Friday, December 4, 2009

Q&A: When and Where to Save

Now that we've made a decision on where to put our money, generally speaking (and it's okay if your decision is different than mine), it's time to decide on when to put it there. First, we'll look at which accounts get priority when allocating contributions. Then, we'll look at the timing of those contributions throughout the year.


The highest priority for your money is definitely 401(k) contributions that qualify for employer matching contributions. This is typically an instant 50-100% return, depending on your employer's plan. Once you've passed the match cutoff, deciding between 401(k) contributions and IRA contributions depends on a number of factors. Hey, it sounds like we need yet another bulleted list!
  • Maxing out contributions? - If you plan to max out both 401(k) and IRA contributions, keep in mind that the only way to contribute to your 401(k) is through salary deferrals. It is important to contribute enough to your 401(k) early in the year to make maximizing your contributions possible. There is more flexibility in contributing to an IRA. You have all year to contribute, plus until tax filing of the following year. Your 401(k) is more time-sensitive, and therefore may have a higher priority.

  • Investment options - 401(k)s typically have a very limited number of investment options. For example, IBM offers mutual funds that follow large sector indexes. Additional mutual funds are available for a small administration fee, though even these choices are limited. By contrast, my IRA through E*TRADE has access to over 7000 mutual funds, 1000 ETFs, plus stocks, bonds, and options, of course. The nice thing about 401(k) investment options is that they usually (but not always) have very low expense ratios. Still, it's important to look at net returns, and IRAs often have many more investment options than 401(k) plans, which means more opportunities for better overall returns.

  • Roth vs Traditional - If your employer doesn't offer a Roth 401(k), but you've decided that Roth is a better option for you, prioritizing contributions to a Roth IRA before additional 401(k) deferrals makes sense.

  • IRA vs Nothing - Of course, if your employer doesn't offer a 401(k) at all, an IRA is your only option. I would strongly suggest taking the issue up with management or HR!

Naturally, tax-advantaged accounts have received the priority. When you have extra money and no tax-advantaged accounts left to put it in, a regular brokerage account finally comes into the picture.


Generally speaking, trying to time the market is not recommended. It is possible, perhaps likely, that you will miss out on significant gains. I'll admit to some attempts at timing the market, though. I think the important thing is to be careful not to try to time the market too much. It would probably be bad to hold your $5000 IRA contribution waiting for a low point in the market, but I don't think it's bad to alter your 401(k) deferral percentage based on large market trends. For example, I lowered my my 401(k) deferral percentage at the beginning of 2008 and 2009, then raised it about halfway through so that I would contribute more during the latter half of the year, while still maxing out my contributions. For 2006 and 2007, when the market was good, I maxed out my 401(k) contributions in little more than 6-8 months. The economy shows some signs of improving, so I might set my deferral percentage to max out my 2010 contributions around August. This is different than the usual definition of timing the market, too - I still have all previous contributions invested, and I am still making regularly timed contributions. Basically, I don't feel bad about my 401(k) deferral adjustments. In all years, I contributed to my IRA fully in the first quarter. As discussed previously, I am using my Roth IRA for more aggressive stock and option trading through E*TRADE. This year, I didn't try to time the market with my IRA contribution(s), but I did not make a contribution until I had a specific trade I wanted to make. It just so happened that there were trades I wanted to make in February and March.

There are, of course, some other things to consider than how to best time the market without trying to time it too precisely. For example, it is very important to maximize your employer match, as it is highly unlikely that market gains will be as high as 50-100%. When I max out my contributions early in the year, IBM will continue to make their matching contributions with each paycheck. Basically, as long as I've contributed up to the match cutoff, IBM will match fully, no matter what the timing of my contributions. Some employers may not have a match maximizer program. In this case, it is important to spread out your 401(k) contributions so that you get your full matching contributions each paycheck. This isn't always ideal from a budgeting standpoint, however. It can be nice to max out your contributions (and here I don't necessarily mean the yearly contribution limit, but whatever amount you plan on contributing) a bit before the end of the year so you have more spending money for the holiday season.

One nice thing about 401(k) contributions is that they are usually added to your portfolio without transaction fees. In regular brokerage accounts and IRAs, investing money can often be subject to transaction fees, immediately reducing your return. You can get around this by choosing to invest in no-load, no-transaction fee mutual funds, for example. Another option involves the timing of your contributions - making fewer but larger individual investments will result in lower overall transaction fees. If your IRA is not readily accessible online, it can also be a hassle to write multiple checks throughout the year. Before I moved my IRA to E*TRADE, I made my IRA contribution in one or two payments just because I am that lazy when it comes to check writing.

Finally, I'd like to mention a more technical note on mutual funds and taxes as it relates to timing investments. As we discussed earlier, mutual funds are required to pass on gains to share owners. They usually do this at the end of the year, but the actual timing can vary. As I mentioned before, as an owner of the mutual fund, you own a portion of the profits and those count as income, even when reinvesting them in the mutual fund. When buying mutual funds in a taxed account, it can be beneficial to wait until after this distribution so that you avoid the tax liability on profits you didn't actually receive. (More information on mutual fund NAV pricing and distribution tax consequences.) Similarly, it can be beneficial to sell a mutual fund from a taxable account before this profit distribution. If you read the second link in the preceding parenthetical statement, this may sound counter-intuitive. If the distribution lowers the NAV, wouldn't the gain from the sale be reduced accordingly, making the tax burden the same? The difference is that the distribution likely contains significant short term gains, while a sale is more likely to be long term gains. Of course, how much of this sale is long term gains depends on your transaction history, but you should be able to estimate the upcoming gains distribution's short term percentage based on prior years' distributions.

Thursday, December 3, 2009

Q&A: Investment and Tax Strategies Across Accounts

The different tax structures of the various account types - traditional, Roth, and regular taxed brokerage accounts - should be taken into consideration when planning your investment strategies. How do we take advantage of these different account types, all while maintaining a balanced portfolio? The answer is to break up your asset classes into each type of account, rather than trying to make each one roughly balanced. It can be advantageous to hold certain asset types in each account type. I'm going to keep things relatively simple and talk just about stocks, bonds, mutual funds, and ETFs (and a bit about options, I suppose, but not commodities or specifics on market capitalizations and whatnot).
  • Stocks - Your basic stock has dividends and stock price appreciation. While some stocks are chosen for their dividend yield, when we talk about stocks, we usually are focused on stock price appreciation as a goal. For stocks that are held longer than a year, we expect/hope that the majority of our profits are the result of stock price appreciation. This will result in long term capital gains, which is always taxed at a lower rate than regular income tax.

  • Bonds - Bonds have coupons and price, which taken together produce a yield. Because the coupon (the interest rate) doesn't change, price and yield are inversely proportional. While the price may go up and down while you hold the bond, your yield is locked in when you buy the bond. We are usually focused on this yield, which provides a steady stream of income (and is taxed as such). Bonds are a more conservative investment, where yields are expected to be lower than the average return of stocks, but with less risk.

  • Mutual funds - Mutual funds provide a convenient way of diversification. Owning a share of a mutual fund gives you an ownership stake in all assets the fund holds. You also own a share of the profits, and the taxes due on those profits. The form of those profits - short term or long term - are mostly under the control of the fund manager, and may not be ideal for your current tax situation. Some funds are actively managed and change their assets often (have high turnover). These funds tend to have a lot of realized gains every year, and behave more like bonds, tax-wise. Other funds are passively managed, or tax managed, and do their best to avoid gains that have to be passed on to the shareholders. These funds tend to have fewer realized gains per year, and behave more like stocks, tax-wise. The performance of mutual funds depends on the assets it invests in.

  • ETFs - Exchange-traded funds (ETFs) are like mutual funds, but all ETFs follow an index, and so are like passively managed mutual funds. They also don't have to buy or sell their underlying stocks as often as mutual funds, and instead do in-kind trades, which the IRS doesn't tax. So, ETFs generally behave more like stocks, tax-wise, than mutual funds, but there are a few ETFs that aren't as tax-efficient as their mutual fund peers, but these tend to be mutual funds that themselves already behave as stocks. More information, for anyone who wants it.

  • Options - Options include your two basic types of options contracts - puts and calls. A put option is merely a contract to buy a block of shares (usually 100) at a given price. Similarly, a call option is a contract to sell a block of shares at a given price. Most options trades are for short term contracts, and are therefore short term gains taxed at high rates. For example, so far all of my options profits and losses have been short term. Options can be used to add extra value to owned stocks, insure an equity position, or put cash to use, but either way, gains (and/or losses) are expected to be relatively large.

With our asset types defined, we can now match them with their ideal account type. First, let's take a quick look at how much of your portfolio each should be. Unfortunately, there's no single answer. Each investor has to decide for themselves what level of risk they are willing to accept in their pursuit of returns. Common stock/bond ratios are 80/20, 70/30, and 60/40. This can be achieved through mutual funds and/or ETFs, or directly through individual stocks and bonds - with individual stocks and bonds being more risky. The percentage of your portfolio invested in bonds usually increases as you approach retirement, as well. Because I am young and have time to make up any losses I might suffer, I have decided to be risky and have nearly 100% stocks, including some individual stocks. I also use some options trading, which has definitely been risky.
  • Brokerage accounts - Regular brokerage accounts are taxed as often as possible. Every trade in the account is subject to income or capital gains taxes, as applicable. They are not tax advantaged at all. Consequently, brokerage accounts lend themselves to few trades that result in long term gain. From above, that would be ETFs and stocks - specifically stocks that are good buy-and-hold stocks.

  • Traditional accounts - Traditional retirement accounts are taxed as regular income when you take the money out, but grow tax free. I think traditional accounts are ideal for the bond portion of your portfolio. Bonds are full of short term gains that we can avoid the tax on, and aren't expected to produce returns as large as other investment types, which means our tax at retirement will be lower. Perfect!

  • Roth accounts - Since Roth accounts grow tax free and end tax free, I find them to be ideal for my more aggressive investments. As I said, most of my portfolio is made up of stocks, but if I did have bonds, I would try to keep them out of my Roth accounts. Also whenever possible, I do my options trading in a Roth account.

So, to summarize, I would like my Roth accounts to contain mostly aggressive stocks and mutual funds, my traditional accounts to hold mostly bonds and bond-like mutual funds, and my brokerage accounts to contain mostly stable stocks and ETFs, or tax-exempt bonds/mutual funds. Of course, it's not always easy to allocate things between traditional and Roth accounts. For example, my 401(k) plan has a limited number of investment options - all mutual funds (or IBM stock). To make things more challenging, my 401(k) does not make it easy to consolidate information on which assets are in traditional versus Roth accounts, and managing separate investment allocations between pre and post-tax accounts is not automatic. Thus, I have not implemented any special treatment for the traditional side of my 401(k) as of yet. If your IRA account is through a financial planner, they may only offer mutual funds, or hands-on trading may be impractical. It was for the latter reason that I transferred my Roth IRA to E*TRADE. This gave me access to thousands of mutual funds and ETFs, along with individual stocks and bonds. It also let me take advantage of options trading opportunities tax free.

In my next post, I will take a look at the relative priority of each type of account, and my thoughts on spacing contributions throughout the year.

Wednesday, December 2, 2009

Q&A: Roth Versus Traditional

I was recently asked a few interesting (to me) financial questions about 401(k)s, IRAs, and contribution strategies. I've decided to answer those questions in a few Q&A blog posts so everyone can benefit (or get screwed if my strategies aren't sound).

The primary difference of concern between Roth and traditional IRAs and 401(k)s is taxes. Traditional contributions are pre-tax (they are tax deductible), but the distributions are considered as regular income and taxed accordingly. Roth contributions are post-tax, but the distributions are tax-free. So, traditional contributions lower our tax burden now, but increase it later, and Roth contributions raise (or don't benefit) our tax burden today, but lower it later. Another way of looking at it is that traditional contributions are tax-deferred, and Roth contributions include prepaid tax. This gives us two things to think about: our tax bracket now and our expected tax bracket when we start taking distributions.

The general wisdom is that if you expect your income tax bracket to be higher in the future, you should choose Roth retirement accounts. Determining if your tax bracket will be higher can be a complicated question. Personally, I took the following items into consideration when trying to evaluate my future tax bracket:
  • Current income - For IRAs, traditional contributions are only tax deductible for those earning less than $53,000 (phased out through $63,000). This made my decision for IRA contributions easy - Roth is still allowed until you make $105,000-$120,000. Traditional 401(k) vs Roth 401(k) still required the following bullet points, too.

  • Future income - I've been maxing out my 401(k) and IRA contribution limits since I've been working at IBM. I am on track to have more money coming in than I really know what to do with. I expect my future income to be quite high.

  • Current vs. future tax deductions - I can currently deduct mortgage interest, but when I retire, I will not have a mortgage. That's actually my only major deduction at the moment. But, does your employer only offer a traditional 401(k) plan, or have you already decided against the Roth 401(k)? Have children? Taking classes? More deductions that might not apply in retirement!

  • Historical tax bracket trends - As you can see from the graph in the link, we are enjoying relatively low tax rates (especially for the rich, which we all hope to be). Does this mean tax rates will rise in the future? Not necessarily, but it wouldn't surprise me.

  • National sales tax - I like a lot of the features of a national sales tax instead of an income tax. However, if we go to a national sales tax, our future tax brackets will all be zero percent. After George W. Bush got torn apart for merely suggesting that we look at the plan, I decided a national sales tax isn't too likely to happen, but it's still something to consider.

  • Alternative Minimum Tax - The AMT is one of the most complicated set of tax laws out there. It was designed to ensure the wealthy can't deduct their way out of too many taxes, basically. There is some fear that an AMT-like system will be implemented to tax some ROTH distributions that are currently promised to be tax-free. As much as the government loves to tax, I think this, too, is unlikely.

Another thing to consider is how much you will contribute. When you contribute fully, there is an advantage to Roth accounts. Each dollar contributed into a Roth account is equivalent to a pretax contribution plus taxes. Thus, you can make a larger (pre-tax equivalent) retirement contribution via a Roth account. This assumes the same tax bracket now and at retirement, and is definitely not the only consideration. This same type of idea is relevant to estate planning, too. Roth accounts are more valuable, dollar for dollar, than traditional retirement accounts. Retirement accounts are assessed at their account value, not at their after-tax value. A traditional and a Roth account of the same value will be taxed the same amount as part of the estate tax, but the traditional IRA will then have additional income taxes taken out when your heirs take their mandatory distributions.

There are a couple of features that really sold Roth IRAs to me. Because Roth 401(k)s can be converted to a Roth IRA without having to pay taxes when you leave the company, these also end up applying indirectly to Roth 401(k)s! The first feature is that there are no forced distributions from a Roth IRA. You can keep compounding those returns as long as you don't need the money. This gives you a lot more flexibility in your tax and estate planning. The second feature is that Roth IRAs allow you to withdraw the contributions at any time. This makes Roth IRAs a sort of emergency fund - but definitely an emergency fund of near-last resort. Once withdrawn, there is no way of putting that money back in, and you will lose future compounding returns. A better option is probably a 401(k) loan, and a better option than that is probably a home-equity loan (HELOC). Still, it's a nice feature.

As I mentioned in the current income bullet above, only the Roth IRA made sense for me at all. For 401(k)s, there are no income limitations for the vast majority of people. When deciding between a traditional 401(k) and Roth 401(k), or a mix between the two, I looked at the above points and decided that my income is likely to be greater in the future, my tax rate is likely to be higher, and the Roth variety gives me more flexibility later. Still, it is tempting to hedge your future-tax-bracket bet by splitting 401(k) contributions between traditional and Roth 401(k)s. Splitting contributions is allowed, but I have decided against it for the time being for two reasons. First, the Roth 401(k) option has only been offered at IBM as of the beginning of 2008. This means I've already bet two years worth of contributions on traditional 401(k) being better because there was no other bet to make. This year will mark two years of Roth 401(k) betting. Second, employer match contributions have to sit in a traditional 401(k) account. I view these matching contributions as an additional bet on traditional 401(k). Even if you don't view it as a bet, it is at least going to affect your future income levels at retirement and/or when forced distributions kick in at 70.5. Thus, I am maxing out my Roth 401(k) contributions, for the time being.

[For anyone curious, as of the time of this writing, Roth contributions make up 47.19% of my 401(k), and 100% of my IRA.]

In my next post, I will take a look at how tax-advantaged accounts can affect investment choices and how I (plan to) balance my portfolio across my varying accounts to better utilize that tax advantage.