Personal Finance Myths Revoked
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I hear these two statements frequently, “Never get money back on your income taxes.” and “Always roll your 401k into an IRA.” In today’s market environment I disagree with both these statements and I lay my case out below.
For those lucky enough to still have a job, you have probably seen it written that you should never get a tax refund because you are giving the government a free loan. First off, taxes don’t the fund the government, but instead regulate aggregate demand. That is beside the point, the idea being that you could invest this money and get a better return than 0%.
That may have been that case in a different time, but now you can get 0.1% for a 1-year Treasury. That is $100 if you are lucky enough to pay $100,000 in TAXES. So you are giving up next to nothing. With the economy weak and declining real wages, Americans are finding it very hard to save. They want to, but things come up.
Why not change your W-4 to have more money taken out as a means of increasing savings. When you get the check, you might be surprised that you saved more than you expected. Obviously, if things become too difficult you don’t want to start racking up credit card debt. You can always switch it back to the original withholding. If you employ this method, you may just be able to build up that emergency cash reserve - often cited as six to 12 months of current disposable income.
The other common myth applies to those who might have lost their jobs or were successfully able to switch companies. Common advice is to roll your 401k into an Individual Retirement Account. The thought process is that you can get better diversification and have better investment opportunities. I disagree here because 401k plan sponsors have a fiduciary responsibility to the employee participants and most give you plenty of diversification. Secondly, the investment opportunities might not be any better outside the 401k. There are certainly more risky options, but they may not be better for you.
Hypothetically you might want to open an IRA and buy dividend stocks because that is all the rage. A proxy for a diversified basket of sixty high-quality dividend paying stocks is the SPDR S&P 500 Dividend ETF (NYSEMKT: SDY). You will likely be disappointed when the results mirror the broader SPDR S&P 500 (NYSEMKT: SPY). Since the market bottomed on March 3rd, 2009, SPD and SPY have consistently maintained 90% correlations.
And it is not just dividend stocks - according to Ned Davis Research, the 63-day correlation of S&P 500 stocks to the S&P 500 recently hit a record 86% and currently resides at 82%. That is remarkably high and well above the 30-year average of 46%. So you will likely not pickup any alpha in this environment, unless you are willing to maintain a concentrated portfolio, but you will pick up plenty of transaction costs.
By switching to an IRA you likely will become fully invested and follow a buy and hold strategy or pay a significant amount of transaction costs to be nimble. In these shaky markets you want to be as nimble as possible or at least have the opportunity if the need arises without incurring a boat load of fees. I am not talking about day trading, but you may want to make tactical adjustments once or twice a year that could significantly impact your performance.
How can you accomplish this? Leave your money in your 401k and if you want to rebalance in January - no fees. Want to go 100% risk-on for a quarter - no fees. If you do have a niche that you absolutely love, for me it is tiny biotech names that I really don’t know anything about, then allocate money from a different source to these special plays if at all possible. Consider these ideas and how they apply to your particular situation and you may be financially better off.
I own shares of none of the stocks mentioned above.