Nearly every investor experiences a gap between what the market returns and what they actually return in their portfolio. We believe that the shrinking of that gap should be the key focus of investors and their advisors. This post is the first in a series that is designed to determine what the factors are that lead to the gap's existence and what investors can do to shrink it. Carl Richards, the NYT blogger, refers to this as the "Behavior Gap", and while behavior is a factor that causes underperformance, it is by no means the only factor causing investors to fall short of the returns they are entitled to. Below is the graphic we show clients:
There are things we can do that are additive to portfolio performance. Diversification, exposure to specific risk factors and how we implement rebalancing are some of the key contributors to adding value. On the other side there are factors that drag down performance. Taxes, fees and poor investment behavior may not be entirely avoidable but investors need to have a process on how to minimize their impact on a portfolio.
How much value can you add to your portfolio by shrinking this gap? Everyone is different, but we believe that 2% per year is attainable for most investors. What does that mean in dollar terms? A lot.
For a 50 year old investor with $1 million the difference between 6% and 8% over the next 40 years is over $11 million ($10.285MM vs. $21.724MM). This series will provide you a playbook on how to shrink the gap and earn what you are entitled to.
A Roth IRA is a wonderful vehicle, especially if someone has already maxed out their other tax-advantaged accounts (e.g., 401K). For those not eligible for a Roth IRA or those who just can’t get enough Roth, there is a relatively new option – an in-plan conversion from a traditional pre-tax 401K to a Roth 401K. Because of 2013 legislation, more participants than ever are now eligible for this conversion (as long as their employers’ plans allow it).
The decision to convert from a standard 401K to a Roth 401K is similar to determining whether to convert from a traditional IRA to a Roth IRA. While there are numerous considerations, the primary advantage is that once it becomes a Roth, no additional taxes will be due. The downside is that taxes must be paid now at one’s ordinary income tax rate (and in most cases, the taxes should be paid from non-retirement accounts). The benefit of converting is due to the concept of “tax diversification” – owning some assets that are taxed now (e.g., Roth) and some assets that will be taxed in retirement (e.g., traditional IRA/401K).
For someone earlier in his/her career who might be at a lower 10%-15% income tax rate, a conversion could be a good strategy since rates are likely to be higher (or at least the same) in retirement. But for someone who is a high earner, the additional income from the conversion could trigger a higher marginal tax rate as well as a phaseout of deductions and exemptions. For these individuals, converting a large lump sum might not be optimal.
Due to the complexities, two sensible strategies could be to a) Contribute a portion of your 401K to a Roth. For example, if you contribute $10,000/year, consider $5,000 for the traditional 401K and $5,000 for the Roth 401K; or b) Instead of a full conversion, convert smaller amounts each year to minimize the tax ramifications in any single year.
As we’ve said before on this blog, it’s very hard to estimate tax rates 10 years from now, let alone 20 or 30+ years away. Before converting a large amount, talk to your accountant and financial advisor so they can help customize a solution for you.
I often read articles that talk about the virtues of long-term tax planning. This could be in the form Roth IRA conversions, charitable planning or gifting strategies. In general most of these articles are correct in their reasoning, but they tend to under-emphasize one important item: what may happen to the tax code over the period they are planning for. The idea for this post came after I have been reading both the President’s and Republican plan for altering the tax code. Let me start by saying that both proposals have little chance of passing, but for those of us planning for future taxes, it should give us pause when arguing for long-term planning. These proposals have significant changes to how income is taxed. Changes in tax rates, deductions or the different types of income being planned for can have massive impact on tax planning in the future. Those that believe we will be in the same brackets 20 or 30 years from now should revisit their history books. For example, here is a chart of the top tax rate from 1913 to 2008:
Let this be a reminder that the tax code has underwent massive changes over the years and the odds are that this volatility will continue. We have found the best tax planning can be done over short periods of time 1-5 years, where we have some more certainty around tax rates. In addition, “slam dunk” strategies tend to be situations when clients are in zero or very low brackets and are expected to earn higher income in the future (or vice versa). Those can be ideal times to plan for client’s taxes. The only thing I feel reasonable certain about is that we all will be paying taxes in the future, and those that have/earn more, will pay more. Other than that, it is hard to be certain about anything.
An article at the website “Think Advisor” today got my attention with a catchy headline, “Your Clients Will Pay for World’s Debt, Advisor Warns“. The article paints the picture of a world with higher tax rates due to the inability of developed countries to reign in their debt. The last couple sentences summed up the entire article well:
But the bottom line is that today’s developed world, budgetary imbalances imply higher taxation. “The debt is going to have to be paid for one way or another,” Hatchuel says.
In speaking with clients over the past few years, I would say this is the prevailing wisdom. In fact, we were probably in the same camp up until a couple years ago, but the evidence is no longer suggesting that this is the case. Government deficits are not only shrinking, but shrinking fast. This is due to the slight bump in taxes, the sequester, but most especially growth in the economy. I am not sure that the theme of this article should still continue to be taken as fact. Let’s take a look at the government deficit.
You’ll see that since the recession hit, the deficit has been contracting. The Congressional Budget Office is now saying that the deficit has shrunk another 20% over the first two months of fiscal 2014. Are we still spending more than we bring in? Yes, but the gap is closing fast and the debt as a percentage of GDP (a figure used by most economists) is expected to stay fairly stagnant over the coming years, and that is without any additional tax increases. Growth cures a whole lot of our ailments. If the US is able to continue its modest recovery over the comings months and years, there is a good chance that higher taxes may not be necessary to close our budget gap.
If you were to ask most investors what is the least risky investment you can purchase you probably wouldn’t be surprised to hear treasury bonds and gold as their answer. Treasury bonds are literally considered risk free assets as they are backed by the full faith and credit of the United States. Gold has historically been known as a great “store of value”. The thought goes that countries can devalue their currencies but gold will always hold its value through periods of extreme inflation or deflation.
So let’s say going into 2013 you were worried about the upcoming year. You’d probably have quite a few reasons to feel that way. Although it was a long time ago, you probably remember the “fiscal cliff” fiasco, strained government negotiations, higher tax rates, sequester spending cuts, and the upcoming rollout of Obamacare. In anticipation of these events you might have decided that this was a time to get “safer” with your portfolio, allocating a healthy dose of gold and treasury bonds to your portfolio mix. Let’s take a look at how you would have fared.
Treasury Bonds (as measured by the TLT ETF) is down around 12% this year. Gold is down 25% for the year. The point of this post is not meant to say these investments should not be in your portfolio (well, maybe not gold), but that trying to outsmart the market by re-positioning portfolios based on what direction you think the market is going is a dangerous game. The other lesson we have learned is that even perceived safe investments can lose money.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.