Monday, March 28, 2011

Money Tips from the NFL Players' Association

If you are a sports fan, you know that the NFL is in the middle of labor strife.  The owners of the 32 NFL teams have instituted a lockout.  The NFL has barred the players from entering team facilities in an attempt for force them to accept the owners' terms for their next collective bargaining agreement.  That means no football until the labor situation is resolved.  For the NFL players, that means no paychecks.  For players used to living the high life, no paychecks could be a bit of a shock.  Some players are coping by moonlighting in other jobs.  However, the majority of players are sitting tight - hopeful that they will be back to work shortly.

For its part, the NFL Players' Association has published a handbook for players which contains several money-saving tips for players faced with the prospects of prolonged unemployment.  Some of the tips ("reduce the size of your entourage") are geared towards the lifestyle of the professional athlete.  However, some are quite practical and applicable to everyone:

- Hold off on buying "motorized toys".  Cars are a person's second-biggest purchase, so buying wisely can save you tens of thousands of dollars.

- Save 25% of your annual pay.  Putting money away for a "rainy day" is never a bad idea.  This is especially true of football players and others whose income is variable and uncertain.

- Say no to money requests from family or friends.  Loaning money to friends is an excellent way to lose your money or your friends (or both).

- Don't pay friends to perform work that you can easily do.  While you may not pay your friends to perform trivial services, think of all the money we waste out of convienence. 

According to the article, the handbook also gives advice on mundane financial topics like refinancing mortgages and obtaining continuing health care coverage.  The article closes with some comments by current NFL player Heath Evans.  Anticipating the possibility of a lockout, he planned ahead by selling some property and putting the money aside for him and his family.  I guess living the athlete's lifestyle is taking on new meaning these days!

Thursday, March 24, 2011

What Is Your OTHER Number?

Many financial planners are now touting something called your retirement number.  This is the amount of money that you will need in order to retire comfortably.  Of course, this is based upon a number of assumptions (life expectancy, inflation, Social Security, etc); however, it provides a target amount for which to shoot.  The thought is that once you know how much you might need, you can then determine how much you need to save each year.  That, of course, brings us to a second number that is of utmost importance when planning for retirement:

Your estimated investment returns

What investment rate of return you assume has a huge impact on the amount of money you think you might need to save.  Let's illustrate it with an example...

You've plugged all of your information to the magic retirement number calculator, and it says that you need one million dollars in order to retire comfortably.  You have 40 years to go until your retirement.  You run the numbers assuming a 7% rate of return on your investments, and you determine that you need to put aside about $5,000 a year to reach your goal.

Now let's fast forward 40 years later, and you are now on the precipice of retirement.  For whatever reason, your rate of return fell short of your assumption by a mere 1%.  By how much did you miss your retirement goal?  You couldn't have missed by that much.  After all, 1% isn't a lot, right?  Well, you would be wrong.  By overestimating your rate of return, you have missed your retirement number by over 22%!  Ouch!

On the plus side, if you underestimated by 1%, you will overshoot your retirement number by almost 30%.  Wow!

Here is a quick summary of the impact of a 1% variation over 40 years:

Rate of ReturnTotal SavingsDifference% Difference
6%$768,809.83 $(224,365.73)-22.59%
7%$993,175.56 $- 0.00%
8%$1,290,282.59 $297,107.03 29.91%

Economists call this type of experiment sensitivity analysis.  Sensitivity analysis studies how the change in one variable (interest rate in this case) affects the outcome (total savings in our example).

Another interesting observation is that the effect of a 1% variation in the assumed interest rate increases as your time horizon increases.  Consider the same type of analysis over 20 years...

Rate of ReturnTotal SavingsDifference% Difference
6%$178,927.96 $(21,049.51)-10.53%
7%$199,977.46 $- 0.00%
8%$223,809.82 $23,832.36 11.92%

...or over 30 years...

Rate of ReturnTotal SavingsDifference% Difference
6%$390,290.93 $(77,013.00)-16.48%
7%$467,303.93 $- 0.00%
8%$561,416.06 $94,112.12 20.14%

The longer your time horizon, the more a slight variation in your rate of return makes a difference.  Obviously, variation on the high side is a good thing.  After all, who wouldn't want to have more money in retirement than anticipated?  However, missing the mark on the low side can have serious consequences.  It could mean the difference between retiring comfortably versus having to scrimp in your golden years.  Therefore, it makes sense to choose your other retirement number, your assumed investment return, as conservatively as possible.  Of course, that is easier said than done.  Choosing a lower assumption means that your retirement contributions need to be higher.  Putting on the rose-colored glasses means that you fool yourself into thinking you don't have to put aside as much each year.

Consider the State of California... 

The California Public Employees' Retirement System (CALPERS), which manages the pension fund for state workers, decided to leave its assumed investment rate of return at 7.75%.  This was despite the fact that the plan's chief actuary reccommended lowering it to 7.5%.  ONn the one hand, keeping the assumed rate at 7.75% means that the cash-strapped state would not have to bump up its retirement contributions.  This is one way to help meet the budget shortfall in the state.  However, let's say that their actuary is right and their actual investment return is only 7.5%.  That means that either future retirees will have to take less, or future taxpayers will have to make up the difference.  Either way, it seems like a big gamble.

Monday, March 21, 2011

IRA's By the Numbers

In a previous article, I talked about some of the different types of common IRA's.  Here is a quick summary of the three common ones:

IRA TypeAre Contributions Taxes?Are Earnings Taxed?Are Withdrawals Taxable?Other Notes
Traditional, DeductibleNoNoYesIncome limits if in a retirement plan
Traditional, Non-deductibleYesNoOnly Earnings
RothYesNoNoIncome limits

As a follow-up, I thought I'd put together some numbers to show the differences between them for a couple of different scenarios.  I also added a fourth option for comparison:  a Health Savings Account.  If you remember from one of my previous articles, a Health Savings Account (HSA) allows you to contribute money tax free and withdraw it tax free.  The only catch is that you have to use withdrawn money to pay for a qualified health expense.  However, in retirement you can expect many opportunities to pay for those.

Scenario One:  25% tax bracket now.  33% tax bracket in retirement.

In this scenario, the tax rate that applies now is lower than your tax rate in retirement.  This situation is one that may be faced by a young, single person at the start of his or her career:

IRA TypeContributionContribution After TaxesBalance After 20 years @ 5%/yearBalance After Taxes
Traditional, Deductible$5,000.00 $5,000.00 $13,266.49 $8,888.55
Traditional, Non-deductible$5,000.00 $3,750.00 $9,949.87 $6,666.41
Roth$5,000.00 $3,750.00 $9,949.87 $9,949.87
Heath Savings Account$5,000.00 $5,000.00 $13,266.49 $13,266.49

As you can see, the Roth IRA comes out ahead of the other two flavors of IRA's.  As you would expect, since you are in a lower tax bracket now, it is better to pay taxes now rather than later.  The Traditional, Non-deductible IRA comes out on the bottom.  This is to be expected since you are paying taxes both on your contributions and your withdrawals.  Of course, the HSA comes out ahead of all of the IRA's since you don't pay taxes on contributions or withdrawals.

Scenario Two: 33% tax bracket now. 25% tax bracket in retirement.

This scenario is common to somebody who is at the height of their career.  The conventional wisdom is that your tax bracket will be lower in retirement than during your prime working years because you don't have to replace all of your income in retirement.  You may not have a mortgage, commuting expenses, the expense of raising kids, etc.  Obviously, this may not apply to everyone.

IRA TypeContributionContribution After TaxesBalance After 20 years @ 5%/yearBalance After Taxes
Traditional, Deductible$5,000.00 $5,000.00 $13,266.49 $9,949.87
Traditional, Non-deductible$5,000.00 $3,350.00 $8,888.55 $6,666.41
Roth$5,000.00 $3,350.00 $8,888.55 $8,888.55
Heath Savings Account$5,000.00 $5,000.00 $13,266.49 $13,266.49

In this case, it is better to pay taxes later than now, because you will be in a lower tax bracket later.  That is why the Traditional, Deductible IRA comes out ahead of its fellow IRA brethren. 

Scenario Three:  25% tax bracket now.  25% tax bracket in retirement.

This scenario shows what happens if you are in the same tax bracket now and in retirement.  This could be the case if you are planning to spend as much in retirement as you do when you are working.  Maybe instead of the expense of raising kids, you will use that money to travel more, eat out more, or just spend it on the grandkids.

IRA TypeContributionContribution After TaxesBalance After 20 years @ 5%/yearBalance After Taxes
Traditional, Deductible$5,000.00 $5,000.00 $13,266.49 $9,949.87
Traditional, Non-deductible$5,000.00 $3,750.00 $9,949.87 $7,462.40
Roth$5,000.00 $3,750.00 $9,949.87 $9,949.87
Heath Savings Account$5,000.00 $5,000.00 $13,266.49 $13,266.49

In this case, it doesn't matter whether or not you pay your taxes now or later - you will end up with the same amount of money in the end.  That is why the Roth and the Traditional, Deductible IRA's come out the same.

While it is possible to know how much taxes you are going to pay now, you may not know what your tax rate is going to be in retirement.  This is especially true if you are many years away from retirement.  There is one school of thought which says that taxes are bound to rise in the future in order to make good on the Federal debt.  One viable option is to diversify for taxes.  What do I mean by this?  I mean, you should put some money in a Roth IRA and some money in a Traditional, Deductible IRA (or a Traditional 401(k) if you can't contribute to a Traditional IRA).

Here is one possible diversification strategy:

- When you are just starting out in your career, put 100% of your retirement money in a Roth IRA.  When you are young, you are likely in the lowest tax bracket that you are going to be in for your entire life.  It makes sense to pay your taxes now at this lower rate rather than paying taxes later.

- As your career blossoms and your income rises, start to shift some of your contributions from a Roth IRA to a Traditional, Deductible IRA.  As you make more money, you will be in a higher tax bracket.  The chances of you being in a higher tax bracket in retirement start to decrease.  However, since you cannot know what Congress is going to do to the tax code, you play it safe by continuing to direct some of your contributions to a Roth IRA.

- As you moving to higher and higher tax brackets, you continue to direct a greater percentage of your retirement money into a Traditional, Deductible IRA.  You still keep some contributions directed into a Roth IRA just to hedge against higher taxes in the future.  However, at a certain point you may no longer be eligible to contribute to a Roth IRA directly.  In that case, you can contribute to a Traditional IRA and then convert some of that money to a Roth IRA.

Note that all of the above applies equally to a Traditional 401(k) and a Roth 401(k).

Of course, this strategy only takes into account maximizing your after tax income in retirement.  There are some other considerations when deciding which type of IRA to use:

- A Roth IRA allows you to withdraw the contribution portion of your account balance without a penalty.  However, withdrawals from a Traditional IRA prior to age 59 1/2 are subject to a 10% penalty on top of the taxes that you would pay normally.  This gives you some flexibility to access your money if you really REALLY need it.  Why would you want to do that, though?  It's supposed to be for retirement!

- A Traditional IRA requires that you make a mandatory minimum withdrawal (also know as the Required Minimum Distribution or RMD) starting at age 70 1/2.  This forces you to move your money out of a tax deferred account into a taxable account.  A Roth IRA does not have this limitation.  You can keep money in it as long as you want, allowing your earnings to compound tax free for as along as you want.

The decision of which type of IRA to use is a personal, individualized choice.  However, armed with the basic facts about the different types of IRA's work, you should be in a position to make an informed decision.

Friday, March 18, 2011

A Novel Retirement Strategy? Or Planning to Fail?

Recently, I came across an interesting and thought provoking retirement strategy.  Christine Fahlund of T. Rowe Price proposes the following way to make sure you have enough money for retirement:

Continue to work until you are age 70.

Sounds like fun, huh?

In order to make it more palatable, she offers the following perk.  If you retire when you are 70, you can stop contributing money towards your retirement at age 60 and use that extra money for vacations, a new car, Botox treatments, or other little indulgences to make up for the fact that you can't just up and move to Florida and play golf year round.

Here is an illustration of how the financials might look for a typical married couple (courtesy of T. Rowe Price):

On the one hand, this makes some sense.  By delaying your retirement, you get the following benefits:

1. Your retirement nest egg doesn't have to last as long, since you are going to be spending less time in retirement.

2. Your retirement nest egg has more time to accumulate interest.

3. Retiring at 70 allows you to max out your Social Security benefits.

4. If you are lucky enough to have a traditional pension, retirement at 70 allows you to have a larger pension payout.

However, there are some huge caveats with Ms. Fahlund's proposal.

1. The strategy assumes that you have saved up a sizable chunk of money by the time you are 60.

2. The strategy assumes that you will be able to work until you are 70.  You may not be able to work that long due to your health, your family's health, or loss of job.

My opinion is that this strategy is half right.  I agree with the notion that deferring your retirement date will help your finances in retirement.  You maximize your Social Security and pensions while minimizing the amount of time you spend in retirement.  However, stopping contributions to your retirement fund altogether seems a little bit risky to me.  By following this strategy, you are assuming that you will be able to work until you are 70.  You are banking on too many things going right.

You are banking on the fact that your retirement money will continue to earn a good return.  What if the stock market tanks in those 10 years?

You are banking on the fact that you won't lose your job.  What if you get laid off and cant' find another comparable position?

You are banking on the fact that your health and your spouse's health will allow you to continue to work.  What if you get sick and are unable to work?  What if your spouse gets sick and you have to be his or her caregiver?

Those are risks that are out of your control to a large extent.  In order to mitigate this risks, you can do something that is under your control:  continue to save money just in case.  Knowing the risks and doing nothing about it seems like a plan to fail to me.

Tuesday, March 15, 2011

It's IRA Season!

The calendar might say 2011, but the IRS still considers it to be 2010.  What is this insanity?  Do those silly IRS people use the Mayan calendar or something?  Of course not!  The IRS lets make 2010 contributions to your IRA up through April 18, 2011.  (Note that the deadline usually is April 15, but due the fact that April 15th is a holiday in the District of Columbia and the 16th and 17th are on the weekend, the deadline has been extended to the 18th).

IRA stands for Individual Retirement Arrangement (not "Account" as most people believe).  This is a type of account that allows you to save money for your retirement.  The main advantage of an IRA is that it allows you to save money on taxes.  In an effort to encourage people to save for their retirement, the Government has provided certain tax advantages for saving money in an IRA.  There are three main flavors of IRA's:

1. Traditional IRA
2. Non-deductible Traditional IRA
3. Roth IRA

All three allow you save money for retirement, but each one is treated differently for tax purposes.  For more information about IRA, you can refer to IRS Publication 590 -  the definitive source for information on IRA's

Traditional IRA

A Traditional IRA allows you to contribute up to a certain amount towards your retirement account.  Generally speaking, you can contribute up to $5,000 in 2010.  However, if you are over 50, you can contribute up to $6,000.  The value of your contribution can be taken as a tax deduction on your 2010 taxes, which means that you don't pay taxes on the amount you contributed.  This allows you to invest the full amount of your investment towards retirement without having to set aside money to pay for taxes.  In addition, if you earn interest, dividends, or capital gains on the money in your IRA, you don't have to pay taxes on those earnings either.

The catch to this tax benefit is that when you withdraw money from your IRA in retirement, you have to pay taxes on your withdrawal.  However, if your tax bracket is lower in retirement than it was when you contributed, this isn't such a bad deal.  If that is the case, the money that you withdraw is taxed at a lower rate.

There are a couple of other catches.  If your employer has a retirement plan, there are limits to what you can deduct based upon your income level.  If you are single, made more than $66,000 in 2010, and covered by a retirement plan, you cannot deduct your Traditional IRA contribution.  Bummer.  How do you know if you are covered by what the IRS considers to be a retirement plan?  Check your W-2 form.

Non-deductible Traditional IRA

As the name suggests, this is a Traditional IRA where you cannot deduct your contributions.  If your employee has a retirement plan and you make more than the IRS limits, then you would fall into this category.  Because you still have to pay taxes on your contributions, this flavor of IRA works a little differently.  The earnings on your contributions still grow tax free, just like in a Traditional IRA.  However, when you withdraw your money, you only pay taxes on the earnings; you don't pay taxes on your contributions.

Let's say you contributed $5,000 to your non-deductible IRA, and let it grow for 20 years.  After 20 years, your account now has $9,000.  Now let's assume that you withdraw all of that money for your retirement.  Only $4,000 counts towards your taxes - the $4,000 that represents your gains on investment.  The $5,000 that represents your original contribution isn't taxed.

Roth IRA

A Roth IRA turns the Traditional IRA on its head.  Your contributions are not tax deductible, meaning that you pay taxes on them up front.  However, when you withdraw your money in retirement, you don't pay any taxes on the money you take out.  Basically, you are paying taxes up front.

If you anticipate being in a lower tax bracket at the time your are contributing compared to during retirement, then a Roth IRA generally beats a Traditional IRA.  However, if your tax rate is higher now, generally your better off in a Traditional IRA (assuming it is deductible).

The Roth IRA has its own little twist.  If your income is greater than a certain threshold, you cannot contribute to a Roth IRA.  Of course, if your income is high, your tax rate is high so you probably shouldn't be in a Roth IRA anyway!

Here is a quick summary of the three IRA's discussed:

IRA TypeAre Contributions Taxes?Are Earnings Taxed?Are Withdrawals Taxable?Other Notes
Traditional, DeductibleNoNoYesIncome limits if in a retirement plan
Traditional, Non-deductibleYesNoOnly Earnings
RothYesNoNoIncome limits

There are other nuances related to minimum withdrawals, early withdrawal penalties, and the like, but this covers the basics.

One thing that stands out is the fact that the Traditional, Non-deductible IRA is a bad deal compared to a Roth IRA.  In both cases, you pay taxes on contributions, but not earnings.  However, when you withdraw your money, a Roth IRA lets you off the hook without any taxes, while you pay taxes on earnings when you withdraw from a Traditional, Non-deductible IRA.  Why would you want to contribute to a Traditional IRA when you cannot deduct your contributions?

There is one situation where this makes sense.  If your income is over the Roth IRA contribution limit, and you are covered by a retirement plan, then the Traditional, Non-deductible IRA is the only game in town.  The good thing is that there is a "backdoor" way to open a Roth IRA.  While you may not be able to contribute to a Roth IRA directly, you can convert a Traditional IRA to a Roth IRA without any income limit.  This strategy goes something like this:

1. Contribute to a Traditional, Non-deductible IRA.  Because there is no income limit, you can contribute up to the limit regardless of your income.

2. Convert your Traditional IRA to a Roth IRA.  At a later point in time, you perform the Roth IRA conversion.  IRS Publication 590 says the following: 

"You must include in your gross income distributions from a traditional IRA that you would have had to include in income if you had not converted them into a Roth IRA"

If you had withdrawn this money from your IRA and not converted it, you would only have to pay taxes on the earnings.  You wouldn't have to pay taxes on the contributions.  If you were to perform the conversion immediately after contributing to your Traditional, Non-deductible IRA, you would have no earnings.  Therefore you would have no taxes.  In essence, you have created a no-income-limit Roth IRA for yourself.  Now when you withdraw money from your Roth IRA in retirement, you won't have to pay taxes on your contributions or your earnings.  Sweet deal!

[Important Note:  As always, talk to your tax advisor to see if this strategy is right for you!]

Friday, March 11, 2011

King Hearings: Profiling Is Not The Answer

Back on Martin Luther King Day, I posted my thoughts on why discrimination hurts our country.  This week, another King is in the news for his Congressional hearings on the "radicalization" of Islam and its impact on Homeland Security.  Representative Peter King, chairman of the House Committee on Homeland Security, convened the hearings to focus on what he perceives as a growing threat to the safety of the United States.  I have never met Representative King, so I am not going to speculate on his motives for holding such hearings.  However, the hearings themselves are, at best, misguided, and, at worst, can be harmful to the well being of this nation.

The unstated implication of these hearings are that we, as a country, should be suspicious of Muslims.  The obvious next step is that Muslims should be subjected to extra scrutiny where no suspicion exists.  This is wrong on so many levels.  Others probably can make the legal and moral arguments more eloquently than I could.  The point that I am going to make here is that this profiling of Muslims are terror suspects is actually damaging to national security.

The goal of a smart terrorist is to blend in with the rest of society in order to gain access to a high value target, and once in sight of the target, perform the terrorist act.  If you know that law enforcement and security personnel are going to be on the lookout for a particular type of person, you as a terrorist are going to want to avoid matching that profile.  A smart terrorist is going to travel under an assumed name.  A smart terrorist is going to change his or her appearance to look less Middle Eastern.  In summary, a smart terrorist is going to do everything to not fit the profile.  Homeland Security, like all Government agencies, has very limited resources.  If they put all of their resources focusing on those who fit some profile, they naturally will not give much focus to those who don't fit the standards profile.  However, this is precisely the attack vector that a smart terrorist would use in their next attack.

Likewise, once this whole "recruiting at the Mosque" concept becomes part of the law enforcement profile, what is a smart terrorist going to do?  He or she is going to recruit through a different venue.  Law enforcement is going to be so focused on keeping an eye on the thousands of Mosques that nobody will have time to be on the lookout for other threats.

There is danger when you act on a profile rather than hard evidence.  Not only do you waste resources chasing ghosts, but you ignore the real criminals who may not fit your narrow conception of what a terrorist looks like or acts like.  There is an old saying about how the military is always preparing to fight yesterday's war while ignoring the war of tomorrow.  Representative King is thinking about how we were harmed in the past, while those who oppose the United States are thinking about how to harm us in the future.  Let's not fight yesterdays war with this dangerous concept of profiling.

I said that I would leave the legal and moral arguments to those who are better equipped to make such statements.  However, I will leave you with one more thought:

One of the greatest Americans of the 20th Century is a man named Muhammad Ali.  Yes, he was a great fighter - arguably the greatest of all time.  However, what made him great American was that he had the courage of his convictions.  Fighting in the Vietnam War was against his beliefs.  He gave up four years of his boxing career in his prime in the name of his beliefs.  This is precisely what America is about:  making the hard choices because they are right choice.  The U.S. Constitution is filled with hard choices.  Giving people freedom of speech is a hard choice because that freedom means that we might have to listen to things that we don't want to hear.  Giving people the freedom from unreasonable search and seizure is a hard choice because it means that sometimes criminals are protected by these freedoms, too.  However, these hard choices that our Founding Fathers made are what make America what it is.

Yes, what Representative King sounds like the quick and easy.  We'll just single out all Muslims and all Mosques as a threat so we don't have to do the hard work of actually investigating the real threats.  Easy, but wrong.  In order to truly protect this country, both in term of security and in terms of its soul, we have to suspect nobody until they merit suspicion.  We have to be like Muhammad Ali and make the hard choice, which is also the right choice.

By the way, Muhammad Ali was a Muslim.

Saturday, March 5, 2011

Tax Refunds Are For Suckers

According to CNNMoney, the average tax refund for those who have filed so far this year is $3,129.  They point out that the average drops as it gets closer to April 15th because those with big refunds coming often file early.  However, they say that the average tax refund for 2010 was around $3,000, so it probably isn't going to drop by that much.

I've always been of the opinion that tax refunds are for suckers.  If you receive a tax refund, that means that you have paid the Government too much in taxes through your paychecks during 2010, so the Government gives you that money back.  Here's the rub:  the Government doesn't give you any interest on this money that you overpaid to them.  They've gotten a chance to hold onto that money in their coffers for up to 16 months, and yet you don't get any interest on this money.  (As an aside, if you pay your taxes late, the Government charges you interest:  the federal short term interest rate plus 3%).  You are giving the Government what is essentially a zero interest rate loan.  That makes no sense to me.

On the flip side, if you owe money on your taxes, you are getting a zero interest rate loan from the Government.  Of course, if you owe too much money at the end of the year, you will be hit by an underpayment penalty, so you don't want to underpay by too much.  As always consult with a professional accountant to figure out where you stand with your own specific situation, as I am neither professional nor an accountant.  That being said, my own personal strategy is to try to owe some amount to the Government every year.  I have less withheld from my paycheck and more to put into the bank.

Of course, you have to make sure that you can write that check to the Government come April 15th.  If you take the extra money you receive in your paycheck and blow it on beer, then maybe you are better off with that refund.  You are still a sucker though...