Q&A: How Many More Topics Do You Have?

Zero! The answer is zero! Wow, that was a quick blog post. Want more? If so, let me know what you want me to talk about! It can be about anything. Just because most of my recent posts have been financial in nature doesn't mean that's all I will discuss. So, give me some ideas!

Q&A: Should I Buy a Bigger House for Roommates?

Following last week's post on the ROI of rental properties, another interesting question is whether you should buy a small one-bedroom condo (for example) to keep expenses low, or a three- or four-bedroom house to gain some rental income. There are two main considerations: ROI and overall financial safety.

As far as ROI is concerned, I think it's very similar to last week's calculations. There are some differences in the details, though. Your principal and interest (P&I) payment will be higher, but when determining the ROI on the rental portion of your property, I think it should be specified as the difference between the large house's payment and the small home's P&I. You would have had the base P&I payment anyway, so it's not really a cost associated with the renters. Similarly for most of the expenses. Property taxes and insurance will be higher for a larger house, usually. Maintenance costs will be higher with the increased wear and tear, and you'll need a larger refrigerator, but maintenance costs haven't risen that much for me. Utilities will be higher, but probably not terribly so.

Your investment amount should be the increase in down payment, or the difference in overall home value. In this scenario, I am strongly inclined to use the overall home value in my calculations. This gets into the overall financial safety aspect. A pure rental property can be abandoned and sold off if you don't want to deal with renters anymore. If you get tired of having roommates, you can kick them out, but you still have to pay for the entire house. Lowering your expenses requires moving and the house-buying-and-selling process and headaches associated with it.

Consequently, I think it is very important to buy a house with many financial cushions included, even when you plan on having roommates. As I mentioned ages ago, I bought my home knowing I could afford the payments and other costs using just my base salary after all my preferred expenses had been taken out - 401(k) contributions, IRA contributions, miscellaneous spending money. Each of these expenses was a cushion, and any rental income was a nice bonus.

And there are other reasons why you may not have roommates anymore. I would guess that most people are single when they contemplate having roommates in a house they are buying. It's possible you meet that special someone that thinks you're a special someone, too. Roommates may get in the way then. It's possible that special someone comes with a second income that's much higher than that provided by roommates, but they might also be going (back) to school, or you might be having kids right away and one of you will be staying home. Either way, it'd be nice to be able to spend your first year together in wedded bliss, rather than struggling to downgrade your home.

For me, it seemed to make sense to buy a bit bigger. It's definitely worked out so far. On the other hand, I'd have a much lower debt than I have now, and might have purchased a standalone rental property already. It's hard to know exactly how things would have been different, but I can't say I've had any major regrets with my house and/or roommate situation.

Q&A: What's My ROI on My Rental Property

When evaluating the return on investment of a rental property, you have a few different options on which numbers to use. The numbers depend on what exactly you consider income, and/or what exactly you consider an expense, and what exactly you consider your initial investment.

On the income and expense side, you have the following:

• (+) Rent.
• (-) Principal and interest payment.
• (-) Property taxes.
• (-) Homeowner's insurance. The cost of homeowner's insurance will vary based on location, age of the house, construction type, environmental factors, etc. Mine costs 0.4% of my home value, so I've been using that as a starting point.
• (-) Maintenance costs. For my house, I estimate 1% of my home value in maintenance costs each year. For a rental property, I think I'd estimate 2%. A common rule of thumb is to use 3%, and you can't really go wrong planning conservatively.
• (-) Utilities. This depends on the setup you have for rent - utilities included, a fraction of utilities per room, or utilities in the name of the tenants. In other words, it might not be applicable, but it's not really optional.
• (+ optional) Principal portion of P&I, because it is adding equity to your net worth, but it doesn't help your cash flow.
• (+/- didn't forget about it) Taxes. The interest portion of your P&I isn't directly tax deductible like it is for your primary home, but it is a business expense that offsets your business income. (Your business in this case is being a slum lord.) This applies to all expenses above, plus depreciation of the house, if you go that route. Tax laws concerning business income and losses are somewhat complicated, so I'm not going to go into them.

The net income is fairly straightforward to calculate once you choose what exactly you're including. It's much harder to estimate before you buy the property, unfortunately. Other than the estimates I listed above for insurance and maintenance, many house listings include the previous year's tax amount. Some will also include a history of utility costs, but you usually have to talk to the listing agent and/or current owner. Estimating the rent you can charge requires looking at rooms and/or houses in the area. I use craigslist.org and Google Maps (with the "Real estate" overlay enabled under the "More" button/menu and the Listing type selected as "For rent"). Then, just to be safe, I assume I will rent to college students that move out every summer and leave me with a 25% vacancy rate.

After all that, you find yourself with a net monthly income. You then have to determine how you want to calculate your return on investment. It comes down to whether you consider your initial investment as the amount of cash you parted with - your down payment, or the amount that you're responsible for - the total property value. You can also reevaluate your return on investment at any time using your current equity as your investment amount.

Personally, I'm not a fan of using your current equity to reevaluate. The theory is that as your equity increases, you can increase your ROI by selling the house and using the increased equity to get a new house (or two) with higher income potential. To me, this seems like messing with a good thing. I also hate being in debt, so this might be an entirely emotional position on my part. I also don't view increased equity from home appreciation as an increase in your investment. It's more of an unrealized gain. The only equity I would count is principal reduction, but in that case I would definitely include the principal portion of the P&I as income. The amortization schedule, where the principal portion increases each month, will then take care of the principal reduction to some extent.

Naturally, I made a calculator for this. Utilities aren't included because of the complexity in options. "Maintenance Costs" is a good place to tack that on if you need to. It's fun to play with, if nothing else. I view my maintenance cost and vacancy rate assumptions as conservative. If I can have a positive ROI even with these estimates, I consider it a win. Any extra is a nice bonus. Plus, rent will increase with inflation while P&I should remain constant (until it goes away completely!).

Home Value ($):
Down Payment ($):
Interest Rate (%):
Property Taxes / Year ($):
Homeowner's Insurance / Year ($):
Rent Income / Month ($):
Vacancy Rate (%):
Maintenance Costs / Year ($):
Count Principal as Income?
Yearly ROI?

P&I	Monthly Costs	Monthly Income	Net Income	ROI down payment	ROI total value

Q&A: What's a good down payment size?

This is actually quite a complicated question. For one, things can change rapidly. For example, the interest rate penalties for high loan to value (LTV) ratios used to be higher. I believe they have been reduced in many cases as part of the effort to improve the housing market. On the other hand, a lot of loan regulations have gotten stricter to avoid bad loans entering the market again. Basically, rate changes related to your LTV need to be discussed with your lender.

Private Mortgage Insurance (PMI) still needs to be purchased when your LTV is greater than 80%. PMI is typically equivalent to a 0.50% to 0.75% interest rate hike for the period it needs to be paid. Some lenders advertise PMI-free loans even when your LTV is greater than 80%. The PMI still has to be purchased, but for these loans the lender buys it. They will pass this cost on to you via a higher interest rate - there is no such thing as a free lunch. Because your interest rate won't change for the life of a standard 30-year fixed rate mortgage, this interest rate, even if it results in lower monthly costs than buying PMI, could very well cost you more in the long run. Again, go over the details with your lender.

When it comes to deciding between making a larger down payment and buying PMI (or accepting a higher interest rate to cover PMI expenses), you have to look at the best use of your money. My previous post on whether or not to prepay your mortgage could be helpful in evaluating your options. Personally, I would rather avoid PMI than invest a few thousand dollars, say. Whatever you invest that money in would have to earn you more than the PMI payments and extra principal and interest payment amount (minus taxes on the interest and PMI, since PMI is tax deductible like mortgage interest). In fact, this should be considered an addendum to my previous post: The return needed to overcome PMI probably warrants paying extra principal at least until you reach 80% LTV. Psychologically, I just hate the idea of paying private mortgage insurance because it only benefits the lender.

Paying extra principal at the beginning such that you have less than 80% LTV ratio mostly follows my previous post's recommendations. The only difference is that the extra principal in this case does reduce your minimum monthly payment. When determining the terms of your loan, though, you have another option to reduce your payment: you can pay points to reduce your interest rate. As you can see using my refinancing calculator, reducing your interest rate can reduce the interest portion of your payment more than the total monthly payment amount in some cases. You have a choice in which number you use in determining your break even point, but obviously the total monthly payment might be all you care about.

I would make a point-paying calculator, but the cost of each interest rate reduction isn't always the same. For example, it may cost you half a point to move from 5.000% to 4.750%, but another half a point to move from 4.750% to just 4.625%. The user interface of such a calculator would be clunky at best. You can use the refinancing calculator fairly easily to get individual values and compile your own table of break-even times, though. Just find a payment amount for a 0-point loan and plug that into the current loan information fields. Then zero out the closing costs and adjust the points value and find the resulting interest rate entry.

Overall, I would tend toward a 20% down payment if you can afford it so you can avoid PMI. After that 20%, paying points will usually reduce your monthly payments more than extra principal. I paid half a point on my first loan, I think, and zero points on my refinance, other than the quarter-point fee I paid to waive escrow. For the most part, it comes down to what you feel comfortable paying up front versus owing later. I'm not sure there's ever a clearly wrong decision!

Q&A: Should I Pay Down Extra Principal Each Month?

Whether or not to pay down extra principal each month is a complicated question, and one that doesn't have a universal answer by any means. For the purposes of this discussion, we'll assume that an extra payment fits in your budget. Otherwise, the question is a bit moot.

Paying down principal has two primary effects. First, it takes money out of your pocket. Second, it increases your equity. Increasing your equity has the effects of reducing the interest you pay over the life of your loan and increasing your borrowing power. We'll go backwards through these effects this time around.

The borrowing power I'm referring to here will usually take the form of a home equity line of credit (HELOC). If you make a larger down payment, your monthly expenses can be lower, which can increase your borrowing power for a new loan, but if you're just getting a mortgage, chances are you're not looking for many other new loans. (Indeed, you shouldn't be, as new loan credit inquiries can negatively affect your credit score! Wait for your mortgage to be finalized before looking at car loans, for example.) The only thing I would use a HELOC for is an emergency fund. It's a great way to be able to pay down principal and still have access to that money in a pinch. If the pinch comes and you don't already have a HELOC, you're unlikely to be able to get a HELOC, so it's important to plan ahead. HELOCs are usually restricted to whatever equity you've built beyond 20%, so that your combined LTV remains at 80% or less. They also usually require a recent appraisal, so even the no-fee HELOCs aren't entirely cost-free to set up.

To me, though, this benefit of paying down principal isn't a major selling point, as evidenced by the fact that I do not have a HELOC. For emergency funds beyond my cash on hand, I would rely on loans from my family. I haven't formalized that line of credit in any way, and maybe I should do so rather than taking it for granted. At the same time, I can make sure my family knows that I would be there for them, too.

I view principal reduction as an investment that returns a savings in interest payments. Unfortunately, the rate of return on that investment isn't always just the interest rate of your mortgage. I included a simple calculator in my post on your effective mortgage interest rate, but that doesn't give a complete picture of your investment.

First, just as in my discussion on S&P 500 growth, values were not inflation adjusted. When it comes to the returns of the S&P 500, you have to subtract the inflation rate to get an inflation-adjusted return (approximately, anyway). Your mortgage works much the same way except that inflation helps debt, so you get to subtract the inflation rate from the interest rate you pay and get an inflation-adjusted interest rate. You get a benefit now (the home) and pay for it with less and less valuable dollars. Not a bad deal for the purchase, but it lowers the rate of return on principal payments. For the default values in the calculator above, the effective interest rate is 3.75%. After adjusting for inflation by subtracting 3.3% (though recent inflation has been lower), you're left with a nice low 0.45% inflation-adjusted effective interest rate.

Second, paying down principal now takes off interest from the very end of the loan. Your minimum payment doesn't go down and you can't readily access that money except through a HELOC. It is definitely a long-term investment, and the rate of return is locked for that entire period. It's similar to buying a multi-year CD with a rather - even ridiculously - low rate, given the current interest rate environment.

Third, paying down principal really shows the nature of compounding. Every payment that goes by, the principal you pay down saves you one fewer compounding of interest. Take a look at a monthly amortization schedule (my favorite calculator). You'll notice that the principal you pay goes up each month, while the interest paid goes down. Where you are in the schedule depends entirely on the principal outstanding, so to move up the schedule by a month (and in effect take a payment off the back end), you just have to pay the principal for the next month ahead of time. Thus, the extra payment required to gain a month goes up each time. The rate of return doesn't go down, but the time horizon is shortened and the compounding reduced. If that shortening of the time horizon is your goal, there are definitely diminishing returns.

As mentioned above, paying principal takes money out of your pocket. Whether or not paying principal is a good investment really depends on which pocket the money comes from. If it's coming from a cash account, chances are good that you will get a larger return by eliminating interest. If you are paying extra principal instead of making an IRA or 401(k) contribution or otherwise investing, then you are missing out on what is very likely to be a higher return in the stock market. Remember that it is important to compare inflation-adjusted rates to each other, and non-inflation-adjusted rates to each other. Mixing and matching is not a valid comparison.

Basically, as near as I can tell, prepaying principal doesn't make financial sense unless mortgage interest rates are over ten percent or so. I don't think many people today would pay down their mortgage if it weren't for the psychological benefits. Being in debt just doesn't feel very good - especially when it's tens or hundreds of thousands of dollars and can result in being homeless. Conversely, there's no feeling quite like knocking another month off the end of your mortgage. It's also a lot of fun to reduce your principal by the first $1,000; the first $10,000; the first $100,000 (I imagine). I'm also really looking forward to the day (soon, I think!) when my various investment and cash accounts could pay off my mortgage if I liquidated them. That would mean I could pay off the house if I had to, significantly lowering my monthly expenses so that I could live off a minimum wage job, for example. However, when I get close to the end of my mortgage, I imagine that I will pay it off simply for the monthly cash flow improvement, whether I need it or not.

In the end, I pay a couple hundred extra each month despite the logic behind investing it instead. I guess that's the price I put on the psychological benefits above. Pretty cheap therapy, actually.

Q&A: What's My Effective Mortgage Interest Rate?

When you sign and initial the hundred or so times required to purchase a home, chances are good that you wind up with a mortgage to go along with the property. That mortgage has an associated interest rate that is used to calculate how much you're charged each month, but it isn't always an accurate measure of how much you pay, in the end. (The mortgage also has an advertised APR that includes points, lender fees, and any applicable PMI thanks to the Truth in Lending Act. Honestly, I've never found the APR that helpful, and it definitely isn't helpful in this discussion - we need to look at the base interest rate.) The net interest you pay depends on your tax situation, and results in what I call your effective interest rate (not to be confused with the more official effective annual interest rate - new name suggestions are appreciated!).

Mortgage interest is tax deductible, which is great in theory, but it doesn't always help very much, if at all. Individuals get a standard deduction of $5,700, and married couples filing jointly get $11,400. If your mortgage interest isn't greater than whatever standard deduction applies to you, then the mortgage interest deduction doesn't help you on its own. You may have other deductions like qualified medical expenses, 401(k) contributions, charitable giving, and the like. If you have a mortgage, chances are good that you have an income and pay state and/or local income taxes, and chances are even better that you have property and are paying real-estate taxes, both of which are deductible. With these deductions, the mortgage interest deduction can be more beneficial.

My medical expenses are well below 7.5% of my adjusted gross income, so those are not deductible. My 401(k) contributions go into a 401(k) ROTH account, so they are not deductible. I have some donations and the occasional miscellaneous deduction, but my main deductions are the state income and property taxes I pay. In the end, most of my mortgage interest winds up being deductible. That means I pay a lot of state and local taxes, though, so that's not entirely a good thing.... It doesn't apply to me this year, but your deduction can also span tax brackets, making the calculation that much more complicated. Some of the deduction may save you 28%, while some may save you 25%, for example.

The amount actually deducted (we can call it the effective deduction until a better suggestion comes in) affects the effective interest rate you pay. For a 5% mortgage with outstanding principal of $200,000, your interest payments will be around $10,000. Say you contribute to a 401(k) and so can deduct all your interest and are in the 25% tax bracket. You effectively reduced the interest paid by 25% * $10,000 = $2,500. You are now paying a net of $7,500 for an effective interest rate of around 3.75%.

Because I'm such a fan of calculators, I just couldn't resist making another one!

Interest Rate (%):
Interest Paid ($):
Interest Deducted ($):
Tax Bracket (%):

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.

Where

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.

When

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.

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.

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.