it?
Southwick: That's why you two have jobs.
Brokamp: That's true. If it would be simple, we'd be out of work.
Southwick: That's true. Last question comes from Joe, "At 61 years old, it's time to preserve some wealth. Are bond funds the way to go? Are bonds at risk due to low rates?"
Brokamp: The quick answer is yes, but just a bit. There's no question that when rates go up, the value of existing bonds goes down, at least temporarily. For money you want to keep absolutely positively safe, cash is the only way to go. But you're going to get low returns historically, by investing in bonds, you earned maybe 2%-3% more a year than over cash. I don't think you're going to get that now. But I would say that if you are looking for a place to put money that's not stocks, that has the potential to earn a little bit more than cash and you're holding onto it for three, five, seven years. Basically, it's just like a balance to your portfolio. I think a mix of bond funds can be good. I like a diversified mix of actively managed bond funds as well as index bond funds. We love index funds for stocks here on the show. I like them for bonds, too, but there is more potential diversification and returns with actively managed bond funds, look for the total return bond funds from companies like Dodge & Cox, Metropolitan West, PIMCO, Doubleline, TCW. They each have their own specialties in terms of corporates versus treasuries, mortgage bonds, some a little bit of international bonds. But buying a handful of those, I think you get some good diversification, some good potential for outperforming cash. But generally speaking, Joe's right, bond funds are facing a headwind, so you are looking at very low returns, certainly for the near future because study after study has showed the best predictor of bonds over the next five, seven years is current interest rates, and current interest rates are still historically very low.
Southwick: Way to go, guys, that was it. Dan, thank you so much for joining us. I know Bro gets you every week at Fool Live, but we only get you once a year apparently.
Caplinger: We'll make it more often, I'll come by, definitely.
Southwick: We'll have to do that. Well, yes, that's the show. It's edited musically for the masses by Rick Engdahl. Our email is [email protected]. For Robert Brokamp, I'm Alison Southwick. Stay Foolish everybody!