Posts Tagged ‘saving


misconception about roth IRA first time home buyer distribution

Well, with April here, spring in the air, flowers blooming and tax time looming, we thought we would dispel a misconception about the Roth IRA first time home buyer’s reduction in earnings while taxes are fresh in the mind of half the population.

We’ve seen this lately being mentioned as an advantage of a Roth IRA here, here and here.  And, we’ve attempted to alert some of them to the complexity of this acrobatic maneuver they suggest.  Some willing to learn, but mostly with us being shrugged off.  So, we thought we would move it to a stage where we can fully (at least attempt to) explain this complex tax move.

First, we should point out, that we think using an IRA for anything else other than retirement is a mistake.  GASP!  A blanket statement.  They are powerful tools which help people to retire.  In an indirect way, yes, buying a home does help one to retire, or paying for a child’s college education (if that is an expense you decide to bear) does help you to retire.  But, there are other ways to help you save for those things.  Look at it this way, you only get $5000/yr (under current rules) to contribute.  Maxing this out year after year will barely get you into retirement, if ever.  Use a wrench to turn nuts & bolts, and a hammer to pound nails.  So, even if you read through what we are about to say and still think saving for a home in a Roth IRA is a good idea, you certainly don’t have our endorsement.  But, our opinion is worth what you paid for it (should we set up a paypal link for some luv?).

The origin of the Roth IRA first time home buyer’s earnings distribution misconception is the interwebz.  It is undoubtedly true that you can withdraw from a Roth IRA, an amount up to $10,000 for the purchase of a primary residence to be your “first” home (usually if you haven’t owned a home in two years, you are a born again “first” time home buyer).  We would certainly hope everyone would due their do diligence (why do we feel like we messed something up there?).  And, if you want a great summary of why most people think this is an easy peasy tax move, read Publication 590, page 62, bottom right of the page.  It is right there, plain as day under big bold words that say, “What are Qualified Distributions”:

One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).

And if you’re looking at the Pub 590 document that we link to, page 62 and you click on the hyperlink of “first home,” then it takes you to the part where it defines who you can buy a home for, what defines a “first” home and even points out that you and your spouse can both do this for the same home!

This is a qualified distribution, so the normal roth ordering rules don’t apply (rules which say when there is a non-qualified distribution that you first take out your contributions, then conversions-this has a few caveats-and then earnings).  Being a qualified distribution, you can take from the earnings.  If you think you can have your cake and eat it too by keeping your contributions as an emergency fund and reducing your earnings for the home purchase you are WRONG!  You will have to reduce your basis (or contributions) by the amount of earnings you withdrew the prior year for a first time home purchase, up to $10,000.

Sounds confusing, well it is.  Let’s look at some tax forms.  To do this, we must go back to 2010 so you can see how this works.  For our example we’ll assume you have $30,000 in a Roth IRA, $10K of earnings and $20k of contributions.  Let’s say you want to tap that $10k of earnings for a home in 2010.  First off, you must have a Roth IRA account at least 5 years old.  Withdrawing anything before that can trigger taxes and penalties.  But, what is so lucrative about using the earnings instead of the contributions?  The main reason is so in our example, you could take all $30k out for a home purchase, tax and penalty free.  But, if you aren’t going to completely wipe out the account, you are not gaining anything (and some would argue you are loosing things).

One of the hard sells of Roth IRA’s are their flexibility.  And they are the Gumby of retirement investment vehicles because contributions can be tapped, tax and penalty free.  If you like this about a Roth, here is why you need to be cautious with this first time home buyer deal.  Let’s assume you take the $10k of earnings in our example above in 2010 for the purchase of your first home.  You would fill out the 2010 form 8606 like so…

That’s it.  You can download this 2010 8606 form here.  The 2010 form is a little more complicated than other years because of being able to allocate taxes due on conversions over two years, but all that is in Part III.

So, in 2011 (or any year into the future), let’s say you want to take out the $20k of contributions, for whatever reason.  Let’s fill out your form 8606 in 2011.  This is what it would look like (oh, and you’ll need the instructions, linked here for your pleasure).

WHOA! What just happened?  How did you end up with taxable money in line 36?  Should line 22 be $10,000?!  OR $20,000?  As they say, the devil is in the details.  Let’s look at those instructions for the 2011 8606, line 22.

Figure the amount to enter on line 22 as follows.

  • If you did not take a Roth IRA distribution before 2011 (other than an amount rolled over or recharacterized or a returned contribution), enter on line 22 the total of all your regular contributions to Roth IRAs for 1998 through 2011 (excluding rollovers from other Roth IRAs and any contributions that you had returned to you), adjusted for any recharacterizations.
  • If you did take such a distribution before 2011, use the chart on page 9 to figure the amount to enter.

We hop to page 9 and find the following chart.

So, using this chart on page 9 of form 8606 instructions for 2011, if we took a distribution for a first time home buyer in a prior year, we must take that off of our Roth basis in the following year (2010 8606 line 29 less line 26).  Essentially, the Roth ordering rules are restored and the Roth basis (contributions) is reduced by the amount used for the home buyer’s distribution in any following year you take a distribution.  You can find the 2011 8606 form here.

If you were planning on having an emergency fund and use a home buyer distribution within your Roth accounts, it would be wise to treat the home buyer distribution as being from the basis.  In fact, it would be wise, if you aren’t wiping out the entire amount of Roth funds, to take from the basis and save yourself not only a headache, but your lifetime $10,000 home buyer  distribution from any IRA.  The wisest thing you could do, however, is not touch your retirement accounts until needed in retirement.

And you should check out our legalese page to know we are not professionals at anything, except maybe at barking.  H&R block won’t even hire us to prepare 1040EZ’s.  So, talk to them or a real tax professional.  


Risk & Reward

We all know the age old rule that the more risk we take, the higher the potential reward.  And we tend to think this relationship looks something like this:

We tend to think the relationship between risk and reward is linear.   In other words, for an additional amount of risk we take, we are compensated a proportional amount of reward, with no limit on the amount of reward we can reap.  This is common thinking when describing the Risk/Reward balance.

If we were whipping up charts to model our ideal Risk/Reward relationship, this is what we would want.

This way, we are compensated exponentially over the long term for taking more risk.  And, just as with the linear chart, there is no limit to the amount of reward one can reap.  Sadly, neither of these are the case when it comes to the stock market.

We are more likely to see diminishing returns for incremental risk that we take on.  Something like this:

Eventually we run into an asymptotic behavior, when we go out to infinity with our risk, the reward will seize rewarding for that additional risk.

So, when people say, “more risk = more reward,” stop a moment and think how you are being rewarded.  Is it in proportion to the amount of risk you are willing to take?  Will you be exponentially rewarded for your risks?  Will you take additional risk that barely return you more reward?

Food for thought.  What’s your risk/reward relationship?


Peer-to-Peer lending is a bad idea for investing

Maybe we’re just old curmudgeons who fear change and new things?  We’re the same people who won’t click anything on our computer screen if we don’t know what it is for fear of our computer combusting.  And, we don’t like peer-to-peer lending.  Or “P2P” if you are a young hipster who wildly clicks everything on their computer (sans combustion).

Why you ask?

  • We can’t help but ask, why don’t these people go to a bank and take out a loan?  Why won’t the people who are professionals offer them a loan?  Is there not enough exposure through investing in a bank?
  • How quick we are to forget the credit crisis of a few years ago.  When shit hits the fan, self preservation becomes the number one priority for people.  People will go so far as to use you as a shield so they don’t get the durdy stuff on them.
  • People will say anything or do anything to make you believe they are up for sainthood…and so you give them money.
  • We also find some irony to personal finance blügs pushing P2P lending.  These loans are typically for the very thing personal finance blügs preach against.  Yet they “invest” in it?  Not to mention, blügs are often paid for you signing up with a click through their affiliate links.
  • Some of the reasons given to loan people are uncorrelated to their ability to pay the loan back.  This mainly revolves around business loans.  Their credit rating has nothing to do with their ability to run a business.  And if the business tanks, good luck collecting.
  • It is time consuming.
  • It is risky.

General consensus is for a person to use a small portion of their portfolio for P2P lending.  And that is ok in our mind if that portion is part of their equity allocation.  P2P lending should be viewed as a risky “investment.”  And since we know reaching for yield is a bad idea, P2P lending shouldn’t be part of fixed income allocation or emergency funds.  That, in our mind, is OK.

So, why don’t we use a small portion of our portfolio for P2P lending?  Two reasons: 1) it takes time and research.  In fact, it would take us a significant amount of time to understand websites like  and then we have to read through loan after loan to understand where to put our money.  Limiting exposure by investing the minimum $25 in multiple loans?  All the more reading and research.  2) if we are going to risk a small portion of our portfolio and invest time, why not invest in a hobby or something we get non-monetary gain from?  Or go on a vacation which provides us excellent utility, especially while working.

Overall, we don’t think this is a right or wrong decision as long as people are assigning the risk of P2P lending to the correct risk bucket and limiting their exposure (<5% of their portfolio).  But, it is a time consuming endeavor, which can, for some people provide them utility.  And that is a good thing, as some people may enjoy helping someone consolidate their debt and get out of their hole.  But, it shouldn’t be viewed as a serious investment, but more of a hobby.  In fact, we’ve spent less time checking our portfolio and re-allocating our investments than we did researching P2P lending.



Actively Managed Funds do worse than expected

We’ve read on other personal finance blügs that 50% of actively managed funds (ones where you pick people to “beat” an index or benchmark and in turn pay higher fees) do worse than their benchmark.  We were curious about this because everyone throws it out there like it is common knowledge but never citing any sources.

Well, we’ve rolled up our sleeves and found some data.  Standard & Poor’s keeps a scorecard which is called SPIVA (S&P index versus active).  One issue they account for is survivorship bias, as other entities who track this don’t count a fund who fails as doing worse than it’s benchmark which is one reason you see 50% of active funds underperforming rather than the much higher SPIVA numbers.  Seriously, the first page is a must read.  Some of our favorites:

  • There are no consistent or useful trends to be found in annual active versus index figures. The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.
  • There is a common perception that the large-cap market is efficient and should be indexed while the small-cap market is inefficient and should be active. This principle has stood the test of time; indexing continues to be much more deeply entrenched in the U.S. large-cap market than the U.S. small-cap market. However, over the last decade, SPIVA has consistently shown that indexing works as well for U.S. small-caps as it does for U.S. large-caps.
  • Bear markets should generally favor active managers. Instead of being 100% invested in a market that is turning south, active managers would have the opportunity to move to cash, or seek more defensive positions. Unfortunately, that opportunity does not often translate to reality. In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.

Without further adieu, here are some high level results from Report 1, page 7:

% of funds outperformed by their benchmark

With the bar set low at 50% of actively managed funds doing worse than their benchmark, this is certainly bad news for their advocates.  These are the 5 year numbers, because as S&P points out, year to year data will fluctuate.  But, if you think you can pick the winners, then the 1 year numbers are in the report as well.

It should also be noted that Large Cap value funds have less than 50% outperformed by their benchmark, or 36.71% were outperformed.  This is the only category to do so.  It is also the category with the lowest survivorship, at 91.8%.  Or, over 8% of the funds which were started have failed.

This nothing new to us and our dawghouse.  We are big believers in passive, indexed, mutual funds.  Not only because of the performance, but because the fees are lower.  It would be interesting to compare after fee returns of all funds.  We think over the long term an actively managed fund will do worse after fees than a low-cost index fund.


What we can learn from Thoreau

Like.  Whoa.  Woff.  Woff.  Joe over at Retire by 40 has a blüg post that we agree with and were so into, that neighbor’s dawg was able to sneak in and pee on our dawghouse (no worries, it is been properly claimed back as ours).  RB40’s actual article was good, but what floored us and got us really hooked was the naive young bloggers who think they can earn their way into financial independence (if this is your definition of rich).

And we agree with RB40 when he adds this point:

The problem is, most people succumb to lifestyle inflation and spend more money every year as well. This is where being frugal comes in. If you can minimize lifestyle inflation while earning more every year, then you will eventually become rich!

Certainly, lifestyle inflation is a wealth killer.  It happens to the best of us.  And in our opinion, a little bit is ok (another discussion).  Letting it run rampant, no nos gusta!  I think this is a point we can all agree on: if Expenses < Income, we are all good (cue up Winston Churchill cliché quote).

What we think is most appalling is no one pointed out what Henry David Thoreau learned in the mid-19th century as he spent 2 years, 2 months and 2 days at Walden Pond.

A man is rich in proportion to the number of things he can afford to let alone

Ok, we didn’t expect anyone to want pull out a favorite quote of ours, but…

Is that saying the same thing as don’t let lifestyle inflation creep into your life?  Sort of.  What we think is important, as highlighted by RB40, wealth or being rich, is not just how much money you can accumulate, but it is the connection between wealth and what you spend.  But being rich means different things to different people.  In our dawghouse, we want to enjoy a few simple pleasures in life and not have to go into an office if we don’t want to (in other words, financial independence).

Here’s another example illustrated by Nords showing the connection between income and expenses.  In other words, at a 5% rate of return, if you save 15% of your income, you will be come financially independent in 43 years.  If you started working at 22, that means you’ll be 65 when you reach early retirement.  Will anyone think you are rich when you retire at 65?  It certainly doesn’t impress us.  But, at the same rate of return, if you up your savings rate to 40% of income, you’re financially independent in 22 years.  So, if you retire at 44, is that an impressive feat?  Of course, there are assumptions in these equations and neglects things like social security.  And we can all tweak them to our heart’s content, so no sense arguing over rate of return.  Nords has a spreadsheet on his blüg you can play with.

What we think is more important than the nominal value of your savings, is what can you actually do with it?  If you had $3MM, could you pull the plug? or do you have to keep at the grind?  A $3MM nest egg is impressive, but not in our minds if you have to keep to the grind.  We’d much rather have $2MM and be financially independent.  To us, that would be rich.  We considered Jacob to be wealthy.

And finally, We’ll leave you with a neat math trick to chew on like a big new juicy bone.

1 penny saved is the same as 1.47 pennies earned.

So, mathematically, saving is better than earning more.  What say you?