Michael Townsend
Vice President, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.

The next big fiscal battle in Washington is starting to take shape. It just won't be here as soon as we thought.

On May 18, temporary legislation to suspend the debt ceiling expires. That means the clock will start ticking as the Treasury Department takes "extraordinary measures" to avoid defaulting on the nation's debts.

But higher-than-expected tax receipts and other factors have beefed up the Treasury's balance sheet. What had been anticipated as a summer showdown in Congress over increasing the debt ceiling is now going to be put off until this fall.

How we got here

The United States hit the current debt limit of $16.4 trillion on December 31, 2012.

The next day, Treasury started taking extraordinary measures—which really just means slowing some payments, shifting money between government accounts, and using other accounting techniques to avoid default. That usually buys about six to eight weeks before default looms again, but Congress pushed out that deadline by passing a law that suspended the debt ceiling until May 18.

On May 19, the debt ceiling will return at roughly $16.8 trillion—the old limit ($16.4 trillion) plus the amount incurred since it was suspended (an estimated $400 billion). We expected that, once again, Treasury would employ extraordinary measures to give Congress six to eight weeks to negotiate an increase. However, it looks like they'll have a bit more time, because the government is taking in more and spending less than originally projected:

• In April, the US Treasury took in a surplus of $113 billion due to increased tax revenue—the largest monthly surplus in five years.
• Government spending is down, in no small part due to the automatic spending cuts, known as the "sequester," that kicked in on March 1.
• Fannie Mae announced it would pay a one-time dividend of $59.4 billion to the government before the end of June, and Freddie Mac announced it would pay the government $7 billion. The payments represent efforts to pay back part of the bailout the housing agencies received in 2008.

The combination of factors led Treasury Secretary Jacob Lew to confirm that it would be "at least Labor Day" before the debt ceiling would need to be raised. Some analysts have said the deadline could be as late as October 1.

No plan going forward

Secretary Lew has urged Congress to not wait until the last minute to resolve the situation, but we don't think it's likely that Congress will heed his warning. The deep divisions over fiscal issues remain, and they aren't likely to melt away soon.

Both Republicans and Democrats would like to see the debt ceiling increase as part of a larger package of steps to reduce the deficit. But Republicans want deficit reduction to focus on spending cuts and entitlement reforms. Democrats have long insisted that spending cuts be balanced with tax increases, which Republicans strongly oppose.

House Republicans have been discussing a plan that would pair a short-term debt ceiling increase with the start of a comprehensive tax reform process, then bump up the debt limit incrementally with each hurdle a tax reform plan clears: House passage, Senate passage, Presidential approval. But in a sign of how challenging the issue is, House Republicans can't reach an agreement on such a plan—to say nothing of Democrats in either the House or Senate.

So expect the stalemate to continue. And expect the debt ceiling battle to be another high-wire, last-minute affair.

Just don't expect it until the fall.

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

Many investors use exchange-traded funds (ETFs) to get low-cost, diversified access to a variety of markets. Stock ETFs are widely known, and many investors have also become familiar with ETFs that hold portfolios of bonds with a fairly constant average maturity.

Fewer investors are familiar with target maturity bond ETFs, which hold diversified portfolios of bonds that are all expected to mature in the same calendar year. These relatively new ETFs can provide investors with some of the diversification benefits of a typical bond mutual fund or ETF, but can also provide some expectation of a certain maturity date, much like holding individual bonds.

The mechanics: How does it work?

Target maturity bond ETFs track indexes of bonds, much like other bond ETFs do. However, most traditional bond ETFs hold an ever-changing portfolio of bonds in order to maintain a more or less constant average maturity. For instance, a fund that tracks a benchmark such as the Barclays US Aggregate Bond Index will hold a wide variety of bonds, some with a long time until they mature and some with a shorter time. As bonds in the portfolio mature, the portfolio manager will reinvest the proceeds into other bonds. The manager might also sell some bonds that leave the underlying index and replace them with other bonds that are in the index. The overall effect is that the ETF is always invested in bonds.

Target maturity bond ETFs are different. For these funds, the underlying index is made up of bonds that are all expected to mature in a single calendar year, such as 2016. In the years prior to the maturity year, the ETF collects interest from the bonds in the portfolio and pays it out to shareholders, just like other bond ETFs do, but no bonds mature.

Then, over the course of the target year, the bonds in the ETF begin to mature. Instead of reinvesting the proceeds into other bonds, the ETF will hold the cash. By the end of the year, the expectation is for all of the bonds to have matured, leaving the ETF with only cash. At this point, the ETF distributes the cash to shareholders and closes down. Of course, shareholders are not obligated to hang onto the ETF until the very end of the target year; shares can be bought or sold any time on the normal stock exchanges like any ETF.

What's the yield?

Understanding the yield on target maturity bond ETFs can be tricky. Since interest rates have been falling in the market for many years, bonds that were issued long ago tend to pay higher coupons than bonds issued today. This means that investors are willing to pay more than the "par" value for those high-coupon bonds, which means that they trade at a premium to par value. 

Let's look at an example. If a bond will mature for $1,000 in 2015 ($1,000 is its par value), it might be trading for $1,050 today. This bond would be said to be trading at a 5% premium to par value. However, the value of this bond will fall as it gets closer to maturity (since the borrower will only return par value, in this case $1,000, to the bond holders at maturity regardless of current interest rates). 

This means that an investor who buys an ETF whose bonds are trading at premiums to par value will likely see the price of the ETF fall as the bonds get closer to maturity. The dynamic of high coupons and declining par value is reflected in the fund's "yield to maturity" calculation, which will generally be much lower than the fund's "weighted average coupon." The extra interest that these bonds will pay can still make them attractive but it's important to understand the yield calculation.

What are the choices among target maturity bond ETFs?

Currently, two different companies offer target maturity bond ETFs:

• Guggenheim Investments has BulletShares ETFs.
• iShares has target year municipal and corporate bond ETFs.

As with any newly launched ETF, investors would be well advised to monitor these funds to see that they have adequate assets and liquidity before jumping in.

The name BulletShares refers to the bond portfolio term "bullet," a strategy of holding bonds that all mature around the same time. There are two different groups of BulletShares:

• Investment-grade corporate bonds (from companies with relatively high credit ratings) currently exist for each year from 2013 to 2020.
• High-yield bonds (from companies with lower credit ratings) currently exist for each year from 2013 to 2018.

iShares has a family of target maturity municipal bond ETFs for each year from 2013 to 2018. The overall approach is similar to BulletShares, but the iShares funds hold municipal bonds, whose interest is exempt from federal income tax and in some cases the alternative minimum tax. 

In April 2013, iShares launched target maturity bond ETFs for the years 2016, 2018, 2020 and 2023. These products invest in corporate-grade bonds, specifically excluding the financial sector from their holdings. 

Uses for target maturity bond ETFs

Investors might use target maturity bond ETFs in a few different ways.

The first use is laddering. To build a bond ladder, an investor would normally buy a series of individual bonds maturing in a range of years. For instance, a ladder might consist of:

• $5,000 worth of bonds maturing in one year,
• $5,000 of bonds maturing in two years,
• $5,000 of bonds maturing in three years,
• and so on, through $5,000 of bonds maturing in ten years (or longer).

One difficulty with this approach is that it takes a relatively large amount of money to be able to buy bonds from enough different issuers to be diversified. A target maturity bond ETF might be a good tool in this situation because it holds bonds from a wide range of issuers while still fitting into a rung of the bond ladder.

A second use is for a specific capital need, such as paying for a child's college. Since target maturity bond ETFs are expected to become cash in a certain year, they could be useful tools for investors who will need cash in a particular year.

A third use is for interest rate positioning. If an investor believes that interest rates are likely to rise, they may want to hold shorter-term bonds, which are likely to lose less value in a rising rate environment. Short-term alternatives exist in target maturity bond ETFs, which become shorter-term as the target year approaches. One caveat, though, is that if you hold these ETFs until the end of the target year, you'll be left with cash to reinvest, which may or may not be what you're looking for.

What you should know

As with any investment, target maturity bond ETFs have risks that are important to understand.

The first risk is credit risk. Bonds held by these ETFs are either municipal bonds, investment-grade corporate bonds or high-yield corporate bonds. All three have the possibility of default, which would cause the ETF to lose value. This is no different from any fund that holds these types of bonds, nor is it different from holding the bonds directly, but it's an important risk to understand. Mitigating this risk somewhat is the fact that ETFs hold bonds from many different issuers, which helps to lessen the impact if one issuer were to default.

The second risk is interest rate risk. If interest rates rise, the values of existing bonds will generally fall, which would cause ETFs that own those bonds to lose value. The longer a portfolio has until maturity, the bigger the impact of this risk, so shorter-maturity ETFs have less risk here.

The third risk is liquidity risk. Target maturity bond ETFs are a relatively new innovation, which means that many of them have relatively small asset bases and little trading volume. It's especially important to be careful when you're planning to be trading (as against holding it for a longer term) an ETF that isn't very actively traded or widely owned. The spread between the bid price and ask price of illiquid ETFs can be wide, which means a higher transaction cost for investors.

Hitting the target

Target maturity bond ETFs aren't for everyone, but they might be useful tools for investors who want to combine the diversification of a bond fund with the expected cash payout date of individual bonds. Understand the choices, the uses and the risks, and you might be able to put this innovative tool to work in your own portfolio.

by Carrie Schwab-Pomerantz,
CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.

Dear Reader,

I've always believed that children can learn meaningful lessons about money at a very early age. In fact, by about age three, they're listening and learning from us whether we're aware of it or not. When we take our kids to the grocery store, to the bank or clothes shopping, even if we don't include them in the transactions, they're picking up signals and attitudes about money and how we handle it. Why not turn these passive experiences into active learning opportunities?

Your four-year old is already aware that money has value; it can be used to buy something special. So now would be a perfect time to help her understand that there are limits to what money can buy, and also that she may have to make a choice. There are some fun ways to do this. 

Start with a simple piggy bank

At four, your daughter is probably a proficient counter, so help her learn more about the value of money by first putting any coins she gets into a piggy bank. Periodically take the coins out so she can count them. At the same time, you can help her identify what they are, and what each is worth, i.e., 10 pennies make a dime; 5 nickels make a quarter.

Once she's accumulated enough to buy something—even a dollar or two—explain to her that different things cost different amounts of money. Then, when you go to the store together, you can look at price tags and discuss what that means. Let her select an item that she can afford, pay for it, get a receipt and keep any change to put back in the piggy bank. She'll probably be proud of her successful transaction.

To keep this lesson going, you can do some comparison shopping and let her handle small purchases whenever appropriate. 

Introduce a fun way to save for something special 

Saving is another money lesson kids can learn at a young age. I'd start now to help your daughter understand that she may have to wait to buy the things she wants. For instance, the next time she has her heart set on something, talk with her about how much it costs and tell her she can save her money until she has enough to buy it.

You might have her decorate a special jar for that particular savings goal. As she gets money from her grandparents, have her put it in the savings jar. Think how excited she'll be when she finally goes with you to make the purchase with the money she's saved.

Consider an allowance at about age five

An allowance gives kids a chance to have money of their own on a regular basis and learn to manage it. Age five to eight is about the right time to start.  

There are different points of view on whether to tie an allowance to household chores. Whatever you decide, be very clear about your daughter's responsibilities and if you expect her to pay for certain things with her own money.

How much you give is up to you (you might talk to other parents to get the going rate) but it should be enough so that your daughter can actually use it in a meaningful way, making spending and saving decisions. With a young child, I'd keep the amount small and make it weekly. You can change the parameters as your daughter gets older, increasing the amount and time frame, and perhaps the responsibilities that go along with the allowance.

The most important thing with an allowance is to let kids make their own spending decisions—and learn from their own mistakes. Don't jump immediately to the rescue if you daughter misspends. Rather, help her work through the situation and make better decisions the next time.

Enjoy every milestone

I applaud you for starting your daughter's financial education early. As she gets older, you can help her through other money milestones like making a first big purchase, buying a car, and saving for college. These real-life experiences will give you the chance to teach her important financial lessons, and give your daughter the chance to take pride in her accomplishments. Most importantly, you'll be setting her on a solid path to financial independence. To me, that's the real value.

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

It's probably no surprise that a common question I hear these days is, "Has the stock market come too far too fast?" There are underlying questions as well, including "If it's not retail investors buying (they're not, at least not aggressively), who is doing the buying?"

I'll tackle a component of the latter question in today's report and focus particularly on some of the more interesting buying forces present today. In short, some of the biggest recent increase in stock buying has come from foreign central banks as well as bond mutual funds (yes, you read that right). Along with the increased demand has come decreased supply courtesy of stock buybacks.

Triple top breakout

Indeed, there remain traditional supports for the market's advance, notably very strong earnings and still-reasonable valuations—this can be seen in the chart below, which shows the S&P 500® Index having broken out of the "triple top" formation. Compared to both the 2000 top and the 2007 top, earnings are notably higher, valuations more reasonable and interest rates (and inflation) much lower.

S&P breaking out

Source: FactSet, Federal Reserve, ISI Group, Standard & Poor's, as of May 10, 2013.

As for supply…

Supply has been dwindling, thanks to a big increase in stock buybacks. According to Birinyi Associates, there were $78.1 billion in buyback authorizations during the month of April. That brings the year-to-date total to $286 billion, the strongest start to a year in the history of their data. It's an 88% increase from the $152 billion recorded in 2012 and the 340 total authorizations this year is 26% higher than last year's 269 authorizations.

Stock buybacks surging

Source: Birinyi Associates, Inc., FactSet. Data is year-to-date through April for all periods.

The month of April was the strongest April Birinyi has ever recorded, due in large part to a $50 billion authorization by Apple (the largest ever by a company). The year is on pace to record $859 billion in authorizations, nearly in line with 2007's record $863 billion.

As for demand…

Last month, Central Bank Publications and Royal Bank of Scotland Group Plc conducted a survey of 60 central bankers. Nearly 25% of respondents said they own stock shares or plan to buy them. The Bank of Japan, featured heavily in the news recently and holder of the world's second-largest level of reserves, said it will more than double investments in stock exchange-traded funds by 2014. The Bank of Israel bought stocks for the first time last year, and the Swiss National Bank and Czech National Bank have upped their holdings to at least 10% of reserves.

Of the 60 banks surveyed, 14 said they'd already invested in stocks or would do so within five years. In fact, this is the first time ever the question about stocks has been in this annual survey.

Behind the heightened interest in stocks are growing central-bank reserves requiring increased diversification. In US dollar terms, the four largest central banks have expanded their balance sheets to more than $13 trillion, compared to only $3 trillion 10 years ago. Most central banks have had heavy and consistent reliance on fixed-income securities, but with yields low (and falling) in many countries, keeping all reserves in fixed income risks a declining value of reserves.

However, 70% of the central banks in the survey (including the US Federal Reserve) indicated that stocks remain "beyond the pale." A few central banks, including the Fed and the Bank of England, have no mandate to purchase stocks directly.

Jim O'Neill, chairman of Goldman Sachs Asset Management, weighed in: "I don't think people should worry about (central banks owning stocks). Frankly, it makes a huge amount of sense in a world of floating exchange rates and such incredible opportunity, why should central banks keep so much money in very short-term, liquid things when they're not going to ever need it?"

Should we call them "stond" funds?

The number of bond mutual funds that own or are buying stocks has surged to its highest point in 18 years, according to Morningstar (see the past 10 years in the chart below). A caveat: although the number of bond funds buying stocks is at an all-time high, the percentage has remained fairly stable relative to the number of bond funds overall.

Bond and income funds have more leeway to invest in other securities than many people might believe. The Securities and Exchange Commission does require funds to invest at least 80% of their assets in the type of assets suggested by their names; however, vaguer terms like "income" or "value" do not trigger the requirement.

Bond funds become big stock buyers

Source: FactSet, Morningstar Direct, as of December 31, 2012

Russ Wermers, an associate professor of finance at the University of Maryland, has been at the forefront of recent research on the subject. He notes that many bond-fund managers think of stocks as simply the lowest rung in a company's capital structure, below corporate bonds, preferred stock and/or other debt. As a company's bonds become more expensive (as yields decline), its stock starts to look like a better value by comparison. In that way, it can make sense for bond-fund managers to consider reaching down into stocks.

The trend is easy to understand when considering the quandary many fixed-income investors face. There's been a bull market in bonds for more than 30 years, and yields, which move in the opposite direction of prices, are near record lows.

In sum

The market has yet to attract high levels of interest from traditional individual investors, but that hasn't kept it from consistently surpassing all-time highs since March. Look a little further and you'll find that keen interest in stocks has come from a couple of interesting buyers, while at the same time, supply has been dwindling thanks to near-record buybacks.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

In the same way that a bank will lend you money if you have equity in your house, your brokerage firm can lend you money against the value of certain stocks, bonds and mutual funds in your portfolio. That borrowed money is called a margin loan, and can be used to purchase additional securities or to meet short-term financial needs. 

Each brokerage firm can define, within certain guidelines, which stocks, bonds and mutual funds are marginable. The list usually includes securities traded on the major U.S. stock exchanges that sell for at least $5 per share. Also, keep in mind that you can't borrow funds in retirement accounts or custodial accounts.

How does margin work?

Generally speaking, brokerage customers who sign a margin agreement can borrow up to 50% of the purchase price of marginable investments (the exact amount varies depending on the investment). Said another way, investors can use margin to purchase potentially double the amount of marginable stocks than they could using cash.

Few investors borrow to that extreme—the more you borrow, the more risk you take on—but using the 50% figure as an example makes it easier to see how margin works.

For instance, if you have $5,000 cash in a margin-approved brokerage account, you could buy up to $10,000 worth of marginable stock—you would pay 50% of the purchase price and your brokerage firm would front the other 50%. Another way of saying this is that you have $10,000 in buying power. (Schwab clients may check their buying power by referring to the "Margin Details" module on the right side of Trade pages and selecting the "Marginable Securities" option in the drop-down menu.)

Similarly, you can often borrow against the marginable stocks, bonds and mutual funds already in your account. For example, if you have $5,000 worth of marginable stocks in your account, you can purchase another $5,000—the stock you already own provides the collateral for the first $2,500, and the newly purchased marginable stock provides the collateral for the second $2,500. You now have $10,000 worth of stock in your account at a 50% loan value, with no additional cash outlay.

Because margin uses the value of your marginable securities as collateral, the amount you can borrow fluctuates day to day along with the value of the marginable securities in your portfolio. If your portfolio goes up, your buying power increases. If your portfolio falls in value, your buying power decreases.

Margin interest

As with any loan, when you buy securities on margin you have to pay back the money you borrow plus interest, which varies by brokerage firm and the amount of the loan.

Margin interest rates are typically lower than credit cards and unsecured personal loans. And there's no set repayment schedule with a margin loan—monthly interest charges accrue to your account, and you can repay the principal at your convenience. Also, margin interest may be tax deductible if you use the margin to purchase taxable investments (subject to certain limitations, consult a tax professional about your individual situation).

The benefits of margin

Margin can magnify your profits as well as your losses. Here's a hypothetical example that demonstrates the upside; for simplicity, we'll ignore trading fees and taxes.

Assume you spend $5,000 cash to buy 100 shares of a $50 stock. A year passes, and that stock rises to $70. Your shares are now worth $7,000. You sell and realize a profit of $2,000.

What happens when you add margin into the mix? This time you use your buying power of $10,000 to buy 200 shares of that $50 stock—you use your $5,000 in cash and borrow the other $5,000 on margin from your brokerage firm.

A year later, when the stock hits $70, your shares are worth $14,000. You sell and pay back $5,000 plus $400 interest1 which leaves you with $8,600. Of that, $3,600 is profit.

So, in the first case you profited $2,000 on an investment of $5,000 for a gain of 40%. In the second case, using margin, you profited $3,600 on that same $5,000 for a gain of 72%.

The risks of margin

Margin can be profitable when your stocks are going up. However, the magnifying effect works the other way as well.

Jumping back into our example, what if you use your $5,000 cash to buy 100 shares of a $50 stock, and it goes down to $30 a year later? Your shares are now worth $3,000, and you've lost $2,000.

But what if you had borrowed an additional $5,000 on margin and purchased 200 shares of that $50 stock for $10,000? A year later when it hit $30, your shares would be worth $6,000.

However, if you sell your shares for $6,000, you still have to pay back the $5,000 loan along with $400 interest¹, which leaves you with only $600 of your original $5,000—a total loss of $4,400. As you can see, when taken to the limit, trading on margin makes it possible to lose your initial investment and still owe the money you borrowed plus interest.

Margin call

Remember, all the marginable investments in your portfolio provide the collateral for your margin loan. Remember, too, that while the value of that collateral fluctuates according to the market, the amount you borrowed stays the same. If your stocks decline to the point where they no longer meet the minimum equity requirements for your margin loan—usually 30% to 35% depending on the brokerage firm²—you will receive a margin call (also known as a maintenance call). Your brokerage firm will ask that you immediately deposit more cash or marginable securities into your account to meet the minimum equity requirement.

An example: Assume you own $5,000 in stock and buy an additional $5,000 on margin, resulting in 50% equity ($10,000 in stock less $5,000 margin debt). If your stock falls to $6,000, your equity would drop to $1,000 ($6,000 in stock less $5,000 margin debt).

If your brokerage firm's maintenance requirement is 30% (30% of $6,000 = $1,800) you would receive a margin call for $800 in cash or marginable securities to make up the difference between your equity of $1,000 and the required equity of $1,800.

Triggering a margin call

What happens if you don't meet a margin call? Your brokerage firm may sell assets in your portfolio and isn't required to consult you first. In fact, in a worst-case scenario it's possible that your brokerage firm will sell all your shares, leaving you with no shares yet still owing money.

Again, most investors choose not to purchase as much as 50% on margin as presented in the examples above—the lower your level of margin debt, the less risk you take on, and the lower your chances of a margin call. A well-diversified portfolio also helps reduce the likelihood of a margin call.

If you decide to use margin, here are some additional ideas to help you manage your account:

• Pay margin loan interest regularly.
• Carefully monitor your investments and margin loan.
• Set up your own “trigger point” somewhere above the official margin maintenance requirement.
• Be prepared for the possibility of a margin call—have other financial resources in place or predetermine which portion of your portfolio you would sell.
• NEVER ignore a margin call.

The bottom line

Buying stock on margin is only profitable if your stocks go up enough to pay back the loan with interest—and you could lose your principal and then some if your stocks go down. However, used wisely and prudently, a margin loan can be a valuable tool in the right circumstances.

If you decide margin is right for your investing strategy, consider starting slow and learning by experience. Be sure to consult your investment advisor and tax professional about your particular situation.

1. Example uses a hypothetical, simple interest rate calculation at a rate of 8%. Actual interest charge would be higher due to compounding. Contact Schwab for the latest margin interest rates.

2. At Schwab, margin accounts generally receive a maintenance call when equity falls below the minimum "house" maintenance requirement. For more details, see Schwab's Margin Overview and Disclosure Statement.

 

May 9, 2013

Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

We continue to believe that it’s too early to make a strong, tactical move toward a more cyclical bent with sectors. Defensives have led the rally to this point and although we’ve seen some signs of a shift in leadership, with cyclicals outperforming on several instances lately, we need to see more convincing evidence before making a shift, both on the economic and market fronts. Additionally, we believe there’s a decent chance of a noticeable pullback in the broader market in the near term, leading us to have a bit of hesitancy to make a bold move at the moment.

However, we see some attractive values developing at the sector level, and although most often this space is dedicated to shorter-term, tactical moves, we suggest even longer-term investors use this opportunity to make sure their broad equity portfolio is appropriately diversified. With the underperformance to this point in the year, and still decent earnings performance for the most part, sectors such as industrials, materials, and technology appear to be undervalued based on several historical levels. We don’t believe valuation is a particularly useful timing tool, but as we urge a longer-term view to most equity positioning, buying cheaper shouldn’t be frowned upon. For investors that need to raise their allocations to the above mentioned sectors, we believe now is a great time to do so. There may be some continued underperformance, although we believe that is nearing an end, but waiting raises the risk of having to buy it at even higher levels, when the valuations may not be so attractive.

Conversely, if a portfolio has become over concentrated in the more defensive sectors, perhaps due to a search for yield, now would be a good time to bring down allocations to the utilities, staples, and telecommunications sectors, as valuations appear extended to us. One final note on portfolio construction, investors searching for yield in the equity world should recognize that it is more risky by nature than the fixed income world and should not be thought of as a direct replacement for fixed income holdings. Additionally, we urge investors looking for higher dividend payers to look beyond the traditional utilities and telecom sectors and recognize that there are quite a few stocks in even cyclical sectors that are paying a good dividend, and may have better prospects of growing that yield.

We strongly suggest looking for details on all of our specific sector views and information on our outperform and underperform ratings by reading the expanded analysis below, and then making adjustments to portfolios as you see fit. One final note: Our tactical recommendations change quickly at times as we continually monitor economic progress and factors influencing individual sectors, so check back often.

Source: Schwab Center for Financial Research and Standard and Poor's as of May 6, 2013.

Consumer discretionary: Underperform

We are starting to see some cracks develop in the consumer world, with retail sales numbers being somewhat disappointing and personal spending revealing relatively tepid results. We believe this is the start of what will be a stretch of disappointments that will result in the discretionary sector underperforming in the near future. Therefore, we continue to hold our underperform rating on the group, despite the admittedly disappointing results to this point.

Although resilient to this point, as mentioned there are cracks appearing as several retailers have reported disappointing results from the first quarter, and we continue to believe changes in the fiscal situation are impacting consumers at least marginally and will continue to do so for the foreseeable future. Higher payroll taxes for nearly everyone, higher taxes in general on upper income earners, and the impact from the spending cuts seem to us to inevitably impact the consumer. We believe this pressure on consumers' incomes at all parts of the spectrum will result in pressure on earnings potential for stocks in the discretionary group.    

Additionally, from a broader perspective, the discretionary sector tends to be an early cyclical mover, meaning that it is one of the first sectors to react to changes in economic direction. And we’ve seen the group outperform the broader market over the past year. With the fiscal drags on growth facing the US economy in 2013, it seems unlikely to us that we’ll see a near-term increase in the growth rate, leading us to believe that the early cyclical trade may be nearing an end.      

Certainly the picture is not all negative as we've seen some of the perceived larger headwinds facing consumers appear to dissipate somewhat. We have seen consumers reduce their debt load and housing show increasing signs of improving and the job market appears to be accelerating at least slightly. Additionally, commodity prices have eased at least somewhat, which could help to offset at least some of the burdens consumers are facing. 

We acknowledge the American consumer has shown a remarkable ability to overcome obstacles, but we believe some near-term disappointment are in store as challenges grow, and reiterate our underperform rating on the discretionary sector.    

Positive factors for the consumer discretionary sector:

• Inventories remain quite lean. This could provide retailers with some pricing power as activity picks up.  
• The Federal Reserve continues to be quite accommodative, which could help to support the consumer, although further accommodation seems unlikely at this point. 
• Global central banks appear to be firmly in an easing stance, which could help bolster the consumer.  

Negative factors for the consumer discretionary sector:

• The unemployment rate is relatively high, and improvements have been slow to come.
• Credit standards remain tight, although there are signs of slight easing.
• Tax bills are moving higher in 2013, which should impact consumers' ability to spend. 
• Recent retail sales readings have largely been below expectations.  
• The Federal government is facing budget issues and is employing spending cuts and tax increases in order to address the issue. This could result in less money in consumers' pockets.   

Return to top

Consumer staples: Marketperform

The consumer staples group has had a good start to the year as it appears to us that investors who had been out for some time are tiptoeing back into the stock market by starting with more defensive areas such as staples. We believe this has a limited time horizon and are concerned that the group may be a bit extended at this point, while also believing that investors may start to move out the risk spectrum, leaving us unwilling to move to an outperform rating on the staples sector at this point.     

Although a consumer group, in contrast to the discretionary sector, the staples group is considered defensive because it tends to sell items that will be purchased regardless of the economic environment, such as toilet paper and laundry detergent. While this is a positive during tough economic times, it can also be a negative during times of improving economic conditions as consumers don't typically expand their spending on such items as the economy improves—demand tends to stay relatively constant. And with pocketbooks being squeezed even more as outlined in the consumer discretionary section, relative performance of the staples sector may hold up fairly well.    

However, staples companies typically deal with relatively narrow margins, which can make it difficult to rapidly increase profitability and thus support swift growth in stock prices. These margins could be squeezed even further as the payroll tax hikes impact Americans.  

Even when we had the group at an underperform rating, we weren't overly negative on many fundamentals of the staples group, and they remain relatively solid in our view. And since the market could be in for an increasingly tumultuous environment, we believe that a marketperform rating is most appropriate.

Positive factors for the consumer staples sector:

• Staples retailers have aggressively cut costs and are attempting to create more perceived value for consumers, which could support sales.
• The defensive consumer staples group could benefit from tighter consumer wallets if confidence declines in the coming months.

Negative factors for the consumer staples sector:

• Competition continues to accelerate and is exacerbated by the increasing emergence of low-cost, emerging market production, which could potentially cause pricing power in the group to evaporate by compressing margins and squeezing earnings.
• An acceleration of economic growth would likely cause the staples sector to underperform. 
• Numerous central banks are now firmly in easing mode in an effort to stimulate the economy, which could hurt the more defensive sectors. 

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Energy: Marketperform

Oil prices continue to be relatively volatile, but within a relatively wide range. Energy, and especially crude oil, tends to have a large speculative element at times which can make it difficult to focus on the underlying fundamentals, but we believe that's exactly what investors should do. Although there are likely to be many twists and turns, we believe it ultimately comes down to supply and demand factors, influenced largely by the global economic outlook. And right now, while accommodative Fed policy would typically help the price of oil and the energy sector, as the dollar would often weaken, helping commodity prices, there appears to be bit of a race to the bottom with currencies that at least partially offsets the Fed's efforts. With these two competing forces, we believe a marketperform rating continues to be appropriate, but with the level of global accommodation by central banks continuing to rise, a move to outperform may not be far off.   

We continue to believe the US and Chinese economies will drive the direction of the sector. To that end, China's response to its economic softening was initially more tepid than we would have expected but the new leadership appears to be stepping up. Conversely, the Federal Reserve has been extremely aggressive, but its effectiveness appears to be diminished at the present time.   

Moving past the short-term movements in the energy markets, economic developments seem to be moving more in the direction of supporting the energy sector. The US economy continues to expand but at a modest rate, China appears to be moving past their soft patch, but Europe's economic situation continues to be in question with some disappointing data lately, although there are signs that the economic decline may be bottoming. However, there is also an increase in domestic production that could bring prices lower as US supplies of energy products build.   

Longer term, we have a mainly positive outlook for the energy sector and believe a buying opportunity may present itself during a renewed retrenchment in oil prices. Developing countries will almost certainly continue to need more fuel, demand will likely continue to grow but we also note that supplies are increasing as well leaving us with a relatively neutral view for at least the time being. 

Positive factors for the energy sector:

• Global uncertainties could threaten some supplies. 
• Developing nations will likely need more energy as they improve their infrastructures and modernize their economies.
• Global central banks appear to generally have an easing bias, which could help the more cyclical sectors such as energy.

Negative factors for the energy sector:

• Supplies could increase dramatically with a renewed commitment to exploration and technological improvements. We've already seen new discoveries and existing fields produce more oil than originally projected.
• Purchasing manager index (PMI) surveys around the globe continue to be lukewarm, which could portend improving growth prospects.  
• Conservation efforts and new technology could impact the growth in demand for energy products.

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Financials: Marketperform

There are still risks for the group, although we believe the sector's fundamentals and broader macroeconomic developments help to offset some of those risks. An extremely accommodative Fed provides financial companies with low borrowing rates on money that they can then lend out at higher rates. And although the spread isn't historically large, the potential for longer-term interest rates to move slightly higher while the short end remains anchored by the Fed provides the opportunity for margin expansion. Also, balance sheets of consumers and companies appear to be improving. Corporate cash balances are high and household debt as a percentage of disposable income for consumers has fallen. This has enabled banks to gradually reduce the reserves on their balance sheets for loan losses. And the continued improvement in the housing market should, in our view, bolster financials as they are able to get foreclosed homes off their balance sheets more quickly, while mortgage demand may start to rise. 

We still have concerns, and chief among them is the regulatory environment. Regulations that limit trading financial institutions can do for themselves, which has been a major profit driver for some companies, remain a concern for us. And already-instituted new capital requirements restrict the amount of money banks can lend, limiting profit potential for many of them.

We maintain relative confidence in the ability of the financial industry to reshape itself and adjust to the changing environment as it has done so many times, but are watching developments in Washington carefully to determine what our next move may be.

Positive factors for the financials sector:

• Most financial institutions have paid back government loans and are increasing share buybacks and dividend payments, illustrating their growing health and stability.
• Recent delinquent loan estimates have decreased among credit card companies, indicating improving balance sheets.
• Lending standards have loosened somewhat, which could help loan volume grow.  
• Businesses could increase borrowing once more certainty regarding the fiscal situation occurs. 

Negative factors for the financials sector:

• Confidence in the financials sector, though improved, remains shaky. Concerns about hangover from the housing bust—combined with increased government regulation—continue to hover over the group.
• Government intervention, such as new limits on certain fees that can be charged, has already started to affect the financial industry and could hold back performance for the foreseeable future.
• A new round of foreclosure uncertainty or a push by the Federal government to again loan to higher risk borrowers could pose problems for the financial sector.   

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Health care: Marketperform

We've liked the health care sector for some time as the fundamentals of the group have remained attractive to us but the area continues to face political headwinds, leading us to maintain our marketperform rating. Health care continues to be at the center of much political discussion, even after the Affordable Care Act was solidified by a Supreme Court decision and the election results. However, implementing the numerous provisions of the Act still remain under debate and seem to change on a relatively frequent basis—causing some additional volatility in the group. We did see a recent positive development for the sector, and managed care insurers specifically, as Congress reversed its plan to cut Medicare Advantage payments.  

Containing costs remain a high-profile issue and increased government involvement could mean a more challenging environment for at least some of the space. Until we get a little better handle on what impact the current negotiations have on the economy as a whole and the health care sector specifically, we believe a marketperform rating is appropriate. The sequestration cuts, if sustained, would likely have an impact on the sector due to the scheduled cuts in Medicare reimbursements (different from the cuts reversed above). 

But it's also important to remember that the political aspect is only one piece to the puzzle and that investors should also look to the overall fundamental picture. In our view, these fundamentals look good as valuations are still depressed, balance sheets are solid, the group has good dividend yields, and the overall cost structure appears to have been much improved. And while the fight in Washington is largely on how to pay for health care, there seems to be little debate that there is an increasing demand for health care products and services, which is typically a good sign for an industry.

Finally, we believe the health care sector provides both growth and defensive characteristics, which can be attractive to investor, leading to our relatively positive view of the sector and the possibility that it may regain its outperform rating in the near future.

Positive factors for the health-care sector:

• The aging population could provide a boon for the industry as an increasing number of Americans require more extensive drug treatments and medical care.
• Americans are increasingly obese, which results in a greater need for medical attention due to the myriad of health issues that coincide with obesity.
• Balance sheets in the health-care sector remain flush with cash, boosting the possibility of higher dividend payments, share-enhancing stock buybacks, and mergers and acquisitions. 

Negative factors for the health-care sector:

• Government regulation will likely continue to increase during the coming years as more seniors demand intervention in order to theoretically lower their out-of-pocket health-care costs.
• The current and fiscal situation in Washington creates continued uncertainty regarding the group. 
• Medicare spending could be reduced as the government seeks to reduce the deficit, which could hurt some of the health care sector. 

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Industrials: Marketperform

The global manufacturing picture appears quite murky to us at the present time. The national ISM Manufacturing Index stayed in territory depicting expansion but was weaker than expected, causing a small bit of concern that the US recovery may be stalling slightly. Additionally, Europe remains weak and recent data has disappointed, but governments appear to be shifting off of some of the more onerous austerity policies that could help to boost growth and China's situation is still uncertain but appears to be at least marginally improving. This somewhat disjointed picture leads us to believe that a marketperform rating remains appropriate.         

We have concerns, but they are slowly being balanced out as Europe is in an apparent recession but has made progress on their debt crisis, despite recent flare-ups, China's growth is slow relative to history but may have bottomed, India's bureaucracy remains troubling although there are nascent signs of reforms, and US political concerns continue to weigh on companies but some dialing down of the rhetoric in Washington appears to be helping. We believe corporations will remain somewhat cautious in the near term, but the investment picture appears to be brightening as the year progresses.     

We also continue to watch fiscal austerity measures around the world, which could dampen growth in the industrials arena, but as mentioned above do appear to be dialed down at least somewhat. Finally, after a long tightening campaign by China that has dented expectations for global growth, the country is reversing course and somewhat easing monetary policy, but at a rate that has been somewhat disappointing and could dampen enthusiasm for the industrials sector.   

Positive factors for industrials:

• Corporate balance sheets remain relatively cash rich, which could help push management to invest in new, more-efficient equipment to help offset production losses due to layoffs.
• Lending standards, while still tight, have started to loosen, which should help boost capital spending. 
• Inventories in much of the manufacturing area appear relatively low, leading to the possibility of a demand-inspired rebuilding phase.  
• Countries are now considering undoing some of their more stringent austerity-related policies, which could help to boost economic activity and demand for industrial goods.

Negative factors for industrials:

• Access to credit remains limited in many cases—among smaller businesses, for example—which tends to dampen spending plans.
• Fiscal austerity, if maintained, could result in slower economic growth and decreased demand for industrial products.
• The Chinese central bank's apparently cautious approach to easing has resulted in concerns that the country's growth may slow more than initially expected.   

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Information technology: Outperform

We've seen some nascent signs of a perk up in performance of the, to this point in the year, disappointing tech sector, and we continue to believe that the sector is poised to outperform and reward those investors who are patient. The innovation and entrepreneurial spirit that seems to pervade the tech sector are factors that are sometimes difficult to quantify but make us excited about the future of the sector and push us to have an outperform view on the group.       

With large cash balances, increasing dividend payments, solid management and tight inventory controls, the tech sector appears far more stable than it was in the late 1990s environment that so many still remember. We've been touting this stability as one of the reasons to stick with the group and in fact the sector has outperformed during the past couple of downturns in the market, illustrating some of the tech defensiveness we’ve seen developing. We believe those who remain invested in tech will continue to be rewarded with outperformance in the coming months.

The fundamentals of the group also appeal to us. Companies that have underinvested in technological improvements during the past couple of years appear to be at the point where they need to upgrade equipment. Such investments are typically attractive because they tend to increase companies' efficiency and productivity at all levels.

As a result, companies can produce more with fewer workers—as we're seeing with relatively high productivity numbers but still-high unemployment readings—which allows them to cut back on costs and potentially expand margins.

Additionally, balance sheets in the sector appear solid, with large cash balances and relatively low debt. This enables the group to increase dividends and pursue mergers and acquisitions that might help performance as competition is removed and expenses consolidated. We believe this also helps provide stability to the group, which in turn gives it a certain level of defensiveness mentioned above, contrary to its high-beta history.

Positive factors for information technology:

• Growth in business investment in technology is now outpacing growth in total business investment.
• Real tech investment has been below trend for several years, which could bode well for the future of the sector as spending returns to more normal levels.
• We're starting to see banks loosen lending standards, which could slowly help revive capital investments. 

Negative factors for information technology:

• Increasing global competition, especially in areas with low labor costs, will likely continue to compress profit margins.
• We see signs that companies remain hesitant to increase capital spending.
• Governments are reining in spending, which could dampen investment in technology-related projects.

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Materials: Marketperform

After struggling through the latter half of 2012, the materials sector perked up to start the year but has returned to the struggles seen late last year. We believe this mixed action is largely due to uncertainty surrounding global economic growth with a recession in Europe that may or may not be bottoming, Chinese growth that has disappointed, and a stronger US dollar that dampens profitability from abroad. Risks appear somewhat elevated as none of the improvements are appear to be gaining substantial traction but we believe our marketperform rating is appropriate as we believe global growth will slowly take hold.           

Accommodative monetary policy, as we are now seeing in most of the globe, has typically been a positive for the materials sector as growth expectations increase. China recently reduced its reserve requirements, a definite sign of easing, while India surprisingly implemented a larger rate cut than was expected. These actions have not resulted in a surge in growth so far, however, but we view these as signs that important central banks around the world are starting to come over to the Fed's view of bolstering growth. This could provide a bit of a tailwind behind the materials sector, warranting at least a marketperform rating, with an eye toward another upgrade should global improvement continue.     

Positive factors for the materials sector:

• Developing countries continue to need more natural resources to support their infrastructure building.
• Global central banks are now largely in easing mode, which should help to support economic activity and the materials sector.

Negative factors for the materials sector:

• Chinese demand for processed commodities might be slowing as technological advances and a build-out of production facilities allow the country to produce more of its own materials. China recently transitioned from a net importer to a net exporter of steel.
• Several governments are implementing austerity measures, which could crimp demand for materials.
• Wage costs are rising in the materials sector as we’ve seen skilled labor shortages in certain segments of the market.
• Continued US dollar strength could undermine the results in the materials sector.

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Telecommunications: Marketperform

The telecom sector held up relatively well during the pullback seen in the market near the end of 2012 and we are keeping are marketperform rating on the group, but concerns are growing. The yield provided by the sector, and traditionally defensive nature of the group, can make it attractive to investors in an environment such as we are seeing now, leading us to maintain our current rating…at least for now.    

The telecom sector has lost some of its traditional defensive appeal, in our opinion, given that the group has moved much of its business model from the seemingly stable, regulated fixed-line business to the more variable, consumer-dependent wireless arena, while also dealing with an onslaught of competition from a variety of sources. But consumers are increasingly demanding more wireless services, which could boost revenues, but costs remain elevated which could make profitability more difficult. 

Generally, many investors apparently do still view telecom as defensive, seeing the remaining fixed-line business as a cushion against variable revenues in less certain times. Additionally, dividend yields in the space remain relatively attractive to income-hungry investors. But we are seeing wage costs, which had been under control, start to rise, while announcements of increases in capital expenditures could reduce margins, causing us some increasing concern.

Competition for increasingly budget-conscious consumers remains fierce, and telecom certainly hasn't been immune to bargain-hunting shoppers, as evidenced by declining pricing power in the space. We're watching developments in this area especially closely given that new products still seem to be enticing consumers to spend, but we wonder how many times the sector can draw from that well.

In contrast to the technology sector, companies in the telecom sector have a lot of debt on their balance sheets, so we continue to view the group with caution.

Positive factors for the telecommunications sector:

• Wireless demand appears to be increasing as more communication and media devices move to the wireless arena, although some of that movement is likely to take away from fixed-line revenue.
• The higher dividends typically paid by telecom companies are increasingly attracting investors tired of paltry fixed-income yields. But the yield advantage these companies have over the market appears to be diminishing. 

Negative factors for the telecommunications sector:

• Consumer spending on telecom compared to total spending is now falling, which has typically coincided with underperformance for the sector.
• Net profit margins are declining for the telecom sector as competition squeezes margins.
• Capital expenditures in the telecom space are rising as companies look to improve and expand their networks, which could be a burden on profitability in the near future.
• The telecom sector has the highest debt-to-equity ratio of any nonfinancial sector. That could hurt the group in this time of tight credit.

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Utilities: Marketperform

We have been concerned about stock valuations in the utilities sector for some time as investors chased the relatively higher yields, and we cut the rating to underperform from marketperform. But after a bought of selling, that also may have been due partially to investors unloading high dividend payers ahead of a potential tax increase, which is now reality, we recently moved the rating back to marketperform but are having renewed concerns after the nice run to start the year for the utilities group.  

Although the Fed appears to be attempting to make riskier assets more attractive through extremely loose monetary policy, the traditionally defensive utilities sector seems to be attracting renewed investor interest as fixed income yields remain low. Should interest rates creep higher with stronger economic growth, the yield characteristics of the utilities sector may become less attractive, but that doesn't appear to be in the cards in the near term, leading us to believe a marketperform rating is most appropriate.    

Certainly, if the economic situation deteriorates, the utilities sector could benefit from a search for perceived safer assets. Additionally, an improving housing market could result in an increase in electricity needs in developing areas, and we're seeing signs that may be occurring as housing starts have started to creep higher. It is this balanced outlook that leads us to our rating, although developments could occur in the next couple of months that lead us to move yet again. 

Positive factors for the utilities sector:

• Dividend-paying stocks remain attractive as long as yields on conservative fixed-income products remain relatively low. And should economic prospects decline more than currently expected, defensive, dividend-paying stocks could become even more attractive.  

Negative factors for the utilities sector:

• Utilization rates of electric and gas utilities have moved down modestly while production has spiked, indicating a potential oversupply issue that could pressure margins.
• Capacity growth has been rising, which has been a sign of underperformance for the sector in the past.
• Accelerating economic growth would likely make the defensive utilities sector less attractive.  

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About Schwab Sector Views

Schwab Sector Views were developed by Charles Schwab & Co., Inc.'s ("Schwab's") Investment Strategy Council. Schwab Sector Views are Schwab's outlook on the 10 broad sectors as classified by the widely recognized Global Industry Classification Standard groupings. The GICS structure comprises sectors, industry groups, industries and subindustries. Schwab Sector Views are at the sector level. While Schwab Equity Ratings and Schwab Industry Ratings utilize a disciplined approach that evaluates all stocks (Schwab Equity Ratings) or all industries (Schwab Industry Ratings) in the same manner, Schwab Sector Views uses analytical techniques and methods that vary from sector to sector.

Explanation of columns in the table: The benchmark weights are provided for reference and represent each sector's market capitalization weight in its index.

Schwab Sector Views represent our current outlook on each particular sector. All investors should be well-diversified across all sectors. However, investors who want to tactically overweight or underweight particular sectors may want to consider our three- to six-month relative performance outlook reflected in this column. These views refer only to the domestic equity portion of investors' portfolios.

How should I use Schwab Sector Views?

Investors should generally be well-diversified across all sectors, at or near the respective sector market capitalization weights relative to the overall market (benchmark). However, investors who want to make tactical shifts to those weights with a goal of outperforming the overall market can consider the Schwab Sector Views as a resource. Schwab clients can also use the Stock Screener or Mutual Fund Screener to help identify buy and/or sell stock or mutual fund candidates in particular sectors that they may be underweighted or overweighted in their portfolios.

How to use Schwab Sector Views in conjunction with Schwab Equity Ratings

Sector diversification is an important building block in portfolio construction. Schwab Sector Views are expressed in terms of outperform, marketperform and underperform, and can be particularly helpful in evaluating and monitoring your portfolio composition. Schwab Sector Views can be useful in screening new stock purchases and in identifying portfolio holdings for possible sale. A review of sector weights coupled with individual stock concentration should be a critical measure of equity portfolio diversification. Schwab Equity Ratings provide an objective and powerful approach for helping you select and monitor stocks.

Rob Williams
Director of Income Planning, Schwab Center for Financial Research

When the topic of tax reform arises, the exemption on interest from municipal bonds often comes under scrutiny (along with other deductions and exemptions). Most recently, President Obama's annual budget proposal included a proposal to cap the value of all itemized deductions and exclusions at 28%. While we don't think it's likely such a proposal will get approved by Congress any time soon—as it would probably discourage the type of infrastructure investment that the president wants to promote, and it would generate smaller revenues than other major tax breaks currently in place—we still think it's worth a look at what the implications might be for muni bond investors.

The president's proposal applies to all deductions and exclusions, not just tax-exempt muni bonds. The cap would apply to all deductions and exemptions, including the deduction of state and local taxes and mortgage interest, two deductions with a larger cost—and therefore potential revenue benefit—to the federal government than the tax exemption on muni bonds.

The cap would apply only to taxpayers in the 33% federal tax bracket and above. If the proposal did become law, investors in the 33%, 35%, and 39.6% tax brackets would have to pay some federal tax on the interest from municipal bonds. The amount of tax would be the difference between their marginal tax rate and 28%. For example, an investor in the 35% tax bracket would pay 7% federal tax on interest income received from municipal bonds. There would be no impact for investors at the 28% marginal income tax bracket and lower.

A change to the tax code could increase borrowing costs for issuers, potentially discouraging infrastructure improvements. The Securities Industry and Financial Markets Association (SIFMA), a leading securities industry trade group, anticipates that interest rates would rise 0.7% if deductions were to be capped. A $5,000,000 project would thus cost the issuer an additional $35,000 per year. We think this additional cost for issuers would most likely reduce the scale and number of municipal infrastructure projects—the opposite of what the president wants, and one reason why we believe this proposal won't go through.

Capping municipal bond interest wouldn't dramatically reduce the deficit. The Joint Committee on Taxation, a nonpartisan committee of Congress, recently released a report analyzing the "cost"—or tax revenue not received by the federal government—of major tax exemptions and deductions between 2012 and 2017. Based on their analysis, the municipal bond tax exemption is the 10th most expensive tax break, and will "cost" the federal government an estimated $247 billion. If the exemption were capped at 28%, only a portion of the $247 billion would be recovered. Our opinion is that capping the muni tax exemption wouldn't have a significant positive impact on the federal deficit, and is another reason why we don't believe this proposal will survive.

Estimates of federal tax expenditures for fiscal years 2012—2017

Source: "Estimates of Federal Tax Expenditures for Fiscal Years 2012–2017," Joint Committee on Taxation, February 1, 2013.
Note: Total interest on muni bonds is derived from interest exclusion on public purpose state and local government bonds ($191billion) and private activity bonds that are generally exempt from federal tax but subject to AMT ($55 billion). Numbers are rounded.

Bottom line. We don't suggest a change in your municipal bond investment strategy based on ongoing discussions about reforms to the federal tax code. Higher yields in the muni market relative to Treasuries and corporates are already compensating for some of this risk. In addition, taxes on other forms of investment income (such as dividend income and interest on taxable bonds) have already increased—making municipal bonds more attractive, barring some other change in tax policy. And the impact would be limited to higher-bracket tax payers at only a portion—not all—of their marginal income tax rate.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Investors often overlook the liability side of their balance sheets, as they focus on their portfolios and other assets. But your personal net worth has two sides: assets and liabilities. Now may be a good time to get the liability side into shape.

Your first step is figuring out what overall debt level is right for you. There's an industry rule of thumb called the 28/36 rule.

The first number means that no more than 28% of your pretax household income should go to servicing home debt. That includes all home-related debt costs, including principal payments, interest, property taxes and insurance (sometimes abbreviated as PITI).

The second number means that no more than 36% of pretax income should go to all debt payments, including credit cards, auto loans and home debt. As a guideline, consider the following ranges of total debt payments as a percentage of pretax income:

• Below 30%: Great!
• 30% to 36%: OK
• 36% to 40%: Borderline
• More than 40%: Red flag, especially if you're carrying a lot of variable rate debt and your income doesn't keep up with rising rates.

If you can manage the payments, then the right debt level for you hinges on how much you're paying for the use of the borrowed money, and what you plan to do with it.

Assuming an acceptable level of overall debt, you should next focus on how to minimize your debt payments. Among the highest-cost forms of debt are credit cards and unsecured installment loans: Their rates are typically in the double-digit stratosphere, and the interest expenses are generally not tax deductible.

Thankfully, individual taxpayers still have three primary sources for low-rate loans with tax-deductible interest:

• Mortgage and home-equity debt
• Margin loans on securities
• Student loans

Here are some savvy strategies to help you make the most of them.

Mortgage and home-equity debt

Mortgage and home equity lines of credit (HELOCs) are among the most attractive debt options—and not just when rates are near historic lows.¹

The interest is tax deductible on mortgage debt up to $1 million on your primary and/or secondary residence, whether for purchase or major improvements. The same is true on up to $100,000 of home-equity debt, which can be used for any purpose.

Check with your tax advisor, especially if you think you might be subject to the alternative minimum tax.

Any points you might pay when taking out a mortgage loan can be deducted as well—either in the year you pay them (for an original mortgage) or during the life of the loan (in the case of a refinancing). Unamortized points from a previous refinancing are also deductible in the year of the new refinancing, if you refinance with a new lender.

Another major—and often overlooked—factor influencing the potential cost and structure of the debt on your primary residence is how long you plan to live in it. If you plan on staying for the long haul (10 years or more), this is still a great time to lock in a low rate for the life of the loan (and shift the risk of rising rates to the lender rather than taking it on yourself).

Many people gravitate to fixed-rate mortgages even if they don't plan on staying put for long. However, if you plan to stay in your home five years or fewer, you're probably better off with a variable-rate mortgage—even if rates begin to rise. If you plan on staying fewer than 10 years or so, you might even consider an interest-only loan. Of course, it all depends on your individual circumstances.

Finally, homeowners with high-rate consumer debt (credit card debt, for example) may want to consider rolling it into a low-rate HELOC—but only if they can keep from running up their credit card balances all over again.

Margin debt

Just as banks can lend you money if you have equity in your home, your brokerage firm can lend you money against the value of certain stocks, bonds and mutual funds in your portfolio. This is known as a margin loan.

Because margin loan rates generally track short-term interest rates, they're more likely to fluctuate in line with moves by the Federal Reserve.² There's no fixed repayment schedule with a margin loan, though you may be required to deposit funds if the value of your account falls below a certain point.

Borrowing on margin isn't for everyone, and it's important to understand the risks. If you use margin to purchase investments, you could potentially magnify your return. But the opposite is also true—margin can magnify losses as well, and you could lose more than your original investment.

However, if your marginable portfolio is diversified enough and large enough (relative to the level of margin debt) to help mitigate that risk, margin can be a convenient, flexible and low-cost borrowing alternative—not just to increase leverage in your investments, but for noninvestment uses, as well.

Just remember, with margin debt the IRS "tracing rules" apply. That means the interest expense is tax deductible only if you use the proceeds of the debt to purchase taxable investments—which excludes a Porsche or trip to Europe. Check with your tax advisor.

Student loans

Student-loan interest rates are low compared to other sources of unsecured debt such as credit cards. What's more, interest paid on a student loan can be tax deductible—up to $2,500 per year—depending on your income level.

For 2013, full deductibility is phased out if your adjusted gross income is between $60,000 and $75,000 for single filers and between $125,000 and $155,000 for married filing jointly.

So even if you can afford to pay your children's college tuition from other sources, you might want to consider having them take out a low-rate student loan. That way, you can devote the money you saved to another investment goal—your retirement, for example.

Other considerations

If you have enough resources, borrowing may be purely discretionary. In this case, maintaining a manageable level of debt becomes an individual choice based on the numbers involved.

For some folks, however, the desire to be debt-free may override other considerations. In that case, opportunity costs and income taxes take a back seat.

Here are a couple of final points to keep in mind, even if you're debt-averse by nature:

Liquidity preference. Even if you can't do as well or better with an alternative use of the money, a preference for liquidity might keep you from paying off a low-rate loan prematurely if the opportunity cost is negligible to you. Diversification could play a role here, as well.

Income tax considerations. Everybody's tax situation is different, so check with your tax advisor to see what applies to you. For mortgage debt, don't forget the $1 million debt ceiling is limited to acquisition debt (purchase or capital improvement). Once you've paid off an original mortgage, you'll be limited to the $100,000 home equity deductible debt ceiling unless you make capital improvements or buy another home.

Keep in mind, however, that even at the highest marginal tax rate the cost of borrowing can still be significant (for example, a fully deductible 40% combined tax rate still means you're paying 60 cents on the dollar for carrying the debt).

It's nice to get a deduction on debt you can't avoid, but don't get so wrapped up in taxes that you fail to see the forest for the trees. Stay focused on the big picture—the idea is to minimize expenses, not maximize deductions. If the goal were to maximize deductions, then a 6% rate would be better than a 5%, right?

While you're at it, why not see if your county will let you pay more in property taxes? After all, it's all deductible. Hopefully, these ideas sound as crazy to you as someone suggesting you borrow more than you need or are comfortable with just to get a bigger income tax deduction.

Compare rates and other loan features

Lender rates will vary, depending on such things as the type of loan, where you live, your credit history (FICO score), the amount borrowed, term of years, fixed or variable rate structure, and so forth.

The following table compares some recent average rates and features for various common sources of credit. Of course, rates will fluctuate depending on current economic conditions.

Source: Bankrate.com, as of March 21, 2013 (original mortgage loan is average for 30-year fixed, auto loan is average for 48-month new car, credit card is average standard variable). Source for margin loan rate is Schwab.com, as of February 11, 2013 (Schwab margin rate shown applies to loans of $50,000–$99,999; base rate of 6.50% last changed on May 20, 2008 and is subject to change without notice). Rate levels are for comparison only and are not representative of current levels. Nothing herein is or should be interpreted as an obligation to lend.

The bottom line

The liability side of your personal net worth statement deserves as much attention as the asset side. Just as a well-run business might wisely manage debt to add shareholder value, you can benefit by making smart use of debt within the context of your financial goals. Just be sure you're the master of your debt and not the other way around. Shop for the best terms based on your situation, go for the lowest rates you can find in that context, and take advantage of any tax breaks available to you.

1. With home equity loans and lines of credit, the financial institution will take a deed of trust to secure the debt. You could lose your home if you do not meet the obligations in your agreement with the financial institution.

2. Interest on your margin loan accrues daily and is posted to your loan balance monthly.

3. Not all securities are marginable. Main types that are not marginable include mutual funds for the first 30 days of purchase; unlisted, low-priced, or illiquid equities; and low-rated corporate bonds.

Michelle Gibley
CFA, Director of International Research, Schwab Center for Financial Research

Australia exports many of its abundant natural resources to China, so many investors view investing in Australia as a way of participating in the China "story." But if the two countries are so closely linked, why haven't falling commodity prices and a slowdown in China had a greater effect on the Australian stock market?

Commodity prices struggle, but Australian stocks still rise

Source: FactSet, Standard & Poor's, Commodity Research Bureau. As of April 26, 2013.

We think it's because other sectors—namely financials, which account for nearly half the Australian stock market—continue to perform well. But we're beginning to see signs suggesting Australia's stock-market rally won't continue forever.

Domestic economy appears to be weakening

The weakness in the commodity outlook may be starting to affect Australia's broader domestic economy. The mining sector is cutting its capital spending plans amid price pressure on commodities, and non-mining investment has yet to pick up. As a result, Australia's leading index has been falling since September 2012.

Australia's growth may be moderating 

Source: FactSet, OECD. As of April 26, 2013.

The Reserve Bank of Australia (RBA) is hoping that consumer demand will start to respond to six rate cuts that totaled 1.75% in the 14 months through December 2012. Thus far the results are inconclusive; retail sales in the first two months of 2013 posted the biggest back-to-back gain in almost four years, but consumer confidence slipped in April after three months of increases. More broadly, business lending demand has weakened since September.

Demand for loans has fallen 

Source: FactSet, Reserve Bank of Australia. As of April 26, 2013.

Soft landing in the housing market

Despite concerns of a bubble in Australia's housing market, banks' conservative lending standards appear to have helped avert a crash. While home prices were falling a year ago, the RBA reports that prices have been increasing from the mid-2012 trough. Mortgages in arrears worsened in January, but were down from a year ago and appear to be somewhat stable, according to Moody's Investors Service. That said, there are still risks to the housing market if the domestic economy weakens significantly.

Australia's banks a source of stock market strength

Financial stocks account for nearly half the Australian stock market (46% of the S&P/ASX 200 Index as of April 17, 2013). Global investors have been attracted to Australian banks' high dividend yields and conservative lending practices, which have helped keep down the ratio of loans in or nearing default. High consumer savings rates have provided strong deposit inflows, reducing banks' reliance on more expensive wholesale funding and helping to lower their risk profile—all of which have helped recent financial stock performance.

On the revenue side, total lending was rising in early 2012 due to strong demand from businesses, while mortgage lending was weak. However, in late 2012, business demand for loans also started waning. By March, the NAB monthly business survey noted "very weak demand for credit overall," with just 22% of respondents requiring financing. This is the weakest level of credit demand since the survey began in November 2008, and raises some concerns because it comes despite bank lending conditions easing and the central bank cutting rates. Therefore, it is uncertain if Australian banks can continue their breakneck stock performance.

Search for yield and Japan could be positive offsets

Australia is unique among developed markets in that it has both a AAA credit rating and high interest rates: The benchmark rate is 3.0%, compared to the US benchmark of nearly zero. Global investors are already looking for yield, and Japanese investors in particular may turn to Australia now that their central bank's dramatic quantitative easing program could keep domestic yields low. 

Australia may also benefit from Japan's desire to join the Trans-Pacific Partnership, a free-trade pact that could reduce tariffs and boost exports. Additionally, if the Japanese economy rebounds due to the Bank of Japan's stimulus, Australia's exports of thermal coal and natural gas could rise to support demand for electricity. However, there could be a limit to this demand, as the yen's relative weakness makes importing natural gas more expensive.

Caution for Australia's stock market

We are cautious on the Australian stock market because it appears expensive, and because the challenges—including weak demand for credit and a struggling commodity sector—seem more significant than potential upsides such as new Japanese investment.

Tatjana Michel
Director, Currency Analysis, Schwab Center for Financial Research

Once considered a currency with safe haven appeal, the euro's image was first tarnished by the European debt crisis and then further undermined by recent economic and political uncertainties in Cyprus, Spain, and Italy. As a result, many currency investors are looking for other currencies to help weather future economic turmoil. What's the outlook for alternatives to the euro?

What's a "safe-haven" currency?

Let's first note that investors can get exposure to the euro and other currencies either by purchasing international assets in local currencies or by engaging in pure currency trading. For traders, who bet on very short-term movements of a currency pair, a currency's safe-haven aspect is not so important. However, for long-term investors, the safe-haven aspect is important. By spreading international investments across markets and currencies that respond differently to global events, investors may help lower their overall portfolio risk.

Generally speaking, safe-haven currencies are those perceived as least risky and most likely to hold or increase in value during times of global distress. According to the European Central Bank (ECB),¹ safe-haven currencies are usually not from emerging market countries but from developed countries likely to: 

• Be economically and politically stable,
• Have large, well-developed and liquid financial markets,
• Have the lowest interest rates among developed markets prior to the outset of any crisis,
• Maintain unrestrictive economic and regulatory policies (no pegs or capital controls).

The ECB found that a large, liquid stock market and a low level of international indebtedness have enhanced safe-haven appeal more than any other factors.

Up after Lehman bankruptcy in 2008, down after 2009 European debt crisis

When the global financial crisis hit in 2008, the euro served as a relative safe haven and appreciated against riskier currencies such as the British pound, the Swedish krona and the Norwegian krone. However, it was not considered a safe haven relative to currencies with more favorable combinations of market capitalization and debt level: the Japanese yen, the Swiss franc and the US dollar (chart below).

Dollar, yen and franc appreciated vs. euro after Lehman bankruptcy

Source: Bloomberg as of April 22, 2013.
Note: The graph shows the performance of foreign currencies against the euro in percent relative to the rate on September 12, 2008. The euro does not show explicitly because it is embedded in the bilateral exchange rates. In an exchange rate, there are always two currencies (for example, EUR/USD). The first currency in an exchange rate such as EUR/USD is the base currency and is always 1. The second currency is the quote currency and shows what that one unit of base currency is worth in the other currency.

In 2009, the euro began to depreciate not only against the major safe havens but also against currencies that were seen as riskier before the European debt crisis.

As European debt crisis intensified, euro depreciated

Source: Bloomberg as of April 22, 2013.
Note: The graph shows the performance of foreign currencies against the euro in percent relative to the rate on October 1, 2009. The euro does not show explicitly because it is embedded in the bilateral exchange rates. In an exchange rate, there are always two currencies (for example, EUR/USD). The first currency in an exchange rate such as EUR/USD is the base currency and is always 1. The second currency is the quote currency and shows what that one unit of base currency is worth in the other currency.

European alternatives

The Swiss franc is usually the main European safe-haven alternative to the euro—but right now, we don't think it's a desirable choice. Inflows from currency investors seeking a safe haven drove up the value of the franc starting in 2008, and the Swiss National Bank (SNB) eventually installed a limit on the strength of the franc in order to support the Swiss economy. There's now a limit of 1.20 francs to the euro—the franc can become less expensive compared to the euro, but not more. This means that the franc basically moves with the euro and appreciates against the dollar when the euro does. We believe that the SNB will maintain the cap until the European crisis stabilizes. In the meantime, per the ECB's provisions, this restrictive policy eliminates the safe-haven status of the Swiss franc.

The British pound, Swedish krona and the Norwegian krone all have the potential to appreciate against the euro if the debt crisis continues, but they don't hold any safe-haven appeal in the absence of a eurozone crisis. Each country carries its own domestic risks. The United Kingdom is facing high levels of public debt and deficits in combination with low growth. Sweden has high levels of household debt and a housing bubble, and tries to keep the krona from diverging too much from the euro because of its close economic ties to the eurozone. And while Norway is relatively healthy (fiscally and economically), it's vulnerable to oil price shocks and has small financial markets and relatively low liquidity. Additionally, although they're not in the eurozone, banks in the United Kingdom, Sweden and Norway still need sufficient capital to weather a potential blowback from a sovereign default within the eurozone.

Yen faces challenges

The Bank of Japan has tried in the past to weaken its currency, but with little success; for years, an ever-strengthening yen depressed Japan's exports and economic growth. In April 2013, in an attempt to end deflation and boost the economy, the central bank introduced a very aggressive monetary stimulus package that aims at almost doubling the amount of yen in circulation by the end of 2014. The additional liquidity is likely to dilute the value of the yen—making it relatively unattractive as a safe-haven currency for as long as the program is running.

What about the dollar?

The 2008 financial crisis in the United States unsettled investors and raised questions about the sustainability of a global currency system with the dollar at its core. Then, the debt ceiling debacle in 2011 caused the dollar to lose value and safe-haven appeal relative to other developed currencies, which shows that even the dollar is not always a preferred safe haven.

In addition, since 2008, the dollar's performance has been weakened by the US Federal Reserve's massive quantitative easing program. The search for alternatives and for yield drove up the prices and valuations of smaller developed-market currencies such as Australian, New Zealand, Canadian and Singaporean dollars. It makes sense to add foreign currencies to the mix in order to help protect a portfolio from a loss in the US dollar's purchasing power or a rise in inflation. But despite the fact that the US dollar's safe-haven shine may be tarnished, we still believe that it will remain a major preferred currency for investors, given the country's sheer market size (over 45% of world equity market capitalization, as measured by the MSCI All Country World Index).

Can the euro regain safe-haven appeal?

With the exception of the Swiss franc, the euro tends to be the European currency with the greatest safe-haven appeal during a financial crisis outside the eurozone. While it has lost a fair amount of that appeal since the onset of the European debt crisis, we expect the euro to regain its relative allure once the region recovers. After all, the eurozone boasts the second-largest equity market capitalization in the world (over 10%, as measured by the MSCI All Country World Index).

Alternatives aren't easy to find right now

The fact that recent financial crises originated in traditional safe havens such as the United States and the eurozone has driven up the values of currencies with even limited safe-haven appeal. As a result, these currencies are either very expensive (for example, the Norwegian krone or the Australian, New Zealand, or Canadian dollar), temporarily linked to other currencies (Swiss franc) or weakened by interest-rate cuts and unprecedented amounts of quantitative easing (Japanese yen, US dollar, British pound and many other currencies competing in the so-called "currency wars").

Such an environment makes it very difficult for an investor to find viable and cheap alternatives to the euro and the dollar. Higher-yielding developed market currencies (like the above-mentioned Australian, New Zealand and Canadian dollars) could be good options, but they're currently overvalued, they carry their own domestic risks, and small, open and resource-heavy economies tend to be vulnerable to slowdowns in global growth.

How long-term investors can gain currency exposure

We believe that a mix of foreign currencies with their underlying assets can help manage US dollar volatility within a portfolio—but they should be added selectively. Fortunately, a portfolio with foreign exposure doesn't have to be built in one day, one month or even one year. We think it's best to wait for periods in which global risks have abated and perceived safe-haven currencies have become relatively cheap before adding them as a hedge against future periods of risk aversion.

Exchange-traded funds (ETFs) or mutual funds with exposure to various currencies and their underlying securities can offer a relatively cost-effective and convenient way to diversify a US portfolio. Some ETFs and mutual funds also offer exposure to a basket of currencies without the underlying assets; these are seen as "alternative strategies" and should only make up a small portion of a portfolio.

1. European Central Bank, Working Paper Series 1288, January 2011, Maurizio Michael Habib and Livio Stracca: "Getting Beyond the Carry Trade: What Makes a Safe-Haven Currency?"

John Wightkin
Director of Equity Research Applications, Schwab Center for Financial Research

With the record low interest rate environment over the past few years, income-seeking investors have bought shares of nearly any high dividend-paying company.

But, as we noted recently, this pursuit of yield has caused many of these stocks to become expensive relative to their fundamentals. We also found that these highest-yielding stocks are more likely to cut their dividends than other dividend-paying stocks.

So where else can investors turn? Our research has shown that a strategy emphasizing shareholder yield—a more-comprehensive measure of equity income that includes both dividends and share repurchases—tends to produce more attractive total returns than those earned from just a dividend-yield strategy. Additionally, we've found that a shareholder yield strategy might help investors find attractively priced non-dividend paying stocks.

What's shareholder yield?

Shareholder yield is a measure of the total cash returned to the shareholders—the combination of cash dividends and share repurchases. With share repurchases, a corporation pays out cash to shareholders selling in the open market. The remaining shareholders benefit as their shares are now worth more.

Let's look at a simplified example to help explain the principles of share repurchases. Imagine that you already own one share of company XYZ that has 10 shares total outstanding. Company XYZ's market cap is $1,000,000 which means that each share is worth $100,000. XYZ's management team and board agree to buy back one share of their outstanding stock leaving nine outstanding shares. All else being equal, now that same market capitalization of $1,000,000 is spread across fewer shares (nine) which increases their value to $111,111 per share.

This simplified example does not imply that all share repurchases will increase an existing shareholder's value. It just demonstrates one scenario where share repurchases could increase a shareholder's value. Companies have also been known to destroy value by buying back their shares at overvalued prices.

How does the shareholder yield strategy perform?

To test shareholder yield as a stock-selection strategy, we first examined the performance of a hypothetical dividend-yield strategy and a share repurchase strategy separately. We then combined them to see if the share repurchase factor would have added any extra return.

To start, we divided the top 1,500 stocks in the US market by market capitalization into five segments based on a stock's current dividend yield or its share repurchase value. Using the current dividend yield measure, we first separated the dividend-paying stocks from the non-dividend paying stocks. The non-dividend paying segment constituted, on average, approximately 500 stocks from the top 1,500. For the stocks that paid a dividend, we divided them equally into five groups (on average approximately 200 stocks per segment) based on dividend yield. Group 1 contains the stocks with the highest yield while Group 5 holds the lowest-yielding stocks.

For the share repurchase value, we calculated the year-over-year change in shares outstanding. This value can be negative (net share repurchase) or positive (net share issuance). Using this measure, we divided the top 1,500 stocks in the US market by market capitalization into five equal segments (on average approximately 300 stocks per segment). The first segment (Segment 1) included all the stocks that had, on average, repurchased their shares. The next four segments were comprised of stocks that had increasingly greater number of share issuance, on average, year over year.

We formed our five buckets for the dividend and the share repurchase measure as of the end of each month from 1990 through 2012. We calculated the subsequent average 12-month return for each segment and then averaged these overlapping twelve month returns (276 returns) over the entire test period. The table below shows this hypothetical average 12-month return, the average dividend yield and the standard deviation of returns for each of these groups:

• Highest dividend-yielding stocks—stocks in top 20% of all dividend-paying stocks (Group 1 described above)
• Highest shares repurchased—stocks in Segment 1 described above
• Combination of the two groups above (the intersection of stocks from Group 1 from the dividend yield segments and Group 1 from the share repurchase segments)
• Overall stock universe—top 1,500 stocks in the US market by market capitalization

Hypothetical Performance of the Five Groups of Stocks from 1990 to 2012

Source: Schwab Center for Financial Research as of December 31, 2012. These returns are simulated, historical results, calculated with the benefit of hindsight, and are not intended to be replicable by individual investors.

In analyzing these results, please note that they are indicative of the general tendencies of a large distribution of returns associated with historical dividend yield or share repurchase values.

Looking at the table, the share repurchase strategy appears to be a better stock-selection strategy than the highest dividend yielding strategy (outperforming it by close to 2% on average for past 12-month periods, 15% versus 13.1%), although with more price variability (i.e. higher standard deviation of returns).

There are two main reasons why a share repurchase strategy appears to work. When a company buys back its shares, the remaining shares become more valuable—like cutting a pizza into six slices instead of eight. In other words, the investors' ownership in the company increases on a percentage basis as we explained above.

The other reason has to do with what management may be signaling to the market. Buying back shares could tell the market that company management has a favorable attitude toward shareholders and an ability to generate profits that can be used to buy back shares.

Another insight drawn from the table is that the highest-yielding stocks surprisingly only matched the overall universe returns. Given their high average yield, you might expect their total return to exceed the market. However, dividend cuts and overvaluation may explain why this might not be the case.

One major benefit to owning high-yielding stocks is that their variability of returns has been significantly less than the overall market (standard deviation of 17.5% versus 42%). This means, you may have smaller swings in your returns—especially important during market declines.

In our study, combining the highest stock repurchase and dividend yielding strategies added extra return. Note that the highest yielding stock's average 12-month return increased from 13% to almost 15% when combined with stock repurchases. For investors looking for an additional edge in buying high-yielding stocks, employing shareholder yield may help to improve returns while still providing a relatively attractive dividend yield (5.5% on average).

Help with non-dividend-paying stocks

An additional and unexpected result from our research was how looking at share repurchases may help select non-dividend paying stocks.

The universe of non-dividend-paying stocks is primarily comprised of faster-growing companies that reinvest all their earnings back into operations. Some professional investors are prohibited from buying these stocks because they don't pay a dividend. Others often have difficulty identifying the more attractively priced stocks among these faster-growing companies. The results from our research appear to help both investor types.

Focusing on just the non-dividend-paying stocks in our top 1,500 stock universe, we used the stock's share repurchase value to divide this universe into five segments. The first segment (Segment 1) included all the non-dividend paying stocks that had, on average, repurchased their shares. The next four segments were comprised of non-dividend paying stocks that had increasingly greater number of share issuance, on average, year over year.

We then calculated the subsequent 12-month return for each segment at the end of each month from 1990 through 2012 and then averaged these overlapping 12- month returns (276 returns) over the entire test period.

In analyzing these results, please note that they are indicative of the general tendencies of the distribution of returns associated with the non-dividend paying stocks and the share repurchase values. Therefore, investors may not be able to replicate these simulated historical returns going forward.

The results of this test are summarized in the graph below. It shows the hypothetical average 12-month return to each of the five segments along with the overall average return to the non-dividend paying universe.

Note the relatively attractive total return earned by the stocks of companies buying back their shares (the "net share repurchase" segment). The stocks in our study had historically earned close to 18.7% on average for past 12-month periods, about 4.5% more than the average non-dividend paying stock return.

Another interesting finding was the underperformance of stocks issuing the greatest number of shares (approximately 4%). Fast-growing companies that fund their growth with heavy share issuance appear to do a disservice to their shareholders, as more outstanding shares dilute the share value of all shareholders.

Considering our findings, more growth-oriented stock investors might want to focus their attention on stocks of companies buying back shares while avoiding the stocks of companies heavily issuing shares to fund growth.

For income investors, expanding their definition of income beyond companies that just pay a dividend to companies that also return capital to its shareholders via share repurchases could allow them to widen their selection universe to include some faster-growing companies and potentially find better returns.

Source: Schwab Center for Financial Research as of December 31, 2012. These returns are simulated, historical results, calculated with the benefit of hindsight and are not intended to be replicable by individual investors.

by Carrie Schwab-Pomerantz,
CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.

Dear Reader,

For many young families, debt is a fact of life. But that doesn't mean it has to control your life. Of course, with young kids, you have a lot of essential financial obligations. And it's quite natural to also want to provide a few extras so the kids can enjoy sports, special trips, birthday parties—all the things that make childhood special.

Realistically, you may not be able to cover everything. But you can make it a lot easier on yourself, and on your kids, by not only prioritizing your debt payments, but also getting a handle on everyday expenses. Because, no matter how you look at it, paying off debt and budgeting wisely go hand in hand.

Start by prioritizing your debt payments

Some debts work for you and some work against you. Debts like student loans and mortgages that are taken out for a benefit, for instance to create career opportunities or to purchase a potentially appreciating property, can work in your favor. They're usually lower interest and may have some tax advantages.

With these debts, while you have to make your payments on time, you don't necessarily need to focus on paying them off quickly at your stage in life. In terms of your student loans, just be sure to make at least the minimum payment on each loan to keep the government at bay and protect your credit rating.

High interest consumer debt like credit cards and car loans is another story. This is potentially costing you a bundle. So I'd focus on paying these off first with a bit of basic money management.

Start with your credit cards:

• List your credit cards and balances, from the highest interest card to the lowest.
• Pay off the highest interest card first, paying more than the minimum each month if you can.
• Continue to at least make minimum payments on the rest.
• Work your way down until all the cards are paid off.

Another way to approach multiple credit card debts is to consolidate them on a low interest card and pay the maximum that you can afford each month. But look at credit card consolidation offers closely. There are often fees involved.

When you have the credit cards paid off, direct any extra money to your car payment. With that taken care of, consider increasing payments on your student loans, once again focusing on the higher interest loans first.

Put payments on automatic where you can

Once you have your debts outlined and prioritized, set up automatic bill pay wherever possible. It will help you make payments on time and keep you focused on paying down your debt. I'd also suggest making an automatic deposit to your savings account each month to create an emergency fund. With these payments automatically deducted from your checking account, you won't be tempted to spend the money on extras.

Take another look at your budget

Speaking of extras, you now need to take a realistic look at your overall expenses. Write down the essentials—mortgage payment or rent, utilities, food, health insurance, transportation, school costs, childcare, loan payments—anything that's absolutely necessary for you and your family. Now write down the nice-to-haves—movies, restaurants, new clothes, video games—all the things you'd like to provide, but don't really need. Put real numbers next to these items to see how you currently spend, or perhaps overspend, your money. While it's not easy, you may have to cut back for a time in order to stay on top of debt.

Get your kids involved

If you do need to cut back, don't apologize to your kids, enlist their help. Make a game out of finding the best deal in the grocery store or when buying clothes or toys. Have them save their allowance or gift money to contribute to the special things they want. Even young kids can learn valuable money lessons by making choices. Because that's the key to managing debt—making balanced choices so you can handle both your needs and your wants with the money you actually have to spend. Best of luck.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

For US stock investors, the year 2012 came in above the long-term historical averages, with the broad-based S&P 500® Index up 16% on a total return (dividends and appreciation) basis. As usual, some categories did better than others, with diversified international stocks returning 17.3% and intermediate domestic bonds delivering 4.2% (MSCI EAFE® Index Net of Taxes and Barclays US Aggregate Bond Index, respectively).

But how did your portfolio do? And more importantly, what progress did you make toward your long-term financial goals? While investment performance is important, long-term financial success depends on a lot more than what "the market" does from year to year. Below, we'll walk through four key steps to help you get a handle on just how you're doing vis-à-vis the market and your financial goals.

Step 1: Benchmark your portfolio's performance

First, assess the performance of your portfolio as a whole, including all your taxable and tax-deferred accounts. Compare your portfolio's actual performance in 2012 (allowing for any deposits or withdrawals during the year) to a benchmark return of appropriate market indexes weighted to match your target asset allocation.

For example, say you're a moderately conservative investor and your target asset allocation is 25% large-cap stocks, 5% small-cap stocks, 10% international stocks, 50% bonds and 10% cash investments. To calculate your benchmark return, follow the process illustrated in the table below. Look up the 2012 return for each asset class's benchmark index, and multiply it by your percentage weight for that asset class to get a weighted return. Then add up the results for your benchmark portfolio return.

Note: Performance is typically measured as a time-weighted rate of return for reporting purposes, which ignores cash inflows and outflows (it assumes investment income and distributions are reinvested). If you added new money or took withdrawals from your portfolio during the course of the year, you could also measure your performance using an internal rate of return calculation which takes cash inflows and outflows into account on a money-weighted basis. (Schwab clients can check with their representatives for more information.)

To get an idea of how your portfolio performed relative to the market, compare the benchmark return to your portfolio's actual return (if you use an investment advisor, they should be able to do this for you). Chances are some areas of your portfolio did better than others, which is fine. It's not likely every area will do well at the same time—that's why it's critical to be well diversified across (and within) asset classes.

For instance, if in 2012 your domestic large-cap stocks did worse than your international holdings, that doesn't mean you should give up on domestic large-cap. The important question is how your portfolio performed relative to its appropriate benchmarks. If it underperformed, step two will help to address the problem.

Here's an example of a custom benchmark that was created for a hypothetical portfolio with a moderately conservative target allocation. The custom benchmark will change, of course, depending on what benchmarks you use for different asset classes and how you weight them.

Source: Schwab Center for Financial Research. Past performance is no guarantee of future results. Returns include reinvestment of dividends and interest. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

This is also a good time to rebalance your asset allocation back to your long-term target if you didn't get around to it at year end. With the tax-law changes we've seen over the past few years, you may be able to give yourself an additional edge by being tax-smart about how you implement your asset allocation between taxable vs. tax-advantaged accounts.

For example, investments that generate long-term capital gains and stocks paying qualified dividends are generally good candidates for taxable accounts, since they are generally taxed at a lower rate compared with ordinary income. Investments that tend to lose more of their current return to taxes—taxable bonds, real estate investment trusts (REITs), stocks and stock funds that generate lots of short-term capital gains which are taxed at the higher ordinary income rate—could be placed in tax-advantaged accounts such as your 401(k) and traditional IRA.

Step 2: Measure the performance of individual investments

Once you see the big picture, you'll want to see how each of your stocks, bonds and mutual funds performed in 2012 relative to their appropriate peer group and index. Start by logging into your account on schwab.com.

• For mutual funds: Click on the ticker, which will take you to our Mutual Fund Report Card. Then click on the Performance tab, and you'll see a comparison of your fund's performance to its fund category average and an appropriate index. If a mutual fund is seriously underperforming its category average, clients can consider using the Schwab Mutual Fund OneSource Select List® to find alternatives.
• For stocks: Click on the ticker, which will also take you to a Schwab research report. Click on the Peers tab, and you'll find a comparison of that stock's performance to an appropriate index, as well as its Schwab Equity Rating®. Stocks rated A or B are projected, on average, by Schwab to outperform the equity market in the year ahead. Stocks rated D or F are expected to underperform.

Step 3: Assess your personal net worth

Now it's time to update your personal net worth statement. This is similar to what a business does with its balance sheet at the end of the year. Start calculating your personal net worth by totaling up all your assets, including:

• What you own, in both your taxable and tax-advantaged investment accounts
• Equity in your home
• Other real-estate properties
• Equity in your business
• Any vested options or employer stock units.

When you're calculating your liabilities, you should examine what you currently owe (a mortgage, credit-card debt and so on) but also what you'll owe if you sell any of your assets. That list of liabilities may include:

• Income taxes on tax-deferred retirement accounts
• Real-estate commissions
• Long-term capital gains taxes
• Loans against other real-estate properties.

Then complete the picture with a statement of personal cash flows—all sources of annual income minus expenses.

If you did all this for 2011, you can compare how your finances performed since then. Did your bottom-line net worth increase in 2012? If it did increase, how did that happen, and by how much? With financial statements in hand, you can see what portion came from the return on your portfolio vs. other factors, such as changes in the value of your home or other real estate, paying off debt, and so on.

This is also an opportunity to see if you stayed on track with your savings goals in 2012. Did you max out your 401(k) or other employer retirement plan? Did you still have positive overall cash flow after all your essential expenses, including taxes? If so, how much of that money did you spend instead of save?

Remember, the amount you save is critical to achieving your long-term goals and growing your personal net worth over time. That's why it's smart to budget in your savings target as a non-discretionary line item on your cash flow statement.

Step 4: Make or update your savings and investment plan

Measuring progress toward your goals is difficult, if not impossible, when you don't have a plan. Putting one in place involves assessing your current situation, identifying your goals—retirement, college funding for children and so on—then formulating a savings and investment plan to help you reach them, as well as a distribution plan to fulfill your goals. Of course, no matter how good your plan is, it won't be of much help unless you take action.

A sound plan, properly implemented and monitored along the way, can increase your chances of achieving your goal—as you find the right balance between working toward your future goals, including a secure retirement, and enjoying the here and now.

The discipline of financial planning

Remember, measuring progress toward your goals involves much more than simply focusing on the performance of your investments. It's a comprehensive look at your spending and saving habits, debt management, tax planning, gifting and more—all within the context of the economic, financial and market environment. Remember, too, that planning is not a one-time event, but an ongoing, lifelong discipline.

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

The connection between the stock market and the economy seems obvious. If the latter is performing well, the former should follow. In reality, not only is the opposite typically true—stocks lead the economy—but the two can often appear to be completely disconnected.

Instead of the market and economy being glued at the hip, as many investors assume, it's more like they're tethered at the hip by a fairly long rope. Ultimately they can't get too far apart, but the two can move in different directions—and at different paces—in the shorter term. The trick for investors is to understand the relationship and know how to avoid some common mistakes.

Strong market, weak economy

We recently entered the fifth year of the bull market that began in March 2009, in conjunction with all-time highs reached for both the Dow Jones Industrial Average and the S&P 500® Index. But investors are generally flummoxed, and one of the most common questions I get when I'm on the road talking to clients is, "Why are the stock market and the economy/fundamentals so disconnected?"

I've written and spoken a lot over the years about the relationship between the economy and stocks, but it's worth a refresher. US real gross domestic product (GDP) growth has averaged a relatively paltry 2.1% since the recovery began in mid-2009, yet the stock market is up more than 150% since its low the same year.

Yes, the economy suffered consecutive mid-year slowdowns in 2010, 2011 and 2012, and the stock market behaved poorly during those stretches as well. We're likely in a milder version of a slowdown this year—for the fourth consecutive year. But the stock market has barely blinked, so far.

Before I get to the connection (or perceived disconnect) between stocks and the economy, let me first alert readers to our view that a correction is possible in the near term, although we believe it would be less severe than those of the past three years. And, like then, any correction should ultimately serve as a buying opportunity.

First-quarter GDP—its first estimate reported last week—was weaker at 2.5% than the consensus expectations. Although that's up from a much slower rate of growth during last year's fourth quarter, many find it hard to square with stocks hitting all-time highs during the first quarter. The punch line to the perceived joke is that there's little evidence that GDP in any year reliably correlates with the performance of stocks.

Stocks as leading indicator

Remember, the stock market (as measured by the S&P 500) is one of 10 sub-indexes in the Conference Board's Index of Leading Indicators. Many investors assume it's the opposite—that economic growth is a leading indicator of the stock market. For a compelling visual of the relationship, see the following pair of charts, which I'll explain below.

Stock Market at Economic Inflection Points

Source: FactSet, as of March 31, 2013. Y-axis of upper chart in logarithmic scale. Y-axis of lower chart represents year-over-year percentage change in US GDP.

The lower chart simply shows the year-over-year rate of change for US GDP. At each trough I put a green dot, and at each peak when growth exceeded 6%, I put a blue dot. (Do note that we haven't had any blue dots since the early 1980s, which I believe is a consequence of the ever-rising burden of debt.)

On the S&P 500 chart above, I put the corresponding green and blue dots. What you can see clearly is that the biggest market rallies occur when the economy is weakest, while the biggest sell-offs occur when the economy is booming. A highlight of the details is in the table below.

Source: Ned Davis Research, Inc. Further distribution prohibited without prior permission. Copyright 2013 (c) Ned Davis Research, Inc. All rights reserved. March 31, 1960-March 31, 2013.

The bottom line is that the stock market, as a leading indicator, tends to launch into rallies and/or corrections around economic inflection points. By definition, a rally-inducing inflection point occurs when economic growth stops falling and begins to rise (green dots), which means GDP growth is at its worst. This is part of why new bull markets can breed rampant skepticism.

A great example of this relationship, and the power of possible inflection points, was the performance of Greece's stock market last year. The country's economy is in a near-depression amid its debt crisis, yet the Athens Stock Exchange was the best-performing stock market within the European Union in 2012—up more than 33%!

Other factors come into play for stocks

Not only is there a timing issue to consider; it's also the case that factors other than economic growth have a significant impact on stock-market returns. Earnings growth and valuation are two of those factors, but even here the connection can appear disconnected at times.

As my friend Larry Kudlow has often said, "Earnings are the mother's milk of stock prices." But is it always true in the short-term? I ask the rhetorical question because many investors are wondering why stocks have continued to perform well in the face of slowing earnings growth.

As the grid below (courtesy of our friends at Strategas) shows, 42% of the time over the past 62 years, stock prices and earnings have moved in opposite direction in any given year. While prices generally track earnings closely over the long term, year-to-year divergences can be significant.

Source: Strategas Research Partners LLC, as of December 31, 2012.

So, what are the factors that can drive stock prices other than economic or earnings growth?

1. Valuation is a major determinant of stock-market returns. An economy with high GDP growth is likely only a good investment opportunity if stock valuations are low. And even an economy with low GDP growth can provide good stock returns if the market is reasonably priced. The current trailing P/E on the S&P 500 is about 16, slightly below the long-term median of 18. In addition, valuations tend to be greater than long-term norms when inflation is less than 4% (it's presently less than 2%). This suggests valuation could expand further without heavy lifting by earnings.
2. History shows that it's often economic surprises—good or bad—that matter more than the absolute level of growth. An economy that's performing better than low expectations, even if that growth is relatively weak, can often be accompanied by a rising stock market. As John Kenneth Galbraith once said, "The only function of economic forecasting is to make astrology look respectable."
3. As coined by my first boss and mentor for 13 years—the late, great Marty Zweig—"Don't fight the Fed." The Federal Reserve has pushed interest rates so low that many savers are being pushed from cash vehicles and US Treasuries into stocks in search of both income and capital gains. In fact, relatively tepid growth has been good for the stock market in the past—and will likely remain so, as it will keep the Fed's foot on the accelerator while keeping inflation at bay.

I'll conclude with one final force that the stock market can have going for it. Bull markets can be self-perpetuating: as prices go up, more people want to buy. This has clearly been a force during this bull market, and it isn't likely to change, notwithstanding our view that a pullback is increasingly likely.

Rob Williams
Director of Income Planning, Schwab Center for Financial Research

"Interest rates must rise—it's inevitable. And if they do, bond prices will fall."

Whether you're concerned about the first part of this statement or not, the second part is unquestionably true. A rising-interest-rate climate is not good for bond investments … at least in the short term.

Both individual bonds and bond funds share interest-rate risk—that is, the risk of locking up an investment at a given rate, only to see rates rise. At least with an individual bond, you can re-invest it at the higher, market rate once the bond matures. But the lack of a fixed maturity date on a bond fund increases concern for many bond fund investors.

Whether you're invested in bond funds for income or as part of a diversified portfolio, what should you do (if anything) if interest rates start to climb? To address this question, we'll look at the components of bond-fund returns and how different fund types might perform if rates rise. Then we'll look at a strategy to help you choose bond funds wisely based on your investment horizon.

The components of bond-fund returns

For stock mutual funds, the primary source of investor returns is rising stock prices, translated into a rising net asset value (NAV) and fund share price. Dividends can be meaningful for some fund types, but are a secondary source of return for most.

Returns from bond funds, however, come from two sources: interest payments, paid out as fund dividends, and changes in price. Over time, interest payments typically contribute far more to returns than changes in price, at least for most bond funds.

When bond prices increase, the rising prices increase the NAV and add to the return of a bond fund, and when bond prices fall, NAV, and returns, decline. Over time, the ups have tended to be balanced out by declines, as shown in the chart below (using the Barclay’s U.S. Aggregate Bond Index as a proxy for performance in a diversified, investment-grade bond fund). This has been true even over a 30-year period where interest rates have been decreasing, widely acclaimed as a 30-year “bull market” for bonds.

Whatever happens to the value of bonds investments, however, income is always positive, and it's been the more reliable part of bond fund returns over time. More than 90% of the total return since 1976 generated from a broadly balanced portfolio of US investment-grade Treasury, agency and corporate bonds has come from interest payments as opposed to change in price, as you can see in the table below.

Income drives bond fund returns over time

Source: Barclays Capital. Returns shown are from monthly Barclays US Aggregate Bond Index returns from January 1976 to December 2012. Total return equals income plus change in price with a reinvestment of interest payments. Past performance does not guarantee future results.

While price returns varied over that time period depending on interest rates and economic cycle, rising periods tended to be counteracted by periods where prices decreased. Also, unlike stocks, bonds held individually, or in mutual funds, generally mature and ultimately pay off a par value at maturity—they don’t rise in price indefinitely. Over time, interest payments generate the majority of returns, especially as fund managers were able to reinvest interest payments and principal to accumulate and compound over time.

Bond funds in a rising-rate environment

But what happens in the shorter term when interest rates rise? Basic bond math tells us that prices will fall if interest rates rise. The longer the maturity, the more severe the drop.

However, this drop in price is not a "realized" loss unless you or the fund manager chooses to sell before maturity. Most bonds continue to generate interest payments, and their prices move back toward par at maturity, whether held by you as an individual or in a bond fund.

After the short-term hit of a change in price, a rising-rate environment will eventually help bond fund investors, in our view. As bonds in the fund mature, the fund manager is able to re-invest principal at higher yields as rates rise. These higher rates boost fund income returns, eventually offsetting the drop in price.

The question is, "How long might this take?" If you have some sense of the answer to this question, you can focus on a question you can control: "How long is your investment horizon?"

Here's a hypothetical illustration of "time to recovery," using some very basic assumptions:

"Time to recovery" for a sample intermediate-term fund

Source: Schwab Center for Financial Research. Assumes starting average interest rate of 3.0%, an even 1% increase in rates each year for the first five years, average duration of 4.5 years and reinvestment of interest income. Shows cumulative return, not annualized return or dividend yield. Note: This is meant as an illustration, and won’t represent actual performance for any specific mutual fund. Actual performance will depend on fund management, as well as market conditions.

If you won't need your principal and want income during this holding period, you'll benefit from the higher yields from longer-duration (maturity) funds even if the NAV of the fund falls and recovers over time. (However, you won't benefit from the compounding of reinvested interest/dividends, as shown in the example above). Just don't forget your time horizon and risk tolerance.

Choosing bond funds by duration and your investment horizon

Professional fixed income managers, as well as pension fund and other institutional investors, often use a concept called "immunization" to match their investment horizon to interest risk, no matter the interest-rate environment.

First, decide when you'll need to spend your initial investment—that is, your principal. Might you need it tomorrow? Within the next couple of years? Four years or more, or some longer time horizon?

You'll want to match your fund investments with your time horizons. For principal you might need over the next one to four years, choose short-term bond funds. Money you don't need right away, consider intermediate-term funds. Save longer-term funds only for money you won't be needing for a long time (or avoid them altogether if you'd prefer to avoid the volatility if rates rise).

We see limited value and higher risks in long-term funds today compared to intermediate-term funds. The benefits of a slightly higher rate aren’t well-balanced with the increased interest-rate risk, in our view, for funds with average maturities much greater than 10 years. An exception might be if you’re focused on income and income alone and won't need to sell, or if you believe that interest rates will fall. While we believe rates could stay lower longer than many investors expect, they will rise eventually.

Match the average maturity¹ of a fund with your investment horizon. Over time, this will match interest-rate risk with higher returns over this targeted investment horizon.

Choose Morningstar Bond-Fund Categories Based on Time Horizon

Source: Schwab Center for Financial Research

Keep in mind that we're not talking about when you might need to spend income, if you're an income investor, as opposed to one who doesn't need income today, but reinvests bond fund dividends to maximize total long-term returns over time. You can choose to do either.

The question is principal. When might you need to sell, to cash out principal and realize any loss (or gain) from a bond fund investment? Over a longer time horizon, a fund with a similar horizon should have time to recover any drop in bond prices with higher income if interest rates do rise.

Other issues to consider

In the current low-interest-rate environment, there are a couple of other stumbling blocks to be aware of, including:

• Leveraged funds. This includes many closed-end bond funds, many of which borrow money in the short-term market and then use that borrowed money to buy longer-term bonds with higher yields, adding leverage and boosting yield from the funds. This can work great when short-term interest rates are low, but it makes leveraged closed-end funds more susceptible to a more rapid decline in prices when rates rise.
• Unconstrained funds. Many new types of "unconstrained" or alternative strategy bond funds have been launched over the past few years. These funds use derivatives and other strategies to change duration and interest-rate risk based on market conditions. Some may even achieve a negative duration² through the use of derivatives. This is not a recommendation to avoid them—just to understand what you own.
• Floating-rate funds. Many commentators have pointed to floating-rate as well as bank-loan funds—mutual funds that hold bonds whose rates adjust with market rates—as a solution to manage interest-rate risk. These may make sense for some investors for a more opportunistic portion of their bond-fund allocation, but they may not provide the degree of protection in a rising-rate environment that investors may believe. Floating-rate funds are not a cure-all to interest-rate risk, and may include securities with higher credit risk or with interest-rate caps that may not increase in lock-step with the market.

Using Schwab's Fund Select List

For ideas, and the benefit of the Charles Schwab Investment Advisory Group's analysis of thousands of funds, clients can look for funds in the Morningstar fund categories referenced above on the Schwab Mutual Fund OneSource Select List®. Be sure to match the type of fund with your risk tolerance and time horizon.

1. More specifically, match the duration of a fund with your investment horizon. Duration measures the weighted average of the present value of the cash flows of a fixed income investment. Bonds with higher duration (given equal credit, inflation, and reinvestment risk) generally have greater price volatility than bonds with lower durations.

2. Negative duration is a situation in which the price of a bond or other debt security moves in the same direction of interest rates. That is, negative duration occurs when the bond prices go up along with interest rates and vice versa.

Randy Frederick
Managing Director of Trading and Derivatives, Schwab Center for Financial Research

Options strategies can have a number of goals—such as protecting the value of an asset (hedging), generating income (from option sale proceeds), or specifying exit and entry prices. In this article, we'll focus on a strategy that emphasizes the latter two goals—buying and selling securities at prices you like, while generating income, but also providing a limited amount of hedging. To do this, we use covered calls and cash secured equity puts (CSEP) in an alternating fashion.

A covered call is a popular options strategy in which the investor owns a security and writes (or sells) call options on that same security. In essence, it allows you to specify the price where you'd like to sell a particular security while you generate income. It's almost like you are getting "paid" to enter a limit sell order.¹

A CSEP involves writing (selling) a put option and setting aside enough cash in your account to buy the security if you are assigned. CSEPs are generally written out of the money (OOTM), meaning at a strike price that is below the underlying stock's current price. In other words, you are specifying the price where you'd like to buy this security plus generating income. It's almost like you are getting "paid" to enter a limit buy order.¹

Why use these strategies together?

Take a look at the profit and loss profile of a CSEP and a covered call below. You'll notice that the profit and loss characteristics of these two strategies are quite similar. A key difference however, is that a CSEP generates income first but might ultimately result in a stock purchase; a covered call generates income after a stock is purchased but might ultimately result in a stock sale—so why not sell CSEPs to buy your stocks and then write covered calls to sell your stocks? If you have the time and desire to actively manage your account, this two-pronged approach can perform quite well under the right circumstances.

Source: Schwab Center for Financial Research.

Source: Schwab Center for Financial Research.

Investors considering this strategy should have a sizable cash balance in an account with at least level "1" option approval at Schwab, and be interested in building an equity portfolio.

Check the chart

If technical analysis is a part of your regular trading strategy, be sure to check the chart before you trade. Remember, you are hoping to buy these stocks at prices you consider favorable and viewing a chart may help you identify technical support levels that you consider good entry prices.

I have selected CVX as an example from the list above. Note that CVX was selected for illustrative purposes only and I'm not making a recommendation of this security. Also, note that ratings, prices, and other information is dated.

In the one-year chart below, it appears that CVX has experienced some resistance (red arrows) and some support (green arrows) at approximately $110. You may interpret the chart differently, but I'll use $110 for this illustration.

Source: StreetSmart Edge®.

CSEP order entry

Should you decide that you are comfortable buying CVX around $110, you could either:

• Enter a limit order to buy 200 shares at $110,
• Or sell two put options with a 110 strike price expiring in 65 days at the current bid price of $1.15. This would bring in a cash credit of $230 before commissions. 

CSEP assignment

If CVX is below $110 at (or before) expiration, you will be assigned and purchase 200 shares of CVX at $110. If you apply the $230 credit you already received, your effective cost basis would be $108.85 before commissions, which also means that CVX would have to drop below $108.85 before you would incur a loss. At its current price of $115.93, that equates to a decline of more than 6% in about two months. If you are assigned and your goal was to acquire CVX at a price that you considered fair, you would basically be done at this point.

If CVX is above 110 at expiration, your put options will expire and the maximum profit you would earn is $230 less commissions. In other words, you could miss out on a much larger profit opportunity if the stock rises sharply.

Of course, if CVX drops way below $108.85, your losses could be substantial, and you may find yourself in a position where you have no covered call strike prices (discussed below) available that will result in a profit if assigned. The net loss on your stock position will have wiped out your short-term income and then some. Since it is not a good idea to sell a covered call at a strike price that will result in a loss if assigned, you may need to wait for some upside price movement before you can sell covered calls.

Covered call order entry

Let's assume that CVX drops to $109 by expiration and you are assigned. At this point, with a cost basis of $108.85, you may look at the chart again and decide that you would be happy to sell CVX if it reaches $115 again. Like before, you could simply enter a limit order to sell 200 shares at $115 or you could sell two covered call options with a 115 strike price expiring in 65 days at the current bid price of .95. Doing so would bring in a cash credit of $190 before commissions. At this point by applying the new covered call premiums to your original effective cost basis of $108.85, you would have a new effective cost basis of $107.90.

Covered call assignment

For purposes of this example, let's assume that CVX increases to $116 by expiration and you get assigned at $115 at (or before) expiration. With an effective cost basis of $107.90 on 200 shares, your overall profit would be $1,420 ([$115 – $107.90] x 200) before commissions. This equates to a profit of just over 6% in a little more than four months. Of course if CVX rises sharply above $115, your profit doesn't change, but you will have missed out on the opportunity for a potentially much larger profit. In other words, the covered call caps your selling price (and thus your profitability) at the strike price.

If CVX drops sharply after you sell your covered calls, your losses could be substantial. And while your first two covered calls will expire worthless, you may not be able to recover your losses with subsequent sales of covered calls, as there may be no covered call strike prices available that will result in a profit. Again you may need to wait for some upside price movement before you can sell additional covered calls.

CSEP expiration

If we step back for a moment to when you were still short the original 110 puts, if CVX had not dropped below 110 at expiration, the put options would have expired worthless and you could have kept the $230 credit with no further obligation. You then may or may not have chosen to sell more put options at the same or different strike price for a later expiration and start the process all over again.

While it's impossible to know ahead of time if you'll be assigned or not, viewing the Delta of the CVX 110 put options (-.23) tells you that at the moment you enter the trade, there is theoretically about a 23% chance of assignment at or before expiration. Of course Delta is a dynamic calculation, so as the stock price dropped, the odds of assignment also increased.

Covered call expiration

Likewise, if we assume you were assigned on the CSEPs, but we step back to when you were still short the 115 calls, it's possible that the calls might not be assigned. If CVX had not risen above $115 at expiration, the call options would have expired worthless and you would get to keep the $190 credit with no further obligation. You then might or might not have chosen to sell more call options at the same or different strike price for a later expiration and wait again to see if you get assigned. As with the puts, viewing the Delta of the CVX 115 call options (.21) would have told you that at the moment you entered the trade, there was theoretically about a 21% chance of assignment at or before expiration.

Repeat the process

Expanding upon this example, assume you went through a similar process and identified 10 of the 41 stocks in the screener list that you would like to own. If you then proceeded to sell 65-day OOTM (out-of-the-money) put options on the other nine stocks and they had a similar Delta you might expect to be assigned on maybe two or three of them each month, at expiration.

For those two or three on which you get assigned on the puts, you can sell covered calls if the prices haven't dropped too far. For the other seven or eight, if you still like them, you can decide to sell short puts again and wait to see if you get assigned. While the probabilities can change over time, since all OOTM puts will initially have less than a 50% chance of assignment it is very unlikely that you'll be assigned on all of them, unless the market drops substantially before expiration. Likewise, since the OOTM covered calls will also have less than a 50% chance of assignment, it is very unlikely that you'll be assigned on all of them, unless the market increased substantially.

What to keep in mind

If you follow a process similar to the one outlined above, at any point in time you'll likely have some equity positions in your account, some short puts outstanding, some covered calls outstanding, some puts expiring and some calls expiring. This type of situation requires careful attention to monitor properly, so be sure you have the time and risk tolerance this strategy requires. Using these strategies in this more complex manner requires a higher risk tolerance than might normally be required of an occasional option trader.

• Because this strategy involves many option trades, commission charges could be substantial and are a much greater consideration that a buy and hold stock strategy. Be sure to factor commission charges into all profit and loss calculations.
• Keep in mind that if this strategy is used on dividend paying stocks, you will not be entitled to any dividends unless you purchase the actual stock before the ex-dividend date. You also will not be entitled to voting rights or any other benefits of stock ownership unless you own the actual stock.
• Both CSEPs and covered calls will prevent significant profit potential if the stock moves substantially higher.
• While the income generated by these strategies does provide a small amount of downside risk protection, that protection is limited only to the option premiums.
• If the price of the underlying stock drops substantially prior to the expiration date of the option, your losses could be significant.
• Losses are reduced only by the amount of option premium you received on the initial sale of the option.
• While the examples above assume that you hold the position until expiration, you can usually close out short options prior to expiration by buying them to close at the current market price.
• Keep in mind that if your covered call or short put is in the money, you could be assigned at any time.

1. With a limit buy (sell) order, you'll get filled anytime the stock drops below (rises above) the limit price. With a short put (covered call), there is no guarantee that you'll be assigned, unless the stock is below (above) the strike price on the expiration date of the option.

2. All stock and option symbols, ratings, and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Michelle Gibley
CFA, Director of International Research, Schwab Center for Financial Research

Both Dutch finance minister Jeroen Dijsselbloem and European Central Bank (ECB) President Mario Draghi have recently distanced themselves from the idea that Cyprus could be a "template" for future European bank crises. In other words, just because Cyprus has pushed risks onto private investors using "bail-ins," doesn't mean other countries will follow suit when faced with a similar situation.

In a "bail-in" scenario, private investors such as equity shareholders and bondholders, as well as uninsured depositors, may be called upon to help a failing bank recapitalize. In a "bailout," some outside entity—typically the national government—loans funds to help an ailing institution.

European leaders may be coming around to the idea of more private sector involvement in bank rescues. Certainly Dijsselbloem's original remarks (that Cyprus could be a template for future European bank crises) and commentary by other officials suggest a philosophical shift in how European leaders approach banking problems—as does the recent example of SNS Reaal NV, a Dutch bank and insurer that was seized by the government with no compensation to subordinated bondholders.

The consequences of bail-ins

If bail-ins do indeed become standard practice, it could reduce banks' profitability and harm economic growth for the region. Why? Because banks may have to: 

• Absorb higher funding costs if investors perceive a greater probability of loss 
• Pull back on lending 
• Raise lending rates 
• Fund national deposit guarantee schemes and a eurozone resolution fund 
• Pay higher interest on deposits above 100,000 euros

Any combination of these consequences could ultimately delay the eurozone's recovery.

If Cyprus isn't a template … what is?

Over the past few months, there's been no predictable pattern to how the burden of bank failures is spread. While the private sector shouldered a large burden in the case of SNS Reaal and the crisis in Cyprus, in some cases creditors were protected. These include the surprisingly light conditions on Greek banks in the second bailout in December 2012, the second injection of state aid for French-Belgian bank Dexia in December 2012, and state aid for Italian bank Monte dei Paschi in February 2013.

The eurozone needs a common legal template for failing banks, and right now it's up to the European Crisis Management Directive (CMD), the Eurogroup's common resolution framework, to provide one. But no such template is expected until 2018, although ECB President Draghi said this needs to be implemented "way, way sooner, like 2015," or even earlier.

The road ahead

The good news, such as it is, is that the ECB's conditional bond purchase pledge appears to have tempered the broader market reaction to events in Cyprus. A year ago, before Draghi vowed to do "whatever it takes" to preserve the euro, the Cyprus situation would have likely resulted in a bigger market decline.

That said, the eurozone debt crisis is still playing out, and there remain unknowns. We don't know the long-term after-effects of capital controls in Cyprus, which have been in place since March 28 (although restrictions have eased somewhat lately). The immediate effect has been to block euros from moving freely in the monetary union. If capital controls stay in place for an extended period, there could be pressure for Cyprus to leave the euro, which could create more volatility in European financial markets.

The takeaway

Eurozone stocks could continue to struggle near term as investors weigh lower growth prospects, but we believe valuations and earnings are depressed and a fair amount of negative news has likely already been priced in.

by Carrie Schwab-Pomerantz,
CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.

Dear Reader,

In my opinion, there are a lot of positive reasons to have a prenuptial agreement. While I understand your fiancé's hesitation—so often a prenup is associated with divorce—to me it's not a sign of distrust. In fact, creating a prenuptial agreement takes a willingness to be completely open and honest about everything—what you own, what you owe, and how you want to live your financial lives together. That takes absolute trust.

Plus, there's a basic tenet in any prenup that you can't include anything that a court would consider "unfair" to either of you. There's lots of room for different arrangements, but fairness is a given.

That said, a formal prenuptial agreement is most important if either one of you has considerable assets, large debts, or kids from a previous marriage—anything that makes your finances more complicated. If this isn't you, a formal agreement is less necessary. Every couple, though, should provide complete financial disclosure and share their feelings about money. This will undoubtedly head off disagreements down the road and create a closer bond.

Here are some practical financial issues I believe every couple should discuss before they walk down the aisle.

What assets you'll share and what you'll keep separate

You say you've both accumulated some assets, so start there. Property-wise, what do you own? Where do you keep your money, and how is it invested?

Look at the whole picture—savings, investments, retirement accounts, real estate, cars, artwork, jewelry—and decide what you'll share and what you'll keep separate. Then ask yourselves questions like: Will you pool your money to buy a house? Do you want to keep individual control of a certain amount for some personal future goal?

One common approach is to consider all assets owned before the marriage as separate and assets acquired after as joint. Just remember that if you co-mingle any separate property (for example, if you combine your separate accounts into a joint account, and then make deposits and withdrawals), it becomes jointly owned.

To me, there's nothing wrong with a little financial independence in a marriage—in fact, I think it's important for every adult to have a degree of financial autonomy. But it's important to agree on what that means at the outset, so there are no hurt feelings later on.

How you'll handle current and future debts

While you're not legally responsible for debts incurred by your spouse before the marriage, put all your debts on the table and decide how you're going to handle them. If one of you has a mountain of debt, the other could agree to help pay it down to lighten the load. It would be smart to agree on this in advance.

Debts incurred during your marriage are another story. State laws vary, but, in general, if you have joint credit cards, car loans or mortgages, you'll be jointly liable. If one of you is a spender and one a saver, confront this now and come to an understanding about how you'll handle debt.

Who will be financially responsible for what

Some couples choose to stipulate upfront how they'll split up household expenses, for instance, those you'll share (commonly the mortgage, utilities, groceries, etc.) and those you'll keep separate (perhaps clothes, personal entertainment, etc.). You can also decide on a system for how this will work (for example, a joint account for shared expenses, individual accounts for personal things). Deciding this in advance can help keep small financial decisions from becoming large bones of contention.

If one of you makes considerably more money than the other, talk about what that means for your lifestyle. Most couples will want to have financial equality, but the details are up to the two of you. You might also discuss how financial responsibilities would change if one of you stays home to raise a family.

What happens if the worst happens

Although no one wants to contemplate divorce, a prenuptial agreement gives you an opportunity to think clearly and rationally about what you'd want to do if you split up. An agreement should include decisions about division of property, spousal support, and how you'd deal with conflict if a dispute arises—for instance, agreeing in advance to mediation.

Another consideration is an illness or disability. If one of you becomes disabled and unable to work, how will this impact your financial arrangement? Or if one of you faces major medical expenses, how will you pay for this as a couple?

There's more that can be in a prenup. If you decide to go ahead with a formal document, an attorney can help you determine what you and your fiancé think is important to include. But to me, the main thing is to talk through these issues well before the wedding. Approach it in a loving way, listen to each other and form a trusting financial bond. That way, you can put your money concerns aside and look forward to a long and happy life together.

The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified ATTORNEY, tax advisor, CPA, financial planner or investment manager.

Michael Townsend
Vice President, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.

Last week, President Obama unveiled his budget proposal for fiscal year 2014, which calls for $1.8 trillion in deficit reduction over the next decade through a combination of spending cuts and tax increases. Let's examine the proposal and how it might affect the ongoing debate about deficit reduction.

First, it's important to be clear about what the proposal is and is not. This is a broad framework document, an outline of the administration's priorities and positions. It is not a legislative proposal. It will not receive an up or down vote in Congress.

In some ways, the president's budget seeks a middle ground between the Republican budget approved by the House and the Democratic budget approved by the Senate. His proposal has fewer tax increases and more spending cuts (including some cuts to entitlements) than his previous proposals, which is a significant concession to Republicans and has angered members of his own party. Still, the Republican reaction has been tepid at best.

It's the president's latest attempt to get to a "grand bargain"—a major agreement on a long-term deficit reduction package.

Key items for investors

Several of the president's proposals are noteworthy for investors:

• The "Buffett Rule" is back. The proposal named after financier Warren Buffett seeks to ensure taxpayers with more than $1 million in income pay a minimum of 30% in taxes.
• Cap on itemized deductions. The president has re-introduced an idea from last fall's campaign—capping at 28% the value of itemized deductions for higher-income filers.
• Estate tax changes. The fiscal cliff agreement in January made the estate tax permanent at a top rate of 40% and an exemption amount of $5 million. The president's budget proposal calls for setting the top rate at 45% and lowering the exemption amount to $3.5 million, starting in 2018.
• Cap on retirement savings. This proposal has already stoked a fair amount of controversy in Washington. It suggests capping at $3.4 million the amount that any individual can accumulate in tax-preferred retirement accounts. The cap would apply to the combined value of all accounts, including IRAs, 401(k)s and other plans, and assets in a defined benefit plan. Many people have already raised questions about the mechanics of this proposal, and have voiced concern about whether the government should be determining how much tax-advantaged retirement savings is "enough." 
• Cost-basis changes. This proposal would require the average cost basis method for all cost-basis calculations, eliminating investors' ability to designate which shares of stock they are selling.

We think the chances of any of these happening are pretty low. But they represent the White House's policy, and they are likely to be proposed in the context of deficit-reduction negotiations in the coming months.

Democrats' and Republicans' budget proposals

Republicans and Democrats have been stuck for several years in a bitter dispute about how to reduce the deficit. The result has been a series of short-term, last-minute agreements (continuing resolutions) that keep things moving but have not addressed the big issues. The different parties' budgets are an attempt to tackle those big issues, and they could hardly be more different:

• The Senate-approved (Democratic) budget calls for $975 billion in spending cuts and an equal amount in tax increases over the next decade.
• The House-passed (Republican) budget aims for $4.6 trillion in spending cuts and no tax increases over the next 10 years.

Normally, the two chambers would meet in a conference to hammer out a compromise after they'd each put forth their proposals, but no conference has yet been organized.

What happens next? 

The debt ceiling will need to be raised sometime in July or else the US will risk defaulting on its obligations to international creditors. In advance of this, we think you'll see a renewal of the process that happened back in the summer of 2011, when the president and Congressional leaders—most notably House Speaker John Boehner (R-OH)—tried to use a deadline to raise the debt ceiling as an occasion to reach a "grand bargain" on long-term deficit reduction. Look for the president to point to the compromises in his recently proposed budget in order to put pressure on Republicans to compromise as well.

Consensus is still a long shot, but…

While recent history gives us little reason to be optimistic, the icy relations between the two parties seem to have thawed somewhat in recent weeks. Republican leaders have been relatively low-key in their criticisms of the president's budget proposal, perhaps indicating an openness to negotiations.

With the mid-term elections still 18 months away, the next few months may represent the best chance yet to achieve a long-term deficit reduction deal. But consensus remains very difficult to achieve.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

With new cost-basis reporting requirements in effect, more people may run afoul of the wash-sale rule. Here's some background on the rule and answers to common questions about it.

I want to sell a stock to take a tax loss, but I plan to buy it again because I want it in my portfolio. What are the tax implications?
If you sell a security at a loss and buy the same or "substantially identical" security within 30 calendar days before or after the sale, the loss is typically disallowed for current income tax purposes. This is because of the so-called wash sale rule.

What is the IRS trying to accomplish with the wash sale rule?
Basically, the wash sale rule is designed to prevent taxpayers from taking losses on securities if they acquire a substantially identical position within 30 days.

How do wash sales work?
A wash sale will trigger several consequences. First, if you violate the wash sale rule you can't claim your loss on the sale in the current tax year. Instead, your loss will be added to the cost basis of the replacement purchase. When you sell the replacement stock, you can recognize the previously disallowed loss. Your holding period for the replacement stock includes the holding period of the stock you sold.

Here's a quick example of a wash sale.

On 9/30/XX, you buy 500 shares of ABC at $10 per share. One year later the stock price starts to drop, and you sell all your shares at $9 per share on 10/4/XY. Two days later, on 10/6, ABC bottoms out at $8 and you buy 500 shares again. This series of trades triggers a wash sale.

The holding period of the original shares will be added to the holding period of the replacement shares, effectively leaving you with a long-term position. Additionally, the cost basis on your 10/6 purchase will be adjusted to $4,500, reflecting the cost of acquisition ($4,000) plus the $500 disallowed loss from your 10/4 sale.

I want the tax loss, but I don't want to be out of the market for an entire month just so I can avoid the wash sales rule. What's my alternative?
You could double up on your position, wait 31 days, and then sell your original loss position. Of course, that means you would be increasing your exposure. But if you don't want to either be out of the market or increase your exposure for a month, you could take the loss and immediately replace the security you sold with a similar (but not "substantially identical") investment that suits your asset allocation and long-term investment plan.

With this strategy, you can also sell off investments that are no longer a good fit and keep your portfolio on track by reinvesting in more suitable, better-rated and/or more tax-efficient securities in the same asset class. That way, while you're harvesting losses to get the tax break, you can better position your portfolio going forward by rebalancing and improving tax-efficiency.

Here's a hypothetical example to show how this might work. Let's say Joan, a single income tax filer, holds position XYZ. She originally purchased XYZ for $6,000, but it's currently worth only $3,000. The position is part of Joan's overall portfolio plan, which she wishes to maintain. Joan is reluctant to sell and recognize the loss, especially if it means upsetting her investment plan or being out of (or doubling) the position for 31 days to avoid the wash sale rule. What can she do?

Joan could do a little research to find a suitable replacement. For instance, using Schwab Equity Ratings®, she may find that security ZZZ is as good as or better than XYZ, given her overall goals and objectives. She could simultaneously sell XYZ and purchase ZZZ, avoiding the wash sale rule while maintaining her investment plan.

• Value of position XYZ before transaction: $3,000
• Value of position ZZZ after transaction: $3,000 (less commissions or fees, if any)

As far as her portfolio is concerned, Joan is in the same financial position after the sale as she was before (less commissions or fees). But, if Joan has a combined federal/state marginal income tax bracket of 35%, she could also receive a current income tax benefit of up to $1,050. In effect, her loss would be reduced from 50% to 32.5%. The scenario would hold true if XYZ and ZZZ were individual stocks in the same industry or mutual funds with similar investment objectives.

If I purchase and sell shares of a stock at a loss in one of my Schwab accounts and then repurchase them in another Schwab account, will I still trigger the wash sale rule?
Yes. Wash sale rules apply to the investor rather than to a particular account when an investor holds multiple accounts. IRS regulations only require Schwab to track and report wash sales on the same CUSIP number (a unique nine-character identifier for a security) within the same account. Individual taxpayers are responsible for tracking sales in different accounts (their own and their spouse's) for the purposes of the wash sale rule.

Does the wash sale rule apply to options, ETFs and mutual funds?
Yes. Keep in mind that if the security has a CUSIP number, then it's subject to wash-sale rule reporting. Switching from one ETF to the identical index in another fund or ETF could trigger the wash-sale rule. There are ways around this problem. For example, investors holding the Schwab S&P 500 Index Fund at a loss might consider switching into the more diversified Schwab Total Stock Market Index Fund. The same idea could apply to similar, but not substantially identical ETFs.

What happens if I sell at a loss in a taxable account and then immediately repurchase it in a retirement account, such as an IRA?
The IRS has ruled (Rev. Rul. 2008-5) that when an individual sells stock or securities for a loss and causes his or her IRA or Roth IRA to buy substantially identical stock or securities within 30 days before or after the sale, the loss on the sale is disallowed under section 1091 and the individual's basis in the IRA or Roth IRA is not increased by virtue of section 1091(d).

Can I sell at a loss on December 15 in order to harvest losses for the current tax year and then purchase the shares back in early January?
No. Wash-sale rules are not confined to calendar years, so in this situation, your loss would be deferred if you reacquired the position within 30 days.

Michael E. Lind
CFA, Senior Quantitative Analyst, Charles Schwab Investment Advisory, Inc.

Each year, Charles Schwab Investment Advisory, Inc. (CSIA) calculates long-term return estimates for stock, bond and cash investments. Here, we'll answer common client questions concerning this research, including an explanation of the methodology behind our estimates.

• Why are long-term return estimates important?
• How do you define "long term"?
• How do short- and long-term forecasts differ? Is one better than the other?
• What are your long-term return estimates for stocks, bonds and cash investments?
• How do you calculate your estimates?

Why are long-term return estimates important?

Severe market fluctuations make it hard for investors to reliably plan their financial futures. Having a sound financial plan serves as a road map to help investors reach long-term financial goals, but to get there, you need reasonable estimates of what long-term stock- and bond-market returns might be.

For example, if your return estimates are too optimistic, you run the risk of not being able to retire on time or pay for a child's education. If they're too pessimistic, you may needlessly sacrifice some of your current lifestyle by over-saving for retirement.

Similar to the axiom "garbage in, garbage out," you can't use unrealistic assumptions to determine realistic outcomes, and this is especially true when developing your long-term financial plan.

How do you define "long term"?

When it comes to return forecasts, there's no specific definition of "long term," though a widely accepted rule of thumb is a time period of more than 10 years. A balance is struck when you consider both shorter-term market fluctuations (think 2008) and extremely long periods of time when your confidence in making predictions greatly diminishes. Accordingly, CSIA used a 20-year time horizon for the estimates provided here, though calculations using a time horizon between 15 and 30 years should produce similar results.

How do short- and long-term forecasts differ? Is one better than the other?

For some investors, the strategic asset allocation can serve as a starting point to make shorter-term tactical changes to their asset allocation. For example, an investor may target a long-term, strategic allocation of 50% stocks and 50% bonds. Depending on the market environment, the investor may want to temporarily favor stocks over bonds, or vice versa.

Continuing with the example, suppose the investor thinks that the stock market is currently undervalued. The investor may choose to act on this belief by temporarily adjusting her current allocation, possibly to 60% stocks and 40% bonds.

The process of making these shorter-term changes is called tactical asset allocation. These temporary shifts generally occur when estimates of short-term returns deviate from long-term estimates. Short-term return estimates are typically based on current economic and market conditions, whereas current conditions are not as relevant for estimating long-term returns.

When it comes to meeting your long-term goals, however, choosing an appropriate long-term, strategic asset allocation is more important than making short-term, tactical bets.

Some people argue that investors should focus exclusively on short-term returns and short-term asset allocation because it's difficult to accurately estimate long-term returns. The problem is that it's equally difficult to accurately estimate short-term returns!

And because most investors have at least one long-term goal—retirement—they need reasonable long-term return estimates to help determine how much money they'll need to fund their retirement lifestyle, and in turn, how much they'll need to save to get there.

For this reason, the focus of this study is on long-term returns.

What are your long-term return estimates for stocks, bonds and cash investments?

These estimates are significantly below the historical annual compound returns on large-cap stocks and bonds of 9.9% and 8.2%, respectively, during the 1970-2012 time period. Of course, these are estimates of average returns—in any one year, stocks and bonds may return far more or far less and may even be negative.

Why are the estimates below historical averages? There are two reasons:

• Our estimate of long-run inflation is 2.5%, just shy of two percentage points below the actual inflation rate during the 1970-2012 time period.
• Current and expected interest rates are much lower than what has transpired historically, especially compared to the high-interest-rate environment of the 1980s. 

What you can do now

So, what can you do in a single-digit-return environment? Thanks to the power of compound returns, what you do (or don't do) today can have big implications for your ability to meet your long-term goals.

When faced with expected returns that are lower than you may have anticipated, try to resist the temptation to simply wait in the hope that the market will provide higher returns in the future that will allow you to "catch up" on your financial plan. If it does, that will be a great bonus. But it's far better to plan for a more realistic scenario.

Here are a couple things you can do. First, try to avoid unnecessary fees and taxes, particularly in a lower-return environment. Second, if you don't have a long-term financial plan, it's a good time to put one together.

How do you calculate your estimates?

Our return estimates contain two parts: a current risk-free rate component that's the same for all asset classes and an asset-class premium that varies by each asset class because of differences in expected risk.

The current risk-free rate is estimated by directly observing Treasury yields in the marketplace. Because we're estimating returns for a 20-year time horizon, the risk-free rate is measured as the yield of a 20-year US Treasury bond, which was 2.7% as of January 7, 2013. Keep in mind that no investment is entirely free of risk, but because US Treasuries are generally considered to be the asset class with the least risk (aside from cash), Treasury rates are typically used as a "risk-free" benchmark.

The asset-class premium measures the incremental return (generally higher for stock asset classes and lower for fixed-income asset classes) demanded by investors for investing in that asset class as opposed to a risk-free bond.

Stocks: The asset-class premium for large-cap stocks is called the equity risk premium (ERP), which measures the relative attractiveness of large-capitalization stocks versus a risk-free bond. It also serves as the foundation for estimating asset-class premiums for mid/small-cap stocks and international stocks.

There are two primary ways of estimating the ERP:

• The historical long-term approach takes the historical difference in returns between stocks and risk-free bonds and assumes that the future will look like the past.
• The valuation approach relies on fundamental data, such as dividends, earnings, gross domestic product (GDP) growth and valuation levels and then uses well-established financial theory to estimate an ERP.

Valuation approach vs. historical long-term approach

The primary criticism of the valuation approach is that it's very difficult to forecast variables such as dividends, earnings or GDP growth over the short-run, let alone over long horizons. As such, we view long-term return estimates that use this approach to be highly suspect.

The historical-return approach is based on the realization that it's difficult, if not impossible, to forecast long-run stock-market returns using current market or economic conditions. Since current market information is generally not a useful predictor of long-run ERP, the basis of the historical-return approach is that the best estimate of the future ERP is the historical average ERP calculated over a long history.

The primary criticism of the historical-return approach is that realized returns over a particular time period can differ, sometimes dramatically, from what's expected. As such, blindly extrapolating these returns into the future can result in unreasonable estimates.

The approach adopted in this study addresses this criticism.¹ To better understand it, we first break down the sources of average returns for large-cap stocks. In doing so, we look "under the hood" to help determine which components of average returns may be expected to repeat in the future and, more importantly, which ones may not.

Looking Under the Hood: Decomposition of Average Returns for Large-Cap Stocks

As you can see, there are three levels of decomposition:

Level 1 starts with the return on large-cap stocks, which was about 9.5% compounded annually over the 1926-2012 time period.

Level 2 breaks down the return on large-cap stocks into three primary components: inflation (A), returns derived from capital appreciation after inflation (B) and returns derived from dividends (C).

Level 3 breaks down the inflation-adjusted capital appreciation component (B) into two additional pieces: growth in the historical price to earnings (P/E) ratio (D) and growth in inflation-adjusted EPS (E).

This results in a final equation of A + D + E + C = historical average return.

Source: Charles Schwab Investment Advisory, Inc. as of January 7, 2013.

In researching the sources of historical returns, we don't expect the growth in the P/E ratio—amounting to a roughly 0.5% per year average return—to repeat in the future, as this return did not come from earnings growth. Instead, it represents what the market was willing to pay for every dollar in earnings during the 1926-2012 time period.

There are a number of possible reasons why the P/E ratio expanded during this time, including higher expectations for future earnings and less return demanded by investors for holding stocks. Regardless, it's not realistic to think that such an expansion will occur again.

As a result, we do not include the 0.5% attributed to P/E growth when estimating future returns, which results in an adjusted historical return on large-cap stocks equal to the following components:

Inflation + growth in inflation-adjusted EPS + dividends

3% + 1.8% + 3.9% ≈ 8.7%²

The adjusted historical return of 8.7% is not our estimate of future returns because it reflects historical interest rates and inflation. It's used to estimate the ERP. Specifically, we take the adjusted historical return on large-cap stocks and subtract from it the historical income return provided by the risk-free asset (proxied by the Ibbotson Long-term Government Bond Index)³:

ERP ≈ 8.7% - 5.1% ≈ 3.6% (compounded annually)

Mid-/small-cap stocks: When estimating the asset-class premium for mid-/small-cap stocks, we use the ERP of 3.6% as the starting point, and then make adjustments based on the unique risk level for the mid-/small-cap asset class relative to the overall stock market.

To do this, we first adjust the ERP to reflect the premium for the overall stock market. We accomplish this by estimating the historical sensitivity, or beta, of overall stock market returns to large-cap stock returns. This beta of 1.01 is then multiplied by the ERP of 3.6% to obtain the asset-class premium for the overall stock market. The result is an asset-class premium for the overall market of just about 3.6%.

We then use this overall market premium to assist with estimating the mid-/small-cap premium. Specifically, we multiply it by the historical sensitivity between mid-/small-cap stock returns to overall stock market returns of 1.4⁴.

International stocks: Data limitations prevent us from analyzing the sources of historical returns for international stocks. As such, we explore two alternate approaches for estimating the international asset-class premium. The first uses the domestic stock market asset-class premium as an anchor in developing the international equity premium.

This approach has two steps, the first of which is to estimate the world ERP as measured by the return demanded by investors holding a world-stock portfolio that is more than the US risk-free rate. This is estimated by dividing the domestic stock market asset-class premium of 3.6% by the historical sensitivity of domestic stock returns to world stock market returns of 0.93, the quotient of which is a world ERP estimate of 3.9%.

In the second step, the world ERP is multiplied by the historical sensitivity of international market returns (excluding US stocks) to world market returns (including US stocks) of 1.04. This results in an asset premium estimate for the international asset class of roughly 4.0%.

This approach assumes that domestic and international stock markets are integrated, meaning there are no barriers to financial flows and that assets with the same levels of risk command the same return no matter the country. In addition, the approach relies heavily on sensitivities between domestic and international returns that prove to be relatively unstable over time.

As an alternative approach, the international asset-class premium is estimated by taking the historical difference in returns between international and domestic stocks, which results in an estimate of about 2.9%.

The historical asset-class premium is substantially less than the estimate that uses the domestic ERP as an anchor. Which approach is better? Unfortunately, at the present time we have no overwhelming theoretical or empirical basis to choose one or the other method, as both appear to be reasonable.

Bonds and cash investments: The asset-class premium for bonds consists of a default premium, while the asset-class premium for cash investments consists of a horizon premium.

Since we assume a 20-year forecast horizon, and our risk-free rate is derived from a 20-year Treasury, we only need to adjust our bond estimate to reflect the additional amount of compensation an investor requires for holding credit risk. To do this, we estimate a default premium or an additional return demanded for investing in corporate and mortgaged-backed securities. It is measured as the historical difference in monthly total returns between the Barclays US Aggregate Bond Index and a government bond maturity-matched to the Barclays US Aggregate Bond Index.

To approximate a cash estimate, we must first adjust for a horizon premium. The horizon premium estimates the return differential derived from holding bonds with a maturity other than a 20-year time horizon. It's positive for bonds with a time horizon of more than 20 years and negative for bonds with a time horizon of fewer than 20 years. It's measured as the historical difference in monthly income returns between two government bonds, with the maturity of the first bond matching that of our asset-class benchmark and the maturity of a second matching the assumed time horizon of 20 years.

How we estimate long-term inflation

The 20-year inflation estimate is derived by comparing the yield of 20-year Treasury Inflation Protected Securities (TIPS) to the yield of US Treasury bonds of the same maturity. The yield on a conventional Treasury bond must compensate the investor for the expected decrease in purchasing power associated with inflation. Buyers of inflation-protected securities require no such compensation because interest and principal payments are indexed to inflation. Treasury bonds and TIPS of the same maturity should offer the same inflation-adjusted return because the US Treasury backs both of them.

If this were not the case, savvy bond-market investors would buy the security with the higher inflation-adjusted yield, causing its price to adjust, and resulting in both securities offering the same inflation-adjusted yield. Therefore, the yield difference between conventional Treasuries and TIPS of the same maturity represents an estimate of the inflation rate expected by market participants. Using the spread as of January 7, 2013, this approach resulted in a long-term inflation estimate of roughly 2.5% per year for the next 20 years.⁵

Asset class benchmarks

The table below lists the benchmarks assigned to each asset class. In cases where the benchmark has a short history, it's extended by using a statistically similar longer-lived proxy.

Note: Although Ibbotson S&P 500 return data are available, we use returns from Wilson and Jones for the 1926-1956 time period because they provide a return series that we believe represents a more diversified portfolio of large-cap stocks over this time period. The large-cap stock returns are obtained from Wilson and Jones, 2002, "An Analysis of the S&P 500 Index and Cowles's Extensions: Price Indexes and Stock Returns, 1870-1999," Journal of Business 75, 505-533. For bond and cash investments, we use returns that begin in 1970, even if we have access to a longer return history. This is because changes in the market structure and bond pricing in the fixed income markets make data prior to the 1970s not relevant when developing future prospects. These changes include the Federal Reserve changing its operating procedures from targeting interest rates to managing money-supply growth, the change from fixed—to floating—rate regimes, and the abolishment of the gold standard.

1. It is consistent with the approach developed in Ibbotson & Chen, 2003, "Long-Run Stock Returns: Participating in the Real Economy," Financial Analysts Journal, Volume 59, Number 1, 88-98.

2. The symbol ≈ means approximately equals. The decomposition does not exactly equal the total return due to an approximation used to simplify the illustration.

3. When measuring the historical performance of our risk-free proxy, we use income returns instead of total returns. Income returns are derived from the cash coupon received from holding a fixed-income instrument. We use income returns for the risk-free asset because it provides a better estimate of what investors expected to receive for holding these bonds to maturity.

4. Another approach is to directly estimate the sensitivity of the asset class to large-cap stocks. We don't do this, however, due to data limitations. Specifically, historical benchmark returns for large-cap stocks prior to 1957 are from Wilson and Jones (2002). They provide returns on an annual basis. But we prefer to follow common practice and use monthly data, whenever possible, to estimate betas because doing so increases the accuracy of the estimate.

5. An alternative to this approach is to use statistical models and historical data to develop inflation estimates. These estimates, however, are often highly variable and rely heavily on numerous assumptions, making them highly suspect. Our approach prefers the use of directly-observable market yield spreads instead.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

If you own foreign investments—either directly via a stock or bond, or indirectly through an exchange-traded fund or mutual fund—the issuing foreign country may withhold taxes on your investment income.

Fortunately, US tax law prevents double taxation by allowing you to claim either an itemized deduction for foreign taxes paid (or accrued), or a foreign tax credit on your US income tax return.

Itemized deduction or tax credit?

Generally, you must choose to take either a credit or a deduction for all your qualified foreign taxes. For those who itemize deductions on Schedule A of Form 1040, taking a deduction for foreign taxes paid is the easiest way to go.

However, an itemized deduction only reduces your taxable income, whereas an income tax credit can provide a dollar-for-dollar reduction of your actual tax liability.

For example, if you're in the 33% income tax bracket, a $200 deduction would only reduce your taxes by $66 (assuming full deductibility), whereas a tax credit would provide a $200 reduction in tax liability (if you are eligible for the entire credit).

Taking a tax credit seems like the obvious choice, right? Unfortunately, the foreign tax credit has limitations and requires you to fill out Form 1116, which can be complex (more on this below).

Claiming a credit

The amount of foreign tax credit you're allowed to claim is limited to the lesser of the amount of foreign tax paid or the US tax liability on the same income.

If your US tax liability were the same or higher than the foreign tax paid, you would be eligible to claim the full credit. In other words, you avoid double-taxation but always end up paying tax at the highest tax rate.

If you paid more foreign tax during the current year than you can claim as a credit, you can carry back the excess for one year (that is, file an amended return for the previous tax year) or forward the excess for 10 more years. The ability to carry back or carry forward any unused tax credit only applies if you file Form 1116, and is restricted by the amount of excess limit available in those carryback or carryforward years.

For example, if you pay $350 in foreign tax but only owe $250 in US tax on the same amount, you would have $100 in unused foreign tax that you could carry forward or carry back. However, in order to apply that amount to future tax years (or the previous tax year), you need to have excess to use in those tax years.

In the hypothetical example below, you could either carryback or carryforward that $100 because both years have an excess limit of at least $100.

Even if you're limited in the amount of credit you can claim, you're probably better off taking the credit rather than claiming an itemized deduction in most cases. One problem with taking the credit, however, is that Form 1116 is complex and can take a lot of work to complete.

Even when using tax-preparation software or a professional preparer, you still have to figure out how much foreign tax was paid to each separate country. In the case of mutual funds, this information is generally provided by the fund annually but the IRS will allow you to aggregate foreign sourced income for mutual funds on Form 1116 (see links to Form 1116 Instuctions and IRS Publication 514 below).

You'll also need to figure your carrybacks or carryforwards separately for each limit income category. The passive income category, which includes dividends and interest income, is one of five income categories.

Fortunately, if you pay $300 or less in foreign taxes for the year ($600 for married filing jointly), you can claim the credit without having to fill out Form 1116, though additional eligibility rules apply.

For example, all of your foreign income must be passive income and reported to you on a payee statement such as Form 1099-DIV or Form 1099-INT. See the Form 1116 Instructions and IRS Publication 514 for more detailed information.

Deferred accounts

Since you don't pay current taxes on investment income in your IRA or 401(k), there's no deduction or credit currently available for foreign taxes paid on investments held in these accounts.

Think of it as a timing issue: The amount you pay in foreign taxes today reduces your retirement assets, and therefore reduces the amount of tax the IRS is able to collect when you start making withdrawals.

A Roth account is another story since qualified withdrawals are tax-free in the United States. In the case of a Roth, you're just out the money. However, it could still make sense to hold foreign investments in tax-advantaged retirement accounts. There are many other factors to consider apart from what might be a relatively immaterial amount of foreign tax.

Take charge of your taxes

No matter how you choose to handle your foreign taxes, just be sure to claim something. Otherwise, you could end up paying more than you should.

Nathan Peterson
Senior Derivatives Analyst, Schwab Center for Financial Research

A new product has arrived in the options marketplace—mini options. As the name suggests, they are a smaller version of the standard option contract. Specifically, these contracts represent only 10 shares of the underlying security rather than 100 shares. The goal of mini options is to give investors more flexibility in managing smaller, high-priced stock positions.

Let's find out when you might use them and how they work. 

Why use mini options?

These options were primarily introduced to accommodate investors who own between 10 and 90 shares of certain high-priced securities. Mini options allow these investors with smaller positions to take advantage of option strategies that were previously unavailable.

For example, an investor who owns 10 shares of AAPL¹ now has the ability to sell a covered call, purchase a protective put, or do both and collar the position. In addition, investors who don't have a position in these higher-priced securities may use mini options as a lower-cost way to gain exposure to these stocks. When considering long options as a substitute for stock exposure, however, keep in mind that stocks do not expire, may pay dividends, have voting rights and loan value, while options expire, have a much higher risk of 100% loss of principal, do not receive dividends, and do not have voting rights.

How do they differ from standard options?

There are two primary differences between standard and mini options:

Contract size: Mini options represent 10 shares of the underlying security, so exercising one mini option results in the delivery of 10 shares of the underlying security (long call holders receive 10 shares at the strike price and long put holders deliver 10 shares at the strike price).

Premium multiplier: The mini option premium multiplier is $10 rather than the standard $100. This means that the quoted price for a mini option is multiplied by $10 in order to determine the cost. For example, if the quote on a mini option is: $5 by $5.10, you can expect to pay $51 ($5.10 × 10) to purchase one contract or receive $50 ($5 × 10) when selling one contract (not including commissions).

There are a few other minor differences to be aware of (discussed below), but otherwise mini options are very similar to standard options:

Comparison of Mini Options vs. Standard Options

Source: Schwab Center for Financial Research.

Which stocks/ETFs trade mini options?

Mini options are currently only available on five securities. Remember that the main driver behind mini options is to provide flexibility for investors who own high-priced securities. Here are the underlying securities¹ for which mini options are currently available: 

Additional securities could be added to this list in the future (depending upon demand and regulatory approval). But right now the eligibility requirements are restrictive: The securities must be stocks or ETFs with a minimum share price of $100 with a three-month average option trading volume of at least 45,000 contracts.

What else do I need to know about mini options?

Here's some additional information about mini options to keep in mind:

• Price increment: Mini options are bought/sold at the same price increments on the underlying security as standard options. This means that options on AAPL, AMZN, and GLD trade in penny increments up to $3 and nickel increments above $3, options on GOOG trade in nickel increments up to $3 and in dime increments above $3, while options on SPY trade in penny increments for all price levels.
• Commissions: The commission for buying or selling a mini option is the same rate as buying or selling a standard option contract: $8.95 + $0.75/contract. Keep in mind, however, that even though one standard option contract is theoretically equivalent to 10 mini option contracts, the commission cost will be greater to purchase 10 mini options.
• Mini option pairing: Mini options can be paired with stock in a 1/10 ratio or with standard options in a 10/1 ratio. For example, 10 mini option contracts can be paired with 100 shares of stock or one standard option contract.
• Mini and standard option order entry: Investors can't combine order entry for mini and standard options.

How can mini options be identified?

Symbols for mini options have the same four primary components as their standard counterparts:

• Underlying security ticker
• Expiration date
• Strike price
• Call or put identifier

Mini option symbols can be distinguished from standard option symbols by the number 7, which is appended to the underlying security. Here's an example:

If there's a corporate action (stock split, merger, etc.) and the mini option deliverable becomes something other than 10 shares, the number appended to the underlying component of the option symbol will be changed to an 8 or a 9 (example: AAPL8 04/20/2013 500.00 C).

At Schwab, mini options are labeled as adjusted options due to the fact that they have a non-standard deliverable and multiplier (that is, 10 instead of 100). This can also help you to identify mini options within our trading platforms—see below for examples of what mini options look like in the options chain of each trading platform.

StreetSmart Edge®

Mini options are grouped by expiration date, and the non-standard deliverable and multiplier are indicated in parentheses to the right of the group's expiration date.

Contract Specifications (you can see this by clicking the arrow next to the option symbol.)

Schwab.com

Mini options are located under their own tab, which is labeled with the mini option root symbol (example: AAPL7). The non-standard deliverable and multiplier are listed below the mini option tab.

StreetSmart.com

Options are listed by strike price. Mini options can be identified by their root symbols (example: AAPL7).

StreetSmart Pro®

For those of you who are still using our legacy trading platform StreetSmart Pro, options are listed by strike price. Mini options can be identified by their root symbols (example: AAPL7) as well as the "Adj" non-standard deliverable indicator to the right of the strike price.

Contract Specifications (you can see this by right clicking the option contract and selecting "Option data for…")

Bottom line

Hopefully, the introduction of mini options gives you more flexibility in managing your high-priced stock positions. For more information about mini options, or for help using Schwab's options trading tools and platforms, call a Schwab Options Specialist at 800-435-9050.

1. All stock and option symbols and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Previously, we talked about using a hedge as a way to help defend against financial loss, particularly if you're overly concentrated in a single stock. Investment hedges can also be used to help offset potential losses in a portion of your diversified portfolio—or your entire portfolio—when you're temporarily unwilling or unable to enter into an outright sale.

Before you consider a hedge, you need to be aware of the important tax rules that come into play whenever you enter into an offsetting position. Running afoul of these rules could severely limit the effectiveness of your hedging strategy. Talk to your CPA or other tax professional to see how the following rules (and related IRS and state tax rules) might apply to your particular situation.

Straddle rules

According to the IRS, a straddle is an "offsetting position with respect to personal property." When you enter into an offsetting position to limit the risk on another position—as you do with a hedge—the straddle rules usually come into play. Straddle rules are complex, but here are some key points to keep in mind:

• You may have to wait to deduct any losses. If you have a capital gain in one position of a straddle and a capital loss in the other, you can't recognize the loss for income tax purposes until you dispose of both positions. For example, let's say you had a highly appreciated stock position and you purchased protective put options (which give you the right to sell the stock to someone else for a period of time at a predetermined price) to offset the risk. However, the stock continued to rise and your put options expired worthless. You must defer recognition of the loss on your put options until you sell and recognize the gain on the original, appreciated position.
• Your capital gain holding period may get clipped. The moment you enter into a typical straddle, the capital gains holding period on your offsetting positions is frozen. This isn't such a big deal if you've already held the original, appreciated position for more than one year (qualifying for the long-term capital gains rate). But if you've held the original position one year or less, not only is the holding period frozen, it starts all over again when you dispose of the offsetting position.
  
  In most cases, a hedge will be ineffectual if your goal is to protect your short-term position while you wait for long-term treatment.
• You may not be able to deduct any interest expenses or carrying charges. During the offsetting period, any interest or carrying charges associated with the straddle are not currently tax deductible, but must be capitalized (added to cost basis).

Constructive sale rules

The constructive sale rules arrived as part of the Taxpayer Relief Act of 1997. In a nutshell, certain offsetting transactions can require you to recognize the capital gain on your original position even though you haven't actually sold it. These rules severely limit the usefulness of an old standby, the "short-against-the-box" strategy.

Importantly, a put option used by itself to hedge the risk on an existing position should not trigger a constructive sale as long as the exercise price is at or below the price of the existing position. And there are a number of other viable hedging and diversification strategies which, when properly structured, can help avoid constructive sale treatment.

Qualified dividends

Under the Tax Relief Act of 2003, qualified stock dividends are taxed at the maximum long-term capital gains rate of 15%. In 2013, Congress increased the top rate to 20% for single filers with $400,000 or more of taxable income and married joint filers with over $450,000. However, in order to receive qualified dividend treatment, the stock must remain unhedged during the required holding period (more than 60 days during the 121-day period surrounding the ex-dividend date).

Get expert help

For more information on straddles, constructive sales and related tax rules (including information on the tax treatment of options), see IRS Publication 550: Investment Income and Expenses. We strongly recommend getting expert help, preferably from both your trusted investment advisor and your tax professional working together.

Also, beware of tax strategies that sound too good to be true, such as tax elimination schemes (as opposed to tax deferral), offshore deals and the like.

A final point to keep in mind: Just because hedging is a sophisticated solution doesn't mean it's the best solution for your situation. Sometimes it makes more sense to take your gain, pay your taxes and move on. Likewise, gifting appreciated long-term positions to family members or qualified charities can be a tax-effective way to diversify out of a concentrated position.

We'll look at some common hedging techniques next.

Collin Martin
CFA, Senior Research Analyst, Fixed Income, Schwab Center for Financial Research

What are floating-rate notes?

Floating-rate notes, also called floaters or FRNs, are a type of bond without a fixed coupon rate. Here we'll be focusing exclusively on investment-grade floaters. Our discussion doesn't include floaters issued by sub-investment grade corporations, which we think are too risky for most individual investors.

The coupon on a floating-rate note is usually based on a benchmark or reference rate, such as the quarterly London Interbank Offered Rate (LIBOR), plus a quoted spread. The reference rate tends to fluctuate based on market conditions, but the quoted spread remains constant. As a result, the coupon payment of a floater will rise and fall based on the reference rate fluctuations.

Floating Coupon Rates Tend to Move with Short-Term Benchmarks

Source: Barclays and Bloomberg using monthly data as of February 28, 2013. Barclays US Floating-Rate Notes Index and BBA US Dollar 3-Month Libor (US0003M).

The quoted spread above the reference rate tends to vary based on factors such as issuer credit quality and time to maturity. The spread is an indication of risk: Investors earn a higher rate than the reference rate to compensate them for the risk of holding a bond, such as default risk. All else equal, bonds with lower credit ratings tend to have higher spreads above the reference rate.

Unlike plain-vanilla, fixed-coupon bonds that pay interest semiannually, floating-rate notes tend to pay more frequently. Often, a floater will pay quarterly interest payments, and the coupon rate generally resets each time the payment is made.

Floaters sometimes have a "floor" or a "cap." A floor is the minimum coupon rate it will pay regardless of the floater's reference rate plus spread.

Take a floater with a floor of 3%, for example. If, at the time of the coupon reset, the floater's reference rate is 1% and the spread is 1%, the "floating" coupon rate should be 2%. However, since the floater has a floor of 3%, it will actually pay an annualized 3% coupon rate for that period. So if the reference begins to rise, the coupon rate on the floater will only rise once the reference rate plus spread crosses the floor threshold.

Therefore, floaters trading at their floor rates may not give an investor the appropriate exposure to rising interest rates that they desire. Only when the reference rate plus spread crosses the floor will an investor in the floater begin to benefit from higher coupon rates.

A cap, on the other hand, is the maximum coupon rate a floater would pay. If a FRN has a cap of 7%, for example, and the reference rate plus spread adds up to more than 7%, the floater would still only pay an annualized 7% coupon rate.

Floaters tend to have short- to intermediate-term maturities, often below five years. The coupon rate of a floater is generally refreshed a few times a year—usually quarterly—so it automatically adjusts to market interest rates. That puts its duration, which is a measure of interest rate sensitivity, near zero. The consequence? Floaters' prices don't move much when interest rates move. The table below compares the average maturities and durations of floaters to fixed-coupon bonds.

FRNs tend to be targeted for large institutional investors, not individual investors. Generally, they have higher minimum investment amounts (such as a minimum trade size of $100,000, for example). The most common way for individuals to invest in the floating-rate notes is through a fund or an exchange-traded fund (ETF). This way, investors get access to the market for a smaller dollar amount and professional management, along with a greater degree of diversification than by just buying a few individual issues. But such funds, unlike an investment in individual notes, don't have a predictable market value at maturity, and have management fees paid by the investors.

Characteristics: Floating-Rate Bonds vs. Fixed-Coupon Bonds

Source: Barclays as of March 13, 2013.

Floaters do have risks

Floaters do come with risks, however. Like any corporate bond, they carry credit risk, or the risk of default. As seen in the previous table, the average credit rating for the Barclays U.S. Floating-Rate Note Index is higher than that of an index of fixed-coupon bonds. But higher credit ratings shouldn't be confused with zero credit risk.

The average credit rating of the Barclays US Floating-Rate Note Index is between Aa3 and A1, according to the Moody's rating scale. This compares to an average credit rating of the Barclays US Corporate Bond Index between A3 and Baa1, a difference of roughly three notches. A characteristic that leads to a higher average credit rating is the inclusion of "non-corporate" bonds in the floating-rate index, which generally includes many international, government-sponsored issuers (also called "supranationals") that carry high credit ratings. Despite the high ratings, they carry credit risk as well, just like corporate bonds—they are only as strong as the countries or institutions backing them. Non-corporate bonds make up roughly 15% of the Barclays US Floating-Rate Note Index.

The majority of FRNs are issued by financial institutions, which also tend to have higher credit ratings than their industrial and utility counterparts. As a result, floaters have a higher degree of sector concentration. As of March 6, financial institutions made up more than 65% of the Barclays US Floating-Rate Note Index, compared to about 33% of the broader Barclays US Corporate Bond Index. Even fixed-coupon bonds with similar maturities have less sector concentration: The Barclays US Corporate Bond 1–3 Year Index has a 49% allocation to financial institutions.

While sector concentration is generally a negative factor on its own, financials tend to have higher risk profiles than the industrial and utility sectors. We often think of financial institutions as a leveraged play on an economy. Therefore, the performance of their securities tends to be tied to the overall economic picture. If the outlook for the economy turns negative, bonds issued by financial institutions tend to suffer.

And because of the floating nature of their coupon, floaters lack certainty regarding the future stream of their income. Many fixed income investors are looking for just that—a fixed income from a fixed coupon. Without knowing what you'll receive, floating-rate notes may not be appropriate for all investors.

Due to their short maturity and low duration, investors may incorrectly view floaters as cash substitutes. Since they have low durations, floaters have lower interest-rate risk and experience lower price volatility when interest rates change. But they do have credit risk—we know that because the coupon rate includes a "spread" over the reference rate. Although that spread is fixed, meaning the coupon rate will always be made up of the reference rate and the fixed spread, once in the secondary market, investors ultimately decide how much additional yield above a Treasury they prefer.

In other words, if market conditions change or the fundamentals of a corporate bond deteriorate, investors may demand a higher yield, or higher spread, to own that bond. In this case, the floater's price would decline relative to Treasuries.

During the financial crisis, the average price of floaters dropped roughly 9%, as measured by the Barclays US Floating-Rate Note Index—just as much as the Barclays US Corporate Bond 1-3 Year Index.

Prices of Floaters are Just as Susceptible to Major Market Shocks

Source: Barclays using monthly data as of February 28, 2013.

Also keep in mind that, although interest rates broadly tend to move together, a floater's reference rate may not move in the same direction, magnitude or at the same rate as other interest rates. Therefore, a floater tied to one rate (such as LIBOR) may not perform as expected against another (such as US Treasury rates) if the rates don't move in tandem.

In short, floating-rate notes can help investors when short-term interest rates rise, but it's important to remember they still come with many of the same risks as fixed-coupon bonds, and some of their own as well.

Michelle Gibley
CFA, Director of International Research, Schwab Center for Financial Research

The large emerging-market economies of Brazil, China and India have run into growth, inflation, and structural challenges. Combine that with a potential peak in commodity prices that could damage heavy commodity exporters such as Brazil, South Africa, Russia, Indonesia and Chile, and we see reason to be cautious on emerging markets (EM) as an asset class.

High economic growth doesn't assure strong stock performance

Just five years ago, emerging markets, including the BRIC sub-group (Brazil, Russia, India and China) showed great promise. Chinese and Indian incomes were growing; Brazil and Russia boasted abundant and valuable natural resources; and low government debt and high levels of foreign exchange reserves in many emerging markets seemed to pave the way for rapid growth. 

Source: FactSet, IMF. Estimates used after vertical line are as of Oct. 2012, World Economic Report database.

Unfortunately, growth rates have taken a noticeable step down, and emerging-market stocks have underperformed over the past two years. Some investors have held on to emerging-market allocations on the premise that the growth outlook for these countries remains above that in the developed world. 

Paradoxically, higher economic growth doesn't always equate to the best investment returns—academic research suggests no clear correlation. While stronger economic growth creates the potential for greater sales growth, high earnings per share and dividend growth don't necessarily follow. Profits can suffer if wages rise faster than productivity increases. Weak corporate governance can reduce returns when profits are expropriated rather than passed along to shareholders. Additional capital can be needed to sustain high growth, which can reduce shareholder returns. 

The role of expectations and valuations is also very important. High growth expectations can be accompanied by high valuations, resulting in future underperformance—the good news is priced in. We believe that missed growth expectations in emerging markets are the likely culprit for the underperformance over the past two years.

Emerging market growth may have difficulty improving

So are expectations now low enough to get in? We view valuation as an important basis for future performance, but not the only factor. We are cautious on emerging markets (EM) as an asset class due to growth constraints for 60% of the weight in the universe, as defined by the MSCI Emerging Market Index. We believe addressing these constraints could involve difficult transformations or decisions by policymakers in the largest countries.

• A combination of stagflation and structural issues in the large emerging market economies of Brazil, China and India, which represent 40% of the MSCI Emerging Market Index.
• Commodities are potentially peaking, which represents roughly 20% of the MSCI Emerging Market Index, excluding Brazil (included above).

China: Still growing, but sources are suspect

Construction spending has been the primary driver of China's economic growth in recent years, but it was fueled by a massive issuance of debt, which grew at 30% of GDP for four straight years. That rate of growth can't continue forever, so we think property and infrastructure construction will likely slow from the rapid pace of the past. Additionally, the overhang of debt could result in a credit crunch that reduces growth for the overall economy. 

China's government is trying to transition to a more consumer-led economy, which will likely be an eventual positive for consumer spending—but we could see policy mistakes and uneven economic progress along the way. It's much harder for a government to control consumer spending than it is to order new infrastructure construction or command a state-owned company to build another factory. Wages are rising, which benefits consumers, but sales and labor productivity are slowing, constraining corporate profits. Corporations have had difficulty with pricing power.

Additionally, China has a host of challenges related to the growth of its shadow banking sector. See more in "China's Hidden Risks: Shadow Banking and US Delisting" and "Avoid China - Subprime-Like Bubble Brewing."

Source: FactSet, People's Bank of China, Bloomberg. In current dollars using the December 31, 2012 exchange rate. Total credit as measured by total social financing. As of January 29, 2013.

Brazil: Stressed consumers and government bureaucracy

Brazil's economy relies heavily on consumers, who represent 60% of GDP—and right now, consumers are challenged by inflation and high levels of household debt.

Inflation in Brazil accelerated to 6.3% in February and has exceeded the central bank's 4.5% target for more than two years. The country's tight labor market could further propel inflation. With flagging productivity gains and low unemployment, employers won't find it easy to get more productivity out of the existing workforce or hire lower-wage workers—which means that rising wages may be next. This is good for workers, but often leads to accelerating inflation. 

Additionally, the rapid growth in consumer credit that helped to fuel Brazil's economy in recent years may now be waning. Brazil's households spend roughly 20% of their disposable income servicing debt, compared to 14% at the peak for the US consumer in 2007, according to Capital Economics. With consumers spending so much money servicing debt, there's little disposable income left over for new consumption.

Source: FactSet, Banco Central do Brasil, Bloomberg. As of March 15, 2013. *Household debt is the sum of consumer loans outstanding and housing loans outstanding. 

On the business side, government bureaucracy and increased interference in the private sector has created a difficult operating environment—particularly for the two largest stocks in the Bovespa Index, as well as utilities and banks. For example, the government limited the price Petrobras could charge for petrol fuel in order to dampen inflation—but this reduced profits for the oil company. Meanwhile, Brazil's central bank has pursued a somewhat volatile monetary policy. It has overshot at times, creating volatility in both growth and inflation, and has instituted controls that limit foreign investment.

India: Reforms needed, but hopes fading  

Economic growth in India has roughly halved from the 9-10% range in the late 2000s to a 4.5% annualized rate as 2012 ended, well below the country's 8% growth goal. From a funding perspective, India suffers from both a large fiscal deficit and the need for foreign investment due to low savings rates. Therefore, reforms to reduce fiscal spending and attract investment are important to reinvigorate growth.

Source: FactSet, Bloomberg, India Central Statistical Organization. Estimates used after vertical line are provided by India Central Statistical Organization. As of March 15, 2013.

The fiscal budget released in February 2013 was a disappointment for investors hoping for reforms. The budget projected optimistic revenue increases and placed a greater tax burden on corporations, but lacked reforms to spending, preserving populist measures such as costly fuel, food and fertilizer subsidies. Reforms to open the economy to competition announced in 2012 were a positive first step, but momentum has stalled and the possibility of progress ahead of elections in April 2014 is fading.

Meanwhile, inflation is stubbornly high due to swings in food prices, which constitute a large portion of consumer spending. This volatility is the result of supply bottlenecks that stem from insufficient power and warehouse facilities, low agriculture yields, an inefficient public food-distribution system and dependence on the unpredictable monsoon season for irrigation.

Commodity prices may be peaking

As emerging-market economies continue to build out infrastructure and housing, they'll support demand for commodities such as industrial metals and construction materials. However, the pace of demand growth is likely to slow. China constitutes 40% of demand for many commodities right now, and we expect slower growth in future demand from China as construction of infrastructure and property slow. We don't see any countries that could replace China as a major commodities consumer—both Brazil and India are potential candidates, since they appear to need large investments in infrastructure, but government bureaucracies and lack of funding are barriers to progress.

Revenues for commodity producers are a function of both demand (where we expect slower volume gains) and prices. Prices of some commodities may have difficulty increasing, as demand growth in the past was met with significant increases in supply. Stagnant commodity revenues could be a challenge to economic growth for the commodity-oriented emerging economies of Brazil, South Africa, Russia, Indonesia and Chile.

Source: FactSet, Commodity Research Bureau. As of March 15, 2013.

Monetary policy may tighten

In Brazil, central bank chief Alexandre Tombini said in February that he was "uncomfortable" with current inflation levels and that the bank will not hesitate to raise rates. At its March 6 meeting, the central bank removed the language (used since October) that it would maintain monetary policy for a "prolonged period of time," suggesting it has shifted its priority from encouraging growth to fighting inflation. Brazil was the first major emerging-market country to ease in August of 2011, and its moves could be reflective of broader trends. 

Source: FactSet, IBGE, Indian Ministry of Labor. As of March 15, 2013.

In China, Governor Zhou of the People's Bank of China (PBoC) noted in March that China should be on "high alert" as inflation could accelerate later this year. As a result, monetary policy in China is now in "neutral" territory, and the next move for the PBoC is more likely to be tightening than easing.

Attractive valuations, but disappointing earnings

In a fourth straight quarter of disappointing results, more than 59% of companies in the MSCI BRIC Index reported quarterly earnings that trailed analyst estimates, while profits rose less than 1%, according to Bloomberg. Earnings estimates for emerging markets may still be overly optimistic, as economic growth continues to come in below expectations.

Consumers in some countries (such as Brazil) and other borrowers (such as local governments in China) appear tapped out on credit, and without credit to help fuel consumption we may see slower economic growth. Additionally, rising labor costs in many emerging markets could put a damper on corporate profits. While valuations appear attractive relative to historical averages, lower growth and potentially unmet estimates will likely necessitate lower valuations until these trends turn around.

Investment implications

As long as China's economic reacceleration continues, emerging-market investments could benefit in the short term. However, we believe longer-term investors may want to consider re-orienting international exposure away from China and emerging markets and toward developed international markets. Earnings in non-US developed markets such as Europe and Japan have been cut quite dramatically, and economic data has shown steady (albeit modest) improvement. Additionally, valuations in Europe and Japan look low relative to historical averages, so stocks in these markets could be a relative bargain.

Collin Martin
CFA, Senior Research Analyst, Fixed Income, Schwab Center for Financial Research

Bond yields are still near all-time lows—giving them much more room to rise than fall. Because bond yields and prices move in opposite directions, a rise in yields generally corresponds to a drop in prices. That's why many bond investors are worried about the effect of rising interest rates on their portfolios.

Floating-rate notes (FRNs) may offer one way to combat the effects of rising interest rates. Their coupon rates adjust as short-term interest rates change, and the frequency of adjustment can vary—most investment-grade floaters tend to adjust monthly or quarterly. The shorter the time between coupon rate resets, the quicker they can offer the advantage of higher interest rates. However, they would also reset at lower coupon rates if interest rates fall.

When do floaters make sense?

We think floating-rate notes make the most sense when short-term interest rates are expected to rise soon. For this discussion, our focus is on the investment grade floating-rate bond market. Sub-investment grade floating rate-bonds, also called bank loans or leveraged loans, have different characteristics and different risks, and are not considered in this discussion. Due to their near-zero duration¹, floaters aren't as sensitive to rising interest rates as fixed-coupon bonds, and their prices tend to be less volatile.

However, while their prices tend to respond less to interest rate risk, FRNs are sensitive to credit risk. Floaters are subject to many of the same risks that fixed-coupon bonds have—such as the risk of default—and prices can still fall if the outlook for corporate bonds deteriorates.

When are floaters less helpful?

Floaters can help offset changes in short-term interest rates, but they may not be as helpful if long-term interest rates rise.

Often, long-term interest rates will start to rise in anticipation of a rate hike by the Federal Reserve. However, the reference rates for floaters tend to rise much closer to the actual Fed hikes. In fact, Libor, commonly used as a reference rate, tends to rise only a month or two before the Fed begins to raise its target rate.

So although long-term bond yields may begin to rise many months in advance of a Fed hiking cycle, floaters tend to see higher coupon rates much closer to the actual increases. If you don't think short-term rates are going higher anytime soon, it may not make sense to try and get in the market early.

Because Libor closely tracks market expectations of moves in the Fed's target rate, a rise in Libor may signal a good time to consider investing in floaters.

What do floater prices react to?

There is essentially a limit to how high the price of a floater may go. Investors are generally willing to pay a premium price for above-market coupon rates; that's why bond prices rise when interest rates fall. Since the coupon rate of floaters resets over the course of the year, with various reset frequencies, they are essentially paying the "market" interest rate, and there is not much need for investors to pay a premium.

The average price of the Barclays U.S. Floating-Rate Note Index has never risen higher than $100.20 in the 10 years since the index was created. As of March 6, 2013, its average price was $100.06. We think there is little potential for price appreciation, and any potential upside will be driven by higher coupon rates if and when rates rise, not by higher prices. Like all corporate bonds however, there is the risk of price declines as well, if the economic outlook deteriorates or default rates begin to climb, for example.

FRN issuers don't seem to expect an imminent rate bump

Remember that when corporations issue bonds, they are looking for terms that are in their best interest. An increase in floating-rate note issuance may signal that many corporations believe rising interest rates are still some time away.

And this year, we've seen a significant acceleration in floating-rate note issuance. New issuance of non-callable, floating rate corporate notes jumped more than 50% in the first two months of the year to $19.3 billion, compared to $12.7 billion a year earlier, according to the Securities Industry and Financial Markets Association (SIFMA). In fact, January's issuance of $11.1 billion was more than any single month in 2012.

Assuming interest rates remain at current levels, corporations may be better off issuing floating-rate notes, as their cumulative interest payments may be lower than payments on fixed-rate bonds. For example, assume an investment grade floater is issued with a coupon rate of 3-month Libor plus 30 basis points (0.3%). If Libor is 0.28%, the coupon rate would be 0.58%. But a 3-year Treasury yield is about 0.38%—assuming a similar spread of 30 basis points, the coupon would be 0.68%. If Libor remains unchanged, the floater would yield 0.58% to maturity, compared to the fixed coupon bond yield to maturity of 0.68%.

Fixed-coupon bonds offer higher "yield to worst" for now

When bonds have call features, it's best to examine the yield to worst (YTW), which is the lowest potential yield that can be received, barring a default from the issuer. It is the lower of a bond's yield to maturity or lowest yield to call on every possible call date. (Yield to maturity represents the annualized yield an investor would receive if the bond is held to maturity, while the yield to call represents the annualized yield if the bond is retired prior to maturity at its first call date.) The YTW of a floater is hypothetical—a snapshot of the current environment. It assumes the index's most recent coupon rate (which fluctuates) remains constant going forward.

Right now, fixed-coupon bonds generally offer a higher YTW. As of March 6, the Barclays US Corporate Bond 1-3 Year Index offered a 1.1% yield to worst, while the Barclays U.S. Floating-Rate Note Index yield was 0.7% as of March 6. These two indices have similar average maturities.

Of course, the YTW of the floating-rate index will rise when short-term interest rates rise. But when will that happen? We continue to believe the Fed will remain on hold until at least 2015. If that's the case, floaters may not experience a coupon increase for another two years or so.

So we know that floaters may benefit if interest rates rise. But there is an opportunity cost of investing in floaters—the opportunity cost of fixed-coupon bonds if rates don't rise.

Given the higher YTW of fixed-coupon bonds with similar maturities, we think it may be a little early to get into floaters.

The bottom line

Investment-grade floating-rate notes can help investors when interest rates rise, but they still come with many of the same risks fixed-coupon investment-grade bonds offer. We continue to believe the Fed will remain on hold until at least 2015, a stance that would likely keep short-term rates depressed for another year or two. While floaters can serve as a good diversifier or hedge to a fixed income portfolio, we think it may be a little early to position a portfolio based on an expected rise in interest rates.

1. "Duration" is a term used to measure a bond's sensitivity to changes in interest rates. Maturity directly affects duration, in that longer-term bonds usually have longer durations and tend to be more volatile than shorter-maturity bonds. In general, the longer the duration of a bond, the more its market value is going to fluctuate with the interest-rate cycle.

by Carrie Schwab-Pomerantz,
CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.

Dear Reader,

People are living longer. That's the good news. But the downside is that more people are running the risk of outliving their money—and the younger generation is being asked to step in to fill the financial gaps. A recent nationwide Pew Research Center survey found that nearly a third of adults in their 40s and 50s provided some sort of financial aid to a parent age 65 or older in the past year. Interestingly, in the same survey three fourths of respondents said that adults have a responsibility to provide financial assistance to an elderly parent in need. That's a generosity of spirit I applaud. However, feeling generous doesn't make coming up with the money any easier.

Fortunately, helping your parents doesn't only mean paying their bills for them. You can also help them plan and make decisions that could perhaps lighten their financial burden—as well as your own.

Start with an honest assessment of your parent's finances

A lot of families don't like to talk about money, but now's the time for an open discussion with your parents about what they have, what they need, and changes they may need to make.

Take a look at their income and assets. Make sure they're getting their full Social Security benefits. For instance, if your mother didn't work, is she taking the spousal benefit, which would be half of your father's benefit?

Do an inventory of their financial resources—CDs, pensions, IRAs, brokerage accounts. Review how their assets are invested and see if there's a way to increase their regular stream of income. You might set up a meeting with their banker or investment advisor to discuss how to help them maximize their income opportunities.

Discuss the possibility of downsizing or taking a reverse mortgage

This may be a sensitive issue, but it's worth considering. If your parents are still in the family home, a move to a smaller space might be a significant money-saver that would ultimately let them remain independent longer.

What about a reverse mortgage? As long as you do your research and understand the potential pitfalls, a reverse mortgage could be an effective supplement to your parent's monthly income. A lender can put you in touch with a HUD approved counselor who can advise you on the particulars.

Work with them on a budget

Getting a handle on your parent's monthlies may be the easiest and most practical way to help them—and help you determine which bills you can most easily pay.

First, take a look at their budget together and find ways to lower expenses. For instance, can they find a less expensive cable plan or take better advantage of senior discounts?

Then, list all their recurring household and medical expenses. How much can they cover with their current income? Can you cover any gap? Perhaps you can agree to supplement a certain amount each month. Knowing that you'll have a set monthly obligation may make it easier for you to plan and adjust your own budget accordingly.

Get other family members to help

You don't say whether you have siblings, but if you do, talk to them about sharing the financial responsibilities. Other family members such as aunts and uncles or even adult grandchildren might also be willing to step up to the plate. If nothing else, it would be good to know you have a support system of people who understand the situation and are willing to offer what help they can should the need arise.

Check on possible tax benefits

As you suggest, it's difficult to get any tax benefits for caring for a parent. There are income requirements for claiming adult dependents that usually preclude this possibility as well as level of support requirements. For instance, for 2012, your parent's gross income (excluding Social Security) could be no greater than $3,800. Plus, you would have to prove that you provided more than half of their support. But it's always good to know the parameters just in case. If you're interested, IRS Publication 501 has a section on exemptions for dependents that gives greater detail.

Also, keep the gift tax rules in mind. You can give up to $14,000 to as many individuals as you wish for 2013 without dipping into your lifetime exemption of $5.25 million. Spouses can split gifts so if you're married you could give $28,000 to each of your parents for a total of $56,000 this year without using your lifetime exemptions. Beyond that, if you pay medical providers directly on behalf of others it doesn't count as part of the annual $14,000 exclusion.

Your parents are fortunate that you're able to help them, but I advise you to take care of yourself, too. Use their situation as a motivation to make sure that you continue to save for retirement and create an emergency fund. Then maybe you won't have to pass a similar financial burden on to your own family in your later years. Best of luck to all of you.

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Ask a bear about valuation and he'll likely say the market is very expensive. Ask a bull about valuation and he'll likely say the market is quite cheap. What gives? Assuming by "valuation," you mean price-to-earnings (P/E) ratio, the answer is in the eye of the beholder, and/or a function of the denominator (E, or earnings) you opt to plug in. There are three popular P/E ratios:

• Forward P/E (on subsequent 12-month earnings forecasts)
• Trailing 12-month (TTM) P/E (on most recent 12-month past earnings)
• Robert Shiller's Cyclically Adjusted P/E (CAPE)

The CAPE uses earnings from the prior 10 years and has become a widely followed valuation measure. Yale professor Robert Shiller defines the numerator of the CAPE as the real (inflation-adjusted) price level of the S&P 500® Index and the denominator as the moving average of the preceding 10 years of S&P 500 real reported earnings, where the US Consumer Price Index (CPI) is used to adjust for inflation. The purpose of averaging 10 years of real reported earnings is to control for business-cycle effects. The CAPE is also sometimes referred to as the P/E10.

Before I share my thoughts on how to use valuation to assess the market (and which is my preferred metric), I want to pick a little at the CAPE and express some caution about following it too dogmatically. First, take a look at the chart of the CAPE below, all the way back to the 19^th century. Comparing today's reading of 22.7 to the long-term median of 15.9 suggests the stock market is about 43% over-valued, assuming a mean-reversion to the "norm."

CAPE Signaling Stock Market Overvaluation

Data and methodology courtesy of Professor Robert J. Shiller (www.econ.yale.edu/~shiller/data.htm), as of March 27, 2013.

CAPE Crusader

There are several problems with the construction of the CAPE, detailed in a terrific report by Steve Wilcox for The American Association of Individual Investors posted on the Seeking Alpha site in 2011, from which I'll pull some data.

In their classic 1934 book Security Analysis, Benjamin Graham and David Dodd noted that traditionally reported P/Es can vary considerably because earnings are strongly influenced by the business cycle. To control for cyclical effects, Graham and Dodd recommended using multi-year averages of earnings. Shiller opted for a 10-year series.

The problem with using a 10-year period for earnings is that the average business cycle only lasts about six years. More recently, recessions have become shorter and expansions longer (notwithstanding the long "Great Recession" which ended in 2009), as you can see in the table below. As a result, CAPE tends to overestimate "true" average earnings during a contraction and underestimate "true" average earnings during an expansion.

Source: National Bureau of Economic Research.

There are also problems with the deflator for CAPE's real earnings since the Bureau of Labor Statistics frequently changes the manner in which the CPI is determined, so, there's an apples-to-oranges problem using a static CPI within the CAPE.

Finally, both accounting standards and corporate taxation policies have changed significantly over time. Public accounting in the United States was still in its infancy in the late 1800s, and it's questionable how useful these early earnings numbers are to any analysis using them as inputs. 

More recently, the move toward fair-value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions during the recent financial crisis. Yet that effect now appears to have been transitory. If an accounting item is deemed non-recurring, it's common practice to ignore it when determining underlying earnings (i.e., using "operating" instead of reported earnings). But CAPE continues to reflect the effect of non-recurring items for the 10 years that follow their initial recognition in reported earnings.

The punch line is that one has to question the validity of the CAPE long-term median when many of the major factors affecting reported earnings are peculiar to specific time periods. One final point: Even if you follow CAPE as a valuation tool, be mindful of the simple fact that the stock market can become "overvalued" and stay that way for a long time.

In the present bull market, the first month the CAPE crossed into overvalued territory (i.e. went above its median) was May 2009, just two months after the market's bottom, since which time the market has more than doubled. Even more dramatic was the cross into overvalued territory by the CAPE in February 1991, a mere nine years shy of the top of the great 1990s' bull market.

Shorter time frames

The other common P/E ratios used to value stocks look at a shorter time frame for earnings. Below are the forward P/E and the trailing 12-month P/E, both relative to their long-term medians, and showing a relatively cheap market. The peril of using forward earnings is of course the notoriously bad forecasting ability of the analyst community; however, there's presently a "cushion" built in given that the P/E is below its median.

Forward and TTM P/Es Signaling Stock Market Undervaluation

Source: FactSet, Standard & Poor's, as of March 27, 2013.

One of my favorite P/E ratios, created by Steve Leuthold, uses five-year "normalized" earnings in the denominator. What I like about this measure is that it looks both back and forward by using four-and-a-half years of historic earnings and two quarters of estimated earnings. In addition, the five-year span is closer to the six-year average business cycle than the CAPE. Finally, it takes the mid-point between reported and operating earnings, unlike CAPE, which only looks at reported earnings.

Five-Year Normalized P/E Signaling Slight Stock Market Overvaluation

Source: The Leuthold Group, as of March 15, 2013.

On this basis, the market is a few points overvalued—but there is a caveat: When looking at historic inflation zones, we're presently in a zone that's seen this version of P/E hit an average of more than 20, suggesting that today's valuation is about in-line.

Inflation Versus Valuation Signaling Reasonable Market Valuation

Source: Bureau of Labor Statistics, FactSet, The Leuthold Group, 1946-February, 2013.

Valuation, another way

Valuation can also be calculated in relative terms by comparing the stock market's value to bonds or the risk-free rate, and one way to do that is to compare yields. But since some companies don't pay dividends—and those that do pay out a small percentage of their earnings—dividend yields can understate companies' ability to boost shareholder wealth and stock-price appreciation.

A better measure of stocks' long-term potential is "earnings yield"—the reciprocal of the P/E ratio, or the ratio of earnings to price. You can then compare that to the yield on a bond or the risk-free rate.

In a recent memo from Oaktree's Howard Marks, he reviewed a few key points:

• The post-World War II average trailing P/E on the S&P 500 is about 16, for an E/P ratio of 1/16, or an earnings yield of 6.25%. Assuming a "normal" risk-free rate of 3%, the yield differential is 3.25%. The ratio of the yields is therefore 2.1 (6.25% divided by 3.0%).
• At the market high in 2000, the trailing P/E on the S&P 500 was about 32, for an E/P ratio of 1/32, or an earnings yield of 3.12%. The risk-free rate at the time was about 2%, so the yield differential was 1.12%. The ratio of the yields was therefore 1.6 (3.12% divided by 2.0%).
• Today, the trailing P/E on the S&P 500 is back to about 16, so the earnings yield is 6.25%. The risk-free rate is near-zero, but let's round up to 0.5% (Howard Marks rounded fully up to 1.0% in his analysis). As such, the yield differential is 5.75% and the ratio of the yields is 12.5.

To sum it up:

The yield comparison is highly favorable for stocks today and is actually the best it's been in the past century. Although much of stocks' current attraction is because interest rates are so low, history shows that when rates begin to rise from a very low absolute level they tend to be accompanied by rising stock valuations.

The moral of the story…

Valuation is often in the eye of the beholder, and one can likely find a version of the P/E to support any view. I do still side with the bulls on the market. We never recommend investors use any valuation metric (or any indicator for that matter) as a market-timing tool. I'm often asked whether investors should "get in" or "get out," often on the basis of valuation. Neither "get in" nor "get out" are investment strategies…they're gambling on a moment in time, whereas investing should be a continual process.

Randy Frederick
Managing Director of Trading and Derivatives, Schwab Center for Financial Research

When I teach options seminars, I like to ask how many participants are brand-new to options. Almost always, about half to three-quarters have never traded an option contract before. It strikes me that perhaps there’s a non-stop stream of investors interested in getting started in the options markets, but perhaps many of them are intimidated and don’t know where to start.

No option strategy is suitable for all investors, or even all options traders. For those who believe that options may suit their portfolio objectives, this article provides a step-by-step guide to help you accomplish two specific goals:

1. Set up your very first covered call options trade.
2. Possibly sell a very small stock position at a favorable price.

I also encourage you to read my articles about getting started with options and how to put options to work.

Do you have a long-term stock position?

If you have been an investor for any length of time, you probably have some equity (stock) positions in your account that you've owned for a long time. If the price was right, you might consider selling at least some of these shares. After all, unless your goal is strictly to get dividends, you probably bought this stock in the hope that it would eventually appreciate and you could sell it at a profit.

When first making the decision to trade options, successful stock pickers sometimes turn to long call options. Unfortunately, the results are often disappointing because both time and price can work against the owner of long calls and inexperienced investors may not be fully aware of the risks. Instead, I recommend covered calls as a first options trade because when structured properly, time and price can both work in your favor. Additionally, a covered call is generally considered a relatively low risk strategy, and approval to trade covered calls can usually be granted to investors that have never traded options before.

Let's look at how to set up a covered call. 

Step 1: Identify the position

Step 1 toward executing your first covered call trade is to select a stock position in your account in which you already own a large position (say 300 or more shares; the more shares the better). Make sure the position you select is trading at a higher price now than what you originally paid for it. For purposes of this trade, a stock that does not pay dividends, or pays very small dividends would be a better choice than a stock that pays large dividends. (For your very first options trade you will be selling only one covered call, and doing so on a larger position will ensure that you can continue to capture upside gains in the remainder of your shares, in case the stock increases sharply in price unexpectedly.)

Step 2: Determine price

After you've selected your position, you need to determine a price at which you would be willing to sell 100 shares of this stock, anytime within the next 30 to 60 days. In making this decision, it might help to view a one-year price chart. Let's assume that it is December 12, 2012 and you've chosen stock XYZ, in which you own 500 shares.

You only want to sell 100 shares if the stock's price returns to its peak, reached this year. As you can see in the chart below:

• The current price of XYZ is $75.91.
• The stock has traded within about a 10-point price range over the past 12 months.
• The highest price that XYZ has reached over this time was around $77.80 in early May.

Source: StreetSmart Edge® as of December 26, 2012.

You could attempt to sell 100 shares of XYZ at $77.80 by entering a GTC (good-til-cancelled) sell order at a limit price of $77.80 and then wait. If XYZ reaches $77.80 any time over the next 60 days, the shares will be sold. If it does not reach $77.80, the sell order will automatically expire after 60 days at Schwab. However, this is a regular limit sell order. So while it may meet your goal of selling some of your stock at a profit, it doesn't accomplish your goal of executing your first options trade.

Step 3: Consider a covered call

Another way to potentially accomplish both of these goals is to sell one covered call option on XYZ with a strike price near $77.80 and an expiration date 30 to 60 days from now. To determine if both of these goals are feasible, launch the Symbol Hub or Trade tool in StreetSmart Edge.

Source: StreetSmart Edge.

1. Enter the underlying stock symbol in the symbol box (upper left-hand corner).
2. Click on the Options tab.
3. Select "Calls" in the strategy window.
   
   
   

   Source: StreetSmart Edge.

4. The only expiration date that falls within your 30 to 60 day window is January 19, 2013, (which is 38 days away). On that date, there is a call option available with a strike price of $77.50, which is fairly close to your $77.80 target price.
5. Click on this contract, select "Sell to Open" for your Action and select your limit price ($1.02 in this example).
        a. If you want to change your limit price, you can use the up and down arrows next to the price, but for your first
        trade, consider just entering a limit price that is equal to the bid. This will likely result in an immediate execution and
        eliminate the need to wait for the stock price to change in order to get executed.
        b. Be sure you have also selected the appropriate quantity ("1" in this example and "GTC" for your Timing).
6. Notice that the trading platform automatically calculates your Max Gain, Break Even, and Max Loss for this sale of one call option. However, because the system does not realize this is a covered call until it executes, these calculations do not include the sale of 100 shares of XYZ if you get assigned.
        a. Max Gain occurs if you get assigned and your stock is called away.
        b. Max Loss occurs if XYZ drops to zero, which is very unlikely. Your actual max loss would be -$7,489 (-$7,591 on
        the stock +$102 on the option).
        c. Similarly, the actual Break Even price of $74.89 is below the current market price, so this trade actually provides
        a small amount of downside protection, which comes from the 1.02 option premium.

Select the "Review Order" button. Then, verify the trade and place the order.

Source: StreetSmart Edge.

When this order is executed you will have a short call position and receive a credit of $102 (before commissions are deducted). This call will automatically be "paired" as a covered call against 100 shares of your 500 share XYZ position. (Typical commission charges for this trade would be $8.95 ticket charge + $0.75 per contract or a total of $9.70).

Step 4: Wait

It's always wise to occasionally review your positions. But it's unlikely that you will need to do much for the next 38 days but wait.

This $102 credit isn't free money. Option strategies are usually about making tradeoffs, and this is no exception. An option is essentially a contract, and once this order is executed, you take on a contractual obligation that you may or may not have to meet sometime over the next 38 days. 

When you sold your covered call, someone else bought it, and that person (or anyone else holding the same call contract) has the right to exercise the call at any time until expiration. If he/she decides to exercise the call, he/she will buy your stock from you (this is called "being assigned") and pay you $77.50 per share ($7,750 for your 100 shares of XYZ). However, doing so usually only makes sense if XYZ is trading above $77.50 in the market at that time.

The owner of the option can exercise it at any time, and you have no control over when/if that occurs. So it's important to be prepared to have your stock called away any time the option you sold goes "in the money," that is, the stock price becomes higher than the option's strike price.

Beware of ex-dividend dates

The price of a stock is adjusted for normal quarterly dividends. This happens on the morning of the ex-dividend date—the first day following a dividend declaration when a stock buyer is not entitled to the next dividend payment. However, option prices are not adjusted for normal quarterly dividends.

As a result, when you sell a covered call on a stock that pays dividends, you are at risk of being assigned early if the call goes in the money. This assignment usually occurs exactly one business day before the stock goes ex-dividend. If the stock you select for your first options trade is a stock that pays dividends, take note of the ex-dividend date. If the option's expiration date is after the ex-dividend date, you must be prepared not only to potentially have your 100-share position called away, but also to lose the next dividend payment on those shares.

Option assignments take place after hours. If you are assigned, the transactions will be placed in your account very early in the morning (typically before you log in to your account). When you log in, you will see a sale of your shares and an assigned option transaction in the Transactions window of your Account Details screen.

Source: StreetSmart Edge.

If the option remains out of the money (the stock price is lower than the strike price) you will not have your shares called away. Assuming you don't get called away early, let's explore what could happen if XYZ is at a few different prices when the option expires 38 days from now.

XYZ increases to $79 per share

• You keep the option premium and your 100 shares of XYZ will be assigned (sold) at 77.50.
• Your remaining 400 shares of XYZ have increased in value by 3.09 points.
• Total gains = $1,497 before commissions ($102 + $159 realized) + ($1236 unrealized).

XYZ increases to $77 per share

• You keep the option premium and your short call option expires worthless.
• Your 500 shares of XYZ have increased in value by an additional 1.09 points.
• Total gains = $647 before commissions ($102 realized) + ($545 unrealized).

XYZ remains unchanged at $75.91 per share

• You keep the option premium and your short call option expires worthless.
• Your 500 shares of XYZ have not changed in value.
• Total gains = $102 realized (before commissions).

XYZ drops in price to $75 per share

• You keep the option premium and your short call option expires worthless.
• Your 500 shares of XYZ have decreased in value by -.91 points.
• Total losses = -$353 before commissions ($102 realized) + (-$455 unrealized).

The table below compares holding 500 shares of XYZ and doing nothing to holding 400 shares and selling one covered call against 100 shares. Remember that the stock's starting price is $75.91 and the strike price of the covered call is $77.50. The first column (expiration price) shows some hypothetical prices for XYZ at expiration date and the last column (covered call impact) shows which strategy would perform better.

How Do They Stack Up?

Source: Schwab Center for Financial Research.

Looking at the table, you can see that:

• An assignment (sale of 100 shares at $77.50) will occur at any price above the strike price ($77.50). The overall impact on the account is only negative if XYZ rises above $78.52 ($0.72 above its year-to-date high) because the 400 shares you still own can increase in price indefinitely, but the 100 shares on which you sold the covered call, will not be able to participate in any price increases beyond $77.50.
• By contrast, for all prices below $78.52, the income received from the sale of one covered call will provide a net benefit to the account of up to $102, even when the overall account value declines.

What to remember about covered

• Although the premium received from the sale of a covered call provides some downside risk protection, it does not eliminate risk entirely.
• If the price of the underlying stock drops substantially prior to the expiration date, your losses could be significant.
• If your short calls go in the money, you could be assigned at any time.
• Anytime you sell a covered call, you have established a maximum selling price for your stock. Any movement in the stock beyond that established price creates no additional profit.
• It is rarely a good idea to sell a covered call if your stock position has already moved significantly against you. This could cause you to establish a closing price that ensures a loss.
• While the example above assumes that you hold the position(s) until expiration, you can usually close out a covered call at any time by buying it back at the current market price.
• Early assignment usually occurs exactly one day before the ex-dividend date.

Test the waters

While options trading can be complex and the variety of trading strategies is virtually limitless, the options market doesn't have to be intimidating. For many traders, options can provide a sensible and effective way to generate modest amounts of income or try to hedge against market and portfolio risk.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

A Coverdell Education Savings Account—also known as an ESA—is a special account designed to help pay for your child's education. You set up the ESA and choose how to invest the money, typically on behalf of the child beneficiary.

When you invest in an ESA, potential earnings grow tax-deferred, which means your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains.

Even better, withdrawals are free from federal taxes so long as you use the money to pay for qualified education expenses, which typically include tuition, books, supplies, uniforms, room and board, computer equipment and internet service.

Tax-free withdrawals apply not only to college expenses, but to elementary and secondary education expenses as well, no matter whether the schools are public or private, secular or religious.¹

What if your child's plans change? Or, your child graduates and there's money left over in your ESA? You can change the beneficiary on the account to another member of the original beneficiary’s family. Don't worry about finding a family member who needs money for college; the IRS broadly defines the term "family member" to include everyone from siblings and parents to step-siblings and in-laws. Also, remember that the beneficiary has until age 30 to use the money.

If you withdraw funds for non-qualified expenses, the amount is taxable to the beneficiary, along with a 10% federal penalty.

How to open and contribute to an ESA

Anyone can set up an ESA at a brokerage or other financial institution or directly with a mutual fund company. Once an ESA is opened in your child's name, anyone can contribute as long as they follow a few rules:

• Collectively (if more that one account/contributor), no more than $2,000 per year can be put in a child's ESA(s) under current law.
• The beneficiary must be under age 18 in the year of contribution (unless he or she is a special needs child).
• The money must be used (or transferred to another beneficiary) before the child turns 30.
• You can change the beneficiary to another family member once per year.
• The contributor's 2012 adjusted gross income can be no more than $110,000 for single filers or $220,000 for joint filers.
• You have until April 15 of the following year to contribute for the previous year.

Effect on financial aid

The US Department of Education has indicated that ESAs should be treated as an asset of the parents. That means ESAs should only have a minimal impact on financial aid, as is the case with 529 plans.

Saving and investing for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid.

For more about financial aid, check out FinAid.org or the College Board.

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

Many investors use exchange-traded funds (ETFs) to get well-diversified, low-cost access to broad indexes of stocks or bonds, in order to fill gaps in their portfolios or take advantage of shorter-term market opportunities. ETFs can also be useful to investors seeking a stream of income.

Given the low yields on so many investments at the moment, income-focused investors may want to consider every tool at their disposal to generate cash flow, and ETFs are a dynamic tool.

Fixed-income ETFs

When most investors think about income investments, they think about bonds (the primary example of a fixed-income instrument). Most bonds have a coupon, which means that they will distribute interest payments to their holders on a regular basis (often twice a year).

The downside of holding individual bonds, especially corporate bonds, is the risk of default—the company that issued the bond might not be able to pay it back.

One way to mitigate this risk is diversification—spreading your assets among a lot of different bond issuers. ETFs excel at diversification, because when you own an ETF you own a fractional share of a pool containing lots of different securities.

It's important to keep in mind that the value of a bond ETF will go up and down with the value of the underlying bonds in the portfolio, and it does not have a fixed maturity date like individual bonds do. As bonds in the portfolio mature, the ETF manager will reinvest the proceeds into other bonds. The exception is target maturity date bond ETFs, where the fund will close and liquidate on a set date (the year the underlying bonds all mature).

Most bond ETFs make monthly income distributions, though some pay out their income less frequently depending on how much they generate.

Below are various types of fixed-income ETFs you might consider for your income-focused portfolio.

• Treasury bond ETFs. Yields on Treasury bonds are near historic lows at the moment, making these ETFs less attractive for income-sensitive investors. However, the essentially nonexistent risk of default on Treasury bonds still makes them an important piece of a portfolio.
• Treasury Inflation-Protected Securities (TIPS) ETFs. TIPS pay low coupons, but their face values go up as inflation increases. The low coupons make them less attractive for most income-focused investors, but those concerned about inflation may still want to consider TIPS.
• Investment-grade corporate bond ETFs. These funds invest in bonds issued by companies with good credit ratings, which are seen as unlikely to default. Investment-grade corporates are somewhat riskier than Treasury bonds, but they generally pay higher interest.
• High-yield ("junk") bond ETFs. Investing in even riskier bonds than their investment-grade peers, high-yield ETFs tend to pay out more income (as the name suggests) with greater risk of default. The fact that so much of the return on junk bonds comes from their interest payments makes them a little less sensitive to price movements as interest rates in the economy change, giving them some protection against rising interest rates (which generally cause bond values—and the prices of bond ETFs—to fall).
• International bond ETFs. Most of the ETFs that invest in non-US bonds invest in government bonds from foreign countries. These are still riskier than US Treasury bonds, of course, though they offer the additional feature (and risk) of currency diversification. For investors who are concerned about potential weakness in the US dollar, or who simply want to diversify their currency exposure, international bonds may make sense.
• Municipal bond ETFs. If you are in a high tax bracket and you're investing in a taxable account, be sure to consider municipal bond ETFs. These funds produce income that is generally free from federal income tax and even, in some cases, free from state income tax. If you expect to be subject to the alternative minimum tax (AMT), take a look at funds that track AMT-free indexes. Note that the yields on municipal bonds tend to be lower than taxable bonds, but the tax benefits may make them more attractive on an after-tax basis.
• Preferred stock ETFs. Preferred stocks, as the name indicates, are actually equity securities, not bonds. However, these special stocks have fixed dividend payments attached to them, which puts them in the "fixed income" category. In certain circumstances these securities may move more like stocks than bonds, which puts them at greater risk of losing value. Also, preferred stocks don't provide the same guarantees of interest payments and payment at maturity as bonds. For most types of preferred stocks, management can defer payments of dividends at its discretion, if the company runs into a tough period. However, deferrals of payments don't happen often—partly because, if they did, they'd limit the appeal to investors, of course, but also because a company isn't permitted to pay dividends on common stock while deferring payments on any outstanding preferred securities. In other words, payments on preferred securities must come first; hence the name "preferred."  The fixed stream of income makes them worthy of consideration in a portfolio, especially when you can get a diversified basket of them, as you can with an ETF.

Real estate ETFs

Another area where many investors search for income is real estate, specifically in the form of real-estate investment trusts or REITs. These are pools of real-estate interests, often holding income-producing properties such as apartments, shopping centers, office buildings and hotels.

REITs pass along any income they receive to their shareholders, and ETFs that hold REITs pass that income along to their shareholders, in turn.

Just as a stock or bond ETF helps diversify investors' risk away from just one or two companies, a REIT ETF helps investors diversify away from having too much exposure to real estate of any one type or in any one region.

REIT ETFs are available that focus on both US real estate as well as global real estate. Yields on REIT ETFs generally make them quite attractive to income-focused investors.

Stock ETFs

Income doesn't stop with fixed income and real estate—it can also come from stock dividends. Not every stock pays a dividend of course, but many do.

Fortunately for income-focused investors, there are ETFs designed to track indexes of stocks that pay healthy dividends. Each index is constructed a little differently, but the general idea is to include stocks with a history of paying steady and, in many cases, increasing dividends over time.

Given the low yields on many bonds at the moment, dividend yields on stocks have begun to look attractive to many investors, and dividend stock ETFs offer good income potential. Keep in mind, though, that stocks are inherently more volatile than bonds and have more risk of falling in value (though they also offer more potential for appreciation).

There are two main types of dividend stock ETFs: US and international. Both can play a role in a well-diversified portfolio, but keep in mind that international ETFs will give you exposure to non-dollar currencies.

Master Limited Partnership (MLP) ETFs: MLPs engage in businesses such as the management of pipelines for the transportation of oil and gas. These businesses often generate high levels of income, which can be of interest to income-seeking investors.

ETFs that own MLPs have elected to be taxed as corporations in order to avoid complicated tax situations for investors (including multiple K-1 statements). This is different from most ETFs, which simply pass the income they receive directly to their shareholders without paying any taxes at the ETF level.

The positive side of this arrangement for investors is that the taxation of these ETFs is comparatively straightforward, much like individual equities or stock ETFs; there are no K-1 statements to deal with. One negative side is that investors miss out on some tax benefits involving depreciation that may be available to direct MLP owners.

More importantly, all of the returns realized by the ETF will be net of federal corporate income taxes. For instance, if the ETF earns $5 per share in income but it pays a 35% tax rate on that income, it will only be able to distribute $3.25 per share to investors (even before the ETF manager’s fees are taken out). A typical stock ETF that earns $5 per share in income will pass all of it on to shareholders (after the ETF manager’s fees have been paid). This MLP ETF tax arrangement can be a significant drawback for investors, especially considering that these ETFs tend to have high expense ratios compared to most other ETFs.

Selecting an ETF

When looking for ETFs that provide income, take these factors into account.

• Yield. Obviously, you are searching for a fund that pays a good yield. That said, be cautious if the yield is exceptionally high relative to similar ETFs—the fund could be exposed to some non-obvious risks.
• Assets. Look for a fund with at least $20 million under management (smaller ETFs may eventually be closed by their managers). More is usually better.
• Trading volume. While not a perfect measure of liquidity, a higher trading volume—look for at least 50,000 shares per day—can give you some confidence that the fund won't be overly expensive to trade.
• Bid-ask spread. Check the difference between the prices at which market makers are willing to buy the ETF (the lower "bid" price) and to sell the ETF (the higher "ask" or "offer" price). This is essentially a cost to you for trading the ETF, and preferably, it should be no more than 0.25% of the ETF's price.
• Commissions. With most ETFs, you pay a commission to your broker every time you trade shares. However, some brokers offer certain ETFs commission-free. All else being equal, consider commission-free ETFs, especially if you're investing a small amount of money or only plan to hold the investment for a short time.

Taking action

David Suarez
Senior Research Analyst, Schwab Center for Financial Research, Charles Schwab & Co., Inc.

If you are interested in income-focused ETFs, you may want to consider the following funds, all of which seek to provide some level of income. These funds were evaluated by Charles Schwab Investment Advisory based on total cost of ownership, how closely they track their indexes, the relationship between market price and net asset value, and more. Of course, you should carefully review each fund's prospectus to evaluate whether any of these funds or other income-focused ETFs are right for your portfolio and investment profile.

ETFs for Income: Funds to Consider

Type of ETF	Ticker	Name	Morningstar category	12-month yield	Expense ratio
Treasury bond	SCHR	Schwab Intermediate-Term U.S. Treasury ETF	Intermediate Government	1.03%	0.10%
TIPS	SCHP	Schwab U.S. TIPS ETF	Inflation-Protected Bond	1.60%	0.07%
Corporate bond	VCIT	Vanguard Intermediate-Term Corporate Bond Index	Intermediate-Term Bond	3.25%	0.12%
High-yield bond	PHB	PowerShares Fundamental High Yield Corporate Bond	High-Yield Bond	4.97%	0.50%
International bond	BWX	SPDR Barclays Capital International Treasury Bond ETF	World Bond	2.11%	0.50%
Municipal bond	MUB	iShares S&P National AMT-Free Muni Bond	Muni National Long	2.83%	0.25%
Preferred stock	PGX	PowerShares Preferred	Long Term Bond	6.39%	0.50%
US REIT	SCHH	Schwab US REIT ETF	Real Estate	2.40%	0.07%
Global REIT	VNQI	Vanguard Global ex-US Real Estate ETF	Global Real Estate	5.52%	0.35%
US dividend	SCHD	Schwab US Dividend Equity ETF	Large Blend	2.65%	0.07%
International dividends	DWX	SPDR S&P International Dividend ETF	Foreign Large Value	6.19%	0.45%
MLPs	YMLP	Yorkville High Income MLP ETF	Equity Energy	NA	0.82%

Source: Morningstar as of February 28, 2013.

Bond ETFs:

1. Use the predefined Fixed Income ETFs screen.

2. On the resulting page, you can use the Morningstar Category link to refine your choices—for example, if you're looking for one of the specific types of fixed-income ETFs mentioned above, make sure the appropriate category is checked and uncheck any other categories, then click Save.

3. Click View Matches.

REIT ETFs:

1. In the Choose Criteria pane, click Basic Criteria.

2. Check Morningstar Category.

3. In the Currently Selected Criteria pane, click the Morningstar Category link and check Real Estate.

4. Click Save and View Matches.

Dividend stock ETFs:

1. In the Choose Criteria pane, click Basic Criteria.

2. Check Fund Category.

3. In the Currently Selected Criteria pane, click the Fund Category link and check Diversified Domestic, then click Save.

4. Back in the Choose Criteria pane, under Basic Criteria check Distribution Yield.

5. In the Currently Selected Criteria pane, click the four buttons for yields of 2% and over.

6. Click View Matches.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Custodial accounts—sometimes called UGMA or UTMA accounts after the Uniform Gifts to Minors Act and Uniform Transfers to Minors Act that created them—are set up for your child and managed by you. When your child reaches a certain age, usually 18 or 21 depending on the state of residence, the money becomes his or hers.

Custodial accounts used to be the only tax-advantaged way to save for college. But lately they've been eclipsed by the tax-free benefits of 529 plans and Education Savings Accounts.

Still, custodial accounts have their place when you want to invest money for your child's college education. If you want to set aside money for college expenses that aren't covered by an ESA or 529 plan—sorority dues or private voice lessons, for example—a custodial account may be just the thing.

Keep in mind that a custodial account is essentially an irrevocable gift to your child. Let's say you're managing a custodial account for your daughter. You may both agree that the money should be used for college, but when she turns 18, 21 or 25 (depending on the state where she lives), she can use the money for anything she wants—college, a new car or a European vacation, for instance.

How to open and contribute to a custodial account

You can open a custodial account at virtually any brokerage or financial institution. The minimum to open a custodial account typically ranges from $500 to $2,000.

Anyone (parents, grandparents, other relatives and friends) can make unlimited contributions to a custodial account once it's open. However, a person can't contribute more than $14,000 per year ($28,000 for a married couple) without triggering the gift tax.

Kiddie tax

Custodial accounts can't match the tax-free benefits of 529 plans or ESAs. Furthermore, the so-called "kiddie tax" rules apply to unearned income (i.e., investment income) which means the child will pay tax at the parents' rate on investment income over a certain threshold:

Tax Benefits of Custodial Accounts

*Full-time college students under the age of 24 are also taxed at their parents' rate on unearned income in excess of $2,000, unless the students' earned income is greater than one-half of their support.

Effect on financial aid

Custodial accounts can have a heavy impact on financial aid. Because the money in a custodial account is your child's asset and not yours, financial aid formulas consider 20% of the money to be available to pay for college.

Saving and investing for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid.

For more about financial aid, check out FinAid.org or the College Board.

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

As the number of ETFs (exchange-traded funds) continues to grow, the choices can be overwhelming. In certain widely used categories, such as US large-cap equity, you can find ETFs tracking indexes from many different providers.

In many respects, traditional index providers are trying to do the same thing: Provide lists of stocks that do a good job of representing a particular market or slice of a market. The general approach tends to be the same, but the details differ.

So what are the differences between the indexes behind these ETFs, and how can you pick one that works for you? We're here to help you understand!

How is the index weighted?

Most ETF investors start with "traditional" stock indexes, which weigh companies according to their market capitalization. This means that the companies with the highest total stock market value (share price times the number of shares outstanding) get the most weight in the index—hence the name "cap-weighted" indexes.

Other weighting systems exist, including equal weighting, fundamental weighting, and low-volatility weighting, but even focusing on just the traditional cap-weighted indexes leaves you with a lot of choices.

Who are the index providers?

Some of the biggest providers of cap-weighted stock indexes are Standard and Poor's (S&P) Corporation, Russell Investments, MSCI, Inc, Dow Jones (now part of the same company as S&P) and FTSE Group. Smaller players include Morningstar Inc., CRSP (the Center for Research in Security Prices) and providers of alternative weighted indexes such as RAFI (Research Affiliates, LLC) and WisdomTree Investments, Inc.

Barclays Capital is the biggest name in bond indexing, with other bond indexers having very little market share at all. Similar to stock indexes, most bond indexes are weighted by market capitalization. In the case of bonds, though, this means that the most-indebted issuers tend to have the most weight in the index, since they have borrowed the most money and therefore have the most bonds outstanding.

Which securities do they include for tracking?

Each index provider looks at a different universe of stocks and bonds, even within the same asset class. For example, for a US stock index, some providers might exclude companies that do business in the United States but are legally headquartered in the Cayman Islands for tax purposes, while other providers might include them. Some might build a broad market benchmark of 1,500 stocks, while others might include 4,000 or more. Providers might handle IPOs and spin-offs differently, or they might adjust differently for "closely held" shares (often referred to as "free float adjustment"). The exact threshold for how large or how liquid a company must be before being included in a broad index can also vary across index providers.

In practice, these differences don't tend to matter much when it comes to index performance. Even the major index providers agree (based on anecdotal evidence) that their broad-market indexes don't differ significantly.¹

Different ways to slice the market

Where providers do vary is in their definition of what type of security belongs in which category. The most salient examples are in their categorizations of market cap, country classification, sector and style. 

Market cap. Investors who look into indexing in detail are often surprised to learn that "large cap," "mid cap" and "small cap" have no formal definitions and vary from firm to firm. The general approach is to rank stocks by market capitalization (the total value of outstanding shares) and then to set cut-off ranks for the different size indexes. Some providers have non-overlapping indexes, while others carve the mid-cap index out of the lower end of the large-cap index and/or the higher end of the small-cap index.

Different Approaches to Capitalization

Sources: S&P U.S. Indices Methdology, March 2012; Russell U.S. Equity Indexes Construction and Methodology, August 2012; Guide to the Dow Jones U.S. Total Stock Market Index Family, undated (retrieved January 2013).

Country classification. Which countries are developed, emerging or frontier markets? Any classification system will involve borderline cases, and a country's level of development can change over time. A prominent example is South Korea. MSCI, a widely-followed provider of international stock indexes, currently classifies South Korea as an emerging market. FTSE, a provider growing in acceptance in recent years, classifies it as a developed market. Thus, when a major fund company recently moved the underlying benchmark index for its international index funds from MSCI indexes to FTSE indexes, South Korea's standing in the emerging market fund morphed from number one to nonexistent. This can create turnover in index funds and cause meaningful differences in performance if South Korea performs much better or much worse than other emerging-market economies.

Sectors and styles. Stock indexes are often broken up into smaller indexes that track styles such as growth, value and blend (or core), or economic sectors like technology, consumer staples and health care. To determine style, index providers typically focus on characteristics such as a company's price-to-earnings ratio (P/E) and earnings growth rate. Some classify companies as growth only or value only, while others count borderline companies partially in the growth index and partially in value. Some providers have "pure growth" and "pure value" versions of their indexes, which exclude borderline companies entirely.

For sectors, the broad strokes tend to be similar, with stocks classified into one of about ten sectors. Some providers, however, refer to "consumer staples and consumer discretionary" while others have "consumer cyclical and consumer non-cyclical," and the treatment of telecommunications relative to technology also varies. Unless you're investing in specific sector indexes, these differences don't usually matter much since the broader indexes will simply include all of the sectors.

Performance impact

When it comes to US total market indexes, the biggest providers (S&P, Russell and Dow Jones) have all been very similar over the past 17 years, finishing within $800 of one another over that long time frame assuming an initial investment of $10,000.

Source: Morningstar Direct as of December 31, 2012.

Large-cap stock indexes have seen a little more variation in returns, with the Dow Jones index lagging slightly over the whole period. The Dow Jones index performed a bit better during market downturns, while S&P and Russell gained a bit during extended market rallies.

Source: Morningstar Direct as of December 31, 2012.

For small-cap stock indexes, the Russell 2000® index has lagged steadily behind the other indexes over this time period. It's worth noting that the Russell index includes more stocks than the other two, including "micro-cap" stocks that the other indexes exclude. Thus, the Russell 2000 can be seen as the most broadly diversified, though this has not translated to stronger performance in recent decades.

Source: Morningstar Direct as of December 31, 2012.

What if your ETF's index changes?

It is worth taking the time to compare the new index to the old index. For broad equity indexes, the differences may be negligible but in other cases, your portfolio make-up may change; for example, if an emerging-market index adds or removes a major country. In such cases, you'll want to make sure that the new index still fits with your portfolio and that the costs of changing indexes are acceptable to you (increased turnover could lead to higher transaction costs and potentially capital gains distributions). If the new index still fits your needs, you can stick with it.

Zero in on costs

Because the actual differences in cap-weighted indexes tend to be fairly small, investors should focus on the cost of investment. Generally, investors will be accessing indexes through index mutual funds and ETFs, whose costs can vary. Focus on controlling what you can control: the cost of your investments.

1. Index provider panel at 2013 Inside ETFs conference.

March 27, 2013

by the Schwab Center for Financial Research

1. We've avoided a government shutdown.

On March 21, Congress approved a "continuing resolution" that funds federal government operations through September 30. The relatively controversy-free agreement keeps government funding at current levels, and gives the Pentagon some additional flexibility in managing the cuts imposed by the sequester. With this issue resolved, Congress can move its focus to other priorities—at least for a few months.

2. The debt ceiling is the next big fight.

In late January, Congress passed a bill that suspended the debt ceiling until May 19. At that point, the debt ceiling will be reset at $16.4 trillion, plus whatever debt we've incurred between late January and that date—estimated to be about $400–450 billion. The Treasury can then begin employing extraordinary measures and buy six or eight more weeks of time, so the real deadline is likely to be sometime in mid-July. We predict this will be a very contentious fight in Washington.

3. Dueling budget blueprints shows the distance between the parties.

Both the Republican-controlled House and the Democrat-controlled Senate recently approved their own budget blueprints. The vast gulf between them shows just how difficult it's going to be to reach consensus on a long-term deficit-reduction plan. The House-passed plan achieves a balanced budget within 10 years by cutting federal spending by more than $4 trillion in the next decade, lowering tax rates and reducing some entitlements. The Senate-passed plan has an equal balance of $975 billion in spending cuts and $975 billion in tax increases. But with Republicans seemingly intractable in their position of no more tax increases and Democrats set in their insistence not to cut entitlements, it’s hard to see how consensus is going to emerge.

4. We'll probably start to feel the effects of sequestration soon.

Across-the-board spending cuts of about $85 billion went into effect March 1, but agencies in Washington needed a few weeks to assess and begin to implement the cuts. We think they'll become more noticeable by April.

5. Some defense funding will likely be restored.

The implementation of the spending cuts might seem like a signal to lighten up on the defense-industry portion of your portfolio, but we caution against making hasty decisions, either to sell or to add to defense positions at this point. Given the defense industry's position in the economy, its role as a major civilian employer and funder of scientific research, and its strategic importance for national security, it seems likely to us that at least some of the funding it lost in the sequester will be restored eventually.

6. Cuts could affect the health care industry.

The mandated cuts to non-defense spending aren’t as specific in terms of industries, but it appears to us that health care could be hit. Medicare spending is scheduled to be reduced by 2%, which would affect providers and insurers.

7. Austerity could have a positive long-term impact.

The Congressional Budget Office projects the sequester will create a drag of 0.6% on this year’s gross domestic product—maybe not enough to take the economy into a recession, but a negative nonetheless. On the plus side, the cuts do reduce the deficit and debt, and the ratings agencies have said they view spending cuts—no matter how they're implemented—as a positive credit indicator. Additionally, as uncertainty around government policy and spending decreases, we may see increased business confidence, capital spending and investment.

Rob Williams
Director of Income Planning, Schwab Center for Financial Research

After all your hard work saving for retirement, you'll need to manage market risk and generate income that lasts. Annuities are one tool that can help—particularly if you're seeking a stream of income that you know will be around as long as you are.

There are two types of annuities we believe may be worth considering to generate income: immediate fixed annuities and variable annuities. Many variable annuities offer an optional rider (often called guaranteed lifetime withdrawal benefits, or GLWBs) that can provide additional protection for your income.

Immediate fixed annuities provide pension-like income, while variable annuities provide a guaranteed stream of lifetime income at retirement, either through "annuitization" or the purchase of an optional GLWB rider.

Under the standard annuitization option, an investor's retirement income is based on the performance of the underlying investment options he/she selected. Adding a GLWB rider locks-in a minimum level of income that can rise with the performance of the investment options but can never fall.

Annuities add protections to your retirement

First off, why consider an annuity? One reason beats all the others, in our view: Unlike a portfolio of stocks and bonds, annuities combine characteristics of standard investments with insurance features. Most life annuities provide a reliable stream of income that you can't outlive, and some can help you reduce or transfer the risk of investing in the market for part of your portfolio to an insurer.

Annuities are also a way to systematically turn savings into income. This may seem complicated, but it's one of the most important steps to consider when managing your retirement portfolio—how, exactly, will you create regular withdrawals from your portfolio that will last?

Immediate fixed annuities provide pension-like income for life

Immediate fixed annuities are the oldest, most common type of annuity: you pay an insurance company a lump sum up front, and in return, you receive a fixed monthly payment for life (or some other specific time period)—a reliable stream of income you can't outlive.

Immediate fixed life annuities may make sense, in our view, if you're seeking income now and don't want to worry about market fluctuations—at least for a portion of your savings. The insurance company manages those details and makes sure you receive a fixed payment that lasts for life. As long as the insurance company is solvent, you'll receive a payment for the same amount every month.

If you live longer than average, you'll benefit from owning an immediate fixed life annuity. The rate of return depends on your initial investment and how long you live. Annuity experts call this a "mortality credit." If you live longer than other investors, you'll benefit. In fact, it may be most useful to think about an immediate fixed annuity not purely as compared to other investments, but more for its insurance features.

What about the current low-interest-rate environment—can that impact payments from an annuity? It may not make the most sense to load up on immediate fixed annuities when interest rates are low, as the payments depend, to a degree, on the market. But if you need guaranteed income, it probably won't pay to wait too long either. One strategy is to stagger your purchase of immediate fixed annuities over time, much like a bond ladder but using annuities, as your guaranteed income needs grow.

It's worth noting that monthly payments from immediate fixed life annuities are generally higher the older you are at the time of purchase. The insurer anticipates that it will be making payments for a shorter period of time, so it can pay a higher proportion of the lump sum on a monthly basis. This feature isn't shared by variable annuities with GLWBs.

Variable annuities with GLWBs: income protection, flexibility and growth
potential

In contrast to immediate fixed annuities, variable annuities with an optional GLWB rider don't require that you to turn cash over irrevocably to an insurance company. Rather, the investor retains control of the money and makes withdrawals from a portfolio of investments that is held within the variable annuity.

When purchased with a GLWB feature. (at an additional cost), the rider may protect against market downturns by guaranteeing your ability to take withdrawals for life at a certain minimum level, no matter how the market performs, without annuitizing the contract. In other words, you can stay invested in the market and benefit from flexibility and potential for growth.

You should be aware, however, that the GLWB is not a contract value and is not available for withdrawal like a cash value. Your actual contract value will deplete with each withdrawal, though you'll continue to take income for life even if withdrawals and market losses deplete your annuity's value to zero. There's also an annual cost associated with the additional rider.

This type of annuity can be more complex than immediate fixed annuities, so it's important to examine the details and talk with a professional to make sure you understand them thoroughly. But at the most basic level, purchasing a GLWB rider with a variable annuity adds an additional layer of protections to a portfolio of investments held within a variable annuity to generate retirement income. If markets don't perform well, you have protections, and if they perform better than expected, you have some potential for growth (after accounting for fees and withdrawals).

One tradeoff compared to immediate fixed annuities is that variable annuities with GLWBs generally promise a lower guaranteed payment initially once withdrawals begin. A "typical" guaranteed annual withdrawal rate from a variable annuity with GLWB may be 5% of an "income base" generally based on the highest contract anniversary value the contract achieved since purchase of the GLWB rider. An immediate fixed life annuity will generally quote a monthly or annual payment. But the amount of the withdrawal, if calculated as a percentage of the lump sum invested, will generally be higher.

Another consideration is cost. GLWB riders are purchased at an additional cost, generally starting at around 0.8% per year and rising. This is the cost of adding more protections to the flexibility and growth potential. Besides the cost of the rider, variable annuities are subject to a number of charges. These charges will reduce the value of your account and return on your investments.

How to choose an annuity for you

Both types of annuities—immediate fixed and variable with GLWBs—provide guaranteed income in retirement, but neither type will be right for every investor. Do you value a higher guaranteed lifetime income in a simple package, or do you value flexibility and growth potential? Are you still preparing for retirement and looking to protect part of your savings, or are you already well into retirement and looking for income now?

The table below shows factors to consider when choosing which type might make sense for you compared to, or (more typically) as a complement to a traditional portfolio.

Factors to Take Into Account When Considering Annuities

Note: * All guarantees are subject to the claims-paying ability of the insurer.

It's possible to choose a combination of all three, depending on your needs. Each approach has pluses and minuses that can work in isolation or together. Immediate fixed annuities provide higher guaranteed income for the cost, while variable annuities with GLWBs help flexibly protect retirement income from market risk. And of course a traditional portfolio provides the most flexibility at the lowest cost of the three approaches, but doesn't include lifetime income protection.

How much should you invest?

As a general rule of thumb, we don't believe you should commit more than 50% of your investable assets to either type of annuity. Most investors will want some assets available for liquidity as well as full growth potential without additional fees.

If you value lifetime income, you may wish to consider predictable income sources such as lifetime income from annuities, to cover essential expenditures in retirement—then invest the rest for liquidity and growth. For more insights on how to build your retirement income, see Schwab's Retirement Income Fundamentals.

Next steps

If you need help learning about annuities, you're not alone. The details can be complex, so it'll help to talk to an unbiased professional who can weigh the pros and cons.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

The rules surrounding conversions of traditional IRA money to a Roth IRA changed in 2010. Before that time, only individuals with modified adjusted gross incomes (MAGIs) of $100,000 or less could convert. The 2010 change eliminated that cap, making more investors eligible to convert their traditional IRAs to Roth IRAs (state rules may vary). On top of that, new rules in effect for 2013 also expand eligibility to convert from a traditional 401(k) to a Roth 401(k) if your employer offers both.

But just because you can convert to a Roth doesn't necessarily mean you should. As a general rule, tax planners advise against paying a tax today that you can defer until later. Of course, there are always exceptions to any general rule, and converting to a Roth IRA may well be one of them.

Before looking at the pros and cons of conversion based on your unique situation, here’s a brief recap of the basics:

Traditional IRA vs. Roth IRA

• Traditional IRA: Money put into a traditional IRA is generally tax-deductible, with some limitations. If you're an active participant in a qualified employer plan like a 401(k), those limitations—called "phase-outs" because the amount you can deduct from your taxes phases out as your income climbs from the bottom to the top of an IRS-set range—are more restrictive than if you're not covered by an employer plan.
  
  Phase-outs for traditional IRA deductibility: Modified adjusted gross income
  

  	Single	Married*	Married with nonparticipant spouse**
  2012	$58,000-68,000	$92,000-112,000	$173,000-183,000
  2013	$59,000-69,000	$95,000-115,000	$178,000-188,000

  
  

  * Assumes joint filing, with both spouses participating in employer-provided plans.
  ** Assumes joint filing, with only one spouse participating in a qualified retirement plan. Limit applies to nonparticipant spouse.

  Even though traditional IRA distributions are taxed at ordinary income tax rates, it can still make sense to contribute if you are eligible to receive an up-front deduction. However, because long-term capital gains and qualified dividend tax rates are currently lower than ordinary income tax rates, a nondeductible contribution to a traditional IRA rarely makes sense. There's no up-front deduction, and earnings are eventually taxed at higher ordinary income rates when withdrawn. If you're not eligible to deduct your traditional IRA contribution and you're not eligible to contribute to a Roth IRA, then it’s usually better to invest tax-efficiently in a regular brokerage account so you can take advantage of lower long-term capital gains rates.

• Roth IRA: With a Roth, contributions are not tax-deductible, but earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years. And you don't need to take required minimum distributions (RMDs) starting at age 70½, as you do with a traditional IRA.
  
  Phase-outs for Roth IRA eligibility: Modified adjusted gross income

  	Single	Married filing jointly
  2012	$110,000-125,000	$173,000-183,000
  2013	$112,000-127,000	$178,000-188,000

• The maximum individual contribution for 2012 to a traditional IRA or Roth IRA, whether single or filing jointly, is $5,000 (you can make your prior year contribution up to April 15^th of the following year). For 2013, the basic contribution limit is $5,500. If you're 50 or older, you can make an additional $1,000 "catch-up" contribution for either year. You can choose either type of account or contribute to both, but your total contribution cannot exceed the maximum of $5,000 for 2012 or $5,500 for 2013 ($6,000 or $6,500 respectively if you're 50 or older).

So, if you qualify for a deductible traditional IRA and a Roth IRA, which one makes the most sense? While facts and circumstances may vary, here are some generally applicable rules of thumb to help you choose wisely:

• If you have many years to go before you'll need to withdraw the money in retirement and you think your income tax bracket will be the same or higher when you retire than it is today, then a Roth IRA probably makes sense. For example, a Roth can be especially attractive for younger workers who are far from their peak earning years.
• If you think your income tax bracket will be lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. See income tax brackets here.

Roth IRA conversion

If you’re not eligible to contribute to a Roth IRA and your employer’s plan doesn’t allow you to make Roth-designated contributions to your 401(k) plan, then another way to take advantage of a Roth IRA's potential benefits is to convert some or all of your traditional IRA money to a Roth.

Even though you have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:

• You think you will be in the same or a higher tax bracket when you withdraw,
• You have a long time horizon, and
• You can pay the tax from sources other than your IRA, such as regular taxable brokerage or bank accounts. (See the additional notes about paying the conversion tax below.) 
  OR
• You don’t need to use the money and want to leave an income-tax-free Roth IRA to your heirs for gift and estate-planning purposes.

A few important notes about paying the conversion tax:

• If you pay the tax from your IRA, you lose the potential benefit of tax-free growth on that amount, defeating the purpose. Of course, if you’re under 59½, withdrawing money to pay the tax would be an even worse idea, since you would also incur a 10% federal penalty. (State penalties may also apply.)
• Ideally, you will have cash on hand to pay the income tax. If you need to sell appreciated assets to pay the conversion tax, the additional capital gains tax would work against the case for a Roth conversion.
• Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the "opportunity cost" of what that money could have earned had it remained invested in a taxable account. (See hypothetical example below.)

A hypothetical example

Here, we estimate the dollar advantage or disadvantage of converting $1,000 from a traditional IRA to a Roth IRA. We assume a current income tax rate of 25% and a 6% average annual return. As you can see from the table below, a future retirement tax rate equal to or higher than the current tax rate favors the Roth conversion, while a lower future tax rate favors leaving the money in a traditional IRA. Of course, given these assumptions, the longer the time horizon the greater the advantage (or disadvantage).

Advantage or Disadvantage per $1,000 of Conversion (Current tax rate=25%, average annual rate of return=6%1)
Future tax rate	Time horizon (years)
	5	10	15	20
35%	$149	$216	$308	$435
25%	$15	$37	$69	$115
15%	($118)	($142)	($171)	($206)

Note that a Roth conversion has a slight advantage even if the future tax bracket remains the same. That’s because we assume current taxes will be paid from taxable accounts and the full conversion amount will go into the Roth. If taxes were paid from the IRA at the time of conversion, then there would be no advantage or disadvantage no matter how long the time horizon, assuming the future tax rate is the same. For example, consider the following scenario:

Traditional IRA balance = $1,000

Current federal income tax rate = 25%

Future federal income tax rate = 25%

If you pay the conversion tax using IRA funds, you are left investing $750 in your Roth. (You'll have even less to invest if you're younger than 59½ at the time of conversion and use IRA funds to pay the tax, since you'll also incur a 10% federal penalty, and a state penalty and taxes might also apply.) Assuming an initial investment of $750 and an average annual return of 6%, after 20 years you'll have $2,405 in your Roth.

If you left your traditional IRA alone and earned the same return, you would have $3,207 after 20 years. Assuming the same tax rate of 25%, you would end up with exactly the same amount after withdrawing the money and paying $802 in federal income taxes: $2,405.

Keep in mind that the higher your Roth balance, the greater the potential advantage. That's why it's important to pay the conversion tax from outside funds, if possible. Of course, you still need to account for the "opportunity cost" of taxes paid with outside funds, since that money could have been invested all along if you'd simply left your traditional IRA alone.

However, as you factor in the hypothetical opportunity cost in your analysis, remember that the ongoing return lost to taxes each year and long-term capital gains tax at liquidation of this hypothetical account are likely less than the ordinary tax rate you would incur on a future withdrawal from a traditional IRA. That's why there will be a slight advantage with the Roth conversion even if the future tax bracket remains the same.

Who most stands to gain now that Roth conversion eligibility has expanded?

The primary reason for expanding Roth conversion eligibility in 2010 and 2013 was to accelerate the collection of income taxes that might have otherwise been locked up in traditional IRAs or 401(k)s for decades to come. That doesn't mean it still can't be a good deal for certain taxpayers under the right set of facts and circumstances. But, who is most likely to gain from Congress' "generosity" (besides the U.S. Treasury)? Those who are in the lower tax brackets now (i.e., younger workers yet to reach peak earning years) could benefit from a Roth conversion.

Taxpayers in the top brackets might find the projections less compelling because of a lower probability they will be in the same or a higher bracket after retirement. Nevertheless, if you’re in the highest brackets and expect to stay that way throughout retirement, it could still make sense—especially if you’re convinced that tax rates will continue to rise no matter how much you make.

Income taxes aside, very high-net-worth individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime. Though the value of a Roth will still be included in the gross estate, because there are no RMDs, the account could grow larger than it otherwise might under traditional IRA distribution rules—leaving more for heirs to withdraw income-tax-free over their lifetimes.

What's more, the income tax paid at the time of conversion (preferably from assets other than the IRA) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift.

Other considerations

Here are a few more caveats to consider:

• Traditional IRA aggregation rule: If you have made nondeductible contributions to your traditional IRA in the past (hopefully, tracked all along on IRS Form 8606), you can't pick and choose which portion of the traditional IRA money you want to convert to a Roth. The IRS looks at all traditional IRAs as one when it comes to distributions, including Roth conversions. Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money. For more on the aggregation rule, see IRS Publication 590.
• Converting nondeductible IRA contributions to a Roth: Since the 2010 rule change, high earners otherwise not eligible to make Roth contributions can make nondeductible contributions to a traditional IRA and then convert those amounts to a Roth. This process could be repeated every year. Don't be surprised, though, if Congress changes the law at some point to eliminate this option.
• Recharacterization: You can recharacterize a contribution or conversion any time up to the income-tax-filing deadline, plus extension, for the tax year of the conversion. For example, if you converted in the 2012 tax year, you can recharacterize as late as October 15, 2013 (though you'd need to file an amended federal and state income tax return if you didn’t request an extension and previously filed your return by the normal April 15 due date). If you recharacterize a Roth conversion, you can’t reconvert back to a Roth until the calendar year following your original conversion (e.g., 2013 or later if you converted in 2012), and you must wait until the 31^st day after the recharacterization (no reconversion is allowed within 30 days of the recharacterization). NOTE: Under current law, there is no recharacterization provision for traditional 401(k) conversions to a Roth 401(k).

The bottom line

Eligibility for a Roth conversion doesn't automatically make it a good idea. That said, under the right circumstances, converting to a Roth IRA can have significant benefits. Conversion for estate-planning purposes may also add value.

Each situation needs to be evaluated on a case-by-case basis. Take a close look at your own situation and, if it makes sense, consider taking advantage of these rule changes. Remember that tax laws are subject to change, so stay current at www.irs.gov. Also, be sure to talk with your accountant or other professional tax advisor about whether converting to a Roth makes sense for you.

Finally, we realize that the decision to convert is complex. If you have additional questions about Roth IRA conversion, call a Schwab investment professional at 800-424-5750 to talk about your particular situation.

1. Table shows the difference between the projected future values of the Roth minus traditional IRA. Note that we subtract an opportunity cost from the Roth projection, assuming the conversion tax paid from taxable accounts would have been invested the same but would lose some return to ongoing taxation, as well as a 15% long-term capital gain tax on the adjusted cost basis at liquidation.

Brian L. Burda
CFA, Vice President, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research

Enron-style accounting scandals have a habit of occurring over and over, and when several of them occur in a short period of time, investors become understandably concerned with the quality of corporate earnings. After all, fortunes can be lost when a company is found to have manipulated its financial results and its stock plunges. And when the economy slows, some companies may be tempted to stretch a little—or a lot—in order to meet their earnings targets.

But what is earnings quality? Some would say that it's like truth or goodness—impossible to define, but they know it when they see it. We believe Schwab Equity Ratings® takes a more disciplined approach. For the purpose of stock selection, we define quality as the odds that a company's reported earnings will (1) not be restated downward at some point, (2) persist going forward and (3) increase in the future.

Who should be concerned about earnings quality? Value investors typically rely on measures that emphasize cheapness regarding a company's historical and prospective earnings or other metrics. Growth investors generally prefer measures that emphasize the magnitude of a company's past and future earnings changes. As a result, all investors, regardless of style, have an interest in seeking stocks with higher earnings quality.

Cash is king

What should earnings quality-conscious investors be looking for, and where would they find it? A company's earnings are made up of income on a "cash" basis, where sales are received and costs are paid immediately, and so-called "accruals" (sales for which cash payment will be received in the future and costs will be paid in cash in the future). Corporations use accruals to shift the recognition of cash flows over time in order to make earnings a better measure of company performance.

The problem for investors is that accruals are based on accounting assumptions, judgments, and estimates, all of which may contain errors that require correction—restatements or revisions—in the future. Not only are accruals less reliable than cash, they can be more easily manipulated—think Tyco International, Worldcom, or Parmalat¹.

Our analysis finds that companies with a high percentage of earnings on a cash basis, as opposed to an accrual basis, tend to have higher earnings quality. So do companies that demonstrate an ability to "do more with less," that is, to make more efficient use of working capital such as inventories and receivables. Schwab Equity Ratings refer to these factors as "Cash Flow Strength" and "Efficient Management of Working Capital."

There are many stocks which Wall Street analysts consider "Buys," but which Schwab Equity Ratings rates C ("Hold") or lower. Why the difference? One possible reason might be that Schwab Equity Ratings look beyond the size and pace of a company's earnings growth to identify quality earnings: Net income may be rising as a result of accruals, rather than cash earnings, and receivables turnover may be slower than that of other firms due to the extension of credit to less creditworthy customers.

An assessment of earnings quality is critical in stock selection, but it is even more effective when used in combination with other types of information that have historically been shown to add value. Among them: improving earnings and price momentum, lower volatility and relative cheapness. Schwab Equity Ratings were founded on this "whole is greater than the simple sum of the parts" approach.

Looking for ideas?

To find your own set of candidate stocks from different sectors with a Schwab Equity Rating of A or B and quality earnings, use the "Stock Screener" on schwab.com. After logging in to your account, start at the "Research" tab, then go to the "Stocks" tab and the "Screeners" sub-tab. In the "Screen for Stocks" section's left-hand column, click on "Analyst Ratings." Then select "Schwab Equity Rating" and click on "A" and "B" from the list of Schwab Equity Rating letter grades.

You can also choose a Market Cap category and Sector from the "Basic Criteria" section if desired. At the bottom of the screener settings, click on "View Matches" to see the stocks that met your criteria. Clicking on a stock's ticker symbol opens the "Stock Summary" page for that stock, and on the "Ratings" tab, under "Schwab's Viewpoint" you'll see the rationale for the company's Rating. Look for stocks with quality earnings—they'll have "positive" ratings for "Efficient Management of Working Capital" and "Cash Flow Strength."

1. The CEO and CFO of Tyco were found guilty of theft from the company, although they claimed that the amounts involved were compensation payments authorized by the company's Board of Directors. A small group of Worldcom financial executives were found to have engaged in accounting practices designed to disguise decreases in the company's earnings. Parmalat was found to have falsified the amounts of the company's assets, debts, and operating losses.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

In addition to a number of routine annual inflation adjustments, Congress recently enacted some major changes to federal tax law. It's especially important to take advantage of every tax break you're entitled to. After all, it's not what you make but what you keep that counts. Here are several tips to consider.

Take advantage of federal income tax changes

To keep pace with inflation, the IRS has widened the federal income tax brackets and increased certain exemptions, deductions and credits1 (see table below). For additional information, please visit the IRS website.

2013 Federal Income Tax Brackets

Source: IRS.

Payroll and Medicare taxes

Payroll taxes for Social Security benefits are collected under the authority of the Federal Insurance Contributions Act (FICA). Many people simply refer to these taxes as FICA tax. The wage base limit for Social Security (Old-Age, Survivors, and Disability Insurance or OASDI) withholding was increased to $113,700. For 2011 and 2012, Congress temporarily lowered the Social Security withholding rate to 4.2%, but for 2013 the rate returned to the old 6.2% level. That means a maximum of $7,049.40 per employee will be withheld in 2013 ($113,700 × .062).

The wage base for Medicare withholding remains unlimited (employee tax rate of 1.45%), but health-care reform legislation increases Medicare payroll withholding by 0.9% to 2.35% in 2013 for amounts over $200,000 (single filers) or $250,000 (married filing jointly). Also, an additional 3.8% surtax applies to net investment income for taxpayers with AGI over $200,000 (single filers) or $250,000 (married filing jointly).

If you're married filing jointly and pay excess Medicare taxes, you'll be eligible for a credit when you file your tax return—you can't just ask your employer to stop withholding the extra tax during the year. For example, let's say you're the only earner in a married couple. You make $225,000 in the course of the year, and your employer automatically withholds the additional 0.9% tax on your wages between $200,000 and $225,000. You'll be eligible for a credit when you file, because your total income falls below the $250,000 threshold for married joint filers.

For more information on these and other changes, please see articles on retirement plan changes and other inflation adjustments at the IRS website, and Social Security cost-of-living adjustments at SSA.gov.

Long-term capital gains and qualified dividends

The old top rate of 15% applies to qualified dividends and the sale of most appreciated assets held over one year (28% for collectibles and 25% for depreciation recapture) for single filers with taxable income up to $400,000 ($450,000 for married filing joint). Long-term capital gains or qualified dividend income over that threshold are now taxed at a rate of 20%.

Phaseout of itemized deductions and exemptions

The previous phaseout of itemized deductions and exemptions has been reinstated in 2013 for single taxpayers with adjusted gross income (AGI) above $250,000 and married taxpayers filing jointly with AGI above $300,000. Many itemized deductions (such as mortgage interest expense, charitable contributions and state and local taxes) are reduced by 3 percent of the amount by which the AGI exceeds that $250,000/$300,000 threshold, with a maximum of 80% of itemized deductions. The personal exemption phase-out applies at a rate of 2% for each $2,500 increment over the threshold up to a maximum of 100% elimination of personal and dependent exemptions.

See if you're exempt from the Alternative Minimum Tax (AMT)

Retroactively for the 2012 tax year, Congress made the AMT "patch" permanent and raised the income exemption amounts to $78,750 for married couples filing jointly and $50,600 for single filers. The exemption amount will now be adjusted for inflation in future years.

Take advantage of lower tax rates for children

In 2013, children under 19 will pay no federal income tax on the first $1,000 of unearned income (such as capital gains or interest) and will be taxed at their own rate on the next $1,000. However, they will be taxed at their parents' tax rate on unearned income in excess of $2,000. (This will also be the case for full-time college students under age 24, unless their earned income is greater than one-half of their parents' support.)

Individuals age 19 and older (and dependent full-time college students age 24 and older) pay taxes at their own rate.

Boost your retirement savings and potentially enjoy tax benefits

As the table below shows, the federal government increased the maximum amounts you can contribute to certain retirement accounts.

2013 Federal Limits for Retirement Accounts

Source: IRS.

A few things to note about contribution limits:

• Traditional IRAs. Money you put in a traditional IRA is generally tax-deductible unless you're an active participant in a qualified workplace retirement plan, such as a 401(k) or 403(b). In that case, restrictions apply. If you're a single filer, your contribution is partially deductible if your modified adjusted gross income (MAGI) is between $59,000 and $69,000. If you're a married couple filing jointly, your 2013 contribution is partially deductible if your MAGI is $95,000 to $115,000. If you don't participate in a retirement plan at work (but your spouse does) and you file jointly, your contribution is partially deductible if your MAGI is $178,000 to $188,000².
• Roth IRAs. If you're a single filer and your MAGI is $112,000 or less, your contribution limit is $5,500 (or $6,500 if you're 50 or older) in 2013. The contribution limit is gradually reduced for those with MAGIs of $112,000 to $127,000. If you're a married couple filing jointly and your MAGI is $178,000 or less, your contribution limit is $5,500 ($6,500 if you're 50 or older). That contribution limit is gradually reduced for those with MAGIs of $178,000 to $188,000.
  
  • Anyone can convert a traditional IRA to a Roth IRA, regardless of income level or filing status. Converting all or part of a traditional IRA into a Roth IRA could be advantageous if you expect to be in the same or higher tax bracket when you eventually withdraw the money, have a reasonably long time horizon, and can afford to pay the conversion tax from a source other than your IRA at the time of conversion.
• Charitable deductions. Congress has also extended (through 2013 only) the option for traditional IRA owners age 70½ or older to make tax-free charitable contributions of up to $100,000 directly from their traditional IRAs.

Manage college expenses with these nifty tax benefits

Consider these tax-favored ways to pay for college costs:

• A Coverdell education savings account. If you're a single filer, you may make a maximum contribution of $2,000 per year per child, subject to income limitations. Be careful if accounts are established by different family members for the same child. Total contributions may not exceed $2,000 in any one year.
• A 529 college savings plan. Although there's no limit to how much you can contribute each year, each state's plan has its own lifetime limit—typically more than $200,000 per designated beneficiary³. You can also treat a 529 contribution as being made over five years for gift tax purposes. So a married couple could contribute up to $140,000 per child up front without using any of their lifetime gift tax credit (see below).
• Tax credits. The American Opportunity Credit is a modification of the Hope Credit and makes the credit available to a broader range of taxpayers. Through 2017, you may claim up to $2,500 on eligible college expenses paid from a non-529 account, subject to income limitations. 
• Tax deductions. You may be able to deduct up to $2,500 of student loan interest, subject to income limitations.

Plan your gifts and estate to make the most of these tax breaks

• The gift tax annual exclusion amount increases to $14,000 for 2013. That means you generally can give up to $14,000 annually (or $28,000 for spouses splitting gifts) to any number of people, and none of the gifts will be taxable. You can also give unlimited amounts toward tuition or medical expenses if you pay the provider directly. Beyond that, Congress has made permanent the $5 million lifetime gift and estate tax exemption, adjusted for inflation in future years—which should translate to a $5.25 million exemption for 2013. The top gift and estate tax rate has increased to 40% (see table below).

Estate and Gift Tax: 2013

*Adjusted for inflation

1. In some instances, modified adjusted gross income (MAGI) may be used to determine eligibility for certain deductions. MAGI calculations vary, so consult your tax professional.
2. Within certain AGI (or MAGI) phase-out ranges, you receive partial deductibility (or eligibility to contribute, in some cases) for certain tax breaks. At or below the low end of the range, you can receive full deductibility (or eligibility), but at or above the high end of the range, you lose deductibility (or eligibility).
3. As with any investment, it is possible to lose money by investing in a 529 plan. Before investing, carefully consider a plan's investment objectives, risks, charges and expenses. Additionally, if you are investing in a 529 plan outside the state in which you pay taxes, you should consider your own state's 529 plan to determine if you can obtain any tax or other benefits offered by your own state's plan.

by Carrie Schwab-Pomerantz,
CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.

Dear Reader,

Doing your taxes can seem like a huge chore, but for many people, it's really a simple process. The key is a little upfront organization. That way, whether you're using an online tax prep program or old-fashioned paper and pencil, you'll have the information you need handy and can plug in the numbers.

Even if your financial situation is more complex and you need the help of an accountant, being prepared can save you time and money.

Have identification numbers handy

While this may seem obvious, not having all the necessary Social Security or other Tax ID numbers handy can be the first frustration when sitting down to do your taxes. If you're single, no problem. But if you're married and have dependents, make sure you have all of their Social Security numbers in front of you before you get started. You'll also need their birthdays. 

Collect documents that show your earnings

There are different forms to designate different types of income. If you're an employee and your regular job is your only source of income, the only form you'll need is your W-2 from your employer. This will show what you've earned and the taxes you've already paid through withholding.

However, if you have other income, for example from interest, dividends, capital gains, freelance work, or Social Security, you should also receive 1099 forms that show how much you've earned. These forms are sent to the IRS by the issuing institution, so it's important that you report all of this income, no matter how small the amount.

Companies are required to mail these forms by the end of January each year. If you don't receive them sometime in February, make an effort to follow up.

Even if you don't receive an expected 1099, be sure to include the income on your tax return.

And if you received income that won't be reported on a W2 or 1099, such as self-employment income or alimony, you're not off the hook. You also need to include this income on your return. Best to have some sort of written documentation, whether it's a bank statement or your own records.

All this adds up to your gross income.

Gather documents that reduce your income

What you've earned is only one side of the equation. Equally important is documentation for what are called "adjustments to income." These include things like IRA contributions, contributions to health savings accounts, alimony paid, qualified student loan interest, higher education expenses, moving expenses if you moved for a new job and more.

Add up these adjustments and subtract them from your gross income to get your "adjusted gross income," or AGI.

Have appropriate records and receipts for itemized deductions

The next step is to decide whether to itemize or take the standard deduction. Itemized deductions include things like mortgage interest, medical and dental expenses that exceed 7.5 percent of AGI, state and local taxes, property taxes, charitable contributions, and casualty and theft losses. If the sum of these amounts is more than the standard deduction, that’s the way to go. Otherwise, simply take the standard deduction, which is $5,950 for singles, $11,900 for married filing jointly in 2012. If you decide to itemize, make sure you have records and receipts to prove your expenses in case of an audit.

Now subtract your personal exemptions ($3,800 for 2012) from your AGI to get your taxable income. You get one exemption for yourself, one for your spouse if married filing jointly, and one for each qualified dependent.

When you know your taxable income, you can start to calculate the taxes you may owe. Remember, taxes are progressive, meaning you pay a proportionately larger amount of taxes on higher levels of income. That results in significant pieces of information: your marginal rate, which is the amount you pay on your last dollar of income (important to know, for example, when you get a bonus or other extra income); and your average rate, which is the average amount you pay taking into consideration all of your income (important when you’re figuring out the tax impact of an investment, for example). So if your marginal rate is 25%, your average rate is probably lower. Knowing this may lessen the sting a bit.

Don't forget about credits

Finally, there are a number of tax credits available for things such as child and dependent care, qualified adoption expenses or an electric car. If you qualify, have those documents handy as well. You can subtract these credits from taxes you would otherwise owe. 

Create a filing system to make next year even easier

Once you have a handle on this year's taxes, set up some simple files to keep on top of earnings, deduction, and credits for the coming year. While doing taxes may never be your favorite pastime, with a little organization you can look forward to getting it done sooner rather than later. 

March 20, 2013

Kathy A. Jones
Vice President, Fixed Income Strategist, Schwab Center for Financial Research

No big surprises

There were no big surprises from the latest Federal Open Market Committee (FOMC) meeting. Current policies were kept intact, with the fed funds target remaining near zero and quantitative easing (QE) continuing at its current $85 billion-per-month pace until there's substantial improvement in the labor markets.

However, in his press conference, Federal Reserve Chairman Ben Bernanke indicated that the amount of purchasing could be adjusted over time, depending on financial conditions, leaving the door open to tapering down the pace of purchases in the months or years ahead. However, based on the Fed's updated economic projections, it appears the committee doesn't expect to see interest rates increase until 2015.

The updated projections for the economy showed a slight decline in upper end of gross domestic product (GDP) growth expectations for 2013 and 2014, reflecting the Fed's view that fiscal policy has become "somewhat more restrictive," apparently referring to federal spending cuts going into effect this year. Inflation expectations were also lowered slightly, and the statement noted that inflation (as measured by the PCE deflator) is currently running below the 2% level.

Economic Projections of Fed Board Members and Fed Bank Presidents 

Source: Federal Reserve Board, March 20, 2013. Projections of change in real GDP and projections for both measures of inflation are from the fourth quarter of the previous year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures (PCE) and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant's projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant's assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. December projections were made in conjunction with the meeting of the FOMC on December 11-12, 2012.

Long-term unemployment is key

Although the Fed updated its employment projections to reflect the recent drop in the unemployment rate to 7.7%, the 6.5% target level isn't expected to be reached until 2015 or beyond. Bernanke made it clear that the Fed is watching leading indicators of employment, such as weekly jobless claims, rather than waiting for the rate to fall to a certain level.

However, he's often cited the plight of the "long-term unemployed" as a key indicator of labor-market strength. The percentage of the unemployed who've been out of work for more than 27 weeks has fallen from its peak level, but is still substantially greater than what it was at the peak of past recessions. In the past, Bernanke has emphasized that a high number of long-term unemployed indicates considerable slack in labor markets, which in turn tends to keep inflation pressures subdued.

Source: Bureau of Labor Statistics, as of February 28, 2013. Shaded areas represent recessions.

Costs and risks

Bernanke, in his press conference, indicated that the committee discussed the costs and risks of its various policies, including the risk that investors are taking on excessive risk in search of yield. On the one hand, he defended the policy, noting that improvement in the housing market and falling unemployment could be attributable to the Fed's policies. But the minutes also noted potential negative effects from the Fed's large balance sheet on the amount of money the Fed remits to the Treasury and on financial stability.

Although it sounds like there must have been a fairly robust discussion of the risks of QE and low interest rates over long periods of time, the policy still appears to have solid backing from a majority of the voting members. Only one committee member, Esther George of the Kansas City Fed, dissented from endorsing the Fed's current policy. Otherwise, a full 13 members see short-term rates staying on hold until 2015.

FOMC Members' Assessments of Appropriate Timing of Tighter Monetary Policy

Source: Federal Reserve Board, December 2012. The height of each bar denotes number of FOMC participants who judge that, under appropriate monetary policy, the first increase in the target federal fund rate from its current range of 0 to 1/4 percent will occur in the specified calendar year. In December 2012, the number of FOMC participants who judged that the first increase in the target federal funds rate would occur in 2013, 2014, 2015 and 2016 were, respectively, two, three, 13 and one.

Still lower for longer

The bottom line is that the Fed plans to keep its near-zero interest rate and QE policies intact for the foreseeable future. The door is open to reducing the pace of bond purchases under QE on signs of improvement in unemployment or due to rising inflation expectations. However, based on the minutes of the Fed meeting and Bernanke's comments, we wouldn't expect that to happen until later this year at the earliest. Meanwhile, interest rates are likely to stay "lower for longer."

Michael Townsend
Vice President, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.

Policymakers in Washington are closing in on a deal that would provide funding for federal government operations through the end of the fiscal year on September 30. A deal would prevent a government shutdown on March 27, which is when the current temporary agreement on funding expires.

Continuing resolution now with Senate

On March 6, the House of Representatives passed a "continuing resolution" to keep government funding at its current level through the end of the fiscal year. The legislation then went to the Senate, which is expected to consider its own version this week. Once the Senate approves the bill, it has to go back to the House for a final vote before the President signs it into law.

Nearly 100 amendments have been proposed to the Senate version, so Senate leaders are now working to pare down the list in the hopes of maximizing the chances of the Republican-controlled House passing the final version. Both parties want to complete a deal before Congress' two-week Easter recess begins on March 22.

The continuing resolution vs. the "grand bargain"

The continuing resolution concerns government funding for the very near term. It's a stopgap funding measure for times when Congress hasn't approved a regular budget but still needs to make appropriations for the various agencies. In recent years, continuing resolutions have become very common—sometimes lasting for only a few days at a time as Congress works to find common ground on a spending plan. The current agreement was approved in late September last year and expires on March 27.

The "grand bargain" refers to a long-term deficit reduction agreement combining both entitlement and tax reform. The dueling budget proposals issued by both parties last week shows some of the challenges in getting to a grand bargain:

• House Republicans unveiled a plan to balance the budget in 10 years by cutting spending by more than $4.5 trillion. 
• Senate Democrats introduced a plan to stabilize the debt as a percentage of GDP rather than balance the budget by a certain deadline, and proposed $975 billion in spending cuts and $975 billion in tax increases—mostly on wealthier taxpayers.

Parties still far apart on budget matters

Earlier this month, a series of meetings between the president and various members of Congress ignited talk of a new spirit of bipartisanship in Washington. President Obama took 12 Republican Senators out to dinner; had lunch at the White House with House Budget Committee Chairman (and defeated vice presidential candidate) Paul Ryan (R-WI); and then had a series of meetings on Capitol Hill with Democratic and Republican lawmakers. While the meetings appeared to at least temporarily improve the dynamics in Washington, a comprehensive agreement on deficit reduction remains a long way off.

Republicans have insisted on keeping additional tax increases out of any budget agreement. They feel that the "fiscal cliff" deal in January, in which they acceded to the President's demand for $600 billion in increased revenue, must now be balanced by spending reductions.

On the other hand, the president and Democrats in Congress insist that any deficit reduction agreement must include both tax increases and spending cuts.

The basic philosophical divide between the parties—Republicans resisting tax increases, Democrats blocking entitlement reforms—limits chances for consensus. Thus, the chances of a grand bargain at this point remain slim, though a dialogue has at least begun.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

When it comes to retirement savings, the Roth IRA offers unique retirement-savings benefits. First introduced in 1998, it provides no tax deduction for contributions, but your investments can grow tax-free and withdrawals are tax-free. In addition to gaining key estate-planning benefits, you can avoid early distribution penalties on certain withdrawals, and there's no need to take required minimum distributions (RMDs) once you reach age 70½.

Roth IRA versus traditional IRA

Contribution limits: Roth IRA

If you're single, your ability to contribute to a Roth IRA for tax year 2012 phases out for modified adjusted gross incomes (MAGI) between $110,000 and $125,000. If you're married and filing jointly, contribution eligibility phases out between $173,000 and $183,000 MAGI. In 2013, the phase-out increases to $112,000–127,000 for single and $178,000–188,000 for married filing jointly.

Contribution limits: traditional IRA

Money put into a traditional IRA is generally tax-deductible, unless you're an active participant in a qualified employer plan like a 401(k). In that case, for 2012, your traditional IRA contribution is fully deductible if you're a single filer and your MAGI is $58,000 or below (phasing out up to $68,000). If you're married filing jointly, it phases out between $92,000 and $112,000 (and between $173,000 and $183,000 for the nonparticipant spouse of an active plan participant when filing jointly). For 2013, the limits are $59,000–69,000, $95,000–115,000, and $178,000–188,000, respectively.

Nondeductible traditional IRA

Given current tax law—particularly, low long-term capital gain and qualified dividend rates—a nondeductible contribution to a traditional IRA rarely makes sense. There's no up-front deduction, and earnings are taxed at higher ordinary rates when withdrawn. With a deductible traditional IRA, distributions are taxed at ordinary rates, but you receive an up-front deduction.

So if you do qualify for a deductible traditional and a Roth IRA, how do you choose between them? Of course, everyone's situation is unique, but here are some generally applicable rules of thumb to help you make a decision:

• If you think your tax bracket will be higher when you retire than it is today, you should probably consider a Roth IRA—especially if you're a younger worker who's yet to reach your peak earning years. In the table below, you can see that the Roth is better when your marginal rate at the time of withdrawal is the same or higher compared with your marginal rate at the time of the initial contribution.

Roth versus traditional IRA

• If you think your tax bracket will be much lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. In the table above, you can see that your marginal rate at the time of withdrawal would need to be about 5% less than a current assumed rate of 25% for a deductible traditional IRA to be the better option, all else being equal. 
• If you think your tax bracket will be the same when you retire, it's almost a wash for income tax purposes. But with a Roth, you aren't subject to minimum distributions, and if you leave a Roth behind when you die, your heirs can stretch out their own income-tax-free distributions.

Another advantage of a Roth IRA is that contributions may be withdrawn anytime for any purpose without tax or penalty. However, just because you can do this doesn't mean you should. Taking it out early carries hefty opportunity costs because you'll have that much less working over time toward your retirement. You can put in only $5,000 for 2012 ($5,500 for 2013), plus an additional $1,000 "catch-up" contribution if you're age 50 or older, so taking out previous contributions may be hard—or even impossible—to make up.

Roth IRA conversions: potential tax and estate-planning benefits

Another way to take advantage of a Roth IRA's potential benefits is to convert a traditional IRA to a Roth. Prior to 2010, eligibility to perform a Roth IRA conversion had an income cap—for most taxpayers, MAGI had to be $100,000 or less in the year of conversion. However, beginning in 2010, the rules surrounding conversions of traditional IRA money to a Roth IRA changed. MAGI limitations are no longer in effect, meaning all investors are eligible to convert their traditional IRAs to Roth IRAs. New rules in effect for 2013 also expand the eligibility to make a conversion from a traditional 401(k) to a Roth 401(k) if your employer offers both.

If you choose to convert, you must pay the income tax in the year you make the conversion. But that could still be a good option if you expect to be in a higher bracket down the road, have a long-term time horizon and can pay the income tax from other funds.

Aside from potential income tax benefits, however, converting part or all of a traditional IRA to a Roth could be advantageous as an estate-planning strategy if you have significant IRA balances you don't plan to tap during your lifetime. Though the value of a Roth will still be included in your gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional distribution rules—leaving more for your heirs. Also, your beneficiaries can make income-tax-free withdrawals during their lifetimes.

What's more, income tax you pay on conversion (preferably from assets other than the IRA) will reduce your gross estate. In effect, you're prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift. This could be particularly beneficial when there's little or no taxable estate to speak of anyway, because in such cases, there'd be no future tax deduction available to beneficiaries for previously paid estate taxes.

Roth 401(k)s: particularly appealing for younger workers

If your employer offers the Roth 401(k), it works much like a Roth IRA: Contributions come from after-tax dollars (no up-front deduction), and qualified withdrawals are free from income tax. One big difference is there are no income limits to participate, and the contribution limit of $17,500 per person in 2013 (plus an additional $5,500 catch-up contribution if you're 50 or older) is much higher than the Roth IRA limit.

Additionally, you can roll over the balance from a Roth 401(k) into a regular Roth IRA. According to the rules, any employer match would automatically go into a separate traditional 401(k) account, regardless of where your contributions are directed. The choice of a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement. That might not be a bad guess if you expect to generate lots of portfolio income and anticipate hefty retirement distributions. Also, there's the risk that currently low marginal federal tax brackets might be raised to deal with looming federal budget and entitlement program deficits.

As with a Roth IRA, the Roth 401(k) could be especially attractive if you're young and have yet to reach your peak earning years. Whatever your situation, if your employer offers both types of 401(k)s, you can stay flexible by splitting contributions between the traditional and Roth options. That way, your retirement income will be further diversified between taxable and nontaxable buckets.

Qualified rollovers

You can directly convert a traditional 401(k) into a Roth IRA without having to roll it into a traditional IRA first—say, if you change jobs. However, you must pay federal income tax on pretax contributions and earnings.

Roth IRA conversions

If you're ineligible for a Roth IRA, you might consider maximizing contributions to a traditional IRA so you can convert to a Roth. However, before taking this course, consider these caveats:

• You can't pick and choose which portion of traditional IRA money is converted. The IRS looks at all traditional IRAs as one when it comes to distributions (including Roth conversions). Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money. So making nondeductible contributions to a traditional IRA with the goal of later converting to a Roth IRA would likely work best if you have little or no existing deductible IRA balance to muddy the waters. Still, any earnings leading up to conversion would be subject to income tax (which, as always, is best paid from outside funds).
• As the law currently stands, high earners otherwise not eligible to make Roth contributions could make nondeductible contributions to a traditional IRA and then convert to a Roth the next day with no tax consequence whatsoever. This could be repeated every year, circumventing Roth income limits on contributions. If this is what Congress intended, it would have just eliminated Roth contribution limits along with the conversion limit, so don't be surprised if Congress writes some sort of anti-abuse provision into the law at some point.

The bottom line

A Roth IRA can be a great long-term savings tool, so try to take advantage of these rule changes if you can. Just remember that tax laws are subject to change, so stay current www.irs.gov. Also, be sure to talk with your accountant or other professional tax advisor about whether a Roth IRA makes sense for you.

1. Another way to compare a traditional deductible IRA and a Roth IRA would be to assume that only $3,750 would be invested in the Roth ($5,000 minus $1,250 in taxes paid today). In that case, if marginal tax rates then and now were the same, ending after-tax balances would be identical at $25,682. For illustration purposes, however, we assume the full $5,000 would be invested in both types of accounts. To make it a fair comparison, we account for the fact that the $1,250 up-front tax savings could have been invested in a taxable account. In cases where the tax savings are not invested (i.e., when they are spent), a lower opportunity cost might be justified, which would make the Roth look even better by comparison.

2. Assumptions: The lump-sum withdrawal (liquidation) after 25 years will be taxed at individual income tax rates of 30%, 25% or 20% for the traditional deductible and nondeductible IRA; it will be tax-free for the Roth IRA. Long-term appreciation is taxed at the 15% long-term capital gains rate for the taxable account.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Understanding what constitutes income and how different types of income are treated under the federal income tax rules¹ can help you better position your finances so that you end up keeping more of what you make. While the rules periodically change in one way or another, there are some important fundamentals all investors should become familiar with.

Everything is income

The Internal Revenue Code (IRC) begins with the presumption that all income is includable for reporting purposes.

IRC Section 61 defines "gross income" as (bold added for emphasis):

… all income from whatever source derived, including (but not limited to) the following items:

1. Compensation for services, including fees, commissions, fringe benefits and similar items
2. Gross income derived from business
3. Gains derived from dealings in property
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Alimony and separate maintenance payments
9. Annuities
10. Income from life insurance and endowment contracts
11. Pensions
12. Income from discharge of indebtedness
13. Distributive share of partnership gross income
14. Income in respect of a decedent
15. Income from an interest in an estate or trust

Gross income doesn't just mean cash. It includes realized income in any form, including property or services you receive or are entitled to receive.

The amount of income you're required to recognize for tax purposes depends on the extent to which the IRC allows:

• Special exclusions, such as tax-free municipal bond income, gifts, inheritances and life insurance proceeds.
• Adjustments, such as above-the-line adjustments for retirement plan contributions, alimony and self-employed health insurance.
• Deductions, such as the standard deduction or itemized deductions for such things as qualified mortgage interest, state and local taxes, and charitable gifts.
• Personal and dependent exemptions.
• Credits, such as foreign tax credit.

How to calculate your federal income tax

The basic formula for figuring individual federal income tax looks like this:

For more information and details on these categories, see IRS Publication 17, Your Federal Income Tax For Individuals. Publication 17 also provides a list of more specific IRS publications, including one that investors will find particularly useful: IRS Publication 550, Investment Income and Expenses.

Types of income

For tax purposes, income is categorized by type. The major categories are:

• Ordinary: Income from wages, self-employment income, interest, dividends, etc.
• Capital: Income from the sale of property.
• Passive: Income from investments in real estate, limited partnerships or business activities where participation is immaterial.

There are further classifications within some of these categories. For example, some interest income is considered tax-exempt (for example, interest from state and local municipal bonds) and some dividends are deemed "qualified" and receive special long-term capital gain tax treatment.

Also, while capital gains can be either short-term (held for one year or less and taxed at the ordinary tax rate) or long-term (held for more than one year and taxed at a lower rate), there are further categories for such things as collectibles or recaptured depreciation (see IRS Publication 550 noted above).

Long-term capital gains and qualified dividends are not taxable for taxpayers in the 15% ordinary bracket or lower.  For those in the 25% bracket or higher, a tax rate of 15% applies to qualified dividends and the sale of most appreciated assets held over one year (28% for collectibles and 25% for depreciation recapture).  For single filers with taxable income over $400,000 ($450,000 for married filing jointly), long-term capital gains and qualified dividend income over that threshold are taxed at a rate of 20%.

Finally, special rules apply to the interaction between these categories. For example, passive losses can usually only offset other passive income, not ordinary income.

Also, while capital losses can offset capital gains without limit, only $3,000 of capital losses per year can be used to offset ordinary income ($1,500 for married filing separate). For both passive and capital losses, carryover rules allow unused losses to be saved for use in future years.

Use the tax rules to your advantage

Knowing how income is taxed by type helps you to increase your after-tax return by prudent account placement. Broadly speaking, investments that tend to lose less of their return to income taxes are good candidates for taxable accounts. Likewise, investments that lose more of their return to taxes could go in tax-deferred accounts.

Where Tax-Smart Investors Typically Place Their Investments

Of course, this presumes that you hold investments in both types of accounts. If all of your investment money is in your 401(k) or IRA, just focus on asset allocation and investment selection.

Now you see it, now you don't

Sometimes the rules treat certain categories of income as income for one purpose but not another. Here are a few examples:

• Muni interest income: Interest income from munis is tax-exempt for regular federal income tax purposes, but gets added back for the purpose of computing the taxability of Social Security benefits. Also, certain muni interest income generated by "private activity" bonds may be tax-free for regular purposes, but could be included when computing the alternative minimum tax (AMT). On the other hand, muni interest income is excluded when computing the 3.8% health care surtax on net investment income.
• Treasury interest: Interest income from direct obligations of the US Treasury is excluded for state income tax purposes, but included for federal income tax purposes.
• Incentive stock options (ISOs): The ISO spread (difference between the exercise price and fair market value) at the time of exercise is excluded for ordinary tax purposes, but gets added back in for AMT.

The difference between effective and marginal rates

Our income tax system applies higher tax rates to higher levels of income and lower tax rates to lower levels of income. Currently, the rates range from 10% at the low end to 39.6% at the high end.  The cutoff between the graduated tax rates is known as a tax bracket. 

Your effective (or "average") tax rate is the total amount of tax you pay divided by your taxable income (or, alternatively, by your adjusted gross income).

Your marginal tax rate is the tax you pay on your last dollar of income.  If you're single and you make over $400,000 a year, you'll fall into the 39.6% tax bracket this year—and will pay $39.60 for every $100 you make over $400,000 in taxable income.² But for every dollar prior to that $400,000 threshold, you'll have paid less:

2013 Federal Income Tax Brackets

Knowing your marginal bracket can help you with all kinds of decisions, such as whether municipal or taxable bonds make sense in taxable accounts, which assets go best in taxable vs. tax-advantaged accounts, or how much bang for the buck you might receive from harvesting capital losses. 

Bottom line

You don't necessarily want taxes to dictate your investment strategy, but it's a good idea to consider the tax consequences of your financial actions, especially prior to entering into any significant transaction.

Remember, virtually all the goods and services you purchase are bought with after-tax dollars. Keeping more of what you make is even more important when finances are tight and investment returns are low. Knowledge is power, and understanding the basics of our tax system is just a first step.

1. State tax rules generally conform to federal rules but can vary significantly in certain cases. State income taxes can have a material impact on your financial decisions, so be sure to check with your state.

2. The actual marginal rate may be higher for some taxpayers, as many itemized deductions (such as mortgage interest expense, charitable contributions and state and local taxes) are reduced by 3 percent of the amount by which the AGI exceeds that $250,000/$300,000 threshold, with a maximum of 80% of itemized deductions. The personal exemption phase-out applies at a rate of 2% for each $2,500 increment over the threshold up to a maximum of 100% elimination of personal and dependent exemptions. Also, beginning in 2013, an additional 3.8% surtax applies to net investment income for taxpayers with AGI over $200,000 (single filers) or $250,000 (married filing jointly).

Daniel O'Neil
Vice President, Futures, optionsXpress®

As an investor, you know that diversification can help you reduce overall portfolio risk. Investing in a basket of stocks that is well diversified across industries, geographies, and market capitalizations can potentially improve overall returns and provide some cushion against market downdrafts.

However, diversification may not always provide meaningful protection. Some events pose "systemic risks" that can impact the entire market—a Federal Reserve monetary action or a significant geopolitical event, for instance. And as we learned during the depths of the financial crisis, many stocks can move in tandem during serious market swoons. So diversification, while certainly helpful, can't be counted on to snuff out risk entirely.

Another way to help protect the value of your stock investments is to use stock index futures and options. Here, we'll take a look at what they are, when you might want to consider them and how to calculate the appropriate number of contracts for hedging.

What are stock index futures?

Stock index futures track equity market benchmarks like the S&P 500® Index, the Nasdaq® 100 Index, and the Russell 2000® Index—widely recognized barometers of the US stock market.

Chicago Mercantile Exchange launched S&P 500 stock index futures in 1982. However, mainstream interest took off when individual investors began noticing a downsized, electronically-traded version of this product that debuted in 1998—the E-mini S&P 500 contract. By 2011, the S&P's little brother was trading more than two million contracts per day on average.

Companies and individuals trade stock index futures for different reasons, but the primary goal is to profit from—or protect against—changes in the price of the underlying indexes.

Let's take a look at how holding an appropriate number of S&P 500, Nasdaq 100, or Russell 2000 index futures or options contracts can help protect your portfolio value from market risk.

How do I hedge with stock index futures?

Suppose you're holding a well-diversified portfolio of stocks valued at approximately $1,000,000. You're concerned about a possible market decline but don't wish to sell your stocks just yet—perhaps due to tax reasons or to avoid missing out on dividend payments. Or maybe you believe in the long-term potential of the stocks in your portfolio, even in the face of a general market decline.

In this situation, selling index futures contracts might provide an approximate hedge. If the market declines, your short futures position may yield profits to offset the losses on your stock holdings. If the market rallies, the futures position may produce losses that would offset appreciation in your stock portfolio. The hedged position is generally stabilized in value until you remove the hedge.

How many contracts do I need?

Now, let's suppose that the composition of your stock portfolio resembles the S&P 500. To provide rough coverage, divide your portfolio value by the current index value times $50. This is the number of E-mini S&P 500 contracts needed to roughly equal the value of your stock portfolio. This calculation provides an approximation that's adequate for most individual investors.

Want to get more complex? More complete hedge coverage requires a calculation of your portfolio beta—a statistical comparison of the portfolio's changing value to the changes in the relevant index value over time. A portfolio beta of 1.0 indicates that over time the portfolio value has moved in the same proportion as the index. A portfolio beta of .7 indicates that the portfolio value has moved only 70% as far, on average, for each index price change.

Let's look at our example again. Suppose you compare your $1,000,000 portfolio statistically against the S&P 500 and calculate a portfolio beta of 1.2. To find the number of contracts for full coverage, divide your portfolio value by the current value of the S&P 500 index, and multiply by the portfolio beta, one type of hedge ratio.

Full coverage with futures would require the sale of 16 contracts. This would effectively neutralize the portfolio, so that you'd expect neither to gain nor lose materially on the overall stock/futures position. If you later decide to increase or decrease the size of your portfolio, recalculate the needed coverage and adjust your hedge accordingly.

A partial hedge

A hedge doesn't need to neutralize an entire portfolio—you might want to consider phasing in a futures or options hedge. You could immediately initiate, say, 50% of the number of contracts you would need for a complete hedge. If your concern about the direction of the market proves correct and prices begin to decline, you may choose to increase your coverage, perhaps to 75% of the portfolio value. When you feel that the market is poised for a recovery, remove the hedge by phasing it out in a similar manner, or by offsetting the entire position. You can constantly make adjustments in this fashion, depending on how your market outlook changes.

Buy put options on E-mini S&P 500 futures

If you have experience with equity options, you'll find options on stock index futures to be similar. All the same principles and fundamentals apply, though in the case of options on futures, the underlying is a futures contract, rather than an individual stock or a stock index.

In the earlier section on hedging with futures, we used an example of a $1,000,000 portfolio requiring the sale of roughly 16 E-mini S&P 500 futures contracts for protection against an adverse downward move. Another possible alternative is to hedge using options. By buying 16 put options, you could defend against a large decrease in the value of the portfolio, while still maintaining your profit potential (less the cost of the put purchase) if the market were to rise.

To set up this strategy, you would buy the number of puts dictated by the short futures hedge ratio calculation. The degree of coverage is determined by the choice of the strike price. Higher strike puts would be more expensive than lower strike price puts, but the protective feature of higher strike puts becomes effective much sooner. The hedger is therefore faced with the decision of how much protection to take on, and at what cost.

Sell call options on E-mini S&P futures

The principal reason to sell (or write) call options is to earn the premium. The writer of an E-mini S&P 500 call option receives payment (the premium) from the buyer of the option in return for the obligation of taking a short position in the futures contract at the exercise price if the option is exercised. The call writer's risk is unlimited, while the call buyer's risk is limited—and the call writer's profits are limited, while the call buyer's profits are unlimited.

In periods of stable or declining markets, call writing can mean an attractive cash flow from a relatively small capital investment. The hope is that, at expiration, the settlement price of the futures contract will be at or below the exercise price of the option. The option will then expire worthless—and you keep the entire premium.

The premium also gives limited protection against a drop in the futures price. The risk is that the value of the stock portfolio might decline by more than the premium received, and the trader may experience a net loss. However, depending on the strike price of the sold calls, the underlying stocks may rise in value without incurring a loss on the call options.

Investors should also note that if the market rises above the strike prices of the short calls, you may miss out on a market rally, as gains on the stock portfolio may be largely or entirely offset by losses on the short call position.

Protect your portfolio

Stock index futures and options offer investors numerous investing and trading opportunities—and in a declining or volatile stock market, they may be used as a hedging vehicle to help protect the value of your stock portfolio.

Like any other investment, the ultimate decision of whether or how to incorporate stock index futures into your portfolio should be based upon your personal goals and risk tolerance. But it's important to know that futures and options strategies like those described in this article are available to individual investors.

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

It's never too early to start investing for a child's college education. There are no guarantees with the market, but the longer your time horizon, the better—the sooner you start, the more time your money has to potentially benefit from the power of compound growth, which is growth on top of growth.

If you want to keep up with rising college costs, you should try to invest for growth. Historically, stocks have offered the best chance for your money to grow over the long term. If college is 10 or more years away, consider investing primarily in stocks and/or stock mutual funds or exchange-traded funds (ETFs).¹ Then, gradually move those funds to more conservative holdings as your child nears college age.

Is it ever too late to start?

What if you've put off saving, and college is only a couple of years away for your child? Should you skip saving altogether and hope for financial aid or fall back on loans? Not necessarily—saving late is better than not saving at all. Remember, college costs don't arrive all at once; they trickle in over four years (at least). Even if you wait until the last minute, you still have an opportunity to invest for college. If you're in this situation, you'll want to consider investments with a shorter time horizon.

The first part of your strategy: Choosing the right account for you

The government has created two accounts—529 plans and Education Savings Accounts (also known as Coverdells)—to help you save for your children's college education. These accounts provide many advantages over custodial accounts, general brokerage accounts and savings accounts.

• A 529 plan is a state-sponsored program that allows parents, relatives and friends to invest for a child's college education. Generally, you can choose from a selection of age-based or static investment portfolios that are professionally managed by the program's fund manager. The account belongs to you, not your child, and any potential earnings grow tax-deferred—which means that your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains. What's more, you pay no federal taxes on withdrawals as long as they're used to pay for qualified educational expenses.
  
  529 plans don't limit how much you can contribute per year. Instead, they have a lifetime contribution limit (often greater than $200,000) per beneficiary that varies by state.
• An Education Savings Account (ESA) is managed by you on behalf of your child. You can invest the money you contribute to an ESA in stocks, bonds, mutual funds—pretty much whatever you're comfortable with. When your child turns 18, you can choose to hand over the reins or continue managing the account yourself.
  
  ESAs provide tax advantages similar to 529 plans: Your money grows tax-free and you pay no taxes on withdrawals if they're used to pay for qualified educational expenses. However, ESAs can be used for certain elementary or secondary school expenses as well as for college expenses. You can contribute a maximum of $2,000 annually, if you qualify.²
• A custodial account is an account managed by a parent or guardian on behalf of a child. The money belongs irrevocably to the child, so if you're managing a custodial account for your daughter, when she turns 18, 21 or 25 (depending on the state rules governing the account), she can use the money for anything she wants—a new car or a European vacation, for instance.
  
  Custodial accounts offer minor tax advantages and have no restrictions on how the money can be spent, as long as it's for the benefit of the child. If you want to set aside money for expenses that aren't covered by an ESA or 529 plan—sorority dues or private voice lessons, for example—a custodial account may be just the thing.
• You can use a brokerage account to invest for college, but it offers no tax advantages. A 529 plan, an ESA or even a custodial account is probably a better choice. However, supplementing your tax-advantaged college investments with a taxable brokerage account sometimes makes sense—for example, if you want to save money for nonqualified college expenses and maintain control of the money.
• A savings account may be a place to put away a few dollars for a rainy day, but it's a poor choice for college savings. Historically, savings accounts usually don't even keep up with inflation, much less rising college costs.

The second part of your strategy: When and how to invest your money

18 years before college

• Open the account of your choice and contribute money every month, perhaps by signing up for an automatic investment plan. Contribute extra money whenever possible.
• If appropriate given your risk tolerance, invest the money in stocks or stock mutual funds (or ETFs) for long-term growth.

Eight to 10 years before college

• Has anything changed in your life? A new baby? A better-paying job? Consider these changes and recalculate your needs.
• If you haven't yet opened an account, do so right away. You may want to go with a 529 plan, which allows much larger lump sum contributions and may give you a chance to make up for lost time.
• Contribute any windfall money to your college savings account.

One to two years before college

• Several years out, you can ballpark your Expected Family Contribution (EFC)—a number that financial aid officers use to determine a student's financial need—using an online calculator such as the College Board's EFC Calculator. This will give you some idea of what results to expect when you fill out the Free Application for Federal Student Aid (FAFSA), which generates the official EFC that most schools rely on.
• Fill out the FAFSA as soon after January 1 as possible in the year your child expects to enroll. It's worth filling out even if you don't expect your child to qualify for aid based on your income, because the FAFSA considers other factors (such as cost of living, family size, the number of family members in college, and the age of the older parent) to determine a student's eligibility for federal and state grants, work-study programs, and loans.
• Look into other options for financial aid and scholarships. 
• Reassess the risk level in your accounts. As college approaches, consider moving the money into less risky investments, such as shorter-term bonds and money market funds.  

Comparing 529 Plans, Coverdell ESAs and Custodial Accounts

1. While growth investments (stock and stock mutual funds) offer the potential to keep up with rising college costs, they put your principal at greater risk than income securities and bank products.

2. Full-time college students under the age of 24 are taxed at their parents' rate on unearned income in excess of $2,000, unless the students' earned income is greater than one-half of their support.