Tired of contributing a paltry $5,500 per year ($11,000 for couples) to your Roth? If you like to contribute more than that, why not find a way to generate returns in a taxable account that mimic those of a Roth IRA? Impossible, you say? Under very specific conditions it is possible to generate after-tax returns in a taxable account that replicate those of a Roth IRA. We call it the Synthetic Roth IRA.
- In no way do we recommend foregoing a Roth IRA altogether. If you like your Roth, keep it and keep contributing. Our idea is for folks who already max out their Roth IRA (direct or back-door) every year and like to get additional exposure to Roth returns, but can’t due to annual contribution limits
- Our approach involves the use of leverage and derivatives (index futures) and it’s not for everyone. Moreover, this only works for pretty large size accounts: $70K+
- Our general, more detailed disclaimers all apply as well!
Why a Roth IRA?
The appeal of a Roth IRA is obvious: money grows tax-free and withdrawals are tax-free as well. If you can come up with the after-tax money to fund the Roth and like the idea of tax-free growth and withdrawals it’s a great investment vehicle. There is also the added flexibility that, in contrast to a regular IRA or 401(k), Roth IRAs have no minimum required distribution requirements (RMD) so you can allow your tax-free assets to grow for the longest period in your portfolio.
The disadvantages of the Roth are mostly the obstacles imposed by the tax-man:
- Income limits for direct Roth IRA contributions. Most high-income households are ineligible. One way to circumvent the income limits is the “back-door Roth.” Make a contribution to a traditional (after-tax) IRA, then convert the same thing to a Roth the same day.
- Annual contribution limits of only $5,500 per spouse, which increases to $6,500 post age 50. This applies to both the direct Roth and the back-door Roth.
- While we can access the principal of a Roth at any time, capital gains are only accessible after age 59.5 to avoid the penalty on early withdrawals.
- If rolling over an existing IRA into a Roth, the previously tax-deferred portion will become taxable income in that tax year
- If the value of the Roth goes down, there is no way to write off a capital loss. In other words, there is no tax loss harvesting in a Roth IRA.
Quantify the advantage of the Roth IRA over a taxable account
In the chart below we plot the after-tax portfolio value of an initial $1,000 as a function of the capital market return r. Clearly, for the Roth IRA, the final value is 1000(1+r), while for the taxable accounts it is 1000(1+r(1-MarginalTaxRate)). In fact, you could do even slightly better in the taxable account if taking into account tax-loss harvesting, which we ignore for now.
There are several implications from this analysis:
- The Roth IRA is only advantageous over a taxable account if you actually make money. If you lose you’re better off with a taxable account, and that advantage gets even bigger if you can use tax loss harvesting.
- The after-tax return distribution of a taxable account is exactly identical to the Roth return multiplied (scaled down) by a factor of (1-MarginalTaxRate). Equivalently, a Roth IRA is statistically identical to a levered taxable portfolio, scaled up by a factor of 1/(1-MarginalTaxRate)
- If we could find a cheap (or even no-cost) way to exactly lever up the taxable portfolio by that factor we could exactly replicate the Roth IRA performance, after-tax
How to gain leverage
There isn’t an easy way for most retail investors to achieve the leverage necessary. Hence, the advantage of the Roth IRA is due (in part) to the average retail investor’s lack of access to easy and inexpensive leverage. Here are two suggestions, but they are not exactly attractive and workable:
- Buying equities on margin: That could get expensive. Most brokers have pretty hefty margin interest rates: Check here for a comparison. We’re talking about 5% margin interest for account sizes around $100,000-200,000. So, if you like to lever up your account by a factor of 1.25 (corresponding to a marginal tax rate of 20%) we’re looking at a performance drag of about 1.25% p.a., which seems quite high. Interactive Brokers seems to be an outlier with only 1.36%, so for that 25% extra leverage, you lose around 0.34% p.a.
- Buying levered equity ETFs. To gain 1.25x leverage, one could buy 75% (unleveraged) equity funds plus another 25% in a 2x levered ETF. Fees for those funds are high, around 0.8-1.0% p.a., so for the extra 25% of leverage, we’re looking at 0.2-0.25% drag on performance. For some people, this might be already close enough to the Roth.
Still, there are several problems and issues with these two approaches. For buy and hold investors in the taxable account: what’s the marginal tax rate? If you intend to hold on to your equity funds in the taxable account to defer the capital gains as long possible, you will have to gauge not only what’s the marginal tax at a date decades in the future but also how to distribute that marginal tax throughout all the years of the holding period. Leveraged ETFs tend to have a return drag in sideways-moving markets.
So, while the leverage idea through these two routes seems interesting as a theoretical exercise, the implementation in practice is just such a can of worms, it may not be so attractive after all. For us, if those two routes were the only ones to implement this, we’d give this synthetic Roth a pass. But: if someone out there has experience on how to implement this efficiently with portfolio margin and/or levered ETFs, please let us know and leave a comment below!
Let’s not waste any more time and instead look at the actual implementation we use:
Low-cost leverage through equity futures contracts
Futures contracts are a very easy and inexpensive way of generating leverage. Here are the requirements to make this work:
- An account with a futures trading platform. We use Interactive Brokers (IB), which seems to have very low trading commissions. For the record, we don’t make any referral fee if you sign up with IB, so our recommendation is unbiased.
- Some basic trading experience and clearance from your broker to trade index futures. See our intro to derivatives.
- A relatively clear picture of your likely marginal tax rates, both federal and state (and local if applicable), for the current calendar year. Your marginal tax rate for index futures and their derivatives (IRS Section 1256 contracts) is 60% long-term capital gains and 40% short-term gains, irrespective of the holding period.
- A large enough account to make this worthwhile: the absolute minimum would be the value of one single futures contract times one minus your marginal tax rate on Section 1256 contracts. Example: marginal tax rate 30%, ES future quote 2,090, multiplier 50, then the principal necessary would be 50x2090x(1-0.3) equal to about $73,000.
Synthetic Roth IRA mechanics
- Divide your desired account balance by one minus your marginal tax rate. Example: you have $150,000 ready to invest and your marginal tax rate is 28% (combined state, local and federal tax for Section 1256 contracts). $150,000/0.72=$208,333. This is the equity futures exposure you target. That is pretty close to two ES contracts, so go long two contracts.
- Keep an amount equal to the maintenance margin of the long futures contracts (plus maybe a small cushion) as cash in the account. Currently, the maintenance margin is $4,200 for the ES future.
- Invest the rest of the cash in a low-risk interest-bearing fund. This could be a money market fund or something with a little bit more duration and/or credit risk to juice up returns a little bit more. In other words, why not do better than the 0.3% in a money market account: You could get around 0.9% yield in a floating rate ETF (no interest rate risk, only credit risk) or even more than 1% with short-duration (1-3 year maturity) corporate bonds.
- ES futures contracts expire on the third Friday of March, June, September and December each year. If you are currently holding the June ES Future you have until June 17, 9:30 am EDT to sell the contract and buy a later-dated contract such as the September or December contract. This process is also called “rolling a futures contract” and needs to be repeated every quarter, ideally a few days or weeks before the contract expiration. It should take only a few minutes.
- Sit back, relax and watch your synthetic Roth exactly replicate the after-tax return in a Roth IRA.
Assume you’re in the 28% federal bracket for short-term gains, 15% for long-term gains and 5% bracket for state taxes. The marginal tax for the futures returns is 0.6×0.15+0.4×0.28+0.05=25.2%. Interest income is taxed at 0.28+0.05=33%. The first example looks at what if you invest the available margin cash exactly at the risk-free rate in a money market account. I pick the initial wealth such that the leveraged futures position comes out as exactly the value of an ES futures contract at a price of 2,100, close to where it was around writing this WO=$2,100x50x(1-0.252)=$78,540.
The synthetic Roth yields an after-tax return exactly 0.14% percentage points below the Roth IRA, irrespective of the market return. This return drag is due to two effects
- Not all the margin cash yields interest, because you need the $5,250 sitting around in cash, which doesn’t pay you anything in the IB account.
- The interest income on the funds actually invested is subject to income tax.
We can alleviate, maybe even reverse this drag by investing in slightly higher yielding assets (subject to adding a little bit of return variation vs. the Roth). For example, one could invest in a floating rate ETF from iShares (ticker: FLOT) for a little bit of extra yield. Current yield around 0.90%.
With the additional after-tax interest income, we’re able to beat the Roth IRA return by 0.18%:
Update (June 2017):
We implement this strategy not with index futures but options on futures (see more details in our Put Writing Post). Also, in light of higher and rising interest rates, we need to jack up the yield we generate from investing the margin cash. We currently hold a Muni Bond fund and Preferred Shares. The yield on both easily overcomes the drag from taxes and the margin cushion. But we also introduce a certain degree of duration risk.
Advantages of the Roth replication
- There is no upper limit on the account size. Except for how much money you feel comfortable putting into this. S&P500 futures are very liquid, with a daily trade volume of over 1 million contracts on most days (worth around $100 billion).
- Liquidity of assets outside the inflexible Roth IRA. No need to wait until age 59.5 and no need to wait 5 years to withdraw rollovers.
- Futures contracts have a zero expense ratio. But there is a cost of trading and rolling contracts, which should amount to about 0.01 to 0.02%, still below the expense ratio of even the cheapest S&P 500 index fund. If you really want to skimp on the transaction costs you could also try to roll only twice a year, i.e., June and December, cutting that roll cost in half.
- It’s easy to do other fun financial rocket science, such as covered call selling on your futures holdings, downside protection through puts or, if feeling really lucky, naked put writing (shorting) which is something we do very effectively. Another idea: mix in some 10Y Treasury Futures for some small extra yield and great diversification with the equity futures.
- Keep your margin cash in a higher-yielding bond fund to further boost returns, maybe even a tax-free Muni bond fund to shield your interest income from the taxman. If you are willing to take on a little bit of credit and/or duration risk you could not only avoid any return drag but even beat the return of a Roth IRA invested in an S&P500 index fund. See example 2 above.
- International index futures exist as well. Nikkei futures trade on the CME as well, and they even have a currency hedged version so you would take on only the pure equity return risk, while you are protected from currency fluctuations (which can be substantial between JPY and USD). I checked on iShares and they charge close to 0.50% expense ratio for those single country ETFs. With Futures contracts you can do the same for a fraction of the cost.
- Your futures contracts don’t have to be rebalanced continuously the way the levered ETF do, which saves on transaction costs.
Disadvantages of the synthetic Roth through equity futures
- Futures contracts require quarterly “rolling”, that is, selling the contract approaching expiration and buying a new contract with a later expiration date. It’s imperative that futures be held in an account where you can do this rolling in a cost-effective way. Some providers have very high fees that can make the whole exercise moot, but Interactive Brokers seems pretty reasonable.
- Large minimum investments: the smallest denomination of one single S&P500 index futures contract is the CBOE e-mini contract at 50 times index value, currently over $100,000, as the levered-up amount. Probably around $70,000-$80,000 for most investors.
- Depending on your tax situation and the level of risk-free interest rates there may be some performance drag relative to the actual Roth IRA. One can juice up the yield by holding higher yielding funds and mitigate or even reverse this drag into an advantage over the simple index fund in the Roth IRA, as mentioned above.
- Limited selection of investments: S&P500 futures are very liquid, Dow Jones, Nasdaq 100 and a few international indexes as well, but anything exotic, like REITs or small cap index futures, doesn’t trade very much. Personally, we focus on the S&P500 and its options because there is a lot of liquidity and trading activity. Most other equity indexes are highly correlated and if we have demand for them, we just use our other accounts, IRAs, 401(k), etc. to hold them.
- We need to fill out an additional tax form: IRS form 6781: Gains and Losses From Section 1256 Contracts and Straddles. It’s relatively easy: our brokerage company sends us a Form 1099, and there is no need to itemize the futures transactions. Rather, we simply enter one single number, the net profit or loss from Section 1256 contracts. That number will be split into 60% long-term gains and 40% short-term gains, to be added to our 1040 Schedule D (capital gains).
- The potential loss of means-tested government benefits (e.g. Obamacare/ACA), college financial aid for your kids etc. This is a serious issue if it affects you. In our case, we plan to have taxable income in retirement too high for ACA subsidies. We have no idea yet what are the typical upper-income limits we want to avoid to maintain eligibility for financial aid for Little Miss ERN when she heads off to college. Looking for some advice from the blog community!
- An actual Roth IRA is protected from the greedy fingers of ambulance-chasing trial lawyers. If someone sues you for damages, a privately-owned brokerage account for your replication portfolio is fair game in frivolous lawsuits. An LLC or a family limited partnership as a wrapper around your at-risk assets would offer some protection against greedy lawyers.
- Marginal taxes aren’t really constant. When you increase/decrease your income you may go from one tax bracket to another. That means you will have to keep track of your year-to-date income (all income including your realized futures gains and losses so far) and potentially adjust the notional exposure if your tax bracket changes. For us personally, we are so far away from those kink points that we don’t have a problem. Our marginal tax rate is pretty much the same no matter what the market throws at us.
- The dreaded $3,000 maximum of capital gains per year you can use to offset ordinary income. But the solution is that you can carry forward unused short-term losses to offset future gains. Even better: for Section 1256 contracts you can carry losses backward (!!!) to offset up to three years worth of prior gains.
Under the most basic assumptions, you’d currently experience a 0.14% p.a. return drag behind the actual Roth IRA. That’s still unpleasant, but some people are willing to sacrifice much more return for much less tax-arbitrage. For example, those who have maxed out all their tax-friendly accounts and go with “Deferred Variable Annuities” pay about 0.25% p.a. in fees even at the low-cost providers, like Fidelity. And with those annuities, you would only defer not eliminate income taxes. Before putting any serious money into a variable annuity, you’d definitely want to consider the synthetic Roth. What’s more, in the synthetic Roth you are able to juice up the interest income by simply investing in something with a slightly higher yield than the risk-free rate. Then you can even come out ahead of the Roth invested in an index mutual fund.
Has anybody else thought about the Roth IRA as a leveraged taxable account? We’re interested in hearing your suggestions from folks who have maxed out all traditional routes of tax deferrals and seek more tax-arbitrage!