Roth IRA Conversions

To Convert or Not To Convert…That is the Question

We are all about to be inundated with media and financial industry chatter regarding Roth IRA conversions.  What is happening is that in 2010 the Roth conversion modified adjusted gross income (MAGI) limits will be eliminated.  MAGI limits for Roth IRA contributions will still be in effect but not for conversions from a Traditional IRA or other qualified plan.   Roth conversions have always been available for households who make less than $100,000.  The way a Roth conversion works is that the balance that is converted from the Traditional IRA is considered as ordinary income, and is a current year taxable event for the owner.  This converted amount is added to your income prior to the tax calculation.  So the federal government gets paid now instead of when the money would have come out of the Traditional IRA in the future.   With a Roth IRA conversion, someone is essentially making a decision that income tax rates will be equal or higher in the future than what their marginal income tax rate will be in the current year.  The conventional wisdom has always been that your marginal tax rate will be lower after you stop working and that deferring paying taxes until then made sense.    The first step in determining whether a Roth IRA conversion makes sense is whether the taxes that will be paid can come out of nonretirement plan assets.  If not, then it generally will not make sense to convert.  Paying the taxes from non-IRA money allows for a larger amount to benefit from the long-term tax-free growth potential of the Roth.     Roth IRAs already make sense for young people and those in lower income brackets because of the long-term tax-free growth potential and also the likelihood of their being in equivalent or potentially higher tax brackets in the future.  Roth conversions will now likely be extremely appealing to the very wealthy, where wealth is defined by annual earnings.  If someone is already in the highest marginal income tax bracket and expects to remain there in the future, then there is little downside to the conversion.    The middle ground is where it is a more difficult decision, and where most investors will find themselves.  A Roth IRA conversion could be used as a hedging strategy where you have multiple accounts where the taxes on distributions are calculated differently:  non-retirement funds, Traditional IRA, Roth IRA, and annuity.  While tax rates are anticipated to increase, there is no way to know how much and who will be most affected.   There is going to be the temptation (and pressure) for some to convert the entire balance of a Traditional IRA.  The thing to remember about a Roth conversion is that it is considered a distribution from a Traditional IRA and thus a taxable event.  So there could be some unintended consequences such as pushing you into a higher marginal tax bracket and also a phaseout of certain allowable deductions.  It could also have tax consequences for those that are already collecting Social Security by potentially making that income taxable in the year of conversion.  It is also important to be careful on conversions of annuity accounts.  The present value of the annuity’s riders, or additional benefits, could be added to the conversion amount.   The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) will permanently eliminate the limits, so it is not expected to be a one year opportunity.  Early conversions have some advantages due to the extra time for potential growth in the account, opportunity to recharacterize the conversion, and ability to spread the tax payments over a two-year tax filing period.  But it may make sense to do partial conversions to limit the impact in any one year as well.   The key takeaway is that it is vitally important to do the math first before doing any conversions.  As my wife reminded me over the weekend while I was hanging some pictures:  measure twice, drill once.

Friends Don’t Let Friends…

Friends don’t let friends buy gold coins in their IRA.  We’re not sure exactly where the push is coming from, but several clients have asked us recently about buying gold coins within their IRA.  This may be a good strategy if you think that civilization is coming to an end and we will be living in a permanent Renaissance festival.  The problem with buying actual gold coins is that you are going to have to pay someone to store them and then also figure out how (and who) you are going to sell them to at some point.
 
There are better ways to get exposure to gold within your investment portfolio if that is your desire.  Even then we would not recommend more than a 5-10% allocation at the most; use for portfolio diversification, not speculation!  You never want to be purchasing anything out of fear which is how some brokers and purveyors are positioning their sales pitch.
 
The falling value of the dollar and worries of potential inflation are also stoking the flames of worry.  What’s interesting is that the dollar actually rose in value during the financial crisis last year as investors around the world were searching for a safe haven, still proving the U.S. dollar’s status as a reserve currency.  There are many reasons for the recent drop in the value of the dollar versus other currencies, with low interest rates being one of them.  In a recent Barron’s article the argument was made that the U.S. economy could handle short-term rates of 2% (versus the virtual 0% for T-Bills right now).  We are seeing the extremely odd juxtaposition of some money market funds offering higher yields than 2-year CD’s.  Normally you receive a premium for locking up your money versus immediate liquidity.
 
The continuation of extremely low interest rates in the U.S. is finally forcing savers out of cash positions and into other asset classes in an attempt to achieve some rate of return.  Stocks, bonds and gold have all risen double digits over the last three months; this has only happened twice before in the past 50 years, both instances in the 1980’s.  No matter what happens, it is still important to maintain proper portfolio diversification and make rational decisions rather than fear-based ones. 
 
If you are interested in a smarter way to add alternative asset classes such as gold to add additional diversification to your portfolio, please don’t hesitate to contact us for more information.  

Warren Harding and The New Normal

You will be hearing (or have already heard) of the popular new economic buzzword/phrase, the new normal.  This has been coined to describe the type of economy that we are expected to see going forward.  Most of the ink written about this subject suggests two distinct possibilities:  One possibility is a world economy which returns roughly to its pre-crisis rate of growth, without regaining the ground that was lost (this is what typically has happened after financial crises).  The other possibility is that growth stays at a permanently lower rate, with investment, employment and productivity growth all more feeble than before.  

The difference between these two outcomes is rather large; the higher growth outcome will only be achieved if policymakers can do enough to stabilize financial markets and promote free trade without putting in too many burdensome regulations; and also without promoting policies that are politically popular but do not allow economies to reinvent themselves and replace dwindling industries with new thriving ones.  Protectionism and lack of R&D (research and development) are real dangers to a growing world economy. 

But getting back to the new normal term, what exactly was the old normal?  Warren Harding said that normalcy is what people call normality when they no longer take it for granted.  Looking at normal from a statistical viewpoint (my academic background) means that the expected outcomes from a process or event will take the shape of a normal distribution (the bell-shaped curve with the line for average/mean when graphed).  If you can determine the shape of the distribution, then it is easier to describe/predict. 

Over the long-term, the economy and financial markets may indeed be normal but the difficulty is that a person’s lifetime is rather short, and the relevant time period may not be normal since it consists of only a relatively small sample size.  So what to do? 

There are four items within our control:  How long we work, how much we spend, how much we save, and how we allocate our assets.  All of these elements are critical data for creating a financial plan. 

Within our process, there are four major topics that we cover; two are definitely normal, one is for the abnormal and one that is everywhere in between.  The two normal (and certain) items are Death and Taxes, these are covered through proper Estate Planning and Tax Management.  Risk Management is for the abnormal things that may occur (the outlier events) which can wreak irreparable harm if not provided for via some type of insurance coverage or other contingency plan.  Proper Investment Management is critical for any environment, whether considered normal or not. 

Have an old normal week. 

Source(s):  A “new normal” for the world economy.  The Economist, October 3^rd-9^th 2009, page 11

Boys of Summer

I want to take the opportunity to congratulate the Gwinnett Braves on a very successful and memorable inaugural season.  I made the decision to buy season tickets as soon as I heard the Braves’ AAA team was moving to Gwinnett, especially since the new stadium was going to be close by in Buford/Lawrenceville.  This probably was not the most financially sound decision since we ended up attending only about half of the games; weekday games were tough, made all the more challenging by accommodating the needs of 3- and 1-year old boys.  But it’s one of those deals where the time spent with your loved ones is something that you can never regret.  So there was some sadness when we found out their playoff run came to an end over the weekend. 

This does, however, afford me the chance to integrate two of my passions, baseball and financial planning.  A professional baseball game has nine innings and it’s not too big of a stretch to imagine someone’s lifespan consisting of nine innings as well, where each inning represents a decade. 

The ideal strategy in a baseball game would be knock out the opposing team’s starting pitcher early on by putting some runs on the board.  Getting ahead early puts pressure on the other team, forces them to use relief pitchers and puts you in a better position to ultimately win the game.  It is extremely difficult to come from behind in a modern day professional baseball game, given the way that specialized players for pitching and defense are used.

This has some obvious parallels with financial planning, where putting away money early on in life leads to a compounding effect that puts you in a much better position in the later years (or innings).  This is easier said than done and most headway is usually made in the middle innings, 40s-60s.  It is also difficult to come back if you fall behind in financial planning; you are left relying too much on market returns or some other risky strategy to make up the difference.  The question then becomes, how many runs are going to be enough, and how long is the game going to last?  

This is where financial planning really comes in to play; making sure that the best players take the field and are ready to step in when called upon.  The savings and investment accounts are going to do most of the heavy lifting when it comes to putting runs on the board and playing defense.  However, the game can be cut short due to unexpected circumstances or it can also go into extra innings.  It is this variability that makes planning so difficult, and why additional players (in the form of insurance) are needed to come off the bench. 

As circumstances change, the team and strategy need to be reevaluated.   One of the most interesting things about the game of baseball is that it is a team sport comprised of individual battles, opportunities and decisions.  When you look at the entire spectrum of a financial plan, it is also made up of individual battles, in the form of daily financial decisions, which taken together decide the ultimate outcome. 

We are here to help our clients make smarter decisions throughout their lifetime.

Jobs Pipeline Backing Up

I read a recent article in The Economist which illustrated the disproportionate impact this economic downturn has had on young workers.  This group has always had a lower percentage of participation in the workforce due to the fact that many are still improving their skills through pursuing a college education, etc.  But unemployment in this age group has risen sharply recently. 

There are several possible reasons for this increase.  The first and most obvious reason is the economic recession which we are currently working through in the U.S.  This has certainly impacted businesses that typically hire new entrants into the workforce.  Another reason is the increase in the minimum wage; increasing the minimum wage makes it more costly for businesses such as fast food, retail stores, to hire additional employees so most are trying to get by without that extra body that they may have been able to afford in the past.

In addition, we could also be witnessing the effect that longevity and poor retirement planning are having.  Workers at the other end of the spectrum are choosing to stay in the workforce, either out of necessity or out of an interest to stay active and engaged.  This is potentially crowding out younger workers due to seniority and also a lack of general work experience.

What happened in the equity and fixed income markets over the past year has caused many people to reconsider whether they can now afford to retire.  It has also caused some that retired to move back into the workforce to supplement their income, now that they are trying to live from a much smaller nest egg.  Add low interest rates on top of a reduced balance and it has become difficult to generate significant income from a portfolio of financial assets.

To avoid becoming someone who is forced back into the workforce when you are expecting to “finally enjoy life”, it is more important than ever to take control of your finances and create a plan for financial independence.  Long gone are the days when you could expect the company you work for to take care of you in retirement, and government programs will only supply a small income, if any.  The traditional 3-legged stool model of retirement security has been replaced by a ladder; a ladder which is built upon your ability to manage both your human capital and financial capital throughout your lifetime.

Saving for College

The beginning of another school year is a reminder to parents, grandparents and caretakers that their kids/grandkids are getting older and will sooner than you realize (if not already) be heading off toward college.  The question is what tools are available to help prepare for that event, at least financially?  

While there are several choices available, each with unique pros and cons attached to the particular type of account or plan, the one which has been growing the most quickly over the past several years has been the Section 529 plan.  So I am going to outline the basics of a Section 529 plan for you.  

Most of these plans are state-sponsored plans and are now available in most every state.

There are two types of these plans; one is a prepaid tuition plan which lets you lock in future tuition at certain universities at today’s rates.  The other is a qualified tuition plan; the qualified tuition plan is typically going to be the more attractive type since it allows for much more flexibility. 

University of Illinois - Altgeld Hall

Contribution Limits:  Depends upon the state program, but the IRS has ruled that contributions cannot exceed 5 times the average cost of covered institutions.  The Georgia limit right now is $235,000. 

Who can contribute:  Anyone. 

Tax Benefits:  Earnings are tax-deferred and withdrawals are tax-free if used to pay for qualified educational expenses.  Contributions may be tax-deductible at the state level under certain income limits.  

Qualifying Expenses:  Tuition, fees, books, supplies, room and board, and equipment required for enrollment or attendance at a college eligible to participate in federal financial aid. 

Financial Aid Effect:  Treated as parents’ assets. 

Estate Tax Treatment:  Contributions are completed gifts and will be removed from the donor’s estate in most instances. 

Investments:  Donors cannot make any direct investment decisions, as they must select from a list of investment options.  This is why the options are typically professionally managed mutual funds.  Choices can be made between which state plan to use and changes can be made between options annually (exception for 2009 where two changes can be made). 

Withdrawals:  Withdrawals not used for education expenses are subject to a 10% penalty tax, and earnings are included in the gross income of the recipient.  Amounts may be rolled over to another beneficiary from the same family (broadly defined) without penalty. 

Hidden Costs:  Varies by state but may include a fee to establish an account, account maintenance fee, and asset management fees. 

A Section 529 Plan is a great option for saving for college and can be established by anyone for a child’s (or your own) benefit.  When considering a 529 Plan account, it may make sense to first look at your own state’s plan to see if it is competitive from an investment and fee standpoint.  If not, then there are several good alternative plans to choose from.

We still advocate saving for your own retirement goals first before putting yourself at financial risk by funding college instead.  Please don’t hesitate to give us a call if you would like to discuss saving for a child’s college education and we will be happy to inform you of all of the alternatives in addition to a 529 Plan.

Happy schooling!

Temporary Tax Benefits and Market Benchmark Review

“Cash for Clunkers” has been the most talked about of temporary government tax benefits/stimulus programs, but it is not the only one of which to be aware.  The American Recovery and Reinvestment Act (ARRA) stimulus bill offers several other important tax benefits in 2009 and 2010.  Three of these are the First-time Homebuyer Credit, Sales Tax Deduction for new vehicle purchases and American Opportunity Credit.  I have outlined some of the details below:

 

First Time Homebuyer Credit

First-time Homebuyer Credit

• Targeted at young adults who haven’t owned a home before and whose income falls below $75,000 (for individuals) or $150,000 (for married couples).
• $8,000 tax credit for homes purchased after 12/31/2008 and before 12/1/2009.  It is actually a credit of 10% of the purchase price, to a maximum of $8000.
• You can help children and grandchildren take advantage of this credit.  As long as the home is in the child’s name and the child lives in the home, parents can help with financing and even make the mortgage payments; the child, however, is the one who receives the credit.
• You can claim the $8000 credit this year.  If someone qualifies and purchases a home in 2009, they can file an amended return for 2008 and get the money back now instead of waiting until they file their 2009 return.  This was part of the stimulus bill so it is an attempt to get the economy stimulated as soon as possible.
• More details:
  • The credit does not have to be paid back.
  • The credit is refundable (the government will issue a check for difference over tax bill).
  • Escrow must close before 12/1/2009.
  • The home cannot be purchased from a close relative.

 

New Vehicle Sales Tax Deduction

Sales tax deduction for new vehicle purchases

• Vehicle must be purchased after 2/16/2009 and before 1/1/2010.
• The deduction is limited to the tax on up to $49,500 of the purchase price of an eligible vehicle.
• There is no limit on the number of vehicles that may be purchased.
• The deduction is phased out for individual with modified AGI between $125,000 and $135,000; and joint files with MAGI between $250,000 and $260,000.
• The deduction may be taken regardless of whether a taxpayer itemizes deductions; it may be added to the standard deduction.
• It is taken on the 2009 tax return.
• Purchases made in states without a sales tax also qualify.  The deduction is based on fees or taxes assessed on the purchase of the vehicle and must be based on the vehicle’s sales price or as a per-unit fee.

 

American Opportunity Credit

American Opportunity Credit

• This is for people (or parents of) paying for college.
• The amount of the credit is 100% of the first $2000, plus 25% of the next $2000, spent each year on tuition, fees and course materials, for a maximum credit of $2500.
• The credit applies to all four years of college.
• The credit phases out for individuals with MAGI of $80,000 to $90,000, and for joint filers with MAGI between $160,000 and $180,000.
• The credit cannot be claimed for any expenses paid using funds from other tax-preferred vehicles, such as 529 plans and Coverdell savings accounts.
• On a related note, the ARRA expanded the definition of qualified higher education expenses for 529 plans to include expenses for computer technology and equipment or Internet access and related services.  This applies to 2009 and 2010 only.

Market Benchmarks

This week I want to take a moment to review how the markets have fared, as measured by some of the most commonly reported indices, both year to date and since 3/6/2009 which appears to be the most recent low point.  These indices can sometimes serve as gauges for certain portions of the securities markets and also as a measurement of the general level of stock prices.

These can serve as certain indicators of the overall market’s health, but the more important measurement for anyone’s investment portfolio is whether or not they are on track to meet their own personal financial planning goals.  With that distinction in mind, following are how some of the more common stock and bond market indices have performed, listed in three columns (Performance Year to Date, since 3/6/09, and description):

 Year to Date    Since 3/6/09   Description

+10.97%         +45.99%         S&P 500

+4.50%           +39.08%         Dow Jones Industrial Average

+11.66%         +46.50%         Dow Jones Wilshire 5000

+17.95%         +53.86%         S&P Mid Cap 400

+11.07%         +60.23%         S&P Small Cap 600

+17.81%         +55.16%         MSCI Developed EAFE

-7.22%             +62.16%         Wilshire REIT

+10.27%         +12.40%         Barclays US Aggregate Credit Bond

+0.09%           +0.07%           Citigroup 3-Month US Treasury Bill

While the stock market returns since the low in early March have been spectacular, it is important to remember that there is still a long, long way to go to reach the high points that were achieved in October of 2007.  It would take another 50% return from here to get us there.

S&P 500:  Value-weighted index of the 500 largest publicly-traded U.S. companies.  DJIA:  Price-weighted index of 30 of the largest publicly-traded U.S. companies.  DJ Wilshire 5000:  Market capitalization-weighted index of the market value of all stocks actively traded in the U.S. (6300+ components).  S&P Mid Cap 400:  Index of 400 U.S. stocks with market capitalizations between $2 billion and $10 billion.  S&P Small Cap 600:  Index of 600 U.S. stocks with market capitalizations under $2 billion.  MSCI Developed EAFE:  Index of stocks from 21 developed markets/countries, excluding the U.S. and Canada.  Wilshire REIT:  Index of publicly traded real estate securities.  Barclays US Aggregate Bond:  Market cap-weighted index of U.S. traded investment grade bonds (excluding munis and TIPS).

Debt Management Ratios

One of the primary reasons for the financial market collapse and economic turmoil from last year is the large amount of debt that has been accumulated at all levels of society:  personal, corporate and government.  The relative ease of obtaining credit and our natural needs, wants and desires worked together to fuel the U.S. economy over the past several decades.  Everything worked great as long as the underlying assets (mostly real estate) continued to rise in price to serve as collateral for the increasing amount of borrowing.  

Long-held debt management ratios seemed to get put by the wayside by both borrowers and lenders, with too much focus being placed on getting the lowest monthly payment (with no heed to other vitally important details such as interest rates, repayment terms, etc.).  Also credit scores took on much greater prominence with lenders not taking into account all the potential sources of credit which someone could access.  So I think it is important to get back to outline some of the traditional rules of thumb regarding the use of debt:

• Consumer debt payments should not exceed 20% of take-home pay.  Consumer debt refers to credit card payments and other installment loans, such as for an automobile or major appliance.
• Monthly mortgage payments should not exceed 28% of gross income or one week’s take-home pay. 
• Monthly payments on all debt should not exceed 36% of monthly gross income. 

As an example, on $50,000 of gross annual income, the maximum mortgage payment should be $1166.67/month (28%).  This can buy a really nice house in most parts of the country.  But if someone went that high with the mortgage, the consumer debt payments should be kept to $333.33/month (36% of gross when combined with the mortgage). 

It’s important to understand that there is a balance of objectives and decisions need to be made about which is more important:  having a larger, more expensive home or having expensive toys?  Lenders may have different ratios than what I have listed above, but these will generally keep you out of too much trouble.

Dregs of Society

Andrew Crane and I had quite an interesting morning yesterday at the Caribou Coffee in the Forum shopping center next to our offices. 

We noticed this guy at the table next to us who was getting rather animated, clearly extremely agitated, and seemed to be directing some comments toward us.  While we made the crucial mistake of attempting to engage him to figure out what in the world was going on, he started putting away his laptop into his backpack. 

Then he begins asking, more like yelling, “Do you know Greek?  Do you know Greek?”  I tried to respond that I knew some of the alphabet from my math classes but he clearly didn’t care at this point or was not expecting an actual answer.  So he yells “Parakletos!!  Parakletos!!” 

We were quite stunned and not sure what to make of this individual; we both somehow managed to contain any laughter, and waited to see what might happen next as it appeared as though he might actually get physical.  We asked what does Parakletos mean and he just uttered an expletive with a profanity and finally left the building; although he continued to glare at me all the way to his car which was a gold Chrysler 300.

It didn’t dawn on me until later that maybe he had read my previous blog about Greek triremes and investing and thought I actually knew some of the language.  In any event, it was a genuine “wt…?” moment which brought me back the good old days of late night MARTA rides from the Georgia State campus while working on my Masters degree.

Then I started wondering to myself, “OK, what if it had actually turned physical?”  How hilarious would that have been for the patrons to see a scuffle in the Caribou between supposed professionals first thing on a Monday morning?  Maybe it was an experiment to ramp the coffee drinking experience up a notch in order to boost some business.  One thing it certainly did was to reinforce my personal preference for soda over coffee, that’s for sure.

You CAN Take it with You

One important consideration when making a job change is what to do with the money you have saved in your former employer’s retirement plan.  There are four options available: 

1. Take Money Out of the Plan.  This is probably going to be the worst possible option.  Not only will you have to pay ordinary income taxes on the entire amount of the distribution, but also an additional 10% penalty if taken out prior to age 59½.
2. Leave Your Savings in your Former Employer’s Plan.  Although preferable to taking a distribution, this is generally not the best choice.  If you no longer want to work there then why force your money to stay?  This would be a good option only if the employer’s plan is truly exceptional, with a wide variety of investment choices and simple and inexpensive administration of the plan.
3. Move Your Savings to your New Employer’s Plan.  If your new employer’s plan will accept a rollover into the plan, then this is another option available.  Similar to leaving it in your old plan, you want to be sure that you are moving it to a truly exceptional plan.  This option will allow you to keep everything in one place once you are able to participate in the new plan but may not be the best choice.
4. Rollover to a Traditional IRA.  An IRA rollover is an effective way to keep your money accumulating tax deferred and provides several advantages when compared to the other options, the greatest advantages being choice and flexibility.
   

   Smart guy with his retirement nest egg

     

By utilizing an IRA Rollover, you can transfer your retirement savings to an account at a private institution of your choice and you will be able to choose how to invest the funds.  There are two ways to effect an IRA Rollover:  you can either do what’s called a direct rollover (the preferred method) or you can rollover the balance after taking a distribution from your former employer’s plan.  The direct rollover is preferred because it will allow you to avoid potential penalties and a 20% automatic tax withholding from your former employer’s plan.  Also, with the other method you only have 60 days to have the funds deposited into the IRA once the distribution is made and you have to make up for the 20% withholding and 10% penalty from your personal funds.

Most employer-sponsored plans have a limited number of investment options available, whereas an IRA can be custom-tailored to your particular needs and goals.  Also, if you have multiple accounts sitting with former employers, they can all be consolidated into one IRA for easier management and better control of your assets.

Earnings in a traditional IRA will grow tax deferred until distributions are made.  Distributions from a traditional IRA are taxed as ordinary income and may be subject to an additional 10% federal income tax penalty if taken prior to age 59½.  Just as with employer-sponsored retirement plans, you must begin taking required minimum distributions from a traditional IRA each year after you turn age 70½.

For early retirees, there is something called a 72(t) where you may be able to take substantially equal distributions to assist with retirement income needs.  There are several methods for calculation.  The rules state that once started, you must keep receiving these distributions for a period of five years or until age 59 ½, whichever is longer.