Archives for March 2012

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Good and Bad Reasons to Contribute to a Roth IRA

If you read other personal finance blogs, you probably noticed that yesterday was the Roth IRA Movement — a day where many personal finance bloggers got together (at the suggestion of Jeff Rose from Good Financial Cents) to promote the Roth IRA to young investors.

Most of the articles I saw were well-written, and I think it’s great to encourage investors to save via tax-advantaged accounts.

That said, I also ran across a few poorly-reasoned arguments in favor of the Roth as compared to tax-deferred savings vehicles, such as a 401(k) or traditional IRA. (I’m not naming names, because my desire is not to pick on anyone but rather to challenge ideas.)

I thought it might be beneficial to sort through some of the good reasons to contribute to a Roth and some of the poor reasons to contribute to a Roth.

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 (Remember, Roth IRA contributions can be withdrawn free from tax and free from penalty at any time.)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.

Regarding the topic of the commutative property of multiplication and how it applies to the Roth vs. traditional decision, I’ll leave you with an allegorical explanation via one of my favorite blogs (the now dormant Bad Money Advice):

“Once upon a time there were two farmers named Joe and Bob who lived in the Kingdom of Ira. The King of Ira said to Joe and Bob that they must pay one fourth part of their grain as a tax. But, being a kind and wise king, he gave them a choice. They could pay a fourth of their seed in the spring or a fourth of their harvest in the fall.

Joe chose to pay a fourth of his seed and so could sow only three fields, but kept all that he reaped. Bob decided to keep all his seed, and planted four fields, but had to give the bounty of one of those fields to the king. Both farmers had three fields worth of grain to feed their families and so lived happily ever after.”

Update: Bogleheads author Taylor Larimore wrote in to mention an additional advantage of the traditional IRA:

In a marginal situation, the Traditional may be better. By investing in a traditional IRA the investor gets a tax deduction.   She may also be able to later convert to a Roth with little or no tax during the period of low/no income after retiring and before the taxable income from Social Security or IRA RMDs begins.  The result is a deductible IRA with tax-free accumulation that is tax-free at withdrawal.

Investing Blog Roundup: Thanks for Spreading the Word

Thanks to each of you who told somebody else about the promotion regarding the 2012 edition of Investing Made Simple. In the last 48 hours, an eye-popping 12,000 people have downloaded the free Kindle version.

(As a reminder, today’s the last day to get the Kindle version for free or to pick up a print copy for just $5).

Investing Articles

Other Money-Related Articles

Thanks for reading!

Free Book, Investing Made Simple Updated

This last week, I finished the 2012 update for Investing Made Simple. The changes include:

  • Updated tax information in the chapter regarding IRAs and 401(k) accounts,
  • An updated section about ETFs as compared to index funds,
  • An updated section about target retirement funds, and
  • A reworking of the chapter about asset allocation and risk tolerance.

Get a Free Book

To kick things off and to say thanks to regular readers, I’ve decided to have a brief promotion. Starting now and lasting through this Friday (3/23):

Answers to Questions

I don’t own a Kindle. Can I still read the Kindle edition somehow?

Yes. There’s no need to own a Kindle to read a Kindle book. They can be read using free software on a regular PC or Mac.

I’ve already read the prior edition. Should I buy this one too?

Overall, it’s the same book with the same message, and I’ll also be sharing a couple chapters here on the blog over the next week or so. So there’s probably no need to buy it again. (On the other hand, for a price of zero, there’s little reason not to pick up the Kindle version.)

Can I tell other people about the promotion?

Yes. If you know anyone who might benefit from the book, please don’t hesitate to let them know about it so they can pick up a free Kindle copy or inexpensive print copy.

Why does the Amazon page show the old copyright date?

Because the new edition is published under the same ISBN as the old edition, the copyright date on Amazon’s description page will not be updated. But the edition that is being shipped out is the 2012 edition — I’ve tested it myself with multiple purchases to be sure.

On the off chance that you receive an old edition that Amazon had been saving just for you in a warehouse somewhere, send me an email letting me know what happened, and I’ll have a copy of the new edition sent to you directly from the printing company.

I already have the old edition on my Kindle. How do I update it to the new edition?

Before buying the new one, you’ll have to delete the old edition from your Kindle and from your Kindle account on Amazon. To delete an item from your Kindle account:

  • On Amazon go to the “Your Account” page,
  • Click on “Manage Your Kindle” in the “Digital Content” section, and
  • Click the “actions” drop-down menu for the book in question and choose “delete from library.”

Click here to see the book on Amazon. I hope you find it helpful!

Should Asset Allocation Change Over Time?

This last weekend I read Zvi Bodie and Rachelle Taqqu’s recent book Risk Less and Prosper. One of the central points of the book is that, contrary to conventional wisdom, stocks do not become less risky over time.

We’ve been over this before, but I think the hullabaloo over such statements is mostly due to different people meaning different things when they say the word “risky.” As far as I can tell, most experts actually seem to agree that:

  1. The longer the time period in question, the less likely it is that stocks will lose money relative to their starting value (“stocks become less risky”);
  2. The longer the time period in question, the less predictable the ending value of a stock investment (“stocks become more risky”);
  3. The longer the time period in question, the more likely it is that stocks (and just about everything else, for that matter) will experience a catastrophic loss relative to their starting value due to a genuinely catastrophic economic event (“stocks become more risky”); and
  4. The longer the time period in question, the more likely it is that stocks will outperform safer investments.

The suggestion that young people should have stock-heavy allocations is often based on the idea that stocks become “less risky” over time. Bodie and Taqqu reject this idea, but they still make the case that younger investors can typically afford to have a larger portion of their portfolio invested in stocks than older investors can. Their reasoning is that, while stocks don’t get any less risky with time, investors become less risk tolerant over time.

Economic Risk Tolerance

Bodie and Taqqu argue that young investors can take on more risk because they have a greater degree of financial flexibility. (As you’ll see — next week, hopefully — this is very much in line with my explanation of risk tolerance in the 2012 edition of Investing Made Simple.) This increased flexibility is the result of a few factors, including:

  • The more years you have left in the workforce, the more chance you have of being able to shift to a higher-paying position (or career), should it be necessary to increase your savings rate due to poor investment returns.
  • The younger you are, the greater the impact of cutting your expenses by a given percentage. For example, bumping up your savings rate from 15% to 20% will have a huge impact if you make the change at age 30 but only a minor impact if you make the change just a few years before retirement.
  • It’s much easier to stay in a job than it is to find a new job, so risk tolerance declines significantly immediately upon retirement.

Emotional Risk Tolerance

An investor’s emotional ability to take risk often declines over time as well, due to the simple fact that his/her portfolio is larger than it’s been in the past. For example, a 40% portfolio decline at age 25 might mean losing an amount of money equal to just a few months of wages. At age 55, it’s the equivalent of a few years of wages. Many people become understandably nervous when they see that their portfolio has lost more money in the last 6-12 months than they’ve earned in the last 4-5 years.

How Much Safe Retirement Income Do You Need?

Monday’s post about building a super-safe retirement portfolio drew a few questions about how to take the same idea, but scale it down a bit. For example, one reader asked:

“Could it make sense to do this ‘super safe’ sort of thing with a part of my portfolio, but use regular stock and bond mutual funds for the rest of it? I was fortunate enough to get to choose when I retired, so I think my savings are adequate. But I still like the idea of having some income I don’t need to worry about.”

In short, my answer is an emphatic yes. I think most retirees would do well to use safe sources of income to satisfy their most basic spending needs. Then, once you’ve satisfied your must-have level of income with safe, inflation-adjusted sources, it can (depending on your preferences) make sense to use a higher risk allocation for the rest of your holdings in the (quite reasonable) hope of earning higher returns.

Prioritizing Your Spending

My best suggestion for how to implement this idea is to run through your current budget, consider how it will change in retirement (if you’re not already retired), then ask yourself which budget items you could eliminate or reduce without feeling that your standard of living was disappointingly low.

In other words, rather than simply shooting for one retirement spending goal, try breaking it down at two different levels:

  • “I do not want to have less than $X per year” and
  • “I hope to have $Y per year.”

Then, depending on your risk tolerance, you can pick which of those levels you want to satisfy via safe, inflation-adjusted income sources such as Social Security benefits (remember, delaying Social Security is an excellent way to increase your safe level of income), pension (if any), inflation-adjusted lifetime annuities, and TIPS.

Brief tangent: As you can see here, risk tolerance is about more than just choosing an overall stock/bond allocation. It also plays a role in answering other important questions such as how much of the portfolio to annuitize and when to claim Social Security benefits.

After you have a high enough level of safe income that you no longer need to worry, you can allocate the rest of the portfolio however you wish.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Building a Super-Safe Retirement Portfolio

A reader writes in asking,

“I was laid off 20 months ago at age 61 and have been unable to find another job. I think at this point it’s time to start calling myself retired. I had planned to work until 65 at least, so my savings aren’t what I’d hoped they’d be.

My question is about asset allocation. I don’t care about getting rich. I don’t feel the need to go on cruises or travel the world. I just don’t want to run out of money.

I just want to know what is the safest allocation I can use. I know that bonds are safer than stocks, but with no stocks, how does one keep up with inflation? On the other hand, I understand that it’s problematic to be caught by a bear market at the beginning of retirement if you have too much in stocks.”

Inflation-Adjusted Fixed Income

The idea that bonds expose you to a great deal of inflation risk is left over from a time prior to the existence of inflation-adjusted bonds. These days, there are fixed income investments that provide inflation-adjusted income:

  1. Treasury Inflation-Protected Security (TIPS), and
  2. Inflation-adjusted lifetime annuities.

TIPS are Treasury bonds that promise a specific after-inflation (“real”) interest rate, as opposed to a before-inflation (“nominal”) interest rate. And a lifetime inflation-adjusted annuity is essentially a pension that you can buy from an insurance company, that will be adjusted upward with inflation.

If your goal is to come as close as possible to eliminating the risk of running out of money, these are the tools for the job. Of course, the drawback is that using your entire portfolio to buy TIPS and inflation-adjusted lifetime annuities will completely eliminate any possibility of a happy surprise — the sort of thing that at least could happen with stocks.

In addition, it’s important to recognize that neither TIPS nor inflation-adjusted lifetime annuities are risk-free. (Nothing is risk-free.)

Risks with a TIPS Ladder

A bond ladder is a portfolio of individual bonds, designed so that some bonds mature each year, thereby freeing up money to spend. If you create a ladder of TIPS, your two primary sources of risk would be reinvestment risk and longevity risk.

Reinvestment risk is the risk that, when your bonds mature, you’ll have to reinvest the money at a lower rate of interest than you had anticipated. This risk arises because it’s not always possible to find TIPS with the exact maturity dates you need. For example, the longest-term TIPS mature 30 years from now. If you wanted to build a 35-year TIPS ladder, there’s no way to know right now — while you’re doing your planning — what interest rates you’d get in years 31-35.

Longevity risk is the risk that you’ll live longer than you had planned. For example, if you design a TIPS ladder to be liquidated over 25 years, but then you end up living 30 years, you have a financial problem.

Risks with a TIPS Mutual Fund

If you hold an individual TIPS until it matures, you know exactly what return you’ll get over the life of the bond. If you sell the bond prior to maturity, however, there’s no way to know with certainty what return you’ll earn, due to the fact that TIPS’ market prices fluctuate with changes in market interest rates (specifically, real interest rates).

With a TIPS mutual fund, each time you sell shares to pay living expenses, you’re effectively selling a smattering of TIPS of different maturities, all before their maturity date. As a result, if you’re using a TIPS mutual fund (as opposed to a TIPS ladder), you’ll have an additional source of risk: interest rate risk.

Risks with Inflation-Adjusted Lifetime Annuities

Because inflation-adjusted lifetime annuities promise a certain (inflation-adjusted) level of income for your entire life, they do not expose you to longevity risk or interest rate risk.

They do, however, expose you to more credit risk than TIPS because they’re backed by an insurance company rather than by the federal government.

Overall, however, the degree of credit risk is quite low given that:

  1. Insurance companies tend to be financially healthy, and
  2. There’s a second level of credit protection provided by the state guarantee associations.

(It’s worth noting, however, that those guarantees have limits, which vary by state, and it’s not the state itself that provides the guarantee. Rather, the association is funded by the insurance companies doing business in the state.)

TIPS or Inflation-Adjusted Annuities?

Given that TIPS and inflation-adjusted annuities expose you to different types of risk, the safest overall plan, naturally, is to use some of each.

As far as choosing how to allocate between the two, it’s largely a question of whether you care more about:

  1. Spending more during your lifetime, or
  2. Leaving more to your heirs.

Because lifetime annuities provide a meaningfully higher level of income than TIPS, they allow you to spend more per year. But the money disappears when you die, whereas a not-entirely-liquidated portfolio of TIPS would be left to your heirs.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
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