This communication contains two completely unrelated sections: Market Commentary, and Why a Roth Conversion Now? We have chosen to present these in the same document because the section on Roth IRA conversions is quite timely, such that for those who choose to pursue this strategy, the process should be initiated soon.
We have frequently mentioned that the price of the stock market reflects anticipated future, not current, conditions. In the weeks leading up to the election, the S&P 500 fell precipitously on news of increasing COVID-19 cases and gridlock on the next round of stimulus – both of which portend lower corporate earnings. From October 12ththrough the 30th, the index lost 264.26 points, (-7.5%).
From November 2ndthrough November 5th, the S&P 500 gained back 240.49 points (+7.35%). If the market was expressing a preference, that preference is divided government with the incumbent out of office and the Republican party maintaining the Senate. There was no “blue wave” or “red tide”. Historically, capital markets favor divided government. Expected market volatility has dropped to nearly half of the October 28thhigh. The S&P 500 posted its largest post-election-day gain since 1932.
In such an environment, certain partisan policy initiatives, such as higher taxes and additional regulations are less likely. While both sides agree that additional fiscal stimulus is appropriate, the scope of such stimulus is likely to be more conservative. There may be bipartisan support for scaling down or completely eliminating the trade war initiated by the current administration.
With attention devoted elsewhere, it is worth noting that earnings season has been stellar. Third quarter earnings for the S&P 500 exceeded expectations by 20% (the highest percent outperformance since 1986 when the dataset began). Further, S&P 500 earnings are expected to surpass pre-COVID 19 levels in the first quarter of 2021. Despite the headwinds from political strife and the ongoing pandemic, many US firms are making necessary adjustments to their business models to move forward profitably and efficiently.
The US dollar has weakened meaningfully as a result of the election. A weaker dollar makes foreign markets more appealing to US investors, and a more amicable trade environment, without tariffs, makes imports more attractive to US businesses and consumers. These dynamics should be a tailwind for the non-US equity investments in PIM clients’ portfolios.
Risks remain. We commented recently that a prolonged and contentious battle to determine the outcome of the election would be detrimental. While the trajectory of the election appears clear, this isn’t over. Reports from our institutional research sources suggest that Republican challenges to a Biden victory in Pennsylvania may have legal merit but are unlikely to succeed. Our hope is that
capital markets remain patient as the final votes are tallied and whatever legal processes are brought to bear reach a conclusion.
Until then, what can we convey with reasonable certainty? Neither political party achieved their election goals. The democratic process is working, however messy. With the Republican party apparently retaining control of the Senate, a $2-3 trillion stimulus bill, championed by Democratic legislators, is most unlikely.
Without a large stimulus bill, the Federal Reserve will be forced to act as a backstop for the US economy and capital markets, by continuing asset purchases of US Treasury Securities, mortgage backed securities, and investment grade corporate bonds.
This suggests that interest rates on US government debt, inflation rates, and US GDP growth will remain low for several more years. In this environment the market will continue to favor growth oriented companies. Technology firms stand out as they have proved to be able to flourish in this type of environment. This also means that traditional valuation metrics are somewhat sidelined for the time being. In other words, stocks may remain “expensive” by historical standards for as long as bond yields remain at historic lows.
Democracy is the foundation of a free market economy and worth preserving, even when, or especially when being tested so strenuously. We encourage you to remain optimistic.
“Many forms of government have been tried and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government, except for all those other forms that have been tried from time to time….”
Winston S. Churchill, 11thNovember 1947.
Why a Roth Conversion Now?
Converting retirement plan assets that are taxable upon distribution to a Roth IRA is a tax and wealth management strategy. Now may be an opportune time to consider a Roth conversion. Before explaining why, let us review the details of the strategy first.
What is a Roth Conversion?
A Roth conversion is the process of transferring assets from a tax-deferred retirement account such as a 401(k), 403(b) or IRA into a Roth IRA account. Roth IRA accounts have two distinct advantages over other tax-deferred retirement accounts. Roth IRA account distributions are not taxable (if qualified), and Roth IRA accounts are not subject to Required Minimum Distributions. Further, Roth IRA beneficiaries do not pay tax on distributions, though they will be subject to the inherited account 10- year distribution rule.
For a distribution to be qualified, the Roth IRA has to have been in existence for at least five years, and the account owner must be at least 59 ½ years of age. Distributions that do not meet these rules may still not be fully taxable. Consult with your tax professional for further guidance. Amounts “converted” from a non-Roth tax-deferred account into a Roth IRA are fully taxable, as income, to the account owner in the year of the conversion. Tax may be paid as part of the conversion transaction, deducted from the gross conversion amount. Or, tax may be paid with separate resources, which is preferable, particularly for account owners under age 59 ½.
The federal policy response to the COVID-19 pandemic included the option of suspending RMD for 2020. PIM clients who elected to cease RMD may have lower taxable income this year than originally planned and therefore, may have space available within their marginal tax bracket to incur additional taxable income without increasing their overall effective tax rate. Further, regular Roth IRA contributions are typically subject to employment and income tests. Roth conversions have no such limitations.
A Roth conversion may not be for everyone. If you are in a high-income tax bracket this year and anticipate being in a lower income tax bracket in the future, then considering a Roth conversion down the road may make more sense. If paying tax on the Roth conversion would create financial stress, then the strategy may not be appropriate at this time.
Choosing to employ the Roth conversion strategy requires careful consideration. If the timing seems appropriate to you for a meaningful conversation, please reach out to your PIM financial adviser and your tax professional.
Personal Investment Management, Inc.