• Briefly Noted
  • Briefly Noted

    Deadline Approaching for Roth IRA Conversions

    A deadline for converting to a Roth IRA is quickly approaching. Investors have until the end of this month (December 2010) to defer taxes on a conversion.

    A Roth IRA is funded with aftertax dollars. In other words, you pay taxes on dollars contributed into a Roth IRA. Future withdrawals are then eligible to be made on a tax-free basis, regardless of how much the account balance has grown. Conversely, a traditional IRA is funded with pretax dollars and withdrawals are taxed. This means you are taxed on the amount of the withdrawal, which includes the original deposit and any realized gain on that deposit—a big difference.

    Previously, individuals were allowed to convert traditional IRA assets to a Roth IRA if their income was below $100,000 and if they paid taxes at the time of conversion. At the start of this year, the maximum limit on income was eliminated. Moreover, a one-year rule was instituted that allowed the taxes on the conversion to be paid over a two-year period. This rule is about to expire.

    Here is how it works: If you convert from a traditional IRA to a Roth IRA by December 31, 2010, you can either pay the taxes on the conversion this year or you can opt to pay half the balance due in 2011 and the other half in 2012. If you wait until January to convert, you will lose this option to defer the tax payments.

    Whether you should convert depends on what you believe your future tax rates will be and on your ability to pay taxes. The argument for converting to a Roth IRA is that you get to take advantage of current tax rates rather than risking higher tax rates in the future. The other consideration is whether you can pay the taxes with money from a non-retirement account. The rationale is that by doing so, you are not drawing on your retirement savings.

    For more information about whether or not to convert to a Roth IRA, read “New Rules for Converting to Roth IRA,” by William Reichenstein, in the January 2010 AAII Journal and “Retirement Plans: Evaluating the New Roth IRA Conversion Opportunity,” by Christine Fahlund, in the November 2009 AAII Journal.

    Sources: AAII Journal; The Altfest Advisory Letter, Altfest Personal Wealth Management.

    The Impact of Math Skills on Wealth

    A new study from the RAND Corporation says a couple’s math skills can have a dramatic impact on their wealth.

    The study’s authors found that “when both spouses answer [three numeracy-related] questions correctly, wealth is $1.7 million—when neither spouse answers any question correctly, household wealth is about $200,000.” Furthermore, there was a direct correlation between math skills and stock allocations. Couples with higher math skills had a greater proportion of their portfolios allocated to stocks.

    There were a few other notable findings from the survey. First, the math skills of the spouse heading the family’s financial matters had a direct impact. Secondly, wealth levels rose with both education and average family income. Finally, higher levels of education for either spouse increased the odds of that person being assigned the task of managing the finances.

    We cannot say that we are surprised by the data. Education and wealth are tied together, with higher education leading to more wealth and greater wealth providing more educational opportunities. Job security and advancement are both aided by strong cognitive skills, which in turn help to create wealth. The study also theorized that a person who scored well on the cognitive tests may find more in common with a mate who also scored well.

    The study did find that husbands were far more likely to be the financial decision maker than wives. Though there was a preference for the more educated spouse to handle the finances, the probability of the wife being in charge was only 50-50 when the husband scored a perfect zero on his numeracy test. (Sorry, ladies.)

    This last finding brings up an important point: Regardless of who is in charge of the finances, it is important that the other spouse is made aware of all decisions. This is not only a matter of fairness, but it is also critical to a family’s financial well-being that either spouse be able to manage affairs when necessary.

    Source: “Financial Decision Making and Cognition in a Family Context,” The Economic Journal, 120 (November 2010).

    How Correlated Are Preferred Stock With Bonds?

    Some AAII members have been taking closer look at preferred stocks. This is not surprising given record low yields on Treasury bonds.

    As John Deysher explained in the August 2010 issue of the AAII Journal (“Preferred Stocks: An Overlooked Alternative”), preferred stocks provide a stream of income and are senior to common stock, but they are subordinate to debt. He also stated that preferred stocks have interest rate risk, meaning their prices could fall if interest rates rise.

    But how correlated are preferred stocks to bonds, and for that matter, to common stock?

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    Sam Stovall, chief equity strategist at Standard & Poor’s, provided answers in a November 2010 research report. He looked at the performance of the S&P U.S. Preferred Stock Index, the S&P 500 and the Barclays U.S. Aggregate Bond Index, which includes both government debt and corporate bonds. He found that preferred stocks had a low correlation with bonds (0.16) and a higher, but somewhat modest, correlation with common stocks (0.51).

    To put these numbers in perspective, a correlation of 1.0 means two assets experience the same rate of change in their price. A correlation of –1.0 means prices move in the exact opposite direction. Lower correlations mean better diversification. Stovall’s findings show that preferred stocks have moved more in line with stocks than with bonds, though the price movements were not in lockstep.

    The data suggests that preferred stocks have provided diversification benefits to a portfolio that is otherwise invested in bonds and common stocks. Though this is a positive, it is important to note that Stovall also found that preferred stocks experienced a higher level of volatility than bonds or common stock, as is shown in the table below. Thus, though preferred stocks provided both diversification benefits and income, they are hardly immune from price fluctuations.

    Index  Compound
    Ann’l Grth
    Rate (%)
    Correlation With
    Stocks Bonds
    S&P 500 Index  3.8 15.9 NA 0.36
    S&P U.S. Preferred Stock Index  4.3 22.6 0.51 0.16
    Barclays U.S. Aggregate Bond Index 4.6 5.2 0.36 NA

    Source: Standard & Poor’s Global Equity Strategy: U.S. Sector Watch, November 8, 2010.

    From the Bookshelf

    A willingness to do research and analysis is a common theme of “The Warren Buffets Next Door” (John Wiley & Sons, 2011), along with an emphasis on a valuation. In this book, Forbes Media investing editor Matthew Schifrin profiles 10 individual investors who have shown they can handily beat the market.

    Though a willingness to ignore what stock is rising on a given day and seek out true bargains is not a new concept, one thing that distinguishes these 10 individuals (along with their returns) is their ability to take time-tested techniques and personalize them. For example, Kai Petainen incorporates some of Joseph Piotroski’s concepts, such as a low price-to-book ratio, into his investing strategy. Schifrin does a great job of explaining the key characteristics each investor looks for in a stock.

    Perhaps the biggest lesson from the book is that seeking out companies with strong business models and reasonable valuations will increase the odds of outperforming the market. This is a strategy that has consistently worked and should continue to work in the future.

    One AAII member asked us to take a look at “Bank on Yourself” (Vanguard Press, 2009) by Pamela Yellen. The member was suspicious that this book might be promoting a concept that is too good to be true. Sadly, we have to say his suspicions are correct.

    Yellen advocates taking out a life insurance policy and then borrowing against the cash value of that policy. Her strategy is to buy a policy from a non–direct recognition company, so that dividends will be credited to cash value regardless of whether a loan has been taken out. She believes this will allow investors to both get essentially free loans and have the value of their portfolios grow.

    However, Tony Steuer warns in “Questions and Answers on Life Insurance” (Life Insurance Sage Press, 2010) that a life insurance policy loan “is not truly a loan.” Rather, it is an advance that the insurer must eventually pay out. Worse yet, Steuer explains that policy loans can erode a life insurance policy over time. Finally, Steuer points out that there are potential tax liabilities.

    Borrowing against any asset carries risks, including a net devaluation of the asset if the loan is not paid. The prudent strategy is to treat your investments as means for achieving your financial goals. Loans, when necessary, should be taken out separately from your portfolio.


    Richard from CT posted over 5 years ago:

    Please see my commentary on my blog/web site regarding the recent article about the RAND study (correlation between math skills and wealth) at http://proactinvest.net/?p=1044

    It's a different take on the matter.


    Richard Wiegand

    founder ProActInvest.net

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