Tax planning is a cornerstone of a solid retirement plan, ensuring you can enjoy retirement while maximizing the savings accumulated throughout your career. Understanding how different income sources are taxed, and leveraging strategies to minimize these taxes is critical. Additionally, the guidance of a trusted financial advisor who knows your situation, understands the complex tax landscape, and acts as a sounding board for your ideas and questions is indispensable. 

Understanding Your Retirement Income Sources

Retirement income has unique tax implications, depending on the account type or investment:

Utilizing Tax-Efficient Withdrawal Strategies

The strategy you use to withdraw from your retirement savings plays a crucial role in managing your tax impact. Typically, prioritizing withdrawals from taxable investment accounts first, to take advantage of potentially lower capital gains rates, is advisable.

Then, accessing funds from tax-deferred accounts like 401(k)s and traditional IRAs can help, as these are taxed as ordinary income upon withdrawal.

Integrating Roth IRAs into your strategy adds valuable tax diversification and flexibility, given that qualified distributions are tax-free.

Understanding the nuances of Required Minimum Distributions (RMDs) and selecting the appropriate investments to liquidate are also essential for minimizing tax liabilities. At Canty Financial, we emphasize tax-efficient withdrawal planning as a vital part of our retirement planning services, aiming to enhance your financial outcome in retirement.

Investing in Tax-Advantaged Accounts and Portfolio Structures

Considering tax implications prior to making investments can lead to substantial tax savings and provide increased after-tax returns. The choice between investing in traditional IRAs versus Roth IRAs, for example, should be influenced by your current and expected future tax situations.

Contributions to Health Savings Accounts (HSAs), if eligible, also offer tax benefits and can act as a substitute for your IRA or other tax-deferred accounts. Contributions to HSAs are tax deductible and if used for qualified medical expenses distributions are tax-free. Any distributions from HSAs after age 65 are considered ordinary income, but not subject to a 10% penalty.

Exchange traded funds are more tax efficient and have less capital gain distributions compared to similar mutual funds, allowing you to keep your money invested rather than having to pay large tax bills each year. We construct portfolios of ETFs at Canty Financial, giving our clients more tax-advantageous portfolio structures.

Harvesting Losses and Gains

Tax-loss harvesting is a strategy to offset capital gains with losses reducing your net tax burden. At Canty Financial, we leverage our portfolio rebalancing software, 55IP, to automate this process. Tax loss harvesting opportunities are consistently analyzed every 30 days, allowing our clients to take advantage of fluctuations in the market. If a fund can be sold at a loss, we will realize the loss by selling that ETF and then purchasing a very similar fund. This allows our clients to take advantage of the loss while remaining fully invested at all times. This approach is particularly beneficial for managing large, unrealized gains and for transitioning accounts to a new portfolio with minimal tax impact.

Charitable Contributions

Charitable giving, including Qualified Charitable Distributions (QCDs) from IRAs, can reduce taxable income and is highly effective if you are subject to RMDs or if you take the standard deduction. Donating appreciated assets directly to charity can also circumvent capital gains taxes, offering a tax-efficient way to support charitable causes.

Estate Planning and Gifting

We assist clients in developing estate planning strategies that minimize transfer taxes and facilitate the efficient transfer of wealth to heirs. This may involve the use of trusts, beneficiary designations, transfer on death titling, and strategic gifting. Understanding the rules and benefits of annual gifting can further reduce tax bills.

State Tax Considerations

State taxes can also affect retirement income. For instance, New York State does not tax Social Security or public pensions and offers a $20,000 exclusion for retirement account withdrawals.

Certain income such as interest from U.S. government bonds are also tax-exempt in many States.

Planning for State taxes, especially if considering a move in retirement, is crucial for minimizing overall tax burdens.

Consult with a Professional

Tailoring tax planning strategies to individual circumstances requires professional insight. The landscape of tax laws and personal situations is ever-changing, highlighting the need for ongoing tax planning.

At Canty Financial, we prioritize the integration of tax considerations into your comprehensive financial plan, covering areas such as retirement, estate planning, and investment management. Our approach ensures that our clients experience no gap between their tax strategy and their broader financial decisions, a common issue when advisors lack sufficient tax knowledge.

Engaging with a financial planner or tax professional goes beyond mere tax compliance, it's about maximizing your financial potential in retirement. By understanding and applying these strategies, retirees can significantly reduce their tax burdens, securing a more prosperous and worry-free retirement.

Bill Canty, CFP®, CPA, Financial Planner

Ed Canty, CFP®, Financial Planner

Joe Canty, CFP®, Financial Planner

Tina Alteri, CPA, Tax Advisor

Maureen Walsh, EA, Tax Advisor

We are excited to begin 2024, marking the 37th year of our firm's history. As we continue our journey, here are some important updates and enhancements to our services that we're thrilled to share with you.

Firm Updates and Our Services:

Market Overview:

Read our latest market insights and our recent rebalance strategy in our CFM Investment Commentary. We invite your questions and look forward to discussing these topics with you.

Enhanced Portfolio Management:

We're excited to continue our collaboration with institutional portfolio managers such as J.P. Morgan, BlackRock, Clough Capital, and State Street. This partnership aims to optimize our model portfolios, leveraging their extensive market experience and advanced analytical tools. This strategy enhances our ability to offer you diversified, robust investment options tailored to meet your individual financial goals.

Technology Resources & Updates:

Stay Informed:

Stay up to date on the latest financial planning news by subscribing to our monthly newsletter here.

Looking Forward to 2024:

We encourage you to explore the new features of our software and connect with a CFM advisor for personalized and tailored guidance. We look forward to helping you navigate your financial journey into the new year.

Best regards, The Canty Financial Management Team

Bill Canty, CFP®, CPA, Financial Planner

Ed Canty, CFP®, Financial Planner

Joe Canty, CFP®, Financial Planner

Tina Alteri, CPA, Tax Advisor

Maureen Walsh, EA, Tax Advisor

It’s important to understand the tax implications of investment decisions because taxes can have a significant impact on your investment returns. Here are some real-life examples we’ve seen of tax investment mistakes.

Misuse of IRAs and Roth IRAs

There are several common tax mistakes associated with IRAs and Roth IRAs, including:

Taking Large Distributions out of Retirement Accounts to Purchase Real Estate

Taking a large distribution out of a retirement account to buy a house can have several negative consequences, including:

  1. Taxes and Penalties: Withdrawing a substantial amount of money to buy real estate can push you into a higher tax bracket. This can considerably decrease the amount of money you receive from the withdrawal. Additionally, if you take out money from a traditional IRA or 401(k) before you reach the age of 59½, you may incur a 10% early withdrawal penalty on top of taxes due on the distributed amount.
  2. Impact on Growth of Retirement Savings: Taking a large distribution out of a retirement account will significantly reduce your retirement savings. Even if you plan to repay the money later, you may miss out on potential investment growth, which can impact your long-term financial security. Instead of taking a large distribution to purchase real estate, you can make a down payment and allow your investment returns to pay off the real estate purchase over time.

Understand Your Cost Basis Before You Sell

Understanding your cost basis is essential before selling an investment. The cost basis is the original purchase price of an asset. When you sell an asset, you will owe taxes on any gain above the cost basis. If you sell an asset for less than the cost basis, you may be able to claim a loss for tax purposes.

If you sell an asset after holding it for less than a year, any gains will be considered short-term capital gains and will be taxed at your ordinary income tax rate. However, if you hold the asset for more than a year before selling it, any gains will be considered long-term capital gains, which are taxed at a lower rate.

For this reason, understanding your cost basis is crucial to accurately calculate your tax liability and avoid overpaying or underpaying taxes. If you do not know your cost basis, you may end up paying more in taxes than you owe or risk facing penalties for underreporting your income.

Not Taking Full Advantage of Stepped-Up Basis

As an elderly person, it can be better to not realize gains on investments and instead hold onto them to get a stepped-up basis because it can potentially reduce the capital gains tax liability for you and your heirs.

When an individual dies, their heirs generally receive a "stepped-up basis" for inherited assets, including investments. This means that the basis of the asset is "stepped up" to the fair market value on the date of the individual's death, regardless of the original purchase price. For example, if an individual purchased a stock for $10 and it is worth $50 at the time of their death, their heirs would inherit the stock with a basis of $50.

If the heirs were to sell the inherited asset, they would only owe capital gains tax on any increase in value that occurs after the date of the individual's death. This can potentially reduce or even eliminate the capital gains tax liability. However, this strategy should be considered in the context of the individual's overall financial situation and goals, as there may be other factors that weigh against holding onto investments for an extended period.

Capital Gains Distributions Can Erode Returns

Frequent large capital gains distributions out of mutual funds can erode investment returns over time. Mutual funds can issue capital gain distributions to the fund’s shareholders at any time. These distributions are taxable, even though the shareholder did not sell any portion of the mutual fund. Depending on the size of the distribution and the shareholder's tax bracket, the tax liability can be significant, reducing the overall investment return.

On the other hand, ETFs (Exchange Traded Funds), offer more control over taxable events. Most ETFs do not have capital gain distributions, so taxpayers are less likely to be hit with a large tax surprise at the end of the year. Shareholders of ETFs realize gains when they sell, so they have much more control over when they would like to realize a gain. At Canty Financial we build our portfolios primarily using ETFs with the goal to maximize our client’s after-tax returns. 

Overall, it's important for investors to be aware of the potential impact of capital gains distributions on their investment returns over time. If investors are forced to sell investments to pay a large tax bill on a capital gain distribution each year, then it's highly likely to have a negative impact on long-term returns. 

If you have any questions about the tax implications of your investments, please feel free to reach out, we are here to help. 

Bill Canty, CFP®, CPA

Ed Canty, CFP®, Investment Advisor

Joe Canty, Investment Advisor

Maureen Walsh, EA, Tax Advisor

Tina Alteri, CPA, Tax Advisor

Changing jobs is a time of transition with a lot to do. Getting up-to-speed at your new employer is important and a top priority. When leaving a company, it’s crucial not to forget about your old 401(k) account. What to do with this retirement money is a critical decision to make during this period of transition. 

Your Options 

When leaving your employer you have several options regarding your 401(k) account balance. 

Taking a distribution will generally result in the money being subject to taxes and potentially a 10% penalty for those who are under age 59 ½. Unless the money is needed immediately for some reason, we generally do not recommend this option. 

Leaving the money in your old employer’s plan can be a good option in some cases. However, some plans treat former employees differently from active participants in terms of the investments available to them. They may even place their money in a separate account designated for former employees who have left their balances in the plan. 

We generally advocate that clients who are leaving their job consider rolling their plan balance over to either an IRA or in some cases to their new employer’s plan if applicable. 

The Benefits of Consolidation 

To the extent possible, it makes sense for investors to have their investments in as few places and accounts as is feasible for their situation. For example, it's easy to forget about an old 401(k) account at a former employer, especially if the account balance is relatively small. All retirement savings are important and should be managed in line with your overall retirement planning and investment strategy. 

Rolling your 401(k) account to an IRA at an outside custodian or to a plan at your new employer, if applicable, can help ensure that this money is properly managed and not forgotten. It's easier to focus on managing funds in a smaller number of locations than if the money is spread across a number of accounts held by various custodians. 

Having investments spread around in a number of locations is also terribly inefficient and takes more work on your part in terms of reviewing your asset allocation and other aspects of your overall portfolio. 

Advantages of a Rollover to an IRA 

Rolling a 401(k) over to an IRA account at an outside custodian offers a number of advantages in terms of managing your portfolio. It is often the path we recommend to our clients who are leaving their job and moving on to another company, or into a self-employment situation. 

First, the IRA will offer a much wider array of investment choices than leaving the money in an old employer’s 401(k) or rolling the money over to a new employer’s plan. This includes investments such as individual stocks, bonds, and ETFs plus a much broader array of mutual funds than what is typically available inside a 401(k) plan. 

This wider range of investment choices allows us to integrate this additional retirement money into the overall investment strategy we employ for the client’s other assets directly under management by us. We always work with clients to integrate the choices within their employer’s 401(k) plan into their overall strategy. But having the money in an IRA allows us to utilize the same investment options we use elsewhere in the client’s portfolio. 

The quality of the investment menus inside 401(k) plans varies widely. Some plans offer a solid array of investment options. Plans offered by larger employers may offer a better menu than plans from smaller employers. However, when our client’s money is rolled over to an IRA, we can often invest the money in lower-cost options than those that were available in their old 401(k). 

IRAs can also offer a degree of planning flexibility that may not be available in a 401(k). If it makes sense to do so, money held in a traditional IRA account can be converted to a Roth IRA. Money that was held in a designated Roth account in an old 401(k) can be rolled over to a Roth IRA where it will not be subject to required minimum distributions when you reach that age. 

Rolling Over to a New Employer’s 401(k) Plan 

In some cases, we find that it makes sense for a client to roll their 401(k) balance over to a new employer’s 401(k). The key factor is the quality of the investments offered in their new employer’s plan. If this is the case, then merging their old 401(k) account into this new plan can enable you to manage a large portion of your retirement in a consolidated fashion that is in line with your overall strategy. 

For those who are working at age 73 and beyond, money held in their employer’s 401(k) is exempt from required minimum distributions as long as they are not a 5% or greater owner of the company and if their company makes this election as part of the plan documents. 

Additionally, 401(k) plans offer higher levels of creditor protection than IRAs, which can be a factor for some investors. 

Summary 

When leaving an employer, your choices regarding your 401(k) are important. This retirement money needs to be managed in a fashion that is consistent with your overall investment strategy to help ensure that it keeps working to fund your retirement goals. Generally rolling this money to an IRA, or in some cases to a new employer’s 401(k), will be the best course of action. 

Please give us a call to discuss your 401(k), IRA, or any other financial issues. We are here to help. 

Bill Canty, CFP®, CPA

Ed Canty, CFP®, Investment Advisor

Joe Canty, Investment Advisor

Maureen Walsh, EA, Tax Advisor

Tina Alteri, CPA, Tax Advisor

ETFs and mutual funds are the two main types of managed accounts for investors. The IRS tax treatment of ETFs and mutual funds is the same, however, the structure of ETFs can make them a more tax-efficient option for taxable accounts. 

Let’s take a look at why ETFs are generally more tax-efficient than mutual funds. 

Structural Differences 

One of the biggest reasons for the generally greater tax efficiency of ETFs compared to their mutual fund counterparts are differences in structure. First, there is a higher percentage of actively managed mutual funds compared to the number of actively managed ETFs. The turnover in an actively managed fund is generally much higher during the year than with either an index mutual fund or ETF. 

Even when compared to index mutual funds, ETFs still have the advantage when it comes to tax efficiency. Mutual funds, even passively managed index mutual funds, can be forced to generate capital gains inside of the fund when they need to raise cash to meet client redemption requests. When a mutual fund manager needs to raise cash, they need to sell stocks or bonds held inside the fund. This can lead to the generation of unplanned capital gain distributions, both long-term and short-term. These capital gains are passed through to all remaining shareholders of the mutual fund. 

By contrast, only around 10% of the trades made by an ETF fund manager involve buying or selling the underlying securities held by the ETF. When ETF shareholders need to raise cash for whatever reason, they would simply sell some or all of their ETF shares during the trading day as they would with shares of an individual stock they might own. Any capital gains or losses realized by a shareholder of an ETF impact solely them and not the other ETF shareholders. 

Creation Units and In-Kind Redemptions 

ETF managers manage investment inflows and outflows through the creation or redemption of creation units. These creation units allow the ETF manager to do in-kind redemptions and exchanges of individual securities for ETF shares, reducing the need to sell these individual securities for cash and generating capital gains inside of the ETF. This process can help eliminate or drastically reduce the generation of capital gains during the process of rebalancing the portfolio. 

Year-End Surprises 

One aspect of mutual fund investing that can be very frustrating for investors are year-end distributions. In some years, mutual fund investors in taxable accounts may receive hefty capital gains distributions. This can be especially costly and frustrating if those capital gains are short-term gains that are taxed at their ordinary income tax rate. Often investors or their advisors must wait until the end of the year to find out what types of year-end, taxable distributions they are facing. 

ETF Capital Gains 

Like mutual funds, stocks, or other securities, ETF investors will incur capital gains taxes if they sell shares of an ETF and realize a gain on the sale. But in this case, the investor has control over when shares of an ETF are sold and the timing of any capital gains. 

ETF Dividends 

Dividends from both ETFs and Mutual funds may be taxed as qualified dividends if the investor has held the fund for at least 60 days. Qualified dividends are taxed at a rate ranging from 0% to 20%, depending upon the investor’s tax bracket. If the shares have been held for less than 60 days, then the dividends are taxed at the investor’s ordinary income tax rate.

Exceptions 

Some international equity ETFs, both in developed and emerging markets, have the potential to be less tax efficient than domestic equity ETFs. Especially with emerging markets ETFs, there may be rules prohibiting in-kind exchanges. Some commodity and inverse ETFs also may not be as tax efficient as ETFs focusing on domestic equities and bonds. 

Advantages of using ETFs within Portfolios 

In building our client model portfolios we use ETFs extensively in large part due to the tax efficiencies mentioned above. This is especially true for clients whose portfolios include taxable accounts. We feel that minimizing taxes is important not only for the current year's tax returns of our clients but minimizing taxes can help add to returns over a longer period of time. 

Beyond taxes, ETFs offer several other advantages for our clients. 

Our investment process is about balancing risk and reward for our clients as a key part of their overall financial planning strategy. The individual components of our investment models are each chosen based on our assessment of how they contribute to this overall goal. ETFs offer a number of advantages, even beyond their tax efficiency, which is why we use them in constructing client portfolios in both taxable accounts and in tax-advantaged accounts like IRAs.

To learn more about our investment strategies and how they can help you achieve your financial planning goals, please feel free to reach out.

Bill Canty, CFP®, CPA

Ed Canty, CFP®

Joe Canty, Investment Advisor Rep.

Maureen Walsh, EA, Investment Advisor Rep.

Tina Alteri, CPA, Tax Advisor

Asset location pertains to the types of investment assets that are best held in various types of accounts. Asset location is a tax minimization strategy that matches various types of investments with the type of account best-suited for that type of investment holding. 

Asset Location Basics 

Asset location is about strategically holding investments in accounts where you are likely to achieve the highest after-tax returns. This includes taxable investment accounts, tax-deferred accounts such as a traditional IRA or 401(k), or tax-free accounts which are usually Roth accounts. 

Due to the nature of dividends, interest, or capital gains connected with certain types of investments, it might be most tax-efficient to hold them in one type of account versus another. This is the essence of asset location. 

While it is not always possible to align your entire portfolio in a perfect fashion in terms of asset location for each holding, it does make sense to pay attention to this when deciding which investment holdings fit best into your various accounts. 

Investments to consider holding in taxable accounts 

The following types of holdings can be well-suited for a taxable account: 

Note at this writing we don’t know what, if any, changes the current administration might propose to the tax rates for long-term capital gains. If capital gains rates are drastically increased as some have speculated, this might change some of our thoughts above. 

Tax-deferred and tax-free retirement accounts 

Certain types of investments may be best suited for tax-deferred retirement accounts such as traditional IRA and 401(k) accounts or tax-free Roth accounts. Some examples include: 

Asset Allocation Should Govern Your Portfolio

Asset location can be an important consideration in investing as we all want to invest in the most tax-efficient way possible. 

In our opinion, however, asset allocation should govern your investing strategy. This includes the types of investment vehicles, the asset classes included in your portfolio, and the percentage amounts allocated to each of the various asset classes. 

Sometimes your situation doesn’t allow you to perfectly align the asset location of every holding within your portfolio. This might be a function of the relative size of the balances in your various types of accounts or other factors. 

Considerations for Asset Location 

Where appropriate and feasible, we feel that using asset location principles to determine which holdings are located in various types of accounts makes sense for most investors. However, we would caution investors to use good common sense in implementing an asset location strategy. 

For example, incurring unnecessary taxable income to realign your portfolio generally defeats the whole purpose of asset location which is tax savings. 

There are a number of ways to realign your portfolio to be more in line with an asset location strategy that best fits your situation. These include: 

When considering an asset location strategy for your portfolio, it's important to keep both current and future tax implications in mind. For example, will you be in a higher or lower tax bracket in retirement? 

Summary 

Asset location should be implemented as part of your overall financial plan and your investing strategy. If done correctly, asset location can be a key tool in your tax planning efforts. 

If you are looking for a fee-only fiduciary financial advisor who will always put your interests first, please give us a call to discuss asset location or any other financial issues. We are here to help.

Bill Canty, CFP®, CPA

Ed Canty, CFP®

Joe Canty, Investment Advisor Rep.

Maureen Walsh, EA, Investment Advisor Rep.

Tina Alteri, CPA, Tax Advisor

For many of us, our employer’s 401(k) plan is our primary retirement savings vehicle. Participating in the plan is generally easy and painless. Your contributions are deducted from your paycheck each pay period, there is nothing that you need to do other than select how you want your money invested. Some companies even offer a matching contribution on top of what you contribute. 

Even with these attributes, you still want to be sure that your company’s 401(k) plan is a good one and that it is a good place for your retirement savings. It's important to evaluate the plan in several areas. 

Investments Offered 

A key factor in evaluating your company’s 401(k) is the quality of the investment lineup offered. Quality encompasses several features. 

Do the mutual funds or other investment offerings allow you to build a diversified portfolio? Are there funds offered across a range of asset classes and sub-asset classes for stocks, bonds, and a cash option? Does the plan offer several low-cost index funds, for example, an S&P 500 index or one that replicates the total U.S. stock market? 

How do the funds compare to other funds in the same asset class? Where mutual funds or ETFs are used you can check on this using a service like Morningstar. The annual fee notice report that you receive from your employer will generally show a comparison of the investments to a benchmark like the S&P 500 or the Russell 2000, but usually not to other funds in the same asset class peer group. 

Company Matching 

Matching from your employer can help increase your plan balance. This is basically free money. The matching formula might be on the order of a 50% match on the first 6% of your salary deferral contributed to the plan. The higher the match obviously the better.

Another aspect of the employer match is the vesting formula, this refers to the time period in which the company match is yours should you leave the company. A typical formula is that you earn ownership in 20% of the match each year with full ownership occurring after five years with the company. 

In addition to a matching contribution, some companies will make an annual profit-sharing contribution to your 401(k) account. These contributions are optional, the company can skip a year if they had a bad year financially or for any other reason. 

All of these company contributions serve to enhance your retirement savings efforts beyond your own contributions. The amount that your company contributes to the plan on your behalf is a factor in evaluating the quality of your plan. 

Expenses 

High expenses are a major impediment to retirement savers trying to build a retirement nest egg. Studies by the SEC and others have shown that even a relatively small difference in investment expenses can have a dramatic impact on the growth of your investments over time. 

Plan expenses come in several forms. There are the expense ratios of the mutual funds or other investments offered. Expense ratios are deducted from the gross returns of the funds the same as with investments in mutual funds made outside of the 401(k). 

Some plans may also charge some or all of the administrative costs of running the plan to the accounts of the participants. This is generally done on a pro-rated basis determined by the relative size of your balance as a percentage of the total assets in the plan, but there may be a different formula used in some cases. 

Plan expenses are disclosed in the annual fee notice that your employer is required to send to you. You may have to dig through it a bit to determine what expenses beyond the mutual fund expense ratios are being charged to your account. What you will need to do is to look up the fund’s expense ratio in the prospectus that you were given, or in the case of mutual funds, you can do so on a site like Morningstar. If there is a difference between the expense ratio of the fund and the amount listed on the annual fee report, this will represent the plan administrative fees being charged to your account. 

What Can You Do if Your Plan is Subpar? 

If you’ve done your homework and you decide that your company’s plan is not as good as it could be, you have some options. One is to not contribute to your plan or to only contribute enough to receive the full match offered by your company if they do matching contributions. This isn’t the most preferable option as you are missing out on the ability to contribute to a tax-advantaged retirement account. 

If you are married and your spouse has access to a good plan through their employer, be sure to max out contributions to that plan. 

If you feel your employer’s plan could be improved in terms of the plan’s expenses or the quality of the investment menu, it can pay to voice your concerns to the plan’s administrator or to senior management. Of course, you want to be respectful in voicing your concerns, and you will need to be able to articulate the issues you see. Perhaps it is with the quality of the investments or the costs of the plan. With the rash of participant lawsuits against 401(k) sponsors in recent years, many employers are more receptive to this type of feedback. For many companies having a good 401(k) plan is a vehicle to attract and retain top employees in a competitive job market. 

We periodically review our client’s 401(k) plans as part of the financial planning and investment services we provide. The assets in their 401(k) accounts are a key piece of their overall investment portfolio. In the process of determining how they should invest their 401(k) assets, we review the overall quality of the plan to help us make those recommendations. 

If you have any questions about your investments, including your 401(k) plan, please reach out. 

Bill Canty, CFP®, CPA

Ed Canty, CFP®

Joe Canty, Investment Advisor Rep.

Maureen Walsh, EA, Investment Advisor Rep.

Tina Alteri, CPA, Tax Advisor

 

Asset allocation is an investment strategy that adjusts the percentage of each holding in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. 

One famous industry study indicated that over 90% of the return from an investment portfolio was attributable to the portfolio’s asset allocation. While some have questioned whether or not the percentage is actually this high, there is little question that your portfolio’s asset allocation is a critical factor in determining your return. 

Here are some thoughts as to why asset allocation is so important to your investment portfolio. 

Risk Management 

A key factor in any sound investment strategy is a strong consideration of the investor’s risk tolerance. This might be tied to their age, time horizon, or if the portfolio is needed for a specific goal like retirement. 

Asset allocation is a tool to balance the management of the portfolio’s potential downside risk with its potential return through the appropriate allocation to holdings in various asset classes. 

Diversification 

One of the basic tenets of long-term investing is portfolio diversification. In a nutshell this means holding a variety of investments that are not all highly correlated to each other. Asset allocation is the most efficient way to set up an investment strategy that accomplishes this for our clients. 

For example, bonds have a correlation of -0.20 to U.S. large cap stocks. A correlation of 1.00 would mean that these asset classes were perfectly correlated to each other. A perfect correlation means that the price movements of holdings in the two asset classes would move roughly in lockstep with each other and that these price movements would be influenced by the same market and economic factors. 

On the other hand, a correlation of 0.00 would indicate little or no correlation in the price movement or in the factors that influence these price movements. 

In the example above, there is a very low correlation between the two asset classes. Additionally, the negative correlation indicates that factors that might push one asset class higher would tend to push holdings in the other asset class lower. As we’ve seen over time, bonds tend to hold up better than equities when the stock market is experiencing a period of correction. 

Rebalancing Provides a Level of Discipline 

Certain asset classes and individual holdings will outperform others at different points in time. Having a target asset allocation helps investors in that it provides a “starting point” so to speak.  A key piece of the portfolio review process is a review of your asset allocation. Is it still in line with your portfolio’s target asset allocation

Reviewing your portfolio periodically is important. This is typically done quarterly. We discourage clients from looking at their portfolios daily and we feel that rebalancing too frequently may do more harm than good. Reacting to every movement in the market is at odds with the benefits of taking a long-term approach to investing. 

Many advisors set a range for the various asset classes within a client’s portfolio. If an asset class falls outside of that range then they will rebalance those holdings back to within the target range. A range of +/- 5 percentage points deviation for the target is common for many advisors. 

It’s human nature to want to let an investment that has recorded large gains keep running. This may be fine for a period of time, but invariably these gains will level off or be reduced when the holding turns around and gives some or all of those gains back. 

The discipline that an asset allocation target brings to investing is that as one or more asset classes grows to a level that exceeds the target allocation by the stated percentage, a portion of the holdings in this asset class are then sold to bring the overall asset allocation back to within the target allocation range. This helps maintain the balance between the portfolio’s upside potential and it’s downside risk. 

A Total Portfolio Approach 

Many investors have multiple accounts of different types. This might include taxable accounts, IRAs, a 401(k) or similar workplace retirement account or others. The retirement accounts may be traditional, Roth or both. 

While the asset allocation of the various accounts may differ a bit, taking a total portfolio approach to asset allocation is important. This helps you focus on the overall level of investing risk you are taking. 

A part of a total portfolio approach includes paying attention to asset location as part of this process. Certain types of investment assets are more tax-efficient if held in one type of account versus another. 

For example, stocks or equity ETFs or mutual funds that you plan to hold for a period longer than one year are a good fit for a taxable account due to the preferential tax treatment of long-term capital gains. Taxable bonds, including ETFs and mutual funds that invest in them, may be a better fit for an IRA or other tax-deferred (or tax-free in the case of a Roth) retirement account due to the level of fully taxable income they throw off each year. 

Asset Allocation is Not a One-Time Thing 

Asset allocation is meant to be a target that you try to maintain over time. As a key part of the overall financial planning process, your target asset allocation provides a base point for rebalancing over time when the markets move in one direction or another. 

Over time, your target asset allocation will likely change as part of the ongoing financial planning process. As you get older an asset allocation that takes less risk might be appropriate for you. You might also adjust your asset allocation to take less risk if your portfolio performs exceptionally well over a several year period. You may find that you are farther along towards accumulating the amount needed to achieve your goals than your financial plan had called for. 

Summary 

Asset allocation is perhaps the most important part of crafting and implementing an investment strategy. It is also an integral part of your overall financial planning efforts. 

If you are looking for a fee-only fiduciary financial advisor who will always put your interests first, please give us a call to discuss your portfolio’s asset allocation or any other financial issues. We are here to help.

Bill Canty, CFP®, CPA

Ed Canty, CFP®Investment Advisor

Joe Canty, Investment Advisor

Maureen Walsh, EA, Investment Advisor

Tina Alteri, CPA, Tax Advisor

Inflation is frequently mentioned in the news and particularly by the financial press. Lately we’ve heard about inflation connected with many products and services as we emerge from the pandemic. Inflation is often linked with Federal Reserve policy as well. 

Inflation is a key variable to consider in your financial planning, especially for those nearing and in retirement. 

What is Inflation? 

Inflation is generally defined as a loss of purchasing power due to increases in the cost of various goods and services in the economy. Inflation is often discussed in terms of the Consumer Price Index (CPI). This is a measure of the price increases of a specific basket of goods and services that is used as a proxy for the entire economy. 

The problem with CPI or similar inflation benchmarks is that this is not representative of everyone’s situation. Different types of goods and services are impacted in different ways by inflation and at different times. At a personal level, the impact of inflation on your situation is a function of the specific goods and services you consume. 

Money Supply Inflation vs Supply/Demand Inflation 

In some periods, the supply of money set by the Federal Reserve may outstrip the growth in supply of some goods and services. This is a situation where there is too much money chasing too few goods. There is more money in the hands of many people and they want to spend it. If the supply of the goods and services they want hasn’t grown in proportion with the money supply, this can cause inflation as these consumers use their extra cash to bid up prices.   

Inflation that is based on supply and demand is different. The inflation may be based on a lack of supply relative to the demand for a product or service. As we’ve begun to emerge from the pandemic, we’ve seen a shortage of workers in many industries. This has led to wage inflation in some cases as restaurants, airlines and other employers are forced to pay up to be able to hire the workers they need. 

Inflation and Retirees 

Many of the products and services used by retirees have been hit inordinately hard by inflation in recent years. As a case in point, take the price of prescription drugs and healthcare. These costs have risen at a higher rate than the general rate of inflation that might be reflected in an index like the CPI. Another area that has seen dramatic price increases over time is the price of long-term care and related services. 

Inflation in these and other critical goods and services frequently used by retirees comes against a backdrop where retirees are often on a fixed or semi-fixed income. Their portfolios may be invested in a fashion to minimize downside risk that may not fully keep pace with the inflation on the basket of goods they normally consume. 

Sources of income such as a pension or Social Security may offer minimal or no cost of living adjustments (COLA). For example, most private sector pensions do not offer any COLA increases. Public sector pensions and Social Security do offer COLA adjustments, but these inflation adjustments are often based on a benchmark like the CPI which doesn’t reflect the true impact of inflation on the goods and services used by retirees.   

Inflation Rates Differ Widely 

Inflation is a function of supply and demand. If something is in short supply but there is a high demand for it, the price will likely increase. As we come out of the pandemic we are seeing many examples of this.

The housing market in many areas of the country is hot. We’ve read about instances where home buyers are bidding on homes without ever seeing them in person. This is an outgrowth of the desire of many residents of major cities to move to desirable suburban areas with more space. 

The price of many new cars has risen due to a shortage of microchips used in the manufacturing process for most modern day vehicles. This chip shortage has impacted a number of other industries and has helped to drive prices up in many cases. The cost of travel and related costs has risen as people long to go on a trip after being at home so much as a result of COVID. 

Protecting Your Money From Inflation 

Regardless of your age, it’s important that your investments generate returns that stay ahead of inflation. Asset classes like stocks, real estate, some commodities, precious metals and others have generally outpaced inflation over the long-term. For bond investors there are even inflation protected Treasuries (TIPs) where the interest rate is tied to an inflation benchmark. 

For younger investors this generally will not be too much of an issue. Their portfolios should be weighted towards equites and other investments that can generate the types of returns. They have a relatively long time horizon until retirement, and they are young enough to weather the types of fluctuations that these types of investments might experience over time. 

For those who are nearing or in retirement, this is where the right asset allocation is critically important. Investing in retirement is a balancing act between managing downside risk and taking enough investment risk to stay ahead of inflation. 

Regardless of your age, a diversified portfolio is important. Holding assets that can serve as a hedge against inflation is a key component of your asset allocation at all ages. Some of the asset classes that serve as hedges against inflation also serve as solid portfolio diversifiers due to their relatively low correlation to asset classes like stocks and bonds. Examples include gold and other precious metals, commodities, and real estate.

Certainly investors want to minimize the potential for losses on their investments from a decline in the value of their holdings. Lost purchasing power due to the impact of inflation on your investments is another type of loss that you want to avoid as well.

We can help allocate your investments to provide protection against the impact of inflation. Give us a call to see how we can help you implement an investment strategy that is tailored to your unique situation.

Bill Canty, CFP®, CPA

Ed Canty, CFP®Investment Advisor

Joe Canty, Investment Advisor

Maureen Walsh, EA, Investment Advisor

Tina Alteri, CPA, Tax Advisor

Ballston Spa: 518-885-3230

Naples: 239-435-0090

For investors, there are two key metrics, risk and return. Return is the reward for investing. Investment returns are what fuel the attainment of financial goals such as retirement and funding your children’s education.

Managing your portfolio’s investment risks is a key factor in achieving the types of long-term returns you are seeking. 

What is Risk? 

There are a number of definitions of risk. In general investment risk is the risk that the returns from your investments will differ from their expected returns. Most investors, however, define risk as the risk that their investments will decline in value.

In our experience, the risk of a significant loss on their investments is how investors typically define risk. 

In building and managing portfolios for our clients, the balance between potential downside risk and potential rewards are the main driver. Factors such as the investor’s time horizon for needing the money and their personal risk tolerance need to be considered in determining how much potential risk is appropriate for their portfolio. 

Beyond the risk of loss, there is the risk of the investor falling short of their goals by not taking enough risk. For example, an investor entering retirement needs to balance out the potential for downside risk with the need to invest aggressively enough to stay ahead of inflation and to help ensure they don’t run out of money in retirement

Asset allocation and diversification 

Diversification is the investment version of the old adage, don’t put all of your eggs in one basket. A well-diversified portfolio contains some holdings that are not highly correlated to the rest of the portfolio. By not highly correlated we mean that some investments will behave differently from each other under the same set of market or economic circumstances. 

For example, a popular large cap stock ETF and an ETF that tracks the total bond market have a correlation of -0.05 to each other over the past decade. The low, negative correlation means that these two ETFs will often behave quite differently in many market environments. Building a diversified portfolio that consists of some holdings with low and/or negative correlations can help in managing the portfolio’s overall risk. 

A key tool in implementing portfolio diversification and managing investment risk is asset allocation.

Asset allocation is the distribution of the investments in an investor’s portfolio among various asset classes such as stocks, bonds, and cash. A client’s asset allocation generally goes to another level to include sub-asset classes such as large-cap stocks, small caps, foreign, and so on. There might be several types of bonds such as short-term, corporates, and others. 

The exact asset allocation will depend upon the client’s unique situation in terms of their investment time horizon and their tolerance for risk.   

Check Your Risk Tolerance Here Using Our Risk Questionnaire

Concentrated stock positions 

In some cases investors may find themselves with a concentrated position in one or more individual stocks. This might arise from an inheritance, from stock-based compensation from their employer or from a position that has been held for a period of time where the stock has experienced unprecedented growth. 

In any event, a concentrated position in one of just a few stocks can increase investment risk. If a concentrated position experiences a significant drop in price this can have an outsized impact on the investor’s portfolio.

If the concentrated position is in the stock of an investor’s employer and the company experiences financial difficulties, this could create a double risk. Not only might the stock decline in value, but the investor’s job might also be in jeopardy. 

We try to work with clients to deal with concentrated stock positions in the best way possible for their situation, including the potential for using some of the shares for charitable contributions if desired. 

Rebalancing 

While it is not a perfect solution, periodic portfolio rebalancing is critical to maintaining an investor’s asset allocation. Rebalancing means “resetting” the investor’s portfolio back to their target asset allocation. It's typical to set parameters that are acceptable and where no action is taken if the allocation is within those parameters. A common example might be +/- 5% of the target allocation for a given asset class. 

The performance of different portfolio holdings relative to one another can cause a portfolio’s asset allocation to deviate from the target asset allocation. Using a simple two security portfolio as an example, an investor’s target allocation might look like this: 

After a significant rally in stocks, their allocation might look like this: 

At this level for stocks, the investor is taking on too much risk in the event that the stock market corrects. 

Under a scenario where we’ve experienced a significant stock market decline, the investor’s portfolio might look like this: 

In this case, the reduced level of stocks means that the investor is likely taking too little risk and may not be able to generate sufficient gains to meet their financial objectives. 

Rebalancing is commonly done by selling positions in asset classes that are above the rebalancing threshold and reallocating the proceeds to holdings in asset classes that are below their thresholds.

Rebalancing can also be accomplished by taking any new funds added to the portfolio and directing this money to asset classes that need to be shored up. 

When rebalancing it's important to take a full portfolio view to include taxable accounts as well as retirement accounts. The overall portfolio allocation is key to controlling overall investment risk. Tactics such as tax-loss harvesting are used with taxable accounts where applicable to minimize the tax impact of rebalancing when it makes sense. 

Our investment team at CFM believes that a review for potential rebalancing should be conducted at regular intervals such as every three months. 

Portfolio reviews 

We feel the best tool to mitigate investment risk is the regular review of our client’s portfolios. This review combines a review of the portfolio’s asset allocation versus the target as well as a review of the portfolio’s holdings.

Are these securities still performing in line with our expectations in terms of relative risk and return compared to other securities in their peer group? 

Moreover, we review the portfolio in light of the client’s current financial situation to ensure that their investments are properly positioned in terms of the balance between potential returns and potential downside risk.

Check Your Risk Tolerance Here

Bill Canty, CFP®, CPA

Maureen Walsh, EA, Investment Advisor Rep.

Tina Alteri, CPA, Tax Advisor

Ed Canty, CFP®

Joe Canty, Investment Advisor Rep.

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