Thinking About Roth Conversions

Pay now or pay later, that’s the main question when we think about taxes on our retirement accounts and it’s one with lasting consequences. A client recently sent me an article about converting traditional IRAs to Roth IRAs in the context of government debt. Let’s touch on that while discussing some of the basic considerations for people who feel they need to play catchup when it comes to Roth accounts.

The history of individual retirement accounts coincides with the decline of employer-sponsored pension plans. I won’t go into all of that here. However, some context is important. The shift began in the 70’s and 80’s to account types that were owned, managed, and the responsibility of employees instead of employers. This led to the 401(k) structure we’re all familiar with and, over time, the expansion of IRAs. To incentivize savings the government gave workers a tax deduction on contributions and the employer got a tax break (and less burden from not having to provide workers with a pension) when it added money to an employee’s account. Employers had rules to follow when structuring plans, but otherwise employees were on their own to manage their 401(k)s if that was an option and, if not, their IRA.

That was (and still is) the primary option for retirement savings until the late-90’s when Roth IRAs were created by Congress. Roth accounts flipped the tax savings thinking around – savers gave up a tax deduction on their contribution but got tax free growth if they left money in the Roth long enough. As with traditional IRAs, Roth accounts weren’t available in the workplace. Instead, savers opened and funded these accounts based on various limitations, such as the original $2,000 maximum annual contribution. This was raised over time to the current $7,000, or $8,000 for those age 50 or older.

Decades of inertia around this led to most savers having most of their money in tax-deferred 401(k) accounts and IRAs instead of in a Roth. Any dollar saved for retirement is positive, but the long-term reliance on traditional plans leaves many savers facing a series of tax bills because every dollar in those accounts will be taxed as ordinary income when withdrawn.

Say you contributed $100,000 during your working years and your balance grew to $1 million. Nice job! You saved on taxes while saving for retirement and haven’t paid taxes on dividends, interest, and gains in your account the whole time. The US Treasury has been waiting decades for tax revenue and they’ll eventually get it. Part of how they collect is by requiring you to start taking distributions by age 73 whether you need the money or not. Most retirees would have already started taking distributions for obvious reasons, but many don’t. These latter folks are left paying taxes on income they don’t actually need. On a million-dollar balance the first required distribution could be $38,000, all taxable in the year distributed. That could kick the account owner into a higher tax bracket or more if this income coincides with a spouse’s distribution, Social Security income, and so forth. Too much taxable income is a good problem to have but it’s still a problem.

It’s this group that Roths appeal to most in hindsight since Roth IRAs don’t have the minimum distribution requirement. The challenge is how to get money that’s currently in a traditional retirement account into a Roth.

This is where Roth Conversions come in. You do this by having your existing custodian (your workplace plan or brokerage firm) move cash and/or investments from your traditional balance into Roth. Sounds straightforward, right? There might be some forms but otherwise it’s all electronic and shouldn’t cost anything… in fees. However, the conversion gets taxed as income during the year you convert. You have the option to withhold taxes at the time, but generally speaking it’s better to pay at tax-time with other money (doing so helps the Roth conversion break even faster). The ultimate tax bill depends on a variety of factors that are beyond the scope of this post, but your tax advisor or humble financial planner can help you figure this out.

So planning ahead to reduce the impact of required distributions makes good sense depending on your current tax situation. But what if taxes are higher in the future, and should you try to preempt that by converting more now? Aren’t higher taxes a given with government debt being so high?

Our national debt is massive, more than twice that of any other country and larger than the next four higher-debt country’s debt load combined, according to a quick Google search. That sounds bad. However, we should remember that our economy is equally massive and our nation’s debt functions differently than our personal household debt does. To grossly oversimplify, our government can continue to refinance its debt indefinitely so long as there are willing lenders. And willing lenders abound. Our bonds are the most liquid in the world and our currency is involved in an overwhelming majority of all foreign exchange transactions. Sure, there may come a time when our economic status and currency is meaningfully different, but that’s not likely anytime soon.

Ensuring long-term dollar primacy requires that we keep our fiscal house in order. However, it doesn’t necessarily matter in the way many in the marketplace use to scare (for lack of a better word) people into buying a product or books about investing in gold or paying abnormally high tax bills when converting traditional retirement account balances into a Roth.

So consider your motivation for doing a Roth conversion and make sure it makes sense for your personal situation. Run some tax projections while weighing other options for shielding your IRA from taxes, such as donating money from your IRA to charity tax-free if you’re at least 70.5 years old. This can be a good way to offset taxes on required minimum distributions while helping the organizations you value. Beyond that, be careful about how quickly you try to play catchup with the perceived benefits of a Roth IRA. 

Have questions? Ask us. We can help.

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Quarterly Update

The second quarter (Q2) of 2024 continued this year’s A Tale of Two Markets: AI Versus Everyone Else. Large indexes like the S&P 500 performed well but this was driven primarily by a handful of large companies. Otherwise, market breadth was mixed with performance growing worse as company size grew smaller. Bonds also continued their tale of woe while experiencing a couple of positive glimmers during the quarter.

Here’s a roundup of how major markets performed during Q2 and so far this year, respectively:

  • US Large Cap Stocks: up 4.4%, up 15.2%
  • US Small Cap Stocks: down 3.3%, up 1.6%
  • US Core Bonds: about flat, down 0.7%
  • Developed Foreign Markets: down 0.2%, up 5.8%
  • Emerging Markets: up 4.4%, up 6.7%

As I just mentioned, major stock indexes in the US looked great on paper as average returns seemed to rise steadily throughout the quarter. The largest publicly-traded stocks related to artificial intelligence performed best. Microsoft, Apple, and Nvidia each ended Q2 with a $3+ trillion market capitalization and the worst performer of the bunch, Apple, was up 24% during the quarter. These and other popular Large Cap Growth names within the Technology and Communication Services sectors, like Google and Meta, now occupy such a large portion of the market that they massively impact index performance. Last quarter was positive because of this but performance could easily have gone the other way. This is plain when looking at benchmarks like the Russell 1000 that include the 500 largest stocks (similar to the S&P 500) and the next 500 smaller companies. According to my research partners at Bespoke Investment Group, this index rose by a respectable 3.3% during Q2. However, the top four stocks in the index added four percentage points of gain. Without them the remaining 996 stocks would have collectively averaged a small loss. Nvidia alone was worth almost 48% of the index’s gain. Besides the aforementioned sectors along with Consumer Staples and Utilities, up 1% and 4.6%, respectively, all other sectors in the US were negative during Q2. This is a reminder of how imbalances in the markets can be masked by average index performance and how this can promote investor complacency. Always look beyond the label – it’s what’s inside that matters.

This sort of imbalance isn’t unprecedented. Markets reflect the economy and substantial changes in market perspectives have coincided with every major development from the railroads to the creation of the internet. The rise of AI seems likely to be historically significant for the economy and markets, and maybe that’s a vast understatement. Only time will tell but we have to watch how these imbalances impact your portfolio in the meantime.

Beyond AI impacting the stock market, the bond market saw some positive moments during Q2 compared to recent quarters. Bond prices are highly sensitive to changes (anticipated or actual) in interest rates and rates were on the minds of investors again. As 2024 began investors expected the Federal Reserve to cut rates as much as half a dozen times during the year assuming inflation improved. However, inflation remained elevated and Fed officials indicated that rates could stay higher for longer. Investors quickly recalculated and the yield on the 10yr Treasury, an important benchmark, rose in April causing bond prices to fall. This reversed a bit in June as inflation and Fed policy forecasts seemed to improve. As Q2 ended the CME FedWatch website indicated investors were again expecting the Fed to reduce rates 3-4 times this year (and more into early-2025). These expectations could be overeager and have whipsawed quite a bit in recent weeks. This uncertainty will likely persist during the second half of this year.

So what to do about AI-driven imbalances in the stock market and the continued plight of core bonds. If you’re doing the “right” thing you’ll have diversification across asset classes (stocks, bonds, and cash), sectors (Technology, Healthcare, Financials, and so forth – there are eleven sectors in the US), and industries. Within bonds you’ll likely have exposure to those issued by the US Treasury, large corporations, and government agencies. You may also have bonds issued by states and smaller municipalities. You’ll have ready cash that pays essentially nothing in terms of interest, but you might also have some cash in a money market or CD at a decent rate. You have all these investment types so you’re not pinning your hopes on any one or two at a time. Sure, it would be nice to luck into having all of your money in Nvidia stock as it grows exponentially, but what if Nvidia got walloped or failed? I’m not suggesting this is likely. However, recall some of the many examples over time of massive growth followed by massive failure like Enron or maybe Those stories should stimulate a prudent desire to hedge your bets. Own it all in manageable and appropriate proportions. Then rebalance as needed based on a specific and repeatable process. You’ll get lift from AI-related stocks (or whatever else is popular at the time) while enjoying safety in numbers. You probably won’t beat the market on any given day but you’ll have a good chance of beating the system over the long run. And bonds are still helpful as a store of cash for the medium-term. You should continue to hold them in your portfolio along with complimentary instruments like short-term CDs and money market funds.

There’s uncertainty as we enter a new quarter, as always, but the economy is doing well and most of the stock market isn’t overvalued. I’m optimistic about returns for the rest of the year but I plan to stay disciplined and focused on long-term performance versus chasing what’s popular. I humbly suggest you do the same.

Have questions? Ask us. We can help. 

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Check Your Beneficiary Designations!

Your beneficiary designations matter and are easily overlooked, sometimes for years. You list them on your retirement accounts and life insurance contracts, and maybe on your bank and brokerage accounts. If you skip this step, perhaps assuming you’ll handle it later, the default option is often your “estate”, meaning your accounts have to go through probate.

We’ve discussed this in prior posts over the years but this concept is worthy of repetition.

The paperwork for some accounts, such as Schwab’s IRA application, often has a predetermined order of priority if you forget to name your own beneficiaries. First it’s your spouse and then your kids (natural or legally adopted) but the form doesn’t automatically include stepchildren. Third comes your estate as beneficiary and that usually means probate.

Is that what you want? Would you instead prefer to list your own beneficiaries to avoid ambiguity? Or do you have beneficiaries whom you’d like to receive an uneven portion of your account? Maybe charities? Or as is the case with the story I’m linking to below, did you list someone during what’s now a prior life and want to update that to your current situation?

Here are a few important points to remember when thinking about beneficiary designations.

  • They’re per account and designations on one don’t apply to another. There’s nothing stopping you from listing your spouse on all of your IRAs, your grandchild on your Roth IRA, and charities on your life insurance, whatever you want. Your spouse typically has to agree by signing a form if someone else is a primary beneficiary, but you can get creative.
  • Lots of account types can have beneficiaries. IRAs, Roth IRAs, your plans at current and former workplaces, even bank accounts, and of course life insurance. Adding beneficiary designations wherever possible is cheap estate planning.
  • Beneficiary designations can override your will. Just because your will or trust lists your current spouse as beneficiary of “everything”, that usually has no bearing on an old 401(k) still held with a former employer that lists your ex-spouse as beneficiary.
  • Accounts with named beneficiaries usually bypass probate. In my experience most beneficiaries (spouses, adult children, and so forth) get access to the funds in a week or two after signing some paperwork and submitting a death certificate. Compare that to probate in CA taking a year or more. Your beneficiaries can accelerate the process if your estate is small (less than $185K in CA currently) but avoid this if possible. And probate is expensive. Some sources suggest that 4% to 7% of an estate can go to various costs.
  • Your beneficiary designations are revocable but durable – nothing changes without you! You should review your designations periodically to ensure they look right. For most people this is simple because you probably listed your spouse as primary beneficiary and maybe your kids as equal contingents. But I ask again, are you sure this is what you want? Do you want to equalize a financial gift for one kid by increasing another’s share of a retirement account? Have your balances grown and you want to shift who gets which account and how much, maybe considering tax consequences? Lots of options to personalize your beneficiaries if you think about it…

Okay, so on to the story that started the wheels turning this morning…

The following link goes to The Wall Street Journal and details a legal battle between brothers fighting to keep their deceased brother’s old 401(k) from going to a girlfriend he had decades ago. Her claim is clear – she’s listed as the 100% beneficiary of a specific account and there’s paperwork to prove it. The brothers’ claim is ambiguous – we don’t think that’s what our brother intended. Who knows what can happen in the legal system and I’m not an attorney, but everything I’ve learned over the past 20+ years in this business indicates that the former girlfriend is the decedent’s lawful beneficiary. Is that what the brother actually wanted? Who knows because apparently the only document he left behind was the beneficiary form he completed decades ago.

Don’t let that be you. Don’t let this happen to the person or people you feel should inherit your remaining assets. Don’t make them go through probate unnecessarily and help them avoid the legal system if at all possible.

You can check your account statements to see who you’ve listed as beneficiaries. If it’s not there, check your online portal. If you can’t find them anywhere, call the company! Or if we’re managing your accounts, reach out to us and we’ll tell you exactly how you’re set up and can assist with updating as needed.

One of the issues in this lawsuit was the former employer not making information from “old” paper documents viewable online. I’ve seen this before. Your beneficiary listing will say something like “on file” versus showing specific names. Trust but verify, as the saying goes. Doing so could save your beneficiaries a lot of trouble.

Here's the link to the story I mentioned.

Have questions? Ask us. We can help.

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The Vibecession

Have you heard of a vibecession (pronounced like recession but beginning with “vibe”)? Apparently the term was coined by an economics blogger a couple of years ago and it’s been showing up quite a bit lately. I heard some people discussing the term the other day as if it were old news. Well, not to me…

We’ve discussed this idea several times before but it goes something like this, according to the blogger, Kyla Scanlon, who wrote an interesting piece about her idea back in 2022 (a link is below if you’re interested).

“Vibecession – a period of temporary vibe decline where economic data such as trade and industrial activity are relatively okayish.”

Relatively okayish – I like that. It seems to meet the moment. To me, a vibecession happens when enough people feel bad enough about their outlook, regardless of their current situation, that they cut back enough on spending for it to impact national economic data. A self-fulfilling prophecy, essentially. Have we seen one and/or are we in one? It depends on who you ask.

Sentiment was definitely negative in 2022 when the termed originated. Inflation peaked that summer and the Fed quickly raised interest rates to fight it. Stocks had a bad year as did bonds. Median national home prices dipped in response. And consumer sentiment cratered that summer, as you would expect from combining negative forces like these.

All of that happened and we still managed to skip an economic recession, at least going by the official definition. But we absolutely saw a vibecession, or whatever else you want to call it, and it lingers for many. The issue now is that much of what fed into the confused and somber mood ended up being transitory, at least by traditional economic metrics. National average inflation has come back to more normal levels. Interest rates are high compared to recent history but aren’t especially high when compared to long-term averages. Bonds have been struggling while stocks have come roaring back, and home prices continue to make record highs. Additionally, the job market is in good shape and, perhaps surprisingly, investment in US manufacturing has been making a big comeback.

That said, consumers still say they feel down in the dumps. This is odd because, just to cherry-pick one contrary data point, people are flying. The TSA reports that roughly 2.5 million US passengers flew per day around Independence Day last week and 3 million flew last Sunday, a single day record! Perhaps that’s partly due to the average cost of plane tickets being lower than 2022, according to tracking from the website, Nerd Wallet. This is just one example but consumers continue to spend across the economy even as they express concern over inflation and the job market, to name a couple typical pain points.

So why are so many people still professing to be in good shape now but gloomy about their prospects? Look at the chart below from my research partners at Bespoke Investment Group? Pessimism hasn’t matched up with reality for a while now. Is this cognitive dissonance at work, bad data, or a symptom of some broader issue?

The reasons for this go far beyond the realm of personal finance. People point to the news and social media, politics, and so forth, as feeding into a general sense of negativity and unease. This shows up across the demographic spectrum but seems more prevalent with younger people. I don’t understand all the reasons for this. However, at least on the finance side it’s clear that those with assets have been doing much better than those without. This is by design since our economy and even entire financial system favors those who own assets like homes and stocks. If you rent and don’t have savings, you don’t feel increases in the so-called wealth effect. You don’t benefit from home equity improvement – home ownership is just more unattainable. And rising stock prices don’t help for the same reason. Lots of American consumers have seen inflation in recent years without a way to counteract it. Even the Fed indirectly punishes these folks because borrowing cost more when the Fed raises interest rates. Perhaps folks in this category are more inclined to be surveyed and that skews the numbers? But wouldn’t they be less likely to say their present situation is good? It’s confusing.

Enough negative sentiment can become a self-fulfilling prophecy. The vibecession concept has been showing up more in the culture lately if not yet in most macroeconomic numbers, so it must be gaining traction. Maybe it will reach critical mass or maybe it’s simply an indicator of a gloominess that can, perhaps strangely, exist amid optimism and growth. Whatever the answer this is certainly an odd situation we should all pay attention to.

Here's the link I mentioned above.

Have questions? Ask us. We can help.

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Thinking About Rebalancing

With just one week left in the quarter let’s talk about rebalancing.

First, I am absolutely not one to make market calls or suggest this or that day is the right time to buy or sell. However, it’s hard to overlook the dramatic price and valuation increase of companies related to artificial intelligence.

This has been going on for a while but really took off when ChatGPT was released. Nvidia is the most newsworthy as the company’s stock is up nearly 160% this year after a banner year in 2023. I mentioned these points in a recent post but the value of Nvidia has continued to rise along with a handful of other big names and that’s been pushing major indexes higher. It’s also likely created some imbalances in your portfolio.

As of last Friday the Tech and Communication Services sectors are collectively worth over 40% of the S&P 500 (from maybe 25% pre-Covid) and this has been leading the index’s performance all year. Of the top ten holdings in the S&P 500 eight are within these two sectors with the outliers being Berkshire Hathaway and Eli Lilly. The names are Microsoft, Apple, Nvidia, Amazon, Meta, Google (listed twice in the typical ETF for this space, ticker symbol SPY) and Broadcom. The S&P 500 weights its holdings by market size and this is the current order. These stocks now make up nearly a third of the S&P 500 by themselves and about 87% of the two sectors just mentioned. Year-to-date as of last Friday the typical Tech sector ETF, ticker symbol XLK, is up about 19% versus the S&P 500 up 15%. Compare this to a common S&P 500 index, ticker symbol RSP, that weights companies equally instead of by size. RSP is up a little better than 5% YTD. Talk about a top-heavy market!

Some compare this to the Tech Bubble and worry that a “pop” could happen any day. There are lots of reasons why this isn’t the case and I tend to agree with most of them, so anything you do with your investments shouldn’t be done out of fear. Instead, imbalances like this present opportunities for basic portfolio maintenance.

One idea is to take some profits. Not sell everything and head for the hills, just rebalance by trimming back a bit because the rest of the market is doing fine.

The easiest approach is to trim from common stock holdings in the companies listed if you have any. This can be taxable if these positions are held in a non-retirement account so you’ll want to be thoughtful about realizing capital gains. Ideally you hold some of these stocks in an IRA or Roth IRA where you can sell without tax concerns. How much to sell depends on your allocation plan, model portfolio, and so forth. In general you could cut 10% or perhaps trim by a position’s YTD performance and plan to repeat should prices continue higher.

If you’re like most people, however, you don’t hold common stock in these names but instead have indirect exposure via mutual funds and index funds. You can double check the holdings within your funds via Google and probably at your custodian. But since nearly 80% of the Tech sector and over 90% of Communication Services is primarily comprised of these companies, trimming from either sector fund, if you have one, should be obvious. Beyond that, a broad market stock fund or anything labeled “Large Cap Growth” in your portfolio should indirectly trim these names as well.

You can do other things to work around growing positions, such as buying non-correlated sectors and asset classes. You could also give appreciated shares to charity from your brokerage account or from your retirement account as part of your RMD, but those details are beyond the scope of this post.

Again, it’s been a good year so far for stocks. Who knows what the second half will bring but taking time to trim your winners and give to your losers (I hate phrasing it that way but it works…) or to generate excess cash for spending needs is the essential thrust of rebalancing.

What if you never rebalance? Are you missing out on anything by rebalancing? Typically, without rebalancing your portfolio grows more top-heavy over time. This makes you feel more of the sting when markets turn as they always do. You can miss out on some additional performance when you trim your winners. However, since none of us has perfect foresight we leverage processes like rebalancing instead of simply winging it. It’s counterintuitive and this makes it hard, but having practices like rebalancing really helps keep you on a good financial path over the long term.

I’m doing stuff like this for you already if I’m responsible for managing your portfolio, but feel free to ask questions. Otherwise, we’re all watching to see how AI shapes our world and our markets. Just don’t be too passive with your investments and allocation along the way.

Have questions? Ask us. We can help.

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Finfluencer? Yikes...

Okay, I’ll come right out and admit to being a little out of touch with the reality of social media. My (now young adult) kids sometimes chide me for this. I use Facebook only superficially. I’ve watched a few videos from a singer/songwriter I like on Instagram. And of course I’ll watch stuff on YouTube, but I don’t really surf around and I don’t follow anybody.

I also don’t use Twitter (I refuse to call it “X”). I tried some years ago but quickly gave up. Since I’m self-employed and thankfully not looking for a job I also don’t use LinkedIn much. And I’m certainly not on TikTok. I’ve tried a couple of times but TikTok’s format and explosion of short videos just isn’t my cup of tea.

That said, I do read about what’s happening on TikTok and the rise of “finfluencers” offering quick and casual videos about personal finance. It’s troubling or at least unsettling. Some of these people have millions of followers and pull down $100,000, even $300,000 a year, sometimes much more. They do this indirectly through paid ads within their TikTok, Instagram, and YouTube videos via algorithms at Google, brand sponsorships, and by directly selling products.

I’m sure that structure isn’t news to you because it isn’t to me, but what I don’t appreciate is the lack of disclosure on all this stuff when it comes to people providing financial advice, education, or whatever they might choose to call it. I want people, and especially younger people, to get educated about how the financial world works. Personal finance isn’t taught in schools very much anymore, so people need to get the information wherever they can and that’s fine. However, I question how much value can be found in videos lasting a minute or two. Granted, some of these link to longer videos on YouTube, but how many people make it that far?

After reading more about this in recent days I spent some time looking at finfluencer content on TikTok and was reminded of just how scattershot the information is. It’s also really hard to locate meaningful disclosure about the finfluener’s credentials and how they’re paid. It was also interesting to see the fluid nature with which content creators move between providing information and infomercial. At times it seemed like the sales pitch was more natural than the primary content and I wondered how much the person actually knew about the topic. I mean, these days you can just ask ChatGPT and pretend to know a bunch of stuff.

For example, one creator extolled the virtues of a credit card as part of a life hack process while leaving out a bunch of fine print. I understand adding more detail would make the video too long, but he left out quite a bit. The viewer was then directed to a list of favored cards below which linked to an affiliate program, which eventually linked to the credit card company and the relevant details. Does the viewer have any recourse against the finfluencer for providing incomplete or otherwise bad information? Was the credit card being touted actually “the best right now” for the viewer or the finfluencer?

Now, I don’t want to seem overly stodgy. People need to learn and the end can justify the means, I get that. Many of these creators are well-intentioned and their content is often interesting. If it’s sometimes a little basic and lacking in detail or risky to apply in the real world, maybe we can blame the short-form nature of the delivery platform. Or maybe it’s the short attention span of the viewer – which came first, I’m not sure. Either way, the result is something that’s common in my industry: often inexperienced people providing advice that’s really just a sales pitch.

So the main issue I have with finfluencers today is a lack of disclosure that would lift the veil, at least a little, on why they chose to discuss topics, if they have any expertise or training in the topic, and how they stand to benefit. I have to do this in my work. I have to tell you my background, training, and if I’m selling you something. I have to stay current with contuing education requirements. I have to tell you who my regulator is. And I have to tell you about conflicts of interest that impact our work together. I don’t see why finfluencers, who often provide advice with real-world consequences, don’t need to disclose similar information. Some do and that’s great, but most don’t. This is unfortunate because upgrading the professionalism of these folks would probably benefit a lot of people.

If you’re interested, here’s a great video on this topic from the CFA Institute. There are a few different things on this page so scroll down to the video from Richard Coffin.

Have questions? Ask us. We can help.

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