Limitations of IRAs
There are certain strategies that are simply not allowed with IRAs or other government sponsored retirement plans, with the biggest one being trading on margin. In the right hands, in the hands of a very skilled trader, it is possible to achieve much bigger returns than with traditional investing, but this is going to involve much more frequent trading than just about any investor would ever contemplate as well as a level of skill well beyond their present abilities.
Trading on margin is an incredibly bad idea with what we normally consider investing, holding positions for years, and even slightly leveraged investing such as the 2:1 you get with some ETFs will reduce rather than increase your return overall, curiously enough, because the strategy of leveraging and investing just don’t mix.
The more you leverage your positions, the more risk you take on, all other things being equal, and to manage this, we need to limit how much a position can go against us. Investing looks to hold things longer term and take on the potential for big swings against us, but leveraged trading, and especially highly leveraged trading, simply cannot because you’d get to the point where you’d just be wiped out by normal market fluctuations if there were not tight controls present.
It’s nice to say that you could take a normal market return of 6% and seek to multiply that by 20 and get 120%, but if you don’t manage the risk here, you’re looking at losing a lot of money and maybe all your money. This is how so many traders go broke in fact and we do not want to be doing this with our retirement money without being confident that our risks here are well managed.
If we can pull this off though this can make normal returns look pretty pedestrian indeed, although to get to the point where this becomes realistic is going to require us to master a number of skills, involving both timing markets and having the psychological fortitude to put our plan into action without a lot of mistakes.
If we are not there, then it is very wise to stick more to the beaten path, and although this path is still fraught with risks, which we should be looking to manage, this journey can be taken with an IRA. Investing in an IRA does not mean that we are committed to the buy and hold strategy and there’s a number of things that we can do for ourselves to better manage risk and seek better returns, although margin trading and short-term strategies aren’t a part of this.
For those who do have a desire to step outside these boundaries, it is imperative that we not start out with real money and spend an appropriate amount of time trading on a simulator, and only add real money gradually as our results warrant.
In the end, we may end up where we want to be and trade more and more of our retirement portfolio, and even get to the point where the trading portion of our assets manages risk better than our approach with our IRAs, but given that there is a lot on the line here we want to be sure enough about this and especially ensure we’re not expanding our risk trading outside the IRA.
This is not about taking more chances with our money to shoot for bigger gains, like most people think, and if that is the case, we should not be doing this actually. The place we really need to be is to increase our returns and reduce our risk at the same time, something good traders can pull off, but only after enough training and understanding.
The great majority of people have difficulty fathoming how both of these objectives can be sought at the same time, and if we are asking yourselves this, or especially have not shown the ability to do this with a high level of confidence, we are not in a position to attempt this with real money and should be practicing instead if we are motivated to acquire these skills.
Traditional IRAs as an Option
The decision on whether we should put money into an individual IRA therefore depends on several factors, whether we have the money to do this, whether or not we should put this extra money in a retirement plan at work, or whether we should put this money to work outside the constraints of an IRA.
Assuming that we can contribute to an IRA and we feel that this is the best use of our funds, we then need to decide whether to go with a traditional IRA or a Roth IRA. While both of these are IRAs, individual retirement plans, and both allow for the potential for paying less tax, they approach these tax savings quite differently.
Traditional IRAs, which are the original IRA, seek to defer income tax on contributed amounts until withdrawn. If we are saving up for retirement, we may be in a lower tax bracket at that time due to our income being reduced enough for this to happen, and we will end up paying back less than we owed at the time of contribution.
We also get to use this borrowed money as long as it is kept within the traditional IRA, and this feature is more important than a lot of people think. Let’s say we put in $5500 in an IRA this year and our marginal tax rate is 25%, and we expect it to drop down to 15% in retirement, an ideal situation for the tax savings overall.
We’re going to save 10% in tax on the principal in the end, which works out to $550. We also get to use this $1375 that we avoided in tax now, and let’s say that we’re not going to spend the money for 20 years and average a 6% return on this money.
We’ve then made $1650 from having the ability to invest this money over this period of time instead of just paying this tax at the time. Of this amount, we’re going to have to pay tax on it at our 15% marginal tax rate, so that will leave us with a net gain from the investment side of things of $1402.50.
When we compare this number with the $550 that we gained from the tax savings, we earned almost three times as much from investing this tax money than with the tax savings even though this tax savings is the best-case scenario for this end of things.
If, instead, our marginal tax rate was 28% and we expect it to drop to 25%, which would be the case with many people, then we end up deferring $1540 in tax and paying $1375 later, netting $165 in tax savings in the end. With the same 6% return over 20 years, this provides a net return on the tax money deferred of $1386 after taxes.
In this case the gap is even wider as we’re getting almost all of our money from investment returns on the deferred tax money. The total return here would be $1551, as opposed to the $1952.50 we made with the much bigger reduction in our tax rate, so while that is clearly better, the difference between cutting our tax rate by 10% instead of just 3% in the second example isn’t as big as we might have thought, and both examples provide clear and significant benefits.
How a Roth IRA Compares
We will now look at these two scenarios to see how contributing to a Roth IRA instead would stack up under the same conditions.
With a Roth IRA, we’re going to grow our $5500 by the 6% a year over the 20 years, and earn $6600. There is no tax paid on the returns of a Roth IRA. To compare with traditional IRAs, we’re going to have to be looking at total returns net of tax with a traditional IRA, to see which one ends up having us with more money in our pocket.
This is going to involve us also considering how much we have made on the principal with a traditional IRA, so we’ll assume that in both cases we’ve withdrawn all of the money at the marginal tax rate at the time.
We’ll also assume that we reinvest our tax savings in the traditional IRA, so at a 25% rate now and a 15% rate later, so we’re actually investing $6875 over the 20 years, as we’ll assume that we get the deferred tax in on the same year as the contribution for simplicity.
After taxes, this gives us a total of $7012 earned, so this is higher than the $6600 that we earned with the Roth IRA. If we do the same calculation comparing a 28% tax rate initially and then dropping to 25%, we end up with a net gain of $6082.56, which is less than the $6600 earned in the Roth.
While a traditional IRA will benefit us in both these cases, seeing the drop of 10% in our marginal tax rate will have the traditional IRA winning, while only seeing this go down by 3% will have the Roth IRA clearly on top. This is why our expected income at retirement needs to be within the range of this 15% rate for a traditional IRA to make more sense, and when it is not, the Roth IRA will be the better option.
If our returns are less or more than this will affect this decision as well, and lower rates of return will improve the standing of a traditional IRA, where higher rates of return will favor the Roth IRA. The income dividing line though, the upper limit of the 15% tax bracket, currently at $38,700 per year, will still remain the decisive factor though.
Deciding between a traditional or Roth IRA is therefore not a complicated matter and it really does come down to having a good idea of whether our income will be over or under this amount in today’s dollars. Advisors will simply tell us that if we expect a reduction in tax rate in retirement to go with a traditional IRA, but in actual fact, our tax rate not only needs to go down, it needs to go down enough.