Categories
Physician Retirement Planning

You Just Inherited An IRA. What Do You Do Now?

The individual retirement account (IRA) is the cornerstone for many people’s retirement savings. They are easy to set up – you can open one through nearly all investment companies on-line in a matter of minutes. They are available to anyone with an income – you can contribute pre-tax dollars if you earn a low or middle income and post-tax dollars if you earn a high income. They are convertible – you can can move funds from your traditional IRA into a Roth IRA and you can (usually) move funds from other tax-deferred investments, such as a defined benefit pension, 401(k), 403(b), or 457 into a traditional IRA. And they give you almost limitless choices – you can invest your IRA into stocks, bonds, mutual funds, annuities, and even real estate. For these reasons, it is easy to understand the popularity of IRAs – 42% of American households have one and they account for one-third of all U.S. retirement assets. They are even more common among retirees – a whopping 52% of households headed by someone over age 65 own an IRA.

Make sure that any required minimum distributions are paid up from the IRA for the year the decedent dies.

Be sure that you take annual required minimum distributions from the inherited IRA if required by the decedent’s age at death.

Know your withdrawal options depending on whether you are a spouse, eligible designated beneficiary, designated beneficiary, or non-designated beneficiary.

Make withdrawals strategically in order to minimize income taxes.

Choose investments for the inherited IRA based on your specific circumstances

 

Because of they are so popular for retirees, it is common for Americans to inherit an IRA from a spouse, parent, grandparent, or some other relative when they die. The rules for inherited IRAs are a bit complicated and when you inherit an IRA you have many choices. These choices fall into two categories: (1) what you legally have to do with the money in the IRA and (2) what you strategically should do from an investment standpoint. The IRS rules regarding inherited IRAs are detailed in publication 590-B. For the purposes of this post, we will be looking at inherited traditional IRAs – inherited Roth IRAs are handled similarly but with some additional nuances.

What you legally have to do

The first branch in the decision-making tree regarding inherited IRAs is based on who you are in relation to the deceased owner of the IRA and can be divided into four groups: (1) spouses, (2) “eligible designated” beneficiaries, (3) “designated” beneficiaries, and (4) “non-designated” beneficiaries. The IRS has different rules for each of these categories so let’s start by taking a look at the withdrawal requirements for each of these groups.

  1. Spouses. If you inherit an IRA from your deceased spouse, you have the greatest flexibility and you can choose from four options to withdraw money from the inherited IRA:
    1. Transfer it to your own IRA. This is usually the best option for most people as long as they are the sole beneficiary of the IRA. In this situation, you simply move money from your deceased spouse’s IRA into your own IRA and then it becomes subject to the withdrawal rules that apply to your IRA. The downside is that you cannot withdrawn the funds before age 59 1/2 without incurring an early withdrawal penalty But the upside is that you would not have to start withdrawing the funds until your own required minimum distribution clock starts at age 73.
    2. Open an inherited IRA using the life expectancy method. In this situation, you would open an inherited IRA (“beneficiary IRA”) in your name that is separate from your own IRA. However, regardless of your age, you will have to begin taking required minimum distributions (RMDs) from the inherited IRA at the later of either (1) December 31st the year after your spouse’s death if your spouse was 72 years old or older or (2) the year your spouse would have turned 73 years old. The amount of those required minimum distributions are based on life expectancy – the IRS publishes tables of your life expectancy and the percentage amounts of required minimum distributions for every age (IRS publication 590-B, appendix B, tables I, II, & III). The required minimum distributions are based on either your life expectancy or your spouses, whichever is longer.
    3. Open an inherited IRA using the 10-year withdrawal method. With this option, you open an inherited IRA (“beneficiary IRA”) in your name and then you have until December 31st of the 10th year after your spouse’s death to withdraw the funds from the inherited IRA. If the decedent died before their age of required minimum distributions, then you can take as much or as little out each year as long as all of the funds are withdrawn by the end of the 10th year. If the decedent died after their age of required minimum distributions, then you have to take at least the RMD amount each year and all funds must be withdrawn by the 10th year. For most people, this option gives less flexibility than either transferring the spouse’s IRA into your own IRA or into an inherited IRA and using the life expectancy method.
    4. Take a lump sum withdrawal. On the surface, this may seem like the simplest option but it has huge tax implications that can cost you dearly. The IRS treats withdrawals from a traditional IRA as ordinary income – the more you withdraw, the higher your income for that particular year. And the higher your income, the higher your income tax rate. A common misconception among Americans is that income only affects tax rates when that income crosses into a higher tax bracket. The reality is that with our marginal income tax system, your income tax rate goes up by a small percentage for every additional dollar of income that you have. So, regardless of your tax “bracket”, you will pay a higher tax rate if you take a lump sum withdrawal and this could result in a huge tax bill that year.
  2. Eligible designated beneficiaries. These are beneficiaries who are not the spouse and fall into one of four groups: (1) minor children of the decedent, (2) chronically ill individuals, (3) permanently disabled individuals, and (4) those who are no more than 10 years younger than the decedent. “Chronically ill” is defined by IRS Code Section 7702B(c)(2)(A). Eligible designated beneficiaries have three options for withdrawing the funds:
    1. Open an inherited IRA using the life expectancy method. This works essentially the same as it does for spouses above. However, if the beneficiary is a minor child, then the life expectancy method automatically changes to the 10-year withdrawal method when that beneficiary becomes 21-years-old.
    2. Open an inherited IRA using the 10-year withdrawal method. This works essentially the same as it does for spouses above. Annual required minimum distributions will apply if the decedent reached the age of required minimum distributions at the time of death.
    3. Take a lump sum withdrawal. This works essentially the same as it does for spouses above.
  3. Designated beneficiaries. This is a more common situation than “eligible designated beneficiaries” and includes adult children, other relatives, and friends as long as they are not chronically ill, disabled, or close to the decedent’s age at death. A person who is listed as a beneficiary on the original IRA documentation is known as a “designated beneficiary”. Designated beneficiaries move the funds into an inherited IRA and must withdraw all of the funds from that inherited IRA within 10 years of the decedent’s death. In addition, if the decedent was old enough to have to take required minimum distributions from their IRA, then you will have to take RMDs every year during that 10-year withdrawal period. In other words, if the decedent was 73 years old at the time of death, then you cannot just sit on the inherited IRA for 9 years and then take a lump sum withdrawal on year 10.
  4. Non-designated beneficiaries. If the decedent did not list any beneficiaries on their IRA documents and that IRA becomes part of the overall estate to be distributed based on the decedent’s will, then the people who inherit that IRA as part of the estate are non-designated beneficiaries (as opposed to “designated beneficiaries” above). In this situation, a 5-year rule applies, meaning that all of the funds from the inherited IRA must be withdrawn by 5 years after the decedent’s death. If you own an IRA, you should always designate beneficiaries on the IRA documentation – otherwise, the IRA can be subject to probate, can be tied up if someone contests the will, and whoever ends up with the IRA will be bound by the 5-year rule (as opposed to the 10-year rule).

Importantly, when you open an inherited IRA (“beneficiary IRA”), it is essential that this be done by a trustee-to-trustee transfer of the funds. This means that whatever investment company holds the money in the decedent’s IRA transfers the money into whatever investment company you use to create your inherited IRA and you do not touch the money. If, on the other hand, you have the investment company holding the decedent’s IRA write you a check and then you cash the check and try to deposit the money into your inherited IRA, you won’t be able to. That is because if you receive that check directly, the IRS considers it a lump sum distribution and so you will have to pay an enormous amount of taxes on all of that money for the year you received the check.

You can take money out of an inherited IRA but you cannot put your own money into an inherited IRA. This means that you cannot make additional contributions to the inherited IRA from your own funds. The only exception to this is if you inherit an IRA from your spouse and then transfer that IRA into your own traditional IRA, in which case you can continue to contribute to the account since it is now your own traditional IRA. If you are not a spouse and you inherit an IRA, then you would need to open up a separate traditional IRA in your own name and then you can make contributions to that second IRA.

The pesky RMDs and basis

There are two kinds of required minimum distributions (RMDs) in an inherited IRA: the amount that the decedent has to pay and the amount that you have to pay. If the decedent was at required minimum distribution age, then the year that the decedent dies, there must be a withdrawal from the decedent’s IRA of at least the RMD based on the decedent’s age. The current required minimum distribution age is 73 but it has progressively increased from 2019 when the RMD age was 70 1/2. The specific RMD age for each year since 2019 is listed here on the IRS website. The RMD amount is calculated by dividing the amount of the IRA by the “life expectancy factor”. The older a person gets, the lower the life expectancy factor. So, for example, if you inherit a $100,000 IRA from your uncle who was 80 years old when he died on March 1, 2024, then the Internal Revenue Service life tables indicate that the life expectancy factor for an 80-year-old is 20.2. By dividing $100,000 by 20.2, the RMD for 2024 is $5,155. If your uncle already withdrew at least $5,155 from his IRA in 2024 before he died, then you do not need to make an RMD from the inherited IRA in 2024. However, if your uncle did not make any withdrawals in 2024 before he died, then you must withdraw at least $5,155 from your inherited IRA in 2024 to satisfy your uncle’s RMD obligation for 2024. Therefore, it is essential that you obtain records of the IRA account activity for the year of the decedent’s death so that you know whether or not you have to withdraw an RMD for the year you inherit the IRA. This can be particularly challenging if the decedent dies in December because you may not have time to get the decedent’s IRA transferred into your inherited IRA before the December 31st deadline to take an RMD withdrawal. If this is the case then either direct the executor or the trustee of the decedent’s IRA to make the RMD withdrawal to the decedent’s checking account or you can request a waiver from the IRS.

The other complicating factor is basis. Most people’s traditional IRA is derived from pre-tax dollars that they contributed to that traditional IRA as a tax-deferred retirement account. However, if your income is too high, you cannot contribute pre-income tax money into the IRA but you can contribute post-income tax money into the IRA. The total amount of any post-income tax contributions that you make to the traditional IRA over your lifetime is the basis of that IRA. When you withdraw money from that traditional IRA in retirement, you do not have to pay income tax on the amount of the post-income tax contributions but you do have to pay income tax on the return on investment of those contributions. For example, say your income in 2010 was too high to make a pre-tax contribution to your traditional IRA so you instead contributed $1,000 from your checking account after paying all of your 2010 income taxes. By 2024, that initial $1,000 has grown to $2,900. If you withdraw all of the money in that traditional IRA, you will have to pay income tax on $1,900 ($2,900 minus $1,000). Things get complicated when you have both pre-income tax contributions and post-income tax contributions to your traditional IRA over your lifetime. It is essential that you track all of your post-tax contributions so that you know what the basis of your IRA is; otherwise, you will end up paying income tax on the entire withdrawal – in essence being taxed twice.

It gets even more complicated if the decedent has more than one kind of IRA – the basis is determined by the sum of all of a person’s traditional IRAs, SEP IRAs, and Simple IRAs. As an example, I have a traditional IRA that is composed of both pre-income tax contributions and post-income tax contributions. In addition, I have an SEP IRA that is composed entirely of pre-tax contributions. Because the basis is determined by by the sum of these IRAs, I have both taxable and tax-free components to both my SEP and traditional IRA withdrawals in retirement, even though all of the original contributions to the SEP were made with pre-tax dollars. It can make your mind spin when doing your income taxes every spring.

When you inherit a traditional IRA, you need to track down any post-tax contributions that the decedent made to that IRA so you can determine the basis of the IRA. If you don’t, then you risk paying a lot more in income taxes than you have to. This is normally done on IRS form 8606 which serves as a historical cumulative record of the IRA basis.

The good news is that the basis in your own regular traditional IRA is not used in determining taxes owed on your inherited IRA withdrawals and vice versa. Your regular IRA(s) and your inherited IRAs are treated like completely separate accounts, each with their own basis used to calculate income tax on withdrawals. But this means that you will have to file two IRS 8606 forms with your income taxes each year – one for the inherited IRA and one for all of your regular IRAs.

What the wise investor should do

Once you have figured out whether or not you need to take an RMD for the year you inherit an IRA and once you figure out what the basis of the inherited IRA is, you then have to decide how you are going to invest the money in the inherited IRA and how you want to strategically withdraw money from that inherited IRA. Let’s take withdrawal strategies first.

You are going pay federal and state income tax on the withdrawals from the inherited IRA for each year that you take a withdrawal. Because those withdrawals are included in your gross taxable income for any given year, the more you withdraw, the higher your income tax rate will be for that year. Your goal is to keep your income tax rate as low as possible every year. Therefore, in years that your income is lower, you should make larger withdrawals from the inherited IRA and in years that your income is higher, you should make smaller (or no) withdrawals from the inherited IRA. It is not always possible to know in advance what your income for any given future year will be but here are some situations that could factor in:

  • You are 66-years-old and want to delay starting to take Social Security in order to maximize the amount of your Social Security payments. By taking withdrawals from your inherited IRA in the years prior to taking Social Security, you can avoid a high income (and a high income tax rate) once you start taking Social Security.
  • You plan to work part-time for a few years. Maybe you are going back to get an MBA in your 40’s or maybe you want to cut back on work for a couple of years after having a child. These are good years to take withdrawals from your inherited IRA to even out your taxable income and your income tax rates over future years.
  • You get a big bonus. Maybe you changed jobs and got a signing bonus this year or maybe your company went public with an IPO and you cashed in your stock options. If you have a windfall in income one year, then skip taking withdrawals from the inherited IRA that year.
  • You anticipate moving to a different state. If you currently live in a state like Florida where there is no income tax but in the future you plan to move to California where the income tax rate can be as high as 12.3%, then taking withdrawals from the inherited IRA when you are a resident of Florida can save you money.
  • If your federal tax rates are going up in the future. We are currently living in an era of historically low income tax rates but these current rates are set to expire at the end of 2025. If rates do increase in 2026 as Congress originally planned, then it is wise to take larger withdrawals in 2024 and 2025 before income tax rates go up.

After deciding when to withdraw the money from an inherited IRA, you have to decide how you are going to invest the money in the inherited IRA. What you invest the money in depends on your individual circumstances:

If your plan is to spend the withdrawal money. Most designated beneficiaries will have to withdraw all of the funds from the inherited IRA over a 10-year period. If your intention is to spend that money when you withdraw it, then you should invest the inherited IRA in a low-risk investment. For example, new 5-year U.S. Treasury Notes are currently being sold with annual interest rates of 4.6%. Bond mutual funds have recently taken a beating as the yields on component bonds have increased to match interest being paid on newly issued Treasury Notes and Bonds. Consequently, now is a great time to invest in bond funds while they are cheap. For money that will be withdrawn from an inherited IRA over the next 2-3 years, even a money market can be a great option (currently paying about 5.25% annual interest).

If your plan is to invest the withdrawal money. Let’s say you are mid-career and working and then you inherit an IRA and you want to use that money as a component of your overall retirement investment portfolio. You still have to withdraw all of the funds over 10 years and pay the income taxes. In order to minimize taxes, determine the proper mix of stocks:bonds in your overall retirement portfolio based on your investment horizon (your age) and your personal willingness to accept risk. Then put the inherited IRA in low risk investments (such as bonds) and move an equal amount of your other tax-deferred investments (from your regular traditional IRA, 401k, 403b, or 457) into higher risk investments, such as stocks. This strategy allows you to maintain your overall stock:bond ratio while minimizing the risk of increasing your income tax rates over the upcoming 10 years.

If you inherit an IRA from your spouse. Normally, you cannot convert an inherited IRA into a Roth IRA. The one exception is if you inherit a traditional IRA from a spouse. In this case, you can make the inherited IRA your regular traditional IRA in your name and then convert some or all that traditional IRA into a Roth IRA. This can be a particular good strategy if your spouse dies and leaves both an IRA as well as cash and regular taxable investments. If you are able to live off of that inherited cash and the taxable investments for a few years, then your taxable income rate will be relatively low. This is a great time to do a Roth IRA conversion because with a low income tax rate, you won’t have to pay as much in income taxes when doing the conversion.

If you plan a big purchase in the near future. Maybe you plan to buy a house in 3 years and will need cash for a down payment. Maybe you are planning an expensive wedding in 2 years. Maybe your child will be starting college in a year. If you will need a large lump sum withdrawal in the near future then invest the inherited IRA in a very low risk investment such as a CD or a money market. Just be sure that the maturity date of the CD is sooner than the date you need the money. In this situation, your primary goal is not minimizing income taxes, instead your goal is to ensure that your investment hasn’t lost money when you need to take it out, such as if the stock market nose-dives.

If you want to donate to charity. If you are younger than age 70 1/2, the only way to donate money in an inherited IRA to charity is to take a withdrawal, pay income taxes on that withdrawal, and then donate whatever is left after taxes to the charity. But if you are older than age 70 1/2, then you can donate to a charity directly from the inherited IRA, without paying any income tax by making a qualified charitable distribution. This means that the donations do not add to your taxable income and thus do not increase your effective income tax rate. The donations can count toward your required minimum distributions for that year. Also, because the money donated to charity is not taxed, the amount that the charity gets is greater. There are some rules, however.

  • The charity must be recognized by the IRS as a qualified charitable organization. This is generally a 501(c)(3) organization.
  • The donation cannot go to a donor-advised fund.
  • The total amount of all qualified charitable distributions allowed is $105,000 per person per year in 2024.
  • The donation must be reported as a death distribution from the inherited IRA.
  • The donation is not included in your Schedule A itemized deductions.
  • The donation must be made from the inherited IRA directly to the charity (“trustee-to-charity”), otherwise you would have to declare the money as income and pay taxes on it.
  • Two additional caveats: (1) make sure you get a receipt from the charity for documentation purposes and (2) each state has different rules regarding state income tax and qualified charitable distributions so check your specific state’s tax laws.

Inherited IRAs can be complicated

The rules regarding inherited IRAs are incredibly complicated – if there was ever a justification for simplifying the U.S. tax code, look no further than publication 590-B. Use this post for general guidance but read the sections of publication 590-B that pertain to your specific circumstances before making final decisions about managing your inherited IRA. If in doubt, get professional help from an attorney, accountant, or financial advisor with expertise in inherited IRAs.

May 6, 2024

Categories
Physician Retirement Planning

Should You Contribute To A Roth IRA After Age 65?

For most of us, retirement is a time to travel and do the things we did not have time to do while working. But that means having the money in your retirement portfolio to do them and making that money last for the rest of your life. Roth IRAs are an essential component of a balanced retirement investment portfolio.

Conventional investing wisdom holds that you should preferentially invest in Roth IRAs when you are young and have a lower taxable income and then preferentially invest in tax-deferred investments (such as a 401k or traditional IRA) when you are older and have a higher taxable income. The premise behind this is that you pay income tax on the money in a Roth IRA when you contribute the money during your working years and pay income tax on tax-deferred investments when you take the money out during your retirement years. Because most people have their lowest taxable income in their early working career years, a higher taxable income in their retirement years, and the highest taxable income during their later working career years, this strategy results in paying the lowest amount in taxes over one’s lifetime.

But should you contribute to a Roth IRA after you retire? The answer is… it depends.

First, you have to have an income

In order to contribute directly to an IRA, you have to have earned income, either as a salaried employee or from contract work. With the former, your income is reported on a W-2 form and with the latter, your income is reported on a 1099 form. If your taxable income is low enough, you can contribute directly to a Roth IRA; otherwise, you can only contribute by doing a “backdoor Roth IRA” by first contributing to a traditional IRA and then promptly converting that money into a Roth IRA. The income limits are complicated so you should review the 2024 IRS rules to see how your specific situation affects your ability to contribute. But as an example, for a single person who does not have access to an employer-sponsored retirement plan, the income limit for direct contribution to a Roth IRA is $146,000 and for a married couple filing jointly, the income limit is $230,000. Many Americans over age 65 are no longer working full-time for an employer but instead are working part-time as contract workers and are thus not eligible for an employer-sponsored retirement plan.

If all of your income comes from a pension, 401(k), 403(b), 457, Social Security, and/or traditional IRA, then you cannot directly contribute to a Roth IRA – you must have annual income that you have earned during that year. Furthermore, you cannot contribute more than you actually earned. The IRA contribution limits in 2024 are $7,000 if you are younger than 50-years-old and $8,000 if you are over age 50. If you do not have any earned income, then you cannot contribute directly to a Roth IRA or do a backdoor Roth contribution. However, anyone can do a Roth conversion, regardless of whether or not they have any earned income.

Roth conversions

If you have money in a tax-deferred retirement account (traditional IRA, SEP IRA, 401k, 403b, or 457), you can convert some or all of that money into a Roth IRA. The catch is that the amount that you convert adds to your taxable income for the year of the conversion. As a result, the more you convert, the higher your taxable income will be and consequently the higher your marginal income tax rate will be.

There are two ways of doing Roth conversions: a direct rollover and an indirect rollover. In a direct rollover, the administrator of your tax-deferred retirement account delivers the converted amount directly to the financial institution holding your Roth IRA and you never touch the money. Direct rollovers are simple and low-risk. In an indirect rollover, you withdraw funds from your tax-deferred retirement account and put those funds into your checking/savings account and then you transfer that money into your Roth IRA yourself. Indirect rollovers have a minor element of risk – you only have 60 days from the time you receive the distribution from your tax-deferred account to the time you deposit it into your Roth IRA. After 60-days, you are no longer permitted to put that money into your Roth IRA.

Before doing a Roth IRA conversion, it is essential that you have an idea of when you will need to eventually withdraw the money from your Roth IRA because conversions are subject to the IRS 5-year rules.

The 5-year rules

The IRS looks at each Roth IRA as having three components: contributions, earnings, and conversions. Contributions are the dollar amount that you put into the Roth IRA each year that you do a direct contribution. Earnings are the dollar amount that the initial direct contributions grew by before you withdraw them from the Roth IRA. Conversions are the dollar amount that you either did with a backdoor Roth, a direct rollover, or an indirect rollover. Each of these components have different rules regarding when you can withdraw them from a Roth IRA. These 5-year rules can impact whether or not it makes sense for you to contribute to a Roth IRA after age 65.

  • Contributions. These can be withdrawn anytime from your Roth IRA without penalty.
  • Earnings. These can only be withdrawn after (1) you turn 59 1/2-years old and (2) at least 5-years have elapsed since your very first contribution to the Roth IRA. Early withdrawal results in significant penalties.
  • Conversions. These can only be withdrawn after (1) you turn 59 1/2- years old and (2) at least 5-years have elapsed since the amount withdrawn was converted. Each conversion has its own 5-year requirement so, for example, you can take the amount of your 2023 conversion out in 2028 but you cannot take the amount of your 2024 conversion out until 2029.

There are also separate rules regarding the timing of withdrawals from inherited Roth IRAs. The rules are complex but in general, if you inherit a Roth IRA from someone other than your spouse, you are required to withdraw all of the money from that Roth IRA within 10 years of the inheritance if you are listed as a designated beneficiary on the Roth IRA. If you are not listed as beneficiary and instead just inherit it through a will, then you only have 5 years after the date of inheritance to withdraw all of the funds.

So, I’m older than 65, should I put money in a Roth IRA?

The decision of whether or not to contribute to a Roth IRA or do a Roth conversion requires some strategic planning. Here are some situations where it can be advisable or not advisable to put money into a Roth when you are over age 65-year-old.

People who should put money in a Roth IRA:

  • You anticipate that your taxable income is going to go up in the future. In your first year or two of retirement, you may be living off of your cash or your regular (non-retirement) investments. You probably will not yet be taking Social Security. If this is the case, then you are only paying taxes on your investments’ interest, dividends, and capital gains resulting in your taxable income being fairly low. This is a good time to either contribute to a Roth IRA (if you have some earned income from part-time work) or do a Roth conversion because you will have a lower marginal income tax rate (i.e., you will be in a lower income tax bracket) than you will be in the future.
  • You anticipate that tax rates are going to go up in the future. We are living in an era of historically low income tax rates that went into effect in 2017. However, these tax rates automatically expire at the end of 2025. Unless congress passes new tax laws to extend these cuts, everyone’s income tax rates are going to go up in 2026. If tax rates do go up, then 2024 and 2025 will be good years to put money into your Roth IRA. This is especially true for Roth IRA conversions – you will pay less in taxes to take out money from your 401k or traditional IRA now to convert into a Roth IRA than you will to take that same amount of money out of your 401k or traditional IRA to spend starting in 2026. We may have a more clear picture about future tax rates after the 2024 elections.
  • Your investments have recently lost value. The goal of investing is to buy when it is low and sell when it is high. When you do a Roth conversion, then you are essentially buying shares of that Roth investment. The value of stocks and bonds goes up and goes down. If you convert a traditional IRA or 401k when it has recently lost a lot of value, then you will pay less in taxes on that conversion than you will when the value of that traditional IRA or 401k eventually goes up. In the summer of 2022, the stock market tanked and lost 27% of its value – that was a great time to do a Roth conversion. Since 2022, the stock market has regained that 27% and you will incur a lot more in taxes to convert any given percentage of your traditional IRA or 401k today than you would have in September 2022. If the stock market continues to go up in the next few years, then 2024 could still be a good year to do a Roth IRA conversion but no one has a investment crystal ball to predict the future.
  • You anticipate RMD pain. When you turn 73, you are required to take a certain percentage out of your tax-deferred retirement accounts such as your traditional IRA, SEP IRA, 401(k), 403(b), and 457. These are called required minimal distributions (RMDs) and they add to your annual taxable income. If you have a lot of money in these accounts, then starting at age 73, your annual taxable income could go up significantly. As your taxable income goes up, so does your marginal income tax rate, meaning that you will pay exponentially more in taxes. You can lower the amount of the RMDs by doing Roth IRA conversions before age 73 to reduce the overall value of your tax-deferred investment accounts. Your RMD is based on your life expectancy – as an example, the RMD on a $1,000,000 tax-deferred account for someone turning 73 this year is about $40,000 per year. Unlike tax-deferred retirement accounts, Roth IRAs are not subject to RMDs.
  • You want to maximize your estate for your heirs. If you do not anticipate needing to use the money in your Roth IRA for yourself during your lifetime then you may be able to  allow the value of that Roth IRA to increase undiminished by required minimum distributions, thus leaving more for your heirs to inherit.

People who should not put money in a Roth IRA:

There are certain situations when you want to avoid doing Roth IRA conversions in retirement. Here are some considerations

  • If it makes your Medicare premiums go up. For the vast majority of Americans, Medicare Part A is free. But we all have to pay monthly premiums for Medicare Part B and the amount of those premiums is based on your income. Medicare Part D premiums vary by the specific Part D plan level you choose but regardless of the level, the amount of the premium also increases based on income. When you do a Roth conversion, your taxable income that year goes up by the amount of the conversion and this could push you into a higher Medicare Part B and Part D premium bracket. The tax advantages of a Roth IRA conversion can be wiped out by the increase in your Medicare premiums. For example, if your taxable income is $249,999 and you do an $8,000 Roth IRA conversion, you will pay a total of $3,090 in Medicare Parts B & D premiums. But if you do an $8,002 Roth IRA conversion (just $2 more), then your Medicare premiums will go up by $1,503 to $4,593.
  • If it moves you into a higher capital gains tax bracket. Regular income tax is a marginal tax rate system meaning that your tax rate increases incrementally for every additional dollar of taxable income. Short-term capital gains occur when you hold an investment for < 12 months and are taxed at your regular marginal income tax rate. Long-term capital gains occur when you hold an investment for > 12 months before you sell it. The long-term capital gains tax is not based on your regular marginal income tax rate but is instead based on your capital gains tax bracket. The capital gains tax rate is not a marginal tax, thus if your income pushes you into a higher marginal tax bracket, you will pay that higher tax rate on all of your capital gains. If you have a lot of capital gains, either because you were selling and buying investments over the course of the year or because you were taking money out of non-tax-deferred investments, then a Roth IRA conversion could push you into a higher capital gains tax bracket and those higher capital gains taxes could erase any tax advantages of the Roth IRA conversion. Here are the 2024 capital gains brackets:
  • After age 73, things change. Once your tax-deferred retirement accounts become subject to required minimum distributions at age 73, you cannot use those RMD amounts to do a Roth IRA conversion. If you are working after age 73, you can still contribute earned income into a Roth IRA. You can also so a Roth IRA conversion on any money you take out of your tax-deferred retirement accounts over and above your RMD for that particular year. But for many people over age 73, doing a Roth IRA conversion on top of RMDs can push them into a higher marginal tax rate that erases any tax advantages of the Roth IRA conversion.
  • You plan to give a large amount to charity. Once you turn 70 1/2, you can donate up to $105,000 directly from your tax-deferred accounts to charity via a qualified charitable distribution without having to pay income tax on the amount of those donations. And as a bonus, if you are over age 73, the amount of those donations count toward your RMDs! In this situation, Roth IRA conversions when you are younger can be counterproductive to your future tax-minimization strategy of charitable giving after age 73.

Diversify, diversify, diversify!

One of the most important reasons to have a Roth IRA (or Roth 401k or Roth 403b) is to have a diversified retirement portfolio. Ideally, you should have money in four buckets: tax-deferred accounts, Roth accounts, regular investments, and fixed income sources. Each of these different types of retirement income sources have different income tax implications. By strategically adjusting how much you withdraw from each of these different sources every year, you can keep your income taxes to a minimum. In a year during your retirement when you have a lot of expenses (for example, buying a vacation home), you can withdraw more from your tax-free Roth IRA and avoid having a high taxable income that year. In a year in retirement when you do not have a lot of expenses, you can leave your Roth IRA alone and instead withdraw from your tax-deferred retirement accounts. Your retirement portfolio withdrawal strategy should be based on minimizing taxes over your lifetime and that strategy requires having the flexibility of a diversified portfolio. For this reason, I believe that everyone needs a Roth IRA (or Roth 401k or Roth 403b). The challenge is determining when is the best time to put money into that Roth IRA. For many people, putting money into a Roth IRA by contributions or conversions after age 65 can make sense.

January 15, 2024

Categories
Physician Retirement Planning

Here Is How To Make Your Medicare Premiums Tax-Deductible

Health insurance in the United States is expensive and Medicare premiums are no exception. If you are a physician or in another high-income profession, you are going to pay even higher Medicare premiums. Fortunately, there are three ways that you can make those premiums tax-deductible.

The vast majority of Americans enroll in Medicare when they turn 65-years-old, regardless of whether or not they are still working. For most Americans, Medicare Part A (inpatient care) is free. But there are monthly premiums for Medicare Part B (outpatient care). There are additional premiums for Medicare Part C (Medicare Advantage plans) and Medicare Part D (Medicare drug coverage). For those who do not enroll in a Medicare Part C plan, purchase of a Medicare supplemental policy (Medigap) is advisable to pay for those charges not covered by Medicare Parts A & B. All of these additional coverage plans have their own premiums and consequently, most seniors pay far more for health insurance than just their monthly Medicare Part B premiums.

But amount that you pay for Medicare Part B and Medicare Part D premiums is based on your income. As a result, if you are still working after age 65 or if you have a lot of retirement income from a traditional IRA, 401(k), 403(b), or 457, then you are going to pay more for your Medicare premiums than other seniors. Medicare will check your most recent federal income tax return to determine your income-based premiums. For example, to determine your 2024 premiums, Medicare will look at the tax return you filed in 2023 which would cover your income during the 2022 tax year. Here is how your 2022 modified adjusted gross income will affect your annual Medicare premiums in 2024:

In the table above, the annual Medicare Part B premiums are listed. Part D premiums vary depending on which specific policy is purchased but for any policy, there is an annual add-on amount based on your income that is listed in the table. Your income does not affect premiums paid for Medicare Part C (Medicare Advantage plans) or supplemental Medicare insurance (Medigap plans).

Options to make your Medicare premiums tax-deductible

Many Americans will find themselves paying more for health insurance premiums after they go on Medicare than they did before going on Medicare. This is because during your working years, employers will generally pay for part of the cost of health insurance as an employment benefit. The employee will usually pay a share of the cost of the premiums but for most employer-sponsored group health insurance plans, those premiums are paid out of your pre-tax income, which is equivalent to making these premiums tax-deductible. Once you go on Medicare, you have to pay for the entire cost of premiums yourself. Unlike employer-sponsored group health insurance, what you pay for Medicare premiums is not automatically tax-deductible However, there are three situations that will allow you to take a tax deduction for your Medicare premiums: (1) using health savings accounts, (2) itemizing deductions, and (3) having self-employment income.

Use a health savings account (HSA)

As an investment, HSAs are a true triple threat when it comes to tax advantages. When you put money into an HSA, those contributions are tax-deductible. You don’t pay any annual taxes as the HSA accrues in value. And then when you eventually take money out to pay for health expenses, you don’t pay any taxes on the withdrawals.

However, not all Americans are eligible to have an HSA. First, you cannot make contributions to an HSA after you enroll in Medicare at age 65. For those people younger than 65, only those who purchase an “HSA-eligible health plan” can contribute to an HSA. These health plans are also called high-deductible health insurance plans – they come with lower annual premiums but have higher out-of-pocket costs compare to other plans. Unfortunately, most employer-sponsored HMO or PPO health insurance plans do not qualify. But, if you are self-employed and purchasing health insurance through the Health Insurance Marketplace or if your employer offers high-deductible health insurance plans, then you may elect to enroll in an HSA-eligible health plan. High-deductible health plans are defined by the IRS. For example, for 2023, the IRS defined these plans as having a deductible of at least $3,850 for individual HSAs with maximum out-of-pocket spending of no more than $7,500. If married, both spouses can have their own HSA. There is a limit to the how much you can contribute to an HSA each year – for 2024, that limit was $4,150 for an individual HSA ($5,150 if over age 55). 

For those people who are eligible to contribute to an HSA, they are truly a great deal. Even if you never get sick or injured a day in your entire life, you will still have to pay Medicare premiums after age 65 and you can use HSA withdrawals to pay for those premiums. Note, however, you cannot use HSA withdrawals to pay for Medigap premiums.

Itemize deductions

Most Americans do not itemize deductions. The income tax cuts resulting from the 2016 tax law increased the standard deduction (currently at $14,600 if filing single and $29,200 if filing jointly for the 2024 tax year). The standard deduction increases after age 65 by an additional $1,950 if filing single or $3,100 if filing jointly. You can only itemize your deductions if the total deduction amount exceeds the standard deduction amount. Things that can be itemized include charitable deductions, certain taxes (local, state, and property taxes up to a maximum of $10,000 in total), business expenses, and mortgage interest. Healthcare expenses can be itemized only to the extent these expenses exceed 7.5% of your adjusted gross income for the year.

If you have a lot of out-of-pocket healthcare expenses, then it may make sense to itemize those expenses, including the expense of your Medicare premiums. One strategy to increase your deductions over the standard deduction amount is to make charitable deductions every other year. By contributing twice as much to charities in one year, those charitable deductions can push your total deductions above the standard deduction amount, thus allowing you to deduct healthcare expenses (to the extent that they exceed 7.5% of your income that year). Then the next year, you do not make any charitable deductions and instead take the standard deduction. If you really want to be able to contribute to a charity every year, then consider opening a donor-advised fund. You can contribute a large amount to the donor-advised fund one year and and take a tax deduction on the amount contributed as an itemized deduction. Then, you can make contributions to individual charities each year from the donor-advised fund and on those years, just take the standard deduction.

The current tax cuts expire on December 31, 2025 and unless there is new Congressional legislation to extend those cuts, income tax rates will increase and the standard deduction amount will fall in 2026. At that time, more Americans may be eligible to itemize deductions, including their Medicare premiums.

Have self-employment income

If you have income that is reported on Schedule C, then you have self-employment income. This could be from consulting, from honoraria, or any other employment income that is reported on a 1099 form. This does not include Social Security income, pension income reported on a 1099-R form, or investment income reported on a 1099-DIV or 1099-INT form. You can deduct your Medicare premiums from your Schedule C self-employment income. However, you cannot deduct more than you earn so your Medicare premium deductions cannot exceed the amount of your Schedule C income. If you have any Schedule C income then you should definitely deduct your Medicare premiums.

If you are self-employed, you can deduct Medicare Part B premiums, Medicare part D premiums, Medicare Advantage plan premiums, and Medigap premiums. There is an important caveat, however. You cannot deduct your Medicare premiums from self-employment income if either you or your spouse is eligible for an employer-subsided health plan.

Healthcare is expensive

It is unavoidable – healthcare is expensive. And the older you get, the more you are going to end up paying. CMS reports that the average male child (under age 18) generates $4,415 per year in healthcare costs; female children are slightly lower at $4,009. A man during his working years generates $8,3,13 of healthcare costs per year. Women in their working years generate $9,989, considerably more largely due to reproductive expenses. After age 65, annual healthcare costs increase to $22,597 for men and $22,162 for women. After age 85, per capita healthcare costs increase further to $35,995 per year. Because of this, commercial health insurance during one’s working years has to cover a much lower healthcare cost per person than Medicare has to cover after age 65. We pre-pay a portion of our Medicare premiums via payroll taxes during our working years, otherwise, the annual Medicare premiums we pay after age 65 would be exorbitant. But even so, Medicare premiums for seniors are very costly and can account for a significant amount of one’s disposable income after age 65.

Before age 65, everyone pays the same for health insurance premiums but after age 65, your Medicare premiums are based on your income. So, if you have saved diligently into tax-deferred retirement accounts, or if you have a pension, or if you continue working after 65, then you are likely going to have a relatively high income in retirement. That’s a good thing overall but it does mean that you are going to pay more for Medicare. But careful planning can allow you to make your Medicare premiums tax-deductible and thus take some of the bite out of those premiums.

January 3, 2024

Categories
Physician Retirement Planning

Understanding Bonds – And Is It Time To Invest In Bonds?

Most people understand stock investment but investing in bonds is… well, confusing. Part of the confusion comes from the interplay of the interest that the bond pays versus the price of the bond. But another aspect of confusion comes from the words used in bond investment that can seem like a totally different language that requires a translator for the average investor.

Summary Points:

  • When bond prices or bond mutual fund share prices fall, their yields increase
  • Bond prices tend to fall during inflation and when the Federal Reserve increases the Federal funds rate
  • This year, stock prices have risen substantially whereas bond prices have been flat resulting in most retirement portfolios now being overweighted in stocks
  • Because bond prices are currently low and bond yields are high, bonds are now becoming an attractive investment
  • Now is a good time to rebalance retirement portfolios by buying bonds or shares of bond mutual funds

 

The foundations of a healthy investment portfolio for retirement are diversification and balance. Diversification means owning stocks or bonds in a lot of different companies. The simplest way to achieve diversification is to invest in a broad sector index mutual fund, for example, an S&P 500 index fund for stocks. Balance means maintaining a desired percentage of stocks versus bonds in your portfolio. A simple way to achieve balance is to own a target retirement mutual fund that frequently buys and sells stocks and bonds in order to keep a fixed percentage of stocks and bonds; the fund then adjusts that percentage each year as you get closer to retirement. If you are the kind of person who does not want to put a lot of time into investing, then a target retirement mutual fund that is composed of index stock funds and index bond funds is for you – no investment expertise is required and the annual expenses are low.

But if you invest in individual stocks or stock mutual funds, then it is up to you to ensure that your portfolio is diversified and balanced. This is particularly the case if you are invested in a 401(k), 403(b), or 457 plan that does not offer target retirement mutual funds as an investment option. This then raises the question of when is the best time to re-balance your portfolio by buying or selling bonds? To answer that question, one must first understand the basics of bond investing.

Bond investing 101

Terminology

When you purchase a corporate bond, you are loaning a company money for a specific amount of time and in return, that company will pay you interest every year until the loan is paid off. A government bond is similar – you are loaning the government money for a specified amount of time and in return, the government pays you interest every year until they repay the loan. So, if you purchase a 30-year bond at 3% interest, then the company or government will pay you 3% of the value of the bond every year for 30 years and at the end of the 30 years, you redeem that bond and get back the amount of money that you originally paid for the bond. This is exactly what happens if you purchase a bond, hold it for the entire duration of the bond, and then redeem it at the end of that period of time. However, most people do not purchase a bond and then hold it for the entire duration, instead, most people resell and buy bonds in a secondary market. And this is where the terminology gets complicated. Let’s take a look at some of the words used in the language of bonds. To illustrate these terms, let’s take an example of a bond that is initially sold for $1,000, pays 6.0% annual interest, and has a duration of 10-years before it will be redeemed. Two years after the initial purchase, the bond is then re=sold on a secondary market for $900.

  • Maturity. This is the amount of time until the bond is redeemed. Think of this as the duration of a loan. In the example above, the maturity is 10 years when the bond was initially purchased but 8 years when it was re-sold on the secondary market.
  • Par. This is the original face value of the bond when it is first issued. It has absolutely nothing to do with golf. In the example above, the par value is $1,000. This is also the amount that the buyer of the bond is paid by the bond issuer at the end of the maturity period ($1,000).
  • Coupon. This is the dollar amount of annual interest that is paid by bond. The amount of interest is set at the time that the bond is first issued and is then fixed for the entire duration of the bond. In the example above, the coupon is $60 ($1,000 x 6.0%).
  • Coupon rate. This is the amount of annual interest (coupon) paid each year expressed as a percentage of the initial purchase price (par value) of the bond. In the example above, the coupon rate is 6.0%. In simplest terms, the coupon rate is the interest rate.
  • Price. When a bond is re-sold on a secondary market, this is the amount that that bond sells for. Bond prices fluctuate and so the price is usually not the same as the par value. In the example above, the price of the bond was $900 when it was re-sold. When the price is lower than the par value, it is said to be sold “at a discount”. When the price is the same as the par value, it is said to be sold “at par”. When the price is higher than the par value, it is said to be sold “at a premium”. Importantly, regardless of the price paid for a bond in a secondary market, the redemption amount of that bond will still be the bond’s original par value. So, in the example above, the person who bought the bond at $900 would be paid $1,000 when they cash it in at the end of 8 years in addition to being paid $60 in interest in each of those 8 years. To take into account both the change value of a bond when it is eventually redeemed as well as the value of the annual interest payments until it is redeemed, we need another measurement and this is where “yield” and “yield-to-maturity” come into play.
  • Current yield. Here is where bond terminology gets even more complicated. In simplest terms, the current yield is the coupon divided by the current price. Think of it as a way of adjusting the effective interest rate when the price of a bond varies. In the example above, the yield of the bond when it was resold was 6.7% ($30 ÷  $900). The current yield will fluctuate as the bond price fluctuates on the secondary market. A key point to understand about bonds is that there is an inverse relationship between a bond’s price and its yield. When the price goes down, the yield goes up and vice-versa.
  • Yield-to-maturity. This is expected annual rate of return earned on a bond under the assumption that the bond is held until maturity and all annual interest is re-invested at the same interest rate. Think of it as the effective interest rate when the current price paid on the secondary market for a bond is different than the original par value of that bond. The calculation is illustrated in the equation below and shows that in our example, the yield-to-maturity is 7.6% when the bond is re-sold at $900 with 8 years of maturity left. For simplicity, you can also use an on-line calculator to determine the yield to maturity of a bond. The good news is that bond mutual funds will normally calculate the average yield-to-maturity of all of the component bonds that it holds and the mutual fund will update the fund’s yield-to-maturity number on-line regularly.

Types of bonds

The term “bond” is fairly generic and is often used to describe a lot of different forms of loans that investors can make to corporations and governments. A more accurate, all-encompassing term is “securities”. Here is a list of some of the more common types of securities:

  • Treasury bills. These have a maturity of less than 1 year. Currently, the U.S. Treasury offers bills of 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week maturities.
  • Treasury notes. These have maturities between 1 year and 10 years. Currently, the U.S. Treasury offers notes of 2-year, 5-year, 7-year, and 10-year maturities. The 10-year Treasury note (10-year T-note) is often monitored by investors as representative of the overall U.S. government bond market.
  • Treasury bonds. These have maturities between 10 years and 30 years. Currently, the U.S. Treasury offers bonds of 20-year and 30-year maturities.
  • Treasury inflation-protected securities (TIPS). These have variable interest rates that fluctuate based on the current inflation rate. The U.S. Treasury currently offers TIPS of 5-year, 10-year, and 30-year maturities.
  • Floating rate notes (FRNs). These have a coupon (interest rate) that moves up or down based on the most recent coupons of Treasury bills sold at public auction. The U.S. Treasury currently offers FRNs with a 2-year maturity.
  • Government National Mortgage Association (GNMA) securities. These are bonds sold by the GNMA (an agency of the U.S. Department of Housing and Urban Development) to provide money to buy mortgages from banks and other mortgage lenders. These are mortgages that are insured by the Federal Housing Administration (FHA), which typically insures mortgages to first-time home buyers and and low-income borrowers. Think of a GNMA security as a bundle of a lot of different mortgages.
  • Municipal bonds. These are bonds sold by state and local governments and are tax-free for federal income tax and state income tax from the state that the bond was issued from. Because the interest is tax-free, municipal bonds pay lower interest rates than other government bonds.
  • Corporate bonds. These are sold by private corporations. Because companies can go out of business before the bond maturity date, they are considered riskier than government bonds and consequently pay higher interest rates than Treasury bonds. The interest rate is affected by the company’s credit rating. “Junk bonds” are issued by companies with a low credit rating and pay higher interest rates than other corporate bonds because of the higher risk that the company will go out of business.
  • International bonds. These are bonds issued by non-U.S. corporations and governments.

The individual investor can either purchase bonds directly or purchase shares of a bond mutual fund. The U.S. Treasury regularly auctions off bills, notes, bonds, TIPS, and FRNs through the TreasuryDirect website. Individual investors can create a TreasuryDirect account through which they can bid on and pay for these auctioned bills, notes, and bonds. They can also be purchased through a bank, broker, or dealer if you do not want to bid through a TreasuryDirect account. Once you own one of these securities, you can sell them on the secondary market if you wish.

Most people prefer to purchase shares of bond mutual funds rather than buy and sell individual bonds. This adds another layer of bond complexity because a given mutual fund will contain many different bonds with different coupon rates and different maturity dates. This is where the yield-to-maturity value can be helpful because it allows the mutual fund to express the overall average yield-to-maturity of all of the component bonds when the fund is composed of bonds of varying coupon rates, prices, and maturities. Bond mutual funds are categorized based on the average maturity dates of the component bonds and are typically classified as short-term (average maturity about 2-3 years), intermediate-term (average maturity about 6-8 years), and long-term (average maturity about 22-23 years). Bond mutual funds may be composed of corporate bonds, government bonds, or a mix of both so it is important to look at the composition of each bond mutual fund.

The 2 major risks with bonds

Inflation and a future rise in interest rates are the two main risks of bonds. If the inflation rate of the U.S. economy is higher than the coupon rate of a bond, then over time, the owner of the bond actually loses buying power. Inflation is perhaps best measured by the consumer price index (CPI) which is the average amount that consumers pay for common goods and services. The U.S. Bureau of Labor Statistics website reports the CPI. Since 1958, the CPI has averaged 3.7% but as shown in the graph below, it has varied from a low of 1.0% in 2010 to a high of 12.4% in 1980. The Federal Reserve strives to keep inflation at 2% by using its monetary policy, which includes adjusting the Federal funds rate (the interest rate charged for banks to lend each other money overnight to maintain liquidity). For 25 years (from 1995 – 2020), the Federal Reserve’s monetary policy worked quite well and kept inflation at an annual average of 2.1%. The COVID pandemic was highly disruptive economically, however. As a result, during 2022, the CPI increased 6.2%, giving 2022 the highest annual inflation rate in 40 years.

Rising interest rates is the second major risk of bonds. Let’s say you have a bond with a par value (i.e., initial purchase price) of $1,000 that has a coupon rate (interest rate) of 3.0% with a 30-year maturity. Plugging those numbers into the yield-to-maturity formula above, the YTM on the day that you first purchased the bond was 3.0% (the same as the coupon rate). Now let’s say that 5 years later, the coupon rate (interest rate) for new bonds being issued has increased to 5%. If you want to sell that bond that you bought 5 years earlier, no one is going to pay you $1,000 for it because it would still have a yield-to-maturity of 3.0% whereas a newly issued 30-year bond would have a yield-to-maturity of 5.0%. Therefore, to find a buyer for that older bond, you would have to drop the price below the par value (initial purchase price) of $1,000. If you do the math, you would have to drop the price of the bond to $700 in order to give it the same yield-to-maturity as a newly issued bond. In other words, over the 5 years that you owned the bond, you would have made $150 in annual interest but you would have lost $300 when you sold the bond. This illustrates why it is not advisable to buy bonds just before interest rates are hiked up.

The corollary of this is that it is a good time to buy bonds if (1) inflation remains lower than the coupon rate of the bond and (2) interest rates are about to fall. In other words, when you buy a bond, you are betting that the bond’s yield is higher than the future inflation rate. You are also betting that the bond’s current yield is higher than coupon rate for bonds sold in the future.

How bond interest rates are determined

In a pure free market setting, interest rates would be governed by supply and demand. When demand for bonds is low, corporations and governments have to pay higher interest rates to entice people to buy their bonds. Conversely, when demand is high, corporations and governments can drop interest rates and still sell plenty of bonds. However, there are a number of non-free market forces that have a profound effect on bond interest rates (coupon rates). One of the most important is the Federal Reserve lending rate (funds rate). This is the rate that the Federal Reserve sets for banks to charge other banks to lend money, usually for overnight loans to maintain liquidity.

The Federal funds rate has a profound effect on short-term bond yields but has less effect on long-term bond yields. In the graph below, the Federal funds rate set by the Federal Reserve is in blue and the market yield for the 6-month Treasury bill is in purple. The two lines match almost exactly, illustrating the close relationship between the Federal funds rate and short-term bond yields. The market yields for 5-year Treasury notes (a form of intermediate-term bond) is in red. The graph shows that intermediate-term bonds are also affected by the Federal funds rate but the relationship is not as tight as with short-term bonds. The market yield of 30-year Treasury bonds (a long-term bond) is in green and this shows even less correlation with fluctuations in the Federal funds rate. The reason for these relationships is that short-term bond yields reflect current interest rates and inflation whereas long-term bond yields reflect what investors think will be future interest rates and inflation.

The current yields on U.S. Treasury bills, notes, and bonds are shown in the table below based on Federal Reserve data from August 16, 2023:

In addition to the Federal funds rate, there are several other variables that affect bond interest rates (and thus bond yields):

  • Anticipation of future inflation. When investors believe that inflation will go up in the future, they are less willing to buy bonds unless the yields on those bonds rises, either because issuers of new bonds pay higher coupon rates (interest rates) or sellers of older bonds on the secondary market are willing to reduce the selling price of those bonds to below the initial par value (initial purchase price).
  • Anticipation of future increases in market interest rates. Similarly, if investors believe that the coupon rates (interest rates) on newly issued bonds is likely to rise in the future, then they will be unwilling to buy old bonds with lower coupon rates on the secondary market unless the sellers of those old bonds drop the price below the par value (i.e., initial purchase price) of the bond.
  • Anticipation of future fall in the stock market. If investors believe that stocks are about to lose value in the future, then they will often move money from stocks into bonds since bond prices are not as volatile as stock prices. This can increase demand for bonds and so unless there is a flood of new bonds being issued on the bond market, the price of bonds on the secondary market will rise, resulting in a drop in the yields of those bonds.
  • Governments or corporations increase borrowing. This can happen if governments increase spending or decrease taxes. When corporations anticipate an increase in demand for their goods, they will also borrow more money in order to build factories, buy new equipment, or hire new workers. This happens during periods of economic growth. When a lot of new bonds are being sold, the supply of bonds can exceed the demand by investors resulting in corporations or governments having to pay higher coupon rates (interest rates) in order to entice investors into buying their bonds.
  • Governments or corporations decrease borrowing. The opposite happens when companies and governments stop selling bonds resulting in a reduced supply of new bonds on the market. In this situation, investors may be willing to accept lower coupon rates (interest rates) to purchase new bonds. On the secondary market, bond prices then rise with a concurrent fall in yields.
  • Wars and international political instability. The U.S. government is currently perceived as being among the most stable and reliable in the world. It is seen as one of the least likely to default on its debts (bonds) and therefore has a very high credit rating. When wars break out or there is the threat of political or economic instability, investors flock to U.S. Treasury securities given their perceived safety relative to other countries’ bonds. This can increase demand for Treasury bonds and thus reduce the coupon rates (interest rates) of new bonds sold at public auctions. A danger of U.S. legislative debt stand-offs and government shut-downs is that they can erode the U.S. credit rating, thus pushing up the interest rates that the Treasury must pay when issuing new bonds.

Nevertheless, U.S. Treasuries are currently considered to be the lowest risk bonds in the world and sell at lower yields than other bonds. In the graph below, 10-year U.S. Treasury note yields (green) are consistently lower than Aaa corporate bonds (red) and Baa corporate bonds (blue). This illustrates the maxim that credit ratings determine interest rates.

Is now a good time to buy bonds?

The current state of bonds

Currently, the yield-to-maturity of the Bloomberg U.S. Long Treasury Index is 4.1%; the intermediate Treasury index is 4.2%; and the short Treasury index is 4.7%. The corporate bond yield-to-maturity for companies with a high credit rating is running about 1% higher than U.S. Treasuries. The Bloomberg U.S. Aggregate Float Adjusted Index (a gauge of the total U.S. bond market, including both corporate and government bonds) has a current yield-to-maturity of 4.9%, midway between the Treasury and corporate values. Most total U.S. bond market index mutual funds should have a similar yield-to-maturity value – around 4.8% – 4.9%.

The inflation rate has been cooling off for the past several months. The consumer price index has increased 4.7% from July 2022 to July 2023. But for the past 3 months, it has only increased by a total of 0.8% and if that trend continues for the next year, then that would result in an annual inflation rate of 3.2%. Although not back to the Federal Reserve’s target inflation rate of 2.0%, it appears that the worst of inflation is behind us.

The Federal Reserve’s Federal Open Market Committee holds eight meetings each year. During those meetings, decisions are made about whether to change the Federal funds rate. Most analysts predict that the Committee will raise the Federal funds rate one more time this year and this would put it at about 5.6%. If inflation appears to be under control, this may be the peak in the Federal funds rate before the Committee eventually starts to lower the rate in another year or two. This implies that current coupon rates (interest rates) on newly issued bonds are likely also at or near their  peak values. Because new bond coupon rates correlate with bond yields when bonds are re-sold on secondary markets, this means that bond yields-to-maturity are also likely at or near their peak. Because bond yields are inversely correlated with bond prices, this additionally means that bond prices (and bond mutual fund share prices) are at or near the lowest point that they will be for the next few years.

Rebalancing your investment portfolio

I have covered investment portfolio balancing in a recent previous post. But in general, the stock-to-bond ratio (“balance”) in a retirement portfolio depends on two factors: the number of years to retirement (in other words, your age) and your tolerance for investment risk. An example of how these two factors affect your desired stock-to-bond ratio is shown in the graph below:

Since January 2023, the S&P 500 index is up 20% but the total U.S. bond market is only up 2%. As a result, investors who last rebalanced their retirement portfolios in January are now significantly out of balance with higher percentages of stock holdings than bond holdings. What this all of this means for the average investor is that now is a good time to buy bonds, whether that means buying newly issued U.S. Treasury securities or buying shares of bond mutual funds. I am normally not a fan of “market-timing”, that is, making investment decisions based on when you think the market is at a high or low. However, the bond market is undeniably attractive right now.

Perhaps the safest strategy is to do a checkup of your portfolio now to determine your current actual stock-to-bond ratio and compare that to your desired stock-to-bond ratio. Next, calculate the amount of money that you would need to re-allocate to bonds in order to re-balance your portfolio to your desired stock-to-bond ratio. Then spread out those bond purchases over the next 4-6 months, using a “dollar-cost averaging” tactic. As an example, say that your desired stock-to-bond ratio is 70%/30%. Because of the recent strong stock market and weak bond market so far this year, you now find that your actual stock-to-bond ratio is 75%/25%. To re-balance, you would then convert 1% of your stock holdings into bond holdings each month for the next 5 months. By spreading those conversions over 5 months, you avoid the potential pitfall of trying to time the stock-to-bond conversion to when you think the Federal Reserve will do its final Federal funds rate hike.

So, is now a good time to buy bonds? More than likely, the answer is… yes!

August 18, 2023

Categories
Physician Finances Physician Retirement Planning

When Is The Best Time To Rebalance Your Investment Portfolio?

An essential element of investment portfolio health is periodic rebalancing. This means evaluating your current mix of stocks, bonds, cash, and real estate investments, then selling and buying these various components to ensure that the actual proportions are the same as your desired proportions. For example, let’s say you want a portfolio that is 60% stocks and 40% bonds. If the stock market falls and you find yourself with 55% stocks and 45% bonds then you sell some bonds and buy some stocks to rebalance to the 60/40 mix. But how often should you rebalance and is there a best time of the year to rebalance? By using a little strategy in deciding when to rebalance, you can increase your overall investment returns.

Components of a diversified investment portfolio

The simplest way to think of portfolio diversification is stocks and bonds. As a general rule, when a person’s investment horizon is long, that person should have a higher percentage of stocks compared to bonds in their portfolio. On the other hand, when a person’s investment horizon is short, that person should have a  higher percentage of bonds compared to stocks in their portfolio. Consequently, a 25-year old who is 40 years away from retirement should be primarily invested in stocks. A 65-year old who is ready to retire should have a higher percentage of bonds and a lower percentage of stocks in their investment portfolio.

In addition to one’s investment horizon, one’s willingness to take investment risk also affects the stock:bond ratio in a portfolio. For any given investment horizon, a higher risk portfolio will have a greater percentage of stocks than a lower risk portfolio. Because of this, a higher risk portfolio will have a greater chance of larger long-term returns but also has a greater chance of short-term losses. Investment anxiety is one way of determining investment risk. For example, if you lose sleep every time your 401(k) falls in value, then you should take a lower risk approach to investing. On the other hand, if the ups and downs of the stock market does not bother you, you can adopt a higher risk approach to investing. Life expectancy also affects investment portfolio risk. For example, a person in excellent health who anticipates living to an old age can afford to have a higher risk portfolio since their investment horizon is quite long, even at the age of retirement. Having a pension serves as a buffer in the event of short-term losses, therefore, a person with a sizable pension can afford to have a higher risk portfolio. If a person’s anticipated monthly income from their retirement portfolio is considerably higher than their monthly basic living expenses, then that person can afford to not take money out of retirement investments in years that the market has fallen and thus that person can also afford to have a higher risk investment portfolio.

By combining one’s investment horizon (i.e., age) with one’s willingness to accept investment risk, an individualized stock:bond ratio for their retirement portfolio can be created and might look something like this:

Merely looking at the ratio of stocks to bonds is an over-simplification of investment diversification. A better way to diversify is to subdivide stock and bond investments into U.S. versus foreign and to add a real estate component. This results in 6 categories of investment components:

  1. Cash
  2. U.S. stocks
  3. Foreign stocks
  4. U.S. bonds
  5. Foreign bonds
  6. Real estate

Cash is any account that you can readily access for discretionary or emergency spending. Most people should have a minimum of 3 months and preferably 6 months of living expenses held in cash. Cash accounts include checking, savings, and money market accounts. Some people put certificates of deposit in the cash category but this can be risky. A 12-month CD results in money being tied up for 12 months before you can access it. This is fine for money you are planning to use for a down payment on a house you plan to buy a year from now but is inaccessible if you lose your job and need to buy groceries next month.

Stocks can be divided into those from U.S. companies and those from foreign companies. The difference between them can be confusing. For example, some foreign companies are traded on the New York Stock Exchange and many U.S. companies have a global presence by generating revenue from sales of products in other countries. Most mutual funds will specify whether their component stocks are from U.S. companies or foreign companies. So, for example, an S&P 500 index fund consists of 500 U.S. companies whereas a European index fund will consist of only European companies. However, the terminology can be confusing because a “global”, “international”, or “all-world” index fund may or may not include U.S. companies so it is important to understand the make-up of any given mutual fund.

Bonds can be divided into U.S. versus foreign but can also be divided into government bonds versus corporate bonds. As a general rule, corporate bonds have greater risk but higher potential returns than government bonds. Municipal government bonds are often tax-free whereas returns on U.S. treasury bonds are subject to tax.

Real estate can be an investment property that you personally own but most investors do not buy individual properties. Instead, they purchase REITs (real estate investment trusts) that are sort of like mutual funds for real estate. The REIT will own multiple properties (typically office buildings, hotels, apartment buildings, and shopping centers). The investor then buys shares of that REIT, just like they would buy shares of a stock mutual fund consisting of stocks from multiple companies.

Because the U.S. economy has historically out-performed most other nations’ economies and because the U.S. economy (and government) has also been more stable than most other nations’ economies, it is prudent to have a higher percentage of one’s investments in U.S. companies than in foreign companies. A typical tactic for stocks in a portfolio would be to maintain a ratio of 60% U.S. stocks and 40% foreign stocks. A typical tactic for bonds in a portfolio would be to maintain a ratio of 70% U.S. bonds and 30% foreign bonds. When it comes to risk and potential returns, REITs tend to fall in-between stocks and bonds. Therefore, it would be prudent to maintain a small percentage of one’s investment portfolio in real estate, for example, 5% of the total portfolio.

All of this can be complicated, so many people just purchase an “all-in-one” mutual fund that combines U.S. and foreign stocks and bonds in ratios depending on one’s investment horizon. These will sometimes be labeled as “Target Retirement 2045” for a person anticipating retiring in about the year 2045, for example. The following is the breakdown of Vanguard’s all-in-one mutual funds:

These all-in-one funds are a good choice for the investor who lacks the time, knowledge, or confidence to manage their own investment portfolio. An advantage of these funds is that the investment company does all of the rebalancing in order to maintain the desired ratio of stocks:bonds and then adjusts that desired ratio each year as a person gets older and their investment horizon shortens. However, these funds do not take into account the individual investor’s willingness or ability to assume risk and simply rely on investment horizon. Furthermore, the all-in-one funds generally do not include any real estate holdings, such as an REIT.

How often should you rebalance?

The largest investors on the planet are pension funds that can have billions or even trillions of dollars of invested assets. Although there is a lot of variation, most of pension funds rebalance monthly or quarterly. But for the individual investor, this is probably too frequent. For most of us, rebalancing once or twice a year is sufficient. The danger of rebalancing too frequently is that you can over-respond to short-term fluctuations in the market, resulting in a lot of buying and selling of investments. This can in turn result in a lot of investment transaction fees and a lot of capital gains. Those capital gains get taxed at either short-term or long-term capital gains tax rates. Short-term capital gains are on those investments that you sell less than 12 months after you purchased them; these are taxed at your regular federal income tax rate. Long-term capital gains are on those investments that you held for more than 12 months before selling and are taxed based on annual income levels at either 0% (for very low income investors), 20% (for very high income investors), or 15% (for most of us). As a general rule, your long-term capital gains tax rate will be lower than your short-term capital gains tax rate. The effect of this is that by rebalancing your non-retirement investment portfolio too frequently, you end up paying more in income taxes.

The danger of rebalancing too infrequently is that your investment portfolio can become too conservative (resulting in diminished long-term returns) or too aggressive (resulting in an excessively high-risk portfolio). Therefore, the timing of investment portfolio rebalancing is the intersection of patience and prudence.

I recommend doing a comprehensive rebalancing once a year and then doing an investment check-up every 3 or 6 months. During the check-up, if you find that your portfolio has become unexpectedly and significantly out of balance, then go ahead and rebalance at that time. What constitutes “significantly” out of balance is open for debate but I recommend using a 5% rule: if the percentage of one category of investments is off by more than 5 percentage points from your desired percentage, then it is significantly out of balance.

Take taxes into account

Investments can be grouped into three different categories: (1) regular investments, (2) tax-deferred retirement investments, and (3) Roth retirement investments. Regular investments are those that you purchase with your cash and you will pay capital gains taxes on them when you sell them. In addition, you will pay regular income tax on any interest or ordinary dividends that you earn from those investments each year.  You will pay capital gains tax on any qualified dividends you get from an investment each year. If you own a stock for less than 60 days before the dividend date, then those dividends are considered ordinary and if you own a stock for more than 60 days before the dividend date, then those dividends are considered qualified. Tax-deferred investments include the 401(k), 403(b), 457, and traditional IRA. You pay regular income tax on any withdrawals when you are retired. There is no additional annual tax on interest and dividends earned from those investments but you will pay regular income tax on money generated from interest and dividends when you withdraw that money in retirement. Roth retirement investments include Roth IRAs, Roth 401(k)s, Roth 403(b)s, and Roth 457s. For these investments, you pay regular income tax in the year that you originally earn the money and deposit it in the Roth account; that money then grows tax-free until you take withdrawals in retirement. There is no tax on interest, dividends, or withdrawals.

The investment horizon differs for each of these three categories of investments. In general, Roth accounts have the longest investment horizon because it is prudent to wait until you turn 72 years old to begin withdrawals from Roth accounts. This is because required minimum distributions from tax-deferred retirement accounts (such as a 401k) begin at age 72 so it is usually to one’s advantage to begin to spend down those tax-deferred retirement accounts prior to age 72. Roth accounts are not subject to required minimum distributions. Regular investments typically have the shortest investment horizon because these are often used for non-retirement purchases, such as a house, college education, etc. Because of these differing investment horizons, it is wise to have stocks comprise most or all of one’s Roth accounts, a mix of stocks and bonds in one’s tax-deferred retirement accounts, and a higher percentage of bonds and cash in one’s regular investments.

The differences in how these different investments are taxed has implications for portfolio rebalancing. Most people will have their highest annual taxable income during their middle or late working years (i.e., in their 40’s, 50’s, and 60’s). This equates to having a higher marginal income tax rate during those years. Because you will be taxed at your regular income tax rate for any short-term capital gains, you will end up paying more in income taxes if you rebalance using regular investments during those peak earning years. Instead, it may be wise to rebalance using investments in your tax-deferred retirement account during those working years when you have a high income.

The exception to this is when you can take advantage of tax-loss harvesting. For example, say you find that your stock:bond ratio is 65:35 but your desired ratio is 60% stock and 40% bonds. So, you decide to sell some of your stock investments and buy some more bond investments. If one of your stocks has lost money since you originally purchased it, you can sell it for a loss. Tax-loss harvesting works by off-setting up to $3,000 in taxable capital gains each year with those losses. If your losses from sales of securities are greater than your capital gains from the sale of other securities for the year, then you can also use tax-loss harvesting to reduce your annual taxable income by up to $3,000. As a result, you can reduce your federal income tax in two ways: you have less income subject to tax and because of that your marginal income tax rate falls. But remember that tax-loss harvesting only applies to regular investments and not to the sale of securities within tax-deferred retirements or Roth accounts.

Rebalancing checklist

Taking all of these various factors into consideration, late December is an ideal time for most people to do a comprehensive investment rebalancing. By then, you should have a good idea of what your annual taxable income will be for that year and you can determine whether tax-loss harvesting will be beneficial. Early July is a good time to do a 6-month investment check-up. The following are considerations to take into account when rebalancing:

  • What is the dividend calendar? Some funds pay dividends once a month but others pay dividends once a quarter or even less often. Many funds pay dividends in mid-December. Do not rebalance by selling an investment just before dividends are paid or you could lose out on those dividends.
  • How long have you held an investment? If you rebalance by selling an investment that you have held for less than 12 months, you could end up paying the higher short-term capital gains tax rather than the lower long-term capital gains tax.
  • Is your emergency fund sufficient? Every year, our basic living expenses increase due to inflation. But a new child adds considerably to those monthly expenses as does a new house with a larger mortgage or a new car loan. A marriage may increase or decrease the combined emergency fund needs of the two spouses, depending on individual circumstances. Reassess your current basic expenses to ensure that you have 3 to 6 months worth of those expenses held in cash.
  • Do you have new non-retirement expenses in the future? Maybe you are planning on buying a more expensive new house in a year or two. Or maybe a new car. Or maybe you need a knee replacement surgery. If you need money for these types of expenses in the next 2-3 years, then the money should be in a safe investment such as a certificate of deposit or a money market. If you anticipate needing money for an expense 3-5 years from now, then some of that money could also be in bonds (but not in stocks).
  • Have you lost money on some investment securities? If so, you may be able to take advantage of tax-loss harvesting.
  • Has your investment horizon changed? Did you change your mind about when you or your spouse plan to retire, either earlier or later?
  • Has your life expectancy changed? No one knows exactly how long they will live but in the past year, if you were diagnosed with cancer or developed congestive heart failure, then your life expectancy has likely decreased so you should adopt a lower risk investment strategy. On the other hand, if you successfully quit smoking, lost excess weight, and committed to a regular exercise program, then your life expectancy likely increased so you can adopt a higher risk investment strategy.
  • Did your pension status change? If you change jobs so that you are no longer eligible for a pension, then you should adopt a lower risk investment portfolio. On the other hand, if you just got a job at a Veterans Administration hospital and will now be eligible for a federal pension, then you can adopt a higher risk investment portfolio.
  • Did the total amount of your investments grow significantly? In retirement, the closer your annual income is to your annual basic living expenses, the less risk you can afford to take with your investments. This is because if the market falls, then you will have to deplete your retirement account faster than you anticipated in order to pay your living expenses. On the other hand, if your annual income in retirement is much higher than your basic living expenses, then you can reduce discretionary spending during years that the market falls and avoid depleting your retirement account. Consequently, if your retirement account has grown significantly in the past year, you may be able to adopt a higher risk investment portfolio. This is why the rich get richer – they can afford to.

Rebalancing is security

It is often said that money can’t buy you happiness. Although this is true, it can help you avoid unhappiness, which in not exactly the same thing. Annual or semi-annual investment portfolio rebalancing can increase your long-term investment returns. This can help to ensure that you have the money you need for a new home purchase, a wedding, or the life you dreamed about in retirement. But even more importantly, rebalancing forces you to critically evaluate your investment portfolio and this can give you confidence in your future and can give you a sense of control over your future. The real value of rebalancing is more than just the money.

June 16, 2023

Categories
Physician Retirement Planning

The Best Way To Do A Roth IRA Conversion? Try “Reverse Dollar Cost Averaging”

Dollar cost averaging is an investment strategy where a fixed amount of money is invested on a regular basis, for example, monthly. There are several advantages to the investor to utilize dollar cost averaging. These same advantages apply to converting money in a traditional IRA into a Roth IRA. However, the conversion advantages of this strategy is to minimize income tax incurred from the conversion and thus maximize long-term investment returns.

Summary Points:

  • In dollar cost averaging, an investor purchases a set amount of an investment monthly.
  • In “reverse dollar cost averaging”, an investor regularly sells shares of a traditional IRA to convert money into a Roth IRA.
  • By using this strategy, an investor can maximize long-term investment returns

 

What is a Roth IRA conversion?

There are essentially two types of IRAs: traditional IRAs and Roth IRAs. The rules about who can contribute to them and how they are taxed are a bit complicated. Both types of IRAs are subject to federal and state income tax but the differences are in when you pay those taxes: when you put the money in (during your working years) or when you take the money out (during retirement years).

  • Traditional IRAs. In 2023, you can contribute $6,500 into a traditional IRA ($7,500 if you are over age 50). For tax purposes, the IRS divides money in your IRA into two categories: the amount you initially contributed (the IRA contribution amount) and the amount that you made in profit from that initial contribution (the IRA profit amount). Everyone pays regular federal and state income tax on the traditional IRA profit amount when that money is taken out of the traditional IRA in retirement. But when it comes to the contribution amount, things get complicated and taxation depends on your annual income for the year of that contribution and your IRS filing status for that year.
    • Filing single. If you are covered by an employer retirement plan and your 2023 income is less than $73,000, then your traditional IRA contributions are all pre-tax, meaning that you do not pay income tax on those contributions until you withdraw the money in retirement. If your 2023 income is greater than $83,000, then your traditional IRA contributions are all post-tax, meaning that you pay income tax on those contributions this year, when you earned the money for those contributions. Then, in retirement, you do not have to pay any income tax on the withdrawals for the amount that you initially contributed. If your income is between $73,000 and $83,000, there is a phase-out, meaning that some amount of your contributions are pre-tax and some amount are post-tax.
    • Married filing jointly. If you are married and the spouse making the IRA contribution is covered by a workplace retirement plan, the income limit for pre-tax contributions is $116,000. All contributions are post-tax if the annual income is greater than $136,000. There is a phase-out if the income is between $116,000 and $136,000. However, if you are an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the phase-out range increases to between $218,000 and $228,000
  • Roth IRAs (direct contributions). There are two ways you can contribute to a Roth IRA, either directly or by doing a traditional IRA to Roth IRA conversion. All contributions to Roth IRAs (regardless of annual income) are post-tax meaning that you pay federal and state income tax this year on any contributions you make this year. When money is withdrawn in retirement, all withdrawals are tax-free. The amount that the IRS allows you to contribute directly to a Roth IRA depends on your annual income for the year that you make the contributions.
    • Filing single. If your 2023 income is less than $138,000, then you can make direct contributions to a Roth IRA of up to $6,500 (or $7,500 if you are over age 50). If your annual income is greater than $153,000, then you cannot contribute any amount directly into a Roth IRA. If your income is between $138,000 and $153,000, then there is a phase-out, meaning that you can contribute directly to a Roth IRA but less than the usual maximum amount of $6,500 ($7,500 if over age 50).
    • Married filing jointly. The income limit for direct contributions to a Roth IRA is $218,000. If the annual income is less than that, then both spouses can directly contribute up to $6,500 each ($7,500 if over age 50) into a Roth IRA. If the household income is greater than $228,000, then neither spouse can make direct contributions to a Roth IRA. There is a phase-out if the income is between $218,000 and $228,000 resulting in a maximum direct contribution to a Roth IRA of less than $6,500 ($7,500 if over age 50).
  • Roth IRAs (conversion contributions). The second way of contributing to a Roth IRA is by doing a traditional IRA to Roth IRA conversion. This is sometimes called a “backdoor Roth” since the IRS code allows a person to first contribute money into a traditional IRA and then promptly convert that money into a Roth IRA. This strategy is used by people whose income is too high to directly contribute to a Roth IRA but it is also used by anyone who already has money in a traditional IRA and wants to move some of that money into a Roth IRA. There is no limit to the amount that you convert in any given year – you can convert as much as you want. However, the conversion is considered taxable income for that year, so the more you convert, the higher your annual income and therefore the higher your marginal tax rate becomes. Also, you must leave the amount that you convert in the Roth IRA for at least 5 years before you can withdraw that money without incurring an IRS penalty. You can make as many conversions as you want in any given year. The amount of income tax you pay when doing a Roth IRA conversion depends on whether your previous contributions to your traditional IRA were post-tax contributions, pre-tax contributions, or a mixture of the two.
    • Pre-tax traditional IRA contributions. If all of your previous contributions to your traditional IRA were made with pre-tax money, then you will pay regular federal and state income tax on the full amount that you convert to a Roth IRA.
    • Post-tax traditional IRA contributions. If all of your previous contributions to your traditional IRA were made with post-tax money, then you will pay regular federal and state income tax on the profit amount of the traditional IRA but you will not pay income tax on the contribution amount that you made to that IRA. This require you to keep a record of the amount of post-tax contributions that you make to your traditional IRA every year. When you convert a portion of your traditional IRA into a Roth IRA, the IRS requires you to calculate the percentage of the conversion that is from the profit amount and the percentage that is from the contribution amount in order to determine your income tax.
    • Mixed traditional IRA contributions. Here is where things get difficult. You must keep a record of the amount of pre-tax and post-tax contributions to your traditional IRA that you make every year. When doing a conversion to a Roth IRA, you must first determine the percentage of the conversion that is from the contribution amounts and the percentage that is from the profit amounts. Next you determine what percentage of the contribution amounts is from post-tax contributions. You do not pay regular income tax on that percentage of post-tax contributions but you do pay regular income tax on all of the rest of the conversion.

When is the best time to do a Roth IRA conversion?

There are two situations when it is advantageous to do a traditional to Roth IRA conversion. The first is when your current income tax rate is lower than your anticipated income tax rate in retirement. For most people, this is early in their career, when their annual income is lower than it will be later in their career. However, if a person is out of work for a period of time, then their annual income can fall that year, making a Roth IRA conversion worthwhile. Another situation when your income tax is lower is when Congress lowers income tax rates. It is impossible to predict what future income tax rates will be in 5, 10, or 25 years. However, the tax cuts passed in 2017 have given us some of the lowest federal income taxes in memory and it is doubtful that they can go much lower in the future without severe cuts in government programs.

The second situation when it is advantageous to do a traditional to Roth IRA conversion is when there is a significant fall in the stock market.  When the value of a traditional IRA falls, then you will pay less income tax on the conversion. Ideally, you would wait for the market to drop and then convert investments in your traditional IRA into similar investments in your Roth IRA. When the market eventually recovers, you will have paid less in taxes than if you had waited and taken the money out of the traditional IRA in retirement. Ideally, you would wait until the market is at its lowest, then do the conversion. The problem with this is that no-one has a crystal ball to see into the future to know when the market has bottomed out. However, it is clear that 2022 was a terrible year for both U.S. stocks (down 19% over the past 12 months) and U.S. bonds (down 13% over the past 12 months).

Reverse dollar cost averaging in 2023

Eventually, the stock and bond markets will recover and the prices for stock and bond mutual funds will increase. It is possible that the markets have already reached a bottom and the only way that they will go is back up. But it is also possible that stocks and bonds will continue to fall in value in 2023. That is the thing about predicting future stock and bond values – you just don’t know until you know and you don’t know until it has already happened. In other words, no one can predict future market values in the short-term. However, we can predict that future markets will be higher in the long-term.

So, 2023 would seem to be a good year to do a traditional IRA to Roth IRA conversion. The stock and bond market has lost a lot of value and we are currently living in a time of historically low income taxes (the 2017 income tax cuts will expire in 2025). But exactly when in 2023 should you do the conversion? This is where the concept of “reverse dollar cost averaging” comes into play.

In dollar cost averaging, a person invests a set amount at regular intervals throughout the year, typically monthly. By doing so, the person buys a lot of shares of of a mutual fund when they are cheap and buys fewer shares when they are expensive. This is a great strategy to ensure that you stick to a retirement savings plan. It also keeps you from trying to “time the market” (no one can accurately predict the future market so trying to time the market is generally unsuccessful). The “average” in dollar cost averaging refers to the result that by buying a few shares each month, then after 12 months, you will have a lot of shares with an average purchase price over the entire year. If you put a certain an amount of your paycheck into your 401k, 403b, or 457 each month, then you are already doing dollar cost averaging.

To see how dollar cost averaging works, let’s take the example of an investor who had $12,000 to invest on January 1, 2022. In the first scenario, the investor thought that the stock market was only going to go up in 2022 and invested the entire amount on January 1st. In the second scenario, the investor invested $1,000 every month for the full year. As it turned out, 2022 was a terrible year for stocks, dropping 19% for the year. The graph below shows the 2022 performance of the Russell 3000 Index, which is a benchmark for the total U.S. stock market.

 

In the first scenario, the investor who tried to time the market and put the entire $12,000 into a Russell 3000 index fund would have $9,669 at the end of the year. In the second scenario, the investor who used a dollar cost averaging strategy and put $1,000 into a Russell 3000 index fund every month would have $11,050 at the end of the year. Both investors will have lost money but the investor who used a dollar cost averaging strategy would have lost considerably less than the investor who tried to time the market.

You get the same benefit by spreading out your Roth conversions over the entire year. If an investor converted $12,000 of a traditional IRA invested in a Russell 3000 index fund into a Roth IRA that is also invested in a Russell 3000 index fund in January 2022, that investor would have 4.38 shares of the index fund at the end of the year. On the other hand, if an investor converted $1,000 of that traditional IRA into a Roth IRA every month in 2022, then at the end of the year, the investor would have 5.01 shares of the index fund. Now let’s assume that over the next 10 years, the Russell 3000 Index increases by an average of 8% per year. In 10 years, the investor who did one single $12,000 conversion would have $20,876 in the Roth IRA. But the investor who did twelve $1,000 conversions would have $23,857 in the Roth IRA. In other words, the reverse dollar cost averaging approach resulted in the investor having $2,981 more after 10 years.

“Sell high but convert low”

When it comes to maximizing investment returns, the old adage is “buy low and sell high”. But just the reverse is true for Roth conversions when long-term returns can be maximized by converting when the price is low. In essence, in a Roth conversion, you are selling an investment to yourself so that you are selling your traditional IRA low but also buying your Roth IRA low. When you eventually sell your Roth IRA tax-free in retirement, you will come out ahead.

In summary, it is looking like 2023 will be a good year for many people to do a traditional IRA to Roth IRA conversion. But resist the temptation to do one big conversion all at once. Instead, do 12 smaller conversions every month or 6 conversions every two months. When you are retired, you will be happy that you did.

January 7, 2023

Categories
Physician Finances Physician Retirement Planning

End Of The Year 11-Point Financial Health Checklist

The end of the calendar year is the time to do a check-up of your personal finances and investments. As we enter December, there are a few important things to do in order to ensure that you are taking advantage of tax breaks, performing needed investment portfolio maintenance, and adapting your personal finances for inflation. Here is a short list of eleven tasks for your financial health to do before the end of the year.

Eleven point financial checklist

1. Do a “backdoor” Roth IRA.

I believe that everyone should have a Roth IRA as part of a diversified retirement portfolio. Unlike a traditional IRA, 401k, or 403b, once you put money into a Roth IRA, you never have to pay any taxes when you withdraw money from it. This allows you to withdraw money in retirement from different types of investments in order to take maximal advantage of your income tax situation in any given year of retirement. If your income is less than $129,000 (or $204,000 if filing a joint income tax return), then you can directly contribute to a Roth IRA using post-tax income. If your income exceeds these amounts, then you cannot directly contribute to a Roth IRA but you can do a “backdoor” Roth by first contributing post-tax income into a traditional IRA and then promptly doing an IRA conversion by transferring that money from the traditional IRA into a Roth IRA. For 2022, you can contribute $6,000 to an IRA if you are under age 50 and $7,000 if you are older than age 50.

The best time to do a backdoor Roth is when the stock market has fallen. Stocks inevitably go up and down – your goal is to buy stocks when the market falls so that you can make the most money when you sell those stocks in the future. Stocks have taken a real beating this year… and that is good for the long-term investor since this creates a buying opportunity. For example, the S&P 500 index has fallen 17% since January 1, 2022. By contributing to a backdoor Roth today, when the stock market eventually recovers to its January 2022 value, you will have made a 17% return!

In 2021, Congress proposed eliminating the backdoor Roth in the Build Back Better Act but the legislation died in the Senate leaving backdoor Roths alone for now. With the U.S. House of Representatives and the U.S. Senate now controlled by different political parties, the resultant gridlock makes backdoor Roth elimination in the next 2 years unlikely. However, predicting Congressional legislation is difficult so anything is possible. Nevertheless, now is the best time to do a backdoor Roth – when they are still legal and when the stock market is down.

2. Do a Roth IRA conversion.

If you already have money in a traditional IRA, then you can convert some (or all) of that money into a Roth IRA without doing a backdoor Roth conversion. There are 2 ways that you can contribute to a traditional IRA, with pre-tax income or with post-tax income. If your current annual income is less than $129,000 (or $204,000 if filing a joint income tax return), then you can contribute pre-tax income into the traditional IRA and then when you withdraw money from that traditional IRA in retirement, you pay regular income tax on the entire amount. If your current annual income is higher than these values, then you cannot contribute pre-tax income into the traditional IRA but you can contribute post-tax income into a traditional IRA. In this latter situation, your tax on withdrawals in retirement gets complicated – you do not pay income tax on the amount of money that you originally invested but you do pay income tax on the accrued value of the investment. This requires you to keep careful record of the amount of your contributions over the years and then do some mathematical gymnastics to calculate the percentage of any given year’s withdrawals that are taxed and not taxed.

I see no reason why anyone should put post-tax income into a traditional IRA and leave it there since you would have to pay income tax on the accrued value when you take withdrawals in retirement. If you had instead converted that post-tax money in the traditional IRA into a Roth shortly after making the original contributions to that traditional IRA (i.e., a backdoor Roth), you would never have to pay taxes on the withdrawals in retirement. So, if your traditional IRA is composed fully (or mostly) of post-tax contributions, convert that traditional IRA into a Roth now in order to minimize your taxes.

Traditional IRAs composed of pre-tax income are different and the decision of whether or not to convert these traditional IRAs into a Roth IRA requires some strategic financial analysis. Your overall goal is to pay the least amount in income taxes. When your traditional IRA is funded by pre-tax income, then when you convert money from that traditional IRA into a Roth IRA, you have to pay income tax the year that you do the conversion. In other words, that conversion to a Roth IRA counts as a withdrawal from the traditional IRA for income tax purposes. There are 2 situations when it is advantageous to do convert money from a pre-tax traditional IRA into a Roth IRA:

  1. When your income tax rate today is lower than your income tax rate in retirement. This is difficult to know with certainty since no one can predict what the income tax rates will be 30 years from now – tax rates go up and go down, depending on how much money the federal and state governments need to keep running. As a general rule, your income tax rate is likely to be lower when you are early in your career and higher after you have been working for 20-30 years. Therefore, doing a Roth conversion in your early working years is generally preferable to doing a Roth conversion later in your career.
  2. When the stock market is down. Since you pay regular income tax on any withdrawals from a traditional IRA that was originally funded with pre-tax income, you will pay less tax if you do a Roth conversion when the stock market has fallen and the overall value of the traditional IRA is lower. Then, when the stock market recovers, all of the accrued value will be in your Roth IRA and you will not have to pay income tax on it when you take withdrawals in retirement. Conventional wisdom is that when it comes to stocks, you should sell when the value of a stock is high. In order to minimize taxes when doing a Roth conversion it is just the opposite: sell (convert) when the value of the traditional IRA is low. Since the stock market is currently down 17% compared to January 1, 2022, now is a great time to do a traditional IRA to Roth IRA conversion in order to minimize the total amount of income tax that you will pay over the course of your lifetime. However, don’t forget that the amount of the conversion will add to your adjusted gross income for the year of the conversion and will result in an increase in your income tax rate that year. You will need to weigh the cost of the increased income tax rate against the benefit of the IRA conversion.

3. Contribute to a 529 plan.

The 529 college savings plans allow you to invest money today and then never have to pay any taxes when you withdraw money for college expenses in the future. Think of 529 plans as Roth IRAs for college savings. That tax-free feature of 529 plans make them an unbeatable tool to save for college and you can use the money to pay for college for yourself, your spouse, your children, or your grandchildren. There are several reasons to consider contributing to a 529 plan in December.

  1. Get a tax deduction. Each state has its own 529 plan and they all vary considerably with respect to their state income tax advantages. For example, here in Ohio, residents of the state can deduct the first $4,000 of annual contributions to an Ohio 529 plan. That tax deduction applies to each child’s account you hold so if you have 3 children, you can deduct $4,000 of annual contributions from each child’s account for a total of $12,000 state tax income deduction!
  2. The best time to contribute is when the market is down. The 529 plans are designed to be long-term investments. When you open an account at the birth of a child, that money will not be withdrawn for at least 18 years. The U.S. bond market is down 13% this year and the U.S. stock market is down 17%. This means that stocks and bonds are the cheapest that they have been in 2 years. Now is a time when you can “buy low”.
  3. They make great Christmas presents. I have a granddaughter who lives in a different state. Last year, I opened an Ohio 529 plan in her name when she was born. This year, we’ll contribute to her 529 plan for her Christmas present. Older children usually expect tangible stuff for Christmas but for toddler grandchildren, a 529 plan contribution is perfect. A Lego set will hold a kid’s attention for a couple of weeks but an education lasts a lifetime.

4. Maximize your deferred income retirement contributions.

In 2022, the maximum amount that you are permitted to contribute to a 401k, 403b, or 457 plan is $20,500 if you are younger than 50 years old and $27,000 if you are over 50. Some people (such as employees of state universities) can contribute to both a 403b and a 457. This can bring your annual contribution up to $41,000 ($54,000 if you are over age 50). If you have not yet contributed the maximum allowed amount this year, you still have time to do a one-time contribution in December to bring you up to the annual contribution limit.

In addition, this is also the time to change your monthly 401k, 403b, or 457 plan contributions. In 2023, the contribution limit to these plans will increase to $22,500 for people younger than 50 and $30,000 for people older than age 50. Be sure to get the contribution forms submitted to your human resources department now so that your monthly contributions increase in January.

5. Consider tax loss harvesting.

Tax loss harvesting is when you sell an investment that has lost value (capital loss) on in order to offset a profit that you make selling another investment that increased in value (capital gain). The amount of capital gains tax that you pay is the total of all of your capital gains minus all of your capital losses for that year. If you have more losses than gains, then you can take up to $3,000 of the excess losses and apply them as a tax deduction to your regular income tax. December is normally the best time to decide if selling an investment for tax loss harvesting makes sense and to determine how much of that investment should be sold to optimize your taxes. Because the stock market has fallen so low this year, many people have lost money on investments making tax loss harvesting a viable financial option for more people than in previous years.

There are a couple of important caveats to tax loss harvesting. First, the losses only apply when the selling price is lower than the purchase price. For example, the S&P 500 has fallen in value by 17% in 2022 but it increased in value by 27% in 2021. Therefore, if you bought an average stock on January 1, 2022, you would have a capital loss. But if you bought that same stock on January 1, 2021, you would have a capital gain if you sold the stock today, even though that stock lost value in 2022.

Second, tax loss harvesting is more of a capital gains tax-deferral strategy than a capital gains tax-reduction strategy. If you sell a losing stock today to take advantage of tax loss harvesting and then turn around and invest the proceeds of that stock sale into a second similar stock that has also lost value recently, then when that second stock eventually increases in value in the future, you’ll pay more capital gains taxes on the sale of the second stock because your capital gains will be higher. For example, say Ford and GM shares are always the same price. You buy shares of Ford in 2021 at $100 per share and then today, Ford has fallen to $80 per share. You then sell your shares of Ford for tax-loss harvesting purposes and turn around and buy shares of GM at $80 per share. In 2024, you sell your shares of GM at $120 per share. If you had held onto Ford until 2024, then you would have $20 per share in capital gains when you sold it in 2024. Instead, you would have $40 in capital gains when you sell the GM stock in 2024. In other words, tax-loss harvesting just postpones when you pay capital gains tax if you re-invest the proceeds of your investment sale.

Tax-loss harvesting can be to your benefit if you take the capital losses as an income tax deduction since most people’s federal income tax rate is higher than their capital gains tax rate. However, this can be tricky since you have to be able to estimate what your 2022 income tax rate will be in order to ensure that it is less than your capital gains tax rate. Also, many people forget that their mutual funds will usually have capital gains each year since the fund managers are constantly buying and selling the component stocks within that fund so even if you do not sell any of your shares of that mutual fund this year, you may still have capital gains from that mutual fund. You have to calculate what all of those mutual fund capital gains will be this year in order to be sure that your capital losses from tax-loss harvesting exceed those mutual fund capital gains so that you can apply those capital losses as an income tax deduction. And remember, the maximum income tax reduction from tax-loss harvesting is $3,000.

6. Optimize schedule A deductions.

The Tax Cuts and Jobs Act of 2017 increased the standard income tax deduction from $12,700 in 2017 to $24,000 in 2018 (married filing jointly). This reduced the amount of income tax that most Americans paid but it also eliminated itemized deductions for most Americans. The standard deduction for 2022 is $25,900 (married filing jointly). Therefore, you cannot make any itemized deductions unless those itemized deductions total more than $25,900. Itemized deductions can include charitable donations, mortgage interest & points, medical & dental expenses, and taxes paid (property, state, and local). However, the maximum amount of property and other taxes that you can apply to itemization is $10,000.

December is the time to estimate the amount of your itemized deductions. If those itemized deductions are close to your standard deduction amount ($25,900 if married filing jointly), then you may be able to increase your itemized deductions now so that those itemized deductions exceed the standard deduction amount. For example, you could make extra charitable contributions now rather than in 2023. Or, you could pay your next property taxes early, before December 30th. Or, you could buy the new eye glasses now that you had planned to wait until next summer to buy.

7. Contribute to an SEP.

An SEP (simplified employee pension plan) is a deferred income retirement account for self-employed people. Even if you have a regular employer but have a side gig doing consulting, getting honoraria, or selling artwork, you can open an SEP for the income that you earn from that side gig. The SEP allows you to invest pre-tax income and then pay taxes on the the withdrawals from the SEP when you are in retirement. In that sense, the SEP is functionally similar to a 401k, 403b, 457, or traditional IRA. Although you have until April 2023 to make contributions to an SEP for your income earned in 2022, it may be better to contribute to an SEP now, since the stock market has lost so much value recently – in other words, contribute to an SEP now, while stocks are “on sale”. You can contribute up to 25% of your total self-employment income and up to a maximum contribution amount of $61,000. December is a time that you should be able to reasonably estimate your total self-employment income for the past year and then calculate the amount that you can contribute to an SEP.

8. Review your beneficiaries. 

Every investment account should have a designated primary beneficiary and secondary beneficiaries in the event of your death. If you are married, the primary beneficiary will probably be your spouse. If you have children, they will probably be your secondary beneficiaries. By specifying beneficiaries on those investment accounts, you can make it faster for your family to access those funds in event of your death. Also, your heirs can avoid costly legal fees that would be incurred if no beneficiaries were listed and the accounts need to go through probate court. For most investment companies, you can do this quickly and easily online.

9. Rebalance your portfolio.

This has been a wild year for investors. The bond market is down, the stock market is down more, and real estate is down even more. Meanwhile, inflation is reducing the value of fixed income pensions and increasing the interest rates on certificates of deposit. The net result is that the relative percentages of stocks, bonds, real estate, and cash in most people’s investment portfolios has changed significantly since January.

Now is the time to rebalance those portfolios to ensure that the percentage of each type of investment is at its desired amount. For example, since real estate investments have fallen more than stocks, you may need to sell some shares of your stock mutual fund and buy some shares of a real estate investment trust (REIT) fund to rebalance. Since stocks have fallen in value more than bonds, you may need to sell some shares of your bond mutual fund and buy some shares of a stock mutual fund. Rebalancing not only ensures that your portfolio has a healthy diversification but it also results in you “selling high and buying low” in order to maximize your overall returns.

10. Increase disability and life insurance policy amounts.

The U.S. inflation rate has risen with the result that the consumer price index has increased 13% over the past two years. In other words, you need 13% more money today to buy the same amount of stuff you bought in 2020. However, most disability insurance policies and life insurance policies have not changed their values. The $100,000 life insurance policy that you bought in 2020 would only be effectively worth $87,000 in today’s money. December is a good time to critically evaluate those policies to see if the payout amounts are still appropriate – in many cases, you may need to increase those amounts to ensure that should you become disabled, you will still have enough money to live on. Or, should you die, your family will still have enough money to live on.

11. Update next year’s budget.

Inflation does not affect everything you buy equally. For example, for the 12 months ending in October 2022, the price of food was up 10.9%, gasoline was up 17.9%, new cars were up 8.4%, and clothes were up 4.1%. This means that the amount that you budgeted for all of these items a year ago has changed. Each family’s inflation is a little different. So, although housing costs nationwide are up 11%, if you bought your house a year ago and have a fixed monthly mortgage, then your housing costs may not have gone up at all. Similarly, if you heat your house with electricity, your energy costs went up 14.1% in the past year but if you heat your house with fuel oil, your costs went up 68.5% in the past year.

To prepare next year’s budget, start with your credit card statements. Most credit card companies will divide each of your purchases into different categories, for example, groceries, transportation, housing, utilities, etc. You can often do the same with your checking account. This will give you a reasonable idea of where you spent your money over the past year. You can then use the Bureau of Labor Statistics Consumer Price Report to estimate how much each of those categories will need to be increased for your next year’s budget. Keeping to that budget ensures that you will have enough cash to pay off your credit cards and loans each month without dipping into your cash emergency fund.

Your annual financial checkup should be in December

The end of the year is the best time to do your annual financial checkup. By December, you should have a good idea of your total 2022 income and know whether you are likely to get a raise next year. Retirement account contribution limits usually change in January giving you the opportunity to change your monthly contributions. Also, you should be able to estimate how much you can spend  this year on charitable contributions, 529 account contributions, IRAs, and SEPs. The best way to start the new year is to finish the old year on solid financial ground.

November 30, 2022

Categories
Academic Medicine Physician Retirement Planning

Is Your Public Pension Safe? Check The Pension’s Vital Signs!

Physicians at academic medical centers often have an option to contribute to a state teacher’s pension plan. Although a pension can be an important component of a diversified retirement portfolio, some public pensions are currently in danger. How safe is your state’s public pension and should you contribute to it? The answer is in the pension’s vital signs.

Summary Points:

  • Most physicians employed by public universities can participate in their state’s public pension
  • Each state’s public pension is managed separately
  • Some public pensions are healthier than others
  • The funded ratio and the funding period are two important vital signs that indicate the health of a public pension

 

In Ohio, the State Teachers Retirement System (STRS) is our state’s public pension for academic physicians at state-funded universities (such as the Ohio State University). STRS is similar to Social Security or an annuity in that it gives university-employed physicians an option to participate in a defined benefit plan that will pay you a fixed amount of money every month that you are alive after you retire. There is also an option for survivor benefits so that your spouse can continue to receive a monthly payment after you die. The advantage of defined benefit plans, such as STRS, is that you never run out of money in retirement. The disadvantage is that as an investment, you may be able to come out ahead by investing the money yourself rather than contributing to the pension during your working years.

In the past, most American workers had access to employer-sponsored pensions but many private employers have abandoned pensions and replaced them with 401(k) plans. However, pensions are still quite common for employees of state and local governments. Everyone’s retirement portfolio should be diversified and contain several different types of investments, such as stocks, bonds, and real estate. A pension can be an important component of those investments, less risky than bonds but also having a low rate of return.

However, all types of investments have risk and a pension is no different. Social Security is generally considered to be very low-risk, as investments go. But even Social Security is in danger of running out of money in 2035, unless action is taken by the U.S. Congress in the future. Private company pensions occasionally run out of money, leaving retirees with reduced or no monthly pension payments. State public pensions are somewhere in-between Social Security and private company pensions with respect to investment risk.

In some states (such as Ohio), academic physicians have an option of either participating in the public pension (STRS) or self-directing payroll deduction retirement savings into investments of their own choice. In other states, participation in the public pension is mandatory and there is not an option to self-direct. When deciding whether or not to participate in a public pension or deciding whether or not to take a university job in a mandatory public pension state, you should look carefully at the state’s public pension. Some states’ public pensions are considerably safer than others. When researching a state’s public pension, there are two pension vital signs that are important: (1) the funded ratio and (2) the funding period. Understanding these two numbers is critical to understanding the health of a public pension.

The Funded Ratio

The funded ratio is the ratio of a pension’s assets to its current and future liabilities. In simple terms, the assets are all of the money that the pension currently has in cash and in investments. The liabilities are the total amount of money that the pension plan will pay out to retirees now and in the future plus the administrative cost of the pension. In an ideal world, the funded ratio should be 100% or higher. In other words, the pension plan should have enough money to pay for the pensions of all of its current participating members. A funded ratio below 100% can be cause for concern and a funded ratio below 80% can be a sign that the pension plan is in jeopardy. The Equitable Institute recently released its annual State of Pensions report for 2022 and there are some concerning findings. From the map below, it is apparent that some states’ public pensions have very strong funded ratios and others have very poor funded ratios.

Washington, Utah, South Dakota, Wisconsin, Tennessee, New York, the District of Columbia, and Delaware all have funded ratios greater than 90% (dark green). On the other hand, Illinois, Kentucky, South Carolina, New Jersey, Connecticut, Hawaii, and Rhode Island all have severely low funded ratios that are below 60% (dark red). In between these extremes are thirteen states that mildly low funded ratios between 80-90% (light green). Fourteen states have moderately low funded ratios between 70-80% (yellow). And nine states have moderate-severely low funded ratios between 60-70% (light red).

One of the main reasons that many states’ funded ratios have recently fallen is the downturn in the stock market in the past 7 months. Public pensions do not just keep all of their money in a checking account, they invest the money in order to keep up with inflation and to ensure that they have sufficient money to pay their retirees in the future. Most public pensions estimate that their investments will have an average 6.9% annual return. Last year, in 2021, the average pension plan’s rate of return was 25.3% – an extraordinarily high rate of return, primarily because stock markets had an exceptional year. So far in 2022, the average pension plan has had a -10.4% rate of return. In other words, instead of gaining 6.9% this year, the average pension has already lost 10.4%.

There are several reasons why a state might have a low funded ratio:

  1. Inadequate funding. Public pensions are funded by a combination of employee contributions (payroll deductions) plus employer contributions (usually as a fixed percentage of gross salary). If the contribution rates are set too low, then the public pension fund will not have sufficient funds to pay monthly retirement benefits. Currently, the average employee contribution is 8.07% of total salary, an increase from 7.06% in 2001. In addition to employee contributions to the public pension, there are also employer contributions to the pension and these currently average 29.8% of total payroll, an increase from 9.13% in 2001.
  2. Excessively high retirement benefits. Similarly, if the amount of money that retirees receive in their monthly pension payments is set too high, then the funded ratio will fall as the pension gradually runs out of money. The amount of the pension fund contributions and the amount of the pension fund distributions requires a very careful actuarial analysis and this in turn requires well-trained and highly skilled actuaries. Not every state has equally high-quality actuaries working for their public pensions. Public pensions should have periodic external audits to validate the conclusions and recommendations of the pensions internal actuaries. These audit reports should be available to pension participants and can be a valuable source of information about the pension’s health.
  3. Poor investment choices. Each state’s pension is managed differently – some by internal fund managers and some by external investment companies that employ their own fund managers. Inevitably, some fund managers will be better than others at selecting winning investments. However, as has been shown with managed mutual funds compared to index funds, most fund managers will not beat the overall stock market. This year, one of the particularly bad investment choices was in Russian investments. Prior to the Russian invasion of Ukraine, U.S. public pensions held approximately $5.8 billion in Russian market assets, securities, and real estate. These investments have lost enormous value since 2021. Over the past 15 years, there has been a growing trend to outsource investment decisions – currently 15% of public pension funds are managed by either a hedge fund or a private investment company.
  4. Unrealistic projected rates of return. The average annual rate of return on public pension fund investments is 6.9%. If a fund projects a higher rate of return, say 8.5%, then there is a high likelihood that their investments will not meet their projected rate of return, leading to lower than anticipated asset value. A pension fund’s rate of return on its investments will be largely determined by the ratio of stocks:bond:real estate in the fund’s investment portfolio. This ratio is in turn determined by the decisions made by the pension fund managers.
  5. The value of stocks and bonds fall. Some years, the stock and bond markets go up and some years they go down. Because public pension funds are mainly investing for the long-term, it is expected that the funded ratio will fall during short-term market downturns but then go up when the market recovers. 2021 and 2022 exemplify this perfectly with large losses in stock and bond values in 2022 but even larger gains in 2021. This resulted in a higher average funded ratio in 2021 that then fell in 2022 (graph below). It is more important to look at public pension fund investments over a several year period to determine how well the fund is doing.
  6. Inflation. If the public pension fund retiree distributions are tied to inflation, then there can be large cost of living increases in monthly pension payments during years that there is a high inflation rate. In these pensions, when inflation rises unexpectedly high (as in the previous 12 months), then the funded ratio can fall due to higher than expected monthly pension payments. Of 372 public pensions, 204 of them have automatic cost of living increase provisions with the majority of these linked to the inflation rate or the fund’s overall performance. Because of the danger of inflation eroding the funded ratio, other public pensions limit or do not give any regular cost of living increases in pension distributions.
  7. Increased life expectancy. This is often cited as a cause of a low funded ratio because if retirees live longer than expected, then the overall amount that the pension fund pays those retirees will be higher than expected. However, it turns out that annual increases in life expectancy have only a very small effect on funded ratios. It remains to be seen whether the opposite effect (shorter life expectancy) will improve funded ratios in the next few years since the majority of the more than 1 million U.S. COVID-19 deaths in 2020 and 2021 were in retirees.

The Funding Period

When a public pension’s funded ratio falls, or when actuarial analysis projects that it will fall in the future, there are a number of tactics that the pension can take to rectify the low funded ratio. For example, the pension managers can suspend cost of living increases in pension distributions. Or they can increase the contributions by increasing the percentage of employed pension members’ salaries going into the pension fund. Or they can increase the number of years a member must work before being eligible for full retirement benefits. When a public pension makes these corrective actions, it can take many years for the funded ratio to increase to 100%. The projected number of years that it will take to reach 100% is called the funding period.

Simply having a low funded ratio may not necessarily be bad as long as the public pension managers have taken corrective actions to improve the funded ratio. How effective these corrective actions are projected to be is measured by the length of the funding period. In general, the shorter the funding period, the better. In Ohio, the State Teachers Retirement System is required by state statute to have a funding period of less than 30 years. Funding periods in excess of 30 years are generally too long and can be a sign of an unhealthy public pension.

Many of the same variables that affect the funded ratio also affect the funding period. For example, the Ohio State Teachers Retirement System funding period dropped from 30 years to 8 years in 2021 due to the unusually large rate of investment return in 2021.

Public pensions with both a low funded ratio and a long funding period are in trouble. These pensions are in danger of being unable to meet future obligations. From a retirement portfolio standpoint, they are poor investments.

A Story Of 3 States

To illustrate the variability in public pension health, let’s examine three states: one that is in trouble, one that is in great shape, and one that was in trouble but has taken effective measures to improve.

Illinois. Illinois has 5 different state government public pension programs and all of them have a long history of being underfunded. At the end of 2021, these public pensions had an average funded ratio of only 46.5%, the highest ratio for the Illinois public pensions since 2008, before the great recession. Although improved, this is still among the lowest of all states’ public pension funded ratios. The state legislature has created a plan to increase the funded ratio to 90% by the year 2045. However, the state’s actuary and outside actuarial consultant have advised that a 90% funded ratio target in 23 years is insufficient and instead have advised a funding period to a 100% funded ratio of no more than 25 years. So far, no legislative action has been taken to improve the funding period. As a consequence, participation in the Illinois public pension is very risky compared to other states’ public pensions.

Wisconsin. The primary state public pension is the Wisconsin Retirement Benefit. It has a track record of being well-managed and as a consequence, it has a funded ratio that exceeds 100%. In fact, the funded ratio at the end of 2021 was 120.6%. That puts its funded ratio as the eighth highest out of 167 statewide public pensions in the country. Academic physicians can feel secure that their contributions to the Wisconsin public pension will be safe and that they can count on their monthly pension benefits in retirement.

Ohio. There are 5 statewide public pensions in Ohio. Academic physicians have the option of participating in one of them, the State Teachers Retirement System of Ohio.  In 2001, STRS was in good shape with a funded ratio of 91%. The great recession severely impacted STRS and by 2012, the funded ratio had fallen to 56%. By 2017, the funding period to reach a funded ratio of 100% had risen to 60 years, putting the entire pension in jeopardy. STRS enacted three corrective measures to stabilize the pension fund: (1) suspension of annual cost of living increases in retiree pension distributions, (2) a 2.91% increase in the employer contributions to the pension fund, and (3) an increase in the number of years of service to full retirement benefits from 30 years to 35 years. By the end of 2021, the pension’s funded ratio was 80.1% and the funding period was 8 years. STRS’s willingness and ability to make hard decisions to increase contributions and limit distributions has resulted in it once again becoming a safer retirement investment for participants.

Even healthy public pensions are vulnerable to forces that can destabilize them. For example, the next pension fund manager could make poor investment choices. The state legislature could enact statues that acquiesce to lobby pressure to increase retiree benefits or decrease employee/employer contributions. The next actuaries may make faulty life expectancy projections. For these reasons, it behooves all participants to periodically check the status of their public pension. At a minimum this should entail reviewing the current funded ratio and funding period of the pension. In this sense, a pension is an investment and should be monitored similarly to how one monitors their 401(k) or 403(b) fund.

“If you’ve seen one public pension, you’ve seen one public pension”

A strong and secure retirement investment portfolio is one that is diversified. Ideally, one’s portfolio should consist of a mixture of stocks, real estate, bonds, fixed income, and cash. For each of these types of investments, the potential long-term return is directly related to the short-term risk of the investment.

For most Americans, the fixed income component is Social Security. But academic physicians and other employees of state-funded universities usually do not participate in Social Security. The public pension substitutes for for Social Security and is thus the main component of the fixed income portion of academic physicians’ retirement portfolio.

Some financial pundits have argued that it is better to not participate in a public pension and instead take the money that would have gone into the pension fund from payroll deduction and invest that money into stocks. The argument is that in the long-term, the rate of return from stock investments will be greater than the return from pension distributions in retirement. However, a more accurate view of a public pension is that it forms a crucial low-risk/low-return component of a balanced retirement portfolio. By having a public pension in the portfolio, the academic physician can devote a larger percentage of other retirement investments (403b, 457, IRA, etc.) into higher risk stocks and real estate.

In addition to functioning as a fixed income retirement investment, public pensions have other features that can increase their value to the participant. Survivor benefits for one’s spouse and dependents can replace the need to purchase separate life insurance. Disability benefits can replace the need to purchase separate disability insurance. Access to group rates for health, dental, and vision insurance can result in insurance premiums that can be thousands of dollars less per year than equivalent insurance policies purchased individually. And access to financial counselors at the public pension can provide some elements of free financial planning advice.

But each state’s public pension has different degrees of risk as evidenced by their varying funded ratios and funding periods. Before committing to participating in a public pension, it is important to carefully examine the health of that particular state’s public pension. Do a routine vital sign check of the pension by following its funded ratio and funding period.

July 22, 2022

Categories
Physician Retirement Planning

A Bear Market Means It Is Time To Rebalance Your Retirement Portfolio

A bear market is defined as a prolonged decline in the stock market and generally refers to a 20% fall in stock market value. A bear market is a great opportunity to rebalance your retirement portfolio in order to give you the highest returns when you ultimately retire.

Summary Points:

  • A bear market represents a buying opportunity for your retirement account
  • In a bear market, the value of stocks tend to fall more than the value of bonds
  • By rebalancing your retirement portfolio, you can purchase stocks when they are inexpensive and increase the overall value of your portfolio when you ultimately retire

 

Last month, I outlined why a bear market is the perfect time to convert a traditional IRA into a Roth IRA in order to reduce the total amount of investment taxes you pay over your lifetime. Although a bear market Roth IRA conversion will reduce your taxes, it will not improve your overall investment returns when you eventually take the money out in retirement. But rebalancing your investments during a bear market can improve those long-term retirement portfolio returns.

What is rebalancing?

Traditional investment wisdom calls for the wise investor to “buy low and sell high”. In the short-term, it is nearly impossible for any investor to know whether the value of an investment is going to go up or going to go down. However, in the long-term, the value of broad stock and bond indices always goes up. When a broad stock market index falls into bear market territory, then you know that you have an opportunity to ‘buy low’.

My own investment philosophy has been to buy some shares of a stock index fund whenever the S&P 500 index drops in value by 10%. When the S&P 500 drops by 20%, I buy as much as I can. When the stock market drops that much, I consider stocks to be on sale. This strategy has served me very well over the past 30 years. There are two ways to buy stocks – either purchase them using your cash savings or purchase them by exchanging shares of bond investments for shares of stock. If buying stocks with cash savings, don’t forget to always keep enough in cash reserves to cover 3-6 months of expenses. In other words, don’t sacrifice your emergency fund to take advantage of a bear market.

If you do not have enough cash savings to buy stocks, then you can still exchange bonds for stocks and that is where rebalancing comes in. Rebalancing means maintaining a constant stock:bond ratio in your portfolio. For example, if you had previously been maintaining a retirement portfolio of 70% stocks and 30% bonds and then the value of the stock component increases during a bull market, then your portfolio could end up being 75% stocks and 25% bonds. In this case, you would want to exchange some of your shares of stocks for shares of bonds so that you can restore your desired 70/30 stock:bond ratio.

Why rebalance now?

In the past six months the value of both stocks and bonds has fallen and we have now entered a bear market. However, stocks have fallen much more than bonds and as a result, many investors are now finding that the relative percentage of bonds in their overall retirement portfolio has increased and the percentage of stocks has decreased. Let’s use the Vanguard Total Stock Market Index Fund as a measure of overall stock market performance and the Vanguard Total Bond Fund as a measure of overall bond market performance:

Since the beginning of 2022, the Vanguard Total Stock Market Index Fund has fallen in value from $118.25 per share to $89.48 per share, a 24.3% reduction. During that same time period, the Vanguard Total Bond Fund has dropped from $11.10 per share to $9.80 per share, an 11.7% reduction. In other words, stocks have fallen in value more than bonds.

If the stock:bond ratio in your retirement portfolio was 70/30 on January 1, 2022, it has now fallen to 66.7/33.3. In order to rebalance and restore your portfolio to the desired 70/30 ratio, you need to exchange some of your bond investments for stock investments. Once you do the math, this means that if your total retirement portfolio is worth $100,000, you should convert $3,335 of your bond investments into stocks. If your portfolio is worth $500,000, you should convert $16,675 of bonds into stocks. And if your portfolio is worth $1,000,000, you should convert $33,350 of bonds into stocks. Investors who should exchange the most from their bond funds into stock funds are those who originally had a 50/50 stock:bond mix in January as shown in the table below:

From this table, it is clear that the current bear market has left all portfolios out of balance and just about everyone’s retirement portfolio is now too heavy in bonds. So, we should all be converting some of our bond investments into stock investments right now. How much to convert depends on what your desired stock:bond ratio is.

How long do bear markets last?

One of the problems with entering a bear market is that you cannot predict how much further the price of stocks will fall before they bottom out. The price of stocks could start to increase tomorrow or maybe not until 2024. No one has a crystal ball that can see into the future and anticipate all of the thousands of variables that affect the price of stocks. However, we can look back to history to see how other bear markets have behaved. Since 1950, there have been eleven other bear markets that have lasted anywhere from 1 month to 2.6 years. The time that it takes for full recovery from a bear market has taken anywhere from 3 months to 5.75 years.

Given the uncertainty regarding the duration of our current bear market, one tactic could be to incrementally rebalance your retirement portfolio over the next several months. That way, if the value of the stock market continues to fall, you can take advantage of lower stock prices.

Know your investment time horizon

Investment pundits often talk about the investment time horizon in terms of the number of years until retirement. I believe that a better investment time horizon is the number of years until death. No one withdraws all of their retirement investments on the day that they retire – those investments have to keep earning returns for your entire remaining life. Obviously, you can choose your retirement date but you can’t choose your death date. But if you believe that there is a reasonable chance that you will live to be 95 years old, then you have a longer investment horizon than if you do not believe that you will live past age 70. It is that investment horizon that should dictate your retirement portfolio’s stock:bond ratio.

The decision about whether or not to rebalance your stock:bond ratio should not depend on your investment horizon. It is just as important to rebalance if you are 80 years old as it is if you are 30 years old. Those investors with a short time horizon should have a relatively higher percentage of their retirement portfolio in bonds than investors with a long time horizon. This insulates the short horizon investor from the worst effects of bear markets. Although short horizon investors’ portfolios have dropped in value, their portfolios have not fallen as far as portfolios of investors with a long investment horizon (who have a high percentage of their portfolios in stocks). This is illustrated in the table below, again using the Vanguard Total Stock Market Index Fund as a measure of stock performance and the Vanguard Total Bond Fund as a measure of bond performance:

A retirement portfolio that was valued at $100,000 on January 1, 2022 would now be worth $769 if the investor had a 90/10 stock:bond ratio whereas it would be be worth $870 if the investor had a 10/90 stock:bond ratio.

What is the best stock:bond ratio?

In a previous post, I discussed the factors that should determine what the ideal stock:bond ratio should be for any given investor. The most important determinate is your investment horizon which is generally tied to your age.

However, age alone should not be the only determinant of your retirement portfolio’s stock:bond ratio. Equally important is your personal degree of investment risk. Investors who should adopt a low risk portfolio include those who get anxious about market volatility, are pessimistic about the future economy, lack a pension, anticipate a short life expectancy, and have annual living expenses that are close to their annual retirement income. On the other hand, investors who can adopt a high risk portfolio include those who do not get anxious about market volatility, are optimistic about the future economy, have a pension, expect to live to an older age, and have annual retirement income that substantially exceeds their annual living expenses.

Those investors who adopt a low risk portfolio are those who need the relative safety of bonds in the event of a protracted bear market whereas those who adopt a high risk portfolio are those who can afford to ride out a long bear market without fear of running out of money later in retirement. It is important to note that an investor’s personal degree of investment risk should not affect the decision about whether to rebalance their portfolio. Every wise investor should rebalance in a bear market. One’s willingness to take investment risk should only affect their desired stock:bond ratio.

The stock:bond ratio is an oversimplification of most retirement portfolios. A healthy portfolio should consist of U.S. stocks, U.S. bonds, foreign stocks, foreign bonds, and real estate. Some investors may also include commodities, gold, collectibles, etc. No matter what your retirement portfolio is composed of, you should always know what the ideal percentage of your portfolio should be in each type of holding, based on your age and personal investment risk. You should then periodically rebalance those holdings in order to ensure that the percentage of each component stays constant.

Bears are scary animals and bear markets are scary financial times. Although it is easy to be frightened when you look at your finances right now, the current bear market should be viewed as an opportunity to increase long-term returns from your retirement investment portfolio.

June 21, 2022

Categories
Physician Retirement Planning

Now Is The Time To Do A Roth Conversion

Whenever you hear the words ‘bear market’, you should be thinking the words ‘Roth conversion’. The U.S. stock market is currently down more than 15% compared to its all-time high on December 27, 2021. A falling stock market is the best time to do a Roth conversion. Therefore, now is the best time to do a Roth conversion.

Summary Points:

  • Convert a portion of your traditional IRA into a Roth IRA during a bear market
  • Convert those individual investments that have lost the most in their value
  • Replenish your traditional IRA by doing a rollover from your 401(a), 401(k), 403(b), or 457 plan
  • Multiple small Roth IRA conversions are smarter than doing one large conversion in an attempt to time the bottom of the bear market

 

There are two situations when it is to your advantage to convert a traditional IRA into a Roth IRA: (1) when your income tax rate is low and (2) when the value of your traditional IRA falls. We are currently in a time when both federal income taxes are low compared to the past and the value of stocks and bonds has fallen. When you convert a traditional IRA into a Roth IRA, you will pay federal and state income tax on the value of the IRA at the time of the conversion. Therefore, if the value of the traditional IRA is low, you will pay less in income taxes when you do the conversion. History teaches us that when the stock market falls, it eventually goes back up. After you do the Roth conversion, the value of that Roth investment will eventually go back up and when it does, you will not have to pay any income taxes on it!

Let’s say that on December 27, 2021, you had $50,000 invested in an S&P 500 index mutual fund in a traditional IRA and you decided to convert it into a Roth. And let’s further say that your federal income tax rate is 15%. You would have to pay $7,500 in federal income tax when you did the conversion. But if you did that conversion last week, when the S&P 500 index had fallen to 3,901, the $50,000 in your traditional IRA was now worth $40,926 and you would have paid $6,139 in federal income tax – a savings of $1,361!

But what if I don’t have a traditional IRA?

There are 3 ways to put money into a traditional IRA. First, you can contribute pre-tax income directly into a traditional IRA but only if you have an income of less than $78,000 per year ($129,000 if married, filing jointly). In this situation, the traditional IRA is very similar to a 401(k) or 403(b).

Second, you can contribute post-tax income into a traditional IRA if your income is above $78,000 per year ($129,000 if married, filing jointly). Under either of these two situations, the annual contribution limit to a traditional IRA is $6,000 per year (or $7,000 per year if you are over age 50 years old). This is a great strategy for doing an annual ‘backdoor’ Roth but it is generally not a good strategy to put post-tax dollars into a traditional IRA and then leave it there. The reason is that you will pay regular income tax on the accrued value of the traditional IRA but would have paid the lower capital gains tax on the accrued value had you put that money in a regular investment.

The third way of putting money into a traditional IRA is to do a rollover from an employer-sponsored retirement plan. These plans include the 401(a), 401(k), 403(b), and 457 retirement plans. There is not a limit to the amount that you can rollover each year. There are several important rollover rules, however:

  1. You can only do 1 rollover per year. When you do a rollover, you have to wait 12 months before you can do another rollover.
  2. You must deposit the rollover money into the traditional IRA within 60 days of withdrawing it from the employer-sponsored retirement plan. The safest way to do the rollover is to do a “trustee-to-trustee” rollover meaning that the investment company that holds your traditional IRA arranges for the money to be directly transferred from the employer-sponsored retirement plan into the traditional IRA without touching your hands. If, instead, you have the employer sponsored retirement plan send you a check, then it is up to you to ensure that you deposit that money into the traditional IRA within 60 days.
  3. You can only do a rollover if either the employer discontinues the retirement plan or you are no longer employed by that employer. The latter most commonly occurs when you change jobs to a new employer or you retire.

Traditional IRAs give you more investment choices than employer-sponsored retirement plans. Also, you can often find similar investments with lower annual expenses that you can include in your traditional IRA. When you leave your employer for a new job, you have the option of either rolling your old employer’s 401(k)/403(b)/457 into your new employer’s 401(k)/403(b)/457 or rolling the funds into your traditional IRA. I would argue that it is better to do the rollover into your traditional IRA because of the prospect of lower expenses, the wider choices of investments, AND the opportunity to do Roth IRA conversions during bear markets.

It is easiest if you have your traditional IRA with the same investment company that you have your Roth IRA. If you have your Roth IRA with Vanguard, then also have a traditional IRA with Vanguard. If your Roth IRA is with Fidelity, then have a traditional IRA with Fidelity. Using a large investment company for both makes it very simple to move money from the traditional IRA into the Roth IRA when doing a conversion. Large investment companies (like Vanguard or Fidelity) will also work with you to facilitate trustee-to-trustee rollovers from your employer-sponsored retirement plan, even if that plan is with another investment company. On-line accounts allow you to do your rollovers and conversions from your own home on your own time, without having to drive someplace to meet with an investment advisor.

Beware of the 5-year rule

When you put money into a Roth IRA, that money grows tax-free and you do not have to pay any tax on withdrawals when you take the money out in retirement. That means no income tax, no capital gains tax, no interest tax, and no dividend tax. Furthermore, unlike other deferred income accounts (such as a traditional IRA, 401(l), 403(b), or 457), there are no annual required minimum distributions from the Roth IRA after you turn age 72.

However, it is important to be aware that you cannot withdraw money that you put into a Roth IRA for 5 years. In other words, if you convert $10,000 from a traditional IRA into a Roth IRA today, you cannot withdraw that money from your Roth IRA account until 2027.

Because of the 5-year rule, you should consider any Roth conversion to be a long-term investment. In other words, don’t put the newly converted money into a low rate of return investment such as a money market account or certificate of deposit within the Roth account. Money from Roth conversions should ideally be put into a broad stock market index fund in the Roth account. In the past 30 years, there have only been 2 times that the S&P 500 index took more than 1-year to recover from a downturn: in 2000 (7 years to recover) and 2007 (6 years to recover). In both of these prolonged downturns, if you had waited to do a Roth conversion until the S&P 500 index had fallen by 15% of its peak, you would have only had 3 1/2 years to recover after the 2000 downturn and only had 2 1/2 years to recover after the 2007 downturn. In both cases, your Roth fund would have fully recovered and then increased in value by the time the 5-years was past.

How should I time my Roth conversion during a bear market?

One of the simultaneously wonderful and maddening things about the stock market is that no one can predict when it is going to go up and when it is going to go down. In a bear market, when stock prices are falling, the only way to know for sure when prices have bottomed out is in retrospect, after prices have started to rise again. Rather than trying to guess when stock prices have hit their lowest and then doing your Roth IRA conversion, it is safer to spread your conversion out and do multiple small conversions every month or two.

A bear market is usually defined as a 20% drop in the prices of stocks. But for the purposes of Roth conversions, I don’t think you need to wait for the S&P 500 index to fall by 20%. Instead, think of a ‘big bear’ market as a 20% drop in value and a ‘little bear’ market as a 15% drop in value. Begin doing small Roth conversions when the broad stock indices fall to the level of a ‘little bear’ market, you can continue regular small conversions until the indices rise back up and out of the ‘little bear’ market values for those indices.

Unlike a rollover from an employer-sponsored retirement plan into a traditional IRA that can only be done once per year, you can do many Roth conversions per year. There is no limit to the number of traditional IRA to Roth IRA conversions you do each year nor is there a limit to the amount that you can convert. However, it is important to remember that the money that you convert from a traditional IRA into a Roth IRA is taxable income by IRS definitions. Therefore, the money that you convert will not only be subject to federal income tax but it will also add to your total taxable income for that year. As your annual taxable income goes up, your effective income tax rate will also go up. At some point, the amount that you convert will result in a large enough increase in your federal income tax rate to outweigh the advantages of doing a bear market Roth conversion.

Which investments should I convert?

If you have been a prudent investor, then you will have a diversified retirement investment portfolio. Your deferred income accounts may include your 401(k), 401(a), 403(b), 457, 415(m), and traditional IRA accounts. Within these deferred income accounts, you should have a mix of U.S. stock mutual funds, foreign stock mutual funds, U.S. bonds, foreign bonds, real estate investment trusts, and cash. The best individual investments to convert are those that have lost the most value in a bear market. Because bonds are less volatile than stocks, the value of stock mutual funds will generally fall more than the value of bond mutual funds and thus it is generally not a good idea to convert bond funds. It is almost never a good idea to convert cash (including money market accounts and certificates of deposits) since there will be no (or very little) tax advantages to convert these accounts in a bear market.

Look at your deferred income portfolio and identify those investments that have lost the most value and convert those investments from your traditional IRA into your Roth IRA. For example, if your Emerging Markets Stock Index Fund is currently down 23% and your U.S. Total Stock Index Fund is down 16%, then convert the Emerging Markets Stock Index Fund. In order to maintain your portfolio diversification balance, put the converted money into a new Emerging Markets Stock Index Fund in your Roth IRA.

It is wise to regularly replenish your traditional IRA by doing rollovers from your employer-sponsored retirement plans (assuming you are eligible to do rollovers, as discussed above). Since you can only do one rollover per year, you will want to do a sizable enough rollover to allow you to maximize any Roth IRA conversions that you might do later that year. Ideally, you should start each year with enough money in your traditional IRA to fund bear market Roth IRA conversions later in the year since no one can predict when a bear market will occur. You want to be prepared so that you can take advantage of those bear markets to do your Roth conversions. As an example, on January 3, 2022 when the NASDAQ composite index closed at 15,832, investors did not anticipate that the NASDAQ would fall by 29% to 11,264 less than five months later on May 24, 2022.

It’s all about investment strategy

 

Your retirement investment goals are to have enough money to do the things you want to do when you are retired, to ensure that you do not outlive your retirement savings, and to pay as little in taxes as legally possible. A strategy of periodic rollovers from employer-sponsored retirement plans into a traditional IRA and conversions of the traditional IRA into a Roth IRA during bear markets can help you meet all three of these retirement investment goals.

May 27, 2022