Mailbag! Accounts for Early Retirement, Roth Conversions, Closed-End Funds, and More

0:03D-bills, closed-end funds, the best accounts for early retirees, and more this week on a financial planning mailbag episode of the Motley Fool Hidden Gems Investing Podcast.

0:19I'm Robert Brokamp, aka Bro, and it's time for our second personal finance mailbag episode. And like the last time, I'm joined by longtime Motley Fool contributor, Dan Kaeplinger, who is a former financial planner and trust attorney. Dan, welcome back to the show. Thanks again for having me. Always glad to be here. So like our last Mailbag episode, we have chosen six questions that we've received from our wonderful listeners. I'll read each one. Dan and I will take turns taking a first crack at it. And then the other one of us will add some thoughts. So with all that said, here's the first question, and it comes from Anonymous, who asked recently if it's mentioned buying treasury bills directly through Treasury Direct or Vanguard.

0:57Could you guys expand on how doing that compares to holding other short-term options like the iShares 0-3 Month Treasury Bond ETF, ticker SGOV, the Vanguard 0-3 Month Treasury Bill ETF, ticker VBIL, or Vanguard Treasury Money Market Fund, ticker VUSXX? so anonymous i would say that the do-it-yourself buy treasury bills directly either through your broker or from the government's own treasury direct.gov website it's kind of the whether you decide that you want to pay the fees to an etf that will do that for you if you feel like saving that depends on how much money you are investing if you only have a couple hundred dollars probably is not going to make that much of a difference if you've got a couple hundred thousand dollars then suddenly even a tenth of a percentage point can make enough of a difference that you know take you out for a nice dinner once a year or something like that but with treasury bills that you buy you are responsible for monitoring when you buy them by participating at auction or by buying them in the secondary market you are responsible for knowing when they mature and then when they mature either if you need the money you withdraw it if you don't need the money, then you're responsible for then reinvesting that matured T-bill into another T-bill, or if you want a stock or another investment, whatever that may be.

2:24With the ETFs that you're talking about, they handle most of that for you. Once the money is in the ETF, you essentially own a piece of many different treasury bills with many different maturities. all of the ETFs that you were talking about, as well as the Money Market Mutual Fund, all of those have maturities that are coming due probably every day, at the very least several times a week. And so they are handling, their management team is responsible for jumping in, reinvesting that. They'll charge a modest expense ratio. It's not that much, but it is something that if you are doing the self-serve option, then you can avoid that while also customizing to your particular needs with the ETF.

3:11It's all on them to decide what they're buying when. I'll just point out a few stats about these. So both SGOV and V-bill are yielding about 3.6%. The Vanguard Money Market Fund is yielding 3.8%. But if you go and buy a three-month T-bill straight from the government, it's yielding 4.2 % right now. And you'll see that in a situation where interest rates are rising, what you get from the money market funds and the ETFs will lag what happens. So, because they have older T-bills. Now, the opposite will happen when interest rates go down. You know, so if you're buying a new T-bill, it's going to be lower than what you're getting from these ETFs.

3:49So that's just something else to think about. And I'll also point out that because these are treasuries, they are free of state income taxes, so that's always something to consider. All right, let's move on to our second question from Ben. I am 38 and hope to retire well before age 59 and a half. I have consistently maximized my available tax-advantaged retirement accounts, but this has left me with less that I would like in my taxable brokerage account to fund the years before traditional retirement age. Should I continue maximizing my tax-advantaged accounts and plan to use Rule 72T, a substantially equal periodic payments for early retirement income?

4:26Or should I redirect some future contributions into my taxable brokerage account for greater flexibility? So Ben's concern here is obviously the 10 % early distribution penalty when you take money out of a tax-advantaged retirement account before age 59 and a half. Now, there are many exceptions to this. You can get away around that 10 % penalty. So you should certainly know those if you're going to retire early. The IRS website has a whole page of them. One of them is this substantially equal periodic payments, and it can get very complicated, so I'm just going to highlight very quickly, that you're basically committing to a series of payments for at least five years or until you reach age 59 and a half, whichever is longer.

5:09Once you start it, you cannot stop or change the payment amount outside of some approved modifications without facing not only a penalty in that year, but retroactively, so you You got to make sure you stick with it. And you have to choose from among the IRS's approved three methods of calculating the substantially equal periodic payment. So it's all very complicated, but many people in the financial independence retire early community follow this. So it is doable. I'll just add some other thoughts. So first of all, you certainly want to at least contribute to your 401k or employer account to get the employer match.

5:43You definitely want to do that. another option is to contribute to roth accounts because with roths the contributions come out tax and penalty free it's the earnings you have to worry about being taxed and penalized before age 59 and a half now it gets a little complicated with the difference between roth iras and 401ks with the roth ira the contributions always come out first so that's easier with the roth 401k the every distribution is a proportional mix of contributions and earnings so it's messier with the Roth 401k. Final thing to think about is a health savings account if you have access to it and you have money in it.

6:18Because the interesting thing about the HSA is the money comes out tax free for qualified expenses, but they don't have to come out in that year. So what many people do is over many years, they keep the receipts for their qualified medical expenses, but they don't take the money out until they retire. And then they get the tax free distribution. So they just say, I have to have all those receipts ready in case the IRS comes knocking with an audit. So those are some thoughts. You could also do the taxable brokerage account as well. And that would definitely give you a lot of flexibility. Dan, do you have any thoughts on that?

6:53I'll just add on that last point. One of the things that using that taxable brokerage account allows that people don't necessarily think about is that in a taxable brokerage account, if you have a stock that goes up in value quite a bit, then you're going to have long-term capital gains treatment. The tax treatment on that is more favorable than a withdrawal from a traditional IRA or a traditional 401k account. And so if you are indeed planning to use that money before you reach age 59 and a half, that tax advantage in a taxable brokerage account might be a factor erring towards going ahead and putting some money in that taxable brokerage.

7:34Very good point.

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8:53Whether it's through unique interior finishes or custom wheel options, the ways to personalize your Range Rover Sport are nearly unlimited. Command attention and experience ultimate luxury in motion. Exclusive offers are available now. Explore further at RangeRover.com. All right, let's move on to question number three. It comes from Scott. Why is there seemingly no love in the professional community for closed-end funds? I know they're a bit esoteric, but the yields are usually fabulous, and the risk seems to lie somewhere between bonds and equities. It seems like a decent strategy might be holding closed-end funds over bonds in your 30s to 40s and then transitioning to bonds in your 50s and 60s, if one is using the traditional 60-40 portfolio.

9:37But this idea seems foreign to boast. I have held closed-end funds since the early 2000s and have found them to be wonderful for income generation. And I'm just wondering, what am I missing that keeps others from singing their praises? Maybe you fools can help me out as to why. Well, Scott, I have been following closed-end funds for a long time. I dabbled in them from time to time. And I share your confusion about why they get so little attention because in many ways they combine sort of the predecessors to modern exchange-traded funds. But you always have that lovely premium or discount question because with these closed-end funds, what we're referring to here are funds that, unlike most ETFs and mutual funds, you cannot just go to the fund and not even an institutional investor can go to the fund and say, you know what, I've got these shares, I want the actual assets that are held in the fund in exchange.

10:38That's why with traditional mutual funds, you almost always get net asset value. With ETFs, the price generally stays pretty close to net asset value. But with closed end funds, they can vary widely. You can have some funds that trade at a discount to the actual value of the assets that they hold. You can have others that trade at a premium. I think that that may be one of the reasons why professionals have so much difficulty with them. There are certainly very popular closed-end funds that trade at huge premiums until whatever it is that they hold kind of falls out of favor. And when those assets fall out of favor, suddenly the closed-end fund declines, it loses the premium, and some investors may face losses even if the net asset value of shares goes up.

11:28The fact that you bought at a huge premium suddenly means that when that premium disappears, you could have a loss even when the underlying investment is doing well. The other thing that I would caution folks with, a lot of closed-end funds use leverage. They borrow money in order to take leverage positions in the assets that they hold. That can be very favorable with bond closed-end funds. That was a winning argument for much of the first 20 years of the 21st century as interest rates were gradually coming down. You got kind of highlighted exposure to a positive bond market. That has not been the case over the past three, four, five years.

12:10And that is something to take a look at. Always be careful with closed-end funds. Look at the nature of the distribution. Is it actually coming from income or is it a return of your own capital? Just because it looks like a dividend payment doesn't mean that the fund actually generated the income that you are getting back. I'll just add that if your interest is piqued, the best source on the Internet for information about closed-ended funds is cefconnect.com, which is owned by Duveen. But they have great information on all providers of closed-ended funds, screening tools, some education. So check that out.

12:47And as I often say, when you are considering any kind of ETF, especially if it's a new asset class to you, look back at past returns, both good years and bad years, just to get a sense of how the fund or asset class will perform in different environments. All right, let's move on to question number four, and it comes from Tony. For retirees with a relatively secure funding source, such as a pension in my case, or adequate social security, would a more aggressive investment strategy be appropriate for a discretionary fund? I am contemplating a 90 % stocks, 10 % bonds portfolio for my deferred and Roth funds to be used for travel and experiences.

13:25I stress-tested it on a year 2000-2020 time period, and it did well. better even than a glide path scenario from 30 % to 60 % equities over the first 15 years. What I learned is that opportunity cost is a real thing. So I would say that I think Tony is on to something and he points out a few things that I want to highlight. So first of all, you know, pension and social security income or really any other source of secure income like that, maybe an annuity or a business could really be considered like a big holding in bonds. And the more of you get of that income, the more risk you can take with the rest of your portfolio.

14:02And you can actually even value that as a holding of bonds by doing some sort of present value calculation. If you don't know or don't want to know how to do that, visit valueyourpension.com. It was created by Professor Benjamin Bailey, who wanted to basically create a present value calculation for his pension. He couldn't find one online, so he created the website. And Tony's also says he's going to be more aggressive with his discretionary funds for his travel and experiences. And I think that makes a lot of sense. We've had several guests on the show recommend that you break your retirement spending into essential and discretionary expenses.

14:36You try to cover your essential expenses with a very secure sources of income, hedge and social security, bond ladder, maybe annuity, something like that. But then you can take more risk with your non-essential expenses. And that sounds like that's what Sony's doing. Now, 90 % stocks is pretty aggressive, but there have been studies that have looked at it. I think conspired often by Warren Buffett, who wrote in his 2013 annual letter that in his will, he advised the person who's going to manage his wife's assets to invest 90 % of it in an S &P 500 index fund and 10 % in short-term government bonds.

15:10And the studies have found that it could definitely pay off, assuming you can stand the ups and downs of such an aggressive portfolio. And it does mean that you're going to have to cut back on your discretionary spending during bear markets. And then my final point is, I'll just add that Tony's reference to the glide path increasing from 30 % to 60 % over the first 15 years, I think he's referring to studies that have found it very beneficial to play it really safe around what's often called the retirement danger zone. It's like five to 10 years before retirement, five to 10 years after retirement, but then it's okay to let your stock allocation rise once you've survived that first 10 years or so of retirement.

15:46So that's what he's referring to. Those studies, I think I find compelling. I personally want to play it probably pretty safe in those first few to several years of retirement. But then getting more aggressive, it turns out, is perfectly fine. Dan, what do you think? I agree 100%. I'll just add that if Tony or any listener in this situation, if you have this sort of excess money above and beyond what your necessities are, one question always to ask is, do you have plans, hopes to leave a legacy for future generations? In that case, taking a more aggressive portfolio stance essentially borrows that extended time horizon of the person that you're getting.

16:27So you may be retired and have a relatively short time horizon, but if you're hoping to leave that money for kids or grandkids, their time horizon is much longer justifying a more aggressive asset allocation for that portion of the portfolio above and beyond those necessities. All right, moving on to question number five, and it comes from Ben. I am considering going back to grad school and could cover all the tuition by selling about a third of my portfolio. I've been debating this versus taking out student loans. While current market valuations do play a role in my consideration, I'm also thinking that this type of life move is exactly what an investment portfolio can be intended to pay for.

17:07Did you help me get over my anxiety of pulling back from the market a bit to invest in my future career goals? I will only be penalized via taxes for selling from this account. So Ben, let me applaud you for having the flexible mindset of an investor who understands the value of investing early, who understands the value of time in the market, but who also is willing to think twice before just sticking with a single-minded way of approaching money. because I'm just going to say this. One of the best investments that you can make, especially early in a career, is building your human capital. It's your human capital that is going to be the source of the salary income, of the business opportunities, of so many of the things that are going to affect your financial security for the rest of your life, that making an investment in that makes a lot of sense.

18:11The question often comes up, okay, yeah, well, there are student loans available. Why would you take money out of the market when you have potentially good debt available? And there is some validity to that. But one thing to keep in mind is that there's been big shifts in the way that the student loans work in recent years. You have sometimes had a federal government that seemed committed to making that funding available. At other times, now you're starting to see the federal government pull back from being as committed to making that funding available. And so it leaves borrowers who kind of got in in one period of time questioning, okay, well, things have changed.

18:56I don't have as much flexibility as I thought that I would. And so you are in a fortunate situation. you have the flexibility of having these assets to say, you know what, I don't even want to deal with that. I just want to take some money and invest in my immediate future to generate more of more career earnings over the rest of your lifetime. I applaud that. I think that that's a worthy goal. Yes, there is going to be potentially some opportunity cost to not being in the market as long, but hopefully your investment in grad school more than pays off enough to make up for that over the course of your lifetime.

19:34I would imagine that the rates you pay on these loans could be a factor. The rates on federal loans for grad school are ranging between 8 % and 9 % nowadays. For private loans, it could be as low as 3%, as high as 17%. So obviously, the higher the loan interest rate, the more I would be inclined to sell some of my portfolio to pay that off. And, you know, if you're going to sell some of your investments, you could always do some things to try to manage the tax consequences, maybe, you know, offset losses with gains and identify shares with lower embedded capital gains. So you could manage that.

20:06The final point I would make of this is just understand that selling and realizing some taxable income may reduce any need based aid that you could be eligible for. So keep that in mind if you're, you know, also counting on getting some need based aid.

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21:34Whether it's a dashboard with detailed charts or automated workflows with the right triggers, conditions, and approvals. Ready to rule your business? Head to rippling.ai slash fool to get the only AI built to give you full visibility and take complex actions across your entire organization. That's r-i-p-p-l-i-n-g dot a-i slash f-o-o-l. Sign up for exclusive access today, rippling.ai slash fool. All right, let's move on to our sixth and last question, and it comes from Tom. I'm 61 years old and planning to retire in the first half of 2027. Congrats, Tom. My wife is 62 and has chosen to continue to work for a few more years.

22:15When I retire, we will lose my income and need to start pulling from my retirement accounts. Unfortunately, about 95 % of our assets are in pre-tax 401k accounts, so traditional accounts here. So not only do I want to withdraw enough to replace my income, but I'd also like to withdraw enough to start some Roth conversions, add to my cash accounts, and pay the income taxes required for these withdrawals. Is this a reasonable plan? And what else do I need to consider as I make these changes? So, Tom, I'll just say that there's this sort of rough rule of thumb when you are taking money from your accounts after you retire.

22:52It's that you drain your taxable accounts first, then traditional tax deferred and then Roth. In your situation, it doesn't sound like you have too many options, though, right? But you might start with that 5 % that it seems that you might have in a taxable brokerage account. But then you're going to have to do the traditional accounts. It does seem that really the crux of your question is whether you should do the Roth conversions. So I would say, first of all, there are two main reasons to do Roth conversions. And one is that you expect to be in a higher tax bracket in the future. When you do the conversion, the amount you convert will be added to your taxable income.

23:22So you have to pay taxes on it today, but it's going to grow tax-free after that if you follow the rules. So if you're going to be in a higher tax bracket in the future, then it makes sense to do the Roth conversions. That said, most people are actually in a lower tax bracket once they retire. especially since your wife is still working. This is generally because people spend less in retirement, but plus after age 65, there's a higher standard deduction. There's the new bonus senior deduction. It is due to expire in 2028, but we'll see what happens. But the bottom line is most people are not in a higher tax bracket in retirement versus when they're working and your wife is still working.

23:57But of course, it depends on your situation. But you still might want to do Roth conversions for the second reason. And that is if you don't, the required minimum distributions from your traditional accounts at age 75 are going to be much higher than you need and it will result in a much bigger tax bill. Roths, on the other hand, aren't subject to RMDs. You can just let them keep growing. So that's another reason to consider doing that. And you actually can find calculators on the internet that can help you project your RMDs. So that's another consideration. Just know that those conversions, if you do some Roth conversions, they're going to increase your adjusted gross income, which could reduce your eligibility for various tax breaks, you know, various deductions and credits, and it could eventually require you to pay those income-related monthly adjustment amount surcharges on Medicare.

24:47You don't take Medicare, or at least aren't eligible for Medicare until age 65, but those IRBA surcharges are based on your tax return from two years prior. So once your wife starts hitting age 63, then you have to start thinking about that. So your strategy, the bottom line here is could make sense, but it really depends a lot on your situation. Dan, what do you think? I agree. And I highly recommend, Tom, that you do kind of a multi-year analysis. Look at what happens if you do it the way that you do it right now when you're 61. Then also look at what if you do it that you decide to put off doing the Roth conversions until your wife decides to retire.

25:26Maybe that's at 65. Maybe it's a couple of years, one side or the other of that. But see what happens. There's a lot of daylight between age 65 and when you need to start taking required minimum distributions at age 73 or 75, depending on what your birth year is. That may make a difference in your calculation. It's worth taking a little bit of extra effort to run the numbers and see what it comes out with. And with that final answer to our final question, we've come to the end of our show. Thank you, Dan, for joining us once again. And thanks to Bart Shannon, the engineer for this episode. As always, people on the program may have interest in the investments they talk about, and The Motley Fool may have formal recommendations for or against.