Should you convert your Traditional (pre-tax) IRA to a Roth IRA in 2010?

Updated: September 1, 2015

The US Congress, in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2006, eliminated the income limit for conversions from pre-tax retirement accounts (Traditional IRAs (including Rollover IRAs) and 401(k)s, 457s, and 403(b)s) to Roth IRAs as of 2010. Before 2010, your (Modified Adjusted Gross) income had to be less than $100,000 for you to be able to convert. Beginning in 2010, anyone, regardless of income, can convert his or her pretax retirement accounts into Roth IRAs. To avoid having to say pre-tax retirement assets (Traditional IRAs (including Rollover IRAs) and 401(k)s, 457s, and 403(b)s every time, I’ll just refer to all such assets as “Traditional” from now on.)

Should you convert any of your Traditional assets into Roth IRA assets?

Yes, if at least one of the following is true:

  • You expect to pay a higher income tax rate than you do now when you start to draw from your IRA.
    • If you are under 59½ and you would pay the tax on conversion using funds from your IRA, the future rate must be at least 10% higher.
  • You want to make an unusually large contribution to your IRA.
  • You want the greater flexibility offered by a Roth IRA.
  • Your heirs may benefit from the simplicity afforded by a Roth IRA.

No, if none of these reasons applies to you.

Read on for some analysis that will help you think about that question. However, I recommend that you get personal objective professional advice before you make a decision. The rules are complicated, and this brief article can’t address every detail of your situation.1, 2

The table summarizes the major differences between Traditional accounts and Roth accounts.

  1. You see one big difference right away, when you make retirement contributions. With a Traditional, your taxable income does not include your contribution, so contributing will reduce your taxes. On the other hand, withdrawals count as taxable income – withdrawing will increase your taxes. With Roth accounts, you cannot deduct your contributions from income, so your income taxes don’t change if you contribute. Withdrawals from Roth accounts are not taxable income, however: you can withdraw as much as you want without paying any tax later on (after age 59½).
  2. With a Traditional, you must make a withdrawal (Minimum Required Distribution, or MRD) every year after you turn 70½. There are no MRDs for Roth IRAs.3
  3. Once you’ve had a Roth IRA account open for 5 years, you can withdraw your contributions without penalty. A 10% penalty applies on Roth IRA earnings withdrawn before age 59½. That 10% penalty applies to all withdrawals from Traditionals.

So, what does all this mean? Should you convert or not? Several factors are important.

    • If you expect to pay a higher tax rate after you retire than you pay now, you should pay your taxes now, at the lower rate, by converting to Roth. The table at the right illustrates the situation, if you are 59½ or older, and you pay the taxes using funds from your Traditional. In the shaded squares, there is a clear advantage to converting.
      • For example, suppose your tax rate now is 10%, and you expect to pay 35% after you retire. If you have $100 in a Traditional now, and earn a 4% return every year until you withdraw in 11 years, you’d have $38 more with a Roth than if you keep your Traditional (the advantage is 38% of your current Traditional balance).
      • On the other hand, if your tax rate now is 33%, and you expect to pay 25% when you retire, you’d have $12 more in 11 years with the Traditional than if you convert to the Roth (12% of your current balance).
      • If you expect to pay the same rate, you’ll have the same amount whether you choose the Traditional or the Roth. It makes no difference at all.

  • If you are younger than 59½, there is a further complication. Withdrawals from the Traditional to pay taxes incur a 10% tax penalty. So, if you must draw funds from your Traditional to pay the taxes, it makes sense to convert to a Roth and pay the taxes now only if you expect your tax rate in the future to be significantly higher. The table at right shows that rates at withdrawal need to be at least 10% higher in the future to offset the 10% penalty. Again, there is a clear advantage to converting in the shaded squares.
  • Now, suppose you can pay the taxes using funds outside the Traditional. This is just like making an additional Roth contribution. For example, suppose there is $100 in the Traditional, and you are in the 25% tax bracket. If you paid the $25 tax from the IRA (and if no penalty applied), you’d have $75 in the Roth. However, if you have $100 in the Traditional, and you can use $25 of free cash from outside the IRA to pay the tax, you can have $100 in the Roth. In fact, it is advantageous to pay the taxes now even if you expect to pay slightly lower rates in the future: you receive the advantage of tax deferral on more assets. (Again, see the shaded squares for advantageous combinations of current and future tax rates.) For the example we’ve been using, with 4% returns, and 11 years until withdrawal, the Roth has a $4 (4%) advantage even if tax rates on withdrawal are 33% vs 35% now. The advantage is larger for longer waits until withdrawal.
  • Roth conversion has extra advantages if you expect not to need withdrawals from your IRA until later in retirement than 70½. The Roth allows you to defer taxes longer – there are no Minimum Required Distributions. Thus, even if your tax rate analysis suggests rough equivalence between traditional and Roth IRAs, you may wish to convert.
  • On the other hand, if you expect to need some of your IRA assets before age 59½ (say, to pay college tuition), you may also wish to convert some Traditional assets to a Roth IRA in order to take advantage of its greater flexibility. You can withdraw Roth contributions (and conversions) for any purpose 5 years after you open the account.
  • Finally, if you expect that your estate may incur Federal estate tax4, your heirs may have simpler tax returns if you bequeath them a Roth IRA. The Traditional balance includes deferred taxes. Your estate may owe estate tax on these deferred taxes. When your heirs take withdrawals from the bequeathed IRA, they would get credits for the estate tax already paid on the taxes. To get the credits, however, they must remember to apply for them every year! This requires very knowledgeable heirs and very conscientious accountants. With the Roth, there are no deferred taxes, so no need to apply for credits. Much simpler! If your heirs will face much lower tax rates than you do now, more careful analysis is necessary.

In summary, Roth conversion is likely to have substantial advantages unless you expect to face lower tax rates in the future. And, the Roth’s greater flexibility may make it advantageous even if you expect future tax rates to be the same, or even a little higher.

One word of caution: it may be difficult to compare current and future tax rates. Converting to a Roth now may actually reduce your future tax rates (and make Roth conversion less attractive than at first blush!) – you’ll have less future income because Roth withdrawals aren’t taxable income. This effect may be even larger than you might think – reducing post-retirement income enough may reduce the taxed proportion of your Social Security benefits. On the other hand, Roth conversion can increase your current tax rates by pushing you into a higher bracket, thus making the conversion still less attractive.

If you are seriously considering Roth conversion, seriously consider doing a careful analysis – conversion impacts on both current and future taxes are far from obvious.

1As a very simple example, you can’t convert an employer retirement plan like a 401(k) or 403(b) if you still participate in the plan.
2Unless your plan specifically allows qualified distributions before you retire. I told you this was complicated!
3Inheritors of Roth IRAs (and Traditional IRAs) must take MRDs once they inherit the account.
4Currently, there is no Federal estate tax. In 2011, the Federal estate tax reverts to the rules in effect before 2001.

Establishing a Streamlined Tax Structure

Updated September 1, 2015

Have you seen the simplified 1040? It looks like this:

How much money did you make last year? ________________
Send it in ________________

No place for special exemptions, special deductions, credits or other fancy footwork.

In the real world, with the real 1040, there are plenty of special opportunities to save on income taxes. Lobbyists spend every waking hour and no little expense to persuade Congress that their special interest group members deserve special consideration when April 15th rolls around. The resulting special tax advantages can be very valuable, but they are, well… special, and not available to everyone.

On the other hand, everyone has potential opportunities for tax savings via careful transaction timing. Fundamentally, our tax system is progressive – the tax rate on the next dollar of income (the marginal tax rate) is higher for higher incomes. Reduce your income, and pay a lower tax rate. Or, pay your taxes later, and earn interest on the money until you pay them1. So, in general, tax-reducing tips focus on accelerating deductible expenses and deferring income.

If you belong to a special interest group, you probably already know how to take full tax advantage. If you have an accountant, you are likely well-advised on how to manage your income and expenses to best advantage. In either event, you can still benefit from what you’ll read in this article.

This article has a long-term focus. I’ll highlight tax strategies that will keep your taxes down permanently, and raise your after-tax spending power significantly. They are the tax strategy counterpart to “buy and hold” index investing.

You may find it useful to think about your finances over your lifetime as a car taking a long trip. Taxes are a drag! Income and expense timing are comparable to putting new tires on the car, aligning the front-end, getting a tune-up, and having the car detailed. Every one of these steps will improve the car’s mileage and performance somewhat, but not one changes the car’s aerodynamics in any fundamental way. Next year or in 10,000 miles, you’ll have to do the same things all over again. [If you are, or are not, in a special interest group, there’s not much you can do about it.]

Now consider redesigning the car to make it more aerodynamically sleek. Imagine reshaping a Model T (the original box on wheels!) into a Porsche. Even if the two cars had the same engine, the one with the Porsche body would outperform the Model T dramatically. Less drag! Completely redesigning a car is hard – witness the 70 years or so to it took the boxy Ford Model T to evolve to the sleek Porsche 911. Only an engineer can understand (let alone love!) the many incremental steps it took to get there. Nevertheless, the result of all of those incremental steps is an enormous [and permanent] increase in miles per gallon due to (among other things) reduced drag.

It’s somewhat the same with your taxes – organizing your finances for long-term tax efficiency requires taking a number of steps, some of them time-consuming. However, when you are finished you’ll have a financial structure with much less tax drag, year in and year out. Just as the Porsche slips smoothly through the air, you won’t notice or measure the daily impact of each component of the structure – you don’t have to save taxes you don’t owe!

The suggestions you’ll find in this article are of the second kind – intended to change the arrangement of your financial resources to minimize the burden of taxes year in and year out. You can make these changes any time, but now is always the best time. The sooner you establish a streamlined financial structure, the longer you’ll have to enjoy it (and the more after-tax spending power you’ll have).

Establish a Streamlined Financial Structure (Tax-wise)

Your financial structure consists of accounts – locations to hold assets and locations you owe money (debts or liabilities) – and the assets and liabilities themselves.

Only some accounts have tax advantages. The first step toward long-term tax efficiency is to be sure that you are using all of the tax-advantaged accounts available (and useful) to you. Tax-advantaged credit or debt accounts and tax-advantaged asset accounts are both available.

Tax-Advantaged Credit

Your mortgage and home equity line of credit are the most obvious tax-advantaged credits. Interest on these loans is tax-deductible2. In addition, interest rates on home mortgages tend to be lower than car loans or credit card loans. As a result, the after-tax rate of interest you pay on a mortgage loan is likely to be a lot lower than the rate you’d pay on a car or credit card loan.

For example, suppose you have a mortgage at 6%, a $20,000 car loan at 8%, and $5,000 in credit card loans at 12%. Let’s assume you are in a 40% state plus Federal marginal income tax bracket (that is, the IRS and your friendly state and local tax authorities tax your next dollar of income at 40%). Your annual after-tax savings from shifting your borrowing to your mortgage would be $1300 per year, or nearly 60% of the $2200 interest you’d pay otherwise.

The after-tax interest rate on your mortgage is 3.6%, while the after-tax rate on the car is 8% (no tax benefit). That 4.4% difference is worth $880 per year to you. The after-tax rate on the credit card is 12% (no tax benefit there, either), so the 8.4% difference is worth $420. Adding $25,000 to your mortgage and paying off the car and credit card loans with the proceeds would save $1300 per year.

Strictly speaking, this saving is due both to lowering the interest rate you pay, and to the tax-advantaged nature of the (low interest) mortgage loan (see table). However, even if the car loan and the credit card loan were both at only 6% pre-tax (the same as the mortgage), you’d still get a $600 (40%) refund on the $1500 interest bill for the car and credit card.

By the way, car leases involve interest, too, even though car dealers are reluctant to emphasize the point. So – pay cash for your car, pay off your credit card each month, and save a lot on taxes (and interest).

Are there drawbacks to this strategy? There are at least three:

  • Credit card debt is unsecured; only your car secures car loans. Defaulting on credit card debt poses a risk to your credit rating, defaulting on a car loan will cause repossession of your car. Default on your mortgage loan or home equity loan risks loss of your home. This is a risk each family must assess and decide for itself.
  • High-income families will receive a smaller tax benefit. The tax deduction for mortgage interest (and other itemized deductions) begins to phase out for (adjusted gross) incomes above $142,700. The deduction declines by 3% of AGI above $142,700, with a maximum decline of 80%. For higher incomes, in other words, the deduction is (much) smaller, and the benefit of consolidating car and credit card debt into a mortgage or home equity line of credit is limited.
  • Consolidating a credit card loan into your mortgage increases your ability to borrow on that card. It’s important to have an effective strategy for keeping your credit card debt at zero3.

Tax-Advantaged Assets

Asset accounts targeted at retirement and higher education offer valuable tax benefits. You can increase your family’s spending power by taking full advantage of each, to the extent they are relevant and appropriate for you.

The sheer number and variety of tax-advantaged retirement accounts is bewildering. There are individual plans (such as regular and Roth IRAs) and employer sponsored plans (such as 401(k)s and 403(b)s). There are even hybrids of the two – you might call these employer-sponsored individual plans (such as SEP IRAs and SIMPLE 401(k)s). This article will not review the merits and demerits of each one, nor attempt to help you determine which one or ones might be right for you. We’ll have to leave that for another article.

Once you’ve identified your retirement plan of choice, you must be sure to do five things:

  1. Establish the account in time to realize a benefit this year. You can establish some accounts (such as traditional and Roth IRAs) until the due date for taxes for the year in question – April 15, 2007 for 2006. You must establish others much earlier – for example, a SIMPLE IRA must be established by October 1st, while individual 401(k) plans must be established by December 31st or the business fiscal year end. You have to have an account in order to contribute to it.
  2. Contribute to your accounts. Having a retirement account will produce a tax benefit only if you contribute to it. The tax benefit is a higher after tax rate of return on any investment in the account. The advantage depends upon the pre-tax rate of return on your investment, and the number of years you have to gain the tax advantage. The table at right illustrates (assuming a 40% tax rate). The tax benefit is larger for higher rates of return. For example, at ten years, the tax benefit is $20 per $1,000 invested at a 4% rate of return, and nearly $100 at 8%. The tax benefit is larger for longer holding periods. For a 6% rate of return, the tax benefit is $554 per $1000 for 25 years, and nearly twice that if you can hold the asset in the tax advantaged account for 30 years. Note: These benefit estimates assume that investments in both taxable and tax-deferred accounts are in fixed income assets (bonds). The benefits may be smaller for equity investments (see the discussion of asset location below).

  3. Contribute enough to receive matching contributions from your employer if your employer’s plan offers them. Like the lower interest rates on home mortgages, employer-matching contributions are a benefit associated with a tax-advantaged account that is not a tax benefit, strictly speaking. However, these benefits are extremely valuable4. 100% matches represent 100% returns on your money, 50% matches are 50% returns, etc. Alternatively, you can think of employer matching as a raise you don’t even have to ask for. Choose the description you find most motivating, and act on it.
  4. Contribute early in the year. We just saw that the tax benefit is larger for longer holding periods. If those holding periods are long enough, the advantage of just one more year is very large – and one more year is what you get by contributing on January 1st rather than December 31st (you get more than a year by contributing January 1st rather than April 15th of the following year). The table at right shows the additional tax benefit of contributing early in the year. If you can expect your holding period to be at least 20 years, the incremental benefit goes from $14 to $100 as the rate of return ranges from 4% to 8%. Even if you are 65, and ready to retire, chances are very good you may not draw on the money for 20 years – there’s still good reason to contribute early in the year.

  5. Take your required minimum distributions. Rules for distributions from retirement plans are very strict, and the penalties for breaking them are draconian. The rules are also extremely complex – when it’s time to start to take distributions, you may find it worthwhile to seek guidance from a professional specializing in this area5. By law, distributions from most retirement plans (Roth IRAs are the major exception) must begin in the year after you turn 70½. The IRS has promulgated tables of minimal distribution rates. Failure to meet the requirements results in penalties of 50% (half!) of the shortfall from the required distributions. That could ruin your whole day – not to mention its negative impact on your net tax benefit.

There are several potential drawbacks to tax-deferred retirement savings:

  • You can save too much. In this case, you don’t spend as much as you could when you are young, and find yourself being able to increase your standard of living dramatically when you retire. At that point, it’s too late to go back and take the vacations you missed, and buy the car you had wanted to buy. Another risk of saving too much is discovering that you need to take distributions before 59½ (the earliest allowable date in most cases). Such early distributions involve tax penalties of 10% – again reducing your tax benefit. You can overcome these risks, but it’s hard work. Better to set your savings target correctly in the first place.
  • You can save in a low tax bracket, only to withdraw in a high tax bracket. If you expect a big inheritance or if you expect tax rates to rise a lot in a short period of time, your tax rate may be higher after you retire than when you are contributing. This will reduce the size of your tax benefit, but unless the time horizon is short (say 5 years or less), the benefits are still positive. This is not an issue in the case of Roth IRAs – you owe no taxes on those distributions.
  • You can turn capital gains into ordinary income. Capital gains tax rates are lower than ordinary income tax rates. Ordinary income tax rates apply to distributions from most tax-advantaged retirement accounts (except Roth IRAs). If you plan to invest your retirement contribution in equities that you intend to produce significant capital gains, and if you plan to withdraw the contribution and its returns in a short time (say 5 years or less), then the tax benefits are likely to be small6.

Saving for higher education also offers opportunities for tax benefits. You should consider these opportunities carefully – financial aid reductions may reduce the tax benefits significantly (see my article, “Saving for College,” on Index Investor for a full discussion). Education account tax benefits are usually smaller than retirement account benefits – you save smaller amounts, and you have a shorter time to realize the benefits. On the other hand, you pay no tax (as in zero) on 529 and Coverdell education savings account distributions used for higher education expenses. As a result, if you decide that a tax-advantaged college savings plan is for you, the tax benefits can be very significant. The rules for success are generally the same for education savings accounts as they are for retirement savings accounts.

  • Establish the accounts timely. You can set up a Coverdell account for this year by April 15 of next year. However, Federal gift tax rules govern 529 accounts – gifts must be completed (the plan must cash the check!) by the end of the calendar year to qualify for that tax year.
  • Contribute to the accounts. Each parent can add up to $12,000 per child per year to these accounts. Moving money to these accounts turns taxable returns into tax-free returns. Larger contributions produce larger tax benefits, as do contributions earlier in your child’s life. Even contributing just one year before you expect to need the money generates tax benefits, however. If you can contribute ten years ahead, even earning only 4% on your investment yields a tax benefit of an extra 21% ($213 per $1000 invested) in spending power.

  • Contribute early in the year. Just as with retirement savings, contributing on January 1 rather than December 31 is worth a good deal (and of course, worth even more than waiting until April 15). If you can wait 5 years, the extra benefit [beyond the benefits shown in the previous paragraph] of investing early in the year is $22/$1000 at 4% (an extra 2%). It can be as much as a full $274/$1000 (an extra 27%) for money invested when your child is born, drawn as a last payment for her education, and earning 8% in the interim.

  • Don’t contribute too much. A 10% tax penalty applies to money not used for higher education. That is –ordinary income rates apply to all returns – and an additional 10% penalty is charged. The cost is small, $20-$30 / $1000 invested for a wide range of returns and periods, but there is no need to incur it. The numbers at the lower right corner of the box may tempt you – invest for a long time at a high rate of return, and you make out well even after the tax penalty. Unfortunately, you must close Coverdell and 529 accounts by the time the beneficiary reaches 30, and the contribution constraints limit the usefulness of this “option” (even if the rates of return were attainable with bonds).

  • Withdraw according to the rules. The same tax penalties apply to all withdrawals not used for higher education. Errors here can void your entire tax benefit.

Finally, there are tax-advantaged accounts offered by life insurance companies. These come in two main varieties – cash value life insurance and variable annuities. Usually, a commissioned life insurance agent or retail securities broker will bring one or both of these types of products to your attention. That usually means high fees and expenses to cover the commission, and a less-than-objective view on the benefits.

If you have exhausted all of the tax-saving opportunities available through retirement and educational savings, a product of this type may offer some benefit. Unless the fees and expenses are very low, you will do better with a buy-and-hold index investment strategy for fixed income. If you are considering an equity investment, expenses must be extremely low (and your investment horizon very long) for these products to beat a simple index strategy.

Manage capital gains and losses

In tax-advantaged accounts, you can trade to your heart’s content without affecting your tax advantages. The impact on your returns is likely to be negative, but that’s another story.

In taxable accounts, trading has tax consequences. Taking losses has benefits – you can deduct up to $3,000 of losses from income in any year. Furthermore, you can carry losses forward from one year to the next, and you can use them to offset gains that you realize as you rebalance, if you must.

Taking gains has costs – capital gains taxes must be paid now rather than (much) later. The benefits of tax deferral are lost.

Therefore, the trading rules for taxable accounts are very simple:

  • Take your losses every year.
  • Rebalance only when you must to maintain your target asset allocation.
  • Don’t trade otherwise. (Taking gains forces you to pay taxes rather than defer them, reducing your lifetime after-tax returns).

Allocate your assets to maximize tax advantages

Once you’ve established a streamlined account structure, and you’ve contributed assets to all of the accounts you’ve set up, the next question is how to invest the assets. Your choices here can have a significant influence on the spending power you realize during your life, beyond the return you earn on each investment.

Your first investment decision is asset allocation – how much to stocks (and which kinds of stocks), how much to bonds (and which kinds) and how much to cash. (Stocks, bonds and cash are asset classes.) This decision is also beyond the scope of this article. offers sophisticated asset allocation advice, and so do many investment advisors.

Once you have an asset allocation, your next decision is asset location – assigning asset classes to accounts. You should plan your asset location to produce the largest possible after-tax rate of return on your entire portfolio. The basic rules are simple:

  • Line up your asset classes from most to least susceptible to tax advantage.
  • Place the most susceptible in the tax-advantaged accounts (retirement and college savings) first.
  • Then place the next asset in the tax-advantaged accounts.
  • Continue until you’ve used up all of the capacity in your tax-advantaged accounts.

Ranking the assets on susceptibility to tax advantage depends on a number of factors – time horizon, return assumptions, your tax rates, and your trading tendencies to name just the most important. The following ranking rules are good rules of thumb:

  • Commercial real estate is most susceptible to tax advantage (its dividends count as interest).
  • Higher yielding bonds are next.
  • Higher risk and return equities are next (emerging markets and small cap stocks are good examples), with special advantage to high dividend asset classes.
  • Ordinary equities follow – still susceptible to tax advantage, but less so than the asset classes above.
  • Cash and low yielding bonds are last – highly susceptible to tax advantage in percentage terms, but the returns are so low that the dollar impact is minimal.

Let me emphasize, however, that these are just rules of thumb. The most tax-advantaged allocation will depend upon the likely returns for each asset class, the nature of your tax deferral opportunities, your self-discipline in terms of taking capital gains, and your time horizon.

The following table illustrates the analysis that forms the basis of the rules of thumb: the table indicates the dollar value at the end of a 30-year investment horizon of $1000 invested in each of two asset classes. For example, $1,000 after-tax dollars invested in each of equities and REITs would produce 7% more if the REITs are sheltered in a 401(k) than if the equities are sheltered. Bold type highlights the better decision. Note that the nature of the tax sheltered investment matters a great deal. Variable annuities (VAs) and non-deductible IRAs produce very different results than 401(k)s and Roth IRAs because the tax advantages are smaller, and in the case of VAs, expenses are higher.

The assumptions matter. For example, slightly higher fixed income interest rates reverse the preferred allocation of equity and fixed income investments in 401(k)s. For the table, the assumptions are:

  1. Pre- and post-retirement ordinary income tax rates both 40%
  2. Capital gains and dividend tax rates both 15%
  3. 30 year investment horizon
  4. Account types: VA – variable annuity, ND IRA – non-deductible IRA
  5. VA mortality and expense ratio – 100 bps
  6. Rates of return:

You can see that in some cases the location decision doesn’t matter much, and in other cases it matters a lot. For larger asset bases, the percentages translate into more dollars, and it’s worth more to get the asset location decision right.

In Summary

  • Streamlining your financial structure, and maximizing your after-tax spending power once your brilliant investment strategy has succeeded is conceptually very simple:
    • Use your tax-advantaged borrowing power in preference to other forms of borrowing.
    • Maximize your tax-advantaged saving opportunities: retirement first, then education.
      • Set up the accounts
      • Contribute to the accounts
      • Contribute early in the year
      • Follow the withdrawal rules to avoid tax penalties
    • Trade in your taxable accounts only to realize losses and to rebalance.
    • Locate your assets to maximize the tax-deferral benefits.
  • Tax-deferral benefits can be quite significant. After-tax returns in tax-deferred accounts can be more than double those in taxable accounts.
  • There are only a few practical difficulties:
    • Planning and self-discipline are essential.
    • Assessing asset location benefits can be complex, and may require professional advice.

Take Advantage of Low Taxes on Investments

Updated: September 1, 2015

How can you take advantage of dividend and capital gain tax rates at historically low levels?

Sensible Financial™ identifies 4 specific strategies you can use to maximize your benefit.

The 2003 tax law1 reduced the tax rate on capital gains from 20% to 15%2. In addition, the treatment of dividends changes – once ordinary income, with tax rates as high as 39%, you now pay taxes on these returns at capital gains rates. This sounds like an unmitigated benefit. Who doesn’t like to pay less in taxes?

The mitigation is that these benefits are scheduled to last only five years or so, terminating December 31, 2008. Sensible Financial knows of no way to predict whether they will continue beyond that date or not. However, we’ve designed the advice below to be effective even if the reductions don’t continue.

How can you take the fullest advantage of reduced tax rates? Aside, that is, from smiling a bit when you file your 1040 next April, as you say to yourself, “I saved $100 (or pick your number) because tax rates are historically low.”

Not surprisingly, the actions we recommend have to do with moving assets into situations where their earnings pay taxes at the lower rate. And, that requires moving them out of other investments where the costs are now relatively higher.

“Buy and hold” and “value” investing strategies are more attractive for your taxable accounts

  • Buy and hold. Long term capital gains are now relatively even more valuable than short term gains in taxable accounts. A dollar of long-term capital gains is worth 85¢ after tax (the only dollars you can spend) in a taxable account3, while a short-term capital gain dollar is worth only 75¢ (if you are in the 25% bracket) or even 65¢ (in the 35% bracket). So, waiting until your capital gains have their first birthday, and become “long-term” makes even more sense than it did before.

    Active trading tends to produce short-term gains and losses. If you must trade, trade in your tax-deferred accounts. Incidentally, managed mutual funds that trade a lot (and take a lot of short term capital gains) are relatively less attractive now – their tax efficiency will be even worse relative to index funds.

  • Emphasize “value” equities. “Value” stocks have low P/E or price to earnings ratios, and they tend to pay dividends. Dividends are significantly more valuable now – you can keep 85¢ of every dollar now, versus 75¢ before (if you are in the 25% bracket) or even 65¢ (in the 35% bracket). Plus, you keep 85% of the capital gains, versus only 80% before. As a result, your after tax rate of return on value stocks is likely to be much higher now than before (6.6% vs 5.2% for value stocks with 6 percentage points of the expected 8% return from dividends).

    In contrast, “growth” equities’ values depend more on the expected growth of the underlying companies. Your rate of return on these stocks (and if you are a Sensible Financial client, growth index mutual funds) doesn’t change in taxable accounts, staying at 7.1%.

The advantages of “tax-advantaged vehicles” are less

If taxes are less, then so are tax advantages. In some cases, the “tax advantages” actually have become negative. And, for some “tax-advantaged” vehicles charging extra fees, the fees have become much more likely to swamp the “tax advantages”.

    • Reconsider how much you should be contributing to non-deductible IRAs. Non-deductible IRAs allow the tax-deferred accumulation of investment returns. However, the investment returns are ultimately taxed at ordinary income rates. The advice here is a little bit complicated. For most of the advice, we’ll assume that you expect your tax rate to be the same after you retire as it is now, or even lower.
      • If you intend to hold only fixed income assets in the non-deductible IRA, go for it. This is pure tax deferral, in effect earning investment returns on your taxes before you finally have to pay them. REITs (Real Estate Investment Trusts – vehicles for investing in commercial real estate) should be thought of as fixed income assets in this context – their dividends are treated as “interest” for income tax purposes.
      • If you intend to hold “growth” equities in the non-deductible IRA, don’t do it. Even for the longest time horizons, you end up with more spending power paying low capital gains taxes in the future rather than higher ordinary income taxes.
      • For “value” equities, the decision depends upon your time horizon. If you will be holding the investment for more than 10 years or so, the benefit of tax deferral outweighs the lower tax rate you pay on dividends versus ordinary income and you should use the non-deductible IRA. If your time horizon is short, the reverse is true — you should stick with an ordinary taxable investment account4.
      • If you expect your tax rate to go up after you retire, don’t invest in a non-deductible IRA. In this case, deferring taxes means avoiding low taxes now, waiting until later when you can pay high taxes. Not a good idea before, not a good idea now.
    • Think three times, not twice, when offered the opportunity to buy a variable annuity (or VA)5. VAs are a favorite offering of securities brokers and insurance agents as vehicles for investing in equities while deferring taxes . Their potential advantage for clients is that they can be used to defer taxes6. Their advantage (not potential) to the brokers and agents is the very significant commission that they typically carry. In fact, they function very much like a non-deductible IRA with extra expenses.

      In the tax rate environment that was in force until the passage of the new tax law, a VA was most likely to deliver on its promised tax savings for someone whose tax bracket after retirement was lower than before retirement, and who invested in higher yielding securities7. VA earnings are ultimately taxed at ordinary income rates. Since dividends were also taxed at ordinary income rates (39.6% in the example), deferring taxes on dividends was always an advantage. On the other hand, capital gains were taxed at lower rates (20% for most people who had enough spare cash to be attractive targets for brokers and agents). If you expected to retire in a high bracket under the old tax laws, putting off capital gains tax rates to pay ordinary income tax rates was already not such a great idea. In fact, as the graph shows, for investments with low yields (and high capital gains), buyers of VAs with high post-retirement tax rates, actually paid more taxes than non-buyers (the zones labeled in pink, beige and red).

      With the new, lower tax rates on capital gains, and especially, on dividends, buyers never realize the potential advantage. Basically, the new tax law has eliminated the advantages of tax deferral – putting off the low tax rates on capital gains and dividends in order to pay higher ordinary income tax rates later is a money-losing idea.

The economics of your mortgage have changed ever so slightly

Your new tax rate is probably slightly lower than previously. As the following chart illustrates, rates have declined by 2 or 3 percentage points, depending on your taxable income. If you have a mortgage, this means that your after-tax cost of borrowing has gone up slightly. If your mortgage interest rate is 6%, your after-tax rate is now .12% to .18% higher. If your mortgage interest rate is 5%, your after-tax rate is now .10% to .15% higher.

For example, if you were in the 27% bracket, and are now in the 25% bracket, your 6% mortgage was costing you 4.38% after-tax, and now costs 4.5% after-tax.

Compare this to the after-tax economics of investing in equities that we mentioned above, where expected investment returns on growth equities are unchanged at around 7%, and expected returns on value equities have improved from 5.2% to 6.6%.

You may have heard that paying of your mortgage gives you a guaranteed return, and it does. Your return is the after-tax interest rate. The tradeoff has changed: paying off your mortgage is now a slightly better deal, investing in value equities after tax is now a significantly better deal.


The implications for you of this tax rate environment depend on many factors, and it may be worth thinking through your options. Sensible Financial is ready to help. Give us a call if you’d like assistance in creating a solid plan of action.

Five Simple Rules for Harvesting Capital Gains

Updated: September 1, 2015

The end of the year is upon us1. Your tax advisor (if you have a tax advisor) may be asking you how much capital gain income you have. He or she may also be suggesting that you match any realized capital gains with capital losses to minimize your tax bill. Even if you don’t have a tax advisor, you may be asking yourself about your capital gains position, and what you should do about it.

Now, just raising the subject of capital gains and capital gains taxes may be enough to give you the willies. You may see it as just the first in an endless stream of complicated, confusing items you’ll have to deal with in the course of paying for the government that is a major element of the infrastructure of this great country of ours.

Fortunately, it need be neither complicated nor confusing. In fact, as Sensible FinancialTM‘s contribution to simplifying your year-end tax planning, we provide herewith our (soon to be) famous Five Simple Rules for Harvesting Capital Gains2:

  1. Set your asset allocation first. Manage your taxes second.
  2. Whenever possible, DO realize net capital losses of up to $3,000 in every calendar year3.
  3. DON’T realize capital gains to offset capital losses realized in the course of diversifying or rebalancing your portfolio.
  4. DO realize capital losses to offset capital gains realized in the course of diversifying or rebalancing your portfolio.
  5. DON’T take capital gains just to realize them, even if you have offsetting unrealized losses.

If you’re willing to take our word for these rules, you can stop right here. If you’d like to dig a little deeper, keep on reading. We’ll apply our usual principles of simplicity and maximizing lifetime spending power.

The reasoning behind our Five Simple Rules focuses on just a few factors:

  • Basis – the original investment cost of your portfolio
  • Trading Costs – how much it costs to realize capital gains and losses
  • Time Value of Money – a dollar today is worth more than a dollar tomorrow
  • Tax Rates – capital gains tax rates are lower than ordinary income rates for many people (see footnote 3 above).
  • Financial Life Phase – Most people have two main phases in their financial lives – the accumulation phase (saving and growing financial assets), and the distribution phase (spending the accumulated financial assets). In the accumulation phase, one typically doesn’t have capital gains and losses unless one is trading – and Sensible Financial recommends trading only to diversify or rebalance.

We’ll take the rules one at a time. The first ones apply mostly in the accumulation phase, when trades are focused on diversification or rebalancing.

  1. Set your asset allocation first. Manage your taxes second. [The less comfortable you are with risk, the less a highly concentrated position is worth to you.] Diversification and asset allocation should be the primary drivers of your investment and trading decisions. If you save a few dollars in taxes one year by, say, deferring a capital gain in a concentrated position, and lose a lot in that concentrated position the next year, your overall spending power is reduced.
  2. Whenever possible, DO realize net capital losses of up to $3,000 in every calendar year. [Reduce highly taxed income now, increase lower taxed income later.] Capital losses up to $3,000 reduce your earned income (taxed at higher rates) for tax purposes. Realizing the losses also reduces your basis in your investment portfolio, but any recovery of basis as the value of the investments grow will be taxed at (lower) capital gains rates. There are enough different index funds for most asset classes that you can replace funds sold at a loss with similar funds to maintain diversification. In fact, realizing more than $3,000 in losses can be a good idea – you can “carry forward” the losses into the following year, offsetting ordinary income then, too.
  3. DON’T realize capital gains to offset capital losses realized in the course of diversifying or rebalancing your portfolio. [Defer paying capital gains taxes as long as you can.] This follows directly from the second rule – you want to preserve those capital losses to offset (higher taxed) ordinary income.
  4. DO realize capital losses to offset capital gains realized in the course of diversifying or rebalancing your portfolio. [Defer paying capital gains taxes as long as you can.] This is again very like the second rule – if you’ve sold a concentrated position, or you’ve reduced a position that has made your portfolio too risky, and you have some unrealized capital losses you can take, why not take them? Again, you can buy a comparable index fund to replace most positions.
  5. DON’T take capital gains just to realize them, even if you have offsetting unrealized losses. [Defer paying capital gains taxes as long as you can. Minimize trading costs,] There is no point in paying taxes just to pay them. One might argue that Congress is likely to increase the capital gains tax rate to its previous 20% level. Even this is not necessarily a reason to make the sale now4.

In the distribution phase of your financial life, you will find yourself faced with choices between selling assets in taxable accounts with significant unrealized capital gains and selling assets in tax deferred accounts such as IRAs and 401(k)s. While there can be estate planning issues that are too complex to address in this brief article, if your estate is not large enough to require the payment of estate taxes, spending power is maximized by using the assets in your taxable account first. [Pay lower capital gains taxes now, pay higher ordinary income taxes later.]

The bottom line:

  • Get your asset allocation right first – get out of risky holdings even if you have gains – who knows how long the gains will last?
  • Take your losses as they are available – they help reduce income taxes.
  • Defer your capital gains – don’t pay taxes until you need the spending power.

What to do with your income tax refund

Updated: September 1, 2015

April 15 has just passed¹. With a little luck, you may have come into some extra money – Uncle Sam or your home state (or both, if you were very fortunate) may have sent you a refund check. What should you do with it?

You just know that a financial planner isn’t going to suggest that you buy a new sports car, or take a lavish vacation. Financial planners are sober-sided, conservative folk (and we at Sensible Financial™ have to be sensible, besides).

You probably know intuitively that it’s easier to save out of a windfall than out of your regular income. Economists have done some work that confirms your intuition. Basically, people who increase their saving out of their income tend to view that as a reduction in their standard of living, and they really resist that. Saving out of “found money” is much easier.

So, save that money. But where? Here are five great ideas, in priority order:

  • If you are carrying a credit card balance, pay it down, or better yet, pay it off. Credit card interest rates are usually punitive, and the interest payments aren’t tax deductible. Paying off your credit card balances is the first step toward establishing your sustainable living standard – a key to financial peace of mind. Then, keep the balance at zero. This may not seem much like saving, but reducing debt increases your net assets (assets minus debts), so it counts. Plus, reducing your debt and the associated interest payments is guaranteed to make you feel better!
  • Build up your “rainy day” fund. You can call on this reserve if you lose your job, or have a family emergency that requires your full attention. For many families, this account isn’t nearly big enough. As a rule of thumb, it’s good to have 6 months of spending (including mortgage payments or rent) in a reasonably liquid, taxable (and thus accessible without penalty) account. Roughly speaking, if you spend everything you earn, except for contributing to your 401(k) plan, you should have 6 months of take home pay in this account. [If you do start or add to a “rainy day” fund, you should keep it in an account that is a bit difficult to reach so you’re not tempted to tap it except in a true emergency.]
  • Increase your 401(k) contribution by the amount of your refund, especially if your employer will match it. This earns a very high rate of return on your money right off the bat – a 50% match is an immediate 50% return – pretty tough to beat. Of course, if you’ve already maxed out your 401(k) contribution, you can’t increase it.
  • Contribute to an IRA (either traditional deductible or Roth) to start earning returns right now². If you don’t qualify for either one, you should contribute only if you intend to invest the contribution in fixed income assets, or if you have a relatively long time horizon before drawing on the assets (capital gains tax rates are lower than the ordinary income tax rates that IRA earnings are subject to).
  • Start or add to your child’s 529 or other college savings account. The earnings are tax free if used to fund your child’s college education. Anything you can sock away now means more consumption and/or less borrowing later.

Of course, you may have used up all of these opportunities. You can save the refund anyway. Put it in mutual funds, hold it for a down payment on that second home you’ve been thinking about buying (or as a start on some other dream you have that requires some scratch).

The planner in me can’t resist making two additional points:

  • Only a comprehensive financial plan can tell you how much you should be saving each year (and how much you should be saving in your retirement accounts versus college savings, etc.). If you have a plan, you’ll know whether or not you can spend some of your refund – and how much.
  • If you save a good chunk of your refund, you’ll feel better about spending the rest of it. Alternatively, spending a little of it is a good reward for saving the rest (and will encourage you to save from next year’s refund).

So – save that refund – you can even save it all in one place!

How to avoid the next Madoff scam

Updated: September 1, 2015

What can we learn from the Madoff fraud? Let’s start by listing what we know about it:

  • The investor group seemed like a private club – only the invited could invest. Many investors were friends with each other and with Madoff or introducing advisors.
  • Madoff was unwilling to describe his strategy. Inquiring too deeply into the strategy or its results may have caused the invitation to invest to be withdrawn.
  • Madoff or his company issued customer statements.
  • Madoff reported positive (and very stable) returns in all market environments.
  • Many investors in Madoff’s scheme had most or all of their assets with Madoff.
  • If Madoff had really been using his claimed strategy for the amount of assets he claimed to have, his trading would have swamped actual market volumes.

Each of these facts (except perhaps the last) was visible to many or all of Madoff’s investors. They provide powerful clues to how you can avoid being a victim of the next investment scam.

Fundamentally, the lesson is very simple: when it comes to investing, Ronald Reagan’s “Trust, but verify” motto turns out to work extremely well. However, it may not be immediately obvious how to apply it when a specific investment opportunity arises.

The following table addresses each of the “facts” and provides specific recommendations about how to protect yourself as consider any investment.

Madoff scam “fact” How to protect yourself (trust, but verify)
The investor group seemed like a private club – only the invited could invest. Many of the investors were friends with each other and with Madoff or introducing advisors. Insist on objective assessments before you invest your money. Your money is too important for you to invest it solely on the advice of friends.
Your friends may be excellent judges of service quality; they are extremely unlikely to assess advisor investment skill accurately. Even professionals and academics have great difficulty in divining investment skill. An objective and respected third party such as Morningstar or Financial Engines is your best source of information if the advisor claims extraordinary skill or results.
Finally, ask yourself and your friends why the advisor is running a club rather than a business, and why the advisor is offering to include you (why are you so important to the advisor?).
Madoff was unwilling to describe his strategy. Inquiring too deeply into the strategy or its results may have caused the invitation to invest to be withdrawn.

You (and your independent objective advisor such as your accountant, your lawyer, or your financial planner) should understand the investment strategy, and should be able to explain it in words a ten year old child can understand. If you can’t understand the strategy, you can’t evaluate it.

Importantly, some investment managers claim to have “proprietary” investment strategies and processes that other managers would copy if they became known. Such managers should still be willing to summarize both strategy and process. For example, if the strategy involves buying “undervalued” stocks, you can understand the concept without knowing the specific algorithm they use.

Marketers know that buyers like to be “in on a secret.” Mystery may make perfume or clothing more enjoyable and prestigious, but it is the road to ruin in investing.

Madoff issued customer statements.

You should receive statements from an independent third party custodian. This will allow you to verify several essential facts:

  • The value of the securities in your account as reported by the third party is equal to the value of your securities as reported by your advisor. This will protect you from Ponzi schemes: if your securities are in your account, they can’t be used to pay off other investors. [This raises another important point – if you see only an undifferentiated fund on your statement rather than individual securities, you need to see periodic audited financial statements for the fund. The auditor should be a firm whose name you recognize.]
  • The returns as measured by the changes in your account value are equal to those reported by your advisor.

The transactions in your account are consistent with your investment advisor’s strategy as you understand it. Thus, for example, if your advisor is buying “undervalued” stocks, the transactions in your account should involve stock purchases and sales, not options or borrowing on margin.

Madoff reported positive (and very stable) returns in all market environments.

If it sounds too good to be true, it probably is (too good to be true).

Investing in stocks is risky. If someone offers or promises “guaranteed” returns as good or better than stock returns, with less risk, walk away (actually, run away).

Many investors in Madoff’s scheme had most or all of their assets with Madoff.


  1. Hold the world market portfolio. This is as diversified as you can get.
  2. If you insist on taking non-market risk, diversify it
    1. Divide your non-market investments among multiple advisors (portfolio managers who select individual securities such as stocks, bonds, or derivatives such as options and futures).
    2. If you work with an advisor who selects mutual funds, satisfy yourself that the funds cover a broad range of investment categories – large and small companies, US and international, multiple industries – concentrated portfolios are riskier than diversified ones.
    3. If your employer offers a 401(k), insist that the holdings be diversified and transparent, or don’t invest in it. Non-diversified holdings pose extra risk, and without transparency, you have no idea what you own.
If Madoff had really been employing the strategy he claimed to use for the amount of assets he claimed to have, his trading would have swamped actual market volumes.

Perform due diligence; check out the advisor:

  • Assess the advisor’s reputation with the governing regulatory or certifying organization – check with the SEC for investment advisors, FINRA for brokers and CFP Board for financial planners. If the advisor has no regulatory affiliation, why not?
  • Who is the advisor’s custodian? Does the custodian have requirements that the advisor must meet?
  • Meet with the advisor. Ask for his or her qualifications. If you were hiring a doctor, you’d want to know where she went to medical school, and what her specialty is. An advisor should be happy to tell you about their academic background, how they learned about investing, and about any certifications they hold such as the CFP® or CFA.
  • If you are unfamiliar with the advisor’s strategy, seek an objective third party evaluation. Objective means that you, not the advisor, should pay the evaluator.


How Bad is It?

Updated: September 1, 2015

  • Stock market returns since October of last year are among the worst 15% of nine month returns since 1926.
  • Only 7% of nine month periods have been worse.
  • Many, but not all, of the 9 month periods with comparable returns are infamous, most have been memorable. Some have been much worse.
  • Many of the worst nine month declines have been part of longer stock market declines, which have ultimately reduced stock prices more.
  • Unfortunately, there is no way to know whether the market will continue to decline or will rise from this point.
  • This is an opportunity to assess your comfort with the risk in your portfolio. If you are uncomfortable, you should reduce your exposure to stocks.

As I write at the market close Monday, September 15, Lehman Brothers is filing for bankruptcy, Bank of America has acquired Merrill Lynch, and large insurance holding company AIG is scrambling to raise capital. The market is down about 4.5%.

Through the end of July, the stock market had declined from its October 2007 peak by approximately 16%, using a very broad measure of market return. If you hold stocks, this was a very unpleasant nine months. One logical question is: “how bad is it?” In US stock market history, has it been this bad before? When, and what were the circumstances? Has it been worse?

All of these questions are intended to give us stock investors a sense of perspective on the market.

As we begin, it is important to remind ourselves that no one knows what will happen to the stock market from this day forward. The experts cannot agree on what will happen next in important sectors that seem to be influencing the stock market strongly these days (US housing, oil, credit), and no one knows the extent to which the stock market already has assessed the likely developments in these sectors, and factored those assessments into stock prices.

That is, we can gain perspective from the assessment we are about to undertake, but we cannot make predictions.

We’ve used a broad database of stock returns data, drawn by Kenneth French of the Tuck Business School at Dartmouth College from the Center for Research on Securities Prices (CRSP) at the University of Chicago. This database contains returns for all US common stocks traded on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the NASDAQ from 1926 to the present. The measure of “market” returns is the market value weighted average return of all of the stocks in the database. Conceptually, this is the same analysis performed by Standard & Poor’s (S&P) in constructing the S&P 500 index, but for the whole market rather than for the 500 large firms S&P selects.

We calculated returns for every nine month period starting with the nine months ending in March 1927 and concluding with the nine months ending July 2008. That’s 977 nine month periods in all. Approximately 7% of the nine month time periods had worse returns than the 3 quarters we’ve just been through.

If returns were distributed randomly through time, approximately one of every 14 nine month periods would be this bad or worse, and we’d expect one every 11 years or so.

The graph displays rolling nine month returns since 1927. We’ve truncated the display at positive and negative 40% so that we can see the detail better. Just a glance tells us that very few 9 month declines have been as large as the one we’re suffering through. We can also identify by eye the times that have been as bad or worse. The table below identifies when the decline occurred, the situation, and the peak to trough decline (that is, the decline from the market high point to the market low point before the next sustained increase).

9 Month Period Ending Situation 9 Month Decline Peak to Trough Decline Trough Date Discussion
October, 1929 through May, 1932 Beginning of the Great Depression 20% 84%
June, 1932
A series of declines interspersed with recoveries began in October, 1929. The market did not recover to its September, 1929 peak until 1944. However, the market recovered its June, 1926 level by June, 1933.
September, 1937 to May, 1938 Recession of 1937    
Viewed as part of the Great Depression by many observers
June, 1940 Outbreak of World War II 17% 17%
June, 1940
The evacuation of British troops from France at Dunkirk was completed June 4, 1940
April, 1942 WW II low point for US 23% 23%
April, 1942
Japan nearly completes conquest of Southeast Asia
February and April, 1947 Post World War II 18% 23%
April, 1947
No particular explanation available
June, 1962 Early 1960s 17% 23%
June, 1962
No particular explanation available
January & June, 1970 Penn Central Bankruptcy 22% 27%
June, 1970
Increase in commercial paper interest rates
June – December, 1974 OPEC oil price shock 22% 41%
June, 1970
Increase in commercial paper interest rates
November, 1987 Largest one day decline in US history (October 19) 20% 30%
Nov, 1987
Conclusion of a 3 year boom in stock prices (trough to peak increase was 130%)
March – December, 2001, September, 2002 Bursting of the technology bubble, terrorist attacks 22% 31%
Sep, 2002
The decline began in September 2000, followed by another sharp decline in November 2000. Successive falls in February and March 2000 brought the 9 month drop to 22%. After further declines spurred by the attacks on September 11, the market recovered in October and November before further steady declines ending in September 2002.
July, 2008 Sub-prime credit crisis 16% 16% (so far)
July, 2008 (so far)
First monthly decline was in November, 2007, and several months of decline have followed. Ongoing problems in various credit markets have contributed to the stock market’s decline. Official data for August are not yet available, but there is evidence the market was up slightly. So far in September, the market is down.

There are some bad market periods on this list – the recent decline is in some extreme company. In fact, many of them have been worse than the one we are experiencing now has been so far. Most recently, in terms of market decline, the bursting of the technology bubble in 2000-2002 was worse.

This is the kind of market downturn that we as stock investors must expect and factor into our investment decision-making. It is unusual (as we said above, only 7% of nine month periods are as bad or worse), but far from “the worst in living memory.”

So, will this decline continue to get worse, or will stock prices begin to improve soon? Unfortunately, there is no way to know. Stock prices could continue to go down, or they could begin to rise again.

We can take some comfort from our diversified approach. For example, while the financial company stocks have suffered most severely in this decline (down some 40% since the October peak), our exposure to them has been limited, and our stock portfolios, while they have declined, have declined far less.

As I did earlier in the year, I encourage you consider this decline as an opportunity to assess your comfort with stock investment risk. If your discomfort is high, please let me know, and we will adjust your allocation.

1. Dr. French kindly makes this data publicly available on his website at

2. You might ask whether the fact that the time periods overlap might somehow affect the analysis. There are 109 non-overlapping nine month periods since March 1927, and 5.5% of them have been worse than the most recent one. 5.5% is different than 7%, but not much different.

3. Using non-overlapping nine month periods, one in every 18 or so would be this bad, and we’d see one like this every 14 years or so.

Market decline and volatility – what does it mean for my portfolio?

Updated: September 1, 2015

You may have heard or noticed that the stock market has been going through a bit of a rough patch. As of Tuesday, January 22, US stocks, as represented by the S&P 500, were down nearly 11% year to date, and over 16% from their most recent high point on October 9, 2007. This latter drop, being larger than 10%, qualifies as a “correction.”

Non-US stock markets have suffered similarly. The table shows the returns of various indices over the same time periods. Non-US equity markets have declined slightly more than the broad US market, and US real estate significantly more.

  Returns Since
Market Index 9/10/07 31/12/07 31/12/06
US Large Company S&P 500 -16.3% -10.8% -7.6%
US Large Company DJ Industrial Average -15.5% -9.8% -3.9%
International iShares MSCI EAFE (EFA) -17.4% -11.2% -4.8%
Emerging Markets iShares MSCI EM (EEM) -16.4% -12.2% -15.6%
US Commercial RE Dow Jones Wilshire REIT -25.9% -7.9% -27.2%
Commodities Dow Jones AIG Commodities 6.9% 0.2% 11.3%
US Bonds Lehman Brothers Aggregate Bond 6.0% 2.6% 10.4%
Inflation Protected US Bonds iShares Inflation Protected Bond (TIP) 8.1% 3.3% 10.6%

On the other hand, bonds and commodities are up approximately 6% since October 9, as measured by the indices or index funds we report.

If we look back to the end of 2006, stock index returns are much less negative, bond returns are positive and Emerging Market equities are still enjoying significant net gains. So, if you’ve been investing since the end of 2006, your portfolio is probably down less since then (than since the end of 2007), and it may even be up a bit.

You might reasonably ask:

  • Why has the market gone down so much?
  • Is my portfolio at risk?
  • What should I do?

My short answers are:

  • The economy is reacting to a period of excessive economic activity brought on by loans that encouraged purchases that people and companies could not afford. The market is reacting to what it thinks will happen next in the economy.
  • Your portfolio is probably at a bit more risk than in less turbulent times.
  • Ideally, you have selected your target asset allocation with some care and thought. Times like these can be very useful – you get to see how you really feel about risk. If you are uncomfortable with your portfolio allocation in light of recent events, get in touch with your advisor – adjust your target allocation, revise your Investment Policy Statement to reflect the change, and modify your portfolio. Otherwise, sit tight: I don’t recommend attempting to “time the market.”

Now, for my longer answers. You certainly don’t have to read them, but they provide more detail than my somewhat cryptic short answers.

What is causing this decline?

While no one really knows (this is the kind of event that economists will be arguing about for years), there are two widely accepted (and inter-related) candidates: the “sub-prime crisis” and the anticipated arrival of a recession.

  • The sub-prime crisis is the most visible manifestation of a credit shortage that has followed a long period of relaxed credit standards. Fundamentally, interest rates were (too) low, and many lenders had an extended lapse in judgment about how to lend. They lent too much money to people and organizations who were unlikely to be able to repay the loans. When many loans became delinquent (late) and even fell into default (really late, and borrowers announced they couldn’t repay), the lenders suffered large losses. Some of these lenders were among the most reputable US financial institutions (Citibank, Merrill Lynch, Bear Stearns). Lenders have now recovered their senses and raised their lending standards (perhaps over-reacting and raising standards too much), but as a group they will be unable to recover their losses. Owners of these companies will share in the losses through reduced stock prices.

    In addition, many of these loans are part of very complex securities. The values of these securities are uncertain when some of their constituent loans are delinquent or in default. As a result, owners of the securities don’t know what they are worth (and investors in the companies that own the securities don’t know what the companies are worth). Some of the companies that own the securities have also been overseas, and even in emerging markets, which might account for some of the decline in these indices.

    These losses, and uncertainty about the losses, are making investors nervous, and that nervousness is manifest in the stock market declines we have been experiencing.

    If you’ve been following the economic news, there has been a lot of discussion about whether the economy has entered, or is about to enter, a recession. According to the National Bureau of Economic Research, a recession is simply

    “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”

    That is, less people working, less buying and selling, etc. In these circumstances, company profits decline. When investors expect company profits to go down, they aren’t willing to pay as much to own the company, and its stock price goes down. When they anticipate a recession, investors expect most companies’ profits to go down, and most stock prices go down.

Is my portfolio at risk?

  • I do not mean to be flippant when I say that the stock component of your portfolio is always at risk (the bond component is, too, but mostly not subject to equity market risk). Ideally, when you established your target allocation, you did so bearing in mind the risks of investing in stocks. Those risks are always present, and they are present now.

Well, is my portfolio at more risk than usual?

  • Market volatility (the day to day ups and downs in prices) has increased recently. This can be a sign of more declines to come. On the other hand, volatility was greater in April 2003, at the beginning of the recent sustained increase in stock prices, than it is today.

As an investor, what should I do?

  • I do not recommend that you attempt to “sell now, and buy back at the bottom.”
    – You may recall that in earlier articles I have written about the great difficulty of market timing. That difficulty has not diminished. When the market goes down in a sustained fashion, we tend to expect it to go down further. It may, but it may not. If we do sell, and the market starts to go back up, we (including professional investors and money managers) tend to want to wait “to be sure” before re-entering the market. We thus tend to sell low, and buy high (the reverse of what we’d prefer to do).
    – There is some evidence that stock prices are lower relative to bond prices than usual, suggesting that this might not be the best time to sell.
  • I do recommend that you get in touch with your advisor to adjust your portfolio allocation target if you feel uncomfortable about your portfolio and your long-term strategy in light of the volatility we are experiencing. You should modify both your Investment Policy Statement and your holdings. Life is too short to spend it worrying about your money and your investments.
  • I do not recommend that you monitor the market on a minute by minute basis. As usual, a lot of the “news” is noise (that is, the view of this pundit or that, and lots of anecdotes that attempt to explain what’s going on). While the news may make you feel better or worse (probably worse, as “good news is no news”), it is extremely unlikely to contain information that will help you to predict accurately what the market will do.

Please contact me if you would like to discuss these issues or any concerns you might have with me directly. I will not be able to provide any more certainty about what is happening or what is going to happen, but I can certainly help you think through what to do.

Fifty Ways to Leave Your Broker

Fifty Ways to Leave Your Broker[1 , 2]

Updated: September 1, 2015


  • You trust your financial future to any broker who manages your assets, so it’s important to be sure you have the right advisor.
  • Once you select a broker, it’s hard to admit that you may have been wrong (it’s a big decision).
  • You don’t need your broker to be your friend.
  • If you do decide to move to a new advisor, you owe your old broker only simple courtesy as you dissolve the relationship.
  • Good preparation eases the transition.

Many people come to Sensible FinancialTM or another new advisor while still involved in one or more existing financial services relationships. Even if you have decided to retain a new advisor to help you manage your financial assets, you still have the seemingly difficult problem of severing existing tie(s).

You seek out a new advisor for a reason. You may be unhappy with your recent investment performance or with the service you’ve been receiving. Even so, you may feel uncomfortable telling your current broker you’ve decided to work with someone else.

This article discusses why you might be uncomfortable, why you shouldn’t be, and what you can do about it.

We’re talking about your life here

Choosing someone to manage your financial assets is both complicated and important. Complicated because it’s not always clear what advisors should do for you, and it’s difficult to identify advisors who do those things well. Important because your financial assets are the product of your hard work and saving discipline. They are your hope for your future – education for your children, a comfortable retirement for you, and the potential to realize your dreams.

You should feel confident in your choice, and your experience with your broker over time should reinforce your confidence. A mistake can waste much of your hard work and effort, and result in a future much less financially secure than you hoped for.

Big decisions mean strong commitments

It’s easy to change small purchase decisions. If a store serves you poorly, you find another store. If a product (a breakfast cereal, a dishwasher detergent, a car) doesn’t satisfy you, you buy another product. You don’t give either decision a second thought.

Firing your broker is much harder.[3] You seem to have a relationship with your broker, in a way you don’t with the store owner, the breakfast cereal manufacturer, or even the car dealer. You’ve (probably) shared personal information with your broker, perhaps over a cup of coffee (provided by the broker). You may even have played golf together. Perhaps most importantly, you’ve “given” your money to your broker to manage.

You may need to make a change because circumstances are different now – your broker may have been right for you when you started, but no longer. Your needs may be greater than before, or you may want a new perspective. Or, it may be that you made a mistake.

If you feel that you made a mistake, this can make changing more difficult. It can be hard to admit to ourselves that we may have made a mistake on a big decision – it gives rise to difficult questions:

  • If you made a mistake before, how can you be sure you aren’t making another?
  • How much damage have you suffered?

Even beginning to think about these questions can be painful, and can cause you to put off making a change.

Don’t give up! Choosing the right investment advisor is important. Changing if your broker isn’t right for you is also important – the stakes are high. If you buy the wrong breakfast cereal, you’re out $3. If you have the wrong broker, and don’t change, your whole future is at risk.

As you think about a change, considering some key questions can help you move forward, even if some of them are difficult:

How are circumstances different now, and what does that mean for your choice?

What made your broker right for you before, and what has changed? What do you need from an advisor now?

What aspects of your relationship with your current broker aren’t working?

For example, do you need more information than you are receiving? Are the results different from what you expected? Are you receiving less attention from your broker than you anticipated?

If you made a mistake before, how can you be sure you aren’t making another?

You know more now – you can make a better decision. You have a better sense of what you need and want. If you made a mistake before, you can watch out for the factors that pushed you in the wrong direction, and you can be more careful this time.

How much damage have you suffered?

It doesn’t really matter.[4] Whatever there is in the way of damage has already been done, and staying with your current broker won’t undo it. The most important thing now is to avoid more damage.

Then, make the change.

Your broker is your friend until you take your money away

Several Sensible Financial clients have had the unpleasant experience of learning that their broker ceases to be their friend the minute they announce a decision to move their account. Telephone conversations turn brusque and formerly attentive service turns to indifference.

If your broker really was your friend, your relationship wouldn’t depend on whether you continued to be a client. True friendship builds on common interests, shared experiences, and mutual caring.

You most require from your broker reliable advice that is:

  • Technically correct
  • Focused on your personal circumstances and preferences
  • In your best interest

The last two points require that your advisor know you and your circumstances well. They do not require that your advisor be your friend. In fact, the list of requirements is very similar for all professional advice you seek, such as from a doctor or an attorney. Most people don’t think of their doctors or attorneys as friends, and if they do, the friendship is much more likely to be genuine.

How much do you really owe your broker?

It’s not surprising that you would feel a personal link or obligation to your broker. As good salespeople (most brokers are product salespeople)[5 ], brokers attempt to induce a sense of obligation in you, the customer. If a salesperson can make you feel obligated, you are more likely to buy what they are selling, and less likely to argue about the price. As a result, successful brokers are likely to be good at encouraging you to like them, and at engendering in you a sense of personal obligation.

It’s fair to ask how far your obligation extends, or if you even have an obligation.

We owe obligations, just as we owe debts. In our personal relationships, we accrue obligations as someone does things for us without compensation. Small personal favors, exchanging small gifts, expressions of concern – each of these is an expression of interest in, and concern for, the other person in the relationship, and the receiver incurs a small personal obligation to the giver.

In contrast, you have paid for all of the small personal favors, gifts, and expressions of concern your broker may have given you. Whether the fees and commissions are explicit or not, the makers of the products and services you have purchased have passed on some of your dollars to your broker.

However, because those payments are indirect, because you do not write your broker a check, you may not realize that you have already paid your broker.

So, how much more do you really owe your broker? Because you have paid for all of the services and all of the small extras you may have received, common courtesy suffices. You owe your broker no more than you owe any other provider of services.

One way

If you decide to dissolve your relationship with your broker, the best approach is professional and matter of fact:

  • Make a list of your reasons – your broker is likely to ask, and you will feel uncomfortable if you have no good answer. This step also helps to ensure that you have made a good decision.
  • Confirm with your new advisor the logistical steps you will be taking, and what, if anything, the process will require of your old broker. Now you will be able to tell your old broker exactly how to proceed.
  • Recognize that your old broker may react with hostility to your decision – while you are moving on to a new advisor, your old broker is losing a client, and losing revenue.
  • It’s also a good idea to be sure that any unusual requests you may have for your old broker be completed before you move to close your account. (For example, many new advisors will recommend that you sell certain security holdings. Knowing your cost basis for all securities acquired through your old broker will be very helpful in these circumstances.) Once you announce your decision, your old broker will have more to gain from serving ongoing clients than from meeting your needs. In addition, even if your old broker intends to continue to serve you well until your account is closed, your broker’s firm may have rules that make that difficult[6 ].
  • Once you are ready to proceed, speak with your broker to communicate your decision and specify your action requests. It may be helpful to follow up in writing. A direct approach minimizes bad feelings and confusion.
  • Be prepared for your broker to try to convince you to stay. Your list of reasons will come in handy here.
  • Rely on your new advisor to help with the transition. This is an excellent opportunity to observe your new advisor in action. Do things proceed smoothly? Does your advisor warn you in advance of the glitches that can (and frequently do) occur? Good preparation is essential to making the process as painless as possible.

As with many actions that can seem difficult, the anticipation is frequently worse than the event. Especially if you didn’t know your old broker before, your relationship may simply cease to exist once the transition is complete.

If your broker is “family”

If you hired a friend or family member as your broker, moving to a new advisor is likely to be more difficult. You do have a real relationship. Once you move to a new advisor, you’ll still have contact (perhaps a good deal of contact) with your old broker. In these situations, the matter of fact approach is doubly important.

There are likely to be hurt feelings even if you treat the situation professionally. You must judge whether the expected improvement to your finances is worth the anticipated damage to the relationship.

The extra difficulty of leaving a “family” broker suggests that hiring one in the first place may be a poor idea. If things don’t work out, you are likely to suffer more damage to your financial situation by waiting longer to move your account. Introducing your money into a personal relationship can cost you both your money and your friend.

Make a new plan

It’s easy to feel locked into a relationship with your current broker, even if you’re dissatisfied. You may find it very difficult to tell your broker you’ve decided to move on. Additionally, and importantly, you may be uncomfortable making a change because doing so seems to admit that you have made a mistake.

However, having the right advisor is much more important to you than potentially hurting your broker’s feelings, or even hurting your own feelings. Your financial future is at stake.

Ultimately, if you decide you can’t afford to leave your financial security in your current broker’s hands, you owe it to yourself to make the appropriate transition.

Load Mutual Funds – Hazardous to Your Wealth

by Rick Miller

Updated: September 1, 2015

  • Investors who use mutual funds with loads:
    – pay higher mutual fund expenses and
    – receive worse mutual fund performance
    than investors in no-load mutual funds.
  • The load fund disadvantage is
    too small for the casual investor to notice
    too large for you to ignore

Broadly speaking, you can invest in two kinds of mutual funds1:

No-load funds (also “direct-sold” or “direct channel” funds)

An investor buys a no-load fund directly from the mutual fund company, or through a fee-only advisor. The company pays no compensation (or very little compensation) to the advisor, if there is one.

Load funds (also “broker-sold” or “broker channel” funds)

An investor buys a load fund through a broker or other advisor. The fund company charges a load (an extra fee2) to the investor, sharing it as a commission with the broker or advisor. The buyer cannot recover the load, even when selling the fund.

In recent work3, Daniel Bergstresser, John Chalmers, and Peter Tufano compare these two kinds of mutual funds, focusing on costs and performance. They conclude that even without considering distribution costs, that load funds underperform no-load funds significantly:

“The bulk of our evidence fails to identify tangible advantages of the broker channel. In the broker channel, consumers pay extra distribution fees to buy funds with higher non-distribution expenses. The funds they buy underperform those in the direct channel even before deductions of any distribution related expenses. Even before accounting for distribution expenses, the underperformance of broker channel funds (relative to funds sold through the direct channel) costs investors approximately $9 billion per year.”4

But there are lots of investors – millions of them. If you divide $9 billion by millions, maybe the extra cost isn’t really so bad. Let’s make it personal. How much could load funds cost you? There are two answers, and both are important:

a) Too little for the casual observer to notice
b) Too much for you to ignore

Too little for the casual observer to notice

Depending on how you calculate, the average load equity fund underperforms the average no load fund by between about 8 and 135 basis points per year, or .08% to 1.35%. For bonds, the disadvantage ranges between .7% and 2.0% per year. Due to the variability in fund performance, in any given year, many load funds will outperform many no load funds. Look at your favorite financial publication, and you’ll see annual differences in fund performance of 10%, 15%, even 20%. The casual observer will see some load funds near or even at the top, and some no load funds at or near the bottom. It takes careful analysis (the authors of the paper are university professors, after all!) to sift the data and determine the impact.

The tables (one for equities, one for bonds) show their findings. First, distribution expenses [12(b)1 fees] are a big problem for load funds. Including them increases the disadvantage of load funds at least 50 basis points or .5%. Secondly, for equities, more careful analysis5 shows the load fund disadvantage to be bigger (as adjustment increases toward the bottom of the table, the advantage grows by 70 to 85 basis points). For bonds, more careful adjustment6 has less clear impact, but the load fund disadvantage is larger.

Too much for you to ignore

These differences sound small – 2% per year at the most for bond funds, even less for stock funds. What difference would they make to you? Suppose you have $100,000 to invest in a 60/40 mix of equity and bond funds. Consider the dollar impact after distribution expenses (you can’t get a load fund without paying them). Investing in load funds rather than no-load funds is likely to cost you a bundle. After 10 years, you’re likely to be between almost $12,000 and nearly $25,000 behind. After 30 years, the difference is $100,000 to $200,000 – you’ll have paid once or twice your entire initial investment for your advisor’s counsel. And that’s before considering the cost of the load itself!

Why are the differences in dollar returns so large, when the differences in expenses sound so small? Those differences turn out to be large relative to the investment returns you can expect. Stocks, over the long haul, might return 7% per year after inflation, on average7. Bonds might return 4%. The cost differential between load and no load funds is as much as 15 to 20% of your potential return, year in and year out. Buying a load fund is equivalent to signing up for extra taxes – if you are in the 15% Federal bracket for investment returns, you might as well increase your rate to 30% to 35%.

How to identify a load fund

The easiest way to tell if your broker or advisor is offering you a load fund is to ask. They must tell you, and they are likely to tell you that the load is the mechanism you use to pay them. They may be less likely to tell you about the ongoing higher distribution costs [the 12(b)1 fees of 45 basis points or so], and they may even be unaware of the higher expenses of other sorts, and the lower returns on average.

You can also identify the companies that offer the mutual funds that the paper classifies as ‘broker channel’. Some of the largest providers include8:

On the other hand, there are fewer relatively large no-load fund families9:

It’s important to note that the research we are summarizing here does not imply that every no load fund will always outperform every load fund. It does mean that load fund purchasers are making a choice that they are likely to regret, and that the regret is likely to grow deeper over time.

As with many aspects of investing, in deciding what kind of mutual fund to buy there are no guarantees, just strong tendencies. You have to decide whether to harness those tendencies to your advantage, or ignore them, hoping against long odds to come up a winner.