Posts
Wednesday, July 1, 2009
Monday, June 29, 2009
Pure Annuities
In a comment to June 19’s post, Anonymous asked what I mean by “pure” annuity. “Pure annuity” is not a term of art, I’m afraid. I made it up. Forgive me for not defining my terms.
What I meant by “pure” annuity is an annuity that pays an agreed annual payment, beginning at an agreed starting date, either for your life, or for the life of you and your spouse. It is “pure” in the sense that it does not contain the following features:
• Payment does not vary with the performance of some asset class, such as with the S&P 500 index; that’s called a “variable” annuity. In my mind, however, an annuity that varies with an inflation index is an acceptably pure annuity.
• Payment is not guaranteed for a minimum period, such as 10 years, should you not live that long. It’s purely for your life. In my mind, however, an annuity that continues for the life of your spouse, should he survive you, is pure enough. Most couples properly view themselves as a single economic unit.
I’m no expert on annuities. I know what I like about them in concept, but I don’t know enough about them to know when they’re a good deal or a rip-off. For a good informative website about annuities, go to AnnuityDigest.com.
What I meant by “pure” annuity is an annuity that pays an agreed annual payment, beginning at an agreed starting date, either for your life, or for the life of you and your spouse. It is “pure” in the sense that it does not contain the following features:
• Payment does not vary with the performance of some asset class, such as with the S&P 500 index; that’s called a “variable” annuity. In my mind, however, an annuity that varies with an inflation index is an acceptably pure annuity.
• Payment is not guaranteed for a minimum period, such as 10 years, should you not live that long. It’s purely for your life. In my mind, however, an annuity that continues for the life of your spouse, should he survive you, is pure enough. Most couples properly view themselves as a single economic unit.
I’m no expert on annuities. I know what I like about them in concept, but I don’t know enough about them to know when they’re a good deal or a rip-off. For a good informative website about annuities, go to AnnuityDigest.com.
Sunday, June 28, 2009
TIPS and Losses
In a comment to June 24’s post, Paul asks a good question: Can “investing in TIPS lead to zero possibility of losses over any and all time periods?”
I think the answer is “no,” but perhaps it depends on the way you look at it. Here are the dangers of TIPS.
Treasury Inflation Protected Securities, or TIPS, are issued by the U.S. government and backed by the full faith and credit of the United States. That means the likelihood of default is close to zero. Not zero, but close to zero. We think of default by the U.S. Treasury as inconceivable, but perhaps it’s more accurate to characterize it as inconceivably bad, rather than inconceivable.
Another obvious danger of TIPS derives from the manner in which it is adjusted for inflation. The Treasury increases the principal value each year to reflect changes in the Consumer Price Index. But the CPI is an imperfect measure of inflation. It’s made up of changes in the prices of a typical basket of goods and services. But a “typical” basket ain’t your basket. The goods and services in the CPI are not necessarily those that you need; nor are they necessarily measured in your part of the country. I don’t foresee the day when the Treasury starts publishing “CPI-Paul.”
Perhaps the most important point to recognize about TIPS and losses is this: Like other bonds, TIPS can gain or lose value in the marketplace. You likely won’t lose principal, but you can lose value. Those are two different things. TIPS are subject to the same laws of supply and demand as other securities. With the government backing of their principal, and their inflation protection, TIPS ought to be less volatile than stocks or other bonds. And I imagine they are, although I have not confirmed that. (Maybe someone reading this post has looked at this. Anyone?) Less volatile, perhaps, but somewhat volatile nonetheless. The market value of TIPS is determined by millions of purchasers and sellers, each acting based on his own financial needs, opinions, and prejudices. So if you have to sell some TIPS to meet your need for cash, you will find that their value has gone up or down, notwithstanding their rather conservative nature. So there is quite a distinct possibility of losses.
You could minimize that possibility by buying TIPS with staggered maturities, so you never have to sell them; just wait around to collect the proceeds as they mature. But your ability to do that is limited by both the impossibility of predicting your future spending needs, and the fact that you simply can’t get TIPS of any maturity in any denomination you wish. They’re not that fine-grained.
So the bottom line is there is no hiding from the possibility of real losses, even with TIPS.
Besides, you would pay a steep price for that low probability of losses in the form of measley returns.
I think the answer is “no,” but perhaps it depends on the way you look at it. Here are the dangers of TIPS.
Treasury Inflation Protected Securities, or TIPS, are issued by the U.S. government and backed by the full faith and credit of the United States. That means the likelihood of default is close to zero. Not zero, but close to zero. We think of default by the U.S. Treasury as inconceivable, but perhaps it’s more accurate to characterize it as inconceivably bad, rather than inconceivable.
Another obvious danger of TIPS derives from the manner in which it is adjusted for inflation. The Treasury increases the principal value each year to reflect changes in the Consumer Price Index. But the CPI is an imperfect measure of inflation. It’s made up of changes in the prices of a typical basket of goods and services. But a “typical” basket ain’t your basket. The goods and services in the CPI are not necessarily those that you need; nor are they necessarily measured in your part of the country. I don’t foresee the day when the Treasury starts publishing “CPI-Paul.”
Perhaps the most important point to recognize about TIPS and losses is this: Like other bonds, TIPS can gain or lose value in the marketplace. You likely won’t lose principal, but you can lose value. Those are two different things. TIPS are subject to the same laws of supply and demand as other securities. With the government backing of their principal, and their inflation protection, TIPS ought to be less volatile than stocks or other bonds. And I imagine they are, although I have not confirmed that. (Maybe someone reading this post has looked at this. Anyone?) Less volatile, perhaps, but somewhat volatile nonetheless. The market value of TIPS is determined by millions of purchasers and sellers, each acting based on his own financial needs, opinions, and prejudices. So if you have to sell some TIPS to meet your need for cash, you will find that their value has gone up or down, notwithstanding their rather conservative nature. So there is quite a distinct possibility of losses.
You could minimize that possibility by buying TIPS with staggered maturities, so you never have to sell them; just wait around to collect the proceeds as they mature. But your ability to do that is limited by both the impossibility of predicting your future spending needs, and the fact that you simply can’t get TIPS of any maturity in any denomination you wish. They’re not that fine-grained.
So the bottom line is there is no hiding from the possibility of real losses, even with TIPS.
Besides, you would pay a steep price for that low probability of losses in the form of measley returns.
Wednesday, June 24, 2009
Stock Market Losses
In a comment to May 7’s post, David asked for some clarification. May 7’s post was about the frequency with which stocks and bonds have exhibited real (i.e., inflation-adjusted) losses over different time periods. It was noted that since 1926, the longest period it has taken stocks to recover their purchasing power after a loss was 19 years. Yes, unfortunately, that was a 19-year stretch; not 19 months. And yes, that means, had you been investing then, you might not have lived long enough to see your investments recover.
Let’s put that observation in perspective (especially since we’ve just been through a major down market in late 2008 and early 2009).
• 19 years is the worst so far. The one we’ve just been through might be even worse yet. History is just history; not a predictor of the future.
• If you’re focusing on worst case, bonds have exhibited even worse results. We have gone through a period where it has taken bonds 52 years to recover their purchasing power. There is no shelter from the storm.
• Take heart! Both stocks and bonds have been winners more often than losers. How much more often? It depends on the length of time you’re looking at, as shown in the graph in May 7’s post. In investing, time is your best friend.
• That particular measure—frequency of a real loss—is just one small aspect of risk and reward. It says nothing about how bad your loss might be. Nor does it say anything about the reward side: How large might you expect your gain to be.
Investment risk and reward is too multi-dimensional to capture in a single measurement. Take a look at March 16’s post for a refresher.
Let’s put that observation in perspective (especially since we’ve just been through a major down market in late 2008 and early 2009).
• 19 years is the worst so far. The one we’ve just been through might be even worse yet. History is just history; not a predictor of the future.
• If you’re focusing on worst case, bonds have exhibited even worse results. We have gone through a period where it has taken bonds 52 years to recover their purchasing power. There is no shelter from the storm.
• Take heart! Both stocks and bonds have been winners more often than losers. How much more often? It depends on the length of time you’re looking at, as shown in the graph in May 7’s post. In investing, time is your best friend.
• That particular measure—frequency of a real loss—is just one small aspect of risk and reward. It says nothing about how bad your loss might be. Nor does it say anything about the reward side: How large might you expect your gain to be.
Investment risk and reward is too multi-dimensional to capture in a single measurement. Take a look at March 16’s post for a refresher.
More on Short-Term Tax Savings vs. Long-term Benefit
Editorial note: This post was supposed to appear on June 23.
Yesterday’s post discussed how there is often a trade-off between short-term tax savings and long-term tax benefit. Paul Anonymous identified one particular manifestation of that issue as he considers whether to contribute to a non-deductible IRA now, or wait until just before he converts it to a Roth IRA in early 2010. The former approach likely has a slightly higher short-term tax cost. The latter approach likely has a slightly higher long-term tax benefit. How do you know which outweighs the other?
Before providing some rules of thumb (which, as we all know, are always wrong), a couple of observations.
Observation #1: You can never know for sure. Accept that, as in all things in life, you must make a decision in the face of uncertainty about what the future will bring. All you can do is make your best guess.
Observation #2: (This one is hard for many people to swallow.) Your guess must necessarily be based on long-term projections. That’s because long-term benefits can only be assessed in the long term. Duh.
Observation #3: Be sure you’re comparing the right output. It’s not which approach pays the least in taxes. Rather, for most of us, it’s which approach leads you to the highest after-tax retirement spending. (For a lucky few—the wealthy—the right output to measure is which approach leads to your children’s highest after-tax wealth.)
So how do you know if you benefit more from a lower short-term tax or from the long-term benefit of a larger Roth IRA? Here’s a couple of rules of thumb:
Rule #1: If you’re 20 or more years away from retirement, then you’ve got enough time to benefit from long-term savings. Pay the higher tax.
Rule #2: If you’re wealthy, regardless of age, then you’ve got enough time to benefit from long-term savings. By “wealthy” I mean either of the following: (1) you have enough assets outside your tax-favored retirement plans to meet your spending needs during your lifetime, and don’t ever need to tap into your tax-favored retirement accounts, except as required by law; or (2) you are spending as much as you care to during your lifetime, and any additional resources will end up in the hands of your beneficiaries after your death. While both categories of "wealthy" benefit from long-term savings, the latter category (the "really wealthy" (?)), derive a greater degree of benefit than the former.
Unfortunately, those two rules of thumb don’t nearly cover the whole waterfront. They still fail to address Paul Anonymous’ situation and that of most readers of this blog. Most of us are not wealthy, and are either at or too near retirement to make use of Rule #1. In that case, the only approach I can recommend is to do a full-blown long-term financial projection. Or, short of that, do what Paul Anonymous is doing and go with your gut instinct.
Yesterday’s post discussed how there is often a trade-off between short-term tax savings and long-term tax benefit. Paul Anonymous identified one particular manifestation of that issue as he considers whether to contribute to a non-deductible IRA now, or wait until just before he converts it to a Roth IRA in early 2010. The former approach likely has a slightly higher short-term tax cost. The latter approach likely has a slightly higher long-term tax benefit. How do you know which outweighs the other?
Before providing some rules of thumb (which, as we all know, are always wrong), a couple of observations.
Observation #1: You can never know for sure. Accept that, as in all things in life, you must make a decision in the face of uncertainty about what the future will bring. All you can do is make your best guess.
Observation #2: (This one is hard for many people to swallow.) Your guess must necessarily be based on long-term projections. That’s because long-term benefits can only be assessed in the long term. Duh.
Observation #3: Be sure you’re comparing the right output. It’s not which approach pays the least in taxes. Rather, for most of us, it’s which approach leads you to the highest after-tax retirement spending. (For a lucky few—the wealthy—the right output to measure is which approach leads to your children’s highest after-tax wealth.)
So how do you know if you benefit more from a lower short-term tax or from the long-term benefit of a larger Roth IRA? Here’s a couple of rules of thumb:
Rule #1: If you’re 20 or more years away from retirement, then you’ve got enough time to benefit from long-term savings. Pay the higher tax.
Rule #2: If you’re wealthy, regardless of age, then you’ve got enough time to benefit from long-term savings. By “wealthy” I mean either of the following: (1) you have enough assets outside your tax-favored retirement plans to meet your spending needs during your lifetime, and don’t ever need to tap into your tax-favored retirement accounts, except as required by law; or (2) you are spending as much as you care to during your lifetime, and any additional resources will end up in the hands of your beneficiaries after your death. While both categories of "wealthy" benefit from long-term savings, the latter category (the "really wealthy" (?)), derive a greater degree of benefit than the former.
Unfortunately, those two rules of thumb don’t nearly cover the whole waterfront. They still fail to address Paul Anonymous’ situation and that of most readers of this blog. Most of us are not wealthy, and are either at or too near retirement to make use of Rule #1. In that case, the only approach I can recommend is to do a full-blown long-term financial projection. Or, short of that, do what Paul Anonymous is doing and go with your gut instinct.
Monday, June 22, 2009
Another Good Roth Conversion Issue
In a comment to June 18’s post, Paul Anonymous has raised another good issue. (Thank you, Paul—whoever you are—you are a veritable fount of good ideas for blog posts.)
Paul’s situation presents a tax-planning issue that comes up all the time, in many sizes and many variations. When is a short-term tax cost outweighed by a long-term benefit? The question is simple. The answer? Not so much.
Here’s Paul’s version of the issue. He plans to make $11,000 nondeductible IRA contribution for 2009 (between him and his spouse, one of whom has reached age 50). He will then convert all his IRAs to Roth IRAs in 2010, when the rules change and the Roth dam bursts. If he contributes the $11,000 now, the tax cost of his Roth conversion will go up on account of any investment earnings between now and the conversion. Paul expects that that Roth conversion tax cost will exceed the tax cost of enjoying those investment earnings outside the shelter of the IRA. Why? Because he intends to invest his $11,000 in stocks, and, at least for the time being, the tax rate on dividends (and long-term capital gain) is lower than the general tax rate that applies to Roth conversions.
(An aside here. Actually, the tax rate on a 2010 Roth conversion might in fact be lower after you factor in the special tax deal on 2010 Roth conversions, as described in February 28’s post. The value of delaying tax by a year and a half brings the effective tax rate down a bit. But for the sake of discussion, let’s assume the tax cost of converting those investment earnings to a Roth account exceeds the tax cost of earning dividends outside the IRA.)
So. Here’s the ubiquitous issue. Is it worth it to pay that extra tax to shift more dollars from your taxable account into your Roth IRA? What’s more powerful—the short-term savings or the long-term benefit?
(Before answering, here’s another aside. The amount at issue here is truly miniscule. In terms of making a meaningful contribution to his future retirement security, Paul is planning to do two big important things with very favorable long-term consequences. (1) He and his wife are contributing the maximum ($11,000 in their case) to their IRAs. (2) And they are planning to convert their traditional IRAs to Roth IRAs in 2010. Way to go, Paul! So why am I even discussing the relatively minor issue of whether he makes the contribution now or just before the Roth conversion? How much could possibly be at stake? $100 investment earnings over the next 7 months maybe? Why am I wasting electronic ink? Just because it’s interesting to me; that’s why. I really need to get a life.)
So, anyway, what’s the answer? Well, it depends on many factors, so there is no one right answer.
But in my experience, after doing untold numbers of projections with varying degrees of precision, I find that the long-term benefit of shifting that hypothetical $100 into the Roth account often exceed the short-term cost of paying a greater rate of tax on an extra $100 in 2010. Or, more precisely, on half in 2011 and half in 2012.
A bit more on this tomorrow.
Paul’s situation presents a tax-planning issue that comes up all the time, in many sizes and many variations. When is a short-term tax cost outweighed by a long-term benefit? The question is simple. The answer? Not so much.
Here’s Paul’s version of the issue. He plans to make $11,000 nondeductible IRA contribution for 2009 (between him and his spouse, one of whom has reached age 50). He will then convert all his IRAs to Roth IRAs in 2010, when the rules change and the Roth dam bursts. If he contributes the $11,000 now, the tax cost of his Roth conversion will go up on account of any investment earnings between now and the conversion. Paul expects that that Roth conversion tax cost will exceed the tax cost of enjoying those investment earnings outside the shelter of the IRA. Why? Because he intends to invest his $11,000 in stocks, and, at least for the time being, the tax rate on dividends (and long-term capital gain) is lower than the general tax rate that applies to Roth conversions.
(An aside here. Actually, the tax rate on a 2010 Roth conversion might in fact be lower after you factor in the special tax deal on 2010 Roth conversions, as described in February 28’s post. The value of delaying tax by a year and a half brings the effective tax rate down a bit. But for the sake of discussion, let’s assume the tax cost of converting those investment earnings to a Roth account exceeds the tax cost of earning dividends outside the IRA.)
So. Here’s the ubiquitous issue. Is it worth it to pay that extra tax to shift more dollars from your taxable account into your Roth IRA? What’s more powerful—the short-term savings or the long-term benefit?
(Before answering, here’s another aside. The amount at issue here is truly miniscule. In terms of making a meaningful contribution to his future retirement security, Paul is planning to do two big important things with very favorable long-term consequences. (1) He and his wife are contributing the maximum ($11,000 in their case) to their IRAs. (2) And they are planning to convert their traditional IRAs to Roth IRAs in 2010. Way to go, Paul! So why am I even discussing the relatively minor issue of whether he makes the contribution now or just before the Roth conversion? How much could possibly be at stake? $100 investment earnings over the next 7 months maybe? Why am I wasting electronic ink? Just because it’s interesting to me; that’s why. I really need to get a life.)
So, anyway, what’s the answer? Well, it depends on many factors, so there is no one right answer.
But in my experience, after doing untold numbers of projections with varying degrees of precision, I find that the long-term benefit of shifting that hypothetical $100 into the Roth account often exceed the short-term cost of paying a greater rate of tax on an extra $100 in 2010. Or, more precisely, on half in 2011 and half in 2012.
A bit more on this tomorrow.
Friday, June 19, 2009
401(k) Investment Options
My friend David asked what I think of adding more participant investment options to his company’s 401(k) plan. He’s on his company’s 401(k) committee, and their investment advisor has recommended adding more options to the current array of 15. Additional fixed income options are on the table.
The easy, short, and largely correct answer is: If that’s what your professional advisor recommends, then do it. That’s what you pay them for.
But maybe David was looking for more substance than that rather facile response.
Initially my reaction is how can more choices ever be bad? If your 401(k) plan is thin on fixed income options, why not add one or two more? It’s always better for participants to have more choices, right?
Not always. Behavioral finance research (which I’m too lazy to look up and cite) has shown that offering too many choices can actually paralyze some people. When faced with too many confusing choices they can react by not choosing at all. In the context of a 401(k) plan, that might mean that their account defaults to some “safe” option determined by the plan, which in the past has often meant a money market fund. In the long run that's a bad choice. (That’s changing, as more and more plans move to a life-cycle fund as the default option.)
For some employees, 401(k) paralysis might be worse. It might mean that they're put off from making an elective deferral at all, which is an awful result.
So the desire to improve the array of options for the group should be tempered by the desire to limit 401(k) paralysis. How many employees can benefit by adding more refined asset classes, compared to how many will now suffer 401(k) paralysis? That’s not an easy question. For one thing, the more fine-grained the asset classes you offer, the fewer employees who can appreciate the subtle distinctions among them. My speculation is that with 15 options you’re getting to the point where only those employees who are receiving professional advice can actually benefit from more options.
Now, having nibbled around the edges of the question, I may as well offer a couple of substantive observations.
One: As long as you’re increasing your plan’s fixed income options, it would be a shame if you fail to offer a TIPS (Treasury Inflation Protected Securities) option.
Two: If you really want to do your employees a favor, offer them a pure annuity option. Not a variable annuity, but a pure annuity that they can add to on a paycheck-by-paycheck basis. This will enable those employees who long for a traditional pension to create one of their own within the confines of your company’s 401(k) plan. (For why I think annuities are valuable for a portion of one's retirement assets, see March 9's post and March 15's post.)
Thank you, David, for giving me the opportunity to shoot my digital mouth off.
The easy, short, and largely correct answer is: If that’s what your professional advisor recommends, then do it. That’s what you pay them for.
But maybe David was looking for more substance than that rather facile response.
Initially my reaction is how can more choices ever be bad? If your 401(k) plan is thin on fixed income options, why not add one or two more? It’s always better for participants to have more choices, right?
Not always. Behavioral finance research (which I’m too lazy to look up and cite) has shown that offering too many choices can actually paralyze some people. When faced with too many confusing choices they can react by not choosing at all. In the context of a 401(k) plan, that might mean that their account defaults to some “safe” option determined by the plan, which in the past has often meant a money market fund. In the long run that's a bad choice. (That’s changing, as more and more plans move to a life-cycle fund as the default option.)
For some employees, 401(k) paralysis might be worse. It might mean that they're put off from making an elective deferral at all, which is an awful result.
So the desire to improve the array of options for the group should be tempered by the desire to limit 401(k) paralysis. How many employees can benefit by adding more refined asset classes, compared to how many will now suffer 401(k) paralysis? That’s not an easy question. For one thing, the more fine-grained the asset classes you offer, the fewer employees who can appreciate the subtle distinctions among them. My speculation is that with 15 options you’re getting to the point where only those employees who are receiving professional advice can actually benefit from more options.
Now, having nibbled around the edges of the question, I may as well offer a couple of substantive observations.
One: As long as you’re increasing your plan’s fixed income options, it would be a shame if you fail to offer a TIPS (Treasury Inflation Protected Securities) option.
Two: If you really want to do your employees a favor, offer them a pure annuity option. Not a variable annuity, but a pure annuity that they can add to on a paycheck-by-paycheck basis. This will enable those employees who long for a traditional pension to create one of their own within the confines of your company’s 401(k) plan. (For why I think annuities are valuable for a portion of one's retirement assets, see March 9's post and March 15's post.)
Thank you, David, for giving me the opportunity to shoot my digital mouth off.
Thursday, June 18, 2009
Roth Conversion Questions
In a comment to May 15’s post, Paul Anonymous raises a number of questions about 2010 Roth IRA conversions. Good man, Paul, you're planning ahead! I’ll try to answer them.
Paul already has both a traditional and a Roth IRA. One question is whether you need to open a separate Roth IRA to hold the assets converted from a traditional IRA, or can you use the existing Roth IRA. The answer is that you don’t need to open a new Roth IRA. One acceptable method for converting a traditional IRA to a Roth is to transfer assets from an existing traditional IRA to an existing Roth IRA. That seems like the administratively easiest thing to do, rather than maintain two separate Roth IRA's needlessly. Although that won’t work if you want to keep the assets at different institutions. Then you’ll of course need separate IRAs.
Paul next asks a question about the wisdom of maintaining a small traditional IRA. Here’s the scenario. Paul apparently intends to convert all (or virtually all) of his traditional IRAs to Roth IRAs. He doesn’t say that explicitly, but that appears to be his plan. And apparently he does not expect to meet the qualification requirements for annual Roth IRA contributions—too much Adjusted Gross Income perhaps. So, looking to the future—2011 and beyond—Paul is planning to make annual traditional IRA contributions and then immediately turn around and convert them to Roth IRAs. Good planning! But that raises the question of whether he should leave some money in a traditional IRA—perhaps a nominal amount—so he doesn’t have to re-open a new traditional IRA every year. I think that’s a terrific idea, as it saves the administrative headache of opening a new account every year--a process that has gotten increasingly burdensome. Keep just enough in the traditional IRA to minimize administrative fees, and then convert the rest to a Roth IRA.
Paul plans to delay his 2009 nondeductible traditional IRA contribution until early 2010. At that point, he will make both his 2009 and 2010 nondeductible traditional IRA contributions, and then immediately turn around and convert them to Roth IRAs. Paul’s thinking is that by delaying the 2009 contribution, he will avoid investment earnings on that amount and reduce the tax cost of converting his whole traditional IRAs to Roth IRAs.
Not so fast, Paulie. I’ve got to disagree with your analysis there. If you keep your $5,000 in your taxable account for the rest of 2009, aren’t you going to earn some returns inside your taxable account—say $50? And then won’t that therefore generate an income tax. In fact, if you invest in interest-bearing investments, the tax you save on the Roth conversion will exactly equal the tax you’ll owe on your taxable investment earnings, so there will be no tax savings at all, plus you will have lost the opportunity to house the $50 inside that most valuable Roth investment environment. Even if you invest in equities, the earnings on which enjoy lower tax rates, the long run benefits of having the $50 inside the Roth environment easily outweigh the short-term detriment of paying a greater Roth conversion tax than a corresponding income tax on the $50 investment earnings. So if I were Paul, I would make my 2009 traditional IRA contribution now, and thereby divert that hypothetical $50 from my taxable bucket to my tax-exempt bucket.
An aside here. It appears that Paul is planning to convert virtually all his traditional IRAs to Roth IRAs in 2010. Would it still be his best strategy to make a 2009 nondeductible IRA contribution if he were planning to convert only a portion of his IRA's to Roths—let’s say 25% of his traditional IRAs? That’s a tougher question. Because then he would only get to recover 25% of his nondeductible contributions tax-free in 2010, and he’d have to wait until later years to recover the remaining 75%. Let’s say he makes a $5,000 nondeductible traditional IRA contribution in 2009, and then converts 25% of his traditional IRAs to a Roth in 2010. The amount he pays tax on is reduced by 25% of his cumulative non-deductible contributions, including the one from 2009. So he contributes $5,000—no deduction—and ends up paying a Roth conversion tax on $3,750. He’s just increased his taxable income by $3,750; he’ll eventually recover the other $3,750 tax-free, but it will take years for that to happen. Is that good planning? I don’t know. I suspect it is, but I think the issue needs some closer study. Look for more on this question in a future post.
Paul already has both a traditional and a Roth IRA. One question is whether you need to open a separate Roth IRA to hold the assets converted from a traditional IRA, or can you use the existing Roth IRA. The answer is that you don’t need to open a new Roth IRA. One acceptable method for converting a traditional IRA to a Roth is to transfer assets from an existing traditional IRA to an existing Roth IRA. That seems like the administratively easiest thing to do, rather than maintain two separate Roth IRA's needlessly. Although that won’t work if you want to keep the assets at different institutions. Then you’ll of course need separate IRAs.
Paul next asks a question about the wisdom of maintaining a small traditional IRA. Here’s the scenario. Paul apparently intends to convert all (or virtually all) of his traditional IRAs to Roth IRAs. He doesn’t say that explicitly, but that appears to be his plan. And apparently he does not expect to meet the qualification requirements for annual Roth IRA contributions—too much Adjusted Gross Income perhaps. So, looking to the future—2011 and beyond—Paul is planning to make annual traditional IRA contributions and then immediately turn around and convert them to Roth IRAs. Good planning! But that raises the question of whether he should leave some money in a traditional IRA—perhaps a nominal amount—so he doesn’t have to re-open a new traditional IRA every year. I think that’s a terrific idea, as it saves the administrative headache of opening a new account every year--a process that has gotten increasingly burdensome. Keep just enough in the traditional IRA to minimize administrative fees, and then convert the rest to a Roth IRA.
Paul plans to delay his 2009 nondeductible traditional IRA contribution until early 2010. At that point, he will make both his 2009 and 2010 nondeductible traditional IRA contributions, and then immediately turn around and convert them to Roth IRAs. Paul’s thinking is that by delaying the 2009 contribution, he will avoid investment earnings on that amount and reduce the tax cost of converting his whole traditional IRAs to Roth IRAs.
Not so fast, Paulie. I’ve got to disagree with your analysis there. If you keep your $5,000 in your taxable account for the rest of 2009, aren’t you going to earn some returns inside your taxable account—say $50? And then won’t that therefore generate an income tax. In fact, if you invest in interest-bearing investments, the tax you save on the Roth conversion will exactly equal the tax you’ll owe on your taxable investment earnings, so there will be no tax savings at all, plus you will have lost the opportunity to house the $50 inside that most valuable Roth investment environment. Even if you invest in equities, the earnings on which enjoy lower tax rates, the long run benefits of having the $50 inside the Roth environment easily outweigh the short-term detriment of paying a greater Roth conversion tax than a corresponding income tax on the $50 investment earnings. So if I were Paul, I would make my 2009 traditional IRA contribution now, and thereby divert that hypothetical $50 from my taxable bucket to my tax-exempt bucket.
An aside here. It appears that Paul is planning to convert virtually all his traditional IRAs to Roth IRAs in 2010. Would it still be his best strategy to make a 2009 nondeductible IRA contribution if he were planning to convert only a portion of his IRA's to Roths—let’s say 25% of his traditional IRAs? That’s a tougher question. Because then he would only get to recover 25% of his nondeductible contributions tax-free in 2010, and he’d have to wait until later years to recover the remaining 75%. Let’s say he makes a $5,000 nondeductible traditional IRA contribution in 2009, and then converts 25% of his traditional IRAs to a Roth in 2010. The amount he pays tax on is reduced by 25% of his cumulative non-deductible contributions, including the one from 2009. So he contributes $5,000—no deduction—and ends up paying a Roth conversion tax on $3,750. He’s just increased his taxable income by $3,750; he’ll eventually recover the other $3,750 tax-free, but it will take years for that to happen. Is that good planning? I don’t know. I suspect it is, but I think the issue needs some closer study. Look for more on this question in a future post.
Wednesday, June 17, 2009
Keeping Track of Nondeductible IRA Contributions
In a comment to Monday’s post, David raises a question about keeping track of non-deductible contributions to a traditional IRA. He asks if his IRA manager should be expected to keep track of this for him.
The short answer is “no.” Your IRA trustee or custodian—or for that matter, any other financial institution involved with your IRA, such as an investment advisor or mutual fund company—is not obligated to keep track of your nondeductible contributions. Not only are they not obligated to do this, they can’t do it, since the facts that determine whether a given IRA contribution is deductible or not is beyond their knowledge. They don’t know about your status as an active participant in your employer’s retirement plan; nor do they know your AGI. So if you think you’ve lost track of your nondeductible contributions, you can’t look to them for help.
(By the way, the rules for determining whether a traditional IRA contribution is deductible or not—which are way more complicated than they need to be—are summarized in February 14’s post.)
But wait! All is not lost! The only one who can keep track of your cumulative nondeductible traditional IRA contributions is you. And chances are pretty good you’ve done so, even if you don’t remember. Here’s why. Whenever you make a nondeductible traditional IRA contribution, you’re required to file a Form 8606 with your tax return for that year. And that form picks up your cumulative nondeductible contributions from prior years and makes you keep a running total. So all you have to do is find your tax return from the most recent year in which you made a nondeductible contribution, and, voila!, there it is. You don’t have to comb through all prior years’ returns—just the most recent one.
And then when you start taking distributions later in life, the same Form 8606 helps you (actually, makes you) keep track of how much of your distribution is tax-free, and how much you have left to recover tax-free in later years.
If you can’t find your tax return for the year you last made a nondeductible contribution, all is not lost. Maybe your accountant kept a copy. Or if you used tax preparation software, maybe the software kept track of it on your computer. I know from personal experience that Turbo-Tax keeps a running record of it, and carries it forward from year to year.
One other point David raised that I want to touch on. In his comment he asks if he should have expected his IRA manager to have “segregated” his nondeductible contributions. Segregating your nondeductible contributions is neither necessary nor at all helpful. That’s because, as described in February 15’s post, when it comes time to take distributions and enjoy some tax-free distributions, IRS rules force you to aggregate all your traditional IRAs in figuring the amount that’s tax-free. Segregating them into one IRA does you no good.
’Til manana.
The short answer is “no.” Your IRA trustee or custodian—or for that matter, any other financial institution involved with your IRA, such as an investment advisor or mutual fund company—is not obligated to keep track of your nondeductible contributions. Not only are they not obligated to do this, they can’t do it, since the facts that determine whether a given IRA contribution is deductible or not is beyond their knowledge. They don’t know about your status as an active participant in your employer’s retirement plan; nor do they know your AGI. So if you think you’ve lost track of your nondeductible contributions, you can’t look to them for help.
(By the way, the rules for determining whether a traditional IRA contribution is deductible or not—which are way more complicated than they need to be—are summarized in February 14’s post.)
But wait! All is not lost! The only one who can keep track of your cumulative nondeductible traditional IRA contributions is you. And chances are pretty good you’ve done so, even if you don’t remember. Here’s why. Whenever you make a nondeductible traditional IRA contribution, you’re required to file a Form 8606 with your tax return for that year. And that form picks up your cumulative nondeductible contributions from prior years and makes you keep a running total. So all you have to do is find your tax return from the most recent year in which you made a nondeductible contribution, and, voila!, there it is. You don’t have to comb through all prior years’ returns—just the most recent one.
And then when you start taking distributions later in life, the same Form 8606 helps you (actually, makes you) keep track of how much of your distribution is tax-free, and how much you have left to recover tax-free in later years.
If you can’t find your tax return for the year you last made a nondeductible contribution, all is not lost. Maybe your accountant kept a copy. Or if you used tax preparation software, maybe the software kept track of it on your computer. I know from personal experience that Turbo-Tax keeps a running record of it, and carries it forward from year to year.
One other point David raised that I want to touch on. In his comment he asks if he should have expected his IRA manager to have “segregated” his nondeductible contributions. Segregating your nondeductible contributions is neither necessary nor at all helpful. That’s because, as described in February 15’s post, when it comes time to take distributions and enjoy some tax-free distributions, IRS rules force you to aggregate all your traditional IRAs in figuring the amount that’s tax-free. Segregating them into one IRA does you no good.
’Til manana.
Tuesday, June 16, 2009
The Value of Budgetary Flexibility
Here’s a question for you:
If you said, “E. All of the above,” shame on you. You’re not being responsive to the question. I said greatest impact. Of course they’re all important, but you have to pick one.
My educated guess is that the answer is D. Flexibility in your budget. Someday I hope to do a study confirming the relative importance of those factors, but for now it remains an educated guess. Consider the following tale.
Rita Rigid and Zelda Zen are twin sisters. Both are about to retire with $2,000,000 of assets (in a traditional IRA). Both use the same financial advisor. Both want a standard of living that’s as luxurious as possible, consistent with prudence—neither wants to run out of money. The sisters are alike in every way, except for one key difference. While Rita Rigid wants to live on a budget that doesn’t fluctuate from year to year, except for increasing with inflation, Zelda Zen believes she can stand some ups and downs in her annual spending.
Here is the advice they get after consulting with their financial advisor. Rita is advised to plan on spending $70,000 per year, increased annually by inflation, plus necessary income taxes. That’s 3.5% of her starting assets. Zelda is advised to spend $110,000 plus necessary income taxes. Every year, Zelda's budget is to be 5.5% of her remaining assets, but no less than $60,000 and no more than $130,000 (with those brackets increased for inflation each year). Zelda is told to expect her future budget to be both unknown and erratic, to fluctuate significantly between the $60,000 and $130,000 brackets. But the central tendency of her expected annual budget will be about $96,000 (plus taxes).
Depending on which number you look at (Zelda’s $110,000 starting budget or her $96,000 expected budget), Zelda’s standard of living is either 57% or 37% greater than Rita’s. That entire difference arises from her willingness to be flexible in her annual spending. Of course Zelda might experience an unlucky investment environment in the future, and her spending will be less than Rita’s; but she has expressed a willingness to accept that. And it is precisely that willingness that enables her to prudently spend more than Rita.
These figures come from an article I wrote that will appear in a professional journal later this year (CCH Journal of Retirement Planning). They were not just pulled out of a hat, but were based on a rigorous study of how Rita’s and Zelda’s investments might be expected to behave in uncertain markets. Rita prudently deals with that uncertainty by reducing her spending to a conservative amount so that she has a low likelihood of running out of money. Her desire for budgetary certainty demands that conservatism. Zelda prudently deals with uncertainty by anticipating that her spending will fluctuate—within the limits she has set—as the unknowable future unfolds.
Either approach is legitimate. But it’s eye-opening to see that Zelda’s budgetary flexibility is worth a whopping 37%-57% of her standard of living. It’s positively Zen-like. The less you must spend, the more you can spend.
Which of the following has the greatest impact on your standard of living in retirement?
A. Employing a wise asset allocation.
B. Having a wise investment advisor.
C. Having a wise tax advisor.
D. Having flexibility in your budget.
If you said, “E. All of the above,” shame on you. You’re not being responsive to the question. I said greatest impact. Of course they’re all important, but you have to pick one.
My educated guess is that the answer is D. Flexibility in your budget. Someday I hope to do a study confirming the relative importance of those factors, but for now it remains an educated guess. Consider the following tale.
Rita Rigid and Zelda Zen are twin sisters. Both are about to retire with $2,000,000 of assets (in a traditional IRA). Both use the same financial advisor. Both want a standard of living that’s as luxurious as possible, consistent with prudence—neither wants to run out of money. The sisters are alike in every way, except for one key difference. While Rita Rigid wants to live on a budget that doesn’t fluctuate from year to year, except for increasing with inflation, Zelda Zen believes she can stand some ups and downs in her annual spending.
Here is the advice they get after consulting with their financial advisor. Rita is advised to plan on spending $70,000 per year, increased annually by inflation, plus necessary income taxes. That’s 3.5% of her starting assets. Zelda is advised to spend $110,000 plus necessary income taxes. Every year, Zelda's budget is to be 5.5% of her remaining assets, but no less than $60,000 and no more than $130,000 (with those brackets increased for inflation each year). Zelda is told to expect her future budget to be both unknown and erratic, to fluctuate significantly between the $60,000 and $130,000 brackets. But the central tendency of her expected annual budget will be about $96,000 (plus taxes).
Depending on which number you look at (Zelda’s $110,000 starting budget or her $96,000 expected budget), Zelda’s standard of living is either 57% or 37% greater than Rita’s. That entire difference arises from her willingness to be flexible in her annual spending. Of course Zelda might experience an unlucky investment environment in the future, and her spending will be less than Rita’s; but she has expressed a willingness to accept that. And it is precisely that willingness that enables her to prudently spend more than Rita.
These figures come from an article I wrote that will appear in a professional journal later this year (CCH Journal of Retirement Planning). They were not just pulled out of a hat, but were based on a rigorous study of how Rita’s and Zelda’s investments might be expected to behave in uncertain markets. Rita prudently deals with that uncertainty by reducing her spending to a conservative amount so that she has a low likelihood of running out of money. Her desire for budgetary certainty demands that conservatism. Zelda prudently deals with uncertainty by anticipating that her spending will fluctuate—within the limits she has set—as the unknowable future unfolds.
Either approach is legitimate. But it’s eye-opening to see that Zelda’s budgetary flexibility is worth a whopping 37%-57% of her standard of living. It’s positively Zen-like. The less you must spend, the more you can spend.
Monday, June 15, 2009
Losses in Retirement Accounts
I’m back from vacation! Actually I was back a couple of weeks ago, but I was a bit lazy about getting back to The Two Legged Stool. But I’m here now.
I thought I would restart by responding to a couple of comments. First Paul. In his comment to the May 15 post, Anonymous (aka Paul) raises a couple of issues. One of them deals with losses inside a nondeductible IRA. Paul wonders if you can deduct up to $3,000 of losses that you have incurred inside your nondeductible Individual Retirement Account.
You can’t directly deduct losses that occur inside your IRA. Instead, you indirectly get the tax benefit of your losses by having that much less to distribute during your retirement years and therefore reporting that much less taxable income. Remember, everything that goes on inside your IRA is generally irrelevant for income tax purposes. You don’t (yet) pay taxes on interest or dividends; you don’t pay taxes on any capital gains; and you don’t get to deduct any capital losses.
There is one possibility for deducting a tax loss in a nondeductible IRA, but it’s very unusual and I hope it never happens to you. Here it is. When you are at the point of taking out the last dollars from all your traditional IRAs, deductible and nondeductible, if you still have any nondeductible contributions left that you haven’t yet deducted (also sometimes called “basis”), and your losses have been so great over your lifetime that your basis actually exceeds the amount remaining in your IRA, then you can take a tax loss for the difference. I hope this doesn’t happen to you! Picture how unusual it is. It could only happen at the waning years of your life when you’re ready to completely deplete your IRA. (It could also happen sooner if you convert all your traditional IRAs to Roth IRAs.) And your losses would have had to have been pretty bad to exceed all your income and gains during your lifetime. And you have to look at all your traditional IRAs in the aggregate when figuring whether you have a net loss or not. So overall it’s pretty unusual to realize an actual net deductible loss on your IRA.
It's good to be back.
I thought I would restart by responding to a couple of comments. First Paul. In his comment to the May 15 post, Anonymous (aka Paul) raises a couple of issues. One of them deals with losses inside a nondeductible IRA. Paul wonders if you can deduct up to $3,000 of losses that you have incurred inside your nondeductible Individual Retirement Account.
You can’t directly deduct losses that occur inside your IRA. Instead, you indirectly get the tax benefit of your losses by having that much less to distribute during your retirement years and therefore reporting that much less taxable income. Remember, everything that goes on inside your IRA is generally irrelevant for income tax purposes. You don’t (yet) pay taxes on interest or dividends; you don’t pay taxes on any capital gains; and you don’t get to deduct any capital losses.
There is one possibility for deducting a tax loss in a nondeductible IRA, but it’s very unusual and I hope it never happens to you. Here it is. When you are at the point of taking out the last dollars from all your traditional IRAs, deductible and nondeductible, if you still have any nondeductible contributions left that you haven’t yet deducted (also sometimes called “basis”), and your losses have been so great over your lifetime that your basis actually exceeds the amount remaining in your IRA, then you can take a tax loss for the difference. I hope this doesn’t happen to you! Picture how unusual it is. It could only happen at the waning years of your life when you’re ready to completely deplete your IRA. (It could also happen sooner if you convert all your traditional IRAs to Roth IRAs.) And your losses would have had to have been pretty bad to exceed all your income and gains during your lifetime. And you have to look at all your traditional IRAs in the aggregate when figuring whether you have a net loss or not. So overall it’s pretty unusual to realize an actual net deductible loss on your IRA.
It's good to be back.
Friday, May 15, 2009
Thursday, May 14, 2009
The Social Security Trust Fund
On Tuesday, the trustees of the Social Security Trust Fund issued their annual report. It’s getting bleak; like our 401(k) statements.
Of all the key projections, the keyest projection of all is the year the retirement Trust Fund is expected to run bone dry. That is now projected to happen in 2037, a full four years earlier than last year’s projection. That’s a big change. And it’s as much a testament to the fragility of long-term projections as it is to the fragility of the Fund.
What happens when the well runs dry? Revenues are then still pouring into the Fund—remember all those FICA taxes you’re paying—but they will be insufficient to pay 100% of promised benefits. In fact, they’re projected to be enough to pay only 76% of promised benefits. Unless, the law is changed, that’s all retirees will get: 76%. Some promise, huh!
Another key date that’s deteriorating is the year the Fund stops growing. Taxes and interest grow the Trust Fund, building up a needed surplus to deal with a substantial projected increase in promised benefits. The Fund is projected to switch from growth to erosion in 2016, one year earlier than last year’s projection.
There’s lots of reasons for this deterioration—greater unemployment, slower growth in wages, low interest income on the Treasury bonds comprising Trust Fund’s assets. But at least the Trust Fund hasn’t been decimated by last year’s poor stock market performance. There ain’t no stocks in the Fund.
Clearly all our political leaders need to agree to resolve the solvency of the Trust Fund. Even if the solution ultimately favored by the majority is not their favorite solution, at least they should agree that some early action is better than inaction. It is manifestly unfair for future retirees to see their “promised” benefits shaved when they (we) have been cheerfully—or at least dutifully—supporting current retirees with our payroll taxes.
What are your favorite solutions to the actuarial shortfall? I've previously bloviated as to my own favorite fix, in January 11's post. I've shown you mine; you show me yours.
Of all the key projections, the keyest projection of all is the year the retirement Trust Fund is expected to run bone dry. That is now projected to happen in 2037, a full four years earlier than last year’s projection. That’s a big change. And it’s as much a testament to the fragility of long-term projections as it is to the fragility of the Fund.
What happens when the well runs dry? Revenues are then still pouring into the Fund—remember all those FICA taxes you’re paying—but they will be insufficient to pay 100% of promised benefits. In fact, they’re projected to be enough to pay only 76% of promised benefits. Unless, the law is changed, that’s all retirees will get: 76%. Some promise, huh!
Another key date that’s deteriorating is the year the Fund stops growing. Taxes and interest grow the Trust Fund, building up a needed surplus to deal with a substantial projected increase in promised benefits. The Fund is projected to switch from growth to erosion in 2016, one year earlier than last year’s projection.
There’s lots of reasons for this deterioration—greater unemployment, slower growth in wages, low interest income on the Treasury bonds comprising Trust Fund’s assets. But at least the Trust Fund hasn’t been decimated by last year’s poor stock market performance. There ain’t no stocks in the Fund.
Clearly all our political leaders need to agree to resolve the solvency of the Trust Fund. Even if the solution ultimately favored by the majority is not their favorite solution, at least they should agree that some early action is better than inaction. It is manifestly unfair for future retirees to see their “promised” benefits shaved when they (we) have been cheerfully—or at least dutifully—supporting current retirees with our payroll taxes.
What are your favorite solutions to the actuarial shortfall? I've previously bloviated as to my own favorite fix, in January 11's post. I've shown you mine; you show me yours.
Wednesday, May 13, 2009
Magnitude/Likelihood Matrix of Real Returns
May 11’s post and May 12’s post described extreme results—the worst and the best—for stocks and bonds over three different time frames. But hidden within the charts in May 11’s post is a third facet of risk and uncertainty: It’s an entire matrix of possible outcomes ranked by magnitude and likelihood.
You can—and should—use bad extremes to eliminate investment and spending plans with outcomes you just couldn’t stand. (Or should I say “investment-spending plans,” the way physicists say “space-time,” since the two are so intimately linked.) But then you’re (hopefully) left with a range of remaining choices. It helps to have a sense of (a) just how good (or bad) an outcome might be, and (b) the likelihood of that size outcome.
One way to get a sense of life’s magnitude/likelihood matrix is to look at historical percentiles. You surely remember percentiles from when you took the SATs. For example, in the numbers below, the 30th percentile real return is 8.6%. That means 8.6% is the aggregate real return that is better than 30% of all the outcomes studied. Looked at another way, you stand a kinda’ sorta’ 70% likelihood of realizing an 8.6% or greater real return; and a 30% kinda’ sorta’ likelihood of realizing less than 8.6% aggregate real return. You gotta’ be real lucky to experience a 90th percentile future; and real unlucky to experience a 10th percentile future.
With that as background, and by way of example, here’s the magnitude/likelihood matrix for aggregate real returns on a portfolio with a 50%-50% mixture of stocks and bonds over 60-month periods between 1926 and 2008.
90th percentile: 67.8%
80th percentile: 55.5%
70th percentile: 44.2%
60th percentile: 36.1%
50th percentile: 27.7%
40th percentile: 19.0%
30th percentile: 8.6%
20th percentile: 1.4%
10th percentile: -5.1%
Two caveats:
1. Don’t get fooled into thinking these percentiles tell you the probability of future outcomes. They’re only "kinda’ sorta’" probabilities. You can’t use the past to predict the future; but you can use it as a tool to help you plan in the face of uncertainty.
2. The foregoing figures represent the aggregate five-year growth (or shrinkage) in the real (inflation-adjusted) size of a pot of assets. As pointed out in yesterday’s post, that’s not really the right yardstick. Ultimately, your allowance is the right yardstick when planning your retirement. I chose this particular measurement because it’s an easy one to measure, and it’s useful in illustrating the concept of a magnitude/likelihood matrix.
You can—and should—use bad extremes to eliminate investment and spending plans with outcomes you just couldn’t stand. (Or should I say “investment-spending plans,” the way physicists say “space-time,” since the two are so intimately linked.) But then you’re (hopefully) left with a range of remaining choices. It helps to have a sense of (a) just how good (or bad) an outcome might be, and (b) the likelihood of that size outcome.
One way to get a sense of life’s magnitude/likelihood matrix is to look at historical percentiles. You surely remember percentiles from when you took the SATs. For example, in the numbers below, the 30th percentile real return is 8.6%. That means 8.6% is the aggregate real return that is better than 30% of all the outcomes studied. Looked at another way, you stand a kinda’ sorta’ 70% likelihood of realizing an 8.6% or greater real return; and a 30% kinda’ sorta’ likelihood of realizing less than 8.6% aggregate real return. You gotta’ be real lucky to experience a 90th percentile future; and real unlucky to experience a 10th percentile future.
With that as background, and by way of example, here’s the magnitude/likelihood matrix for aggregate real returns on a portfolio with a 50%-50% mixture of stocks and bonds over 60-month periods between 1926 and 2008.
90th percentile: 67.8%
80th percentile: 55.5%
70th percentile: 44.2%
60th percentile: 36.1%
50th percentile: 27.7%
40th percentile: 19.0%
30th percentile: 8.6%
20th percentile: 1.4%
10th percentile: -5.1%
Two caveats:
1. Don’t get fooled into thinking these percentiles tell you the probability of future outcomes. They’re only "kinda’ sorta’" probabilities. You can’t use the past to predict the future; but you can use it as a tool to help you plan in the face of uncertainty.
2. The foregoing figures represent the aggregate five-year growth (or shrinkage) in the real (inflation-adjusted) size of a pot of assets. As pointed out in yesterday’s post, that’s not really the right yardstick. Ultimately, your allowance is the right yardstick when planning your retirement. I chose this particular measurement because it’s an easy one to measure, and it’s useful in illustrating the concept of a magnitude/likelihood matrix.
Tuesday, May 12, 2009
Magnitude of 12-Month Real Gains
Yesterday’s post explored one facet of risk: The potential magnitude of real losses you would have experienced over different time frames in past years with your stock and bond investments. It pays to know the extremes of bad outcomes you might expect, as that can help you select an appropriate asset allocation; you can then eliminate asset allocations with potential outcomes you simply could not stand.
But why are you looking at just the worst outcomes? What are you, some kind of paranoid? What about the best outcomes? Take a look at the right hand extremes of the charts in yesterday’s post. These endpoints represent the best historical real returns of stocks, bonds, and a 50%-50% mixture over different time frames.
To summarize, here are the historically best aggregate real returns between 1926 and 2008:
Over 12 Months:
Stocks: 182%
Bonds: 26%
50%-50% mixture: 99%
Over 60 Months:
Stocks: 347%
Bonds: 105%
50%-50% mixture: 157%
Over 120 Months:
Stocks: 473%
Bonds: 146%
50%-50% mixture: 216%
Of course, you don’t plan your future by looking at the rosiest outcome. To the contrary. You plan by eliminating options that carry a meaningful likelihood of disastrous results. But it’s instructive to understand the other extreme as well.
Two important caveats: (1) Future outcomes can certainly be worse than any experienced in the past. (2) The growth and shrinkage of your pot of retirement assets is something of a red herring. The right yardstick is the growth and shrinkage of your future annual spending. While the size of your pot is an important key determinant, it’s just a step on the road to what really matters: Your standard of living as reflected in the allowance you allow yourself, given the size of the pot. More to come on this in future posts.
But why are you looking at just the worst outcomes? What are you, some kind of paranoid? What about the best outcomes? Take a look at the right hand extremes of the charts in yesterday’s post. These endpoints represent the best historical real returns of stocks, bonds, and a 50%-50% mixture over different time frames.
To summarize, here are the historically best aggregate real returns between 1926 and 2008:
Over 12 Months:
Stocks: 182%
Bonds: 26%
50%-50% mixture: 99%
Over 60 Months:
Stocks: 347%
Bonds: 105%
50%-50% mixture: 157%
Over 120 Months:
Stocks: 473%
Bonds: 146%
50%-50% mixture: 216%
Of course, you don’t plan your future by looking at the rosiest outcome. To the contrary. You plan by eliminating options that carry a meaningful likelihood of disastrous results. But it’s instructive to understand the other extreme as well.
Two important caveats: (1) Future outcomes can certainly be worse than any experienced in the past. (2) The growth and shrinkage of your pot of retirement assets is something of a red herring. The right yardstick is the growth and shrinkage of your future annual spending. While the size of your pot is an important key determinant, it’s just a step on the road to what really matters: Your standard of living as reflected in the allowance you allow yourself, given the size of the pot. More to come on this in future posts.
Monday, May 11, 2009
Magnitude of 12-Month Real Losses
May 7’s post explored how frequently your investments might be expected to experience real (i.e., inflation-adjusted) losses after different lengths of time. The graph in that post showed, historically, how frequently investments in stocks, bonds, and a 50%-50% mixture of stocks and bonds have exhibited real losses over periods ranging from 12 months to 52 years.
Pretty good information. It provides you with a gauge of how frequently you might get scared. But there’s another dimension to consider. Just how scared will you get? Are we talking “Ghostbusters” or “Alien”?
The charts below attempt to give an idea of the magnitude of the real losses (and gains) that the markets have historically provided. Rather than the frequency of bad results, it measures their size.
The bottom chart summarizes the results over short (12-month) periods. As might be expected, stocks have been very scary over the short run, exhibiting the worst potential losses over 12-month periods—as bad as a 64% loss in value. In contrast, bonds’ worst 12-month real loss has been only 16%. A 50%-50% mixture of stocks and bonds resulted in a 27% worst-historical-case loss. The range between worst cases and best cases are shown in 10-percentile increments. (As with May 7’s post, I looked at all 12-month periods between January 1, 1926 and December 31, 2008. There have been 977 of them. For stocks, I used total return on the S&P 500; for bonds, intermediate term Treasury bonds; and for inflation, changes in the Consumer Price Index. In other words, the usual suspects.)
If you lengthen the period between measurements, ignoring interim ups and downs, things start to change. The middle chart shows the same data for 60-month (5-year) periods. Stocks still exhibit the potentially worst result, with a worst-case real loss during 1926-2008 of up to 51%, with bonds’ worst real loss over a 60-month period of 28%. With time, stocks' worst performance gets better, and bonds' worst performance gets worse. And the 50%-50% mixture of stocks and bonds now exhibits the best worst case, with only a 21% loss.
And if you lengthen it further to 120 months (10 years), the pattern continues to hold: A 50%-50% mixture of stocks and bonds has provided the least bad worst case, as shown in the top chart below.
By the way, those of us who suffered through 2008 will not be surprised to learn that between 1926 and 2008, the worst 120-month period for stocks, in terms of inflation-adjusted losses, was the 120 months from December 1, 1998 to November 30, 2008. Just thought you might want to know.
Pretty good information. It provides you with a gauge of how frequently you might get scared. But there’s another dimension to consider. Just how scared will you get? Are we talking “Ghostbusters” or “Alien”?
The charts below attempt to give an idea of the magnitude of the real losses (and gains) that the markets have historically provided. Rather than the frequency of bad results, it measures their size.
The bottom chart summarizes the results over short (12-month) periods. As might be expected, stocks have been very scary over the short run, exhibiting the worst potential losses over 12-month periods—as bad as a 64% loss in value. In contrast, bonds’ worst 12-month real loss has been only 16%. A 50%-50% mixture of stocks and bonds resulted in a 27% worst-historical-case loss. The range between worst cases and best cases are shown in 10-percentile increments. (As with May 7’s post, I looked at all 12-month periods between January 1, 1926 and December 31, 2008. There have been 977 of them. For stocks, I used total return on the S&P 500; for bonds, intermediate term Treasury bonds; and for inflation, changes in the Consumer Price Index. In other words, the usual suspects.)
If you lengthen the period between measurements, ignoring interim ups and downs, things start to change. The middle chart shows the same data for 60-month (5-year) periods. Stocks still exhibit the potentially worst result, with a worst-case real loss during 1926-2008 of up to 51%, with bonds’ worst real loss over a 60-month period of 28%. With time, stocks' worst performance gets better, and bonds' worst performance gets worse. And the 50%-50% mixture of stocks and bonds now exhibits the best worst case, with only a 21% loss.
And if you lengthen it further to 120 months (10 years), the pattern continues to hold: A 50%-50% mixture of stocks and bonds has provided the least bad worst case, as shown in the top chart below.
By the way, those of us who suffered through 2008 will not be surprised to learn that between 1926 and 2008, the worst 120-month period for stocks, in terms of inflation-adjusted losses, was the 120 months from December 1, 1998 to November 30, 2008. Just thought you might want to know.
Sunday, May 10, 2009
Annuities I’d Like to See
Yesterday’s post discussed the three main functions of that pot of assets you’ve accumulated toward your retirement. Since the mainest of the main functions is to provide you with a stream of retirement income for the rest of your indeterminate life, the purchase of an annuity with some of those assets theoretically serves that function quite well. Emphasis on the word “theoretically.” If only the absolute right insurance product existed! If anyone out there knows of a product that meets all of the following criteria, please post a comment or send me an email. And pass this post on to your insurance agent to get some additional professional perspective.
Longevity Insurance. According to some academics, the most efficient use of your hard-earned assets would be to use a small portion of them (I’ve seen estimates of 10% to 15%) to purchase an annuity that doesn’t start to pay you unless and until you reach an advanced age. Say 85. So the annuity is really a form of insurance. Longevity insurance. Some insurance companies, but not too many, offer annuities of this sort.
Buying a pure annuity requires a trade-off. You lose emergency access to the funds, and you eliminate your children’s inheritance. But you get something valuable in exchange: Every dollar goes toward providing you a lifetime allowance. So using only 10%-15% of your assets for this purpose sounds like a pretty good trade-off .
Inflation Adjustment. The ideal annuity/longevity insurance would have inflation protection by increasing annual payments by changes in the Consumer Price Index. Such a product exists (one is offered by AIG) in the world of immediate annuities, but not in the world of longevity insurance where payout is deferred 20 years or so. That would be nice to have.
Low Creditor Risk. Speaking of AIG, you want to buy an annuity only from a company that is superbly solvency. You’ll be relying on that solvency for a long long time. All states offer a guaranty fund in case an insurer goes belly up, but only up to stated limits which differ from state to state, and which may not cover your entire annuity.
Rate Risk. The annuity you’re able to buy will vary, largely with current interest rates, depending on when you buy it. For example, an article by Chen and Malevsky point out that $100,000 would have purchased a $1,150/month annuity in the 1980’s, but only about $700/month in 2003. That’s a 36% drop, just depending on what year you bought the thing. An ideal annuity product would allow you to buy a little slice of your longevity insurance each year during your working years—and beyond—in order to hedge against this fluctuating market.
Transparency. It’s hard to know whether you’re getting a good deal from your insurer. It would be nice if there was some uniform basis on which to compare similar, but not identical, products from different insurers.
If there were products meeting these criteria, maybe that would solve the "annuity puzzle," as it's been called: The mystery of why more people don't buy these things.
Any annuity you purchase ought to then have an impact on how you invest and spend the balance of your assets. Indeed, the same statement applies to your Social Security benefit and any pension you’ve earned. The existence of these largely-guaranteed streams of income can free you up for greater spending and a higher percentage of riskier higher-yielding investments.
All credit for some of the good ideas expressed in this post goes to discussions with my friends Peter (of Stembrook Asset Management) and Jennifer. All of the bad ideas, of course, are mine.
Longevity Insurance. According to some academics, the most efficient use of your hard-earned assets would be to use a small portion of them (I’ve seen estimates of 10% to 15%) to purchase an annuity that doesn’t start to pay you unless and until you reach an advanced age. Say 85. So the annuity is really a form of insurance. Longevity insurance. Some insurance companies, but not too many, offer annuities of this sort.
Buying a pure annuity requires a trade-off. You lose emergency access to the funds, and you eliminate your children’s inheritance. But you get something valuable in exchange: Every dollar goes toward providing you a lifetime allowance. So using only 10%-15% of your assets for this purpose sounds like a pretty good trade-off .
Inflation Adjustment. The ideal annuity/longevity insurance would have inflation protection by increasing annual payments by changes in the Consumer Price Index. Such a product exists (one is offered by AIG) in the world of immediate annuities, but not in the world of longevity insurance where payout is deferred 20 years or so. That would be nice to have.
Low Creditor Risk. Speaking of AIG, you want to buy an annuity only from a company that is superbly solvency. You’ll be relying on that solvency for a long long time. All states offer a guaranty fund in case an insurer goes belly up, but only up to stated limits which differ from state to state, and which may not cover your entire annuity.
Rate Risk. The annuity you’re able to buy will vary, largely with current interest rates, depending on when you buy it. For example, an article by Chen and Malevsky point out that $100,000 would have purchased a $1,150/month annuity in the 1980’s, but only about $700/month in 2003. That’s a 36% drop, just depending on what year you bought the thing. An ideal annuity product would allow you to buy a little slice of your longevity insurance each year during your working years—and beyond—in order to hedge against this fluctuating market.
Transparency. It’s hard to know whether you’re getting a good deal from your insurer. It would be nice if there was some uniform basis on which to compare similar, but not identical, products from different insurers.
If there were products meeting these criteria, maybe that would solve the "annuity puzzle," as it's been called: The mystery of why more people don't buy these things.
Any annuity you purchase ought to then have an impact on how you invest and spend the balance of your assets. Indeed, the same statement applies to your Social Security benefit and any pension you’ve earned. The existence of these largely-guaranteed streams of income can free you up for greater spending and a higher percentage of riskier higher-yielding investments.
All credit for some of the good ideas expressed in this post goes to discussions with my friends Peter (of Stembrook Asset Management) and Jennifer. All of the bad ideas, of course, are mine.
Saturday, May 9, 2009
Three Functions of Retirement Savings
OK. So you’ve built up this nice big pot of assets on which to retire. As you embark on the difficult quest of adopting a retirement spending plan—your scheme for determining how much you’re going to allow yourself to spend each year—your allowance, as it were—it’s helpful to consider the three main functions of that cache. Here they are in order of importance, at least for most people:
1. A source for your annual retirement spending. Duh.
2. A reserve for unanticipated emergencies.
3. An inheritance for your heirs, usually your kids.
Let me dwell on these functions in reverse order.
Inheritance. Not so important for most people. You’re struggling just to maintain your own lifestyle, so how can you give any weight to luxuries for the next generation? So function #3 is strictly on the back burner. But two points are worth noting.
First, at some point, if the pot is large enough, the marginal utility of spending another dollar on your standard of living is just not enough to outweigh the pleasure you’d get from leaving—or giving—something to your kids. Maybe you’d rather help them make a down payment on their first house than buy yourself that pearl-handled backscratcher you admired in the window at Tiffany’s.
Second, as discussed in March 20’s post, leaving an inheritance is an inevitable, if unintended, by-product of not knowing how long you and your spouse are going to live.
Emergency Reserve. Stuff happens. You plan to spend your assets roughly equally each year, but then the roof springs a leak. Or Bowser contracts canine chilblains. Whatever. Even if you do your financial planning perfectly, and your investments perform just as you project (which they won’t; I’m just making a point here) life will hit you with your own personalized pig bladder. So you need to keep a reserve for the inevitable unexpected. (Is it correct to call the inevitable “unexpected”? Probably not.)
Note, however, that your need for an emergency reserve shrinks with your shrinking life expectancy. One year older? That’s one less year of financial curveballs ahead of you.
Retirement Spending. The main function of that pot you’ve accumulated (the financial one; not the one hanging over your belt) is to provide a stream of spending for your indeterminate lifetime. While you don’t know how much you’re going to need for the future, you have a rough sense that it shrinks as you get older: fewer years left to spend on yourself; fewer years to get stung by crummy financial markets. So perhaps the percentage of assets that you spend should somehow—slowly and conservatively, but somehow—grow with the passing years. Maybe an 85-year old can prudently spend a bigger percentage of her assets than a newly superannuated 65-year old.
So those are the three main functions of your treasure trove. (What have I left out? Send me an email or post a comment.) Now the tricky part is to translate these generalizations into a scheme for spending your assets prudently. More to come on this—much more.
1. A source for your annual retirement spending. Duh.
2. A reserve for unanticipated emergencies.
3. An inheritance for your heirs, usually your kids.
Let me dwell on these functions in reverse order.
Inheritance. Not so important for most people. You’re struggling just to maintain your own lifestyle, so how can you give any weight to luxuries for the next generation? So function #3 is strictly on the back burner. But two points are worth noting.
First, at some point, if the pot is large enough, the marginal utility of spending another dollar on your standard of living is just not enough to outweigh the pleasure you’d get from leaving—or giving—something to your kids. Maybe you’d rather help them make a down payment on their first house than buy yourself that pearl-handled backscratcher you admired in the window at Tiffany’s.
Second, as discussed in March 20’s post, leaving an inheritance is an inevitable, if unintended, by-product of not knowing how long you and your spouse are going to live.
Emergency Reserve. Stuff happens. You plan to spend your assets roughly equally each year, but then the roof springs a leak. Or Bowser contracts canine chilblains. Whatever. Even if you do your financial planning perfectly, and your investments perform just as you project (which they won’t; I’m just making a point here) life will hit you with your own personalized pig bladder. So you need to keep a reserve for the inevitable unexpected. (Is it correct to call the inevitable “unexpected”? Probably not.)
Note, however, that your need for an emergency reserve shrinks with your shrinking life expectancy. One year older? That’s one less year of financial curveballs ahead of you.
Retirement Spending. The main function of that pot you’ve accumulated (the financial one; not the one hanging over your belt) is to provide a stream of spending for your indeterminate lifetime. While you don’t know how much you’re going to need for the future, you have a rough sense that it shrinks as you get older: fewer years left to spend on yourself; fewer years to get stung by crummy financial markets. So perhaps the percentage of assets that you spend should somehow—slowly and conservatively, but somehow—grow with the passing years. Maybe an 85-year old can prudently spend a bigger percentage of her assets than a newly superannuated 65-year old.
So those are the three main functions of your treasure trove. (What have I left out? Send me an email or post a comment.) Now the tricky part is to translate these generalizations into a scheme for spending your assets prudently. More to come on this—much more.
Friday, May 8, 2009
Timing of Roth Conversion
In a comment to May 4’s post, “Financial Planner Atlanta” (if that’s your real name) raised a good question. How does the timing of a 2010 distribution from a 401(k) plan and follow-up IRA rollover affect the decision to convert a traditional Individual Retirement Account to a Roth IRA?
The fortunate answer is that the timing of the rollover is irrelevant to the tax cost of converting a pre-existing IRA to a Roth IRA.
Let’s say the IRA is worth $200,000 and the 401(k) is worth $1,000,000. By rolling over the $1,000,000 to a traditional IRA, that $1,000,000 is excluded from your Adjusted Gross Income and from your taxable income. So when you add the $100,000 IRA balance to your other 2010 income to figure your tax cost, the $1,000,000 doesn’t appear anywhere or affect any of your tax calculations.
And the same is true if you elect to have the $200,000 taxed in 2011 and 2012, $100,000 each year. The $1,000,000 rollover disappears from those tax calculations as well.
And the same is true whether the 401(k) rollover occurs before or after the Roth IRA conversion. Or even if the Roth IRA conversion happens during the up-to-60-day period between when the 401(k) plan distributes the $1,000,000 and you roll it into your IRA.
Finally, once the dust settles on the rollover, you have th rest of the year to decide if you want to Rothificate some of it in addition to the original $200,000. At a greater tax cost, of course.
I hope that answers the question.
The fortunate answer is that the timing of the rollover is irrelevant to the tax cost of converting a pre-existing IRA to a Roth IRA.
Let’s say the IRA is worth $200,000 and the 401(k) is worth $1,000,000. By rolling over the $1,000,000 to a traditional IRA, that $1,000,000 is excluded from your Adjusted Gross Income and from your taxable income. So when you add the $100,000 IRA balance to your other 2010 income to figure your tax cost, the $1,000,000 doesn’t appear anywhere or affect any of your tax calculations.
And the same is true if you elect to have the $200,000 taxed in 2011 and 2012, $100,000 each year. The $1,000,000 rollover disappears from those tax calculations as well.
And the same is true whether the 401(k) rollover occurs before or after the Roth IRA conversion. Or even if the Roth IRA conversion happens during the up-to-60-day period between when the 401(k) plan distributes the $1,000,000 and you roll it into your IRA.
Finally, once the dust settles on the rollover, you have th rest of the year to decide if you want to Rothificate some of it in addition to the original $200,000. At a greater tax cost, of course.
I hope that answers the question.
Thursday, May 7, 2009
Frequency of 12-Month Real Losses
April 28’s post and yesterday’s post explored the frequency with which your investment accounts might be expected to show real, inflation-adjusted losses. Let’s look at that from just one more perspective.
April 28’s post looked at calendar year periods of different lengths. But we can get a more robust sense of how long it might take for different asset classes to recover from real losses by looking at 12-month periods of all sorts—not just calendar years. After all, there have only been 83 calendar years between 1926 and 2008—the period studied—but there have been 988 12-month periods to pore over if we look at all 12-calendar-month periods (e.g., April 1 2008 – March 31, 2009) between January 1, 1926 and March 31, 2009.
The pattern we saw in April 28’s post holds. Take a look at the graph below. Historically, both stocks and bonds have recovered from real (i.e., inflation-adjusted) losses given enough time. The longer the period between measurements, the less likely your investment will have experienced a real loss. Stocks (the blue line) have taken as long as 19 12-month periods, and bonds (the red line) have taken as long as 52 12-month periods. A 50%-50% mixture of stocks and bonds (the green line) has taken up to 20 12-month periods, but overall has tended to suffer fewer losing periods than either stocks or bonds standing alone.
As in prior posts, I measured stock performance by the total return on the S&P 500; bond returns by the total return on intermediate term Treasury bonds; and inflation by changes in the consumer price index.
As previously pointed out, this is just one aspect of investment risk, and a rather narrow one at that. Stay tuned for more and different ways to wallow around in risk.
April 28’s post looked at calendar year periods of different lengths. But we can get a more robust sense of how long it might take for different asset classes to recover from real losses by looking at 12-month periods of all sorts—not just calendar years. After all, there have only been 83 calendar years between 1926 and 2008—the period studied—but there have been 988 12-month periods to pore over if we look at all 12-calendar-month periods (e.g., April 1 2008 – March 31, 2009) between January 1, 1926 and March 31, 2009.
The pattern we saw in April 28’s post holds. Take a look at the graph below. Historically, both stocks and bonds have recovered from real (i.e., inflation-adjusted) losses given enough time. The longer the period between measurements, the less likely your investment will have experienced a real loss. Stocks (the blue line) have taken as long as 19 12-month periods, and bonds (the red line) have taken as long as 52 12-month periods. A 50%-50% mixture of stocks and bonds (the green line) has taken up to 20 12-month periods, but overall has tended to suffer fewer losing periods than either stocks or bonds standing alone.
As in prior posts, I measured stock performance by the total return on the S&P 500; bond returns by the total return on intermediate term Treasury bonds; and inflation by changes in the consumer price index.
As previously pointed out, this is just one aspect of investment risk, and a rather narrow one at that. Stay tuned for more and different ways to wallow around in risk.
Wednesday, May 6, 2009
Frequency of Monthly Real Losses
April 26’s post explored the frequency with which your investment accounts can be expected to show real, inflation-adjusted losses. And the clear pattern was this: Look at your account annually, and it’s scary; losses are depressingly frequent. Stretch out your interval between measurements, and losses tend to melt away. Time—if you’ve got it—heals all losses.
What if you go in the other direction? What if you measure the progress of your investment account more frequently, rather than less? After all, who can resist reviewing their accounts frequently? As indeed you should.
Not surprisingly, it turns out the pattern holds when you shorten the interval to a month. The frequency with which investments have incurred monthly real losses is a bit greater than the frequency of annual real losses. Here are the results for the 999 months between January 1926 and March 2009. Stocks have suffered a real loss in value 41% of the time (compared to 33% calendar year losses). Bonds have suffered a real loss 44% of the time (compared to 39% calendar year losses). And a 50%-50% mixture of stocks and bonds has suffered a real loss 41% of the time (compared to 31% calendar year losses).
As in April 26’s post, stock performance is measured by the total return on the S&P 500, including appreciation, depreciation and dividends. Bond performance is measured by the total return on intermediate term Treasury bonds. And inflation is measured by changes in the consumer price index.
So what’s the message? Quoting the great philosopher, Betty Davis in “All About Eve”: “Fasten your seatbelts. It’s going to be a bumpy ride.”
What if you go in the other direction? What if you measure the progress of your investment account more frequently, rather than less? After all, who can resist reviewing their accounts frequently? As indeed you should.
Not surprisingly, it turns out the pattern holds when you shorten the interval to a month. The frequency with which investments have incurred monthly real losses is a bit greater than the frequency of annual real losses. Here are the results for the 999 months between January 1926 and March 2009. Stocks have suffered a real loss in value 41% of the time (compared to 33% calendar year losses). Bonds have suffered a real loss 44% of the time (compared to 39% calendar year losses). And a 50%-50% mixture of stocks and bonds has suffered a real loss 41% of the time (compared to 31% calendar year losses).
As in April 26’s post, stock performance is measured by the total return on the S&P 500, including appreciation, depreciation and dividends. Bond performance is measured by the total return on intermediate term Treasury bonds. And inflation is measured by changes in the consumer price index.
So what’s the message? Quoting the great philosopher, Betty Davis in “All About Eve”: “Fasten your seatbelts. It’s going to be a bumpy ride.”
Tuesday, May 5, 2009
State Taxation of Retirement Distributions
How will your state tax your retirement distributions? That’s a cost which you will need to take into account as you set your savings goal.
Most states have their own income tax. A few states, like Florida, have no income tax. (What fuels their government? Sunshine? ) Of the states that do impose an income tax, many have chosen the expedient scheme of piggy-backing onto the federal income tax system by starting the state tax calculation with the income and deduction figures from your federal tax return, and then adding and subtracting a few adjustments from there. So in these states, if a dollar of distribution from a retirement account is taxable for federal purposes, it will be equally taxable for state purposes, at least initially. And in these states, if—as with a well-timed Roth IRA distribution—it’s not taxable for federal income tax purposes, then it won’t be taxable for state income tax purposes either.
Some states have enacted a special benefit for their senior citizens. New York, for example, exempts up to $20,000 of otherwise taxable retirement income from state tax. Thank you, New York!
Imagine this scenario, which is not atypical. You work all your life in a high tax state, like New York or California. During all those years you are earning contributions to retirement accounts which are not being taxed. Some contributions are made by your employer, and some are made by you (think 401(k)). These contributions have gone into the Tax Time Machine, as described in January 29’s post. Then you retire to sunny Florida—which has no income tax—and you start taking distributions from these accounts. “Wait a minute,” says the state of California, “you earned those dollars when you were working here. We want to collect some of that tax revenue, no matter where you live. We’re coming to get you!”
Can California do that? No, they can’t. They tried to, a number of years ago, and in response Congress passed a law making it illegal for a state to tax retirement plan distributions to residents of another state, even if the non-resident had earned the contributions while living and working in the taxing state. This law applies to tax-favored retirement accounts, like IRA’s and 401(k)’s, but it doesn’t apply to many non-qualified deferred compensation plans.
(What’s a non-qualified deferred compensation plan? It’s a kind of retirement plan only available to highly paid employees. If you’ve got one, you know what it is.)
So as you do your planning, and project your tax costs, pay a bit of attention to your state’s taxing scheme.
Most states have their own income tax. A few states, like Florida, have no income tax. (What fuels their government? Sunshine? ) Of the states that do impose an income tax, many have chosen the expedient scheme of piggy-backing onto the federal income tax system by starting the state tax calculation with the income and deduction figures from your federal tax return, and then adding and subtracting a few adjustments from there. So in these states, if a dollar of distribution from a retirement account is taxable for federal purposes, it will be equally taxable for state purposes, at least initially. And in these states, if—as with a well-timed Roth IRA distribution—it’s not taxable for federal income tax purposes, then it won’t be taxable for state income tax purposes either.
Some states have enacted a special benefit for their senior citizens. New York, for example, exempts up to $20,000 of otherwise taxable retirement income from state tax. Thank you, New York!
Imagine this scenario, which is not atypical. You work all your life in a high tax state, like New York or California. During all those years you are earning contributions to retirement accounts which are not being taxed. Some contributions are made by your employer, and some are made by you (think 401(k)). These contributions have gone into the Tax Time Machine, as described in January 29’s post. Then you retire to sunny Florida—which has no income tax—and you start taking distributions from these accounts. “Wait a minute,” says the state of California, “you earned those dollars when you were working here. We want to collect some of that tax revenue, no matter where you live. We’re coming to get you!”
Can California do that? No, they can’t. They tried to, a number of years ago, and in response Congress passed a law making it illegal for a state to tax retirement plan distributions to residents of another state, even if the non-resident had earned the contributions while living and working in the taxing state. This law applies to tax-favored retirement accounts, like IRA’s and 401(k)’s, but it doesn’t apply to many non-qualified deferred compensation plans.
(What’s a non-qualified deferred compensation plan? It’s a kind of retirement plan only available to highly paid employees. If you’ve got one, you know what it is.)
So as you do your planning, and project your tax costs, pay a bit of attention to your state’s taxing scheme.
Monday, May 4, 2009
Your Own Retirement Goal
All rules of thumb are wrong.
For instance, you sometimes read that a reasonable retirement goal is to spend 85% of what you are spending during your working years. At least I think that’s the rule of thumb. Or maybe it’s that your retirement income should be 85% of what your income was during your working years. These are two different things.
Whatever. It really doesn’t matter what the rule of thumb is, because it doesn’t apply to you anyway. In a comment to April 27’s post, for example, David suggests that his expenses will actually increase during his retirement years. In his case, he expects to incur higher travel costs. If he follows a rule of thumb in setting a retirement saving goal, he may have to actually use his thumb for travel.
So it pays to set a retirement savings goal based on your own spending needs. And what are they? Well, you can start with what you’re spending today and think through appropriate adjustments. How do you know what you’re currently spending? You could look at that directly by combing through your checkbook for the last few years, but that might be pretty tedious. Perhaps it’s easier to get at that indirectly by looking at your income and subtracting out your savings.
Then you can think through all your categories of spending, and project whether they will change—up or down. Here are a few items that may change:
• Retirement savings. That’s one “expense” that goes away. No more 401(k) deferrals; no more IRA contributions.
• FICA taxes. These stop when you’re no longer working.
• Your mortgage. When will this be paid off? Perhaps it's a disappearing expense. Unless you’re one of those refinancing addicts who take out a home equity loan before each visit to the gas station.
• Health insurance. Maybe this will go up, if your employer is now subsidizing this cost but won’t after retirement. Or maybe it will go down if you expect to rely on Medicare.
• Food. Maybe you’re cooking for four now, but that will drop to two after the kids are grown. Or maybe you’ll then eat out more. Or maybe dining out will cost less as you come to enjoy those early bird specials.
• Commuting expense. Goes down. Way down.
• Clothing. The cost of business suits goes down. But then again, Bermuda shorts, floral shirts and white shoes can be expensive, too.
• Travel. It’s a conundrum. Just when you have the time for more travel, your financial resources get constrained. But you’re able to take advantage of last-minute deals on cruises to Mexico and such.
• Grandchildren. That’s a whole new category.
What did I miss?
For instance, you sometimes read that a reasonable retirement goal is to spend 85% of what you are spending during your working years. At least I think that’s the rule of thumb. Or maybe it’s that your retirement income should be 85% of what your income was during your working years. These are two different things.
Whatever. It really doesn’t matter what the rule of thumb is, because it doesn’t apply to you anyway. In a comment to April 27’s post, for example, David suggests that his expenses will actually increase during his retirement years. In his case, he expects to incur higher travel costs. If he follows a rule of thumb in setting a retirement saving goal, he may have to actually use his thumb for travel.
So it pays to set a retirement savings goal based on your own spending needs. And what are they? Well, you can start with what you’re spending today and think through appropriate adjustments. How do you know what you’re currently spending? You could look at that directly by combing through your checkbook for the last few years, but that might be pretty tedious. Perhaps it’s easier to get at that indirectly by looking at your income and subtracting out your savings.
Then you can think through all your categories of spending, and project whether they will change—up or down. Here are a few items that may change:
• Retirement savings. That’s one “expense” that goes away. No more 401(k) deferrals; no more IRA contributions.
• FICA taxes. These stop when you’re no longer working.
• Your mortgage. When will this be paid off? Perhaps it's a disappearing expense. Unless you’re one of those refinancing addicts who take out a home equity loan before each visit to the gas station.
• Health insurance. Maybe this will go up, if your employer is now subsidizing this cost but won’t after retirement. Or maybe it will go down if you expect to rely on Medicare.
• Food. Maybe you’re cooking for four now, but that will drop to two after the kids are grown. Or maybe you’ll then eat out more. Or maybe dining out will cost less as you come to enjoy those early bird specials.
• Commuting expense. Goes down. Way down.
• Clothing. The cost of business suits goes down. But then again, Bermuda shorts, floral shirts and white shoes can be expensive, too.
• Travel. It’s a conundrum. Just when you have the time for more travel, your financial resources get constrained. But you’re able to take advantage of last-minute deals on cruises to Mexico and such.
• Grandchildren. That’s a whole new category.
What did I miss?
Sunday, May 3, 2009
3% is Depressingly Small
In a comment to April 27’s post, David points out how depressingly small 3% is. It simply ain’t that much. If that’s all your savings can generate, it doesn’t sound like you’re in for a luxurious retirement. That’s the main reason I don’t care for the 4% Plan (or 3% Plan or 3.5% Plan). It’s too darn miserly.
First, let me recap. When you retire, you need a plan for determining how much of your assets you’re going to spend each year. The goal is to spend as luxuriously as possible, without imprudently risking running out of money before your ticket is punched. That’s your “Retirement Spending Plan.”
One such plan, often written about in the financial press, is the 4% Plan. Add up your assets on the day you retire, multiply by 4%, and that’s your allowance for the year. Then the following year, increase the dollar amount of your allowance by inflation. And so on, and so on. As pointed out in April 27's post, 4% is the “right” percentage for assets in a tax-favored retirement account. But then if it’s a traditional IRA or other pre-tax account, income taxes will shave your after-tax spending (the part you can actually enjoy) down to 3%. (Not so with Roth accounts.) And maybe the “right” percentage for taxable accounts is 3.5% rather than 4%. Either way, these numbers—and therefore your allowance—simply aren’t that big. They do depress one, don’t they.
What are you buying by limiting your first year withdrawal to a miserly 4%? Two things. One is the security that you will not likely run out of spending money during your lifetime. That aspect of retirement security is, in my view, well worth the price.
But you’re buying something else for which you are paying dearly; too dearly in my view. That is the ability not to have to ratchet down your lifestyle in years when the financial markets are unkind. (And in the course of a typical retirement, there will be such years.) The 4% Plan allows you, to a degree, to ignore short-term losses and simply keep spending according to plan. But if you have some fat in your lifestyle—expenses you can cut back if need be—you can use that flexibility to buy a more luxurious lifestyle. You just have to be willing to have your annual allowance float with the ups and downs of the financial markets, and therefore your retirement assets. Then you can increase that 4% to something closer to 6%. That’s a 50% pay increase! Moreover, that 6% can gradually get bigger and bigger as your life expectancy decreases. Life is grand!
But you can’t have it both ways. If you increase your payout percentage you have to give up on the certainty of a fixed allowance. You have to be willing to cut back on your discretionary expenses when Mr. Dow Jones tells you to. And 2008 taught us that Mr. Dow Jones can be very cruel indeed. Cutting back is easier said than done.
More on the 6% Plan in future posts.
First, let me recap. When you retire, you need a plan for determining how much of your assets you’re going to spend each year. The goal is to spend as luxuriously as possible, without imprudently risking running out of money before your ticket is punched. That’s your “Retirement Spending Plan.”
One such plan, often written about in the financial press, is the 4% Plan. Add up your assets on the day you retire, multiply by 4%, and that’s your allowance for the year. Then the following year, increase the dollar amount of your allowance by inflation. And so on, and so on. As pointed out in April 27's post, 4% is the “right” percentage for assets in a tax-favored retirement account. But then if it’s a traditional IRA or other pre-tax account, income taxes will shave your after-tax spending (the part you can actually enjoy) down to 3%. (Not so with Roth accounts.) And maybe the “right” percentage for taxable accounts is 3.5% rather than 4%. Either way, these numbers—and therefore your allowance—simply aren’t that big. They do depress one, don’t they.
What are you buying by limiting your first year withdrawal to a miserly 4%? Two things. One is the security that you will not likely run out of spending money during your lifetime. That aspect of retirement security is, in my view, well worth the price.
But you’re buying something else for which you are paying dearly; too dearly in my view. That is the ability not to have to ratchet down your lifestyle in years when the financial markets are unkind. (And in the course of a typical retirement, there will be such years.) The 4% Plan allows you, to a degree, to ignore short-term losses and simply keep spending according to plan. But if you have some fat in your lifestyle—expenses you can cut back if need be—you can use that flexibility to buy a more luxurious lifestyle. You just have to be willing to have your annual allowance float with the ups and downs of the financial markets, and therefore your retirement assets. Then you can increase that 4% to something closer to 6%. That’s a 50% pay increase! Moreover, that 6% can gradually get bigger and bigger as your life expectancy decreases. Life is grand!
But you can’t have it both ways. If you increase your payout percentage you have to give up on the certainty of a fixed allowance. You have to be willing to cut back on your discretionary expenses when Mr. Dow Jones tells you to. And 2008 taught us that Mr. Dow Jones can be very cruel indeed. Cutting back is easier said than done.
More on the 6% Plan in future posts.
Saturday, May 2, 2009
Predicting Income Tax Rates
Can anyone predict the future of our income tax rates? David raised that issue in a comment to April 27’s post. I guess the correct answer is, yes you can predict future income tax rates; just not accurately.
In that regard, income tax rates are just like any other unknown variable that affects your retirement planning. How will your investments perform? How long will you live? What will Polident cost? You make your best guess and project from there. Then you stress test. You change your assumptions to see how that affects your projections.
My crystal ball is just as cloudy as yours, but I expect income tax rates will have to rise to pay for new health care initiatives, the recent stimulus plan, the unrecovered costs of bailing out the financial system, and the rest of the $10 trillion national debt that has accumulated since 1791.
A good starting point for projecting future income tax rates is to look at President Obama’s proposal. Right now it’s a little short on detail, but one feature would increase the highest marginal tax rate from 35% to 39.6% for incomes over $250,000 (over $200,000 if single). It would also increase the long-term capital gains tax rate and dividend tax rate to 20% for the same taxpayers. The phase-out of personal exemptions and itemized deductions would be reinstated, effectively tacking on a hidden tax rate of about one percentage point to high income people’s nominal tax rate. And the tax benefit of itemized deductions would be capped at something like 28%.
An aside about that last potential change. It sure sounds like it’s going to add a huge amount of complexity to an already overly complex Tax Code. And how will it interact with the Alternative Minimum Tax? Under one scenario, people who live in high-tax states like New York and New Jersey, whose deductions are already wiped out by the Alternative Minimum Tax, might not be adversely affected by this new wrinkle. But residents of no-tax states like Florida and Texas will. Maybe Treasury Secretary Geithner, in his spare time, can think of a way to get a similar revenue impact without adding undue complexity. Perhaps just add a point or two to the highest tax bracket.
The likelihood of higher future tax rates really turbo-charges the idea of converting your IRA to a Roth IRA in 2010.
In that regard, income tax rates are just like any other unknown variable that affects your retirement planning. How will your investments perform? How long will you live? What will Polident cost? You make your best guess and project from there. Then you stress test. You change your assumptions to see how that affects your projections.
My crystal ball is just as cloudy as yours, but I expect income tax rates will have to rise to pay for new health care initiatives, the recent stimulus plan, the unrecovered costs of bailing out the financial system, and the rest of the $10 trillion national debt that has accumulated since 1791.
A good starting point for projecting future income tax rates is to look at President Obama’s proposal. Right now it’s a little short on detail, but one feature would increase the highest marginal tax rate from 35% to 39.6% for incomes over $250,000 (over $200,000 if single). It would also increase the long-term capital gains tax rate and dividend tax rate to 20% for the same taxpayers. The phase-out of personal exemptions and itemized deductions would be reinstated, effectively tacking on a hidden tax rate of about one percentage point to high income people’s nominal tax rate. And the tax benefit of itemized deductions would be capped at something like 28%.
An aside about that last potential change. It sure sounds like it’s going to add a huge amount of complexity to an already overly complex Tax Code. And how will it interact with the Alternative Minimum Tax? Under one scenario, people who live in high-tax states like New York and New Jersey, whose deductions are already wiped out by the Alternative Minimum Tax, might not be adversely affected by this new wrinkle. But residents of no-tax states like Florida and Texas will. Maybe Treasury Secretary Geithner, in his spare time, can think of a way to get a similar revenue impact without adding undue complexity. Perhaps just add a point or two to the highest tax bracket.
The likelihood of higher future tax rates really turbo-charges the idea of converting your IRA to a Roth IRA in 2010.
Friday, May 1, 2009
Taxation of Social Security Benefits
In a comment to April 27’s post, David raised a question about the taxation of social security benefits. Actually, David touched on a number of issues, for which I am grateful as it provides fodder for future blog posts. But for today, it’s Social Security.
When you start receiving Social Security benefits, are they subject to federal income tax? Not totally. Here’s the story.
For many years social security benefits were totally tax-free. That was a great deal, but it didn’t last. In the early 80’s, as part of an effort to ensure the long-term solvency of the Social Security system, Congress decided to subject part of your benefits to income taxation. (That worked well, didn’t it?) Someone in the government actually keeps track of this little slice of our income tax revenue, and transfers that amount from the general coffers into the Social Security trust fund. But that doesn’t affect us individually, so let’s move on.
When Congress resolved to tax Social Security benefits, they didn’t go all the way. The thinking was this. Part of your benefit is funded with your share of FICA taxes; you know, that’s the 6.2% tax on the first $106,800 (in 2009) of your salary. But you already paid income tax on that amount during your working years; unlike a traditional 401(k) elective deferral, your Social Security contribution is not deducted when figuring your taxable income. So to tax that amount again when you start receiving benefits would be to tax the same compensation dollars twice. That doesn’t sit well, does it?
To avoid an unfair double-tax, Congress decided to limit the amount of your benefit that’s subject to income tax to no more than 85%. Where did that figure come from? On average, the remainder, 15% of your benefit, is the portion of your benefit that’s funded by your own FICA contributions. The other 85% is funded by your employer’s half of the FICA tax and by investment earnings within the trust fund over your working life. Neither of those components has ever been subjected to income tax, so in that sense it’s fair to do so when you begin receiving benefits.
Congress wisely decided not to try to keep track of your actual tax basis in your Social Security benefit, as you have to do when you make after-tax contributions to a traditional IRA. The 85% number achieves rough justice, so it was deemed good enough.
But that’s not the whole picture. It gets complicated. So as not to over-burden low income people during their golden years, the Tax Code excludes Social Security benefits from the taxable income of low income people; and middle income people are only subjected to tax on 50% rather than 85% of their benefits. Only higher income people are subjected to tax on the maximum 85% of their benefits.
The process for figuring out what portion of your Social Security benefit is taxable (0%, 50% or 85%) is complicated beyond all human understanding. You can find a worksheet for figuring this out in the instructions for the Form 1040. Or just plug in your numbers and let Turbo-Tax do it.
But these three levels of taxation carry an impact of which you should be aware. To avoid an abrupt spike in your income tax when you move from 0% to 50% or from 50% to 85%, the Tax Code creates phase-out ranges. If your particular income tax picture puts you in one of these ranges, your actual—but hidden—tax bracket is much higher than your nominal tax bracket. Maybe one-and-a-half times as big. Which is ironic, since it has the effect of subjecting low income people to a high tax rate.
Another side effect of these phase-out ranges carries an implication for the taxation of municipal bond interest. Interest on state and local bonds is generally exempt from federal income taxation. But it’s nonetheless counted for purposes of determining the percentage of your Social Security benefits that’s taxed. So if you’re in one of the phase-out ranges, in effect municipal bond interest is taxable. But it’s a hidden tax. Nothing's easy, is it?
The good news in all this is that if your taxable income is over a certain threshold, all the complexity melts away, and a flat 85% of your benefits is taxed. No, wait. That’s bad news!
When you start receiving Social Security benefits, are they subject to federal income tax? Not totally. Here’s the story.
For many years social security benefits were totally tax-free. That was a great deal, but it didn’t last. In the early 80’s, as part of an effort to ensure the long-term solvency of the Social Security system, Congress decided to subject part of your benefits to income taxation. (That worked well, didn’t it?) Someone in the government actually keeps track of this little slice of our income tax revenue, and transfers that amount from the general coffers into the Social Security trust fund. But that doesn’t affect us individually, so let’s move on.
When Congress resolved to tax Social Security benefits, they didn’t go all the way. The thinking was this. Part of your benefit is funded with your share of FICA taxes; you know, that’s the 6.2% tax on the first $106,800 (in 2009) of your salary. But you already paid income tax on that amount during your working years; unlike a traditional 401(k) elective deferral, your Social Security contribution is not deducted when figuring your taxable income. So to tax that amount again when you start receiving benefits would be to tax the same compensation dollars twice. That doesn’t sit well, does it?
To avoid an unfair double-tax, Congress decided to limit the amount of your benefit that’s subject to income tax to no more than 85%. Where did that figure come from? On average, the remainder, 15% of your benefit, is the portion of your benefit that’s funded by your own FICA contributions. The other 85% is funded by your employer’s half of the FICA tax and by investment earnings within the trust fund over your working life. Neither of those components has ever been subjected to income tax, so in that sense it’s fair to do so when you begin receiving benefits.
Congress wisely decided not to try to keep track of your actual tax basis in your Social Security benefit, as you have to do when you make after-tax contributions to a traditional IRA. The 85% number achieves rough justice, so it was deemed good enough.
But that’s not the whole picture. It gets complicated. So as not to over-burden low income people during their golden years, the Tax Code excludes Social Security benefits from the taxable income of low income people; and middle income people are only subjected to tax on 50% rather than 85% of their benefits. Only higher income people are subjected to tax on the maximum 85% of their benefits.
The process for figuring out what portion of your Social Security benefit is taxable (0%, 50% or 85%) is complicated beyond all human understanding. You can find a worksheet for figuring this out in the instructions for the Form 1040. Or just plug in your numbers and let Turbo-Tax do it.
But these three levels of taxation carry an impact of which you should be aware. To avoid an abrupt spike in your income tax when you move from 0% to 50% or from 50% to 85%, the Tax Code creates phase-out ranges. If your particular income tax picture puts you in one of these ranges, your actual—but hidden—tax bracket is much higher than your nominal tax bracket. Maybe one-and-a-half times as big. Which is ironic, since it has the effect of subjecting low income people to a high tax rate.
Another side effect of these phase-out ranges carries an implication for the taxation of municipal bond interest. Interest on state and local bonds is generally exempt from federal income taxation. But it’s nonetheless counted for purposes of determining the percentage of your Social Security benefits that’s taxed. So if you’re in one of the phase-out ranges, in effect municipal bond interest is taxable. But it’s a hidden tax. Nothing's easy, is it?
The good news in all this is that if your taxable income is over a certain threshold, all the complexity melts away, and a flat 85% of your benefits is taxed. No, wait. That’s bad news!
Thursday, April 30, 2009
The Tax Cost of Turnover
Yesterday’s post discussed the costs of turnover in your account—the selling and buying of stocks. I thought it would be instructive to quantify the tax costs of turnover to see just how much it’s worth worrying about. It turns out that over time, the tax cost can be meaningful. Remember, this discussion only applies to taxable investment accounts, since turnover inside tax-favored retirement accounts is tax-neutral; it carries no tax cost.
Let me describe two little experiments. The first applies to those who are not yet retired and are still accumulating assets and the second applies to those who are in retirement and spending down their assets.
The first experiment. Picture a hypothetical person just like you (but not as good looking). At age 30, he’s got $1,000,000 of cash to invest, which he intends to invest 75% in stocks and 25% in bonds. His goal is to accumulate a retirement fund at age 65. Assume all gains are long-term capital gains, and there are no commission costs. Applying reasonable assumptions, with very modest turnover (1% per year, which is about right for an index fund), he can expect to accumulate $4,512,913 in real (inflation-adjusted) dollars, after taxes.
Now change just the turnover assumption to 70% annual turnover (not unusual for an actively managed stock fund). Capital gains tax costs lower the after-tax accumulation at age 65 to $3,677,357. That’s a 19% drop in the retirement fund, which would likely translate into a 19% drop in available retirement spending. Small costs add up!
Now the second experiment. Picture someone age 65, with a $5,000,000 taxable account. She plans to spend an amount which will leave her children with half her wealth remaining if she were to die 30 years hence at age 95. She plans to invest her account 50% in stocks and 50% in bonds. Assume only a modest 1% turnover, and her after-tax allowance from this taxable account is $208,050. Change that turnover assumption to 70%, and her after-tax allowance drops to $190,225. That’s a 9% cut in lifestyle.
Again, turnover matters.
Let me describe two little experiments. The first applies to those who are not yet retired and are still accumulating assets and the second applies to those who are in retirement and spending down their assets.
The first experiment. Picture a hypothetical person just like you (but not as good looking). At age 30, he’s got $1,000,000 of cash to invest, which he intends to invest 75% in stocks and 25% in bonds. His goal is to accumulate a retirement fund at age 65. Assume all gains are long-term capital gains, and there are no commission costs. Applying reasonable assumptions, with very modest turnover (1% per year, which is about right for an index fund), he can expect to accumulate $4,512,913 in real (inflation-adjusted) dollars, after taxes.
Now change just the turnover assumption to 70% annual turnover (not unusual for an actively managed stock fund). Capital gains tax costs lower the after-tax accumulation at age 65 to $3,677,357. That’s a 19% drop in the retirement fund, which would likely translate into a 19% drop in available retirement spending. Small costs add up!
Now the second experiment. Picture someone age 65, with a $5,000,000 taxable account. She plans to spend an amount which will leave her children with half her wealth remaining if she were to die 30 years hence at age 95. She plans to invest her account 50% in stocks and 50% in bonds. Assume only a modest 1% turnover, and her after-tax allowance from this taxable account is $208,050. Change that turnover assumption to 70%, and her after-tax allowance drops to $190,225. That’s a 9% cut in lifestyle.
Again, turnover matters.
Wednesday, April 29, 2009
Turnover
Turnover carries costs. I’m not talking about those flaky fruit-filled pastries that Pillsbury sells. I’m talking about the selling and buying of stocks in your investment account.
First, there are the obvious transaction costs. When you sell one stock and buy another, you incur a commission cost. Commission costs have gone down in recent years, but they’re still not zero. Then there’s the spread between the stock’s bid and ask prices, the difference between what buyers are offering to pay and what sellers are willing to sell for. That’s another cost.
There’s also a tax cost if your securities are in a taxable investment account: the capital gains tax you incur if the stock has appreciated. (This tax discussion does not apply to sales inside tax-favored retirement accounts like traditional IRA’s and Roth IRA’s. Which is why those types of accounts can make you a better investor, as described in April 20’s post.) For as long as you hold a stock, its appreciation is tax-free to you. You get to determine when to pay the tax on that appreciation by choosing when to sell the stock. You can defer tax by deferring the sale. In fact, under current law, if you delay long enough and die holding an appreciated stock, your heirs get a new tax basis equal to the stock’s value at the date of your death, so nobody ever pays tax on the appreciation. What a deal! Makes you feel kind of foolish, doesn’t it, for having sold that Google stock the week before you got hit by a bus. (The rule about disappearing gains at death is scheduled to change next year, but there’s reason to believe Congress might act to keep the old rule. Watch this space for developments.)
Under the circumstances, why have any turnover? Well, there are plenty of good reasons for turnover. First, you may own a stock that did well for a while, but which you think is no longer a good investment. Second, you may need to sell an appreciated stock to generate cash to meet your spending needs. You can’t eat appreciation. Third, you may need to sell an appreciated stock to rebalance your portfolio back to your desired asset allocation mix.
But just because you have to have some turnover does not mean it has to be excessive. You can be astute about how you manage your stock sales. You can wait until short-term gain has ripened into long-term gain (generally, after one year and a day), since long-term gains enjoy significantly lower tax rates. You can offset gains by also selling some depreciated stocks. You can arrange your stock sales to serve triple duty: investment changes, cash generation, and asset class rebalancing, all at the same time.
One easy way to reduce excessive turnover is to invest in index funds rather than actively managed funds. By their nature, index funds tend to have low turnover, since not too many stocks enter or leave the index. Conversely, actively managed funds tend to have higher turnover, as fund managers make frequent sell and buy decisions. An in-between approach is to select a tax-efficient stock fund, where the fund managers take tax costs into account as they make their sell and buy decisions.
Okay. So there’s a tax cost to turnover. Just how significant is that cost? More on that tomorrow.
First, there are the obvious transaction costs. When you sell one stock and buy another, you incur a commission cost. Commission costs have gone down in recent years, but they’re still not zero. Then there’s the spread between the stock’s bid and ask prices, the difference between what buyers are offering to pay and what sellers are willing to sell for. That’s another cost.
There’s also a tax cost if your securities are in a taxable investment account: the capital gains tax you incur if the stock has appreciated. (This tax discussion does not apply to sales inside tax-favored retirement accounts like traditional IRA’s and Roth IRA’s. Which is why those types of accounts can make you a better investor, as described in April 20’s post.) For as long as you hold a stock, its appreciation is tax-free to you. You get to determine when to pay the tax on that appreciation by choosing when to sell the stock. You can defer tax by deferring the sale. In fact, under current law, if you delay long enough and die holding an appreciated stock, your heirs get a new tax basis equal to the stock’s value at the date of your death, so nobody ever pays tax on the appreciation. What a deal! Makes you feel kind of foolish, doesn’t it, for having sold that Google stock the week before you got hit by a bus. (The rule about disappearing gains at death is scheduled to change next year, but there’s reason to believe Congress might act to keep the old rule. Watch this space for developments.)
Under the circumstances, why have any turnover? Well, there are plenty of good reasons for turnover. First, you may own a stock that did well for a while, but which you think is no longer a good investment. Second, you may need to sell an appreciated stock to generate cash to meet your spending needs. You can’t eat appreciation. Third, you may need to sell an appreciated stock to rebalance your portfolio back to your desired asset allocation mix.
But just because you have to have some turnover does not mean it has to be excessive. You can be astute about how you manage your stock sales. You can wait until short-term gain has ripened into long-term gain (generally, after one year and a day), since long-term gains enjoy significantly lower tax rates. You can offset gains by also selling some depreciated stocks. You can arrange your stock sales to serve triple duty: investment changes, cash generation, and asset class rebalancing, all at the same time.
One easy way to reduce excessive turnover is to invest in index funds rather than actively managed funds. By their nature, index funds tend to have low turnover, since not too many stocks enter or leave the index. Conversely, actively managed funds tend to have higher turnover, as fund managers make frequent sell and buy decisions. An in-between approach is to select a tax-efficient stock fund, where the fund managers take tax costs into account as they make their sell and buy decisions.
Okay. So there’s a tax cost to turnover. Just how significant is that cost? More on that tomorrow.
Tuesday, April 28, 2009
Frequency of Losses—Asset Class Mixture
Sunday’s post looked at one aspect of risk—a very narrow aspect, at that—and compared the riskiness of stocks and bonds. But of course nobody ought to have all of their retirement investments solely in one asset class or another. How risky is investing if your assets are in a mixture of stocks and bonds?
I’m glad you asked. The green line in the graph below builds on the information shown in Sunday’s post. It answers the musical question, “In the past, how frequently would you have experienced a real (i.e., inflation-adjusted) loss if your assets were invested 50% in stocks and 50% in bonds?”
As in Sunday’s post, the answer depends on how frequently you choose to measure your investment progress. Historically, a 50%-50% mixture of stocks and bonds has been slightly less risky—at least as measured by this particular and narrow dimension of risk—than either stocks or bonds standing alone. If you had looked at your investments every calendar year, your mixture would have shown a real loss during 31% of the 83 years studied. That is slightly better than 33% for 100% stocks and 39% for 100% bonds.
And, as with stocks alone or bonds alone, the green line shows a generally decreasing frequency of real losses as you increase the length of time between measurements. With a 50%-50% mixture, in the past 83 years there has been no period of 18 years or longer during which such a mixture exhibited a real loss.
Important: Note that the green line is mostly lower than either the blue line (100% stocks) or the red line (100% bonds). Which means that a nice mixture of stocks and bonds has proven less risky than putting all your eggs in one basket. At least as measured by this particular (and limited) facet of risk.
But, like a Batman villain, risk has many faces. More to come.
I’m glad you asked. The green line in the graph below builds on the information shown in Sunday’s post. It answers the musical question, “In the past, how frequently would you have experienced a real (i.e., inflation-adjusted) loss if your assets were invested 50% in stocks and 50% in bonds?”
As in Sunday’s post, the answer depends on how frequently you choose to measure your investment progress. Historically, a 50%-50% mixture of stocks and bonds has been slightly less risky—at least as measured by this particular and narrow dimension of risk—than either stocks or bonds standing alone. If you had looked at your investments every calendar year, your mixture would have shown a real loss during 31% of the 83 years studied. That is slightly better than 33% for 100% stocks and 39% for 100% bonds.
And, as with stocks alone or bonds alone, the green line shows a generally decreasing frequency of real losses as you increase the length of time between measurements. With a 50%-50% mixture, in the past 83 years there has been no period of 18 years or longer during which such a mixture exhibited a real loss.
Important: Note that the green line is mostly lower than either the blue line (100% stocks) or the red line (100% bonds). Which means that a nice mixture of stocks and bonds has proven less risky than putting all your eggs in one basket. At least as measured by this particular (and limited) facet of risk.
But, like a Batman villain, risk has many faces. More to come.
Monday, April 27, 2009
The 4% Plan vs. 3% Plan vs. 3.5% Plan
A number of prior posts have mentioned the 4% Plan. That’s one of a few schemes for rationally spending down your assets once you have retired and switched from saving to consuming. But whether 4% is the “right” number will depend on many factors. One of them is the type of savings buckets in which your assets dwell.
First, what is the 4% Plan? Under the 4% Plan, you add up your investment assets on the day after your retirement party, multiply by 4%, and that’s your budget for the year. Then every year you increase the dollar amount by the prior year’s inflation, and you've got yourself a new budget. I’m not crazy about the 4% Plan, but at least it’s a plan, and it's simple enough.
Of course, nothing’s simple. Because taxes matter, and one of the important variables we have glossed over is this: In which of the three main types of savings buckets do your assets sit? Are they in a pre-tax retirement account like a traditional Individual Retirement Account? Or a newfangled Roth account? Or a taxable investment account? (Chances are they are in some combination of the three, but for the sake of discussion, let’s pretend they are all in one or another.)
Here’s why the answer matters. The number 4% was arrived at by financial professionals to result in a distribution amount that is as big as possible, while still maintaining a high likelihood that you will not run out of assets during your lifetime (or the joint lifetimes of you and your spouse). The professionals who arrived at that figure assumed your assets were invested in a traditional tax-favored retirement account, like a 401(k) account or IRA.
So let’s follow that through. Let’s say on your retirement day you have $1,000,000 saved in a traditional IRA. You figure 4% is $40,000, so that (plus future inflation) is your budget. But what about taxes? You haven’t paid taxes yet! If, for example, your overall marginal income rate is 25%, then $10,000 goes to pay your taxes, and you are left to live on $30,000. You can’t eat taxes. 4%, it turns out, is the rate at which you can deplete the account; not necessarily what you get to spend. That looks more like 3%.
Now let’s change the facts. Say you have the same $1,000,000, but it’s not in a traditional IRA; instead it’s in a Roth IRA. Your sustainable distribution is the same 4%, or $40,000, but now all income taxes have already been paid, so you get to spend the whole $40,000 on yourself. With a Roth savings bucket, 4% is truly 4%.
One more scenario. Assume the $1,000,000 is in a taxable investment account. You’ve already paid income taxes on that $1,000,000 so you get to spend your entire distribution on yourself. But it should be a bit less than 4% in this case. I’m not sure how much less, but I think probably around 3.5%, or $35,000 in the example. Why do you have to shave the 4% down? Because the professionals who came up with the 4% number assumed you were investing your $1,000,000 in some sort of tax-exempt environment, like an IRA, in which you would not have to pay income tax on your investment earnings (although you would have to pay income tax on your distributions, as we saw two paragraphs above). So if your investment returns (not your distributions) have to be shaved by income taxes, it stands to reason that your long run sustainable distribution percentage will have to be shaved as well. Perhaps down to 3.5%. For a description of the factors that go into this particular haircut, see February 3’s post.
As I said, in reality your retirement savings will likely be housed in all three types of savings buckets, so your own spending percentage will be some blend of the three numbers.
Oh, by the way, your own percentage will also vary depending upon your asset allocation plan. But that discussion is for another day.
First, what is the 4% Plan? Under the 4% Plan, you add up your investment assets on the day after your retirement party, multiply by 4%, and that’s your budget for the year. Then every year you increase the dollar amount by the prior year’s inflation, and you've got yourself a new budget. I’m not crazy about the 4% Plan, but at least it’s a plan, and it's simple enough.
Of course, nothing’s simple. Because taxes matter, and one of the important variables we have glossed over is this: In which of the three main types of savings buckets do your assets sit? Are they in a pre-tax retirement account like a traditional Individual Retirement Account? Or a newfangled Roth account? Or a taxable investment account? (Chances are they are in some combination of the three, but for the sake of discussion, let’s pretend they are all in one or another.)
Here’s why the answer matters. The number 4% was arrived at by financial professionals to result in a distribution amount that is as big as possible, while still maintaining a high likelihood that you will not run out of assets during your lifetime (or the joint lifetimes of you and your spouse). The professionals who arrived at that figure assumed your assets were invested in a traditional tax-favored retirement account, like a 401(k) account or IRA.
So let’s follow that through. Let’s say on your retirement day you have $1,000,000 saved in a traditional IRA. You figure 4% is $40,000, so that (plus future inflation) is your budget. But what about taxes? You haven’t paid taxes yet! If, for example, your overall marginal income rate is 25%, then $10,000 goes to pay your taxes, and you are left to live on $30,000. You can’t eat taxes. 4%, it turns out, is the rate at which you can deplete the account; not necessarily what you get to spend. That looks more like 3%.
Now let’s change the facts. Say you have the same $1,000,000, but it’s not in a traditional IRA; instead it’s in a Roth IRA. Your sustainable distribution is the same 4%, or $40,000, but now all income taxes have already been paid, so you get to spend the whole $40,000 on yourself. With a Roth savings bucket, 4% is truly 4%.
One more scenario. Assume the $1,000,000 is in a taxable investment account. You’ve already paid income taxes on that $1,000,000 so you get to spend your entire distribution on yourself. But it should be a bit less than 4% in this case. I’m not sure how much less, but I think probably around 3.5%, or $35,000 in the example. Why do you have to shave the 4% down? Because the professionals who came up with the 4% number assumed you were investing your $1,000,000 in some sort of tax-exempt environment, like an IRA, in which you would not have to pay income tax on your investment earnings (although you would have to pay income tax on your distributions, as we saw two paragraphs above). So if your investment returns (not your distributions) have to be shaved by income taxes, it stands to reason that your long run sustainable distribution percentage will have to be shaved as well. Perhaps down to 3.5%. For a description of the factors that go into this particular haircut, see February 3’s post.
As I said, in reality your retirement savings will likely be housed in all three types of savings buckets, so your own spending percentage will be some blend of the three numbers.
Oh, by the way, your own percentage will also vary depending upon your asset allocation plan. But that discussion is for another day.
Sunday, April 26, 2009
Frequency of Investment Losses
There are many, many facets of investment risk and uncertainty. I catalogued a bunch of them in March 16’s post. Today’s post focuses on just one aspect of investment risk: How frequently can you expect to experience a loss?
First, let me narrow the inquiry. How frequently might you expect to experience a real, i.e., inflation-adjusted, loss? If you just look at the nominal value of your account, your perceived losses will be much less frequent. But we’re much too wise to ignore the hidden loss engendered by inflation. So we’ll ask the question “How frequently can you expect the inflation-adjusted value of your account to decline when you invest in different asset classes—stocks and bonds?”
Not surprisingly, the answer depends on how frequently you look at your account statement. The shorter the interval, the more frequent the incidence of real loss. Time erases all losses. Time also erases outsized gains, but that’s an inquiry for another day; today we look at losses.
If you look at your investment results every calendar year you’ll find that a sickeningly high percentage of the time you will have realized an inflation-adjusted loss. 33% with stocks and 39% with bonds. Where did these percentages come from? I looked at the 83 years from 1926 through 2008 (yes, that horrible 2008). For stocks, I measured the total return on the S&P 500; for bonds, I measured the total return on intermediate term treasury bonds; for inflation, I measured the change in the Consumer Price Index.
But if you expand the interval between measurements—increasing the interval from one year to every two years, things improve a bit. The percentage of losing periods drops to 27% for stocks and 32% for bonds. And so the trend continues, as shown in the graph below. Although the trend is more pronounced for stocks than for bonds. By the time your time horizon increases to 18 years, you find that stocks have not shown a real loss for any period of 18 years or longer between 1926 and 2008. For bonds, the magic number is somewhat higher—the interval has to be 50 years before you can say bonds have never exhibited real losses during the 83 years studied.
So time heals all losses. But there’s four hairballs on this particular lollypop: (i) the future might be worse than the past; (ii) you might simply not have enough time to recoup your losses; (iii) the scariness of the ride along the way (think 2008) might cause you to change your asset allocation in ways you’ll later regret; and (iv) the graph says absolutely nothing about the magnitude of losses, just the frequency. Magnitude is for another day.
First, let me narrow the inquiry. How frequently might you expect to experience a real, i.e., inflation-adjusted, loss? If you just look at the nominal value of your account, your perceived losses will be much less frequent. But we’re much too wise to ignore the hidden loss engendered by inflation. So we’ll ask the question “How frequently can you expect the inflation-adjusted value of your account to decline when you invest in different asset classes—stocks and bonds?”
Not surprisingly, the answer depends on how frequently you look at your account statement. The shorter the interval, the more frequent the incidence of real loss. Time erases all losses. Time also erases outsized gains, but that’s an inquiry for another day; today we look at losses.
If you look at your investment results every calendar year you’ll find that a sickeningly high percentage of the time you will have realized an inflation-adjusted loss. 33% with stocks and 39% with bonds. Where did these percentages come from? I looked at the 83 years from 1926 through 2008 (yes, that horrible 2008). For stocks, I measured the total return on the S&P 500; for bonds, I measured the total return on intermediate term treasury bonds; for inflation, I measured the change in the Consumer Price Index.
But if you expand the interval between measurements—increasing the interval from one year to every two years, things improve a bit. The percentage of losing periods drops to 27% for stocks and 32% for bonds. And so the trend continues, as shown in the graph below. Although the trend is more pronounced for stocks than for bonds. By the time your time horizon increases to 18 years, you find that stocks have not shown a real loss for any period of 18 years or longer between 1926 and 2008. For bonds, the magic number is somewhat higher—the interval has to be 50 years before you can say bonds have never exhibited real losses during the 83 years studied.
So time heals all losses. But there’s four hairballs on this particular lollypop: (i) the future might be worse than the past; (ii) you might simply not have enough time to recoup your losses; (iii) the scariness of the ride along the way (think 2008) might cause you to change your asset allocation in ways you’ll later regret; and (iv) the graph says absolutely nothing about the magnitude of losses, just the frequency. Magnitude is for another day.
Saturday, April 25, 2009
Refundable vs. Nonrefundable Saver’s Credit
Yesterday’s post described the Saver’s Credit, a taxpayer-paid matching contribution designed to encourage and assist low income workers to save for their retirement. In a thoughtful comment, David highlighted the purpose of the Saver's Credit, which is to asist low-income workers in saving for their own retirement.
Which leads me to focus on one particular feature of the Saver's Credit: it’s a nonrefundable credit. That’s tax jargon for a credit that is limited to your tax liability. A nonrefundable credit can only operate to reduce your tax liability. If your potential credit is a dollar more than your tax liability, you don’t get that extra dollar.
There’s currently a bill recently introduced into the House of Representatives by Congressman Pomeroy (H.R. 1961) that would turn the Saver’s Credit into a refundable credit. If your potential Saver’s Credit exceeds your tax liability for the year, the taxpayers give you a refund anyway—although “refund” is a poor choice of words, since the dollars would come from other taxpayers.
What is the point of drawing a bright line at your tax liability? Opponents of refundable credits call it welfare, since the refundable part comes from other taxpayers. If you limit the credit to tax liability, it’s easier to characterize it as a tax reduction. (“Welfare,” “tax reduction.” Words are really loaded, aren’t they?) Proponents of refundable credits note the arbitrary nature of the line that’s being drawn at the taxpayer’s tax liability. If she’s engaging in the favored activity that generates the credit, why draw a line at her tax liability? Particularly as the complexity of the Tax Code, with all its other deductions, exemptions and credits, makes that line increasingly arbitrary.
It’s instructive to note what other credits in the Tax Code are refundable. What activities are so favored by Congress that they are willing to have other taxpayers support the activity? The big one is the earned income credit, which constitutes taxpayer help for the working poor. There are also a couple of narrowly targeted credits aimed at farmers with high fuel costs and some unemployed individuals who need help with their health insurance costs. Most other credits—the child tax credit, adoption assistance, dependent care, the list is a long one—are nonrefundable. Congress just hates stepping over that line.
So what do I think? (Actually, nobody really asked me, but I have the floor.) I favor making the Saver’s Credit refundable. In my view, helping low income workers save for their retirement falls into the same category as the earned income credit for the working poor. They’re doing everything society wants and encourages them to do, yet often through no fault of their own they need help making ends meet. They’re exactly the ones the rest of us, through our tax dollars, ought to encourage, assist and support. They're the productive ones, the good guys.
Besides, if you look at the way the Tax Code is structured, you get the definite sense that deductions and credits serve fundamentally different purposes. Deductions are generally aimed at figuring the "right" measure of your ability to pay income tax. Credits, on the other hand, are designed to encourage specific activities; they are not germane to calculating your fair share of the country's overall need for tax revenue.
So what do you think? I’d like to know. Send me an email at TheTwoLeggedStool@gmail.com. Or, better, post a comment.
Which leads me to focus on one particular feature of the Saver's Credit: it’s a nonrefundable credit. That’s tax jargon for a credit that is limited to your tax liability. A nonrefundable credit can only operate to reduce your tax liability. If your potential credit is a dollar more than your tax liability, you don’t get that extra dollar.
There’s currently a bill recently introduced into the House of Representatives by Congressman Pomeroy (H.R. 1961) that would turn the Saver’s Credit into a refundable credit. If your potential Saver’s Credit exceeds your tax liability for the year, the taxpayers give you a refund anyway—although “refund” is a poor choice of words, since the dollars would come from other taxpayers.
What is the point of drawing a bright line at your tax liability? Opponents of refundable credits call it welfare, since the refundable part comes from other taxpayers. If you limit the credit to tax liability, it’s easier to characterize it as a tax reduction. (“Welfare,” “tax reduction.” Words are really loaded, aren’t they?) Proponents of refundable credits note the arbitrary nature of the line that’s being drawn at the taxpayer’s tax liability. If she’s engaging in the favored activity that generates the credit, why draw a line at her tax liability? Particularly as the complexity of the Tax Code, with all its other deductions, exemptions and credits, makes that line increasingly arbitrary.
It’s instructive to note what other credits in the Tax Code are refundable. What activities are so favored by Congress that they are willing to have other taxpayers support the activity? The big one is the earned income credit, which constitutes taxpayer help for the working poor. There are also a couple of narrowly targeted credits aimed at farmers with high fuel costs and some unemployed individuals who need help with their health insurance costs. Most other credits—the child tax credit, adoption assistance, dependent care, the list is a long one—are nonrefundable. Congress just hates stepping over that line.
So what do I think? (Actually, nobody really asked me, but I have the floor.) I favor making the Saver’s Credit refundable. In my view, helping low income workers save for their retirement falls into the same category as the earned income credit for the working poor. They’re doing everything society wants and encourages them to do, yet often through no fault of their own they need help making ends meet. They’re exactly the ones the rest of us, through our tax dollars, ought to encourage, assist and support. They're the productive ones, the good guys.
Besides, if you look at the way the Tax Code is structured, you get the definite sense that deductions and credits serve fundamentally different purposes. Deductions are generally aimed at figuring the "right" measure of your ability to pay income tax. Credits, on the other hand, are designed to encourage specific activities; they are not germane to calculating your fair share of the country's overall need for tax revenue.
So what do you think? I’d like to know. Send me an email at TheTwoLeggedStool@gmail.com. Or, better, post a comment.
Friday, April 24, 2009
The Saver’s Credit
Your federal government wants you to save for your own retirement. In fact, they want it so much they are willing to give you a matching contribution of sorts. But only if you have low income. In other words, you can get a reward for saving only if you are too poor to afford to save. Oh well.
Notwithstanding that Catch 22, there are plenty of people who can afford to save for retirement and who meet the requirements to benefit. Here are the ground rules.
• This governmental benefit comes in the form of a tax credit. It’s not an actual matching contribution, in that it’s not added to your retirement account, like your employer’s 401(k) match. Rather, it comes to you in the form of reduced income tax liability (or an increased refund) come April 15. So your tax credit ought to free up an equivalent number of other dollars, enabling you to increase the amount you otherwise were able to contribute to a retirement plan. Economically, the tax credit can act just like a matching contribution. That’s the theory anyway.
• The tax credit is not a refundable credit. That means it is limited to no more than your income tax liability for the year. Unfortunately, this takes a lot of low-income people out of the running.
• You become entitled to the credit by contributing to a tax-favored retirement plan of some kind, either an Individual Retirement Account, a Roth IRA, or your own contribution to a 401(k) plan, 403(b) Plan, 457 Plan, or SIMPLE IRA Plan.
• The maximum contribution that’s matched is $2,000 per year.
• The credit percentage, or matching percentage if you will, is based on your Adjusted Gross Income. The lower your Adjusted Gross Income, the higher your matching percentage. It starts out at a healthy 50% match if your AGI (in 2009) is under $16,500 ($33,000 if married), and ratchets down to 10% if your AGI is under $27,750 ($55,500 if married). AGI above those amounts, and you’re out of luck. No credit for you!
• To avoid abuses, your contribution that otherwise entitles you to a tax credit is reduced by any recent distributions you took from a retirement plan—during the year of your contribution or the following year up to the due date of your tax return, or either of the two preceding years.
• To avoid even sneakier abuses, your matched contribution is also reduced by recent retirement plan distributions taken by your spouse. They’re up to your tricks, you rascal.
• Those under age 18, full time students, and those claimed by a parent as a dependent cannot qualify for the saver’s credit.
• You claim the credit by filing a Form 8880 with your tax return.
If you meet all these requirements, you have extra reasons to strive to put away a little something for the future.
Notwithstanding that Catch 22, there are plenty of people who can afford to save for retirement and who meet the requirements to benefit. Here are the ground rules.
• This governmental benefit comes in the form of a tax credit. It’s not an actual matching contribution, in that it’s not added to your retirement account, like your employer’s 401(k) match. Rather, it comes to you in the form of reduced income tax liability (or an increased refund) come April 15. So your tax credit ought to free up an equivalent number of other dollars, enabling you to increase the amount you otherwise were able to contribute to a retirement plan. Economically, the tax credit can act just like a matching contribution. That’s the theory anyway.
• The tax credit is not a refundable credit. That means it is limited to no more than your income tax liability for the year. Unfortunately, this takes a lot of low-income people out of the running.
• You become entitled to the credit by contributing to a tax-favored retirement plan of some kind, either an Individual Retirement Account, a Roth IRA, or your own contribution to a 401(k) plan, 403(b) Plan, 457 Plan, or SIMPLE IRA Plan.
• The maximum contribution that’s matched is $2,000 per year.
• The credit percentage, or matching percentage if you will, is based on your Adjusted Gross Income. The lower your Adjusted Gross Income, the higher your matching percentage. It starts out at a healthy 50% match if your AGI (in 2009) is under $16,500 ($33,000 if married), and ratchets down to 10% if your AGI is under $27,750 ($55,500 if married). AGI above those amounts, and you’re out of luck. No credit for you!
• To avoid abuses, your contribution that otherwise entitles you to a tax credit is reduced by any recent distributions you took from a retirement plan—during the year of your contribution or the following year up to the due date of your tax return, or either of the two preceding years.
• To avoid even sneakier abuses, your matched contribution is also reduced by recent retirement plan distributions taken by your spouse. They’re up to your tricks, you rascal.
• Those under age 18, full time students, and those claimed by a parent as a dependent cannot qualify for the saver’s credit.
• You claim the credit by filing a Form 8880 with your tax return.
If you meet all these requirements, you have extra reasons to strive to put away a little something for the future.
Thursday, April 23, 2009
Roth Accounts for Federal Employees?
Riddle: What does a Roth 401(k) account have to do with smoking cigarettes?
Answer: Read on.
I am a big fan of Roth savings, as expressed in a number of prior posts; particularly for those who would like to save more in their tax-favored retirement plans, but are prevented from doing so because of limitations in the Tax Code. So Roth 401(k) accounts, potentially available since 2006, have been a great recent development, since they carry no income-related restrictions. But Roth 401(k) accounts are only an option if your employer chooses to make them available.
What about federal employees? Federal employees are covered by the Thrift Savings Plan, a 401(k)-like retirement savings plan. Unfortunately, there is no provision for Roth accounts in the Thrift Savings Plan, so federal employees are out of luck.
But that may change soon. The Board governing the Thrift Savings Plan has this week endorsed a proposal to add a Roth option to the TSP. That’s the good news. Now here’s the bad news: actually adding such a feature requires legislation. The House of Representatives passed a bill adding Roth accounts to the TSP, but the Senate and President also have to act.
Now back to the riddle: What does Roth saving have to do with cigarette smoking? In the real world, nothing. In Bizarro congressional world, apparently they are deeply related in ways the rest of us can’t begin to fathom. The provision for adding a Roth savings option to the TSP is included in a bill to give the FDA authority to regulate tobacco. So whether federal employees get a favorable retirement saving opportunity may hinge on how your senator feels about giving the FDA the power to regulate tobacco.
Federal employees, join the rest of us. We in private industry only get Roth opportunities if our employers choose to add it to our 401(k) plans; you only get them if your senator believes in federal regulation of tobacco.
Answer: Read on.
I am a big fan of Roth savings, as expressed in a number of prior posts; particularly for those who would like to save more in their tax-favored retirement plans, but are prevented from doing so because of limitations in the Tax Code. So Roth 401(k) accounts, potentially available since 2006, have been a great recent development, since they carry no income-related restrictions. But Roth 401(k) accounts are only an option if your employer chooses to make them available.
What about federal employees? Federal employees are covered by the Thrift Savings Plan, a 401(k)-like retirement savings plan. Unfortunately, there is no provision for Roth accounts in the Thrift Savings Plan, so federal employees are out of luck.
But that may change soon. The Board governing the Thrift Savings Plan has this week endorsed a proposal to add a Roth option to the TSP. That’s the good news. Now here’s the bad news: actually adding such a feature requires legislation. The House of Representatives passed a bill adding Roth accounts to the TSP, but the Senate and President also have to act.
Now back to the riddle: What does Roth saving have to do with cigarette smoking? In the real world, nothing. In Bizarro congressional world, apparently they are deeply related in ways the rest of us can’t begin to fathom. The provision for adding a Roth savings option to the TSP is included in a bill to give the FDA authority to regulate tobacco. So whether federal employees get a favorable retirement saving opportunity may hinge on how your senator feels about giving the FDA the power to regulate tobacco.
Federal employees, join the rest of us. We in private industry only get Roth opportunities if our employers choose to add it to our 401(k) plans; you only get them if your senator believes in federal regulation of tobacco.
Wednesday, April 22, 2009
Longevity Risk and Market Risk
Yesterday’s post made a point about saving up a sufficient amount to meet your retirement needs. And the point was this: that in a world of many uncertainties, the uncertainty of how the financial markets will treat all of us exceeds the uncertainty of how long your particular lifespan will be.
And today’s point is this: So what! You have to live with both uncertainties. You don’t get to choose one or the other.
There is a silver lining of sorts: The financial risk of an extra-long life is presumably independent of the risk of an extra-crummy market environment. (Then again, maybe they’re not independent. Maybe suffering through a bad market environment makes you want to die. I know it’s making me pretty sick.)
Assuming they are unrelated, your true financial risk is that you will suffer through both bad situations simultaneously. This point was made by Messrs. Blanchett and Blanchett in the article discussed in January 14’s post. (I shouldn’t refer to long life as bad. Long life is generally a good thing. It’s just the financial aspect of it that’s bad.)
How does this affect Goldilocks from yesterday’s post? If she saves enough to meet her projected needs for an average life expectancy in an average market environment, she actually has about a 75% chance of not running out of money while still alive. That’s not too bad. (Caveat: These percentages incorrectly use the historical performance of the financial markets to measure the likelihood of future success. It's wrong to do that, but I do it anyway. Like eating potato chips.)
Unfortunately, Goldilocks gains only diminishing returns in her level of certainty as she increases her savings. For example, building up her retirement savings by an additional 30% gets her from a 75% up to about an 88% chance of not outliving her life retirement savings.
Don’t you just hate uncertainty?
And today’s point is this: So what! You have to live with both uncertainties. You don’t get to choose one or the other.
There is a silver lining of sorts: The financial risk of an extra-long life is presumably independent of the risk of an extra-crummy market environment. (Then again, maybe they’re not independent. Maybe suffering through a bad market environment makes you want to die. I know it’s making me pretty sick.)
Assuming they are unrelated, your true financial risk is that you will suffer through both bad situations simultaneously. This point was made by Messrs. Blanchett and Blanchett in the article discussed in January 14’s post. (I shouldn’t refer to long life as bad. Long life is generally a good thing. It’s just the financial aspect of it that’s bad.)
How does this affect Goldilocks from yesterday’s post? If she saves enough to meet her projected needs for an average life expectancy in an average market environment, she actually has about a 75% chance of not running out of money while still alive. That’s not too bad. (Caveat: These percentages incorrectly use the historical performance of the financial markets to measure the likelihood of future success. It's wrong to do that, but I do it anyway. Like eating potato chips.)
Unfortunately, Goldilocks gains only diminishing returns in her level of certainty as she increases her savings. For example, building up her retirement savings by an additional 30% gets her from a 75% up to about an 88% chance of not outliving her life retirement savings.
Don’t you just hate uncertainty?
Tuesday, April 21, 2009
Longevity Risk vs. Market Risk
Words matter. The words that are used to describe something color—even distort—how we think about that thing, and can easily mislead us.
I read an article about a retired person’s risk of running out of money before she runs out of pulse. Financial professionals call that “longevity risk.” What I don’t like about those words is the connotation that running out of savings during retirement is somehow your fault. You chose to live too long, you selfish Baby Boomer. It’s not something that happened to you, it’s something you brought on your own damn self. Or maybe it’s your parents’ fault for bequeathing you such sturdy genes. Where’s George Carlin when we need him?
But the risk of living too long is minor compared to the risk of living through a crummy market environment. And the market environment is not something you brought on yourself, like healthy living; it’s something that’s thrust upon you (and all your classmates) by the accident of when you reached retirement age. 1926? A great year to retire. 1969? Terrible.
In what way is market risk greater than longevity risk? Here’s a little fairy tale.
Goldilocks has turned 65 and is about to retire. She needs for her savings to generate $50,000 per year, plus inflation. She has saved up $649,271, which, it turns out, is just right if she lives an average female life expectancy (which at age 65 is 20 years) and retires in an average market environment.
But wait! Goldilocks is smarter than that. Despite the bear thing, which happened when she was very young, so it doesn’t count. She realizes she might live longer than average. So to be cautious, she magically increases her savings to $849,006. (This is a fairy tale, so she can do that.) That’s the amount she’ll need if she lives to age 98, which only 5% of 65-year-old women are expected to do. (These projections came from a table of life expectancy statistics on the Social Security website.) So by increasing her savings by $200,000 she is 95% sure not to get stung by longevity risk.
But wait! What about market risk? Goldilocks prudently plans to invest her savings 50% in stocks and 50% in bonds. What if the upcoming future for stock returns, bond returns and inflation is worse than the historical average? It turns out that market risk is much scarier than longevity risk. Goldilocks studies 83 20-year periods from 1926 through 2008 and sees that during 10 of them—more than 15% of the time—her extra $200,000 of extra savings would have been an insufficient cushion; she would have run out of bucks before the end of her average 20 year life expectancy.
Goldilocks's extra $200,000 of savings bought her 95% certainty of avoiding longevity risk, but only 85% certainty of dodging market risk.
It turns out that market risk—the one that’s shared by you and everyone who got the gold watch in the same year—is bigger than longevity risk—the one that’s unique to you. And 2008 turned out to herald a very inauspicious start for the current crop of graduating retirees. Can you just picture a whole cohort of 65-year olds, eyes glazed over, all wandering around Miami Beach at 4:30, all looking for the same early bird special?
I read an article about a retired person’s risk of running out of money before she runs out of pulse. Financial professionals call that “longevity risk.” What I don’t like about those words is the connotation that running out of savings during retirement is somehow your fault. You chose to live too long, you selfish Baby Boomer. It’s not something that happened to you, it’s something you brought on your own damn self. Or maybe it’s your parents’ fault for bequeathing you such sturdy genes. Where’s George Carlin when we need him?
But the risk of living too long is minor compared to the risk of living through a crummy market environment. And the market environment is not something you brought on yourself, like healthy living; it’s something that’s thrust upon you (and all your classmates) by the accident of when you reached retirement age. 1926? A great year to retire. 1969? Terrible.
In what way is market risk greater than longevity risk? Here’s a little fairy tale.
Goldilocks has turned 65 and is about to retire. She needs for her savings to generate $50,000 per year, plus inflation. She has saved up $649,271, which, it turns out, is just right if she lives an average female life expectancy (which at age 65 is 20 years) and retires in an average market environment.
But wait! Goldilocks is smarter than that. Despite the bear thing, which happened when she was very young, so it doesn’t count. She realizes she might live longer than average. So to be cautious, she magically increases her savings to $849,006. (This is a fairy tale, so she can do that.) That’s the amount she’ll need if she lives to age 98, which only 5% of 65-year-old women are expected to do. (These projections came from a table of life expectancy statistics on the Social Security website.) So by increasing her savings by $200,000 she is 95% sure not to get stung by longevity risk.
But wait! What about market risk? Goldilocks prudently plans to invest her savings 50% in stocks and 50% in bonds. What if the upcoming future for stock returns, bond returns and inflation is worse than the historical average? It turns out that market risk is much scarier than longevity risk. Goldilocks studies 83 20-year periods from 1926 through 2008 and sees that during 10 of them—more than 15% of the time—her extra $200,000 of extra savings would have been an insufficient cushion; she would have run out of bucks before the end of her average 20 year life expectancy.
Goldilocks's extra $200,000 of savings bought her 95% certainty of avoiding longevity risk, but only 85% certainty of dodging market risk.
It turns out that market risk—the one that’s shared by you and everyone who got the gold watch in the same year—is bigger than longevity risk—the one that’s unique to you. And 2008 turned out to herald a very inauspicious start for the current crop of graduating retirees. Can you just picture a whole cohort of 65-year olds, eyes glazed over, all wandering around Miami Beach at 4:30, all looking for the same early bird special?
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