Section IV - Lesson 9
Dealing With Lump Sums (Part II)
Other than moving from one stock fund to another, as discussed in the previous lesson, you’ll usually face timing problems when moving a lump sum. In your 401(k), for example, you may currently be invested in inappropriate securities such as company stock, bond funds, or cash reserves, and after taking this course you’ll hopefully want to re-deploy this money into the most appropriate diversified stock fund offered by your plan.
Unless the amounts involved are extremely small, you don’t want to instruct your plan coordinator to make these switches in a single lump sum. At the very least, move half your money now, and the other half six months from now. Better yet, move one fourth of it every quarter, and if you have a really large amount to re-allocate, move one-eighth of it every quarter over a two-year period.
The concept is to convert a lump sum to a series of smaller payments, while still keeping the remainder of the money working in some way or another. For your regular money you may face similar situations. If you’re starting this program with an accumulation of money already saved in a credit union or savings account, for example, you need to feed it gradually into your S&P 500 Index fund, along the lines of what we just discussed. Don’t move this money all at once unless it's a really small amount!
Once you’ve finished with moving old savings into your new program, the lump sum situations that you’ll encounter will arise mainly from windfalls, such as sizeable bonuses, refunds, inheritances, sales of property, legal settlements or whatever.
For small to moderate windfalls we suggested paying off debt you may have at interest rates of 10% or higher, while simultaneously increasing monthly payments to your regular account by an amount equal to the monthly payments that you no longer owe on this debt. This is a win-win situation! You are eliminating high interest charges, while converting a problematic lump sum situation into nice, safe monthly contributions to your investment account.
Another suggestion was to pay off an auto loan (or two) and increase your monthly regular contributions by the amount of the now unnecessary monthly car payments. You’ve already budgeted for the car payments every month. Now they just go to a mutual fund account instead of to a lender. You’ve simply made yourself the new “payee.”
But how do we manage the really big windfall? Don’t snicker. These things really happen, and more often than you think! Many of us, for example, will choose to take a lump sum distribution from our pension plan at retirement that could total several hundred thousand dollars. Other large amounts can occur as a result of insurance policies, lawsuits, divorces, and inheritances, and these can easily produce a major lump sum problem for a recipient.
Let’s resume the example, started earlier in the previous lesson, where we assumed that you inherited $100,000 that you want to add to your regular account, that has only $50,000 in it to begin with. You’ll remember that you were able to convert about $36,000 of this windfall into monthly contributions by paying off some debt, but you have $64,000 left that needs to be invested on a gradual basis to your S&P 500 Index fund.
We suggested that you could make four quarterly payments to this fund of about $16,000 each, or better yet, eight quarterly payments of about $8000 each.
But how do you keep the bulk of your $64,000 windfall balance working as you gradually feed this money into your index fund? The best solution is to warehouse this remaining balance in what is called a bond market index fund, where it can earn about 5% or so, without much worry of losing principal value, while you move your quarterly amounts to your S&P 500 Index fund until nothing remains in the bond fund.
The warehousing works like this. Most fund companies, such as Vanguard, have Bond Market Index funds as well as S&P 500 Index funds, and these funds all belong to the same fund family. Both types of fund are no-load, minimum fee type products, and the fund company makes it simple for you to move your money from one fund to the other.
On the day you invest the $64,000 balance of your windfall, you deposit your first quarterly payment of $8000 to the S&P 500 Index fund, and the remaining $56,000 to your newly opened Bond Market Index fund. Three months hence, you call your fund company on its toll free line and request that they move $8000 from your bond fund to the stock fund, and you do this every quarter until the entire amount is transferred and the bond fund account is empty.
This procedure allows you to earn at least some money on the balance of your windfall, while protecting you from the very real danger of making a big lump sum stock purchase at the worst possible time. While we would never dream of leaving money in a bond market index fund for the long-term, we have no problem utilizing such a fund for 12 to 24 months to warehouse windfall money.
We need to mention that you’ll have tax consequences as a result of this procedure. Uncle Sam will take note that you made purchases and sales of this Bond Market Index fund, and will expect you to report any profits or losses that accrued from these transactions. Fortunately these will not amount to much because the prices of these funds do not fluctuate all that much over a short period of time. You’ll also have to report and pay taxes on the interest income that you earn from the bond fund, even though you tell the fund to reinvest this interest.
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