“My husband is currently unemployed and we’re on COBRA,” Carol says. “He received an inheritance. Should we bank it? Pay off the house? Put it aside for college? Or…?”
From the inheritance, the couple, in their mid-40s, has $150,000 in a money market fund and another $54,500 in an inherited IRA from which Ralph must take IRS-mandated required minimum distributions (RMDs) every year. Additionally, they’ve set aside $56,100 in 401(k) plans, $29,600 in IRAs, $5,100 in a cash balance plan, $4,700 in college savings for their 12-year-old child, $1,000 in savings bonds and $100 in checking.
The Star-Ledger asked Matthew Mozer, a certified financial planner with RegentAtlantic Capital in Morristown, to help the couple get back on their feet financially.
“They are concerned with their cash flow,” Mozer says. “They are living paycheck to paycheck while Ralph is unemployed, but want to save more for retirement.”
Before thinking long-term, though, the couple has some present needs. Because of Ralph’s unemployment and their tight cash flow, Mozer says they should use part of the inheritance for an emergency fund.
“A typical emergency fund consists of three to six months’ worth of expenses depending on if the household has one or two income sources,” he says. “While Ralph is actively pursuing employment, I would recommend setting aside $30,000, or six months’ worth of expenses.”
Mozer next took at a look at the couple’s health insurance situation. He suggests they take advantage of the Health Savings Account (HSA) offered by Carol’s employer.
“I would recommend that she contribute the maximum amount for 2012 — $6,250 — into her HSA,” he says.
Carol has until April 15 to make the contributions.
Mozer says an HSA is an effective tool that allows contributions to go in tax-free and any distributions for qualified medical expenses come out tax-free. But, he recommends that if she has enough after-tax assets to pay for medical expenses, she should first pay them out-of-pocket and not through distributions from her HSA.
“This strategy would allow her contributions to accumulate in the HSA and [she could] withdraw those funds in retirement — including any earnings and appreciation — tax-free for medical expenses such as Medicare premiums,” he says.
Additionally, if they keep track of the medical expenses they pay out-of-pocket, in retirement, Carol can make a tax-free withdrawal from the HSA for unreimbursed qualified medical expenses that she incurred in the past — a tax-free distribution.
Mozer recommends both Ralph and Carol make Roth IRA contributions. Carol worked in 2012 and is currently employed, and meets the income eligibility requirements.
Mozer says a non-working spouse may also contribute to a Roth IRA, if together, the couple meets the income eligibility requirements. They are both eligible to make a 2012 contribution before April 15, 2013, for $5,000 and a 2013 contribution for $5,500 each.
After those contributions, Mozer recommends they invest a significant portion, about $74,000, of the inheritance into a taxable account.
“They have a longer investment time horizon before retirement, about 20 years, and therefore have the ability to ride out some short-term market volatility,” he says. “In the end, the investments have the ability to benefit from being invested in diversified, highly-liquid mutual funds.”
Also, those investments will be fully accessible if they need assets to cover lifestyle expenses.
Mozer recommends they consider rolling over all their old 401(k) plans to IRAs with a reputable custodian.
“A direct rollover to an IRA would preserve the assets tax-deferred status,” he says. “An IRA would also provide an investment account at a lower fee than an employer plan and would provide access to more investment options to create a better diversified portfolio.”
The moves would also provide more simplicity in terms of managing their assets.
Mozer says while it is great that most of their assets are invested in mutual funds, they have holdings in individual stocks and closed-end mutual funds, too. Overall, he says mutual funds are better for them.
“Mutual funds are a cost-efficient way to own several hundreds or thousands of holdings and provide adequate diversification,” he says. “Owning individual stocks increases an investor’s concentration in one company, and creates unnecessary risk that they could lose all of their investment if that company would go bankrupt”
Mozer says closed-end funds are also not appropriate for Carol and Ralph. A closed-end fund issues a fixed number of shares once, and then no new shares are issued, so closed-end funds often present liquidity problems because shares can only be traded between investors. Additionally, Mozer says, closed-end fund prices are determined by market forces of supply and demand. As a result, their prices can deviate from their net asset value (NAV), and cause the fund to trade at a premium or discount.
Overall, the couple’s portfolio needs better diversification.
“For example, an asset class such as emerging markets stocks would experience a much different return over the past two decades compared to the return of only U.S. large-cap stocks,” he says. “Having exposure to multiple areas of the market allows an investor to participate in the better-performing asset class while mitigating the damage from the poorer performer.”
On college, the couple has a New York State 529 Plan. Mozer says the plan is very competitive with its diversified age-based investment options and low fees.
“529 plans are a great way to save for college education costs,” he says. “All gains are tax-deferred, and are tax-free if used towards qualified educational expenses.”
From the inheritance, he recommends they make a large one-time contribution, approximately $25,000, to the 529 plan.