Fenced Money Strategy

[Nashville]

This is a discussion about the wisdom of "fenced money" and I hope to hear a broad spectrum of responses.

Much of my demeanor might be attributable to a mistrust of government and other instututions and their "suggestions" for people to observe conventional wisdom, which more often than not backfires. "Fenced money" is so-called because access to it is restricted and frought with many tentacles. I speak of IRAs, 4701ks, MSAs, 529 plans, etc.

I've been around for many of the years that IRAs have been preached to the public. Soon on its heels were 401k, 403b, SIMPLE, and all manner of other plans. Many of my customers actually believed it to be a good idea to save for retirement, children's college, medical and other devices that involved "fenced money." Let this money be taxable when you are in a LOW tax bracket.

The overwhelming majority of these people are now in a higher tax bracket than when they put the money aside. Most of them cringe at receiving RMDs. Seems like most of the money in 529 plans have their earnings eaten up by custodial fees, as well as a choice made by the institution or poor earning bank products. The life of a 529 plan is only 18 years or thereabouts.

Earning interest tax free? Yes, but a typical 401k plan may earn 9% and have 3% of this eaten up in fees. This is not a tax, but is a 33% charge realized against income just as a tax.

How about your clients that you've had for a long time? Would they not have been better off just investing in securities without the "fence", and enjoying 15% dividend and capital gains rates? No worry about RMDs, taxing the children when taxpayer dies, etc.

What about the Roth? Sounds good, and none of the above-mentioned problems exist (except fees). No RMDs. I can't legitimately criticize the Roth but do remember the clip about Roosevelt - "and Social Security will NEVER be taxed!!!" I can only tell you what I've accumulated has no fence and I sleep well at night knowing there are no inherent tax liabilities embedded therein. And yes I pay a maximum of 15% in dividends and capital gains but the money resulting from the taxable transactions is always available for me to pay it.

[DaveO]

There is much to recommend keeping money in taxable accounts. The tax paid on reinvested dividends and capital gains spreads the pain over many years. I was not convinced of the benefits of IRA’s early on but saw the contribution as a way to reduce current taxes and bought in being a ”bird in the hand” sort of guy. When the ROTH came around I started splitting my contributions to arrive at an optimum tax situation. I will not have an employer provided pension of any sort so for me it will be a matter of balancing the RMD with ROTH distributions and dividends from my taxable account to supplement SS if it is there. I would like to think I might have a tax problem in my dotage but at present it doesn’t seem like a problem.

I have many retired clients who do pay in frightful amounts of tax. Some will convert traditional IRA’s to ROTH’s just to cut out the tax man but doing that just prior to retirement is poor planning in my opinion. I had a couple in this year both about 5 years from retirement. Their financial planner convinced them to roll over their 401K balance to an IRA and then convert to a ROTH invested in a nice safe annuity. The conversion was spread over two years so they paid a big chunk of tax in both years. While reviewing their information I noticed they still had some money in a Traditional IRA. I inquired about their plans for that money and they said their planner wanted to roll it this year. I ran out a projection based on historical earnings and showed them how the RMD from that account wouldn’t even be close to taxable since everything else was in ROTH accounts.

The biggest drawback to the taxable retirement account in my opinion is that most people today can’t keep their hands off their savings. With no “fence” it’s just too easy to dip in for every little want that comes along.

[Roberts]

The biggest drawback to the taxable retirement account in my opinion is that most people today can’t keep their hands off their savings. With no “fence” it’s just too easy to dip in for every little want that comes along.

Not only dip into the account routinely, how about spending the money before it makes it into the account.

Tax deferred accounts are protected in a bankruptcy if that's relevant.

Per the US Government, the average 50 year old has saved $43,797 for retirement and they won't work as long as they hope. For most people, withdrawing money from a tax deferred account isn't going to be a major tax issue, the major issue is not having enough. 80% below the age of 55 feel they won't have enough to retire.

529 plans aren't retirement plans. They are education plans or inheritance planning vehicles. They can technically last your lifetime, not just 18 years. You own the account and must name a beneficiary who is of a certain age but you direct the funds. That person could be your kid, then your grandchild. At one point, most of the money invested in 529 plans were lump sum inheritance investments to garner tax deferred growth for later generations.

Taxes on any equity investment that is active at all could reduce your return by 1% per year. Plus management fees are the same generally in or out of a tax deferred account.

[taxxcpa]

There is no need to pay any management fees. My rollover IRA is in E-Trade. Their only charges are low-cost commissions when I buy or sell a stock, bond or option. My account is over twice the amount I started with after having taken RMDs for over 20 years.
As I grow older and the RMD percentage increases, I've started taking more the the minimum withdrawal so that I won't get hit with a requirement to withdraw 25% or 50% or even more if I live to be 100. Withdrawing it doesn't mean you have to spend it all on wine, women and song. I've invested it in real estate and in securities in my non-IRA account, but if I need to spend some, I won't hesitate to do so.

The IRA tax deferral had enabled me to trade stocks without reporting gains, losses and dividends on my tax returns.

I would strongly suggest that if you can defer taxes with an IRA 403B or 401K plan as long as you can before you reach 70 or 80 years old.

[JohnH]

I feel grateful that I expect to have to deal with RMD's when I reach 70, and that's what I generally tell clients who complain about them. It's even more of a blessing for anyone who has sufficient income in retirement to be required to pay tax at the rates they paid when working full time. We all see way too many retirees who don't have either of those problems, and who would willingly exchange places with anyone who does.

Most people can "mirror" their investments and asset mix in their qualified plans, so if they don't need their RMD for living expenses, they can usually direct the amount remaining after the tax haircut back into the same type of investment on a non-qualified basis. It's really no big deal if they bother to give it some thought.

I do agree about the drag which commissions and fees place on earnings on any investment (qualified or non-qualified). If one is an active trader, this is simply a cost of doing business, and they are betting that they can earn more on an after-commission basis than a professional can earn. Some succeed, some don't.

But if they are investing the majority of the equity portion of their portfolio in mutual funds, then they have no excuse for paying excess fees (unless their only options are 401k plans through clueless or dishonest employers who make bad decisions on the available choices). For those who have control, they should invest in the Total Stock Market Index Fund from Vanguard. Year-after-year it outperforms 80-90% of professionals with results GUARANTEED to equal the average of the entire US economy. And the drag on earnings is minimized because fees (expense ratios) are the lowest in the industry. Investment advisors constantly trot out all sorts of lame reasons to discredit this type of investing, while they simultaneously and consistently underperform the major indexes while charging high fees for their mistakes.

[buzzardbreath]

Vanguard

OK I guess to drift into investments - it's still relevant to our body of knowledge.

Consider what you have said about Vanguard. If it outperforms the others, it would simply be because of low fees. But it is easy to have low fees when your staff doesn't have to research. Most of what they carry are index funds, so their stock selection is literally a fixture. This includes your "Total return index" fund, which of course is going to be guaranteed to perform at the same level as the total economy.

That having been said, I regard the above explanation as a positive rather than a negative comment. If this fixed choice which requires no decision-making can outperform 80%-90% of the other mutual funds, then what does that say for the rest of them, who hire brilliant research analysts to seek out great securities? And then beef up their fees to pay for them?

Could it be that the stock market is simply bigger than these legions of investment analysts whose brilliance claims to pay for themselves by performing well enough to overcome their fattened fees? If they were that brilliant, why can't they beat the low-fee Vanguard funds who don't research and simply index everything?

[JohnH]

To clarify, I don't think the performance benefits of a good index fund are simply due to the low fees. The performance benefits derive from the fact that a good index fund is structured so as to guarantee the average. A true index fund invests across a broad spectrum of the economy, such as the S&P Index or the Total Stock Market Index. This means that you will never outperform the market, but you will also never underperform the market.

But a properly designed index fund, operated in an honest manner, SHOULD offer very low expense ratios - typically .20% or less vs. as much as 2-3% for some actively managed mutual funds. Not even all of Vanguard's funds meet those low-cost criteria, but their S&P 500 Index and their Total Stock Market Index do. I prefer the Total Stock Market Index because it better meets my definition of "broad spectrum index". It invests in over 3,800 companies, representing over 99% of the US publicly-traded companies, and it has an expense ratio of only .05%. (Fidelity also offers low-cost index funds, but I don't think they offer a Total Stock Market Index).

Here's a good article about expense ratios and how they are a drag on earnings. It also talks about the difference between expense ratios and loads, which is a separate conversation altogether.

http://www.fool.com/school/mutualfunds/costs/ratios.htm

Mutual Fund companies are like the house at Las Vegas. They rake off a portion of everything gambled, and they really don't care who wins or loses because their profit comes from turnover. Also for some games, they rake off a lot more - just because they can. They do this by charging more to let you play the most exciting games, or in some cases simply because they have devised ways to keep you confused on how much the house is really taking on each roll of the dice, spin of the wheel, or deal of the cards.

The turnover issue is also important if you invest in a mutual fund with non-qualified money. An actively-managed fund will often throw off sizable capital gain distributions, which in turn generate a tax liability in a non-qualified account. I compare that to "churning" in accounts which own individual stocks. It is is supposed to be frowned upon, although it is a common practice in the industry. (The ethical issues are usually side-stepped by getting the client to sign disclosure & consent CYA forms, which most clients really don't understand in the first place). But a properly-managed index fund operates pretty much on auto-pilot, so there's no fund manager trying to make a name for himself by constantly trading to chase the latest hot product. The index fund periodically rebalances bases on pre-determined criteria, so there are some CGD's, but they are minimal. Therefore, since there are less CGD's, the index fund is more tax-efficient with respect to non-qualified money.

Incidentally, since such a high number of mutual funds fail to outperform the broad spectrum indexes, there's another wrinkle here. It involves the issues of survivorship and volatility. On a year-over-year basis, the actual mutual funds which beat or simply match the index will change. Theres is no way to predict which individual actively-managed fund will over-perform or underperform. And some of those which fail will be found to underperform spectacularly - they lose a lot of money out of proportion to the presumed risk. So trying to find the right funds to beat a good index fund is like trying to find a needle in a haystack, but there are multiple fields with different needles & haystacks, and you are only allowed to search one field at a time.

[Roberts]

401-k accounts can have high fees whether you invest via index funds or not.
An index fund may have a .2% fee but the custodial fees can be rather substantial and not very obvious. A lot of times you have to seriously search to find the exact figure and it can be shockingly high.

A lot of mutual funds can have a fee in the range of .8% so it isn't a massive difference - certainly not 3%. A $50 annual custodial fee wouldn't be an issue percentage wise if you are worried about taking a RMD at 70 1/2.


Not paying any income or dividend / cap gain taxes for 40 years and then complaining you have to pay tax = misguided complaining.
Complaining you have to take a RMD in retirement when 95% of people would be taking it anyway?

Typically, I buy quality stocks who pay dividends and plan on holding them for the rest of my life. (an etf could hold for life or until they are so beaten down they no longer qualify to be included in an index)

[Snaggletooth]

Fees are layered

A lot of mutual funds can have a fee in the range of .8% so it isn't a massive difference - certainly not 3%. A $50 annual custodial fee wouldn't be an issue percentage wise if you are worried about taking a RMD at 70 1/2.

Not paying any income or dividend / cap gain taxes for 40 years and then complaining you have to pay tax = misguided complaining.
Complaining you have to take a RMD in retirement when 95% of people would be taking it anyway?

Typically, I buy quality stocks who pay dividends and plan on holding them for the rest of my life. (an etf could hold for life or until they are so beaten down they no longer qualify to be included in an index)

Roberts, fees on a 401k plan certainly ARE in the neighborhood of 3%. The mutual funds in the selection made available to employees do not bear horrendous fees - in fact I like your range of 0.8%. But then the custodian (i.e. the sales agency) tacks on another 2.5-3.5% on top of what the mutuals charge. What's worse, until recently they were able to advertise returns which computed with the fund fee ONLY.

The way they get their fee typically is take 100% of the available money to invest, then buy only 97% of the fund shares to hold in the custodial account. This 3% (or thereabouts) is also taken from reinvested dividends. So even if you do invest in a low-fee fund of 0.5%, your total amount of the return you are deprived can be 3.5% or more. The only redeeming feature of a 401k plan is the fee is usually lower than the employer match.

What good is it to avoid 30% taxation if your 10% return is reduced by a 3% fee? Roberts, like yourself I bypass the games they play and invest only in quality stocks that pay dividends. I have to pay $50 a year in account fees just like what the custodians charge for an IRA, and don't complain.

[Bees Knees]

So far, you have failed to mention the part about IRAs and 401(k) plans being used to earn income on money that would have otherwise gone to the government in taxes. Earning income on deferred taxes can more than offset any fees charged to manage retirement accounts. And perhaps that is why it appears retired people are paying higher taxes. It is precisely because a good portion of those taxes they pay today are taxes they deferred from 20 years ago plus the taxes on earnings from the tax money that was used to earn more income rather than pay taxes.

You also failed to mention that a good number of 401(k) plans are ones where the employer matches a percentage of employee contributions. If my employer matches 10% of my contributions and I contribute $17,500 to my 401(k) this year, that is $1,750 of money my employer gave me that I would not have otherwise received had I not put money into my 401(k). This 10% of employer matching is greater than any 3% fee the 401(k) might charge to manage my money. I will gladly pay 3% on my money in exchange for receiving an additional 10% of my money I would never have otherwise received.

[Snaggletooth]

Maybe I've missed something

Earning income on deferred taxes can more than offset any fees charged to manage retirement accounts.

Bees, I guess I'm missing something. If the return is 10% and the fees are 3%, that is the same effect as paying taxes of 30%. Losing out on earnings on the tax savings would thus be equivalent of losing out on earnings on what would have been available had the fees not been charged.

You also failed to mention that a good number of 401(k) plans are ones where the employer matches a percentage of employee contributions.

I thought I did mention that the employer match was the single redeeming feature of a 401(k). In spite of my feelings about fenced money, I never discourage anyone from joining a 401k plan with employer match, even though in recent years some employer matches have grown skimpy. I will also concede that the employer match usually overwhelms the fees charged.

[Bees Knees]

Bees, I guess I'm missing something. If the return is 10% and the fees are 3%, that is the same effect as paying taxes of 30%. Losing out on earnings on the tax savings would thus be equivalent of losing out on earnings on what would have been available had the fees not been charged.

OK, lets do an example:

$1,000 that could be contributed to a retirement account, earning 10% minus a 3% management fee, or $1,000 that could be contributed to an after tax account earning 10% without a 3% management fee. Assume a 30% combined federal and state tax rate (23% for capital gains and qualified dividends). And 10 years before cashing in the investment at retirement.

Pre-tax retirement account balance:
End of year 1: $1,000 plus (10% minus 3%) = $1,070
End of year 2: $1,145
End of year 3: $1,225
End of year 4: $1,311
End of year 5: $1,403
End of year 6: $1,501
End of year 7: $1,606
End of year 8: $1,718
End of year 9: $1,839
End of year 10: $1,967 minus 30% = $1,377 after tax cash.

After-tax investment account balance:
End of year 1: $1,000 minus 30% = $700 plus 10% minus 23% of earnings = $754
End of year 2: $812
End of year 3: $875
End of year 4: $942
End of year 5: $1,015
End of year 6: $1,093
End of year 7: $1,177
End of year 8: $1,268
End of year 9: $1,366
End of year 10: $1,471 after tax cash.

It took 10 years for the after tax investment to overtake the retirement account. BUT ONLY because you are assuming the pre-tax retirement account has an extra 3% management fee and the after tax investment does not. Make the two investment rate of returns equal and the after-tax account will never catch up. I would disagree with the assumption that a pre-tax retirement account will always cost an extra 3% in management fees. None of my IRAs or 401(k) plans have such a cost.

[TXEA]

The discussion of fees in 401(k) plans and IRA's has been blown way out of proportion. I have looked at many IRA account statements and 401(k) statements over the years, and the only accounts that remotely approach 3% fees are those held in variable annuities. And, even those are not at 3%. The vast majority of workers and IRA owners pay around 75-125 basis points in investment management fees depending on holdings.

I have seem many small plans where the employee pays no sales charges and no admin costs on the 401(k) plan. The 3% is the exception that we all hear about because a small percentage of plans charge too much.

Either way, almost every scenario you can run (various websites make the calculation) will indicate that the tax deferral over many years more than outweighs the benefits of investing in a taxable account for retirement. Consider a basic safe harbor 401(k) plan that allows dollar for dollar matching up to 3% and 50% of the next 2%. If an employee contributes 5%, he/she will get a 4% match.

Example assuming no growth. The account just breaks even.

Annual Earnings - 50000.00 - Employee Contribution - 2500.00 / Employer Contribution 2000.00 per annum. Over 20 Years working, the employee will receive 40000.00 in contributions from the employer and 50% employee contributions. Total Value in account Assuming 2% Fees =

90000-1800 = 88200.00 (and in this example, I did not assume that the client invested the tax savings on the deferral which is a possibility. The tax savings would have been $7,500 at the 15% bracket.


If we assume the employee opts out of 401(k) and has to pay taxes on the 2500.00 that they contribute to a taxable account, they have $2,125 to put aside (at 15% bracket). They will accumulate $42,500 over 20 years, plus they get to pay taxes on d ordinary dividends, interest, and ST Capital Gains. Let's assume that averages $50 year. Total Value in account - 41500.00 assuming no fees which is unreasonable.

So, just to avoid fees and RMD's the client has $46,700 less in retirement assets.

Now it is RMD time - First year RMD on the 88200 would be 3218.98 less tax of $483 assuming 15% bracket. So, net of 2,736.13

It would take 96.69 years of tax at $483 to offset the 46,700 in money left on the table of 46,700 by opting to not participate in the 401(k). Finally after about 8-10 years of these RMD's the client (with no growth) will still probably have more retirement assets than the one that opts out simply due to having a matching contribution.

[Snaggletooth]

My version of the example

I have re-done the example using 3% of all incoming money in the IRA, including earnings, and a full 30% tax on all income on a
conventional investment. FWIW, the example bears in favor of the IRA. The difference appears to be on the compounded effect of
the initial 30% tax which would have been foregone in the very first year. The 3% is not assessed as a portfolio fee, but instead on all
incoming money. This means 97% of the returns accumulate until withdrawn. Interesting.

I believe 30% is unrealistically high tax rate. Also the 3% is NOT unrealistically high, but it is only on incoming dollars and not on
the entire accumulated balance.

$1,000 that could be contributed to a retirement account, earning 10% minus a 3% management fee, or $1,000 that could be contributed to an after tax account earning 10% without a 3% management fee. Assume a 30% combined federal and state tax rate (23% for capital gains and qualified dividends). And 10 years before cashing in the investment at retirement.

Pre-tax retirement account balance:
Initial invest: $ 970 (the fee is assessed on all incoming $)
End of year 1: $ 970 (plus 10% minus 3% of earnings) = $1,064
End of year 2: $1,167
End of year 3: $1,280
End of year 4: $1,405
End of year 5: $1,541
End of year 6: $1,690
End of year 7: $1,854
End of year 8: $2,034
End of year 9: $2,231
End of year 10: $2,447 minus 30% = $1,713 after tax cash.

After-tax investment account balance:
End of year 1: $1,000 minus 30% = $700 plus 10% minus 23% of earnings = $754
End of year 2: $812
End of year 3: $874
End of year 4: $941
End of year 5: $1,014
End of year 6: $1,091
End of year 7: $1,175
End of year 8: $1,266
End of year 9: $1,364
End of year 10: $1,469 after tax cash.

best regards

[Roberts]

I've never seen an IRA where a 3% custodial fee was applied.

If your 401-k has a 2-3% custodial fee, you need to change employers because they aren't looking out for your best interest.
I have sold 401-k plans and the worst case scenario is about 1.90% annual fee for a small business plan for the mutual fund company I used. We were the person signing up all the employees, educating them and doing all followups. Of that 1.9% - about .8% was the mutual fund fee, .7% came to me and the rest was the mutual fund custodian fee. My fee could drop to .25% if they company did all the real work of signing people up.