Insider Jeff Fleming

Asset Allocation: Planning Your Future Income

Whether you're investing a large inheritance or amassing funds for your retirement, a deliberate asset allocation plan should figure into your calculations.

Dear Jeff:
I have inherited $700,000 and would like to invest it and live off the interest if there is a way that I could. And [I'm looking for] ways to cut the IRS ding that I know will occur.

Jeff Says:
Your income objectives, portfolio development, investment selection, risk tolerance level, income taxes, estate taxes, and inflation are some of the issues that immediately came to mind when I read your question.

Not surprisingly, my first recommendation is: Don't handle these issues yourself unless you are actually qualified to do so. I strongly encourage you to work with a financial advisor who can guide you through this maze of issues. Having said that, here are some key points to think about.

The current interest rate paid on certificates of deposit and money market accounts is around 5 percent, give or take a little. If you invested all of your inheritance and received 5 percent interest, you would have an annual income of approximately $35,000 before the IRS "dings" you for income taxes. Is this enough for your lifestyle?

And, consider, would you like your income to increase every year to keep pace with inflation? If this income is not enough, or if you want to increase your income every year without dipping into principal, this investment approach won't work--unless, of course, interest rates grow every year.

As an alternative, you could develop your portfolio using an asset allocation strategy. Think of this as creating a portfolio pie where each piece represents a different type or class of security. The broadest category of investment classes includes stocks, bonds, and real estate.

The principle behind asset class investing is that you will achieve an optimal return while reducing risk because you own some of each type of asset. You avoid playing guessing games like stock picking and market timing.

For example, your portfolio could be comprised of 50 percent stocks and 50 percent bonds, or any number of other combinations. Your stock portion could be further broken down to include small company, large company, and foreign stocks in varying percentages. The actual percentages of each class are determined, in part, by your risk tolerance level, which can range from defensive to aggressive.

An investment advisor can help with this and in selecting the appropriate investments to fill the pieces of your portfolio pie. Also take ThirdAge's Risk: How Much Can You Take? Brain Booster to find out how much risk you can tolerate.

Now, with respect to your income, you should determine your income as a percentage of the principal rather than "interest only." If you withdraw 5 percent in the first year, but your portfolio earns 8 percent, your principal actually grows compared to the "interest only" plan. Of course, you could have a year in which the amount of your withdrawal exceeds the amount of your growth. Historically, which is certainly NO guarantee of future results, the asset allocation strategy will provide you with greater wealth accumulation or preservation.

This is merely a sketch of ideas that might be appropriate for you in light of your rather large inheritance. Of course, you may not feel these are appropriate for you and, in that case, there are alternatives. Additionally, your estate may now be sufficiently large enough to require additional estate planning measures to reduce estate taxes that could be due upon your death. Therefore, I would again stress that your first mission should be to find a financial advisor with whom you can work.