Should You Contribute to a Roth or Traditional Retirement Account?

To Roth or not to Roth….that is the question. We get asked this all the time by our members.

And we always answer with question:   Will your tax bracket in be higher now or in retirement?

If it’ll be higher now, then DON'T do a Roth.

If it’ll be higher in retirement, then DO do a Roth.

It's that simple.

A Roth (IRA or 401k) allows you to pay taxes now instead of later.  So pay your taxes whenever your tax bracket will be lowest.

If your tax bracket will be lower in the future, pay your taxes then. Or if your taxes are lower now , then pay your taxes now by contributing to a Roth.

But wait a minute, what about the tax-free growth that comes with a Roth?  That's gotta be worth something, right? 

Nope.   Doesn't make a lick of difference. 

Once you put money into a Roth, it grows tax-free forever.  You never ever pay taxes on that money again.   Surely paying taxes on a small amount now is better than paying taxes on a big amount later. 

It's as intuitive as a flashing Walk/Don't Walk sign.  Except it's not correct.

To prove I'm not taking crazy pills, here's some very simple (I promise) math:

You have $10,000 to put in a Roth 401k or a Traditional 401k.

TO ROTH:  To put it in the Roth, you must pay taxes on it first - let's say 20%.   So $8,000 actually goes into the Roth.  It doubles over the next 10 years and now you've got $16,000.

Simple. 

NOT TO ROTH:  If you put it in a Traditional 401k instead, you don't pay any taxes now.   So all $10,000 goes in.  It doubles in 10 years to $20,000.  But NOW you've got to pay your 20% in taxes….which….drum roll….leaves you with $16,000.

!?!?!?!?!   *mind explodes*

So full circle… the only consideration when deciding "To Roth or Not to Roth" is whether your tax bracket will be higher now or later. 

P.S. This does not apply when considering a non-deductible Traditional IRA vs. a Roth IRA.  For that one, talk to your guy/gal.   Don't have one?  Then contact us!

How to Save For Retirement

We are all just children staring at marshmallows.  

"Psychologist Walter Mischel… described the interaction between emotion and cognition in the famous marshmallow experiments of the 1960s and 1970s. They presented four-year-olds with a marshmallow, telling them that they could eat it at any time or wait and eat two marshmallows when the experimenter returned. They found that children who were able to wait longer did so by cognitive strategies such as covering their eyes, singing songs, or imagining that they faced a cotton ball rather than a tasty marshmallow." (Finance for Normal People: How Investors and Markets Behave)

Aren't we are all just children staring down the temptation of a marshmallow?   We know if we don't eat one now, we'll get two a little later.  So why is it so hard not to eat that marshmallow…right…this…second?

It's simple.  Our monkey brain places more value on rewards that are more immediate (even if they're smaller) than rewards that are further away (even if they're larger).  It's called "Hyperbolic Discounting".

That makes sense.   Our monkey brain has been around for millions of years.   It's been appropriately trained to worry about the present more than the future.  

Until the last 30 years, considering how your actions today affect your future wasn't all that important.  You worked.  You retired and got a pension for a few years.  You died.  

But now we need to survive for 30 years after the money stops rolling in.   This is a brand-new human experience and one we are not very good at yet.

So how can we beat our monkey brain and avoid eating cat food out of our kid's basement?

Cover your eyes.  Sing a song.  Imagine cotton balls. 

Just don't give your monkey brain the opportunity to decide.

Save first.   Don't give yourself the choice to save or spend because we know how that one goes.  PAY. YOURSELF. FIRST.

Set up automatic savings to put away at least 10% of your income - 401k, IRA, savings account.  Where you save it isn't nearly as important as just saving it.   And if you're an overachiever your bogey is 20%. 

Your monkey brain won't like eating cat food any more than you will.   Do both of you a favor and box it out of your decision-making process.  Your monkey brain is much better at running from saber-tooth tigers than saving for retirement. 

What Should You Do with Your Old 401k?

You nailed the interview, negotiated a nice, fat salary and completed the HR paperwork.

Congratulations on the new gig!  Good on you!

But in all the excitement of your new job, don't forget about your old 401k!

After you leave a company, you have options.   With your old 401k, you can: 

  1. Leave it behind

  2. Roll it over into your new 401k

  3. Roll it over into an IRA

  4. Take the money…pay Uncle Sam 50% in taxes & penalties… and run!

Just because it's an option doesn't mean it's a good one.    Obviously, taking the money out and paying taxes on the whole thing PLUS a 10% early withdrawal penalty (if you're younger than 59.5) is a terrible idea. 

Leaving it where it is or rolling it over into your new 401k aren't as bad, but they're only a little better.   Want to know a secret?  Come a little closer…

401k's are great for saving, but they are TERRIBLE for investing. 

Why?

Each 401k plan is different, but even the most robust 401k's offer only a limited number of funds to invest in.  You're options are limited to whatever Human Resources has picked out for you.

I've seen the investment options of hundreds of 401k plans.   And I can tell you from experience, the funds usually kinda suck.  (And that includes the Target Date funds I bet you're invested in right now.)

So you're forced to pick the best of the mediocre and call it a day…until you leave your company.

Once you leave, you can roll your 401k into an IRA - Individual Retirement Account. 

It's tax-free and penalty-free to do so.   More importantly, once it's in your IRA  you can invest in pretty much anything you want.   Instead of picking from the best of the mediocre, you can pick from the best of the best!  Woohoo!

Then you can invest in a well-diversified portfolio of low-cost index funds, which is how you should manage all of your "serious money".  And what's more serious than your retirement savings!?

Then as you progress throughout your career and get better and better jobs, you consolidate all of your old 401k's into the same Rollover IRA.  

If you have old 401k's laying around, we'd be happy to help.   Check out our website - www.financialzen.com - and if you like what you see, schedule a free initial consultation

Disclaimer: This information is for educational purposes only and should not be considered advice or a recommendation.   Speak to your financial advisor for help with your specific situation.

Should You Contribute to a Non-Deductible IRA?

You have until April 15 to make last year’s IRA contribution.

But just because Uncle Sam says you CAN, doesn't mean you SHOULD.

Traditional IRA
How it works: 

  • You deposit money in it today.Your money grows for the next 10, 20, 30 years tax-free.

  • You withdraw the money in retirement to buy groceries, vacation, etc.

  • You pay taxes on the money you withdraw. (You pay at your tax-bracket rates, NOT the lower, long-term capital gains rates.)

 

Roth IRA
How it works:

  • You deposit money in it today.

  • Your money grows for the next 10, 20, 30 years tax-free.

  • You withdraw the money in retirement to buy groceries, vacation, etc.

  • You do NOT pay taxes on the money you withdraw.

 

I know you're asking yourself "Why would I ever put money in a Traditional IRA?  If I wouldn't pay any taxes when I withdraw, shouldn't I only put money into a Roth IRA?"

Spooky how I knew that, huh?

That's a very smart question.  There's a good reason you might still want to put money in a Traditional IRA.   And it depends on how much income you make today.

You need a little more info to answer that question…

There are two types of contributions you can make to a Traditional IRA:

 Before-Tax Contribution (aka a “deductible contribution”)

If you make a deductible contribution then you can deduct the contribution from your income.   Which means you'll  get a bigger tax refund… YAY!   But then you'll pay income taxes on all of it when you take it out in retirement - NOT the lower capital gains tax rates…BOO! 

 

After-Tax Contribution (aka a “non-deductible contribution”)

If you make a non-deductible contribution you can't deduct the contribution from your income.  Which means you won't get a bigger refund… BOO!   But you also won't pay income taxes on that money when you take it out.  You'll only pay taxes on the growth and interest….YAY!....but at the higher tax-bracket rates, not lower capital gains rates….BOO!

(Roth IRA contributions works this way too.  You put in after-tax money.  The difference is you won't pay taxes on the growth and interest….YAY!)

 So before April 15, you have 3 different IRA contributions you can make for last year:

  • Roth IRA contribution

  • Deductible traditional IRA contribution

  • Non-deductible traditional IRA contribution

Out of the three options, which should you choose?  Uncle Sam decides for you.

How much money you make determines which contributions are allowed. 

These are the limits for 2017.  (For the nerds - these are all based on your Modified Adjusted Gross Income):

MAGI Contribution Limits.png

The rule of thumb for deductible and Roth contributions is "if you can, you should".  

If you file taxes "married, filing jointly," and make under $99,000 you should probably make a deductible contribution to your Traditional IRA.

If you're "married, filing jointly" and make more than $99,000, but less than $186,000, then you should probably contribute to your Roth IRA.

Like all good rules of thumb, these are just guidelines.   You need to talk to your financial planner to determine if the rule of thumb applies to you.  (Don’t have one? Call us!) Current retirement savings, future retirement savings, and future income are just a few of the things that factor in.

Now comes the tricky part - if you make over $186,000 ($118,00 single) and can't do a deductible or Roth contributions, should you make a non-deductible IRA contribution?

It’s the great white whale of personal finance - the non-deductible Traditional IRA contribution.   You CAN.  But SHOULD you?!?!?  Bum bum buuum

To unravel the mystery, let's jump in our time machine.   Fast forward to your 141st half-birthday. 

You're exhausted from blowing out 70.5 candles when you hear a knock at the door.  It's Uncle Sam!  He wishes you a Happy Half-Birthday and reminds you that you have to take money out of your Traditional IRA today. 

"But why Uncle Sam?  I don't need the money," you ask.

"Because when you take money out of your Traditional IRA, you pay me taxes.  And I needs mah taxes!" Uncle Sam replies. 

It's called a Required Minimum Distribution (RMD for short).  It applies to Traditional IRA's and BOTH Traditional and Roth 401k's... but not Roth IRA's.    (Got that?  Don't forget we pay Congress to come up with this stuff.)  

Your RMD is calculated by dividing the money you have in your IRA by an age-factor.   At 70.5, the age factor is 27.4.  

So if you have $100,000 in your IRA at 70.5 years old, you have to withdraw $3,650 (100,000 / 27.4 = 3,650)

Still with me? 

That $3,650 IRA withdrawal counts as income on your tax return.  So you'll pay taxes on it as if you earned it from a paycheck.

Now if you have $100,000 in your IRA, adding $3,650 to your income won't have a huge impact on your taxes. 

But what if you have $100,000,0000? (Lucky you!)  Then your RMD is $3,650,000.  Adding $3,650,000 to your income will push you into the 37% tax bracket.    That's $1,350,500 in taxes you're paying Uncle Sam.  Oof.

Buuutttt what if your $100,000,000 was in a regular brokerage account, not an IRA?  Well, none of that would have happened because RMD's don't apply to regular brokerage accounts. 

Ah ha!

THE BIG REVEAL:  

Whether or not you should make a non-deductible IRA contribution TODAY depends on how much you'll have in your IRA when you turn 70.5.  

(Warning: That's a rather complex calculation best left to a professional.  Talk to your financial planner.)

If your forecasted RMD will force you to pay a ton of taxes, then you SHOULD NOT make a non-deductible IRA contribution today.  Instead, save that money in a regular brokerage account.

It won't stop your weird Uncle Sam from coming to your 70.5 birthday party, but his visit will be a little less painful and a little less weird…. well, less painful anyways.  

Wishing Well Retirement

Retirment Cartoon 2.gif

How much you need for retirement depends on a lot of variables specific to you and your family.

However, a good rule of thumb to see if you're headed towards a "wishing well retirement" is to multiply your pre-tax income by your age and divide by 10.

For example, if you're 50 years old and make $200,000 year, you should have $1,000,000 already saved.

(50 x 200,000 = 10,000,000 / 10 = 1,000,000)

Like any rule of thumb, this does not take the place of a well-structured and well-thought-out financial plan.  As always, consult your financial planner.  

They Don't Match - Should You Still Contribute?

You're in Safeway doing your weekly grocery shopping, and you spy a "buy 3, get 1 free" deal on your brand of toilet paper. 

Being a smart shopper, you take advantage because after all - you'll probably need more toilet paper, right? 

But last week the offer was "buy 2, get 2 free."  If you're out of toilet paper are you going to wait to see if the better deal comes back?   (I hope not.)

And yet, that's how many people think about their 401k (or 403b).  "My employer doesn't match, so it's not worth putting money in." 

Admittedly, it's a better deal if your company matches.  But even if they don't, you still get a "buy 3, get 1 free" deal on your retirement savings.

The "buy 3, get 1 free" deal is always available for your 401k - whether your employer matches or not.

The reason is simple - you don't pay taxes on the money you put in your 401k (until much, much later). 

Follow me with some simple math (promise it won't hurt). 

Example 1) You're in the 25% tax bracket and you DON'T put money into a 401k.   If you make $100,000, you give $25,000 to Uncle Sam, leaving $75,000 for yourself.  (That wasn't so bad, was it?)

Example 2) You're still in the 25% tax bracket, but you DO put money into a 401k.   If you make $100,000, you can put up to $18,000 in your 401k.  If you do, you only pay taxes on $82,000.   Times that by 25% and now only $20,500 is going down the drain…err…to Uncle Sam.   You just kept $4,500 more in YOUR pocket and out of Uncle Sam's (drain)*

Still with me?

When you contribute $18,000 to your 401k, you're only putting in $13,500 of money you would otherwise spend on lunch and vacations and toilet paper.

"Buy 3, get 1 free"….or really"Save $13,500, get $4500 free".

Just like toilet paper, you know you'll need money for retirement.   Doesn't it make sense to get the best deal you can on it?  

P.S. I oversimplified the examples for proof of concept.  Your actual "deal" will depend on your income and tax bracket.  For most it will be even better.

Disclosure: This is not a recommendation and any decision regarding retirement savings should be discussed with your financial planner.  

How to Turn $13,500 into $22,500 Instantly

If you give me $13,500, I'll give you $22,500 in return.  Do I have your attention?

What if I offered you this deal every year from now until the day you retire?  What if you don't even need to pay ME $13,500?  You just need to pay yourself $13,500, and it will magically turn into $22,500?

No-brainer, right?  Get $22,500 and all you need to do is find $13,500 to save. 

What's the catch?  There is no catch.  This isn't a scam.  This is real life stuff written into law.

What is this magic money trick?

Your 401(k) plan.

???????????????!!!!!!!!!!!!!!!!!!!!!!!!!!!!

You didn't know your 401k did magic tricks, did you?  But it does.  Here's how:

  1. (Hopefully) your employer matches your contributions.
  2. You don't pay taxes on money you put into your 401k (until, much, much later)

Employer matches are different for each company.   But most companies match up to 4.5% on your income.*   So if you make $100,000, they will throw in $4500.

The catch is they only throw in money if you do.   If you don't contribute $4500, neither are they. 

How do you get this free money?  Just save the percentage of your salary that they match.

If your company "matches up to the first 4.5%", then you should at least save 4.5%.*

You put in $4,500 and it magically turns into $9,000!*  What's not to like?

But what if you're company doesn't match?  Whomp whomp. 

Is it still worth saving money in your 401k?

YES.     YES YES and YES!*

And I'll show you why next week….

 

*As usual I'm simplifying the details to illustrate the point.  The specifics of your 401k plan, how much you contribute and all other detail of your financial situation should be discussed with your financial planner before making any decisions.

The Right Way To Invest In Retirement

Disclaimer: The following is for informational purposes only.  It is not intended to be actionable financial or investment advice. To determine if it's right for you, contact your financial planner.

If you've paid attention the last two weeks, you've learned that:

When you get negative returns doesn't matter if you're in "growth mode" and
When you get negative returns matters A LOT when you're in "withdrawal mode"

If you're invested wrong when you first retire and the markets go down, you could easily find yourself unretired very quickly because you suddenly can't afford retirement.

The wrong way is keeping the same portfolio you had before you retired, but with less risk (ie more bonds, less stocks).

The right way is using retirement "buckets".  There's only two buckets:

Bucket 1 - living expenses for the next 15 years
Bucket 2 - living expenses for all the years after that

Sounds pretty simple, right?  It is.

The reason you divide up your money into different buckets is because each bucket has two different goals. 

The goal for Bucket 1 is to protect your money.
The goal for Bucket 2 is to grow your money.

It's impossible to protect AND grow your money at the same time.  That's why you can't keep the same portfolio you had before you retired.  Back then, you were ONLY growing your money. 

Bucket 1 is invested in cash and investment grade bonds.  The value of cash and bonds don't go up and down.  Except for the small chance of bonds defaulting, you know exactly the interest you'll earn and how much money you'll have when the bonds mature. 

This is what will be paying your bills for the next 15 years, so you want it invested nice and safe. 

I can hear you asking, "If it's nice and safe, why don't I put all my money in cash and bonds?"

Great question!  And it has a one word answer: inflation.

Historically inflation depletes your spending power at 3.74% per year.  In 2017, a portfolio of cash and bonds will earn about 3.74% year, just keeping pace with inflation.    So none of your money is actually growing.  

If you're sitting on a pile of money so high that you can afford to earn a 0% real return (a real return is your return after inflation) and still make it last a lifetime, then good for you!

If you're like the other 99% of us, you need to grow some of your money to stay ahead of inflation. 

Enter Bucket 2, your growth bucket.  Bucket 2 gets invested in a well-diversified equity portfolio using low-cost index funds. 

It will have good years and bad years.   When it has bad years, you just ride it out and don't touch the money.

When it has good years, you trim off the gains to replenish what you've spent from Bucket 1.

And safe retirement investing is just that easy.*  

*Word of caution:  I vastly oversimplified this to explain the concept.  Below is a list of some of the additional things you would need to discuss with your financial planner:

  • Determining your living expenses
  • Social Security benefits strategy
  • How to construct a well-diversified bond ladder for Bucket 1
  • Ways to diversify bond risk
  • What kind of bonds to buy
  • How to construct a well-diversified equity portfolio for Bucket 2
  • What kind of asset allocation to implement
  • How much you actually need to support your lifestyle
  • And many, many, many more (there's a reason there's an entire profession dedicated to this stuff!)