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

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

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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Inflation trends

The Federal Reserve’s recent announcement to hold short-term interest rates at 5.25-5.5% was well received by the markets this past week and was clearly influenced by inflation trends. After the S&P 500 recently fell into a “correction”, defined as a 10% drop from a recent peak, the index returned over 5% last week. In this post, we highlight recent inflation trends towards lower rates and note that there is still some work to do to reach the Fed’s target inflation of 2%.

Inflation over the last 12 months

According to Statistica.com, the 12-month inflation rate was 3.7%. As the chart below shows, this is a significant reduction in peak inflation of over 9% in June 2022. This reduction was largely due to seven quarters of increasing short-term interest rates, which should reduce economic activity by increasing borrowing costs. But, the Fed also has a mandate to keep unemployment low.

Monthly 12-month inflation rate in the United States from September 2020 to September 2023.
Monthly 12-month inflation rate in the United States from September 2020 to September 2023.
Source: Statistica

Unemployment and a soft landing?

Unemployment has stayed low, as the next chart shows.

Monthly unemployment rate

It is our opinion that the Federal Reserve appears to be close to reaching its goals of low unemployment and inflation. And, this all appears to be happening without triggering a recession. Our final chart shows GDP, which when its rate is negative for two quarters, is the official trigger for a recession in the U.S. As this WSJ article notes, the U.S. economy is “Improbably Strong”.

Real GDP

We conclude from these macroeconomic indicators that the U.S. economy, inflation, and unemployment appear good for now. With the year nearly over, we will see very soon how consumer sentiment and consumer spending around the holidays may influence these indicators.

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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 Federal Funds Rate and ETFs

In early 2022, the U.S. Federal Reserve began raising the federal funds rate in an effort to reduce inflation. According to TradingEconomics.com, this effective rate grew from near 0% to over 5% in the past seven quarters, reaching a 22-year high. In this post, we examine ETF returns during this period of rate increases.

Stock and Bonds ETFs

The chart below shows the last seven quarters of ETF total returns, which includes price appreciation and short-term capital gains. This time frame corresponds to the increase in the federal funds rate. Investors saw positive returns in only two ETFs during this period of increasing rates.

Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate.
Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate.
Source: ETFreplay.com

Stock ETF returns during this period were mixed. As shown in black, the iShares S&P 500 Value ETF (ticker: IVE) was the best-performing stock ETF. During this time, the iShares Core S&P 500 ETF (ticker: IVV) in green and the iShares S&P 500 Growth ETF (ticker: IVW) in red lost 7% and 17%, respectively. Clearly, investors preferred value over growth during this period. Investors may have had concerns about the increasing cost of financing a firm’s growth opportunities. Alternatively, investors may have preferred dividend-producing firms commonly found with value stocks.

Intermediate and short-term Bond ETFs returns and increasing federal funds rate

The iShares Core U.S. Aggregate Bond ETF (ticker: AGG) also had a negative return during this period, consistent with how rising bond yields generally reduce bond prices. However, for short-term treasury bond ETFs like the iShares Short Treasury Bond ETF (ticker: SHV), investors saw a slow and steady climb. As we’ve written before, the increasing federal funds rate contributed to this growth. And, this short-term bond fund also has tax-efficient benefits when compared to money market funds and short-term certificates of deposit.

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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 Roth 401(k) for retirement

The Roth 401(k) has been slowly growing in popularity since its creation in 2006. According to this WSJ article, over 80% of employer retirement plans now offer these. In this article, we will discuss this relatively new way to accumulate retirement savings and the trade-offs made when using one.

Roth 401(k) plans continue to grow.

Pay taxes now or later

Employers that offer both traditional 401(k) and Roth 401(k) plans give employees greater control over when taxes are due on their retirement savings. An employee can defer taxes on retirement contributions with a traditional 401(k) plan. These contributions will likely reduce their current taxable income and consequently the amount of taxes owed during each working year. Additionally, gains in a traditional 401(k) plan grow tax-deferred. However, ordinary income taxes are generally due on future withdrawals or on Roth conversions of these tax-deferred plan assets rolled into an IRA.

Conversely, when an employee contributes to a Roth 401(k), there is no tax-deferred benefit. Instead, the contributions are part of their current year’s income. However, once the funds are in the Roth 401(k), like in a Roth IRA, the funds grow tax-free. Additionally, qualified withdrawals during retirement are generally tax-free.

Pros and Cons of a Roth 401(k)

Retirees gain the most obvious benefit from a Roth 401(k) when future taxes are higher. For example, if the Tax Cuts and Jobs Act (TCJA) from 2017 expires at the end of 2025 without the U.S. Congress intervening, tax rates will revert to pre-2017 levels, which are higher than current rates. Additionally, younger workers who expect significant wage growth may also benefit from the Roth 401(k). And, if there are unexpected large expenses in retirement, having some after-tax funds can help retirees avoid spikes in taxable income.

If you are not sure how much to contribute to a Roth 401(k), you can follow research by David Brown, an associate professor of finance at the University of Arizona. His research suggests a rule of thumb where you add 20 to your age and put that percentage into a traditional 401(k), with the rest in a Roth 401(k). For example, a worker who is 45 should put 65% of their 401(k) savings in pre-tax contributions, and the remaining 35% as after-tax Roth 401(k) contributions.

Our software may help

We offer two online software tools to help in this planning decision. The first can predict future retirement savings balances across tax-deferred, tax-exempt, and taxable accounts based on future contribution amounts. The second can predict the longevity of your portfolio, or what your non-spouse heirs may expect for an inheritance, based on the U.S. progressive tax system. We encourage you to use tools like these to better understand savings decisions made today to meet your future retirement goals.

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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Bond ETFs amid rising interest rates

Interest rates continue to rise, with the Federal Reserve recently raising its benchmark rate to a range of 5.25% to 5.5%. While borrowers may face higher costs, new investors in short-term Treasurys now realize these higher annual rates. However, investors in certain bond ETFs could also realize this rate with added liquidity, and convenience, while potentially avoiding state and local taxes.

US Treasury Bills are backed by the full faith and credit of the U.S. Government

Short-term investment options

There are several common approaches for investing in the short term, which we characterize as less than one year. Thankfully, these investments have zero default risk because the full faith and credit of the US Government backs them.

These investments include bank CDs, direct purchases of US short-term Treasury bills, money market funds, and certain Bond ETFs. Firstly, bank CDs and money market funds may be the most convenient for individual investors. Short-term bank CDs are currently yielding over 5%, and money market funds provide similar returns within most brokerage accounts. Unfortunately, both of these short-term investments are often subject to both state and federal income taxes. For residents of California, Hawaii, and New Jersey, the top state income tax rate exceeds 10%.

Bond ETFs for Tax-efficient investing in the short term

Alternatively, similar returns are possible if an investor chooses to purchase short-term Treasury bills from the U.S. Department of the Treasury. Or, an investor may purchase US Government Bonds ETFs. Both of these options are exempt from state taxes. However, treasury bills have maturity dates of 4, 8, 13, 26, or 52 weeks. So, at maturity, the investor receives back their investment plus interest. That means that an investor would need to regularly re-invest in treasuries at TreasuryDirect.gov.

To avoid the need to continually re-invest, and likely avoid state taxes, there are several short-term Bond ETFs to choose from. Here are just a few, that with reinvested dividends have returned 2.5-2.8% so far this year (e.g. from December 30, 2022, to July 28, 2023).

  • 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)
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