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Roth IRA... a good time?
- Thread starter thinks
- Start date
imported post
thinks,
Absolutely, Personal IRAs should be a priority for all concerned...Depending on age and a few other factors determines either a ROTH or Traditional....
Traditional IRA money deposits are tax deferred as are the gains until you begin taking the money out of your account
Roth IRA you pay the tax on your deposit up front, however the GOLDEN part of this equation is that you never pay tax on any of the capital gains....ie; you might invest $12,000 over the next 4 years and if it were to gain to say $50K you would not be taxed on any of the $50K. Additionally, if you ever needed to take any of your original contributions back out, you may without penalty because you already paid taxes on the $12K.
Make your contribution.. it is not until you invest in either stocks, or funds or bonds that the money goes at risk
Good Luck.........smart move!
thinks,
Absolutely, Personal IRAs should be a priority for all concerned...Depending on age and a few other factors determines either a ROTH or Traditional....
Traditional IRA money deposits are tax deferred as are the gains until you begin taking the money out of your account
Roth IRA you pay the tax on your deposit up front, however the GOLDEN part of this equation is that you never pay tax on any of the capital gains....ie; you might invest $12,000 over the next 4 years and if it were to gain to say $50K you would not be taxed on any of the $50K. Additionally, if you ever needed to take any of your original contributions back out, you may without penalty because you already paid taxes on the $12K.
Make your contribution.. it is not until you invest in either stocks, or funds or bonds that the money goes at risk
Good Luck.........smart move!
imported post
The best time to start your Roth IRA is, well, yesterday!! Sooner rather later!! Just do it!! Okay, you get the idea.One thing you may want to do withyour Rothis to invest in value stocks or international small stocks. Don't just put it into anotherS&P fund - diversify.
The best time to start your Roth IRA is, well, yesterday!! Sooner rather later!! Just do it!! Okay, you get the idea.One thing you may want to do withyour Rothis to invest in value stocks or international small stocks. Don't just put it into anotherS&P fund - diversify.
imported post
I make the max Roth IRA contribution on January 2[suP]nd [/suP]from my cash reserves. The sooner you make your IRA contributions, the sooner you get tax-deferred growth. I also have a regular margin account, into which I contribute 5%-25% of my income monthly.
The priorities: TSP (since it lowers my taxable income), IRAs, then regular brokerage account.
I make the max Roth IRA contribution on January 2[suP]nd [/suP]from my cash reserves. The sooner you make your IRA contributions, the sooner you get tax-deferred growth. I also have a regular margin account, into which I contribute 5%-25% of my income monthly.
The priorities: TSP (since it lowers my taxable income), IRAs, then regular brokerage account.
imported post
Roths only help a current year's taxes in that the earningsgrow tax deferred. There is no allowable deduction for Roth IRA contributions. Hope you didnt take a deduction for a Roth IRA contribution
.
If you're wondering why the IRS keeps up with Roth IRA contributions, its because you are allowed to withdraw the contributions tax free (not the earnings) simply because you already paid taxes on them...... or you should have.
Azanon
Roths only help a current year's taxes in that the earningsgrow tax deferred. There is no allowable deduction for Roth IRA contributions. Hope you didnt take a deduction for a Roth IRA contribution
.If you're wondering why the IRS keeps up with Roth IRA contributions, its because you are allowed to withdraw the contributions tax free (not the earnings) simply because you already paid taxes on them...... or you should have
.Azanon
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For 2003 if a persondid a IRA one received the Retirement Savings Contribution Credit. I can't remember right now more about it w/o looking but recall something along the lines of one w/o retirement benefits so I didn't do the deduction but was able to use the credit.
For 2003 if a persondid a IRA one received the Retirement Savings Contribution Credit. I can't remember right now more about it w/o looking but recall something along the lines of one w/o retirement benefits so I didn't do the deduction but was able to use the credit.
imported post
Really??? I haven't heard of that, and i did my taxes using Quicken. Considering I had Roth IRA contributions for 2003, i'd be disappointed to find out that there was a credit I could take.
If you come across a link showing that guidance, i'd be interested in seeing it.
Really??? I haven't heard of that, and i did my taxes using Quicken. Considering I had Roth IRA contributions for 2003, i'd be disappointed to find out that there was a credit I could take.
If you come across a link showing that guidance, i'd be interested in seeing it.
imported post
here's the info: just paste/copy for ya
Retirement Savings Contributions Credit
Tax Tip 2004-50, March 12, 2004
This tax credit, which will be available only through 2006, could help you offset the cost of the first $2,000 contributed to IRAs, 401(k)s and certain other retirement plans.
The Retirement Savings Contributions Credit applies to individuals with incomes up to $25,000 ($37,500 for a head of household) and married couples with incomes up to $50,000. You must also be at least age 18, not a full-time student, and not claimed as a dependent on another person’s return.
The credit is a percentage of the qualifying contribution amount, with the highest rate for taxpayers with the least income, as shown below:
Credit Rate
[align=left]Income for Married, Joint[/align]
[align=left]Income for Head of Household[/align]
[align=left]Income for Others[/align]
[align=left]50%[/align]
[align=left]up to $30,000[/align]
[align=left]up to $22,500[/align]
[align=left]up to $15,000[/align]
[align=left]20%[/align]
[align=left]$30,001–32,500[/align]
[align=left]$22,501–24,375[/align]
[align=left]$15,001–16,250[/align]
[align=left]10%[/align]
[align=left]$32,501–50,000[/align]
[align=left]$24,376–37,500[/align]
[align=left]$16,251–25,000[/align]
When figuring this credit, you must subtract the amount of distributions you have received from your retirement plans from the contributions you have made. This rule applies for distributions starting two years before the year the credit is claimed and ending with the filing deadline for that tax return.
Form 8880, Credit for Qualified Retirement Savings Contributions, is used to figure the amount of the credit, which is then reported on line 48 of Form 1040 or line 32 of Form 1040A. You cannot use Form 1040EZ to claim this credit.
Using Form 880 for your 2003 tax return, you would first subtract distributions received from January 1, 2001, through April 15, 2004, from your total 2003 retirement contributions. Then you would multiply the result (but not more than $2,000) by the credit rate that applies to your filing status and income level. The maximum credit amount allowed for 2003 is $1,000, or up to $2,000 if married filing jointly and each spouse made contributions.
The subtraction rule does not apply to distributions which are rolled over into another plan or to withdrawals of excess contributions.
The Retirement Savings Contributions Credit is in addition to whatever other tax benefits may result from the retirement contributions. For example, most workers at these income levels may deduct all or part of their contributions to a traditional IRA. Contributions to a 401(k) plan are not subject to income tax until withdrawn from the plan.
For more information, review IRS Publication 590, Individual Retirement
Arrangements (IRAs). The publication and forms can be downloaded from this Web site or ordered by calling toll free 1-800-TAX-FORM (1-800-829-3676).
Related Items:
here's the info: just paste/copy for ya
Retirement Savings Contributions Credit
Tax Tip 2004-50, March 12, 2004
This tax credit, which will be available only through 2006, could help you offset the cost of the first $2,000 contributed to IRAs, 401(k)s and certain other retirement plans.
The Retirement Savings Contributions Credit applies to individuals with incomes up to $25,000 ($37,500 for a head of household) and married couples with incomes up to $50,000. You must also be at least age 18, not a full-time student, and not claimed as a dependent on another person’s return.
The credit is a percentage of the qualifying contribution amount, with the highest rate for taxpayers with the least income, as shown below:
Credit Rate
[align=left]Income for Married, Joint[/align]
[align=left]Income for Head of Household[/align]
[align=left]Income for Others[/align]
[align=left]50%[/align]
[align=left]up to $30,000[/align]
[align=left]up to $22,500[/align]
[align=left]up to $15,000[/align]
[align=left]20%[/align]
[align=left]$30,001–32,500[/align]
[align=left]$22,501–24,375[/align]
[align=left]$15,001–16,250[/align]
[align=left]10%[/align]
[align=left]$32,501–50,000[/align]
[align=left]$24,376–37,500[/align]
[align=left]$16,251–25,000[/align]
When figuring this credit, you must subtract the amount of distributions you have received from your retirement plans from the contributions you have made. This rule applies for distributions starting two years before the year the credit is claimed and ending with the filing deadline for that tax return.
Form 8880, Credit for Qualified Retirement Savings Contributions, is used to figure the amount of the credit, which is then reported on line 48 of Form 1040 or line 32 of Form 1040A. You cannot use Form 1040EZ to claim this credit.
Using Form 880 for your 2003 tax return, you would first subtract distributions received from January 1, 2001, through April 15, 2004, from your total 2003 retirement contributions. Then you would multiply the result (but not more than $2,000) by the credit rate that applies to your filing status and income level. The maximum credit amount allowed for 2003 is $1,000, or up to $2,000 if married filing jointly and each spouse made contributions.
The subtraction rule does not apply to distributions which are rolled over into another plan or to withdrawals of excess contributions.
The Retirement Savings Contributions Credit is in addition to whatever other tax benefits may result from the retirement contributions. For example, most workers at these income levels may deduct all or part of their contributions to a traditional IRA. Contributions to a 401(k) plan are not subject to income tax until withdrawn from the plan.
For more information, review IRS Publication 590, Individual Retirement
Arrangements (IRAs). The publication and forms can be downloaded from this Web site or ordered by calling toll free 1-800-TAX-FORM (1-800-829-3676).
Related Items:
Form 8880, Credit for Qualified Retirement Savings Contributions (PDF 46K)
Form 1040, U.S. Individual Income Tax Return (PDF 176K)
Form 1040A, U.S. Individual Income Tax Return (PDF 136K)
Publication 590, Individual Retirement Arrangements (IRAs) (PDF 449K)
Tax Topic 610
imported post
azanon wrote:
No, I do not mind at all...personal finance has become a big hobby of mine over the last year or so and I enjoy finding people with whom to discuss it.
hehe, Single. I get a lot of, "Oh! That explains it!", to which Iwryly reply, "But I have a cat! She eats expensive cat food!"
This is my third time being single; I survived two divorces unscathed.
My income is a little better than average, full-time job plus two sideline businesses. The more time I spend on the businesses, the more income as a result and the less time I have to spend money; my computer geek hobbyis a little profitable. Anything above my salary goes towards investments.
Being frugal is the bulk of it. By no means do I deprive myself, but I do strategise purchases, buy the best value (which is not always the best price), and take care of my stuff for longevity. I also shop online a lot since items are much cheaper that way. I definitely do enjoy my things, particularly having the 'best' several years after I bought it.
Thinking long-term is the key: "What do I want 10/15/20/whatever years from now?" Frankly, I would love to have the 2005 Bentley Continental when it is available, but that just ain't gonna happen, so the question to myself is, "How can I afford that X years from now?" and strategising toward that goal.
Probably the most critical habit of all is paying yourself first.Put your calculated X dollars into your investments before you paid the mortgage, bills, etc. and never touch it. "What if I run out of money before I run out of month?" Err...well...don't!
The point is that it is easy to slack on our investments, so take care of it first. Personally, I need that, for I am precisely the opposite of 'Mister Disciplined'.
I started in January 2003 and the bulls came-a-runnin' in March, so I got to enjoy a very lucrative market very easily. I more thandoubled my money in a year in fact. Seeing that kind of opportunity in my grasp makes spending my money more controlled and easier to delay gratification (and oh, boy am I the last guy to 'delay gratification'). "I can hold off buying this now, and buy two of them later." i.e. Don't just think 'money', think 'money over time'.
Okay, enough of the paradigm-shifting pep-talk, I like definitive tangibles, too:
Some books that helped give me a clear perspective and knowledge that I recommend: The Truth About Money, Cashflow Quadrant, Peter Lynch's Beating the Street, J.K. Lasser's income tax guides, and--I have only read 1/3 of it so far but a must-read for everyone--The Millionaire Next Door. My attention diverts itself easily (glad I am not a child now, I would be ritalin-boy for sure, blecch) but I could not put these books down, they were very informative, entertaining, and well-written. Ric Edelman's books will have you laughing out loud as you read them, highly unexpected from a tome about personal finance.
hehe, Ihope there something for everyone in all of that.
azanon wrote:
No, I do not mind at all...personal finance has become a big hobby of mine over the last year or so and I enjoy finding people with whom to discuss it.
hehe, Single. I get a lot of, "Oh! That explains it!", to which Iwryly reply, "But I have a cat! She eats expensive cat food!"
This is my third time being single; I survived two divorces unscathed.
My income is a little better than average, full-time job plus two sideline businesses. The more time I spend on the businesses, the more income as a result and the less time I have to spend money; my computer geek hobbyis a little profitable. Anything above my salary goes towards investments.
Being frugal is the bulk of it. By no means do I deprive myself, but I do strategise purchases, buy the best value (which is not always the best price), and take care of my stuff for longevity. I also shop online a lot since items are much cheaper that way. I definitely do enjoy my things, particularly having the 'best' several years after I bought it.
Thinking long-term is the key: "What do I want 10/15/20/whatever years from now?" Frankly, I would love to have the 2005 Bentley Continental when it is available, but that just ain't gonna happen, so the question to myself is, "How can I afford that X years from now?" and strategising toward that goal.
Probably the most critical habit of all is paying yourself first.Put your calculated X dollars into your investments before you paid the mortgage, bills, etc. and never touch it. "What if I run out of money before I run out of month?" Err...well...don't!
The point is that it is easy to slack on our investments, so take care of it first. Personally, I need that, for I am precisely the opposite of 'Mister Disciplined'.
I started in January 2003 and the bulls came-a-runnin' in March, so I got to enjoy a very lucrative market very easily. I more thandoubled my money in a year in fact. Seeing that kind of opportunity in my grasp makes spending my money more controlled and easier to delay gratification (and oh, boy am I the last guy to 'delay gratification'). "I can hold off buying this now, and buy two of them later." i.e. Don't just think 'money', think 'money over time'.
Okay, enough of the paradigm-shifting pep-talk, I like definitive tangibles, too:
- When I moved here, I bought a brand new townhouse before construction was completed. The monthly payment with insurance and taxes was still cheaper than renting an apartment with half the space. A comparable single-unit house (3/3/2.5, 1500 sq. ft., garage) was $40-$50K more. Plus, I hate yardwork.
- On that note, keep your mortgage, especially now. That money is cheap, do not hurry to pay it back any sooner than you have to. I am continually amazed at how much Depression-Era thinking permeates our society, "I want to 'get out from under' my mortgage." I mean, people younger than I are saying that and I am 33!
- Calculate refinancing. Six years into paying that mortgage, I refinanced to knock off a point in interest, bring it back up to 30 years, and reduce my monthly payment. The difference between the old payment and the new payment goes into my brokerage account. The refund from escrow and the difference in principal (I stated a figure higher than what I owed, hehe) went right into my brokerage account.
- Be shrewd. Everyone has an angle, have one better than they. The money made from the mad-refinancing is that they charge you points. They also usually make the mistake of comparing their mortgage with your original mortgage: in my case, they compared theirs to my 30-year mortgage rather than the 24-year mortgage I actually had since I paid it for six years. I let Mr. Salesman think he got one on me, waited until a few hours after he left, called the company, berated them for wasting my time and stated that these two points they are charging me makes me pay more than what I am now. They dropped the two points and had new paperwork for me the next day.
- I bought my first new vehicle in 1990 when I was 19.The loan rate was 22% and full-coverage insurance was outrageous. I paid cash for it and kept liability/uninsured only and was confident that I would not total my own car. That cash also let me buy it at invoice price. (Sticker: >$16K, paid $10.8K)
- I finally sold it just last year--it was about to have many problems and no longer financially feasible to keep it--and bought my PT Cruiser. I re-accomplished my financial schedule (budget) and decided to spend $21,450. Sticker on the PT: $27.7K. I paid $21,500...$1800 under invoice. I really think I could have gotten it for $20K even, but I really, really, really wanted this particular PT Cruiser and it was the only one I found within 900 miles.
- Like mortgages, car loan money is cheap. It would cost me more to pay cash for my PT than to finance it, so that money stayed in my brokerage account and I am more than happy to make a car payment.
- Your largest expenses are taxes, your house (it is an expense, not an asset), and your wheels. Scrutinise those first.
- Learn how to make your own Financial Statement. I really got a clear picture when I put together mine and it is the basis from which all my financial moves are made.
Some books that helped give me a clear perspective and knowledge that I recommend: The Truth About Money, Cashflow Quadrant, Peter Lynch's Beating the Street, J.K. Lasser's income tax guides, and--I have only read 1/3 of it so far but a must-read for everyone--The Millionaire Next Door. My attention diverts itself easily (glad I am not a child now, I would be ritalin-boy for sure, blecch) but I could not put these books down, they were very informative, entertaining, and well-written. Ric Edelman's books will have you laughing out loud as you read them, highly unexpected from a tome about personal finance.
hehe, Ihope there something for everyone in all of that.
imported post
Rolo, awesome post!! I'll have to look for those books at the library... thanks for your recommedations.
I found part of your post intriguing in particular because I was looking over someone's reasoning behind one should pay off your mtg first even before any $ goes to investments... To be honest, I'm going to have to look it over again because at the time I didn't have much time. I'm trying to find the link but can't find it at the moment so I'll copy/paste at the end and I would love to her your response to the information when you get time because I was under the impression like you had said but we've only had our mtg since Jan. and this moneymgmt(?good name?) is becoming to be a hobby of mine too(wink). Hopefully, I'll find the link that I'll add later. The person who wrote it I believe his name is in the info.
p.s. My dh loves the PT Cruiser. I thought maybeyour site was the link but doesn't look like it...
The following is Copy/paste... not written by me... I would reference but still looking for it so will add when I find it:
Prepaying your mortgage vs. investing: the perennial decision. This material summarizes and extends a discussion about prepaying held on FIA mailing list during November of 2003.
The gold standard text for prepaying is "The Bankers Secret" by Marc Eisenson. It is likely to be available in your local library. The book is thick, but it's 90%+ tables. The material itself is only about 40 pages, and written at the 8th grade level. Computer users with a spreadsheet package can run out their own amortization table pretty easily, so there's no need to buy anything. Now, just make sure everyone avoids the "biweekly payment conversion" scam... ;-)
Carolyn spake: "I think that at some point you have to almost become obsessed with the goal of paying your mortgage off early."
Jonathan: Absolutely. And it's fun too. I still have the amortization tables we used.
And then this little bit popped in (again from Caroyln):
"I'm glad Penny Yunuba raised the point about fully funding your retirement accounts before paying off mortgages early. I absolutely, enthusiastically concur."
Jonathan: Augh!!!!!!!! This is conventional wisdom and in many cases is simply **not** the best thing to do. Everyone *must* run the numbers in order to determine the best thing for them. Please note that the discussion following applies only to US citizens considering prepaying their home mortgage. There are accounting reasons why this discussion does not apply to investment or business properties (although even then I'd assert you need to run the numbers out).
I too heard that "wisdom" about funding your retirement accounts before prepaying your mortgage. Being spreadsheet-savvy, I decided to model the situation and see what the reality actually was. Here is what I found. First off, some definitions and assumptions:
1) You can afford a building and want one enough to actually buy one.
2) You have arranged your financial affairs such that the mortgage is your only debt and you have an adequate (whatever that means to you and your family, if any) cushion already built up to stave off financial emergencies. If you have no cushion, this whole discussion is moot - go fund a minimal cushion first!
3) You have excess money that you can choose to either prepay your mortgage with or invest with each month. This amount is assumed to be the same each month to make the spreadsheet manageable. In reality, we found this amount to be highly variable, though there was seldom a month we didn't have some excess we could prepay with.
4) The measure of "wealth" is net worth. That is, increasing your net worth is the goal, *not* avoiding taxes. We'll come back to taxes. I think any YMOYLers who have thought about their personal cash-flow will agree with this definition (note 1). My definition is just a way of measuring relative value differences in the spreadsheet model, nothing more. Feel free to disagree that this is a valid discrimination method and contact me to discuss it.
So I set off to model the accumulation of net worth across time. I picked a period of 60 years to model for various reasons, none germane here. The real point is that it's more than 30 years a conventional mortgage can last. I did the modeling in Excel-97 and with the Analysis Toolpak installed for the financial functions (note 4). I modeled four possible scenarios:
1) Conventional wisdom (CW) is to put money into investments, not your mortgage, to preserve your tax deduction and earn compound interest on your investments.
2) No Invest (NI) is paying your mortgage off before you invest a single penny. The whole extra amount is sent in as a Regular Prepayment, to use Eisenson's terms.
3) Splitting the difference (50/50) - pay 50% of what you can invest into your mortgage to retire it early, and invest the rest.
4) Irregular prepayments (IP) is paying as many principle payments as you have money for each period. Unused "investment principle" carries over to the next period. Investments begin after mortgage pay off. This is an Irregular prepayment scheme as Eisenson would label it. Incidentally, this is the approach my wife and I took while prepaying our mortgage, and we are not sorry in the least, even though it can underperform some of the other models.
Then I ran the numbers. That is, I put a sheet together for each model. Each sheet calculates net worth across 720 months. I created another sheet to make comparisons and collect the data in one place to make graphing easy. Finally I created a chart page with a graph of all four options and a common place to change numbers and run scenarios from. That's the workbook associated with this file.
So let's discuss a few scenarios. The common elements of all the scenarios below will be the amount borrowed: $150,000; 30 year conventional mortgage, $0 down, average tax rate of 20% (see note 1 for the calculation), and a mortgage interest rate of 7%. This makes the principle and interest portion of a mortgage payment $997.95 per month. I'm also assuming there is $302.05 available to invest each month. As a point of comparison, these numbers represent the median values in my current housing market (12/2003 in the Midwest) and roughly equate to an annual income of $52,000 as the bankers calculation of acceptable income to support this amount of indebtedness (note 5). All the numbers below take place at month 360 - just when you'd have paid off the last mortgage payment under the conventional wisdom.
Consider for the moment you are considering the NI option vs. the CW option (this is the most radical choice you can make to many). Further assume that the rate earned on investments is 7% *pretax* and earnings are not taxed each year. If you follow CW, at 30 years your net worth is $688,540.27. If you follow NI, at 30 years your net worth is $511,897.14. I don't know about you, but the mutual funds in my tax deferred accounts are making nowhere close to 7%+ at the end of 2003.
Now, I picked 7% for the tax-deferred return precisely because it was a relatively high return (Treasury bonds are returning around 5% during 12/2003) and because it was close to the equivalency point (7.101%) between NI and CW scenarios. Here's a table with various investment rates/net worths to consider:
I-Rate CW NI 50/50 IP
3.000% $325,667.86 $420,082.81 $370,456.29 $422,468.13
4.000% $358,405.99 $440,774.37 $393,880.75 $443,494.19
5.000% $398,911.77 $463,517.49 $421,748.44 $466,589.76
6.000% $449,213.46 $488,537.40 $455,141.02 $491,977.49
6.825% $499,899.24 $511,070.10 $487,811.77 $514,822.20
7.000% $511,897.14 $516,085.42 $495,431.84 $519,904.45
8.000% $590,265.11 $546,442.06 $544,368.35 $550,645.67
9.000% $688,540.27 $579,920.55 $604,178.40 $584,506.62
10.00% $812,129.95 $616,870.68 $677,707.39 $621,827.72
11.00% $967,966.82 $657,683.30 $768,595.52 $662,986.97
12.00% $1,164,949.57 $702,795.19 $881,506.86 $708,404.96
13.00% $1,414,513.08 $752,694.63 $1,022,425.64 $758,550.59
14.00% $1,731,366.40 $807,927.62 $1,199,039.80 $813,944.61
15.00% $2,134,448.57 $869,104.89 $1,421,237.62 $875,166.40
16.00% $2,648,167.14 $936,909.69 $1,701,751.26 $942,861.97
17.00% $3,304,003.93 $1,012,106.67 $2,056,991.02 $1,017,749.48
I picked 3% to reflect the traditional inflation rate, and the rate at which conservative investors are making about now (end 2003) across their portfolios. Clearly prepaying makes sense before any investing at this rate. CW doesn't catch up to NI until 7.1%, as noted above. In fact, your best deal is the IP plan over the NI plan across all the rates in this example (note 2). Note the 50/50 option overtakes NI and IP after 8% as well. Finally at 14%, picked because it's exceedingly aggressive (note 3), but not out of the realm some brokers will try to sell you off at, now the CW and 50/50 start to look pretty good compared to NI and IP, though IP is still better than NI.
What's going on here? As you can see, *the more conservatively you invest, the more likely you are to benefit by prepaying!* It's not until you start taking serious risk (more than 8%) in the investment markets that you start to see the CW and 50/50 models start to pay off. As a YMOYLer, I think you have to be realistic about what you can get in the bond market. And by the way, that's the downfall of this model: assuming a steady rate of return on the investments and that your tax rate will remain the same.
Now, about those taxes. I chose to model with taking taxes into effect. If we go back to the 7% model and assume combined federal, state, and city income taxes average 20%, then the effective rate of the mortgage is in fact around 5.83%. It depends on how close you are to itemizing being better than the standard deduction without mortgage interest and several other variables. I never managed to see more than $0.25 tax return per $1 mortgage interest (note 1).
So I hope you're convinced that you *must* run the numbers when deciding between prepaying your mortgage and investing. As a rule of thumb, if you can make more than 1.5-2.0%+ over your mortgage rate on your total investment portfolio, then splitting 50/50 has a good chance of increasing your net worth faster than any of the other methods. And remember, that's 2%+ pretax. You'll have to increase that by your average investment tax rate if you're investing post-tax.
I'd be delighted to take any feedback you may have on this write-up or the workbook, especially if you find an error. Note that you may disagree with the ways I've handled the tax factor in the workbook. If so, change the sheets to suit your inclinations. But I'm not going to help you if you change the workbook formulas or VBA code! So do this *at your own risk*!
Note: Please read *ALL* the comments on the PlayTime sheet of the workbook before doing anything with it!
(Note 1) There are tax-phobes that will refuse to understand this definition because they "lose their deduction" and are so desperate to screw Uncle Sam that they do stupid things financially even though it's demonstrable to an 8 year old that the deduction is worth far less than freedom from debt (prepaying). But I digress. If you want to debate this point, we can. But before you get your e-mail client all fired up to send me mail, please consider the following scenario and do the math for your situation. You will need the current years tax forms, so it's best to consider this whole concept shortly after you file your taxes for the prior year.
First figure out how much mortgage interest you actually paid for the tax year. You ought to be able to just read this off your 1040 Schedule A. If you didn't itemize deductions, then you have **no excuse** for not prepaying - you aren't even using the mortgage deduction in the first place!
Next, run out your taxes as if you did not have the mortgage interest deduction. That is, pretend the house was already paid off and redo your taxes on that assumption. This may mean you take the standard deduction instead of itemizing; that's fine. Do what makes sense.
Now you should have three numbers:
1) The amount of mortgage interest you actually deducted, call it MI.
2) The amount of taxes you actually paid from your 1040, call it TP.
3) The amount of taxes your would pay if you did *not* deduct the interest, call it WP.
So make the following calculation: (WP - TP). This is the amount of tax you managed to avoid paying because you deducted your mortgage interest. (This is actually one amount the federal government directly subsidized your lifestyle by, but let's not get into political rants here.) If TP is greater than or equal WP, then something has been calculated wrong; go check your math again.
Now let's do the really interesting math. Calculate (WP - TP) divided by MI; this is the fraction of your mortgage dollar that you actually deducted. Let's call it PD, for Percent Deducted. The calculation result should be a fraction less than 1.0, for example 0.21, so convert it to a percent (multiply by 100 to get 21%). Again, if MI is less than (WP-TP) or if PD > 100%, you've got some math done incorrectly somewhere. When my marginal tax rate was 28%, the highest I ever saw PD was 25%. The *highest*; your numbers will vary because the tax rates have changed since I had a mortgage, among other things.
Let's put this in concrete experience though, because these numbers are rather abstract. In order to "earn" that interest deduction, you had to pay the mortgage holder MI dollars. You got back from the government PD*MI (or WP-TP) dollars. If your PD was 25%, you paid out a dollar to get back a quarter. If you didn't have your mortgage, you would have paid that quarter in taxes and had 75 cents left over in your pocket. Which would you rather have? 25 cents? Or 75 cents? Or rather, PD*MI or (1-PD)*MI? Remember, it's *your money* you went out an earned. Are you quite so tax-phobic now?
OK, if you're still not convinced by the math, go back and read the rest of this file before hitting send. ;-)
(Note 2) This is actually an anomaly related to the tax calculations from Eisensons's point of view. If you set taxes = 0.0%, you'll see that regular prepayments (the NI option) beats out irregular prepayments (IP plan) most every time.
(Note 3) For comparison, consider the average returns on a portfolio made up solely of:
Investment Return
Small Company Stocks 16.9%
Large Company Stocks 12.2%
Long Term Corp Bonds 6.2%
Long Term Govmt Bonds 5.8%
Intermed Trm Govmt Bnd 5.6%
US Treasury Bills 3.8%
Inflation 3.1%
Source: Ibbotson and Associates, SBBI 2003 Yearbook, pg. 33. Remember that return compensates for risk, so the more return, the more risk.
(Note 4) To turn on the Analysis Toolpak, make sure it's installed as part of your MS-Office installation. Then open up Excel-97, pull down on Tools | Add-ins and make sure all the Analysis Toolpak boxes are checked. Close Excel and then load the spreadsheet.
(Note 5) For the pedants among us, this is about $8,000 more than the median income for the USA in 2003, but pretty close to the median for my area.
Rolo, awesome post!! I'll have to look for those books at the library... thanks for your recommedations.
I found part of your post intriguing in particular because I was looking over someone's reasoning behind one should pay off your mtg first even before any $ goes to investments... To be honest, I'm going to have to look it over again because at the time I didn't have much time. I'm trying to find the link but can't find it at the moment so I'll copy/paste at the end and I would love to her your response to the information when you get time because I was under the impression like you had said but we've only had our mtg since Jan. and this moneymgmt(?good name?) is becoming to be a hobby of mine too(wink). Hopefully, I'll find the link that I'll add later. The person who wrote it I believe his name is in the info.
p.s. My dh loves the PT Cruiser. I thought maybeyour site was the link but doesn't look like it...
The following is Copy/paste... not written by me... I would reference but still looking for it so will add when I find it:
Prepaying your mortgage vs. investing: the perennial decision. This material summarizes and extends a discussion about prepaying held on FIA mailing list during November of 2003.
The gold standard text for prepaying is "The Bankers Secret" by Marc Eisenson. It is likely to be available in your local library. The book is thick, but it's 90%+ tables. The material itself is only about 40 pages, and written at the 8th grade level. Computer users with a spreadsheet package can run out their own amortization table pretty easily, so there's no need to buy anything. Now, just make sure everyone avoids the "biweekly payment conversion" scam... ;-)
Carolyn spake: "I think that at some point you have to almost become obsessed with the goal of paying your mortgage off early."
Jonathan: Absolutely. And it's fun too. I still have the amortization tables we used.
And then this little bit popped in (again from Caroyln):
"I'm glad Penny Yunuba raised the point about fully funding your retirement accounts before paying off mortgages early. I absolutely, enthusiastically concur."
Jonathan: Augh!!!!!!!! This is conventional wisdom and in many cases is simply **not** the best thing to do. Everyone *must* run the numbers in order to determine the best thing for them. Please note that the discussion following applies only to US citizens considering prepaying their home mortgage. There are accounting reasons why this discussion does not apply to investment or business properties (although even then I'd assert you need to run the numbers out).
I too heard that "wisdom" about funding your retirement accounts before prepaying your mortgage. Being spreadsheet-savvy, I decided to model the situation and see what the reality actually was. Here is what I found. First off, some definitions and assumptions:
1) You can afford a building and want one enough to actually buy one.
2) You have arranged your financial affairs such that the mortgage is your only debt and you have an adequate (whatever that means to you and your family, if any) cushion already built up to stave off financial emergencies. If you have no cushion, this whole discussion is moot - go fund a minimal cushion first!
3) You have excess money that you can choose to either prepay your mortgage with or invest with each month. This amount is assumed to be the same each month to make the spreadsheet manageable. In reality, we found this amount to be highly variable, though there was seldom a month we didn't have some excess we could prepay with.
4) The measure of "wealth" is net worth. That is, increasing your net worth is the goal, *not* avoiding taxes. We'll come back to taxes. I think any YMOYLers who have thought about their personal cash-flow will agree with this definition (note 1). My definition is just a way of measuring relative value differences in the spreadsheet model, nothing more. Feel free to disagree that this is a valid discrimination method and contact me to discuss it.
So I set off to model the accumulation of net worth across time. I picked a period of 60 years to model for various reasons, none germane here. The real point is that it's more than 30 years a conventional mortgage can last. I did the modeling in Excel-97 and with the Analysis Toolpak installed for the financial functions (note 4). I modeled four possible scenarios:
1) Conventional wisdom (CW) is to put money into investments, not your mortgage, to preserve your tax deduction and earn compound interest on your investments.
2) No Invest (NI) is paying your mortgage off before you invest a single penny. The whole extra amount is sent in as a Regular Prepayment, to use Eisenson's terms.
3) Splitting the difference (50/50) - pay 50% of what you can invest into your mortgage to retire it early, and invest the rest.
4) Irregular prepayments (IP) is paying as many principle payments as you have money for each period. Unused "investment principle" carries over to the next period. Investments begin after mortgage pay off. This is an Irregular prepayment scheme as Eisenson would label it. Incidentally, this is the approach my wife and I took while prepaying our mortgage, and we are not sorry in the least, even though it can underperform some of the other models.
Then I ran the numbers. That is, I put a sheet together for each model. Each sheet calculates net worth across 720 months. I created another sheet to make comparisons and collect the data in one place to make graphing easy. Finally I created a chart page with a graph of all four options and a common place to change numbers and run scenarios from. That's the workbook associated with this file.
So let's discuss a few scenarios. The common elements of all the scenarios below will be the amount borrowed: $150,000; 30 year conventional mortgage, $0 down, average tax rate of 20% (see note 1 for the calculation), and a mortgage interest rate of 7%. This makes the principle and interest portion of a mortgage payment $997.95 per month. I'm also assuming there is $302.05 available to invest each month. As a point of comparison, these numbers represent the median values in my current housing market (12/2003 in the Midwest) and roughly equate to an annual income of $52,000 as the bankers calculation of acceptable income to support this amount of indebtedness (note 5). All the numbers below take place at month 360 - just when you'd have paid off the last mortgage payment under the conventional wisdom.
Consider for the moment you are considering the NI option vs. the CW option (this is the most radical choice you can make to many). Further assume that the rate earned on investments is 7% *pretax* and earnings are not taxed each year. If you follow CW, at 30 years your net worth is $688,540.27. If you follow NI, at 30 years your net worth is $511,897.14. I don't know about you, but the mutual funds in my tax deferred accounts are making nowhere close to 7%+ at the end of 2003.
Now, I picked 7% for the tax-deferred return precisely because it was a relatively high return (Treasury bonds are returning around 5% during 12/2003) and because it was close to the equivalency point (7.101%) between NI and CW scenarios. Here's a table with various investment rates/net worths to consider:
I-Rate CW NI 50/50 IP
3.000% $325,667.86 $420,082.81 $370,456.29 $422,468.13
4.000% $358,405.99 $440,774.37 $393,880.75 $443,494.19
5.000% $398,911.77 $463,517.49 $421,748.44 $466,589.76
6.000% $449,213.46 $488,537.40 $455,141.02 $491,977.49
6.825% $499,899.24 $511,070.10 $487,811.77 $514,822.20
7.000% $511,897.14 $516,085.42 $495,431.84 $519,904.45
8.000% $590,265.11 $546,442.06 $544,368.35 $550,645.67
9.000% $688,540.27 $579,920.55 $604,178.40 $584,506.62
10.00% $812,129.95 $616,870.68 $677,707.39 $621,827.72
11.00% $967,966.82 $657,683.30 $768,595.52 $662,986.97
12.00% $1,164,949.57 $702,795.19 $881,506.86 $708,404.96
13.00% $1,414,513.08 $752,694.63 $1,022,425.64 $758,550.59
14.00% $1,731,366.40 $807,927.62 $1,199,039.80 $813,944.61
15.00% $2,134,448.57 $869,104.89 $1,421,237.62 $875,166.40
16.00% $2,648,167.14 $936,909.69 $1,701,751.26 $942,861.97
17.00% $3,304,003.93 $1,012,106.67 $2,056,991.02 $1,017,749.48
I picked 3% to reflect the traditional inflation rate, and the rate at which conservative investors are making about now (end 2003) across their portfolios. Clearly prepaying makes sense before any investing at this rate. CW doesn't catch up to NI until 7.1%, as noted above. In fact, your best deal is the IP plan over the NI plan across all the rates in this example (note 2). Note the 50/50 option overtakes NI and IP after 8% as well. Finally at 14%, picked because it's exceedingly aggressive (note 3), but not out of the realm some brokers will try to sell you off at, now the CW and 50/50 start to look pretty good compared to NI and IP, though IP is still better than NI.
What's going on here? As you can see, *the more conservatively you invest, the more likely you are to benefit by prepaying!* It's not until you start taking serious risk (more than 8%) in the investment markets that you start to see the CW and 50/50 models start to pay off. As a YMOYLer, I think you have to be realistic about what you can get in the bond market. And by the way, that's the downfall of this model: assuming a steady rate of return on the investments and that your tax rate will remain the same.
Now, about those taxes. I chose to model with taking taxes into effect. If we go back to the 7% model and assume combined federal, state, and city income taxes average 20%, then the effective rate of the mortgage is in fact around 5.83%. It depends on how close you are to itemizing being better than the standard deduction without mortgage interest and several other variables. I never managed to see more than $0.25 tax return per $1 mortgage interest (note 1).
So I hope you're convinced that you *must* run the numbers when deciding between prepaying your mortgage and investing. As a rule of thumb, if you can make more than 1.5-2.0%+ over your mortgage rate on your total investment portfolio, then splitting 50/50 has a good chance of increasing your net worth faster than any of the other methods. And remember, that's 2%+ pretax. You'll have to increase that by your average investment tax rate if you're investing post-tax.
I'd be delighted to take any feedback you may have on this write-up or the workbook, especially if you find an error. Note that you may disagree with the ways I've handled the tax factor in the workbook. If so, change the sheets to suit your inclinations. But I'm not going to help you if you change the workbook formulas or VBA code! So do this *at your own risk*!
Note: Please read *ALL* the comments on the PlayTime sheet of the workbook before doing anything with it!
(Note 1) There are tax-phobes that will refuse to understand this definition because they "lose their deduction" and are so desperate to screw Uncle Sam that they do stupid things financially even though it's demonstrable to an 8 year old that the deduction is worth far less than freedom from debt (prepaying). But I digress. If you want to debate this point, we can. But before you get your e-mail client all fired up to send me mail, please consider the following scenario and do the math for your situation. You will need the current years tax forms, so it's best to consider this whole concept shortly after you file your taxes for the prior year.
First figure out how much mortgage interest you actually paid for the tax year. You ought to be able to just read this off your 1040 Schedule A. If you didn't itemize deductions, then you have **no excuse** for not prepaying - you aren't even using the mortgage deduction in the first place!
Next, run out your taxes as if you did not have the mortgage interest deduction. That is, pretend the house was already paid off and redo your taxes on that assumption. This may mean you take the standard deduction instead of itemizing; that's fine. Do what makes sense.
Now you should have three numbers:
1) The amount of mortgage interest you actually deducted, call it MI.
2) The amount of taxes you actually paid from your 1040, call it TP.
3) The amount of taxes your would pay if you did *not* deduct the interest, call it WP.
So make the following calculation: (WP - TP). This is the amount of tax you managed to avoid paying because you deducted your mortgage interest. (This is actually one amount the federal government directly subsidized your lifestyle by, but let's not get into political rants here.) If TP is greater than or equal WP, then something has been calculated wrong; go check your math again.
Now let's do the really interesting math. Calculate (WP - TP) divided by MI; this is the fraction of your mortgage dollar that you actually deducted. Let's call it PD, for Percent Deducted. The calculation result should be a fraction less than 1.0, for example 0.21, so convert it to a percent (multiply by 100 to get 21%). Again, if MI is less than (WP-TP) or if PD > 100%, you've got some math done incorrectly somewhere. When my marginal tax rate was 28%, the highest I ever saw PD was 25%. The *highest*; your numbers will vary because the tax rates have changed since I had a mortgage, among other things.
Let's put this in concrete experience though, because these numbers are rather abstract. In order to "earn" that interest deduction, you had to pay the mortgage holder MI dollars. You got back from the government PD*MI (or WP-TP) dollars. If your PD was 25%, you paid out a dollar to get back a quarter. If you didn't have your mortgage, you would have paid that quarter in taxes and had 75 cents left over in your pocket. Which would you rather have? 25 cents? Or 75 cents? Or rather, PD*MI or (1-PD)*MI? Remember, it's *your money* you went out an earned. Are you quite so tax-phobic now?
OK, if you're still not convinced by the math, go back and read the rest of this file before hitting send. ;-)
(Note 2) This is actually an anomaly related to the tax calculations from Eisensons's point of view. If you set taxes = 0.0%, you'll see that regular prepayments (the NI option) beats out irregular prepayments (IP plan) most every time.
(Note 3) For comparison, consider the average returns on a portfolio made up solely of:
Investment Return
Small Company Stocks 16.9%
Large Company Stocks 12.2%
Long Term Corp Bonds 6.2%
Long Term Govmt Bonds 5.8%
Intermed Trm Govmt Bnd 5.6%
US Treasury Bills 3.8%
Inflation 3.1%
Source: Ibbotson and Associates, SBBI 2003 Yearbook, pg. 33. Remember that return compensates for risk, so the more return, the more risk.
(Note 4) To turn on the Analysis Toolpak, make sure it's installed as part of your MS-Office installation. Then open up Excel-97, pull down on Tools | Add-ins and make sure all the Analysis Toolpak boxes are checked. Close Excel and then load the spreadsheet.
(Note 5) For the pedants among us, this is about $8,000 more than the median income for the USA in 2003, but pretty close to the median for my area.
imported post
hmmm..I thought I did put links in there.
PTCrew.com (http://www.ptcrew.com) Have your other check it out for sure!
My car, The Rolocoaster: http://members.cardomain.com/rolox2
Let me chew on the pasted info there for a while (omw to work right now, hehe). My knee-jerk responses are:
hmmm..I thought I did put links in there.
PTCrew.com (http://www.ptcrew.com) Have your other check it out for sure!
My car, The Rolocoaster: http://members.cardomain.com/rolox2
Let me chew on the pasted info there for a while (omw to work right now, hehe). My knee-jerk responses are:
- I plan/strive to have an average annual return on my investments of 30% or greater, in which case 12% would be a very bad year. If I can only do 12%, then I am wasting my time; I should just buy some index funds and move on to something else.
- Investment balance-to-mortgage balance ratio is important. My investments just got beaten-up over the past two months and my portfolio is still 50% of the amount I owe on my mortgage. Hence, simplified,
30% * $50K > (1-TaxRate) * (5.5% * $100K)
{Investment Earnings} > {Mortgage Cost}
The investment balance will grow much more quickly, which affects the dollars earned. The mortgage is fixed, so the cost of it is constant. The difference between the two continually widens. Ultimately, you want to have your investment income make your mortgage payment and still grow--A Financial Prepetual Motion Machine! hehe
I'll dig up my Excel spreadsheet that shows how a Ferrari is cheaper than a PT Cruiser.
imported post
Thanks thinks, for that very informative post.
Another interesting personal finance "guru" is Ric Edelman (http://www.ricedelman.com/). He is a big advocate of getting a big, long, cheap mortgage and investing the payment savings. "Never pay off your mortgage" he says. I don't disagree but my timing was terrible.
I read his book in 1999 or 2000, and at the time I had a 15 year mortgage. His book convinced me to go refinance to a 30 year loan and using the extra money to start a Roth IRA. Since I had my TSP I decided to get into a very aggressive fund to start out. It was a newwireless mutual fund that opened at $20 a share. At the time techs were flying and I had many years to go before retiring. Well, we all know what happened to the market during the following three years. The fund went from a high of $22 a share down to $1.75. (It has sincebounced to almost $5 but is now closer to $3.50). Of course I was dollar cost averaging the whole time so my losses aren't as bad as they seem.
I don't really have a point to the story because I do believe in the concept. I do doubt that it is practical foreverone. You have to be disciplined. If you don't invest that savings you are making a big mistake and I bet many people intend to do that but never get around to it."Let's investafter we ..."
I understood what was happening and that the market would eventually turn around and I would be glad I had all those cheap shares etc., but try telling my wife that
. She seems to focus on the fact that we would have hadless than 10 years left on the mortgage now. (As a side note, I did refinance again last year for 15 years at 4 7/8%. That just seemed hard to pass up.) Now I am focusing on investing in real estate. The leveraging andusing OPM makes real estate very attractive. But that's another subject.
Thanks thinks, for that very informative post.
Another interesting personal finance "guru" is Ric Edelman (http://www.ricedelman.com/). He is a big advocate of getting a big, long, cheap mortgage and investing the payment savings. "Never pay off your mortgage" he says. I don't disagree but my timing was terrible.
I read his book in 1999 or 2000, and at the time I had a 15 year mortgage. His book convinced me to go refinance to a 30 year loan and using the extra money to start a Roth IRA. Since I had my TSP I decided to get into a very aggressive fund to start out. It was a newwireless mutual fund that opened at $20 a share. At the time techs were flying and I had many years to go before retiring. Well, we all know what happened to the market during the following three years. The fund went from a high of $22 a share down to $1.75. (It has sincebounced to almost $5 but is now closer to $3.50). Of course I was dollar cost averaging the whole time so my losses aren't as bad as they seem.
I don't really have a point to the story because I do believe in the concept. I do doubt that it is practical foreverone. You have to be disciplined. If you don't invest that savings you are making a big mistake and I bet many people intend to do that but never get around to it."Let's investafter we ..."
I understood what was happening and that the market would eventually turn around and I would be glad I had all those cheap shares etc., but try telling my wife that
. She seems to focus on the fact that we would have hadless than 10 years left on the mortgage now. (As a side note, I did refinance again last year for 15 years at 4 7/8%. That just seemed hard to pass up.) Now I am focusing on investing in real estate. The leveraging andusing OPM makes real estate very attractive. But that's another subject.Similar threads
