One thing that often gets ignored by financial media – perhaps intentionally because it makes for better ratings – is the very wide gap between Wall Street (stock returns) and Main Street (economic data).  These two things are not the same.  Not even close.  Next month’s employment report, retail sales data, or GDP report (if the Bureau of Economic Analysis ever reopens for the date to be calculated and reported) all look backwards.  It is usually several months into a recession before we know from the economic data that we’re in a recession.

The stock market, in contrast, discounts forward-looking expectations of corporate profits.  Consider these important words, working from right to left:

• Corporate Profits.  The stock market is not a measure of job creation, GDP, consumer spending, or economic growth.  The stock market reflects corporate profits – how much companies make less what they spend.  Adding further separation from the economy, the stock market does not reflect corporate profits for the trendy bakery on the corner, the massively popular technology start-up, or the local bowling alley.  Rather, the stock market represents corporate profits for a fraction of the economy – large, publicly traded companies.  And when the flawed and terribly outdated Dow Jones Industrial Average is the barometer of stocks, the stock market effectively represents corporate profits of just 10-15 domestic public companies.  This alone can obviously create huge disconnect between the stock market and the economy.
• Forward-Looking Expectations.  Again, economic data reflects the past.  The stock market reflects expectations about the future.  Past results and future expectations are obviously different things.  But many investors still fail to appreciate the difference.  Consider that you knew in advance, before anyone else, that Company XYZ will announce 110% profit growth versus last quarter when they report earnings.  This is clearly a strong measure of historic results.  But this information alone would arguably give you zero trading advantage from which to profit.  In order to benefit from this information, you would need to understand the expectations.  Is Company XYZ currently expected to grow at 200% for the next several quarters to where 110% would be disappointing and cause the stock to fall?  Stocks often win on bad news and lose on good news because it’s the expectations that matter.
• Discounts.  The stock market “discounts forward-looking expectations of corporate profits.”  The first word here – ‘discounts’ – may be the most important word because stock prices don’t just reflect forward-looking corporate profits of public companies.  Stock prices reflect these anticipated future profits discounted back at some interest rate.  And this “discount rate” is overwhelmingly important in the valuation of stock prices.  Changing the equity discount rate by just a small amount can have a huge impact on stock prices.  This means that no change in expected corporate profits is required to move stock prices.  Just a positive or negative change in investor sentiment – which sometimes swings as wildly as the mood of a pubescent teenager – will cause huge stock market movements.  If you’re looking for an explanation as to how the S&P 500 Index can lose -9.5%, gain +9.3%, and then lose -12.0% on consecutive days in March 2020, this is a big part of that explanation.   

Snowfall in Finland is above average this winter so I don’t know why the Knicks keep losing

It should be clear by now that there is a rational disconnect in statements such as, “Economic data this month has been really strong so I can’t figure out why stocks are declining.”  One might similarly surmise, “Snowfall in Finland is above average this winter so I don’t know why the Knicks keep losing.”

But perhaps you are not convinced of the large divide between economic forecasts and stock returns and still seek someone who can make successful economic forecasts to profit off those forecasts.  Let’s assume for a moment that you find a financial advisor who can project the economic future better than nearly everyone else in the history of economic forecasting – far better that the smartest and most successful professionals.  While the best investors and forecasters in the world tend to be correct in their economic forecasts roughly 55% of the time, we will assume that is child’s play for your advisor.  He or she trades on economic surprises with an astounding 75% success rate, almost certainly making your advisor the best economic forecaster of all time.

How much of a fee should this financial advisor charge for this historically unprecedented forecasting prowess?  Fees approaching 20% per year like the most successful hedge fund investor of all time?  According to a recent whitepaper, your omniscient advisor may be of no added value.  The paper, which uses historical economic data and stock market returns from 1992 – 2018, indicates that predicting economic surprises with a 75% success rate and then trading on them would have produced returns similar to that of a buy-and-hold investor who did absolutely nothing other than rebalance.  From the paper’s concluding paragraphs:

“Do short-term surprises hint at long-term risk-reward dynamics that can inform strategic asset allocation decisions?  In a word: no.  Surprises don’t matter for long-term returns…Our analysis of the relationship between economic surprises and asset returns yields two insights: First, the odds of successfully trading on surprises are low.  Second, what can seem consequential in the short run is irrelevant to the long-term investor.”

What should you be doing now

Like many fee-only financial advisors, we create an investment policy statement (IPS) for every client and occasionally update this IPS, as warranted by changes in a client’s life.  The investment policy statement is intended to guide the investment actions of both us and our clients. 

Not a single IPS describes a plan to raise cash when political uncertainty causes nervousness and then stay in cash until we feel better about the political climate.  Not one suggests that we shift the investment risk level based on what the “trusted” or “expert” prognosticators are saying.  There is nothing about changing the asset allocation based on what a neighbor, work colleague, college roommate, or Uber driver are doing with their own portfolios.

An IPS describes how the portfolio will remain prudently diversified across asset classes, styles, and risks in an attempt to reduce overall volatility.  It lays out a targeted risk level that is individually designed based on things like risk appetite, financial objectives, time horizon, and anticipated cash flow needs.  The IPS uses the important term of ‘discipline’ to describe the investment approach.  

On this note, Fidelity Investments published a study in 2017 of more than 6.5 million workplace retirement plan and IRA account holders.  The report titled “Ten Years Later” compared the investment returns of investors who sold all their stocks in 2008 to those who stayed invested.  Investors who maintained an allocation to stocks during the bear market saw their retirement account balances grow by 240% from pre-crisis levels at the beginning of 2008 to the end of 2017.  Those investors who moved to cash at some point during the market decline of 2008-2009, even if only for a few days, experienced gains of just 157% during the same time 10-year period.  The study highlighted a similar result when comparing those who stopped contributing to their retirement accounts during the bear market versus those who continued contributing despite market losses. 

The market will fluctuate

In hindsight, it is easy to speak about the benefits of maintaining a discipline during unsettling periods.  Losing hard-earned money in the stock market is not fun.  It is scary. Many investors understand the benefits of long-term discipline but the evidence suggests that few practice it.  

In a world of instant gratification, maintaining a discipline is difficult.  But the empirical evidence overwhelmingly falls on the side of maintaining a discipline over tactical trading based on news, speculation, or emotion if the objective is to achieve long-term financial success.  Subsequently, this is precisely why we believe that one of the most important things we can do to help our clients achieve their financial goals is to establish a portfolio that is allocated according to objectives and personal risk appetite and then to adhere to that discipline. 

When asked, nearly a century ago, whether he thought the stock market would go higher or lower, investor J.P. Morgan is famously said to have responded, “The market will fluctuate.”

The stock market will continue to fluctuate.  Up and down.  And employing an appropriately allocated, disciplined plan is the best way we know to achieve financial success through those inevitable ups and downs.

The history books will show no Wimbledon champion in 2020, no Boston Marathon winner, no Final Four participants, and no 2020 Summer Olympic medalists. Just a lot of asterisks. A graph of crude oil prices will show a point in April 2020 when the price fell below zero. 2020 college transcripts – in many cases – won’t have traditional letter grades – just a P or an F for pass or fail. Economic charts – like those for weekly unemployment claims – have been forced to dramatically expand the y-axis to incorporate the data plots for 2020. 

You are likely tired of hearing about the unprecedented events and incredulous aberrations of 2020. With this in mind, we apologize in advance for the following (and for the preceding). Given all that has transpired this year, it is entirely understandable that one of the most examined, discussed, and debated stories within the institutional investment world in 2020 has gone largely unnoticed by most retail investors. While the election, the economic recession, Covid-19, and the stock market volatility continue to garner the attention of mass media, it is the historically unprecedented disconnect between value and growth stocks that earns attention and debate deep within investment circles in 2020.

This is a good time to pause and explain:

1. What is meant by “value stocks” and “growth stocks”;
2. How unprecedented the value-growth disconnect is;
3. What has caused the disconnect; and
4. What specifically this means going forward.

What Is Meant by “Value Stocks” and “Growth Stocks”? 

I recently explained one of the most fundamentally misunderstood investing concepts to my kids: that when evaluating the cheapness or expensiveness of a stock, the stock’s price – in isolation – is literally of zero value. Zilch. I went on to explain how a stock priced at $3,000/share might be dramatically cheaper than a different stock priced at $1/share to engrain this concept.

When we own a share of stock, we own a percentage of the underlying company’s assets, future revenues, cash flows, etc. And when we evaluate whether a stock is cheap or expensive, we should compare the price per share to the cash flow per share, the earnings per share, the book value per share, the revenues per share, or some other fundamental measure.  

Furthermore, when we evaluate stocks using a ratio where price is the numerator and one of these fundamental measures like earnings is the denominator (such as price / earnings), value stocks are those that trade at a below average ratio. Conversely, growth stocks – which is just a pleasant way of saying expensive stocks – are the stocks that trade at an above average ratio.

Value stocks are companies such as Colgate-Palmolive, Campbell Soup, and Hanesbrands that sell boring, low-growth, low margin products like dish soap, toothpaste, chicken noodle soup, and underwear. Value stocks often have significant issues within their business that makes them cheap. Conversely, growth stocks are companies such as Apple, Amazon, Google, and Tesla. They tend to have an exciting narrative and trendy products.  

Most investors get far more excited about the second group of stocks than the first. This is a big part of why the story plays out as it does. Value investing owes some of its success to the lottery preference of human brains – an inherent behavioral desire we have to prefer long-shots at the racetrack or an exciting technology company with the small potential of a 20x return. Investors, as a result, pay more than they should for trendy growth stories or 100-1 race horses which, conversely, drives down their expected return.  

You may also be familiar with the concept of recency bias – the behavioral tendency of humans to extrapolate the recent past into the future. Recency bias in investing is a real thing and results in investors overestimating the persistence of high growth or high profitability. The historic reality is that growth and profitability are not very persistent because competition in a capitalist society erodes any profitability or growth advantage over time. Conversely, investors underestimate the ability of companies with depressed profitability to exceed the depressed expectations in the future. As a result, growth stocks often fail to live up to the implied expectations (which means they tend to be overpriced) and value stocks often tend to exceed the lowball expectations (which means they tend to be underpriced).

The Historic Disconnect Between Value and Growth Stocks

We just described some of the explanations for why value stocks should outperform their more expensive counterparts but does the historical data support these theories? Nearly a century of market data reflects the following: Investing in value stocks tends to result in a performance advantage of several percent per year relative to investing in growth stocks. Between 1927-2019, value stocks outperformed growth stocks by a calendar year average of 4.4%¹. The historical evidence is persistent (value works across long periods of time), pervasive (value works across sectors, countries, regions), and robust (value works across different measures such as price/book, price/earnings, etc.).

The economic advantage of value investing over time should be clear from the charts above. While not a free lunch that “wins” every day or every year, value investing has rewarded long-term investors with a very sizeable economic advantage. The value premium is not something that just exists in the US. It has been persistent and robust around the globe².

Yet over the first eight months of 2020, value stocks underperformed growth stocks by the largest calendar year margin ever (39.0%)³. The previous worst underperformance of value stocks came during the heart of the tech boom when growth stocks beat value stocks by 24% in 1999. The growth-value performance gap in 2020 runs circles around even the dot.com boom. It has not just been a 2020 phenomenon. Growth stocks have outperformed value stocks over the past decade by the widest margin ever: 8.8% per year as of August 31, 2020.

What Has Caused the Value – Growth Disconnect

The historic departure of the value premium have investors and academics asking the hugely important question: Is value investing broken?

Much has been written and said to address this question. If we are being intellectually honest, then we have to occasionally retest our hypotheses and question our assumptions in all facets of investing. And so we must assess whether value investing should have the same success in the future as it has in the past.

There are several rational theories that seek to explain the recent demise of value investing and for sake of brevity, here is a summarized narrative of each:

• Overcrowding Hypothesis: The return premium of value investing is well documented and popularized such that value investing has become overcrowded, thereby eliminating any premium in the future. The problem with this hypothesis is that value stocks have become significantly cheaper relative to growth stocks and the valuation spread has expanded. Were value investing to become overcrowded, we would have expected the valuation spread to have declined.
• Low Interest Rates Hypothesis: The perceived attractiveness of growth stocks tends to rely heavily or entirely on future cash flows (think of companies like Tesla, Snapchat, or Uber that are losing money now but anticipation of high profits in the future). These future profits have to be discounted to arrive at a present value. When interest rates decline – as they have for the past decade – the lower discount rate (or opportunity cost) results in a higher present value for those future cash flows. This hypothesis isn’t necessarily an argument that value is dead or broken – just that the declining rate environment of the past decade has favored growth stocks. If true, then any increase in interest rates in the future would be favorable for value stocks and unfavorable for growth stocks. And while this may provide a compelling explanation for the recent trend, the empirical data does not support this hypothesis.
• Conservative Accounting Hypothesis: The growing importance of intangible assets (think intellectual capital or successful clinical trials) that are not reflected on financial statements makes many growth stocks look artificially expensive and diminishes the benefit of valuation measures. While a valid criticism for some valuation measures (like price / book value), there are plenty of valuation measures that correct for or ignore these conservative account discrepancies. Using measures that define value and growth stocks without regard for intangible assets does not change the historically robust success of value investing.  

None of the popular hypotheses to explain the divide between value and growth performance really holds up when the underlying data is tested. Furthermore, the underlying data does not demonstrate that growth companies are any more profitable or that value companies are any less profitable. In fact, the profitability of growth stocks relative to value stocks has actually declined by 1% over the past 12 years. In isolation, this should have caused value stocks to outperform growth stocks during that stretch.

So, if value investing is not broken, what then explains the dramatic performance gap? In our view, Occam’s razor does. The simplest explanation appears to be the one that best explains the value-growth spread.

Specifically, the performance spread between value and growth seems driven simply by value stocks getting cheaper and growth stocks getting more expensive. Borrowing a line from fund investor Cliff Asness, “Investors are simply paying way more than usual for the stocks they love versus the ones they hate.” The charts below reflect the historically expensive valuations of growth stocks or – said differently – the historical cheapness of value stocks. The top chart shows that growth stocks in the United States are 6.0 standard deviations above their historic average valuation as compared to value stocks⁴. The bottom of the two charts shows the same historic expensiveness of growth stocks relative to value stocks outside the United States.

What This all Means for the Future

While it is not unprecedented for growth stocks to beat value stocks over extended time periods, the duration and magnitude of this growth outperformance is unprecedented on many counts. What’s more important than this historical data is where we stand today and what it all means going forward.

Depending on what metric we use to measure the valuation of value stocks relative to growth stocks, value stocks are trading somewhere between really cheap and their cheapest level ever. While these relative valuation measures are not useful as short-term trading indicators (because really cheap stocks can get even cheaper and really expensive stocks can get even more expensive), they are helpful as long-term allocation tools.

In the book Expectations Investing, revered investor, professor, and author Michael Mauboussin provided a succinct and powerful explanation for why value investing works:

Having been on the sell side for many years and then on the buy side, I can say categorically that the single greatest error I have observed among investment professionals is the failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the company’s stock price. If the fundamentals are good, investors want to buy the stock. If the fundamentals are bad, investors want to sell the stock. They do not, however, fully consider the expectations built into the price of the stock.

There is this perception among retail investors that if you buy great companies, you will do well as an investor. Nearly a century of data debunks this myth and yet – to Mauboussin’s point – investors continue to buy into it. To be clear: it is not about how great the company is. It has always been about how much you pay. It is about what expectations are built into the price.

In our view, the evidence suggests that investors are increasingly ignoring the expectations built into stock prices – overpaying for great companies and underpaying for the less great companies. We are not alone in suggesting that this is perhaps the single most important trend in the stock market. While there is no time table for how long the trend may continue, an eventual reversion seems likely. And if it is anything like reversions of the past, value investors are positioned to be handsomely rewarded.

Records show that organ donation elections vary dramatically from country to country. Consider two countries that neighbor Germany: Austria and Belgium. 99.9% of Austrian citizens and 98% of Belgian citizens are registered organ donors. In Germany, only 12% of citizens are organ donors.  It turns out that these dramatic differences are the result of opt-in or opt-out choices. In Austria and Belgium, citizens have to check a box to opt-out of the organ donation program. In Germany, citizens have to opt-in to the program. Rather than make a decision or change, people tend to take the path of least resistance.      

Insurance companies are not naïve to the tendencies of consumers. Get consumers to sign up for a plan and then change the terms, deductibles, price, etc. in future years knowing that consumers are unlikely to change to a competing plan. As a result of these consumer tendencies, the Medicare insurance providers are economically motivated to create low cost plans that attract consumers over a 1-2 year stretch and then flip the economics upside down in favor of the insurance company, knowing the consumer propensity is to renew again next year.

It may be natural to think that since you’re not taking any additional medications and you have not changed doctors, that you can likewise put Medicare on auto-pilot during open enrollment. This, in fact, tends to be a costly decision for nearly 9 out of 10 individuals.

With the annual Medicare open enrollment period (October 15 – December 7) nearly upon us, we thought it would be useful to highlight five common and expensive mistakes of Medicare open enrollment season. The biggest mistakes tend to be relying on auto-pilot but there are other important mistakes that consumers make each year during open enrollment. If you are on Medicare, you would be well served to assess whether any of these mistakes apply to your situation and to seek guidance if you are unsure before the open enrollment period is over.

1) You automatically renew last year’s Medicare Part D Prescription Drug plan without reviewing other options. 

Prescription drug plans can and do change dramatically from year-to-year. Yet research estimates that 87% of Medicare participants enroll in the same prescription drug plan as the prior year. Consider some of the most common Medicare Part D plan changes from one year to the next:

• Significant premium increases;
• New deductible hurdles before covering your medication;
• Changes to the preferred pharmacies; or
• Increased share of costs consumers must cover for drugs.

The discouraging reality is that only 13% of Medicare D participants change plans from one year to the next but 88% of participants have a better plan available to them with the savings ranging from $276 to $562 per year. This means that most Medicare participants are throwing away several hundred dollars per year by ignoring the opportunity to re-evaluate coverage.

The remedy for Medicare participants is simple. If you are enrolled in a Medicare Part D prescription drug plan, you should, without fail, visit the Medicare Plan Finder every year during the open enrollment period or have someone (a relative or health insurance agent) do it on your behalf. The Plan Finder makes it easy to enter your current medications, dosages, and preferred pharmacy and then to compare the costs of all plan options in your area. Its interface is user-friendly and the outputs provide a convenient way to compare options. Even if you have not changed medications or you are not taking prescription medications, the best plan for you last year may be far more costly than the best Medicare D plan this year.

One note of caution when comparing plans is to ignore the “Annual Drug Deductible” as this is a misleading data point (the deductible may not apply to all prescription drugs and ignores the copay). Instead, use the “Estimate of What YOU Will Pay for Drug Plan Premiums and Drug Costs” to determine the lowest cost option that is personalized to your unique situation.

2) You purchase the same Medicare D Prescription Drug Plan as your spouse.

You have been trained through life to buy insurance together with your spouse on a single policy through the same carrier to reduce costs and minimize complexity.  This is generally not an ideal strategy when it comes to Medicare D Prescription Drug plans. If neither you nor your spouse are taking any prescription medications, then it may be appropriate to be on the same low cost plan. Otherwise, both of you should independently go through the annual review process during open enrollment season to determine the best plan for each of you. There are no benefits to enrolling in the same plan since there are no Medicare Part D family discounts and you will be billed separately (usually deducted from your respective Social Security payments).

3) You fail to use the mail order option or enter your pharmacy(ies) of choice when using the Medicare Plan Finder to search Prescription Drug plans.

It is not uncommon for there to be significant price differences – hundreds of dollars per year – for prescription drugs, depending on where you get your medications. The Plan Finder makes it simple to evaluate the costs for mail order or for nearby pharmacies. In real-life examples, plans that have the same drug coverage can differ in price by over $1,000 for the calendar year, depending on the pharmacy where medications are purchased. 

4) You leave your Medicare Advantage plan on autopilot.

If you are enrolled in a Medicare Advantage plan, you are allowed to switch to a different Advantage plan during open enrollment each year without underwriting. As with the Medicare Prescription Drug plan, anyone enrolled in a Medicare Advantage plan should compare options each year during this open enrollment period. You can again use the same helpful Medicare Plan Finder to compare Medicare Advantage options in your area. It is valuable to compare premiums and out-of-pocket costs for the different options, which the Medicare Plan Finder makes simple. Moreover, you should verify each year that your preferred doctors, hospitals, and other health care providers are covered within your chosen plan. Medical insurance experts suggest that you call the office of your preferred physician or medical provider and ask to speak with the person at the front desk who files insurance claims. This person will be the most expert and reliable source to understand which Medicare Advantage plans are accepted.

5) You go it alone.

Whereas the Medicare Plan Finder may be an easy-to-use tool for many, that does not mean it is an easy-to-use tool for all. The reality is that many Medicare participants do not use computers or may struggle to effectively navigate the Plan Finder tool. Medicare can be a maze and it is wise to ask for help each year. We assist clients in the annual evaluation of Medicare plan choices and there are insurance agents who are more equipped that us to tackle this evaluation. Given the high costs of choosing an ill-fitting plan – either in dollars or in the inconvenience of learning later that your doctor is no longer covered by your Medicare Advantage plan – Medicare participants owe it to themselves to get help in this annual process.

Your tax return is nearly complete and your tax accountant or the tax filing software you are using informs you that you can still make an IRA contribution for the previous tax year. You remember something you read in the past from a reputable source encouraging IRA contributions as a wise tax move. You have the cash available and elect to make the annual IRA contribution. Seems like a good idea that might save taxes in the future. Furthermore, you repeat the same process in years to follow.

It was all well-intentioned. And this is how a potential tax problem begins. Most married taxpayers with six-figure income who are eligible to participate in an employer-sponsored retirement plan (such as a 401k or 403b) are not permitted to make deductible IRA contributions. The income limits for single filers are even lower (income eligibility figures can be found here). When you make an IRA contribution but are not eligible for a deduction, the funds are treated as an after-tax contribution (also called a non-deductible contribution). The contribution is then deemed to be “IRA basis” and has to be diligently tracked every year thereafter via the IRS Form 8606 to avoid being taxed twice. We’ll explain this in a moment.

As a general rule, we discourage clients from making these non-deductible IRA contributions unless the contribution is specifically intended for a backdoor Roth strategy. The biggest problem with non-deductible IRA contributions (those not intended for a backdoor Roth), as we explain in detail here, is that the contributions usually result in higher taxes – often because the contributions are not tracked properly over the course of decades and get taxed twice or simply because the subsequent gains get taxed at higher rates than they would otherwise be taxed.

But back to basis. If you made non-deductible IRA contributions in the past, you should be tracking the basis each year with the Form 8606 that accompanies your tax return. Each time you make a new non-deductible IRA contribution, you add to the basis. Not diligently tracking this basis results in a costly problem – paying excessive future taxes because of double taxation. Happens all the time. The error of not properly tracking basis can and should be fixed by correcting the Form 8606 dating back to the initial non-deductible IRA contribution. The more non-deductible contributions you have made without proper tracking, the bigger the adverse tax problem you will face – if not corrected.

Assume now that you are properly tracking this basis. This means that some portion of your retirement account balance will not be subject to taxation when eventually distributed. Consider the following example to help understand how this works:

High income families faced with high annual taxes are often looking for ways to reduce their taxes or save additional dollars in tax-efficient ways.  Unfortunately, the pursuit of lower taxes often results in irrational behaviors or unfavorable outcomes (such as paying more taxes than you would have otherwise paid by doing nothing).  Among the classic examples of generally ill-advised tax-saving strategies are non-deductible IRA contributions.

What is a Non-Deductible IRA Contribution?

Different rules apply for making deductible IRA contributions depending on marriage status, income, and eligibility for a workplace retirement plan.  Individuals not covered by a workplace retirement plan (such as a 401k) or married couples where neither spouse is covered by a workplace plan are eligible to make IRA contributions, regardless of income.  Alternatively, a husband and a wife who are both covered at work by retirement plans cannot make deductible IRA contributions if their combined income exceeds $124,000 (2020).  The full set of deductible contribution limits can be found here.

Many successful working professionals eventually become disqualified to make deductible IRA contributions as their income grows.  Despite pervasive public belief to the contrary, this is not the end of the road for IRA contributions.  The IRA deduction rules merely limit the ability of individuals to make deductible IRA contributions – they do not prevent individuals from making non-deductible IRA contributions.  In fact, any working individual or spouse of a working individual, regardless of income or availability of a workplace retirement plan, is eligible to make non-deductible IRA contributions.

The basic idea of a traditional IRA is that you make contributions each year which can then be deducted from income and resultantly reduce your tax liability.  The tax is avoided upfront but paid in the future – ideally after many years of tax-deferred growth.

If the benefit of a traditional IRA contribution is the immediate tax deduction, then why contribute after-tax dollars to an IRA without any deduction?  There are generally two viable reasons to make non-deductible IRA contributions.  First, the individual may be a prime candidate for the backdoor Roth conversion – the initial step of which is the non-deductible IRA contribution.  The second reason is that any growth or income that accrues inside the IRA after the contribution is tax-deferred and only taxed whenever distributions begin in the future.

What Are the Drawbacks of Non-Deductible IRA Contributions?

Given the potential benefit of deferred taxation, non-deductible IRA contribution may seem to be an underutilized opportunity.  However, there are a number of potential drawbacks that tend to make these contributions only useful for short-term traders.

1) Favorable capital gain tax rates instead become less favorable ordinary income tax rates.  

Non-deductible IRAs do not eliminate taxes on gains – they merely defer taxes.  In many cases, simply buying an index fund in a regular brokerage account can be far more tax efficient than buying the same fund in a non-deductible IRA.

Consider the scenario where you contributed $6,000 to a non-deductible IRA, invested in a stock fund, and the investment grew over the past 25 years at 8% per year.  You’re now ready to liquidate the IRA – now valued at $41,091.  Because of other income sources and Social Security, you find yourself in the 24% federal tax rate which means paying taxes of $8,421 on the distribution.  Had you made the same investment in a regular brokerage account, you would be paying long-term capital gain taxes at 15% which translates to $5,263 of taxes – a savings of more than $3,000.

If you’re planning to day-trade the investments or do a lot of trading and would not likely achieve the minimum 1-year holding period to qualify for long-term capital gain rates, then the deductible IRA would be a better choice.  Otherwise, the premise that the non-deductible IRA will save taxes over the long-run may be ill-conceived.

2) You face forced taxable distributions in the future.  

Even if you had not needed to liquidate the IRA account in the example above, the IRS would have forced you to start taking mandatory distributions beginning at age 72 and every year, thereafter.  Each of these distributions would again be taxable as the less favorable ordinary income rates.  In contrast, the regular brokerage account imposes no forced distributions so investments can be left to grow tax deferred until the funds are needed.

3) You lose the potentially valuable step-up in basis.

Continue with the same example and assume that you never needed to use the proceeds from the hypothetical investment account.  At death, the IRA would still be taxable as ordinary income to your beneficiaries at their then-current tax rate.  In contrast, the regular brokerage account gets a favorable “step-up in basis” at death meaning that your beneficiaries could sell the appreciated investments and owe zero taxes.  The non-deductible IRA contribution converted $35k of gains into ordinary income and $8.4k of taxes that could have entirely been avoided.

4) There’s a good chance you pay taxes on the same dollars, twice.  

In the world of fallible human beings, the best action is often not the economically optimal option.  That is, practical considerations matter and often matter a lot.  Someone could evaluate the tax benefits of making non-deductible IRA contributions and determine that they are economically optimal based on the individual circumstances.  Yet this still does not mean the IRA contributions are the best course of action.

When you make a non-deductible IRA contribution, the IRS expects that you file a Form 8606 not only in the year of the contribution but every year, thereafter.  This form tracks your IRA basis so that when it comes to distribute from the IRA, you’re not paying taxes on the same dollars twice.  In the real world, many people lose track of filing this form.  They switch to a new accountant or to new tax software and Form 8606 stopped getting filed.  Forgotten IRA basis is even more likely when the IRA owner dies.  Although beneficiaries are able to avoid tax on any inherited IRA basis, this information almost never gets communicated from the executor to the beneficiaries.  The next time a new client brings in an inherited IRA and knows the basis or received the Form 8606 from the executor will be the first time.

All of this simply means that a large amount of non-deductible IRA contributions are being taxed twice – once at the time of the contribution (since the contribution is made with after-tax dollars) and then at the time of the distribution (since without a record of basis, all distributions are assumed to be taxable).  Speaking from experience, we would bet that more IRA basis is ultimately lost and taxed twice than the amount properly recorded and taxed just once.  This likelihood of double taxation is another real-world drawback of the non-deductible IRA contribution as it contradicts with the initial objective of reducing taxes.

Closing Thoughts

Experience suggests that many high income earners start by looking for perceived tax-efficient saving vehicles like 401(k) plans, non-deductible IRAs, or tax deferred annuities and then fill up those buckets without really examining the ultimate tax efficiency of the entire retirement savings strategy.  We suggest a better approach is starting not with the solutions but with the question “how much do I need or want to save for retirement this year?”  Only after first addressing that question does it make sense to then evaluate the implementation.  In many cases, investors will find that the perception of tax savings from strategies like the non-deductible IRA contribution are really just perceptions that get in the way of a useful big picture retirement strategy.

In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, providing $2.2 trillion dollars of economic stimulus. Among the benefits in the CARES Act was the suspension of required minimum distributions (RMDs) in 2020 for individuals who are subject to RMDs either because of age (formerly age 70.5, now age 72) or by ownership of an inherited retirement account.

For individuals who depend on the funds from their required minimum distribution each year to fund regular living expenses, this one-year RMD suspension is effectively a non-event. Such individuals will distribute funds from retirement accounts in 2020 not because they are legally required to do so but to fund consumption and pay the bills. Conversely, this one-year suspension provides a nice reprieve for individuals who would normally be subject to RMDs but have funds available from other sources (pension income, after-tax investment and bank accounts, Social Security, etc.) to afford regular living expenses without the RMD funds.

Many individuals who fall in this second category will take the easy route and simply forego the 2020 RMD based on the short-sighted fallacy that to do so is advantageous. While this easy “do-nothing” route will almost always yield lower taxes in 2020, it will typically result in higher long-term taxes for most individuals who fail to exploit the one-year opportunity.

Astute individuals who are annually required to withdraw retirement funds that they do not need will appreciate that the 2020 reprieve from RMDs provides an attractive opportunity for long-term tax planning – an opportunity that will expire at midnight on December 31. Consider the following example:

Example 1: David and Carol turned 73 years old in 2020. They each collect Social Security that pays a combined $36,000 per year and Carol has a pension that pays $40,000 each year. They also have two investment accounts – David’s IRA with $1,500,000 and a joint brokerage account with $1,000,000 that together provide for the remainder of their retirement spending. In light of cancelled travel plans due to Covid-19 and limited expenses for dining out or other discretionary expenses, their spending needs in 2020 are relatively modest and they only require an additional $1,000 per month (12,000/year) beyond what Social Security and Carol’s pension provides. They have no mortgage, expect to use the standard deduction every year, and were able to harvest taxable losses during the March market selloff such that they will have $3,000 of capital losses to offset other taxable income.

The simplest strategy would be for David and Carol to use the joint brokerage account to fund the $1,000/month of additional spending needs and move onward to 2021 when David will again face required distributions from his IRA. In doing so, their federal tax situation looks as follows:

The good news under this scenario: David and Carol owe $6,070 in federal income taxes, a significant break from what they typically owe when faced with a required distribution from David’s IRA. The bad news: they squandered the chance to exploit their significantly lower 2020 tax bracket.

When the RMD suspension is lifted in 2021, David will face a required minimum distribution of approximately $60,000 from his IRA, resulting in total taxable income for the married couple that exceeds $120,000 and throwing David and Carol squarely in the 22% ordinary income tax bracket. Such will be the reality for them beyond 2021.

While accelerating income and prematurely paying income taxes is rarely celebrated, David and Carol would be well-served to do just that in 2020. With approximately $20,000 of extra room in the 12% tax bracket this year, they could withdraw $20,000 from David’s IRA to fill up the 12% tax bracket. This results in an added tax of $2,400 ($20,000 * 12%) but allows them to avoid taxation of $4,400 (20,000 * 22%) in the future, when they will face a higher tax rate. The math is as follows:

It is important to note that the optimal way to achieve this result is always by way of a Roth conversion rather than merely an IRA distribution. David would simply open a Roth IRA and convert $20,000 from the IRA to the new Roth account. The benefit here is that any future growth or income on the $20,000 avoids taxation in the Roth IRA whereas that is not the case if he simply distributes this amount to the joint account.

The general advice for individuals with suspended RMDs in 2020 is to fill up the temporarily lower tax brackets before year-end. In this example, David and Carol fill up the 12% tax bracket – an extremely favorable tax rate that they are unlikely to ever see again in the future based on their expected taxable income. If they can withdraw tax-deferred funds that will eventually be taxed and only pay 12 cents for every dollar withdrawn, that’s going to be advantageous to paying 22 cents of tax for every dollar withdrawn in the future.

The larger the size of an RMD, the more valuable such a strategy can be. Additionally, there will be more value in this for taxpayers who temporarily drop from the 22% bracket to the 12% bracket in 2020 or from the 32% bracket to the 24% bracket than from the 24% bracket to the 22% bracket.

In outlining this general advice, it is also worth noting that the calculation is not always just about using Roth conversions to fill up the remaining room in a tax bracket. One complicating factor that impacts the calculation in many situations is the unique taxation of Social Security. Consider the following example,

Example 2: Assume all the same circumstances as the prior example with two exceptions. Instead of Carol’s pension income of $40,000 and combined Social Security income of $36,000, Carol has pension income of $25,000 ($15,000 reduction from Example 1) and David and Carol have combined Social Security income of $51,000 ($15,000 increase from Example 1).

Example 2 may appear to effectively mimic the first Example 1 as the reduced pension income is exactly offset by the increased Social Security income. However, there is a substantial difference from the first example because of the unusual way in which Social Security income is taxed. In Example 2, David and Carol face what is referred to as the “tax torpedo” – a dramatically elevated marginal tax rate as more of their Social Security income becomes subject to taxation. The following figures help explain. Without accelerating any additional income in 2020, their tax calculation is:

Although David and Carol receive $51,000 of Social Security benefits, only $25,119 is subject to federal income tax – based on a calculation called ‘provisional income’. As a result, they have $38,712 of taxable income and face $3,613 of federal tax.

In Example 1, the $20,000 Roth conversion (or IRA distribution) intuitively increased their taxable income by exactly $20,000. In this Example 2, the same $20,000 Roth conversion has a less-intuitive impact on taxable income. In fact, the $20,000 conversion increases their taxable income by an even $37,000 because an additional $17,000 of Social Security income becomes subject to taxation (plus the $20,000 Roth conversion). As a result, this conversion increases their tax liability by $4,440 – a marginal tax rate of 22.2%. ($4,440 tax / $20,000 conversion amount)   

The high marginal tax cost of the Roth conversion in Example 2 means that David and Carol would be better served to bypass any retirement account distributions or Roth conversion this year and enjoy the benefits of the RMD suspension.

Other Factors to Consider

• Don’t forget the Qualified Charitable Distribution (QCD). We think nearly every American over age 70.5 who donates any amount to charity should use the qualified charitable distribution (QCD) as a way to reduce taxes. We will keep driving this home until the QCD is a mainstream concept but it is worth noting that the QCD is relevant to the topic above. We wrote about the unique QCD math related to 2020 earlier this year.
• Beneficiaries may matter to the calculus. The examples above use the expected future tax rates for David and Carol to assess the benefits of accelerating income in 2020. What also may matter is the expected tax rate of the ultimate beneficiaries. Suppose David and Carol have a financially successful son, Charlie, who they plan to leave all their assets to after their lifetimes. If Charlie earns a high income that will put him in the 37% tax bracket for the rest of his life, then it’s likely going to be advantageous for David and Carol to exercise Roth conversions of more than $20,000 in both Examples 1 and 2. By doing so, David and Carol are increasing the after-tax value of their estate for Charlie.
• Inherited IRA owners also need to evaluate the math. In our experience, some of the greatest benefit from this 2020 income acceleration strategy goes to retirees with an inherited IRA who have not yet reached age 70. This is to say that the above strategy is not just for individuals who have reached age 72.
• Concerned about higher tax rates in the future? All of the analysis above relies on the current tax code but we appreciate that plenty of Americans are concerned about tax hikes in the future. Any such tax increases – at the federal level – would make the income acceleration strategy even more valuable or, conversely, make the cost of doing nothing even more costly.

Closing Thoughts

This article obviously dives into the wonky tax weeds but if you want to ignore everything else, here’s the one critical takeaway: Anyone who was planning to enjoy the 2020 temporal RMD reprieve by doing nothing is possibly doing long-term tax harm by sitting idle. The examples above are highlighted to show both the benefit of the opportunity and the uniqueness of the calculation for each unique situation. For everyone with an RMD in 2020 that they were not planning to take, it will be valuable to communicate with your financial planner or accountant about the potential benefits of accelerating income in 2020 at a temporarily depressed marginal tax rate.

Financial Advisors say a lot of things that they inherently know are false because they sound good, market well, and attract new clients. Worse yet from a competency standpoint (albeit better from an integrity standpoint) are financial advisors who promote the same agendas without the awareness of their misguided promises. Both embarrass and discredit the industry of financial advice. While the list of such misguided or deceitful statements is long, we highlight three common ones that should concern – if not frighten – clients.

1) Promoting investment hedging strategies that reduce risk without compromising return or investments that offer high returns with low risk.

Look, we all want low risk and high return. It is an alluring concept – the holy grail of investing. Yet it does no good for investment managers, financial media, and financial advisors to promote this fictitious concept of low risk and high return investment opportunities or strategies. A hedging investment strategy that promises to reduce risk also reduces returns. An insurance product or variable annuity that limits the downside also sells off some of the upside to create the downside protection. A hedge fund promising stock-like returns with bond-like risk often relies on investment returns being normally distributed when robust historic evidence proves they are not. Financial advisors peddling investment strategies that dynamically reduce risk in periods of market stress fail to similarly peddle the resulting cost of lower long-term returns.

There is no free lunch. It really is that simple. Hedging, covered calls, dynamic risk management, guaranteed income benefits, market-linked CDs – whatever the label – they are all forms of insurance that reduce upside in some capacity. Suggesting that there is a free lunch promotes bad investing behavior. And this is not to say that downside protection is a bad thing for risk-averse investors but we need to call a spade and spade. Advisors peddling strategies that provide downside protection without explaining the sacrifice to returns or the secondary risks are either intentionally misleading customers or they are naive to how these strategies actually work – both of which are concerning.

2) Using “stay the course” as an excuse for apathy and inattentive service.

Humans are inherently hard-wired to make poor investment decisions. Among a long list of flaws, we overweight events of the recent past, we are overconfident in our prediction abilities, we are lousy at decision-making in times of stress, and we treat equivalent gains and losses differently. As a result of all these behavioral flaws, there is great value in setting a discipline and sticking with the discipline to avoid letting our emotions and behavioral tendencies deter our financial success.

However, let’s be clear on what staying the course actually means – it means intelligently assessing and setting an appropriate risk level and then consistently maintaining that risk level. It does not mean letting sharp market movements dictate your personal risk level.

Consider a ship that sets sail from London to Miami but then encounters bad storms and choppy seas which put it on a path towards Nova Scotia. Either the captain makes the necessary adjustments to stay the course towards Miami or the captain just lets the boat end up in Nova Scotia.

Investment markets of 2020 provide clear example of this storm and the wide gap between staying the course and doing nothing. An investor starting the year with an asset allocation (and targeted mix) of 60% stocks and 40% bonds who did nothing would have deviated to own an equal amount of bonds and stocks by March 23rd. This significant change in portfolio risk – the equivalent of going off course to Nova Scotia – is precisely why inactivity and staying the course are in clear opposition during periods of sharp market movement. Investors who let the market movements adjust portfolio risk without staying the course – in the honest sense – had a lower risk level than they targeted when the market rebounded and coincidentally captured more downside than upside. As a result, it will take them longer to get to the intended destination.

Advisors who preach staying the course but fail to rebalance to the targeted risk level when markets move in one direction (redirect the ship back to Miami during the storm) effectively use this stay-the-course message as an excuse for laziness at the ultimate expense of the client.

3) Using phrases such as “We are unbiased” or “Our fee-only model eliminates conflicts of interest”

Fee-only financial advisors are justifiably proud of their fiduciary responsibility and their legal commitment to work in the best of interest of their clients. Very proud. By completely avoiding product sales or commissions, fee-only advisors (of which we are proudly one) face fewer conflicts of interest than a commissioned broker or someone who sells insurance.

But here’s the thing: any fee-only fiduciary advisor who publicizes that he/she is free of conflicts is either outrageously naive or intellectually dishonest. Fee-only fiduciaries face plenty of meaningful conflicts of interest. Consider, for example, that fee-only advisors who charge a fee tied to assets under management have an incentive to recommend that clients employ a larger mortgage, sell a business sooner than might be appropriate, hold a smaller cash reserve, maintain expensive student loans, or avoid buying real estate, second homes, and immediate annuities. That just covers a few of the many conflicts.

There are conflicts of interest in the advice industry. Conflicts are unavoidable, regardless of the business model or the fee structure. Advisors who fail to embrace and communicate these conflicts of interest are doing a terrible disservice to their clients. Either a) the advisor is aware of the conflicts but denies they exist – a clear signal of dishonesty; or b) the advisor is ignorant to the inherent conflicts of interest – a signal that the advisor may not be fit to provide advice.

In the corporate world, businesses have a CEO who makes operating decisions and a CFO who makes financing decisions. The CEO decides to expand a business line. The CFO determines how that expansion is going to be paid for.

When you choose to buy a home, you have made an operating decision. When you elect to use a mortgage in lieu of paying cash for the home, you have made a financing decision. These are separate decisions. The problem is that home buyers often fail to separate these decisions. In my experience, many people treat their home purchase as a financing decision while ignoring the operating decision. This can have dramatic long-term consequences that are not appreciated until long after the initial decision.

Consider a couple, Dan and Susan, with $200,000 saved in an after-tax brokerage account who determine that their after-tax cash flow leaves them an extra $3,000 per month after covering their core household expenses. With a 30-year mortgage rate of 3.125%, they can borrow $700,000 and afford the resulting $2,999 monthly mortgage cost. Armed with that information, Dan and Susan calculate that they can buy a home valued at $900,000 by using their $200,000 savings for the downpayment and financing the other $700,000.

What’s wrong with this thinking? Absolutely nothing if their singular objective is to buy as much home as financing will allow. Dan and Susan will have $3,000 of excess cash flow each month and they can use all this money to pay the monthly mortgage cost (with $1 left over each month).

But consider how this home purchase is reframed if we think of it as an operating decision rather than a financing decision. Dan and Susan first contemplate – based on circumstances – whether it is more appropriate to buy a home or rent a home. That means considering whether their family is likely to expand (more kids) or contract (kids going off to college) in the next 5-10 years, whether the family might relocate to a different state or a different part of town over the next 5-10 years, and the costs of renting versus buying in their specific location.

Fast forward and assume that Dan and Susan evaluated circumstances and decided to buy a home. They now have to make an operating decision about allocating resources to this new home. The CFO says “we have $3,000/month in excess cash flow” and the CEO has to decide how much of this cash flow should go towards the home, how much towards retirement savings, how much towards college, how much towards vacations, or how much towards philanthropy. If coming at this from an operational perspective, Dan and Susan effectively need to decide how much money should be allocated or budgeted to each business line. Ultimately, this means deciding which family business lines are going to get cut and by how much to take on this new business line (buying a home).

And what happens if Dan and Susan elect to allocate the entire $3,000/month towards the mortgage (i.e. only view this as a financing decision of how much home they can afford)? They have inherently made an operating decision to discontinue or de-emphasize funding of their other business lines: retirement savings, college, vacations, philanthropy, etc. As with the business that decides to focus all R&D and marketing on one business line at the expense of all other lines, Dan and Susan are choosing to buy a bigger house at the expense of a delayed retirement, fewer family vacations, more limited college choices they will be able to afford, and cut-backs to other discretionary items in the future.  

There’s another important point here – once Dan and Susan make the operating decision and buy this house, future financing decisions don’t change this operating decision. What does that mean? There is a pervasive myth that the way someone finances or does not finance a home changes their exposure to the home value. People think that if they have more equity in their home, they benefit more if the home appreciates in value. This is decidedly not true.

Assume that you own a home worth $500,000. If you have an extra $1,000 in the bank and you decide to use that money to pay down your mortgage, that decision does not change your net worth (you’ve simply moved reduced assets by $1,000 and reduced liabilities by $1,000). Paying down your mortgage also does not change your exposure to the home’s value (your home is still worth the same $500,000). If your house value increases by 10% to $550,000, your net worth increases by $50,000 whether you have a mortgage or not. Same if the home value decreases by 10%.

So when someone says “I have too much money tied up in my house” – that is an operating issue, not a financing issue. The only way to reduce that exposure is to downsize to a smaller home, not change how the home is financed. If Dan and Susan come upon an unexpected bonus and decide not to pay down their mortgage because they “already have too much exposure to the house”, they’re using misguided logic.

All of this is to say that we overwhelmingly tend to treat home purchases from the vantage of the financing decisions while not giving enough respect to the operating decisions. In contrast, we’d be better served by clearly separating these decisions.