Monthly Archives: March 2010

Roth IRA Conversion – Modern-day Alchemy?

From ancient days, many have pursued the ability to transform something common (lead, for example) to something precious (gold).   Although the alchemist’s dream was never realized, people’s interest in the prospect of “a free lunch” continues.  My cynical nature (polished shiny by years on Wall Street) usually keeps me far away from anything which seems too good to be true (the answer is “false” most of the time).  But, when I learned about the details of the ROTH IRA conversion, my skepticism melted.  This might be one of the best things I’ve heard about in a long time.  Read on…

In 1974, the U.S. government established the Individual Retirement Account (IRA).  It was (and is) a great way to save money over the course of one’s working career to supplement retirement income.  One benefit of the IRA is that it could be funded with pre-tax dollars.  Another benefit is that the assets in the account can grow, tax-free, until the assets are taken out.  Anyone with a HP 12-C calculator can tell you the power of compounding – the longer the time-frame, the greater the benefit.

In 1997, the government created the ROTH IRA.  In many ways, the ROTH IRA was a huge improvement over the traditional IRA.  For one thing, contributions are made after tax and distributions, including all investment gains, are tax free.  Also, one can pull money out of the account before retirement as the need might arise (and certain conditions are met).  Unlike the traditional IRA, there are no required distributions – if one doesn’t need the funds in retirement, they can continue to grow, tax free and then be passed on to one’s heirs.  Too good to be true?  Well actually, yes.  Congress limited who could contribute to a ROTH IRA based on income.  So, high income earners (over $100,000) were effectively shut out of this wonderful investment vehicle.

Enter the new decade.  I’m still trying to figure out why this happened, but in 2010 the income limitation has been removed for ROTH IRA conversion.  So now anyone can convert IRA assets into a ROTH IRA.  But, like so many things with the government and retirement accounts, there is a catch.  One must pay taxes upon the taxable amount of the IRA assets rolled over.  In my view, the key factor in the decision to convert or not comes down to whether the tax-free-forever nature of the ROTH IRA is worth the tax payment today.  There are other complications (which frankly make my head hurt a bit to consider), but the choice seems to boil down to short-term payment vs. long-term gain.

One can find ROTH IRA conversion calculators plastered all over the Internet.  I’ve tried to use a few of them, but always got bogged down in the details.  How am I supposed to know what my tax rate will be in 20 years!?  So, happy was I when I found this simple questionnaire.  It doesn’t tell me how to convert, but simply tells me whether or not I would be good candidate for conversion.  Here it is:

Roth IRA Questionnaire

(1) Will you be in a high tax bracket in Retirement?

(a) YES – I expect my tax bracket to be higher in retirement (3 points)

(b) NO – I expect my current tax bracket is higher (0 points)

(2) Are outside assets available to pay tax on conversion income?

(a) YES – I have taxable assets available to pay tax (2 points)

(b) NO – I would need to use IRA assets to pay tax (0 points)

(3) Do you plan to pass IRA assets to heirs?

(a) I do not plan on needing any of my IRA assets in retirement (2 points)

(b) I plan to use some of my IRA assets in retirement but not all (1 point)

(c) My IRA assets will be my main source of income in retirement (0 points)

(4) How long is your investment horizon for IRA assets?

(a) My investment horizon is more than 10 years (2 points)

(b) My investment horizon is between 5 and 10 years (1 point)

(c) My investment horizon is less than 5 years (0 points)

(5) Does your IRA investment strategy seek capital growth?

(a) YES – Long term appreciation is a primary objective (LT Rate of Return > 6%) (1 point)

(b) NO – My investment strategy is very conservative (LT Rate of Return < 6%) (0 points)

(6) Do you have any tax basis in your current IRA?

(a) YES – A portion of my IRA will not be subject to tax upon distribution  (1 point)

(b) NO – all assets in my IRA are tax-deferred (0 points)

Total Score:

0 – 3   :    Roth Conversion may not be a good option
4 – 7   :    Roth Conversion should be considered
8 – 12 :    Roth Conversion should be strongly considered

That’s it – six simple questions, one score.  If you think you might be a good candidate for ROTH IRA conversion, talk to your tax account or financial advisor right away.  If done properly, the Roth IRA conversion can fulfill, in some small measure, the alchemist quest, not turning lead into gold, but turning taxable retirement assets into tax-free retirement assets.  It may not be magic, but in these days of lowered expectations, I will take any good news I can find.

Happy Birthday, Mr. Market!

Happy Birthday, Mr. Market!Nearly every media outlet is marking the one-year anniversary of the current bull market.  The basic facts are obvious – the market has staged a very impressive rally (+68% for the S&P 500), most economic data have improved and US companies have posted surprisingly good earnings growth over the last four quarters.  What is less obvious is what exactly happened over the past year to bring us to this point.  In trying to answer this apparently simple question, we can also find a very broad range of opinions.  Some would suggest that government intervention – fiscal and monetary stimulus, the TARP program, and other such measures – was the cause of the rally.  Others would suggest that aggressive cost cutting by companies at the cusp of the recession allowed them to post better-than-expected earnings, which reassured investors and helped to turn the market around.  Other more-cynical types call it some kind of conspiracy or shell game, an artifice of smoke and mirrors that any second could collapse revealing nothing of substance behind. Others see it simply as the logical rebound from a market break caused by irrational fears.  Whatever the reality, I would submit that it began just as every other bull market has since 1933 – in the middle of a recession, at a point where pessimism and cash levels were at their peak.  The old saying “the harder the fall, the bigger the bounce” also seems appropriate here.

The tone of the celebration is quite muted, in my view, by lingering doubts expressed by nearly everyone about the sustainability of the current rally.  It is hard to find but a handful of truly bullish portfolio managers or strategists.  Most seem quite cautious, suggesting that problems such as the high unemployment rate, the high valuation of the market, the big move in the market, housing market woes, budget deficits and looming inflation are likely to deflate this new bull market any day now.  In a way it’s quite ironic that we find this kind of sentiment at this point in the cycle.  At the bottom of the market we all had tons of fear and could find really solid reasons to be cautious.  Now that the “worse case scenarios” we could conjure up in those dark days have passed us by, many still feel compelled to be cautious.

In my mind, this is one reason to remain bullish.  Another is earnings growth.  Consensus estimates suggest that the S&P 500 stocks will grow EPS about 14% this year and another 18% in 2011.  Even if interest rates move up a bit (haven’t we been forecasting higher rates for about a year already?), I would think that double digit earnings growth could help stocks move higher.  What about valuation?  There are number of measures people use for this, but in my experience, valuation, as important as it is, is rarely by itself a reason for the market to go up or down.  I can still find good quality stocks trading at substantial discounts to what I consider fair value.  I don’t know about the market, but many stocks are still cheap.  The recent spate of acquisitions may also support this idea.  High cash levels are another reason for optimism, in my view.

But don’t we have problems and worries?  Sure, but we always do.  The stock market does not need utopian fundamentals to perform well; it simply needs incrementally more positive news.  The early stages of the rally were marked with the news being less bad than before.  That was enough to get it started.  Now we will need more good news to keep it going.  The average bull market lasts 51 months.  Because this new bull market began under similar circumstances as every other one before, I think the burden of proof lies with those who think “this time is different” (still the four most dangerous words in the investment world).  For me, I think the weight of history is on my side and I fully expect to ride this young bull for a few more years.  Let ‘er rip!

That’s What I’ve Been Trying to Say!

That's What I've Bee Trying to Say!

Long-time readers know that I have a “thing” about people who offer apparently “free” investment advice in the media.  The central tenet of my philosophy about all this free stuff flowing into our homes on a daily basis is this: “Why would anyone give away for free any significant, insightful, accurate and actionable investment advice, when they could get paid for it?”  If your answer to this question is “Because they like us and want to help us make money” then there’s little point in reading any further…

If, on the other hand you share my more cynical view of these articulate ersatz altruists (i.e. they’re selling something), allow me to flesh out a few details.  The media outlets which find the daily fountain of economic data, market chatter and pundit prognostications so endearing and entertaining may not have your best interests in mind.  Instead of helping listeners indentify and implement an investment strategy which would not only make them money but that would fit well with their individual personality and circumstance, they shower the viewers with so much data and commentary, that it would be nearly impossible for the average investor to make any sense of it.

Then, we must also consider the source of this information.  Whenever Warren Buffett or David Einhorn speaks about the market or their investments, we can be assured that they know what they’re talking about.  These are seasoned investors who have a well-defined investment style, which they follow systemically and which has made them lots of money.  So even if one of these seasoned professionals is trying to sell us something, we can be fairly confident that what they say is backed up with serious research and money on the line.

On the other hand, we should find no confidence when other market “observers” (journalists, academics, former hedge-fund managers, etc.) offer their opinions.  Just as you would not seek an airline pilot’s opinion on a medical issue, journalists can probably not help you consistently make money in the market.  All of these people are professional, well intended and likely sincere, but they are not professional investors.  This disconnect between speaking intelligently about the markets and being able to invest intelligently was highlighted by Ron Insana’s hedge fund experience.

Mr. Insana was a highly-regarded CNBC anchor who in 2006 decided to launch his own hedge fund.  He had been covering Wall Street and hedge funds for over a decade.  He seemed to know what he was talking about.  He had great contacts.  The fund closed within two years for a number of reasons, but to me the lesson is clear.  He was an airline pilot trying his hand at medicine!  I suspect that he learned more about the investment business in those two years than he did in all his years as a journalist.  It’s not as easy as it looks.

This brings me to a fellow named Brad Tuttle, who posted a very honest and refreshing article last month about this very topic.  You can read the whole thing here.

Here are a couple of highlights I want to share:

“Journalists are storytellers. They get by excited by new ideas and innovation. But as to how an interesting back story about a CEO or how some new product translates to a company’s long-term profits or stock prices? Most writers don’t go there, and shouldn’t go there. Why? They don’t know what they’re talking about.”

“If following the conventional wisdom led to wealth, then we’d all be rich—which is sorta impossible, because there have to be winners and losers.”

“…Warren Buffett: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”

And the final, perfect quote, “So where should you invest your money? Don’t ask me. I’m a journalist.”

I couldn’t have said it any better…