Atlanta Planning Guys

As warmer months approach, many of us get the itch to travel.  Summer is a traditional time to spend on the road with family and friends.  With the Internet at your fingertips, there are unlimited ways to be smart about your travel plans.  Here are just a few ideas that might help shave dollars off your summer trip.

In Case of Emergency:  Nothing can undermine a great trip like the unexpected.  Do as much on the front end of a trip to prevent anything from derailing the fun.  It can be a costly undertaking to be ill prepared when something does goes wrong.

• Road Side Assistance: do you have it?  Most cars come with some type of benefit, but for only a few years.  There are several well known travel services that give you someone to call if you should break down, have a flat or otherwise be immobile during your journey.  If you are driving, it wouldn’t hurt to have the air in your tires checked and even schedule a car service before you hit the road on a long trip.
•  Emergency Contacts:  Make sure that family/friends/neighbors know you are headed out of town and where to reach you.  Having a neighbor/friend looking after the house can be helpful these days.  I recently had an attempted break in at my house.  My neighbor saw it happening and was able to alert me about it.

Use the Web:  If you will be traveling to someplace you have never been, do your research.  There is so much information out there nowadays; don’t be afraid to use it.

• Restaurants: Mapping out a few places you think you would like to eat helps avoiding those frantic trips around town to find something you crave.  Most restaurants offer some type of pricing online that allow you to budget your dining out accordingly.
• Entertainment:  Seeking out activities to do on your trip ahead of time will allow for price haggling and reservations to be made.  This cuts out on “waiting in line” sometimes and gives parents the ability to avoid those touristy traps that can cost an arm and a leg.

 Rental Houses: Depending on the length of your trip, it may prove worthwhile to explore your options to rent a house at your final destination.

• The Kitchen: gives you access to all the items you need to spend a late morning enjoying breakfast without having to get in the car and go somewhere. 
• More space: if you’re traveling with a crew, you don’t have to worry with who is in what room or coordinating “meeting spots.”  Rounding everyone up to head to the beach, dinner or movie is as simple as meeting in the living room
• You might save a pretty penny:  You’ll be giving up the luxury of having someone make your bed every morning.  You probably didn’t need that chocolate on your pillow anyway.  Compare the pricing for a rental house versus hotel and make an informed decision.

Consider a Travel Agent:  If you’re like me, you like to plan things yourself.  That said, a travel agent can often coordinate a trip for you and will be very aware of deals being offered.  It can be well worth exploring a local travel agency to help plan your next adventure.

Depending on your ultimate goals for the big summer trip, some of this may be pointless.  However, making some carefully planned decisions can be beneficial to your wallet and state of mind.  Go forth and conquer the summer.  Happy trails to you.

Summer presents a fantastic opportunity to treat your taste buds to tons of fresh produce.  All the craze, in recent years, seems to be focused on the ‘organic’ movement when it comes to your veggies/fruits.  My brother is a farmer in East TN.  I’ll try to stay off my organic vs. non-organic soap box for a moment (Michael’s produce is amazing and not organic).  Regardless of your feelings about the use of pesticides, the time of year approaches that there will be a TON of fresh foods in supermarkets all over Atlanta for you to try out.

How does/can this relate to my finances?  Well, my culinary experience has led me to explore all over Atlanta in search of fresh produce.  There are tons of opportunities to save money on better food just by looking around.  An interesting article by The Atlantic pits several meals made from produce purchased at Wal-Mart against the same cuisine prepared from produce purchased at Whole Foods.  I’ll save you a price shopping excursion and tell you that ‘typically’ produce from Whole Foods is much more expensive than the same items purchased at Wal-Mart.  However, if you click through and take a look at the above article, you will find that there were many areas where the quality, taste and overall texture of produce purchased at Wal-Mart held its own against Whole Foods.

I’m so very excited about the next few months.  There are already baby tomatoes all over my garden and with all this rain…tomato/basil salads aren’t too far off.  With fresh veggies abounding, don’t be afraid to hop in your car one weekend and go shopping.  Stay away from the traditional ‘supermarkets’ and look for other options.  Yes, a trip to Wal-Mart might be in order.  However, Atlanta offers an abundance of fresh markets, farmer’s markets & side-street vendors offering up their freshest fare.  If you enjoy fresh food, take this opportunity to seek out some new spots.  Here are a few places to start:

• Dekalb Farmers Market: it doesn’t matter where you live in Metro ATL…this place is worth the trip.  Try to avoid Sunday’s b/w 11 & 2, unless you are up for huge crowds.
  • Incredible Meats, Veggies/Fruit, Spices from around the world
• Cobb International Farmers Market: Great choice for Cobb County
  2350 Spring Rd SE, Smyrna, GA 30080
  • Great Veggies/Fruit & Fish
•  Buford Highway Farmers Market: Gwinnett and North Fulton folks try here
• Georgia State Farmers Market: One of the largest in the world.  I consider this a great tourist attraction with the added benefit of tons of produce
  16 Forrest Pkwy, Forest Park, GA 30297

Any internet search is bound to land you in the thick of plenty of other options.  Not to mention the countless ‘seasonal’ stands that will be popping up in communities all over the city.  Now for a few shopping tips:

• Bring Cash: if you plan on going to outdoor stands or down to the Georgia State Farmers Market…cash is king.  You’ll be amazed what $20-$40 will buy you.
• Be Ready to cook:  there is a chance that you might get carried away when you see how far your dollar stretches.  Have recipes in mind when you depart on your adventure so that you don’t end up wasting all that fresh goodness.
• Ask an expert: chances are really good that if you go to some of the larger markets you will see produce you won’t see in other stores.  If something looks inviting, wait until someone else bags up a few and ask them how they prepare it. Or if the farmer is there, ask him or her for some tips. This is good to do with any veggie.  Folks are usually happy to share their recipes.
• Prices tell the story: if it seems really inexpensive, that means it’s in season…not that it isn’t good.  Prepare for sticker shock on some of the produce you seek.  However, the really inexpensive stuff is most likely in great abundance.
• Ready your taste buds: foods that are in season are just better.  They don’t have to be shipped from far-away places…when they’re local, they retain more of their freshness.

Happy shopping.  Your mouth, tummy and wallet will certainly thank you for venturing out into this brave new world.

 In recent weeks, Cass and I have devoted a great deal of time talking about the unique opportunities for our clients in 2010 regarding taxes.  From Roth IRAs to Long Term Capital Gains, there is much to discuss and be aware of in this ever-evolving environment.

Part of the tax cuts implemented by the Bush administration in 2003 established more favorable tax treatment for most ordinary dividends.

Prior to this legislation, taxes levied on these dividends were paid at ordinary income tax rates.  Since then, a more favorable treatment has benefited many Americans.  Equalizing the tax treatment of ordinary dividends with that of Long Term Capital gains effectively gave many folks in higher tax brackets more money in their pockets.

In 2011, these tax cuts will expire.  Taxation will revert back to the old system that treats ordinary dividends as income and taxes them accordingly(as high as 39.6% for those in higher tax brackets).  This will undoubtedly have a sweeping impact on investor sentiment toward dividend paying instruments and tax-exempt options.

Consumers with a heavy reliance on dividend income as a primary source of retirement income should weigh their options carefully.  These tax changes will inevitably impact the ‘net’ income coming from these sources.  There is opportunity in every situation.  Make sure you make informed decisions to better yourself and your portfolio. Talk to your investment advisor and accountant about how this will impact your particular situation now. 

For many of us, Spring cleaning is an annual ritual where we find the time to get everything spit-shined, polished and put into place.  I personally love this time of year because I get to spend time getting dirty in my garden.  It seems that Spring has been declared the national season to “get things done!” The taxes are in, school is winding down and the mall’s have yet to begin their “who can get Holiday decorations up first” skirmishes. Here are just a few of my thoughts on how to turn traditional Springtime activities into life & financial lessons:

Get out the Video Camera:  If you have decided to dig into closets, cupboards & storage rooms to clean out from the winter, kill 2 birds with one stone.  Take a video camera with you and record all of your household belongings.  It will add an extra minute or two to your weekend project.  However, that will document much of your belongings in the event that something bad happens to the house (robbery, fire, meteor, etc.).  Store your videotape in a fire-proof safe or a safety deposit box.

Family Lessons:  Chances are that some of the toys your children got last year have lost some of their luster.  Schedule a weekend to search through all of the kids’ toys, clothes and other items around the house that the family really doesn’t use anymore.  Gather these things up and research a local charity that needs, and accepts, these items.  Load the kids, clothes, toys, 39 cookbooks and 172 bottles of hotel shampoo up and head down to the donation site.  Not only is being thankful for all that you have a valuable lesson for all kids to learn, but it also teaches them how important it is to be involved in your community and help those less fortunate. Most of these organizations will also give you a donation form for tax purposes.  Take another opportunity to discuss the benefits of charitable contributions with your kids and ways that they can help others throughout the year.

If you don’t have children, this is still a wonderful thing to do to de-clutter and donate your lightly used items to those who could really use them.

Get it in the ground: Find something fun to plant and put on your gardening gloves.  Whether you’re in a 5th floor apartment or walking out the back door to a sprawling yard, this can be a terribly rewarding experience.  Flowers can add color and serenity to any room or patio.  Fresh herbs offer up some fresh zest to any meal.  It is well documented how much our money, career and the market can stress us out.  I can’t tell you how rewarding it is for Julie and I to head to the garden in June/July to pick fresh tomatoes and peppers. Imagine the fun you could have with your children and the life lessons being taught. A well placed herb or flower can wash away all sorts of anxiety and frustration at the end of a long day.  These are very inexpensive ways to brighten up your life and reconnect with some of its simplest pleasures. Oh…and yes…also save on your grocery bill!

The biggest difference between the two types of accounts has to do with taxation.

For the purposes of this discussion, and in all blog entries on our site, the term “Traditional IRA” also includes rollovers from 401(k)’s and other corporate retirement plans.

This is a simple chart meant to compare the key difference between the two types of accounts:

Like many great ‘client friendly’ tools, the Chappell Mayfield Investment Dashboard™ was born out of necessity.  During our quarterly and annual investment reviews, it became apparent that we were inundating our clients with information from too many sources.  Each fund had its own quarterly fact sheet with statistics and numbers, the actual advisory statement was nearly a dozen pages, commentary from the managers varied from one to five pages, and the various benchmarks took up at least two pages.  We needed a way to organize several key pieces of information in an easy to read format.  A client, who is a retired executive with extensive experience reviewing numbers, assisted in the creation of the template and served as our sounding board.

Soon after, the Chappell Mayfield Investment Dashboard™ was born.  Over the years, we have refined the visual appearance of the Dashboard, to increase clarity, as well as the criteria we use to evaluate performance. The dashboard addresses four critical areas—Performance, Allocation, Contributions/Distributions and Changes Made to the Portfolio.  Many of these metrics are missing from even the most sophisticated client investment statements.  We subscribe to several different software programs and reporting tools to gather the data and put it all into one fluid report.  Each of the dashboard’s components serve a vital purpose in helping the client understand exactly where their portfolio, and their retirement plans, stand at that particular point in time:

1)  Performance: The investing world is full of statistical measures that are very difficult for most investors to understand. Using an intuitive layout and color coded tabs (click here for a larger, easier-to-read Dashboard), we were able to create a tool that virtually any client can understand, regardless of investment experience. Performance is shown in the following metrics:

• Performance relative to Benchmark (most recent quarter, 1, 5 & 10 years)
  • GREEN indicates outperformance versus the benchmark, YELLOW indicates even versus the benchmark and RED indicates underperformance versus the benchmark.
  • Performance versus the benchmark is important, but it doesn’t indicate how other investments with the same benchmark may have fared.  That requires that we show:
• Performance relative to Peers (measured in percentile over 3 & 5 Years)
  • GREEN indicates top quartile, YELLOW indicates second quartile, and RED indicates bottom half.
  •  Several studies have shown that most top managers spend at least some time in the bottom half of their peers – we take that into consideration.
  • The “home run” is having a manager move from the bottom half to the top quartile WHILE you are invested with them.
  • A manager that is moderate or even conservative may never appear in the top quartile.  Then again, they may never appear in the bottom quartile either.
  • That leads us to try to quantify risk:
• Upside/downside Capture versus Benchmark (measured in percentages)
  • In the last 12 quarters, when the benchmark has gone UP, how much has this investment participated?
  • In the last 12 quarters, when the benchmark has gone DOWN, how much has this investment participated?
  • Numbers over 100 indicate more volatility than the benchmark
  • Ideally, an investor would want a higher number in the UP capture and a lower number in the DOWN capture
• Outlook indicates our general opinion of the particular investment
  • GREEN means that we are firmly in support of this investment
  • YELLOW indicates that we have this investment on our “watch list,” but it is too early to recommend a change
  • RED is the “sell” signal.  When clients see RED in this column, they know that we will have a change to recommend to them

2)  Allocation:  the Dashboard illustrates the portfolio of the client according to asset classes

• Color coordinated pie charts show  the percentage in every asset class
• Illustrates holes in portfolio or lack of proper balance among stocks/bonds/alternatives
• Shows the return of the entire portfolio over various time frames

3)  Contributions/Distributions (not shown):  shows the historic account of money coming into or out of the client’s portfolio

• The actions of the investor will affect performance
• Client’s need to know how much they have taken/added to their portfolio – having it all in one place makes the investing experience easier

4)  Changes to Portfolio:  tracks any changes made to their investments

• A critical component to hold us accountable for our recommendation to buy/sell something
• Gives some retrospective view to historic performance and decisions

Combining this information into one place is not just unique, it is extremely powerful.  The Dashboard’s most valuable trait is that it helps us focus the client on what matters.  It is color coordinated.  So, if the client sees RED in the outlook column, they know that we are going to be recommending changes.  If it is all GREEN, we will spend more time talking about their family vacation.  There isn’t a single document, to our knowledge, that simultaneously addresses all four of these critical areas.  In a matter of minutes our clients know exactly where they stand. Without a doubt, this has been an important component in building loyalty and strengthening the relationships that we have with each of our clients.

• A critical component to hold us accountable for our recommendation to buy/sell something
• Gives some retrospective view to historic performance and decisions

Combining this information into one place is not just unique, it is extremely powerful. The Dashboard’s most valuable trait is that it helps us focus the client on what matters. It is color coordinated. So, if the client sees RED in the outlook column, they know that we are going to be recommending changes. If it is all GREEN, we will spend more time talking about their family vacation. There isn’t a single document, to our knowledge, that simultaneously addresses all four of these critical areas. In a matter of minutes our clients know exactly where they stand. Without a doubt, this has been an important component in building loyalty and strengthening the relationships that we have with each of our clients.

This week, I received a performance piece in the mail from one of the money managers we use with our clients.  Its focus was on dealing with investor behavior and the emotions we assign to our money.  If you have been reading our blog for a while, you know what’s coming.  Our behaviors and emotions can wreak havoc on our investments, sometimes leading to severe mistakes when it comes to decisions about how our money is invested. But I assure you, taking the emotion out of your investment decisions can save you a lot of…well…heartache.

Now that we have some time to look back, I thought it relevant to apply some of the behavioral principals to what we have seen in the preceding 13 months.  For my research, I looked at the S&P 500 Index (net of dividends and stock splits).  The market low was March 9th, 2009.  On that day, the S&P closed at 676.53.  In the days leading up to this low, it had gradually spiraled down to this point.  As we look at the days/weeks that followed this point, I want you to keep in mind some of the “behavioral” thoughts we assign to investments.  Cass touched on several of these in his blog post from November of last year.

• March 9, 2009: S&P closes at 676.53- the market low
• March 16, 2009: S&P closes at 753.89- up 11.43% a week later
• March 23, 2009: S&P closes at 822.92- up 21.64% two weeks later
• March 30, 2009: S&P closes at 787.53- up 16.41% three weeks later
• April 6, 2009: S&P closes at 835.48- up 23.49% four weeks later
• April 9, 2009 (1 month from the low): S&P closes at 856.56- up 26.61% one month later
• April 21, 2010 (I’m writing this on the 22^nd): S&P closes at 1205.94- up 78.25%

Disclaimer: Past performance is no guarantee of future results. The market for all securities is subject to fluctuation such that upon sale an investor may lose principal.

What am I trying to illustrate from this exercise?  We have a real world example of how investor behavior can really take a chunk out of your long term growth.  I’ll focus on two distinct behaviors:

1-      Representativeness: Where an investor labels an investment as “good” or “bad” using recent performance.  It is easy to see how someone could have done just that with the S&P in March 2009.  The probability of “sidelining” your money based on the previous decline could be very high.

2-    Snake-bite Effect: Investors forego strong growth opportunities, regardless of whether or not the circumstances are different, if they were “bitten” before.  You can’t argue with the “opportunities” posed by a historic low in the S&P.  With the Y2K/Tech bubble bursting still pretty vivid in the minds of many investors, it’s easy to see how confidence may have been overcome by fear.  In the face of the decision to stay invested, the traditional investor would have likely stayed out of the market.

 Let’s assume for a moment that you were “out” of the market already on March 9th, 2009.  When does one decide to get back in?  Well, usually the decision to start investing again comes with a price.  In this case, the price of waiting would be pretty steep.  We already know that if you were invested from the low up through close on April 21st, 2010 you were rewarded with a 78.25% return.  What would that look like if you waited until your “confidence” in the market was restored (compare to 78.25% return for those who stayed in the market):

-          Waiting 1 week – return: 59.96%

-          Waiting 2 weeks- return: 46.54%

-          Waiting 3 weeks- return: 53.13%

-          Waiting 4 weeks- return: 44.34%

-          Waiting 1 month- return: 40.79%

Observe that an investor who waited a month to get back in ended up with only a little more than half the investor who remained committed to the market.

Of course hindsight is 20/20. It’s easy it is to look back on the last 13 months and tell yourself that you would have jumped in on March 9th, 2009; but did you?  Waiting just 1 month to “get back in the market” would have cost you a whopping 37.46% return on your money.  Given the slight downturn in the market the week of March 30th, 2009 it’s easy to see how an investor might have justified waiting just a bit longer.  Taking the emotion out of investing is one of the hardest lessons for most investors to learn—but is often times the most valuable.

Over 26,000 racehorses were foaled in 2007.  On Saturday, May 1st, twenty of them will “Run for the Roses”.  One will win.

That horse will be #1, Lookin at Lucky, with Jockey Garrett Gomez aboard.

Being the morning-line favorite, and at odds of 3-1, this isn’t exactly stepping out on a limb.  Anyway, here are some key observations:

Lookin at Lucky has won 6 of his 8 races.  The two races he didn’t win involved SUBSTANTIAL traffic issues, most recently in the Santa Anita Derby. 

Many horseplayers will use that to bet against Lucky in this spot.  Starting in the 1 gate is TOUGH for a closer and 20 horses makes for a log-jam.  Derby history is littered with great horses who didn’t win the Roses because of a poor trip, only to go on to Hall of Fame careers (see Point Given - in 2001, he finished a troubled fifth in the Derby, only to go on to win the Preakness, Belmont,  Haskell, and Travers).

It’s the way that Lucky handled the traffic in the SA Derby that makes me so excited about his chances. 

The horse came to a virtual STOP at the 5/16th pole to avoid another horse and then took off again,  passing several horses to finish 3rd to Sidney’s Candy.  Lucky ran evenly with Sidney’s Candy for the rest of the race, even though he had to stop  and re-start.
See Video

He turned in a final furlong of 12.45 and a final 3/8 of less than 37 seconds in his last prep.

Conventional wisdom dictates a final furlong and final 3/8 of less than 13 and 38 seconds,  respectively, in a horse’s last prep race.  The Derby will be the longest race any of these horses has  ever run.  If a horse was tiring in its last prep race it doesn’t bode well for the added distance of the  Derby.  Other horses in this year’s Derby have met both criteria, but Lucky did it under very  difficult circumstances.

He is a CLOSER

There is a lot of early speed in this year’s Derby which creates the possibility of a pace meltdown.   Sidney’s Candy, breaking from gate 20, will have his hands full.  By my count, there are four other  early speed types in this race.  Line of David and Conveyence will be pushing Candy all the way.   This should bode well for a closer like Lucky….but also for #2 ICE BOX (my official sleeper).

Bob Baffert, the trainer, has won three times before and Garrett Gomez, the best rider in the country, is well known for being able to time the wire just right

The Derby is full of “feel good” stories.  This would be no different.  Garrett Gomez saw his career  briefly end from mid 2002 to late 2004.  He battled substance abuse and even spent some time in  jail.  Through hard work, Garrett has resurrected what is sure to be a Hall of Fame career by winning the last four earnings titles.  See his Wikipedia page 

Here’s to hoping there isn’t a traffic jam for Lookin at Lucky!

Post time is 6:24, mint julep at 6:26

There is much to be said for the financial opportunities afforded us in 2010.  You can look at any number of the recent postings to get a good feel for what is going on.

I feel it is prudent to discuss another monstrous opportunity that exists this year. This isn’t about income taxes.  I’m talking about taxes owed on long term capital gains.  When you purchase an investment in an after-tax account your purchase price establishes your cost basis.   When you sell that investment, you will owe taxes on the gain.  Assuming it was owned it for 12 months plus 1 day, you will owe the more favorable long term capital gains tax.  Currently, long term capital gains (LTCG) are taxed at 15% (unless you are in a 10-15% income tax bracket).

The long term capital gains tax rate is set to increase to 20% in 2011.  This presents a unique opportunity to harvest some gains on your after-tax portfolio in 2010 at the lower rate.  If you’re a savvy investor and made some well-timed investments in the market a year ago (the market low was March 9th), you are likely looking at some sizable gains in your portfolio.

Selling the investment now allows you to realize some of those gains.  Putting that money right back to work in the market would reset your cost basis at a point higher than your original investment.  Here is an example:

Approach 1
John invests $100,000 in XYZ company on March 1st, 2009.  Today, that investment is worth $130,000 (it was a pretty good year in 2009).  Assuming John sells the investment today and realizes a $30,000 gain, he would owe 15% tax on the gain ($4,500) when he files his taxes for 2010.  John takes $4,500 and sticks it in his savings account to pay the future tax liability.  The remaining proceeds, he reinvests.  His new cost basis is now $125,500.  Fast forward (a year later) to April, 2011.  John’s investment is now worth $163,150 (another stellar year of returns).  If John decides to sell his investment, he will owe LTCG Tax on the gain.  $163,150 minus $125,500 equals a $37,650 gain.  Taxes due on that transaction would be 20% (the new LTCG rate) or $7,530.  John’s original $100,000 investment is now worth $155,620 (after taxes).

Approach 2
John makes the same investment in XYZ on the same date.  Only here, he holds the investment for the entire 2 years.  He keeps his $4,500 in taxes owed (from approach 1) in the market and it continues to grow.  In April, 2011, John sells his investment for $169,000.  He will pay taxes on the entire gain ($69,000) at the higher tax rate of 20%.  This nets him $155,200.  The extra $4,500 he had working for him in the market for that year was negated by the effective 33% increase in taxation of his gains (from 15% to 20%).

Note: This illustration uses a 30% annual rate of return.  This is not typical. 

Taxes on gains are inevitable.  The idea that any investment is worth the amount printed on your statement just isn’t true.   You must always account for the taxes due on any gains.  Talk to your advisor today about how best to position your money for the long term.  If you can ‘pay the piper’ now by capturing some gains, that could reduce the impact of that future long term capital gains tax rate hike.

Note:  It is important to note that this strategy also holds true to capturing Long Term Capital losses.  Since losses offset gains on a dollar for dollar basis, John could use any losses to offset future gains.  This also presents an opportunity to take advantage of the tax rate hike.

This is a hypothetical example and is not representative of any specific situation. Your results will vary.  Past performance not indicative of future results.

My official “stance” on the Roth Conversion opportunity

Executive Summary:

It’s at the bottom of this post. But, read the whole article…it’ll be more fun.

In a prior post, I showed how using funds WITHIN the IRA to pay taxes on the conversion does not provide a substantial advantage, even when the assumptions used are favorable to the decision (lower tax now, higher tax later). It is important to note that this strategy works in even fewer situations if the investor is under 59 ½ (because there is also a 10% penalty on the funds taken out to pay the taxes).

So clearly, we have established one of the main conditions that needs to be satisfied before going any further with the analysis:

“Can you pay the taxes that are due on the conversion with funds from OUTSIDE the IRA?”

If the answer is “No”, then the best play may be to do nothing.

Keep in mind, this decision (whether or not to convert traditional IRA funds into a Roth) is not an “all or nothing” proposition. As long as you can afford to pay the taxes on at least a partial conversion, then you will want to keep reading.

Before we get to the charts…

$100,000 in a traditional IRA (or rollover IRA, or anything like it) isn’t really worth $100,000. Taxes need to be paid. The amount of the IRA that will go to taxes will vary based on your income at the time you take the money out of the IRA.

The maximum tax rate in 2010 is 35% for federal and 6% for Georgia (41% total).

SO…A Traditional IRA that has a balance of $100,000 is really only worth something more than $59,000 (if you accessed it in 2010 – and you are over 59 ½). How much more depends on what your tax bracket is.

$100,000 in a Roth IRA, on the other hand, really IS worth $100,000. As long as you are over 59 ½ (with a few exceptions) the account can be accessed tax-free.

Sounds easy, right? Pay the taxes now (in this case $41,000) and that $100,000 Traditional IRA that wasn’t really worth $100,000 anyway is now a Roth IRA that is worth the full $100,000. In other words, by sending $41,000 to the government to pay taxes, you have increased the REAL value of your retirement account by that same dollar amount.

That statement is true ONLY if your tax rate in the future is the same as it is today.

While that could be the case, it isn’t likely to be. Tax laws change frequently. Who knows what the future of taxes will be? (if you know, please call me)

Another issue that hasn’t been considered is the loss of the $41,000 that was just sent in for taxes. Had you not made the conversion, you still would have had the 41 grand.

There is an opportunity cost on the money used to pay taxes.

Our analysis must compare:

An investor who has a $100,000 Traditional IRA AND the money in a taxable account that would be used to pay taxes

With an investor who converted a $100,000 Traditional IRA into a Roth IRA (and thus no longer has those taxable account funds – because they were used to pay taxes)

Important points:

Under current tax law, money outside of an IRA is taxed differently than money inside an IRA. Interest, dividends, and capital gains realized on these funds in the taxable outside account are all taxed a little bit differently.

In this analysis, I am using 15% as the combined tax rate, each year, for growth on the taxable account. This is meant to be a conservative tax rate. There are many situations where the tax burden would be much higher (under current tax law).

Assumptions:

• 8% growth, each and every year, on all investment accounts
• 25% combined tax rate on Traditional IRA distributions now
• 15% tax rate on the taxable account in all years – taxes due paid from taxable account balance
• 25% combined tax rate on Traditional IRA distributions in future years

This is a hypothetical example and not representative of a specific situation. Your results will vary.

Observations:

• With identical tax rates for Traditional IRA distributions now and in the future, the investor who converted fared better
• The difference is caused by the fact that the taxable account is taxable
• By paying $25,000 in taxes, the investor has virtually exchanged $25,000 in taxable funds for $25,000 of increased value in the Roth IRA that will grow tax free (with a few exceptions)
• A higher tax rate in future years would give an even bigger advantage to the Roth conversion

Let’s see what happens when the tax rate on Traditional IRA distributions is LOWER in the future

Assumptions:

• 8% growth, each and every year, on all investment accounts
• 25% combined tax rate on Traditional IRA distributions now
• 15% tax rate on the taxable account in all years – taxes due paid from taxable account balance
• 20% combined tax rate on Traditional IRA distributions in future years

This is a hypothetical example and not representative of a specific situation. Your results will vary.

 

Observation:

• The investor who converted is at a disadvantage

Conclusions and Comments:

• Converting a Traditional IRA to a Roth IRA and paying the taxes with funds from OUTSIDE the IRA may benefit an investor who is in the same, or higher, tax bracket in the future
• If the investor will be in a lower tax bracket in the future a Roth conversion seems to give a much smaller advantage (and it could actually be a disadvantage)
• It is very difficult to predict what tax bracket you will be in next year, let alone 10 years from now
• Tax brackets are always changing
• Historically speaking, taxes are currently as low as they have EVER been
• While it is possible (and some say probable) that taxes will be higher in the future, no one knows

“So Cass. What are you telling your clients?”

Drum roll please……………………

• If you can easily afford to pay the taxes due on a conversion from funds outside the IRA, AND
• If it is at least somewhat likely that you may be in the same, or higher tax bracket in the future, THEN
• Roth Conversion may be for you
• But, talk to a knowledgeable advisor first