Investment showdown -- beyond the Roth, SDP, & TSP

[Jughead]

For a point of reference, here's an example

Your example ignores two key points: 1) not all traditional IRA contributions are deductible (depends on income), so this discussion can be moot for higher earners; and 2) the earnings on that IRA will be taxed for a traditional, but not for a Roth.

To the extent you're saying "every situation is different," you're correct--the Roth is right for some folks, wrong for others, and a coin-flip/"bet" as JS put it for most in the middle. To the extent you're saying the Roth is a bad deal for everyone, you're flat wrong....

[ThreeHoler]

Minor point: The tax paid is $1250, not $2150.

That said, you should probably check out something like: https://research.scottrade.com/public/calculators/ira/ira.asp It might help you see the fallacy of your argument.

[Danny Noonin]

Of course there are situations that favor the traditional. But there are a million that favor the Roth as well.

Being young and in the military typically favors the Roth. Besides deployed tax free, dont forget that a huge chunk of mil income already is tax free--BAH.

The only difference, which is in Person A's favor, is the possibility of their additional deductions knocking them down to the next marginal tax bracket.

Which, for home owners with newer mortgages (and therefore more interest) is an entirely real possibility based on where the bracket lines are drawn.

So between deductions that won't likely be applicable in retirement and a significant amount tax free income like BAH many military folks have a far more favorable tax bracket now than they will expect to have in retirement, which makes the Roth a no brainer for them.

[JS]

Because your IRA options are Roth or Traditional, and Traditional is taken off the TOP of your tax bill (your highest marginal rate), then that rate must be considered and applied toward the alternative, the Roth.

I think I see where your logic is coming from and what you mean by marginal vs effective tax rates. This is a great discussion, by the way, and very important for most folks to understand. But I still honestly believe that you and I are looking at the exact same numbers in a different way, and that you are interpreting tax rates incorrectly.

You are saying that if you dump the $5K into a Roth, that $5K was taxed at your highest marginal rate (say 28% if your taxable income was over $80K) because had you put that into a traditional, tax-deferred plan you would not have been taxed on that last $5K at 28%. I disagree with that line of thinking. For the sake of argument, what if I were to say that my $5K Roth contribution came from the first $5K of my income, which is of course taxed at only 10%???? So was the $5K in this situation (both individuals earning $85K taxable income) taxed at 10% like my argument says, or 28% like your argument says? Neither argument makes sense, which is why I keep coming back to the average, effective tax rate as being the sole number that I look at when making these types of decisions. I just don't see how it makes sense to look at investments and single out certain tax rates. It's almost like you are cherry picking tax rates for your argument - "Roth contribution is taxed at 28% but traditional but retirement withdrawal is taxed at your effective of 20%." Like my above linked article says about tax rates, your $5K of money hits every tax bracket on the way up to 28%. The first $5K of the year that you make is indeed taxed at 10%, even if you make $85K for the year. And yes, the last $5K you make that year is indeed taxed at 28%. Hence the concept of averaging the rates out to come up with an effective tax rate, which is the only rate I believe you should look at for an apples-to-apples comparison.

If you haven't done so, read the article above on how tax rates really work. The fact that you mentioned the phrase "getting knocked into the next tax bracket" means you truly don't understand taxes or tax brackets. Most people don't. There is no such thing as getting knocked into another tax bracket, ever. Period.The use of that phrase tells folks in the tax business that you don't understand tax rates. As the article illustrates, when you earn the proverbial additional dollar going from $80,000 to $80,001 for the year, your overall tax rates do not go from 25% to 28%. Period! Your marginal tax rate changes to 28% for any ​additional income over $80K, but your overall tax rate for the year went from 20.625% to 20.626%. Do the math and run it through a tax calculator. That additional dollar, which "bumped you from the 25% tax bracket into the 28% tax bracket" will literally cost you $.28 in additional taxes, not the $2,000 that some people think. Again, in case I haven't mentioned it, read that freaking article on tax rates if you guys are going to read anything on this argument.

Just to slaughter the already dead horse one more time, here it is graphically. Each additional dollar you earn incrementally increases your overall tax rate for each additional dollar you earn, up to infinity. Your tax rates never spike. If you were to graph your overall (effective) tax rate versus your income, it would be a nice, smooth, increasing curve from middle-school algebra. The graph doesnot look have a series of vertical lines, or jumps in your tax rates like some people think:

How tax brackets work (2007 IRS total tax numbers):

How tax brackets do NOT work (ignore the titles on the axes, just something I quickly grabbed from the web):

EDIT - just to add a caveat to my "you never can jump into another tax bracket" argument above. One way where your overall tax bill can spike would be through the Alternative Minimum Tax (AMT). They keep making exceptions to it, but it really only starts to kick in when you are earning way over $100K from what I understand. I hadn't done more then a cursory review of it, since it doesn't apply to me, but from what I understand, if you literally hit a certain dollar threshold, then deductions and credits start to be disallowed, and your tax bill can indeed spike dramatically with the addition of a single dollar of income.

The logic in my argument above about being bumped into lower/higher tax rate brackets and seeing spikes in your income due to that still stands, though. That is just not the way tax rates and tax brackets work, in case I did not mention that already.

For a point of reference, here's an example with two single-filers who each made $80K in 2012, Person A and B:

A/B

80K/80K = Total income

-5K/-0K = Traditional IRA contribution

75K/80K = Taxable income

14779.60/16029.60 = Taxes paid

60220.40/63070.40 = "Take home" pay

-0K/-5K = Roth IRA contribution

60220.40/58070.40 = Final income after taxes and contributions

Person B paid $2150 to shelter $5000 in their Roth. When Person A withdraws their $5000 in retirement, they will pay the effective rate, assuming their income during retirement comes from their retirement savings. If we assume that Person B saved really well and will have the same income during retirement ($80K), then in this scenario they contributed to their Roth at the 25% marginal rate to avoid a 20% effective rate.

Credits are irrelevant because they're dollar for dollar returns. All things equal, a $1000 child tax credit for Person A and B is $1000 in their pockets.

Deductions are irrelevant also, though slightly more confusing as to why. The deduction you get for contributing to a Traditional is on top of other deductions. So again, if all things are equal, then Person A will have $5K more in deductions. The only difference, which is in Person A's favor, is the possibility of their additional deductions knocking them down to the next marginal tax bracket.

Or you can go with the pros. That's fine too.

I agree that if you are comparing person A to person B, then credits and deductions don't count, because both get them. I am not trying to compare person A to B, my strategy is to figure out if person A (me) is going to have a lower overall tax rate today or if person A (still me) is going to have a lower tax rate at retirement. From that standpoint, deductions and credits matter, because like others have said, you most definitely won't have mortgage interest deductions, child tax breaks, military tax-free pay, etc. in retirement. Plus rates are lower now too. So my summary judgement is that we have lower rates today and over the past few years, and my personal effective rates that I illustrated proves that.

Also, I don't think you have to count on BAH and combat pay to have a low effective rate. Remember, Joe Schmoe with a mortgage and a few kids gets a ton of tax reducing items that he will not have in retirement (assuming the house is paid off and the kids move out - two things that are unfortunately very far from a given these days).

Edited January 30, 2013 by JS

[AnimalMother]

This discussion of course assumes that the government still exempts the Roth withdrawals from taxes in 20 years (if they haven't completely pilfered the TSP that is). I wouldn't summarily discount the value of tax deductions today versus possible tax deductions in the future. Furthermore, tax bracket predictions are rather futile. That being said, they are not mutually exclusive and are both good options. Bottom line, you should properly diversify, and that doesn't mean just a nicely divided pie chart on the homepage of your account.

[Butters]

https://www.youtube.com/watch?v=FTsNEUZx8v8

[AnimalMother]

A fellow subscriber to Wu Tang Financial Quarterly perhaps? I follow their investment advice to the letter. Gold, guns, and diversified bonds and shit. Just dropped 5k on a new grill as well.

[billy pilgrim]

Looking to start another mutual fund.

Any reason not to just throw it all in a S&P 500 index fund? Any good websites anyone would recommend to do a little research? Thanks.

[matmacwc]

Two weeks ago

[MilitaryToFinance]

Looking to start another mutual fund.

Any reason not to just throw it all in a S&P 500 index fund? Any good websites anyone would recommend to do a little research? Thanks.

How much time do you have to do research and keep track of the market? Also how much do you care about having above average returns?

If you have the time, with ETFs these days you should, at a minimum, focus on more specific sectors within the SP500 and rotate between them. Which sectors are performing better at any given time depends on the economic cycle and a number of sectors move inversely to each other(like consumer staples and consumer discretionary). If you buy the SP500 as a whole you get the winners and the losers. Focusing on sector takes a lot less time than trying to pick individual stocks but still gives you the benefits of more focused investments.

If you have the time I highly suggest reading The Visual Investor by John Murphy.

[HU&W]

Nothing wrong with an S&P tracker for long-term lazy investing. At least it beats inflation and is relatively safe if you have to fortitude to ignore market swings. Doesn't take much more work though to select sectors, although that involves more risk if you miss something.

[Day Man]

Agree with Mappleby...look at ETFs. They're basically mutual funds you can trade like stocks, with lower management costs (typically).

[MilitaryToFinance]

Sector Carpets are your friend. You can drill down to each sector and see the leading stocks if you want to get to that level as well. Just click on the sector you are interested in.

https://stockcharts.com/freecharts/carpet.html

[billy pilgrim]

I'll check out the Visual Investor, ETFs and the sector carpets... if this Nigerian deal I'm working on right now falls through.

Thanks for the gouge.

[PolyestherDuck]

I'm deployed for an extended period of time and am somewhat tempted to cash out of my non-IRA mutual funds. This year will be the lowest income year I have for the rest of my life and I can probably get myself down to the 15% tax bracket or lower, which means I'll have very low capital gains tax. I'm leaning towards putting it into precious metals and land. TSP and Roth IRA will still be bumping along.

[matmacwc]

Grain of salt.

Remember all of the flip this house shows 5 years ago along with the commercials, see a trend with the gold/silver commercials in the last year or so? Playing with fire friend.

Bumping along is GOOD.

Edited February 9, 2013 by matmacwc

[Swizzle]

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” - Warren Buffett

[Day Man]

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” - Warren Buffett

I'm not taking investment advice from the guy that sings "Margaritaville."

[Bayou_Eagle_Driver]

A buddy of mine and I were discussing a strategy he's using called the "Permanent Portfolio" which basically consists of 25/25/25/25 split of Stocks/Bonds/Precious Metals/Cash and apparently has shown an average 8-9% return each year after inflation (when run through a model of the past 50 years).

Anyone savvy on this school of thought?

[HU&W]

A buddy of mine and I were discussing a strategy he's using called the "Permanent Portfolio" which basically consists of 25/25/25/25 split of Stocks/Bonds/Precious Metals/Cash and apparently has shown an average 8-9% return each year after inflation (when run through a model of the past 50 years).

Anyone savvy on this school of thought?

Yes. That's an extremely basic and generic form of diversification. Some investors use it to mitigate risk.

[Butters]

Yes. That's an extremely basic and generic form of diversification. Some investors use it to mitigate risk.

Yeah, fuck that 25/25/25/25/25 bull shit, I use:

x2

[JS]

Yes. That's an extremely basic and generic form of diversification. Some investors use it to mitigate risk.

True, that is classic Finance 101 diversification, so if one or two investment classes tanked, hopefully the others would average your whole basket out to get your 10% return.

A few thoughts that I have accumulated over the years on this:

- Many stocks are much less risky than bonds. And many bonds are much more risky than stocks. The adage that stocks are risky and bonds are more conservative is wrong. Stock in Southern Company (the power company) is much more safe than buying bonds from Joe's Biotech Research Company. You have to do a ton of research on each and every stock and bond in order to truly get a decent, mathematical diversification of your portfolio.

- Precious metals - not sure what to think yet. They can be extremely risky or stable,depending on which metal, the state of the overall economy, and the level of the populace's overall paranoia, ignorance, and stupidity (OK, not really a fair cheap shot at the metals investors - they make money too, I just kind of agree with Buffet about gold being a useless mineral that people just shift around and never has any utility).

- Cash is pretty worthless right now. Money market accounts earning 1% or less are losing a lot of money with inflation running at around 3%. Of course, it is safe (sort of, except for the dough you are guaranteed to lose to inflation), so it is a good balancer of a diversified portfolio.

I recently read a great article about diversification. People think that diversification, as an example, would look like a portfolio with stocks in airlines, stocks in real estate, bonds in financial companies, and 20% cash. That portfolio is heavily diversified in terms of industry and asset class. But, if the overall economy went up or down, the entire portfolio would likely follow and go up or down - even if you were in funds or ETFs in those respective industries. In other words, you are not really diversified by diversifying by industry sector or by asset class. This guy wrote that you have to diversify by risk, which is much less intuitive and much more difficult to figure out.In other words, I can make a portfolio made up entirely of industrial stocks that would be way more diversified than a poorly planned 25/25/25/25 portfolio. If the 25/25/25/25 portfolio contents (bonds, stocks, etc) all have the same risk profile, as long as the industrial stocks I stacked in my portfolio truly have very different risk profiles, I am more diversified. In that case, if the overall economy went way up or way down, hopefully my portfolio of all industrial stocks would be more stable.

Example - I built a portfolio of stocks from a casket manufacturing company, a biotech company, a healthcare company, and a restaurant supply company like Sysco. Hopefully if the economy tanks, the casket company and healthcare company would both go up (recession proof industries - sort of) whereas the other two would likely decline (less people dining out, etc). The opposite would be true if the market climbed.

Of course, this is oversimplified, but the concept is there. Bottom line, much research has to be done before just randomly picking 25% stocks, 25% bonds, etc.

[JS]

Highly recommended card, as far as I'm concerned. The wife and I get approximately $350-400 cash back per year (so around $275-$325 after annual fee). Good customer service too.

Sorry for the reply to an old post, but I was just looking back through this thread.

The Amex Blue Cash is a great card for the 6% on groceries. $75/year, but Walmart, Costco, and Target groceries don't give you the 6% on groceries, like others have said. My break-even is about a month with our grocery habits. And like Archa said, the website is really good in terms of categorizing your expenses if you have a business or are trying the budget thing. It is the best credit card website in my experience.

As far as gas, I use a Visa card from PenFed and it gives you back 5% cash on all gas. You just have to become a PenFed "member," which kind of has other benefits too because it is a good credit union (free). I wound up transferring our other car loan there for .5%, I think. And the cash back on the card automatically shows up on the statement - you don't have to "buy" electronic rebates like the Amex Blue card and wait for them to show up on your statement, nor do they fuck around with any kind of points or other gimmick crap.

Along the lines of how great multiple credit cards are for you (sorry, ChampKind, but we are in major disagreement here), I also have two Chase cards - a Marriott card and an Amazon card. Both give triple or quadruple points when used at their respective businesses - and we buy a lot from Amazon, so it pays. Plus I put a lot of my travel on the Marriott, so we always have Marriott points to stay free.

Of course, I have all 4 or 5 credit cards set to autopay, and have not paid interest since I graduated from college over 10 years ago. Like others have mentioned, the cost of credit cards is already built into the price of everything (vendors get charged 1-3% of all swipes, that's how they make money off us Baseops members who don't carry a balance or pay interest), so you are losing the 3-6% of the purchase price if you pay cash for things in this economy. Sorry, but that is the way it works.

Champ is right about one thing, though. You do spend more with plastic versus cash. It is much more difficult to pull out and count large amounts of cash, and many people (myself and my wife included) are much more whimsical with plastic purchases versus cash purchases. But I try to be disciplined and just buy what I need and keep the 5-6% that balance holders are subsidizing for me.

On a side note - always take cash rewards and don't screw with miles or points. Remember, if you read the fine print, they make it pretty clear that THEY own those miles and points, and they can take them away from you if they think you are defrauding them or anything like that. Plus the points needed to buy a $300 plane ticket are just not worth as much as $300 cash due to all of the restrictions, etc.

Oh, and for the record, Dave Ramsey is an idiot with regards to numbers and building overall wealth. He is good for the people who got behind with bad decisions, debt, aren't good with numbers, etc. But the majority of his prescriptions will reduce your wealth. That's why he is an idiot. I can give more examples if anyone wants to hear, but the only thing that mathematically sound and logical that I ever heard him say is when he lambasted the morons who were paying into the stupid Powerball thing a few months back thinking that they actually had a chance at winning. He and I agree (the only thing we agree on) that the lotto is a tax on the dumb and poor who are bad at math. A truly regressive tax used to pay for the education of higher socioeconomic kids.

I guess Ramsey's advice if for the "average" or below average person with regards to financial knowledge. And to paraphrase George Carlin - thing about how fucking dumb the average person is, and then think about the fact that half of all people in the world are more dumb than that.

[nsplayr]

The Amex Blue Cash is a great card for the 6% on groceries. $75/year, but Walmart, Costco, and Target groceries don't give you the 6% on groceries, like others have said. My break-even is about a month with our grocery habits.

+1...got this card about 4 months ago and it's been great so far. It's annoying that the cash back isn't just automatically applied to my statement and it takes over a month to get your money from the previous month but whatever...quibbling when I'm getting 6% on groceries. $300 in the bank per year on groceries alone (5% more than I was getting on my last card), plus the annual fees on all AMEX cards are waived for active duty mil.

Also love my target redcard...to me it's really the best deal because you get 5% off directly at the register when you swipe. No ifs, ands, buts, or waiting, just 5% off, I go online and click "pay balance" from my checking account. Honestly could not be easier.

Like you said, if you're disciplined there is absolutely no reason not to use the various kinds of credit wisely.

Edited February 13, 2013 by nsplayr

[OregonHerc]

plus the annual fees on all AMEX cards are waived for active duty mil.

Did you have to do anything special for this? Different number or code word or something?