The Amateur Financier

I know you’ve probably tried to put it out of your mind, but tax season is just about on us.  Yes, you don’t HAVE to file until April 15th, but why put it off until the last minute?  (Besides tradition, of course.)  Most of your tax documents should have been sent to you by January 31st, or more likely nowadays, are available online when you check your investments or savings.

Even though we’re just getting into the 2010 tax season, it’s not too early to get ready for 2011′s taxes. In fact, now is probably the best time to begin your preparation for next year; changes you make now to the amount of withholding you ask your employer to take out of your paycheck will have a great effect on how much you owe next year, and these can easily be calculated by any of the free tax prep software packages available online. But the question is, should you aim to make your refund as small as possible (thus getting more money with each pay check) or try for the largest refund possible (cutting down your take home pay throughout the year in order to do so)?

The amount of money you get back depends on you

The most common advice I’ve heard is try to minimize your potential refund.  It makes sense; after all, every dollar you get in your refund is a dollar that you (over)paid in taxes initially.  On the other hand, as Green Panda Treehouse and the Financial Samurai note, there are advantages to getting a sizable refund, as well.  Let’s look at both sides of this issue:

Small Refund Pros

-More Money Throughout the Year: The biggest advantage of aiming for a small refund (by putting as many allowances as possible on your W-4) is that you’ll get more money with each paycheck (as less will be withheld for taxes).  This means more for spending, more for investing, more for saving.  If you aren’t giving the money to the government, that means more for you in each paycheck.  Speaking of the government…

-No Interest-Free Loan to the Government: Whether you want to avoid giving the government more money than needed or just want to do your part to keep the national budget under control, minimizing how much you have taken by the government can be a goal in itself.  A small refund is proof that you succeeded in that goal.

-No Temptation to Treat the Refund like ‘Found Money’: Every year around this time, you start to see advertisements for companies offering sales, specials, and other inducements for people to spend their tax refunds.  You even hear about ‘refund anticipation’ loans where companies will offer to let you buy things with the money you’ll get from the government, before you even file your taxes.  This trend of treating a tax refund like money from heaven (rather than a refund of your own money to you) is one reason to consider increasing your allowances and minimizing your refund.

The Advantages of a Large Refund

-Lump Sums are Easier to Utilize: If you have financial goals you’re working to meet, a lump sum is easier to put to work for you.  If you want to build an emergency fund (always a good idea), it’s simple to take a $1200 refund and say, ‘Well, that’s a pretty decent bare bones fund’.  If you got that same $1200 throughout the year (in the form of slightly larger paychecks), you would need the discipline to put it away a little bit at a time, $25 or so every two weeks.  Many people just don’t have that discipline.

-Less Temptation to Spend Throughout the Year: Here’s a simple fact: if you don’t have money, you can’t spend it.  (Well, you can if you use credit cards and carry a balance, but none of my readers would do anything that foolish, right?)  If you are getting less money in each paycheck because you are paying more in taxes, there will be that much less available for you to spend, (hopefully) helping you to rein in your finances.  (This is also a major reason financial advisers will tell you to increase the amount you contribute to your 401(k); less money taken home means less temptation to go crazy with spending.)

-No Risk of Owing Taxes: Sometimes forgotten in the argument over whether to shoot for a small tax refund is the fact that you can overshoot and wind up owing the government money.  Much as getting a few thousand dollars can allow you to easily complete one or more of your financial goals, finding out that you owe the government hundreds or thousands of dollars can empty your emergency fund and possibly derail some of your plan.  If you ensure that you overpay throughout the year, you’ll never find yourself in that situation.

My Suggestion

This is a tough one; either option could be good, depending on how you utilize money.  The biggest question is, what would you do with a sizable refund?  If your answer is something financially responsible, like bulking up your emergency fund, investing it, or paying down credit card debt (hopefully not credit card debt you’ve accumulated since paying down your balance last year with a tax refund), then giving the government an ‘interest-free loan’ is not going to hurt you.  You’ll get the money back next year, anyway, and it probably won’t be bad to get used to living on a smaller paycheck in the meantime.

On the other hand, if you look at a tax refund check as an excuse for prolific spending for a short period of time, then taking steps to minimize the amount you’ll receive is probably the best course of action.   Assuming you have decent spending and savings habits (which is admittedly a big assumption), a slightly larger paycheck each week could prove less of a temptation than a single lump sum.  You should also shoot for a small refund (or even owing money) if you vehemently oppose giving the government any more money than you absolutely must AND you’re  willing and prepared to owe money when you file your taxes.

For myself, I’m reconsidering my previous belief that minimizing your refund is best, and I’m leaning a bit toward claiming fewer allowances on my W-4 when I am next hired.  Besides helping to discipline my monthly spending, I think I have enough discipline to put most of the refund money towards good financial goals (like rebuilding my emergency fund).  But you have to do what you think is right for your own personality.

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Welcome back fight fans, to the first grudge match in Great Debate history.  Yes, although we already fought this issue out a while back, it’s come up quite a bit in the media lately, and with 2010 being the year that anyone can convert their traditional account into a Roth without regard to the usual income limits, the arguments are only likely to increase in the future.  To help you decide which is the better choice, let’s look over the situations where each account really shines (as well as when we can’t tell):

Traditional Accounts Are Best If:

Tax Rates Drop in the Future: This should be pretty obvious; with traditional IRAs/401(k)s, you get a tax break now but pay taxes in the future.  If taxes come down between now and when you retire, you’ll have benefited by delaying long enough to see the tax rates decrease.

We Switch to a Non-Income Tax System: Similarly, if we as a country stop taxing income and start taxing something else, like spending, for example, traditional accounts again win out.  Switching over to spending based tax system (like the Fair Tax) would mean that your money avoided taxation on the way into your retirement account, and could be withdrawn without penalty and reinvested, only be taxed when it was spent.  A Roth account, on the other hand, is filled with money that’s been taxed at least once, and now faces substantial spending taxes, making it a double loser in this situation.

Sail Boats, those scream retirement, right?

(Side Note: in researching the above linked Fair Tax article, I called the Fair Tax organization and explicitly asked about what happens to Roth accounts under this system (since the benefits to traditional accounts were already listed on the Fair Tax website).  The answer I got was that, in short, Roth account holders were going to be hung out to dry if the Fair Tax is implemented.)

Tax Rates Stay the Same in the Future (Or Increase Slightly): This one is probably going to require a little bit of explanation, so hold on to your seats.  It has to do with the difference between marginal tax rates and overall tax rates.  The money you put into your traditional account comes off the top of your income pie, so to speak.  If you were still collecting that money, you would have to pay taxes equal to the highest tax bracket you are in (or a weighted average of the highest and next highest, if the contribution reduces your taxable income enough to move you from one tax bracket down to the next lower one).  So, with $50,000 in income, you’d be in the 25% tax bracket (as of 2010), and you would save 25% of $5000 ($1250) in tax expenses with a traditional account.

However, when you take money out of the account, you are going to be pulling out a much larger amount of money, spread across a wider range of tax brackets.  Because we have a progressive tax system, where your first dollar of income is taxed at a lower rate than you last dollar (aka, the dollars you were putting into your retirement account), your average tax rate is much less.  To pull out $50,000 as a taxpayer filing singly, you would have to pay $6393.75 on that income, or 14.2%, given the current tax brackets and standard deductions.  Same tax rates, much lower rate coming out than going in (as a result of which dollars you specifically added).  As a result, there’s also a bit of leeway at to how high tax rates can rise before it becomes a better deal to pay taxes now at your marginal rate, since taxes can go up a reasonable amount without pulling the average tax rate in retirement above the level of the highest marginal bracket during your working life.

Roth Accounts Are Best If:

Tax Rates Increase Dramatically in the Future: Just as tax decreases would be a boon to traditional accounts, tax increases benefit Roths.  Note the ‘dramatically’ qualification in this point, though; for many people in the middle income brackets (and even more in the upper income brackets), tax rates would have to rise substantially (ten to fifteen percentage points in every bracket, for example) for the taxes paid on withdrawals to be equal to your highest current income tax bracket.

Your Income Rises Substantially From Your Current Income: The lower your current income, and the more it rises in the future, the better a Roth looks.  If you end your career in a tax bracket several steps higher than your current one, there is a good chance that making investments in a Roth now will enable you to benefit from your lower tax bracket and save on taxes in the future.  This is one reason why Roths are particularly recommended for us young whippersnappers; our tax burden is likely to be much higher, even if tax rates stay the same.

We Just Can’t Tell If:

We Switch to a Flat Tax: If we go from a graduated tax system to a flat tax, how good it will be for each type of account depends on your current marginal bracket and the flat tax rate.  If the flat tax is higher than your top marginal rate, having a Roth will be better; if the flat tax is lower, then the traditional account is better.  (As a side note, if the flat tax is lower than your highest marginal tax rate but higher than the average rate you would pay under the current system, then the traditional account is still better, but you’ll be paying more than you would under the current tax system.)

Roth Accounts End Up Being Taxed: This entire discussion is predicated on the withdrawals from Roth accounts being tax free in the future.  If this is not the case, then the case for traditional accounts gets much stronger.  It’s not a slam dunk for traditional plans, though; if Roth withdrawals are taxed at a different, lower rate than ‘normal’ income, it’s possible (although harder) for Roth accounts to be the better deal.

Conclusions

You might notice a common thread for these points; they all depend on knowledge of the future which, unless you are a witch (and thus, weigh less than a duck), you can’t know for certain.  We can make educated guesses; given our large and increasing budget deficit and future obligations for Social Security and other programs, my assumption (one shared by many financial writers) is that taxes are only going to go up in the future, making Roths an attractive proposition.

What do I intend to do?  Basically, try to diversify my accounts; perhaps traditional accounts will save me more, perhaps Roth accounts will, it’s best to attempt to hold some money in both types of accounts, so that I can attempt to optimize my tax situation in the future.  Having money in a traditional account to withdraw until you fill the lower tax brackets, and money in a Roth for withdrawals beyond that point, allows you to lower your average tax rate without having to lower the money you have available.

How much to hold in each account?  That’s a tough one.  Before, I would have recommended mostly Roth accounts, but after reading some of the comments on Financial Samurai’s site and considering the effects of marginal tax rates, I’m leaning more towards traditional accounts.  (Going back to our $50,000 a year earner, to pay the same 25% as the marginal tax rate, he or she would need to pull $185,000 from a traditional account; even if tax rates go up substantially, you could still spend less on taxes with a traditional account.)  A mix of of two-thirds to three-quarters traditional accounts with the remainder as Roth accounts should provide plenty of tax savings now with a nice amount of tax-free income in the future to fill out my income needs without too much tax liability.

Now, as to conversions, particularly this year, given the ability of everyone to convert.  If you are currently invested entirely or mainly in traditional accounts, it might be worthwhile to convert; just remember that the more you convert, the more taxable income you will have.  The more taxable income you have, the higher your marginal tax rate (and overall taxes), and the less likely that future tax rates will make the conversion worthwhile.  In short, don’t convert so much as to greatly boost your taxes now; you’ll be setting a high bar for tax rates to clear.  Better to keep your traditional accounts than to pay out the nose for the privilege of conversion.

The most important thing to do though, is to save now, and take advantage of either type of account if possible; it’s better to use a less ideal retirement plan than delaying things to try to figure out the perfect one for your situation.  You’ll definitely be better off, even if when you retire, the tax circumstances mean your (primary) type of account was not the ‘best’ one.  If you’re really, really worried about your retirement savings, there’s a simple and easy way to ensure your retirement is more secure: save more money, in any type of account.  The more you save, the better off you will be in the future.  Good luck, and happy retirement investing!

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Ah, one of the biggest Great Debates in the financial field, and perhaps the biggest argument when it comes to housing, period.  Which is more beneficial for your bottom line, buying a home outright or renting and investing the difference?  While the overwhelming majority of advisers maintain that buying is better, there are some staunch advocates of renting and investing.  The real story is more complex and nuanced than a simple, all-or-nothing answer.

A caveat before we begin; the entire debate about which method of putting a roof above your head is best assumes that buying a home is more expensive than renting (at least, in the early years), that our renter is putting most, if not all, of the difference in cost into investments, and that these investments will generate a substantial rate of return (high enough to beat house price increases, for example).  If any of these assumptions are wrong, there really is no debate: buying a house is a more profitable prospect.  If buying is less expensive than renting, if the renter blows the extra money on frivolities, or if our renter just socks the money away in a low yielding account, then buying becomes a much better deal than renting.

If we assume these caveats hold, though, things get much murkier.  The commonly held conclusion is that renting is less expensive in the early years of owning a home (because there are large upfront costs to buying, such as a down payment and closing costs on the house, as well as a fixed mortgage rate that is higher than rental costs to start), but after several years of living in the house (usually cited as 5-15), the fixed mortgage payments mean that living costs will be less than the rent paid out.  The common suggestion is that if you know with some certainty that you are going to stay somewhere for at least 5-10 years, buying will be a better deal for you.  But this ignores a number of factors that will influence how profitable each housing technique will be, including:

-Investment Returns: If you do in fact rent and invest the difference, how much your investments return will be a major determinant of whether renting is profitable for you.  If your investments do well, it can more than make up for the ever-increasing rent you’ll be paying; if they do poorly, you’ll be doubly hit, suffering from both rising rents and laggard investments.

-Housing Appreciation: If you buy, on the other hand, one of your major assets is going to be your house.  As it rises in value, you’ll be able to pocket more money if you sell it, making buying more profitable.  If prices shoot to the stratosphere (as they did in the early 2000′s), you’ll have huge potential profits when you sell; if prices lag (or even fall, as many have done in the past several years), buying will look like a much worse idea.

-Years to Collect Down Payment: Something often neglected in even the best discussions of renting vs. buying, how long it takes for our buyer to save up the down payment on the house can be a big factor in which is more profitable.  The longer it takes a would-be buyer to build up their down payment, and the more they have to cut down their investing in order to do so, the more attractive renting and investing start to become.  Especially now, when it’s gotten much harder to get a mortgage without a substantial down payment, the years needed to divert money from (potential) investments into down payment savings can give our renter/investor a substantial head start in building up his/her net worth.

(Dependent on investment returns and housing market conditions, of course; if our would-be buyer has enough saved up for a down payment in a year like 2008, when the stock market seemed to be disintegrating and house prices were falling, they’d be in a pretty good place to buy.  Such is the impact the broader markets (for stocks and homes) can have on the relative profit possibilities of each.)

-Inflation & Taxes: A major factor in determining which is the more profitable, and one that’s even more unpredictable than investment returns or appreciation, these broader conditions have all kinds of influence on which is better.  If taxes are raised on selling houses (or the substantial tax deduction currently available is dropped), renting will start to look better; if investment taxes are raised, buying becomes more attractive.  High inflation can make stocks decline in value while helping to drive appreciation, while low levels of inflation can keep appreciation low and help investments (and even this is a gross oversimplification of how inflation affects the housing and stock markets).

As a result of all these factors (most of which require making assumptions about future conditions), saying definitely which is better, renting or buying, is impossible without knowing more about the specific properties and market conditions.  Luckily, there are several good rent vs. buying calculators out there, which will help you to make your decision:

-MichaelBlueJay.com: Probably the best and most complete renting vs. buying calculator I’ve seen, covering everything I’ve mentioned above (except for the years to save up the down payment) as well as several other factors I didn’t get into (closing costs, maintenance on the property).  It generates a very thorough data table, as well as a simple explanation of when buying becomes less expensive than renting (if ever), as well as whether your investments as a renter will later generate more profits than buying.  It’s a bit complex, but every thing is explained, and it’s a good place to play around with the numbers to see what is the best for you in the long term.

-MotlyFool.com: While not as complete as MichaelBlueJay’s, it’s a pretty thorough calculator, which should enable you to determine which is the better deal.  (Just click on the ‘Am I Better Off Renting?’ link to open it up.)  It also have a few inputs that seem to be pretty unique to this calculator, including points and origination fees, although it’s easy enough to work around this lack in the other calculators.  Still, using it in conjunction with other calculators can lead to a better understanding of the best deal for you.

-NYTimes.com: Possibly the easiest calculator to understand (due to the large graphic in the middle of the page), it provides a nice visual representation of when (if ever) buying will become more advantageous than renting.  Based on the data you enter (in the upper bar, the appreciation/rent increase sliders on the left, and the optional advanced setting entries), you can view a variety of options to see how it affects the graph.

My Conclusions

As mentioned above, it’s hard to say that renting or buying is always better, in all circumstances, because neither really is.  If you are only staying somewhere for short period of time (less than five years, especially, although it’s worth looking closely into your expenses for ten to fifteen years out), renting is almost always better; the transaction costs of buying and selling houses will definitely make it less expensive just to rent.  For longer periods, buying a house is usually better, although if you have the discipline to invest the difference between your rent and your potential mortgage/other buying costs in a reasonably high yielding investment, renting might be better.  But that’s if, repeat IF, you figure out the difference and diligently invest that difference; if you can’t do that (or know that you won’t), buying is probably the better choice for someone who isn’t planning on moving for a while.

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It’s been a while since I’ve done any Great Debates; for all the disagreement and squabbling about individual investments and the direction of the country that you hear, there’s a surprising amount of uniformity as to what constitutes sound investment advice. Invest early, invest often, don’t spend too much time and money trying to beat the market, just worry about keeping up with it; there, twenty-three words that sum up the greater bulk of good investment advice.

That said, the details do matter, and choosing the right investments is important, as well.  One issue you’ll need to resolve, even before sitting down to compare investments and choose the ones that meet your needs, is what investment vehicle to use.  There is a strong consensus among most financial advisers that the best way to invest is to choose well-diversified, easy to purchase investment vehicles that seek to match the performance of the broader market (or some defined segment of the market).

The two investment types best suited for such a plan include index mutual funds (or simply index funds) and exchange traded funds (ETFs).  They both have many of the same advantages, such as easy diversification, an index-following strategy, and low expenses.  But which is best for you and your particular purposes?  We’ll have to take a closer look at each type of investment to draw any conclusions.

Our Current Champion: Index Funds

Index funds are a type of mutual fund that doesn’t have its managers attempting to ‘beat the market’ by picking and choosing stocks (or other investments).  Instead, an index fund holds all (or a large representative sample) of the stocks in a particular stock index.  An S&P 500 index fund would hold all five hundred stocks from the index.  Each share of the index fund in turn represents a fractional share of all the stocks (or, as mentioned before, other investments) that are held, meaning that you would own a tiny, tiny piece of all the companies in which the index fund invests.  The advantages of index funds include:

-No trading costs: You can buy and sell shares of index funds without having to pay commissions or other fees on each purchase or sale.  (Although, if you are swapping the funds in a taxable account, you’ll have to pay taxes on any capital gains.)  As with all mutual funds, you can decide how much money you want to invest, and after the fund’s net asset value is calculated for the day, you’ll receive as many shares as you can purchase with your new contribution.

-Easy Automatic Investing: Most mutual fund companies allow you to set up investments for a particular amount that are enacted on the same date every month, allowing you to dollar cost average your way into a large fund position.  You might be able to do so through your brokerage (I know my preferred brokerage, Sharebuilder, makes automatic investing easy; I can’t speak for all brokerages though, whereas every mutual fund company worth its salt makes automatic investing simple).

Meet The Challenger: ETFs

ETFs are very similar to index funds, in that they are collections of stocks (or other… you probably get the picture by now) that are bought and sold as a single unit.  Unlike index funds or other types of mutual funds, though, ETFs are bought and sold on exchanges like the NYSE and NASDAQ, so they can be traded just like stocks.  This gives ETFs a few advantages over index and other mutual funds:

-Flexibility: Since you don’t have to wait until the end of the business day for the prices to update before you can buy and sell shares, ETFs give you many more options for when you can trade.  Furthermore, you can also do some of the more advanced techniques available to stock investors, such as shorting shares and buying on margin, for many more ways to use ETFs in your investments.

-Lower Expense Ratios: One of the advantages of index funds is that they are cheap; the expenses charged by the fund managers are usually under 0.50%, sometimes as low as 0.10%.  But the expenses of ETFs are even lower, frequently under 0.10% (at least for plain vanilla ETFs).  For example, the Vanguard Total Market Index fund has an expense ratio of 0.18%, while the Vanguard Total Market ETF has an expense ratio of 0.09%.  Same fund family, same underlying investments, but the ETF has half the expenses of the index fund.

-More Tax Efficient: Although index funds are known for being very tax efficient (there is much less buying and selling compared to actively managed funds, leading to fewer tax consequences), ETFs are even better.  Since they are created from a large number of stocks (or…you know) known as a creation unit and then sold, there are essentially no capital gains distributions, making them an improvement on index funds that have to pay out capital gains when they need to meet redemptions.

And the Winner Is…

Which should you choose for your investments?  Well, if you are an active trader, there’s really no option: ETFs are going to be your tool of choice.  That flexibility advantage is all you really need to know; attempting to jump in and out of mutual funds at the drop of a hat is a futile gesture, and the ability to perform more complex trades is vital to success as an active-trader.  (I would remind you that attempting to ‘beat the market’ is considered tough, if not impossible, by most commentators; just because ETFs are better for that purpose doesn’t mean you run out and become an active trader.)

If you are a buy and sell investor holding onto an investment for decades, on the hand, things get more complex.  As mentioned already, the expense ratios on ETFS are lower.  Going back to our Vanguard Total Market investments, the index fund will cost $18 a year on a $10,000 investment, while that same $10,000 would only ‘cost’ $9 with the ETF.  (This is an oversimplification of how expenses ratios work; the money is actually taken by very slightly lowering your investment gains or increasing your investment losses.  You’ll never get a bill or something similar asking you to fork out the expense ratio money, this is just to help you see the difference.)  It seems like the ETF is a no-brainer again, right?

Well, maybe; the other big expense for ETFs is the commission on buying and selling shares that will be charged by your brokerage.  If you happen to have a brokerage that charges absolutely nothing for your trades (such as Zecco.com, at least when certain conditions are met), then yes, ETFs will be the cheaper option.  Otherwise, the costs can quickly add up; buy some shares of the ETF once a month at a brokerage that charges $4 a trade, and by the end of the year, you’ll have spent $48 on top of the $9 from the expense ratio.  Suddenly, that $18 a year looks pretty good, doesn’t it?

If you’re looking to minimize your investment fees with ETFs, you’ll have to (a) limit the number of times you trade (to cut down on the trading costs, (b) invest larger amounts each time (so the smaller fees can counteract the trading costs) and (c) seek a brokerage with the lowest costs possible (a cheap brokerage, to say nothing of a free one, can make this calculation much more favorable to ETFs).  If you can do all of that, then ETFs will likely be your least expensive bet; if not, go with index funds.

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