Category Archives: Investing

Hello 2016! A Toast to an Amazing, Productive, Healthy, and Sane Year

I’ll admit it, 2015 was rough. With my long commute to and from work, my sanity and health sank to perhaps an all-time low. Although I achieved networth growth over the year, it wasn’t nearly as much as I had targeted. In fact, in the year when I made significantly more than I had ever made before, I ended up saving less than I had in the past (including interest.) I closed out the year with $344k in total assets with the exception of my car (I don’t count that in my networth calculations, though, I guess I suppose I should.) I wanted to be at $400k in networth, but between some bad investments, general stock market blahs, and being unemployed for a brief while, I just didn’t get anywhere near that.

What I try to remind myself is that $344k at 32 is not too shabby. If I don’t touch that, don’t add anything else, and it manages to grow at 5% YoY that’s $1.3M by the time I’m 60. Ok, so I want to get to $4M by 60 (which requires about a 10% YoY annual return with my current principal and no annual additions), but even if I get to $1.3M by 60 I think I could remain working and manage to grow that another 5 ¬†years, which gets me to $1.7M and that isn’t counting any savings from future Mr. HECC.

The plan was to hit $500k net worth, have a kid and save for a house while living in an apartment with young kid, and then over the next five years save enough for a 20% downpayment ($300k) on top of the $500k plus annual interest that I wouldn’t touch. That goal is looking rather unlikely right now, and I’m actually ok with that. I’ve gotten to this point where I’ve accepted that the life I am going to lead as an adult is going to be at a lower class level than the one I was used to as a child. While I grew up in an upper-middle class household, my family will be squarely in the middle class (for my region of the country), and we’ll be fine. We’ll still be doing much better than the majority of households in the country, even if we can’t afford a house for a long time, if ever.

Right now, my focus must be 100% on excelling in my job. With my current salary and responsibilities, I have the opportunity to set myself up for a very successful next 20 years of my career. I also am very seriously confronting the reality that if this doesn’t work out for any reason, if this is a failure, then it means a significant shift my career trajectory and networth projections. I very well might return to school – which I’ve been talking bout for a while but haven’t seriously pursued – to study to become a psychologist or design researcher with a psychological focus. But I don’t want to think about that right now, I’m heads down, fully in the game, trying to relax and thrive despite the many challenges at hand. In other words, I refuse to mess this up.

Beyond work, this year is just a huge year of major life changes. I get married in a few months (tax bill goes up next year, woohoo), and I also likely start trying to have kids, confronting the soon-to-be-proven fact that conceiving doesn’t come so naturally to me (thanks PCOS.) I’m hyper-focused on losing weight, eating healthy and exercise right now. My weight fluctuates significantly — in 2012 I was at 180lbs (my highest ever, which is very heavy for a woman who is 5’3), to 155lbs a year later, to 176lbs a year later than that, dropping and holding steady at 170 through 2014 and most of 2015, ending 2015 at 160lbs. I hired a personal trainer 3x a week ($50 a session which is a really good deal for this area) so we’re working on getting my weight down to about 130 in the next couple of months (5 pounds a month is my goal to lose, which is a good, achievable goal.) It’s mostly so I can feel happy with how I look in my wedding pictures, but it’s also just something I need to do in order to save myself from premature aging. Plus, I just feel mentally more clear and balanced when I’m eating healthy and exercising. It’s good to have such short-term goal so I am focused the entire way through, no matter how hard it gets.

This year, my goals are going to be a little less intense on the networth side. I’d like to get to $400k in networth, including $23.5k in new retirement savings (401k & IRA). That leaves $31.5k to make up for in interest and other savings, or about $2.6k per month. I’m planning to try to save an additional $2k per month on average, and hopefully the rest (~$7200) will come from interest on, say, $250k of invested, interest-earning assets, which is about a 3% gain on those investments. I’d prefer to go well over this, but trying to be realistic with the goals, especially with the wedding spending. I don’t think this is going to be a hugely profitable year but I could be wrong.

2016 Goal Summary

1) $400k networth – including $23.5k in retirement savings, $24k in taxable investments, and about $7k in interest.
2) Be 130lbs by summer
3) Thrive at my job (and be gainfully employed and loved by my colleagues when Jan 1, 2017 rolls around)
4) Get pregnant before I’m 33!?!

Well, here’s to kicking off what is sure to be a crazy year. Fingers crossed it’s a good one. I think it will be. I hope it will be. Oh god, it better be. ūüôā

 

 

 

November Networth Check-In and Retirement Update

Now that I am “in between incomes,” so to speak, I am re-focusing my objectives for total assets this year, and beginning planning for 2016 based on my potential earnings at my new opportunities.

As a reminder, my goal was to close out 2015 with $400,000 in net worth. That figure was always a stretch, but it isn’t going to happen this year. My new goal is to wrap up the year with at least $350,000 in net worth, which is about a 15% increase in my nest egg – not bad but not great either. My goal is to give birth to my first child in the summer of 2017, when I’m about to turn 34 (yikes.) That means getting pregnant in the fall of 2016 or soon after would be ideal. That means that I still want to aim for $500k in net worth by the time I have my first kid (let’s call that July of 2017.) This is about 19 months to increase my net worth by¬†$150k.

Let’s start with where I am today — according to www.networthIQ.com my current net worth is $380,783. I will subtract my car ($8000) and stock options that will soon be worth nothing from that ($16,000) to what is my “actual” net worth — so about $356k. I’m also losing money now since unemployment doesn’t cover my monthly expenditures, so assuming the stock market does decently this month and I land a new job for December start (which is looking quite likely) I should be able to close out the year about $350k. A reminder, in January of 2009 I had about $5k to my name (see graph below.)

november net worth

In order to hit my goal of saving $150k in 18 months (assuming ending 2015 with $350k), I need to “save” $8333 per month. How is THAT going to happen?

If¬†I (knock on wood) ¬†increase my income levels in my next job to $190k (which is super exciting and feels like too much yet if the market will pay that for my services, I’ll take it!), that is a take-home of about $9400 a month (which is a lot and really starts making this dream possible – this is where it gets exciting!) Even with my average spending of about $3500 a month, ¬†I will have $5900 per month to put away. But this also, theoretically, is two years of 401k investment, which I can max out each year. So that’s $36,000 of the total $150k right there (assuming I can keep my job and do well at it!) Ok, so one opportunity has a 3% match of your salary on that, which is awesome (I’ve NEVER had a 401k match in my entire career!) That means each year I’d make an extra ~$5700 just for putting the money in my 401k (if I’m understanding the match thing correctly.) So that is $11,400 on top of the $36k. Ok, so that takes care of $47,400 of the $150,000, and leaves a slightly more realistic $102.6k left to save over 18 months, or, $5700 per month. Income is reduced a bit with the 401k investment, of course, by $18000 a year – but that’s all pre-tax. But with bonus, etc, it should balance out to still taking home somewhere around $9k a month, or maybe a little less. That’s still a lot for the short-term goal.

Now, let’s assume my stock portfolio / the market increases by an average of 5% each year. It could be less and it could be more, but let’s say 2% – 5%. That is somewhere between $7000 and $17500 for year one, and a max of $20.9k in year two (at 5%), minimum of $8368 (for the entire year, but I’ll count that in these numbers since even if I’m not working my portfolio will continue to gain interest.) Ok, so on the more conservative end with just a 2% year-over-year gain, I’ll have another $15,368 covered by investment interest…

$150,000 goal
$36,000 = 401k investment
$11,400 = 401k match @ 3% of income
$15,368 = portfolio interest at 2% YoY
———————————————
$87,232 to save in 18 months, or,
$4846 per month

This is very doable, as long as I select a job where I can stay a minimum of 18 months. One opportunity does not have 401k match, so I am leaning toward the one that does, since this clearly helps substantially in reaching my long-standing goal of $500k by childbirth.

Once I have kids, I am expecting to work part-time and see my annual savings levels decrease. Of course, I’ll have a husband who is also working, but he doesn’t earn as much as I do or invest his savings beyond a Roth IRA (which he’ll no longer be eligible for once we’re married – yeay marriage.) We’re not really combining incomes when we’re married – just continuing to split major household expenses. We’ll probably start to split a little more… right now we just split rent (I pay more since I make more) and food (we spend way too much on food for two people) — but in the future when we’re married I can see us splitting healthcare expenses, and maybe things like gas/transit. When we have a kid all those expenses will be split too. Luckily I have a penchant for household accounting. What a great hobby!

Seriously, though, if I can get to $500k before I have a kid, this frees me up so much from this looming fear of the future I have. It’s not exactly a nest egg that will make me rich, but it’s a very good start to be at $500k by 34. The goal was by 30 but so what… goals are meant to be hard to reach, but they keep you focused on getting to where you need to be.

With $500k, if I can manage to not touch that money until I’m 65, at an annual return of 5%, that gets me to about $2M in retirement (not counting any future earnings or my husband’s earnings/savings. At a 10% YoY return that’s about $8.7M in retirement. Heck, if that grows at 10% YoY in 20 years once hitting $500k, that will be worth $3.3M – not exactly placing me in the .01%, but certainly providing enough income for early retirement / starting my own business / doing what I want when I’m 55 years old. I know a lot of women in their early 50s and I can see this age¬†being a good time to have that flexibility. You’re still healthy enough to trade and have fun, your kids are old enough to appreciate spending time with you (hopefully) and overall if you’ve been smart about saving over the years, you can take a moment to actually enjoy life.

So when people read this blog and comment about how this $500k goal is so silly, well, it really isn’t.

The MOST important thing right now for all of this is picking a job where I can stay stable at for the next 19 months, at a minimum. That’s a long time and I’m going to take it month by month and focus on being so productive my employer couldn’t even dream of replacing me. 18 months is just 6 quarters, and that will go fast, especially if I’m pregnant for half of them!

I really hope I can do it. I’ve come so far. This seems within reach. Having my first kid at 33/34 is not ideal, I’m going to have to have my second at 36 and if I want a third, well, that’s going to have to be pretty much right away after that. This leaves me little time to keep earning at the same rate, especially in my field, where having kids doesn’t seem to align with the amount of hours required to work. I have to make the money now, so I can leave the options open for the future.

 

 

 

 

 

 

 

 

One month left to recharacterize your IRA from Roth to Traditional or Vice Versa

On my to-do list for this month: recharacterize my IRA from a Roth to traditional IRA. Why? Roth IRAs have maximum income levels where you’re eligible for this type of investment – and it’s fairly impossible to know if you’ll hit these levels earlier in the year when you’re investing. Luckily, the government realizes you might not be trying to sneak your way into a Roth for the year, and gives you to Oct 15 to fix your classifications.

Fixing the classification isn’t as easy as filling out your simple taxes on TurboTax. It gets a bit complicated. This is why I’ve been putting it off… until now.

Not only do you have to follow the rules of the firm where you invested your money in the Roth IRA to recharacterize it, you also have to refile your tax return if you already submitted it earlier in the year (see IRA website).

If you have already filed your return, you can file an amended return and subtract the amount recharacterized from the taxable amount of the rollover or conversion reported on your original return. Form 1040X, Amended U.S. Individual Income Tax Return (instructions), can be used to amend your return. Generally, for a credit or refund, you must file Form 1040X by the later of:

  • three years (including extensions) after the date you filed your original return, or
  • within two years after the date you paid the tax.

My Roth IRA is at Vanguard, so I will need to first go through their recharacterization process¬†which I haven’t figured out yet. I am probably going to end up calling them to figure this out.

Have you recharacterized a Roth IRA before to a traditional IRA? Are there any gotchca’s I should be aware of?

Holy Hell the Stock Market is Down (Just Breathe)

I’m a bit obsessive about my networth. Ok, a lot obsessive. It’s this game I play which helps me weather the storm of the everyday ups and downs of life. I know you’re not supposed to monitor your stocks on a daily basis, but I do, because that’s what I do. It’s certainly thrilling when they go up. Not so much when they go… down… and down some more.

Today the stock market had its¬†9th biggest decline in history¬†so – when I looked at my Mint account and my jaw dropped to the floor with little birdies flying around my head – well, that was not an overreaction. It’s pretty painful to see all this money you’ve been saving for the year just poof disappear, at least on digital paper. It could come back tomorrow, or more could disappear. Who knows. China is making everyone freak out. My Apple stock is tanking, but so is the rest of the market.

I am not going to sell. I am not going to sell. I am not going to sell.

My entry into the stock market was interestingly timed. I got in right before the great recession. I had enough money in to feel the pain of losing almost half of it, but I was making so little at the time that the amount I was able to invest wasn’t really significant enough to cause serious long-term damage. Then, as the market recovered, I obtained jobs where I made more money, and more money. And I didn’t really like to spend all that money at Sephora, so I invested it each month. As the stock market went up, so did my networth. It was incredible to be investing in the market at that time. It clearly wasn’t going to last forever…

Today the market is overvalued. It’s due for a few major corrections. The trick of corrections is to A) not sell and B) buy more each time your heart jumps to your throat when you check your life savings, but not too much more in case the market continues to drop, which it probably will do.

Think Long Term and Forget About the Short-Term Fluctuations

Today I bought $1000 worth of Vanguard funds and $500-ish of Tesla stock. I’m fighting my stock market fears by throwing money at it whenever it surprises me with a swift downturn. Hopefully that will pay off in the end. It’s not rocket science, but it seems to have worked thus far.

I’m holding my breath right now as I have a feeling 2015-2016 is going to be a majorly bumpy ride. Are you in buy mode right now? How much do you think the market will correct itself before it stabilizes? Do you have any favorite funds that perform well when China implodes on itself for its overvalued currency?

Oh, and forget about my $400k networth goal this year… now I think $350k networth is a much more reasonable goal to close out the year with. That’s still $50k more than I closed out last year, but given my salary increase I thought this year would be a lot stronger. The whole $500k before kids goal is seeming more and more unlikely — though if I can maintain my income level… my plan is to get pregnant in June/July 2016, and then have a kid in March/April 2017… that’s still about a year-and-a-half from now, so I could be somewhere in the $425k range at that point, which isn’t HORRIBLE. $425k growing at an average of 5% per year after 30 years, if I don’t touch it, will =$1.8M, just shy of my $2M retirement goal. ¬†But if it grows at 10% over 30 years then that’s $7.4M. So all I need to do is not touch that future basis and hope that the economy doesn’t entirely crash for a long term depression. $400k-$500k before I have a kid is the NEW goal.

 

 

Question for my Readers: Should I do a Roth IRA conversion?

One of my biggest financial mistakes to date was rolling over my 401k – or at least, I think it was. By rolling over my 401k accounts I made a Roth IRA conversion of my post-tax “traditional IRAs” unwise. There is, however, a way go around my mistake in order to convert my post tax IRA accounts to a Roth. I’m just not sure if it makes sense to do this. In lieu of hiring a CFA, I pose this question to my readers: should I convert (by doing the following) or not?

The Data

I currently have $14,803 in a post-tax IRA (i.e., I thought I was ineligible for a Roth for two years, at which time I funded a post-tax IRA. This was probably a mistake to begin with, but nonetheless, I have $14,803 in the post-tax IRA. I’d like to convert it to a Roth.)

Where did this money come from?

2010 – $5000 contribution
2011 –¬†$5000 contribution

Thus, I currently have $4,803 in unrealized gains in this account.

If I were to convert¬†to a Roth I would have to pay taxes on this… which maybe not worth it to begin with. However, even if that would be worth it, I have another IRA account from my Rollover 401k. If I were to convert to a Roth I would not only have to pay tax on the $4803, but I’d also have to pay income taxes on the entirety of my 401k account (or a percentage of it, depending on the total conversion.)

The catch is — it is possible to rollover my prior 401k and current IRA account into my new work 401k. At least it looks like it’s possible to do this. By doing this I would no longer have an additional IRA so I’d be able to rollover my post-tax IRA into a Roth IRA and pay tax on “just” the $4803 in gains (or whatever it is at the time I do the conversion.)

However…¬†the funds I have access to in my work 401k are not nearly as compelling as those I have access to in my Vanguard IRA. At the moment, most of my investments in this IRA have a .10 expense ratio. My employer 401k options seem to be mostly in the 1.10 expense ratio, with one S&P fund at .54 or something like that. So, ultimately, I would need to do the math to figure out if it would make any sense to bother with all this hassle to convert my two years of traditional IRA investing to a Roth. I’m really not even sure if I wasn’t eligible for a Roth at the time, but I’m pretty sure it’s too late to fix this error if it was an error. Hmm.

My thoughts are as follows:

1) Wait until the last minute to rollover my current IRA into my work 401k. The last minute mean whenever in the future I am about to leave my company, or, in the case of being laid off, filing the paperwork on the day I’m laid off.

2) If that works, I’d wait until the rollover cleared, and I no longer had an existing IRA beyond the Sharebuilder 2010/2011 contributed-to account.

3) Then I wait… until a year when my income is low (probably when I have my first child or when/if I go to grad school, though this is all a hypothetical time/year to begin with – and needs to happen before I get married!)… and convert the existing post-tax funds to a Roth, so my tax rate is low.

4) That said, does it really matter? In 35 years the account will be worth $415,916 if it makes 10% in interest per year. So I’d have to pay tax in retirement on $405,916.¬†Or, I figure out how to do the conversion in the near future and pay tax now on $5000, give or take. I’m not sure if the tax comes out of the account or you can pay that separately, assuming you can pay it separately then I’d still have $15k or so to compound over the years for retirement, and just pay $2500 or whatever it is right now in taxes on the conversion – if I can actually rollover my old 401k IRA into my new 401k.

But… then I need to look at how much is lost due to the higher expense ratios in the 401k account on the $91k-ish that is in my current IRA. If I have to pay 1% more per year in expenses then…

According to this calculator, if I left my $91k in the new 401k for 5 years, paying an additional 1.00% in expenses each year, with a 10% YoY rate of return, the total fees would be $7885.21, including operating fees and opportunity costs, versus $731.32 if I left it alone in my Vanguard account w/ the .10% expense ratio. So, basically, for the five years waiting for a year when I don’t make that much money (assuming I don’t actually get married) then I’d lose $7500 or so waiting to convert the existing post-tax IRA to a Roth, plus I’d lose whatever tax I’d pay on the gains on the interest gained in the post-tax account. So I’d end up probably paying $10k¬†now¬†in order to avoid paying tax on my hypothetical $405k in retirement.

That seems like a fair trade, if it actually worked out. I’m sure there’s a catch somewhere, I just don’t know enough about finances to see it. That’s why I’m asking my readers… ¬†should I rollover my $91k IRA to my 401k in order to convert my $15k post-tax IRA to a Roth?

 

 

 

 

Addicted to Loyal3 Investing

Screen Shot 2014-12-05 at 3.30.57 AM

My investing hobby started with a few hundred dollars of fun money after maxing out my Roth to invest in individual stocks and ETFs to better understand the stock market. This same Sharebuilder account is now worth $101k and is filled with dozens of stocks and funds. Selling them will be a tax nightmare. I plan to hold them for the long run and sell during a few frugal years in early retirement so they get fairly decent capital gains tax rates.

One thing that always bugged me about my Sharebuilder investments is the trading fees. They used to have a better system where you could pay $12 for 12 auto trades per month — $1 trades weren’t bad, but even with the $1 trades you had to pay $8 or so to trade each individual stock/fund out. Now Sharebuilder got rid of the auto-investing plan and made the cheapest auto trade be about $4. That’s not so bad, but it is bad when you consider the whole premise of Sharebuilder is to build your shares slowly – by investing a little bit at a time. When you really start doing the math you realize these fees are massively cutting into your prospective earnings over time. I often wondered – isn’t there a better way?

The good news is – now there is. Loyal3 (not getting paid for this promo, I genuinely am excited about this company) makes it possible for the average everyday investor to invest directly into companies whenever they want for 100% free trade in and out. The companies are footing the bill to help everyday investors buy their stock. While generally speaking investing in index funds is the best bet, if you’re going to be a hobbyist investor and want to pick up a few individuals stocks without getting jipped on fees, now you have a great resource to do so.

So I got a little carried away tonight and purchase 6 individual stocks. They are limited in what stocks are available – but it turns out about 50% of my existing sharebuilder purchases are available. Unfortunately they don’t allow transfers in (bummer) so I’d have to sell my current shares in order to buy them again and trigger a capital gain just to consolidate my shares, not worth it. But the good news is now instead of wasting $4 per transaction on buying more shares of companies from Coca Cola to McDonalds to Apple, I can just buy however much I want to buy at whatever time and never have to worry about fees again. At least for the companies available to buy… which, granted, is limited at this time, but I bet will grow in the future.

I’m also testing the water for some new investments — I stopped adding new individual stocks to my sharebuilder account because the list was getting ridiculous and I couldn’t justify all the diversification¬†with fees cutting away at my gains… but now diversification is easy, fun, and free. My investments aren’t showing up yet (they take 3 days to transfer in) but tonight instead of splurging on a new pair of jeans I bought some stock for $10 here, $25 there. I’m impressed.

*Note if you are new to investing I still recommend buying Vanguard Index funds!!!

 

 

 

 

How Much Will Your Investment Be Worth?

One of the open questions I have re: investing is what – realistically – my investments will be worth after X # of years. Of course, one can estimate 3% annual return on the S&P 500 to be “conservative” and 10% to be the opposite, but in reality, what is the likely average annual return of the stock market?

While there’s no way to predict the future, lucky for us, there is a way to look at historical data to understand how we’d answer this question if we were to begin investing, say, in 1980.

According to this calculator РThe S&P 500 Dividends Reinvested Рwe can find out that answer:

Scenerios

  • We started investing in 1990, and stopped in 2010, giving us 20 years of investment.
    • Total S&P 500 Price Return: 256.374% (inflation adjusted: 118%)
    • Annualize S&P 500 Price Return: 6.6%¬†(inflation adjusted: 3.974%)
    • S&P 500 Return, Dividends Reinvested: 437.278%¬†(inflation adjusted: 228%)
    • Annualized S&P 500 Return, Dividends Reinvested: 8.770%¬†(inflation adjusted: 6.13%)
  • We started investing in 1984, and stopped in 2014, giving us 30 years of investment.
    • Total S&P 500 Price Return: 1094.274% (inflation adjusted: 427%)
    • Annualize S&P 500 Price Return: 8.6%¬†(inflation adjusted: 5.7%)
    • S&P 500 Return, Dividends Reinvested: 2299%¬†(inflation adjusted: 960%)
    • Annualized S&P 500 Return, Dividends Reinvested: 11.175%¬†(inflation adjusted: 8.19%)
  • We started investing in 1974, and stopped in 2014, giving us 40 years of investment.
    • Total S&P 500 Price Return: 2829% (inflation adjusted: 538%)
    • Annualize S&P 500 Price Return: 8.8%¬†(inflation adjusted: 4.7%)
    • S&P 500 Return, Dividends Reinvested: 1204%¬†(inflation adjusted: 1963%)
    • Annualized S&P 500 Return, Dividends Reinvested: 12.049%¬†(inflation adjusted: 7.8%)
  • We started investing in 1964, and stopped in 2014, giving us 40 years of investment.
    • Total S&P 500 Price Return: 2239% (inflation adjusted: 206%)
    • Annualize S&P 500 Price Return: 6.5%¬†(inflation adjusted: 2.2%)
    • S&P 500 Return, Dividends Reinvested: 10367%¬†(inflation adjusted: 1270%)
    • Annualized S&P 500 Return, Dividends Reinvested: 8.748%¬†(inflation adjusted: 5.3%)
  • We started investing in 1999, and stopped in 2014, giving us 15¬†years of investment.
    • Total S&P 500 Price Return: 37.5% (inflation adjusted: -2.845%)
    • Annualize S&P 500 Price Return: 2.1%¬†(inflation adjusted: -.192%)
    • S&P 500 Return, Dividends Reinvested: 81%¬†(inflation adjusted: 28%)
    • Annualized S&P 500 Return, Dividends Reinvested: 4%¬†(inflation adjusted: 1.6%)

Well, what this shows us is that generally investing in the S&P index over the long term works out fairly well. After inflation with dividend reinvestments 5% is a reasonable conservative estimate annual return for a long-term investment. However, if you started investing in 1999 and have invested for 15 years, you’d pretty much be at break even at this point (assuming you put all your money in up front.)

I’m still looking for a more robust calculator that enables one to input annual investments and see what these would have turned out with historic data. Do you know where one exists or care to build one I can use? ūüôā

 

Understanding the Roth IRA Conversion Pro Rata Rule & a Great Trick!

IRAs come in two flavors — traditional and roth. Both have income and contribution limits per year in order to take advantage of their benefits. Roth IRAs require that you pay taxes up front on any income you put into them, but then — this is where the magic happens — your interest grows tax free forever. You can take the total amount out at retirement and not pay any tax on it! You can also pass the total amount onto your heirs without them having to pay taxes. It’s a pretty spectacular deal, especially when you’re in a very low income bracket so you aren’t paying much in the form of taxes up front.

Traditional IRAs, on the other hand, are available for low income earners, often who do not have access to a 401k. With the traditional IRA one would put their money in and not pay taxes on this money up front, but then when they retire and take the money out it’s taxed as income for that year (theoretically your tax bracket would be lower in retirement, but this may not be true.)

Up until recently if you made too much money for an IRA you really couldn’t do anything other than invest in taxable accounts. Traditional IRAs were available but you weren’t able to take the tax deduction up front or when you took the money out in retirement, so the only benefit there was the years of dividends not being taxed and reinvested into your investments. It’s not even that great of a deal because then you’re paying income tax rates on your dividend yields versus dividend rates. Generally traditional IRAs for high income earners are useless.

However for tax benefits, today a higher income earner can do a little trick called a Roth IRA conversion. This occurs when the individual puts up to the year’s limit in a traditional IRA ($5500 currently) ¬†and then immediately converts that to a Roth IRA. Because the individual put in post-tax money and the conversion happened right away, no taxes are owed and basically that higher income individual has gone through a loophole to invest in a Roth. For younger folks in their 20s and 30s the ongoing compound interest and ultimate ability to take out the investments tax free might be better (do your own math to figure out if this makes sense for you.)

The trouble comes when you have multiple IRA accounts. Most often this is from 401k rollovers when you leave a job. A 401k is pre-tax money so if you want to roll that over to a Roth you will have to pay tax on not only the interest earned but also the entire amount of basis. That can be an expensive proposition!

That is where the “pro rata” rule comes in. Understanding how this works is a bit challenging. I’ll try to explain this in simple terms based on my research so it’s accurate and makes sense.

How the Roth IRA Conversion Pro Rata Rule works

At the end of the tax year (not the day you do the conversion) the government will look at all your non-Roth IRA funds to determine how much tax you need to pay. They¬†aren’t nice enough to let you get away without paying taxes on a conversion when there is tax money they could make. Instead they require you to pay pro rata on the amount you convert.

Let’s take an example very near and dear to my heart (so I can finally understand what sort of tax liability I’m looking at here.)

I would like to convert my current IRAs to Roth IRAs before rolling over my high-fee 401k (*or I need to get a new job with a better 401k as I can rollover my 401k to that so I can continue to do Roth conversions year after year.)

Vanguard IRA (from rollover 401k)

$26,987 (all pre-tax)

Sharebuilder IRA

$14,027.47 ($10k is post-tax, $4027.47 is pre-tax)

Due to the pro-rata rule it is not possible for me to rollover just the $10k of post-tax money today.

If I rollover the $10,000 of post-tax money, the pro-rata rule would take my total amount of IRA money $41014.47 to determine how much I actually owe.

To figure this out for yourself, follow the steps listed here.

1. Total up all of your IRAs (non Roth): $41,014.47
2. Total up all of your after-tax dollars in IRAs: $10000
3. Calculate your % of after-tax dollars: 24.38%
4. Determine the taxable amount of your distribution: ($20,000 distributed = $4876 tax free, $15124 taxable(!))
5. Exception for rollovers to a company plan: n/a

In order to take out the full $10,000 of post-tax money, I’d have to¬†convert the entire amount ($41,014.47) and pay taxes on $31,014.47.

Is either scenario worth it? Let’s play this out to the conclusions…

Assumptions:

  • 35 years growth
  • .05% average¬†interest rate
  • 30% federal and 10% state tax in retirement (40% taxes)

1. I do nothing, and leave my $41,014.47 to grow for 35 years until I turn 65 and retire.

  • $226,235 pre-tax
  • Total Value = $135,741 (@40% tax bracket)
  • ((15% tax bracket, in 0% income tax state, low annual withdrawals, would = $192,229))

2. I convert 25% of my IRA plans today

  • Pay tax on $15,124 at today’s tax rates (28% fed, 10% state – $5747.12 in tax)
  • Have $14252.88 remaining to grow tax free forever
  • $78,619 post-tax on conversion
  • + $116068 * 40% tax = $69640
  • Total Value = $148,260

3. Just for kicks, I convert 100% of my IRA today, paying tax on $31,014.47

  • Pay tax on $31,014.47 at 38% rate — $11785.50 in tax paid today
  • $29228.97 remaining to growth tax free forever
  • Total Value = $161,227

4. Additional test thrown in — low income year, 25% tax today

  • Pay tax on $31,014.47 at 25% rate — $7753.61
  • $33260.86 remaining to grow tax free forever
  • Total Value = $183,467

What do these calculations teach us?

  • The value of a Roth Conversion (if you have both deductible and non-deductible IRAs) is determined largely by your current tax rate and your expected tax rate in retirement (oh fun, guessing games.) Apparently people tend to overestimate how much taxes they will pay in retirement (i.e. maybe my 40% estimate is too high. You think?)
  • The conversion for an account that looks like mine MAY make sense if I can hold it for 35 years or longer. But it’s still not a sure bet. (I calculated everything at a 5% return YoY to be conservative.)

When Does the Roth Conversion Not Make Sense?

I haven’t done all of the calculations, but I assume at some age the roth conversions do not make sense UNLESS you have no taxable money to deal with. If you don’t have many years for the interest to compound and make up for what you paid in tax, then you’ve just paid a lot of money to the government to make less in the end. That’s what they want you to do. That’s what a lot of people who aren’t running the numbers are going to do thanks to this new rule.

When Does the Roth Conversion Make a Lot of Sense?

If you have one year of your life where you happen to not be making a lot of money — maybe it’s a year you went to school or took time off to have a kid — you will be able to do the conversion and pay your income tax on that conversion. If you are single and have no income, your first $36,900 of taxable conversion (or mix of conversion amount and income) is taxed at just 15% (the first $9600 at 10%.) This changes the numbers quite a bit!¬†So say you want to convert $20k with $10k of it non taxable and $10k taxable. You pay $1k on the first $9600 and 15% on the $400 ($60) so you’d pay just $1060 to convert your $20k, leaving you with $18940 to grow tax free forever — if you live in a no income tax state, anyway (most states will charge you income tax so factor this into your calculations as well.) That’s still a pretty great deal, but you’re also losing all of the money you could have made that year and put into your investment accounts, so it’s not worth it to do this unless you are already planning to take the time off. (And if you really want to be tricky move to a state with no income tax and don’t work for a year!)

(Note, married couples can stay in the 15% tax bracket up to $73,800 income including the taxable IRA conversion amount.)

The Best Trick I’ve Found (That is legal, at least for now)

If you have a work-sponsored 401k, find out if it allows you to “reverse rollover” pre-tax IRA investments. If you can do this, take all of your pre-tax IRA investments and move them into your 401k. You will have to keep those investments in the 401k until you change jobs again (and at least for a year) so if the 401k offers crappy, high-fee, high-load mutual funds you’re going to want to run all the numbers in your specific situation. That said, if you have a decent 401k and can rollover your funds into it — you can roll them over and then only pay taxes on ¬†your interest on any post-tax IRA contributions for the Roth conversion. This means that you can save a lot of money and do a few years of IRA conversions to grow your roth (esp if you are a high income earner and are already maxing out your 401k.)

Now that I’ve figured out this is do-able, I’ve immediately decided to rollover my existing crap high-fee 401k into my Vanguard low-fee, no-load Admiral funds IRA account. I’ll let those babies grow until I have a nice 401k at a future job (knock on wood) that lets me roll over my IRA for a while, and I’ll convert at least the $14k of traditional IRA investment plus probably another $5.5k for the current plan year. I will have to run the numbers myself at the time but I think this is probably the best idea.

Even if that doesn’t work out, the actual growth on my pre-tax accounts will still be beneficial and perhaps my actual tax rate in retirement won’t be quite as high as I think it will be. It still might be best just to leave these accounts alone and continue putting $5.5k in a Roth every year that I’m eligible, whether I’m in school and working part-time or unemployed and unexpectedly coming in within the income limits to contribute to a Roth.

Have anything else to add? Think I don’t explain this well?

Leave a comment with your tips and ideas for when a Roth IRA conversion makes sense, and when it doesn’t. Did I get something wrong here? Let me know. Thanks!

 

Should I Rollover My 401k? The Cons

Common financial sense says that you should rollover your 401k into an IRA account as soon as you leave a job. Besides keeping all your financial accounts in one place (so you don’t have a bunch of orphan 401k accounts floating around), fees on typical 401k accounts are painfully expensive (remember in our last post we discussed how after 30 years on a $100k investment every .10 increase in percentage points will cost over $50,000 in fees.)

However, there are some lesser known reasons why you should leave your 401k where it is, at least for the short term.

1. Penalty-Free Retirement at 55 vs 59

The government isn’t ok with you withdrawing funds from your IRA before 59 1/2, but for some reason you’re allowed to withdraw from your 401k at 55. This doesn’t make any rational sense but government rules never do (source)

2. Roth Conversions Get Much More Expensive After a Rollover

A few years ago the government made another rule that doesn’t make any sense — you’re not allowed to contribute to a Roth IRA (i.e. after-tax money that you can take out for free in retirement and that you can pass on to heirs tax free) BUT you are allowed to put money in a traditional IRA, post-tax, and immediately convert this to a Roth IRA tax free. (Did I mention the government makes NO FREAKING SENSE?) However, if you have additional IRA funds, especially ones you haven’t paid tax on yet, you have to pay a pro-rata fee for the percentage you want to convert. I’m going to write a separate post about this pro-rata rule because it’s so complicated I don’t even understand it yet, but basically once you have more funds in traditional IRAs you’re liable for tax on part of them as well if you want to do a Roth conversion, and this can be very expensive and eat into your future earnings (source)

3. Better Creditor Protection

In yet another rule that makes no sense (notice a trend here) 401ks are protected more than IRAs in the case of lawsuits and such. How screwed you are in the case of a personal liability lawsuit depends on what state you live in. For example, New Hampshire and New Mexico have no protection against creditors for your IRA, whereas your 401k can’t be touched. (Say it with me now – this doesn’t make any freaking sense!) In some states, such as Texas, Arizona and Washington, your IRA is treated with the same protection of a 401k , so this rule wouldn’t apply to you (source)

4. Fees Can Be Lower (Though This is Unlikely)

Often the 401k offers access to different funds then you would have access to as an average investor. A lot of articles argue that you could be better off staying with a 401k funds… but make sure to look into the fees of these funds. Mutual funds can cost 1.4% per year or .80%, but those are still high fees compared to a basic Vanguard fund at .10% to .25%. Ask yourself if you really think this fund will perform better than an index fund (hint – it probably won’t, or at least not enough to make up for lost earnings due to fees) (source)

Can you think of any other reasons to keep your 401k at your old employer? #2 and #3 seem to be the best arguments. Tomorrow I’ll share a post that further explains Roth conversions – because they confuse the heck out of me so I need to do some better research, and I’ll share my findings with all of you!

Vanguard Admiral Funds: Rebalancing for Lower Fees

One of the things I realized recently that I’ve been spending more than I have to on fees inside of my IRA accounts. While Vanguard funds are low fee to begin with, did you know that Admiral funds (which require $10k minimum investment per fund vs $3k) still have significantly lower fees?

Fees can significantly eat away at your investments, especially over time in your retirement accounts. I know for a fact my old 401k that I haven’t rolled over is wasting money with some of its funds at .90% fees or higher! I’m holding off on rolling that over in the case I will do a Roth IRA conversion if/when I go to grad school on about $100k of other IRA investments, but for all my other accounts I want to be as fee-efficient as possible.

Expense Fees Add Up Fast!

Here’s a little experiment… (try your own out in this expense ratio calculator) say I invest 100,000 today and plan to keep that money invested for 30 years. I earn an average of 10% each of those 30 years (woohoo.)

If my fund has a low .10% expense ratio then I’ll see a 2.96% reduction of my future value due to fees (costing $51,596.) This sounds like a lot, but it really isn’t compared to the cost of most funds.

Say you have a still relatively low-cost fund at .20% expense ratio. You are then spending 5.83% of your future value on fees ($101,716!)

Some funds have high expense ratios too. If you are investing in a fund that has an expense ratio of .80%, 21.51% of your future value is gone thanks to this fee ($373645.77!!) So you see how a little expense ratio can quickly add up.

After reading a bit more about taxes and what funds to hold in Roth IRAs vs traditional IRAs I decided to shift around funds in my Vanguard accounts. I also changed things up over at Sharebuilder because my $10500 basis Roth over there is significantly underperforming, but I’ll cover those changes in another post.

Also, I read that high-dividend funds make sense in your Roth IRA but not in your traditional IRA. Why? ¬†Because dividends have two purposes — to provide you income today at low(ish) capital gains tax rates, or to compound over time in your investments and to be taken out tax free upon retirement (in a Roth.) Going high dividend in a traditional IRA is silly because you have to pay income tax on it when you retire and take it out — i.e. those proceeds would be cheaper today in a taxable account!

Until today, my Vanguard IRA accounts looked like this:

Traditional IRA

VDAIX / .20%
VHDYX / .19%
VGSIX / .24%
VTTSX / .18%
VGTSX / .22%

Roth IRA

VFIFX / .18%
VTSAX / .05%

Updates to my Portfolio

While there was nothing wrong with this breakdown, per se, I had high-dividend REIT and dividend growth funds in my traditional IRA while I had index growth funds in my Roth. I also had certain funds split between my Roth and Traditional IRA where because I had $10k split between two accounts I couldn’t qualify for the lower admiral fund rates.

Luckily at Vanguard it’s free to trade your funds inside your account, so rebalancing is easy (unlike at Sharebuilder where I’m wasting tons of money trading and will eventually give in and just move my “fun money” to Vanguard.)

I made quite a few (free) trades at Vanguard to fix my portfolio. Here is what I have now, which, as you can see is greatly simplified:

Traditional IRA

VIGAX / growth index fund admiral shares .09% expense
VTIAX / admiral version of VGTSX¬†— .14% expense vs .22%

Roth IRA

VDADZ / dividend appreciation index fund — .10% expense ratio
VGSLX / admiral REIT fund — .10% expense to .24% of VGSIX

I also killed off all of my “target retirement date” funds because I’ve read they are too conservative and at my ripe young age of 30 I want to be aggressive but not stupid (working on the not stupid part.)

Why keep my Sharebuilder account open at all?

Good question! Mostly I keep it open so I can trade precious metals in my Roth IRA (i.e. GLD) since they are taxed at a collectible rate (high tax) unless they’re in an IRA, and I can’t buy gold or silver in my Vanguard fund. I also have some specific REITs which I like to watch to learn more about REITs because they are interesting — especially since I do not actually own any tangible real estate. More on that later.