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Investing Blog Roundup: Try Harder or Do Something Easier?

This week I especially enjoyed a piece from Bryan Caplan at EconLib about when to advise people to a) try harder as opposed to b) trying something easier, as well as an investing-specific followup piece at Abnormal Returns.

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When Should I Contribute to a Roth IRA as Opposed to Traditional IRA?

In reply to a recent Vanguard blog post indicating that investors contribute significantly more to Roth IRAs than to traditional IRAs, a reader asked for an explanation of when it makes sense to use a Roth IRA as opposed to traditional IRA.

For most people, the question of whether to make tax-deferred (i.e., “traditional”) retirement account contributions as opposed to Roth contributions is a function of marginal tax rates. (At any given time, your marginal tax rate is the rate of tax you would have to pay on an additional dollar of income.)

A simplified example illustrates how this works:

  • Let’s say you’re a 60-year-old taxpayer in the 25% tax bracket. You contribute $1,000 to a traditional IRA. You leave the money there for one year, during which it earns a 10% return (growing to $1,100). Then you take it out, while still in the 25% tax bracket, leaving you with $825 (i.e., $1,100 x 0.75) available to spend.
  • Alternatively, you could contribute to a Roth IRA. In this case, however, you can only afford to contribute $750, because you’ll no longer be getting the $250 of tax savings that you would have gotten in Year 1 via the $1,000 traditional IRA contribution. The $750 grows by 10%, to $825. When you take it out, you get to keep all $825 because the distribution is nontaxable.**

The key observation here is that if your marginal tax rate in the period of the contribution is the same as your marginal tax rate in the period of the distribution, then you’re left with exactly the same amount of money whether you use a Roth IRA or traditional IRA.

This is just the commutative property of multiplication at work. That is, at some point, the sum of money involved has to be multiplied by 0.75 to account for the 25% tax bite. It doesn’t matter whether we do that multiplication at the beginning (as is the case with a Roth IRA, where you have to pay tax on the income before being able to contribute it) or at the end (as is the case with a traditional IRA, in which you can contribute pre-tax money, but you have to pay taxes on distributions).

If, however, your marginal tax rate changes from the time of the contribution to the time of the distribution, one type of retirement account will come out ahead. Specifically:

  • If your marginal tax rate is greater in the year of the contribution, the traditional IRA will come out ahead, and
  • If your marginal tax rate is greater in the year of the distribution, the Roth IRA will come out ahead.

Guessing Tax Rates

In terms of guessing whether you’ll have a higher or lower marginal tax rate during retirement than during your working years, there are several factors at work.

One big factor in favor of traditional contributions is the fact that most taxpayers have lower levels of taxable income in retirement, because they’re no longer working. And, generally speaking, a lower level of taxable income leads to a lower marginal tax rate.

On the other hand, it’s likely that your marginal tax rate in many years of retirement will be higher than just your retirement tax bracket (e.g., you could be in the 15% tax bracket, yet have a marginal tax rate of 27%). For example:

  • In some cases, with the unique way in which Social Security benefits are taxed, a dollar of income in retirement not only causes the normal amount of income tax (e.g., 15 cents if you’re in the 15% tax bracket), it can also cause an additional 50 or 85 cents of your Social Security benefits to become taxable, which results in even more income tax.
  • If you retire prior to Medicare eligibility (and you do not have health insurance coverage through your former employer or your spouse’s employer), additional income can not only cause the normal amount of income tax, it can also shrink the amount of Affordable Care Act health insurance subsidies for which you’re eligible.

Both of those factors are points in favor of making Roth contributions during working years.

Frankly, I think that for investors who are many years away from retirement, trying to guess their marginal tax rate so far in the future is an exercise in futility, and the best approach is to simply do some of both (i.e., “tax diversify” by having some money in tax-deferred accounts and some money in Roth accounts).

Other Roth IRA Advantages

Finally, it’s important to note that regardless of this marginal tax rate guessing game, Roth IRAs do have three advantages over traditional IRAs:

  • There are no required minimum distributions (RMDs) during the original owner’s lifetime,
  • You can take contributions back out of the account tax-free and penalty-free at any time, and
  • They effectively allow you to tax-shelter more money (though this is irrelevant for anybody who does not have sufficient cash flow to max out their retirement accounts).

**We’re assuming here that you have satisfied the 5-year rule via prior Roth IRA contributions.

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Investing Blog Roundup: Last Call for 2013 IRA Contributions

Just a friendly reminder: We’re down to the wire here on 2013 IRA contributions. Also, for those of you who will have to make estimated tax payments in 2014, April 15 is the due date for payment #1.

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The Social Security Lump Sum Strategy: Don’t Bother

Reminder: Today at 3pm EST, I’ll be participating in a WSJ webcast about creating an action plan for tapping investments and Social Security in retirement. Questions from viewers are very welcome, so please join us. (For anybody who is interested but who cannot make it at the scheduled time, a recorded version of the webcast will be available at the same URL afterward.)

A reader recently asked me about an article in ThinkAdvisor in which the authors suggest that advisors recommend a “lump-sum” Social Security strategy to their clients. The article states:

“For those nearing retirement age, this seldom-discussed strategy can be just the Hail Mary play needed to ensure longevity protection throughout a long retirement. By delaying retirement for a few months, your clients can access the chunk of cash that can be fundamental to purchasing a product to protect them from the unexpected at a time when the client’s retirement needs have finally become a reality.”

As a bit of background: When you file for benefits (whether retirement benefits, spousal benefits, or widow/widower benefits), you can essentially backdate your application by up to 6 months. That is, you can request that the SSA pay you up to 6 months of benefits as a lump sum and treat you going forward as if you had filed 6 months earlier than you really did. (The backdating cannot, however, be applied to any month prior to full retirement age.)

The “lump-sum strategy” discussed in the article consists of:

  • Waiting at least 6 months beyond full retirement age to claim benefits, then
  • Filing a claim that includes a request for retroactive benefits paid as a lump sum, then
  • Using the lump-sum to purchase some sort of longevity insurance (e.g., a deferred lifetime annuity).

So for example, a person with an FRA of 66 following the strategy could wait until age 66 and 6 months to file for retirement benefits. Then he would file for his retirement benefit and request a lump sum payment for the months between his FRA and his current age. And he would then be treated as if he had originally filed at his FRA.

In other words, the strategy consists of holding off on receiving 6 months of benefits, only to receive the exact same amount later as a lump-sum. The only effect on you as an investor (relative to just claiming at full retirement age) is that you lose out on a few months of interest that you could have earned if you’d just taken the money earlier in the first place.

So what’s the point of the strategy? It gives you a lump-sum of cash, with which you can purchase a product from the advisor.

Summary: It’s not really a Social Security strategy. It’s a sales strategy.

Addendum: There can be cases in which it makes perfect sense to backdate a Social Security claim — if you’re filing because you just learned about a medical condition that gives you a significantly shorter life expectancy than you had previously thought, for instance. But planning ahead of time to backdate a claim would not usually make sense. It’s generally better to just claim earlier in the first place.

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Investing Blog Roundup: Social Security and Retirement Webcast

On Monday (April 7) at 3pm Eastern, I’ll be participating in a WSJ webcast about creating an action plan for tapping investments and Social Security in retirement. Questions from viewers are very welcome, so please join us. (For anybody who is interested but who cannot make it at the scheduled time, a recorded version of the webcast will be available at the same URL afterward.)

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Testing an Advisor with Part of Your Portfolio

A reader writes in, asking:

“What do you think about testing an advisor for a few years by giving him just a piece of the overall portfolio before turning everything over?”

I think the answer depends on what type of advisor you’re considering. But first, let’s get something important (and perhaps obvious) out of the way: Intentionally withholding information from your advisor is generally unhelpful if your goal is to get the best advice possible. As a result, anybody giving you financial advice should at least know about all of your holdings.

If we’re talking about a professional who only gives as-needed advice rather than actually managing the portfolio (e.g., an hourly financial planner), you’ll be the one in control of the portfolio the entire time. There’s no real downside to showing them everything – if you don’t like the advice you get you can always choose not to implement it.

If we’re talking about an investment manager, and the idea is to give them a portion of the portfolio to test their performance over a given period, I have to say that such an approach doesn’t make sense to me. Before giving the advisor so much as a dollar, you should have both a good understanding of their investment philosophy and a high degree of confidence in that investment philosophy. It needs to be the sort of relationship where you continue to value their services even during periods of poor performance, because there will be such periods. That is, you should choose an investment manager based on the fact that they practice an investment philosophy you believe in, not based on their performance over a particular short period.

On the other hand, I think there are some cases in which a small-scale test for an investment manager can make sense. For example, if we’re talking about an online-only investment manager (e.g., Betterment or Wealthfront), and your concern is something mundane for which you can get a clear yes/no answer right away (e.g., whether you will like their website, interface, etc)., then it can be perfectly reasonable to move a very small amount of money over to them to see what you think before transferring the whole portfolio.

If we’re talking about a commission-paid advisor, it usually makes sense to stay away completely rather than giving them even a piece of your portfolio. A commission-based pay structure creates significant conflicts of interest between the client and the advisor, which typically results in subpar advice, such as recommendations of undesirably expensive investments.

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