Archives for January 2023

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.)

For More Information, See My Related Book:

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

See it on Amazon.

Topics Covered in the Book:

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.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Read other reviews on Amazon

January 30, 2023

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.

Monte Carlo Failures Aren’t Plane Crashes from David Blanchett
The Dangers of Monte Carlo Simulations from Massimo Young and Wade Pfau

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?)

January 16, 2023

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.

Jeff Levine’s article provides a deeper discussion of most of the provisions relating to retirement accounts.
Jim Dahle’s article provides very brief explanations, but covers more of the provisions.

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.)

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.)

January 2, 2023

What’s the Point of a Trust?

The following is an excerpt from my book More than Enough: A Brief Guide to the Questions That Arise After Realizing You Have More Than You Need.

There are some cases in which assets should not be left directly to one or more of your intended heirs (e.g., because the heir is a minor, disabled, or simply has a history of making poor decisions).

Or consider this scenario: after your death, your surviving spouse remarries. And, when your surviving spouse later dies, all of the assets that you currently think of as your assets are ultimately left to the new spouse. And when that new spouse dies, all of the assets go to his or her kids rather than to your kids or other intended beneficiaries.

A trust is the solution to situations such as the above.

There are many different types of trusts, each of which serves a particular purpose. The basic idea though is that a trust is a legal entity which can own assets. Sometimes trusts are used for tax planning purposes. In many cases though, the purpose is to allow the person who created the trust to exert some control over how their assets will be managed after their death or incapacitation. That is, somebody can create a trust, fund it with assets, and write the terms of the trust in such a way as to stipulate certain requirements as to how the assets will be invested or spent—and then those rules will have to be followed even after the person who created the trust dies or becomes incapacitated.

With trusts, it’s important to get guidance from an attorney who specializes in estate planning. If the attorney is not a tax expert, it’s critical that the firm has somebody on their team who can provide expert tax guidance, as there are both income tax and estate/gift tax considerations involved with trusts.

In order to understand the various purposes for a trust, you first need to know a bit of terminology.

Parties to a Trust

A trust involves three parties: the grantor, the beneficiary, and the trustee.

The grantor (sometimes called the donor or settlor) is the party who defines the terms (rules) of the trust, transfers property to the trust, and, usually, retains the right to change the trust until his or her death.
The beneficiary (or beneficiaries) is the party for whose benefit the assets in the trust are held/managed.
The trustee is the party in charge of managing the trust (e.g., making investment decisions, distributing assets to the beneficiary when applicable, and fulfilling any administrative requirements). The trustee owes a fiduciary duty to the beneficiary (i.e., a duty to put the beneficiary’s interests above the trustee’s own interests). And the trustee must manage the trust in such a way that is in keeping with the terms of the trust.

These parties may be actual human persons, or they may be legal entities. For instance, you could name a law firm or CPA firm as the trustee to a trust. And it’s common to name a non-profit organization as a beneficiary of a trust.

The trust may also designate somebody as a successor trustee, to take over when the initial trustee dies, becomes incapacitated, or relinquishes the role.

The trust may also designate one or more parties as secondary beneficiaries (also referred to as contingent beneficiaries), for whose benefit the assets would be managed if the primary beneficiary has died.

Another important point is that, while there are three parties to a trust, one person may actually be in multiple roles—or even all three roles.

EXAMPLE: Collin is the grantor of a trust (i.e., he funded it with his own assets). The trust is set up so that Collin is also the trustee and beneficiary while he is still alive, with his sister named as the successor trustee and his children named as the secondary beneficiaries.

One way to think about this is that before Collin created the trust, he had various rights in his assets. When he created and funded the trust, he transferred some of the rights in his assets to himself as the grantor, some to himself as trustee, and some to himself as beneficiary. Consequently, he retained all the rights in his assets that he held before the trust was created, but he now holds them in different capacities. In so doing, he creates a mechanism for others to act in the various capacities in the future.

As time passes, his sister may take over management of the trust as successor trustee when, for example, Collin becomes unable to manage his assets on his own. In addition, at Collin’s death, if his sister hadn’t already, she would become successor trustee and his children, the contingent beneficiaries, would become entitled to the benefits of the trust.

Note that there is no successor grantor because the main power given to the grantor is to change the trust. However, when the grantor dies, a trust becomes irrevocable, and cannot be changed.

More Trust Terminology

A trust can be an inter vivos trust or a testamentary trust. An inter vivos trust is created by the grantor during his or her lifetime, whereas a testamentary trust is created at the time of the grantor’s death. That is, with a testamentary trust, the grantor’s will provides for the trust to be created and funded upon his or her death.

A trust can be revocable or irrevocable. With a revocable trust, the grantor can change the terms of the trust (or even terminate it completely) as long as he/she is still alive and of sound mind. With an irrevocable trust, there are some exceptions, but changes generally cannot be made once the trust has been created. (The fact that you cannot make changes to an irrevocable trust is not, in itself, beneficial. But there are certain goals that can only be achieved with irrevocable trusts. For instance, if somebody sues you, they often will not be able to access assets in an irrevocable trust. Similarly, as mentioned later in this chapter, irrevocable trusts can be helpful for minimizing estate taxes.)

More Trust Usage Examples

With the above terminology discussion out of the way, we can go through a few examples of cases in which a trust would be useful.

EXAMPLE: Susie is a widow with three adult children (two daughters and a son). Her son has a long history of making poor financial decisions. In Susie’s will, rather than leaving 1/3 of her assets to each of her children outright, she leaves 1/3 to each of the daughters, and she leaves the remaining 1/3 to a trust. Susie names her son as the beneficiary of the trust, and she names her attorney as the trustee. This way her son still receives the benefits of the assets, but somebody else (the trustee) will be choosing how to invest and spend the assets.

EXAMPLE: Luther and Harriette are married, in their 60s. Harriette has two adult children from a prior marriage. Luther does not get along with Harriette’s children. Harriette is concerned that if she dies before Luther and her assets are simply left to Luther at her death, he will ultimately disinherit her children. As a result, Harriette provides in her will for a testamentary trust to be created upon her death and for her assets to be placed into that trust. The terms of the trust are that Luther will receive the income from the assets while he is alive, and then the assets will be left to her children upon Luther’s death.

EXAMPLE: Nigel and Veronica have an adult son who is disabled. The son is currently receiving Social Security disability benefits. And because of his low level of income and assets, he also qualifies for Supplemental Security Income (SSI) and Medicaid. If they simply leave their assets to him outright, he would lose eligibility for SSI and Medicaid. Instead, they create a special needs trust, which will receive their assets upon the death of the second spouse. Their son is named as beneficiary of the trust, and a trusted CPA is named as the trustee. Because the son has no control over the assets in the trust, it will not disqualify him from receiving SSI or Medicaid. The trustee will not be allowed to outright give the assets to the son, but the assets can be used for a variety of purposes for the benefit of the son.

Trusts are sometimes used to reduce potential estate tax costs. One of the ways to do this is to transfer assets to an irrevocable trust (thereby removing the assets from the grantor’s taxable estate), often while maintaining some current benefit (e.g., the right to take income from the assets for a period of years). By transferring assets now, the grantor will often have a taxable gift, but a significant advantage is that the gift is at today’s value, rather than at some more highly appreciated value at the date of the grantor’s death. There are many different variations on this concept though (e.g., intentionally defective grantor trusts, qualified personal residence trusts, charitable remainder trusts, etc.).

Another common use of trusts is simply to avoid probate. Assets that are placed in a trust do not have to go through probate upon the death of the grantor, because the terms of the trust (rather than state probate laws) govern how the assets are transferred. In some cases, avoiding probate can result in significant savings in terms of costs and time. (The cost of probate and administrative hassle involved vary considerably by state.)

In other cases, people may want to avoid having their assets go through probate for the sake of privacy. Probate records, including the will and estate inventory, are generally public information, whereas trusts are not.

Note though that if your goal for a trust is to have assets pass to beneficiaries without having to go through probate, it will be important that the trust is an inter vivos trust rather than a testamentary trust. Testamentary trusts do not avoid probate. (They come into being as a part of probate, via the will.)

Responsibilities as Trustee

The trustee of a trust has certain responsibilities and powers, which should be spelled out in the trust document.

One of those responsibilities is that the trustee has a fiduciary duty to the beneficiaries of the trust. That is, the trustee must manage the assets in a prudent way for the benefit of the beneficiaries, and the trustee must put the interests of the beneficiaries above the trustee’s own interests (other than to the extent that the trustee is a beneficiary).

The details vary by state law, but the trustee generally has a duty to keep the beneficiaries informed as to the administration of the trust. This often includes providing (at least) annual statements as to the trust’s assets, liabilities, income, expenses, and distributions. If/when the trust is closed, the trustee should send each beneficiary a record of all the major actions taken as trustee, including distributions made.

As with an estate, a trust is a taxable entity. If a trust has gross income of $600 or more for the year (or any taxable income more than zero), the trustee must file a Form 1041 reporting (and potentially paying tax on) that income. (Note: there are some exceptions while the grantor is still alive. That is, with some types of trusts, the trust’s income is simply treated as if it were the grantor’s income. However, once the grantor dies, the trust will be considered a separate taxpayer going forward.)

If you are trustee of a trust, it’s important to keep records of your actions in that role. Document any significant actions that you take (investment decisions, distributions from the trust, etc.) as well as your reason for those actions.

Professional Trustees

If you have (or plan to create) a trust, one important decision you’ll have to make is whether to name a family member or a professional entity as the trustee (or as the successor trustee, if you’re naming yourself as the original trustee).

The primary benefit of naming a family member as trustee (or multiple family members, as co-trustees) is that doing so will avoid some costs. Professional services are not free of course. An additional potential benefit is that a family member will have better knowledge of family dynamics, which can be helpful in some cases.

There are, however, significant points in favor of hiring a professional trustee.

Firstly, having a professional serve as trustee can prevent conflict in some cases, as the trustee will be an outsider, impartial among beneficiaries. And even if conflict isn’t avoided, it can be nice if the ill will is at least directed toward an outsider rather than toward a family member. (In some cases, the beneficiary of a trust comes to see the trustee as “the person who keeps me from getting to my money.” If the trustee and beneficiary are family, this can create permanent rifts.)

Second, naming a family member as trustee often imposes a significant burden on that person, in terms of time, stress, and potentially family conflict. And that burden may last for years.

Third, a professional trustee will have relevant skills and knowledge (e.g., investment experience), which a family member may not have.

And finally, hiring a professional trustee will generally provide some level of oversight. That is, the firm providing the service generally will have some level of internal controls to prevent theft, mismanagement, etc. In contrast, if you name, for example, your adult son as the trustee of a trust with your adult disabled daughter as the beneficiary, there may be no meaningful oversight—nobody checking to make sure that your son is performing his responsibilities appropriately.

Chapter Simple Summary

A trust is a legal entity that can own property. There are many types of trusts, each with a different purpose, but the most common uses of trusts are to avoid probate, minimize estate taxes, or exert some control over a pool of assets after the grantor dies or becomes incapacitated.
The grantor/donor is the party who creates the trust, defines its terms, and funds the trust with assets.
The trustee is the party in charge of managing the trust.
The beneficiary is the party for whom the trust’s assets are managed.
The trustee of a trust has a fiduciary duty to the trust’s beneficiaries.
Naming a professional as trustee of a trust does result in some additional costs, relative to naming a family member. But it also adds meaningful safeguards and may help to prevent family conflict.

What Comes After Financial Independence?

Among people who read personal finance books, many save a high percentage of their income through most of their careers. One thing that eventually happens for some such people is that they reach a point at which they realize they have not only saved "enough," they have saved "more than enough." Their desired standard of living in retirement is well secured, and it’s likely that a major part of the portfolio is eventually going to be left to loved ones and/or charity. And that realization raises a whole list of new questions and concerns.

This book’s goal is to help you answer those questions.

More than Enough: A Brief Guide to the Questions That Arise After Realizing You Have More Than You Need

See it on Amazon.