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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.

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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.

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Optimal decisions under price dynamics for Roth conversions

As the April 15th tax deadline approaches, many retirees may be considering the trade-offs associated with Roth conversions. Seeking optimal decisions can be challenging! In this post, we highlight a peer-reviewed journal article recently published in the Financial Planning Review and add to our previous discussion on this topic.

Optimal decisions under price dynamics for Roth conversions
“Optimal decisions under price dynamics for Roth conversions”
James A. DiLellio, Philip M. Goldfeder, Edward F. McQuarrie

Timing your tax payments

Ordinary income taxes may occur during retirement from tax-deferred account distributions, like withdrawals from a 401(k) plan. However, by conducting a Roth conversion, a retiree can move these tax-deferred assets to a Roth account where future withdrawals are generally tax-free. But, to do so, they may owe taxes on the distribution. There are other rules too. For example, retirees may not convert required minimum distributions. Nevertheless, many financial planners consider Roth conversions when a client’s taxable income is unusually low, thereby taking advantage of lower tax rates in our progressive tax system.

Key Insights

This article provided many important insights when seeking optimal decisions on Roth conversions.

  • If funding the Roth conversion from retirement assets, the conversion will be solely dependent on future tax rates. Thus, the conversion will have a positive (negative) payoff if future tax rates are higher (lower) than the rate paid to convert.
  • If funding the Roth conversion from non-retirement taxable assets, the cost basis of these assets plays an important role. So, the lower the cost basis of these assets used to fund the tax liability caused by the conversion, the less likely that a positive payoff will occur.
  • Using non-retirement assets to fund the Roth conversion’s tax liability also creates a payoff dependent on market returns. Stronger market returns lead to a greater payoff. Also, the calculus of this optimal decision changes significantly whether the non-retirement assets will ever need to be used by the retiree, or if they will receive a step-up in cost basis when left to an heir.
DiLellio-Goldfeder-and-McQuarrie-2023-Optimal-decision-under-price-dynamics-for-Roth-conversion-FPR

The bottom line on optimal decisions for Roth conversions

Making an optimal decision on converting tax-deferred retirement funds to a Roth IRA is not simple. As the results of this research show, there may be situations where it is worthy of consideration. But, there are also many scenarios when Roth conversions should not be pursued. Not sure how it may affect your situation? Our optimal retirement income calculator now includes a Roth conversion analysis. And, you can try it for free!

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AI and the S&P 500

Artificial intelligence (AI) continues to impact markets like the S&P 500 in 2024. If you are already invested in broad-based ETFs, you may be invested in AI, whether you realize it or not. In this post, we discuss how AI companies are influencing cap-weighted indices.

close up photo of monitor
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Fear of Missing Out

Jason Zweig at The Wall Street Journal recently wrote an article about one of the leading AI companies Nvidia. In his article, he noted how this company was now more than 4% of the S&P 500 index, thanks to its recent rise in share price.

And, other companies working in the AI space are also seeing very positive share price increases, like Microsoft. In fact, according to this page on ETF.com, Microsoft and Nvidia now account for about 11.5% of the S&P 500 index. This weighting of AI in the S&P 500 is due to the S&P 500 being a “cap-weighted” index.

A stock market index wherein each component is weighted relative to its total market capitalization

What is a Capitalization-Weighted Index? source: Corporate Finance Institute (CFI)

So, even if an investor thinks they may have “missed out”, they have not if they owned an S&P 500 ETF or some other cap-weighted index fund.

Other firms in the S&P 500

Because the S&P 500 is cap-weighted, the firms in this index become more (or less) significant as their market capitalization increases (or decreases). The image below shows the current top-10 holdings in the S&P 500 ETF (ticker: IVV). Note that over half of those in this list are tech firms that are at the forefront of AI. In fact, for investors in Apple, there may not be enough investment in AI.

Top 10 holdings in the S&P 500 ETF IVV. Source: etf.com
Top 10 holdings in the S&P 500 ETF IVV. Source: etf.com

ETF investor options to embrace or avoid AI

Hopefully, ETF investors realize that they may already have AI investments, if they are invested in one of the ETFs tracking the S&P 500, like VOO, IVV, or the oldest ETF SPY. Alternatively, ETF investors wishing to embrace AI more may seek tech-centric ETFs, like XLK. Or, by seeking dividend-paying stocks not seeking growth from AI, an ETF investor may seek funds like DVY or VTV. Investor preference for growth in the AI space will likely affect investments for many years to come.

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2023 ETF Year in Review and 2024 Outlook

The 2023 year was generally good for the stock market. We wrote previously about the possible market performance during the 3rd year of a presidential term, and 2023 didn’t disappoint. The total return, including dividends, for the S&P 500 ETF (ticker: IVV) was 26.3%, according to ETFReplay.com. However, 2023 ETF equity returns varied significantly across the eleven S&P 500 sectors. We will dive into these sectors in this post.

2023 ETF Returns by Sector

The chart below shows the total returns in 2023 for the 11 sectors in the S&P 500. As we can see, two sectors beat the S&P 500. These were the technology and consumer discretionary sectors. Artificial intelligence was a big theme in 2023 thanks in part to ChatGPT, which explains why the technology sector did so well. Consumer discretionary returns could be explained by continued pent-up demand as the impact of the global pandemic diminishes.

2023 ETF returns
2023 S&P 500 Index and Sector Total Returns.
Source: etfreplay.com

Unfortunaltely, nine sectors of the S&P 500 performed worse than the overall index. Industrials, materials, financials, and real estate did produce double-digit returns, but still underperformed the index. Also, health care, energy, consumer staples, and communication services all were nearly flat for the year. The worst-performing sector was utilities, likely due to the high levels of debt many utilities carry and how refinancing this debt in 2023 likely became much more expensive.

2024 ETF Outlook

So, where will markets go from here? Referring back to the presidential cycle analysis quoted above, the 4th year of a presidency is the second best for total returns of the S&P 500. The political uncertainty associated with year four of a presidential cycle is likely to blame. Many investors may want to see how elections this fall turn out before making larger investment decisions. And, investors may also be looking for indications from the Federal Reserve on future decisions on interest rates. Regardless of what happens on these fronts, 2024 is looking to be a very exciting year for ETF investors.

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Required Minimum Distributions in 2024

Happy New Year! In this post, we discuss some of the salient features of required minimum distributions (RMDs) for those in or nearing their retirement. We also provide a proactive tax-efficient strategy to help reduce the impact of RMDs.

required minimum distributions
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What is an RMD and how does it apply to me?

As their name implies, required minimum distributions (RMDs) are amounts that need to be withdrawn, or “distributed”, from a retirement account. The retirement accounts that impose RMDs typically include those with pre-tax contributions and gains, such as 401(k), IRAs, and 403(b) plans.

Required Minimum Distributions (RMDs) are minimum amounts that IRA and retirement plan account owners generally must withdraw annually starting with the year they reach age 72 (73 if you reach age 72 after Dec. 31, 2022).

U.S. Internal Revenue Service FAQs

The amount of the RMD depends on the account holder’s age, assuming they did not inherit the retirement account. As the retiree ages, the proportion of RMD distributions, relative to their total account value, increases. For example, a retiree expected to live another 20 years based on the IRS life expectancy tables must withdraw 1/20th (or 5%) of their account value to satisfy RMDs. 

Note:  This post has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Implications and Strategies for Tax Efficiency of Required Minimum Distributions

As this recent WSJ article articulated, there are several implications to RMDs on a retiree’s tax liabilities. First, after a strong year of market returns, RMDs will be even higher due to larger retirement account balances. These higher account values and subsequent RMDs could also push the retiree into a higher tax bracket. Lastly, RMDs could also trigger Net Investment Income Tax (NIIT) as well as higher Income-Related Monthly Adjustment Amounts (IIRMA).

A simple strategy to increase tax efficiency in retirement income is to plan for the future, and not always defer distributions from tax-deferred accounts, like IRA and 401(k) plans. We demonstrated in our award-winning peer-reviewed published manuscript how such a tax-efficient approach can produce 0.3% to 0.6% of additional return for a variety of retirees. Is similar planning beneficial to your situation? To find out, we encourage you to try out our retirement income planning tool recently updated for 2024 tax brackets.

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Tax Loss Harvesting

As 2023 heads to a close, many investors are considering whether to sell investments at a loss, often referred to as tax loss harvesting. In this post, we explain this tax opportunity and the financial benefit possible from it. We also describe a pitfall that investors should avoid to achieve the benefit of tax loss harvesting.

notebook and calculator on green surface
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Short-term or long-term?

Why is tax loss harvesting important? To begin, ETF investors must understand the difference between short-term and long-term gains or losses. An investor realizes a short-term loss when they sell an ETF held for less than one year. In general, taxes on losses on short-term investments in securities like ETFs occur at a higher rate than those gains realized from short-term investments. For taxpayers at the highest rates, the short-term rate is 37%, and the long-term rate is 20%.

So, if an investment is below its purchase price within one year of holding it, an investor can sell it and realize a short-term loss. This short-term loss can be deducted from any short-term gains, like those from bond or money market investments. Consequently, an investor’s income tax may be reduced.

Pitfalls

The most obvious pitfall is the wash sale rule. Investors may not obtain a tax benefit if they sell an ETF for a loss within 30 days, and then rebuy it. Consequently, such a violation eliminates the opportunity for tax-loss harvesting. Investors wishing to stay invested in the markets can opt to buy a different ETF that is not “substantially identical” and not wait 30 days.

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