Things not to do ...

-Carl Richards, New York Times

The "Lost Decade of Investing" - Bah!

By now you’ve probably seen an article or heard a news story touting that the past 10 years (2000-2009) was a “lost decade” for stocks. As measured by the media, everyone lost money, and as proof they site the fact that the S&P 500 lost 9.1% from Jan. 1, 2000-Dec. 31, 2009. While this statistic is indeed true, it’s an isolated view.

The S&P 500 is an index composed of 500 of the most widely held (and typically largest) companies in the U.S. While 500 companies may sound like a lot and may seem well-diversified, it’s actually a narrow slice of the universe of companies available for our investment dollars.

At ICM, our portfolios consist of at least six asset classes – not just one (see note below). The portfolios that we are all invested in at ICM contain a piece of more than 10,000 companies. The very smallest companies up to the very largest conglomerates are included in our portfolios. These companies are located in over 40 countries around the globe.

Why maintain such a diversified portfolio? Because each year each asset class has a different return, and when these returns are blended together over a period of time, the effect of diversification tends to increase the portfolio return and decrease the portfolio risk. The chart below shows the total return for the past decade for some of the DFA mutual funds we use. You can see that whereas large company U.S. stocks were negative for the decade, many other asset classes were positive – and some substantially positive. We own many of these funds within our portfolios.

A Look Beyond the S&P 500 January 2000-December 2009
Source: Dimensional Fund Advisors. Performance data represents past performance and does not predict future performance.

Even though it has not been a lost decade for stocks in general, it has certainly been a gut-wrenching ride. The decade began with a bear market in which the S&P 500 was down ~ 49% (March 2000-October 2002) and then remarkably sustained a second bear market that saw the S&P 500 drop ~50% between October 2007 and February 2009.

Looking at it this way, given the severity of these two bear markets over the past decade, it is impressive that the S&P 500 ended the decade with only a 9.1% loss.

Although this was a “lost decade” for the S&P 500, it is exceedingly rare. Between January 1926 and December 2009, 95% of all possible rolling ten-year investment periods delivered positive returns for U.S. large company stocks. This past decade falls into the 5% that failed to produce gains.

We hope that this gives you a better understanding of how diversification has improved the performance and reduced the risk within your portfolio. So ignore the talking heads proclaiming that “this time it’s different.” Take a deep breath and remind yourself: diversification within a prudent portfolio does work, buy-and-hold is not dead, and the laws of gravity have not been suspended.

Note: There are numerous ways to segment the universe of stocks. For simplicity in this example, let’s call the six asset classes U.S. large and small companies, Developed International large and small companies, and Emerging Markets large and small companies. Most of our portfolios also contain bonds, which would be a separate asset class. As you may remember, our portfolios have a tilt toward value companies (versus growth companies) and small companies (versus large companies).

-Julie Schatz, CFP®, Jennifer Cray, CFP®, Rich Chambers, CFP®

Health Care Poetry

"Say," Speaker Pelosi exuded,
When her colleagues to sausage alluded,
"If this casing we're filling
Is best after grilling,
Who cares how the wurst was extruded?"

-Limericks Économiques

Seven Questions to Ask Your Tax Preparer at Tax Time

When you visit with your tax preparer to drop off your tax return documents, be sure to ask the following seven questions and share the answers with your financial planner:

1. Will I be subject to the alternative minimum tax (AMT) in 2010?
2. What will my marginal tax bracket be in 2010?
3. Can you help me estimate my income for 2010?
4. Do I have any remaining capital loss carryforwards for 2010?
5. If I were to do a Roth conversion in 2010, what would my tax liability be?
6. Do you have an recommendations for reducing my 2010 taxes? What about 2011 and beyond?
7. Is there anything my financial planner can do to help my tax situation?

Warren Buffett's Letter to Shareholders

A favorite portion:

“We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.”
-Warren Buffett

To read the whole letter:
http://www.berkshirehathaway.com/letters/2009ltr.pdf

Roth IRA Conversion Concepts

Roth IRA conversions will be much in the news this year. While Roth conversions have been allowed for years, starting in 2010, the income limitations are lifted, so everyone is eligible. We want to prepare you now so you will begin thinking whether or not a conversion could increase your after-tax net worth.

Many people know how Roth IRAs and regular (contributory or rollover) IRAs work. But if you want a refresher, let me know and I’ll send you an educational piece.

Why all the fuss? Because the growth of a Roth IRA isn’t taxed and this is about the closest thing to a freebie that the federal government offers to taxpayers.

The Roth conversion process:

• take money out of a regular IRA
• contribute the entire withdrawal to a Roth IRA
• from another source, pay income tax on the withdrawal

You are paying taxes now in order to obtain future tax-free growth.

Rather than go through a bunch of tedious explanations, we examine a number of scenarios.

Scenario 1: Conversion during a low tax year

Scenario 1, Example 1:
Bill (40) got laid off in January and took the rest of the year off. His income was $12,000 from interest and dividends and a bit of unemployment. His credits, deductions, and exemption add up to $44,000, so his taxable income is -$32,000. Bill has $32,000 in his IRA so he can convert all of it to a Roth with no additional tax owed. At age 90, the after-tax value of Bill’s Roth IRA will be about 43% larger ($284,700) than the unconverted IRA.

Scenario 1, Example 2:
Sarah (40) terminated a business and took an operating loss of $100,000. Her income was $70,000 from interest and earnings. Her credits, deductions, and exemption are $50,000. Similar to Bill, Sarah can convert $80,000 to a Roth for no tax cost and gain a similar 43% ($709,200) advantage at age 90. If Sarah were to convert another $34,000 (maxing out her 10% and 15% tax bracket and costing $4,681 for income tax), the advantage is about 38% for a total after-tax advantage of $920,700.

Scenario 1, Example 3:
Roger (40) has taxable income of $34,000. He wants to max out the 25% tax bracket this year and expects to be in the 25% bracket during retirement. Roger converts $48,400 costing $12,100 in additional income tax. At age 90, Roger’s advantage is 16% ($196,600). If Roger needs $5,000 annually for living expenses beginning at age 70, the advantage is 19% ($85,100).

Typical reasons for low tax years:

• Getting laid off
• Deductions and exemptions wipe out most or all of your income, such as:
• ....Large charitable contributions
• ....Large casualty losses
• ....Large medical expenses
• ....Large nursing home expenses
• Business and other ordinary losses
• Net operating loss carry-forwards
• Selling a rental property at a loss
• Non-refundable tax credits
• Note: Capital loss carry-forwards do NOT help much

The general rule is that you convert to a Roth in years when your marginal tax rate is lower or the same as the marginal rate expected at age 70 ½.

Scenario 2: Conversion for the benefit of your heirs

Scenario 2, Example:
Abby (40) is a very successful entrepreneur, and thanks to a wildly successful IPO, she has considerably more than she needs for the rest of her life. Understandably, Abby can leave a substantial estate to her 2 children ages 7 and 10. A Roth IRA is tax free for Abby’s lifetime and also for the children’s lifetimes. Therefore the Roth IRA is one of the best items to bequeath to your heirs. Abby’s IRA is $100,000 and she expects to be in the highest tax bracket for the remainder of her life. It costs $35,000 in tax to convert, but at 90, the after-tax value of Abby’s Roth IRA is about 22% larger ($531,700) than the unconverted IRA. If the heirs drawdown the inherited Roth IRA over 40 years, the additional advantage is about 47% ($12,809,600).

The general rule is that when all these are true …

• You expect to be in the highest tax bracket forever
• You do not need your IRA assets to live on
• Your estate is to benefit your children
• You can pay the conversion tax with other assets

… You should consider converting everything to a Roth IRA as soon as possible.

Scenario 3: Opportunistic conversion

Scenario 3, Example:
Angus (40) had a $500,000 IRA invested in a IPO stock that was clobbered in the recent bear market, so the IRA is only worth $100,000 now. Angus is completely confident that the company will survive and grow and that the IRA value will recover back to $500,000. Needless to say, we think Angus is nuts, but if he is right, it sure is a great time to convert to a Roth. Angus is in the 35% tax bracket this year but expects to be in the 25% bracket when he is 70 ½. Converting now costs $35,000 in tax, but at age 90, the Roth is about 8% larger ($214,000) than the unconverted IRA, and that is if the stock never recovers. If the stock recovers, and is replaced with diversified investments, the Roth IRA advantage is 34% ($3,528,000).

The general rule is if you think your IRA is temporarily at a low valuation, then it may be a good time to convert to a Roth even if your tax bracket is higher now than in retirement.

Scenario 4: Tax diversification conversion

Scenario 4, Example:
Matt (40) has a $100,000 IRA and he doesn’t believe anyone can forecast future tax rates, plus he cannot forecast his income before or after retirement. Since the tax rates are an unknown, Matt wants to consider having regular IRA and Roth IRA accounts . Matt can choose a low-income year for converting some of the IRA to a Roth, and in retirement he can withdraw from the IRA in low-income years and from the Roth in high-income years. Matt gains better control of his taxes since he has access to taxable income from the IRA and tax-free income from the Roth.

General Roth conversion rules:

• You never, ever want to show a negative taxable income on your tax return. A Roth IRA conversion can be used to get to zero income at no cost.
• Never withhold taxes on a Roth conversion (pay the taxes from external sources).
• If your marginal tax rate is 15% (federal), consider a Roth conversion to use up the entire 15% bracket.
• Roth IRA accounts are among the best possible assets to pass to your heirs. Convert more aggressively if you plan for your heirs to get most or all of your Roth IRA.
• Those expecting to be in the highest marginal tax bracket forever may benefit from an immediate conversion of the entire IRA balance.
• The longer you can compound the Roth IRA, the bigger the advantage of converting. And the longer your heirs hold onto the inherited Roth IRA, the bigger the tax advantage to them.
• Having both an IRA and a Roth IRA provides tax diversification. With both IRA and Roth IRA accounts, you can have better control over your marginal tax rate every year. Generally you want may want to take IRA distributions in low tax years and Roth distributions in high tax years. Having some IRA and Roth IRA assets can be very beneficial for managing for tax rates in retirement.
• When your IRA has a temporarily low valuation, consider converting to a Roth.
• You are not permitted to convert any of your RMD (required minimum distribution).
• In some select cases, estate taxes can be reduced thanks to a Roth conversion.
• If you convert in 2010, you have a choice about paying the resulting income tax. You can report all of the income (from the Roth conversion) in 2010 or report 50% of the income on your 2011 tax return and the other 50% on your 2012 tax return. Normally you want to delay paying taxes, but you must consider future increases in tax rates that make could make waiting more costly.
  

Some things that could occur that could make the Roth conversion less valuable or even worse than not converting:

• Income tax rates are reduced substantially or repealed and a national sales tax replaces the tax revenue.
• You plan to gift to charity all of your required minimum distributions from your IRA.
• You are unable to pay the income tax on the IRA distribution with other assets reducing the amount converted to the Roth IRA.
• The stock market drops precipitously after the Roth conversion. By waiting you could have converted for less tax cost.
• The income from the Roth conversion may cause your Medicare Part B premiums to increase significantly, at least temporarily.
• Many deductions and credits on your tax return are linked to your AGI (adjusted gross income). A Roth conversion will increase your AGI, which may adversely impact other (non-obvious) areas of your total tax. One example, if you are expecting financial aid for college, a Roth conversion can reduce the aid award.

All may not be lost however: If you convert to a Roth, you may recharacterize (move the money from the Roth IRA back to the IRA) some or all of the conversion reducing the taxes owed. There are strict time limits on when the recharacterization may occur.

As you can see, analyzing a Roth conversion is complex and involves multiple factors. Financial planners or tax professionals that perform tax planning are able to help you make wise decisions about Roth conversions.

Assumptions used in all the scenario examples:

• The conversion tax year is 2010.
• The marginal tax rate in retirement is 25%.
• Long-term capital gains rate is 15%.
• Any state income tax is not considered.
• Unless otherwise noted, no living expenses are taken from either the IRA or the Roth IRA. When needed, living expenses are after tax and are to be taken from the IRAs starting at age 70 and increase 3% annually.
• Return rate on IRA investments averages 7% consisting of 2% qualified dividends, 1% interest, non-qualified dividends, and short-term capital gains, and 4% long-term capital gains.
• Each year, 40% of that year's long-term gains are realized.
• No tax credits are affected by converting to the Roth
• All tax owed is paid in the year following the Roth conversion from other resources (not from the proceeds of the IRA distribution, therefore all the proceeds go into the Roth IRA).
• The advantage of the Roth conversion is measured compared to the after-tax value of the unconverted IRA.
• The advantages of a Roth conversion shown in the examples are computed using an ICM-developed worksheet, and while believed accurate, cannot be guaranteed.

© Copyright 2010, Investor's Capital Management, LLC

A Foggy Crystal Ball

"It's a good thing that financial planners and advisors aren't paid to predict the future because, well, nobody seems to be doing a very good job of it lately. I hope you'll remember this as all the major financial magazines come out with their yearly "Here's what will happen in 2010" cover stories.

Reading through some back issues, we find that at this time two years ago, nobody, anywhere, was predicting a fourth-quarter meltdown in the investment markets, or the global economy tottering on the edge of disaster. In fact, not a one of the prognosticators seems to have realized that the U.S. economy had already fallen into a recession. ..."

For the remainder of this interesting article by Bob Veres:
http://tinyurl.com/ybchke3