Last week, I described investing as a task that can be maddening. It’s not just investing, though. Many other questions in personal finance can also drive us crazy. Why is that?
One reason is that often the stakes are high. Mistakes can be costly. A second reason is that all data, by definition, is 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 why financial decisions can be frustrating: Many of the numbers that we rely on to help guide decisions can be confusing, inconsistent and sometimes downright misleading. I used to have a colleague who would describe certain questions as “clear as mud.” It was an apt description for the landscape of conflicting data we all face in personal finance. Below are the five I’ve encountered most often:
IRA distributions, Part I. I remember once speaking with a fellow who had recently turned 70. His plan, he said, was to delay collecting Social Security until age 72 so he could maximize his benefit. This revealed a key point 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 would hit their maximum: age 70.
But now, under the new rules, required minimum distributions (RMDs) 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 rule benefited many investors, it also introduced confusion. And the rule may change yet again: Congress is now considering moving the RMD requirement to age 75. If you’re in your late-60s or early-70s, you’ll want to keep an eye on these rules.
IRA distributions, Part II. For investors who dread required minimum distributions, there are a handful of solutions. One is a Qualified Charitable Distribution (QCD). This allows you to make a contribution to a charity directly from a tax-deferred IRA. You don’t receive a deduction for this type of contribution. But it can satisfy your required minimum distribution requirement—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 wrinkle in these rules to be aware of: 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 help reduce the size of your IRA, thus reducing future required minimum distributions.
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 were the case, you might be able to pay less than the amount shown on your invoice, if you wished.
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 that it is self-sustaining. In other words, the dividends from your accumulated cash value might be sufficient to now 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.
Marginal tax brackets. Some financial decisions hinge on an evaluation of one’s marginal tax bracket—if you’re considering making a charitable contribution, for example, or completing a Roth conversion. But unfortunately, our tax code is so immensely complex that a taxpayer’s marginal tax bracket is not necessarily the tax rate that will apply to the marginal 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 also apply only 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 much more than it’s worth.
For those in their working years, the tax thicket is even worse. That’s because of the mix of tax credits and deductions that phase out as income rises. As a taxpayer’s income hits those phase-out 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.
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 is that it depends. That, in a nutshell, is one of the most fundamental, and also one of the most confusing, topics for bond investors. At issue is a 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” is $1,000. So a bond with a coupon rate of 5%, for example, would pay a bond holder $50 of interest each year. In 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 no different from the purchase price, the investment return will consist of only the 5% coupons. The yield on this bond will thus be 5%.
But now suppose you got a bargain and only paid $950 for this same bond. This can easily happen. Bonds don’t always sell at par. And for simplicity, let’s assume it 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, but 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 10.3%, 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. A bond’s coupon is interesting but only part of the story.