Archives for January 2023

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What’s the Best Time of Year for a Roth Conversion?

A reader writes in, asking:

“I do not believe in market timing and my approach of regular investing over the years without selling has been very successful. However, when you make a Roth conversion, within the year you are market timing.

From what I understand, I can tell my broker whatever date I desire to have my Roth conversion be effective. They will then send me a 1099 indicating the market value on the conversion date. The market value is then treated as taxable income on my federal and state returns.

However, within the year when I will be making my conversion, the market value of my retirement account could fluctuate materially. Should I do the conversion as early in the year as possible to give the longest time for tax free growth? Should I watch interest rates and make the conversion when rates come down? Or should I try to convert in portions throughout the year?

The additional tax caused by poor timing could be significant. I have not seen any discussion of this issue and I thought, in addition to me, it might be of interest to other readers.”

If the dollars that would be used to pay the tax would be coming out of the IRA itself, and the tax rate would be the same at different points during the year, then it doesn’t matter at all when during the year the conversion is done. Returns, whether positive or negative, as well as the payment of tax, are both multiplication functions. And the commutative property of multiplication tells us that we can do those multiplications in any order and end up with the same result. (That’s the rule from grade school math that tells us that A x B x C is the same as C x B x A.)

The tax rate might not be the same though, at different points during the year. For example, imagine that, on January 1, you have $50,000 in an IRA that consists of 1,000 shares of a particular mutual fund. If you convert the whole IRA on January 1, it would be $50,000 of income. Now imagine that, on March 1, those same 1,000 shares happen to be worth only $35,000. It’s possible that the actual tax rate would be different on an additional $50,000 of income rather than an additional $35,000 of income.

If the dollars that would be used to pay the tax on the conversion would be coming out of taxable accounts, then you’re effectively using taxable dollars to “buy more” Roth dollars. And the lower the share price on the date of conversion, the more effectively you are using your taxable dollars.

Overall point being, if you somehow knew in advance which day of the year would have the very lowest market value, that would be the best day to convert, because a) you might be able to pay a lower rate on the conversion (or a portion of the conversion), and b) if you’re using taxable dollars to pay the tax, those taxable dollars will go further, in terms of being able to pay for a larger number of shares being converted.

But, of course, there’s no reliable way to do that.  No way to know when we’ll see the lowest market levels in a given year.

On average — because investments generally go up in value over time — earlier in the year will likely be a better “deal” than later in the year. Conceptually, this is the same as the question of lump-sum vs dollar cost averaging. That is, the earlier in the year you do it, the more growth you would be expected to take advantage of. Though whether it actually plays out that way in any particular year has a large chunk of randomness involved.

There is an important counterpoint though, with regard to conversions. Early in the year, many of the other numbers on your tax return may not yet be known. For instance, in January, you may find that it’s very hard to predict how much earned income, interest income, dividend income, or capital gain distributions from mutual funds you’ll have over the course of the year. Waiting until later in the year can make it much easier to try to target a specific income threshold with the conversion (e.g., staying just below a given IMRAA threshold or staying within a given tax bracket).

On the whole, I think for most people it makes most sense to wait until later in the year, given the uncertainty about all the tax planning inputs.

If, however, you find that you can pretty reliably predict most of the inputs on your tax return (e.g., you’re retired, so you know your earned income will be zero, and you find that your dividend income is pretty reliable each year), converting earlier in the year can make sense. Or, if at some point during the year you happen to notice a major market decline, you could go ahead and do a conversion at that time. (Though of course you’d have to accept the fact that you may be missing out on an even better opportunity that could arise a few days/weeks/months later. There’s just no way to know.)

Related reading:

For More Information, See My Related Book:


Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

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  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

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Investing Blog Roundup: Monte Carlo Simulations

Monte Carlo simulations are a popular way to determine how risky a given level of spending is, for a particular set of household circumstances (i.e., assets, age, other sources of income, etc.). Different software will do such simulations differently — and provide different output as well. But the most common form out output is to show a probability of success/failure — that is, in what percentage of the simulations did the household end up depleting the portfolio before the desired length of time had elapsed.

As David Blanchett discusses in a recent article, many “failure” scenarios wouldn’t even occur in real life. In part, that’s because people tend to cut their spending, if they see that it doesn’t look like things are going according to plan. Second, Monte Carlo simulations are often run using a conservative time horizon estimate (e.g., to age 100). If a “failure” scenario shows the portfolio being depleted at, for example, age 97, there’s a good chance that the original owners of the portfolio would no longer be alive and spending from it.

In another recent article, Massimo Young and Wade Pfau point out a danger of Monte Carlo simulations, which people might not recognize. Namely, while such software randomizes the results, it does so using constraints/assumptions set by the user (or set by the software developer, if the user doesn’t have options to adjust). And the results of the simulations are very sensitive to the assumptions used.

Other Recommended Reading

Thanks for reading!

Financial Planning at an Early Stage: Is It Just Guessing?

A reader writes in, asking:

“I’m 26, single, with a good job. I have been saving 10% of each paycheck since I started working. I’m starting to read more about investing, and I’m using calculators online but one thing I can’t wrap my head around is isn’t all of this just a wild guess? Like, I’m supposed to input a return and an age when I’ll retire. But…I don’t know? And when people talk about Roth and Traditional accounts, they always talk about tax rates. I’m not even sure what my tax rate is this year, but somehow I’m supposed to know what it will be when I’m 70??”

You are absolutely right.

You don’t know what investment returns you’ll get. You don’t know how much you’ll earn each year through your career. You may not, right now, even be able to predict what career you’ll be in 10 years from now — much less the specific position and income. We don’t now what’s going to happen with Social Security. We don’t know what’s going to happen with tax law. You, likely, don’t know if you’re going to get married or what that person’s career will be like. Or how many kids you’ll have, if any.

So, if you’re trying to do projections out to age 65 to see how much you’ll be able to spend based on your current plan, yes, it’s just a wild guess.

But that’s okay!

As you get closer and closer to retirement age, more of those things will become known. You don’t need to know them right now.

Right now, early in your career, the focus of financial planning is mostly about building good habits.

Make a habit of periodically checking that you have proper insurance: health, disability, auto, and renters (or homeowners if/when then becomes applicable). If anybody else is dependent on you financially, you should have life insurance as well.

Get in the habit of tracking your spending so that you know how much you’re spending and on what. For many people, when they do that for the first time, they find that they’re spending a lot on some things that really aren’t that important to them. Whenever you find that to be the case, you have identified an easy area for improvement.

Build an emergency fund of safe, accessible assets. At least a few months of living expenses. Gradually, seek to build that up to 6 months of living expenses. (The primary purpose of an emergency fund isn’t for an unexpected spending need, though those do arise. The primary purpose is to make sure you don’t have an absolute disaster if you lose your job unexpectedly and it takes a while to find a new one.)

You’re already saving a significant part of your income each year, which is great. Admittedly, there’s no way to know how much is “enough” this early. We can make some reasonable guesses (see Wade Pfau’s “Safe Savings Rate” research, for example), but it’s still a guess. The critical thing at this stage is that you have started a habit of saving. Whenever your income goes up, save more.

Get in the habit of investing those savings (other than your emergency fund), in a low-cost and diversified way. Most often this means a single target-date fund or a simple portfolio of 2-3 index funds/ETFs.

And get in the habit of investing in that same simple portfolio, every paycheck, regardless of what the market has done recently. A market downturn isn’t a problem for you — it’s a bargain-buying opportunity.

With regard to accounts, if your employer offers a matching contribution to a 401(k)/403(b), make sure that you’re contributing enough to get the maximum match. And, if you can, contribute to a Roth IRA, rather than just saving in a taxable brokerage account.

It’s true that you can’t predict the future 30, 40, 50 years from now. But that’s OK. There are still a lot of things you can do right now that will improve your future, even if there’s no way to know precisely how that future will look.

(For further related reading, see A Basic Financial Planning Checklist or What is Comprehensive Financial Planning?)

Investing Blog Roundup: SECURE Act 2.0

The SECURE Act 2.0, signed into law 12/29/22, made a long list of changes to retirement accounts. The two best write-ups I’ve seen so far are from Jeff Levine and Jim Dahle.

And of course reading the legislation for yourself can be informative. (The link above will take you to text of the whole Consolidated Appropriations Act, 2023. Do a search for “Division T” on that page to get to the SECURE Act 2.0.)

Other Recommended Reading

Thanks for reading!

My Experience with Check Fraud – And What You Can Learn From It

As many of you know, I’m currently serving as the Secretary for The John C. Bogle Center for Financial Literacy. A few months ago, there was a form I needed to file with the Texas Secretary of State on behalf of the Center.

The form in question requires a $5 filing fee. For just $5, I decided it was simpler to pay the fee myself, rather than bothering Ben Holland (Treasurer for the Center) to have the Center pay the fee. So I wrote a personal check, included it in the envelope with the form, and dropped the envelope in the blue USPS mailbox down the block.

Below is the check I wrote. (Please forgive the messy handwriting. I was not expecting to show this check to thousands of people. The address is an old address, but I rarely write personal checks anymore, so I had never bothered to have new checks made.)

And below is what the check looked like, when it was cashed/deposited. (If the images are not coming through in your email/browser, here’s the original check and here’s what it looked like after alteration.)

Apparently somebody intercepted the check, chemically “washed” it to remove the ink on specific portions of the check, and wrote in a new payee, amount, and (partial) memo.

In the months since this occurred, I’ve seen a handful of articles about the topic and heard from many people who have had a similar experience, as it’s apparently nothing short of a fraud epidemic at the moment.

Per the police detective who was in charge of the case, they’re getting ~30 of these reports per day. And that’s just in our patrol district (i.e., a few neighborhoods in St. Louis).

We did eventually get our money back. But, in total, resolving the situation took more than 3 months and required 14 phone calls (including I have no idea how much time spent on hold), 2 visits to local Bank of America branches, and 2 visits to the police station.

If I had not scanned the original check before mailing it, the process likely would have taken longer.

And we had to close our checking account, open a new one, and switch over everything that automatically charged to the old account.

In short, even if you get your money back, I assure you that it’s an experience you’d like to avoid, if possible.

As far as how to avoid being on the receiving end of check fraud, the most important and easiest thing you can do is just to avoid mailing checks. Pay electronically whenever you can. (I know that’s my own preference regardless of this mess.)

If you do have to mail a check, if possible have it sent via your bank (i.e., using a “bill pay” feature) rather than writing it by hand.

If that’s not possible, write the check in sharpie, as apparently that ink is the hardest to remove.

And if you do have to mail a check, do not put it in your mailbox or a blue mailbox on the corner, as those locations have a higher likelihood of being physically intercepted. Instead, drop it off directly at the post office. (Though I have heard from people who have been victims of check washing fraud despite mailing the check at the post office, which suggests there’s some degree of an “inside job” going on here. So again, best to not mail checks at all, if possible.)

Why Invest in Index Funds?

The following is an adapted, excerpted chapter from my book Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less.

Pay less for a product or service, and you’ll have more money left over afterwards. Pretty straightforward, right? For some reason, many investors seem to think that this rule doesn’t apply to the field of investing. Big mistake.

Index Funds 101

A bit of background: Most mutual funds are run by people picking stocks or other investments that they think will earn above-average returns. Index funds, however, are passively managed. That is, they seek only to match (rather than beat) the performance of a given index.

For example, index funds could be used to track the performance of:

  • The entire U.S. stock market,
  • Certain sectors of the U.S. stock market (the pharmaceutical industry, for instance),
  • Various international stock markets,
  • The bond market of a given country, or
  • Just about anything else you can think of.

Most Actively Managed Funds Lose.

The goal of most actively managed funds is to earn a return greater than that of their respective indexes. For example, many actively managed U.S. stock funds seek to outperform the return of the U.S. stock market. After all, if an active fund doesn’t beat its index, then its investors would have been better off in an index fund that simply tracks the market’s return.

Interestingly, most investors actually would be better off in index funds. Why? Because — due to the high costs of active management — the majority of actively managed funds fail to outperform their respective indexes. In fact, according to a study done by Standard and Poors, for the ten-year period ending 6/30/2022:

  • Less than 9% of U.S. stock funds managed to outperform their respective indexes,
  • Less than 12% of international stock funds managed to outperform their respective indexes, and
  • Less than 27% of taxable bond funds managed to outperform their respective indexes.

Now, lest you think that this particular period was an anomaly, let me assure you: It wasn’t. Standard and Poors has been doing this study since 2002, and each of the studies has shown very similar results. Actively managed funds have failed in both up markets and down markets. They’ve failed in both domestic markets and international markets. And they’ve failed in both stock markets and bond markets.

Why Index Funds Win

The investments included in a given index are generally published openly, thereby making it easy for an index fund to track its respective index. All the fund has to do is buy all of the stocks (or other investments) that are included in the index.

When you compare such a strategy to the strategies followed by actively managed funds (which generally require an assortment of ongoing research and analysis, in order to try to buy and sell the right investments at the right times) you can see why index funds tend to have considerably lower costs than actively managed funds.

Common sense (and elementary school arithmetic) tells us that:

  • If the entire stock market earns, say, a 9% annual return over a given decade, and
  • The average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.1%,

…then the average dollar invested in the stock market over that year must have earned a net return of 7.9%.

Now, what if you had invested in an index fund that sought only to match the market’s return, while incurring minimal expenses of, say, 0.1%? You would have earned a return of 8.9%, and you would have come out well ahead of most other investors.

It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) referred to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Why Not Pick a Hot Fund?

Naturally, many investors are inclined to ask, “Why not invest in an actively managed fund that does beat its index?” In short: because it’s hard — far harder than most would guess — to predict ahead of time which actively managed funds will be the top performers.

In addition to their “indices versus active” scorecards, Standard and Poors also puts out “persistence scorecards” from time to time. In the most recent one (published November 2022), they found that of the funds that had a top-quartile ranking for the five years ending June 2017, only 21.46% maintained a top-quartile ranking for the following five-year period. Pure randomness would suggest a repeat rate of 25%. In other words, picking funds based on superior past performance was usually unsuccessful and proved to be slightly worse than picking randomly.

In another study, Morningstar’s Russel Kinnel looked at the usefulness of expense ratios and star ratings (which are based on past performance) at predicting future performance. Kinnel summarized his findings:

Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. […] Stars can be helpful, too, particularly in identifying funds that might be merged out of existence.

In other words, past performance can be useful for identifying future poor performers. (That is, the worst performing funds tend to continue to perform poorly, and they are often shut down by the fund company running them.) But if you’re looking to pick a future top performer, picking a low-cost fund is your best bet. And looking for low-cost funds naturally leads to the selection of index funds as likely top-performers.

Taxes Are Costs Too.

If you’re investing in a taxable account (as opposed to a 401(k) or IRA), index funds can help you not only to minimize costs, but to minimize taxes as well. With mutual funds, you pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

Because most active fund managers buy and sell investments so rapidly, a large percentage of the gains end up being short-term capital gains. Because short-term capital gains are taxed at your ordinary income tax rate (as opposed to long-term capital gains, which are currently taxed at a maximum rate of 20%), you’ll end up paying more taxes with actively managed funds than you would with index funds, which typically hold their investments for longer periods of time.

Not All Index Funds Are Low-Cost.

Do not, however, invest in a fund simply because it’s an index fund. Some index funds actually charge expense ratios that are close to — or sometimes even above — those charged by actively managed funds. It’s a good idea to take the time to check a fund’s expense ratio and compare it to the expense ratios of other funds in the same category before investing in it.

When Index Funds Aren’t an Option

Unfortunately, in many investors’ primary retirement account — their 401(k) or 403(b) — they don’t have the option to select any low-cost index funds. If you find yourself in such a situation, my strategy for picking funds would be as follows:

  1. Determine your ideal overall asset allocation (that is, how much of your overall portfolio you want invested in U.S. stocks, how much in international stocks, and how much in bonds).
  2. Determine which of your fund options could be used for each piece of your asset allocation.
  3. Among those funds, choose the ones with the lowest expense ratios and the lowest portfolio turnover. (For funds in your 401(k) or 403(b) this information should be available in the plan documents.)

Simple Summary

  • Because of their low costs, index funds consistently outperform the majority of their actively managed competitors.
  • A fund’s past performance (even over extended periods) is not a reliable way to predict future performance.
  • Not all index funds are low-cost. Before investing in an index fund, take the time to compare its expense ratio to the expense ratios of other index funds in the same fund category.
  • If you don’t have access to low-cost index funds in your retirement plan at work, look for low-cost, low-turnover funds that fit your desired asset allocation.
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