Archives For February 2008

Another JLP Roundup

February 29, 2008

It’s been a while since I put together a roundup. Anyhow, here are some interesting findings from the MoneyBlogNetwork and beyond:

Flexo talks about how Ben Stein’s parents are well-off thanks to variable annuities. – Ben also is (or was) a spokesman for the NAVA (the National Association for Variable Annuities) so you kind of have to take his love affair for annuities with a grain of salt.

Nickel has a guest post from AFM reader and commenter, Dylan, about gambling and the stock market.

Six extreme ways to save.

JD says—and I agree—that the the key to wealth is being satisfied with what you already have.

NCN hosted this week’s Festival of Frugality.

This life brought to you by the bank of mom and dad.

BluntMoney with some awesome wisdom: you’re standing in your own way! – Making excuses won’t solve your problems!

Small change can lead to $1,000,000!

Here’s 3 things that will make you better than 99% of investors. – Yeah, it’s all common sense but it’s amazing how many people lack common sense.

Jeremy has a list of 20 books that will change your life and the way you think about retirement. – Even with all the books I have read, I have only read a few from Jeremy’s list.

LazyMan actually learned 3 things from one of the worst personal finance books ever! – Take a wild guess what book I’m talking about.

Jonathan has 9 traits of the middle class millionaire.

Trent reviewed Debt is Slavery.

Finally, here’s how Meg would buy happiness. – Sounds like a lovely day (if you take out all the girly stuff).

I have read in the news lately that more and more people are tapping their 401(k) plans in order to get cash to pay bills. It doesn’t take a genius to figure out that in most cases, borrowing from your 401(k) is a bad idea. That said, I thought would be interesting to try to put some numbers to a 401(k) borrowing scenario to see how much a loan really costs.

The Example

With everything, borrowing from a 401(k) isn’t as simple as it seems. There are a lot of variables involved in trying to make a total cost estimate. For my example, I used the following assumptions:

1. Annual income of $80,000 or $3,333 twice per month (24 times per year).

2. 401(k) contributions of 10% per year before the loan was taken out.

3. A $10,000 401(k) loan is taken out on 12/15/2007 and paid back in equal installments over 48 months (96 payments total).

4. The 401(k) loan carries a 6% interest rate, making the AFTER-TAX payments $117.30 PER pay period.

5. Before-tax contributions to the 401(k) are reduced to 6.5% in order to keep the total amount of the after-tax loan payment ($117.30) and the before-tax contribution ($216.67) roughly equal to the previous before-tax contribution of $333.33 per pay period.

6. The 401(k) balance before the loan was $100,000.

7. The rate of return on the 401(k) is 8% per year or .33% per pay period. – I realize that straight-line appreciation isn’t the norm in the real world, but I had to factor in growth somehow.

8. For the income tax calculation I used 2008’s income tax brackets, standard deduction (for married filing jointly), and personal exemptions:

2008 Federal Income Tax Marginal Rates for Married Filing Jointly

Wow! That’s a lot of assumptions! Now for the results:

According to my numbers, here’s what the situation would look like over the next four years:

So, assuming that over the next four years you didn’t get a raise and the tax rates didn’t change, you would pay roughly $1,700 more in taxes and your 401(k) account would be $14,000 smaller if you went with the $10,000 401(k) loan. The balance difference will grow significantly over the years due to compounding so it’s conceivalbe that the extra $14,000 could grow to over $140,000 over 30 years. That’s a significant difference!

The situation gets a lot better IF you can afford to pay back the 401(k) loan AND keep your contributions the same as they were before the loan:

Your 401(k) ending balance is down a bit but you don’t take a hit on your income taxes because your contribution levels stay the same, which keeps your taxable income the same.

The Bottom Line

So, how can you minimize the negative impact of a 401(k) loan?

1. For starters, don’t take out a loan if you don’t need it!

2. If you do need a loan, then take out the smallest amount possible for the shortest amount of time possible.

3. Try to keep your contributions at the same level during the loan payback as they were before the loan. This will keep your taxable income at the same level and keep you from having to pay more income tax.

4. Take out the loan right before a market decline! LOL! I’m joking on this one since it’s not feasible to time the market.

Any questions or thoughts? Did I miss anything? Leave a comment or shoot me an email and I’ll see if I can answer them.

While doing some research for a follow-up on the Roth 401(k) vs. Traditional 401(k) post from yesterday, I discovered something interesting. One of the campaign promises we keep hearing from members of a certain political party is how we need tax cuts for the middle class. What these candidates have failed to mention is that the tax burden on the middle class is a lot less now than it was under the last administration.

Take a look at the marginal tax rates from 1998 and 2008 (for Married Filing Jointly) along with the standard deduction and personal exemption information:

I wanted to do a side-by-side comparison to see how much a middle-class family of two would pay in taxes over a career if the tax rates stayed the same. Before I ran the numbers I adjusted 1998’s standard deduction and personal exemption for inflation, which brought it inline with 2008’s numbers. I also assumed the following:

1. A married couple filing jointly with a household income of $60,000 in 2008 with a 3% salary increase every year for the next 30 years.

2. A 10% contribution to a traditional 401(k).

3. The couple took the standard deduction and two personal exemptions each year (the 1998 standard deduction and personal exemptions were adjusted for inflation).

4. Taxes were calculated using the numbers from the above brackets.

According to my numbers, over a 30-year career, a couple could expect to pay over $107,000 more using 1998’s numbers than they would using 2008’s tax rates. NOTE: If you are interested, you can download the Excel spreadsheet I put together for this post by clicking here.

Now, in all fairness, I must mention that the likelihood of tax brackets NOT changing over a 30-year career is slim to none. But, as they stand right now, the middle class is paying less in federal income taxes now than they were when Clinton was in office.

The housing and mortgage crisis is quickly becoming an all-out bailout funded by responsible taxpayers.

I’m scratching my head trying to figure out what exactly our government is trying to do regarding the mortgage crisis. Today’s Wall Street Journal had an article ($) detailing Barney Frank’s (or is it Barney Fife?) plan:

Barney Frank (D., Mass.), the chairman of the House Financial Services Committee, is floating an initiative that aims to refinance as many as one million “distressed” homeowners out of high-cost loans using government assistance. The proposal, which could cost as much as $15 billion over five years, would likely involve the federal government buying loans and then helping move borrowers into mortgages backed by the Federal Housing Administration. Certain loans, such as investment properties and those on vacation homes, wouldn’t qualify.

I’ve said it before: unless we give the houses to these people, there’s no way they will be able to afford the payments. Lots of homes (though not all) were purchased using interest-only mortgages. The interest portion of the payment was LESS than the portion that went towards the principal. So, even if you refinanced into a mortgage with a 0% interest rate (which isn’t going to happen), these folks’ payments would still go up.

Though I disagree with Barney Frank’s plan, it’s this part of the article that bothers me the most [emphasis mine]:

The program might be less costly if the housing market improves or if the borrowers with government-backed loans are able to handle their new mortgages. Mr. Frank is also working on a provision that could limit the government’s potential exposure, but in an interview he defended a federal role in stabilizing the housing market. “It was the lack of government intervention that got us here,” he said.

Sure, that’s the answer: MORE government regulation! Give me a break!

Meg’s post from the other day mentioned the possibility of a national sales tax (consumption tax) and the negative impact it would have on the Roth IRA and 401(k) since the contributions to those plans were already taxed and would be taxed again when spent during retirement. This leads me to today’s question of the day:

Do you think the national sales tax will ever fly?

Personally, I don’t ever see us going this route (and I’m not necessarily saying that a national sales tax is a bad idea). I think there are just too many hurdles to overcome and I don’t see our government embracing something so different. In other words, I wouldn’t let the thought of a national sales tax keep me from contributing to a Roth IRA or 401(k).

Now, what are your thoughts?

I saw this little tidbit of information regarding stocks and inflation in yesterday’s Ahead of the Tape column ($) in the Wall Street Journal:

Since 1952, the S&P 500 has gained just 0.2%, on average, in the year after the consumer-price index has grown by at least one percentage point more than its five-year moving average, according to a study by Ned Davis Research.

Currently, the CPI is outpacing its five-year average by 1.4 percentage point, says Tim Hayes, chief investment strategist at Ned Davis Research.

The price-to-earnings multiple for the S&P 500 expanded in the last three quarters of 2007 but has lately fallen to about 16 times last year’s earnings, far from its bubble peak of about 30. If inflation is here to stay, multiples could fall further.

I hate to be pessimistic, but I have a nagging feeling that inflation is here to stay thanks to high energy prices which are starting to impact the price of everything else. How inflation will impact today’s stock prices is anybody’s guess. If you’re a long-term investor, I wouldn’t spend a lot of time worrying about it.

Reader and frequent commenter, Don, sent me this email this morning. It’s his thoughts on the Roth 401(k) vs. Traditional 401(k). I’ve included my thoughts after Don’s email (edited slightly from the original). As always, your thoughts would be appreciated.

I was reading this Marketwatch article recently:

Roth IRAs: Good for you or not?

In it they noted that, “A regular 401(k) beats a Roth for a majority of our stylized households, but both offer a significant improvement over fully taxed savings.”

I wasn’t surprised that fully taxed savings were worse, but I would have expected the regular and Roth IRAs to be neck and neck. The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.

But the article suggests something different, and eventually my mathematical mind found a reason why their claim might be true. It depends on what percentage of your income you expect to be provided from your retirement assets and the fact that we have a progressive tax system. Here is a sort of maximal example.

Consider a couple that makes $80,000 and contributes 20% ($16,000) of their income into deductible 401(k) or IRA investments. That brings them just about down to one of the tax bracket boundaries, between the 15% and 25% bracket. Because it is their high-margin rate income that they put away, they saved 25% of $16,000 in tax, or $4,000 in federal tax.

Assume they retire next year (so we don’t have to think much about inflation or the tax code changing). The maximal case, would be having 100% of their income provided from accumulated retirement assets, although it would probably be less because of social security or pensions or the like. But if next year, we draw the same salary from their retirement assets ($80,000) it would in fact be taxed progressively: the first $15,650 at 10%; and then at 15% up to $63,700; and only the top $16,300 would be at the full 25% rate. Nearly 4/5 of their income would be taxed at a rate lower than the savings they got every year when they invested it even though they are in exactly the same bracket as before.

I believe this changes the naive Traditional/Roth comparison and it would tip in the favor of the Traditional (just as the article implies).

If you are the “typical” person, your Social Security income would account for 40% of your retirement income. In that case, starting from the scenario above, you’d be drawing $48,000 from your IRA. If we allocate the low-margin tax brackets to your Social Security, you’d still have $31,700 drawn from your retirement assets that would be taxed at the 15% and again only the top $16,300 would be taxed at the full 25% marginal rate. Nearly 2/3 of your income (provided by retirement assets) would be taxed at a lower rate than the rate you saved at when you made the contributions.

It seems that the practical advice to take from the analysis is this: if you are near a bracket boundary use Traditional IRA or 401(k) savings to reduce your savings just to the boundary. Further savings should be Roth savings. It makes sense to diversify in any event against tax changes that would adversely affect Traditional or Roth savings anyway since no one knows the future.

If you can’t save down to a boundary but could at least foresee where the boundary would land in retirement, you could split your Traditional/Roth savings to match that. In the example above where 40% of your retirement income is from Social Security, a reasonable person might make 2/3 of their savings Traditional and 1/3 of them Roth. You’re not really ahead or behind mathematically in this scenario, but you get “tax diversification” as well as the potential Roth advantages (no minimal distribution, etc.) on part of the money.

The only issue I have with Don’s thoughts is his computation:

The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.

Is that really how people would contribute to a Roth? I would think most people would contribute $4,000 no matter if they used a Roth or a traditional IRA or 401(k). If they used the traditional IRA of 401(k), they would get the tax advantage up front. If they contributed to the Roth, they would take it on the chin and pay the taxes up front but still contribute the full amount to the Roth. NOTE: I’m going to run some calculations on my own and report back to you what I find.

This is a pretty complex topic because not only are we talking about the here and now, we are also trying to get a grip on the future. Adding to the complexity is the fact that there are benefits to the Roth that aren’t easily computable like the ability to NOT HAVE TO TAKE required minimum distributions and the ability to pass the Roth on to relatives, which gives them the opportunity for tax-free withdrawals. One other advantage to the Roth is the fact that distributions from the Roth DO NOT count towards the income threshold for computing taxes on Social Security.

My concern with the Roth are that the politicians may decide to tax withdrawals at some point in the future. Could it happen? Yes. Is it likely to happen? I have no idea. All I can say is that if times get tough and our politicians are looking for money to pay for their programs, and they see a bunch of tax sheltered assets sitting in Roth accounts, I wouldn’t put it past them to tax them “for the greater good.”

Anyway, there’s more on this topic to come. I’m working on a spreadsheet as I write this post. If I find out anything interesting, I’ll be sure and let you know.

Thanks to Don for his thoughts.