Sometime last year you converted some funds from your pretax IRA account to a Roth. Now, the market is down (The S&P index down about 5% year to date) and you are thinking that paying the tax on the higher value when you first converted isn’t the greatest idea.

Or, you make have realized when you filed your return that the extra taxable income put you into a higher tax bracket. Why pay 25% on that conversion when your regular rate is running at just 15%? In hindsight, it’s easy to look at your return’s ‘taxable income’ line and see where you fall. You can recharacterize just enough to keep you in your original bracket. Don’t forget, you had the option to spread the income over two years, 2011 and 2012 or to take it as income in 2010. If so, you need to look closely at how your 2011 income is doing along with how your investments in the Roth have fared.

It’s nearing the deadline, 6 months after that April 15th Tax Day, or October 17th as October 15th is a Saturday. The clock is ticking!

written by JOE \\ tags: IRA, Retirement, roth ira

It always starts like this – I save (for example) 15% toward retirement, spend 28% on my mortgage, and between Social Security and Medicare 7.65% comes off the top. This is 50% of my income that I won’t have to spend once retired, so a starting point is that I’ll need 50% of my pre-retirement income to retire at the same lifestyle once retired. Add another 20% or so as a buffer for increased medical expenses as I get older, and 70% should be more than enough. Right?

Not so fast, says Dan Ariely, behavioral economist and author of best sellers, Predictably Irrational and The Upside of Irrationality.  In his recent blog post Asking the right and wrong questions Dan suggests that this method (what I call a top-down approach) underestimates the required income for the lifestyle people desire during their retirement. Dan suggests that instead of using the method I started with, that we look not at our current budget and reduce from there, but rather ask the key questions “How do you want to live in retirement? Where do you want to live? What activities you want to engage in?” In Dan’s study (which isn’t shared or linked to, unfortunately) by asking these questions he discovers an average result of 135%.

Let’s take a step back and understand the implications of this. Assuming social security replaces 35% of pre-retirement income (accurate at a $70K income level), then for the 70% replacement, only 35% more is needed, vs 100% as the gap for Dan’s 135% total. This is nearly three times the required retirement savings. If we rely on a 4% withdrawal rate as being safe, it would take 25 times the first year withdrawal as a total amount saved. Just under 9 times your final income to replace 35%, but 25 times final earnings to replace that 100%. Ouch. Considering how low the savings rate is in the US, these numbers are pretty intimidating. I don’t know if these studies serve as a wake up call that we need to save more or if they are just a source of discouragement, showing us how far we are from a satisfying retirement.

What do you think of Dan’s article? How will it impact how you look at what you’ll need to retire?

written by JOE \\ tags: Finance, Retirement, Savings

A few days ago, I saw a tweet that led me to read a CBS article Calif. commish advises teachers give up pensions. The article suggested that the state could no longer afford to pay out on its pension obligations and that changes would have to come. It went on to say that after teaching 35 years, a teacher could expect to get 80% of her salary as a pension each year. Wow! Sign me up, who gets a pension like that in this day and age?

Wait a second. There’s one not-so-minor detail the article conveniently overlooked. These teachers are not in the Social Security system. Another minor oversight – according to a CALSTRS (California State Teachers’ Retirement System) report the teachers still pay in 8% per year of their own money to their pension plan. Now, forgive me, but it’s time to do a little math. In the normal system, one’s employer pays in 6.2% of the employee’s salary to Social Security. Companies’ average 401(k) match is about 3%, but for sake of round numbers let’s assume California puts in a total 8% even, just matching the 8% coming out of the teacher’s pay. So we have 16% per year saved. I pull up a spreadsheet, which will adjust for inflation right till retirement, and enter 16% as the percent saved, a 3% inflation rate, and just an 8% return each year. (Note – Dave Ramsey says I can enter 12% rate of return, but I’ll stick with the 8%) After 35 years, we have 14 times the last year’s income as the amount saved in the retirement account. At 55, an immediate annuity will return 5.82% for a woman (more for a man, we don’t live as long) and to finish the math 14 x 5.82% is…… drumroll…. .816 or 81.6% of final income. No smoke, no mirrors, and just a lousy 1.8% match. My employer gives us 5%, many give more.

What’s ironic to me is that if new teachers simply got this 16% deposited to a private account there’s a great chance they’d actually come out ahead of that 80% income replacement. It comes down to a question of defined benefit vs defined contribution, who will take on the risk? But reflect carefully on the numbers, these teachers aren’t getting a windfall, not by a longshot. Perhaps the author of the CBS article should get, as Paul Harvey says, “The rest of the story.”

written by JOE \\ tags: calstrs, pension, Retirement, teacher

Dave had published his expectations that the market would grow 12% on average and right until 2000 there was little reason to dispute this. Only, there was something wrong with Dave’s math even then. There’s a difference between the long term CAGR (compound annual growth rate) and the average return. Let me explain. If in one year, the market is up 20% and the next year it’s down 10%, you’d be inclined to add (-10+20)= 10, then divide by 2, for a 5%/yr average return, right? But, the way to calculate the CAGR is to take the returns, and multiply, 1.2*.9= 1.08. this is over 2 years, so you take the nth root, in this case 2, and get 3.92% per year. This may seem a minor difference, but it accumulates over time, and down years of say 33%, take a 50% increase to overcome.

Let’s look at the danger of relying on this magic 12%/yr number. First, if you wish to tinker for yourself, I wrote a small spreadsheet you can download to your computer. I start with the premise that (a) we shouldn’t count on Social Security, if it’s there in 30 years, treat it as a bonus. I also believe that 4% is the safe rate of withdrawal from your retirement account. This multiplies up to a requirement to have about twenty times your preretirement income saved as a lump sum, so you can withdraw 80% of your final income each year. Last I use 43 years of work, from age 21 to 63. When assuming a conservative 8% return per year, we find that we need to save 15% of our gross income. Not too crazy if you are dedicated to keeping your spending under control.

Now, if we run the numbers that Dave suggests, a 12% per year return tell you that you only need to save 5% per year. Wow, you think, I can really afford that, but 15% is crazy. You then find that after a decade like we just had, the compound return was a negative 1% per year. You see that by investing only 5%, you saved up about 42% (after losses) of your current income, and even if the market gets back on track, you still find you have only 15 times your final income. If the market return is a lower 8%, you retire with only six times your income, enough to withdraw less than a quarter of what you lived on prior.

On the flip side, by saving 15% as I suggest, even after this bad decade, an 8% return for the remaining time will put you at just under 18 times your final income, just a 10% shortfall. The reason Dave scares me is that even in my most optimistic days, I never assumed a 12% return long term. Not long ago, I wrote an article titled A Change of Plans, in which I looked at the S&P chart from 1980 through 2000 and extrapolate where it should have been 10 years later, in 2010:  3600, 4 times the value it actually was in 2010. Admittedly, I didn’t expect an entire decade to produce a loss, nor did I expect, as Dave did, to see 210% gains.

I’m curious what Dave’s followers did over the last ten years, have your expectations changed? Dave has only dug his heals in further, recently writing The 12% Reality. Sorry, I call it the 12% pipedream. Let me close with one question – would you rather plan for 8% and when returns are actually 12% or higher, find you can retire at 45 or 50, or would you plan for 12% and if the market stumbles even a bit, have to work till you are 70?

written by JOE \\ tags: dave ramsey, investment, Retirement, Savings

I’ve written about Roth Mania and will stick to my premise, that conversion to Roth makes sense for some people, not all, and rarely a whole conversion of all of one’s IRA balance. Today, I’ll share the story of a woman whose taxes I do. She is retired, a widow, and has an IRA with an otherwise growing RMD (Required Minimum Distribution.) The RMD is based on the number of years the actuarial tables say you have left on this earth. As an example, at 70-1/2, your first RMD is 3.6% of your IRA balance, at 75, it’s 4.4%, and by 80, it creeps up to 5.3%. This doesn’t seem too bad, but in normal times, if the market is growing at even a modest 6-7%, the balance in the account is growing as well, and the dollar amount you must withdraw at 80 may be two or three times what you had to withdraw at 70. Years ago, when I first did this woman’s taxes, I observed that she was in the 15% bracket and had about $9,000 or so before she’d hit 25%. So, each year since then, we’ve done a dry run of her numbers, and converted just enough to put her in the 25% bracket. When the final numbers are in, we recharacterize so the taxable income line precisely matches the dollar amount where 15% ends and 25% begins. Got that?

A graph over the years might be cool, but I’ll just offer the tax table from Fairmark, (my thanks to Kaye Thomas for the ok to copy it) a publisher of financial books focusing on taxes and retirement accounts. You can see above, in 2010 any amount over $34,000 is taxed at 25% , but the prior dollar was taxed at just 15%. This strategy of “Topping off” her 15% each year will keep her RMD from growing and forcing her into the 25% bracket. Also, the Roth balances will pass to her heirs on her death, tax free (she’s well under any estate tax concerns) but they will need to take RMDs regardless of their age. Any thoughts on this strategy, I’d love to hear from you.

Joe

written by JOE \\ tags: Finance, IRA, Retirement, Roth, roth ira

In case you are new to the word Roth, a Roth IRA is a retirement account (note – I’m in the US, and most of my tax related writing is going to pertain to US tax laws) which is the opposite of the traditional IRA. The traditional IRA let’s you deduct the deposit from your income and enjoy years of tax deferral, paying tax when you with the funds, presumably at retirement. A Roth IRA lets you make deposits with money that’s already been taxed, but the current law says it will never be taxed again, not even when withdrawn.

Now, the 401(k), 403(b) and starting this year, the 457(b) can have a Roth side, where similar to the IRA, deposits are post tax. Given the Traditional (pre-tax) 401(k) has been around for 31 years now, that’s quite the balance sitting there. Now, the IRS regulations permit you to perform an in-plan rollover, converting your employee retirement plan from the traditional to the Roth side if your employer has adopted the rules as well. The amount converted is taxable as ordinary income, and no penalty is due as might be for an early withdrawal.

I admit, there’s no absolute answer on whether converting to Roth, whether from an IRA or 401(k) is advisable. But I will point out, if you are in the 15% bracket, or lower, it’s worth considering. From my friends at Fairmark, I can see the marginal rates for 2011. For a married couple, the 15% bracket ends at $69,000. The exemptions and standard deduction add another $15,300, so total gross of $84,300 or lower and you are in the 15% bracket. My low-risk strategy is to convert just the amount to “top off” that 15% bracket, bringing your taxable income just to that $69,000 level. Note, if you convert your IRA, you are allowed to recharacterize back to traditional, a financial do-over, but this is not permitted within the 401(k) to Roth 401(k) process. So do the math, choose carefully, ask questions.

written by JOE \\ tags: Finance, IRA, Retirement, Roth, saving