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Always defer taxes in retirement?

Tax-deferred accounts avoid annual tax payments during our working years. Workers who defer taxes in accounts like 401(k)s accelerate growth for many years. However, distributions of retirement income from these accounts usually contribute to a retiree’s ordinary income for that year. So, these distributions are taxed much like wages are during our working years. This recent article in the WSJ highlighted that there are reasons to think more strategically about continuing to defer taxes in retirement.

Defer taxes in retirement?
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“To be sure, the idea of accelerating income violates the first rule of traditional tax planning, which is to defer taxes whenever possible. But there are reasons to rethink this rule now. “

Laura Saunders, 31 January 2025, “When Paying More Tax, Not Less, Is the Smart Play“

We couldn’t agree more! In fact, we made this and other salient points in our award-winning article entitled “Seeking tax alpha in retirement income“. We supported our observations and conclusions through rigorous mathematical modeling of tax laws most relevant to retirees in the U.S.A.

Seeking tax alpha in retirement income

In this post, we highlight this recent news article. We then provide a suggestion on how an individual or financial advisor may improve their retirement income strategy.

Time horizon

A key flaw in deferring taxes is that many retirees need to look at a longer time horizon. Currently, a 65-year-old male retiree can expect to live another 18 years. Similarly, a 65-year-old female retiree can expect to live to 21 years more. So, unless a retiree has some known terminal illness or other significant health issue reducing their life expectancy, tax-efficiency in retirement can take advantage of this time horizon.

Termed “stealth” taxes, tax-deferred account typically force retirees to begin taking requried minimum distributions (RMDs) at age 73. These distributions only grow, as a percent of a tax-deferreed account value, due to a shorter life expectancy for each year a retiree ages. Along with other factors, like the widows-penalty when a surviving spouse files their tax returns as a single, net-investment income tax, and income-related premiums for Medicare, these RMDs can be tax inefficient.

When you may not want to defer taxes

Unfortunatley, there is no single decision that a retiree can make to maximize their tax efficiency. But, for retirees with significant assets in tax-deferred accounts, the algorithms in our article “Seeking Tax Alpha in Retirement Income” are available online. We encourage you or your financial advisor to try our free online calculator. With it, you can see the amount of tax efficiency potentially available by accelerating tax-deferred distributions and avoiding RMDs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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2024 Year-end returns of broad index and sector ETFs

With 2024 officially over, it is a good time to reflect on 2024 equity ETF returns. Like our mid-year post from 2024, this post highlights the top and bottom-performing ETFs by sector. We’ve added the Nasdaq-100 ETF (ticker: QQQ) 2024 returns for comparison. We also discuss what themes likely contributed to this performance.

S&P 500 Sector Returns, S&P 500 and Nasdaq ETF total returns, 2024

Top and bottom-performing sector ETFs for 2024

As the chart above shows, communication services (ticker: XTL) was the top-performing sector ETF of 2024, with a nearly 35% return. This may be surprising, given it was the worst-performing sector ETF in the 1st half of 2024. It appears that this ETF’s exposure to artificial intelligence (AI) and data centers contributed significantly to its total return for 2024. The healthcare sector ETF (ticker: XLV) was the worst-performing sector of the S&P 500 index. Considered a more defensive sector, investors were not looking for this approach in 2024. However, lower prices in the healthcare sector, relative to other sectors in the S&P 500, may bode well for healthcare ETF investors in 2025.

The S&P 500 has another strong year in 2024

For ETF investors who selected the broad-based S&P 500 index (ticker: IVV), this was another strong year, with a total return of nearly 25%. The past two years have been the best returns for this broad-market index in the past 25 years. So, investors looking for a diversified equity ETF did well in 2023 and 2024 by investing in an S&P 500 index ETF.

S&P 500 Index performance since 1995. Source: WSJ.

2025 ETF Outlook

As we noted in previous outlooks at the start of the year, there is plenty of uncertainty going into 2025. With a new political party in the White House, and the Fed still considering the potential of future rate cuts, 2025 should be another challenging year for ETF investors.

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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The biggest ETF may be changing

The largest and oldest ETF is the SPDR S&P 500 ETF Trust (ticker: SPY), with $624 B in assets under management. However, two other S&P 500 ETFs are close behind. The Vanguard S&P 500 ETF (ticker: VOO) and iShares Core S&P 500 ETF (ticker: IVV) have $588 B and $582 B of assets under management. In this post, we discuss the likely change in the largest ETF, what may be contributing to it, and why it matters to investors.

In this post, we discuss the likely change in the largest ETF, what may be contributing to it, and why it matters to investors.
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The oldest ETF, SPY

The SPDR S&P 500 ETF Trust, commonly referred to as SPY, has been around the longest of any ETF. With an inception date of January 1993, SPY created an entirely new way to invest in a passive index that offered greater tax efficiency than mutual funds. As we wrote about a few years ago, the taxable gains between ETFs and mutual funds can be significant. This tax inefficiency makes no difference for Individual Retirement Accounts (IRAs). But for taxable account holders, significant tax drag is drawing investors into ETFs. Several mutual funds are converting to ETFs.

The two other S&P 500 index ETFs

ETFs from Vanguard and iShares also offer ETFs that track the S&P 500 index. This index is very popular with many investors as it diversifies across many equity sectors. But, because of its weighting by market capitalization, some companies hold more significant influence. Nevertheless, it remains a popular index for investors. And, with an expense ratio of 0.03%, these ETFs offer this exposure with very little cost. These expense ratios are in stark contrast to SPY, with its expense ratio of 0.09%. While still small, the expense ratio of SPY is 3X larger, helping VOO and IVV to grow faster than SPY.

Another driver of ETF growth

So, investors seem to be preferring lower expense ratio ETFs. VOO’s unique structure may also be contributing to its popularity. But, this benefit, which Vanguard patented, has expired in 2023. So, IVV and VOO may continue to grow at a similar rate. For individual investors, the small difference between the two ETF structures likely makes little difference in meeting their investment objectives.

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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Catch-up contributions to retirement plans

The IRS recently changed retirement savings plans, like 401(k) plans offered by many employers, for workers nearing retirement. Previously, workers 50 and over could make catch-up contributions. Starting in 2025, employees between 60 and 63 can increase these catch-up contributions by an additional 14%, according to this WSJ article. In this post, we discuss why many workers may want to take advantage of this new rule.

401(k) plan contributions

Employee contributions to 401(k) plans were originally established to encourage growing a nest egg for retirement. By contributing pre-tax income, workers could also reduce their current-year taxable income. For older workers who were unable to save earlier in their careers, these catch-up contributions can help retirees meet their savings goals. Also, as many workers enter their 50s, their income often peaks. So, the deferred taxes on 401(k) contributions may provide an added benefit if income is lower in retirement.

Retirement plan catch-up contributions change for 2025.
Retirement plan catch-up contributions change for 2025

Pre-tax or after-tax contributions to a 401(k)

Workers may also have an option in their retirement plan to contribute to a Roth 401(k) plan using after-tax contributions. While these contributions don’t provide the immediate tax deferral of the traditional 401(k) contribution, they do provide tax-free retirement income. Roth 401(k) contributions also help workers save after-tax dollars and avoid the income limit for direct contributions to a Roth IRA. To make a full Roth IRA contribution in 2024, single filers modified adjusted gross income (MAGI) must be under $146,000, and joint filers under $230,000. Alternatively, some workers and retirees may consider a Roth conversion. For large emergency expenses that may occur during retirement, such as medical-related expenses, retirees can use after-tax retirement savings in Roth accounts to avoid higher tax brackets.

Not sure what to do next with your catch-up contributions?

We offer a free simulator to see if you can reach your retirement savings goal.

Retirement plan catch-up contributions change for 2025.
Our free savings calculator simulates future market conditions to assess saving goals

You can use this tool to see how pre-tax or after-tax contributions may affect your future retirement savings. We hope you find this tool educational!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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Business leaders are cautious

Business leaders and other corporate insiders aren’t as optimistic as others who are contributing to strong market returns for 2024. Also, according to InsiderSentiment.com, their index continues to track below the long-term average. So, this post examines other possible contributors to lower optimism among business leaders, like Warren Buffett, Jamie Dimon, and Jeff Bezos.

business leaders have low sentiment
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The fourth year of a presidential cycle

As we’ve written about previously, the four years of a presidential cycle can have very different market returns. So here, we’ve updated the table below from this previous article, and included the upper and lower 95% confidence limits.

Presidential YearAverage Return (%)95% Lower Limit (%)95% Upper Limit (%)
16.7-2.115.6
23.3-4.911.5
314.06.621.5
46.70.612.9
Average Returns of the S&P 500 from 1928 to 2024. Data Source: www.macrotrends.net

So far, with the S&P 500 up about 21% this year, we are well above the upper limit for the 4th year of the Biden administration. Consequently, this statistical analysis suggests markets may trend back to their long-term mean.

Other factors at play for investors and business leaders

Of course, there have been other factors influencing investors recently. For instance, the Federal Reserve recently reduced short-term interest rates by 0.5%. Also, the monthly jobs report was stronger than expected. Lastly, seasonal hiring appears to be picking up ahead of a potentially strong demand this holiday season. Whether these factors hold until the end of the year is uncertain. And, many expect the presidential election result may also impact future market performance, along with whether the port workers strike again in the early part of 2025. Thus, only time will tell how the market responds to these factors of uncertainty.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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When a Roth Conversion May Be Right for You

A Roth conversion typically moves pre-tax funds from an Individual Retirement Account (IRA) to a Roth IRA. Doing so adds income to the year when account holders convert, so may trigger additional income taxes. But, future withdrawals from the Roth IRA should be tax-free. We’ve discussed some research on this topic before in our article published in the Financial Planning Review. Ed McQuarrie, Emeritus Professor from Santa Clara University just published another article on the topic. It now appears on page 76 in the September 2024 edition of the Journal of Financial Planning. This post will highlight the key findings in this important research related to retirement income and estate planning. We also highlight how our retirement income calculator aligns with these insights for a retiree’s particular scenario.

Roth conversion article by Ed McQuarrie entitled "Net Present Value Analysis of Roth Conversions"

New research contribution

Prof. McQuarrie’s research focuses on the Roth conversion’s Net Present Value (NPV). NPV is an important metric used to value projects, which states that discounted future cash flows must sum to a positive number to add value to the project’s owner. His journal article highlights when NPV turns positive based on the time since the conversion occurred,

Figure 2 from Net Present Value Analysis of Roth Conversions by E. McQuarrie, Journal of Financial Planning, Sep 2024.
Figure 2 from Net Present Value Analysis of Roth Conversions by E. McQuarrie, Journal of Financial Planning, Sep 2024.

As Figure 2 demonstrates, a positive NPV occurs when the retiree reaches age 86. More or less favorable assumptions about future tax rates can decrease or increase the time for NPV to turn positive, and this article highlights a few insightful examples.

Risks in future tax code and individual circumstances

The article continues by discussing several risks faced by a Roth conversion. For example, since the U.S. Congress sets tax laws, taxpayers will never know for certain what income tax rates may be in the future. The Tax Cut and Jobs Act (TCJA) that expires in 2025 may or may not be extended or modified in ways that are favorable to a Roth conversion today. Also, consideration of an heir’s tax rate is important for retirees who have excess funds they wish to pass on after their death. Heirs at lower tax brackets, and certainly heirs who are charitable organizations who may not owe tax on IRA bequests, may benefit more financially in receiving assets from an IRA rather than a Roth IRA. Conversely, a surviving spouse utilizing the standard deduction could significantly benefit from a conversion before the passing of their spouse.

How to assess a Roth conversion for your situation

Given all these complexities, a thoughtful analysis is important before making a Roth conversion. One approach is to use software, like our Retirement Income Calculator. And, given this latest research, there are many nuances to consider before conducting a Roth conversion. This research article nicely highlights four scenarios when a conversion is the least risky and four scenarios when they are most risky and is worthy of review for anyone considering a Roth conversion in the coming years.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs

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Stock and bond ETFs reverse recent trends

Economic data on the rising unemployment rate and corporate missed earnings appear to have contributed to the recent reverse of the upward trend in stock ETFs. This post explores this and other recent trends by highlighting selected ETFs that passively track major stock and bond indices.

NASDAQ market correction

As this WSJ article recently highlighted, the NASDAQ (ticker: QQQ) is officially in “correction” territory now. We define a correction as when prices drop by more than 10% from a recent high. Missed expectations from major investments in Artificial Intelligence by tech leaders Microsoft and Alphabet may have contributed. Nevertheless, the S&P 500 index ETF (ticker: IVV) is still up over 12% year to date, as the chart below illustrates. While returns for these two stock ETFs are lower than their mid-year peak, they are still good relative to other markets, like bonds.

Recent trends in stock and bonds ETFs.
Stock ETFs recently started a downward trend, but bond ETFs started an upward trend.

Recent trends in Bond ETFs

Investors appear to be quickly moving away from stock ETFs and into bond ETFs. This so-called “flight to safety” is clear in the image above in the recent upward trends in bond ETFs. The intermediate-term bond ETF, iShares Core U.S. Aggregate Bond ETF(ticker: AGG), shows some of this new trend. This trend is amplified when a longer-term bond ETF, like iShares 20+ Year Treasury Bond ETF (ticker: TLT), is viewed.

What is next?

The Fed left short-term interest rates unchanged after meeting this past week. But, a rate cut is looking more likely, as inflation is down to 2.5% now, edging closer to the Fed’s target of 2%. The Fed’s next meeting is in September, so investors will be eagerly awaiting the outcome of this important meeting. In the meantime, investors may continue to invest in bond ETFs to potentially hedge any additional losses in stock ETFs.

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2024 Mid-Year Review of Stock-Based ETFs

Welcome to our 2024 mid-year review of stock-based ETFs. Like our previous mid-year reviews, we will discuss here how various sectors of the market performed in the last six months using ETFs. Consequently, we will show a significant performance difference between various sectors of the S&P 500.

Review of the 11 Sectors of the S&P 500

To review, recall that there are 11 sectors in the S&P 500 as shown below. So, while some of these sectors have several ETFs tracking them, we choose the ETFs in parentheses due to their long history in the markets.

  • Information Technology (XLK)
  • Health Care (XLV)
  • Financials (XLF)
  • Consumer Discretionary (XLY)
  • Communication Services (XTL)
  • Industrials (XLI)
  • Consumer Staples (XLP)
  • Energy (XLE)
  • Utilities (XLU)
  • Real Estate (IYR)
  • Materials (XLB)

Then, using this list and reinvesting dividends, we see that some sectors had total returns that did very well in the first half of 2024. However, a couple sectors, such as the Real Estate and Communication Services, lost value in the first six months of 2024.

2024 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx
2024 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx

Best ETF investment performers of 2024

As the chart above shows, the technology sector continues to outperform the broader index. As our favorite WSJ writer recently described, the three largest stocks in the S&P 500 (Microsoft, Apple, and Nvidia) contributed more than 20% of the total market value of the index. In fact, eight of the top ten stocks in the S&P 500 index are technology stocks. This outperformance still appears to be attributable to the substantial investor interest in artificial intelligence (AI) and how this interest is impacting other sectors, like utilities.

Outlook

While we won’t try to estimate where markets will go from here, it does seem reasonable that stock-picking to beat the S&P 500 will continue to be challenging. Thus, the high concentration of technology stocks in this index continues to propel the performance of this market cap weighted index. As a result, if the technology sector does falter, the diversification of this index may help reduce volatility.

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Utility ETFs outperforming

Returns of utility ETFs have been particularly strong over the past three months, exceeding the returns of the S&P 500 index ETF by over 10%. Our favorite WSJ writer mentioned this situation recently, along with some explanations. In this post, we explore other aspects worth considering with utility ETFs.

What is in a utility ETF?

Several ETFs focus their holdings on utility companies. The largest is the Utilities Select Sector SPDR Fund (ticker: XLU), which is over twice as large as the next largest utility ETF, the Vanguard Utilities ETF (ticker: VPU). But, these ETFs track two different indices. XLU tracks the S&P Utilities Select Sector Index, while VPU tracks the MSCI US Investable Market Utilities 25/50 Index. Consequently, XLU has 31 holdings, less than half of the 67 in VPU. However, examining the top ten holdings in each ETF reveals they are very similar. So, not surprisingly, the year-to-date returns for both of these ETFs are identical, at 12.25%.

Top Ten Holdings of the two largest Utility ETFs, as of May 31, 2024. Source: etf.com

What is driving energy demand?

As Jason Zweig’s noted in his recent article, Artificial Intelligence (AI) may be playing a role. Training AI models are very energy-intensive. And, as we’ve written about before, the largest companies in the S&P 500 are actively involved in AI development. But, Maria Pope, CEO of Portland General Electric, believes there are three big drivers increasing electricity demand in the U.S.

  • Manufacturing returning to the U.S.
  • Government support of semiconductor production.
  • Data centers and their need to train and run AI models.

Will this demand remain elevated for the foreseeable future? And, how will the markets respond? ETF investors should consider these points when evaluating sector ETFs like those focused on utilities.

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Bond funds continue to challenge investors

Bond funds continue to challenge investors seeking less risk from the stock market, but also retaining buying power. My favorite writer Jason Zweig also wrote about this recently, along with many of his readers’ opinions. In this post, we illustrate what’s been happening over the last year since we last wrote about bond ETFs.

Bond funds and their time to maturity

Bond fund performance over the last year appears to still be heavily dependent on their time to maturity. As the image below shows, the total return of the shortest-term U.S. treasury bill ETF (ticker: BIL) was gradual and positive. The intermediate-term bond fund (ticker: AGG) nearly broke even for the last 12 months. The long-term bond fund (ticker: TLT) was most sensitive to rising interest rates and had the largest loss and most volatility over the past 12 months.

Shorter-term bond ETFs continue to perform well with low volatility. Source: etfreplay.com
Shorter-term bond ETFs continue to perform well with low volatility. Source: etfreplay.com

Bond ETFs with shorter terms to maturity

Staying with shorter-term ETFs has become much easier with several options for investors to consider. Here is a short list to consider:

  • SPDR Bloomberg 1-3 Month T-Bill ETF (ticker: BIL)
  • iShares Short Treasury Bond ETF (ticker: SHV)
  • Goldman Sachs Access Treasury 0-1 Year ETF (ticker: GBIL)
  • iShares 0-3 Month Treasury Bond ETF (ticker: SGOV)

Referring to the image above, we see that the SPDR Bloomberg 1-3 Month T-bill ETF returned 5.3%. And, as we have written about previously, this return is exempt from state taxes. This exemption is significant for states like California and Hawaii, but irrelevant for states like Texas and Florida that have no state income tax. In any case, with current inflation around 3%, these short-term investments are helping ETF investors to maintain and slightly grow their buying power.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs