Arbor Realty Trust (NYSE: ABR) is a poignant example -- one of many these days -- of a company selling for an astonishingly low valuation by almost any reasonable metric. You see, at last check, its was selling at $1.51/share, or about 8% of its book value ($18.25).
Surely, it must be going bankrupt! After all, last quarter's dividend was not paid, while the company asserted that this was acceptable, in concert with its obligation to pay only 90% of its profits to shareholders. (This derives from its status as a REIT.) With about $0.91/share in the bank, relative to a likely dividend payout of $0.24, I would say that this was a prudent capital-preserving manoeuver.
They also have $2.7B in debt. At first glance, this company is in serious trouble.
But look again. They have over $3.1B in assets (resulting in positive book value) and are still profitable, having produced $0.10/share inQ32008. Yes, this is massively lower than the $1.02 they raked in in Q32007. However, this would annualize to $0.40/year, which at the last traded price, would put their P/E ratio under 4!
If you're not familiar, the longterm average P/E of the S&P 500 index is around 13. So by comparison, Arbor is vastly cheaper. I might add that the price/book ratio of this same index has averaged somewhere around 2 for the last several decades, versus zero point zero eight!
What's wrong here? How could even the most vaguely fair market mistreat a profitable company so harshly? Granted, the company might be lying about its numbers, but considering the amount of enforcement in the markets these days (which is probably beyond the point of cost-effectiveness), this seems unlikely. The key, I think, is their gratuitous use of leverage.
Specifically, they have about $3.1B in assets and $2.7B in liabilities. In other words, if the $3.1B in assets (mostly commercial real estate, apartment complexes, and the like) were to drop by just $400M, the common stock would be worth zero (ignoring bogus assets such as goodwill and some copy machines). That's only about a 13% drop, which, given the layoff rate in the US job market, seems entirely plausible.
However, by the same token, if the company can survive, then the opposite could occur, which is that a small change in their asset value could result in a massive change in their book value. With $0.92/share in the bank, they have some time to sell their underperforming assets, and streamline their operations, before they succumb to this recession. (I talk as if they're losing money, but at this point, they are still profitable.) And realistically, they could also meet their loan payments for a while by selling assets.
But then there's the horrible property market, with commercial real estate slowly following in the footsteps of the residential market's implosion. No doubt, rents will drop, and therefore, so too the values of commercial properties. This won't happen everywhere in America, but I suspect it will be the rule in 2009. So logically, the fear is that this company won't have a positive net worth for long, hence its cheap valuation.
Again, I think this is shortsighted linear thinking. You see, the banks have learned from the residential mess. They learned that, when everyone is selling a certain asset, it's better to allow a borrower to struggle to pay the debt, than to repossess the collateral (a home, or in this case, an office building or apartment complex), and try to sell it into a hopelessly depressed market. This principle is even more relevant to commercial real estate, wherein the landlord is usually an expert on renting to local businesses. If they can't rent it out, and other landlords in the area are suffering similarly, then why should the bank attempt to liquidate the property at an unattractive valuation? It's one thing if a particular mall fails due to mismanagement. But this is a bankruptcy-rife environment, which encourages creditors to negotiate with landlords in order to facilitate longterm debt and interest repayment. For this reason, despite potential weakness in their portfolio, I think that Arbor will not suffer as much cashflow impairment as shareholders might be predicting.
Still, I never put much stock in book value. After all, in a fire sale (which is when book value is most important), assets sell at massive discounts relative to "new and unused" value. Instead, I tend to look at dividends, as even earnings are often mere accounting concoctions. I believe, from their past payments and ostensible financial stability, that this company will be able to pay out $1/year again in the future, perhaps as soon as 2010. If you keep this stock in your IRA, you'll avoid nasty ordinary income taxes on the payments, achieving a dividend rate of about 66% based on the last traded price. With S&P 500 dividends averaging about 4% historically, this would represent a slight improvement.
So surely I must have bought the stock? No, but I almost did. At the last moment, I found an even more obscenely undervalued little gem. I'm not sure if I should publicly disclose my own holdings. While I consider this matter, best of luck with ABR. Warren Buffet would hate it, considering their apparent addiction to leverage. Still, it's late in the real estate crash, and they still have substantial cash and asset reserves relative to the volatility of their earnings, which means that they can probably survive a few more years of austerity. I think, at a certain point, leverage is sufficiently likely to create a titantic return, and sufficiently unlikely to collapse, that if one were to create a portfolio of such ventures, could sustainably outperform the less leveraged market. If you make a fortune, then please tell them to rent me some cheap office space for my research team!
Saturday, February 14, 2009
Friday, February 13, 2009
The SunPower Conundrum
CNN has just published this article on the share classes of SunPower, a prominent solar power equipment manufacterer.
I haven't looked at alternative energy shares in a long time, as last time I did, they had valuations that looked like dotcom stocks during the Dotcom Boom. Now, no doubt, they're cheaper now, but in the meantime, other assets have become appallingly cheap, so I still haven't bothered to research them. Granted, I do believe (well, sincerely hope) that this industry will save us from fossil fuels.
However, in this case, it's not a question of investment. It's a question of arbitrage opportunity. (From time to time, I'm apt to digress momentarily from my central concern in this blog, which is IRA performance, in order to highlight an important investment concept. This is one such case.)
As the article states: "Class B shares are identical to class A, except they have eight times the voting power. Both are liquid. Which ought to be worth more?" Clearly, all else being equal, the Class B shares should be worth more.
The bizarrity is that Class B has been trading for a few percent less since last October, as you can see in this chart. In my opinion, this is stark evidence against the Efficient Market Hypothesis. In a fatal bankruptcy situation, in which the only value to the stock is voting power itself, then we would expect SPWRB to trade for 8X SPWRA. Indeed, if a proxy fight ensued tomorrow, we might expect SPWRB to leap relative to SPWRA. Instead, at the moment, it is debased to subparity with SPRWA.
While I have no idea how this occurred to begin with, other than through market inefficiency, the phenomenon now exists. So now the question is, how can we, as responsibly greedy market participants, fix the problem?
The obvious thing to do is to short sell SPWRA and buy SPWRB. That way, regardless of the financial success of the company, we should make money. In fact, we should make money no later than 2010, which is when, according to the CNN article, the company hopes to combine the shares (and presumably pay some sort of dividend to SPWRB owners in order to compensate for the loss of their extra voting rights). Even if the shares are never combined, however, SPWRB should naturally rise above SPWRA.
Ah, but there is no such thing as a free lunch! You see, unfortunately, it costs money to short a stock -- not just the commission. One must pay "short interest", typically equal to margin interest, to the person from whom the shares are borrowed. Worse, there is a risk that at some inconvenient time, the owner will demand the return of the shares. In this event, another willing lender of shares will need to be identified, resulting in a cost in both money and time. Thus there is a risk to the shorting party that the act of maintaining the short for a sufficiently long time will be unprofitable, arbitrage gains notwithstanding.
Of course, one could simply just buy SPWRB and ignore SPWRA. There is little doubt that it will outperform SPWRA in the next few years. However, it may drop in value, nevermind underperform any number of other stocks.
Over time, it would seem that the laws of nature will restore balance to these fraternal assets. In the interim, hold onto your wallet, and perhaps put some solar panels on the roof.
I haven't looked at alternative energy shares in a long time, as last time I did, they had valuations that looked like dotcom stocks during the Dotcom Boom. Now, no doubt, they're cheaper now, but in the meantime, other assets have become appallingly cheap, so I still haven't bothered to research them. Granted, I do believe (well, sincerely hope) that this industry will save us from fossil fuels.
However, in this case, it's not a question of investment. It's a question of arbitrage opportunity. (From time to time, I'm apt to digress momentarily from my central concern in this blog, which is IRA performance, in order to highlight an important investment concept. This is one such case.)
As the article states: "Class B shares are identical to class A, except they have eight times the voting power. Both are liquid. Which ought to be worth more?" Clearly, all else being equal, the Class B shares should be worth more.
The bizarrity is that Class B has been trading for a few percent less since last October, as you can see in this chart. In my opinion, this is stark evidence against the Efficient Market Hypothesis. In a fatal bankruptcy situation, in which the only value to the stock is voting power itself, then we would expect SPWRB to trade for 8X SPWRA. Indeed, if a proxy fight ensued tomorrow, we might expect SPWRB to leap relative to SPWRA. Instead, at the moment, it is debased to subparity with SPRWA.
While I have no idea how this occurred to begin with, other than through market inefficiency, the phenomenon now exists. So now the question is, how can we, as responsibly greedy market participants, fix the problem?
The obvious thing to do is to short sell SPWRA and buy SPWRB. That way, regardless of the financial success of the company, we should make money. In fact, we should make money no later than 2010, which is when, according to the CNN article, the company hopes to combine the shares (and presumably pay some sort of dividend to SPWRB owners in order to compensate for the loss of their extra voting rights). Even if the shares are never combined, however, SPWRB should naturally rise above SPWRA.
Ah, but there is no such thing as a free lunch! You see, unfortunately, it costs money to short a stock -- not just the commission. One must pay "short interest", typically equal to margin interest, to the person from whom the shares are borrowed. Worse, there is a risk that at some inconvenient time, the owner will demand the return of the shares. In this event, another willing lender of shares will need to be identified, resulting in a cost in both money and time. Thus there is a risk to the shorting party that the act of maintaining the short for a sufficiently long time will be unprofitable, arbitrage gains notwithstanding.
Of course, one could simply just buy SPWRB and ignore SPWRA. There is little doubt that it will outperform SPWRA in the next few years. However, it may drop in value, nevermind underperform any number of other stocks.
Over time, it would seem that the laws of nature will restore balance to these fraternal assets. In the interim, hold onto your wallet, and perhaps put some solar panels on the roof.
Tuesday, February 10, 2009
Please Don't Put Bonds in Your IRA!
The popular financial advice is to put bonds in your IRA (or 401(k)). (Frankly, I would never recommend owning these slow-growth "securities" for other than short periods in unusual market conditions, but that's a topic for another rant.) The reasoning goes like this: IRAs are tax-deferred accounts, meaning that the contents within grow tax free; since taxable accounts tax interest, they will result in slower-growing bond balances.
The reasoning is correct: if one reinvests interest from bonds in the purchase of more bonds, then bond balances will indeed grow more slowly in a taxable account rather than a tax-deferred account. So why would I recommend that you pay the tax? Because by paying taxes on these low-return securities, you will be able to leave your high-return securities in the IRA, to grow taxfree. Yes, over time, your bond holdings will occupy an increasingly small proportion of your portfolio. If you believe in dilutive diversification (in which your portfolio's high-return securities are constantly diluted by its low-return securities as a result of goofy "rebalancing" manoeuvers recommended by your broker), then this is a problem. But your lack of courage does not deter me; I'm here to tell you how to supercharge your IRA. If you can't ride this bull, then watch your friends get rich and enjoy the entertainment.
Let's do the math.
If you're lucky, bonds have a 7% pretax yield. (These days, with the Fed funds rate under 1%, this is dreaming, but they've been there before and will again.) After taxes at the 25% bracket, we're down to 5.25%.
The S&P 500 has averaged around 10% pretax, included reinvested dividends, for all of its history. After 25% taxes on dividends (nevermind the current rate of 15%, which is a historical anomaly), it's close to 8.5%. (It's not 7.5% because some of the gains is capital appreciation, which is untaxed until sale. Bonds held to maturity don't have capital appreciation, by definition.)
In the limit of a long time horizon, we know that one of these investments will outstrip the others by an increasing margin. Why? Because that's what different exponents do as they grow toward infinity: their ratio also grows toward infinity. So we have 2 choices: (1) An 8.5% stock growth rate in a taxable account and a 7% growth rate in a tax-deferred account or (2) A 10% stock growth rate in a tax-deferred account, and a 5.25% growth rate in a taxable account.
Assuming that we invest equally in both (because, after all, our lame investment advisor told us to "diversify"), I choose #2. The reason is that, over time, a 10% return will beat an 8.5% return plus a 7% return -- even without any help from the 5.25% aftertax bonds! How much time depends on your contribution pattern. But the point is that, eventually, the 10% return will dominate your portfolio, and more importantly, your portfolio will be larger than if you had dumped the stock into the taxable account.
But it's better than that: if you ever sold any of the stock in the taxable account, you would be taxed on growth at the capital gains tax rate, which is currently 15% and probably due to rise to 20%. This taxation, which might occur several times before retirement, would lower the 8.5% posttax growth rate to something less. So by keeping the stock in the IRA, we eliminate this problem entirely. We need only worry about bid/ask spreads and commissions. (Better yet, buy highly efficient index funds and never sell. More on that in another article.)
It gets better still. History has shown that if you invest in certain asset classes -- in general, those that are more volatile but contain companies with large earnings and/or dividends relative to their stock prices -- you will be rewarded over time with substantially higher returns. Mostly, I'm talking about smallcap value (small stocks with attractive earnings) and emerging markets (wild, unregulated, and sometimes dishonest companies in banana republics whose only way to get investors to trust them is to pay fat dividends). Do this, and your 10% goes to 14%, or perhaps 17%. Granted, these numbers are all historical. In the future, the hot money might be made in Moon real estate. But generally speaking, the more volatile the underlying security, the greater the longterm return, provided that you purchase it at a sufficiently low valuation ratio (price-earnings ratio, yield, or similar metric).
Yes, you do have to pay taxes when you cash out of the IRA. But, given enough time, this one-time hit does little to affect your longterm growth exponent, or more to the point, your net cashout value. And if you follow my recommendations for slowly converting to a Roth, your tax burden should be low.
Why is it so simple to make so much money?! I have wondered this for a long time. I think the reason is that most people -- even young people with plenty of time to recover from stock market crashes -- mistake volatility for risk. Volatility has nothing to do with risk, in the longterm. Yes, in the shortterm, it's risk. But over the longterm, the risk vanishes into a fairly consistent return.
Now, to be fair, there are some assets which are highly volatile, but offer little longterm reward, such as small "hot growth" companies that have no earnings; and gold, which is virtually the definition of "inflation" magified by tons of random noise. There are also relatively stable asset classes with very attractive longterm growth rates, such as some real estate invesmtent trusts (REITs). But, generally speaking, the stock market pays people to endure volatility. Some people think that the stock market pays people to take risk. I don't think that this is true, in the big picture. It's just that most people confuse longterm volatility with longterm risk. In my view, there's nothing risky about investing in an asset class that has returned 17% annually for decades running, provided that one is investing for the longterm, and enters the market at a sane price relative to earnings.
Now, you might ask, what if you don't have a longterm horizon before retirement? In this case, you might not want to invest in volatile asset classes. (This is the conventional wisdom, with which I don't agree, but I'll explain that in a later post. I just put it out as a warning for investors who fear taking loans to supplement income during downturns, and would rather live a predictable life in bond-induced poverty.) Nevertheless, I think that you will probably fare better with your stocks in an IRA and your bonds in a taxable account, as opposed to the other way round.
What's that? You have 7% taxfree muni bonds? Good for you. Leave them in your taxable account because, well, they aren't taxed anyway. Now, if you have bonds yielding 26% because you bought them from some bankrupt company that came back from the dead, then, OK, leave them in your IRA.
By the way, sell your slowest- growing assets first for the most stable retirement. (I want to give you better advice, which is "don't invest in anything but the assets most likely to produce the highest returns over the longterm". But most people can't take that. So at least, do yourself a favor and liquidate the money market account before the IBM shares, OK?) Conveniently, this usually means selling your most taxed assets first. Isn't it amusing how the most taxed assets also happen to be the slowest-growing to begin with? Is life unfair, or what? The sucker who lends money to his bank at 2% gets hit with a 25% tax bill, whereas his friend makes 12% in stock apprection and dividends, and keeps 11% after taxes on the latter. What can I say? It pays to have an iron stomach. (I say that as though it takes courage to lose money on longterm high-growth assets. It doesn't, unless you're ignorant of longterm trends and don't understand the difference between volatility and risk. I've lost 65% in this crash and I'm feeling fine, because I understand that eventually the market will turn higher, and the longterm return trends will resume, more or less. If I can earn a buck on this blog, I'd be more than happy to buy some of the downtrodden index funds out there.)
If you don't want to take my advice, then diversify: Own stocks, bonds, dirt, outdated milk, soda cans, buttons, and broken car parts. Make sure that stocks compose a tiny percentage of your portfolio, so that you'll be protected from any negative move in the markets. And if there's ever a shortage of buttons, you'll be covered. Oh, and put the soda cans in the IRA. That way, you'll be able to trade the aluminum market with no tax ramifications!
The reasoning is correct: if one reinvests interest from bonds in the purchase of more bonds, then bond balances will indeed grow more slowly in a taxable account rather than a tax-deferred account. So why would I recommend that you pay the tax? Because by paying taxes on these low-return securities, you will be able to leave your high-return securities in the IRA, to grow taxfree. Yes, over time, your bond holdings will occupy an increasingly small proportion of your portfolio. If you believe in dilutive diversification (in which your portfolio's high-return securities are constantly diluted by its low-return securities as a result of goofy "rebalancing" manoeuvers recommended by your broker), then this is a problem. But your lack of courage does not deter me; I'm here to tell you how to supercharge your IRA. If you can't ride this bull, then watch your friends get rich and enjoy the entertainment.
Let's do the math.
If you're lucky, bonds have a 7% pretax yield. (These days, with the Fed funds rate under 1%, this is dreaming, but they've been there before and will again.) After taxes at the 25% bracket, we're down to 5.25%.
The S&P 500 has averaged around 10% pretax, included reinvested dividends, for all of its history. After 25% taxes on dividends (nevermind the current rate of 15%, which is a historical anomaly), it's close to 8.5%. (It's not 7.5% because some of the gains is capital appreciation, which is untaxed until sale. Bonds held to maturity don't have capital appreciation, by definition.)
In the limit of a long time horizon, we know that one of these investments will outstrip the others by an increasing margin. Why? Because that's what different exponents do as they grow toward infinity: their ratio also grows toward infinity. So we have 2 choices: (1) An 8.5% stock growth rate in a taxable account and a 7% growth rate in a tax-deferred account or (2) A 10% stock growth rate in a tax-deferred account, and a 5.25% growth rate in a taxable account.
Assuming that we invest equally in both (because, after all, our lame investment advisor told us to "diversify"), I choose #2. The reason is that, over time, a 10% return will beat an 8.5% return plus a 7% return -- even without any help from the 5.25% aftertax bonds! How much time depends on your contribution pattern. But the point is that, eventually, the 10% return will dominate your portfolio, and more importantly, your portfolio will be larger than if you had dumped the stock into the taxable account.
But it's better than that: if you ever sold any of the stock in the taxable account, you would be taxed on growth at the capital gains tax rate, which is currently 15% and probably due to rise to 20%. This taxation, which might occur several times before retirement, would lower the 8.5% posttax growth rate to something less. So by keeping the stock in the IRA, we eliminate this problem entirely. We need only worry about bid/ask spreads and commissions. (Better yet, buy highly efficient index funds and never sell. More on that in another article.)
It gets better still. History has shown that if you invest in certain asset classes -- in general, those that are more volatile but contain companies with large earnings and/or dividends relative to their stock prices -- you will be rewarded over time with substantially higher returns. Mostly, I'm talking about smallcap value (small stocks with attractive earnings) and emerging markets (wild, unregulated, and sometimes dishonest companies in banana republics whose only way to get investors to trust them is to pay fat dividends). Do this, and your 10% goes to 14%, or perhaps 17%. Granted, these numbers are all historical. In the future, the hot money might be made in Moon real estate. But generally speaking, the more volatile the underlying security, the greater the longterm return, provided that you purchase it at a sufficiently low valuation ratio (price-earnings ratio, yield, or similar metric).
Yes, you do have to pay taxes when you cash out of the IRA. But, given enough time, this one-time hit does little to affect your longterm growth exponent, or more to the point, your net cashout value. And if you follow my recommendations for slowly converting to a Roth, your tax burden should be low.
Why is it so simple to make so much money?! I have wondered this for a long time. I think the reason is that most people -- even young people with plenty of time to recover from stock market crashes -- mistake volatility for risk. Volatility has nothing to do with risk, in the longterm. Yes, in the shortterm, it's risk. But over the longterm, the risk vanishes into a fairly consistent return.
Now, to be fair, there are some assets which are highly volatile, but offer little longterm reward, such as small "hot growth" companies that have no earnings; and gold, which is virtually the definition of "inflation" magified by tons of random noise. There are also relatively stable asset classes with very attractive longterm growth rates, such as some real estate invesmtent trusts (REITs). But, generally speaking, the stock market pays people to endure volatility. Some people think that the stock market pays people to take risk. I don't think that this is true, in the big picture. It's just that most people confuse longterm volatility with longterm risk. In my view, there's nothing risky about investing in an asset class that has returned 17% annually for decades running, provided that one is investing for the longterm, and enters the market at a sane price relative to earnings.
Now, you might ask, what if you don't have a longterm horizon before retirement? In this case, you might not want to invest in volatile asset classes. (This is the conventional wisdom, with which I don't agree, but I'll explain that in a later post. I just put it out as a warning for investors who fear taking loans to supplement income during downturns, and would rather live a predictable life in bond-induced poverty.) Nevertheless, I think that you will probably fare better with your stocks in an IRA and your bonds in a taxable account, as opposed to the other way round.
What's that? You have 7% taxfree muni bonds? Good for you. Leave them in your taxable account because, well, they aren't taxed anyway. Now, if you have bonds yielding 26% because you bought them from some bankrupt company that came back from the dead, then, OK, leave them in your IRA.
By the way, sell your slowest- growing assets first for the most stable retirement. (I want to give you better advice, which is "don't invest in anything but the assets most likely to produce the highest returns over the longterm". But most people can't take that. So at least, do yourself a favor and liquidate the money market account before the IBM shares, OK?) Conveniently, this usually means selling your most taxed assets first. Isn't it amusing how the most taxed assets also happen to be the slowest-growing to begin with? Is life unfair, or what? The sucker who lends money to his bank at 2% gets hit with a 25% tax bill, whereas his friend makes 12% in stock apprection and dividends, and keeps 11% after taxes on the latter. What can I say? It pays to have an iron stomach. (I say that as though it takes courage to lose money on longterm high-growth assets. It doesn't, unless you're ignorant of longterm trends and don't understand the difference between volatility and risk. I've lost 65% in this crash and I'm feeling fine, because I understand that eventually the market will turn higher, and the longterm return trends will resume, more or less. If I can earn a buck on this blog, I'd be more than happy to buy some of the downtrodden index funds out there.)
If you don't want to take my advice, then diversify: Own stocks, bonds, dirt, outdated milk, soda cans, buttons, and broken car parts. Make sure that stocks compose a tiny percentage of your portfolio, so that you'll be protected from any negative move in the markets. And if there's ever a shortage of buttons, you'll be covered. Oh, and put the soda cans in the IRA. That way, you'll be able to trade the aluminum market with no tax ramifications!
Saturday, February 7, 2009
The Art of the Roth Conversion
If you're the impatient type, here are the math formulas that, but for some subtle differences between traditional and Roth IRAs, will usually result in the most profitable account for a given contribution:
Quick Links
1. If you intend to invest any tax savings in a standard taxable account, click here.
2. If you intend to invest any tax savings in a traditional IRA or 401(k), click here.
Otherwise, let's dig in.
The IRS allows a traditional IRA to be converted, all or in part, to a Roth IRA. Transitively, a 401(k) can be converted to a Roth by first rolling to an IRA.
One would want to do this in order to take advantage of the features of the Roth. In addition to some comparatively trivial benefits, the Roth IRA has the advantage of taxfree withdrawals after age 59 1/2. However, contributions occur with posttax dollars, and conversions incur income tax, as though the converted amount had been earned on top of one's existing income. Therefore, it only makes sense to convert when one's annual income falls into a low bracket, which may occur due to unemployment or flowthrough losses from real estate or businesses. Generally, one does not want to convert an entire traditional IRA all at once, unless it's sufficiently small, or your other losses provide room. Furthermore, I suggest that Roth conversions should occur in December, when your tax bracket is more predictable. (After much discussion with the IRS, it seems to me that April 15 is the due date for Roth conversions for the previous year, regardless of whether or not you file an extension. However, this is a gray area, so I advise December.) On the other hand, if your stocks have suffered immensely early in the year, it might be wise to perform a conversion now, before they snap back up and make tax-minimal conversion more difficult.
Does all this monkey business really help?
Let's look at the math. A Roth conversion is just a like a Roth contribution, except that it is subject only to income limits (including, I should add, the converted amount itself), and not contribution limits. We can look at this amount -- call it P1 for "principal" -- as either being contributed to (or remaining within) a traditional IRA, or being contributed to (or converted into) a Roth IRA.
We assume that you will invest in the same securities in either account, since, after all, growth is taxfree in both cases, and investment expenses are likely to be identical. Let G1 be the growth rate, e.g. G1 = 0.08 for a growth rate of 8%.
But before we consider conversion, let's look at the difference in the investment yield of contribution.
The investment will grow for Y years in either case. In either account, P1 will grow at rate G1 within a traditional IRA. In the traditional IRA case, due to the tax deduction we receive up front, we will also have P2 -- the tax we didn't spend -- to invest. P2 will grow at rate G2 in a taxable account, with G2 <= G1 due to taxation. (In principle, you could throw P2 into a tax-deferred account if you have not yet exhausted all contribution limits. At the moment, we're assuming that you throw P2 into a taxable account, but we'll look at this alternative later.)
After Y years, we will have T, the traditional IRA account balance before taxes:
T = P1(1+G1)^Y+P2(1+G2)^Y
But we know that P2 is simply the tax deduction received as a reward for contributing P1:
P2 = CtP1
where Ct is the traditional IRA contribution tax deduction rate.
For example, suppose you contribute $1000. This reduces your taxable income by $1000. The first $400 of deduction occur in the 28% bracket. The next $600 occur in the 25% bracket. Thus:
Ct = (400/1000)(0.28)+(600/1000)(0.25)
Ct = 0.262 (or 26.2%)
So rewriting P2 in terms of Ct, we have:
T = P1(1+G1)^Y+CtP1(1+G2)^Y
Upon liquidation of the investment and subsequent withdrawal of the proceeds, the traditional IRA will be taxed at rate W, which is the ordinary income rate. The taxable account, which held P2, will have only its growth taxed, namely, at rate Q, known as the "capital gains rate". Currently, Q= 0.15 for 15%, although may return to 0.2 in the next few years. The principal (CtP1) will not be taxed. Thus, we will be left with the following net proceeds, Nt, from the traditional IRA and its invested tax deduction:
Nt = (1-W)P1(1+G1)^Y+CtP1+[1-Q][CtP1(1+G2)^Y-CtP1]
Nt = (1-W)P1(1+G1)^Y+CtP1{1+[1-Q][(1+G2)^Y-1]}
In the case of a Roth contribution, there is no P2 because we do not receive an upfront tax deduction, which we might then invest. Therefore, Ct, Q, and G2 are also irrelevant. There is also no tax upon withdrawal, so W is zero. So then, the net proceeds, Nr, from the Roth IRA would be:
Nr = R = P1(1+G1)^Y
We want to end up with as much money as possible. Put another way, we should only contribute to a Roth instead of a traditional when:
Nr > Nt
or
P1(1+G1)^Y > (1-W)P1(1+G1)^Y+CtP1{1+[1-Q][(1+G2)^Y-1]}
which simplifies to the following contribution-size-independent relation:
How to Choose Traditional or Roth Contribution, Where Tax Savings in the Former Case Are Invested in a Taxable Account
If the following relation is true, then contribute to a Roth. Otherwise,
contribute to a traditional:
W(1+G1)^Y > Ct{1+[1-Q][(1+G2)^Y-1]} (The "Roth Test Relation".)
where:
Ct = Rate of tax deduction for the traditional IRA contribution, e.g. 0.28 for 28%. This is not necessarily equal to the bracket at which the deduction occurs, as the deduction may span multiple brackets. Instead, it's the weighted average of all spanned brackets, as illustrated in the above example with 25% and 28% brackets.
G1 = Growth rate inside either IRA, presumed to be equal in both IRAs, e.g. 0.10 for 10%.
G2 = Aftertax growth rate outside the IRA, e.g. 0.09 for 9%.
Q = Capital gains tax rate on the growth of the invested tax deduction, in the traditional IRA case, which is imposed simultaneously with the IRA withdrawal, e.g. 0.2 for 20%.
W = Tax rate upon withdrawal from a traditional IRA, on top of all other retirement income in the same year, e.g. 0.35 for 35%.
Y = Number of years until withdrawal of investment proceeds, presumed to be equal in both IRAs.
Exmaple:
Ct = 28%
G1 = 10%
G2 = 9%
Q= 20%
W = 35%
Y = 40
W(1+G1)^Y >? Ct{1+[1-Q][(1+G2)^Y-1]}
0.35(1+0.1)^40 >? 0.28{1+[1-0.2][(1+0.09)^40-1]}
15.84 > 7.09
The statment is true. Therefore, we should contribute to a Roth.
It's theoretically possible, by the way, that the optimal solution is to contribute to both accounts, as the value of Ct varies stepwise with the size of the contribution. However, this is unlikely to make a material difference to the value of your retirement savings, and is more likely to just increase transaction costs.
Now assume that we have made our contribution to one or the other account. Now, we want to know whether we should convert some of our traditional holdings to Roth holdings. (In theory, we could move the other way, but the ramifications would including filing amended tax returns for many prior years, and would probably not be profitable anyway. Don't go there.)
In most respects, this is exactly the same exercise as determining to which account to contribute:
In the case where we do the conversion, we must first pay some tax on the converted amount, counting it as ordinary income on top of all our other income the same year. After that, the amount will be moved from the traditional to the Roth, where it grows tax free. (I suggest using the same broker for both accounts. Otherwise, you may incur substantial transaction costs.) Upon subsequent withdrawal from the Roth, neither principal nor growth is taxed.
In the case where you leave the money in the traditional, i.e. do nothing, it will grow tax free, then get taxed as ordinary income upon withdrawal. Additionally, you can take the money that you would have spent on conversion taxes, and invest it in a taxable account. (Of course, you might still have room to dump it into your 401(k). But this is unlikely, as the very fact that you've decided against conversion implies that your income is high, and therefore you have already maxed out your tax deferrals for the year. So we won't investigate this possibility.)
Guess what? This is exactly the same as the contribution analysis, except for one small and critical difference: the conversion tax rate may not equal the contribution tax deduction rate. Think of it this way: In one case, you contribute $5000 at the (hypothetical) 30% tax bracket. Congratulations, you saved 30%, or $1500. In the other case, you convert the $5000 from traditional to Roth. This act pushes you from the 30% to the 40% tax bracket. The tax rate associated with this act is 40%, or $2000. Thus adding income does not necessarily have the opposite tax impact as subtracting the same amount.
From above, we have the Roth Test Relation:
W(1+G1)^Y > Ct{1+[1-Q][(1+G2)^Y-1]}
Now, however, there is no Ct, because we are not contributing to a traditional IRA; we are instead converting to a Roth IRA. The tax rate on this latter transaction is Cr:
W(1+G1)^Y > Cr{1+[1-Q][(1+G2)^Y-1]}
Thus we have the same Roth Test Relation, as applied to conversion. Remember, generally, Ct and Cr are different, even if all other values are the same. Thus the decision as to whether or not to contribute $1000 is not the same decision as to whether or not to convert the same amount.
Let's get back to contributions. As I said above, there is some possibility that the tax deduction due to traditional contribution could itself be invested in a tax-deferred account, if one has a roomy 401(k). We assume that this additional investment will always target a traditional IRA or 401(k); otherwise, it is likely too small to justify investing independently. (We know that the major investment is occurring in a traditional IRA or 401(k), as otherwise, there would be no tax savings to invest.) In this case, we need to change the Roth Test Relation:
W(1+G1)^Y > Ct{1+[1-Q][(1+G2)^Y-1]}
to account for the facts that:
1. G2 = G1, because all principal values are invested tax-deferred.
2. Q = W, because all proceeds are taxed as orindary income.
3. All proceeds are taxed -- not just growth.
So in this case,
Nt = (1-W)(P1+P2)(1+G1)^Y
Nt = (1-W)P1(1+Ct)(1+G1)^Y
and Nr is unchanged:
Nr = P1(1+G1)^Y
As before, we only want to contribute or convert to a Roth if Nr > Nt:
P1(1+G1)^Y > (1-W)P1(1+Ct)(1+G1)^Y
So, we have...
How to Choose Traditional or Roth Contribution, Where Tax Savings in the Former Case Are Invested in a Tax-Deferred Account
(1-W)(1+Ct) < 1 (The "Reinvested Roth Test Relation".)
If the Reinvested Roth Test Relation is true, then contribute to a Roth. Otherwise, contribute to a traditional, and dump the proceeds of the tax savings into a traditional IRA or 401(k).
Finally, in all of the above contribution analysis, you can interchange traditional IRAs and 401(k)'s. You cannot, however, directly convert a 401(k) to a Roth IRA; as far as I know, this must be done via a one-year detour through a traditional IRA.
Granted, there are some subtle advantages to the Roth IRA that I haven't discussed. You may wish to review these to help you make a final decision.
Happy investing!
Quick Links
1. If you intend to invest any tax savings in a standard taxable account, click here.
2. If you intend to invest any tax savings in a traditional IRA or 401(k), click here.
Otherwise, let's dig in.
The IRS allows a traditional IRA to be converted, all or in part, to a Roth IRA. Transitively, a 401(k) can be converted to a Roth by first rolling to an IRA.
One would want to do this in order to take advantage of the features of the Roth. In addition to some comparatively trivial benefits, the Roth IRA has the advantage of taxfree withdrawals after age 59 1/2. However, contributions occur with posttax dollars, and conversions incur income tax, as though the converted amount had been earned on top of one's existing income. Therefore, it only makes sense to convert when one's annual income falls into a low bracket, which may occur due to unemployment or flowthrough losses from real estate or businesses. Generally, one does not want to convert an entire traditional IRA all at once, unless it's sufficiently small, or your other losses provide room. Furthermore, I suggest that Roth conversions should occur in December, when your tax bracket is more predictable. (After much discussion with the IRS, it seems to me that April 15 is the due date for Roth conversions for the previous year, regardless of whether or not you file an extension. However, this is a gray area, so I advise December.) On the other hand, if your stocks have suffered immensely early in the year, it might be wise to perform a conversion now, before they snap back up and make tax-minimal conversion more difficult.
Does all this monkey business really help?
Let's look at the math. A Roth conversion is just a like a Roth contribution, except that it is subject only to income limits (including, I should add, the converted amount itself), and not contribution limits. We can look at this amount -- call it P1 for "principal" -- as either being contributed to (or remaining within) a traditional IRA, or being contributed to (or converted into) a Roth IRA.
We assume that you will invest in the same securities in either account, since, after all, growth is taxfree in both cases, and investment expenses are likely to be identical. Let G1 be the growth rate, e.g. G1 = 0.08 for a growth rate of 8%.
But before we consider conversion, let's look at the difference in the investment yield of contribution.
The investment will grow for Y years in either case. In either account, P1 will grow at rate G1 within a traditional IRA. In the traditional IRA case, due to the tax deduction we receive up front, we will also have P2 -- the tax we didn't spend -- to invest. P2 will grow at rate G2 in a taxable account, with G2 <= G1 due to taxation. (In principle, you could throw P2 into a tax-deferred account if you have not yet exhausted all contribution limits. At the moment, we're assuming that you throw P2 into a taxable account, but we'll look at this alternative later.)
After Y years, we will have T, the traditional IRA account balance before taxes:
T = P1(1+G1)^Y+P2(1+G2)^Y
But we know that P2 is simply the tax deduction received as a reward for contributing P1:
P2 = CtP1
where Ct is the traditional IRA contribution tax deduction rate.
For example, suppose you contribute $1000. This reduces your taxable income by $1000. The first $400 of deduction occur in the 28% bracket. The next $600 occur in the 25% bracket. Thus:
Ct = (400/1000)(0.28)+(600/1000)(0.25)
Ct = 0.262 (or 26.2%)
So rewriting P2 in terms of Ct, we have:
T = P1(1+G1)^Y+CtP1(1+G2)^Y
Upon liquidation of the investment and subsequent withdrawal of the proceeds, the traditional IRA will be taxed at rate W, which is the ordinary income rate. The taxable account, which held P2, will have only its growth taxed, namely, at rate Q, known as the "capital gains rate". Currently, Q= 0.15 for 15%, although may return to 0.2 in the next few years. The principal (CtP1) will not be taxed. Thus, we will be left with the following net proceeds, Nt, from the traditional IRA and its invested tax deduction:
Nt = (1-W)P1(1+G1)^Y+CtP1+[1-Q][CtP1(1+G2)^Y-CtP1]
Nt = (1-W)P1(1+G1)^Y+CtP1{1+[1-Q][(1+G2)^Y-1]}
In the case of a Roth contribution, there is no P2 because we do not receive an upfront tax deduction, which we might then invest. Therefore, Ct, Q, and G2 are also irrelevant. There is also no tax upon withdrawal, so W is zero. So then, the net proceeds, Nr, from the Roth IRA would be:
Nr = R = P1(1+G1)^Y
We want to end up with as much money as possible. Put another way, we should only contribute to a Roth instead of a traditional when:
Nr > Nt
or
P1(1+G1)^Y > (1-W)P1(1+G1)^Y+CtP1{1+[1-Q][(1+G2)^Y-1]}
which simplifies to the following contribution-size-independent relation:
How to Choose Traditional or Roth Contribution, Where Tax Savings in the Former Case Are Invested in a Taxable Account
If the following relation is true, then contribute to a Roth. Otherwise,
contribute to a traditional:
W(1+G1)^Y > Ct{1+[1-Q][(1+G2)^Y-1]} (The "Roth Test Relation".)
where:
Ct = Rate of tax deduction for the traditional IRA contribution, e.g. 0.28 for 28%. This is not necessarily equal to the bracket at which the deduction occurs, as the deduction may span multiple brackets. Instead, it's the weighted average of all spanned brackets, as illustrated in the above example with 25% and 28% brackets.
G1 = Growth rate inside either IRA, presumed to be equal in both IRAs, e.g. 0.10 for 10%.
G2 = Aftertax growth rate outside the IRA, e.g. 0.09 for 9%.
Q = Capital gains tax rate on the growth of the invested tax deduction, in the traditional IRA case, which is imposed simultaneously with the IRA withdrawal, e.g. 0.2 for 20%.
W = Tax rate upon withdrawal from a traditional IRA, on top of all other retirement income in the same year, e.g. 0.35 for 35%.
Y = Number of years until withdrawal of investment proceeds, presumed to be equal in both IRAs.
Exmaple:
Ct = 28%
G1 = 10%
G2 = 9%
Q= 20%
W = 35%
Y = 40
W(1+G1)^Y >? Ct{1+[1-Q][(1+G2)^Y-1]}
0.35(1+0.1)^40 >? 0.28{1+[1-0.2][(1+0.09)^40-1]}
15.84 > 7.09
The statment is true. Therefore, we should contribute to a Roth.
It's theoretically possible, by the way, that the optimal solution is to contribute to both accounts, as the value of Ct varies stepwise with the size of the contribution. However, this is unlikely to make a material difference to the value of your retirement savings, and is more likely to just increase transaction costs.
Now assume that we have made our contribution to one or the other account. Now, we want to know whether we should convert some of our traditional holdings to Roth holdings. (In theory, we could move the other way, but the ramifications would including filing amended tax returns for many prior years, and would probably not be profitable anyway. Don't go there.)
In most respects, this is exactly the same exercise as determining to which account to contribute:
In the case where we do the conversion, we must first pay some tax on the converted amount, counting it as ordinary income on top of all our other income the same year. After that, the amount will be moved from the traditional to the Roth, where it grows tax free. (I suggest using the same broker for both accounts. Otherwise, you may incur substantial transaction costs.) Upon subsequent withdrawal from the Roth, neither principal nor growth is taxed.
In the case where you leave the money in the traditional, i.e. do nothing, it will grow tax free, then get taxed as ordinary income upon withdrawal. Additionally, you can take the money that you would have spent on conversion taxes, and invest it in a taxable account. (Of course, you might still have room to dump it into your 401(k). But this is unlikely, as the very fact that you've decided against conversion implies that your income is high, and therefore you have already maxed out your tax deferrals for the year. So we won't investigate this possibility.)
Guess what? This is exactly the same as the contribution analysis, except for one small and critical difference: the conversion tax rate may not equal the contribution tax deduction rate. Think of it this way: In one case, you contribute $5000 at the (hypothetical) 30% tax bracket. Congratulations, you saved 30%, or $1500. In the other case, you convert the $5000 from traditional to Roth. This act pushes you from the 30% to the 40% tax bracket. The tax rate associated with this act is 40%, or $2000. Thus adding income does not necessarily have the opposite tax impact as subtracting the same amount.
From above, we have the Roth Test Relation:
W(1+G1)^Y > Ct{1+[1-Q][(1+G2)^Y-1]}
Now, however, there is no Ct, because we are not contributing to a traditional IRA; we are instead converting to a Roth IRA. The tax rate on this latter transaction is Cr:
W(1+G1)^Y > Cr{1+[1-Q][(1+G2)^Y-1]}
Thus we have the same Roth Test Relation, as applied to conversion. Remember, generally, Ct and Cr are different, even if all other values are the same. Thus the decision as to whether or not to contribute $1000 is not the same decision as to whether or not to convert the same amount.
Let's get back to contributions. As I said above, there is some possibility that the tax deduction due to traditional contribution could itself be invested in a tax-deferred account, if one has a roomy 401(k). We assume that this additional investment will always target a traditional IRA or 401(k); otherwise, it is likely too small to justify investing independently. (We know that the major investment is occurring in a traditional IRA or 401(k), as otherwise, there would be no tax savings to invest.) In this case, we need to change the Roth Test Relation:
W(1+G1)^Y > Ct{1+[1-Q][(1+G2)^Y-1]}
to account for the facts that:
1. G2 = G1, because all principal values are invested tax-deferred.
2. Q = W, because all proceeds are taxed as orindary income.
3. All proceeds are taxed -- not just growth.
So in this case,
Nt = (1-W)(P1+P2)(1+G1)^Y
Nt = (1-W)P1(1+Ct)(1+G1)^Y
and Nr is unchanged:
Nr = P1(1+G1)^Y
As before, we only want to contribute or convert to a Roth if Nr > Nt:
P1(1+G1)^Y > (1-W)P1(1+Ct)(1+G1)^Y
So, we have...
How to Choose Traditional or Roth Contribution, Where Tax Savings in the Former Case Are Invested in a Tax-Deferred Account
(1-W)(1+Ct) < 1 (The "Reinvested Roth Test Relation".)
If the Reinvested Roth Test Relation is true, then contribute to a Roth. Otherwise, contribute to a traditional, and dump the proceeds of the tax savings into a traditional IRA or 401(k).
Finally, in all of the above contribution analysis, you can interchange traditional IRAs and 401(k)'s. You cannot, however, directly convert a 401(k) to a Roth IRA; as far as I know, this must be done via a one-year detour through a traditional IRA.
Granted, there are some subtle advantages to the Roth IRA that I haven't discussed. You may wish to review these to help you make a final decision.
Happy investing!
Why IRAs Don't Suck (But You Think They Do)
What could be more futile than socking away $5000/year for 40 years, hoping for a secure retirement? But this is exactly the "promise" of the traditional and Roth IRAs. That's a mere $200,000. You can barely buy a decent house for that, let alone pay for your hundreds of thousands of dollars in drugs and surgeries as a senior.
"But", you protest, "it's more than that! The contribution limits grow every year!"
Yes, they do. And essentially, over the longterm, they grow with inflation. So $200,000 is measured in 2009 dollars. My analysis doesn't change because, approximately, the price of everything rises at the rate of inflation over the longterm. So while your traditional IRA contributions might total $2,000,000 after accounting for inflation, they still won't buy you much more than a house in 2049.
If you're depressed by now, then you know how I felt as I wrote my first traditional IRA check: totally futile. "This isn't even worth the effort to manage the account. It takes around $2,000,000 per person to retire at age 30 today -- very modestly -- nevermind deacdes from now! How will this lame car drive me where I want to go?"
What I didn't realize at the time was that (1) it matters which assets one purchases in the IRA, (2) the traditional IRA represents a tiny fraction of what you can actually contribute annually to tax-deferred accounts, and (3) most IRAs aren't merely tax-deferred; if you play your cards right, they're nearly taxfree!
Unappreciated Advantages to IRAs
1. Let's talk about assets. The easiest thing to do is visit the Risk and Return Calculator for IFA Indexes, which measures the performance of major investment indices over several decades, with reasonable accuracy. As you can see in this simulation of IFA US Large Company Index returns for the past 40 years, an investment in this index would have yielded an annual return of about 8.62%. But an investment in the IFA Emerging Markets Index would have yielded 15.94%! The second case returned $36,953 in 40 years -- from a one-dollar investment in 1969! The large company index, meanwhile, would still have returned a staggering $2631 in the same time period. Inflation tends to run about 4.5% over long periods of time; over 40 years, this would create prices 5.81X as high for the same products and services. So, after adjusting for inflation, the returns would have been $6360 and $547, in 1969 dollars. Still, this is an incredible fortune, relative to $1 invested. What's even more striking is how much the asset class matters. Just for the sake of tolerating some larger temporary losses, emerging markets would have paid vastly more money. The power of exponents, and particularly large exponents versus small ones, can hardly be overstated. As Einstein once put it, the most powerful force in the universe is compound interest. Especially, I might add, when it comes with little or no tax liability!
2. The traditional IRA is sufficiently famous that you may be ignoring just how much cash you can sock away, to grow tax-deferred until withdrawal. (Even then, you may pay little or no tax, as you'll see later.) Let's look at 2009, for instance. Most people can contribute $5000, in total, to traditional and Roth IRAs. (Some people aren't elligible to contribute to a Roth, as their income is too high.)
Don't forget that you could also contribute $16,500 to a 401(k), which expands that $5000 to $21,500! This benefit alone may justify switching jobs if your current employer has no such program (but you might not need to, as I'll explain below). This also ignores popular employer matching programs, in which employers sometimes match a portion of employee contribution. Now this is becoming a bit more interesting. You'll therefore have $860,000 2009 dollars to retire on in 40 years, assuming a 0% return after inflation, i.e. a 4.5% annual return. Even with the horrendous cost of medical care, that amount might last you 5 or 10 years. But if you invest more aggressively (without taking undue risk), you're likely to end up with vastly more by maxing out both your 401(k) and traditional/Roth IRA every year.
However, $16,500 is just the 2009 limit for employee 401(k)s. If you can manage to earn some income as a self-employed individual, you can contribute up to $49,000 to your 401(k) this year! (See Fidelity's article on the self-employed 401(k).) This includes any contributions you make as an employee, and any employer matches. Granted, in order to do so, you need to earn roughly a quarter million bucks per year. But the contribution ceiling scales with income, such that it may be in your interest to take a side job, or negotiate self-employment status with your current employer, in order to take advantage of this fantastic tax loophole. (Just remember that you may lose other benefits in the process.) So in total, we have $54,000 in tax-deferred income available, if only you can earn enough.
If you're like me, and you hardly earn enough money to eat because you write blogs all day, then this $54,000 is not currently relevant. However, it may be useful for you to get working on a strategy for keeping your current job, while changing your tax status to self-employed, in order to take advantage. In the longterm, when your earnings inevitably rise, you will have the system working for you already. Most importantly, you will have developed the habit of deferring major chunks of income to your retirement account.
3. If this were not enough reason to open a self-employed 401(k), then perhaps this will motivate you: the income, upon withdrawal, may be nearly or exactly taxfree. "But how can this be?" you ask. "My investment advisor always told me that that traditional IRAs and 401(k)'s are taxed upon withdrawal."
Well, technically, they are, but at what rate? One obvious way to reduce the tax rate is simply to withdraw less: retire below the poverty line, and you'll pay little tax. But then you might as well through your IRA in the river, and pay no tax at all.
Alternatively, there is a little-known trick to obtaining taxfree withdrawals -- even from a traditional IRA! It's called "annuitization". Annuitization basically entails the creation of a withdrawal policy designed to make the withdrawals last for life. The IRS is very murky about what constitutes a sustainable lifelong withdrawal policy, because, after all, future returns are uncertain. It can even involve complex computer simulations known as "monte carlo analysis". So I'll leave you to discuss this route with your tax accountant. Frankly, I do not advocate annuitization. Why? Because if you want to retire before your golden years, you should do so using a taxable brokerage account, real estate, or a business to support yourself. You should not sacrifice taxfree growth by withdrawing early from your IRAs. So, I have a better suggestion for accessing the income in a tax-minimized manner upon withdrawal.
You see, there's a handy little tax manoeuver called a Roth conversion. It allows you to convert all or part of your traditional IRA into a Roth IRA. (Since a 401(k) can be rolled into an IRA with zero tax consequences, it can be converted from there to a Roth, although I have not researched the prospect of direct conversion. Only one conversion is allowed per year, probably because the IRS computer systems were not designed to handle more.) Though there are several trivial differences, traditional and Roth IRAs are essentially identical, except that the former generally offers tax deductions upfront, in exchange for taxed distributions upon withdrawal; whereas the latter offers no such deductions upfront, in exchange for taxfree withdrawal after age 59 1/2. (401(k)'s behave, in this sense, like traditional IRAs.)
Of course, the IRS never offers a free lunch, so you need to pay ordinary income taxes on the amount you convert in a given year. For example, if you convert $10,000, then you've just earned $10,000, which is then added to your taxable income. But here's where the art of tax avoidance (as opposed to tax evasion) comes in! Depending on your age, you may have decades to accomplish the conversion. So, little by little, you move money from your traditional to your Roth. Only do this in years when your income is low, or better, you're unemployed and have no income at all. This will minimize the overall tax rate you pay to complete the conversion. If you have shares in a business partnership (for example, real estate, or a grocery store), you can convert more in years that you have large flowthrough losses, which will kill the income from the Roth conversion for tax purposes. Just be aware that the longer you wait, the larger your traditional IRA balance will tend to become, eventually outstripping the rate at which you can convert it in a tax-minimal manner.
Granted, if your income exceeds certain limits, then you're not allowed to contribute to a Roth at all, even through conversion. However, the deductions from a traditional IRA and a self-employed 401(k), and a business with passthrough losses, will help you stay under those limits. (And frankly, if you exceed them, then your tax bracket for the year is sufficiently high that it's not to your advantage to do the conversion anyway. So convert little by little, when the opportunity arises. You can wait until December, when you have a better idea of your likely tax bracket.
Eventually, you'll have most or all of your IRA assets in your Roth, which you can then withdraw taxfree after age 59 1/2.
I will describe this process in more detail in my next post, The Art of the Roth Conversion.
"But", you protest, "it's more than that! The contribution limits grow every year!"
Yes, they do. And essentially, over the longterm, they grow with inflation. So $200,000 is measured in 2009 dollars. My analysis doesn't change because, approximately, the price of everything rises at the rate of inflation over the longterm. So while your traditional IRA contributions might total $2,000,000 after accounting for inflation, they still won't buy you much more than a house in 2049.
If you're depressed by now, then you know how I felt as I wrote my first traditional IRA check: totally futile. "This isn't even worth the effort to manage the account. It takes around $2,000,000 per person to retire at age 30 today -- very modestly -- nevermind deacdes from now! How will this lame car drive me where I want to go?"
What I didn't realize at the time was that (1) it matters which assets one purchases in the IRA, (2) the traditional IRA represents a tiny fraction of what you can actually contribute annually to tax-deferred accounts, and (3) most IRAs aren't merely tax-deferred; if you play your cards right, they're nearly taxfree!
Unappreciated Advantages to IRAs
1. Let's talk about assets. The easiest thing to do is visit the Risk and Return Calculator for IFA Indexes, which measures the performance of major investment indices over several decades, with reasonable accuracy. As you can see in this simulation of IFA US Large Company Index returns for the past 40 years, an investment in this index would have yielded an annual return of about 8.62%. But an investment in the IFA Emerging Markets Index would have yielded 15.94%! The second case returned $36,953 in 40 years -- from a one-dollar investment in 1969! The large company index, meanwhile, would still have returned a staggering $2631 in the same time period. Inflation tends to run about 4.5% over long periods of time; over 40 years, this would create prices 5.81X as high for the same products and services. So, after adjusting for inflation, the returns would have been $6360 and $547, in 1969 dollars. Still, this is an incredible fortune, relative to $1 invested. What's even more striking is how much the asset class matters. Just for the sake of tolerating some larger temporary losses, emerging markets would have paid vastly more money. The power of exponents, and particularly large exponents versus small ones, can hardly be overstated. As Einstein once put it, the most powerful force in the universe is compound interest. Especially, I might add, when it comes with little or no tax liability!
2. The traditional IRA is sufficiently famous that you may be ignoring just how much cash you can sock away, to grow tax-deferred until withdrawal. (Even then, you may pay little or no tax, as you'll see later.) Let's look at 2009, for instance. Most people can contribute $5000, in total, to traditional and Roth IRAs. (Some people aren't elligible to contribute to a Roth, as their income is too high.)
Don't forget that you could also contribute $16,500 to a 401(k), which expands that $5000 to $21,500! This benefit alone may justify switching jobs if your current employer has no such program (but you might not need to, as I'll explain below). This also ignores popular employer matching programs, in which employers sometimes match a portion of employee contribution. Now this is becoming a bit more interesting. You'll therefore have $860,000 2009 dollars to retire on in 40 years, assuming a 0% return after inflation, i.e. a 4.5% annual return. Even with the horrendous cost of medical care, that amount might last you 5 or 10 years. But if you invest more aggressively (without taking undue risk), you're likely to end up with vastly more by maxing out both your 401(k) and traditional/Roth IRA every year.
However, $16,500 is just the 2009 limit for employee 401(k)s. If you can manage to earn some income as a self-employed individual, you can contribute up to $49,000 to your 401(k) this year! (See Fidelity's article on the self-employed 401(k).) This includes any contributions you make as an employee, and any employer matches. Granted, in order to do so, you need to earn roughly a quarter million bucks per year. But the contribution ceiling scales with income, such that it may be in your interest to take a side job, or negotiate self-employment status with your current employer, in order to take advantage of this fantastic tax loophole. (Just remember that you may lose other benefits in the process.) So in total, we have $54,000 in tax-deferred income available, if only you can earn enough.
If you're like me, and you hardly earn enough money to eat because you write blogs all day, then this $54,000 is not currently relevant. However, it may be useful for you to get working on a strategy for keeping your current job, while changing your tax status to self-employed, in order to take advantage. In the longterm, when your earnings inevitably rise, you will have the system working for you already. Most importantly, you will have developed the habit of deferring major chunks of income to your retirement account.
3. If this were not enough reason to open a self-employed 401(k), then perhaps this will motivate you: the income, upon withdrawal, may be nearly or exactly taxfree. "But how can this be?" you ask. "My investment advisor always told me that that traditional IRAs and 401(k)'s are taxed upon withdrawal."
Well, technically, they are, but at what rate? One obvious way to reduce the tax rate is simply to withdraw less: retire below the poverty line, and you'll pay little tax. But then you might as well through your IRA in the river, and pay no tax at all.
Alternatively, there is a little-known trick to obtaining taxfree withdrawals -- even from a traditional IRA! It's called "annuitization". Annuitization basically entails the creation of a withdrawal policy designed to make the withdrawals last for life. The IRS is very murky about what constitutes a sustainable lifelong withdrawal policy, because, after all, future returns are uncertain. It can even involve complex computer simulations known as "monte carlo analysis". So I'll leave you to discuss this route with your tax accountant. Frankly, I do not advocate annuitization. Why? Because if you want to retire before your golden years, you should do so using a taxable brokerage account, real estate, or a business to support yourself. You should not sacrifice taxfree growth by withdrawing early from your IRAs. So, I have a better suggestion for accessing the income in a tax-minimized manner upon withdrawal.
You see, there's a handy little tax manoeuver called a Roth conversion. It allows you to convert all or part of your traditional IRA into a Roth IRA. (Since a 401(k) can be rolled into an IRA with zero tax consequences, it can be converted from there to a Roth, although I have not researched the prospect of direct conversion. Only one conversion is allowed per year, probably because the IRS computer systems were not designed to handle more.) Though there are several trivial differences, traditional and Roth IRAs are essentially identical, except that the former generally offers tax deductions upfront, in exchange for taxed distributions upon withdrawal; whereas the latter offers no such deductions upfront, in exchange for taxfree withdrawal after age 59 1/2. (401(k)'s behave, in this sense, like traditional IRAs.)
Of course, the IRS never offers a free lunch, so you need to pay ordinary income taxes on the amount you convert in a given year. For example, if you convert $10,000, then you've just earned $10,000, which is then added to your taxable income. But here's where the art of tax avoidance (as opposed to tax evasion) comes in! Depending on your age, you may have decades to accomplish the conversion. So, little by little, you move money from your traditional to your Roth. Only do this in years when your income is low, or better, you're unemployed and have no income at all. This will minimize the overall tax rate you pay to complete the conversion. If you have shares in a business partnership (for example, real estate, or a grocery store), you can convert more in years that you have large flowthrough losses, which will kill the income from the Roth conversion for tax purposes. Just be aware that the longer you wait, the larger your traditional IRA balance will tend to become, eventually outstripping the rate at which you can convert it in a tax-minimal manner.
Granted, if your income exceeds certain limits, then you're not allowed to contribute to a Roth at all, even through conversion. However, the deductions from a traditional IRA and a self-employed 401(k), and a business with passthrough losses, will help you stay under those limits. (And frankly, if you exceed them, then your tax bracket for the year is sufficiently high that it's not to your advantage to do the conversion anyway. So convert little by little, when the opportunity arises. You can wait until December, when you have a better idea of your likely tax bracket.
Eventually, you'll have most or all of your IRA assets in your Roth, which you can then withdraw taxfree after age 59 1/2.
I will describe this process in more detail in my next post, The Art of the Roth Conversion.
Dedication
This blog is dedicated to all those, who, like me, found the Individual Retirement Arrangements (IRAs) defined in American tax law to be confusing and dubious vehicles for financial independence. This blog is intended to provide you with viable mechanisms for morphing these lame investment devices into substantial engines of wealth.
Throughout this blog, I will use the term "IRA" liberally -- not just to refer to the traditional IRA into which one may deposit a few thousand bucks per year for a tax deduction and tax-deferred investing. In my view, Roth IRAs, SEP IRAs, 401(k)'s, and other tax-advantaged savings vehicles are also IRAs. If I mean to refer specifically to the "traditional IRA", then I will use precisely that term.
By the way, this blog isn't a solicitation to buy or sell anything. Frequently, I'll suggest that you buy or sell something, because it's my honest opinion that it makes good financial sense to do so. But it's only a suggestion. I don't participate in the securities business. My job, as I see it, is to be blatently honest about sane investing. If you disagree, then say so, but I'm not here to engage in pump-and-dump schemes, or to buy or sell securities.
Throughout this blog, I will use the term "IRA" liberally -- not just to refer to the traditional IRA into which one may deposit a few thousand bucks per year for a tax deduction and tax-deferred investing. In my view, Roth IRAs, SEP IRAs, 401(k)'s, and other tax-advantaged savings vehicles are also IRAs. If I mean to refer specifically to the "traditional IRA", then I will use precisely that term.
By the way, this blog isn't a solicitation to buy or sell anything. Frequently, I'll suggest that you buy or sell something, because it's my honest opinion that it makes good financial sense to do so. But it's only a suggestion. I don't participate in the securities business. My job, as I see it, is to be blatently honest about sane investing. If you disagree, then say so, but I'm not here to engage in pump-and-dump schemes, or to buy or sell securities.
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