March 27 brings us the Motley Fool Answers podcast's monthly mailbag show, which Alison Southwick and Robert Brokamp dedicate to providing their best advice and insights in response to listener questions.
Our podcasting duet learned something last month: Having Ross Anderson -- certified financial planner from Motley Fool Wealth Management -- a sister company of The Motley Fool -- along for the ride makes it so much easier.
Among the topics they dig into this time around: how changes to our tax rates should alter our retirement savings strategies, as well as trusts, pensions, using an IRA to save for a house, the backdoor Roth IRA, and what to do when your house turns out to be more of a financial burden than expected.
A full transcript follows the video.
This video was recorded on March 27, 2018.
Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool.
Robert Brokamp: Hi, Alison!
Southwick: And because it's our March mailbag, I'm also joined by Ross Anderson.
Ross Anderson: Hello!
Southwick: He is a financial planner with Motley Fool Wealth Management, a sister company of The Motley Fool. In today's episode, we're going to answer your questions about trusts, pensions, using an IRA to save for a house, the backdoor Roth IRA [which I know so many of you are excited about], and HOA headaches. All that and more on this week's episode of Motley Fool Answers.
Southwick: Yes, that's right. Ross is back in the studio to help us tackle some questions. Thank you for coming back!
Anderson: Thank you for having me!
Southwick: I'm glad it hasn't been so miserable an experience in the past that you say no to Bro when he comes knocking on your door.
Anderson: Not at all. I love being here with you guys.
Southwick: Oh! Thanks!
Brokamp: The feeling is very mutual.
Southwick: All right! Let's get into it, shall we?
Brokamp: Let's do it!
Southwick: The first question comes from John. With the new tax laws depressing rates for now, do you think it is time to reconsider putting more savings into Roths, HSAs [I hate saying Roth-s].
Southwick: That's a tough one. Savings into Roths, HSAs, and regular brokerage accounts instead of traditional tax-deferred accounts?
Brokamp: Well, John, you bring up a good point. Thanks to the Tax Cuts and Jobs Act, income tax rates have dropped from levels that were already historically low, depending on your tax bracket, to rates that we just haven't seen in a long time. So, yes, I think it makes total sense to look at situations, now, where you are giving up a tax break today, like the Roth, in order to have a tax break in the future. I definitely think it's worth considering the Roth, these days, more than you may have in previous years, because the tax deduction you're giving up just isn't worth as much as it used to be.
As for HSAs [otherwise known as health savings accounts], I'm not sure the new change does much for them. When you put the money in an HSA, you get the deduction and withdrawals are tax-free is you use it for qualified medical expenses. If you don't use the money and you let it grow throughout the years, at age 65 you can take it out penalty-free, but you still have to pay taxes on it, so it's sort of like a traditional tax-deferred account. I think HSAs are great. I just don't think the new tax law does anything for them in terms of making them more attractive or less attractive.
I still think it makes sense to contribute to traditional tax-deferred accounts if you're in a higher tax bracket today, and especially if you expect to be in a lower tax bracket in the future. But the trick there is to really make it worthwhile, you've got to invest the tax savings. By contributing to, say, your traditional 401(k), you're saving $3,000 on your tax bill, you should be investing that and saving it for your future. If you're just going to spend that money, you probably should just go with the Roth.
As for contributing to a regular brokerage account instead of a retirement account, I think the most compelling reason you would do that is if you think you might need the money before you're age 59 1/2.
Anderson: The only thing I would add to that is to look at what you have in terms of deductions. If you are in a high-tax state like California or New York, where you're paying a lot of state income taxes, you're losing that deduction for the most part; and so, even though the rate that you're paying on your taxes is coming down, the amount that you have to pay in taxes may not be. So, before you shift everything from pre-tax to Roth, I would at least look at how the loss of deductions is going to impact you, as well.
Southwick: The next question comes to us from Rob. My wife recently inherited a substantial amount of money -- enough that we can retire -- which is great, but I see a potential problem. We are both relatively young. I'm 50 and she's 56. That money is in a trust for her benefit. I can imagine the possibility of living a nice, long life of leisure until something bad happens to her. She unfortunately has a family history of health issues, but all my relatives lived well past 90. When she dies, the trust money we both have been living on goes back to her family and I'll be broke. What do I dooo?
Brokamp: He had several o's there.
Southwick: He did. I didn't just do that for dramatic effect.
Anderson: This is as classic of a life insurance case as I can imagine. Anytime you're dealing with a situation where one spouse's income or resources are needed to support the other spouse, if a death causes that hardship financially, I think that has to be a life insurance case. You said that you guys are still pretty young, so hopefully health-wise you're still insurable, and healthy, and all of that good stuff.
[In this case], I would get a quote for a permanent life insurance contract, like a guaranteed universal life, or something in that space, so that if the trust money, itself, does divert back to the family, there is something there for you. That means that you're going to have to pay some premiums, but I think it will be well worth it to have that peace of mind.
Brokamp: Another situation where you'd consider this is if one spouse is receiving a pension.
Brokamp: And that pension goes away when that person passes away. The other spouse might consider getting a life insurance policy on that person. The other thing I would add is just to make sure that you see a professional and that you really are in good-enough shape to retire.
One thing you're going to have to do if you both leave work is you're going to have to pay for your own health insurance, which can be very expensive. You mentioned that your wife has a family history of health issues. You're not going to be eligible for Medicare until you're 65, so I want you go into it knowing exactly how much you're going to have to pay for health insurance if you decide to retire at such a young age.
Southwick: The next question comes to us from Mark. I am 36, and my employer offers a 401(k) with a 4% match. However, the investment choices are limited. There are a variety of T. Rowe Price Target Retirement Funds that include a mix of stocks and bonds. They don't interest me. There is an S&P 500 Index fund and an extended market index fund that do interest me. They have the lowest cost of my choices and some of the only all-stock options that I have. The other all-stock option is a foreign markets index fund and I'm not interested in that.
I'm thinking of allocating half of my contributions to each fund, as opposed to just picking one. Do you think that's a wise strategy?
Brokamp: First of all, Mark, I like that you're looking at the expenses on your funds, because the evidence is clear that's one of the most consistent predictors of performance going forward. You're dismissing the target retirement fund out of hand, and that makes sense for someone to a certain degree at your age of 36, because they tend to be pretty conservative.
I will say that T. Rowe Price has among some of the best. You would be looking at something like a 2050 Fund which these days is 55% U.S. stocks, 31% non-U.S. stocks, and 13% cash or bonds. I think that's a pretty reasonable allocation for most people, so I don't want you to dismiss it out of hand.
Moving on to your other choices, the S&P 500 Index fund we all love. That's great. Extended market is basically the total U.S. stock market minus the S&P 500, so it's a mix of small caps and midcaps. Basically, with those two funds you're owning the entire U.S. market and giving a significantly higher weighting to the small and midcaps, which is perfectly fine. Historically, they have outperformed large caps. You're young and you have a long time, so I think that's fine.
The one thing I would say is I would consider putting some of the money in the international fund. You don't feel comfortable with it, obviously, so maybe just a little bit (10%). I personally would be fine with someone putting one-third of their contributions into each of those three funds, but if you're not comfortable, maybe just 5-10%. But I think, long term, having an international allocation makes sense.
Anderson: Most economists that predict these sorts of things [and we're talking about over a 10 to 20-year time frame], but most of the predictions I've seen have international stocks outperforming U.S. stocks, if we're looking forward the next 10 to 20 years. So, you can take that with a grain of salt, but I'm absolutely with Bro on that. And even if we look as recently as 2017, most people don't realize that international stocks outperformed U.S. stocks last year.
Brokamp: Significantly, especially emerging markets.
Anderson: S&P was up 21% and I think international was up 26%.
Brokamp: Yes, and emerging markets up 31-33% depending on which fund you were looking at.
Southwick: The next question comes to us from Al. I remember hearing Robert once suggest...
Brokamp: That's me, by the way. I'm Robert.
Southwick: You can call him Bro, Al. That's cool. I remember hearing Bro once suggest that you look at a pension as a type of bond, so if I were getting $250 a month from a pension, that would be the equivalent of having a bond worth $100,000 paying 3%. In practical terms, let's say I am putting 25% of my portfolio into bonds. My total portfolio is $500,000. That means that if I did not count my pension, the amount I would put into bonds would normally be $125,00; but, since I have that pension of $250 a month worth $100,000 I only need to allocate $25,000 into bonds. Am I interpreting what you said correctly? Is my math, as my seventh-grade algebra teacher, Mr. Wilson, used to say, "abysmal," and I've got this all wrong? Now interestingly enough, Bro is not going to answer this question. Ross is.
Brokamp: Ross chose this one but let me just start off by saying shame on Mr. Wilson for telling a seventh-grader that his math is abysmal. As a former teacher I feel very bad for Al. All right, Ross, take it away.
Anderson: Fair enough. I really love Al's question, because it means that he's looking at his financial life holistically vs. just looking at components of it. In many ways a pension acts a lot like a bond. You've got income. You could calculate a present value of what that's worth and factor that into your portfolio.
The one thing that it doesn't do for you is give you the ability to rebalance out of it. If you were going to allocate 25% to bonds and adjust that over time -- so on an annual basis kind of bring that back into tolerance -- you don't have any way to really add to that pension strongly or to take money out of it. You can always increase the bond allocation, but you can't rebalance from your pension back into stocks. If you end up making your stock portfolio much more aggressive as a result of that balance, you're stuck in that positioning.
If you're thinking about it that way -- and you see a downturn in the markets -- you're going to feel that a lot more because you've got a heavier allocation of stocks than if you had the bond position in there, as well, and you just need to be ready to ride through that.
Brokamp: To me, it's more theoretical than getting it down to the exact dollar. It just means that you have another source of income in retirement that is immune to what happens to interest rates. Immune to what happens to the stock market. It allows you to take more risk in your portfolio if you want to, if you have the risk tolerance, and as long as you have the money you need in the next few years out of the stock market.
And it's not just pensions. There are some people that think you should do the same with Social Security. In fact, John Bogle is one of those people. He told Tom Gardner in an interview that you should really consider your Social Security to be about a bond holding worth $350,000 which allows you to take more risk in your portfolio.
Not everyone agrees with this. If you look at the Bogleheads website, which is a bunch of people who just love Vanguard and John Bogle, they disagree with him on two things. One is John Bogle doesn't think you should have much money in international stocks, whereas most people think you should. And John Bogle thinks that you should consider your Social Security as worth something like $350,000 worth of bonds and factor that in your allocation. But as Ross points out, you can't rebalance it. It's not like if the stock market drops you can sell some of your bonds to buy more stocks when they're down.
Anderson: You cannot sell your Social Security early.
Brokamp: That's right, exactly. To me it's more just theoretical. It's knowing it's OK for you to take a little bit more risk in retirement if you have these other sources of income that you can rely on if the market tanks.
Anderson: To get granular with it, what really should influence that allocation for you is your distribution rate out of the portfolio. And it sounds like you're early enough in this that you're still in savings and accumulation mode; but, as you get closer and closer to retirement, the pension is going to reduce how much you need to take off the portfolio. That's how I would really think about factoring that in, is that you don't need as much cash from the portfolio, and so you're going to let that drive your allocation of stocks and bonds.
Brokamp: Yes. And by the way, in terms of math, another way to factor in how much that's worth as a bond is to calculate the size of an immediate annuity that you would need to create that income. If you're getting $3,000 a year as a pension, that's the equivalent of basically investing about $50,000 into an annuity if you're 65 years old. That's the way I would figure the present value more than the math that you did it, although the way you did it I think is perfectly fine.
Southwick: And absolutely not abysmal.
Brokamp: Absolutely not!
Southwick: The next question comes to us from Tyler. Tyler writes: I'm 27 years old and saving for a down payment for a house. The goal is to have at least enough for a 20% down payment when I'm 35 or so. Since I have a medium-term time horizon for this goal, I'm currently keeping my house fund in a taxable account invested in the Vanguard Wellington Fund in order to grow my savings better, faster, stronger than a boring savings account.
Supposedly you can withdraw up to $10,000 from an IRA to help purchase a first home. I'm already contributing to my retirement, but does it make sense to increase my contributions to my IRA account in order to take advantage of the tax break with the thought that I would use some of the money for a down payment later?
Brokamp: Yes. By the way, great job. You're 27 and doing that. That's awesome. [When you say that you are already contributing to your retirement], I'm going to assume that you are contributing enough, and someone your age should be contributing about 15% of your income and that includes the match. If you're contributing 10% to a 401(k) and your company is matching 5%, you're hitting that 15%. So, you're doing fine with your retirement.
First of all, you're asking, implicitly at least, whether the Vanguard Wellington is a good place to put that money, and I actually think that's a pretty good fund. It's a balanced fund that's 65% stocks and 35% bonds. It's finished in the last top 10% of its category over the last five, 10, and 15 years. Very low cost and gold-rated by Morningstar, so I think that's a great choice for money that you're going to need in the intermediate term. You're looking at like seven or eight years. I think that's great.
As you're pointing out, though, it is in a taxable account and according to Morningstar, you're losing about 1-2% of the return on that fund due to taxes. Should you instead put it in an IRA and use it for a house? I think it's worth considering, because you are right. There is the first-time home-purchase exception to take out money from an IRA to buy a house.
The actual taxes and penalties depends on the IRA. If it's a traditional IRA, it's $10,000. You take the money out. It's still taxable -- you get the tax-deferred growth along the way -- but it's still taxable. You don't pay the 10% penalty, but you do pay taxes when you take the money out. And by the way, that's a $10,000 limit per person, so if you're married, they can take out $10,000. Well-meaning relatives who want to help can also take out $10,000, but it's a lifetime limit, so if you've done it in the past, you can't do it again.
The Roth gives you a lot more flexibility, because when you take the money out for the Roth, the thing that comes out first are the contributions. Those are always tax and penalty-free. Then when you hit the earnings, you can take out that $10,000 without paying a penalty, and if the account has been open for five years, it's tax-free, as well.
So, I think it makes sense to do that for your situation, but I would choose the Roth IRA over the traditional if you can.
And by the way, the definition of a first-time home purchase for the IRS is kind of ridiculous. It just means that you haven't owned a house in the previous two years. If you owned a house three years ago -- if you owned five houses more than two or three years ago -- you're considered a first-time homebuyer by the IRS.
Southwick: The next question comes to us from Amar. When I sell a stock, who is buying it? How come there's always a buyer when I want to sell?
Anderson: Basically, yes, somebody's buying it.
Anderson: You won't ever really know who that is, but I looked up the smallest-cap company in the S&P 500, which is News Corp. The ticker is NWS. I'm not recommending it, but I just wanted to see how much it actually trades. The average volume over the last 10 days has been 637,000 shares a day.
So, there's a lot of people trading a lot of stocks. It is possible that if you got into a thinly traded stock or what's sometimes called a pink sheet [which is an over-the-counter traded stock that is not on an exchange], that you could have an order sit out there that doesn't get filled, either to buy or to sell. You could try and buy a stock and not have that availability there.
But for anything that is really a household name or trades on a U.S. index, most of the time there's just enough buying, selling, and liquidity going on that there's always somebody out there. And really, that is the supply and demand curve being expressed in real time that if nobody's willing to buy it at today's price or the current moment's price, it will continue to drift down until somebody is willing to buy it. That's really what you're seeing with daily price fluctuations, and there's a lot of people out there.
Brokamp: And for the really big names, there are people whose jobs it is, essentially, to buy stocks when someone is selling or to do the opposite, and they're the people you see on the trading floors. They're specialists. It's their job to make a market in the biggest-name stocks. As Ross said, with the smaller ones there's no one out there [who has] that job, so you just have to hope you do it. But there are plenty of people out there who make their living buying from you and selling to another person, basically in a split second, and getting a little bit of a commission along the way.
Anderson: One of the traders for Motley Fool Wealth Management -- we have three traders that implement our strategy -- used to be a market maker. He basically sat there all day watching orders come in and go out and taking a tiny haircut on those transactions.
I chatted with him about this before the podcast, and he said there's a lot less of that going on than there used to be. I think the electronics has changed it, but it's certainly fascinating how fast and how much of that goes on.
Southwick: It's funny. When you watch a movie like Trading Places...
Brokamp: Oh, yeah.
Southwick: ... that's like old Wall Street, where they're yelling. And orange juice futures. And screaming. But when we went and rang the bell for The Motley Fool four or five years ago, it's just a bunch of guys standing around computers. Like half of them look like they just drink coffee and eat sandwiches all day and don't really do that much else. It's not a lot of yelling and waving pieces of paper in the air.
Anderson: A lot of that really exists today for the TV environment. They shoot a lot of TV on the floor of the exchange wanting it to look like it's where the action is happening, but it's not that necessary anymore.
Brokamp: The vast majority is over computers and between institutions.
Southwick: The next question comes from Ben. Should I use government-issued I savings bonds or an online savings account for my cash? What are the pros and cons for both options?
Brokamp: I love that someone is bringing up I bonds. You know that inflation is starting to tick up when people bring up I bonds because you haven't heard about them for years. Alison, have you ever even heard of an I bond?
Brokamp: Right. An I bond is a clever little thing that you can get from Uncle Sam. It's a type of savings bond, so it's about the safest investment in the world. The interesting thing about the I bond is that it has two components to its savings rate. One is fixed through the life of the bond, and the other one is a variable based on the CPI, the Consumer Price Index.
These days with an I bond, the fixed rate is only 0.1%, but when you add the inflation thing, you get a rate of 2.58%, which is pretty good, especially compared to the typical savings account, plus it goes up if inflation goes up, so it gives you a little bit of inflation protection.
A couple of other interesting things about I bonds. You don't collect the interest until you redeem the bond. That means that the interest accumulates tax-deferred, but it also means it's not a really good source of current income. Speaking of taxes, they're federally taxable but free of state taxes. And if you use it for qualified higher education expenses, you don't pay any taxes.
They can't be redeemed for one year, and if you redeem it between years one to five, you'll pay a penalty equal to three months of interest. So, it's not something that's really that liquid. It's not a checking account. You can't use it at an ATM to get access to your savings bond and you can't write a check on it. So, for most people it's probably better to have a regular savings account just because it's more liquid, but if you're looking for a really safe investment for the next five or so years that will adjust for inflation, an I bond, I think, is worth considering.
Southwick: Our listeners love to find places to squeeze more money out of their emergency fund. It doesn't sound liquid enough to put in an emergency fund, though.
Brokamp: It's not, generally speaking, because again you have to hold it for at least a year. I mean, after that you lose three months' worth of interest. It's not a big deal. Another good thing is you can get them free through Uncle Sam on a website called TreasuryDirect.gov. But you're right, it's not the thing for the emergency fund.
But fortunately, because interest rates have gone up, it's pretty easy to find a high-yield savings account that's about 1.5% these days.
Southwick: The next question comes to us from Brandon. My employer offers three 401(k) options: the traditional free tax plan, a Roth, and an after-tax option. This after-tax option seems like the worst of both worlds. You are taxed on money going in and taxed on distributions. Is there an advantage to using this option over the others that I'm not seeing?
Anderson: All right. Brandon is talking about a feature that not every employer's 401(k) has but is an interesting one. The after-tax feature is normally used if you've already maxed out your pre-tax or your Roth contributions. In 2018, if you are below 50 years old, you can put in $18,500. That's gone up, so if you were trying to max out and last year you were at $18,000 you can put an extra $500 in this year, so that's good. If you are over 50, that limit goes up by another $6,000 for the catch-up, so up to $24,500 for the year.
But if you are already doing that and you wanted to continue saving beyond that, you're not allowed to do more pre-tax or Roth money into the 401(k), but you can still contribute in an after-tax fashion. After-tax basically means that you are still paying income taxes on that money, but it's going into the 401(k) and it is tax-deferred.
So, buying and selling short-term, capital gains, all that type of stuff is avoided and when it comes out of the 401(k), you're going to pay income taxes on the gains. It's kind of like an annuity, in that way, if you had a tax-deferred annuity. So, after-tax money in, tax-deferred growth, you pay taxes on the gains coming out.
The other popular use of this is for backdoor Roth conversions. If you put a bunch of money -- if you stuff money -- into that after-tax feature, you can then do a Roth conversion on that piece when you get to retirement and you've separated from service, so you can kind of isolate that amount of your 401(k). Again, it's kind of a lower-cost version of doing a Roth conversion because you have basis. You have actual money that's already after-tax inside the account.
It gets kind of complicated. I realize that's tough to follow just listening to it, but that's really why the after-tax feature is there. It's not intended to be the first thing that you choose, but if you're already maxing out, it could be something to consider.
Southwick: Our next question comes to us from Grace. Did the new tax law remove the ability to do a backdoor Roth IRA? As I understand it, you cannot recharacterize Roth contributions as a traditional IRA, but I'm not sure if you can still convert traditional IRA contributions to Roth?
Brokamp: Here we go -- the backdoor Roth IRA. We get a lot of questions about this.
The complications around the Roth IRA all start with the fact that it's subject to income limitations. For 2018, the ability to contribute to a Roth IRA begins to phase out for singles with a modified adjusted gross income of $120,000 and it gradually fades out to where you can't contribute to a Roth IRA and that figure starts at $189,000 for couples. Once you make that much, you can't do the Roth IRA.
Now, sometimes people contribute to a Roth thinking they're fine, but then as the year goes on, they end up making more money than they thought they would. Maybe they got a bonus, or a raise, or something like that. What you can do is recharacterize the money you put into the Roth as a traditional IRA. The new law did not change that, so if you contributed to a Roth and realized you shouldn't have, you can recharacterize that.
Now, another way to get money into a Roth is to do a conversion. So, you take money that you have in a traditional IRA, you convert it to a Roth. Any of that money that is converted that is attributed to pre-tax money [in other words, contributions that you got a deduction on, and growth] will all be taxable to you in that year. But once you do the conversion, the money will grow tax-free for the rest of your life as long as you follow all the rules.
You used to be able to change your mind on a conversion, too. Do the conversion and then recharacterize that and say, "You know what? I've changed my mind." That is what has changed in the new law. If you're going to do a conversion, make sure that you're sure you want to do it and then you can pay the tax consequences of that conversion when tax time comes around.
Now, this brings us to the backdoor Roth. What some people have done [and by the way, you're still able to do it as the new tax law did not change this] is if you're not eligible to contribute to the Roth, what you do is contribute to a nondeductible traditional IRA. You don't get a deduction. It's all post-tax money. Put the money in that IRA and then convert it to a Roth. There should be little to no tax consequences because, again, you're putting in after-tax money and you're doing the conversion within a certain amount of time, so there's not a whole lot of growth that you'd be taxed on, either. That's why it's called the backdoor Roth IRA. It's pretty simple, and it's still legal.
It becomes complicated if you have other money in traditional IRAs because of something called the pro-rata rule and this is kind of complicated, so pay attention, class. Here's the deal.
Let's assume a person already has $20,000 in traditional IRA assets and it's all pre-tax money. It's all growth [in other words, stuff that would be taxed if it gets converted]. Then this person contributes $5,000 to a nondeductible traditional IRA, bringing the total to $25,000. They put in that $5,000 because they want to do the backdoor Roth. They put in $5,000 and they had $20,000, so now they have $25,000.
If they do the conversion, 80% of that will be taxable, because $20,000 of that $25,000, or 80%, was pre-tax money and growth. Even if it's in a separate account, you can't just look at one account and say, I just want to deduct this money. You have to look across all your traditional IRAs. For that reason, [for] people who already have a lot of money in traditional IRAs, the backdoor Roth is not necessarily a good thing to do. It depends on your situation.
Now, if you can take the money that you have in traditional IRAs and move it to your 401(k), some people have done that. Transfer it to your 401(k) and now, poof! Now you don't have any money in traditional IRAs. Then you do the nondeductible IRA and convert that. That's a strategy worth doing, too. But, some people have done this and moved their money into a 401(k) that stinks, and I don't think it's worth moving money into a 401(k) that stinks just so you can do the Roth conversion.
Everything I said is pretty complicated. You could still do it. The one thing that is debated among financial professionals about the backdoor Roth is how long you have to wait between the time you open the account and the time you do the conversion. Some people say you only have to wait a couple of months. Other people say you should wait at least a year. What they're afraid of is that the IRS is going to decide that this is a big loophole and they're going to come after people and say, you did this to get around the law and we're going to disallow it.
I would say wherever you're going to open the account, call them up. They've probably already done plenty of backdoor Roths. Ask them for the steps on how to do it and how long they think you should wait and follow their directions, because it can get pretty complicated, but they've done, I'm sure, hundreds of them and they can tell you what to do.
Anderson: And when he talked about the nondeductible IRA, like the after-tax in the 401(k) that I was just talking about, that's because they're taxed the same way. Those are basically the same thing, is a nondeductible IRA or an after-tax 401(k) contribution. Those are very similar.
Brokamp: If you want to read about this, the guy who's considered the expert on IRAs in the U.S. is a guy named Ed Slott. He has a great website. Visit his website if you want to read a little bit more about how to do this before you make a decision.
Southwick: Our next question is kind of a long one, so bear with me. It's from John. About two years ago, we moved into a townhouse. We took out a five-year ARM knowing we didn't want to stay there long. The HOA fees were really high, but we felt it was still a good deal, since buying the HOA implemented a special assessment totaling roughly $12,000 over five years. Not happy about that. Our mortgage plus HOA and assessment fees will surpass the proper percentage of our budget.
I'd like to stay in the house for as long as possible considering it's an area that is going up in value, plus we will have sunk $12,000 into the community; but that time when our mortgage rate will adjust is approaching and with rates going up we're going to have to stomach that.
Here's the question. Do we get out soon and incur the cost of moving to avoid current and future high fees, or do we stomach the high fees for the next three to five years? Any thoughts on finding cash for a down payment on our next house and maybe this house as a rental or is that unlikely given our financial situation now, but maybe?
Brokamp: I feel like John's not quite sure how he feels about his townhouse.
Anderson: First of all, it's a loaded question. There's a lot, here. But for the folks that are listening, the first thing I would tell John is if you are looking at a community that has a condo board or an HOA, ask them before you buy for a reserve study.
All these condo boards, all these HOAs on about a five-year basis should be doing what's called a reserve study, which is where they have an expert come in and look at how well capitalized is the association, what expenses they think are coming up, and do they have enough money in the bank to cover it?
That is a huge indicator of whether you're going to be facing things like special assessments. Like rising dues. I mean, it's very common for the dues to rise over time, anyway, just because things do become more expensive with inflation, etc., but [you may have] a board that has been neglecting that reserve fund [they haven't been putting enough money into it because it's typically unpopular every time they do a special assessment]. Every time some president raises the rates on people, they typically get ousted because they're like, "Well, I don't like that guy. He made us pay more." It's funny how that happens.
That would be my first piece of advice. If you're going to buy in a condo or a home community that has one of these, make sure you see if it's well capitalized, because if they're responsible for things like roofs and parking lots, these are big expenses, and so if that comes up, you're going to be dealing with it.
Now, the second thing I would say. There's a lot of competing language in John's question. We got in because we wanted to get out quick, so we went with this short-term, five-year ARM, which means the rate is going to adjust on him in three short years. Then he says, but we'd like to stay in the home as long as possible or maybe even rent it out, which would mean that you're a long-term owner and you're going to convert this into an income-producing property. Those are not really together.
Southwick: Get your story straight, John!
Anderson: If you think that this is going to be long-term property, and that you might be able to come up with the cash for a down payment without liquidating the property, I would refinance it as quickly as possible. Really, we're in a rising-rate environment. We've already seen the Fed increase rates this year. They're projecting to do it a couple of more times, so I think that this is going to get much higher on you.
The other thing is if you're going to buy a different home, you may consider accelerating that, because your purchasing power decreases as rates go up. So, the amount of house that you can buy elsewhere may decrease over the next three years with the same amount of payment, so it might be time to accelerate this.
I think really assessing whether you want to be in the home long term is critical, and then if you're going to treat it as an income property, you've got to lock it in and start thinking long term about the asset and how you've got it leveraged.
The assessment is tough. It's probably going to hurt your selling value if somebody else comes in and they realize that they're going to have this special assessment to pay, or you're going to have to absorb that, somehow, and build it into your purchase price. There's a couple of creative ways that you could maybe structure that. I think it is going to hurt your sale value a little bit, but the good news is maybe you spin it to say, "Well, whatever is causing that assessment has already been fixed. We've already paid for it, so it won't happen it again." Hopefully that helps you, there.
In terms of finding any cash for a down payment, I think that's kind of impossible to answer without knowing more about John's financial situation and just what his assets look like. I can't really touch that one but think hard about what you want to do. Do you want to be a landlord? A lot of people don't actually want to be a landlord. The idea of income from a property sounds really attractive. The idea about getting calls in the middle of a night because a pipe burst sounds less fun, and if you're paying a management company to not deal with those things, a lot of your profit goes right out the window. It will be a long time before you break even. All that fun stuff comes with being a landlord.
I don't know if I helped John, but those are some things I would think about if I were in his position right now.
Brokamp: And to a certain degree, it comes down to the budget. You're right. I think you have to assume that when the ARM resets, it's going to be at a higher rate. Can you afford that as well as this assessment [whatever the HOA fees are]? And if you can't, then it's time to sell and do something else. But if you can and you love the place, just suck it up and enjoy it.
Anderson: I picture the scene -- I think it was the Austin Powers 2 -- where there was the slow-moving car that was going to run over the guy and he sees it coming from really far away but just doesn't move. You're kind of in that spot right now, John. It's coming after you. You've got three years. Don't wait until it's right on top of you before you make a decision because you're going to lose options.
Southwick: And our last question today comes from Joseph. Do IRA deposits have to be made in cash or could I transfer the equities from my individual brokerage account into my Roth IRA without selling anything?
Brokamp: Sorry, no. You do have to make the contribution in cash. The interesting thing is the money that comes out does not have to be cash. This most applies to people who are subject to required minimum distributions, and that's not people who have Roth IRAs. For the people who have traditional IRAs with required minimum distributions, you don't need the cash. What people often do is they sell the stocks in their account, take the cash, and then they buy the stocks again on the other side.
You don't have to do that. You can take the distribution as stocks. You just have to call up your broker to ask how to do that, but unfortunately, when it comes to putting money in the account, it's got to be cash.
Southwick: Let's cover some listener feedback.
Brokamp: Let's do that!
Southwick: Bill heard our episode where we talked about selling stuff on Craigslist and he suggested the website SafeTradeStation.com and SafeDeal.zone for finding safe places to make business deals. If you're going to sell a crib and you want to meet the person in a safe place, there are apparently police stations around the country where they'll let you make the trade in their lobby.
Anderson: Don't sell the crib at your crib.
Brokamp: Hey! And if it's a stolen crib...
Southwick: We also got a listener named Greg from Australia. He heard our episode that had Scott Phillips on and he said, "Well, talking of IRAs leaves me scratching my head. The more general advice is also much appreciated, and I can assure you that you have loyal listeners outside the U.S." Aw!
He said, "Can I suggest looking at Australia's superannuation system as an example of good, regular saving for retirement. All employees must put 9.25% of savings into an approved fund. To my mind, this is having a huge, positive long-term effect for both individuals and the broader economy. And we do say g'day all the time." Thanks, Greg! Thanks for listening.
A few people heard our chat about the downfall of Theranos and Lou on Twitter saw similarities with Elon Musk and Tesla, saying that... Mm.
Brokamp: As a Tesla stock owner.
Southwick: Are you a Tesla stock owner? He's saying that tech journalists are gaga, while the auto journalists are super skeptical.
Meanwhile, Phil saw similarities with... Have you heard of Danielle Fong? She's the former chief scientist of LightSail Energy. She was a wunderkind. She attended university at 12 and then was getting her Ph.D. at Princeton at 17. I think she dropped out and headed to Northern California where she insisted that her technology to store surplus wind energy really worked. And $80 million in investments later from people like Bill Gates and Peter Thiel, it turned out not to be true.
Brokamp: Oh, boy!
Southwick: One article I read about the demise of this company on GreenTechMedia.com had the subhead of "A fish rots from the head down."
Brokamp: Oh, nice!
Southwick: So, if you enjoyed the Theranos storyline, maybe google "LightSail Energy" for some fun reading.
So, that's it. I want to thank Ross for again joining us on yet another, I would say, successful mailbag episode.
Brokamp: Very successful! Not a single fail along the way.
Southwick: There were questions. We answered those questions.
Anderson: It feels like a win!
Southwick: It feels like a win. I'm going to put that in the "W" column. The show is edited fishily by Rick Engdahl. Our email is [email protected]. For Robert Brokamp and Ross Anderson. I'm Alison Southwick. Stay Foolish, everybody!