Volatile markets, recession fears, trade war rhetoric, flagging manufacturing, and rising interest rates were on the minds of investors as we entered 2019. We had just seen a market rout in December and some investors were starting to head for the hills. But then to keep investors on their toes, some of these issues turned around abruptly and economic headwinds became tailwinds.
This shift in outlook led to an impressive year for stocks that continued during the 4th quarter (Q4). Here’s a roundup of how major markets performed in Q4 and for the year, respectively:
Large Cap Stocks – up 8.6% and 31%
Small Cap Stocks – up 10% and 26%
Developed Foreign Markets – up 7.4% and 22%
Emerging Markets – up 11.3% and 17%
Core Bonds – flat during Q4 and up 8.6%
Stocks behaved so poorly so quickly in late-2018, that a turnaround was to be expected. The S&P 500, a common benchmark for the US stock market, had declined almost 20%. But the turn of the year was almost like flipping a switch. Stocks surged in January, up almost 8% that month alone and were ultimately up ten months out of twelve in 2019.
Individual investors had been decidedly bearish but eventually began to turn more optimistic. While still far from being exuberantly bullish, investors showed more interest in stocks as the year progressed. Positive headlines about our trade dispute with China helped with this in Q4, even though no major deal was agreed to.
The Fed helped to juice up returns with three rate cuts during the year. The rate-setting body reversed its “hawkish” tone and indicated it won’t raise rates until inflation is significant and persistent. That could be awhile.
Roth conversions are one of those planning ideas that make a lot of sense on paper. You take money that’s currently in a regular retirement account like an IRA or 401(k), stick it in your Roth and then viola, it turns into tax free money! Sounds great, right? The problem is that several things have to happen first, such as paying a big tax bill. Nobody likes paying taxes and paying them in advance just cuts against the grain for most people, so that’s usually where the conversation stops.
But since it’s still a great planning idea when used correctly, let’s review some of the situations where it makes sense to convert retirement money to a Roth.
Low income now, high income later – Say you’re retiring at 60 and your Full Retirement Age for Social Security is 67. You’ve planned well and want to live off your non-retirement savings (brokerage accounts, cash at the bank, etc) between now and then while letting your retirement money sit. Since you’re not starting Social Security yet, your only taxable income is from interest and dividends in your brokerage account. Your lifestyle remains the same but on paper your taxable income drops off a cliff.
If you’ve been used to paying taxes on $100K per year of income but now interest and dividends is, say, $15K, you have room to convert the other $85K and stay within what you’re used to paying in taxes. You could even do Roth conversions every year until starting Social Security.
Why would you want to do this? Wouldn’t it be nicer to have an extremely low tax bill for a while? Yes, but the looming issue is that your tax bill would rise once Social Security income starts, and then would rise again a few years later when Required Minimum Distributions (which is taxable) kick in. Roth money isn’t subject to an RMD, so making conversions now when taxable income is lower helps smooth out taxes over time. Depending on account balances, you could convert your regular retirement accounts all the way to $0 and eliminate future RMDs altogether.
Well, it’s suddenly December again. I don’t know about you but this year the Holidays sure are coming up fast. There’s a feeling of year-end inertia that settles in right about now, mostly because so much of what I do as a financial planner is based on the tax year, which for most folks ends on December 31st.
As such, here’s a topic I think about all year but that takes special significance as we approach year-end.
Harvesting gains and losses – This has been a good year so far for stocks and bonds, even with all the trade-related headlines. The major US indexes are up 20+% and many bond funds are up high single digits, and some are up more than that. The reasons for these returns, and future expectations, are beyond the scope of this post, but the gains are good, nonetheless.
If you have large expenses coming up or just need money to help fund your retirement spending, it’s a good idea to consider rebalancing your portfolio and turning some of these paper profits into cash.
A quick definition: In the tax jargon, you “realize” a gain or loss when you sell an investment. This is taxable when done in your brokerage account. Until you sell an investment, the gain or loss is “unrealized” and not taxable.
You can realize gains anytime in your retirement accounts (IRAs, 401(k)s, etc) without much regard to taxation, so those are great for rebalancing your portfolio. The government gives you a pass on taxes in those accounts so long as the money stays inside of them (they’re known as being tax-deferred). But getting at that money to spend is more expensive because retirement distributions are typically taxed as ordinary income.
Compare that to a regular brokerage account where anything that happens within is fully taxable. Dividends are taxed in the year received, and so are gains when investments are sold. But this can work to your advantage because most investors get preferential treatment (lower rates) when paying taxes on realized gains on investments held over one year. If held for less time, the gain is considered “short-term” and subject to ordinary income taxes. This makes it beneficial to take profits in your brokerage account and not your IRA, for example, when getting cash to spend since, again, money withdrawn from your IRA gets no special treatment = higher taxes.
As we approach year-end and you think about your income situation this tax year, look at upcoming needs for cash and decide if realizing gains is appropriate. You can also spread your gain over multiple tax years.
For example, say you need to access $20,000 in the next few months. What’s to stop you from selling some of your investment this year and then selling the rest in January? Doing so spreads out your tax liability over two years. Maybe this helps you stay within your current marginal tax bracket or, at loftier income levels, keeps you from paying higher Medicare premiums. It’s a simple process that helps keep more money in your pocket (or your portfolio) over time by keeping your taxes as low as possible.
And then there’s harvesting losses. If you’ve been doing so regularly there may not be any losses to realize in your brokerage account since returns have generally been good this year. But if there are losses, you can sell and realize them along with gains. Doing so helps reduce your taxable gains because you claim the “net” number on your taxes. For example, if you sold some of your stock fund for a $5,000 long term gain, but then sold a bitcoin fund for a $4,000 loss, you’d only pay tax on the $1,000 difference.
Then if you really, really want to you can buy back the bitcoin fund. You just need to wait at least 30 days. Otherwise, the IRS will disallow the loss and call the transaction a “wash sale”, something to be avoided.
So, that’s one of the issues I’m spending time with as we look at closing out the year. Other issues like Required Minimum Distributions and Roth Conversions are present as well. We’ll touch on those in the coming weeks.
As has been my practice over the last few years, I’m taking a brief break from writing these Tuesday morning posts to spend a little more time with family and friends over the Holidays. I’ll be back with another post in early January. There’s a lot to talk about but it will have to wait until then.
I’m still working, of course, so let me know if you have any questions or need any year-end assistance.
Otherwise, we have a lot to be thankful for and this is best celebrated in person. I hope you’re able to spend time in the coming days with the people who are most important to you.
From my family to yours, Merry Christmas and Happy Holidays!
There’s a multitude of tasks that financial planners like me focus on as we approach the end of the year. Among them is the complicated issue of Required Minimum Distributions. This is a simple yet potentially thorny issue to contend with, so here’s a rundown of some of the important aspects.
You’ve saved for years and earned a tax deduction on contributions most (or all) of the time along the way, so the tax man eventually wants to generate some revenue. This is why distributions are taxed as ordinary income. Also, forcing minimum distributions from your retirement account is the government’s way of reducing how much you can accumulate tax-free during your lifetime.
The result is that once retirement savers pass age 70, they have to start taking out a required minimum each year. This is a percentage of a retirement account’s value as of the end of the previous year. Initially a modest amount of about 3.6%, the required percentage increases each year as the saver ages. This is based on a table published by the IRS easily found by simply Googling “RMD table”.
But what happens at age 70.5? All that half year means is that you’ll start taking your first RMD in the year that occurs. This leads to confusion. Say someone turns 70 in December and wants to know when to take their first RMD. It’s the following year because that’s when they turn 70.5. Nothing else needs to happen on that date; it’s just a marker.
The following year, and every year after for life, you take your distribution by the end of the calendar year. You can do so monthly, sporadically throughout the year, or all at once at year-end, it doesn’t matter so long as you’ve at least distributed the minimum. And the price of failure is steep – a penalty of 50% of the amount you were supposed to distribute!
Fortunately, the government gives you a pass on messing up the first time. Instead of the year-end deadline, savers have until April 1st of the following year to take their first RMD. The problem with this, however, is that during that second year you’d take two RMDs, the one missed plus the current one, leading to extra income to pay tax on.
All of this leads to some common questions, so I thought I’d answer them below:
If the past couple of years have taught us anything, it’s that we have a lot to be thankful for. Personally, I’m thankful to live with my family in such a beautiful place while doing work that I love. This week, from my family to yours, I wish you a wonderful Thanksgiving. I hope that you get to spend it with family and others whom you love dearly.
Early one morning last week I was reading an article about continuing care retirement communities for a future blog post. Then I checked my email and… boom, rumors that Schwab was buying TD Ameritrade for $26 billion! This was a shock even though the brokerage industry has been going through changes lately and “consolidation” was likely. Frankly, I had assumed a smaller firm like E-Trade would be taken over, perhaps even by TD itself.
Yesterday morning those rumors were confirmed. There will be regulators to contend with and a host of other issues I’m sure, but most seem to think the deal with close sometime during the latter half of next year.
What does this announcement mean for you? (By “you” I’m referring to those wonderful clients whom I work with on an ongoing basis and use TD as custodian.)
The bottom line, I think, is that the sale (takeover, merger, or whatever else you’d like to call it) of TD to Schwab will have little direct impact on you and your investments. Why? Fundamentally, both firms are custodians, or holders and protectors of your investments, and operate largely in the background. That’s the core role both play in the market today and they do it well.
TD, for example, holds your investments, processes transactions, generates statements, and sends data to other systems I use when working for you. Schwab does the same thing for its institutional clients and I don’t see any of those fundamentals changing through this deal. Size and strength are important in the custody realm and the combined company will hold something like $5 trillion in client assets and 24 million accounts. That’s huge for a financial institution that isn’t a bank.
Both firms are very similar in terms of the nuts and bolts of their service offerings, so it’s hard to complain about this deal from an investor choice perspective. Importantly, both went to $0 trade commissions on most investments back in October, so there isn’t much of a cost difference either. The other differences between the firms are deep in the weeds.
What will likely happen at some point well into 2020 is that your accounts will be “moved” to the Schwab system as the firm absorbs accounts held at TD. Schwab and TD say that total integration could take from 18 months to three years, so it’s no small undertaking, that’s for sure. This could lead to minor headaches, but nothing bad would happen to your investments, or anything like that.
I’ll be keeping you informed along the way, but please feel free to ask questions as they come up.
