Finance 101: October 2024
In October the financial advisors at Ruedi Wealth Management wrote four 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 October all four are below.
Personal Reserve Study
Paul R, Ruedi, CFP®
This year I found myself spending on several big-ticket maintenance items all at once. These were things I knew I needed to do someday, and I had planned for them accordingly. But I have to admit, I was surprised by just how much some of these big-ticket maintenance items now cost, and how much that amount can rise over time.
Everyone knows inflation has pushed up the prices of goods quite a lot in recent years. If you ask people the prices of groceries they buy regularly, they will have a good sense of what those things cost, and how much prices have risen. But if you ask them the price to replace the air conditioner that they haven’t replaced in 20 years, they are likely to vastly underestimate the cost.
The cost of home repairs, car repairs, and other lifestyle maintenance expenses are becoming so large, the vast majority of people can’t expect to have a large enough surplus in their budget to deal with them at any given time.
As a result, these expenses really need to be prepared for in advance. When an HOA or other entity needs to manage known maintenance expenses, they do what is called a reserve study to see if they have enough money to pay for future repairs. I think people should do reserve studies in their personal lives as well.
First, take an inventory of necessary big-ticket spending items you will have to take care of at some point. Then you will want to get a rough idea of how much those things will cost. After that you will want to assess how long you have before you will likely need to spend on each particular item. If that spending needs to occur in the distant future, don’t forget to adjust the future price for inflation.
If you find you are heading towards a situation where you will not have the cash to pay for something when you need to, create a plan to start setting aside enough each month to build up a reserve fund that will be large enough to pay for things when they are needed.
It is important to plan ahead for necessary repairs, maintenance, new vehicle purchases, or anything else that requires a large amount of spending all at once. By doing so, you will put yourself on a path to ensure you have the resources to deal with the problem whenever it shows up. If you think you need help with that, you may want to talk to a financial planner.
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
Compared to What?
Paul R. Ruedi, CFP®
This past week a friend of mine asked me to look at a couple of actively-managed mutual funds that he had purchased decades ago. After such a long period of time, the amount in the funds was significantly higher than the initial amount invested in them. As a result, he assumed they had performed very well.
Of course, compared to not investing at all, this person was much better off in these funds. But was the growth of wealth in each fund actually a result of a particularly skilled manager? Or was it simply a result of investing in stocks in some form? In order to find out, it is helpful to compare the performance of a fund manager to a relevant benchmark. The results are often surprising.
Benchmarks are hypothetical groups of stocks that are used to provide perspective on manager performance. For example, a mutual fund that invests in large, US companies would compare itself to the S&P 500 index – a group of 500 of the largest companies in America. A mutual fund that invests in small US companies might compare itself to the Russell 2000, a group of 2000 small US company stocks.
Benchmarks were originally created to show how great active managers were performing. In an ironic turn of events, they actually showed the opposite. Study after study that looked at manager performance relative to their benchmarks continued to find the same thing: the vast majority of investment managers underperform their passive benchmarks.
If you look at the historical performance of an actively managed mutual fund you own, you will likely find it underperformed its relevant benchmark. If you don’t believe me, try it. If you simply type the ticker of a mutual fund into google, when the results show up you can click a button that says “compare.” That will enable you to plot a passive benchmark or other fund on the same chart to see how the performance compares.
In most cases I look at, this underperformance is much more significant than people expect when compounded over long periods of time. This is because actively managed funds have higher fees, higher turnover, and more concentrated portfolios that often miss out on the star performers that really drive the returns of markets.
If you invested this way in the past, don’t beat yourself up. Pat yourself on the back for investing at all. But don’t make the same mistake twice. Consider switching to lower-cost, passively-managed funds. If you need help with that, talk to a financial advisor.
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
Options Contracts
Paul R. Ruedi, CFP®
Options contracts provide a buyer with a right, but not obligation, to buy or sell a certain amount of a stock (usually 100 shares) at a specified price. The option only exists for a certain amount of time, and can only be “exercised” before the expiration date. The two types of options contracts are called “put options” and “call options.”
A put option provides a buyer with a right to sell a certain amount of stock at a certain price. In other words, they are able to “put” those shares on someone else at a specified price. One reason a person would buy a put option would be to hedge (reduce risk) of a stock they own a lot of shares of dropping in price. A person may buy a put option if they wanted to speculate on the price of a stock dropping even if they do not own the stock.
A call option gives a buyer the right to purchase a certain amount of stock at a certain price. That is, they can “call” the stock away from someone else at a specified price. A person would buy a call option if they wanted to speculate on the price of a stock increasing.
These contracts are purchased from a seller, who is obligated to take the other side of the transaction. Since the seller is taking a risk by guaranteeing to either buy or sell a security at a certain price, they sell options contracts for a price that compensates them for that risk. If the buyer never exercises the option before it expires, they lose what they paid for the option, and the seller is able to pocket that amount.
If the price of a stock moves below the strike price for a put, or above the strike price for a call, the option is “in the money.” A buyer would then exercise that option, and the seller must buy or sell shares accordingly. This makes selling options incredibly risky, as any movements past the strike price start to make it very expensive for the seller to be on the other end of the transaction. The downside of selling a call, for example, is practically unlimited, and all you can gain is the amount you sold the call for.
The risk of buying options is limited compared to selling them, but both should be approached with caution. If you are not absolutely sure you know what you are doing with options contracts, it is probably a good idea to avoid them altogether.
Paul R. Ruedi is a CERTIFIED FINANCIAL PLANNER™ professional with Ruedi Wealth Management in Champaign, Illinois.
The RMD Tax Time Bomb
Paul Ruedi
In my 40 years as a retirement planner, I’ve noticed a lot of diligent savers end up with a significant amount of their wealth in a traditional 401(k) or IRA. Though a large traditional IRA balance is something we’d all feel lucky to have, the mandatory withdrawals known as required minimum distributions (RMDs) from these accounts can present some financial challenges. RMDs, which must begin after reaching age 73 (as of 2024), can trigger hefty tax liabilities, especially for those with sizable account balances.
The core issue stems from the fact that RMDs are taxed as ordinary income, regardless of whether the account holder needs the money for living expenses. The larger the IRA balance, the larger the RMD, and the larger the tax bill. Individuals who have diligently saved and invested over the years could see their RMDs push them into higher tax brackets, triggering additional taxes on Social Security benefits, and even subjecting them to the Medicare income-related monthly adjustment amount (IRMAA).
One of the most challenging aspects of large RMDs is the loss of control. While tax planning strategies can help manage the tax burden of traditional IRA withdrawals in earlier years, once the RMDs start, the minimum amount that must be withdrawn is determined by the IRS’s life expectancy tables. You cannot skip a distribution or take out less. For those with high balances in their IRAs, the RMDs can become disproportionately large, forcing them to pay taxes to withdraw funds well beyond what they need for their annual lifestyle expenses.
One solution to mitigate the impact of large RMDs is to consider Roth conversions early in retirement or in the years leading up to retirement. While this strategy involves paying taxes upfront on the converted amount, it allows future growth to occur tax-free, and Roth IRAs are not subject to RMDs during the owner’s lifetime. This can preserve flexibility, minimize tax burdens in later years, and reduce the risk of large RMDs driving retirees into higher tax brackets.
While the idea of forced withdrawals from a traditional IRA may not seem problematic, for wealthy individuals large RMDs can create a cascade of financial complications and need to be planned for in advance. Proper planning can help alleviate these issues and ensure that retirees are able to live the best retirement possible with the savings they have. If you aren’t sure how to do that yourself, you may want to consider working with a retirement planner.
Paul Ruedi is the CEO of 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.