In our posts from March and April, we discussed several aspects of Roth conversions. We showed that, if tax rates are higher in the future, Roth conversions can have a positive payoff. For tax-deferred assets, like pre-tax assets in a 401(k) or IRA, a retiree may pass some of these assets to an heir. The heir’s income tax rate determines the after-tax value of inheriting tax-deferred assets. This week’s post highlights the most recent software update made to our Optimal Retirement Income Calculator, which now includes Roth conversions and optimal withdrawals simultaneously!
How to model Roth conversions with Optimal Withdrawals
Roth conversions reduce tax-deferred assets by “converting” those assets in any year to a Roth account. Individuals performing a Roth conversion owe income taxes on the amount converted. But, the converted amount increases the individual’s Roth account assets, which a retiree can often access tax-free in retirement. One goal of generating tax-efficient retirement income is for optimal withdrawals to avoid large “spikes” in ordinary income. Our Optimal Retirement Income Calculator does this automatically and considers the tax rate of the heir under three distinct scenarios.
A retiree has insufficient funds to satisfy retirement income
A retiree has sufficient, but not excessive funds
A retiree has excess retirement funds
Excess retirement funds and the importance of your heir(s) tax rate
In scenarios 1 and 2, the top and middle portion of the image above, our calculator already finds the lowest marginal tax rate to efficiently distribute tax-deferred assets. Consequently, our Optimal Retirement Income Calculator already provides a withdrawal strategy to utilize your tax-deferred assets efficiently. So, no additional tax-alpha is possible with a Roth conversion. However, this is not the case in scenario 3 or the lower right portion of the image above.
When a retiree’s assets are far beyond what is needed to support their retirement income needs, many of their assets will eventually be passed to an heir. In this case, our Optimal Retirement Income Calculator previously left a significant amount of tax-deferred assets to an heir. With our latest software update, a new Roth Conversion Analysis includes converting tax-deferred assets to a Roth account “using up” the retiree’s tax brackets that are less or equal to those of the heir. For example, if your heir has an expected income tax rate of 25%, scenario 3 would perform a Roth conversion up to the 24% tax bracket. Doing so typically adds about 0.10% tax alpha. We encourage you to use our Optimal Retirement Income Calculator to evaluate possible situations for you or your clients. You can easily see if a Roth conversion with optimal withdrawals provides an additional benefit.
In our post from last week, we highlighted the potential benefit of converting tax-deferred assets to a Roth IRA. We showed that the amount of tax alpha, or the amount of additional return realized from converting, depended on current versus future tax rates. However, we simplified how a retiree may fund the tax liability by using retirement assets. In this post, we show the additional tax alpha when funding Roth conversions without using tax-deferred assets.
Funding Roth Conversions Using Assets in a Taxable Account
The additional tax-alpha from using taxable account assets arises due to these assets no longer generating taxable interest and dividends owed each year. Instead, a retiree could use these assets to pay for funding Roth conversions. Consequently, the benefit of funding Roth conversions with taxable account assets grows over time. But, two additional complexities arise. The return on the underlying asset is the first. The ultimate intended use of the taxable account assets is the second complexity. Markets dictate the first complexity, but not the second.
So, we may not know how the stock and bond market will perform in the future. But, a retiree may know whether they will use taxable assets to supplement their retirement income needs. If taxable assets are used to supplement retirement income and/or for funding Roth conversions, then there will likely be a long-term capital gain that would reduce the tax alpha. Otherwise, taxable assets may pass to an heir with a step-up in cost basis, thereby eliminating the capital gain tax owed by the retiree.
Case Study Results from Over 20 Years
To help quantify the additional tax alpha, we revisited the analysis in the Roth (2020) article for a 20-year period. We added the two complexities mentioned above, that the tax alpha will depend on market returns and if the taxable account assets received the step-up in cost basis. The left panel below shows the tax alpha without the step-up included. The right panel shows tax alpha when the step-up occurs.
Key Insights from funding Roth conversions
The results above indicate the importance of the step-up in cost basis on the tax efficiency of funding Roth conversions. The horizontal axis represents the fraction of the cost basis of the taxable account assets used. So, using current interest, dividends or available cash from a taxable account implies a cost basis equal to 1, and highly appreciated assets would have a value approaching 0.
From the left pane, the tax alpha ranges from 0.10% to 0.30% per year over twenty years. Lower (higher) tax alpha occurs when markets underperform (overperform) their historical average returns.
When the heir realizes the tax-efficient step-up in cost basis, the tax alpha is up to 0.10% per year over twenty years. Also, the breakeven for this additional tax alpha occurs at approximately 0.70, implying that a highly appreciated asset intended for an heir should not be used for funding Roth conversions.
Roth conversions for retirees and individuals nearing retirement often confuse financial planners and individual investors. In this post, we discuss the pros and cons of converting a portion of tax-deferred assets to a Roth IRA. The insights I share here reflect early results from a recently conducted research initiative.
Why Convert to a Roth IRA?
Converting funds from a tax-deferred account, like a 401(k), 403(b), traditional IRA, or rollover IRA, may seem counterintuitive to many. Indeed, in my recent award-winning article on Seeking Tax Alpha in Retirement Income, which will soon appear in the Financial Services Review, I highlighted how many tax professionals, like CPAs, generally advocate deferring taxes for as long as possible. Converting funds to a Roth IRA imposes a current tax liability, contradicting this conventional wisdom. However, the communicative law of multiplication suggests otherwise for funds converted at the end of the year. A positive payoff occurs when the current marginal tax rate is less than the future marginal tax rate. Stated more simply:
Always seek the lowest marginal tax rate, either now, or in the future, when converting, or distributing tax-deferred assets.
In my recent unpublished research results with Ed McQuerrie, we propose to show the benefit of Roth conversions in terms of tax alpha or the additional annual return realized by converting. If a distribution from the Roth IRA then pays the taxes, the figure below shows the tax alpha over a number of holding periods, from five to 40 years. We see that when future tax rates are higher, there is a significant benefit, but that tax alpha diminishes over time. Similarly, if an investor converts their tax-deferred assets and the future tax rates are lower, the negative payoff can be significant initially, but the loss will also diminish over time.
The Challenge to Roth Conversions
The U.S. Congress sets tax rates. So, we can’t know future tax rates with certainty. But, a retiree is able to control the amount of ordinary income generated by distributions from tax-deferred accounts. Also, the results above assume the investor is at least 59 1/2 so they can avoid the tax penalty on early withdrawals to fund the tax liability. In our next post, we will highlight some beneficial results if an investor pays conversion taxes with a non-retirement account.
The stock and bond markets are off to a great start for 2023. This news is especially notable after a difficult 2022 for stock-based ETF investors. Including dividends and interest, the iShares Core S&P 500 ETF is up 6.3%, and the iShares Core Total US Bond ETF is up 3.3%. While a strong start can be helpful against losses later in the year, what may be more relevant is that we are now in the third year of a presidential cycle. In this article, we discuss this unusually strong relationship.
Data since 1933
According to a researcher at Charles Schwab using data from 1933 to 2015, the S&P 500 had average returns in the first, 2nd, 3rd, and 4th years of a presidential cycle of 6.7%, 5.8%, 16.3%, and 6.7%, respectively. So, in the third year of the presidential cycle, there was nearly a 10% increase in average returns. We revisited this data to include the end of the Obama administration, as well as the four years of the Trump administration and the first two years of the Biden administration. The results appear in the table below, which indicates that, even with the impact of the global coronavirus pandemic, the relationship still holds.
Average Return (%)
Average Returns of the S&P 500 from 1928 to 2022. Data Source: www.macrotrends.net
Clearly, we find that correlation is at play here, although the sample size is not very large. But, what could be the cause of this outperformance?
A 2013 study at the University of Chicago attributed the effect of the 3rd year of a presidential cycle to increased future uncertainty of what a change of administration may cause. Others have argued that in the third year, the current administration has some momentum to start seeing the impact of their policies being implemented. But, it is always important to note that correlation is not causation, and there are likely many other factors at play that are producing this unusual market behavior. By the end of this year, we will see if the 3rd year of the Biden administration continues this outperformance.
Happy 2023! Now is an excellent time to review changes to individual income tax brackets due to inflation. Here, we highlight the relationship between inflation and income taxes. To see details of all the 60 tax provisions changed for 2023, the Internal Revenue Service (IRS) published this document.
How inflation and income taxes are related
As we discussed in our post from last month, the Consumer Price Index (CPI) continues its downward trend. Unfortunately, the CPI of 7.1% for November is still above the long-term norm of 2-3%. However, there is some good news for U.S. income taxpayers in 2023. The IRS adjusts income tax brackets for inflation, so income and capital gains tax brackets in 2023 have increased by about 7%. The images below show these new brackets for income, capital gains, and the standard deduction.
2023 tax rates on retirement income
So, income tax brackets recently changed in a significant way. Our optimal retirement income calculator now provides an updated forecast for after-tax retirement income using the 2023 tax brackets. Forecasts based on the Common Rule withdrawal strategy remain free for 2023. In addition, you can expedite your calculations by registering a free profile. For individuals or financial planners wishing to use our award-winning tool to see the details that led to their individualized tax alpha, please consider subscribing before the price goes up.
Live Software Demonstration
On Saturday, January 14th from 10-11 am Pacific Time (1-2 pm Eastern Time), we will be conducting a live demonstration of our retirement income and retirement savings calculators, fielding your questions, and discussing new features planned for 2023. Please use the link below to join us at this time. If you wish, please contact us prior to this demonstration with any questions you may have or use cases you wish to see.
If you are unable to make this live software demonstration, please contact us to arrange for an individual demonstration.
Inflation continues to persist higher than its long-term norm. Very few sectors of the U.S. economy have performed well. In this article, we discuss how ETFs designed with inflation in mind have fared in this current economic environment.
Historical rates of inflation
The U.S. Bureau of Labor Statistics (BLS) is an excellent free source of historical rates of inflation. The image below shows this data for the last 20 years. Clearly, the current inflation rate is above the norm of 2-3%. However, it does appear to be down somewhat from its high in June. Fortunately, we don’t see any recent “grey” area in this chart, which represents the U.S. in a recession, as determined by the National Bureau of Economic Research.
ETFs to protect against inflation
We chose three ETFs to show that not all ETFs are created equal in addressing inflation. Here, the acronym “TIPS” stands for “Treasury Inflation-Protected Securities”.
iShares Barclays TIPS ETF (ticker: TIP), $25B in assets
SPDR Bloomberg Barclays 1-10 Year TIPS ETF (ticker: TIPX), $1.4B in assets
Vanguard Short-term 0-5 year Inflation Protected ETF (ticker: VTIP), $17B in assets
The most significant difference in these three ETFs is the term to maturity of the bonds contained within them. This difference has led to very different total returns for these three ETFs in 2022, as shown below.
So, what’s going on?
As one of my favorite writers at the Wall Street Journal recently wrote about, rising short-term interest rates are having greater impacts on the price of longer-dated bonds. This impact includes treasuries with inflation protection which each of these ETFs contains. The weighted average maturities for these three ETFs are 7.4 years, 4.7 years, and 2.5 years. By comparison, the broad-based iShares Core U.S. Aggregate Bond ETF has a weighted average maturity of 8.7 years and is down about 11% in 2022. So here, we see the limitation of a fund, like an ETF, that maintains a steady average maturity. Rising interest rates are offsetting the inflation benefit. Unfortunately, investors can avoid this with a bond ladder, but doing so requires investors to leave the relative ease of investing in ETFs.
On October 24th, 2022, the CFP (Certified Financial Planners) board’s Academic Research Colloquium recognized my most recent research (with A. Simon) entitled “Seeking Tax Alpha in Retirement Income” with a best paper award. I wish to thank Charles Schwab for sponsoring my award. In this post, I will highlight some of the key findings from this paper.
In this paper, we found that the Common Rule provides an important heuristic to guide better decisions in generating tax-efficient retirement income. Using it, we divided retirees into the following three categories that appear in the figure below. Then, we define tax alpha as the additional annual investment return necessary for the Common Rule withdrawal strategy to meet the same portfolio longevity or bequest as an optimal strategy.
This chart shows that three regions must be considered with separate algorithms to maximize tax efficiency in retirement income. The opportunity for tax efficiency is highest in the middle region, where the retiree and their spouse have sufficient, but not excessive, assets to support their retirement income needs.
We also conducted a sensitivity analysis to determine how varying our input values, like asset allocation, may affect outcomes for tax alpha. The chart below shows how the baseline of 0.54% per year changes when inputs are varied.
The chart above confirms that higher future taxes and bond interest taxed as ordinary income leads to higher alphas. Also, and somewhat surprisingly, the rate of return of stocks and bonds didn’t change outcomes very much.
What’s your tax alpha?
We invite you to see your tax alpha using our online calculator. Just change the inputs to match your specific situation, hit the “Find Optimal Withdrawals” button at the bottom of the page, then scroll down when the calculations are complete to see your personalized result.
We hope you find this research helpful in planning for your future retirement income needs!
In 2022, many long-term trends in asset correlation appear to be changing. In this post, we discuss the longer-term trends in several popular asset class correlations and highlight recent changes that continued from the first half of the year.
Short-Term Correlations and Long-Term Trends
The stock and bond markets continued their downward slide this month. The iShares Core S&P 500 losses for 2022 reached 24%. In addition, the bond markets continue their losses for the year, with the iShares Core U.S. Aggregate Bond Market ETF down about 15%. This latter result is quite surprising, given the long-term correlation between the stock and bond market is 5%, but has recently grown to over 40%. Thus, the stock and bond market returns are more similar than they were in the past, so provide fewer diversification benefits. The chart below shows this upward trend in the correlation between the stock and bond markets in blue. The horizontal dotted line shows the long-term correlation from returns dating back to February 2004.
Asset Correlation Among Other Sources
The chart above also highlights the diminished effect of other sources on a portfolio’s diversification. For example, international equities are often sought for their diversification benefit. However, the long-term correlation of 88%, which also appears in this figures legend, hasn’t changed much this year. Bitcoin’s long-term correlation is 21%, but this correlation has steadily grown to over 60% this year. The one asset that has performed well this year is a direct investment in the U.S. Dollar ETF, ticker UUP. Long-term, the dollar has an insignificant correlation to the S&P 500. However, in 2022, the dollar’s correlation to the S&P 500 has grown significantly negative, as interest rate rises have increased demand for U.S. dollars. The chart below shows the total return of the five ETFs discussed here.
Given the economic pressures creating these effects on the markets, the remainder of 2022 may continue to surprise investors. In particular, asset classes that formerly had low correlations to the stock market may continue to diverge from their long-term values.
During our webinar earlier this year, we highlighted one of the retirement income challenges called “The Widow’s Penalty”. This situation occurs when the surviving spouse is filing taxes as a single, instead of married filing jointly. In this post, we elaborate on the effect of this penalty on a fictitious couple we call John and Jane and show that tax-efficient retirement income can help mitigate its effect.
Case Study for John and Jane and the widow’s penalty
The bulleted list here summarizes John and Jane’s situation at the start of their retirement.
John is 65 and has a life expectancy of 80. Jane is 62 and has a life expectancy of 82.
Their after-tax retirement income needs are $150,000 per year, reduced to $140,000 per year for the surviving spouse. (Today’s dollars)
Both have RMDs starting at age 72.
Their heir’s marginal income tax rate is 25%.
John and Jane both have retirement assets tax-deferred ($800k, $100k) and tax-exempt accounts ($400k, $50k). John owns a taxable account valued at $1M with a cost basis of $300k in stocks and $272k in bonds.
Their asset allocation is 60%/40% stock/bonds in all accounts, and they increase bond allocation by 1% each year.
John and Jane have annual pension income starting at age 65 of $18,500 each, and social security income starting at age 67 of $11,000 each.
As we showed in our previous post, if Jane is the surviving spouse, she can realize an additional 0.55% of investment return by drawing down from a mix of taxable, tax-deferred, and tax-exempt accounts. But, can this benefit still be realized if Jane lives longer?
Tax efficiency for a longer-living surviving spouse
In the example above, Jane lived for five years as a widow so needed to file her taxes as a single. Re-running our retirement income calculator and increasing Jane’s retirement horizon yields the following results.
So, these results show that Jane can still increase the inheritance for her heirs if she lives up to 15 years as a widow. If she lives 25 years as a widow, she will exhaust all of her savings but will be able to increase her portfolio longevity by 3.5 years. Either of these situations is possible by not following the common rule for retirement account drawdowns but instead using optimal account drawdown decisions.
Want to see how the widow’s penalty may affect your retirement plan? We invite you to try out our calculator to see how your heir’s inheritance or your portfolio longevity may improve!
It has been a very difficult year for cryptocurrency investors. Here, we will discuss the recent trend of cryptocurrency returns. Also, we will highlight the current cost of cryptocurrency mining, and share some thoughts on the future of this asset.
Cryptocurrency returns in 2022
Year-to-date returns of Bitcoin, Ethereum, and the first ETF that tracks bitcoin futures (ticker: BITO) appear below. Like the stock and bond markets, all three of these assets lost value in 2022. Also, in our previous post on the risks of cryptocurrencies, the volatility of all of these cryptocurrency assets was significantly higher than the long-term historical norm of 15-20% for the S&P 500.
The future of cryptocurrency remains uncertain. However, few expect these new innovations in decentralized finance to go away. Instead, we may see longer-term price stabilization, as the investment in mining produces enough cryptocurrency to satisfy demand. Such price stabilization may not entice investors seeking outsize returns but could help cryptocurrency gain wider acceptance if its volatility can also be reduced.
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