Honoring the Roth IRA

In case you missed it yesterday was the national Roth IRA Movement day where personal finance journalists and bloggers focused on educating the public on the Roth IRA.  As you know one of my professional core values is education so although I do not manage investments (IRA’s or otherwise) I love the idea of educating folks on various topics of personal finance.

I wanted to highlight THIS POST by Mike of the Oblivious Investor blog in which he does a nice job of laying out the pro’s & con’s of contributing to a Roth IRA versus a traditional IRA or 401K.

Good Reasons to Contribute to a Roth IRA

In many cases, a Roth IRA is the right choice. For example, Roth IRA contributions are likely preferable to saving via tax-deferred accounts if:

  • You think there’s a meaningful chance that you’ll have to spend the money in the not-so-distant future. (Remember, Roth IRA contributions can be withdrawn free from tax and free from penalty at any time.)
  • You think your marginal tax rate will be higher in retirement than it is now.
  • You think your marginal tax rate will be approximately the same in retirement as it is now, and you want to take advantage of the fact that Roth IRAs do not have required minimum distributions (RMDs).
  • You have no idea how your tax bracket in retirement will compare to your current tax bracket, so you’re “tax diversifying” by using some Roth savings and some tax-deferred savings.
  • You’ve maxed out your 401(k) and you earn too much to be able to make deductible contributions to a traditional IRA.
  • The investment options in your 401(k) are terrible, and you’ve already contributed enough to get the maximum employer match.
(For reference, the above list is not meant to be exhaustive. There are other, less common reasons why you might want to contribute to a Roth. But I think that covers the major ones.)

Not-So-Good Reasons to Contribute to a Roth IRA

There are also, however, some commonly-cited yet unconvincing arguments for contributing to a Roth IRA, including:

  • “Tax-free” is better than “tax-deferred.” It certainly sounds better. But the commutative property of multiplication tells us that paying, for example, a 25% tax now leaves you with the same after-tax amount as paying a 25% tax later. So unless you expect your marginal tax rate to increase between now and retirement, “tax-free” (via a Roth) is no better than “tax-deferred.”
  • You’ll pay less tax with a Roth than with tax-deferred savings. This is usually true, but that’s irrelevant. All that matters is how much you have left after paying the tax. And, as explained above, if the tax rate is the same, it doesn’t matter whether you pay it now or later.
  • Tax rates will increase in the future. If this is true, it is relevant, but it’s not a sufficient reason to prefer Roth contributions to tax-deferred contributions. Even if legislative tax rates go up, your marginal tax rate could be lower in retirement than it is now if your taxable income goes down dramatically when you retire — as is the case for many people.

How to apply asset allocation to multiple investment accounts

Mike over @ the Oblivious Investor blog sent out this post this morning regarding the application of asset allocation targets to multiple investment accounts.  It addresses the question of whether or not an investor needs to apply an asset allocation target to each and every investment account they own (i.e. IRA, 401K, and brokerage account) or if they can view all the accounts holistically and apply the target to all of them as if it was one big portfolio.

In Mike’s opinion the latter is preferable because it allows the investor to shelter the gains in a tax-free account (i.e. IRA or 401K) and hold cash and fixed income investments in taxable accounts.  Furthermore, he points out that it’s worth evaluating the expense ratios of various funds of the same asset class to see where the investor can reduce investment expenses.

To demonstrate he provides this example:

How about an Example?

Sarah has decided that she wants the following asset allocation:

  • 40% U.S. stocks
  • 30% International stocks
  • 30% Bonds

She has $50,000 in a taxable account at Vanguard, $150,000 in a traditional IRA also at Vanguard, and $100,000 in her 401(k) run by Fidelity. (So her total portfolio is $300,000, and she wants $120,000 in U.S. stocks, $90,000 in bonds, and $90,000 in international stocks.)

Sarah has the following investment choices in her 401(k):

  • Fidelity Capital & Income Fund (expense ratio 0.76%)
  • Fidelity Small Cap Stock Fund (expense ratio 1.25%)
  • Fidelity Select Health Care Portfolio (expense ratio 0.88%)
  • Spartan Total Market Index Fund (expense ratio 0.10%)
  • Fidelity Strategic Income Fund (expense ratio 0.71%)
  • Fidelity Blue Chip Growth Fund (expense ratio 0.94%)
  • Fidelity International Growth Fund (expense ratio 1.90%)
  • Fidelity Total International Equity Fund (expense ratio 1.79%)

Sarah could implement her desired 40/30/30 allocation in each of her accounts, or she could implement that allocation for the portfolio as a whole.

The “Multiple Portfolios” Approach

If Sarah views each account as a separate portfolio and uses her 40/30/30 allocation in each one, her holdings might look something like this:

Taxable account:
$20,000 Vanguard Total Stock Market Index Fund
$15,000 Vanguard Total International Stock Index Fund
$15,000 Vanguard Total Bond Market Index Fund

Traditional IRA:
$60,000 Vanguard Total Stock Market Index Fund
$45,000 Vanguard Total International Stock Index Fund
$45,000 Vanguard Total Bond Market Index Fund

$40,000 Spartan Total Market Index Fund
$30,000 Fidelity Total International Equity Fund
$30,000 Fidelity Strategic Income Fund

The “Single Portfolio” Approach

In contrast, if she looks at everything as a single portfolio, she could do something more like this:

Taxable account:
$50,000 Vanguard Total International Stock Index Fund

Traditional IRA:
$40,000 Vanguard Total International Stock Index Fund
$20,000 Vanguard Total Stock Market Index Fund
$90,000 Vanguard Total Bond Market Index Fund

$100,000 Spartan Total Market Index Fund

Why is the Second Portfolio Better?

The second portfolio is an improvement over the first for at least a few reasons:

  • It uses only low-cost funds, whereas the first portfolio has 60% of Sarah’s 401(k) invested in high-cost funds just to meet the 40/30/30 allocation in that account,
  • It’s more tax-efficient because it places all of her least tax-efficient holdings (the bonds) in a tax-sheltered account, and
  • It has only five moving parts to monitor rather than nine.

And Sarah’s situation is relatively simple. For investors with more accounts (especially married couples) or more complex asset allocations (i.e., more than 3 distinct asset classes), the complexity resulting from using the target allocation in each account can be significantly worse.

Investors jump into housing market

One interesting note in this morning’s Existing-Home Sales report from the National Association of Realtors is that the investors purchasing homes comprised of 23% of January’s total.  This is up from December’s figures.  Given that most of the low down payment investment property mortgage programs have been unavailable for a couple years I speculate that many of these investors are experienced players in the real estate market.  Therefore, many of these folks may have been waiting on the sidelines for prices to drop to a certain level and are now entering.  Could this be a sign that home prices have bottomed?  Or are near bottom?  It’s tough to know for sure.

If you are an investor or are a realtor who works with investors I have created a spreadsheet to use in analyzing the financial impact of of owning investment real estate.  After inputting the basics of the purchase, financing package, and rental income & expenses this spreadsheet will produce a detailed breakdown of the annual cash flow, net operating income, taxable income (loss), home equity, and wealth impact on an annual basis for 30 years.  Click THIS LINK to view a sample report.

Email directly if you’d like me to conduct a no obligation review of an investment property purchase on your behalf.

Can QE2 overcome history?

The WSJ’s marketbeat blog pointed me to THIS POST on visualizingeconomics.com.  The chart shows the inflation adjusted S&P 500 stock index back to 1871 and tracks it against the regression line.  This analysis reminds me a lot of Dr. Jeremy Siegel’s presentation that I attended here in Portland back in November 2009.  According to this chart the Fed’s efforts to ease monetary policy might help in the short run but it looks like the S&P has 20% to fall before it gets back to its historical regression line which you would assume will happen at some point.

Trends in Retirement Planning

The Employee Benefit Research Institute just released a report on employee-sponsored retirement plans and employee participation for 2009.  One would expect that during a recession fewer people would participate in their employer-sponsored retirement plans but I found some of the findings downright scary.  HERE is a link to to download the full report.  Here are some highlights:

  • Among full-time, full-year wage and salary workers ages 21–64 (those with the strongest connection to the work force), 61.8 percent worked for an employer or union that sponsors a plan. This is down almost a percentage point from 2008 and almost 8 percentage points lower than the sponsorship high point of 69.4 percent measured in 1999.
  • Among full-time, full-year wage and salary workers ages 21–64, 54.4 percent participated in a retirement plan in 2009….down almost 6 percentage points from the high of 60.4 percent measured in 1999.

For most households employee-sponsored retirement plans play a significant role in providing post-retirement income since social security benefits will only replace a small portion of  pre-retirement income.  Lower participation can only result in fewer people being able to retire or more people relying on public assistance once they hit retirement age.

Tyler Bollhorn provides 30 trading rules

I came across THIS POST earlier today.  I don’t consider myself a “trader” in the stock market (I prefer the term “investor”) but no matter what you call yourself there are some pearls of wisdom.  I’ll post a couple of the rules here but would encourage you to visit the post and read them all for yourself.

3. Never trust a person more than the market. People lie, the market does not.

5. Simplicity in trading demonstrates wisdom. Complexity is the sign of inexperience.

9. The market is usually efficient and can not be beat. Exploit inefficiencies.

15. There is always a reason why stocks go up or down, we usually only learn the reason when it is too late.

18. Don’t worry about the trades that you miss, there will always be another.

Costs of college have risen faster than inflation

The Economist posted THIS today which compares the growth in the cost of college since 1978 to housing prices, wage growth, and consumer prices.  The bottom line? The cost of college has risen much quicker than wage growth.  If you’d like to help your kids with tuition expenses then you’re going to need to start early to take advantage of compound interest.  Contact a financial planner today to learn more about your options.

For the Contrarian in you…

I happen to be a fan of Contrarian Investment Strategies after reading David Dreman’s book on the topic.  If you also like the idea of picking up out-of-favor stocks and holding them for the long-term until the prospects improve then you may like this article in the WSJ that was published over the weekend.  It names home builders, for profit educators, and staffing companies as good contrarian picks.  It also predicts that later on this fall may be a better time to buy.  Take it for what it’s worth…

Last Thursday’s plunge

I mentioned last week that I was going to take some time over the weekend to read about last Thursday’s temporary 1,000 point plunge in the Dow Jones Industrial Average.  I thought NPR’s Planet Money did the best job of explaining it in layman’s terms.  Here is a link to the podcast.  The explanation starts at 1:40.

They mention in the podcast that consulting firm Accenture (ACN) briefly traded at $.01.  That would have been quite a buy considering it is trading at $41.00 currently.  If you were a lucky Joe who had an order in for 100 shares of ACN expecting to pay around $41.00 and then your confirmation comes back which shows you bought @ $.01 (or $1.00 total) you would have experienced a 1-day 4,000% return!

When you start saving for retirement matters

I was studying for my upcoming CFP(R) exam last night and came across an interesting table that showed what percentage of a person’s gross income they’d need to save in order to create enough savings to provide enough income for their retirement years.  Keep in mind that these are just general estimates and each individual should contact a financial planner to have them do the math for their specific situation.

If a retirement saver begins at age 25-35 and saves regularly until retirement they’d need to set aside 10-13% of their gross income.

If a person delays a regular retirement savings plan until they reach the ages of 35-45 they’d have to set aside 13-20% of their gross income.

If a person waits until they are 45-55 they must save 20-40% of their income AND may have to delay retirement until the age of 70.

Let compound interest do the work for you!