Myth Busters: Financial Planning Edition

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Christine Benz, she is our director of personal finance, to bust four financial planning myths.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, the first myth, and this is the one that you hear a lot, is that you could only gift someone $14,000 and anything over that is going to be subject to the gift tax. And this is a pretty pervasive myth you see.

Benz: It is. I hear it from a lot of people. They'll say, well, I want to gift each of my children $14,000 a year, but no more than that because I'll owe gift tax. There's a lot of confusion, and it's understandable because there is this annual amount that you can gift, $14,000 for 2017. If you're above that, you will need to file what's called Form 709 which you need to file along with your tax return for that year. But that gift in excess of $14,000 only becomes taxable if the total gifts during your lifetime combined with your estate upon your death is over $5.49 million in 2017.

So, as you can imagine, this is something that really is only going to affect a very small subset of the population. It will generally only be very wealthy folks who need to concern themselves with this gift tax or with ever having to pay gift tax, which is not to say that you won't have to file this Form 709 if you gift more than $14,000 to any one individual in a year, but you probably won't have to pay gift tax.

Glaser: So, some extra paperwork but not a big problem.

Benz: That's right.

Glaser: The second myth is that everyone should have a Roth IRA no matter what. You think that for some people, it might not be appropriate.

Benz: That's right. You hear so much about the tax benefits of Roth IRAs. So, you are, in exchange for putting in after-tax dollars into the Roth IRA, you are able to take tax-free withdrawals, and there aren't any required minimum distributions on Roth IRAs. Those are both really nice features. But for some individuals it's just not the right answer.

So, the classic profile for whom a Roth probably isn't a great idea is kind of the late-career saver who hasn't yet amassed a lot of assets for retirement. For someone like that it's a pretty good bet that their contribution during their working years if they can earn a deduction on that contribution, they are better off taking that tax break when their tax rate is higher than waiting until when they are retired, when, without a lot in retirement assets, it's a good bet that their tax rate will be lower.

So, it's not one size fits all unfortunately for Roth versus traditional. For a lot of people, I think the right answer is to perhaps combine the two. It's really hard to guess what your tax rate at the time of withdrawal will be relative to what it is at the time of contribution. So, it may make sense to kind of mix and match the two types of contributions. That way you'll have some assets that will be taxed upon withdrawal at your tax rate then and some that will be tax-free as in the case of Roth.

Glaser: The third myth you hear from retirees is that if you're living just on the income of a portfolio, you're not touching the principal, then your withdrawal rate is essentially zero. And you don't think that's the right way to look at it.

Benz: I don't think it is, and I sometimes hear from retirees who think they are being really virtuous. They are just living on the income that their portfolios kick off. And certainly, there are lots of things to like about income coming from a portfolio. Certainly, when you think about the subset of income-producing stocks, generally these are more financially healthy, financially stable companies. So, there are reasons to favor them as part of your portfolio. But the amount that you take out of your portfolio--whether it's coming from withdrawals of capital or whether it's coming from income--counts as a withdrawal either way. So, you shouldn't disproportionately favor income at the expense of periodically taking some money out of capital.

I'm a big believer in investors doing both--that they are harvesting their income proceeds as they occur from the portfolio, but they are also periodically looking at that portfolio, looking at portions of the portfolio that have done really well--and for a lot of retirees today that's equities, U.S. equities in particular--and harvesting some of those winnings and using those to live on as well. But whether it is capital return or income return, it's all a withdrawal.

Glaser: The final myth is that ETFs are always a tax-efficient vehicle and although this is often the case, it's not always true.

Benz: That's right. And certainly, there are lots of reasons to like ETFs. In particular, the broad low-cost ETFs can be terrific building blocks for portfolios for accumulators as well as retirees. But not all ETFs are tax-efficient. Your broad market equity ETFs where there's very low turnover in the index will tend to be about the most tax-efficient mousetrap you can find, so perfect holdings for a taxable account. But if you are talking about some sort of a bond product, whether it's a mutual fund or an exchange-traded fund, most of the return you receive from that product is going to be an income distribution, is going to be taxed at your ordinary income tax rate. It doesn't matter whether it's in a mutual fund wrapper or in an ETF wrapper, it's not a great idea for a taxable account. There are also some niche categories where they will tend to be less than tax-efficient. So, commodities, precious metals would be a couple of categories where, to the extent that I had them in a portfolio, I'd think about holding them in some sort of a tax-sheltered wrapper.

Finally, we have historically seen a handful of ETFs, even equity ETFs, that have had high turnover for one reason or another and have come up with these big distributions from time to time as they have recalibrated their portfolios. You want to be careful about holding them, to the extent that you hold them, you want to be careful about holding them in a taxable account. They will not be tax-efficient.

Glaser: Christine, thanks for busting these four myths today.

Benz: Jeremy, great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.