Millionaire Rule #8

Fund a Roth IRA to the Limit
The Roth IRA is my second favorite type of account for retirement saving. Because I'm the type of guy that really gets excited about the prospect of have a massive amount of money in retirement, it means that I REALLY love the Roth IRA. If you are curious what my number one favorite type of account is check out Millionaire Rule #7. My goal for this post is for at least half of those who read it to get fired up and open a Roth IRA in less than 24 hours from reading this post. Now, to explain why a Roth is so great.

First, we have the benefit common to all forms of IRAs, tax free compounding. That means from year to year an investor does not have to pay taxes on the income generated within the account. So for example consider the following sequence of events: you use the money in your IRA to buy some stock, the value of the stock goes up, and then you sell it for a profit. In a normal taxable account when you file your taxes the IRS will want its share of your profits (called capital gains) which can range from 15% (shares held more than a year) up to 35% or the top income tax rate (shares held less than a year). The tax man would also stick his hand out for income generated from dividends and interest (at the top tax rate) as well. Obviously these taxes can be a massive drag on your portfolio except that an IRA keeps the money safe from Uncle Sam.

The money stashed in a Roth is after tax dollars which means you can not deduct your contributions from your income when it is contributed; while on the other hand, a Traditional IRA is tax deductible. This may seem like a bad thing, except to make up for it, when money is withdrawn from the Roth it is tax free. Yep, as amazing as it sounds, all of the money you manage to build up (from both contributions and earnings) in your Roth IRA is completely tax free when withdrawn in retirement. Zero taxes in retirement give the Roth IRA a huge advantage in my retirement planning strategy.

The next great thing about an Roth IRA is that it allows you to shelter more money from taxes than a Traditional IRA. The reason is slightly complex, but here it goes. Both accounts have a maximum contribution in 2008 of $5,000. I already explained how a Roth is after tax income and a Traditional IRA is pretax income that is taxed instead at withdraw. So the effective amount of savings in a Roth that are sheltered from taxes is the full $5000 (post tax) based on an investment of $6666 in pretax dollars. The Traditional IRA can take a $5000 pretax contribution but will only be able to ultimately shelter $3750 because that $5000 gets taxed at withdraw in retirement. If that is confusing keep on reading.

Here is an example, we start with the same $5000 investment and assume the 25% tax bracket both now and in retirement. The Traditional IRA will get a contribution of the full $5000 and then compounds until retirement. At retirement the money is withdrawn and the 25% tax is paid. The Roth will get a contribution of $3570 (remember it is after tax so $5000 * 0.75) and then compounds until retirement where it is tax free. In this scenario both types of account wind up with the exact same amount of spendable cash in retirement (take the tax before or after it is all the same). However, if you have $6666 that you are able to save, you can put the full $5000 into a Roth you will end up with more money tax free in retirement. In effect, the Roth is able to shelter 25% more money from taxes than the Traditional IRA (assuming you have the extra money to save).

Tax rates change over time. Many people believe (and history would seem to support) that current tax rates are well below their normal levels. Many people (myself included) also expect to be in a much higher tax bracket in retirement than they are now. Early in a person's career they may have a lower income coupled with tax deductions for mortgage interest, dependents, and student loan interest that will disappear by retirement time. I expect to go from the 25% tax bracket now to the 35% bracket in retirement (I'm ambitious what can I say?). A Roth IRA protects your retirement income from the risk of higher tax rates in the future. That means a Roth IRA effectively adds 10% on to its value relative to other tax sheltered retirement accounts like a 401(k) or Traditional IRA for someone like me.

The Roth IRA has a few more benefits I just want to quickly address. The contribution maximum is index to inflation so the amount you can save will increase over time. Roth IRAs are given special treatment in the unfortunate even of their owner's death. A non-spouse inheritor can take withdraws from the Roth over the course of their lifetime while maintaining the tax deferral of capital gains and interest. Normally stocks, bonds, or 401(k)s in an estate incur the full tax burden at the time they are inherited (so no continued tax free growth). Lastly, Roth IRAs can be opened with many different banks and brokerages which provide a massive selection of possible investments. Individual stocks, bonds, options, commodities, futures, mutual funds, ETFs, real estate, art and darn near any thing else you can think of can be used an investment in a Roth IRA. This is very different from a 401(k) which is limited to a single management company selected by the employer and only a limited selection of mutual funds in which to invest. Investments in the Roth can cover all asset classes and are completely controlled by the investor.

It may seem like this list could go on and on, but I have one last special benefit of the Roth IRA. Because the contributions to the account are after tax, there are no penalties or taxes from withdrawing your contributions from the account in the event of an emergency. This is very different from a 401(k) where pulling money out before age 59 1/2 would result in paying taxes on the withdraw plus a 10% penalty. The Roth IRA does not have this problem, and it can give you extra piece of mind and a source of cash in a pinch. I really recommend you stay out of your retirement funds if at all possible but at least you know it is there if you need it.

I've covered most of the great benefits of the Roth IRA. In all honesty there aren't many drawbacks. Over 40 years of contributions at the $5,000 and earn an 8% return your account will grow to over $1.4 million. I highly recommend the Roth IRA as Millionaire Rule #8. Check out the rest of the Millionaire Rules and be sure to subscribe to my RSS feed.

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Income for Life - What Are Your Chances?

Today I'm going to write my second installment in a series about generating an income for life from your nest egg. The first installment was all about generating income from bonds. That posts brings up two huge risk factors to creating a life long income: 1) inflation and 2) volatility.

Inflation is the term for the upward trend in prices over time. Do you remember when gas was a quarter? I don't because I'm too young, but I do remember when it was less than one dollar. I miss the days of $0.99 gas, but inflation has left that price in the dust. There was also a time (so I'm told) that a hamburger, fries, and a coke was only a quarter too. In other words, prices on everything increase over time.

The second risk factor for generating lifetime income is volatility. In layman's terms, volatility is unpredictability or randomness. From one day to the next the stock market can be up, down, or flat and there is no way to accurately and consistently predict which it will be. Sure the broad trend is for markets to go up, but that does not hold for short time frames. The implication of this randomness is that over short periods of time (even years) the market can return significantly less (or significantly more) than the often quoted average.

If all of this is unclear I'll use a few examples to try and help. My first example is a man Jack who retires with a tidy $1,000,000 today. He knows that a conservative mix of stocks and bonds has historically returned 6.0% per year. He then decides to withdraw at the start of each year 6% (or $60,000) on which to live. If we first consider inflation, after 10 years the $60,000 withdraw will now be worth only $45,000. Jack has seen the value of his money drop by 25% in only 10 years! If this process continues for 10 more years Jack will only be able to buy $33,000 worth of goods with his original withdraw. The value and purchasing power of his retirement savings will continue to drop every year.

Now, lets again consider Jack and his $1,000,000 nest egg. We will still assume his mix of stocks and bonds returns an annualized 6%, but now we see that in any given year he can have volatility of 9%. That means each year his returns will be anywhere from -3% to 15%. If Jack starts out with a string of good years and the size of his nest egg will initially go up; Great! he is now in a position where he can withstand an occasional bad year and still maintain his income. However, if Jack starts off with a few bad years (or even mediocre years) near the beginning his nest egg can shrink quickly. Lets say the first year Jack's return is 5%, then 0%, then 9%, and then 10%. The average of these four returns is 6% which would seem to point to a withdraw of $60,000 per year. However, look at what actually happens:

	Nest Egg	Return	Income
Start	$1,000,000
Year One	$987,000	5.00%	$60,000
Year Two	$927,000	0.00%	$60,000
Year Three	$945,030	9.00%	$60,000
Year Four	$973,533	10.00%	$60,000

As you can see after only four years the value of the portfolio has declined 2.6% and Jack's annualized return (even without income distributions) was 5.93%. This effect is called variance drag, where the volatility produces a real return that is less than the average rate of return. It can become even more pronounced if you were to start retirement shortly before a stock market correction in which you could see 30% or more of your nest egg disappear in a couple of bad years. Even without a crash, volatility pushes down the real return of your portfolio so that there must be a significant cushion built in to sustain withdraws over the typical 20-30 year retirement.

I recently came across a great resource to help understand how the effects of inflation and volatility will affect your probability of running out of money during retirement. This tool is called FIREcalc. It is a free calculator that uses the real historical data from the stock market to determine the likelihood of success for obtaining retirement income for life. The way it works is to take an initial assumption about the size of your nest egg, the amount of income you intend to withdraw each year, and how long you need the money to last. Next real historical data from the market is used to project what would happen if you had retired in each year from 1929 to the present. Each of these hypothetical retirements is calculated to determine if the money would run out before the assumed time period. You can see if your strategy would have made it through the Great Depression and the 2000 Tech Bubble and still be able to meet your income needs.

When the previous example about Jack and his $1,000,000 portfolio is plugged into FIREcalc it reveals some scary results. With a $60,000 annual withdraw and a 23 year life expectancy (such as age 62 to 85) the result is a 64.9% success rate out of 114 trials. Simply put, in 40 of the trials Jack ran out of money before he hit 85. The tool is based on real life data, and it clearly shows how volatility and inflation are able to sink a seemingly robust retirement portfolio. If you lower the annual withdraw to $40,000 or 4% of the total, the success rate jumps to 100%. In other words, in the entire history of the market you would not have gone broke during your retirement if you keep withdraws down to 4% per year.

I spent some time running dozens of scenarios since I discovered this great tool and I recommend everyone take some time and do the same. You can learn a lot about the your realistic chances for retiring with income for life. For another take on this topic that comes to very similar conclusions using a different approach (a statistical model called Monte Carlo analysis) check out this article called The Retirement Calculator From Hell. Also be sure to check back with Aspire 2 Wealth to follow my path to wealth and read more articles about personal finance.

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