abcInvesting Blogs

March 2008

March 29, 2008

Obama Not Using a Retirement Account?

Harvard economic professor Greg Mankiw is surprised that Barack Obama is not using a SEP-IRA to put some of his book royalties into a tax-deferred account. Greg looked at the tax return released by the Senator and notes that he has about half a million dollars of book royalty income, but the tax return does not show a contribution to a SEP-IRA.

A SEP-IRA is an IRA for self-employed people. I have one, and it's great. The contribution limits are much higher than for a regular IRA. It reduces your taxable income dollar-for-dollar of your contribution, even if you are in a high tax bracket. And it's a very low-paperwork account. I have mine at a major discount broker, and I use low-cost exchange traded index funds. Another good way to go would be to place it at a mutual fund company. If you have a stock broker or financial planner who is looking at your total investment picture, let that person also handle your SEP-IRA.

If Senator Obama had diverted the maximum amount (for the self-employed, it's about 18 percent, up to a maximum of $45,000) into a SEP-IRA, that money would have grown tax free. He could take it out without penalty--but with regular income tax--anytime after age 59 1/2.

Why wouldn't Senator Obama used a SEP-IRA? Greg Mankiw speculates:

Maybe he is getting bad tax advice. Or maybe he is expecting vastly higher tax rates in the future when the accumulated savings will need to be withdrawn and taxed.

March 24, 2008

Roth 401k or Regular 401k? (Part 2)

What should you do if you don't expect to be in the same tax bracket when you retire as you're in now? Let's look at some more examples to figure that out.

Lois won’t have much taxable income in her retirement; she’ll be living exclusively on Social Security and a little bit of money from her retirement account. Her tax bracket now is 25 percent, but it will only be ten percent when she retires. If she chose a Roth 401k, her results would be just like Ruthie’s. But if she chose a Regular 401k, look at what happens:

Lois puts $400 into her regular 401k plan. This reduces her tax bill this year by $100, so it only costs her $300.
Lois’s $400 grows to $1600 over 20 years.
Lois withdraws her $1600, pays a ten percent tax, which costs her $160, and nets $1440.

The moral to Lois’s story is: If you will be in a lower tax bracket when you retire, use a regular 401k.

We'll look at one more example to show what you would do if you expect to be in a higher tax bracket during retirement.

Hiram was unemployed for the first half of the year, so his tax bracket will be just 15 percent this year. However, he expects to be in a 25 percent tax bracket when he retires. If he uses a Roth 401k, his result is just like Ruthie’s. However, a regular 401k is a little different.

Because he’s in the 15 percent tax bracket, Hiram won’t get as big a tax benefit from his contribution as Reggie did. Hiram puts $353 into his regular 401k, which cuts his tax bill by 15 percent of that amount, or $53. Just like Reggie and Ruth, the contribution cost him only $300.
Over 20 years, Hiram’s money has grown to $1412.
Hiram pays a tax of 25 percent, which is $353, leaving him with only $1059.

Hiram’s results show another lesson: If you will be in a higher tax bracket when your retire, use a Roth 401k.

Now, I’ll consider the most realistic case of all. Connie is confused. She isn’t sure what tax bracket she’ll be in when she retires. She listens to the politicians, but she can’t figure out whether they will raise taxes in the future, or cut taxes. She’s concerned about the worst possible case: that she pays taxes that are higher than she has to.

Connie would benefit from “tax diversification.” That means having some of your assets taxed today, and some tomorrow. Connie’s best strategy is to use both a regular and a Roth 401k, or to make her decision so that with her other investments, she is tax diversified. She won’t make the best possible choice, but she guarantees that she’ll be better off than if she made the worst possible choice. The final lesson about regular 401ks and Roth 401ks:Reduce your risk by having assets in different tax categories.

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