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3 ways to get out of debt

Fortune side with the financially free

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The principle of Seeking Alpha is to help investors, like you, outperform the stock market on a risk-adjusted basis. But just take a moment to think: really beats the market your best financial goal?

This is not mine. I couldn’t predict (let alone control) my portfolio’s performance even if I tried. No, my number one financial goal is something that East under my control: I don’t want to have a lot of debt hanging over my head. I can think of three ways to achieve this and three reasons why I should want this.

(1) Start with your personal debt.

The most obvious ways to get out of debt are to pay off your credit card, avoid leverage in your brokerage accounts, avoid personal loans, and pay off your mortgage. You sometimes read that a fixed rate mortgage (unlike a credit card balance) can be “good debt” and worth keeping even after you retire. Maybe so, but allow me to share a personal anecdote.

My wife and I are retired and have decided to pay for our apartment in Lisbon in cash. I’m glad we did. On the one hand, rents in Lisbon are rising stratospherically. Plus, since we have no monthly mortgage payments, our total housing costs come to just $400 per month in condo fees, plus an additional $200 per year in property taxes (one of the perks of living in a 300 year old building is that property assessments can be quite out of date). The key thing I want to emphasize is that low living expenses give us the flexibility to reinvest more of the dividends in our portfolio – which is especially comforting to do when stock prices are crashing. Falling stock prices are nothing to worry about when you have the opportunity to invest your savings in bargain-priced stocks. Rather the opposite.

The fact is, there is a direct link between your personal finances and your investment anxiety. Take this into account when deciding whether or not to keep “good debt” on your balance sheet in retirement.

(2) Own businesses with no A-rated debt or credit.

Companies with low (or no) long-term debt all have two things in common: (1) they face low (or limited) bankruptcy risk; and (2) the company’s profits are high enough that the company needs little (or no) outside capital to reinvest in growing and sustaining the business. These are two plausible reasons why stocks or companies with little leverage (or no leverage) should theoretically perform less poorly than companies with high leverage whenever the market goes down.

In all honesty, what I’ve found is that low-leverage and non-leveraged companies aren’t necessarily the best performing companies when the stock market is in rally mode. Almost invariably, these are mature companies that lack the pizzazz and instant parabolic returns you might find with the latest cryptocurrency or IPO. Fine. I just earn less during a bull market provided that I lose less during a bear market.

How to build a low volatility portfolio with negligible bankruptcy risk? My solution is that about 90% of my portfolio is weighted towards A-rated companies or companies with no long-term debt. And in practice, is my portfolio less volatile than the overall market?

Google Finance

Portfolio performance year-to-date (Googlefinance.com)

The answer is that my portfolio has indeed managed to lose less money year-to-date than the Vanguard Total World Stock Index Fund (VT). VT is down about 8.5% this year according to Google Finance, while my portfolio is down about 6% (actually a little less thanks to dividends).

Google Finance

One-year portfolio performance (Googlefinance.com)

Looking at the past year, you can see that from November 2021 until today, my portfolio has lost a little less and recovered a little faster than VT. The total annual return is around 8.29% (plus a dividend yield of 2.3%) compared to an annual return of 1.66% for VT (plus a dividend yield of 1.96% according to SeekingAlpha). .com).

In sum, it seems that a portfolio of companies with strong balance sheets satisfies my goal of losing less money when stock prices crash or fall. It’s as good a reason as I should prioritize low or no debt on both my personal balance sheet and the balance sheets of the companies I own.

What’s in my Majority A-Rated Stock Portfolio? All of my portfolio positions and allocations for each public security I own are shown below. You’ll see I’ve included current dividend yields (which I pulled from Seeking Alpha). By the way, please note that the yield calculations do not include the rather huge special dividends paid by T. Rowe Price (TROW) and Old Republic International (ORI) last year. I’ve also included my investment plans (or at least ideas) for each stock in my portfolio (I think that would highlight any biases I might be harboring).

author

Author’s portfolio (author’s personal spreadsheet, data from SeekingAlpha.com and GoogleFinance.com)

(3) Treat your future tax obligations as personal debts.

I have spoken with many people who have spent years building their retirement savings account. After they stop receiving a salary, they may find that their income tax bill drops precipitously…that is, until the Required Minimum Distributions (“RMDs”) kick in. Once these begin, income taxes begin to proliferate like mushrooms.

But here’s something interesting that will happen when you stop working and your only source of income is capital gains and dividends. If you are married and filing jointly, you pay zero Federal income tax on the first $83,350 of eligible dividends and long-term capital gains. Then you can claim a standard deduction of $25,900, which means $109,250 of fully tax-free income.

The Motley Fool

Investment income tax rates (Fool.com)

Once you start earning regular income in retirement (which will happen when you take RMDs), it eats away at your ability to earn $109,250 in tax-exempt qualified dividends and long-term gains. For example, suppose you need to withdraw $40,000 RMD from your IRA this year. The first $25,900 is non-taxable but consumes your standard deduction. The remaining $14,100 of this RMD is subject to ordinary income tax, and how many qualified dividends and long-term gains can you earn tax-free? This number goes from $83,350 to $69,250. In other words, these RMDs can be a double whammy. And what’s worse is that the amount of qualified dividends and long-term gains you can earn tax-free decreases as your RMDs increase in future years. But eliminate the need to take RMDs in the future and you might have a chance to preserve your ability to continue earning the maximum amount of tax-free qualified dividends and long-term capital gains.

That’s what my wife and I decided to do after we retired. Since we have no income other than dividends and capital gains, we have benefited from extremely low federal tax rates and have decided to “spend” some of this tax advantage by regularly converting our accounts IRAs into ROTH IRA accounts. More often than not, if a stock in our IRA was trading sharply lower, we would simply transfer it to our ROTH IRAs at a lower tax cost than we would have faced if that stock had been trading higher. Any subsequent rally in the stock price is tax-free since it takes place in a ROTH IRA.

At this point, all of our retirement assets are in ROTH IRAs, meaning we will never face RMDs in the future. Unless the law changes adversely, this means a future of tax-exempt (or partially tax-exempt) eligible dividends and capital gains MORE tax-free distributions from our ROTH IRAs.

This is a third reason to make a debt-free portfolio and lifestyle worthwhile financial priorities.

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