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Finance 101: January 2024 Thumbnail

Finance 101: January 2024

In January the financial advisors at Ruedi Wealth Management kicked off the year with five more columns for The News-Gazette’s business extra section. Make sure to look for them every Saturday in the weekend edition of the paper, but in case you missed any in January all five are below.

Roth IRAs for Grandchildren

Paul Ruedi

Encouraging young grandchildren to save for their future can be very difficult, as most don’t have the means or discipline to save early. I often receive questions from grandparents about how to kickstart a grandchild’s saving, and they usually bring up the idea of contributing to a Roth IRA on a grandchild’s behalf. But is it a good idea?

I am a fan of getting children to save early regardless of the account type. The impact of saving early and providing money with more years to grow cannot be overstated. Whether their savings are held in a Roth IRA or a regular taxable brokerage account doesn’t have as big of an impact as the grandchild starting to save early.

But Roth IRAs do come with some tax benefits – they are funded with after-tax dollars, grow tax-deferred, and can ultimately be withdrawn tax-free if all the rules are followed. Your grandchild will not owe taxes on the funds in the account as they grow over the years, and can ultimately withdraw from the account without paying taxes if they wait until age 59 ½.

A huge restriction when funding Roth IRAs for grandchildren is that you can only contribute the lesser of their earned income or $7,000. If they have no income, you can’t contribute. Another potential downside is if they do not wait long enough to withdraw their money, they will owe taxes on the gains portion of the distributions as well as a 10% penalty.

There are a few exceptions to this rule, for example if they own the account for at least 5 years they can withdraw up to $10,000 for a first-time home purchase, qualified education expenses, childbirth, adoption expenses, to pay for unreimbursed health care expenses, or health insurance if they are unemployed.

These restrictions on withdrawal could be a positive or negative depending on the grandchild. If a responsible grandchild really needs the money early for something that isn’t on the list of qualified tax-free withdrawals, they will be stuck. Alternatively, they could be viewed as a barrier that makes the money more likely to remain in the account instead of being used for frivolous purchases.

Whether the benefits of a Roth IRA outweigh the restrictions will really depend on the grandchild, but what is more important is the early saving itself. Setting up investment accounts to get grandchildren saving early is a great idea and can have a huge positive impact on their futures.

Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.

Reddit Investing

Paul R. Ruedi, CFP®

As a financial advisor with well-established investment philosophies, it is often hard to be aware of what everyday people are doing with their money. There are several different places you could check, but one of my favorites is reddit. Reddit is a community message board where people with similar interests can gather and discuss a topic. It is a great place for a financial advisor like me to get out of his own echo chamber and see an unfiltered version of what people are doing with their money.

There are as many different groups on reddit as there are investment and financial philosophies. There are Dave Ramsey groups devoted to everything he promotes. There’s a “Bogleheads” group that promotes the type of index investing popularized by Jack Bogle, the founder of Vanguard. There are also general groups about “money” that catch all financial stories and issues. Of course, no discussion about reddit investing would be complete without mentioning the insane risk takers in the WallStreetBets forum. If that name rings a bell, it was the source of all the craziness surrounding GameStop in early 2021.

 The most common post I saw in all the financial groups was people stating their age, showing a picture of an account balance, and asking complete strangers to comment on how they are doing. Rather than indulge people by discussing median net worth and investment balances, I will just state that comparison is the thief of joy. Asking complete strangers about where you stand is completely irrelevant to your financial success. Focus on where you are now, relative to where you were in the past. Ignore everything else.

The second most common post came from the wilder groups like WallStreetBets, and it is in the form of people discussing their options positions. Without going into too much detail, options are highly-leveraged financial instruments that involve a ton of risk. We’re talking about dynamite, next to gasoline, adjacent to a bonfire levels of risk. Though you might expect to see only posts discussing big wins, there are plenty of posts from people in terrible positions asking “did I mess up?”

Spending even a small amount of time “in the wild” reminded me that as a financial advisor, I can create more value for people simply by keeping them from making terrible financial mistakes than I can making subtle tweaks to the holdings of an investment portfolio. If you think you are at risk of making some of the big mistakes I saw on reddit, you may want to talk to a financial advisor.

Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.


Timing Inverted Yield Curves

David Ruedi, CFP®, RICP®

I first wrote of rumblings from the financial media about an “inverted yield curve” in the spring of 2022. The yield curve eventually did invert in July of 2022 and has been inverted ever since. An inverted yield curve is often cited as an indicator of an oncoming recession, which can be concerning to investors. But the past year and a half was a prime example of why you shouldn’t make a market timing strategy out of yield curve inversions.

To understand what an inverted yield curve is, it is important to understand what a “normal” yield curve is. A yield curve is a graphical depiction of the relationship between bond terms (number of years before a bond returns your principal) on the X-axis, and the yields of those bonds, which is on the Y-axis. Naturally, the longer a bond’s term, the higher the return investors demand to loan out their money. Therefore, the farther you go out on the X-axis (years) the higher the yield, resulting in an upward sloping yield curve.

But occasionally, bonds at the shorter-term end of the curve will actually have higher interest rates than the longer-term end of the curve – the opposite of what is usually the case, which is why it is called a yield curve “inversion.” For whatever reason, people are demanding a higher return on short-term bonds than long-term bonds.

Though it is hard to distill the movements of capital markets into a single explanation, if people are demanding a higher return on short-term bonds than long-term bonds, they are likely worried about the short-term prospects of the economy. This doesn’t necessarily mean a recession is looming, but often the concerns that caused a yield curve inversion do materialize and a recession follows.

It is a fairly reliable indicator of recessions, as the yield curve inverted before each of the last seven recessions. But it is tough to predict when that recession will follow, if at all. For example, the yield curve inverted in 1998 and was not followed by a recession.

On July 6 of 2022 when the yield curve first inverted, the S&P 500 index closed at 3902. It is now over 20% higher as I write this. The recession many were certain was around the corner has still yet to show up. Perhaps it is still on the way. But as it stands, investors who abandoned their stock portfolio in the face of an inverted yield curve have missed out significantly. Investors are better off pursuing a simple buy-and-hold strategy and should resist the temptation to time the market.

David Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.


What is a Bond Ladder?

Paul Ruedi

We recently received a call on our radio show from a listener who is planning on using a bond ladder for the fixed income portion of his portfolio during retirement. Though it does take a little bit of self-management, this approach is simple and intuitive. It is a sensible approach that could be implemented successfully by a typical retiree.

Creating a bond ladder involves purchasing bonds (or CDs) of different maturity dates and constantly rolling them over. For example, a person pursuing a 5-year bond ladder would buy individual bonds with 1, 2, 3, 4 and 5 years to maturity. A year from now the one-year bond will mature, and the proceeds will be re-invested in another 5-year bond. That is because the 2-year bond will have 1 more year to maturity, and will be the new “1-year” bond in the ladder.

Though it has 1 year left to maturity, the 2-year bond will still have the yield of a 2-year bond, which under normal circumstances would be higher than a 1-year bond. The 3-year bond matures in 2 years, but retains the yield of a 3-year bond, and so on and so forth. After 4 years have passed, the portfolio will be made up of entirely 5-year bonds (which under normal circumstances have higher yields than 1-4 year bonds) that are maturing each year.  As each bond matures it can be rolled over into a new bond to extend the ladder until an investor decides to stop.

There are a couple downsides to this strategy. The first is the lack of diversification - as most people who will choose one type of bond from one issuer with different maturity dates to build the ladder. The second is that it generally ignores what is going on in the yield curve now.

I specified “under normal circumstances” in the example above, because right now the yield curve is inverted - shorter term bonds are yielding more than longer-term bonds. A bond investor would have to think very hard about whether it makes sense to accept lower yield for locking up their money for a longer period.

Despite these downsides, a bond or CD ladder is a sensible strategy. We gave the caller an A+ on their simplified retirement portfolio that included a bond ladder for the fixed income portion. Those pursuing a bond ladder should only use the highest-quality issuers (no junk bonds!) and stick with their chosen plan of action.

Paul Ruedi is the CEO of Ruedi Wealth Management in Champaign, Illinois.


“Diversifying” Advisors

David Ruedi, CFP®, RICP®

Investors are frequently reminded of the importance of diversification. This often leads people to want to “diversify” themselves by splitting their assets between more than one financial advisor. While this approach sounds intuitive, it creates several unintended problems that leave people in a worse financial position compared to selecting one trusted financial advisor.   

An advisor can’t do their job optimally when they don’t manage the total investment portfolio. Sharing portfolio management with another advisor prevents either advisor from being able to control the overall ratio of stocks and bonds. This is problematic because financial plans are based on maintaining a particular asset allocation.

It also prevents the advisors from being able to rebalance the portfolio effectively and can lead to “overexposure” or “underexposure” to certain asset classes, depending on how the two advisors’ portfolios blend together. These issues can lead to improper diversification and greater investment risk.

Splitting money between multiple advisors can also create structural problems that often result in higher fees. Many advisory firms have tiered fee schedules where you pay a lower fee percentage for higher levels of assets under management. When you divide your assets between multiple advisors, you will generally pay advisory fees at a higher fee tier than if you consolidated your assets with one firm, and received a fee break on the full assets.

Hiring multiple advisors may also lead to higher taxes because the advisors can’t as easily utilize tax-efficient asset location or withdraw from the accounts in the most tax-efficient manner (or perform Roth conversions). Annual tax projections and tax planning are also more difficult when an advisor doesn’t have the complete picture or control over all the assets.

Investors also seem to be more prone to making emotional investment mistakes when their assets aren’t consolidated in one place. When someone uses two different advisors, they inevitably compare short-term investment performance. This often results in moving more assets to the advisor with better recent performance, but this often occurs right before that performance advantage swings the other way.

Investors’ hearts are in the right place to seek as much diversification as possible. However, splitting money between two financial advisors doesn’t create more effective diversification. In many cases, a client ends up less diversified. That, combined with higher fees, higher taxes, and increased likelihood of behavioral mistakes, makes splitting your money between multiple advisors a bad idea. It is better to stick with one advisor you trust.

David Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois. 


Disclaimer: Past performance is no indication of future results. You should not make any investment decisions without first performing your own due diligence and consulting your financial advisor.