The Amateur Financier

Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world.  Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA.  (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)

The big difference between the two types of IRAs is when the the money you invest in them is taxed.  In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate.  Roth IRAs are funded with after-tax money and the withdrawals are tax-free.  The decision then becomes when you want to be taxed, now or when you retire.

Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying.  If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go.  Then, come back to the present and open that style of IRA; easy as pie!

What’s that?  You don’t have a time machine?  That complicates matters a bit.  You can still choose the style of IRA you open based on what you think the future will hold for tax rates.  Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive.  Some other questions to ask yourself:

Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income.  Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement.  If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.

Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes.  As we’ve already discussed, though, tax rates in the future are a big unknown.  If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity.  On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.

(If your taxable income is high enough, you may not even have the option of using a Roth.  For single filers, you can put in the  maximum ($5000)  if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000.  A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)

Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future.  If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify.  Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.

These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you.  As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions.  Happy retirement planning!

• Active, Passive, and Portfolio Income: Which is Best?
• Great Debates: Retirement Account Redux
• Net Worth Update: Post-Thanksgiving Coma

• Roth IRA Contributions And Early Withdrawals
• Roth vs. a traditional IRA
• How to Plan for Tax Free Retirement Income

This morning, I had a little bit of a scare, finding that my blog was down when I went to update it this morning.  It turned out that there was maintenance being done on the server, which is what shut down my blog.  After a brief period of panic, I settled in for a good day’s sleep (one of the advantages of being nocturnal, I suppose), and when I woke up, I discovered that my beloved blog was back up.  So, yay for that.

This whole experience has made me realize that I need to learn more about computer programming and similar technical issues.  I’ve been learning slowly, but if I hope to make my blog into a regular source of income, I will need to be able to maintain my own blog without requiring assistance.  Any suggestions as to where I can learn more about the fine art of blogging?

Some of the blog entries that made me think this week include:

The Advantages and Disadvantages of Going to Community College – Studenomics covers some of the advantages (smaller classes, less expensive tuition) and disadvantages (less challenge, less creditability) of starting your college career in community college.  He raises some interesting points; if I were approaching my college years and didn’t have the financial backing I was able to atain at my univesity, I would consider the possibility of community college long and hard.   It’s not a bad place to start (but probably not finish) your higher educational career.

Using Financial Aid to Graduate Debt Free – Keeping on the subject of decreasing your college education costs, My Life ROI covers some of the types of financial aid available to college student.  Given the rapidly rising cost of higher education (at least if you’re not in a community college), it’s good to know more about ways to defray some of your out of pocket expenses.

Parents Bamboozled by FreeCreditReport.com – Stephanie of Poorer Than You recalls a story where her mother and step-mother used a site (which I have no intention of repeating or linking to here) other than AnnualCreditReport.com in order to get their credit reports.  It’s a good reminder; make sure that you and everyone in your family know not to fall for the deceptive ads for the other site (catchy though their jingles might be).

Anything Worth Doing is Difficult and Requires Sacrifice – Finally, a column from Kevin at No Debt Plan reminds us that though things might not always be easy, the things in life that are worth doing tend not to be.  Getting your financial house in order, putting money aside for retirement, and getting in shape are all things that we should, nay, MUST do to have a good life, but the rewards are more than worth the pain.

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There’s a good chance you’re paying less in taxes than you think.  Why, you ask?  Because of the difference between your marginal tax rate and your overall tax rate. (Note: these discussions are going to focus on the American tax code, as that’s the one with which I’m the most familiar.  Apologies to any international readers, but I can’t really comment on your tax system.)

When most people talk about their tax rate or their tax bracket, they are discussing their current marginal tax rate.  This is the tax rate you will pay on the last dollar of (taxable) income that you earn.  It’s important to know this tax rate so you know how much you will pay should you earn any more money; if you are in the 25% tax bracket, when you earn one hundred dollars more, you will have to pay $25 more in taxes.

However, the average tax rate you pay is the average of the tax rates you pay on each segment of your income.  The first $8,350 of your taxable income, for example, is taxed at 10% (if you are single or married filing seperately), regardless of whether you earned $10,000, $100,000, or $1,000,000 the past year.  A complete tax schedule can be found here.

What are the consequences of this difference?  First, as already mentioned, your average tax rate is less than your marginal tax rate, and so you’re probably paying less in taxes than you might believe.  If you earned $50,000 in taxable, non-capital gains income, you would be solidly in the 25% tax bracket.  But the total income tax you would pay is $8670.50, for an effective tax rate of 17%.  In the same way, your average tax rate will always be less than your marginal tax rate (unless you are earning less than $8,350 each year, in which case both rates will be the same 10%).

A second consequence is that going up a tax bracket will not have a huge impact on the amount of tax that you pay.  You occasionally hear people going to great lengths to stay in the same tax bracket, from foregoing raises to cutting down on overtime, for fear that moving to the next bracket would cause them to lose money.  However, as noted already, this is not the case; if you go from the 25% tax bracket to the 28%, you will only have to pay the higher tax rate on your additional income.  If you go from $82,000 to $83,000, for example, you will only pay an additional $272.50 in taxes as a result; the previous amount you were paying in taxes on the $82,000 will remain unchanged.  Moving up a tax bracket will decrease the amount of money you get to keep for each additional dollar of income, but will not require you to pay more on money you already earned.

Finally, and perhaps most importantly, it adds a bit of a wrinkle to choosing between a traditional and a Roth IRA, although not a huge one.  Because your traditional IRA (and traditional 401(k), as well) contributions reduce the amount of taxable income you have, they will effectively cut down your taxes by the marginal rate you are currently paying.  But on withdrawal of your money, you will be paying taxes according to the then-current tax schedule.  Roth accounts, however, use post-tax contributions, so it’s the current average tax rate you need to consider for the contributions.  Withdraws are tax-free, so it’s just the contributions you need to consider.

Confused yet?  Let’s look at an example to see how this difference could end up being a wash.  If you are earning $50,000 a year before your IRA contributions and put in the maximum amount (currently $5000), you will cut your taxable income down to $45,000 and reduce your taxes by $1250 (25% of $5000).  When you retire, if you withdraw $50,000 a year from your account, have no other taxable income, and the tax rates are still the same (a great big if, especially when you are like me and are decades away from retiring), you will end up paying the same 17% average tax rate on those withdrawals.  Compare that to a Roth; you will have to pay the 17% average tax up front, but when you take out your money at retirement, it’s tax free; you pay no additional taxes on the withdrawals.

Because in both cases, you will pay an average tax rate of 17% on your retirement money, it’s frequently noted that both a Roth and a traditional IRA have the same tax burden, as long as taxes stay the same.  Tomorrow, we’ll look into some of the other factors that will influence which type of IRA is better for you.

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As of today, I’ve been at my temporary job now for one and a half weeks.  The good news is, I do have a job, it pays pretty well, and I can handle the work load without too much trouble.  The bad news is, the job takes up a substantial portion of my time when I used to do much of my writing (late at night is when I write best).  Add in the housework and other things I need to do in real life, and I’m having a tough time getting my blog entries out.

As a result, I’m going to be cutting back on my posting schedule, and I will not be posting anything on the weekends from this point on.  Hopefully, this will allow me time to build up an archive of posts for the future, as well as do some more promotion and maintenance work for my blog (which I’ve been neglecting up to this point).  Plus, it seems as if there is little interest in my net worth statements or commentary on charities, so it should not be a huge loss.

Thank you all for reading my blog, and I hope that it continues to be a source of entertainment and education.  Come again tomorrow, when I’ll be back to my normal money-related posts and other whackiness.

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Today, in a very special Investing 101 column, we’re going to consider ways to help inflation-proof your portfolio.

Q: What is inflation?

A: That’s something of a complicated question.  The basic definition is that inflation is an economy-wide increase in the price of goods and services.  Remember all those stories your grandfather would tell about how milk used to cost a dime and a loaf of bread used to be a nickel?  The higher prices of those items (as well as everything else, from candy to condos) is evidence of inflation.

Q: What causes inflation, anyway?

A: In the simplest form, inflation is caused by a rising supply of money in the economy.  Think of money as a good that you can trade for other goods and services; how much money you need to trade depends on how rare it is.  If the supply of money increases relative to other goods, you will have to trade more money to obtain a particular item.  For a rather extreme example, imagine that in one year, the amount of money in the economy increases by ten percent while the supply of bread remains the same.  If the price of bread started at $1.00, then after inflation, it would cost $1.10.  This example shows an annual interest increase of 10%.

If we’re looking at the broader economy, inflation rates are usually determined by measuring the growth of a broad price index.  In the United States, the Consumer Price Index (CPI), a basket of consumer good prices, is mostly commonly used.  The average rate of increase is about 3-4% per year, which means that prices should double in about twenty years (although, a few years of higher than normal inflation could easily speed that up).

Q: What can we do about inflation?

A: On the national level, there are several possible techniques that can be used to control inflation.  Adjusting the money supply, increasing the prime rate (making it more expensive to borrow money) and, in the most extreme cases, instituting wage and price controls all have the potential to fight inflation, at least when used properly.  On the individual level, the best way to limit the troubles caused by inflation is by holding some investments that do well in inflationary conditions.

Q: Alright, what are some good investments to combat inflation?

A: The best way to deal with normal levels of inflation (the 3-4% average annual inflation rate) is to hold a diverse portfolio with a sizable portion of money in stocks or other investments that provide decent growth.  To deal with higher inflationary rates, or simply to to provide a more explicit hedge against inflation, you could consider either I-Bonds or TIPS from the US Treasury; both provide a greater investment boost when inflation runs high.

I-Bonds are similar to regular Treasuries, but the interest they pay is a combination of a fixed interest rate for the life of the bond and an adjustment for inflation that is set twice a year.  This inflation adjustment means that if inflation starts to increase greatly, so will the returns on your I-Bonds.  (As an added bonus, if you choose to hold the physical bonds, they have pictures of famous Americans such as Helen Keller and Albert Einstein (presumably, after he immigrated) on them.)

TIPS, or Treasury Inflation Protected Securities, also provide inflation protection, but do so in a different way.  They have a set interest rate, but the amount of principle in the bond fluctuates, depending on the current rate of inflation.  As a result, the amount of interest you receive during the life of the bond, as well as the amount of principle you receive at maturity, will increase along with the rate of inflation.

It’s worth noting that although both of these types of Treasuries can protect you against inflation, they are treated much differently for tax purposes.  The interest payments (and thus, tax liability) for I-Bonds can be deferred until maturity, while TIPS are taxed yearly on both the interest they yield and the ‘phantom income’ of the principle adjustments.  Because of this, it is frequently a good idea to put TIPS bonds into a tax-deferred account like an IRA, or better yet, a tax-free Roth account, to avoid such taxation.

Q: What about commodities and real estate; aren’t they good inflation hedges?

A: Somewhat.  Commodities and real estate are often considered inflation hedges because, as real, tangible items, they have intrinsic value, unconnected to their role as investments.  Assuming no change in the demand, inflation will simply mean that more money will needed to be paid for them, increasing their value along with the rising supply of money.  However, since there is no explicit connection between the returns on these investments and the rate of inflation, it’s possible that high inflation rates could cause the demand for real estate or commodities to drop, decreasing their value.  This is not to say that you shouldn’t own these investments; but think of them more as diversifying your portfolio, rather than serving as inflation hedges.

That’s it for our discussion of how to fight inflation; hopefully, you’re all a little more prepared to combat its effects on your portfolio.

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Imagine for a moment that you have received $10,000.  It might be from an inheritance, it might be a bonus for outstanding work at your job, it could be winnings from a gambling trip (although, hopefully you’re not spending much of your money gambling); the source is immaterial to this particular example.  Furthermore, imagine you have two possible options for this money: you can use it pay some of your student debt, which currently has a fixed interest rate of 7% annually, or you can put the money into a diversified portfolio that should return about 10% annually.  Now for the question: which choice will leave you richer one year from now?

The correct answer, of course, is ‘I don’t know’.  It’s pretty easy to calculate the financial repercussions of paying off the debt: Cutting down $10,000 of debt with a fixed interest rate of 7% will save you from paying $700 in interest, giving you a total net worth boost of $10,700. (Actually, you will save a little more; if the debt is compounded monthly, you would have paid $723 in interest on the debt by holding it the whole year, for a real total boost of $10,723 in your net worth.)

But the stock market investment is highly variable; while you can expect a 10% return over the long term (and even that is the subject of more discussion and argument than I’m going to get into right now), in any particular year, stocks could soar, they could crash, or they could be somewhere in between.  Being able to predict how much stocks will return in any given year is a bit beyond the skills of most people; guessing a year in advance how the stock market or particular stocks will do is all but impossible.

Why do I bring all this up?  Quite simply, there’s a tendency among financial writers (myself included) to skim over the difference between fixed returns and variable returns on your investments.  Because variable returns are, well, variable, you should expect higher returns, on average, to compensate for the variability.  If stocks yielded only as much as bonds while still being more variable in their return rates, they would have ceased being a popular investment choice a long time ago.

When considering your investments, then, you need to consider both the expected investment return and the variability of that return.  When you can get a fixed return that is the same or higher than the highest reasonable return from a variable investment, you should go for the fixed return.  If the choice is between paying off credit card debt at 23% or investing in the stock market and hoping for a 10% return, the obvious choice is to pay off the debt.

If the fixed return is lower than the expected variable rate, as it frequently is, things get more complicated.  You have to consider how much of a premium will make the variable investments worth-while to you.  If you are choosing between an 8% fixed and a 10% variable return, it might not be worthwhile, while the difference between a 6% fixed and 10% variable could be worthwhile to you.  (Personally, I happen to follow the latter view, which is why I suggested paying down your debt to a level of six percent in my Ten Steps.  Now, you have a better idea of the logic behind that suggestion.)

You also have to be aware of how much risk you are willing to take in order to achieve your desired return.  It is possible to only invest in instruments with fixed rates and less rate risk, but you will have to deal with lower returns (and thus higher amounts that you need to invest).  Generally, the suggestion goes that you should take more risk in variable return vehicles when you’re younger and have time to make up your losses.  (Plus, if you have decades over which to invest, your returns should approach the averages, allowing you to treat the variable returns as close to fixed returns for your planning.)  Then you gradually shift to investments with fixed returns as you get older, so the swings in value aren’t as severe.

Hopefully, all of this helps you to get a bit of a better understanding of some of the considerations you need to look at when comparing the return rates for your investments and debts.

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• Investing 101: Compound Interest

• Debt Decisions
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• Using History to Understand the Stock Market and my Investing Plan

It’s Memorial Day here in the United States.  To all who have served (which includes both of my parents), I would like to thank you for your effort and sacrifice.  To all who have lost relatives, know that they are honored and remembered, not just today but every day.

Just a few thoughts to remember as we spend the day at picnics or with our relatives.  Please spare a thought about the reason for the special day we’ve set aside.  And, if you have some time to visit a graveyard or other memorial, I’m certain that the fallen soldiers would appreciate the time you devote to them, wherever they are now.

Happy Memorial Day.

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(It’s time once again to drum up some support for deserving charities.   This time, it’s one that I’ve heard quite a bit about in various media, which focuses, interestingly enough, on fixing childhood facial deformities.  It’s an interesting mission, rather more narrow than most of the other groups we’re covered so far.  Still, that makes them no less deserving, and I think Operation Smile would be well served with some more positive press.)

Charity: Operation Smile, International

Website: www.operationsmile.org

Organization: Operation Smile is an independent 501(c)(3) organization.  Contributions are deductible from taxable income according to IRS guidelines.

Goals: Operation Smile aims to fix childhood dental deformities.  They also work more broadly to develop health care systems in underdeveloped parts of the world and work to train health care service people in those areas.

Classification: The NTEE classification on Guidestar lists Operation Smile as a Surgery, Health and Rehabilitative, and Children’s Services charity.

BBB Report:  Operation Smile meets nineteen of twenty Standards for Charity Accountability as set out by the BBB.  These standards ensure that there is adequate oversight, methods of measuring effectiveness, use most of the finances toward charitable purposes and engage in proper fund raising.

Operation Smile fails the last standard as they have more than 10% of their board members receiving compensation from the organization, leading to a potential conflict of interests.  There are also paid members with parents on the board.  The organization has said they are attempting to correct this in order to meet all the standards; in the meantime, be aware of this conflict for 6 members of the 15 member board.

Expenses: As noted by the Better Business Bureau, Operation Smile spends 23% of its budget on fund raising and 4% of its budget on administrative expenses.  It brought in $52 million dollars during 2007.

You can donate to Operation Smile here.

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Well, I’m back at home, and that means that it’s time to go through my finances and see where I stand.  I’m a bit nervous to see how my accounts stack up after spending a week out in California, spoiling my girlfriend (and at times, her sisters as well) and paying a premium on gas.  (To say nothing of the numerous tiny heart attacks I had driving on the California freeways; the higher insurance premiums when I get older aren’t going to be pretty.)

It was a fantastic trip, though, and I wouldn’t change the experience for the world.  Plus, it seems that the economy had something of a good few weeks while I was indisposed, so my net worth didn’t take quite the hit I feared it might while I was away.  Here, as always, is a summary of my finances:

A lot of changes with this one, although you wouldn’t know it from looking at my net worth change.  The increase in my investment values masked all the money I spent on the trip, leading to an increase in my overall net worth.  Hopefully, with my new job and a broader economic recovery (which I hope is here, but would not bet on), my net worth will only increase in the near future.

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• Net Worth Update - June 2008
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• July 2009 update + a few links

Ah, my first Thoughtful Thursday column since I got back from my trip out to California.  I feel I’ve missed so much, more than a week of posts at all the blogs I follow and emails from all the other sites I frequent.  It’ll take me a little while to catch up, but with so many great writers out there, it’ll be fun the whole time.  Here are a few of the articles from this last week that I’ve enjoyed:

How to get a Federal Job – Over on My Life ROI, there’s some good advice for anyone who hopes to gain a job with the federal government.  It’s a pretty article, and given how crummy the broader economy has been doing lately, having a job with excellent benefits and almost no chance of disappearing sounds downright perfect.

Credit Card Reform Treats College Students Like Babies – Stephanie (who is, as always, Poorer Than You) makes note of the recent changes in the laws regulating credit card companies.  In particular, she focuses on the new rules requiring college students under twenty-one to have proof of ability to repay or get a parent to cosign.  I’m less upset by these requirements than others seem to be; if we were talking about a group other than college students, having proof of income or a cosigner would be required anyway.  To my view, all this does is make it harder for credit card companies to guilt parents into paying off their children’s debt on cards about which the parents didn’t even know.  Of course, as with any legislation, I’m certain there will be unintended consequences, but we’ll have to see what happens once this becomes law.

Peer-To-Peer Lending With a Twist – As you might be aware, I do some investing with Lending Club, where I make loans to other individuals and get paid interest back in return.  So, it was with great interest that I read the post about Pertuity over on No Debt Plan.  Apparently, rather than make individual loans as with Lending Club or its nearest rival, Prosper, Pertuity allows you to put your money into a single fund, from which all the interest is paid and all the loans are made.

It’s an interest concept, sort of a mutual fund for peer-to-peer lending.  The ability to pull your money out of the investment without having to sell the loan is plus, as is not being dependent on the reliability of any one borrower.  But, given the relatively low cost of each individual loan on sites like Lending Club, it shouldn’t be too hard to assemble your own diverse portfolio without too much money and effort.  Plus, there is the added personal touch of knowing that your money is going to, say, help someone to consolidate their loans and get out of debt.  Still, Pertuity is something to keep an eye on for the future.

Investment Clichés: Helpful or Not? – On The Writer’s Coin, there’s talk about whether investment clichés are helpful.  In particular, he focuses on whether the oft-quoted ‘8% average return’ on stock investments is useful, especially given the always present warning on investment products, ‘past results are not indicative of future returns’.  Personally, I think it is easy to put too much emphasis on that 8% (or 10%, 12%, or whatever figure you hear), and assume that just because that’s the average stocks have returned in the past, you can expect that return each and every year.  Still, for long-term planning, you need to have some idea of what to expect in the future, and these clichés serve as a good place to start your research.  (Note: start with the clichés, but by all means, don’t stop there.)

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