On Saturday mornings, I often listen to some of the syndicated investment shows on the radio. Recently, I heard a host—who bills himself as one the nation’s leading investment advisers—give two callers answers to questions I think were flat wrong. Because they address fairly common issues, I thought it might be helpful to cover them here.
Bond premiums
The first caller holds a municipal bond maturing in 2017 having a face value of $15,000 that’s now worth $18,000. “Should I continue to hold it?” Caller #1 asked. Without hesitating, the host said, “Sell it,” observing that the premium will go away over time. While that statement is true, it’s not a reason to sell the bond.
The host didn’t ask the obvious follow-up question: “What do you intend to do with the proceeds?” It was apparent that Caller #1 intended to reinvest the proceeds in more municipal bonds. Thus, the advice to sell the bond was wrong for two reasons.
First, capital gains on tax-free municipal bonds are taxable. Assuming Caller #1 paid face value for the bond, the $3,000 premium would be taxed at a combined 25 percent state and federal rate. This $750 tax bill wouldn’t occur if the bond were held to maturity.
Second, municipal bonds are typically bought or sold through dealers, who mark up bonds they sell and mark down those they buy, which is how they make their money. The “spread” between dealers’ buy and sell prices could be 2 percent or more (maybe much more if Caller #1 doesn’t shop around carefully). Selling the present bond and buying a new one would likely eat up another $250 or so of that premium.
Together with the taxes, this means Caller #1 would be giving away $1,000 out of what he thinks is a $3,000 premium, a pretty hefty price to pay. The bond is trading at a premium for a very good reason—it’s yielding 5 percent. For the next six years, Caller #1 will receive $750 per year in tax-free income. Buy a newly issued bond of the same maturity to replace it and Caller #1 will be lucky to get $300 interest per year on the same principal.
To judge whether it makes sense to replace a bond trading at a premium with another, the holder must take into account both taxes and the inefficiencies of the bond market.
The Roth 401K
The 401K plan has become the predominant retirement plan in the workplace. The Roth 401K, available since 2006, turns taxation of retirement savings on its head. The standard deductible 401K is funded with before-tax earnings, reducing current taxable income. At retirement, the employee contributions to the 401K and all investment returns on them are taxed as ordinary income. With the Roth 401K, there’s no deduction for the contribution, but there are also no taxes on the withdrawals during retirement.
Caller #2 said his firm’s retirement plan let him choose between a Roth 401K and a deductible 401K. Should he contribute to the Roth? The host framed the issue by saying it was a question of whether it was better to pay the tax on the money contributed now or to wait and pay tax on that contribution many years down the road. Given the time value of money, it’s a good idea to defer paying a tax to a later date if you can do so.
Unfortunately, the host completely ignored the fact that the investment returns of the Roth 401K are tax-free, while those in the deductible 401K will be taxed as ordinary income as they’re withdrawn.
Given the long time horizon, the total investment returns will be much larger than the contributions when Caller #2 reaches retirement age. If he is puts $10,000 per year into the 401K and invests the funds wisely, generating an average return of 7 percent annually, in 20 years, that $10,000 will grow to $40,000 in either flavor of 401K. The proper comparison is whether it’s better to pay tax on $10,000 now or on $40,000 20 years later. Given our progressive income tax rate structure, withdrawals from the deductible 401K during retirement will likely drive Caller #2 into a higher tax bracket, making deferring taxation even less attractive.
A second reason to consider the Roth 401K is there’s no requirement for Caller #2 to ever withdraw any funds from the Roth version. In contrast, once retired, Caller #2 must begin taxable “required minimum distributions” from the deductible 401K in the year he turns 70.5 and every year thereafter. This makes Roth 401Ks (and Roth IRAs) very attractive assets for estate planning, ideal to pass on to one’s heirs, who also pay no income tax on them.
Finally, here’s perhaps the most important reason to consider the Roth 401K: Retirement plans often contain a “match” feature. A 4 percent match being pretty typical, if Caller #2’s salary is $100,000, then his employer will add $4,000 (4 percent of salary) to his 401K kitty. The match is treated as an expense to the employer, lowering the employer’s taxes. In a deductible 401K, the match is taxed the same as the employee’s deferred salary—it and the investment returns on it are taxed as ordinary income when withdrawn. For the Roth 401K, the match is pure gravy to Caller #2 because neither the match nor the investment earnings on it will ever be taxed.
What other way can you think of that an employer can provide compensation to an employee that is deductible to the employer and tax-free to the employee? If your company offers a Roth 401K option, you should give it serious consideration.
