AS I NOTED LAST WEEK, investing can be maddening. But it isn’t just investing. Many other personal-finance questions can also drive us crazy. Why is that?
One reason: The stakes are often high, so mistakes can be costly. A second reason: By definition, all data are historical, but all decisions are about the future. To the extent that the future doesn’t look like the past, we have a problem.
Those two factors are very real. But there’s a third reason financial decisions can be frustrating: Many of the numbers that we rely on to guide our decisions can be confusing, inconsistent and sometimes downright misleading. Below are the five instances I’ve encountered most often.
1. IRA distributions (Part I). I remember speaking with a fellow who had recently turned age 70. His plan, he said, was to delay collecting Social Security until age 72 so he could maximize his benefit. This revealed a key source of confusion for retirees. Until a few years ago, investors were required to begin taking distributions from tax-deferred retirement accounts at age 70½. That aligned, more or less, with the age at which Social Security benefits hit their maximum, which is age 70.
But under new rules, required minimum distributions (RMDs) from retirement accounts don’t need to begin until age 72. Meanwhile, the Social Security rules are unchanged. Benefits still hit their maximum at 70. While the change to the RMD starting age benefited many investors, it also introduced confusion. And the rules may change yet again: Congress is now considering moving the RMD starting age to 75. If you’re in your late 60s or early 70s, you’ll want to keep an eye on these rules.
2. IRA distributions (Part II). For investors who dread RMDs, there’s a handful of solutions. One is a qualified charitable distribution (QCD). This allows you to make a contribution to a charity directly from you IRA. You don’t receive a tax deduction for your generosity. But it counts toward your RMD—up to $100,000 per year—without registering as income on your tax return.
Those features all make QCDs a great strategy for investors with sizable IRAs. But there’s a quirk in the rules: As noted above, RMDs don’t need to begin until age 72. But you can start QCDs, if you wish, at age 70½. You don’t have to wait until 72. Why would you make a QCD earlier? One reason: If you have significant tax-deferred IRA balances and charitable intentions, this would trim the size of your IRA, thus reducing future RMDs.
3. Life insurance premiums. If you’re like most people, when you receive a bill, you pay it. There can be a wrinkle, though, with whole-life insurance policies. It may be that the premium shown on the invoice is not the actual amount due. This could be for one of two reasons.
First, the amount on the invoice might be an artificial number chosen by the insurance agent, at the inception of the policy, to help build up the policy’s cash value. If that’s the case, you might be able to pay less than the amount shown on your invoice.
A second possibility: If you’ve been making extra payments like that for a period of years, it may be that your policy is now at a point where it’s self-sustaining. In other words, the dividends from your accumulated cash value might be sufficient to cover all of your future premiums. That would allow you to stop making payments entirely. Every policy differs, of course, so you’ll want to consult your agent and check the numbers carefully. But it’s important to keep in mind this possibility—that the amount “due” may not actually be due.
4. Marginal tax brackets. Some financial decisions hinge on an evaluation of your marginal tax bracket—if, say, you’re considering making a large charitable contribution or a Roth conversion. But unfortunately, our tax code is so immensely complex that a taxpayer’s marginal tax bracket isn’t necessarily the income-tax rate that applies to the last dollar of income. This is an inconsistency that can bedevil both working people and retirees.
For retirees, the key drivers are Social Security and Medicare. Social Security benefits are only taxed above certain income thresholds. Similarly, Medicare’s income-related monthly adjustment amount (IRMAA) surcharges only apply above certain income thresholds. But the effect is the same: As your income approaches various levels, the next dollar of income can cause a very significant jump in a retiree’s overall tax rate. In certain cases, just an extra penny of income can cost you far more than that in taxes.
For those in their working years, the tax thicket is even worse, thanks to the mix of tax credits and deductions that phase out as income rises. As a taxpayer’s income hits those phaseout levels, the effective marginal rate can jump significantly—far in excess of what a simple tax bracket analysis would suggest. The solution: If you’re doing tax planning, I suggest using a comprehensive tax calculator or a tool like TurboTax that will factor in the myriad variables. If you’d like to learn more about this topic, CPA and author Mike Piper provides more detail in this article.
5. Bond rates. Suppose you were choosing between two bonds from the same issuer—identical in every way except that one carried an interest rate of 5% and the other 3%. Which would you choose? The answer: It depends. At issue is the distinction between a bond’s coupon rate and its yield.
A bond’s coupon is the amount that it will pay in reference to its par value. In general, a bond’s par value is $1,000, so a bond with a 5% coupon rate would pay a bondholder $50 of interest each year. By contrast, yield describes the total investment return that an investor would realize if the bond were held to maturity. In addition to the coupon payments, yield also takes into account the price at which a bond is purchased.
To understand yield, let’s look at two examples. In the first case, suppose you paid $1,000 for a bond with a 5% coupon. In that case, since the value of the bond at maturity—$1,000—will be the same as the purchase price, the investment return will consist of only the 5% coupons. The yield on this bond will thus be 5%.
But suppose you got a bargain and only paid $950 for this same bond. This can easily happen. Bonds don’t always sell at par. For simplicity, let’s assume the bond matures in one year. In that case, you’d still receive your 5% coupon payments. But in addition, you’d realize a gain on the price of the bond itself. At maturity, the bond’s issuer will pay you $1,000. Since you only paid $950, you’ll enjoy an additional gain of 5.3% ($1,000 divided by $950). In total, then, this bond would end up yielding more than 10%, even though its coupon was just 5%.
The lesson: When evaluating bonds, don’t dismiss bonds with low coupons and don’t be deceived by bonds with high coupons. Always look at yield. That’s the more important measure.