One of the most interesting posts I’ve read recently is Frank Curmudgeon’s* The Roth Segregation Conversion Strategy.

Before we launch into Frank’s strategy, let’s cover the basics.

Recharacterization is the ability to move money that you put into your Roth IRA this year, into a traditional IRA instead.  It was created to enable people to correct their mistakes, such as funding a Roth IRA when their adjusted gross income is too high.  Recharacterization enables correction without penalty.

The basic Roth recharacterization tax-avoidance strategy goes like this:

• At the beginning of the year, you convert your IRA into Roth,
• At the end of the year, you recharacterize the Roth back into the IRA,
• If the Roth earns money during the year, you only have to recharacterize the amount put in at the beginning of the year, leaving the earnings in the Roth forever tax-free.
• If the Roth loses money, you only have to move back remaining amount into the IRA.  And you can try again next year

Mr. Curmudgeon takes it one step further,

• At the beginning of the year, you take your IRA, and divide it into two halves.
• Invest one half long and one half short (e.g. S&P 500 ETF’s), each in a Roth IRA.
• At the end of the year, one investment will be up x%, and the other will be down x%.
• Then you recharacterize both back into IRA’s.
• For the Roth that made money, you need only recharacterize the amount you originally put in, letting you leave the x% in the Roth, forever tax free.

Sounds like a great idea.  I can see why he enjoyed working in a hedge fund.  If you start with $200k, the market moves 10% in a year, and you’re in the 28% tax bracket, you’ll save $2800 in income tax, less transaction costs.  That’s only a 1.4% return on your investment, but it is risk-free.

Towards the end of his post, Frank gets cranked-up and starts optimizing the strategy through winner-take-all strategies.  You can minimize taxes by dividing your IRA investment into 37 Roths and (somehow) bet each on a different number on one spin of a roulette wheel.  One Roth will win, and it ends up with roughly 37 times its original amount, tax free.  All the other Roths are worthless.  The net result is to transfer the original sum into a Roth, tax free.  There’s the little problem that roulette bets are not a legitimate IRA investment option, but a reader proposed an option, if you’re interested.

I thought this all sounded quite interesting but just a little too good to be true.  Why would the IRS let me recharacterize only the original amount?

I began searching the IRS website.  The original IRS Code 408A(d)(6)(B)(i), clearly states that if you recharacterize, you must include the earnings.

If so, that blows the whole scheme.

There are legitimate uses of recharacterization, but use them sparingly to avoid the unpleasant glower of the IRS.  I think I’ll leave the roulette wheel to Frank.

* I love the nom de plume.

Image credit:  Flickr

How do I figure out whether I’m saving enough for retirement?  What’s the impact of one bad year in the stock market?  How much can inflation erode my nest egg?

These are the types of questions that can be addressed by financial modeling.  I’ve written a program that lets you enter data for two people (presumably you and your significant other), and it calculates the probability that you will have enough money to last both of you.

You can use Quicken or other retirement calculators, but they usually do not include a Monte Carlo simulation.  Monte Carlo does not mean you take your life’s savings to Monaco and let it ride on roulette red.  A Monte Carlo simulation is used to model systems that have some random elements and for which the outcome can’t be expressed by a simple formula.  The return on your investments fluctuates from year to year.  Low investment returns are worse if you are close to retirement than if you are just starting out.  So the timing of the market highs-and-lows relative to your time-to-retirement is an important factor.  A Monte Carlo simulation calculates a lifetime of savings and expenses, letting the investment returns vary.  Then it repeats that calculation many times, simulating many possible lifetimes. Continue Reading »

When I posted recently on how to choose whether to fund your 401(k), Roth, or traditional IRA, I forgot to mention another category:  the Roth 401(k).  The Roth 401(k) rocks.  Like a Roth IRA, you put money in post-tax but then (in retirement) you take out the funds (plus appreciation!) without tax.  Unlike a Roth IRA, there is no income limit to be eligible to contribute.  For a Roth IRA, contribution eligibility phaseouts begin (for 2009) at $105k for singles and $166k for married folk.  Only about 20% of employers’ 401(k) plans offer the Roth option, but the percentage is growing.

If your employer offers a both a 401(k) and a Roth 401(k) and matches both, you might consider dividing your contribution equally between the two, to hedge against future changes in your tax rate.  Your tax rate might change if you make a lot more (or less) money or because Uncle Sam decides to change the rules.  Either way, it’s a good idea not to have all your eggs in one basket. Continue Reading »

There are three types of retirement investment accounts for employees: 401(k), Roth IRA, and the traditional IRA.

If your employer offers a match to your 401(k) contributions, then your first priority should be to contribute enough to the 401(k) to maximize any employer match. For example, your employer may offer to match 50% of the first 6% of your salary that you contribute. If your salary is $50,000, and you contribute 6% ($3,000), your employer will match half, or $1,500, for a total of $4,500 in your retirement account. You don’t pay income tax now on either the contribution or the match, but you will when you take it out (plus any gains) during retirement. The idea is that you’ll then be in a lower tax bracket, so you save on taxes. (I’m not sure I believe we’ll be at a lower tax bracket in retirement, but I’ll leave that argument for another post).

Fewer companies are matching these days, and it may be a benefit on the way out, but as long as it’s there, take full advantage of it — it’s free money.  Continue Reading »

This weekend, the Boston Globe had an article on a change made to 401(k) investment plans during the Bush administration.  The change enabled businesses to automatically enroll employees in the retirement plan — employees would have to take action to opt-out.  In addition, if the individual didn’t specify how to invest the funds, they would automatically be invested in stock-heavy funds.  The Globe article estimates that 1-2 million workers were affected by the new law, and of course with the markets in a free fall, these employees have lost much of their initial investment.

This origin of this change was the Pension Protection Act of 2006.  The Act changed many things about pensions and retirement accounts, including creating the default opt-in for 401(k)’s.  It would seem to be a good idea — to give a bit of a push to those folks who are reluctant to fund their retirement accounts, presumably out of procrastination or trepidation.  The default investment was determined by “Section 624(a) of the Pension Protection Act directed that such regulations provide guidance on the appropriateness of designating default investments that include a mix of asset classes consistent with capital preservation or long-term capital appreciation…”  In other words, the default was a conservative investment.  Fast forward to December 10, 2008 and the swift pen of the Joint Committee on Taxation, p. 12, relieved the restriction on default investments.  Hmmm… that was about 41 days before Obama took the reigns.  D’ya think maybe there was just a wee bit of lobbying going on by the investment powerhouses? Continue Reading »

This is the third post in a series on finding the best place to hold an IRA.   Previously, I reviewed transaction fees for stocks and mutual funds and the number of mutual fund offerings at each brokerage.  This time I’ll look at the types of assistance offered.  Then I’ll write a post summarizing all the pros and cons. Continue Reading »

If your employer offers a match to your 401(k) contributions, then your first priority should be to contribute enough to the 401(k) to maximize the match.  Fewer companies are matching these days, and it may be a benefit on the way out, but as long as it’s there, take advantage of it.  It’s free money; don’t leave any on the table. Continue Reading »

This is the second post in a series on finding the best place to hold an IRA.   Last time, I reviewed the stock transaction fees.  Today I’ll look at the number of mutual fund offerings and transaction fees.  Next time I’ll look at the types of assistance offered.  Then I’ll write a post summarizing all the pros and cons.

Mutual funds can be an important component of your retirement portfolio.  Funds offer reduced risk through diversification, as compared to holding individual stocks.  There is a wide range of mutual funds — over 9,000 at last count, with enough well-managed and low-cost funds to fill out most, if not all, of a solid retirement portfolio.

Mutual funds tend to come in three flavors:  no-load no-transaction fee, no-load with transaction cost, and loaded. The no-load no-transaction fee (NTF) funds tend to be a brokerage’s own funds, e.g. Fidelity funds bought through Fidelity.  However, most brokerages also have agreements enabling them to offer other house’s mutual funds with no transaction costs.  Most any brokerage will sell you any mutual fund for a fee, if they do not offer the fund as an NTF.

Here’s a summary of what I found online for each brokerage.  Of course, before taking action and moving your assets, please double-check with the brokerage(s) for your particular situation.

Fidelity: Over 1,400 NTF mutual funds offered.  For any other fund, a $75 transaction fee is assessed, in addition to any load the fund charges.  Fees are assessed if an NTF fund is held less than 180 days, to discourage short-term trading.

E*Trade: Over 1,300 NTF mutual funds offered.  For any other fund, a $50 transaction fee is assessed, in addition to any load the fund charges.  Fees are assessed if an NTF fund is held less than 90 days.

Scottrade: Over 1,200 NTF mutual funds offered.  For any other fund, a $17 transaction fee is assessed, in addition to any load the fund charges.  Fees are assessed if an NTF fund is held less than 90 days.

TD Ameritrade: Over 1,400 NTF mutual funds offered.  For any other fund, a $50 transaction fee is assessed, in addition to any load the fund charges.  Fees are assessed if an NTF fund is held less than 180 days.

Schwab: Over 2,000 NTF mutual funds offered.  For any other fund, a $50 transaction fee is assessed, in addition to any load the fund charges.  Fees are assessed if an NTF fund is held less than 90 days.

Lehigh Acres, FL

Houses in Lehigh Acres, FL are presently 80% off their peak values.  80% !.  How can this happen?  It’s an inland exurb of Fort Myers.  The only economic force fueling the economy was the boom in real estate — construction, sales, and $3 lattes.  When the bubble burst there was nothing of substance to support it.  So, if you’re a soon-to-be snowbird, make sure there’s something to support your local economy other than your Social Security check; otherwise, you’ll be a little less … secure.  Or as Gertrude Stein might have said, “Make sure there’s a little there, there.”

The image here was taken from Google map of Lehigh Acre.  Do you think Mr. Bill was trying to warn us?

(From NY Times article reprinted in Boston Globe.  Original article by Damien Cave.)

Congress passed a law at the end of 2008 letting seniors off the hook for mandatory withdrawals from IRAs in 2009.  Normally, seniors 70 1/2 and older are required to take part of their money out of the IRAs each year (so that Uncle Sam can get his cut).  Failure to do so levies a hefty penalty of 50% of the amount that was supposed to be distributed.  But at least for 2009, seniors won’t have to worry about it.

Article in USA Today