Roth IRAs have been around since 1998, yet most of our clients don’t have a Roth IRA. The reason is that the ability to contribute or convert traditional IRAs to Roth IRAs has been limited to taxpayers with relatively low Adjusted Gross Incomes (AGI).

Despite this limitation, you will be hearing more and more about the opportunity to convert traditional IRAs to Roth IRAs in 2010. The reason for this renewed interest is that the income phase-out to convert traditional IRAs to Roth IRAs, which used to be set at $100,000, will be eliminated in 2010. In addition, Congress has permitted the income recognition on these conversions in 2010 to be recognized in 2011 and 2012. Therefore, the financial press and Wall Street are cranking up their marketing machines to encourage investors to consider a Roth IRA conversion. But, just because you can convert to a Roth IRA does not mean you should.

As a refresher, the primary difference between Roth IRAs and traditional IRAs is that Roths are funded with after-tax contributions instead of pre-tax contributions. As a result, Roths have two big advantages over their traditional cousins:

1. Earnings on contributions grow tax-free in Roth IRAs vs. tax-deferred in traditional IRAs (tax-free treatment requires five-year holding period and attainment of age 59½).

2. Roth IRAs do not have the Required Minimum Distribution (RMD) at age 70½ provisions that traditional IRAs have. In other words, if you don’t need the money in your IRAs to live on and want to leave an income-tax-free Roth IRA to your heirs for gift and estate planning purposes, Roth IRAs make a great deal of sense.

So if Roth IRAs make so much sense, why would you not convert your traditional IRA to a Roth? That answer is that Roth IRA conversions require you to pay the tax now (or, with the new rules, in 2011 and 2012). And, since you don’t want to use money from the IRA to pay the tax (which would greatly diminish the size of your IRA and thus the amount of compounding your portfolio would be able to do), you would need to pay the tax out-of-pocket. For a large IRA, this can be a sizeable chunk of money. For example, converting a $500,000 traditional IRA to a Roth would result in a tax bill of around $205,000, depending on your state’s income tax rate.

Still, even though you have to pay current income tax on the amount you convert to a Roth IRA, it may make sense for some people. Here is a decision matrix for you:

The conversion rules do allow for a partial conversion which may allow you to capture some of the benefits of conversion without wiping out your cash reserves. In addition, some taxpayers may find themselves in low tax brackets due to the economic slowdown and a partial conversion may make sense to the extent you can pay tax on the conversion amount at lower rates.

Keep in mind that even the opportunity to delay and spread the income recognition to 2011 and 2012 may not be a benefit because the tax act that reduced the top marginal rate at 35% is set to expire at the end of 2010, after which the highest marginal rates will go up in 2011 and 2012. Thus, if a conversion makes sense, you may be better off paying the entire tax in 2010.

It is important to recognize that the primary reason for this rule change was to accelerate the collection of income taxes that might have otherwise been locked up in traditional IRAs for decades to come. Therefore, I don’t believe that we will see an enormous amount of people take advantage of the 2010 Roth conversion opportunity.

The bottom line is that if you don’t need the assets in your retirement accounts in your lifetime you should take a look at a Roth conversion. Otherwise, take a look at the matrix above and if you’re a “Likely Candidate,” or somewhere close, feel free to call me if you want to take a closer look at your unique set of facts and circumstances.

The notion of a “wealth manager” is relatively new in the financial services field. The term evolved to differentiate an advisor who primarily offers investment advice (the vast majority of advisors) from an advisor who is dedicated to helping clients achieve all of their financial goals through a consultative process.

To help us describe our concept of wealth management at Capital Directions we use a specific formula:

WM = IC + AP + RM

Wealth Management = Investment Counsel + Advanced Planning + Relationship Management

^{(Note: These components and the consultative process we use to implement wealth management are described more fully at www.capdir.com/individuals.php.)}

One thing this formula does not capture, however, is one of the most important roles for any wealth manager: managing client emotions.

The six-month period from mid-September 2008 to mid-March 2009 was an incredibly challenging time for investors to stay the course and stick with their long-term investment strategy. There were been numerous times where investors were tempted “to take a time out until things calm down.”

Industry data is now showing that many (if not most) investors blinked at the market bottom and cost themselves thousands if not millions of dollars. One industry data point that provides a glimpse into investor behavior is the net mutual fund cash flows compiled by the Investment Company Institute. The chart below shows weekly cash flows into and out of mutual funds and then overlays the value of $1 invested in the S&P 500.

Clearly, most mutual-fund investors panicked at the market bottom in March and fled the market in droves. By comparison, it is very interesting to contrast the cash flows of those retail funds with those of Dimensional Fund Advisors – the funds we use extensively to construct our portfolios at Capital Directions. DFA funds are only offered through approved advisors who adhere to a buy-and-hold philosophy, advocate diversification and focus on wealth management.

DFA recently provided me with the following chart that compares their cash flows to industry cash flows during the recent market turmoil, and the difference is striking:

Note the steady orange line at the top representing net cash flows to DFA (+$8 billion) compared with the net $272 billion that flowed out of the rest of the fund industry. DFA attributes this disparity to their advisors/wealth managers who were focused on keeping clients invested during the turmoil. This is illustrated in the next two charts which highlight quarterly cash flows in the retail fund industry (first chart) compared to DFA (second chart):

The differences are striking. While most investors were pulling assets out of domestic and international stock funds and locking in their losses, advisors who use DFA funds were keeping their clients invested and rebalancing their portfolios by trimming fixed income and adding to equity on the significant market dips we experienced in 2008-09. And that is what being a good wealth manager is all about.

The events of the past year were disconcerting to all of us. We’ve seen home prices plummet, the bankruptcy of major corporations, and the inability of business owners to access credit. The list goes on and on. In response to these historic events the federal government has undertaken an incredible amount of intervention in the economy, including forcing companies to merge, enacting unprecedented amounts of fiscal stimulus and even taking ownership in private companies.

In my conversations with clients, family and friends over the past few months I have heard a recurring theme about this: The belief that all of this government intervention has to bad for future stock returns. The argument goes that the United States’ economy is the world’s strongest because it was built on free-market principles, so therefore more government intervention has to mean our economy – and, hence, stock prices – will suffer.

The leap in the argument that gives me pause is that more government intervention HAS to be bad for stock prices. The reason for my pause is that history has often told a different story. The fact is there are numerous examples in the past when massive government interventions were followed by periods of strong gains in the stock market. And stock return data by country shows little correlation between the degree of government intervention and that country’s stock market performance.

Weston Wellington of Dimensional Fund Advisors provides an excellent history lesson on this in the three-minute video linked below. I hope that after watching this short video you will agree that, while government intervention is certainly a major factor in the economy, it is just one factor among many affecting stock returns.

http://www.dfaus.com/library/videos/governme/ 

As we develop wealth management plans for our clients we find that discovering their goals and creating a plan to maximize the probability that they achieve these goals is sometimes the easiest part. The more difficult part, particularly in volatile markets like 2008, is putting the plan into action, particularly when it involves putting cash into the market. Why? One word – EMOTION.

We’ve had success with several clients who struggle with the decision by introducing a process that creates discipline and minimizes emotion. The process typically includes buy triggers that occur as a broad market index drops OR upon time intervals should the broad market index stay flat or rise. The important part is not the index or the selected trigger points but that there is a disciplined process that removes emotion from the decision.

Interestingly, in the midst of the recent market volatility, one of my clients asked about the other side of this coin, so to speak. He wanted to know if we wouldn’t have been better off using “sell triggers” that would have kicked in at a certain point so that we could have gotten out of the market and protected our assets from the twin bear markets we have experienced in the past ten years; for example, selling when the Dow climbs into a range between 13,000 and 14,000, and then buying back in when the Dow is in a range between 7,000 and 8,000. In such a scenario, the investor would try to generate all of the returns needed to fund retirement from the interest earned sitting in cash and from the appreciation between 8,000 and 13,000 on the Dow.

To see the problem with such an approach, let’s take a look back at June 1982:

An investor at that time would have looked back over the past two decades and seen a trading range in the Dow that was clearly evident, as seen in the graph below:

The Dow had flirted with the 1,000 point threshold on five occasions over that 20-year period, only to fall back to the 600 point level on two occasions and under 800 several other times. This represented drops of 40% and 20% respectively. It would have been very compelling in 1982 to implement a strategy that took advantage of this trading range, jumping out of the market around Dow 1,000 and then buying back in around Dow 700. 

The only problem is that after November 23, 1982 the Dow never went under 1,000 again. 

Now the investor would have had to decide when to get back in the market. Even harder to stomach would be the idea of making your old “top” your new “bottom” and establish a new range between, say 1,000 and 2,000. 

Such a strategy would have been nerve-wracking and ineffective in light of the Dow’s run over the next 20 years (and keep in mind this is a price-return graph that doesn’t factor in the reinvestment of dividends, which is historically 40% of total return): 

When the investment objective is retirement and you have a 20+ year time horizon, equity investing makes all the historical sense in the world. The trade-off is that you've got to BE IN THE MARKET to earn those equity rates of return. Anything else requires adhering more to guesswork than to disciplined strategy, and that is no basis for investment management.