April 15, 2010
Vol 3, Issue 4
Jean Keener
Jean Keener
Happy (or not) tax day! 
We've certainly enjoyed some nice stock market returns over the last couple of months.  All categories of U.S. stocks are now well into positive territory year-to-date. Foreign stocks posted strong gains in March and are also now in the black for the year so far.  U.S. intermediate-term, investment-grade bonds gave up a bit of ground (-0.1%) in March, but are still positive year-to-date.   Developed-markets foreign bonds are down 1.3% for the year so far. Emerging-markets bonds gained an impressive 4% for the month ending the quarter with a 5.4% return. High-yield bonds posted a 3.1% gain in the month, ending the quarter up 4.8%.
Despite all of the stock market increases, I continue to be cautious about our expectations for stock performance going forward given the relative valuation of the market and underlying economic fundamentals.  And bonds are not without risk, especially longer duration bonds, because of likely rising interest rates coming.
In this newsletter, we have summaries of some of the recent legislation regarding healthcare and student loans that may affect you financially, as well as information on the benefits and drawbacks of non-deductible IRA contributions and more.  As always, feel free to e-mail me at [email protected] with requests for newsletter topics you'd like to see covered.  And if you have last-minute IRA contribution questions, feel free to give me a call today.  I'm happy to help.  Thank you, and live well.
In This Issue
Lump Sum Vs. Dollar Cost Averaging
New Financial Aid Provisions
How Healthcare Law May Affect You
Non-Deductible IRA Contributions: Good idea or not?
Keller Public Library Free Retirement Workshop Tuesday
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Lump Sum Vs. Dollar Cost Averaging
Lump sum vs. dollar cost averaging
 I've recently had conversations with several individuals about the merits of dollar-cost averaging vs. making investments in a lump sum.  Like many financial decisions, there are pros and cons to either approach and there's not one right answer. 
This discussion is designed to flesh out the risks and benefits of each approach, but really only applies to how you invest a significant lump sum when received all at once (for example -- severance package, lump sum pension distribution, inheritance, etc.).  For ongoing savings plans, dollar cost averaging will be the default choice based on saving regular recurring amounts over time.
What is dollar cost averaging?
Periodic investing is the process of making regular investments on an ongoing basis (for example, buying 100 shares of stock each month for a year). Dollar cost averaging is one of the most common forms of periodic investing. It involves continuous investment of the same dollar amount into a security at predetermined intervals--usually monthly, quarterly, or annually--regardless of the investment's fluctuating price levels. 
Because you're investing the same amount of money each time when you dollar cost average, you're automatically buying more shares of a security when its share price is low, and fewer shares when its price is high. Over time, this strategy can provide an average cost per share that's lower than the average market price (though it can't guarantee a profit or protect against a loss in a declining market).
The accompanying table illustrates how share price fluctuations can yield a lower average cost perDollar Cost Averaging Graphshare through dollar cost averaging. In this hypothetical example, ABC Company's stock price is $30 a share in January, $10 a share in February, $20 a share in March, $15 a share in April, and $25 a share in May. If you invest $300 a month for 5 months, the number of shares you would buy each month would range from 10 shares when the price is at a peak of $30 to 30 shares when the price is only $10. The average market price is $20 a share ($30+$10+$20+$15+$25 = $100 divided by 5 = $20). However, because your $300 bought more shares at the lower share prices, the average purchase price is $17.24 ($300 x 5 months = $1,500 invested divided by 87 shares purchased = $17.24).
The merits of dollar cost averaging
In addition to potentially lowering the average cost per share, investing a predetermined amount regularly automates the decision-making process, and can help take some of the emotion out of your investment decisions. And if your goal is to buy low and sell high, as it should be, dollar cost averaging brings some discipline to that process. Though it can't help you know when to sell, and your shares could be worth more or less than their original cost when you do sell, this strategy can help you pursue the "buy low" portion of the equation.
The case for investing a lump sum
Several academic studies have compared dollar cost averaging to lump-sum investing and concluded that, because markets have risen over the long term in the past, investing in the market today tends to be better than waiting until tomorrow, since you have a longer opportunity to benefit from any increase in prices over time.
For example, a 2009 study by the Association of Investment Companies found that an investor who put a lump sum into the average British investment company at the end of April 2008 (talk about bad timing!) would have been down 30% one year later. Someone who invested the same total amount divided over 12 months would have been down only 7%. However, when the study examined the previous 5 years rather than a single year, the lump-sum investment made in April 2004 would have been up 26% by April 2009, compared to the periodic investment strategy's loss of 10% over the same time.
Several U.S. studies over several decades (Richard Williams and Peter Bacon, "Lump Sum Beats Dollar Cost Averaging," Journal of Financial Planning, April 1993; G.M. Constantinides, "A Note on the Suboptimality of Dollar-Cost Averaging," Journal of Financial and Quantitative Analysis, June 1979; John Knight and Lewis Mandell, "Nobody Gains From Dollar Cost Averaging," Financial Services Review, 1992) reviewed overall stock market performance and reached a similar conclusion: the longer your time frame, the greater the odds that a lump-sum investment will outperform dollar cost averaging.
Considerations about dollar cost averaging
Think about whether you'll be able to continue your investing program during a down market. The return and principal value of stocks fluctuate with changes in market conditions. If you stop when prices are low, you'll lose much of the benefit of dollar cost averaging. Consider both your financial and emotional ability to continue making purchases through periods of low and high price levels. Plan ahead for how you'll manage the temptation to stop investing when the chips are down. The cost benefits of dollar cost averaging tend to diminish a bit over very long periods of time, because time alone also can help average out the market's ups and downs. Don't forget to consider the cost of transaction fees, which can mount up over time with periodic investing.
Considerations about investing a lump sum
The lump-sum studies reflect the long-term historical direction of the stock market since record-keeping began in 1925. That doesn't mean the markets will behave in the future as they have in the past, or that there won't be extended periods in which stock prices don't rise.  And market valuations relative to historical averages certainly affect your odds of having a lump sum investment work in your favor.  
Lump sum investing allows you to deal with your entire investment all at once and move on to other responsibilities in your life.  You'll still have to revisit annually for rebalancing, but you won't be handling transactions over an extended period of time.  This is one of the benefits.
In the end, deciding between lump-sum investing and dollar cost averaging illustrates the classic risk-reward tradeoff that all investments entail.
Even if you're convinced a lump-sum investment might produce a higher net return over time, are you comfortable with the uncertainty and level of risk involved? Or are you increasing the odds that you won't be able to handle short-term losses (especially if they occur shortly after you invest your lump sum) and sell at the wrong time? 
It's important to know yourself as an investor. Understanding the pros and cons of each approach can help you make the decision that best suits your personality and circumstances.  And whatever choice you make, don't let yourself second-guess later on.  We want to analytically review decisions and learn from mistakes, but there's no benefit to beating yourself up if the other choice would have produced better results in hindsight. 
New financial aid provisions
New student loan provisionWith the nuances of health care legislation getting all the attention, you may be surprised to learn that the recently passed health care  law-the Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act of 2010-includes several provisions related to college. The most noteworthy of these provisions involve:
  • The distribution of federal student loans
  • Pell Grants
  • Income based repayment for federal student loans
The distribution of federal student loans
Currently, there are two ways to obtain a federal student loan-borrow directly from the federal government under the William D. Ford Federal Direct Loan ("Direct Loan") program or borrow from a private lender who participates in the Federal Family Education Loan (FFEL) program. The FFEL program has been in existence since 1965 (the Direct Loan program since 1994), and private lenders in the FFEL program receive government subsidies to encourage them to loan money to students.

Under the new legislation, private lenders will no longer receive government subsidies to make federal student loans, and the FFEL program will be eliminated. Starting July 1, 2010, all federal student loans will be made directly from the federal government to borrowers under the Direct Loan program.
Generally, student borrowers shouldn't notice much of a difference with this change. If anything, the new system should be simpler and less confusing, because borrowers won't have to "shop around" for a private lender to obtain their federal student loans.
Parents who wish to take out a federal PLUS Loan might find themselves better off because the interest rate on a federal PLUS Loan obtained through the Direct Loan program is capped at 7.9%, compared to the interest rate on a federal PLUS Loan obtained through the FFEL program, which is capped at 8.5%.

Pell Grants
The Pell Grant is the federal government's largest financial aid grant program. It is available to undergraduate students with exceptional financial need (typically students from families who earn less than about $45,000 per year). Graduate students aren't eligible.

The new legislation provides for automatic annual inflation-adjusted increases to the Pell Grant beginning in 2013. For the current academic year 2009/2010 (which runs from July 1, 2009, through June 30, 2010), the maximum Pell Grant is $5,350. It is scheduled to increase to $5,550 in 2010/2011, and will remain at that level for the following two years. It will then increase by the rate of inflation (via the consumer price index) in each of the next five years, reaching approximately $5,900 in 2019/2020.

Income based repayment
On July 1, 2009, the federal government's new Income Based Repayment (IBR) program went into effect. The IBR program was created to help college graduates manage their increasingly large student loan payment obligations. Under the program, a borrower's monthly student loan payment is calculated based on income and family size. A borrower is allowed to pay 15% of his or her discretionary income to student loan payments, with any remaining debt forgiven after 25 years. The program is open to graduates with a federal Stafford Loan, Graduate PLUS Loan, or Consolidation Loan made under either the Direct Loan program or the FFEL program.

The new legislation enhances the IBR program. Under the legislation, borrowers who take out new federal student loans after July 1, 2014, will pay 10% of their discretionary income to student loan payments, with any remaining debt forgiven after 20 years.
Healthcare law: how will it affect you?
New Healthcare LawEven though the full effect of the new healthcare law won't be known for some time, it's almost certain that at least some of the provisions will have an effect on you and your family. Some portions of the law become effective in 2010, other elements are phased in over time. For planning purposes, you'll want to start understanding how they may affect you and learning what your options are. Following are some of the most likely ways it will affect individuals, and there's a more detailed list of healthcare law provisions on my blog.
If you already have health insurance
First, by 2014, most U.S. citizens and legal residents will be required to have qualifying health insurance or face a possible fine. But even if you already have insurance, some law provisions may affect you. For instance, beginning this year, you generally can keep your adult child on your coverage up to age 26. And, your insurer will no longer be able to rescind your coverage if you get sick, impose lifetime coverage limits, rescind your coverage except for fraud, or impose coverage exclusions for your child due to pre-existing health conditions. In 2014, you can no longer be charged higher rates based on your health status or gender, and insurers cannot extend waiting periods beyond 90 days.
Starting next year, reimbursements from health flexible spending accounts (health FSAs) and health reimbursement accounts (HRAs) for over-the-counter drugs will be restricted, and tax-free reimbursements from health savings accounts (HSAs) and Archer MSAs for over-the-counter drugs will not be allowed, while the tax on HSAs and Archer MSAs increases for distributions not used for qualified medical expenses. In addition, beginning in 2013, contributions to health FSAs will be limited to $2,500 per year. Finally, the income threshold for itemizing medical expense deductions will increase from 7.5% to 10% in 2013.

If you have Medicare
Medicare beneficiaries will also see some changes to their coverage. You'll be covered for most preventive and wellness care expenses without co-payments beginning in 2011. Medicare Part D participants who find themselves paying all of the cost of their prescriptions after reaching a minimum threshold, a situation referred to as the "donut hole," will gradually see their out-of-pocket expenses decrease, beginning in 2010 with the payment of a $250 rebate, until 2020, when the donut hole is completely filled. If you're a Medicare Advantage beneficiary, however, beginning in 2011, you may see some of the extra benefits offered by these plans dropped as government payments to these plans are restructured and, in some cases, reduced. And, in 2013, if you're an individual with annual earnings equal to or greater than $200,000, or a married couple with joint annual earnings of $250,000 or more, your Medicare payroll tax will increase by 0.9%, from 1.45% to 2.35%. Also, for high income taxpayers, a Medicare tax of 3.8% will be applied to some types of investment income, such as rent, capital gains, and annuity payments, but not distributions from qualified retirement plans, such as IRAs and 401(k) accounts.

If you don't have insurance
If you don't have insurance, or if it's too expensive, the new law may make it easier for you to get and keep health insurance. By 2014, insurers will have to accept you regardless of your health history, and premiums can only vary based on tobacco use and age. Prior to that time, if you haven't been able to get insurance for at least six months due to a pre-existing condition, you will be able to purchase insurance through temporary high-risk pools.
In 2014, Medicaid availability is expanded to those under age 65 with incomes up to 133% of the Federal Poverty Level (FPL). You will also have state-based American Health Benefit Exchanges, available by 2014, through which you can buy health insurance from various plans. In addition, premium and cost-sharing subsidies will be available for individuals and families with incomes at or below 400% of the FPL, which can aid in reducing the cost of insurance purchased through exchanges.
Non-Deductible IRA Contributions: Good idea or not?
Non-Deductible IRA ContributionsIf your income is over the limit for deductible and Roth IRA contributions, you are faced with a dilemma each year: should you contribute to a non-deductible IRA?  Making a non-deductible contribution shouldn't be an automatic decision.  It could be beneficial, or investing the same amount of money in a taxable account could be a superior choice. Like most decisions in personal finance, there's not one right answer for everyone.
Non-Deductible IRA contribution benefits:  
  • Your earnings grow on a tax-deferred basis.  This means that you can reinvest all of your dividends and capital gains without paying taxes on them as you go.  You are also free to buy, sell, and rebalance investments in your account without tracking each investment's cost basis, gain, or loss for income tax purposes.
  • There's a psychological benefit to putting money in a retirement account for many people - you may be less likely to tap into the funds if you know there would be penalties.
  • Non-deductible contributions create Roth conversion opportunities with less tax owed than if the entire conversion were pre-tax.
Non-deductible IRA contribution drawbacks:  

  • Your earnings when withdrawn will be taxed at regular income tax rates rather than capital gains tax rates.  Right now capital gains rates are 15% for those in the 25% and higher tax brackets and are scheduled to go to 20% next year.  So if you're instead paying 35% or higher income tax on the withdrawals, that's a big hit.
  • Loss of flexibility - if you withdrawal the funds before 59 �, you will be subject to penalties unless you qualify for an exception.
So how do you decide if it makes sense for you?
First - Consider what your tax bracket is pre-retirement and what it will likely be in retirement.  
To do this, you or your financial planner will need to consider your likely sources of income in retirement and their tax status. You also need to make some assumptions about future tax rates - of course no one has a crystal ball, so an educated guess is the best you can do with this aspect.  
If you think your tax bracket will be the same, higher, or just slightly lower in retirement, then non-deductible contributions are likely not a good move for you (unless one of the other benefits applies). 
If your tax bracket will be a lot lower in retirement - like moving from 28% to 15%, then non-deductible contributions should definitely be considered.
After you've answered the first question, then you should consider possible Roth IRA conversion opportunities. If you don't have other assets in traditional or roll-over IRAs, you can make non-deductible contributions and convert them to Roth IRAs with only taxes owed on the growth between contribution and conversion.   This can be a very beneficial technique to get assets into a Roth IRA even when your income exceeds the Roth contribution limits. There are very specific rules for conversions, so it's important to consult with your financial or tax advisor to make sure you follow them correctly.
Lastly, if your decision still isn't clear, consider the loss of flexibility. Depending on your money personality, this can be a positive or a negative. The positive is less temptation to tap into retirement funds early. The negative is the penalties for doing so. You need to know yourself and know whether the loss of flexibility is good or bad for your situation.
Bottom line, don't put your non-deductible IRA contribution on auto-pilot.  It's important to do the analysis because your decision can affect how quickly your assets grow and how much income you have in retirement.
Free Retirement Planning Workshop Tuesday
Keller Public Library Free Financial Education SeminarsI will be speaking at a free retirement planning workshop on Tuesday, April 20 at 6:30 pm at the Keller Public Library.  Designed for individuals and couples who are pre-retirement, we will cover how much you need to save for retirement and the best types of accounts to use for different situations for investment options and tax efficiency. We will also go through some worksheets to determine if you are on track with your current level of retirement savings.
Space is limited and registration is encouraged to ensure your space. RSVP to [email protected] or on Facebook.
Future months topics include (always the third Tuesday of the month):
May: Common Investing Mistakes and How to Avoid Them
June: Where does all your money go? How to build a budget that works for you and stick with it.
July: Saving for College in Texas
The Keller Public Library is located at 640 Johnson Road.
I hope you found this newsletter informative.  KFP offers a free, no-obligation initial consultation to start the financial planning process for new clients.  To learn more or schedule a time, call 817-993-0401 or e-mail [email protected].
Jean Keener, CRPC, CFDP
Keener Financial Planning

Keener Financial Planning is an hourly, as-needed financial planning and investment advisory firm working with individuals at all financial levels.
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