Wednesday, December 29, 2010

Investing PART 6: Perhaps some seasonal music

Don’t say “bah humbug” unless you’re so rich you don’t need the money being offered.

Don’t expect “A Partridge in a Pear Tree,” but the tax code does provide it’s version of “Two Turtle Doves.” If you dig into the tax code, you might even find “Three French Hens” and more.

Following up on the use of IRAs to illustrate the importance of starting your investments, this posting’s theme is simply “don’t look a gift horse in the mouth.” IRAs and 401(k)s (or their equivalents -- 403(b)s, etc.) are widely available. They weren’t created for the rich. They were set up to benefit “the working man.” In fact, there are numerous obstacles and limitations on high income earners’ ability to benefit from them. So, when people say they don’t / can't contribute to their 401(k) or IRA, if you want to start a raucous, ask if it’s because they’re too rich. But, don’t be surprised if “the working man” insists on staying “the working man.”

It’s a lot more difficult to construct a spreadsheet like the IRA toy for a 401(k). It isn’t as useful either. With 401(k)s, our wizards in Washington have played around with limits: thus, there is no hard and fast maximum to put in as a placeholder. First, the max was a max on total employee and employer contributions, and then in 1987 they put a max on employee contributions.

Through the history of the 401(k) the government has encouraged, regulated, and generally messed around with the portion of wages that could be contributed pretax. There is also the issue of whether a specific plan allows nondeductible contributions. Many plans used the pretax limits to set the max, thus reducing the max to a percent of wages rather than a dollar amount.

Most crucial of all, each employer can select the structure of their plan. Contribution limits can also be affected by who else contributes. So, there isn’t a typical contribution limit. But, the issue is too important to an investor to ignore.

A 401(k) is one of very few instances of a guaranteed return, and not a small one. To start with, there is the potential of tax deductibility. Depending on your marginal tax bracket, that can be a 10-36% contribution to your income right out of the gate. Earnings on the investment receive the same immediate kick regardless of whether the 401(k) contribution was deductible or not: that’s guaranteed and that’s a pretty nice subsidy to your investment returns. (The same benefits accrue to IRAs). Add to that similar tax treatment in many states and the subsidy is hard to pass up. That alone is justification for maxing out a 401(k).

But, like the late night direct sales commercials shout: “Wait, wait there’s more.” No, it’s not free shipping. It’s the potential of an employer contribution. The employer contribution is optional and varies with your employer’s fortunes, but who else is giving you money just to do what you should be doing anyway?

Now, I’m not a fan of many 401(k) offerings. Some are good, and they certainly have gotten better over time. For example, my first 401(k) offered one fund in each of about five categories and none where low cost or could be expected to deliver market-beating returns; vanilla at best. But, a tax subsidy and employer match made them a dynamite opportunity. The same fund family administered a 401(k) at a more recent employer. It had more funds than anyone could possibly take the time to explore while also holding a full time job. They included both managed and index funds of every conceivable stripe. Many were offered under a variety of load or management fee options.

The point being if mutual funds are your preferred investment vehicle, 401(k)s generally won’t come up short nowadays. (Granted some employers pick bad plan administrators, but competition is forcing most employers and fund managers to offer a viable range of options). However, as discussed in “Wall Street Doesn’t Run the World,” money managers have limits when it comes to meeting your financial objectives. Consequently, I recommend rolling 401(k)s into IRAs as soon as you leave an employer. Then, as will be discussed in subsequent postings, restrict the use of mutual funds to the areas where they have a big advantage. I’m just not a big fan of mutual funds and that especially includes most ETFs.

Again, “Wait, wait, that’s not all.” There is a point that’s even more important than whether your plan is the be-all-and-end-all of investment offerings. The simple fact is that 401(k)s have so much going for them in terms of tax treatment, employer matches, and the automatic deduction of contributions that you’d be a fool to hold out for some hypothetical better alternative. You don’t need your 401(k) to be knocking the socks off of the averages in order to accumulate a nice chunk of change. Besides, as is apparent from the discussion of cash (PART 3), a 401(k) shouldn’t contain your only assets. Knock the socks off the market in your IRA, or better yet, have a taxable account where the range of investment options is only limited by your skill and knowledge.

Don’t think you can live with less than stellar results? Well, it may be a rough estimate, but the table below illustrates what can be achieved. It’s constructed just like the spreadsheet presented in PART 5 except that in this case it’s just a table not a live spreadsheet. If you want to do the same games with your 401(k) as with the IRA, just use the spreadsheet. However, getting all the contributions histories makes it a chore. Realistically, continuous access to a 401(k) much less 29 years of uninterrupted employment and a continuous option to make the maximum contribution are not what most people can realistically expect. Nevertheless, the table illustrates the role your 401(k) can play. Note I’ve added 12% to the range of annual average returns. With tax free compounding and decent occasional employer matches, it’s realistic.

These comments should provide a hint at how I suggest you incorporate your 401(k) into your portfolio, but that’s a topic by itself. Briefly, they’re a good way to accumulate assets to roll into your IRA. You'll need the 401(k): a contributory IRA isn’t going to much more than cover your medical expenses in retirement especially given the cuts in Medicare the administration just enacted. However, it seems logical to leave some assets in your 401(k) as a form of diversification across legal ownership structures, again, especially given the current administrations tendency to play it loose with legal property rights. Even when the administration changes, it can be useful to have some funds in mutual funds in a 401(k) as something to benchmark your investment decisions against. So, have fun.

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