Synthetic Roth via leverage?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
Dioremius
Posts: 13
Joined: Tue Jun 11, 2019 4:16 pm

Synthetic Roth via leverage?

Post by Dioremius »

I recently ran into EarlyRetirementNow's post on How to create a no-limit Synthetic Roth IRA in a taxable account using leverage. It makes a compelling case that Roth IRA (which is boglegood) is equivalent to leverage (which is boglebad) in taxable, and that gives me a terrible bogleheadache! Please help me figure out the paradox, and decide whether to actually execute a Synthetic Roth.

In a nutshell, their thesis is as follows. Consider buying and holding an index fund in taxable. Tax is due when selling it, but you can precisely cover this tax by leveraging your investment by a factor of 1/(1-MarginalTaxRate). Which means your after-tax dollars-in-pocket at the end of the day are the same as if you made the same (unleveraged) investment in a Roth account. This is true regardless of market movement.

But how can it be? Leverage is notoriously dangerous, while Roth is a nice safe tax-advantaged account that of course you should use (unless paying debt or tax-deferred tIRA/401(k) are even better for you), so how can they be equivalent?

My intuition is Roth does carry more risk than taxable, because taxes cushion your losses. It's easiest to see in the extreme were your investment's value drops to zero: in Roth, you've lost it all. In taxable, you recognize a deductible loss, so you get some of your money back. So you could leverage taxable by just the right fraction so that if value drops to zero, you'd really lose all of this investment post-tax, but (crucially!) no more.

With this in mind, leveraging in taxable by a factor of 1/(1-MarginalTaxRate) is just saying: "yes I really am willing to put all of this money at risk on this investment, I don't want your stinkin' cushion for losses, just give me the full upside and downside". Same as Roth.

So, wouldn't it be rational to frame our our asset allocations in terms of such "true after-tax exposure", and then legitimately use any combination of Roth and leveraged taxable to achieve it? Especially in high tax brackets, where this really matters?

And if backdoor Roth is so great but contributions are capped at $6000 or $7000 a year, then if you have more to invest, why not go wild and establish an uncapped amount of synthetic Roth?

I made numerous assumptions and simplifications in the above. Some caveats and notes:
  • This assumes that the costs of leverage (compared to the fees in your Roth account) are small enough. Using futures as the leverage vehicle, EarlyRetirementNow estimated a drag of 0.14%/annum, back in 2016.
  • This assumes a constant, known tax marginal bracket on your leveraged investment. But if your marginal brackets changes over time, you can adjust your leverage to recover the Roth-like 100% exposure. But large unexpected changes (e.g., windfall or market crash) could skew things and in particular cause the leverage to temporarily exceed your tax cushion.
  • In particular, if market movements can cause your marginal tax bracket to change, then your expected after-tax return drops below Roth (because your leverage will be either too much for the low tax bracket deduction in case of loss, or too little for the high tax bracket owed in case of gain, or both).
  • If using futures, margin (collateral) requirements can also cause trouble and tax implications in case of large, sudden market movements.
  • There's the complexity of maintaining leverage. In particular, futures (which seem to be the lowest cost method for retail investors) requires quarterly rolling. (But then, you no longer have to bother doing the annual Backdoor Roth ceremony.)
  • Cheap leveraging is available only for a relatively small choice of assets. Fortunately, these include the Bogleheads-favorite major indices.
  • There's some risk inherent in using the leveraging mechanisms (e.g., you'd become exposed to disruptions in the futures market, or to changes in collateral margin requirements). This risk seems minor if you stick to well-established instruments like E-Mini S&P 500 futures.
  • I ignored tax on dividends. But that's OK, because if you leverage using futures or options, you won't see them directly anyway; they'll just be embedded in your capital gain.
  • You can TLH the leveraged taxable against other investments, which you can't do with Roth.
  • The tax cushion on losses is effective only if you have enough capital gain to deduct the loss from (on other investments in the same year, or soon enough that interest on the deferred deduction is not significant). Plus the $3,000 that's deductible from ordinary income.
  • As EarlyRetirementNow discusses, if you leverage using futures, the growth of your futures is effectively reduced by the risk-free interest, but you have (most of) your cash available for interest-bearing investments that roughly cancel this out. This opens opportunities. For example, if you're in a high tax bracket, you could use the cash to buy tax-free munis, thereby doing a tax arbitrage (you gain tax-free interest on the munis, but the corresponding interest expense embedded in the futures reduces your taxable income). Likewise for high state tax: earn interest on treasuries (no state tax) and "pay" the equivalent interest embedded in the futures (which reduces your state tax).
  • Unlike Roth, you can "withdraw" the full account balance from leveraged taxable at any time, with no penalties.
  • Unlike Roth, leveraged taxable has no RMDs when inherited.
  • Leveraged taxable seems less sensitive to future changes in tax code, because you always keep your basis close to FMV. They could cancel the step-up in basis, they could eat into Roths, they could require more RMDs, you still wouldn't care if you basis is already at FMV.
  • Roth has some creditor protection
  • Roth is sheltered in computing FAFSA college financial aid
So... does this make sense? And why are Bogleheads usually taking for granted the tax cushion of taxable, which affects their true exposure (in terms of in-pocket aftr-tax dollars at the end of the day), even though it can vary drastically between investors and with time?

(My personal circumstances, which are when all of these indeed matters, are: high federal and state tax brackets, and relatively tiny tax-advantaged space even though currently maximizing 401(k), backdoor Roth, state-deductible 529, I-bonds and some DAF.)
Last edited by Dioremius on Mon Jan 27, 2020 5:50 am, edited 3 times in total.
User avatar
firebirdparts
Posts: 1787
Joined: Thu Jun 13, 2019 4:21 pm

Re: Synthetic Roth via leverage?

Post by firebirdparts »

That's interesting, and of course it's not totally wrong. some considerations:
1. It's true you can't tax loss harvest in a Roth. It'll aggravate your soul. That could be significant.
2. Why would you leverage "just enough" to cover taxes? What would be the rationale? What would happen in taxable if you leveraged more?

These are the bigger issues: i.e., what are the risks of different forms of leverage and do I want some. Presuming you are making wise investments, what are the effects of tax loss harvesting? Do I want some? To me, the other issues are not interesting if you are planning on saving a ton of money. I can only put $7000 a year in a Roth anyway, so it really doesn't matter much.
A fool and your money are soon partners
bogglizer
Posts: 320
Joined: Tue Aug 16, 2016 8:56 pm

Re: Synthetic Roth via leverage?

Post by bogglizer »

Risk is money. You are buying risk equal to the tax difference. Upshot is that you have more risk and the government gets more money. As a taxpayer, I approve! However, as a BH, the Roth may be preferable, as the government has given you a free gift equal to the cost risk of aforementioned leveraging.
MotoTrojan
Posts: 10659
Joined: Wed Feb 01, 2017 8:39 pm

Re: Synthetic Roth via leverage?

Post by MotoTrojan »

The “leverage” I get in Roth is free, but I’ll pay interest in taxable. It’s not apples to apples in my view.
SovereignInvestor
Posts: 595
Joined: Mon Aug 20, 2018 4:41 pm

Re: Synthetic Roth via leverage?

Post by SovereignInvestor »

In the example, if someone has $1M, in taxable and market drops 10%, and it's $100K loss, the example treats it as the same as losing (1-marginal tax rate) * 100K in ROTH, but it would likely takes years to reclaim the full benefit of $100K taxable account loss (or futures loss), since there's $3K cap, and market may take a while to recover and generate enough gains to offset.
Topic Author
Dioremius
Posts: 13
Joined: Tue Jun 11, 2019 4:16 pm

Re: Synthetic Roth via leverage?

Post by Dioremius »

firebirdparts wrote: Sun Jan 26, 2020 2:07 pm 2. Why would you leverage "just enough" to cover taxes? What would be the rationale? What would happen in taxable if you leveraged more?
Bankruptcy risk. Up to that leverage ratio, (this slice of) your account is guaranteed to remain positive post-tax. Beyond that, you may not stay solvent. For example, if you leverage using future with the cash in T-bills: with excessive leverage, you run the risk of owing more money on the futures contracts than the value of your T-bills together with your forthcoming tax refund.

(Now sure, maybe you have enough other, uncorrelated assets to cover that debt. And maybe a catastrophe is not very likely if you just mildly overleverage S&P 500. But still there would be new risk introduced, which did not exist with Roth.)
bogglizer wrote: Sun Jan 26, 2020 2:14 pm Risk is money. You are buying risk equal to the tax difference. Upshot is that you have more risk and the government gets more money. [...] the Roth may be preferable, as the government has given you a free gift equal to the cost risk of aforementioned leveraging.
The point of the analysis is that: the risk and reward per dollar invested are the same, whether it's invested in Roth or in properly- leveraged taxable. The government gave you nothing of value. Roth is a way to accept the same risk and reward as mild leveraging, just sugar-coated and easier to execute. (Of course that's in the ideal model, putting aside the secondary concerns raised above.)
MotoTrojan wrote: Sun Jan 26, 2020 2:30 pm The “leverage” I get in Roth is free, but I’ll pay interest in taxable. It’s not apples to apples in my view.
If you leverage using futures, the interest you pay nearly cancels out (between the futures's cost of carry that you pay, and the interest that you earn on the cash you have at hand after posting the collateral margin). See EarlyRetirementNow's original post (or any good discussion of leveraging using futures). It even creates some tax arbitrage opportunities, as discussed above.
SovereignInvestor wrote: Sun Jan 26, 2020 2:35 pm it would likely takes years to reclaim the full benefit of $100K taxable account loss (or futures loss), since there's $3K cap, and market may take a while to recover and generate enough gains to offset.
True. There's an assumption is that you have enough capital gain to deduct the loss from (in the same year, or soon enough). I'll add this to the list above.
jdilla1107
Posts: 849
Joined: Sun Jun 24, 2012 8:31 pm

Re: Synthetic Roth via leverage?

Post by jdilla1107 »

Like many academic cases that involve leverage, this ignores two important points:

- The cost of leverage. (None with roth)
- Margin calls. (None with roth)
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Synthetic Roth via leverage?

Post by petulant »

Dioremius wrote: Sun Jan 26, 2020 2:57 pm
MotoTrojan wrote: Sun Jan 26, 2020 2:30 pm The “leverage” I get in Roth is free, but I’ll pay interest in taxable. It’s not apples to apples in my view.
If you leverage using futures, the interest you pay nearly cancels out (between the futures's cost of carry that you pay, and the interest that you earn on the cash you have at hand after posting the collateral margin). See EarlyRetirementNow's original post (or any good discussion of leveraging using futures). It even creates some tax arbitrage opportunities, as discussed above.
Not quite. The examples in the article are rather obtuse regarding dividends and futures pricing, and reality is a bit more complex than the example.

The Roth IRA invested in an S&P 500 index ETF like VOO will experience price movements and dividend yields that create a total return. Since the fund holds assets substantially similar to the makeup of the S&P 500, the fund's price movements should track extremely closely with the price movements of the index. The dividends will generally match dividends that would be produced by the constituents of the index, less expenses. These dividends have often been 1.9-2.0% in recent years, and after tax might be as low as 1.1-1.2% after all federal and state taxes are applied.

A futures contract works differently. Conceive of a futures contract as a contract between somebody who wants to buy VOO (the ETF) in the future and somebody who already owns VOO, but for some reason they want to delay the actual transaction while shifting economic responsibility for VOO's movements until the transaction closes. In other words, the buyer wants all the benefits now without closing the transaction yet, and the seller limited exposure until the sale.

If they set the price of the future based on the S&P 500 level today, the seller still owning VOO will get the full dividend over the next year, while the buyer will only get the interest he can earn on cash. If the money market rate is .50% and dividends are 1.9-2.0%, the seller will have just made off with the spread, and the buyer would not obtain the exposure they wanted (i.e., all benefits of ownership).

Knowing this, the parties will instead transact using the current price as a starting point and then discounting that for the value of dividends expected until the contract closes. Thus, while VOO trades at the current price level of the S&P 500 with a trivial discount/premium, the S&P 500 future will have a nontrivial discount to make up for the dividend yield. Further, since futures contracts are generally rolled quarterly at times when dividend finances are closer to being known, the discount can be estimated closely.

However, we can expect this dividend discount to be offset by an implied financing rate. (Some refer to this as risk-free rate. I don't agree with that label.) The seller knows if the buyer already has the cash to buy, they don't need a discount for the full dividend. They only need one for the spread between the dividend and the rate available on a low-risk comparable source of return. This implied financing rate should therefore be close to money market rates but can move around it based on available liquidity. That is important because it means if more buyers bid up futures contracts with little cash, they increase the price and eat further into the dividend discount, increasing the implied financing rate.

The result is that an S&P 500 futures contract has a return that is composed of the change in price plus expected dividends as of the date of buying minus the implied refinancing rate plus the aftertax rate of return on cash invested minus fees. We already said VOO had a return equal to the change in price and actual aftertax dividends minus trivial expenses and discount/premium.

There are two key issues that can drive differences, then. One is the spread between the implied financing rate for the buyer and the aftertax return on cash. This is not always favorable, depending on rates, taxes, etc. Further, note that the implied financing rate in 2016 will be very different from today since cash returns were near-zero but are now in the 1.5% range. One should also appreciate the possible risks of improving the spread by pursuing longer durations or more credit risk on the cash asset.

The second issue is the tax difference between investors. Investors in the 0% bracket or in a tax-deferred account may have a better spread since they can achieve higher yields on cash; on the other hand, the dividend discount itself may need to be adjusted for QD rates, complicating the matter. (The .14% drag in the example partly represents a negative spread between the investor's aftertax return in MMF compared to implied financing rate. This spread can grow larger.)

Thus, calculating outcomes for both futures and a Roth IRA ETF by inputing a return, rf, etc. is simply wrong. An investor should review market prices for futures and input those into a model to determine implied financing rates, which can then be compared to available cash assets. This tradeoff can change quarterly. The Roth IRA does not have this potential risk or reward; it would be like the futures strategy, except the financing rate and the cash return are always equal. That is powerful.

Further, what happens when the spread goes too negative? The assets are already in taxable. Roth has no problem. The Roth account also has excellent asset protection from creditors in most states.

Bottom line, it's not simple and the risks are greater than meets the eye.
rascott
Posts: 2347
Joined: Wed Apr 15, 2015 10:53 am

Re: Synthetic Roth via leverage?

Post by rascott »

I think it's a totally reasonable strategy..... but you need to know what the heck you are doing and what the downsides are. Also, in the update at the bottom of the post, they say they ended up using future options.... not actual futures.

Also.... note that since this was written.... micro e-mini futures are now available. These are 1/10th the size of the old school e-mini future contracts. These would be useful for someone attempting this... since they are in roughly $15k increments (at today's SP500 level) , vs $150k emini contract.

Using 3x leveraged ETFs is pricier, but a lot simpler to manage.... and will get you pretty close to the same outcome (something like 90% VOO + 10% UPRO).
User avatar
Ketawa
Posts: 2307
Joined: Mon Aug 22, 2011 1:11 am
Location: DC

Re: Synthetic Roth via leverage?

Post by Ketawa »

I don't see any reason to do this unless you are 100% equities. Otherwise, it should be more efficient and simple to accomplish the same thing by changing your asset allocation by selling fixed income and buying equities, except for cases where there are true arbitrage opportunities due to tax rates.

I already use tax-adjusted asset allocation.
User avatar
firebirdparts
Posts: 1787
Joined: Thu Jun 13, 2019 4:21 pm

Re: Synthetic Roth via leverage?

Post by firebirdparts »

So my Roth is 100% invested at 3x leverage. Gonna need 4x in taxable.
A fool and your money are soon partners
Post Reply