The Cost of Retirement Happiness

US News recently discussed the secrets to a happy retirement. They found that people who are most content in their “golden years” have several common qualities.  In addition to the proverbial good health and personal satisfaction, there were some fascinating findings: not too much TV, not being addicted to achievement, and intellectual curiosity.  These are great tips, and they can actually change your financial plan.  Let’s take a closer look at how these tips can have corresponding costs in your retirement plan.

1.  Good Health – This is fairly obvious.  The healthier you are, the better you feel.  But strongly consider how your health will also influence your retirement costs.  What kind of health problems do you currently have?  What will treating them cost in the future?  What’s my family history?  What kind of supplemental health insurance options are available to me?  Should I consider a Long-Term Care policy?  The answers to these questions and more can cause huge waves in your retirement.  Consider them early and before they rear their ugly heads.

2.  A Significant Other – Partners are important, but many people plan only from their own point of view.  Their partner’s considerations are sometimes left out of the equation.  Many decision makers can’t imagine a time where they’re not making decisions for their family or their partners.  But what happens if you were to pass first?  Are the appropriate instructions and arrangement in place?  What if you lose the mental acuity to manage your portfolio?  Who takes over?  Does your partner share the same investment sensibilities as you?  Do they have a support system or would they do it on their own?  Should you consider trustee services?  Would professional management services be appropriate?  You are not Superman.  Unfortunate things can and do happen, so ensure you taken care of your significant other if they don’t enjoy financial duties.

3.  A Social Network and Don’t Be Addicted to Television – Staying active is great advice for retirees.  In other words, have friends and get of the house, don’t stay home all day anand watch House (a fine show, BTW).  What will your life look like?  Will your social activities and hobbies involve large expenses?  Will you be travel a lot?  Play golf 5 times a week?  Is working with charitable organizations important to you?  All these questions are personal, but your retirement plan will need to address them.

4.  Intellectual Curiosity and Addiction to Achievement – One is encouraged, the other is not.  However, both can manifest in similar ways.  For those that like to be challenged or define their lives with their professional status, a second career or part time work is common.  Consider this in your planning.  Do you like to work?  Is there another career that you would like to pursue?  What kind of income will it generate?  If you go into a full-time second career, are benefits available?  How will this affect your savings plans?  What are the tax implications?  Some retirees start managing their portfolios with gusto as a substitute to their career pursuits.  Is this wise? Is it healthy, for you or your portfolio?

Retirement is a concept that everyone imagines, but few embrace.  Use these lists to think about the realities of life in retirement.  A good rule of thumb is to write down your visualized retirement.  Record your concerns and expected challenges.  This can help you to start addressing the pertinent questions necessary to enjoy your retirement to it’s fullest.  If you work with a planner or advisor, this exercise can be incredibly helpful to them.  They can build a plan for you with your image of retirement in mind.  After all, retirement should be as stress-free as possible.  Planning in advance will be a big help in this pursuit.

Asset Allocation: The Great Balancing Act

Last week we explored the first part of asset allocation in Asset Allocation: Tools of the Trade. We reviewed the asset classes investment managers use to build portfolios for their clients. This week we will explore how client portfolios are constructed and change over time as assets are deployed. Before looking at the mechanics, we should review the primary foundational principle of asset allocation: client objectives.

Client Objectives

Every investor is different. While many may have similar goals, all have unique circumstances. Some might be looking forward to a retirement full of international travel and posh leisure activities. Other investors’ objectives may be more modest in nature, but no less important. Whatever the goal, good investment managers start by understanding their client’s objectives. Then, they put together an investment plan that will seek to meet these objectives while minimizing the risks associated.

Portfolio Construction

A big part of the investment plan is asset allocation, which is using different asset classes to construct a portfolio designed to meet client objectives. These asset classes are varied. They include cash, stocks, bonds, commodities, real estate, insurance, and more. Experienced investment managers use many or all of these asset classes in varying degrees to build portfolios for their clients.

Hypothetical Asset Allocation

To illustrate how asset allocation can work, we have a very simple, hypothetical case: Sam and Sally. Sam, 40 years old, is married to Sally, also 40, and they have no children.

They enjoy what they do, but both want to retire when they are 65. They plan to travel extensively and prefer to relocate to the beach upon retirement. That gives them roughly 25 years to make their world traveling, beach living retirement a reality. Both are comfortable with taking on higher-risk for the potential of more growth in their investments, so they are okay with greater volatility.

Understanding Sam and Sally’s objectives and risk tolerance is crucial for determining how to deploy assets in their portfolio, and typically there’s a lot to work that goes into determining the proper asset allocation. Let’s go forward with the understanding that this extensive planning process had been completed because the point is to illustrate the difference in asset allocation models at different stages in life. A reasonable asset allocation mix over time for Sam and Sally may be:

Phase 1: Age 40-55

• Allocate 60% in stocks, 15% in commodities/real estate, 20% in bonds, 5% in cash.
• Continue to work, receive average raises in relation to inflation, and save 15% of their income per year before taxes.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 2: Age 55-60

• Start re-allocating to a 50% stocks, 30% bonds, 10% commodity/real estate investments, and 10% cash portfolio.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 3: Age 65+

• Start re-allocating 30% in stocks, 50% in bonds, 10% in cash, and 10% in commodities/real estate investments.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

As this couple gets closer to generating income from their portfolio, their investment approach transforms from a growth portfolio to an income portfolio and you can see how their portfolio is restructured over time to reflect this. Still, at no time is their plan one of extremes. There is always a growth component and conservative component, just of differing degrees to reflect their needs in life.

Real retirement plans should never be all in one asset class, whether in growth mode or income mode. You need the proper balance to protect your plan from the multitude of risks out there. Additionally, you’ll notice this asset allocation schedule roughly follows the Three Phases of Retirement Investing. Asset allocation is fundamental to investment planning, and although there are different ways to be successful in managing your investments, it remains a staple of how to reduce risk.

Income Planning: How To Spend Your Retirement

Much has been written about the importance of saving for retirement. However, people pay less attention to an equally important subject – how to take income once you do retire. As we noted in a previous article on the phases of retirement investing, the third phase is less about saving and more about spending.  In other words, how to efficiently spend the money you’ve saved during your working years.  The term professionals use for this process is “capital distribution.”

The goal of capital distribution is NOT to outlive your retirement nest egg, but to maintain the desired lifestyle for you and your loved ones through your non-working years. Capital distribution (not to be confused with capital gains distribution) is about spending your retirement savings the best way for your unique situation.  Here are three common strategies:

1) Annuities

One way to generate income during your retirement is with an immediate annuity, sometimes called an income annuity.  This is not the same as a fixed or variable annuity. An immediate annuity is similar to a self-funded pension. You deposit a chunk of cash with an insurance company and they pay you a certain dollar amount over a period of time. There are different distribution options related to spousal benefits, number of payments to be made, immediate or deferred payments, etc.  No matter the options chosen, the mechanism is the same: give an insurance company some money, and they pay you back every month until you and/or your spouse die.

The risks of this approach can relate to your life span, market risks, performance risk, and whether the insurance company stays solvent. Also, if you die after receiving the first payment, your family may lose the majority of your initial deposit if you did not cover that contingency in the annuity contract.

In addition, a typical annuity payment is fixed even if the market goes up. You may find you have given up some potential opportunities for growth. Finally, you must consider the risk that the insurance company may go bankrupt and will no longer make good on their end of the contract. Annuities can be an effective capital distribution method, but they’re not appropriate in all situations.

2) Systematic Withdrawals

Another way to finance your retirement is through systematic withdrawals.  There are two main methods: constant dollar and constant percentage.  Just as you once saved money systematically and let dollar cost averaging work for you, so also you can systematically pull money from your retirement account on a monthly, quarterly, semi-annual, or annual basis.  The constant dollar withdrawal plan has the benefits of convenience and consistency.

However, there can be a major risk with constant dollar withdrawals.  When you withdraw money from your retirement account during a bear market, you’re locking in a permanent loss to your portfolio. Some advisors suggest that this method, known as “reverse dollar cost averaging,” can be a great detriment to your portfolio when you make withdrawals during a bear market – which you almost certainly will if you live long enough.  So beware of the additional risks associated with constant dollar withdrawals.

Another systematic withdrawal option is the constant percentage method.  Instead of consistently taking out the same dollar amount, regardless of economic climate, you take out a constant percentage, thereby limiting your realized losses in a falling market and not compounding the losses to your nest egg.  The risk is that very few people want their retirement budget to be a slave to the market.  Less consistency in income streams means less ability to plan future life events.

3) Strategic Withdrawals

The final type of capital distribution is a strategic withdrawal of retirement savings.  There are several ways to implement this method. For instance, you can categorize your savings in buckets: low-risk, medium-risk, and higher-risk investments. A strategic withdrawal would be pulling funds from a lower-risk investment regardless of where the market is.  This reduces the negative effects of market risk on your retirement savings.  The risk is that this strategy requires some sort of market-timing plan.  It takes more time and expertise and is far from full proof.

Building a retirement income plan is one of the most important investment decisions that you’ll consider.  While these are three conventional methods used, they certainly aren’t the only ones.  Like most things in life, generally one size does NOT fit all.  Mixing a few of these methods or others may be the optimal blend for your income plan.  Also, often the right method is dependent on the type of assets you’ve saved: individual securities, pooled investments, employee pensions, or a mixture.  All have benefits, but all have risks as well.

Before implementing any of these strategies, discuss your situation with a qualified investment advisor. A professional can guide you through different ways to distribute your assets during retirement so you don’t outlive your savings.

Is Modern Portfolio Theory Out-of-Date?

The investment landscape has seen some major changes in the last two decades.  Financial and technology companies came and went, stock market values soared, plummeted and rebounded, housing derivatives blew up, and other foundations were laid bare.  Even the bedrock of investing theories related to portfolios has come under duress.  Yet the belief in Modern Portfolio Theory has remained robust amongst the investing public.  Should it?

A basic understanding of Modern Portfolio Theory is helpful.  According to the recent Dalbar study we’ve referenced before, Modern Portfolio Theory (MPT)…

“Is grounded in the observation that asset classes are predictably uncorrelated.  MPT is based on the theory that risk can be mitigated by diversifying into uncorrelated asset classes.  However, unless the correlations of the various asset classes are predictable, the mitigation of risk is lost.

Investors expect to be rewarded for the level of risk they are taking in a particular market.  Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning.  This brings into question the very basis for MPT and its ability to forecast an efficient frontier.”

Modern Portfolio Theory is almost 60 years old.  In a 1952 paper and 1959 book, Portfolio Selection, future Nobel laureate Harry Markowitz expounded MPT for the investment world.  Markowitz used mathematics to explain the relationship of risk to return as it relates to asset allocation.  He agreed that higher expected returns necessarily increased the risk in a portfolio.  However, he proved that asset classes acted differently during a market cycle and discussed how portfolios can be constructed to match investor risk tolerance and expected returns.

In its short history, MPT has come under question from various directions.  For one, MPT assumes that investors are always rational and risk-averse.  While Markowitz and other PhDs in Economics may fit that description, most investors do not (see behavioral finance).  That’s why it’s important to match your portfolio with your appropriate risk profile.  You must also modify your risk appetite as you and your portfolio grow older and circumstances change.

Second, MPT assumes all investors have access to the same information at the same time.  This simply isn’t right.  Even if you watch CNBC while the market is open and troll the blogs during the rest of your waking hours, you won’t have the same information in the same timely manner as many professionals.  This can be a huge missing piece to your strategic investment puzzle.

Another assumption of MPT is that investors accurately understand what returns are possible.  This is often not the case and is why many investors often need help from money managers.  Professionals are more likely to understand real-world limitations of Modern Portfolio Theory.
As the Dalbar study explains:

“The Achilles’ heel of MPT is that it simply cannot be reduced to a mathematical model or relied upon as the sole basis for the management of investment decisions.  Instead, it should be thought of as only one reference point for modeling the behavior of a potential portfolio; it is only one dimension of a more comprehensive investment management process.”

In other words, Modern Portfolio Theory as an investment strategy is fundamentally incomplete.  The markets of the last decade have provided such evidence.  However, as a foundation upon which to build a strategy, it still can be of great benefit.

Whether you’re working with a money manager or constructing your own portfolios, it’s important to understand the appropriate risk/return relationship.  In addition, it is worthwhile to address how various asset classes affect the risk and return of your portfolio over time.  Going all in on “short Thailand” may work once, but it’s hardly a long-term investing strategy.

Is Buy and Hold Failing Investors?

When it comes to investment strategy, the mantra of buy and hold has been a prevailing principle of success for decades.  Looking at investment indexes can sometimes support this theory that if you own “the market” long enough that you can have investment growth that outpaces inflation after taxes.  The question becomes, does a strategy of passivity, or “buy and forget about it”, actually work for investors?  Unfortunately, the answer appears to be a resounding — “no”.  Well then, why?

A recent study by Dalbar, Inc., a third-party evaluator of the financial services industry that has been tracking investor behavior since 1976, gives us some insight.  The underlying reasons seem to be that investors, often self-directed, are impatient and irrational.  The Dalbar study (PDF needed) concluded that investors grow impatient during market uncertainty.  They measured this impatience by looking at the average time that investments were held.

According to the study, the average holding period for equity funds is a bit over three years; fixed income holding periods were a fraction less.  Even for the most patient self-directed investors, they didn’t hold their investments past six years. This is a problem.

“After the market dip of 2000-2002, equity fund investors began to heed advice to focus on the future (Read: they held their investments). Until, of course, their patience was tested once again by the 2008 debacle.

Fixed income investors seemed most comfortable during uncertain markets as they fled equities in search of safer refuge. Asset allocation fund investors have historically held on to their funds for the longest periods of time; however, holding periods have never reached even a brief six years.”

A popular theory says it’s not ‘timing the market’ but ‘time in the market’.  While ultimately that may be sound advice for passive investors, most aren’t disciplined enough to abide by it.  If you jump in and out of the market because of a lack of patience, your returns will often be a fraction of what the market returns, robbing you of the longer-term benefits of investing.

The Dalbar study also concluded that most long-term, passive investors are fickle about holding their investments. When retail investors are worried about their investments in equity (stocks), bonds, and asset allocation funds, they move their money.  Often times, investor’s sell at the worst time, at the bottom of an investment cycle and generally will buy in times when news is positive.  In other words, they irrationally buy high and sell low.

So, what does all this mean?  What can we learn from how investors have behaved over the last several decades?  First, I think the study informs us that very few investors actually practice the time-honored theory of buy and hold.  It also gives us insight into what types of economic climates foster the most movement amongst investors.

Taking an active role in one’s investment plan can be of benefit, but only when that activity is coordinated with a disciplined investing methodology.  Plenty of very successful investment mangers actively manage portfolios effectively.  However, their success is grounded in a repeatable and disciplined process.  You must have a plan and an executable system to implement that plan.

If you decide that a hands-off approach is best for you, ensure that your initial asset allocation investment strategy is appropriate for your risk tolerance and then commit to it, even in rocky times.  If not, you’re doomed to become a part of the statistics in this study and your performance will ultimately suffer.  If you find that you can’t handle the volatility inherent with market swings, then revisit your initial plan or consult a professional.  There is more than one way to be successful in the market, but irrational and impatient behavior won’t work, no matter the strategy.

Five Tips For an Easier Retirement

Generally, retirement planning isn’t considered a relaxing leisure activity, but it’s a necessary step to enjoy your later years. We’ve warned you before about four risks that could ruin your retirement. In a more positive context, we want to help your retirement be secure to reduce stress and have a tidy nest egg waiting for you when your working days are over. Here are five tips to help accomplish that objective.

1) Never stop growing.

Inflation isn’t a four-letter word. But when it comes to the impact on your retirement, inflation is one of the nastiest words in the dictionary. Rising costs coupled with taxes can ravage your portfolio without proper planning. Remember that health care costs are rising faster than general inflation, and health care will be one of your biggest costs in retirement.

2) Hedge your bets.

One of the best ways to protect your portfolio against risk is to allocate your resources amongst different asset classes and to diversify your holdings inside those asset classes. Unfortunately, “Asset Allocation” is too narrowly defined at times, and diversification is often not enough to protect common day investors. Real Estate, commodities, and even currency hedges can be a valuable part of an overall investment plan. Also, ensure that you have a strategy for your portfolio. Invest-and-forget can lead to untimely volatility with often severe impacts on your retirement plans.

3) We’re here to pump you up: Always Max Out.

You’d be surprised how many investors don’t contribute all they can to their IRA accounts and 401(k) plans. If you’re under 50, you can contribute up to $5,000 a year to a Roth IRA or to a traditional IRA. Contributions to the latter may be tax deductible. If you’re under 50, you can contribute up to $16,500 a year to a 401(k) plan as well.

If you’re over 50 and need to bolster your nest egg, don’t worry. Take advantage of the “catch up” provisions allowable by the IRS; $6,000 a year to each IRA and up to $22,000 to your 401(k) if you’re over 50. If you have the investable cash available, contribute as much as you can.

4) Hold on loosely.

It always surprises me how many folks confuse loyalty to their companies with holding too much of its stock. Does anyone remember Enron? AOL? Adelphia? Many loyal employees, who decided not to sell their stock or stock options and then diversify, when they had the chance, ended up with next to nothing. This happens all too often, yet many are still compelled to keep a big part of their portfolio in their employer’s company stock. This is too much stress to put on a portfolio. Ten percent or less is a good rule of thumb for one security in a portfolio. Sometimes these holdings can be intricate to unwind, so consult an investment professional if you need help to diversify.

5) Don’t let the tax tail wag the dog.

Few people enjoy paying taxes. Taking advantage of available tax-advantaged accounts is important in retirement planning. Equally important is minimizing tax liability. However, tax avoidance shouldn’t preclude you from mitigating risk. I’d much rather folks pay a little more in taxes and keep more of their portfolio than risk their retirement by refusing to diversify. Yes, you might have to pay some taxes, but that might be better than waiting around only to see the bottom fall out. Remember, capital gains means you made money on an investment. Don’t cut off your nose to spite your face. If your portfolio requires you realize a little taxable gain in order to reduce risk, then you should do it or else risk that gain melting away for good.

The thought of retirement can be captivating, but the road to a successful retirement takes a well thought-out plan and the discipline to follow that plan. Keep your eye on the prize and your feet on the ground. If you don’t know where to begin, consult a professional. Retirement dreams can become reality with hard work and wise preparation.

Four Risks That Could Ruin Your Retirement

What are the risks of retirement and how do we plan for them?  In recent articles, we’ve written a lot about retirement and different aspects of planning for it.  Often risks are specific to your particular retirement plan, but several are common in all plans.  Even after you transition into retirement, it’s still vital to periodically assess your risks.  Kick the tires on your retirement plan every now and then to see if you need to make changes.  Here are the top four risks we see when preparing and living in retirement:

1)  Longevity:  How long will my money last?

One of the most important questions to consider is how long your money will last.  Although it’s impossible to know how long you will live (national averages say about 78 years), it always best to plan and hope for an extremely long life.  Your nest egg must not only be able to provide income for the duration of your retirement, but it needs to be resilient enough to weather all types of economic climate and risks.

This is the most important risk because the consequences of a mistake can be dire.  If you run out of money at 82 years old, what then?  Going back to work probably doesn’t sound fun.  Moving in with your family may not sound that appealing either, so better to plan for having too much than not enough.

Longevity risk can be offset in a few different ways. Building dependable income streams that will pay enough to cover essential expenses now and in the future is always a good rule.  Social Security and employer-sponsored pensions can help, but often those can’t cover essentials by themselves.

Also, a growing percentage of retirees simply don’t have a company pension.  Building an additional lifetime income source through an immediate or income annuity can provide indefinite income during retirement and is appropriate at times.  Just beware of the product restrictions and the associated costs.

2)  Lifestyle:  Fore!

You are not the same person you were 25 years ago.  Similarly, you won’t be the same person during your retirement, either.  Ask yourself these important questions.  What do you want your retirement to look like?  Will you be traveling a great deal?  What hobbies will dominate your time?  Do you want to enjoy two homes?  Will you be relocating?  Downsizing?  Do you want to leave anything behind to future generations?  These are questions that you may often wrestle with at night, and they don’t necessarily go away after you retire.  You need a realistic income plan to address them.

In addition to extra travel or greens fees, family situations can change as well.  Divorce, kids returning home, or even death of spouse can dramatically affect your lifestyle during retirement.  Keep these potential scenarios in mind as you prepare to leave the workforce.

3)  Health:  70 is the new 50.

Another important concern during retirement is health: hospitalization, doctor visits, prescriptions, and even long-term care.  Medicare covers some of these expenses, but not all.  The Center of Retirement Research estimates a 65-year old couple retiring in 2010 will need $206,000 to cover medical expenses during retirement – not including assisted living.  A couple planning on retiring in 2040 would need almost $500,000.

Health risks are very real, especially during retirement.  It’s imperative that you prepare for health care during retirement, even if you have Medicare.  There are many different outlets that can provide information related to long-term care insurance.  Check out Should Boomers Save for Healthcare? for more information about normal health expenses.

4)  Inflation:  A stamp was once 10 cents?

One of the biggest risks during retirement is inflation.  Business Week called it the ‘portfolio killer’.  Although we are presently in a rare period of deflation, more often  inflation eats away at your nest egg like a perennial worm.  Your portfolio needs to beat not only the average 3% inflation, but also consider taxes and rising costs in things like health care which generally grow faster than 3%.  Plus, your portfolio still needs to grow.  You don’t want your nest egg to shrink faster than your rate of withdrawal.

Conservative investors can fight against inflation by considering Treasury-Inflation Protected Securities, or TIPS.  These federal government bonds are guaranteed to keep pace with the government -calculated Consumer Price Index.  Although they’re not always a great solution prior to retirement, TIPS may work for a portion of some portfolios during retirement, but shouldn’t be the only thing in your portfolio.

Retirement should be a great time in one’s life, but is not without risks.  Make sure you’re calculating these before turning in your resignation.  It’s always a good idea to prepare for these risks by consulting a professional who can take an objective view of your plan.  Wise counsel can help bring peace of mind to your golden years.  After all, these are the years that should be the most carefree of your adult life.  Good luck.

Do 401Ks Need ETFs?

Retirement accounts like 401(k)s, 403(b)s and Roth IRAs can be invested many ways. For employee-sponsored plans like 401ks or 403bs, employers usually opt for diversified trading pools, specifically mutual funds. Traditional mutual funds give employees the benefit of diversification while providing 401k plan sponsors and record keepers an easy way to track transactions through traditional mutual fund pricing.  Investors get affordable access to different investment styles and markets. Historically, mutual funds have been a great fit for employer sponsored retirement accounts.

Now this may be changing. Exchange traded funds (ETFs) have grown in popularity since their invention in the early 1990s. ETFs are investment funds traded on the stock exchanges with regular tickers. Like mutual funds, ETFs are collections of stocks, bonds,  or other securities and trade at (or at least near) the net asset value.

As ETFs have become more popular, calls for them to be made available within 401k plans and the like have been loud.  Companies like Sharebuilder 401(k), WisdomTree and Vanguard are finally opening up options for ETFs in retirement accounts.  These firms are trying to capture or keep market share in the nearly 3 trillion dollars currently in 401k mutual funds.

At first glance, the demand for ETFs in 401ks isn’t palpably clear, as some of the advantages that ETFs hold over mutual funds aren’t applicable.  Tax efficiency doesn’t matter in a tax-deferred account.  Also, the benefit of real-time pricing, while attractive to short-term traders, would drive 401k record keepers batty.

Recently plan administrators have found ways to overcome these record keeping and trading issues.  Cost now seems to be driving 401k providers from mutual funds to ETFs. According to BlackRock, the largest seller of ETFs in the country, “the average expense ratio of an iShares ETF is 0.41% versus the average mutual fund’s 1.50%, a difference that can result in tens of thousands of dollars over 30 to 40 years.” Advisors and employees understand the math. If you can make an extra 1% by moving to ETFs, why wouldn’t you do it?

Critics will point out that in larger plans, the difference in cost between ETFs and comparable index mutual funds is negligible.  Also, any cost savings in management fees will be offset by additional record keeping and administration costs that will be passed on to employees.

Will ETF’s displace mutual funds as the preferred investment vehicle in 401ks?  Probably not anytime soon.  Still, ETFs are evolving; mutual fund titans such as Fidelity, Vanguard, and Charles Schwab now have their own ETF offerings.  And as many small and medium sized companies gravitate to ETFs for the cost savings, how long until the big 401k providers sit up and take notice?

To Invest in a Roth or Not?

While the title of this article could stir many a great rock ‘n roll debate about the front men of Van Halen, we’ll focus on investing for retirement.  Americans are not saving for retirement as much as they once did.  The frugality of “the Greatest Generation” has steadily given way to the excess of later generations.  One way to save more is with the Roth IRA, which remains a mystery to some investors despite being a great way to save for retirement.  Today we will try to de-mystify it.

Named after the late Senator William Roth of Delaware, the Roth IRA is a federally structured retirement plan.  It usually serves as a supplemental retirement plan to Americans with employer-sponsored retirement plans.  However, it can be used as a primary retirement savings vehicle in certain situations.  A Roth could be perfect for some people.

Several attributes of the Roth IRA distinguish it from other retirement plans.  For one, Roth contributions have already been taxed.  In other words, you cannot deduct contributions in your current tax year with the Roth.  The upside is that direct contributions to those accounts can be withdrawn tax-free at any time.  The real benefit happens after 59½ – when all monies in the Roth IRA are tax-free.

This is the primary difference between Roth IRAs and Traditional IRAs.  Contributions to traditional IRA’s are tax deductible at the time of contribution.  However, you must pay tax on your distributions during retirement.  You decide whether you want to pay taxes now (with the Roth IRA) or later (with Traditional IRAs).

However, not everyone can contribute to a Roth IRA.  Eligibility phases out at certain income limits.  For single filers, you cannot make more than $105,000 to qualify for a full contribution or $105,000-$120,000 to be eligible for a partial contribution.  For joint filers, you cannot make more than $166,000 to qualify for a full contribution.

There are also contribution limits for those who qualify.  According to the IRS,

“If you are under 50 years of age at the end of 2009: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $5,000 or the amount of your taxable compensation for 2009. This limit can be split between a traditional IRA and a Roth IRA but the combined limit is $5,000. The maximum deductible contribution to a traditional IRA and the maximum contribution to a Roth IRA may be reduced depending on your modified adjusted gross income.”

“If you are 50 years of age or older before 2010: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $6,000 or the amount of your taxable compensation for 2009.  This limit can be split between a traditional IRA and a Roth IRA but the combined limit is $6,000.  The maximum deductible contribution to a traditional IRA and the maximum contribution to a Roth IRA may be reduced depending on your modified adjusted gross income.”

Finally, you can contribute up until the tax-filing deadline in the following year.  In other words, for the 2009 tax year, you have until April 15, 2010 to make your contribution.  For those who qualify, the Roth is often the best way to supplement an employer- sponsored retirement program.  401k, 403b and similar programs are still the best place to save your money over the long-term, but a Roth IRA can be a good idea if you’ve maximized those contributions.  Don’t let the Roth IRA be a mystery any longer, and for the record, I’d go with David Lee Roth, too.