Your Questions … Our Views
I am 35 years old. I was told to leave investments alone and let them ride until I get closer to retirement age, then check to see if my investments should be moved around. The stock investments in my 403b account lost a lot of value during the meltdown, although they have rebounded recently. Should I be watching my retirement investments no matter what age I am?
Yes, you should be watching some aspects of your retirement accounts no matter what your age. But not so much with respect to asset allocation, which seems to be the central part of your question.
With regard to asset allocation, our view is pretty consistent with the advice you quote. In our view, the main driver in determining asset allocation is your time horizon. If you don’t plan to cash out the investment for at least 10 years, we like stocks and real estate –their expected returns over longer periods are significantly higher than the expected returns on bonds and money markets. We would expect someone age 35 to have a time-horizon that exceeds our 10 year perspective, and we think the case for stocks and real estate is even stronger for a longer period.
The gurus generally caution against shifting out of stocks based on recent performance declines. The tendency is to pull money out of stocks when they are relatively cheap and put money back in the market when they are relatively expensive – the opposite of a “buy low, sell high” strategy.
But, in addition to asset allocation, there are two other major areas in building your wealth where you also exert significant control – tax treatment and costs. These areas merit watching no matter what your age. With regard to tax treatment, there have been changes in some retirement plans (such as the University of Iowa 403b Plan) to allow employees to select a Roth plan rather than the Traditional 401k or 403b. If your employer offers a Roth version 401k or 403b, we suggest that you investigate whether it would be useful to you.
With regard to costs, you may have made your investment selections years ago, before you learned how “small costs” can have a large impact on the size of your account at the time you retire. If this is the case, we suggest that you look into the cost structure of your current holdings. In that same vein, some mutual funds adjust their cost structure from time to time and that is worth monitoring. In addition, some retirement plans (again, such as the University of Iowa) have broadened the menu of investment funds that they offer. We suggest that you monitor your plan offerings and investigate whether any newly-added funds might be more attractive to you from a cost-standpoint.
Going forward, we anticipate that there will be continuing changes in the retirement account landscape with respect to tax structures and costs, and we suggest that you monitor them … regardless of your age.
I recently read some advice to an individual on Bankrate.com regarding whether it is more advantageous to convert a traditional IRA to a Roth IRA now, or to wait until later (http://www.bankrate.com/finance/retirement/age-impacts-roth-ira-conversion-debate.aspx). The individual stated that he expected to stay in a high tax bracket. As part of the advice, the article said that it would be relatively more useful if the individual had “dozens of years for the portfolio to increase in value before taking tax-free distributions in retirement.” Do you agree that, all else equal, a longer time horizon makes conversion to Roth more attractive?
This advice reflects a common misunderstanding. Indeed, a June 14, 2010 article in the Wall Street Journal makes the same mistake. It says: “The problem here is that it can take 15 to 20 years for the tax-free growth of a Roth IRA to make up for the taxes paid at the time of conversion, advisers say. … That makes conversion an iffy proposition for people who are nearing retirement.” (http://finance.yahoo.com/news/Why-You-Shouldnt-Convert-to-a-wallstreet-3996886790.html?x=0&.v=1)
We do not agree. In fact, if your tax rate stays the same, The Traditional IRA and the Roth IRA give you the same amount of dollars, in your pocket, at withdrawal. Here’s an illustration that shows how this works:
Suppose you have $10,000 in pre-tax dollars in a Traditional IRA, your combined Federal and state tax rate remains fixed at 32%, your time horizon is 20 years, and the annual return on the portfolio is 10%.
Case A: You never convert to a Roth IRA. After 20 years, you withdraw the entire amount and (as required) you pay the taxes on it. The taxes are 32% so you keep 68% of the amount. Putting it together, the amount you receive at the end of 20 years, after the taxes are paid, is:
$10,000 x (1 + .10)20 x 0.68 = $45,747
Case B: Now suppose you were to convert this Traditional IRA to a Roth IRA right now, paying the taxes now. Paying the taxes now reduces the portfolio by 35%, which leaves 65% of the portfolio going forward. Again, you withdraw the full amount in 20 years and it is tax-free at that time. The amount you would receive would be:
$10,000 x 0.68 x (1 + .10)20 = $45,747
It’s the SAME amount! With the Traditional IRA we compound first and then multiply by the percent we keep after paying the tax (1 minus the tax rate). With the Roth IRA the order is different but the factors are the same – we first multiply by the percent we keep after paying the tax and then we compound. It’s just a different order of multiplication – the answer is the same.