Required Rate of Return

Whenever I meet someone new and am asked the obligatory “what do you do?” I typically get two reactions. Roughly half of folks respond with an unconscious grimace and politely excuse themselves in search of someone more interesting.  The second reaction is one of delight and surprise.

Once this exchange happens with an interested party, the next question I usually get is – what stocks do you like? Now I’m the one grimacing.  The reason being is that stocks are as varied as the investors who own them.  In addition to first understanding an investor’s risk tolerance, time horizon, and long-term goals, picking stocks requires a lot of analysis.  One of the cornerstones of equity analysis begins with something called the required rate of return. If you’re not already grimacing, read on brave reader!

A required rate of return effectively measures what kind of payback you need to get in order to go forward with a stock (or any investment) purchase. To determine a stock’s required rate of return you need three inputs: (1) the economy’s real risk-free rate of return (2) the expected inflation rate and (3) a risk premium to make-up for the added uncertainty that comes with owning a stock.  The first input, the real risk-free rate of return is a return you can theoretically get today with virtually no risk.  We plan to own our stock for ten years, so we’ll use the 10 Yr Treasury bond as our risk-free rate proxy, currently yielding ~2.5%.  We start with the “risk-free” rate because if nothing else, the stock you’re considering should at least deliver a return on par with a very safe US Treasury bond.  And then some, because you need to be compensated for the additional risk you’re about to take.  More on that in a minute.

Next, rising costs will diminish the purchasing power of your dollar over time, so you’ll want to have an investment that at least offsets the deleterious effects of inflation. Expected inflation is currently running around 2%, so we’ll add that to our risk-free rate of 2.5% for a required stock return (so far) of 4.5%.  Finally, because of the added risk you take on by owning a stock, you should demand some kind of compensation for this uncertainty.  We account for this risk by taking a stock’s beta or its volatility compared to the market, and multiplying it by an equity risk premium.  The equity risk premium is generally estimated by subtracting the expected equity market return (stocks have returned 10% on average over the long-term*) from the risk-free rate.  Thus, our equity risk premium is 7.5% or 10% minus the risk-free 2.5%.  Phew.  Using a pretend stock, Widgets-R-Us (Ticker: WIGGY) as our prospective stock investment, with a 5-year beta of about 0.90 – meaning it has historically been less volatile than the market – we get a total risk component of 6.75% (beta x equity risk premium or 0.90 x 7.5%).  Putting it altogether we should require WIGGY to return at least 9.25% before wading in.

Congrats! You calculated a required rate of return.  Although this is an important starting point, I’m sorry to tell you it’s just the beginning.  It’s a good beginning because we now know what return we require in order to buy Widgets-R-Us, but you may have guessed that without an expected rate of return we don’t have a lot to go on.  The good news is that there are plenty of knowledgeable investment professionals who can do the work for you.  And importantly, are willing to take the time to explain how they come to their investment decisions.

*Ibbotson, large cap stocks 1926-2012

Carrie Tallman, CFA

Director of Research

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What is an Index (and why should you care)?

Recently I was on vacation with a friend, and while enjoying the sunshine she received a CNN alert…

Breaking News: Dow Jones Industrial Average soars to an all time high.

She then asked me what the Dow Jones was exactly … “Should I know what this means?” My response was, “it’s a stock market index, of course.” Seeing the perplexed look on her face, I realized that she had no idea what I was talking about. After having this conversation, I wanted to share with you what I shared with my friend.

  1. What is a market index? – A stock market index is simply a measurement of the value of the market or a section of the market. Let’s break it down into a simple example. Assume ABC index is made up of 6 companies. At the end of trading on Monday the index is at 5,000 points. On Tuesday, three of the companies go up in value, two of the companies go down and the sixth company stays the same. The total value of the stocks change by 3% on Tuesday, so now the index is at 5,150 points. This tells you that this section of the market went up in value from Monday to Tuesday.
  2. Why are market indexes important? Choosing appropriate investments is only the beginning. One of the biggest challenges of an investor is to determine how well your portfolio is performing. Are you lagging behind the market or beating it? You can only know the answer to these questions if you have something to compare your investments to. Indexes allow you to measure the performances of your investments against an appropriate benchmark.
  3. How do you choose the right benchmark? In general, when you are tracking the performance of an investment, you look at a benchmark that is most similar to your investment. For example: If your portfolio is all U.S. large cap stocks you would likely use the S&P 500 as your benchmark. If your portfolio is all fixed income then you would most likely benchmark against the Barclays Aggregate Bond index. If your portfolio is a combination of both large-cap stock and fixed income you would want to use a blended benchmark of the two indexes.
  4. All of this is for naught if you don’t know what indexes track which stocks. Here are some of the most common market indexes and the companies they are comprised of.
  • Dow Jones Industrial Average (DJIA) – This is one of the most popular measures of the market. A.K.A. “The Dow” or “Dow 30” is a price-weighted measure of 30 US blue-chip companies. The index covers all industries with the exception of transportation and utilities, which are covered by other Dow Jones indexes.
  • S&P 500 Index – This index is based on 500 U.S. large cap companies that have common stock listed on the NYSE or NASDAQ. These companies are representative of the industries in the U.S. economy.
  • Russell 2000 – This index tracks 2,000 small-company stocks. It serves as benchmark for the small-cap component of the overall market.
  • Dow Jones Wilshire 5000 – This index covers over 5,000 US companies listed on major stock exchanges. This includes US companies of all sizes across all industries.
  • Barclays Capital Aggregate Bond Index – This is a broad-based benchmark that measures the investment grade, US dollar-denominated fixed-rate taxable bond market.
  • MSCI EAFE Index – This index is designed to measure the equity market performance of developed markets outside of the U.S. and Canada. EAFE is an acronym that stands for Europe, Australasia and Far East. (Check out Sarah DerGarabedian’s blog post from last week to read why it’s important to have an international allocation – http://wp.me/plOKq-oE)  
  1. It’s important to remember when comparing your investment returns to compare your results to the long-term market, not just the past year. Typically analysts look at 3, 5 and 10 year returns. Short-term results can often be misleading due to short-term volatility. A quick Google search should provide you with the long-term returns of any of the major indexes.

After explaining all of this information to my friend, I think she had a better grasp on market indexes and hopefully this information is helpful to you too. One realization that came from our conversation is that sometimes financial advisors (nerds) forget that things that seem so common to us aren’t as familiar to those not in the industry. We never want a client to leave a meeting or conversation feeling confused or uncertain. If you have questions, please ask! We may just write a blog post about it.

Ashley Woodring, CFP®

Financial Advisor

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Kit Kats, Blow Pops, and the Benefits of Diversification

“But international stocks are underperforming the S&P 500! Why are you buying international mutual funds in my account?”

We hear this question a lot. People often wonder why we include various sectors and asset classes in our portfolios, but the one that tends to get the most scrutiny is international equity. Many investors exhibit what is known as “home bias,” or the tendency to invest primarily in domestic securities, whether it stems from a nationalistic desire to “buy local” or simply the belief that international investing carries additional costs and complexities. Often, investors eschew international diversification to their detriment, as many studies have shown that the inclusion of international equities lowers portfolio volatility while increasing risk-adjusted return. However, these metrics are not what investors see – they see performance. They see that the return on their international fund is lower than the return on the S&P 500 and fear that it will be a drag on their returns forever. So why don’t we sell it?

Quite simply, we keep it for the diversification benefits. With Halloween just around the corner, perhaps an analogy will help. When you’re trick-or-treating, you knock on the door of every lighted house and collect as much candy as you can carry home. Then you dump it out on the floor and sort through it to revel in the spoils. Hopefully you’ll come home with lots of chocolate candy bars, M&Ms, Milk Duds, Junior Mints, and Reese’s cups. Then there might be a smattering of Smarties, Starburst, and Skittles, which are fine. Invariably there will be a few of those orange and black-wrapped peanut butter taffies, some chalky Dubble Bubble and a handful of Dum Dums – but that’s OK. A few crummy candies won’t ruin the night, since you have so much more of the good stuff. And you never know which houses are going to hand out what candy, so you have to hit them all. (And to the person handing out raisins, just stop. Don’t be that guy.)

Now imagine that your portfolio is a bag of Halloween candy. Even if you love Snickers, it would be pretty disappointing if your entire haul was nothing but Snickers – that would defeat the purpose of trick-or-treating, because you could simply go to the store and buy a bag. No, you want a wide variety from which to choose, based on changing moods and cravings! In a similar way, you need to diversify your investments so that the mood of the day doesn’t destroy your savings in one fell swoop. If your entire portfolio consists of the stock of one bank and the bank goes under, you lose all of your money. If you buy the stock of 5 different banks, but the entire banking industry hits a rough patch, your portfolio plummets…so you buy the stock of 40 different companies in different sectors and industries to spread the risk. But what if they’re all domestic companies and the domestic economy tanks? I think you see where this is going. Different investments zig and zag, moving in opposite directions simultaneously, which dampens the overall volatility of the portfolio.

You may not be a huge fan of Blow-Pops, but what happens if you fill your bag with Kit Kats and you’re suddenly in the mood for Sour Apple? What if you leave your bag in the sun and all the Kit Kats melt? It’s true that if particular sector (such as international equity) underperforms and you have it in your portfolio, you might get a lower return on your portfolio for that period. But when that sector rallies, you’ll be happy you had a couple of Blow-Pops in your bag.

Sarah DerGarabedian, CFA

Portfolio Manager

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Why not Short the Market?

A “short sale” refers to selling stock that you do not own with the hope of repurchasing it at a lower price later. It is a way for an investor to try and profit from their view that a particular investment is overvalued and likely to fall in price. This technique can be used on individual stocks, or on Exchange Traded Funds (“ETFs”) that represent anything from individual sectors to the overall market. While there are many successful investors who have done well on the short side, for most people this strategy doesn’t make a lot of sense due to the risks involved.

The mechanics of a short sale are as follows: An investor goes to their broker, borrows shares of a stock and sells them. The short sale proceeds are credited to the short seller’s account, less a fee for borrowing the stock. You must have a margin account in order to short stock. If the price of the shorted stock rises, the short seller will need eventually to borrow on margin to keep the position open.

The short seller receives interest on the short sale proceeds, although this is minimal currently since interest rates are low. In practice, this interest is often split with the buyer of the shares or the brokerage firm that is facilitating the short sale. The short seller must pay any dividends on the borrowed stock to the purchaser of the shares.

Risks of Short Selling:

Swimming Against the Tide –Since 1926, about 7 out of 10 years have been positive for the overall market. If you are short the overall market, chances are you will be in a losing position after a year.

Timing is Critical—Stocks can move quickly in either direction, and it is difficult to predict the future. If the event that you are betting on fails to materialize, or if the opposite happens, your losses can mount quickly. For this reason, short selling is more common among professional and institutional investors.

It can be Expensive to Maintain a Short Position— With today’s low interest rates, the combination of the borrowing cost and the dividends the short must pay to the long far outweighs the interest on the short sale proceeds that the seller is earning. For example, say you short 100 shares on Johnson and Johnson at $108 because you think Band-Aid sales are going to decline sharply. You receive proceeds of $10,800 and earn money market interest at 0.01%, or $10.80 per year. Your annual cost to carry the position is the 2.8% dividend, or $302.40 plus any borrowing costs charged by your broker. These additional costs can be quite high for stocks that are hard to borrow.

Limited Profits but Potentially Unlimited Losses–At most, any stock can go down 100% in value. However, there is no limit to how far a stock or the overall market can go up. If it goes up by enough to wipe out the equity in your margin account, the brokerage firm will buy-in the security at a loss and close the trade. Say you short a stock at $8/share. The most you can make is $8 if the company goes out of business and you are able to buy back the borrowed shares at $0. But what if good news comes out and the stock goes from $8 to $18? You just lost $10/share when your maximum theoretical profit was $8. In reality, few companies go out of business so your maximum profit is even more limited.

We believe that, rather than trying to profit on short-term price movements, our clients should place the equity portion of their investments in a diversified portfolio of quality companies with the potential for rising earnings and rising dividend income.

Bill Hansen, CFA

Managing Partner

Bill

 

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Market Update Through 3Q 2014

as of Sept 30, 2014
                                                     Total Return
Index 12 months YTD QTD Sept
Stocks
Russell 3000 17.76% 6.95% 0.01% -2.08%
S&P 500 19.73% 8.34% 1.13% -1.40%
DJ Industrial Average 15.29% 4.60% 1.87% -0.23%
Nasdaq Composite 20.61% 8.56% 2.24% -1.82%
Russell 2000 3.93% -4.41% -7.36% -6.05%
MSCI EAFE Index 4.25% -1.38% -5.88% -3.84%
MSCI Emerging Markets 4.30% 2.43% -3.50% -7.41%
Bonds
Barclays US Aggregate 3.96% 4.10% 0.17% -0.68%
Barclays Intermediate US Gov/Credit 2.20% 2.22% -0.03% -0.51%
Barclays Municipal 7.93% 7.58% 1.49% 0.10%
Current Prior
Commodity/Currency Level Level
Crude Oil  $91.16  $105.37
Natural Gas  $4.12  $4.46
Gold  $1,211.60  $1,322.00
Euro  $1.26  $1.36

Mark A. Lewis

Director of Operations

Fears of a “Summer Pause” Prove Ephemeral

Many analysts, pundits and prognosticators were sounding alarms about “cautious consumers” and “threats to continued economic growth” after the Census Bureau reported on August 13 that both retail sales and the broader category of retail and food services sales in July were almost exactly what they had been in June. In other words, both categories were flat from month to month. Even more depressing, June was confirmed to have only increased 0.2 percent from May.

Those of us with more experience and greater knowledge of the volatility of these series cautioned against making snap judgments. We recommended waiting for the next release before becoming concerned about consumer spending, which makes up by far the largest share of GDP (68.5 percent of nominal GDP in 2013). The retail and food services part is about half of total personal consumption expenditures.

As is nearly always the case, this advice proved sound when we read the Census Bureau release of September 12. As the chart shows, not only did retail and food services sales set a new record of $444.7 billion in August, seasonally adjusted, but also both June and July were revised to be much larger than previously reported.

Untitled

July sales are now $ 441.8 billion on a seasonally adjusted basis, up 0.3 percent from June, rather than the originally reported $439.8 billion or 0.0 percent. June is now reported up 0.4 percent rather than 0.2 percent to a total of $440.3 billion rather than $439.6 billion, seasonally adjusted.

For the first eight months of 2014, total retail and food services sales were $3.46 trillion, up 3.7 percent from the same period in 2013. The biggest gain was at auto and other motor vehicle dealers, where sales were 8.0 percent ahead of the first eight months of 2013.

There are several reasons for this. One is that the average age of the 253 million vehicles we own (the “fleet”) is the highest ever, about 11.4 years. Another is that consumers have record levels of income and near-record levels of employment. A third is that banks, car dealers and credit unions are all competing to finance vehicle purchases at very good terms, including low rates, relaxed credit standards and maturities as long as eight years to keep monthly payments down. A fourth reason is that some measures of consumer confidence, while far from record levels, are at the highest point since the recession ended in June 2009.

Nonstore retailers (think catalog and internet stales) are up 6.5 percent from the first eight months of 2013 to $300.9 billion. That amount is 71.3 percent of the total for general merchandise stores ($421.6 billion) and nearly triple the $101.9 billion at department stores, where sales are off 2.5 percent from the first eight months of 2013.

We should see a record holiday shopping season in 2014. That will keep retailers smiling and contribute to several more quarters of real GDP growth above 3.0 percent at a seasonally adjusted annual rate, which is now the consensus for the first time in this expansion. That will be very good news if the economy follows that forecast. We’ve all been waiting impatiently for the US economy to break out of the subpar 2.1 percent a year growth path it’s been stuck in for the five years since the recession ended.

Dr. James F. Smith

Chief Economist

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The Rational Investor… or Not?

This is the last post in a series of six blog entries focused on topics that might be of interest to the Millennial generation. If you would like to see our attempt at making these subject matters entertaining, visit our YouTube page to see a video version of this article.

 

So here’s the setup: you have two large pizzas. One is cut into four pieces, the other is cut into eight pieces. Would you rather have one piece from the former, or two pieces from the latter? If you asked a hungry four-year-old that question, he’d probably be totally confused because you used the words “former” and “latter.” But then he’d go for the 2 pieces because in his mind, two pieces are more than one. Of course, anyone with a basic knowledge of fractions knows this is a trick question, because it’s the same amount.

Let’s imagine now that the pizzas are companies, and the pieces are shares of stock in those companies. You have $1000 to invest. Company A’s stock price is $50, and company B’s stock price is $100. Assuming that there are no trading costs, you can purchase 20 shares of company A and 10 shares of company B. All else equal, which would you buy? Answer: it doesn’t matter – your investment in either company is the same. You’d be surprised at how many people would choose company A because you get “more” shares of stock or because they think the shares are a better “value” by virtue of having a lower price per share. The thing you have to realize is this – a company can issue any number of shares it wants to. If the price per share is $100 they can issue a 2-for-1 split, and now you’ll have 2 shares worth $50 each for every one you had before. Your total dollar investment in the company doesn’t change, though.

We all want to believe we are rational and that emotions are only something that affect other people, but it just isn’t true. We all have made mistakes like the investor in the example above and that’s why behavioral finance is one of the fastest-growing branches of psychology. This is just one example of common investor misconceptions but there are many more – click on the link above for a lighthearted look at a few that we see from time to time. Remember to always discuss your investment decisions with your advisor, so that he or she can lead you in the direction of the logical and unbiased choice.

Sarah DerGarabedian, CFA
Portfolio Manager

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Interest Rates and How They Impact You

This is the fifth post in a series of six blog entries focused on topics that might be of interest to the Millennial generation.

Today I’m going to touch on the exciting topic of interest rates. Okay, let’s be honest, most of us consider the subject boring and highly technical at best, and pure financial torture at worst. But hear me out. I’d like to explain why interest rates are in fact pretty fascinating, surprisingly straightforward, and worth learning about. The truth is that interest rates can have a massive impact on your current and future financial situation.

So what are interest rates? And how do they affect your financial well-being? If you think about it, everything in our modern society has a cost. You pay for a good meal at a nice restaurant, there’s a charge for staying at a hotel, and an education certainly isn’t free. The same holds true for money. It has a cost and that cost is interest rates. In order to get your hands on some money, say for a car loan, a mortgage, even groceries, you pay for that money in the form of an interest rate. When you have a good credit history, i.e. you consistently pay back other people’s money in a timely manner, you’re considered a good credit risk and it becomes cheaper for you to borrow money in the future. In other words, the interest rate you’ll get charged on loans will be lower than the average person. This is a good thing for your financial well-being. On the flip side, if you are even occasionally late on a credit card, car loan, or any other debt payment, you become a less desirable credit risk and the rate at which you’re charged to borrow money in the future goes up. In other words, the interest rate on the next loan you take out will be higher and you’ll pay out more money over the course of the loan, all else being equal.

You may have heard about the compounding power of interest and how it can help you significantly grow your wealth. This is a very true financial tenant when it comes to investing your money. However, this same principle also works against you when you step into the role of a borrower. As an example, consider that the median price of a home in 2013 was about $200,000. Now assume you take out a 30-year fixed mortgage to purchase a home. You’ve worked hard and have 10% in cash to put down. This leaves you with a $180,000 mortgage. Going interest rates for borrowers with good credit are around 4.25%. Even though these are still historically low rates, at 4.25% you can expect to pay approximately $138,960 in interest alone over the life of the loan! That’s in addition to the $200,000 cost of the house. Now let’s pretend that your credit is a little below average, making you a slightly higher-risk in the eyes of a bank. You’re still able to secure a loan, but the bank wants to charge you a 5.00% interest rate in order to compensate for the risk they take on by lending to you. At a 5.00% rate, you can expect to pay $167,760 in interest over the course of the loan, or almost $30,000 more than you would pay with a better credit score. That is some serious money.

On top of the impact interest rates have on our personal investments and debt payments they also affect our spending and saving behavior. Imagine that your bank was offering a savings account with a 10% interest rate. All else being equal, would you be more or less inclined to save? That’s right. Most people would choose to direct more of their personal income towards savings when interest rates are higher. If millions of people were forgoing spending in favor of savings, this would have a significant effect on the overall economy. Interest rates matter. What about high interest rates when you’re the borrower? As we saw above, even a small increase in an interest rate can lead to much larger debt payments. Generally speaking then, higher interest rates tend to depress credit growth and in the end can muddle economic activity as consumers take out fewer loans.

As you can see, interest rates can have a very direct and often significant effect on our personal financial situation, not to mention our saving and spending patterns, and the broader economy. Although we’ve only skimmed the surface, suffice it to say that interest rates are worth understanding, if for no other reason than to help you make smarter decisions with your money.

Carrie Tallman, CFA
Director of Research

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Renting vs. Buying

This is the fourth post in a series of six blog entries focused on topics that might be of interest to the Millennial generation.

In my experience, one of the largest financial decisions clients struggle with is the decision to rent or purchase their residence. There is not necessarily a right or wrong answer, and every individual’s situation is different. However, there are some scenarios that may help guide you in making the right choice.

Let’s start with buying. Here are five factors that may make it more beneficial to purchase:

  1. You like the idea of “forced savings” – as you pay your mortgage your balance owed is reduced. Building this equity in your home will create a form of savings for you. Since the value of the home is locked in, you can’t squander it away on dining out or shopping. You realize the savings once you decide to sell it.
  2. You think the tax incentives are attractive – when you file your taxes, you will be able to deduct mortgage interest. Property taxes will also add a nice deduction. If you do any energy-efficient improvements, you could be eligible to deduct those expenses. Another bonus is that depending on your situation, any capital gain from the future sale of your home is free from federal income tax.
  3. You want stable payments– typically your mortgage payment will never change, while rent is more susceptible to rise with inflation. Purchasing may be right for you if you are looking for a stable cost of living.
  4. You dislike the restraints placed by your landlord – often when renting you must get everything approved. If you want to paint, rip up the carpet and put down hardwoods, take out a wall or have a dog, then owning probably makes more sense. Home ownership allows you to customize a space and really have a place that you can call home.
  5. You value a second-income stream – by owning a home, there is potential to create additional income by renting part of it out. If you have an extra bedroom, finished basement, or a garage for storage, it’s possible to rent to friends, family or others to help cover your mortgage payment.
  6. Bonus – quite possibly the biggest bonus of all is you will be debt free in retirement with no mortgage payment. You will always have the expense of a rent payment if you continue renting.

But guess what… buying may not be right for everyone. It’s important to remember that there is more to owning a home than just a mortgage payment. Between maintenance, fees, and taxes, the costs can add up. And other factors may contribute to make it an unwise choice for some people to purchase. Here are five factors that may make it more beneficial to continue renting:

  1. You plan on moving – home ownership is not a short-term investment. If you think that you may be moving for any reason within the next 3-5 years, it’s wise to continue to rent. Once you are settled, revisit the topic!
  2. You don’t have good job stability – of course you can never be 100% certain if your job is stable, but the possibility of your income going down could greatly impact the type of home you can afford. If you expect to quit your job, or anticipate being let go, hold off on a home purchase until there is a bit more certainty about the future.
  3. You just aren’t that handy around the house – as a renter, you don’t have to worry about maintenance issues. If the pipes burst (something that the author can relate to), then the landlord is responsible for repairs. For a homeowner, it’s 100% on you. It’s up to the owner to paint, shovel the drive when it snows, and fix the garbage disposal when it’s broken. If you aren’t ready for the hassle or expense involved with being the fixer-upper, then perhaps home ownership just isn’t for you.
  4. You have a low credit score – having a solid credit score is vital in purchasing a home. While it may not prevent you from getting a mortgage, it could drastically affect the interest rate that you receive. If you have a score below 700 it would probably be best for you to rent while paying off debt and building up your credit.
  5. You don’t have money for a down payment – if you don’t have any cash squirreled away for a down payment, it may not be the time to purchase. If you don’t have a 20% down payment you will have to pay PMI (private mortgage insurance) which will increase cost of monthly payment. Use this time to save and budget before taking the plunge.

These are some of the basic pros and cons of renting vs. buying. Since every situation is different, it’s always best to speak with a financial advisor about the circumstances surrounding your own decision matrix.

With correct planning and consideration, we’re sure that you will come to the best decision for you!

Ashley Woodring, CFP® Financial Advisor

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Roth vs. Traditional IRA – Do You Know the Difference?

This is the third post in a series of six blog entries focused on topics that might be of interest to the Millennial generation. If you would like to see our attempt at making these subject matters entertaining, visit our YouTube page to see a video version of this article.

 

“Roth IRA” and “traditional IRA” – these are terms that are bandied about willy-nilly by financial advisors and others in the business. You’ve often wondered what the difference is but haven’t asked, because you feel like you should know already. You nod along, meaning to Google it when you get home but of course you forget as soon as you step through the door and directly into a pile of something your loving pet left for you to clean up. Allow me to help! With the IRA definitions, I mean – not the mess. That’s all you.

First, the similarities – both are types of retirement accounts that allow the investments within them to grow without requiring you to pay taxes on any realized gains. So if you buy a stock for $500 and sell it for $1000, you don’t have to pay capital gains taxes on the $500 you made. Awesome, right? Another bonus – you don’t have to pay taxes on any dividend or interest income that you earn within either type of IRA. In a regular brokerage account you would have to pay taxes on realized gains, dividends, and interest income, which would cut into your portfolio return.

So what are the differences? Both traditional and Roth IRAs feature tax advantages on either contributions or withdrawals, but not both. A traditional IRA allows you to make tax-deductible contributions (so the funds you put in there are not being taxed as income). However, when you withdraw the money after age 59 ½, it will be taxed as ordinary income at your marginal tax rate.

Conversely, contributions to a Roth IRA are not tax-deductible (so this is income that has already been taxed). But when you withdraw the money (assuming you’ve had the account for at least 5 years and are older than 59 ½) it’s all tax-free! That’s why traditional IRAs are called “tax-deferred” accounts and Roth IRAs are called “tax-exempt” accounts.

Now, as with anything the IRS gets its hands on, there are all kinds of rules, guidelines, exceptions and so forth when it comes to how much a person can contribute to either type of account, how much is tax-deductible, what types of early withdrawals are allowed without a penalty, etc. Rest assured that all of this information is available on the internet, so I will spare you the details. Better yet, call your financial advisor and ask him or her how the rules affect your unique situation. There are so many different scenarios that, if I were to attempt to address them all, it would completely defeat the purpose of this blog, which is to simply explain the main difference between a Roth and a traditional IRA.

Because your situation is unique, you should talk to your financial advisor about the different account types and which ones are best for you. But now, when you hear phrases like “tax-deferred” or “tax-exempt,” “Roth” and “traditional IRA,” you can nod along knowledgeably.

Sarah DerGarabedian, CFA Portfolio Manager

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