Posts Tagged ‘savings


Reaching For Yield

We once upon a time knew a young women who was getting married in the Spring of 2009.  She and her parents had saved a good chunk of change for the wedding through equity investments, and they made the mistake of budgeting the wedding based on the valuation of the funds at some peak around 2008.  Well, since they continued to think they could reap the same returns, which quite frankly they were lucky to have in the first place for such short-term needs of the funds, they left their money in stocks.  Everyone knows the rest of the story, the girl’s wedding was ruined, she had to buy out of contracts she was already in, change venues and cut back the list of guests.

Their mistake?  They were greedy and wanted more return for their money in the short term for risks they didn’t want to shoulder.  Sometimes people get away with this and they squawk about it at parties.  When they get burned, you are unlikely to hear a peep about their finances.  And while cutting back a guest list isn’t the same as paying a mortgage or putting food on the table, the mistake was a classic, often repeated and common one.

Reaching for yield is what we are talking about, and it is a viral theme often preached as being acceptable in today’s 20 something and 30 something blüg-o-sphere.

We know the fundamental investing principal of “Risk = Reward.” The greater the risk we are willing to take, we are potentially rewarded more.  Reaching for yield is when you veer from your investment plan and take on a greater amount of risk than you are willing to accept for a bucket of funds hoping for greater returns because you think the yields are unacceptable.

What makes a yield unacceptable?  We’ve heard a variety of reasons: the value of cash is being eroded by inflation to a friend getting lucky with junk bonds to thinking one can get ahead without getting burned.  Whatever the reason, reaching for yield, or going up the yield curve can put one’s plan in danger.

More money has been lost reaching for yield than at the point of a gun

-William Bernstein

Just as our bride friend above, a person reaching for yield can find the money they need to be gone when they need it.  Emergency funds are something where we should accept whatever the FDIC savings rates offer.  Whatever you decide on the amount of money you need for an emergency, you never know when you’ll need it.  An emergency, by definition, is an event you don’t plan on happening.

Reaching for yield with emergency funds isn’t the only example of reaching for yield.  Funds being saved for a home down payment, holding too many equities & not enough bonds, using peer-to-peer lending to replace fixed income allocations, etc.

We know the rates on FDIC insured saving vehicles are relatively low compared to 6 years ago and there are fears of inflation eroding the spending power of money away.  We wish inflation was moderate and predictable, we wish savings accounts were yielding 5-6%.  But, it isn’t in cards today without accepting greater risk.  We just hope people will think of the needs for their money and not find their money consumed by the market when they need it.


Roth IRA = Traditional IRA, a case for thoughtful Roth consideration

One of the most frustrating things to read in the blüg-o-sphere is how much better the Roth IRA is than a traditional IRA.  Heck, there is even a website fully dedicated to Roth IRA’s.  People seem to get caught up in paying fewer taxes and tax free growth.  These are all things which a Roth IRA offers, but is the Roth always better?  No, more times than not, it is not better.

It depends on what your definition of “better” is.  If your main goal in life is to stick it to Uncle Sam and pay the absolute minimum in tax, then yes, a Roth IRA is always better.  But, we propose this is not what the average working stiff who has retirement in mind wants.  We think everyone should look at after-tax dollars, not the amount of taxes paid, to weigh their options.

By definition, a Roth IRA has taxed contributions and earnings (growth and dividends) which are never again taxed (people with a year supply of ammunition in their fallout shelter may refute this).  Regardless of your conspiracy theories, the equation for computing after-tax return on an investment in a Roth IRA is:

By definition, a traditional IRA has pre-tax money used for the contribution and earnings which aren’t taxed until distribution, at which time they are taxed as ordinary income (but not FICA).  The equation to compute your after tax dollars of a traditional IRA is:

You see where we are going with this?  If you start out with the same principal investment (“P“), have the same return (“r“, they are the same because you would invest them the same) and you have the same taxes in retirement as you do now (“t“), then these equations leave you with the exact same after-tax dollars.

Of course, if you pay the taxes before compounding, it will be less than paying the taxes after compounding.  So, you do pay fewer taxes with a Roth than a traditional investment vehicle, but the after tax value is the same if the tax rates are the same at contribution time vs in retirement.  It should also be pointed out, that it may be appropriate to apply one’s effective tax rate at distribution time if they are completely in pre-tax dollars.

AH HA!  You wouldn’t take the taxes out of the Roth investment, P*t, instead you would invest the entire amount, P?  Well, that could very well be the case, but, you still have P*t to invest somewhere if you go the traditional route.  So, where do you put it?  Top off your 401(k), or maybe you top off a traditional IRA?  If you do this, you use the exact same equations above and end up in the exact same place as above.

What if you are able to max a 401(k) and an IRA and choose the traditional route?  You have no other tax advantaged accounts to invest in.  The difference would have to go into a taxable account.  If the tax rates are the same, the after tax dollars will favor a Roth investment vehicle.  But, it should be noted that there are other qualitative benefits to having money in a taxable account oppose to a tax advantaged account – liquidity of the money being probably the biggest benefit.

All this can be summed up in the following table which is an output of our nifty spreadsheet found at the bottom of this article.

The table above shows investments made in Roth investment vehicles, Traditional tax advantaged investment vehicles and taxable accounts.  The big surprise is the difference between Roth accounts and some of the traditional accounts is nothing!  It is no surprise that the Roth yields more than a traditional account with taxable accounts.  Even less surprising should be growth in a taxable account is more tax efficient than dividends (wink, wink young dividend investors).  But, don’t forget the qualitative characteristics of having taxable money.

Remember to compare apples to apples and oranges to oranges.  It isn’t fair to compare a Roth where the taxes haven’t been taken out of the principal to a straight traditional IRA where taxes are taken out at distribution and not invest the taxes to be paid for a Roth.

And for curiosity sake, what does the output look like if taxes are less in retirement than working?

Just as if taxes went up in retirement the Roth would be heavily favored, the traditional comes out ahead if taxes decrease.  What is interesting (wink, wink young dividend investors) is if you invest totally in dividends, you are better off in a Roth!

The choice to invest in a Roth should be based on the following:

  1. Income and source of income in retirement
  2. What tax rates will be in retirement
  3. “Intangibles” (e.g. using a Roth for estate planning, having a taxable account for liquidity)

Generally speaking, most people’s income in retirement will be less than what they were bringing home pre-retirement.  Very few people will be able to bring in more than their working income.

We think the Roth investment vehicles are very powerful, especially for those in lower marginal tax rates.  It is not, however, automatic or a “slam dunk” to always invest in a Roth.  We would by no means suggest anyone over the current 25% marginal tax bracket be a shoe in for investing after-tax money in a Roth account.  Yes, you pay fewer taxes now, but you are more than likely to be in a lower tax bracket in retirement, thus your after tax returns will be less.   Roth conversions or maxing out Roth 401(k) & Roth IRA’s are usually best utilized by younger workers (who hopefully have many years of income growth ahead of them), but regardless of age, one should always beware of what their income will be in retirement compared to their income today, their outlook on future tax structure and other “intangibles” such as estate planning or liquidity of other types of accounts.

What we didn’t look at

We aim to provide information applicable to the general readership.  We did not apply any state income or LTCG/Dividend tax.  Also, we assumed in some scenarios that all earnings are from dividends, and this is more times than not completely true.  Therefore, the scenarios in which we did this carry a bit of “penalty,” as some earnings will be growth and taxed at the time of distribution.  Also, tax loss harvesting is not accounted for in taxable accounts (people say that like tax loss harvesting is a good thing).

We’ve attached our spreadsheet for your pleasure (really, so someone doesn’t say, what about this or what about that).  As always, this was created by us, and is therefore our property.  We appreciate a little linky love if used to generate any published material (or if you just think it is cool).



You only need between 0.1% and 200% of your current income to retire

That’s our guess, and it should cover almost everyone, with a few outliers.

But the question of “how much money do you need based on current income” is an interesting and very complex question.  More specifically, a reader on one of our favorite blügs, Grumpy rumblings of the untenured, asked how much moolah does one need (and they wanted to know based on % of income)?

Well, there are rules of thumb (or heuristics as the Grumpies call them).  And you can read every financial magazine and blüg to your heart’s content.  Some will say 90%, some will say 100% (yikes!) and others will say 70%.  So on and so forth.  Applying their rules of thumb, a couple with a pre-retirement income of $50k will need their portfolio to yield anywhere from $35k to $50k annually.  If you’re lucky, this all works out for you.

We don’t like the percent of income approach.  Here is why:

  • Your taxes will be less in retirement.  Ok, we don’t wish to invoke a religious war (yet, we have a post coming up on future tax rates in retirement, our tea leaves were strong this morning), but generally speaking if someone retired today, they would be paying less in tax.  How?  First, you don’t have to pay that nasty Social Security and Medicare tax.  Second, if you were in, for example, the 25% marginal tax bracket pre-retirement, you could drop down into the next marginal tax bracket.  Or, if you are taking dividends and capital gains, currently that is only 15%.
  • You are no longer saving for retirement (because you are doing it!).  So, if you saved 15% of your gross income pre-retirement for retirement, that is 15% of your gross income you don’t need in retirement.  Or someone who arrived late to the saving-for-retirement party may save 50% of their gross income.  Or someone who wants to retire early may have a high savings rate as well.
  • Your pre-retirement expenses do not equal your retirement expenses.  Generally speaking, most people’s expenses will go down.  There are some basic needs people need to cover first – shelter, food, utilities etc.  And covering your basic needs will more than likely be less than your current income (at least we hope so, or retirement is the least of your worries).  Then there are expenses of having to go to work everyday – more miles on a vehicle, gasoline (have you noticed gasoline prices are rising?), clothes for work, eating out at lunch, dry cleaning etc.  In retirement, maybe you pick up your dawg’s poop from the yard instead of paying the neighbor’s kid to do it?  And with your new found time, maybe you fix the leaky toilet instead of hiring a plumber (this may not result in cost savings if your spouse is anything like mine!).  You  also won’t need those life insurance policies (unless you have some expensive estate planning tactic up your sleeve).  But, some things can increase your retirement expenses.  Maybe you want travel the world or pick up an expensive hobby (like fast cars and fast ______)?  Don’t even get us started on health insurance…

There are many variables which can have a huge impact.  Each person is unique.

What we suggest is to track every penny of your current expenses to help you form a retirement budget.  Not only will it show you the cost for your quality of life (generally, most people find some fat to cut out) but, it helps with solving the riddle of how much moolah you need in retirement.  Tracking your expenses will show the cost of your basic needs, it will show you things you won’t need to spend money on in retirement – like SS tax (We know you’ll miss that!), work expenses etc – and it will help you determine how much you want to spend for your retirement goals.  It can be difficult to forecast expenses for your retirement goals, since you may not see them fully represented in your expenses right now, but making an educated guess is better than ignoring them.  Tracking your expenses over multiple years also gives you an idea of the cost of less frequent events, such as home maintenance or tires for the car or whatever surprises life throws at you, which should also put into your retirement budget.

What we like most about this approach, is you more precisely know your income needs in retirement (also accounting for your retirement goals).  And you are highly unlikely to ever have to do the durdiest of durds, eat cat food go back to work, because your basic, everyday, bare bones living expenses should be less than your planned retirement income needs.  Meaning, you can tighten your belt and leave out that trip to Vegas with the gurls when life pees on your favorite tree.

So, doing this exercise of forecasting your current expenses into a retirement budget, do you find your retirement income needs are within the rule of thumb heuristic of 70% to 100% of gross pre-retirement income?  Or are you less?  What say ye?

Now, this only covers how much annual income you will need in retirement.  We’ll get to how you translate that into a total savings dollar value in another post…down the road…sometime.