Often employers offer the option of contributing to a traditional 401(k) or a Roth 401(k). Do you know which one is right for you?
The primary difference is in the tax treatment. The traditional 401(k) gets a tax benefit at the time of contribution, because money contributed to such an account is not taxed. Moving forward, the earnings in your traditional 401(k) are not taxed as long as the funds remain in the account. When you begin to make withdrawals in retirement, the funds withdrawn are taxed as ordinary income.
Roth 401(k)s are taxed the reverse way. In these accounts, money is taxed when the contribution is made. Earnings on investments in your Roth 401(k) account are not subject to tax, and the money is not taxed when it’s withdrawn.
If the investor’s marginal tax rate is the same at the time of contributions and withdrawals, the traditional and Roth accounts would produce the same results.
Because of these differences in tax treatment, taxpayers in the lowest tax brackets should contribute to Roth accounts, while taxpayers in higher tax brackets will want to use traditional retirement accounts. As a general strategy:
When you’re in the 12% tax rate or lower: Contributions should be made to a Roth 401(k).
When you start moving into the 22% tax bracket: 50% of contributions be made to a traditional 401(k), and 50% to a Roth 401(k).
In your peak earning years: As you move into years with marginal tax rates above 22%, most or all retirement contributions should be made into a traditional 401(k) instead of the Roth.
When you reach age 70½, or you inherit a retirement account you plan on stretching the life of, you’re legally required to take an annual withdrawal called a required minimum distribution (RMD) from your retirement account. Failure to take your RMD results in a 50% penalty on the RMD. Below is a list of frequently asked questions regarding required minimum distributions.
When do I have to take my first RMD?
You must take your first required minimum distribution by April 1 of the year after you turn 70½. For example, if you turn 70½ on December 15, 2017, you need to take your first RMD by April 1, 2018. Keep in mind that if you wait until 2018 to take your first RMD in this example, you would have to take two RMDs that year. Since two RMDs in one year could push you up into a higher tax bracket, it’s advisable to take your first RMD by December 31 of the year you turn 70½.
What accounts do I have to take an RMD from?
RMDs apply to pre-tax retirement accounts such as Traditional IRA, Rollover IRA, SEP IRA, Simple IRA, 403(b), 457, and 401(k)s. RMDs do not apply to Roth IRAs.
Current law does require RMDs be taken from Roth 401(k)s, but you can easily avoid this by rolling that account into a Roth IRA. (more…)
As consumers, we love low oil prices for the savings we receive at the pump. As investors in energy companies, we love high oil prices for the earnings and dividends.
Over the past 18 months, we’ve seen oil prices fall precipitously from around $100 per barrel to below $40 per barrel as of year-end. Similarly, big oil players such as ExxonMobil, Chevron and BP have seen declines in their stock prices of 23%, 31%, and 41%, respectively. Is this a value investment opportunity? Could be. Can oil prices fall further? Possibly. However, why worry or attempt to time or choose specific sectors of the stock market to invest in like energy, technology or healthcare? Just like other market events, it would be difficult, if not impossible, to consistently predict drops like we’ve seen in oil, and to determine how long prices will stay this low.
Instead, let’s consider how the prolonged drop in oil prices and the corresponding decline in energy stocks play into the overall stock market indices. For the MSCI All Country World Index (ACWI), the energy component makes up just 6.1% of the overall index. Over that same 18-month period, the global energy sector fell in price by 43%, while the overall MSCI ACWI declined by just 7%. If you owned only a market index, which would remove company- and industry-specific risk from your portfolio, the decline would have been dampened. In fact, when oil prices drop, consumers use those savings from the gas pump to buy products and services that boost other parts of the economy. In addition, industries whose costs are heavily impacted by oil prices, such as airlines and transports, greatly benefit from this shift. This leveling effect provided by investing in various indices can more importantly help keep you from falling off course from reaching your financial goals.
As a result, we continue to believe in the long-term benefits of broad-based diversification provided by investing in indices across the globe.
An investment portfolio is typically described as a basket of stocks and bonds invested across the global markets. These securities usually have sufficient liquidity where they could be sold in a relatively short period of time to receive your money. While not all investments fit this description perfectly, most investors’ portfolios reflect these characteristics, whether that portfolio is invested through an assortment of mutual funds, exchange traded funds or individual securities. In return for capital, the investor hopes to earn capital gains, dividends and interest on a regular basis. By that definition, should real estate holdings be considered as part of your investment portfolio?
Your personal residence has different characteristics. First off, it provides shelter, so it can be considered a necessity. Homes can take anywhere from a few weeks, months or even years to sell, so it wouldn’t be considered a liquid asset that can be sold readily. Also, a home is located in a particular neighborhood, city, state, region and country, so it’s exposed to location-specific risks. You don’t receive dividends and interest annually from owning your home. In fact, you spend money on maintenance, mortgage payments, property taxes and insurance. You can, however, generate capital gains, but that occurs only if your home is sold for a gain. Often, sellers turn around and use the proceeds to purchase a new residence.
From the description above, an investor’s personal residence lacks marketability and diversification, and it requires additional inputs of capital to maintain. Equity real estate investment trusts (REITs), on the other hand, are investable assets and provide exposure to commercial, agricultural, industrial and residential real estate across the country and most parts of the world. Families who own their homes may also own a few rental homes, but most don’t have expertise and resources to own commercial, industrial and agricultural real estate. Exchange traded funds and mutual funds can track equity REIT indices (i.e., FTSE NAREIT) and provide a low-cost, inflation fighting, diversified option with daily liquidity and low investment minimums.
Similar to the reasons for including other asset classes in an investment portfolio, such as emerging markets equity or reinsurance, exposure to real estate through equity REITs adds incremental value to the portfolio. This is because equity REITs are fundamentally different from other asset classes due to differences in taxation, correlation and inflation-fighting characteristics. As a result, we believe equity REITs are better suited than a residence for a well-balanced, diversified portfolio.
Here is yet another example of why we prefer to use Dimensional funds in our MarketWise portfolios:
Morningstar recently issued a new Stewardship Grade for DFA. The firm’s overall grade–which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history–is an A.
Like Merriman, Dimensional believes in the efficiency of markets, places a focus on academics and solid research, and doesn’t give in to chasing investment trends. Read Morningstar’s full analysis of the firm’s corporate culture here.
Before I came to Seattle, I had the pleasure of working for an asset management firm with close ties to lead researchers, Nobel Prize winners and economic powerhouses. One day, a dear friend to many in the company passed away and I was amazed at the outpouring of respect and love. Gordon Murray left a legacy with his co-authored book, The Investment Answer, written during his battle with terminal brain cancer.
Instead of traveling the world or living out the remainder of his time on a beach or mountain, Gordon gave the world the gift of what he learned over 25 years working on Wall Street and consulting with financial firms. The book is a light read (around 68 pages) and can be very powerful for those beginning their investment journey. It simply outlines key decisions every investor needs to make on their path to investing.
If you view the market as your ally rather than an adversary that you must time and compete against, give the book a quick read. Gordon and his co-author, Dan Goldie, outline five considerations:
Decide whether you’ll do it yourself or hire a professional investment advisor.
Determine what asset allocation between stocks, bonds and cash is best for you.
Evaluate what specific asset classes you’ll include in your portfolio, and in what ratio.
Consider whether you believe you can strategically and consistently outperform the market or whether you believe obtaining the market return is most in your favor.
Create an execution strategy around when you will buy and sell funds from your portfolio. (For example, will you rotate asset classes? Sell based on trend following dynamics? Periodically rebalance on a definite time frame?)
For a little more history on Gordon and why this book was created, check out this NY Times article.