Money Management and the Economy

Sunday, May 1, 2011

Traditional IRA and Roth IRA Contributions are Not Equivalent

The Minneapolis Star-Tribune financial advice columnist, Chris Farrell has an article in the Sunday May 1, 2011 edition that epitomizes the results of over-simplified financial analysis. For some reason, most of the media's financial advisers seem intent on ignoring the complexity of comparing Roth and IRA contributions and the result is often poor advice. Let's take a look at the media's conventional wisdom and how it compares to reality.

Most media financial columnists will say that an IRA and a Roth contribution are equivalent assuming that your tax rate is the same on both ends. If you expect your taxes to be lower in retirement, then the IRA will give you a better return. If not, then the Roth is probably a better investment. On one level this is accurate.

If you put $100 into a Roth IRA and are in the 25% tax bracket, you will have spent $125 including the taxes. Lets assume your investments break even over the next ten years and then you withdraw the balance of the account. You will have $100.

If you put that $100 into a Traditional IRA. You will save $25 in taxes, but you will have to pay $25 in taxes when you take the $100 out if you are still in the 25% tax bracket.

Assuming you saved the $25 you would have paid in taxes, this is a wash and you end up in exactly the same spot with $100 to spend. (Whether your investments do better or worse than break even doesn't effect the comparison, they will have the same effect on either choice.)

Unfortunately the assumption that you will save the tax savings never seems to get dealt with. And if you don't save the money you would have paid in taxes, that investment in a traditional IRA is going to be worth 75% of the same investment in the Roth IRA.

Now what happens if, as in the article above, you decide to maximize your contributions to each? For the example in the article that amount is $6000 per year. If you save this amount in a Roth IRA you will have $6000 when you withdraw it. If you save it in a traditional IRA you will have $4500. Again, that assumes the 25% tax bracket. To have an equivalent amount in retirement, you need to put the $1500 you saved in taxes into a traditional savings account to be saved for your retirement along with your IRA contribution.

Essentially for someone in the 25% tax bracket, a quarter of their traditional IRA (or 401(K) and other tax-deferred accounts) belongs to Uncle Sam. When they withdraw their money, they are going to have give Uncle Sam his share by paying the taxes on both the principal and earnings for that 25%. With the Roth IRA, it is just like any other savings account, the money is all theirs and there are no taxes when money is withdrawn.

I suspect one reason this rarely gets discussed is that it makes explicit the fact that you aren't really "saving" anything on your immediate taxes by putting money into an IRA or 401(k). To get the same results as a $6000 contribution into a Roth IRA, you will need to save $1500 in addition to the $6000 contributed to traditional IRA. These tax deferred accounts are simply kicking the tax bill down the road. Its "tax-deferred", not "tax-free", and there are no "tax-savings".

There are still benefits to retirement accounts. There are real tax savings from earnings on the deferred taxes. But a $6000 contribution to a traditional IRA is not equivalent to the same contribution to a Roth IRA, no matter how often the media gurus tell you otherwise.

Sunday, April 17, 2011

Taming the Risk of Markets

You aren't smarter than the market. It really is that simple.

A few years ago, in October 2008 right after the market "crash", I did a post on confusing volatility and risk. Yesterday an article on CNN Money in their "Ask the Expert" column made it clear that confusion about the risk of volatility extends to the media who provide advice on personal finances.

You can read the column for details. But the short version is that someone approaching retirement asked for advice on changing the balance between different assets in their retirement accounts to reduce its overall risk. Specifically they wanted to know "Should we rebalance all at once or slowly over time?"

The columnist response was all at once. His argument was "by transitioning to the new asset mix over time, you're really postponing (or perhaps more accurately, undermining) your decision to re-set the risk-reward balance in your portfolio."

This is just plain bad advice. The market can go up or down several percentage points in a day. The risk from that volatility exists only when you make a transaction. The risk is that you happen to sell when prices are temporarily at the bottom of a cycle or buy when they are temporarily at the top. The more money you move at once, the bigger the impact of luck (good or bad).

If you want to REDUCE your risk the dumbest thing you can do is to move a lot of money all at once. Whether you like it or not, you are timing the market. The only difference is that you are doing it with one random roll of the dice instead of some anticipation of the market direction. Averaging those moves over the course of the year won't eliminate the risk the market will be down or up over a longer cycle. But it will reduce the risk from day to day, week to week and month to month fluctuations. And given current market volataility, those risks are substantial.

Some people will argue that if the market goes back up again, you will have restored whatever losses you had. But that also misunderstands how volatility plays out. If you buy stock at a higher price, you get fewer shares. Regardless of what price you sell them at, you will get less for them in direct proportion to the higher price you paid.

I keep our personal finances in Quicken. I can follow the balance in our retirment accounts as the fluctuate from day-to-day. And occasionally I will joke to my wife that we made (or lost) some big sum of money. Since we have no intention of buying or selling, the reality is that those fluctuations are meaningless. And for accounts that we will not touch for another ten years, monthly and even annual changes don't mean much.

But once you go to buy or sell, those fluctuations can have a dramatic impact. Buy when the price is 5% higher than its average over the next twelve months and you have effectively lost 5% of the value. And that loss is permanent.

Put in different terms. If you gamble a large sum of money on the flip of a coin, there is a 50% chance you will lose it all. If you flip the coin twice, the chances of losing everything drop to 25%, if you flip three times they are 1 in 8 or 12.5% and flip once more and they are down to 6.25%. Of course your chances of winning every time also drop. But if your goal is to reduce risk, then the more times you flip, the less risk. Investments work the same way, the more times you gamble on market volatility the less likely you are to get badly burned.

I would note, I have not considered the cost of transactions here. If you are paying a fee every time you move money then you need to consider how much extra the over time strategy will cost.