Roth IRAs: A Bad Idea?

I have a feeling this may turn out to be one of the most useful things I EVER post.David Collum is a professor at Cornell University and a wickedly funny financial pundit and sometime blogger. Perhaps more consistent and better than I on that count. ;) Each year since 2009 he has written an annual review of what he has found most important to him and his investing thesis. It's a great read. Google it.

Last year his think piece contained a discussion of Roth IRAs. He has an interesting take. In short, he believes they are a scam. I could re-characterize what he said but I found the whole argument so worthwhile that I am going to simply CUT AND PASTE IT and let you hear David and what he has to say, because by comparison to David I am a very poor writer. I did omit the numerous embedded citations though. Enjoy!

Roth IRA: A Bad Idea

Before leaving the world of pensions I’m gonna pick a fight with Roth IRAs. When the Roth IRA was first announced I had a unique—as in only-guy-on-the-planet unique—visceral response. The original IRA was very farsighted: Savers were allowed to compound wealth unfettered by taxes while the government deferred tax revenues to future generations. By contrast, the Roth IRA pulled tax revenues forward, leaving future generations to take a hike. Imagine the truly awesome demographic problems we would have if the Roth had been introduced in the 60s and the entire baby boom generation became entirely tax exempt. Was this an oversight? I don’t think so. The introduction of the Roth and the substantial revenues from regular-to-Roth rollovers coincided with the Clinton administration’s efforts to balance the on-balance-sheet Federal budget for the first time in decades. That is my minor gripe. To set up my really big gripe we must first dispel a widely held misconception and a common oversight.  In a regular IRA, the money is taxed at the end, whereas in a Roth IRA taxes are levied up front. If the two are taxed at the same rate—this is a critical provision—the outcome is identical. They are not just similar, it’s an identity. Break out your calculator if you must. There is no differential advantage offered by compounding in the Roth over the regular IRA. Simply put: Any advantage of the Roth IRA relative to a regular IRA necessarily stems from a lower tax rate while working than in retirement. Period/full stop.  The tax rates of the Roth and regular IRAs are fundamentally different: Roth IRA: Front-end loaded taxes paid at the marginal tax rate (highest tax bracket). Regular IRA: Back-end loaded taxes paid at the effective tax rate (integrated over all tax brackets). The distinction of marginal versus effective tax rate is critical and seems to be lacking from most analyses. One can calculate marginal and effective rates for any income online.  Let’s return to the top-5-percentile family—the 5 percenter. If they had used a regular IRA, they would be paying a 7% effective tax rate incurred on their $48,000 per year withdrawal in retirement. They paid an approximate 32% marginal tax rate—the tax rate at the top bracket—to shelter a few thousand per year in a Roth IRA. The numbers simply do not work. It is worse than that. Let us consider the lucky soul family—the extraordinarily rare couple—who actually accrued 25 annual salaries in their retirement account. For this family a 4% annual withdrawal will be equal to an annual salary while working, placing them in the same tax bracket (ignoring unknowable tax law changes). Even so, they paid 32% marginal tax on the Roth to avoid a 22% effective tax rate incurred by the regular IRA. The numbers still don’t work. I do not understand why the Roth is being sold so enthusiastically to the public. Now ponder all those folks who rolled over a lump sum from a regular to a Roth IRA. They not only paid the marginal tax rate on the rollover but caused the marginal rate to spike to a higher level! It’s hard to imagine that will prove to be a smart move. Congress is considering moving all pension funds to what is effectively Roth IRA rules as part of their Fiscal Cliff negotiations. You young guys are about to get hosed.

It didn't happen but Congress WAS entertaining that last idea. Is it coming? I don't know but it's a huge watch out. Anyway, a great take on Roth IRAs and a valuable counterpoint to all the financial planners and brokers who eagerly pushed their clients into the Roth orbit in The Great Roth Asset Collection of 2011/2012 that we discussed before.

The Rising Tide of Taxes

An ongoing theme of this blog is the necessity of rising taxes in an economy structured in a manner such as ours. Whether it is Tax Freedom Day or Cost of Government Day, we see the historical trend toward later and later dates by and large to fund the operations of government in the U.S. Here's the announcement from the Americans for Tax Reform Foundation and the Center for Cost of Government:

In 2012, Cost of Government Day falls on July 15. Working people must toil 197 days out of the year just to meet all costs imposed by government. 2012 marks the fourth consecutive year COGD has fallen in July. From a different perspective, the cost of government makes up 54.0 percent of annual gross domestic product (GDP).

The most telling event in the latest "fiscal cliff" negotiations was both parties agreeing to end the payroll tax holiday (2%)at a moment in time where the economy was visibly weak. Wow. The government is simply desperate for income.

Note: Last year's date was favorably revised to July 18 from an August initial estimate. The 2012 date represents a three day improvement. Prior to 2008, the date had never fallen past June. The past 4 years have occurred mid-July. MPM

Has It Been Two Years?

I can't believe it. It's been two years since I last posted. I haven't checked the site in MONTHS. Yet I still see I'm getting page views.

Are you people so starved for something to read that you have to visit HERE? To what *I* write? :) Wow. I am humbled.

I do have some thoughts on what is going on. Very dangerous times methinks. I do not see the open ended promises of continuous market injections by Ben Bernanke and the Federal Reserve as a long term good. Do I see it as inflationary? Well we've posted on that before. In my opinion it will take years for substantial inflation to appear in the economy. Too many deflationary forces in place. Is it destabilizing though? You betcha. Junior was just handed a set of keys to the car and only has a learner's permit. I think it was absolutely the wrong signal to give market participants. Will it help the economy? I don't think that QE1 or QE2 helped the economy in any material way and neither will this. Will it help the stock market? In the short term. Maybe even *very* short term. It's clear from my models that these actions are having smaller and shorter effects.

As a planner how does one advise his clients? Again, in the short term I think the chances of a market advance are not insignificant. But less so than the first two rounds of Quantitative Easing. Maybe as little as 55/45. If invested, I'd have two hands on the wheel. If not invested in stocks, I'd find something cheap to invest in. Hedged equities. A cash plus strategy. Certain balanced risk strategies (risk parity), although those will fail too if correlations go to one again (like 2008). Good luck!

A Break In The Action

I haven't been posting lately. I took on some new outside activities for myself in addition to my normal obligations. I'm going to see how those go before deciding whether to resume or not.

The Continuing Saga of Your House As An Investment

From the Report issued by CoreLogic:

CoreLogic reports that 11 million, or 23 percent, of all residential properties with mortgages were in negative equity at the end of the second quarter of 2010, down from 11.2 million and 24 percent from the first quarter of 2010. Foreclosures, rather than meaningful price appreciation, were the primary driver in the change in negative equity. An additional 2.4 million borrowers had less than five percent equity. Together, negative equity and near negative equity mortgages accounted for nearly 28 percent of all residential properties with a mortgage nationwide.

The Rising Tide: Taxation

This is not a political post per se but the theme of inexorably rising taxes has been a focus of this blog. For planning purposes.

We learn today that Cost of Government Day, a calendar date by which the average American is deemed to have paid for the cost of government falls on August 19th this year, the latest date ever recorded. The entire report of the Americans for Tax Reform Foundation is in the link above.

From the Report:

Cost of Government Day: Trends
Cost of Government Day (COGD) falls 8 days later in 2010 than last year’s revised date of August 11. In 2010, the average American will have to work an additional 51 days out of the year to pay off his or her share of the cost of government compared to 2000, when COGD was June 29.

In fact, between 1977 and 2008, COGD has never fallen later than July 20. 2010 marks only the second year that this has happened—2009 being the first. The difference between 2008 and 2009—from July 16 to August 11—was a full 26 days, spurred primarily by the Emergency Economic Stabilization Act (EESA) that created the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment
Act of 2009 (ARRA).

A look at methodology is below:

The Cost of Government is determined by adding the figures for government spending (federal, state and local expenditures) and an estimate of the cost of government regulations (both on the federal
and state level). The total cost of government is then divided by an estimated Net National Product to determine the percentage of national income consumed by government. This percentage is applied to the 365.25 weighted calendar year to determine the date of Cost of Government Day.

More Tax Planning Havoc: Coverdell Savings Accounts

As presently constructed, Coverdell college savings accounts are a great deal, even better than the more widely known 529 savings plans. We've discussed their features here. But the tax breaks that made Coverdells a favorite of so many planners and their clients are expiring at the end of 2010. Will Congress act on this one? We don't know.

You've got about five months to figure out what to do with your account. Here's what we said about Coverdells before:

1. Annual contributions are capped at $2,000 per beneficiary. They can come from any source but if the total exceeds $2,000, the IRS will slap a 6% tax on the excess.

2. Contributions are not tax-deductible. But any growth in the investment is tax-deferred, and money can be pulled out tax-free as long as it is used for qualified education expenses, which include items such as books, tuition, room and board and necessary equipment, such as a laptop computer.

3. Money can be withdrawn to cover approved expenses for kindergarten through 12th grade, as well as higher-education expenses. Approved expenses could include private-school tuition or an after-school tutor.

4. The money has to be used before the beneficiary turns 30. If the beneficiary reaches 30, or if the money is used for anything but education expenses, the IRS will levy a 10% penalty plus regular income taxes on the amount pulled out. One major exception: Special-needs beneficiaries can continue to draw from their accounts, tax-free, to cover approved expenses after the cutoff age. Contributions can also be made for a special-needs beneficiary after he or she turns 18.

Why use a Coverdell instead of a 529 Plan?

* Flexibility: Coverdell money can be spent on expenses for kindergarten through 12th grade; 529s are limited to higher-education expenses only.

* Wider investment choice: Coverdells must be held by a bank, a brokerage or some other institution approved by Federal law to handle them. Depending on the trustee chosen, investment choices in a Coverdell can be very broad, including stocks, bonds, mutual funds and nearly any other type of investment vehicle offered by the trustee. Most 529 plans limit their investors to only those options provided by their plans. Those choices are often as narrow as the limited selection of mutual funds offered by only one company. In a handful of states, 529 investors can opt instead for prepaid tuition plans.

So what should you do?

Well, if you like Coverdells there no reason to assume everything just goes away or that Congress will be punitive with how it handles them going forward.

You can always transfer the balance of your child's Coverdell account into a 529 plan for him or her. Wait to see what Congress decides to do with them and then make your own plan.

You could always pull money out for private school, if that's what you've been saving for. Use it know. There's always the risk that this distinction goes away and it's your last chance.

You could use up the account early by buying a buying a computer for your child or other supplies he/she will use at school.
You can just keep making contributions. I can't see a scenario where Congress doesn't allow you to convert the funds to a 529 plan.