One of the most valuable concepts I learned in studying economics is the importance of factoring in all the consequences of an action, especially ones that aren’t always apparent upfront. I was reminded of that lesson when I recently read three different financial planning articles that came to some dubious conclusions. Let’s take a look at each of them:
Is your home a worse investment than you think?
That’s what this article argues by pointing out all the expenses that reduce the return on home ownership. After subtracting mortgage payments, home upkeep, closing costs, a real estate agent’s commission, and the cost of remodeling and adding a patio to maintain average home size, the author calculates the annualized return on investing in the median home in San Mateo county, CA from 1995-2005 to fall from 23.4% before factoring in the additional costs to 10.8% afterwards. The author does have a good point in that too many prospective homeowners underestimate or fail to account at all for these costs in determining whether buying a home makes good financial sense.
However, he fails to account for the biggest financial benefit of home ownership: having a place to live. After all, if you didn’t own a home, you’d probably have to pay rent that would likely be steadily rising. If you’re going to factor in the cost of adding a patio, you’d also have to factor in the cost of moving to a home with a patio (and the higher rent that comes with it). Unlike rent payments, interest and property taxes are also tax-deductible even if that deduction is more limited now. (You can use a calculator like this to help weigh all the costs and benefits of your particular situation.)
Is a Roth 401(k) (almost) always better than a traditional 401(k)?
That’s the claim made in this blog post that compares investing the same amount in a Roth and traditional IRA and then investing the tax savings from the traditional IRA contributions in a separate taxable account. With a Roth IRA, the earnings can be withdrawn tax-free after 5 years of opening the account if you’re over age 59 ½ and with a traditional IRA, the contributions can be tax deductible but the withdrawals are taxable. The problem here is how the study calculates taxes.
First, they use the same tax rate to calculate the tax deduction on the IRA contributions and the tax on the IRA withdrawals. Let’s ignore the fact that many people will retire in a lower tax bracket than when they were working and contributing and take a single person earning $60k today and retiring in the same 22% tax bracket with $40k of taxable income in retirement. When they contribute to a traditional IRA or 401(k), those contributions would normally get taxed at that 22% tax rate so they save 22% on their taxes. However, when they withdraw those dollars in retirement, only taxable income over $38,700 would be taxed at 22%. Over 96% of this person’s income would be taxed at 12% or less even though they’re in the same tax bracket!
The second problem is that the study assumes that the earnings in the taxable account are taxed at the person’s ordinary income tax rate every year. This only makes sense if the person sells all their gains in less than 12 months every year, which would be terrible tax planning. More realistically, they would mostly be paying a lower 15% capital gains tax rate for holding the investments at least a year and only when they sell. (If they avoid selling, they can eventually pass the investments on to heirs tax-free.) They can also use losses to offset gains and even some of their ordinary income taxes.
Should you take Social Security benefits at age 62?
This article gives 3 reasons why you might not want to wait. The problem is that numbers 1 and 3 are both arguments for retiring early, but as long as you have enough savings to bridge the gap, you can retire at 62 (or earlier) and still decide to collect Social Security at a later age. In fact, a research project at the Stanford Center on Longevity came up with a retirement income strategy that starts with optimizing Social Security by relaying benefits until 70 if you’re single or the primary breadwinner. This is because your benefits grow by 8% for each year you delay, which is more than you can safely expect your retirement investments to grow. Delaying can also increase benefits for a surviving spouse.
Reason number 2 was that you’ll simply collect more Social Security checks by starting early. Social Security benefits are calculated so that you’d get about the same total income if you live until the average life expectancy so it’s true that you’ll collect more Social Security income if you don’t live that long. On the other hand, if you end up living longer than average, you’ll end up collecting more and will actually be around to reap the benefit of that higher income.
None of this is to say that home ownership is necessarily a better investment than you think, that a traditional 401(k) is (almost) always better than a Roth, or that there aren’t valid reasons to collect Social Security benefits at 62. Each of these questions depends largely on the particulars of your personal situation. Just make sure that you understand the whole picture when making a decision or work with a qualified financial planner who does.