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United States41649 Posts
I wasn't sure what to put in my second blog about money but this seemed to follow on pretty naturally from the topic of retirement savings in the first one. These three cover the most common options and most other options are just modified versions of these. Every American taxpayer should have a basic understanding of these because it's important to pay less in taxes and get credits. As I wrote in my last blog, I'm working poor, and that means that the money I can generate using these tricks is pretty fucking great.
What are they?
IRA stands for Individual Retirement Arrangement although the retirement part of that is a bit of a misnomer. What an IRA is, in layman's terms, is very special wrapping paper for an investment account. An IRA will be basically indistinguishable from a normal investment account for practical purposes but because it's called an IRA it gets a bunch of special tax rules applied to it. The investments you package in an IRA are pretty much up to you, just as any other investment account would be, all the IRA label does is let the government know to treat it differently for tax purposes.
There are two types of IRA, Traditional and ROTH. In the traditional you put in pre-tax money (money you have yet to pay tax on or, more commonly, money you have paid tax on but will claim the tax back on in April to make it pre-tax money again). In the ROTH you put in post-tax money. With the Traditional you put the money in without paying any tax on it, it grows and then you pay tax on the original money and the growth coming out. With the ROTH you put the money in after paying tax on it, it grows and then you get the original money and the growth tax free.
Now the very astute among you may be thinking "wait a second, those are the same damn thing" and you'd be right. There is a very common assumption that the ROTH is automatically better because it's tax free but that is not correct. Here is how the maths breaks down both of them.
Traditional
(Money*(Annual Return^Years))*Taxes
Roth
(Money*Taxes)*(Annual Return^Years)
Try it yourself, take $5000 of earned income, a 25% tax rate (so the tax multiplier would be 0.75), a 7% annual return (so use 1.07) and 10 years.
($5000*(1.07^10)*0.75=$7376
($5000*0.75)*(1.07^10)=$7376
How to abuse them
However, and this is where it gets really cool, the taxes are not a constant. On the ROTH you pay taxes at whatever your current rate is this year and are then tax free in the future. On the Traditional you are tax free right now and then pay taxes in the future on a year of your choosing. I think the vast majority of us will experience a fair bit of fluctuation in our incomes and tax brackets in our lives. If you're married and you plan on having kids and having a parent stay at home for a few years then that drop from double income to single income is hugely exploitable with this. Or, if like me, you plan on just QQing out of the system at some point in the future then you want to take all your taxes in the future on the years where your income is very low. This means you can turn your Traditional IRA into a magical tax avoidance box.
The beautiful, beautiful part of this system is that you can, at any time, choose to convert money from a tIRA into a ROTH IRA as long as you pay tax on the conversion as if it were income that year. And once you've done that it's in the ROTH, it's tax free, you don't give a fuck.
Basically when you're at 25% tax (or whatever it is you're at) you can make $5000 (or whatever) disappear from your income that year and not get taxed on it. And then when you're at 0% tax (or 10%, whatever, ideally lower than 25% though or you fucked this up) you can make that $5000 reappear as part of your income for the current year and pay taxes on it then. And if that sounds dumb as fuck then don't worry, you're not misunderstanding, it really is dumb as fuck.
Okay, but don't I have to... like... retire to spend this?
Not necessarily. There are a bunch of rules regarding withdrawing the money from your IRA accounts. They are intended for retirement and therefore if you make distributions before the age of 59.5 then you get hit with a 10% penalty tax (in addition to the tax on it as if it were income in the case of the tIRA). However you can withdraw your contributions to a ROTH IRA at any time, no tax, no penalty, and you can withdraw your conversions from a tIRA to a ROTH IRA at any point after a 5 year vesting period. What these rules let you do is what is called a ROTH ladder.
Basically how the ladder works is that you stagger your withdrawals. Each year you make one tIRA to ROTH IRA conversion and then five years down the line you get to make a distribution of the money you converted five years ago. Also, unlike regular ROTH contributions, there is no limit on how much you can convert into your ROTH.
Okay, 401ks?
Basically the same thing as a tIRA except rather than you putting the money in yourself and then claiming the tax back on it at tax time to make the money pre-tax your employer puts the money in directly out of your wages before you're taxed so it's less hassle. Also your employer will usually offer some kind of match which is free money. Seriously. If you have a 401k and you're not contributing at least to the match then you're just leaving money on the table. Usually it'll be something like they put in 50 cents for every dollar you put in up to around 6% of your income. That's a pretty sweet offer. On an income of $30k then that'd be you putting in $1800 and they give you a free $900 to say thank you for playing along.
How does this relate to all the bullshit above?
401k plans are run by employers for employees (although the funds will actually be held by an investment company, same as IRAs). If you leave the company you have your 401k with then you can either put the money into the next company's 401k or you can roll it directly into a tIRA with absolutely no tax implications or bullshit (because you're putting pre-tax money from one pre-tax account into another pre-tax account). So that lets us set up a pipeline from 401k to tIRA to ROTH to our wallet. And that's why you always take the 401k match. Maybe if you have high interest credit card debt then prioritise that but basically a 401k match will be a guaranteed 50% to 100% (different companies match different things) return on investment.
This is also why I was so excited in my last blog about them offering to match 10.7% of my salary in their retirement plan with a 10.9% contribution. They're literally giving me a 10.9% pay rise with tax deferred to a time of my choosing.
Anything else I need to be aware of?
Actually, yes.
For the purpose of taxes the government doesn't care about your gross income, they care about your Adjusted Gross Income or AGI. Your AGI is your gross after anything you buy with pre-tax money (health insurance, dental, vision, healthcare FSA, daycare FSA and, and this is the good one, pre-tax retirement contributions). AGI is what they use whenever anything has an income limitation, tax credits, deductions, benefits, whatever. And if you can choose how much you set aside for retirement then you can play with your AGI a lot.
For example, if you're married filing jointly and you can get your AGI below $36,000 (and you can fine tune it to $35,999 if you want) then the government will give you a 50% match on any retirement savings you made (and we made a shitton in order to become eligible), on up to $4000. So basically they reward you proportionally to your usage of the tool that made you eligible for the reward which is a beautiful, amazing clusterfuck of exploitability. EITC, AOTC and a few others also use AGI although the EITC doesn't play well with the Saver's Credit. The point is though that once you develop the tools to play with your AGI the system is basically exploitable.
Also there are contribution limits. You can only contribute $5,500 into your IRA (limit is for both combined so you can do $2,000 and $3,500 or whatever) in 2015 and up to $18,000 into your 401k (or equivalent plan). Public sector employees will probably have access to other options too, I have access to my 401k equivalent, a 403b and a 457b in addition to my tIRA which gives me more room than I can use for now. There is no limit to rollovers (401k to 401k, 401k to tIRA, pre-tax to pre-tax) and no limit to conversions (tIRA to ROTH IRA).
IMPORTANT: Read this if you have a 401k
Also a lot of 401k plans are kinda shit in terms of allocation. This is something you need to be aware of, even if absolutely none of the other stuff I mentioned sounds appealing to you. If you're just going about your business, putting 5% into your 401k each year, saving for retirement, and you trust your employer to manage your funds then you're getting fucked. You see the person who makes decisions about where exactly your money gets invested is Sue over at HR and Sue isn't the brightest star in the sky, especially when it comes to looking after other peoples' money. So the smooth talking guy from Edward Jones approaches your company and tells Sue that your company should have their 401k account with Edward Jones and he takes her out to dinner on his corporate card and then he smiles at her and Sue hasn't gotten laid in a while she's not thinking straight. And then Sue gets fucked. And when Edward Jones fucks Sue they get to fuck all of you.
This is the huge, huge problem with 401ks as retirement accounts in the United States. One of the key advantages of them is that they're self directed (within a range that the provider will offer, your employer chooses the provider) but one of the huge problems with it is that the employees don't know and don't care what they're in. If you haven't logged into your account and checked what you're in then you're being fucked. You're literally paying for Sue to get laid. A lot of accounts will have expense ratios of over 1.5% which is crazy, it's 1.5% out of everything you saved, every year, just for having the account. I made a google doc sheet that you can use to compare expense ratios in real terms and I'll link it below. Anything above 0.5% is cause for alarm, ideally you can get below 0.1%. Recently I took a look at my wife's 401k and found a super cheap index fund option which had expenses around 30 times lower than the default allocation. Don't be in the default. The 401k system is a tool that you can use if you inform yourself and if you care but if you don't work with it then you're going to fall victim to the predatory financial system.
Really cool sheet for working out taxes/benefits with different income allocations/deferrals (I did not make this)
https://docs.google.com/spreadsheets/d/1TxSIIVigYyafM4WKLgDAowmlTmpHUXDjauQhUNHDJCE/edit?usp=sharing
Google sheet that lets you compare different expense ratios (I made this, change the numbers in green and everything else calculates itself)
https://docs.google.com/spreadsheets/d/1OtzmhbCvdYoDtmwVA1clTHfYHY8JCQ88Mhfd5JJLY_M/edit?usp=sharing
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United States41649 Posts
Incidentally how this applies to me right now is that I'm making maximum ROTH IRA contributions each year and will be for the next decade or so. I don't need the tIRA reduction to my AGI because my tax rate at the moment is crazy low because I don't really make shit and I defer a considerable amount of what I make using the other vehicles such as my 401k equivalent and 403b.
What this means is that I have a pool of post-tax money appreciating tax free in investment accounts and I can withdraw the contributions, tax free, whenever I want. To put it simply, if you put $5,000 into a ROTH IRA each year for 10 years then after 10 years you would be able to withdraw $50,000 from said account whenever you wanted without it counting either as income or being taxed. Obviously the balance would have grown a little during that time and you can't cash out the growth before 59.5 without taking a penalty, just the original contributions, but that's still okay.
Now 10 years in you pull the plug and you stop working. Your income drops to zero. At this point you make a $25k tIRA to ROTH IRA conversion and the ladder begins. You're taxed on that $25k as if it were income but the tax rate on $25k is pretty low, the sheet puts it at $1,618 which is around 6.4%. You begin withdrawing contributions from your ROTH IRA to pay the bills. Keep that up for 5 years and suddenly your first conversion becomes eligible for tax free withdrawal. Now you're getting that pre-tax earned income to post-tax money in your wallet through the pipeline at an effective tax rate of 6.4% (the tax you paid when you converted from tIRA to ROTH IRA).
Unfortunately you can't withdraw growth on the ROTH money without a penalty which means that the growth in the ROTH is there to stay until 59.5 (but you'll be 59.5 one day and it's compounding away happily enough). However both contributions and growth in the tIRA can be converted to the ROTH, it doesn't distinguish between where in the tIRA the money came from when it converts it and you can withdraw the entire conversion you make.
So the game basically is to get enough money in a tIRA that the annual growth is your expected expenses (minus any side income you may have) and to get enough money elsewhere (for me I'm using the ROTH contributions for this) that you can live for five years. And at that point you're done. You're out. You won the game.
You don't have to ragequit employment as I plan to but if you plan on having kids or whatever at some point and you're expecting your effective tax rate to go down then still defer taxes and do ROTH conversions. This is a very versatile tool which will fit pretty much anyone but people like doctors who have a 30+ working life with constant and crazy income increases throughout.
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roth ira, index funds, set and forget. my strat
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United States41649 Posts
On July 06 2015 09:32 esla_sol wrote:
roth ira, index funds, set and forget. my strat
My strat used to be to put one probe on each mineral crystal because that was obviously the most efficient and therefore optimal outcome. Sure, you could make extra probes but that'd just be wasted minerals when the map was mined out. I was better than all my friends at Starcraft anyway so I was pretty sure I knew what I was doing.
And then, one year in 2004 or something, I got on Battlenet.
That said, +1 on the index funds.
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On July 06 2015 10:14 KwarK wrote:Show nested quote +On July 06 2015 09:32 esla_sol wrote:
roth ira, index funds, set and forget. my strat My strat used to be to put one probe on each mineral crystal because that was obviously the most efficient and therefore optimal outcome. Sure, you could make extra probes but that'd just be wasted minerals when the map was mined out. I was better than all my friends at Starcraft anyway so I was pretty sure I knew what I was doing. And then, one year in 2004 or something, I got on Battlenet. That said, +1 on the index funds.
That might be the new meta in LotV, you never ever know
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thx bro, great post and I thought I had this shit down pretty well but learned alot reading this  .
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Favourited.
This will definitely be extremely useful when I start to sort all my shit out in a year or two.
Thanks Kwark!
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All I can conclude is that I think my NHS pension is shit.
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United States41649 Posts
On July 06 2015 13:20 MoonfireSpam wrote:
All I can conclude is that I think my NHS pension is shit.
Not so sure. For the majority of Americans the 401k system doesn't really work and that's the system that they rely upon for pensions. Most people don't really use it, or not beyond the minimum that many jobs will automatically enroll you for unless you opt out. A lot of people don't even take the match (which is crazyballs but people can't money). And the vast, vast majority of people who do use it are getting fucked by the brokers who are taking most of the growth that the people will need for retirement. A lot of politicians, especially those on the left like Bernie Sanders, have been calling the entire 401k system broken and calling for it to be scrapped. Personally I think it's a great option in terms of individual choice for people who wish to educate themselves and play the game but I accept that those people are a tiny minority of nerds like myself and the system should try and help the rest of them who can't be trusted to make good decisions.
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Have you thought at all about going into tax/accounting policy?
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United States41649 Posts
On July 06 2015 22:52 farvacola wrote:
Have you thought at all about going into tax/accounting policy?
Probably too ethical and too stupid for anything like that. The current situation exists for a reason, it's not that it doesn't work well, it's that it doesn't work well for any of the people that it "should" work for. There is a pretty crazy amount of money on the line for keeping things as they are for the big financial groups.
What I'd like to do once I'm out of the system though is financial literacy classes and help educate people on all the bullshit in the system. Thinking I'll write about taxes next and that's probably the biggest in terms of bullshit. But it's like the Starcraft metaphor I used earlier, it's simply not reasonable for any individual playing against computers to learn to be Boxer, or whatever. There is so much depth and complexity to pretty much any subject that can only really be explored by a community of people who challenge each other's ideas and theories. Finance isn't something you can risk being bad at, even if you think you're doing great because you have your friends beat. People end up like the guy who is the best at Smash Brothers in his school only he's betting his life savings on it.
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United States41649 Posts
Update: I just opened the ARP that I discussed in my previous blog a few seconds ago and set the allocation. The default allocation that it selected for you if you didn't change anything had a fee of 0.75% of every dollar in the account each year. They had similar options available with a fee as low as 0.05%. If you're wondering how they can get away with that shit it's because nobody gives a fuck.
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United States22883 Posts
I've been contributing to a Roth IRA for a few years now, but I'm still trying to determine if I should start a traditional as well. I guess I should try to predict my AGI and add in the traditional as needed to change my tax bracket.
Isn't another aspect that with a Roth, you're not taxed on the interest you've accrued but your contribution is technically lower (or it costs more for the same amount) so you're earning less interest for your money.
My 401k is split 50/50 between traditional and Roth (both in index funds, up to employer's match). When in doubt, diversify.
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United States41649 Posts
ROTH and Traditional contributions into the same thing doesn't get you extra diversification unless you're afraid that someone is going to announce a predatory tax on ROTH accounts or whatever. Normally either ROTH or T will be the right choice for you and you'll max out one or the other, the low limit makes it pretty rare that you'll need both. That said you'll probably need to open a tIRA at some point just to roll a 401k from a past employer into. Fortunately index funds are already pretty diversified, depending on the type of fund of course. If you're young you can shoulder higher volatility but if all your money is in biotech index funds or whatever then you should probably look into greater diversification. Standard three fund portfolio is generally domestic whole market index funds, domestic bonds and international index funds in a ratio that suits your temperament and need for returns. You can mix it up a little beyond that if you like and go into some of the more specialized index funds with some of your play money but you will probably lose diversification compared to whole market index funds.
That said there are those who believe even that approach isn't very diversified and that you should also consider real estate funds, precious metals and, as we go off the deep end, bullets. Your mileage may vary.
As for the interest, basically yes. Traditional contributions go in untaxed so as long as you put in the tax you didn't pay as well then you'll have a bigger starting fund and therefore a more growth. Then the tax hits at the end. ROTH you contribute post tax so what would have been a $1000 pretax contribution is only $850 or whatever. That means it compounds to a much lower number which, if tax rates remain constant, will work out to be exactly the same yield post tax as the tIRA. If taxes remain constant there is no difference between the yields of the two accounts although I do like the fact that ROTH contributions can be withdrawn with no notice which means they can function as an emergency fund.
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Whatever happened to the "MyRA" that our glorious leader discussed in that one SOTU speech? "A decent return with no risk"? Did people just giggle at him until it went away or what
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United States41649 Posts
On July 12 2015 09:47 bookwyrm wrote:
Whatever happened to the "MyRA" that our glorious leader discussed in that one SOTU speech? "A decent return with no risk"? Did people just giggle at him until it went away or what
It was a pretty good idea as a way to get the people who don't believe in banking/investment accounts and so forth to save for their retirement. A special account that only buys US treasury bonds or whatever. It might exist, it might not, it's entirely irrelevant for my readership.
There are already a great many types of accounts that guarantee no risk on the money you put in. Whole Life Investments are a common form of them, for example. They offer lower returns than the index funds will produce over time and then just invest it on your behalf while being so laden with fees and early cashout penalties that you can't access your money during a market downturn without taking a hit on it equivalent to the loss on the market.
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let's just satisfy my philosophical pedantry and amend "no risk" to "little risk except the risk of systemic collapse produced by the doctrine of TBTF" 
Look upon my T-bills, ye mighty, and despair!
Also, aren't these things basically governments subsidies for wall st? Isn't that all kinds of messed up?
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EPT
