Friday, November 30, 2012

Should I invest in a Roth 401(k)? No, probably not.

Many company 401(k) plans have added a Roth 401(k) option.  I believe most people should NOT use the Roth 401(k) option.  The Roth feature seems very appealing since withdrawals from a Roth account can be made tax-free in retirement.  However, these FUTURE tax-free withdrawals come at a high up-front cost since the employee must pay more taxes right NOW.  Let me go through an example and provide an alternative strategy.

Scenario 1:

Take a married couple, 40 years old, with taxable income of $85,000.  This couple would be in the 25% Federal Income Tax bracket and the 7.75% North Carolina State Income Tax bracket.  Let's assume the couple contributes $15,000 per year to a Roth 401(k).  This means the couple is paying an extra $4,912 in income taxes than if they contributed to a traditional 401(k) plan (15,000 x 32.75%).  So, the couple is paying an extra $4,912 for the privilege of placing $15,000 into a Roth account.

Scenario 2:

My suggestion to this couple is to stop making contributions to the Roth 401(k) and instead switch back to the traditional 401(k).  By switching from the Roth 401(k) back to the traditional 401(k) this couple will have an additional $4,912 in take home pay due to the lower income taxes.  The couple should then take that $4,912 in additional take home pay and contribute that money into a Roth IRA (I suggest doing this at Vanguard and use only low-cost index funds).

Thursday, November 29, 2012

Worsification: Diversification Gone Bad

The North Carolina State Retirement System's pension fund is a perfect example of what I call "worsification" or diversification gone bad.  If one takes a look at the most recent investment performance report by clicking here.  You will notice six asset classes:

  1. Global Equity (publicly traded stocks)
  2. Fixed Income (publicly traded bonds)
  3. Real Estate (partnerships that buy shopping malls and office buildings)
  4. Alternatives (private equity, venture capital, hedge funds)
  5. Credit (junk bonds and bank loans)
  6. Inflation (derivative securities on commodities: eg. futures and options on gold or corn, etc.)

Most folks are familiar with the first two categories which are just traditional stocks and bonds.  But, the next four categories might come as a surprise to some pensioners to discover their retirement is being bet on such items as private equity, hedge funds, junk bonds, and derivatives.  The worst part of the surprise is that the four new categories have all produced returns lower than a simple, traditional, 60% / 40% mix of stocks and bonds.

NCRS 10-year returns
Stocks = 8.0%
Bonds = 6.8%
60/40 Stock/Bond = 7.5%
Alternatives = 5.3%
Real Estate = 3.8%

Wednesday, November 28, 2012

529 College Savings Plans

It's not too late to make a contribution to a 529 College Savings Plan and possibly reduce your state income tax bill (depending on your state and income situation).  

One thing I like about my home state's North Carolina 529 College Savings Plan is the ability to utilize very low cost Vanguard Index funds.  The one minor disappointment is the NC 529 Plan charges an additional 0.25% for administrative expenses, but even that amounts to just $12 for each $5,000 invested.  The second thing I like about the NC 529 Plan (for North Carolina residents) is that there are no income limitations in order to receive a state income tax deduction.  

(see the NC Department of State Revenue statement on the NC 529 College Savings Plan by clicking here)

A married couple in the highest North Carolina tax bracket (7.75% for taxable income over $100,000) can save up to $387 in North Carolina state income taxes with a contribution of $5,000 to the North Carolina 529 College Savings Plan each year.  I view this as the state of North Carolina paying me $387 each year for planning for my children's college education.

Tuesday, November 27, 2012

Hedge Fund Mirage

The highly respected magazine The Economist, printed an article on hedge-fund returns earlier this year. Guess what? They are horrible.  Thus, the name of the article is "Rich Managers, Poor Clients." The Economist article is based on a book called The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True.

Oh, hedge fund managers are indeed brilliant - they are masters at identifying inefficiencies in the market and taking advantage of the uninformed patsies.  Unfortunately, the most uninformed patsies seem to be the clients of the hedge funds themselves!  You see, while the hedge fund industry has made the hedge fund managers wealthy beyond belief, their clients have enjoyed a 14 year annualized return of about 2.1% or about half what you could earn investing in riskless treasury bills!

How can this be?  Every pension fund and endowment in America is piling into hedge funds.  How can the returns be so horrible?  Brace yourself, I'm going to use 3rd or maybe 4th grade math to explain the obvious problem with hedge funds.  What I'm about to tell you was not in The Economist article. Ok, are you ready?

Monday, November 26, 2012

Hedge Fund Futility: Why bother?

A recent study by Goldman Sachs highlights the futility of hedge funds.  

Returns through November:
S&P 500 Index 14%
Average Large Cap Mutual Fund 13%
Average Hedge Fund 6%

In other words, index funds have beaten most mutual funds and crushed most hedge funds.  One of the reasons for poor performance from hedge funds is their fee structures.  Many hedge fund fees are 2% per year plus 20% of all profits.  

Consider this example:
A lucky hedge fund manager beats the S&P 500 Index by 3% this year for a return of 17% BEFORE fees (Given the efficiency of the stock market, this would be a monumental achievement).  2% would come off the top leaving a 15% return.  But, the 20% take of the remaining profits would eat another 3%.  This would leave the investor with a net return of 12%, which would have trailed most mutual funds and all S&P 500 Index funds.  

My advice:

Wednesday, November 21, 2012

US National Debt

If you want to learn about the US National Debt and deficit watch the documentary "Ten Trillion and Counting" (<--click there) from my favorite TV show Frontline on PBS (Tuesdays at 10 PM in the Raleigh area).  You can watch the episode on your computer at the link above or on your TV if you subscribe to NetFlix.

Thursday, November 15, 2012

2012 Tax Brackets and How They Could Change in 2013

I found this very handy 2-page 2012 federal tax rate summary information on the internet.
(If the link above stops working, just send me an email to InvestorCookbooks(at) and I will send you the pdf file)

And you can find your state tax brackets by clicking here.

A lot of folks are curious about how tax rates might change in 2013 as part of the "Fiscal Cliff."  Certain tax cuts passed years ago will "expire" in January 2013 unless Congress agrees to extend the cuts.  Here are the main changes set to take place: