Roth vs Traditional IRAs - Which is Best for You?

Author: Ryan Kimes, CFP®

“IRA” is a commonly used acronym for “Individual Retirement Account”. These types of legal accounts are given special tax treatment to incentive individuals to save for retirement. The type of IRA you invest in can significantly impact your long-term savings, so it’s crucial for investors to understand the differences and advantages of these accounts.

Limited Annual Contributions

Many individuals struggle to take the initiative when opening a retirement account, a mistake that can often lead to missed tax-year contribution opportunities. Both Roth and Traditional IRA contributions are limited to $5,500 per year, or $6,500 if age 50 or older. This means that you are limited to the amount of principal that can be invested in the account each year, with the deadline for the previous year being April 15th, tax day. For example, if in 2018 you contribute $250 per month in 2018 ($3,000 by December 31st, 2018), you will have until April 15th, 2019 to contribute the remaining $2,500 for the 2018 tax-year. If the contribution is not made by April 15th, 2019 (tax-day), the $2,500 of remaining contributions will be missed and cannot be made up for in future years. Why does this matter? Because the long-term impact of these account’s tax-advantaged provisions on your net investment are substantial, and income phase-outs can further limit future contribution opportunities.

Tax Advantages

The tax-savings characteristics of Roth and Traditional IRAs differ significantly, so selecting the proper account contribution should be a priority for investors. To start, Traditional IRAs are considered pre-tax contributions. This means any amount invested in the account will not be taxed, providing an end-of-year tax credit to the individual. For example, if an individual who is making $50,000 per year, within a 20% hypothetical tax bracket, contributes $5,000 in a given tax-year, he will only be taxed on $45,000 of income that year. Why is this important? Instead of being taxed 20% on the $5,000 of income invested, netting $4,000 in after-tax dollars, the initial investment in the Traditional IRA will be the entire $5,000 of pre-tax dollars. The long-term compounding on the initial investment will immediately be at an advantage within the traditional IRA. Further, investment capital gains and investment income will be deferred until withdrawal from the account, rather than being taxed each year as with a regular taxable investment account. With taxation being deferred annually, the dividend income and capital gains that would have been lost to taxation remains within the account, continually compounding until withdrawal. However, when the retiree begins to make withdrawals from his Traditional IRA, the full amount of the withdrawal will be subject to income taxes.

Tax Deferred vs Non-Tax-Deferred

Alternatively, Roth IRA funds are deposited after taxes are taken out of the individual’s annual income. Instead of providing tax deferral for dividend income and capital gains, as with Traditional IRAs, earnings within Roth IRAs are tax-free when withdrawn in a qualified manner. Qualified withdrawals include: earnings withdrawals after age 59.5, first time home-purchases (lifetime maximum of $10,000), post-secondary education expenses, certain medical expenses, IRS tax-levies, and health insurance premiums in certain situations. For all qualified withdrawals, the Roth IRA must have been established longer than five years prior to withdrawal.

Roth IRA vs Taxable Account

Other Withdrawal Rules

Another difference to consider when selecting between Traditional and Roth IRA contributions is when the savings must be withdrawn. It is important to remember that a 10% early withdrawal penalty may be imposed by the IRS for Traditional IRA withdrawals before age 59.5. Due to this Traditional IRA early-withdrawal penalty, Roth IRAs are better for those who wish to have access to the funds prior to retirement. So long as the account has been open for five years, contributions to Roth IRAs may be withdrawn without penalty. Again, this no-penalty withdrawal is applied to contributions only, not earnings. Withdrawals of earnings may be penalized if they are not qualified. As previously discussed, for Roth IRA earnings to be withdrawn tax-free before retirement, certain conditions must be met

With Traditional IRAs, you must begin withdrawing what are called required minimum distributions (RMDs), by age 70.5 years old, whether you need the withdrawals or not. This requirement is in place so deferred taxes within Traditional IRAs are eventually realized by the Federal Government. Otherwise, the pre-taxed dollars within Traditional IRAs could remain in the account and potentially grow indefinitely without taxation, should the funds never be used. 

However, with Roth IRAs, withdrawals are never required unless in the case of an inherited Roth IRA. If you do not need income from your Roth IRA, you may allow it to continue growing tax-free through the remainder of your life, making them excellent wealth-transfer accounts.

Income Phaseouts

Roth IRA: Single tax filers may make contributions to Roth IRAs with modified adjusted gross income less than $135,000 (contribution maximum begins phaseout at $120,000). Married individuals filing jointly have a phaseout range of $189,000-$199,000.

If you anticipate a higher income in coming years, it is crucial to take advantage of eligible contribution years. They will likely be limited.

Traditional IRA: All tax-filers may contribute to a Traditional IRA, but tax deductibility rules are based on an individual's income and access to employer retirement plans.

Which Is Right For You?

To determine the best long-term choice for your contribution, you must consider whether your tax-rate for the current year will be greater today or tomorrow. Of course, you cannot predict what the federal income or state tax rates will be in 30 years, but you may anticipate more or less income on any given tax-year.

Traditional vs Roth

Generally speaking, you want to realize taxation by contributing to a Roth IRA in years where your modified adjusted gross income will be less than in future years. Though it is common for individuals to anticipate making less in retirement, lost tax deductions, credits, and increased passive and social security income, often places retirees at a higher adjusted gross income in retirement. In this scenario, a Roth IRA contribution would be the superior choice over a Traditional IRA contribution.

Passive vs Active Management: Efficiency Over Skill

Author: Ryan Kimes, CFP®

Alpha is a statistical financial metric that measures the excess performance of an investment or portfolio relative to a benchmark such as the S&P 500. Although it is possible for investment managers to outperform relative benchmarks (positive alpha), investment underperformance (negative alpha) tends to be more probable after fees and trading expenses are taken into account. Considering empirical studies by Harbon, Roberts, and Rowley 2016, consistent net outperformance is rare, not necessarily due to lack of manager skill, but as a consequence of added expenses born by active trading,

In fact, according to Vanguard calculations using data from Morningstar Inc., over the past 20 years, less than 25% of actively managed U.S equity mutual funds outperformed their relative benchmarks. Consistent underperformance of actively managed funds were found across all asset classes across numerous countries, market segments, and time periods. Studies that conclude the scarcity of persistently outperforming, professionally managed funds include: Sharpe 1966, Jensen 1968, Carhart 1997 (risk-adjusted), Fama and French 2010, and Harbon, Roberts, and Rowley 2016.

Why does this occur? The poor performance of these funds can be understood in the concept of the zero-sum game found in financial markets. According to Sharpe 1991, the zero-sum game explains that within capital markets, the holdings and transactions of all participants aggregates into the market as a whole. For every winner, there is a loser. For every loser, there is a winner. Essentially, for every dollar of outperformance earned by a manager or individual, there is an equally lost dollar to underperformance. Therefore, it is reasonable to suggest that the probability of any given transaction leading to outperformance is 50%. This outperformance probability is considered before expenses and taxes are ever accounted for.

In reality, investors must pay costs associated with participating in the market. These include management expenses, administrative costs, broker/dealer bid-ask spreads, commissions, and of course, taxes. These cost variables will have a significant reduction to an investor’s net return over the long-term. Consequently, the potential for an investor’s outperformance in this zero-sum game becomes increasingly improbable, even with professional active management.

Further, the average return of a relative asset classes’ benchmark (such as the S&P 500) does not equate to the average return realized by an investor investing in that asset class or fund. Undisciplined investors are influenced by emotional decisions when it comes to initial investment timing and tolerance to return variability. Consequently, investors spend too much time and cost succumbing to internal biases that reduce the amount of time their investment is invested, increasing transaction costs, taxes, and introducing the risk of detrimental investment timing.

Market Participant Returns After Adjusting For Costs

 Vanguard

Vanguard

As investors focus too heavily on security or fund selection (bottom-up investing), they make poor investment decisions that hinder the realized return of their investments. Consider that a mutual fund’s exceptional performance would likely attract additional investors, consequently increasing the demand of the underlying securities within that actively managed mutual fund’s portfolio. This increased demand may inflate the value of the underlying assets, potentially making the security overvalued, thus reducing the probability of the fund’s future outperformance. Remember, past performance is not indicative of future results. The figure below illustrates this concept by measuring the difference (green) in average returns of investors (light blue) in various mutual fund classes to the actual returns of those mutual funds (blue).

Investor returns versus fund returns: Ten years ended December 31, 2015

 Vanguard

Vanguard

So what should investors do? Rather than focus on fund or security selection, investors should place a greater emphasis on asset allocation. Also known as “top-down” investing, asset allocation begins with analyzing a client’s financial goals and constraints, then creating a mix of assets (such as stocks and bonds) that best suits the client’s needs. Rather than buying funds with the most attractive returns, an investor focused on asset allocation would place a greater emphasis on maintaining a targeted mix of stocks to bonds, regardless of the characteristics of the underlying securities’ firm. As any individual stock or bond increases and decreases in value, its overall percentage weight within the portfolio will change. Periodically, trades are then placed to readjust, or rebalance, the investments within the portfolio to their original percentage weights. This is done to maintain the volatility-to-return characteristics of the portfolio, rather than actively trade the holdings to produce excess return relative to the stock or bond benchmark. Here, the investor realizes value in maintaining a portfolio that will have an acceptable level of variability and return expectations, while also eliminating as much for-certain expenses as possible.

The Mixture of Assets Defines the Spectrum of Returns

 Vanguard

Vanguard

Security market pricing is highly efficient, meaning excess return from underpriced securities is becoming increasingly improbable. With that said, it is often in the best interest of investors to work with advisors that focus on efficient asset allocation, rather than costly active management. Evidently, logical investment advisors should recommend portfolios that shy-away from for-certain expense ratios or active advisory fees in exchange low-cost asset-exposure alternatives.

When To Start Saving for Retirement

Author: Ryan Kimes, CFP®

Saving for retirement is one of the focal points of comprehensive financial planning, yet it is also one of the most uncomfortable subjects for individuals to discuss when meeting with an advisor. Frequent one-liner excuses from generation X and Y clients include, “I’m too young to be thinking about retirement”, or, “I don’t make enough money to be saving right now”. Sure, anyone can relate to these points, but one of the greatest values in financial planning is understanding the time value of money, and the relationship between compounding interest and intervals of time.

Let’s jump into some technical calculations for just a moment. When calculating the future value of an investment, we perform a calculation using the following formula:

Here, C represents a cash flow (our investment), r is the rate of return (or internal rate of return), and n is the number of periods of time. With time (n) being the exponential variable, the future value of the cash flow will have the greatest impact from a change in the number of periods invested (length of time invested). An example of this concept is illustrated below on an investment of $1.

*Source: The Vanguard Group, Inc. 2016

Why does this occur? Because of compounding interest relative to time. Compounding interest is interest growing on interest. Given more intervals of time, this interest will have time to compound on itself and produce additional compounding interest as years pass (^n=intervals of time), exponentially increasing the future value of our investment (C = cash flow).

With working Americans purchasing about $1,100 worth of coffee per year, according to a study by Acorns Money Matters, it’s pretty difficult to say the average person does not have the means to save even $50 per month. Remember, the goal of this article is to articulate the value of time and its impact on your investments, regardless of the amount saved. Let’s take this concept and calculate time’s true value given various assumptions.

Assumes 8% internal rate of return; compounded monthly

The current annual contribution limits for traditional and Roth IRA’s are $5,500 per year ($6,500 for ages 50+). This equates to about $458.33, but for the sake of simplicity we will round our savings to $450 per month. The above table applies the previously discussed future value equation to our cash flows to calculate the future value of our monthly investments, given an 8% annual growth rate.

Using this example, if a 37 year old individual saved $450 per month for retirement (at full-retirement-age of 67), for 30 years, and earned an annual rate of return of 8%, they would have a portfolio value of $675,133. Now, had the same individual started at 27, saving for an additional 10 years, they would have a portfolio value of $1,581,427. That’s a difference of $852,294 in compounding interest alone ($1,581,427- $675,1533 - [$450 per month x 12 months x 10 additional years]) = $852,294. The additional years of compounding interest on top of compounding interest allows the portfolio to grow exponentially greater than the 30-year savings plan, purely thanks to the time value of money. Do you still think it’s still too early to be thinking about retirement? What if the additional $852,294 in growth was grown tax-free through a Roth IRA? Now that’s a reason to start planning.

Source: The Vanguard Group, Inc. 2016


 

 

Fee-only vs Commissioned Advisors

The Value in Advice-driven Service, Not Sales

Author: Ryan Kimes, CFP®

What is fee-only advising?

To understand the difference between a fee-only and commissioned advisor, you must first be aware of how the average advisor is compensated when recommending financial products to their clients.

Advisors are typically compensated in the following ways:

  • Through a commission-based model. Commissions are generated through insurance and investment product sales.  

  • Through a commission & fee hybrid model. Again, commissions are generated through the sale of insurance and investment products, alongside advisory fees for financial planning or investment account management.

  • Through a fee-only model. Here, the focus is advisory-service and investment management, not product sales. Client fees are predetermined and remain the same regardless of what investment or insurance recommendations are implemented.

An advisor’s financial recommendations can be heavily influenced by these varying levels of compensation. An excellent example of this is the sale of permanent life insurance policies within the insurance industry.

Permanent life insurance products such as variable or indexed universal life insurance are often marketed and sold as retirement-insurance bundled investment vehicles. Policies sold to consumers frequently show annual or monthly premiums that are comparable to contributions to legal retirement accounts (often over $12,000-18,000 per year). What clients are often unaware of are the front-loaded insurance charges, mutual fund sales charges, surrender charges, and poor performance of these investment vehicles that will cost the customer the majority of the potential portfolio’s value over a 10 year period. Even more unfortunate, almost every permanent life insurance policy can have the same protection and benefit from the provider’s term-period policies. Though not permanent, 30-year term policies are often a fraction of the cost of permanent policies, while providing for the same coverage for a specified period.

Despite many undesirable aspects of permanent life insurance policies, advisors push these products for the high-levels of commissions paid by insurance companies. Speaking from experience, compensation for certain indexed universal life insurance policies are over 120% of the first year’s paid premium. Using the example of a policy with an annual premium of $12,000, would you be comfortable knowing your advisor will be compensated $14,400 for the sale of your permanent life insurance policy, a product marketed as a retirement vehicle? For the insurance company to afford to provide this compensation, a high level of profitability must be made from the sale of the product. Who is at the expense of this profitability? You, the unknowing consumer.

While this example can be applied to almost every facet of the financial service industry, the value of unbiased, objective investment advice is critical for the success of the client. When the conflict of interest posed by the sale of insurance and investment products is present, the recommendations to layman clients can vary wildly to generate the largest commission on the sale possible. When clients consider an advisor, they should be aware of the commissions being generated by their investments, as these commissions are a direct indication of the profitability of their business. In turn, these commissions will likely hinder the performance of their investments, and are ultimately in the best interest of the advisor, not the client.