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Investing Blog Roundup: Employer Stock in Your 401(k)

No matter how confident you are in your employer’s prospects, it’s generally a bad idea to hold a significant portion of your portfolio in your employer’s stock, if you have a choice in the matter. As Ron Lieber reminds us this week, investing heavily in the stock of your employer puts you in a position where not only your income but also your savings are dependent upon the results of one company.

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Is a Roth Conversion a Good Idea?

A reader writes in, asking:

“Regarding Roth conversions, is it worth it to convert, putting yourself in pretty high tax brackets if you have a lot to convert? Second is it worthwhile to do some converting when the result would likely still leave you with heavy RMD’s and 85% of SS taxed, nullifying some of the better reasons to convert?”

In the simplest situation — in which a person has only tax-deferred and Roth accounts — it usually only makes sense to do a Roth conversion if your marginal tax rate on the conversion is lower than you expect your marginal tax rate to be at every point in the future. (Otherwise, you could wait until the point at which you do have the lower tax rate and do the conversion then.)

Even with this simple situation, however, there are three additional points to keep in mind.

First, at least in theory, this analysis should be done dollar-by-dollar, because converting isn’t an all-or-nothing question. For example, if you have $500,000 in a traditional IRA, it may make sense to convert some of it. But after you’ve already converted a certain amount this year, you reach a point where your marginal tax rate on additional conversions is higher (e.g., because you’re in a higher tax bracket or because you reach a point where additional income would reduce/eliminate your eligibility for a certain tax break), so the math changes for additional conversions.

Second, you must include any applicable penalty when figuring the marginal tax rate on the conversion. For example, if you have $100,000 in a traditional IRA and you move $85,000 to a Roth IRA and $15,000 to your checking account in order to use it to pay the tax on the conversion, that $15,000 would count as a distribution and could be subject to the 10% penalty if you’re under age 59.5.

Third, as we’ve discussed here on several occasions, your marginal tax rate is not necessarily the same as your tax bracket. (It’s super common, for instance, for retirees to have a higher marginal tax rate than the tax bracket they’re in, due to the way in which Social Security is taxed.)

What if You Have Taxable Accounts As Well?

With taxable accounts in the mix as well, the analysis becomes much more complicated. In short, having money in taxable accounts typically makes Roth conversions more appealing, because you can use that taxable account money to pay the tax on the conversion, rather than having to siphon off some of the IRA assets to pay the tax.

As a result, if you have non-retirement-account assets with which you could pay the tax, Roth conversions typically make sense even if you expect to have only the same marginal tax rate in the future as you have right now. In fact, they can even make sense in some cases in which you currently have a higher marginal tax rate than you expect to have in the future — because the advantage that comes from tax-sheltering more of your assets may outweigh the disadvantage of paying a (relatively) high tax rate on the conversion.

In cases in which your tax rate on the conversion would be higher than the marginal tax rate you expect to face in the future, some of the factors to consider when deciding whether to convert or not would include:

  • How much higher is your current marginal tax rate than the marginal tax rate you expect to face in the future? (The greater the difference, the more appealing it becomes to wait rather than do a conversion now.)
  • How long do you expect the assets be in the Roth account? That is, how long before you expect to spend the money? (The longer, the greater the savings from a conversion due to not having to pay tax on further growth.)
  • What rate of return would you expect for the assets in question? (The higher, the greater the savings from a conversion.)
  • Do you have sufficient cash on hand in taxable accounts to pay the tax (or, alternatively, assets in taxable accounts that have cost basis equal to or greater than their current market value)? If you would have to liquidate taxable holdings — and pay capital gains taxes in doing so — in order to raise cash to pay the tax on the conversion, that’s a point against the conversion.
  • How likely do you think it is that you’ll be leaving these assets to heirs? (In many cases, it’s actually tax-efficient to leave taxable assets to heirs, because the heirs would get a step-up in cost basis.)

As you can see, this isn’t a question to which you can calculate a definitive answer, because many of the factors are unknowable. As a result, you may find that it makes sense to take a middle-of-the-road sort of approach, in which you do relatively modest conversions each year (perhaps converting until you reach the top of your current tax bracket) and sometimes converting more in years in which your income (and therefore marginal tax rate) is lower or the market is down (thereby reducing the cost of a conversion).

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

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

Topics Covered in the Book:
  • The difference between deductions, exemptions, 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!"

Investing Blog Roundup: Rebalancing Isn’t Easy

Over the last few weeks, I’ve repeatedly received questions (and seen similar questions on the Bogleheads forum) about whether it’s worth ditching international stocks entirely, given their poor performance over the last several years relative to U.S. stocks. In short, my answer is that that’s the opposite of what most investors should be doing right now. For any investor following a buy/hold/rebalance investment strategy, now is the time to be rebalancing into international stocks.

By definition, rebalancing means beefing up your allocation to the asset class that has performed the worst recently, in order to bring your overall allocation back in line with the original plan. For many investors, that’s not easy.

This week, Christine Benz has tips on how to rebalance when you’re feeling chicken:

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Which Interest Rates Affect Bond Prices?

A reader writes in, asking:

“I understand that a bond’s price goes up when interest rates go down and vice versa. Do interest rates usually move together with all rates going up by roughly the same amount? And if not, which interest rate is it that determines bond prices? Federal funds rate? Treasury bond rates? Other??”

Firstly, interest rates do not move in lockstep. For example, if the yield on 1-year Treasuries goes up by 1%, you shouldn’t expect the yield on 10-year Treasuries to necessarily go up by the same amount. It might go up by more than 1%, it might go up by less than 1%, or it might not go up at all.

You can see this by looking at how yield curves change over time. For those who haven’t encountered yield curves before, they are charts that show the yields for bonds of various maturities. For example, the following chart shows the yield curve for Treasury bonds as of the beginning of this year.

YieldCurve

If interest rates rose and fell in lockstep, the yield curve for Treasury bonds would always have this exact same shape — it would simply shift up and down as rates move. But that’s not the case.

The following chart shows the Treasury yield curve as of the first day of business on each of the last 5 years. As you can see, the lines do not share exactly the same shape, because interest rates did not move in lockstep. As it turns out, over those five years, short-term rates moved around much less than longer-term rates.

YieldCurves

And the above chart only looks at Treasury yields. If we were to include yield curves for muni bonds or corporate bonds, we’d see even more diversity.

So Which Rates Affect Your Bonds’ Prices?

Imagine that you’re trying to sell your car. The price you’re going to be able to get for it will depend on what other sellers are charging for cars with the same characteristics (make, model, year, mileage, condition, etc.).

The same thing goes for bonds. If you want to sell a bond, it is the yield on other similar bonds that will determine the price that you’re able to get.

So, for example, if you own a Treasury bond with 5 years remaining until maturity, and interest rates on 5-year Treasuries rise, the market value of your bond will go down. (That is, in order to make your bond as attractive to a buyer as a new, higher-yielding 5-year Treasury would be, you would have to lower the price of your bond until it provides the same yield to the buyer as a new 5-year Treasury would.)

Or, if you hold a portfolio of highly-rated short-term muni bonds, the market value of your bonds will depend on what happens with interest rates for other highly-rated short-term muni bonds.

Investing Blog Roundup: Senate Tax Writers Want Your Input

I generally make a point to keep politics out of my writing, because I do not want to alienate anybody. (And I don’t intend to change that policy.) At the same time, many financial topics are important political issues. Kay Bell of Don’t Mess With Taxes has some information this week on how you can participate in the current tax reform discussion, if you’re interested.

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What Are the Advantages of Tax-Managed Balanced Funds?

A reader writes in, asking:

“Now that tax season is beginning to wind down, I was wondering if you might weigh in on the pros and cons of Tax-managed balanced funds and how they might serve a place in a retirement portfolio for a typical investor? I wasn’t able to understand a lot about the advantages of Vanguard’s VTMFX for example.”

If we compare the Vanguard Tax-Managed Balanced Fund to the Vanguard Balanced Index Fund, the tax-managed fund is supposed to be more tax-efficient for two reasons: it uses municipal bonds rather than taxable bonds and it skews the stock portfolio toward holdings with low dividend yields.

The first point potentially improves tax efficiency because muni bonds are exempt from federal income tax. However, it’s critical to remember that, depending on your marginal tax rate, muni bonds may not be the best choice. Muni bonds offer lower yields than taxable bonds with a similar level of risk, so it only makes sense to use muni bonds when the tax savings outweigh the lower yield. (Said differently, it only makes sense to hold muni bonds if they have a higher yield than the after-tax yield on taxable bonds of a similar risk level.)

Skewing the stock holdings toward low-dividend stocks potentially improves tax efficiency because, if a greater portion of a stock’s total return is made up of capital appreciation rather than dividends, the investor has a greater ability to defer taxation. (That is, dividends are taxed right away, whereas capital appreciation isn’t taxed until shares are sold.)

If, however, you’re in the 15% tax bracket or below, it’s possible that skewing toward low-dividend stocks actually reduces tax-efficiency. In that income range, both qualified dividends and long-term capital gains are taxed at a 0% rate. As a result, you’d prefer that a greater portion of the total return show up on your tax return now as tax-free dividends than show up later as long-term capital gains — because later you may not be in the range where LTCGs are tax-free, or tax law may have changed to eliminate the 0% rate.

When Does It Make Sense to Use a Tax-Managed Balanced Fund?

Personally, I would be reluctant to use an all-in-one fund (even a tax-managed one) in a taxable account. While a tax-managed balanced fund is likely to be more tax-efficient than a normal all-in-one fund, it is still going to be less tax-efficient than a DIY allocation, for two reasons.

First, it allows for fewer opportunities for tax-loss harvesting. With an all-in-one fund, you can only tax-loss harvest if the whole fund goes down. In contrast, with a DIY allocation, there will be many occasions on which the overall portfolio is up, yet there’s an opportunity to tax-loss harvest because one particular piece of the portfolio is down.

Second, an all-in-one fund (even a tax-managed one) gets in the way of an asset location strategy. (Under an asset location strategy, you tax-shelter your least tax-efficient assets by holding them in retirement accounts. And it is only your more tax-efficient assets that you hold in a taxable account — to the extent possible, anyway.) For many investors, rather than holding a tax-managed balanced fund, it makes sense to hold only taxable bonds (in order to get their higher yields) and simply keep them in retirement accounts — and hold only stocks (which are naturally tax-efficient, due to the low tax rates on qualified dividends and long-term capital gains) in taxable accounts.

That said, while I have a low tolerance for hassle, I’m sure there are investors who have an even lower tolerance for hassle. For them, a tax-managed balanced fund could make a lot of sense. In other words, if an investor wouldn’t be bothering to tax-loss harvest or pay attention to asset location in the first place, a tax-managed balanced fund might be just as tax-efficient as a DIY allocation.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

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

Topics Covered in the Book:
  • The difference between deductions, exemptions, 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!"
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