Quote of the Week
“Half a truth is often a great lie.” – Benjamin Franklin
The U.S. stock market finished slightly lower last week. Trade tensions between the U.S. and China continued to worsen with no solution in sight. If the Chinese don’t fold to Mr. Trumps demands by December, Mr. Trump plans to increase the tariff on the latest $200 billion from 10% to 25%. So much for the benefit of the tax cut to the middle class when the cost of items in the stores goes up.
The other big news last week, which was expected, was the decision by the Federal Reserve to increase its federal funds rate by 0.25%, making the new range 2.00% to 2.25%. The Fed also increased its forecast for economic growth this year to 3.1%. If the economy continues to grow, wages keep rising, and inflation stays near the Fed’s 2% target, we can expect continued quarterly increases to the federal funds rate.
In addition, the Fed is steadily reducing its bond purchases to shrink its balance sheet from the Quantitative Easing it started after the recession. The balance got to something over $4 trillion and is now being reduced at a rate of $50 billion per month. The future combination of the increase in the federal funds interest rate and the pulling back of the balance sheet will probably lead to a slowing economy. Throw in the tariffs and we could be headed for a recession. The balancing act will be not taking these actions too aggressively and start a downward slide in the economy.
Last week the Dow was down 1.1%, the S&P 500 was down 0.5%, the MSCI EAFE was down 1.1%, and the Nasdaq was down 0.3%. For the year the Dow is up 7.0%, the S&P 500 is up9.0%, the MSCI EAFE is down 3.8%, and the Nasdaq is up 15.7%.
As of now we still have a buy signal on the U.S. stock markets. The buy has been in effect since August 3rd.
Recently during client reviews, we have been discussing the feasibility of doing Roth conversions with our clients who are over age 70½. Future tax rates and when the money will be needed are among five factors to consider.
The biggest benefit of a Roth conversion of an individual retirement account is the tax-free compounding over time. Those who are over age 70 1/2 obviously have less time to make the upfront tax cost of a Roth conversion worth the benefit. Before deciding to convert you should consider the following five factors:
When will the funds be needed
If the plan is to tap into the Roth funds sooner rather than later, it might not be worth it to pay the upfront tax bill. If funds are needed, it’s also more likely that the client may be in a lower tax bracket, resulting in a lower tax on any traditional IRA distributions.
If the funds won’t be needed in the foreseeable future, it could pay to do the Roth conversion. This lets the tax-free accumulation begin since Roth IRAs have no lifetime required minimum distributions. The Roth funds grow tax-free and eliminate uncertainty about the effect that future higher taxes could have on the traditional IRA (RMD) Required Minimum Distributions.
After death, the inherited Roth IRA can be passed on to a spouse who can do a spousal rollover and continue to avoid RMDs, adding more years of tax-free accumulation. If the beneficiary is a child or grandchild, the inherited Roth IRA could be stretched over many decades. In that case, there would be RMDs on the inherited Roth IRA but those RMDs would be tax-free.
Future tax rates
If the client is concerned about higher tax rates in the future, it might pay to pay the tax now. On the other hand, if you project relatively low tax rates, a conversion may not be warranted. Remember: A Roth conversion is not an all-or-nothing choice. Partial conversions may be a way to hedge. We suggest that we work with your accountant to determine the conversion amount so that it doesn’t push you into a higher tax bracket.
The beneficiary’s projected tax rates
Look at the tax rates of the beneficiaries. If they might be in a higher tax bracket, a conversion now can be a good estate planning move so that the beneficiaries can inherit tax-free retirement savings. Of course, the client has to have the funds to pay the conversion tax.
If the beneficiaries will be in a lower tax bracket, then it’s probably best not to convert and let them pay the taxes at their lower rates when they inherit. In addition, if there are multiple beneficiaries, their combined taxes will be lowered since each beneficiary uses up their lower tax brackets. Again, this is not an all-or-nothing decision when it comes to the beneficiaries either. Partial conversions can be done, leaving the Roth funds to a beneficiary who may be in a higher tax bracket and traditional IRA funds to beneficiaries in a lower tax bracket.
Qualified charitable distributions
QCDs are only available to IRA owners (or beneficiaries) who are 70 1/2 or older. The funds to be donated are transferred directly from the IRA to the charity. The amount transferred is excluded from income and counts toward the RMD. For IRA owners who will take advantage of this to reduce or even eliminate the tax on their RMDs, a Roth conversion might not be necessary, unless it is done in addition the RMD amount mainly to benefit beneficiaries as an estate planning move.
Roth conversions probably should be avoided if heavy unreimbursed medical bills are projected. Even under the new tax law, these expenses are still deductible as an itemized deduction if they exceed 7.5% of adjusted gross income (10% for 2019). RMD income can be partially offset by these medical deductions. Roth conversions will increase adjusted gross income and decrease the amount deductible for medical expenses. In addition, when there are significant ongoing medical bills, money may be tight, and paying a tax to do a Roth conversion would not be recommended.
If you would like to discuss the advantages or disadvantages of a Roth conversion for this year give us a call and come to discuss the issues pertaining to your situation.
* Roth IRA distributions are tax-free if made five years after the initial contribution to the plan and you are over age 59½.
By the Numbers
“WHAT IS YOUR END PLAN? – 59% of “working age” Americans (defined as adults between the ages of 21-64) have not accumulated assets in any retirement account – defined benefit pension plan, defined contribution plan (e.g., 401(k) plan) or an IRA (source: National Institute on Retirement Security).” – Michael A. Higley, BTN 10-01-2018
If you have friends or family in need of financial life planning services,
It would be the honor of Laurence Lof Financial Advisors to assist them.
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These are the opinions of Larry Lof and Stephanie Mayoral and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Past performance is not indicative of future results. Due to our compliance review process, delayed dissemination of this commentary occurs.
The S&P 500 is an index of stocks compiled by Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. The index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Indices mentioned are unmanaged and cannot be invested into directly.
Technical analysis represents an observation of past performance and trend, and past performance and trend are no guarantee of future performance, price, or trend. The price movements within capital markets cannot be guaranteed and always remain uncertain. The allocation discussed herein is not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. Please consult an advisor to discuss your individual situation before making any investments decision. Investing in securities involves risk of loss. Further, depending on the different types of investments, there may be varying degrees of risk including loss of original principal.