How to Pay Zero Taxes on Interest, Dividends, and Capital Gains

How would you like to pay zero taxes on your investment income, including interest, dividends, and capital gains? The only downside is that you have to live in a beautiful warm beach town, where the high is usually 82 degrees and the low in the winter is around 65.

If this sounds appealing to you, you should learn more about the unique tax laws of Puerto Rico. As a US territory, any US citizen can relocate to Puerto Rico, and if you make that your home, you will be subject to Puerto Rico taxes and may no longer have to pay US Federal Income Taxes. You can still collect your Social Security, use Medicare, and retain your US citizenship. (But not vote for President or be represented in Congress!) 

Citizens of Puerto Rico generally do not have to pay US Federal Income Taxes, unless they are a Federal Employee, or have earned income from the mainland US. This means that if you move to PR, your PR-sourced income would be subject to PR tax laws. In 2012, PR passed Act 22, to encourage Individual Investors to relocate to PR. Here are a few highlights:

  • Once you establish as a “bona fide resident”, you will pay zero percent tax on interest and dividends going forward.
  • You will pay zero percent on capital gains that accrue after you establish residency.
  • For capital gains that occurred before you move to PR, that portion of the gain would be taxed at 10%, (reduced to 5% after you have been in PR for 10 years). So if you had enormous long-term capital gains and were facing US taxes of 20% plus the 3.8% medicare surtax, you could move to PR and sell those items later this year and pay only 10% rather than 23.8%.
  • The application for Act 22 benefits costs $750 and if approved, the certificate has a filing fee of $5,000. The program sunsets after 2036. This program is to attract high net worth individuals to Puerto Rico, those who have hundreds of thousands or millions in investment income and gains. If your goal is to retire on $1,500 a month from Social Security, you aren’t going to need these tax breaks.

To establish yourself as a “bona fide resident”, you would need to spend a majority of each calendar year in Puerto Rico, meaning at least 183 days. The IRS is cracking down on fraudulent PR residency, so be prepared to document this and retain proof of travel. Additionally, PR now also requires you to purchase a home in PR and to open a local bank account to prove residency. (Don’t worry, PR banks are covered by FDIC insurance just like mainland banks). Details here on the Act 22 Requirements.

Note that Social Security and distributions from a Traditional IRA or Pension are considered ordinary income and subject to Puerto Rico personal income taxes, which reach a 33% maximum at an even lower level than US Federal Income tax rates. So, Act 22 is a huge incentive if you have a lot of investment income or unrealized capital gains, but otherwise, PR is not offering much tax incentives if your retirement income is ordinary income. 

If you are a business owner, however, and want to relocate your eligible business to Puerto Rico, there are also great tax breaks under Act 20. These include: a 4% corporate tax rate, 100% exemption for five years on property taxes, and then a 90% exemption after 5 years. If your business is a pass-through entity, like an LLC, you may be eligible to pay only 4% taxes on your earnings. If you are in the US, you could be paying as much as 37% income tax on your LLC earnings. Some requirements for Act 20 include being based in PR, opening a local bank account, and hiring local employees.

For self-employed people in a service industry, PR is creating (new for 2019) very low tax rates based on your gross income, of just 6% on the first $100,000, and a maximum of 20% on the income over $500,000. Click here for a chart of the PR personal tax rates and the new Service Tax.
A comparison of Act 20 and Act 22 Benefits are available at  Puerto Rico Business Link

When most people talk about tax havens, they would have to renounce their US citizenship (and pay 23.8% in capital gains to leave), or they’re thinking of an illegal scheme of trying hide assets offshore. If you have really large investment tax liabilities or have a business that you could locate anywhere, take a look at Puerto Rico. Besides the tax benefits, you’ve got great weather, year round golfing, US stores like Home Depot, Starbucks, and Walgreens, and direct daily flights to most US hubs, including DFW, Houston, Miami, Atlanta, New York, and other cities. 

Puerto Rico is still looking to rebuild after the hurricane and it’s probably not the best place to be a middle class worker, but for a wealthy retiree, it might be worth a look. Christopher Columbus arrived in Puerto Rico in 1493 and the cities have Spanish architecture from the seventeenth century. I’ve never been to Puerto Rico, but would love to visit sometime in 2019 or 2020. If you’d care to join me for a research trip, let me know!

(Please consult your tax expert for details and to discuss your eligibility. This article should not be construed as individual tax advice.)

A Bond Primer

We have been adding individual bonds and CDs across many accounts since December, as we looked to reduce our equity exposure and take advantage of higher yields now available in short-term, investment grade fixed income. When you are an owner of individual bonds, you are likely to encounter some terminology that may be new, even if you’ve been investing in bond funds for many years. Here are some important things to know:

Bonds are generally priced in $1,000 increments. One bond will mature at $1,000. However, instead of quoting bond prices in actual dollars, we basically use percentages. A bond priced at 100 (note, no dollar sign or percentage symbol is used) would cost $1,000. 100 is called its Par value. If you are buying newly issued bonds, they are generally issued at Par (100). This is called the Primary Market – where issuers directly sell their bonds to the public. We also buy bonds in the Secondary Market, which is where bond desks trade existing bonds between each other. 

In the Secondary Market, bond prices are set by market participants. A bond priced at 98.50 would cost $985, and would be said to be at a discount to Par. A bond priced at 102 would cost $1,020, called a premium. As interest rates rise, the value of existing (lower yielding bonds) will fall. There is an inverse relationship between price and interest rates – when one rises, the other falls.

Bonds have a set Maturity date. That is when the issuer will return the $1,000 they borrowed from the bondholder and cancel the debt. Some bonds are also Callable, which means that the issuer has the right to buy the bond back before its maturity date. This benefits the company, but not the bondholder, because when interest rates are low, companies can refinance their debt to a lower rate.

Most bonds pay interest semi-annually (twice a year). We call this the Coupon. A bond with a 4% coupon would pay $20 in interest, twice a year. If the bond is priced exactly at Par, then the coupon is the same as the effective yield. However, if the bond is priced differently, we are more interested in its Yield to Maturity, commonly listed as YTM. This is very helpful for comparing bonds with different coupons. 

Most bonds pay a fixed coupon, although some pay a step coupon, which rises over time, and others are floating, tied to an interest rate index, or inflation. When we purchase a bond between interest payments, the buyer will receive all of the next payment, so the buyer will also pay the seller Accrued Interest, which is the interest they have earned calculated to the day of sale.

For bonds which are callable, we also have the Yield to Call (YTC), which measures what your yield would be if the bond is called early. Generally, if we are buying a bond at a discount, Yield to Call is attractive. If we buy at 96 and they redeem at 100, that’s a good thing. But if we buy a bond at a premium, we need to carefully examine if or when it might be callable. Yield to Worst (YTW) will show the worst possible return, whether that is to maturity or to a specific call date. 

Some bonds do not pay a coupon and are called Zero Coupon Bonds. Instead, they are issued at a discount and grow to 100 at maturity. Treasury Bills are the most common type of zero coupon bonds. US Government Bonds include Treasury Bills (under one year), Treasury Notes (1 to 10 years), and Treasury Bonds (10 to 30 years). There also are Treasury Inflation Protected Securities (TIPS), which are tied to the Consumer Price Index, and Agency Bonds, which are issued by government sponsored entities, such as Fannie Mae or Freddie Mac.

In addition to Government Bonds, we also buy Corporate Bonds – those issued by public and private companies, Municipal Bonds issued by state and local governments, including school districts, and Certificates of Deposit (CDs) from Banks. 

Most Municipal Bonds are tax exempt, at the Federal and possibly at the state level. If you live in New York, any Municipal Bond would be tax-free at the Federal Level, but only NY bonds would be tax-free for NY state income tax. In states with no income tax, such as Texas, a tax-exempt bond from any state will be tax-free for Federal Income Tax purposes. 

To make their bonds more attractive, some municipal bonds are Insured, which means that if they were to default, a private insurance company would make investors whole. Those municipal insurers got in trouble in the previous financial crisis, and some are still weak today. My preferred insurer is Assured Guaranty (AGMC).

Please note that some Municipal Bonds are taxable; we sometimes buy these for retirement accounts. In addition to the types of bonds we’ve discussed, there are thousands of bonds issued outside of the US, in other currencies, but we do not purchase those bonds directly. 

There are several agencies that provide credit ratings to assess the financial strength of the issuer. Standard and Poor’s highest rating is AAA, followed by AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-. These are considered all Investment Grade. Below this level, from BB+ to C are below Investment Grade, often called High Yield or Junk Bonds. D means a bond has Defaulted. Moody’s ratings scale is slightly different: Aaa is the highest, followed by Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3 for Investment Grade. Junk Bonds include Ba(1,2,3), B(1,2,3), Caa(1,2,3), Ca, and C.

There are about 5,000 stocks issued in the US, but there are probably over a million individual bonds issued, each one identified by a unique CUSIP number. Every week, there are bonds which mature and new ones which are issued. 

Our approach for individual bonds is to buy only investment grade bonds, and ladder them from one to five years with diversified issuers. We also sometimes invest in other types of bonds, such as floating rate bonds, mortgage backed securities, emerging markets debt, or high yield. For those categories, we will use a fund or ETF because it’s more important to diversify very broadly with lower credit quality.  

Your Goals for 2019

Welcome to 2019! A new year brings a fresh chance to accomplish your goals. Maybe you’re dreaming that this will be the year you buy your first home. Maybe you’ve realized that your kids are one year closer to college and it’s time you start preparing. Maybe this is the year you want to exit from your current job so you can spend more time doing the things you love.

Even if your goals are further out than 2019, by December 31 of this year, you can either be several steps closer to achieving those goals, or you can sit right where you are today and risk that they will remain forever out of reach. Time stands still for no one. This is the only chance to do 2019 before it is gone forever.

Many of your goals have a financial component. Whether it is becoming a home owner, paying off your student loans, getting married, saving for a college education, planning for your retirement, or supporting your favorite charity, we can help you achieve your goals. The objective of our financial planning is not to own a bunch of stocks and bonds or get a nice tax break, it is about finding an effective, efficient, and logical way to help you accomplish your life’s goals.

We love when someone has a concrete, specific objective. When you truly embrace an important goal, there is ample reason to find the discipline for whatever steps are needed to achieve your objectives. I can tell you all about the benefits of a Roth IRA or a 529 College Savings Plan, but if that doesn’t fit into your needs, all my words are worthless. The “why” has to be there first, before we can get excited about “how” we are going to do it.

If you have goals that you want to accomplish in 2019 – or 2020 or 2029 – I’d like to invite you to join us and become a client of Good Life Wealth Management today. We serve smart investors who value personalized advice centered on their goals.

I’d welcome the opportunity to share our approach and allow you to consider whether it would be a good fit for you and your family. 

  • Our process focuses on planning first – we want to fully understand your goals and needs before we make any kind of recommendation. You would think this would be universal, but believe me, most of the financial industry has a product that they want to sell you before they have even met you. (Read our 13 Guiding Beliefs.)
  • We have no investment minimums. Younger professionals have financial goals and complex, competing objectives (hello, student loans!) even if they haven’t started investing or only have a small balance in a 401(k). We think helping young professionals build a strong financial foundation is important work. This is our Wealth Builder Program.
  • I’ve been a financial planner for 15 years and hold the Certified Financial Planner and Chartered Financial Analyst designations. Professional expertise and deep investment experience should be a given if you’re seeking financial advice. (More about Scott.)
  • Having your own plan means that you have taken an objective measure of where you are today, that we have created specific goals and objectives, and that we identify and implement steps to achieve those goals. While this is often savings and investment based, we’re going to evaluate your whole financial picture, from taxes and employee benefits to estate planning and life insurance. Bringing in a professional delivers accountability to a plan and protects you from what you don’t know you don’t know. (Financial Planning Services)
  • We are a Fiduciary, legally required to place client interests ahead of our own. Our fees are easy to understand and transparent. We aim to eliminate conflicts of interest wherever possible and if not possible, reduce and disclose. I invest in our Growth 70/30 model right along with our clients; if I thought there was a better way to invest, we would do that instead. (Skin in the Game)

Successful people – in any field – seek out the help and expertise of others. They surround themselves with knowledgeable professionals, not to abdicate responsibility, but to improve their understanding through asking the right questions. I became a financial planner to help others achieve their goals, and I love my job. For me, it is endlessly interesting and personally rewarding.

You could make a New Year’s resolution about your finances, but I genuinely believe you are more like to have a good outcome if you hire the right advisor who can help guide your journey. If you want 2019 to be the year when you turned your dreams into goals and a plan, then let’s talk about how we can work together.

Bonds for Safety in 2019

2018 saw rising interest rates, which hurt the prices of bonds. Most bond funds were flat to slightly down for the year. Rising interest rates also means higher yields, and we now see sufficient yields to justify buying short-term bonds. We have been reducing our equity exposure over the last few weeks, and have been using those proceeds to buy individual investment grade short-term bonds and Exchange Traded Funds (ETFs). 

I wanted to share a couple of themes which will guide our investment process for fixed income in the year ahead. In general, this is not a great time to be taking a lot of risk with your bond allocation. We want to use bonds to offset the risk of stocks to dampen overall portfolio volatility. Thankfully, bonds can now also make a positive contribution to your return albeit in a very modest 2-4% range, and with low or very low risk.

1. Credit doesn’t pay. A credit spread measures the difference in yield between a high quality bond, such as a US Treasury bond, versus say a bond issued by a company which has lower credit. That spread remains very tight today, meaning that you are not getting much additional yield for accepting the credit risk of a lower quality issuer.

This has led us to be selective about which corporate bonds we buy, only buying issues which have enough spread to justify their purchase. In today’s market, this primarily leads us to financial companies, especially the large banks, and to municipal bonds, including the rarely-discussed taxable municipal bonds which are a good choice for IRAs or other non-taxable accounts.

Both Treasury and US Government Agency bonds still have lower yields than CDs. This month, we bought some one-year CDs at 2.70% to 2.75% while the one-year Treasury was around 2.50%. That spread widens as we look to two and three year maturities.

I should explain that we offer “Brokerage CDs”, which are a little different than your typical bank CDs. Brokerage CDs are FDIC-insured against loss and we can shop for the best rates available, from both top banks like Wells Fargo or JP Morgan Chase and from smaller local banks who want to compete for the best yield. 

While you can typically redeem a bank CD early, albeit with an interest penalty of a few months, with a Brokerage CD, you would have to sell the CD in the bond market. If interest rates continue to rise, you would likely have to sell at less than full value. While these CDs offer the excellent rates, they are best used when you can hold to maturity.

We use CD rates as the basis of our spread comparison, rather than the traditional Treasury bonds. If we can’t find an improvement of at least 0.35% to 0.50% for an A-rated bond, then it’s not worth taking even the small risk over the CD. We will still use Treasury Bills for maturities of 6 months or less.

2. 5-year Ladder. In larger accounts, our goal is to create a ladder of bonds and CDs that mature over the following five years (2019, 2020, 2021, 2022, and 2023). This gives us a nice diversification of maturities while still maintaining a low overall duration. When the 2019 bonds mature, we purchase 2024 bonds to maintain a 5-year structure. In a rising rate environment, we are likely to be able buy new bonds at a higher rate. 

Besides being a sensible way to build a bond portfolio, a ladder also can be used to meet future needs for withdrawals or Required Minimum Distributions. Then instead of needing to sell equities or bond funds which could be down, we have a bond that is maturing to meet those cash needs. As a result, an investor might not need to touch their equities for the next five years. If or when their equities do grow, we can rebalance by selling stocks and buying new bonds at the top of the ladder.

While bond prices may go down if interest rates continue to rise in 2019, when you have an individual bond or CD, you know that it will mature at its full face value. So even if prices fluctuate, you will realize your stated Yield to Maturity when you do hold to maturity, which should be very possible with a 5-year ladder.

(Two notes: 1. While we can say that CDs and Treasury Bonds are guaranteed, other types of bonds do have some risk of default and cannot be described as guaranteed. 2. Investors who try to predict interest rates have as little success as investors who try to predict stock markets. We do not want to make bets on the direction of interest rates.)

3. Fixed Annuities. Annuities get a bad rap, but a Fixed Annuity is a third type of guaranteed fixed income investment. They deserve a closer look by investors as a bond substitute and work well with a 5-year laddered approach.

The current rate for a 5-year fixed annuity is 3.80% from one carrier I use. That compares to a 5-year CD at 3.35% to 3.60%. That’s not much of an improvement, however, the Fixed Annuity is an insurance product outside of our managed portfolio, so there are no investment management fees. Your net return is 3.80%. The insurance company will pay me a small commission directly, which does not impact your principal or your rate of return.

I think laddering fixed annuities can make sense for some, as a bond replacement, and more investors should learn about this before dismissing it as soon as they hear the word annuity. A 3.80% percent return on an annuity would be the equivalent of a 4.80% bond if you include a 1% annual management fee.

We wrote about doing a 5-year ladder of Fixed Annuities back in February 2016 in this blog, and I think it still makes sense for some investors. We would count this as part of your fixed income target for your overall portfolio allocation (60/40, etc.).

The stock market gets a lot of attention, but we don’t neglect fixed income in our portfolios. I do think there are benefits to managing your bond portfolio, and we spend as much time sweating the details of our fixed income selections as we do our stock market exposures.

Extend Your Car Warranty for Free

When it comes to saving money, there are two expenses which will make or break your budget: your home and your cars. If you keep those expenses below your means, you will have a surplus to save and invest. That’s how you generate wealth. 

Unexpected car repairs are the worst. You can spend thousands and it feels like you are just flushing your money away. That’s why we love car warranties: they help extinguish our fear of repair bills. For a lot of people, when their car warranty runs out, they want to get a new car because they can’t stand the thought of a catastrophic repair bill. 

But buying a new car every three or four years exposes you to the steepest part of the depreciation curve. Most cars will lose 50 to 60 percent of their value within five years. Owning new cars is trading the mere possibility of car repair bills, which might not happen, for the certainty of significant depreciation, which is inevitable.

Of course, car dealers would love to sell you an extended warranty. It’s one of their most profitable areas. That alone makes me think they are not worth it. You are spending $2,000 to buy a $1,000 warranty. And the insurer probably only pays out 50 to 80 cents in claims for every dollar in premiums it receives. It seems like you would be betting against yourself. 

I don’t usually endorse products or services here in my newsletter, but I came across a benefit which I think many of my readers might enjoy. It’s a way to provide protection against unexpected car repairs. This might allow you to keep your vehicles for longer and then direct more savings into your investment portfolios. (Selfishly, I will make more if my clients have larger investment portfolios, but hopefully that’s a goal we can both agree on!)

There is a company called BG Products which makes fluids for cars and trucks. They make motor oil (including synthetic), transmission fluid, brake fluid, anti-freeze/coolant, steering fluid, etc. BG offers a Lifetime Protection Plan that when you use their product regularly, if that component breaks down, they will reimburse you for the cost of the repair, up to a specific limit.

Best of all, they will cover your car, even if you don’t start using their fluids until 50,000 or 100,000 miles. That means that if you have a car with 80,000 miles, past the manufacturer’s warranty, you can actually add protection to your vehicle today. They offer double the protection if you start before 50,000 miles, so you might want to start sooner if you can. 

There is no limit on miles. As long as you continue to change the fluids within the specified number of miles, your car will be covered. You could keep your car for 300,000 miles and it would still be protected.

Here are the service intervals required for the Lifetime Protection Plan. If your manufacturer suggests more frequent changes, I would follow those instructions. To stay under this protection plan, you need to replace fluids before reaching these limits.

Engine Oil: 10,000 miles

Coolant: 30,000 miles

Transmission Fluid: 30,000 miles

Power Steering: 30,000 miles

Brake Fluid: 30,000 miles

The BG plan will reimburse repairs if these components break, but not for normal wear and tear. You would have to get the repairs done and then submit your receipts for reimbursement, which are subject to the following limits:

Plan 1, started before 50,000 miles: $4,000 coverage

Plan 2: started between 50,001 and 100,000 miles: $2,000 coverage

Full details of covered components HERE.

BG Products are not available in stores, you have to find a shop which uses them. Here in Dallas, I have used M2 Auto Repair, near Love Field. I’ve had a great experience there and can recommend them. If you talk to Eddie, the owner, please tell him I sent you.

If you’re not in the Dallas area, you can find a BG Dealer here. I have not filed a claim with BG, so I cannot vouch for that process, but obviously it is going to be very important to be able to document that you did have the services performed within the mileage limits and that the repairs required were on the specific parts covered by the protection plan. 

It doesn’t cover electronics, which is an increasingly large component in modern cars, but can give you some peace of mind over mechanical failures. If you’ve used BG and had a claim, please send me an email and tell me about your experience. 

I am aware that other fluid makers offer warranties, including Mobil 1Castrol, and Valvoline. In reviewing their warranty pages, they may offer similar benefits, but I think it may be more difficult to document proof of eligibility, and they don’t cover all of the systems that BG Products covers.

I’d also love to hear from you if you have ever filed a claim with another oil company and what result you received.  Regular maintenance is an important part of keeping your car healthy, and it’s great to see a company stand behind its products. I’m no expert on cars, but I have spent a lot of time looking at spending behavior. Any techniques which can help us spend less over the life of our vehicles will help you achieve your other financial goals. So, even if you don’t end up using the Lifetime Protection Plan, just knowing you were covered may provide you with the extra confidence to keep you car for 150,000 or 200,000 miles.

The Persistence Scorecard

As investors begin reviewing their year-end 2018 statements for their 401(k) and other accounts, I know many will want to change funds after a disappointing year. What do investors do? If they have 15 funds available in their plan, they will often sell out of their lagging fund and put money into whichever funds are performing best.

It seems rational enough to believe that a fund manager who is doing well might have above average skills, work harder, or have a better team than other fund managers. That’s why many investors switch funds – in the assumption that an excellent track record is evidence that strong performance will continue. 

You should care about your funds and their managers. But the reality is that switching funds for better performance is not a slam dunk. In December, Standard and Poor’s released their semi-annual Persistence Scorecard. I hope you will read this report. It may change how you invest, how you select funds, and the reasons why you would switch from one fund to another.

In the Scorecard, S&P analyzes returns of over 2,000 US mutual funds, to determine whether high performing funds continue to have strong performance. They evaluate funds by quartile, with data through September 30, 2018. The top 25% of funds would be called first quartile and the worst 25% of funds would be the fourth quartile.

When you buy a fund in the top quartile, what is the likelihood that it will stay a top performer? Let’s go back to September 2016 and track the 550 domestic equity funds that were in the top 25% for the preceding one-year period. Only 21.09% of the top quartile funds stayed in the top quartile in the next year, ending September 2017. And only 7.09% of the 2016 top quartile funds managed to stay in the top quartile for both 2017 and 2018. Of the funds in the top 25% in 2016, only one in thirteen would stay in the top quarter for the next two years.

When you buy this year’s top funds, it is very unlikely that those funds will continue to be the best performers in the subsequent years. Even though we have all heard that “past performance is no guarantee of future results”, everyone still wants to buy the 5-Star fund, even though all that rating tells us is the fund’s most recent performance!

Perhaps you knew better than to put much weight on one year performance. Still, wouldn’t a good manager be able to create a nice long-term track record? The Scorecard also looks at three and five-year returns.

Let’s consider the five-year data:

We will go back to September 2013 and track the 497 funds which were in the top quartile for five-year performance. How did they do over they following five years, through September 2018?

Only 27.16% would stay in the top quartile for another five years. 21.73% would fall to the second quartile, 20.32% would fall to the third quartile, and 21.13% would end up in the bottom quartile. Additionally, 9.46% of the top funds in 2013 would not even exist five years later. Fund companies merge or liquidate their worst performing funds to make their track records disappear. That’s right, when you go on Morningstar and look up funds, what you see is the result of Survivorship Bias. The record has been cleansed of the worst offenders and you only see the survivors. Thankfully, S&P keeps all data and includes deleted funds in its study.

To me this is another reason to use index funds rather than active managers. There is little evidence that when you pick a top performing manager that he or she will persist as a top performer. In fact, there is about only a one-in-four chance a top fund will remain in the top quartile. That’s pretty much a roll of the dice. Switching from one active manager who is underperforming to another active manager who was recently outperforming is very unlikely to be a successful strategy.

Instead of focusing on manager selection and risk chasing performance, we take a more structured approach:

1. Start with the overall asset allocation. Your weighting of stocks and bonds (60/40, 70/30, 50/50, etc.) is the largest determinant of your portfolio risk and return in the long run.

2. Determine how much you want in each category, such as US Large Cap, US Small Cap, US Value, International, Emerging Markets, etc. We base this on correlation, risk and return profiles, and diversification benefits. Then, we adjust the weightings towards categories which we feel are presently undervalued relative to the others.

3. Choose funds which closely reflect those categories. If you are buying a mid-cap fund, it should act like a mid-cap fund. 

4. Expenses matter. According to research from Morningstar: “the expense ratio is the most proven predictor of future fund returns.” We prefer funds with low expenses so you can keep more of the performance you are buying.

5. While we could use actively managed funds, we like the track record of index ETFs, along with their low cost, tax efficiency, and transparency. They are great building blocks for a portfolio.

Being diversified means owning a broad basket of holdings. This can be frustrating sometimes, wondering why you own A instead of B, when A is down this year and B is up. But putting all your money into whichever category or fund is doing best at any one point in time is not an effective strategy. That’s not just my opinion – look at the data from Standard and Poor’s Persistence Scorecard and I think you will reach the same conclusion. Bet on the market, not the manager.

Storm Clouds Gathering

Being an investor requires the humility to acknowledge that no one has a crystal ball and we cannot control the future. I find it best to ignore predictions and forecasts and to tune out day to day news, especially from “experts”. It’s just noise that distracts us from our process. There are always Bulls and Bears, so we run the risk of Confirmation Bias, embracing evidence that conforms to our beliefs and disregarding arguments that differ.

The current Bull Market is nine years old and there have been ample reasons for several years to think that we are in the late innings of this expansion. But anyone who has tried to time the market over the past decade has almost certainly hurt their returns rather than enhanced them.
Over the past two weeks, we’ve observed two significant economic signals which like the proverbial “canary in the coal mine” have been strong predictors of past Bear Markets. Because of their rarity and historical significance, I think investors should consider these signals with more weight than opinions, forecasts, or projections.

1. The crossover of the Equity Circuit Breaker. We’ve described this technical analysis previously, but here is a quick review: We look at the S&P 500 Index and calculate Moving Averages based on the previous closing prices of the past 60 and 120 days. That is each day, we look back at the previous 60 and 120 days. When the market is in an uptrend, the 60 day moving average stays above the 120 day average and both lines are sloping upwards. 

In a Bear Market, a prolonged downturn, the 60 day moving average is below the 120 day average and both are sloping down. The signal occurs when these two lines crossover; this reflects a potential change in regime from an up market to a down market. Because we are looking at longer averages – 60 and 120 days – this analysis usually tunes out brief market panics of a month or two. A crossover occurred this year at the end of November.  

This crossover was a good predictor in past Bear Markets; it would have gotten you out of stocks very early in the 2008 crash and back into stocks in the Fall of 2009. However, it can give false positives. Back in 2016, we also had a crossover occur for several months. That year, if you had traded on the crossovers, you would have gotten out at a loss and then had to buy back into stocks several percentage points higher.

2. Yield Curve Inversion. Typically, longer-dated bonds pay higher interest rates than shorter bonds. This week, however, we briefly saw the five-year Treasury Bond trade at a lower yield than the two-year Treasury, an inversion of the normal upwards slope of the yield curve. 

Why should you care? A Yield Curve Inversion has been a good predictor of previous recessions. This shows that investors are bidding up five-year bonds, preferring to tie up their money for longer, seeing a lack of short-term opportunities elsewhere. It also reflects a belief that interest rates may fall.

Past Yield Curve Inversions have occurred in 1978, 1988, 1998, 2000, 2005-2006. In each case, except for 1998, a recession took place within a year or two. So it does not have a 100% track record of accuracy either, but it is a rare enough of an event that I think it is worth our very careful consideration. The seven previous recessions all were preceded by a yield curve inversion.

Read More: from Bloomberg, “The US Yield Curve Just Inverted. That’s Huge.”

Over the past several years, when people asked me what it would take for me to become concerned about a Bear Market, I would have told them these two things: a crossover of the moving averages and a yield curve inversion. Both have been good (but not perfect) predictors of past Bear Markets and Recessions. And both have occurred since Thanksgiving this year.

The market may continue to go up in 2019, so I cannot assume anything with certainty. Still, I am concerned enough about these two signals that we are going to be slightly reducing our equity exposure and risk levels for our 2019 models. This is a temporary, tactical move and we will look to move back to our target equity weighting either when we feel that prices are significantly distressed, or after the moving averages have crossed back upwards. We are not going 100% to cash; at this point, we are considering reducing equities by 20%, pending further analysis this week.

We will be making necessary trades on a household by household basis before January 1, making sure we minimize any possible tax liabilities. We will look to harvest losses in taxable accounts and to try to avoid creating gains except in IRAs. 

While there’s no guarantee these trades will be profitable, I take these two signals seriously enough that I feel compelled to act and will be doing the same trades in my own portfolio. If we do have a prolonged Bear Market, we may wish to have sold even more. However, I want to balance that risk with the fact that these signals could be wrong this time. Perhaps the market continues up for another year or two before there is a recession and we miss out on significant further gains.  

Investors were not at all successful at timing the market back in 2007-2009, even though with the gift of hindsight, we might think it will be “easy” to see and act next time around. My goal remains to create effective, diversified portfolios that are logical, low cost, and tax-efficient. Making tactical adjustments to reduce risk and hopefully enhance returns is what clients expect from me, but we do not make these changes lightly. If you have questions about your portfolio, or want to talk in more detail about these signals, or the economy, I am always happy to have a conversation about what we can do for you.

Roth Conversions Under the New Tax Law

Everybody loves free stuff, and investing, we love the tax-free growth offered by a Roth IRA. 2018 may be a good year to convert part of your Traditional IRA to Roth IRA, using a Roth Conversion. In a Roth Conversion, you move money from your Traditional IRA to a Roth IRA by paying income taxes on this amount. After it’s in the Roth, it grows tax-free.

Why do this in 2018? The new tax cuts this year have a sunset and will expire after 2025. While I’d love for Washington to extend these tax cuts, with our annual deficits exploding and total debt growing at an unprecedented rate, it seems unavoidable that we will have to raise taxes in the future. I have no idea when this might happen, but as the law stands today, the new tax rates will go back up in 2026.

That gives us a window of 8 years to do Roth conversions at a lower tax rate. In 2018, you may have a number of funds which are down, such as Value, or International stocks, or Emerging Markets. Perhaps you want to keep those positions as part of your diversified portfolio in the hope that they will recover in the future.

Having a combination of both lower tax rates for 2018 and some positions being down, means that converting your shares of a mutual fund or ETF will cost less today than it might in the future. You do not have to convert your entire Traditional IRA, you can choose how much you want to move to your Roth.

Who is a good candidate for a Roth Conversion?

1. You have enough cash available to pay the taxes this year on the amount you want to convert. If you are in the 22% tax bracket and want to convert $15,000, that will cost you $3,300 in additional taxes. That’s painful, but it saves your from having to pay taxes later, when the account has perhaps grown to $30,000 or $45,000. Think of a conversion as the opportunity to pre-pay your taxes today rather than defer for later.

2. You will be in the same or higher tax bracket in retirement. Consider what income level you will have in retirement. If you are planning to work after age 70 1/2 or have a lot of passive income that will continue, it is entirely possible you will stay in the same tax bracket. If you are going to be in a lower tax bracket, you would probably be better off not doing the conversion and waiting to take withdrawals after you are retired.

3. You don’t want or need to take Required Minimum Distributions and/or you plan to leave your IRA to your kids who are in the same or higher tax bracket as you. In other words, if you don’t even need your IRA for retirement income, doing a Roth Conversion will allow this account will grow tax-free. There are no RMDs for a Roth IRA. A Roth passes tax-free to your heirs.

One exception: if you plan to leave your IRA to a charity, do NOT do a Roth Conversion. A charity would not pay any taxes on receiving your Traditional IRA, so you are wasting your money if you do a conversion and then leave the Roth to a charity.

The smartest way to do a Roth Conversion is to make sure you stay within your current tax bracket. If you are in the 24% bracket and have another $13,000 that you could earn without going into the next bracket, then make sure your conversion stays under this amount. That’s why we want to talk about conversions in 2018, so you can use the 8 year window of lower taxes to make smaller conversions.

2018 Marginal Tax Brackets (this is based on your taxable income, in other words, after your standard or itemized deductions.)

Single Married filing Jointly
10% $0-$9,525 $0-$19,050
12% $9,526-$38,700 $19,501-$77,400
22% $38,701-$82,500 $77,401-$165,000
24% $82,501-$157,500 $165,001-$315,000
32% $157,501-$200,000 $315,001-$400,000
35% $200,001-$500,000 $400,001-$600,000
37% $500,001 or more $600,001 or more

On top of these taxes, remember that there is an additional 3.8% Medicare Surtax on investment income over $200,000 single, or $250,000 married. While the conversion is treated as ordinary income, not investment income, a conversion could cause other investment income to become subject to the 3.8% tax if the conversion pushes your total income above the $200,000 or $250,000 thresholds.

You used to be able to undo a Roth Conversion if you changed your mind, or if the fund went down. This was called a Recharacterization. This is no longer allowed as of 2018 under the new tax law. Now, when you make a Roth Conversion, it is permanent. So make sure you do your homework first!

Thinking about a Conversion? Want to reduce your future taxes and give yourself a pool of tax-free funds? Let’s look at your anticipated tax liability under the new tax brackets and see what makes sense your your situation. Email or call for a free consultation.

Investing for Good

Four years ago, I wrote about Socially Responsible Investing (SRI) in this blog. SRI is investing in companies based on an assessment of their Environmental, Social, and Governance policies, or ESG. In 2014, SRI funds had just passed $100 Billion in assets and have since grown twenty-fold to over $2 Trillion globally.

At that time, I had reservations that SRI funds carried a number of pitfalls, including weak diversification, high expense ratios, and poor performance. I discussed one of the original SRI exchange traded funds, KLD, which in 2014 had an expense ratio of 0.50%.

Things have changed for the better. Today we have new SRI funds which are better diversified and have reduced tracking error versus a core Index-based ETF like we normally suggest. Expense ratios have fallen dramatically, with some SRI funds as low as 0.15% to 0.20%, which is much more competitive with traditional ETFs.

With these newer funds, I think we can now say that investing using SRI principles should have similar performance to our traditional portfolios. I don’t know that the performance will be any better, but I no longer am concerned that SRI will automatically condemn you to under-performing a non-SRI approach today.

For the first time, we have the tools to create a globally diversified portfolio of SRI funds which are low cost, transparent, and rules-based. What is lacking, however, is a long track record: of the 38 or so SRI ETFs available to US investors today, about half are less than two years old. This requires extra research and due diligence to understand what you are actually buying and how the fund might perform in different market environments.

For a lot of investors, we want to invest in companies which do good, and not the ones who pollute the environment, support dictators, sell tobacco, or treat their employees, customers, or shareholders with callous disregard. That’s the appeal of SRI; it aligns our money with our values.

When you invest in an index fund, you own all the stocks in a benchmark, including some which maybe you’d rather not own. With the proliferation of index investing, the largest shareholders of many companies are often Vanguard and Blackrock, the two largest index fund providers.

Although index funds vote on behalf of shareholders, they have largely voted in favor of management proposals. Indexers cannot sell their shares if a company is doing bad things. If it’s in the index, the fund has to own it. This weakens the role of shareholders as owners and beneficiaries of corporate decisions and the accountability of executives to shareholders.

I see a beneficial role for SRI investors within capitalism because they tell company executives and boards that they have to do better on ESG criteria or we will not invest in their company. To that extent, I believe we are already seeing improved corporate behavior thanks to SRI investors including ETFs, activist funds, and large pension plans such as CalPERS.

Are you interested in Socially Responsible Investing? Would you like to see what your portfolio might look like if we used SRI funds instead of traditional Index ETFs? We do not want to sacrifice performance, which is why we have been cautious about adopting SRI funds. But with better diversification and lower expense ratios, today’s SRI funds are significantly improved. Let’s talk about how we might implement SRI for you.

You CAN Invest in a Taxable Account

I spend a lot of time talking about retirement accounts, and for many Americans, the only stocks they will ever own are in their 401(k) and IRAs. I don’t know why, but many have never even considered investing outside of a retirement account, and a few have even thought it was not possible.

It is a GREAT idea to invest outside of your retirement accounts. Why? Because the contribution limits are so low for IRAs ($5,500) and 401(k) accounts ($18,500). There are a lot of people who put in that amount and then think they can’t do any more investing or that they don’t need to. There’s nothing magical about these amounts. No one is promised that if you save $5,500 a year into an IRA that you will have enough to retire (especially if you are getting a late start). And if you have ambitions to be wealthy, it may take you 30 or 40 years of 401(k) contributions to break the $1 million mark.

While we often talk about the tax benefits of retirement contributions, let’s actually run through the math of an IRA investment and making the same investment in a taxable account. The results may surprise you.

Let’s say you put in $5,000 to a Traditional IRA this year and also deposit $5,000 into a taxable account. In each account, you buy the same investment, such as a S&P 500 ETF, and hold it for 20 years until retirement. Assuming you get an 8% annualized return for those 20 years, in both accounts, your position would have grown to $23,304.79.

At the 20 year mark you withdraw both accounts. What taxes are due?

From the Traditional IRA, the entire withdrawal is treated as ordinary income. You may be in the 24% tax bracket, in which case you would owe $5,593.15 in taxes. That’s pretty painful and the reason why so many retirees hate taking money out of their IRAs and limit their withdrawals to their Required Minimum Distributions.

What about for the taxable account? You started with a $5,000 cost basis, so your taxable gain is $18,304.79. It is a long-term capital gain (more than one year), and will be taxed at the capital gains rate of 15%. Your tax due is $2,745.72. That’s less than half of the tax you’d pay on the withdrawal from the retirement account that you did for the “tax benefit”. Is that IRA a scam?

No, because you also got an upfront tax deduction for the IRA contribution. If you were in the 24% bracket, you would have saved $1,200 in taxes for making that $5,000 contribution. If you subtract the $1,200 in tax savings from $5,593, you still see that your net taxes paid was quite high: $4,393.

However, that is ignoring the time value of money and getting to save that $1,200 now. If you actually invest the $1,200 you saved that year, and have it grow at 8% for 20 years, guess what it grows to? $5593.15. (If you invested this in a retirement account, you will owe 24% in taxes on this gain, or another $1342.)

The key to coming out ahead with doing an IRA versus a taxable account is that you need to actually invest the tax savings you receive in year one. If you just consume that tax savings, instead of saving it, you actually might have been better off instead doing the taxable account where you could receive the lower capital gains rate.

The best solution is to maximize your retirement accounts AND save in a taxable account. If you want to become a millionaire in 10 years, save $5,466 a month. People have ambitious finish lines, but don’t set savings goals that are in line and realistic with their goals. The short-term activity has to match the long-term objectives. Once you are in retirement, it is a great benefit to have different types of accounts – IRAs, Roth, and taxable – to manage your tax liability.

My point is: Don’t be afraid of a taxable account. Retirement accounts are good, but mainly if you are going to save the upfront tax benefit you receive! Today’s ETFs are very tax efficient. While you will likely have dividend distributions of about two percent a year in a US equity ETF, when you reinvest those dividends, you are also increasing your cost basis. If you’re looking to invest in both a retirement and taxable account, let’s talk about how you can do this in the most effective way possible.