Continued from Part 1: Future Roth IRA Rollover. Now we’ll consider what happens if we don’t convert to a Roth.

To recap, an non-deductible IRA everything is the same as a Traditional IRA except that the initial contribution is not tax-deductible. This means that it grows tax free, but all earnings (dividends + capital gains) are taxed as ordinary income upon withdrawal. The original contribution isn’t taxed again.

This is in contrast to regular taxable account, where you can defer taxes on capital gains until you sell. Currently, if you hold stocks or bonds for at least a year before selling, you’ll be taxed at the long-term capital gains (LTCG) rate of 15% or less. Qualified dividends are taxed when received, but are also currently taxed 15% or less. Non-qualified dividends such as from bonds or REITs are taxed as ordinary income.

So which one’s better? I decided to run a few sample scenarios to find out. Here is the IRA scenario spreadsheet I used, which you can play with as well. I’ll be assuming that current tax rules stay the same when you withdraw, which is almost guaranteed not to be the case, but hopefully we’ll get something out of it.

Assumptions
Initial Balance: $4,000 after-tax
Ordinary income tax rate: 25%
Dividend tax rate: 15%
Time Horizon: Lump-sum withdrawal after 30 years

Scenario #1: Buy-and-Hold With Stock Index Funds
Let’s say you invest in an S&P 500 index fund, with very low turnover. You buy and hold until withdrawal. Total annual return is 8%, with 2% being in dividends each year. With a non-deductible IRA, it keeps growing as gets taxed at the end. After 30 years, you’ll end up with $31,188.

With a taxable account, you’ll get taxed 15% on those dividends every year, but the rest is accumulated as long-term capital gains. Upon selling it and paying 15% on those gains, you end up with $32,834. Taxable wins by $1,646 (5%).

If you lower the ordinary tax rate to 15%, then the non-deductible IRA wins by $1,979 ($34,813 vs. $32,834). If you raise your ordinary tax rate to 30%, then the taxable account wins loses by $3459 ($29,375 vs. $32,834). In general, taxable wins out when your tax rate at withdrawal is about 21%.

Scenario #2: Active Trading With Stocks or Stock Funds
Now if you have lots of buying and selling in your portfolio, then you’ll be subject to short-term capital gains every year. Here, if you assume 100% turnover (holding stocks for just under a year) and you still earn 8% annually, taxable will never win regardless of ordinary tax rates. Even at 9% return in taxable vs. 8% return in IRA. The yearly drag of taxes kills your returns, so you should probably seek the shelter of a IRA if you plan on investing in moderate-to-high turnover funds.

Scenario #3: Buy-and-Hold With Bonds or REIT Funds
Holding a bond fund or REIT (real estate) fund is actually similar to Scenario #2, because most of the earnings from bonds and REITs are due to their interest yield or dividend distributions, and those are taxed at the higher ordinary income rates.

Let’s say you have an REIT fund that also gains 8% annually, and 100% of it’s gains are in the form of unqualified dividends. (REITs have a historical average yield of about 6-8%)

At 25% income tax rates, the taxable account just can’t keep up with an final value of $22,974 vs. $31,188 from the non-deductible IRA. That’s a 35% increase in value by going with the IRA. As income tax rate rises, the IRA’s advantage increases. A similar result occurs for bonds, although the difference is smaller due to lower expected returns.

Liquidity or Early Withdrawal Concerns
A significant advantage of taxable accounts is that you can choose to access, or not access, the funds at any time. With an IRA, with a few exceptions you have to wait until age 59.5 to make a withdrawal without penalties. In addition, you’ll be required to make minimum distributions starting at age 70.5 even if you don’t need to. Some early retirees or those that want to leave a legacy might want to just stick with a taxable account.

Summary
Again, all of these are based on guesses as to what future tax laws will be, but for now my very general summary is:

• IRAs have less liquidity and more restrictions in general. So if the expected net returns are equal, I’d pick the taxable account.
• For low-turnover stock portfolios and index funds, the non-deductible IRA might lose out to a taxable account, but not by all that much. As your trading frequency increases, the taxable account gets less and less attractive. On the flip side, a tax-managed mutual fund might make things sway back in favor of the taxable.
• If you plan on holding any significant amount of REITs, bonds, or other tax-inefficient investments, then a non-deductible IRA can have significant tax advantages over holding them in a taxable account.

Since I do have holdings of bonds and REITs in my portfolio and need all the tax-deferred space I can get, it looks like I’ll be contributing to a non-deductible IRA before the April 15th deadline.

As we’ve seen, after you reach a certain income, both Roth IRAs and tax-deductible contributions to Traditional IRAs are no longer available. After you max out your 401(k) or 403(b) plan at $15,500 per year, you start running out of tax-advantaged accounts quickly. One option is to contribute to a Traditional IRA anyways, even though the contribution will not be tax-deductible. Everything else is the same: your money will still grow tax-free, and withdrawals will be taxed at your ordinary income tax rate. You can sock away $4,000 for 2007 and $5,000 for 2008. So should you do it? I have less than three weeks before I need to decide!

There appear to be two primary ways to answer this question:

1. Future Roth Rollover. In 2010, there will no longer be any income restrictions for Traditional-to-Roth IRA rollovers. Could this mean Roth IRAs for everyone?
2. Compare Returns vs. Taxable Account. If you either can’t or don’t wish to convert to a Roth, will your performance at least be better than a regular taxable account?

Future Roth IRA Rollover

According to current laws, in 2010 the income restriction for Traditional-to-Roth IRA rollover will disappear. Since you’ve already paid taxes on your non-deductible IRA contributions, you will only have to pay income tax on the earning portion when you rollover. This can be seen as effectively allowing you a way to contribute to a Roth IRA down the road. Now, instead of having to pay ordinary taxes upon withdrawal, I don’t have to pay any taxes! I even avoid required minimum distributions.

Catch #1: The Law May Change
I have seen no indication that this Roth “back door” was intentional. Some people see this as simply an oversight that a busy (or lazy) Congress simply hasn’t gotten around to changing… yet. For example, the current low 15% long-term capital gains rate is also scheduled to go up in 2011. Others think that the lure of tax revenue now gained through Roth conversions might be appealing and they’ll let it stay. Now I’ve waited until the last minute to make my decision and it’s almost mid-2008, and nothing has changed, so maybe it’ll happen…

Catch #2: Mixing Deductible and Non-Deductible Contributions
Let’s say you have $10,000 in a Traditional IRA, $4,000 of which was a non-deductible contribution, and $6,000 of which was deductible contributions and earnings within the IRA. If you wanted to convert $4,000 of it over to a Roth IRA, you can’t simply pick out the non-deductible contribution. The $4,000 would be pro-rated to be 40% non-taxable and 60% taxable, in the same proportions as your total IRA.
The only way to convert all of your non-deductible contributions would be to convert everything together, which might not be ideal.

One way around this is to first roll over your deductible IRA money into another qualified retirement plan like your 401(k) if they allow such transfers (and you like your investment options). Then make your non-deductible IRA contribution. That way, the deductible and non-deductible parts can be separated. I don’t have any deductible IRA funds, but I think I could rollover into my Solo 401(k) if desired.

Catch #3: More Paperwork
If you make non-deductible contributions, conversions, or withdrawals you must document them each year using with IRS Form 8606. It’s probably a good idea to simply file the form every year so that you don’t end up forgetting and having to pay extra taxes later.

In general, I think the Roth conversion option is great if it’s available, but I am still not convinced it will still be around in 2010. So I’d better make sure that’s a non-deductible IRA is still a decent deal even without that option. To be continued in Part 2…

If you leave your job and have a 401k or 403b left behind, the common advice is to roll it over into a Rollover IRA. There are several benefits to doing so, but here are the biggies:

1. You maintain the tax-deferred status of the investment. For a traditional 401k, you would still be subject to ordinary income tax upon withdrawal, but along the way it would continue to grow tax-free. If you took the money as a lump sum, you would be subject to both taxes and penalties right away (with specific exceptions).
2. Increased flexibility in investments. Most 401k plans have relatively limited investment choices, but you can open up an IRA at a variety of places. You can the invest in individual stocks, different mutual funds, bonds, ETFs, annuities, or even just a bank certificate of deposit.
3. Save money by paying less fees. Along the same vein, many 401ks contain mutual funds with relatively high expense ratios compared to what is available on the open market. Many would recommend switching to low-cost index funds.
4. You can consolidate accounts. You can combine the Rollover IRA with your other IRAs of the same time (Roth or Traditional Pre-Tax). One less thing to manage.
5. Estate Planning perks.With an IRA, you have the ability to create a “Stretch IRA”, where your child can inherit and IRA and have the distributions “stretched out” across their longer life expectancy. This allows for more time to tax-free growth.

But many of these perks get overshadowed when you have a small 401k balance. My wife has an old 401k with only $2,000 in it at Fidelity. She gets to choose from a variety of Fidelity funds, including their Spartan index funds with 0.10% expense ratios, all with no minimum investment requirements. In addition, I don’t believe she is being charged any sort of administrative fees. We haven’t rolled it over to an IRA because:

• Lonely IRA. We have no Traditional-type IRAs to merge it with at this time. We’d just be left with a $2,000 IRA.
• Flexibility? If we moved it to Vanguard with the rest of our IRAs, we would not meet the $3,000 minimum for most of the funds. The only fund we could buy would be the Vanguard STAR fund.
• No money to be saved? At most brokers, paying a commission for every trade on only $2,000 would really eat into the balance. We could move it to Zecco, which has free trades but also a $30 annual IRA fee. We can do better staying put, although if our existing investment choices were worse, finding a low-cost brokerage and switching to buying ETFs might be an option.
• Itty-bitty estate. Again for small balances, this isn’t much of a factor in my opinion. No kids, anyhow

We could also move it to her new 403b, but it also has less-than-ideal investment choices. For now, it seems like the best move is really to stay put at Fidelity until there is a better opportunity. However, I would agree that our situation is a relatively rare case.

Okay, so I’ve decided upon an asset allocation plan. Now for my least favorite part – juggling and cramming all those asset classes into several different accounts. First, I’ll list my existing accounts, their estimated current balances, and my flexibility in investment options.

So I’ve got 7 asset classes to fit in 5 accounts. Below is a chart that shows the major asset classes sorted by tax efficiency:

Next, I combine my chosen 86% stocks/14% bonds with my asset allocation to find the breakdown below:

For example, with 40% of all stocks as US Large, I get 40% x 86% = 34.4% US Large over my entire portfolio. You might notice that I also sorted them in the tax-efficient order given above.

But in this case, I also need to consider the availability of low-cost index funds as well as placement, especially since all my money is already in tax-deferred accounts. My Roth IRAs are all with Vanguard with a wide variety of index choices, but my Traditional 401ks are limited to a few select index funds. After spending some time with a pencil, paper, and good eraser, here is the compromise I have worked out:

Roth IRA #1
$7,000 Vanguard Short-Term Treasury Fund (VFISX)
$3,000 Vanguard REIT Index Fund (VGSIX)
$8,500 Vanguard Small-Cap Value Index Fund (VISVX)
$8,500 Vanguard Emerging Markets Stock Index Fund (VEIEX)
$19,000 Vanguard Total Stock Market Index Fund (VTSMX)

Roth IRA #2
$7,000 Vanguard Inflation-Protected Securities Fund (VIPSX)
$6,000 Vanguard REIT Index Fund (VGSIX)

Traditional 401k #1
$23,000 Fidelity Spartan International Index Fund (FSIIX)

Traditional 403b #2
$14,500 Diversified [S&P 500 Index] Fund (DISFX)

Traditional 401k #3 (old job)
$1,000 Fidelity Spartan Total Market Index Fund (FSTMX)
$1,000 Fidelity Spartan International Index Fund (FSIIX)

On additional reason for this particular set up is to accommodate future growth. As the year progresses, I can continue to buy more shares of the largest asset classes (FSIIX and DISFX) in our 401ks. To retain the target asset allocation if things get out of whack, I can sell VTSMX in my Roth IRA and buy other funds as needed, with only a $3,000 minimum for most funds. I avoid any other low-balance fees at Vanguard by choosing electronic delivery of statements. In the future, I may switch my IRAs to an brokerage account to simply buy ETFs, but I don’t think that is necessary quite yet. I like the current simplicity and good service.

(By the way, I have such large Roth IRA balances because I did a Traditional-to-Roth conversion while our tax brackets were lower than they are now.)

Over the last year or so, I’ve learned a lot of new things about investing and asset allocation. At the same time, I know that changing your asset allocation too frequently is often a response to recent market activity (aka performance chasing, or market timing). In addition, I’m a highly analytical person and I love for things to have a correct answer to 5 significant figures before committing… which is pretty much impossible here. But at some point I know I just need to take action if I truly believe it is an improvement.

Previous Asset Allocation
In April 2006, I moved from the all-in-one Vanguard Target Retirement 2045 Fund (VTIVX) to a portfolio with more asset classes in an attempt to better optimize risk/reward factors based on historical data. You can see the asset allocation breakdown here. This asset allocation is pretty much what I have right now, except that I added a Micro-Cap stock fund and we moved money into a 401k with limited investment options.

Interim Asset Allocation

I’m still continuing my series on building my portfolio, so I won’t explain all my actions here, but here are some quick summaries:

1. Stocks/bonds allocation. I am shifting to a age-based formula for my stocks percentage. Using 115 minus my age, I am at 86% stocks and 14% bonds.
2. Domestic/international allocation. I am increasing my international allocation to better match the world market. It’s essentially 50/50 if you think REITs are a separate asset class.
3. Small/Value/Emerging Markets. These sub-classes are riskier than their overall market, but have been shown to have diversification benefits. Even if they don’t in the future, I am okay with them simply being more risky along with higher returns. Essentially, I am taking the total markets, and increasing the portion of one additional asset class which I think has the highest diversification benefits. For example, Small Value is a subset of Total US market, and Emerging Markets is a subset of the Total International market.
4. Real Estate. I’m still holding REITs, as they are a way to invest in commercial real estate, and have also been shown to provide diversification benefits. Will give more references later.
5. Micro-Cap, International Value, and Large Value. I think all of these potentially good asset classes to hold, but I think they are of lesser overall importance than the others. So in an effort to simplify, I am dropping them as separate funds. I still continue to have exposure the asset classes within other funds.
6. New Bonds Allocation. I’ve been meaning to this for a while. I’ve been holding an intermediate-term corporate bond fund because it used to have a lower expense ratio after various fees. Inflation-protected bonds are still pretty new, but I’ve been convinced of their utility. I’ve also been convinced that bond ratings agencies just aren’t that good at their jobs, so I’m sticking with the highest quality bonds (Treasuries). The book Unconventional Success was a big influence here.

I call this my interim asset allocation because while I’m very confident this new setup fits my needs and preferences better than my previous asset allocation, I know that I will continue to learn and read. But just like with football coaches, this interim asset allocation might just become my permanent one.

In addition to all the books that I have read (and am still reading), I’d also like to say thanks to the many smart and helpful folks over at the Diehards.org forums for all the indirect and direct help. (I post anonymously at both forums.) Even though they sometimes feed my tendency towards complexity, I love the wealth of information that is available.

I am a proponent and investor in low-cost, passive-managed mutual funds, but even within that philosophy there can be a dizzying array of choices. Although this has been taking a lot longer than I had hoped, but here is an updated compilation of posts about my thought process when re-building my portfolio.

Section 1: Simplified Theoretical Stuff

1. Disclaimer and General Philosophy
2. Consider Simply Buying The Entire Market
3. Efficient Frontier and Modern Portfolio Theory

Section 2: Choosing An Asset Allocation

1. Deciding On The Stocks/Bonds Ratio
2. Deciding On The Domestic/International Ratio
3. Considering The Diversification Benefits Of Small and Value Stocks
4. Equity Asset Allocation: Comparison of 8 Model Portfolios

Recent Transactions
In the last quarter of the year, we ended up putting in the maximum $15,500 salary deferral in both of our 401k/403b’s. I had already put in $12,500 already in my Solo 401k, so I sent in a last-minute check for $3,000. For my wife’s 401k, it was done in big salary deferrals in October, November, and December. We were lucky that the company allows almost 100% salary deferrals.

Summary and Performance
My last portfolio update was back in September, but I figured with the end of 2007 it was definitely time for an update. It was a late decision to go ahead and contribute a lot to our tax-deferred accounts and taking away a bit from our cash hoard, so I was more concerned with getting them in on time than what I was actually investing in. Lots of changes to come soon, so I’m just posting a snapshot of what we have for now.

I did go back and track the cash inflows, and calculated our time-weighted rate of return, which ended up being 2.49% annualized for 2007. For a very rough comparison, the S&P 500 via Vanguard 500 (VFINX) returned 6.13% YTD. Part of this low performance was just due to timing, as the latter half of 2007 was a lot worse than the 1st half, and that was when we invested a lot more money. (Remember, this is the exact performance of our money, not just the averaged returns of all the funds we hold.) In 2006, our portfolio return was calculated at 24.9%. How did you do in 2007?