Split the Difference

Adam M. Grossman

IT’S THAT TIME OF year again, when Wall Street strategists begin publishing their market forecasts for next year. If you’re wondering whether to put any stock in those glossy publications, here’s my recommendation: Think back a year to the forecasts issued at the end of 2019. Did any of them predict that a virus would come out of left field, throwing the economy into recession, triggering a bear market and killing more than a million people worldwide?

This is just the latest illustration of the reality that, for better or worse, personal finance is not a science. To be sure, finance involves mathematical analysis. But anyone who’s being honest about it will acknowledge that, in most cases, financial analysis requires making one or more assumptions. The result, as you might imagine, is that it’s easy for an analysis to provide two conflicting answers to a given question.

Consider a simple example: If you want to make a charitable contribution, should you do it now or wait until 2021? The answer depends on where tax rates are headed. If you believe the new administration will raise tax rates, you’d certainly want to wait, because your deduction will be worth more when rates are higher. But if you think the politicians won’t raise taxes until the economy improves, you’d want to go ahead and claim the deduction this year.

These kinds of questions can be frustrating. In the absence of a crystal ball, many people rely on one of the following approaches—neither of which is ideal—for decision-making.

Option No. 1: Do nothing. When an analysis doesn’t provide a clear answer, it’s natural to want to shelve a decision. In a lot of ways, that makes sense: If you feel like there isn’t a tangible basis for making a decision, maybe it’s best to defer it.

Option No. 2: Do something. If you don’t like the idea of shelving a decision, but you still don’t have enough information to go on, you might just take a guess or go with your gut, figuring that any decision is better than indecision.

I’d like to offer another alternative: When there’s no quantitative way to make a definitive decision, often the best approach is—for lack of a better term—to split the difference. While this might not seem like a rigorous way to make important decisions, I believe it’s better than the alternatives. Where can you apply this split-the-difference principle? Here are seven examples:

1. Roth vs. traditional 401(k). If there’s a Roth option in your 401(k), is it worth making Roth contributions, even though it means forgoing the tax deduction offered by the traditional 401(k)? If so, should you allocate your entire contribution to the Roth account or just a portion? This, of course, depends on a comparison between your current income (which you know) and your future income (which you can only estimate), and also on whether Congress will raise tax rates (which no one knows). My advice: Even if you’re in a high tax bracket today, you might still split the difference with your contributions.

2. Roth conversions. If you’re currently in the early years of retirement and have an IRA you’re considering converting to a Roth IRA, you’ll be asking similar questions about tax rates. But it might be more urgent. The tax cuts implemented by the 2017 Tax Cuts and Jobs Act aren’t set to expire for another five years, but Congress and the new administration might agree to raise them sooner.

Will that happen? That depends on how quickly the economy recovers and on which party controls the Senate. There are probably other political considerations. No one knows where this will all end up. In other words, tax rates might go up, making accelerated Roth conversions more attractive. But they might not, in which case accelerated conversions might end up costing you more. Again, a sensible strategy might be to convert some, but not all, of your IRA funds this year, and then take it year by year thereafter.

3. Mortgage term. In general, if you go with a 15-year mortgage instead of a 30-year, you’ll pay a lower rate and you’ll be done with the loan a whole lot sooner. But your payments will be much higher. How can you split the difference on this? One way is to take out a 30-year mortgage to preserve flexibility, but then commit to making larger payments in months when your cash flow permits.

4. Paying off debt. Suppose you’re in a position to pay off your mortgage or other loans. With rates at all-time lows, is it worth it? This depends on what you would otherwise do with the funds. If you invest it in the stock market, your returns will probably be higher on average, but not necessarily every year, so it might be a good idea or it might not. That’s why you might split the difference, maybe using a third of your cash to pay down debt, investing a third in the stock market and keeping the remaining third in the bank for flexibility.

5. Buying investments. Last week, someone asked me to research options for investing in Israel. I found two funds that fit the bill. I liked them both, but they were different. I couldn’t say that one was necessarily going to be better than the other, so I recommended buying both in a 50-50 split.

6. Selling investments. Do you own overpriced mutual funds or underperforming stocks? Ideally, you would sell them, but that might entail a tax bill. Then again, the cost of underperformance might outweigh the tax bill. Fortunately, it doesn’t need to be all or nothing. You could sell a little bit each year.

7. Claiming Social Security. Do the math on Social Security strategies, and the answer is usually that high-income individuals should wait as long as possible to claim their benefit. But that assumes you’ll live as long as a life expectancy calculator predicts. My advice: In light of this uncertainty, it’s not heretical to at least consider claiming at age 68 or 69.

Adam M. Grossman’s previous articles include Game TheoryTrends That End and Getting Personal. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.

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R Quinn
R Quinn
2 years ago

Adam, maybe you can clarify two points. A Roth conversion makes sense in some circumstances, but rarely is the five year holding period mentioned. Isn’t that a big factor for someone who is up in age, say in their seventies? Also, regarding Social Security, I never understood why the break even point or maximizing the total benefit is relevant. Seems to me what’s most important is maximizing the monthly income at the time it is most needed. Obviously, that can be at 62 or 70, but I’m guessing if a retiree can wait to 70, SS is not a major portion of income. I took it at 66+ while I was still working part-time, but I invested it all in tax-free municipal bond funds and reinvested all interest. All the money is still there and growing. Not recommending that for others, but as you note, it’s not all or nothing.

2 years ago

7. Unless you have health issues that significantly reduce your life expectancy I see no reason for not waiting until 70 to claim if you can afford to do so.

6. Selling “overpriced mutual funds or underperforming stocks” assumes that current performance predicts future performance.

2 years ago

The Roth questions may not be as much of a split the difference situation as people think. There are many reasons to have tax diversification and to own Roth assets. At a minimum, you should contribute and convert to the limits of your current tax bracket. If you’re someone mid-career or later, you’ve likely built up a stash of traditional assets that will be subject to RMDs, potentially thrusting you into an even higher tax bracket than you were when you contributed/converted the funds. Also, if you bequeath Roth assets to a non-spouse, they’ll have the opportunity for 10 years of non-taxable growth followed by a tax-free liquidation of the inherited account.

Bob T
Bob T
2 years ago

I liked this article. I’ve been dithering over whether to convert some of my traditional IRA to add to my Roth, for inheritance considerations, and I keep putting it off. I should consider this.

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