In behavioral finance, there’s an important concept that doesn’t get a lot of discussion: It’s called temporal discounting. The idea is that we tend to view our current and future selves, to some degree, as different people. And thus, there’s the tendency to discount the needs of that “other” person. It’s an interesting idea because, even for the most diligent planners and savers, there is an inherent tension between the financial needs of today and of tomorrow.
There is, for example, the concept of the “latte factor,” which argues that a young person could accumulate nearly a million dollars in savings simply by forgoing a daily coffee and muffin. Personally, I’m not sure that’s the road to financial success, but in principle, the latte factor illustrates the importance of not discounting our future selves. Along these lines, as we look ahead to the new year, here are some financial steps to consider.
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 thirty years ago. Her initial investment was $19,000. When she sold her shares last year, they were worth $268,000. That seemed like a great result, but surprisingly, she actually had a loss on this investment. 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 were reinvested. The result was that she continued to buy more shares throughout the 1990s tech boom. And while her original $19,000 might have had a gain, all of the subsequently purchased shares turned the whole thing into a loss. Worse yet, for decades, she had been paying taxes each year, heaping on unneeded extra income during her peak earning years.
To avoid a similar result, I suggest reviewing your portfolio. If you hold any actively-managed funds in a taxable account, check out the fund’s track record of making capital gains distributions. You can find this information on research sites like Morningstar. Look up the popular American Funds Growth Fund of America, for example, 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 impact to 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 value of the fund in additional 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 it has a sizable unrealized gain, you may be hesitant to sell it. To be sure, it would involve a one-time tax to exit the fund. 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. That is for understandable reasons. And when folks do get these tasks taken care of, they’re usually not in a hurry to revisit them. But over time, it’s important to be 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. If you have whole life coverage, something to consider is cutting back on the whole life, with its relatively higher premiums, and redirecting 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, but unfortunately, that reflects the reality that a disability during our working years is much more likely than dying. The good news is that your employer may already provide some coverage under a group policy. It’s worth checking, though, and running the numbers to see if your family would be able to manage for the long term with that 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 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.
The logic is almost universally applicable, 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. This won’t apply to everyone, but if your tax-deferred balances are north of about $5 million, it might be worth doing some more detailed projections.
Consider an annuity. Annuities have a bad reputation. Some of that is 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 lifelong income.
Pay down your mortgage. An age-old debate in personal finance is whether it makes sense to make extra payments toward a mortgage, or even to fully pay it off. Especially if you have a low rate, the math suggests that you’d be better off not paying down your mortgage any faster than you need to, 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%. But to guarantee that result, you could buy a 30-year Treasury bond today and earn 3.5% with negligible risk, ensuring that you’d come out ahead by not paying off your mortgage early.
That’s what the math says. Still, your future self might thank you if you do the opposite. Why might that be the case? The reality is that none of us knows what the future might bring. Suppose, for example, you choose to retire early. Or maybe money becomes tight for other reasons later in life. In any number of circumstances, it would provide a welcome dose of flexibility to know that your home is paid for.
