What about IRA penalties?

Putting money in a traditional 401k or IRA is a good idea if only for the tax benefits. In the last article on how to invest a 401k I noted that someone in the 25% tax bracket gets an instant 33% gain on their money just by depositing that money in the 401k or IRA.

But 401ks and IRAs have restrictions on when we can make withdrawals. Namely, if we withdraw the money before age 59 ½, then we are required to pay a 10% penalty fee.

This seemingly puts a cramp in the plans of someone who is planning to retire early and wants to take advantage of the tax advantages of IRAs and 401ks. If a person started working at 22 and saved 50% of their income in order to retire in 20 years at 44, then it would seem they’ve still got 15 ½ years left before the money will be penalty free.

While there are a few well-known ways to make IRA withdrawals without the penalty like for buying a first house or for education expenses, there’s also one that’s not so well known called Substantially Equal Periodic Payments (SEPP).

SEPP says that if we agree to take money out of our IRA on a pre-defined schedule, then we can avoid the 10% penalty. This actually turns out to be kind of convenient. We’ll basically be replacing a regular paycheck from our job with a regular paycheck from our IRA.

This article on SEPP is a good primer on the subject.

SEPP can be a little complicated and situation specific, so you’ll want to research it more than just reading that article, but just knowing that the option for penalty-free withdrawal exists opens the way to using them in our financial planning.

No Lose Stocks addition

I added a small but interesting feature to No Lose Stocks this past weekend. I noticed in some cases that instead of buying the put and stock, it’s a better investment to take the money I would have invested in the put and stock, and instead to put that in a money market account, and then use the interest to buy a call option at the same strike price.

The new column shows an interest rate. This is the interest rate you would need to earn to make the call a better investment than the put and stock combo. That way you can decide for your own situation if the call option is better for you depending on where you park your cash.

Here’s a recent example to illustrate.

The data from Friday, September 5, 2008, says that JNJ could be purchased for $70.67 per share, and that a put option expiring on January 15, 2010 with a strike price of $80.00 could be purchased for $11.50. The total amount invested then to put on this trade would be ($70.67 + $11.50) $82.17 per share. Assuming you get the expected $2.30 in dividends by the expiration date, this trade can only go up. So you won’t lose money, but on the flip side you only profit if the price of JNJ goes over $80.00 before January 15, 2010.

Let’s say you consider buying 100 shares of this trade, which would be an investment of (100 * $82.17) $8,217.00. Then let’s say you look at your money market and notice that it’s paying 3.5% interest.

If you deposited that $8,217.00 in the money market for 496 days (the time to expiration), you would make roughly $390.00 in interest.

Another way to make money if the price of JNJ goes over $80.00 by January 15, 2010 is to buy the call option with that strike and expiration. That call option costs $2.60 per share. The $390 in interest divided by $2.60 means you could buy 150 shares of the call option and be in a similar situation to buying 100 shares of the put and stock combination. That means that if you get lucky and JNJ does go up, then you make more money owning the call option than you do owning the stock and put option.

Tracking results

It was suggested that I start showing some results for the Inflatable Dividends and No Lose Stocks Premium Services in order to market the services better. I have a bit of a moral dilemma on this though.

Here’s my dilemma. I don’t use the Inflatable Dividends service. I did initially, but that investing strategy doesn’t fit my goals any more. It exposes me to more risk than I’m willing to take and it doesn’t guarantee that I won’t suffer large negative changes in my account balances.

I’m only willing to be exposed to a very small fixed amount of risk (like the possibility of a dividend being cut). With Inflatable Dividends, since I first have to buy back the call option before I can sell the stock, it’s possible that the stock price could fall fairly far before I could sell the stock. So Inflatable Dividends doesn’t meet my requirements.

But I also recognize that I shouldn’t make decisions for other people because what I want may not be what they want. So I will continue to provide the Inflatable Dividends service as long as people want to subscribe to it.

However because of my behavioral finance research I’m also aware of people’s confirmation bias. This bias means that we look for information that agrees with our current opinion. The information doesn’t prove we are any more right, but we feel much more right. This is like the black swan problem. No matter how many white swans you see, you can’t prove there are no black swans. But the more white swans that you see, the more you will think that you are right that there are no black swans.

So if I posted trade results for the Inflatable Dividends service, it’s possible that they will be good for a long while, and would lull potential subscribers into a sense of safety and consistency. But it could be a false sense of security. If one bad trade can wipe out all the gains made on the previous good trades, then all those good trades are meaningless.

I have the opposite problem with No Lose Stocks.

I do use this service and it does fit my goals of a specifically limited amount of risk. But it suffers from the opposite problem that Inflatable Dividends has. The No Lose Stocks strategy can look wrong for a long time. It can look like you aren’t making any money because a lot of the time you are just breaking even. Then suddenly one of the stocks you own will pop up on good news and you’ll have a gain. The whole idea of the strategy is to make one-way bets and then wait for luck to strike.

A history of these trades looks like a lot of non-winning trades and then suddenly a win. So a history of the trades would scare off or discourage someone who didn’t understand the strategy because it doesn’t have the flash of lots of winning trades.

Either way I don’t think it would be a net gain to post a history for either service.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s