Help Yourself

Adam M. Grossman

IN BEHAVIORAL FINANCE, there’s an important concept that doesn’t get a lot of attention: It’s called temporal discounting. The idea is that we view our current and future selves, to some degree, as different people—and there’s a tendency to discount the needs of the “other” person. It’s an interesting idea because, even for the most diligent planners and savers, there’s an inherent tension between the financial needs of today and those of tomorrow.

Take the “latte factor,” which argues that a young person could accumulate nearly $1 million in savings simply by forgoing a daily coffee and muffin. Personally, I’m not sure that’s the road to financial success. Still, the latte factor illustrates the importance of not discounting our future selves. Along those same lines, as we look ahead to 2023, here are some other financial steps you might take to help your future self.

Sidestep taxes. Earlier this year, I told the story of an investor who had an odd experience with a mutual fund. She first bought shares in the fund about 30 years ago. Her initial investment was $19,000. When she sold her shares last year, they were worth $287,000. That seemed like a great result. But surprisingly, she actually had a loss on this investment for tax purposes.

How could that be possible? The problem was that the mutual fund in question was actively managed and generated sizable capital gains distributions each year, which she reinvested and thereby raised her cost basis for tax purposes. Result: When she sold, her shares were worth less than all the money she’d put into the fund, including those reinvested distributions. While her original $19,000 might have had a gain, all of the subsequently purchased shares turned the whole thing into a tax loss. Worse yet, for decades, she had been paying taxes each year on the fund’s distributions, heaping on unneeded extra income during her peak earning years.

Want to avoid a similar result? If you hold any actively managed funds in your taxable account, check the fund’s track record for making capital gains distributions. You can find this information on research sites like Morningstar. For instance, look up American Funds’ popular Growth Fund of America, and you’ll see that last year it distributed gains of $6.01 per share when the share price of the fund was $71.12.

That translates to a capital gain equal to 8.5% of the fund’s value, delivering a sizable tax bill to the fund’s taxable shareholders. To quantify this, suppose an investor’s capital gains tax rate, including federal and state, is 25%. That fund distribution would have cost an investor 2% of the fund’s value in taxes (25% x 8.5%). That’s on top of the cost of the fund itself, which isn’t insignificant.

If you hold a fund like this, and you have a sizable unrealized gain on your investment, you may be hesitant to sell. To be sure, exiting the fund would involve a one-time tax hit. But you might be doing your future self a favor if that allows you to sidestep future capital gains distributions.

Plan for a rainy day. In my experience, there are two financial tasks that are most susceptible to procrastination: putting together an estate plan and buying life insurance. These may not benefit your future self, but they could be crucial to your family’s financial future.

Moreover, when folks do get these two tasks taken care of, they usually aren’t in a hurry to revisit them. But it’s important to make sure your estate plan and insurance coverage keep up with your needs—especially if you have children. Fortunately, term life insurance can be very inexpensive, making it relatively easy to add more coverage. Got a whole life policy? One possibility: Cut back on the whole life, with its relatively high premiums, and redirect those dollars into a much larger term policy to cover the years until your children are out of school.

Disability coverage is much more expensive. That reflects the reality that a disability during our working years is much more likely than dying. The good news: Your employer may already provide some coverage under a group policy. Nonetheless, it’s worth running the numbers to see if your family would be able to cope over the long term with that employer-provided benefit plus your accumulated savings.

Revisit your 401(k) contributions. For most people, most of the time, it makes sense to defer income into a 401(k). Say you have a handsome household income of $400,000. If you make a 401(k) contribution, your tax savings on that contribution would be 32% at the federal level. If your income in retirement is much lower—as most people’s is—then you’ll come out ahead when you withdraw those dollars from your 401(k) at a much lower tax rate.

But as you advance in your career and your tax-deferred savings grow, it’s worth confirming that this is still the case. If you’re self-employed or in a profession where you have access to multiple tax-deferred retirement plans, it’s possible to end up with very large tax-deferred balances. The result: At age 72, when required minimum distributions begin, your income might leave you once again in a high tax bracket. Indeed, if your tax-deferred balances are north of about $5 million, it might be worth doing some more detailed projections. Your future self may thank you.

Consider an annuity. Annuities have a bad reputation. Some of that’s well deserved, owing to their opacity and high fees. But not all annuities are created equal, and there’s evidence that they can deliver unexpected benefits. Research has found that those with more guaranteed income sources in retirement are both happier and live longer.

In addition to the opacity and high fees, there’s another reason people tend to avoid annuities: The risk that they won’t live long enough to recoup their original investment. In simple terms, people worry about buying an annuity on Monday and dying on Tuesday. That’s an understandable concern, but keep in mind the story of Irene Triplett, who died just a few years ago at age 90. She had been receiving a veteran’s pension benefit from her father. That may not sound remarkable, except that her father was a veteran of the Civil War. The lesson: If you end up living a very long life, your future self might thank you for providing guaranteed lifetime income.

Pay down your mortgage. An age-old debate in personal finance is whether it makes sense to make extra payments toward a mortgage. If you have a low rate, the math suggests you’d be better off not paying down your mortgage any faster than required, and instead investing those dollars where you might earn a higher return.

Today, in fact, the math is easy: Suppose you’re paying 3% on your mortgage—a rate that was available as recently as last year. Instead of making extra payments toward that loan, you could invest those dollars in the stock market where, history suggests, you’d likely earn far more than 3%. Want to guarantee you’ll come out ahead? Instead of purchasing stocks, you could buy a 30-year Treasury bond today and earn 3.5% with negligible risk, ensuring you’d do better than if you used the same dollars to pay off your mortgage early.

That’s what the math says. Still, your future self might thank you for doing the opposite. Why might that be the case? The reality is that none of us knows what the future will bring. Suppose you choose to retire early or perhaps, later in life, money is tight for other reasons. Being mortgage-free would provide a welcome dose of flexibility.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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John Yeigh
John Yeigh
3 months ago

Adam – another solid article. I might suggest further consideration of the level of 401K contributions once tax-deferred balances get around $3 million rather than your suggested above $5 million. A $3 million balance will generate $120K of annual RMDs. Add social security plus other income and a retiree’s tax rates may quickly get to the 28% or 33% level if the 2017 tax rate changes sunset in 2026 as slated. In addition, for anyone still contributing, the deferred tax account potentially has years to still increase in value, and for those married-filing jointly, tax rates could increase if one spouse happens to pass away.
Roths or Roth conversions are likely a worthwhile consideration for those with several million in tax deferred accounts,

Last edited 3 months ago by John Yeigh
Mr Moderate
Mr Moderate
3 months ago

Can I avoid that huge capital gains issue by investing in index funds or index etf’s? Currently I hold Vanguard Admiral shares in US large cap blend, small cap blend, large cap value, small cap value, and one diversified Vanguard ex-US Admiral shares. I only take out 3% of my portfolio every January, not indexed to inflation, just 3% of whatever is there come Jan 1st. Thank-you.

Jonathan Clements
Jonathan Clements
3 months ago
Reply to  Mr Moderate

Capital gains distributions are infrequent with broadly diversified index funds. The problem, of course, is that you may currently own other funds — and swapping into index funds could involve realizing capital gains.

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