The Case Against Roth 401(k)

To Roth or not to Roth, that is the question. Starting in 2008, like many other employers, my employer also started offering the Roth 401k option in our 401(k) plan. This question of whether one is better off with contributing to the Traditional 401k or contributing to the Roth 401k has been the subject of a lot of debate. Although there is no one-size-fits-all answer, I think for most people the majority, if not 100%, of the contribution should go to a Traditional 401(k). I will state my case against Roth 401(k) in this post.

The basic premise of a Roth 401(k), and to some extent a Roth IRA, is that of prepayment. You are prepaying the tax now so you don't have to pay tax later. This prepayment concept is not uncommon. For example, buying a season ticket is prepaying for the individual events. Buying a timeshare is prepaying for vacation accommodation. Whenever we deal with a prepayment scheme, we have to assess whether prepaying is "worth it." The same paradigm also applies to Traditional versus Roth 401(k). There are several factors that make prepaying the taxes now not worth it.

1. Fill in lower tax brackets in retirement. I showed in a previous post Commutative Law of Multiplication that if the marginal tax rate at retirement is the same as it is now, the Traditional and Roth 401(k)'s are equivalent. If the marginal tax rate is higher now than in retirement, one is better off contributing to a Traditional 401k. If the current marginal tax rate is lower, one is better off contributing to a Roth 401k. But that applies only to the marginal dollar, which is the last dollar you can shift between Traditional and Roth 401(k). It is not necessarily the case for the entire contribution or the average dollar. The tax system in the United States is progressive and it will probably stay that way. That means that income is taxed at increasing rates as it goes higher. Even if you think the marginal tax rate in the future will be higher, there will still be lower brackets and these lower brackets should be filled with money from a Traditional 401(k).

This chart below illustrates what the tax brackets are in 2008 for a married couple earning $218,200 between the two of them if they file jointly using the standard deduction (click on the chart to see it in full size).

* Source: Tax Policy Center

The first $17,900 of income is not taxed because it's taken up by deductions and exemptions. The next $16,050 is taxed at 10%, the next $49,050 at 15%, the next $66,350 at 25%, so on and so forth. Because the way a Traditional 401(k) works, the dollars they contribute come off from the top, in the highest tax bracket for their income. After they retire, the dollars they receive from their Traditional 401(k) fill in from the bottom. Even if we assume their marginal tax bracket in retirement will be higher due to tax increases, a large portion of the 401(k) withdrawal may still be taxed at a lower rate than what it was when they contributed the money. This is the same argument raised by a reader on the AllFinancialMatters blog.

Until you know you can generate from your Traditional 401(k) enough income to fill the lower brackets, it doesn't make sense to contribute to a Roth 401(k). For people without a traditional defined benefit pension plan, it means the majority of the retirement savings should go to a Traditional 401(k), not Roth.

If you have a defined benefit pension plan and/or you expect to have a large balance in Traditional 401(k)/IRA, large enough to fill the lower brackets every year, then contributing to Roth makes some sense.

2. Avoid high state income tax. Many people work in high tax states like California and New York today. They work there because there are a lot of well-paying jobs in those states. They won't necessarily retire there because the high taxes take away a significant portion of their retirement income. States popular with retirees like Florida and Texas have no state income tax. If you are working in a high tax state today but there is a chance you will retire in a no/low tax state, contributing to a Traditional 401(k) lets you avoid paying the high state income tax on the contributions. Prepaying the high state income tax now is a dead loss.

3. Leave the option open for Roth conversion in the future. When you leave your employer, you can rollover the Traditional 401(k) to a Traditional IRA, which then can be converted to a Roth IRA at a later time when it is advantageous to you. A Roth 401k or IRA on the other hand can never be converted back to Traditional. With a Traditional 401k, you hold the option, which has value. If you contribute to Roth, you give up that valuable option. You can decide to convert and pay the tax whenever you are in a lower tax bracket than where you are now. Good times for conversion include:

• going back to school for a career change;
• becoming unemployed due to layoffs or burn-out;
• starting a business (not as much income in the first few years);
• two-income couple having one parent stay at home or work part-time for a few years after they have kids;
• a high-income single person marrying a lower-income spouse;
• taking early retirement;
• moving from a high tax state to a no/low tax state;

Unless you are sure that your marginal tax bracket will never be lower throughout your career, you should leave the option open by putting money in a Traditional 401(k) and then convert to Roth when an opportunity comes.

4. Avoid triggering phase-outs and AMT. Because contributing to a Roth 401k does not reduce your gross income, you appear to be richer than you otherwise are if you contributed to a Traditional 401k. There are all kinds of income-based eligibility cutoffs and phase-outs in the tax code. When your exceed the income threshold, your tax benefits from those programs are either reduced or eliminated. Some of these tax breaks include:

• child tax credit;
• Hope credit;
• Lifetime Learning credit;
• itemized deductions;
• personal exemptions;
• eligibility to contribute to a Roth IRA;
• eligibility to contribute to a Coverdell ESA

Think for example the tax rebate from the 2008 economic stimulus package. If a single person earned $90,000 in 2007 but contributed $10,000 to a Roth 401k, he/she is not eligible for the $600 tax rebate. If he/she contributed $15,000 to a Traditional 401(k) instead, he/she is eligible. When your income appears to be "too high," not only you lose tax benefits, you may even trigger the AMT. Contributing to a Traditional 401(k) will help you qualify for tax benefits and escape or reduce the impact of AMT.

With so many disadvantages, whom is Roth 401(k) good for then? Roth 401(k) is good for people in low paying jobs now but expect to have high paying jobs later. Medical doctors in residence programs fit that description very well. They are paid very low while they are in residency but their income is expected to rise substantially higher when they finish the program. Their income will stay high in their career and they will receive a high income after they retire. Prepaying tax now makes sense because they are prepaying at a low rate now and they will avoid paying a higher rate later. College students working part-time jobs or recent graduates working in entry-level jobs are also good examples for taking advantage of a Roth 401(k) while their income (and their tax rate) is low. Roth 401(k) is also good for people who are already in the top tax bracket and expect to be there forever. If they don't see any chance of being in a lower tax bracket, prepaying tax now will lock in the tax rate so they won't have to worry about future tax increases.

What about the idea of tax diversification? Some advocate doing both Roth 401k and Traditional 401k because the tax rates in the future are uncertain. Diversification is good in general but it doesn't mean automatic 50:50. Just like investing in emerging markets provides diversification, but it doesn't mean you should invest 50% of your money in emerging markets. You still have to decide how much you should allocate your retirement savings between Traditional and Roth just like you allocate a portfolio between developed markets and emerging markets. Tax diversification also doesn't mean you have to do it right now if you are in your peak earning years. There might be better times coming up in the future.

For myself, I'm 100% in Traditional 401(k). Prepaying tax now is just not worth it.

See also: Roth vs Traditional 401K on Bogleheads Forum.

[Update on May 16, 2008]: There is a follow-up to this post, Roth 401(k) for People Who Contribute the Max, which includes an online spreadsheet that calculates the value of having a higher effective contribution limit in a Roth 401k.

TFB's Stumbles: Week Ending March 14, 2008

It was another eventful week in the stock market. The Fed offered to lend up to $200 billion to banks and Wall Street firms on Tuesday. It gave an undisclosed amount of emergency funding to Bear Stearns on Friday. According to this Bloomberg article, it is "the largest government bailout of a U.S. securities firm." It's time to re-read Roger Lowenstein's book When Genius Failed: The Rise and Fall of Long-Term Capital Management.

I've been busy buying stock funds. I'm thinking of over-rebalancing beyond my 60/40 stocks/bonds allocation. I think this is the time to tap the batteries I've been charging for so long.

Meanwhile, here are the interesting articles that I came across this week.

Why I Love My Prepaid Cell Phone - Prepaid cell phone works great. I spend less than $10 a month with my prepaid cell phone.

Is Google Bashing Finally Peaking? - I remember the $700 a GOOG share days not so long ago. Whoever goes to the top will have to take the shots. In the 1990s it was Microsoft. Everything they did was evil. Is Google any better now?

Who's To Blame For The Subprime Mortgage Mess - Do you blame the supply or the demand for bad loans? The demand. For if there were no demand, there would be no supply.

Reasons Why Your HELOC Can Be Your Emergency Fund - Using HELOC as emergency fund is fine but you have to be sure you *can* access the HELOC when you really need it. If you lose your job, the bank can refuse to let you borrow against the HELOC. When the economy gets bad, the bank can revoke your HELOC. I wouldn't play games with my safety net.

Have a great weekend!

Schwab AMT Tax-Free Money Market Funds

Charles Schwab started offering AMT tax-free money market funds. I read about it in the spring 2008 edition of Schwab's On Investing magazine. AMT tax-free money market funds are good for investors who are in a higher tax bracket due to the Alternative Minimum Tax, especially those who also face high state income tax.

Previously Fidelity is the only place I know that offers this kind of funds. Schwab now offers one national and four state-specific (CA, MA, NJ, and NY) AMT tax-free money market funds. The national fund and the NY fund also have two share classes with different expense ratios. The Value Advantage share class is cheaper but you can't use them for automatic sweeps. Investors in MA and NJ only have the more expensive Sweep Shares version, while investors in CA only have the non-sweep version. Like the comparable Fidelity funds, these AMT tax-free money market funds all require a $25,000 minimum initial investment.

Here's the complete list of Schwab's AMT-free money funds*:

Fund	Expense	Yield	Comparable Fidelity Fund
Schwab AMT Tax-Free Money Fund - Value Advantage Shares (SWWXX)	0.45%	2.80%	0.43% / 2.83%
Schwab AMT Tax-Free Money Fund (SWFXX)	0.63%	2.61%	N/A
Schwab CA AMT Tax-Free Money Fund - Value Advantage Shares (SNKXX)	0.45%	2.42%	0.30% / 2.76%
Schwab MA AMT Tax-Free Money Fund - Sweep Shares (SWDXX)	0.65%	2.64%	0.30% / 2.72%
Schwab NJ AMT Tax-Free Money Fund - Sweep Shares (SWJXX)	0.65%	2.64%	0.30% / 2.95%
Schwab NY AMT Tax-Free Money Fund - Value Advantage Shares (SWYXX)	0.45%	2.68%	0.30% / 2.95%
Schwab NY AMT Tax-Free Money Fund - Sweep Shares (SWNXX)	0.65%	2.47%	N/A

* Expense ratios and effective yields for the Schwab funds were from Schwab's web site: sweep funds, purchased funds. Expense ratios and effective yields for the Fidelity funds were from Fidelity's web site. All data were retrieved on Saturday March 8, 2008.

Except for the national fund, Schwab's AMT tax-free money market funds all have a substantially higher expense ratio and a lower yield than the comparable Fidelity funds. But if you prefer to keep your money at Schwab, now you have some new options for your short-term cash.

Related posts:

• Which Vanguard Money Market Fund?
• Risks In Money Market Funds
  
• Tax Equivalent Yield Calculator Updated
• A Baby Step for Simplifying My Finances

Want to Encourage Savings? Simplify the Tax Rules

It has been reported that the savings rate in the United States is negative. I've heard arguments saying it isn't really negative but I think it's fair to say that the savings rate is very low. Everybody wants to encourage people to save, which is great. We already have a hodgepodge of tax favored programs. In this election year, politicians are coming up with even more tax incentive proposals of different stripes. I think they are missing the point entirely.

Right now we already have these programs:

• 401k/403b/457, Traditional IRA, SEP IRA, SARSEP IRA, SIMPLE IRA: If you save for your retirement, you can defer taxes.
• Roth IRA: If you save for your retirement, you can avoid tax on your gains.
• 529 plan, Coverdell ESA: If you save for a child's education, you can avoid tax on your gains.
• FSA, HSA: If you save for medical expenses, you can avoid some tax.

Can anybody say with any confidence that they know all the eligibility, phase-out and qualified distribution rules on all of these programs? You wonder why the average consumer is confused? When they have a number of choices which they don't know much about, they either (a) don't do anything for fear of doing something wrong; or (b) give up and hand themselves to a financial service "professional" who happily charge them a neat fee.

You think a 529 plan is simple enough? Find an aged-based portfolio, dollar cost average, and you are done? No. Every state has a different plan. Some states have more than one plans. You need a big web site just to keep it straight. Is it any surprise that nearly 80% of the 529 plan sales went through a financial advisor? Source: SmartMoney article.

We don't need more programs. We need simpler rules. When people are not worried about doing something wrong, they will save. The Canadians are smarter in this regard. They trust their people. The Canadian government recently legislated a new program called Tax Free Savings Account (TFSA). I think it serves as a good example for how a simple program really creates the incentive to save.

Simply put, in a TFSA,

• Everybody over 18 can save 5,000 Canadian dollars a year. No income qualification. No phase-outs.
• If you don't have money to contribute now, the contribution room carries forward, forever. That way when you have more money later, you can catch up. Most U.S. programs are use-it-or-lose-it.
• Contributions are not tax deductible but earnings grow tax free (like a Roth).
• Money can be withdrawn at any time, for whatever purpose, tax free. No 59-1/2, no expense qualification, no questions asked.
• If you had to withdraw from your TFSA for whatever reason, you can make up for the withdrawal later without reducing your contribution room. In a US tax favored plan there's no way to put money back once it's withdrawn (except for limited 60-day rollovers).

If we have a program like Canada's TFSA, what excuse can anybody have for not using it? You save whenever you want, for whatever you want. Whatever you buy, the earnings are tax free. We are so into limiting people on the way in and locking the money up once they are in. That's the wrong approach. If you want to encourage people to save, let them save without so many restrictions. Obama, Clinton, McCain, are you listening?

Tax Equivalent Yield Calculator Updated

Since I introduced my tax equivalent yield calculator in my post Which Vanguard Money Market Fund? in April, I've had very good feedback from people who used it. People told me it's the only calculator on the web that takes into consideration for Treasury fund, the standard or itemized deductions, and AMT. It has been viewed more times than any other post on my blog.

I added a new section for AMT-free tax exempt money market funds. Fidelity is the only place I know which offers this kind of funds. These funds do not invest in private activity bonds which are subject to the AMT. The AMT-free funds yield slightly lower than funds which include private activity bonds. But if you are subject to AMT, you may fare better in an AMT-free fund after you take into consideration the AMT.

For example, at the time I'm writing this post, the yield on Fidelity California AMT Tax-Free Money Market Fund (FSPXX) is 3.57%. The yield on Vanguard California Tax-Exempt Money Market Fund (VCTXX) is 3.73% but the Vanguard fund has 17.8% of its holdings subject to AMT. For a California resident in 35% AMT bracket and 9.3% California state income tax bracket, the Fidelity AMT free fund is better after tax. The Fidelity AMT free fund requires $25,000 minimum initial investment, although you can drop down to $10,000 after the initial investment.

	Quoted Yield	% in Private Activity Bonds	After Tax Yield	Tax Equivalent Yield
Fidelity CA AMT Free Money Market Fund (FSPXX)	3.57%	0%	3.57%	6.41%
Vanguard CA Tax-Exempt Money Market Fund (VCTXX)	3.73%	17.8%	3.50%	6.28%

The calculator is not limited to only Vanguard or Fidelity. You can use it for funds from any other company. Just enter the yield numbers for the funds you are considering. Following suggestions from Ron Lieber and Ari Weinberg at FiLife, I also changed wording on a question in the calculator to make it clearer. You can get to the updated calculator from the original post or access it directly from the hosting site or the alternate hosting site.

Although the calculator was made for money market funds, it works for regular bond funds too. Well, money market funds are bond funds, the very short-term kind. Bond funds also have different tax characteristics (if held in a taxable account, of course). For example here's a rundown on a few bond funds for the same California resident in 35% AMT bracket and 9.3% California state income tax bracket:

	Quoted Yield	After Tax Yield	Tax Equivalent Yield
Vanguard Intermediate-Term Bond Index Fund (VBIIX)	5.03%	2.80%	5.03%
Vanguard Intermediate-Term Treasury Fund (VFITX)	4.19%	2.72%	4.89%
Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX)	3.88%	3.88%	6.96%

For this fictitious California resident, the fully taxable bond fund has the highest quoted yield but it has lower yield after tax. The California state tax exempt fund has the lowest quoted yield but it has the highest yield after tax.

Of course when you choose a bond fund, you will have to consider other factors including credit quality and duration. These topics are out of the scope of this post. Please refer to two useful brochures from Vanguard on bond funds:

• Investing For Income
• Investing For Tax-Exempt Income

Ideally you want to place your bond funds in a tax deferred account so you don't have to worry about the difference in tax treatment. But if you are using a bond fund for an intermediate term goal, or if you don't have enough room in your tax deferred accounts, calculating the after-tax yield or the tax equivalent yield can help you make the decision.

What Type of Bank Is Your Bank?

No, it's not a trick question. While most people think a bank is a bank is a bank, the financial institutions we usually call a "bank" actually come in many different flavors. Some are organized under federal laws, some under state laws. Some are a special kind called thrift, savings and loan or savings association. Some are members of the Federal Reserve, some are not. Depending on the types, they are regulated by different entities. I learned these from the book The Greatest-Ever Bank Robbery which I reviewed a few weeks ago. Here are some categories of banks in the United States:

1. National Bank. These institutions are organized under federal laws. Their primary federal regulator is The Office of the Comptroller of the Currency (OCC). All national banks are required to be members of the Federal Reserve. Their names typically (but don't have to) include the word "national" or end with "N.A." which stands for National Association. For example Zions First National Bank and Bank of America N.A. are national banks.

2. Federal Savings Association. These institutions are organized under the federal Home Owners' Loan Act. They are required to do a substantial amount of business in mortgage lending. Their primary federal regulator is a different branch of the Treasury department called The Office of Thrift Supervision (OTS). They are NOT members of the Federal Reserve, but are instead members of a parallel Federal Home Loan Banks system. Their names often (but not always) include the word "savings" or end with "FSB" which stands for Federal Savings Bank. For example Washington Mutual Bank and ING Bank, fsb are federal savings associations.

3. State Member Bank. These institutions are organized under the state laws but they chose to become members of the Federal Reserve. Their primary federal regulator is the Federal Reserve. For example SunTrust Bank and Fifth Third Bank are state chartered banks which are also members of the Federal Reserve.

4. State Non-Member Bank. These institutions are organized under the state laws but they are NOT members of the Federal Reserve. Their primary federal regulator is FDIC. For example Bank of the West and GMAC Bank are state chartered banks who are not members of the Federal Reserve.

5. State Savings Association. Like their federal counterpart, these institutions also do substantial amount of business in mortgage lending, except they are organized under state laws. Their primary federal regulator is FDIC. For example Emigrant Bank is a state chartered savings association.

	Charter	Is Thrift?	Primary Regulator	Example
National Banks	Federal	No	OCC	Bank of America, Zions
Federal Savings Associations	Federal	Yes	OTS	Washington Mutual, ING
State, Fed Member	State	No	Federal Reserve	SunTrust, Fifth Third
State, Fed Non-Member	State	No	FDIC	GMAC Bank
State S&L	State	Yes	FDIC	Emigrant Bank

 

Finally, a credit union is not a bank at all. Credit unions are not insured by FDIC. They are supervised and insured by a different federal agency NCUA.

How do you find out what type of bank yours is? If you use an online savings account, sometimes they use a trade name and you may not even know who's behind the service. My previous post Online Savings Accounts and Their Backers has a list of popular online savings accounts and the real names of the banks behind them. Then use FDIC's Find an Institution search form. Type in a name and you will see its Bank Charter Class. For example, NetBank, which was shut down by the OTS last week, was a Savings Association.

 

As a customer, should you care? Today both banks and savings and loans offer pretty much the same array of services. They are all FDIC insured. That's probably why most people don't even know they are different under the hood. Yet who regulates them may make a difference. During the 1980s the banking regulators in some states and the predecessor of OTS had looser rules, which contributed to the massive savings and loan crisis. However as long as the banks were insured by the federal government, the customers didn't care whether they were run in a safe and sound manner. They dumped large sums of money to the troubled banks because the troubled banks offered higher interest rates. This phenomenon is called the moral hazard.

The customers are still doing the same today. The Wall Street Journal reported that Countrywide Bank is attracting $50 million a day with its higher interest rate. Customers are not concerned about Countrywide's negative publicity because their deposits are insured.

In my opinion, as a customer, you should care how your bank is run, even if the deposits are FDIC insured. There's a moral aspect to your decision. If chasing the highest yield resulted in a FDIC payout, it means you are taking money from other depositors who may be less well off than you are. Doing that intentionally is wrong.

Related Posts:

• Online Savings Accounts and Their Backers
• What Happens When a Bank Goes Out of Business

NetBank Shuts Down, ING Takes Over

Online bank NetBank was closed by the federal regulator today. FDIC arranged its takeover by ING Direct. This is consistent with what FDIC usually does, as described in my previous post What Happens When a Bank Goes Out of Business.

1,500 unlucky customers have $109 million over the FDIC insurance limit. That's an average of more than $72,000 each! I don't know what these customers were thinking. The trouble at NetBank was known for quite a while. Previously NetBank announced they would merge with EverBank. But the merger collapsed.

For more details, see FDIC announcement.

I-Bonds Fixed Rate Pre-Guess for November 2007

I have written off I-Bonds as an attractive investment or even as a substitute for a 1-year CD. In case someone is still interested in I-Bonds, here is my pre-guess for the fixed rate to be announced on November 1, 2007.

For the inflation adjustment part, we have 5 out of 6 months of inflation data. If the September CPI comes out on October 17 at the same level as in August, the semi-annual adjustment will be about 1.25%.

For the fixed rate part, I use the 5-year TIPS real yield as reference. The current 5-year TIPS real yield is about 2.2%. It was 2.06% on April 30, right before the previous announcement. My guess is that the I-Bonds fixed rate will stay the same at 1.3%, or go up to 1.4% if the Treasury department feels generous.

All together, the composite rate will be 3.8% - 3.9%, still lower than many other alternatives. Another big yawn.

Fidelity mySmart Cash $100 Bonus Received

I forgot about the $100 bonus when I opened the Fidelity mySmart Cash Account, which I think is the best checking account. I registered for the bonus over the weekend, not sure if I will get it after the fact. I received an e-mail yesterday saying the bonus was approved. Today the $100 bonus showed up in my account. That was fast! In addition, new customers to Fidelity may also qualify for up to 25,000 United MileagePlus miles or American AAdvantage miles.

* Don't worry. None of the bonus links are referral links. Just posting as a happy customer.

Risks in Money Market Funds

Reader Kim asked, referring to my post Which Vanguard Money Market Fund? in April,

"In light of the current sub-prime meltdown, some people are questioning whether they should move out of Vanguard Prime MMF into something safer, like Vanguard Treasury MMF. Your blog helps calculate return under different scenarios but leaves off the risk aspect.  Would it be of interest to you to add in some additional calcs. to quantify the risk v. return aspect to give a better picture on each fund?  I am very interested in this issue because it is often neglected.  Thanks!"

I left off the level of risks in the different Vanguard money market funds because I thought (and still think) that difference in risks is only theoretical. The Vanguard Treasury Money Market Fund (VMPXX) and the Vanguard Admiral Treasury Money Market Fund (VUSXX) invest only in Treasurys. They are the safest because the Treasurys are guaranteed by the full faith and credit of the U.S. government. The Vanguard Prime Money Market Fund (VMMXX) invests in high quality, very short term debt issued by corporations. It also holds Certificates of Deposit with banks both in the U.S. and overseas. See the list of holdings from the SEC filing as of May 31, 2007. The various tax-exempt money market funds invest in debt issued by state and local governments and their agencies. These are still safe because Vanguard only invests in issues with high credit quality.

If someone is really worried about these money market instruments defaulting, they should look at the stocks part of their portfolio because those companies would have to go bankrupt first before they default on their money market debt. If you invest in the stock market at all, don't worry about the money market fund. If there were massive defaults, you would likely lose a lot more money from the stock market than from money market funds. In such a scenario, money market funds would be the least of your concerns. 

I don't worry about the theoretical risk difference between the different Vanguard money market funds. However for many people the extra safety afforded by the Treasury money market fund comes for free. The Treasury Money Market Fund yields a bit less, but because the interest income on Treasurys are exempt from state and local income tax, its after-tax yield can be higher, or at least not that much lower, than that of the Prime Money Market Fund. When the Treasury Money Market Fund yields higher after tax, it's a no-brainer. Even if it still yields a bit less, the difference you give up for the peace of mind may very well be worth it. It depends on how much you have in the money market fund. For example if a Texas resident (no state income tax) in 25% federal income tax bracket has $10,000 in a money market fund, the difference between the interest earned from the Treasury and the Prime money market funds is $33 a year after tax. Although I'd be fine investing in the Prime Money Market Fund, if giving up $33 a year gives someone the peace of mind, I have no problems with it. We blow much more than $33 a year on many other stuff.

APR or APY, It Doesn't Matter

It's very strange. I see a lot of people reaching my blog when they search for information on converting APR to APY or vice versa. They end up on my post last year Interest Rate: APY and APR which mentioned two Excel formula: EFFECT which converts APR to APY, and NOMINAL which converts APY to APR. While it's nice to know that 5% APR is 5.13% APY and 5% APY is 4.88% APR, I think they are missing the big picture. The difference between APR and APY is not a big deal.

If someone is carrying a car loan at 4.99% APR and the interest rate on an online savings account is 5.30% APY, is this person better off keeping the money in the savings account or paying off the car loan? Do I need to convert one to the other and compare the numbers? Not really. The difference between APR and APY is so small you can pretty much ignore it. What makes a much bigger difference is taxes. You have to pay federal and state income taxes on the interest earned in a savings account. There is no tax deduction for the car loan. Therefore, before taxes, 5.30% APY and 4.99% APR are about equal; after taxes, 5.30% APY is much smaller than 4.99% APR.

So, if anyone comes to this post again searching for converting APR to APY or converting APY to APR, please stop. Forget it. It doesn't matter. Look at the effect of taxes instead.

60% of Generation X Don't Have an IRA

A recent Schwab survey says 60% Gen-Xers don't have an IRA. I read it in Schwab's On Investing magazine. It's also reported on ItsaSurvey.com:

"Schwab surveyed over 500 Americans between the ages of 25 and 40 -- a range that generally overlaps with the so-called Generation X -- regarding finances and retirement.

... ...

"While more than eight in 10 of those born into Generation X are taking some sort of action to save for retirement, only 40 percent of those who are saving have an IRA. Those who do not have an IRA say they don't need one, don't have enough money to fund one, or believe the accounts are too complicated."

If you are a Gen-Xer with an IRA, congratulations, you did better than 60% of your peers. If you don't have an IRA, make no excuses, because

1. You need one. You are saving in a 401(k) or 403(b), right? Right? The 401(k) or 403(b) is set up by your employer. Many plans have higher expenses and limited investment choices. An IRA is something you have complete control over. You can have the lowest expenses and the best investment choices.

2. It doesn't take much money to fund one. Save up $1,000 and you can open an IRA with the best mutual fund company Vanguard in the best mutual fund for investing less than $3,000. Don't have $1,000? For as little as $100, you can still do pretty well with an AARP fund. See my previous post on investing a small amount.

3. The accounts are not complicated at all. Pick the Roth IRA if you are not sure, unless your income is too high.

There you have it. You, too, can have an IRA. Everybody should have one. 

Commutative Law of Multiplication

Commutative Law of Multiplication is a fancy way of saying when you multiply two numbers, it doesn't matter which number you put down first and which number you put down second.

a * b = b * a

This basic law of arithmetic is taught in the second grade in elementary school. Yet it is very useful when you evaluate the relative merits between Traditional 401k, Roth IRA, and the new Roth 401k.

Blogger Trent writes the popular blog The Simple Dollar, which is one of the most successful personal finance blogs. Unfortunately Trent made the mistake of not recognizing the Commutative Law of Multiplication. In his post The New Roth 401(k) Versus The Traditional 401(k): Which Is The Better Route? he said Roth 401k is better even if the tax rate in the future is lower than the tax rate at present. His reasoning was

"Basically, by paying $2,800 a year now in extra taxes, Joe saves himself $14,000 a year in retirement."

Wrong. It matters not how much tax you pay at different times. What matters is how much money you have left after all the taxes are paid. Sadly when more than one commenters pointed out the problem with Trent's math, he still insisted that his math was correct. You would think a blogger writing about finance and investment should "get it," but I guess not.

In case someone out there is still confused, here's how the math works. Let t₀ be the marginal tax rate now, and t₁ be the marginal tax rate at retirement time. Suppose through successful investing, you are able to grow each dollar to $n when you are ready to retire. For each dollar you invest in a Traditional 401k, you will have $n before tax, and n * (1 - t₁) after tax. In a Roth IRA or Roth 401k, for each dollar before tax, you pay tax first and have (1 - t₀) dollars left after tax. Growing the money to the same degree, you will have (1 - t₀) * n when you are ready to retire. If the tax rate now (t₀) is the same as the tax rate at retirement time (t₁), we have

n * (1 - t₁) = (1 - t₀) * n

There, is the Commutative Law of Multiplication.

If the tax rate at retirement time is lower, t₁ < t₀, Traditional 401k will be better than Roth 401k because the value on the left hand side is larger than the value on the right hand side. The opposite is true if the tax rate at present is lower, t₀ < t₁.

Of course nobody knows what the future tax rates will be or whether they will be higher or lower than today's. In choosing between a Traditional 401k and a Roth 401k, you just have to take a guess or do a little of both. For me, my money is on the Traditional 401k. I think the Roth 401k is a device for the current government to maximize its current revenue at the cost of robbing revenues from the future government. When the future government needs money, it will find ways to raise revenue including taxing on Roth withdrawals either directly or indirectly. The laws on Roth IRA and Roth 401k only say withdrawals from them today are not taxed. They don't say withdrawals won't ever be taxed. Tax laws can be changed by the legislature in the future.

Related Post: The Case Against Roth 401(k)

Tax and Inflation Penalize Savers

I bought some EE savings bonds in May 2002. Today is the first day I get to redeem them without penalty. Each $100 saved back then is now worth $118.40. This is one of my worst investments in the last five years. My return on these EE savings bonds is 3.44% a year over the last 5 years. Inflation, measured by the Consumer Price Index, averaged 2.81% a year in the same period. So it looks like I came out slightly ahead of inflation. But wait, I have to pay tax on the interest. After tax and inflation, I lost money. I loaned my hard earned money to the U.S. Treasury for 5 long years. Now they paid me back less than what I loaned them. How sad. Tax and inflation penalize savers. No wonder Americans are said to have low savings rate. I think taxing inflation is wrong.

I-Bonds Fixed Rate for May 1, 2007

The Treasury Department announced today the new fixed rate for I-Bonds sold between May 1, 2007 and October 31, 2007. I previously guessed that the fixed rate would remain unchanged at 1.4% and I thought any change would be on the down side. Someone on the old Vanguard Diehards forum guessed it would go up to 1.8%. And alas, we were all too optimistic. The Treasury Department reduced the fixed rate on I-Bonds to 1.3%. The composite rate, including the inflation adjustment, will be 3.74% for I-Bonds sold in the next 6 months. Neither the 1.3% fixed rate nor the 3.74% composite rate is attractive relative to alternatives such as TIPS, T-Bills, money market funds or bank savings accounts. Goodbye, I-Bonds, don't call me until your fixed rate reaches 2.0%.

I-Bonds Rate Guess for May 1, 2007

The Bureau of Labor Statistics released Consumer Price Index data for March 2007 this morning. Now I can turn my pre-guess for I-Bonds Rate for May 1, 2007 into a real guess.

Over the 6-month period which will be used for determining the next inflation adjustment, the CPI rose by 1.21%. If the Treasury department keeps the current fixed rate unchanged at 1.4%, the composite rate for I-Bonds sold between May 1 and October 31, 2007 will be 3.84%. That rate is lower than what you can get from bank savings accounts, money market mutual funds and Treasury bills.

My guess is that the new fixed rate on May 1, 2007 will be unchanged. This will slightly narrow the gap between I-Bonds fixed rate and the real yield on 5-year TIPS. When the yield on 5-year TIPS rose last year, I-Bonds didn't follow. Now the TIPS yield is down a little bit, I-Bonds probably won't follow either.

I-Bonds have become a big yawn because the Treasury department purposefully allowed them to fall behind the market yield. I will probably redeem my old 1.6% I-Bonds when they reach their 5-year anniversary.

Which Vanguard Money Market Fund?

[Last updated on April 20, 2008. Special thanks to Ron Lieber and Ari Weinberg at FiLife for suggesting clarifications. Added info on Vanguard Federal Money Market Fund and Schwab AMT Tax-Free Money Market Funds.]

I mentioned in my simplifying finances post that I use a Vanguard money market fund instead of an online savings account for my short term savings. I use a Vanguard money market fund for simplicity and because it gives me a higher yield after tax. Vanguard offers 4 taxable money market funds and 6 tax exempt money market funds. Which one do you choose?

They are all good. The main difference among the 10 Vanguard money market funds is how the funds' income is taxed at the federal and state level. Which one will be slightly better than others for you depends on your federal and state marginal income tax brackets, whether you itemize state income tax deductions, whether you will pay the Alternative Minimum Tax (AMT), and the percentage of the fund's income derived from private activity bonds subject to the AMT.

The incomes from all money market funds may be called "dividends" but they are really just interests. They don't get any special tax treatment for qualified dividends.

1. Vanguard Prime Money Market Fund (VMMXX). The income from this fund is taxed at both the federal level and the state level.

There is also a Vanguard Federal Money Market Fund (VMFXX). For customers in California, Connecticut and New York, the Federal fund is also fully taxable at both the federal level and the state level, just like the Prime fund. For customers in other states, about 20-25% of the income from the Federal fund is taxed at the federal level but not at the state level; the other 75-80% of the income is fully taxable at both levels.

2. Vanguard Treasury Money Market Fund (VMPXX) and Vanguard Admiral Treasury Money Market Fund (VUSXX). The income from these two funds are taxed at the federal level, but not taxed at the state level. The difference between the regular fund VMPXX and the Admiral fund VUSXX is that the Admiral fund is cheaper by 0.16% and it requires a $50,000 minimum investment versus $3,000 for the regular fund.

3. Vanguard Tax-Exempt Money Market Fund (VMSXX). The income from this fund is not taxed at the federal level, but a majority of it is taxed at the state level. Income from private activity bonds in the fund is subject to the Alternative Minimum Tax (AMT).

4. Vanguard state-specific Tax-Exempt Money Market Funds. There are 5 of these, for taxpayers in CA, NJ, NY, OH, and PA. If you are a New Jersey taxpayer and you buy the Vanguard NJ Tax-Exempt Money Market Fund, the fund's yield is taxed neither at the federal level nor at the state level. These funds are sometimes referred to as "double tax free" funds. Income from private activity bonds in these funds is subject to the Alternative Minimum Tax (AMT). If you don't live in these 5 states, then there's no point of buying these. Consider instead the national tax exempt fund Vanguard Tax-Exempt Money Market Fund (VMSXX).

5. AMT Tax-Free Money Market Funds. If you pay AMT, a state specific tax exempt money market fund that doesn't invest in private activity bonds may yield higher for you after tax. Income from these funds is exempt from AMT. Unfortunately Vanguard doesn't offer this kind of funds. Fidelity and Schwab are the only places I know which have them. Fidelity has these funds for four states: CA, MA, NJ, and NY. The minimum initial purchase is $25,000, although you can drop down to $10,000 after the initial purchase. Schwab also has funds for the same four states, but Schwab's funds are in general more expensive than Fidelity's.

In order to calculate which fund pays the highest yield after all taxes are taken into consideration, first you have to know what the funds pay before tax. Vanguard provides this information on their web site. For example here's a snapshot for the Vanguard Prime Money Market Fund as of April 5, 2007:

The Compound Yield is comparable to how the banks calculate APY. It is a net compound yield, after expenses are taken out -- don't worry about the expense ratio number listed under the compound yield because it is already included in the calculation for the compound yield.

If you will pay the AMT and you are considering tax exempt funds, you will also need to know the % of fund's income from private activity bonds, which is subject to the AMT. Vanguard provides that information in the Holdings section for the fund. For example, here's what Vanguard gave for Vanguard New Jersey Tax-Exempt Money Market Fund (VNJXX):

Fidelity lists the yield for their AMT Tax-Free Money Market funds on their website. You will need the "7-Day Effective Yield %" number.

After you gathered all the inputs, it's time to crank the numbers. I made a calculator for computing both the bottom line, after tax yield and the tax equivalent yield. The fund with the highest after tax yield puts the most money in your pocket after all taxes are paid. You get to see how much difference your choice really makes (sometimes very small, to the tune of less than $1 per $10,000). The tax equivalent yield is comparable to the APY quoted by bank savings accounts.

Although this post is about selecting among Vanguard money market funds and Fidelity's AMT free money market funds, the calculator is generic. You can use it for money market funds offered by any company. You can even use it for regular bond funds, although selecting a bond fund will involve more consideration than just yield.

If the inline frame doesn't come up for you, please access it directly from the hosting site or the alternate hosting site.

For example, at the time I wrote this post, a taxpayer in 25% federal, 6.37% state tax brackets, itemizing deductions, not subject to AMT, is better off with the Treasury or Admiral Treasury fund.

Who knew choosing a money market fund can get so complex?

Related posts:

• Best Checking Account Which Is Not A Checking Account
• Risks in Money Market Funds
• Tax Equivalent Yield Calculator Updated
• 2007 Tax Year AMT Brackets

I Bonds Rate Pre-Guess for May 2007

It's close to that time again. The Treasury Department will announce a new fixed rate and the inflation adjustment for I Bonds on May 1, 2007. The inflation adjustment will be known for sure on April 17, when the Bureau of Labor Statistics announces the CPI data for March 2007. At this time, we have 5 months of inflation data, just missing one more data point. Feb. 2007 CPI was 203.499, an increase of 1.083 points from the previous month. The reference CPI number in September 2006 was 202.9. If March 2007 CPI comes out to 204.5, a similar increase as in the previous month, the semi-annual inflation adjustment for the next 6-month cycle will be roughly 0.8%.

On the fixed rate side, real yield on 5-year TIPS dropped from 2.4% in last November to 2.0% now (source). Any adjustment to the fixed rate portion will be down, not up. So we are looking at a maximum 1.4% fixed rate, probably lower to 1.2%, plus a ~1.6% inflation adjustment, for a composite rate of 3% or less. I don't think anybody will be excited about this when Treasury Bills are yielding about 5%.

I Bonds haven't been competitive for quite a few years except for one or two special periods. I will revisit this in April but I don't think the picture will change much then.

References:

• Consumer Price Index data from InflationData.com
• I Bonds composite rate calculation formula from Treasury Direct (scroll down to bottom)

Online Savings Accounts and Their Backers

I mentioned in my previous post What Happens When a Bank Goes Out of Business that I favor larger international or national banks over smaller no-name banks based on the theory that larger banks have larger budget and more sophisticated systems for security. I decided to take a look at the popular high yield online savings accounts and see who their backers are and their relative sizes.

The list of banks were selected from the Bank Deals blog. The deposit data were collected from the FDIC web site. The last column shows the combined total domestic deposit as of Sept. 30, 2006, the latest available from FDIC when I checked. If a bank is owned by a bank holding company which also owns other banks, deposits from all banks under the same holding company are added together. Please note only domestic deposits are counted. Deposits outside of the United States are not included. Citibank, HSBC and ING all have large presence outside of United States.

dba	Bank	Total Deposit ($ billion)
Citibank	Citibank	226.3
Washington Mutual	Washington Mutual	209.9
HSBC	HSBC	74.4
ING Direct	ING Bank	62.5
Capital One	Capital One	45.0
Zions Bank	Zions First Nat'l Bank	31.8
E-LOAN	Banco Popular	23.0
E*Trade Bank	E*Trade Bank	21.2
AmTrust	Ohio Savings Bank	17.2
Emigrant Direct	Emigrant Bank	12.3
UFB Direct	Sky Bank	11.6
GMAC Bank	GMAC Bank	2.9
Amboy Direct	Amboy Nat'l Bank	2.0
iGo Banking	Flushing Savings Bank	1.7
OneUnited Bank	OneUnited Bank	0.4
Presidential Bank	Presidential Bank	0.4

As the data show, there is a huge difference in size between the larger, more established banks and the smaller banks. Citibank has 18 times more deposits in the U.S. than Emigrant Bank. Emigrant Bank in turn has 30 times more deposits than Presidential Bank. These banks, offering the same online savings account service, are on entirely different scales. It's inconceivable that a smaller bank has the same level of investment or sophistication in security measures as a bank several hundred times larger.

If a smaller bank offers higher yield than a larger bank, should you go for the higher yield? You will have to decide for yourself. For me, I don't use any of these banks because I keep my emergency fund in a Vanguard money market fund. See my previous post A Baby Step for Simplifying My Finances.

Zions Direct Online CD Auctions Update

This is a follow-up to my previous post Bank CDs by Auction: Name Your Own Yield. The second online CD auction at Zions Direct closed today at 2:02 pm EST. Up for auction was $2 million 3-month CDs issued by Zions First National Bank with a coupon of 5.25%. The auction received 88 bids from 51 bidders. The final market clearing yield was 5.33%.

As in the first auction, large bidders continued to dominate. Bidder 13192 entered a bid at the very last minute for 2,000 CDs at 5.33% while there were only 2,000 CDs available in the auction. Their bid determined the final result. Whoever bidded for a lower yield (higher price) than that from Bidder 13192 won. Those who wanted a higher yield than what Bidder 13192 accepted lost. [Source: auction result on Zions Direct.]

5.33% yield is still pretty good. It wasn't good enough for me (T-Bills are better), because of the state income tax. But for people in states without state income tax or who want to purchase CDs in an IRA, the difference in state income tax treatment is not an issue. 5.33% APY would place it as #3 on Bankrate.com's list of highest yielding 3-month CDs in the country. I just checked the brokered 3-m