IRAs: Roth and the Other Kind

Poke around the blogosphere and personal finance punditocracy and you will find lots of positive references to Roth IRAs and virtually no nice things said about its dull older brother, the traditional IRA. If you didn’t know any better (and why would you?) you might assume that the younger and hipper Roth IRA was the way to go. After all, it is the cool new thing and the latest in retirement savings technology. Here’s a rundown of the differences and why you are likely to want to go with the unhip kind after all.

IRAs come in two basic flavors. There is the traditional old-style IRA, in which you put pre-tax money, i.e. your contributions are tax deductible, and then later in life pay taxes on your withdrawals as if they were income. And there is the relatively newer type, a Roth IRA, in which contributions are post-tax, i.e. not deductible, but withdrawals are tax-free.

Which is for you? Obviously, you want the one that will wind up making you more money. To tee that up, consider the following.

Tom Traditional and Robbie Roth have identical incomes, and so pay identical tax rates, and they both have $3,000 a year of that income that they wish to put in an IRA. Obviously, each picks the type that matches their name, so Tom puts in the full $3,000 each year and Robbie puts in $2,250 after paying taxes of 25%. The years pass, and they make identical investment decisions until they retire on the same day. Tom’s account is, of course, larger but he needs to pay 25% taxes on anything he takes out, while Robbie can withdraw tax free. Here’s the big question: after Tom pays taxes on his withdrawals, who has more money to spend?

The answer, which seems to surprise a lot of people, is that they have exactly the same amount of money. Assuming the tax rate going into the Roth is the same as the one coming out of the traditional, the financial benefit of the accounts is exactly the same. Fire up Excel and run the numbers yourself if you don’t believe me.

So why do the advocates of saving seem to universally prefer Roths? It’s not about numbers, it’s about conceptual appeal. Saving is about sacrificing now for a benefit in the far-off future. With a Roth, you pay taxes now so you can not pay taxes later, and that has a big attraction to the savings crowd.

Symbolism aside, there are good reasons to choose one type of IRA over the other. Primarily, which one is better depends on the tax rate you pay now and the one you will pay when you are retired. Tom and Robbie came out equal because they always paid 25%. If the tax rate had been 25% when working but only 15% during retirement, then Tom would have wound up ahead because he would avoid the 25% and only pay 15%. Conversely, if the rates were 25% while working and 35% when retired, then Robbie would be better off.

Occasionally you see the pro-Roth argument that given the fiscal problems the government has now and is likely to have in the future, tax rates will inevitably rise. That sounds perfectly reasonable, but it is worth reflecting that the same thing could have been said for the past 30 years and so far it’s been wrong. Predictions of what Congress will do in future decades is hardly a sound basis for your retirement planning.

On the other hand, predictions of how much money you will be making in retirement, and so which tax bracket you will be in, are more practical. If you have a Roth, you are betting that your income, and your tax rate, will be higher in retirement than it is now. That’s some bet. (You do understand that in retirement you won’t have a job, don’t you?) Furthermore, choosing a Roth over a traditional is doubling down the bet on your own future prosperity. If you wind up being a rich retiree, you’ll be happy you have a Roth because you won’t pay high taxes on the withdrawals. But if you wind up a poor oldster you’ll wish you’d picked traditional, because you’d have more money, even after paying the (lower) income taxes on what you take out.

There are other factors to consider when choosing between the two types of IRA. (There’s a nice rundown here and here.) But they are all secondary to the tax rate issue and some of them are pretty esoteric. In the big picture, what matters are tax rates now and when retired. And for many, if not most, people that means that an old-school traditional IRA is a better choice, even if it lacks hipness and the frugal appeal of paying more now for a benefit far in the future.

Yet Another Excellent Carnival

The premier edition of The Carnival of Government & Money features my educational (and only slightly dated) post on how big the stimulus package really is. It’s hosted at the brilliantly named blog Spilling Buckets. Government workers might not enjoy it, but everybody else will.

Frugal Friday Feb. 20

It’s that time again! Here is this week’s highlights from the Frugalosphere.

Lots of questions, sublime and mundane, were asked and mostly answered this week. Lazy Man and Money asked if wine tasting was a frugal hobby. Why, yes, it is. Wine drinking, on the other hand, could set you back a few dollars. Free Money Finance asked Should Christians Have Life Insurance? Again the answer is yes, provided you do not buy more than you need, which apparently raises thorny theological issues. (Possible follow-up posts: Should Muslims Drive Volvos? Should Jews Own a Tivo?)

House Prices: The Long View

There was an interesting post at Debit vs. Credit two days ago suggesting that now may not be the time to buy a house. The gist of the argument was that house prices still have a way to go before they return to normal. This was illustrated with a chart of median new home prices as a ratio to median income since 1963. That’s not the most ideal set of data to use, for reasons that I will spare you.

The most useful measure of house prices are the S&P/Case-Shiller Home Price Indices. They only go back to 1987, but one of the co-inventors of the index, Robert Shiller, has chained together other useful house indexes to patch up a composite going back to 1890. (This is the third post that has mentioned Prof. Shiller in the past month. Just coincidence, I swear.)

I downloaded the data from his site, updated and cleaned up a few things, and produced the following chart, showing the inflation-adjusted sale price index for existing homes since 1890.

If you’ve never seen something like this before, you may be experiencing some shock and confusion. This is normal. Just keep breathing deeply. You thought house prices went up over time, didn’t you? Well, they do, but mostly because of inflation. Recent experience excepted, house prices are generally flat over long periods of time once inflation is factored out.

A few other observations worth making:

1) The last index value in this chart (which is for November 2008) is 144.0, still 13% higher than the 1989 peak of 127.4. That does suggest that we have a little more to go, or at least did as of November. On the other hand, it’s already down 40% from the 2005 peak of 202.5, so the worst may be behind us.

2) The recent run-up in house prices actually began in 1996. (From 1996 to 2005 real prices went up 86%.) It may not have gotten weird enough to be noticed in the media until the last years of the boom, but the index began hitting all-time highs as early as 2000. I mention this because it’s currently fashionable to blame the low interest rates of 2003-04 for the housing bubble. They sure didn’t help, but the worst you can say is that they were gasoline thrown on an already blazing fire.

3) As impressive as the 1996-2005 run up is, it is not entirely out of the ordinary. From 1942 to 1947, real house prices went up 60%, which is the best five year run in history. Further, prices pretty much stabilized after that and did not give back very much of the gain. This needs to be pointed out to those who say, in hindsight, that of course house prices had to fall after 2005, because the rapid gains made in years before were just unsustainable.

So is this a good time to buy a house? That depends. Do you need one to live in? There are many factors to consider, including interest rates, tax breaks and other incentives from the government, and local market conditions. (It is worth stating the possibly obvious that the chart above is a national average. Specifics of a particular area may differ both in the short and long run.)

But if you are looking at a house as a possibly shrewd investment, something you can buy cheap now and sell dear later on, you are likely to be disappointed. Even if the crisis were over today, and house prices returned to their pre-bubble habits, the normal state of things is that they don’t go up very much.

Suze Orman’s 2009 Action Plan, Part 2

[This is the second part of a two part review of Suze Orman's 2009 Action Plan. If you haven't already, you might want to read Part 1 first.]

In general, Suze Orman’s lack of candor can only be inferred from the advice she gives. For example, at several points in 2009 Action Plan she brings up the idea of taking out loans from a 401(k) plan and using the proceeds to, for example, pay down other debt. (For the uninitiated, a loan from a 401(k) plan is just what it sounds like. You allocate some of your 401(k) account to a loan to yourself, which you pay back with interest.) In every case she is firm in her rejection of the idea, even to pay off credit card debt charging 32% interest (p. 59.)

On its face this advice is nuts. Taking out a loan from your 401(k) frivolously, to go on a cruise perhaps, is clearly a poor idea. But within the realm of debt a 401(k) loan is almost certainly the best deal going and using it to pay off a loan with a Tony Soprano interest rate is just about as clear a no-brainer as you can find in personal finance.

So why does Suze Orman wave you off this strategy? Is she nuts? She gives the feeble explanation that in these uncertain times the risk of losing your job, which might mean the loan would be due in 60 days, is too great. That would be a lot more convincing if she did not, in the two ”situations” that immediately follow, discuss withdrawing funds from your retirement accounts for living expenses if you become unemployed.

Reading between the lines, the real reason Orman thinks this is a bad idea becomes clear. She thinks that if you take out the loan and pay off the credit card it will only be a matter of time before you run up the credit card balance again, leaving you with both a large credit card debt and a loan from your 401(k) to pay off. She’s not nuts. She thinks you are. But she can’t say that. So she tells a little white lie and moves on.

Very similarly, she calls using a HELOC (Home Equity Line of Credit, or a second mortgage) to pay off credit card debt “a dangerous mistake. You are putting your house at risk.” (p. 30.) That’s a common bit of folk wisdom, but it’s wrong. Short of bankruptcy, you are going to have to pay back all the money you owe sooner or later, and it would be helpful if the debt had a lower interest rate in the meantime. If you do go bankrupt, you may or may not be able to keep your house (and if you do it will be without much equity) but whether the debt in question was a second mortgage or unsecured loan will not change the outcome. Again, Orman gives the advice she does because she assumes you have a serious willpower problem. If you refinance your credit card with cheaper debt you will only start spending even more and dig the hole deeper.

Do all of Orman’s millions of readers have that sort of psychological dysfunction? For all I know, they do. She certainly has a devoted following who apparently find her advice useful. Even so, I would be a lot happier if somewhere near the beginning of her books she said something like “this book isn’t for everybody” and explained the sort of self-destructive behaviors her work was meant to address. Like they say, the first step is admitting you have problem. But Suze Orman admits nothing. She is like the wife of the compulsive gambler who tells her husband she doesn’t want to visit Las Vegas because she doesn’t like the desert climate. While preaching the importance of honesty and being realistic about your finances, she gives advice that is, in fact, an elaborate and disguised work-around to compensate for her readers’ presumed shortcomings.

Suze Orman’s 2009 Action Plan ends with the platitude that you should “always choose to do what is right, not what is easy.” Sometimes what is right is hard and uncomfortable. It might be hard to hear that your favorite money guru occasionally gives bad advice or that you are acting irrationally, but if it is the truth, it needs to be said. Like the lady says “The lies need to stop.”