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Updated 2016 Tax Numbers

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The IRS has released the key tax numbers that are updated annually for inflation, including tax rates, phaseouts, standard deduction, exemption amount, and contribution limits. Since inflation was very low in 2015, only very small changes have been made. Some notable callouts for those who don’t want to read all the way through the update:

· Social Security payments will not increase (no cost-of-living-adjustment) in 2016. That also means that by law, the Social Security Wage Base (the max amount of income subject to the 6.2% Social Security Tax) also must remain unchanged at $118,500.

· Max contributions to 401k, 403b, and 457 retirement accounts remain unchanged at $18,000 (+$6000 catch-up if you’re at least age 50).

· Max contribution to a SIMPLE retirement account remains unchanged at $12,500 (+$3000 catch-up if you’re at least age 50).

· Max total contribution to most employer retirement plans (employee + employer contributions) remains unchanged at $53,000.

· Max contribution to an IRA remains unchanged at $5,500 (+$1,000 catch-up if you’re at least age 50).

· The phase out for being able to make a Roth IRA contribution is $194k (married) and $132k (single). Phase out begins at $184k (married) and $117k (single).

· The standard deduction remains unchanged at $12,600 (married) and $6,300 (single) +$1,250 if you’re at least age 65.

· The personal exemption increases slightly from $4,000 to $4,050 per family member. Remember that exemption amounts begin to be phased out if your income exceeds $311,300 (married) or $259,400 (single). The exemption is reduced by 2% for every $2500 of AGI over threshold until reduced to $0.

· Itemized deductions are reduced by 3% of the amount AGI is over $311,300 (married) or $259,400 (single).

· The annual gift tax exemption remains at $14,000 per giver per receiver.

· The maximum contribution to a Health Savings Account (HSA) is $6,750 (married) or $3,350 (single).

· Note that mileage rates have not been updated yet for 2016.

Click image below for details…  red indicates not yet updated from 2015.

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Down Markets

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A down Q3 across virtually all asset classes has dragged most everything down over the last 52-weeks. For reference, the performance of those asset classes is shown below:

PS – this is why we don’t just take all client money and put it into an emerging markets fund (which is the asset class with the highest expected growth long-term), and why we include bonds in all portfolios.

Market Update – 8/24/2015

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Most of you know by now that when you see a “Market Update” post from me, something ugly is happening in the financial markets. This time, it’s the classic fear of a global growth slowdown, with China at the center of the action. There’s plenty of literature out there pointing to all of China’s problems, so I won’t bore you with a recap. Growth there is slowing, dramatically, and there’s little debate about that. For a long time, emerging market growth was thought to be enough to overcome the stagnation that has happened through much of the developed world. Slowing growth (maybe even a real recession?) in Asia, eastern Europe, the Middle East, and Latin America has left financial markets wondering what can drive global growth. Without it, it’s hard to imagine that corporate profits can continue to grow, hiring will increase, spending will rise, and the virtuous cycle will continue. Oil prices have plunged, partially due to the increase in supply led by the US shale revolution, but lately, I suspect it’s again due to demand slowdown fears led by China. While lower commodity prices are beneficial for consumers, it puts a halt on the growth of one of the sources of job gains in the US and provides even more basis for worrying about global growth. Add in fears of the Fed starting to raise rates soon (which almost certainly isn’t going to happen in September now thanks to the recent stock rout), and we have the makings of a meltdown.

[As I write this at 9:30am, the US stock market just opened and the market itself is not functioning properly. There are stocks and funds that opened down 20%+, were halted, and bounced back sharply. It looks a lot like the flash crash of a few years ago. I’d venture to guess that many of those trades will be cancelled by the end of the day. Many stocks did not open on time. Don’t believe what you’re seeing for quotes until that’s all resolved. I suspect the Dow was never really down the 1000+ points that were indicated shortly after the open.]

I don’t know how bad China will get. I don’t know how much fear will beget fear and cause stocks to fall. I don’t know how long it will take for everything to stabilize. What I do know is that China won’t be wiped off the map and that a billion people have a massive amount of productivity to deliver to the world as skills, technology, and resources move from other parts of the world to China. There is a massive portion of the developing world that is living in or on the edge of poverty. Technology is moving so quickly, making the world smaller and smaller and it seems impossible that the disparity in standard of living between the developing and developed worlds can continue forever. Emerging markets will drive growth eventually… It just make take a while to get through some of the policy mistakes their governments have made and to normalize some of the capital flows that have probably put too much of the developed world’s central bank provided liquidity into emerging markets in search of yield. While the media may try to convince you otherwise on a day like today, the world is not ending.

Take this as a gut check. After years without a major fall, there is a tendency to think that stocks go up in good times, and do nothing in bad times. We’ve forgotten that stocks also go down and they tend to go down much faster than they go up. This causes stress when portfolios have not been set up appropriately for your goals. Ask yourself this question: “If the stock market loses half its value as it did twice in the last 15 years, will I still be able to achieve my goals?” The answer to that question is dependent on what your goals are, how soon you need your money, and how much of your portfolio is in the stock market. If your goal is retirement in 20 years, then you’re going to have most of your money in the stock market and downturns are going to be painful, but you (and your portfolio) won’t even remember that this downturn occurred by the time your retire. If you’re looking to buy a house with most of your money in the next couple of years, then most of your money is in bonds, which actually do fairly well when stocks move lower allowing them to offset some of the stock fall and mute the impact on your portfolio. The real concern for investors should be whether or not you’ve really evaluated your goals and communicated them to your advisor. As long as we’re on the same page, your portfolio is allocated in a way that the stock market falling 10%, 20%, or even more isn’t going to ruin you. That doesn’t mean your portfolio won’t go down… I assure you it will and that’s a necessary risk in order for it to go up in the good times. It means that you should still be able to achieve your goals even if stocks fall sharply over the short term. As I posted on Twitter on Friday, “If it matters to you that stocks fell today / this week, you’re gambling, not investing.” If you feel like you’re gambling and you’re worried, please contact me. It means you’re letting your emotions get the best of you (and I’m happy to talk you off the ledge) or that your portfolio isn’t in line with your goals (which means we really need to talk).

I’ll conclude with something no one wants to hear while the market is falling, but everyone realizes is true eventually. Investing at lower prices actually increases long-term wealth and the probability of achieving your goals. In my most rational moments (which are admittedly hard when the entire world’s stock markets are down 10%+ over two days), I cheer when the market falls and get more nervous when it rises because I know your long-term goals (and mine) have a better chance of success when prices are lower and we can invest more money at those lower prices (see The Value Of Volatility post from 2013). Would you rather your next 401k contribution get invested at last week’s higher prices or this week’s lower prices? Buyers should always want prices to be lower, even if it doesn’t feel good at the time. On days like today, which definitely don’t feel good, please keep that in mind.

Market Update – Greece & Dominos

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It’s likely to be a volatile day tomorrow and potentially for the rest of the holiday shortened week in the stock market. A few hours ago, Greece announced that its banks will not open on Monday and that when they eventually open (maybe a week from tomorrow), they may impose “capital controls”, a.k.a. limits to how much anyone is able to withdraw from their account each day. The Greek government has been negotiating with the “Troika”, the European Commission, the International Monetary Fund and the European Central Bank (ECB), trying to get them to agree to provide continued emergency support to the banking system, new loans so that the Greeks can pay back other maturing loans, and improved terms on other existing loans to make it feasible for the Greeks to eventually pay those loans back in their entirety. In return, the Troika wants Greece to agree to raise taxes, implement an IRS-like tax-collection agency, and reduce spending (including cutting pensions and raising the retirement age from 61 to 67) so that it is more in line with its tax revenue and sustainable over the long term. If they can’t come to terms, Greece will default on its debts and lose support from the rest of Europe. They’ll also potentially be forced out of the Euro and back to their own currency. If an exit from the Euro happens, Greek Euro deposits will be converted to local currency (Drachmas most likely) which will have much less value. In advance of this, the Greek people have been pulling their Euro deposits out of banks so that they can retain their value in the case of a Euro exit. Since all banks are built on leverage (they loan out $10+ for every $1 they have for example since there’s no need to keep those deposits on reserve for withdrawals because the entire population does not want/need their cash at the same time in normal circumstances), consistent, massive withdrawals essentially cause the banks to run out of money. Even rumors that this could happen can be self-fulfilling and create the classic “run on the banks”. If the banks go down, so does the engine for the economy, which in Greece, is already struggling horribly. No more loans, no more deposits, no way to electronically move money, no way to cash checks, etc.

Negotiations between Greece and its creditors have broken down, with a $1.8 billion loan due to the IMF on Tuesday. A referendum is scheduled in Greece for July 5th, where the people will vote whether they’d rather accept austerity imposed by creditors in return for further assistance, or turn away from the rest of Europe and go at it on their own, likely with their own devalued currency which would work fine purchase and sale of goods made domestically, but would cause massive inflation in prices of anything imported. In the meantime the banks will be closed and the self-fulfilling bank run fears grow. If they reopen without support from the rest of Europe, including emergency liquidity provided by the ECB, they will be forced to institute capital controls and/or begin using a local currency. There simply is not enough money in Greek banks to satisfy the demands of the Greek people.

You may be thinking, “That’s a shame, but what does it have to do with me in the United States?” The problem is not with Greece, per se. Since most Greek debt is owned at this point by the ECB, any defaults can likely be absorbed rather than cause other foreign banks to have liquidity problems. However, if you lived in Spain, Italy, or Portugal, knowing your government is in a ton of debt as well (though not nearly as bad as Greece), has growing deficits, and is relying on the ECB to facilitate low borrowing costs, wouldn’t you start to think the Greek situation could be coming to your backyard someday soon? If there’s a chance that your government might close your banks and institute capital controls, wouldn’t you think twice about leaving your money at those banks? That is precisely the line of thinking that can start a bank run in those other European countries, well in advance of any debt default or exit from the euro. Could they too end up like Greece, lose the support of the ECB and the rest of Europe, and default on their debts? If so, the owners of their debts (which is not well-contained at the ECB as Greek debt is) will lose massive amounts of money. Many of those debt owners are US banks and that means dominos can begin to fall as they did in 2008 with mortgage defaults triggered the ultimate collapse of Lehman Brothers and the resulting seize-up in the US banking/credit system.

We don’t know whether Greece is the first domino in a set of tightly placed dominos that could all collapse if it does. We don’t know that the Greek domino will even fall (though it’s certainly looking like it right now). We also don’t know how much of this is already priced into the markets. The potential for Greek/Europe negotiations to break down has been well telegraphed. What we do know is that there are large players in the financial markets (e.g. hedge funds) that make bets on events like this. Those on the right side reap the rewards. Those on the wrong side typically have to sell lots of assets to cover the cost of their incorrect trade (which is typically leveraged multiple times over). The sale of assets pushes prices down globally, even if temporary, which causes other institutions to have to sell, and has the potential to create panic selling from institutions that have nothing to do with the issue and from retail investors.

My intent is not to scare you, but to keep you informed so that you’re not scared. My intent is not to try to predict what’s going to happen, or to tell you that we should move money around and try to time these events. Markets could fall horribly over the next few days and snap back. They could fall overnight tonight (futures opened down about 2% as I was writing this), and snap back by the time they open in the morning. They could rise dramatically if either there is a positive resolution in negotiations (because then the fears that are priced into the market were incorrect), or even if Greek banks do fail and it does exit the Euro as then there would be certainty for the first time in almost a decade as to the final resolution. They could also rise if more central bank (Fed, ECB, BOJ) stimulus comes as a result (the probability of a September Fed rate hike fell from 45% on Friday to 25% tonight according to Fed Fund Futures). There’s no way to predict what the stock market will do tomorrow (other than the fact that it’s indicated down 2% already), or this week, or this year or how the rest of the world economies and individual events will intertwine and influence those markets. These are the types of events that create the volatility and downside risk that ultimately enables the long-term market returns that the stock market provides. When you invest, you’re making a deal with yourself that you’re willing to ride a roller coaster of ups and downs in order to benefit from the long-term compound returns that come from those investments. We strongly believe that the stock market is THE primary place to be for your long-term investments, regardless of what may be happening at any point in time. We also strongly believe that the stock market is NOT THE primary place for money you need over the short-term, precisely because negative events can happen at any time. Cash emergency funds, conservative short-term investments, and long-term investments in the stock market mean you don’t need to worry about the short-term because that money isn’t primarily in the parts of the market that can fall sharply due to an event, and you don’t need to worry about the long-term because, by definition, it’s not impacted by those short-term events. I provide this as a reminder so that if the stock market falls and the mainstream news sources begin to call this the next “crisis” (i.e. they see the opportunity to fuel the fear fire in return for ratings), you’re one step ahead of the game, know what’s going on, and can stay focused on those things that are in your control. I’ll provide more updates as the situation progresses.

Q4 2014 & Calendar Year 2014 Returns By Asset Class

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New highs in US Large Cap stocks did not follow through to many other asset classes in Q4 2014, largely because of currency shifts (US Dollar gains vs. virtually all other currencies which make foreign currency denominated investments worth less on a relative basis), lagging economic performance in Europe, and a sharp decline in energy prices (oil down over 40% in Q4 alone). The list bellow shows performance for a select set of asset classes using representative ETFs (or spot price in the case of a commodity) as a measure for each:

As always, I’ll provide the reminder that past performance is not indicative of future results and that long-term expected returns (used for planning purposes) remain unchanged.

Market Update 10/15/2014

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I don’t have a crystal ball and can’t tell you where the market is going, but I can tell you why I think it has fallen recently. Here are my top pain points in reverse order of concern/impact over the short-term (#6 having the biggest impact in my opinion):

1) Geopolitical Tensions / Civil Unrest – press on these has eased recently just because there seems to be worse news in other areas to take the headlines, but they’re still very present. Middle East, Russia / Ukraine, Hong Kong… all these sorts of issues threaten global economic growth through lower productivity and inefficient use of resources. Protests, sanctions, wars, fear, and loss of life around the world that seems like it will be ongoing indefinitely.

2) Central Banks – the US Federal Reserve is ending Quantitative Easing (QE), their bond buying program that essentially amounted to printing money to purchase treasury bonds (finance government debt spending) and mortgage backed securities (finance home purchases). Many worry that the end of QE and the ultimate beginning of an interest-rate hike cycle will put the brakes on a recovering US economy. So far, long-term treasury rates and mortgage rates have stayed low despite the Fed pulling back on QE as a potential economic slowdown tends to lower rates on its own. Other major economies of the world are also moving in the opposite direction, embarking on further monetary stimulus programs as the US pulls back. This forces their rates lower and acts as competition for US rates, dragging them lower as well. 10-year government bonds in Germany are paying less than 0.7% right now. US ending monetary stimulus while Europe and Japan extend stimulus tends to push the US Dollar up vs. the Euro and the Yen, making our exports less competitive which can also act to slow down the US economy. As one of very few sources of global economic recovery for the last few years, a lot is riding on continued US growth and the end of QE combined with a stronger dollar jeopardize that.

3) Europe – the majority of the continent’s economy is still a disaster and there aren’t any signs of improvements. Many suspect a QE-like program launching in Europe soon, but the legalities of such a program in a common currency with so many different jurisdictions involved make it difficult to pull off. There’s also no way of knowing how it effective it would even be given how low interest rates in the Euro zone already are. Additionally, some concerns from a few years ago are roaring back. Greece wants to end its participation in its bailout program, but doing so means it won’t be able to borrow at the low euro-zone rates, and potentially means it will need to exit the Euro completely which threatens the stability of the currency as a whole. If Greece reverts to its issues of a few years back, Portugal, Spain, and Italy (maybe even France) can’t be far behind.

4) Oil – the price of oil has been plunging in the past few weeks. While this is good for global economic growth in general (lower prices at the pump, lower heating oil this winter, lower costs for airlines, etc.), a portion of the US recovery has been led by the energy sector and our progression toward oil independence from the Middle East though domestic production and Canadian imports. It appears that OPEC is putting on a sort-of price war now with the US, keeping their production high despite falling prices because their drilling costs are lower than our more complex ways of extracting oil (oil sands, fracking, etc.). If they can push the price down for long enough, they may be able to force a reduction in US / Canadian production and maybe even put some US / Canadian companies out of business which will ultimately push prices back up with a larger share of oil production coming from the Middle East again. As energy prices dramatically fall, hedge funds that are dedicated toward energy investments, sometimes in a leveraged way, are forced to liquidate which causes further drops in energy prices and ultimately in other assets as well. Forced selling begets forced selling and the price of everything tends to fall in a whoosh until leverage is managed, markets clear, and price stability resumes. If oil continues to fall, it’s likely the rest of the market will fall with it until oil stabilizes. The good news is that once the forced selling is done, we’ll be left with lower energy prices overall and as long as the US / Canadian producers survive, that will be a stimulus to the economy in additional discretionary money in the pockets of consumers.

5) Ebola – this is one of those very low probability of extreme catastrophe events that makes it very hard for financial markets to price risk. When markets can’t price risk, then tend to avoid it, and that means short-term traders selling just about everything other than the safest assets (treasuries). Ebola has been around for a long time and there have been other outbreaks. There will be other outbreaks after this as well, since it is carried by animals that can transmit the virus to humans, without illness by the animals. If contained, as it has been in the past, it will come and go again as any other flare up of disease (remember SARS?). If not controlled, given a 70% mortality rate with the latest outbreak, it threatens large sections of the population. The concept of confident long-term market growth is based on population growth and productivity increases over time. If a disease eliminates substantial portions of the population, that premise fails and even over the long-term, economies will shrink and equity markets will shrink with them. Even if the most likely scenario happens (a minor breakout with no epidemic-like results), fear of the disease can temporarily cause fear of being out in public, traveling, shopping, etc. Each time more negative ebola news comes out, stock markets take another leg down. With a 10-14 day incubation period, It could take several weeks to see that the breakout is controlled before some confidence is restored. As I write this, details have emerged about a 2nd healthcare worker in Dallas having ebola and having flown on a commercial jet the night before her symptoms began. Sure enough the market fell to new lows shortly after the news. The US CDC needs to instill confidence soon or ebola will take the economy down in the short-term (best case) and could take it down in the long-term if it truly does become an epidemic. Again, very low probability of extreme catastrophe, but until it’s a zero probability, it will have an impact in financial markets.

6) Fear / Self-Fulfillment – Fear of all of the above having a negative impact on the economy causes markets to fall which causes confidence to fall which causes spending to drop and layoffs to begin, which causes the economy to contract. It can be self-fulfilling and can happen very quickly. The more the stock market falls and the longer the fall drags on due to fear of a recession, the higher the potential that the recession occurs as a result. This is the biggest concern for the stock market short-term. This correction, so far, has happened quickly and hasn’t taken market levels to a point that the fall will impact the economy. That doesn’t stop the market from starting to worry about though.

Remember, markets tend to climb the wall of worry. As long as there are reasons to worry, there’s room for the market to go up. New worries will push it down temporarily (no one was talking about ebola a year ago), but the lower prices go, the better the price you get if you’re using a consistent plan of buying over time. This is why people are so successful with 401ks. Volatility creates wealth for those who don’t fear it (see https://blog.perpetualwealthadvisors.com/2013/06/20/the-value-of-volatility/). While we can’t control the aggregate market going through a fear-cycle, I hope that understanding the reasons that cause the fear helps you avoid it.

Perspective

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The stock market has hit a rough patch over the last couple of months and that has intensified over the last couple of weeks… Just some quick charts on what’s happened since the March 2009 bottom in the stock market for perspective:

Seeing stocks pull back 10-20% from highs is completely normal from a historical perspective. It’s also not predictive of what will happen in the near term future. Stocks could go sharply lower from here, could flat line, or could snap back to new highs. The volatility inherent in stocks, especially over a short period of time, is the price you pay for the long-term expected returns that stocks have historically provided. Any equity investor has to be prepared to lose 50% of their portfolio’s equity holdings at any time in return for those long-term expected gains. As long as money that’s needed for the short-term isn’t primarily in stocks, losses on that money will be muted. For money that’s invested for the long-term, as long as it really isn’t needed until the long-term, short-term performance is not relevant (sign up for the roller-coaster when you invest and hang on during the ride).

After-Tax 401ks & Rollovers To Roth IRAs

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The IRS recently clarified rules surrounding rollovers of qualified plans (401ks, 403bs, etc., all of which I’ll refer to as “401k”s for the rest of this post for simplicity) to IRAs which can have a dramatic impact on a plan participant’s ability to save for retirement in some situations. For those of you who want to read the official IRS notice, it is Notice 2014-54, released on September 18, 2014. For everyone else (which is probably everyone), I’ll summarize what changed and what it means for you. First some background…

Virtually everyone understands the pre-tax portion of a 401k. You defer a portion of your salary as a deposit to your 401k and that amount is not taxed in the period it’s earned. Instead, it grows tax-deferred until retirement, at which time you can withdraw it (usually after age 59 ½ without penalties) and pay tax at withdrawal. Another, newer type of 401k is a Roth 401k. In a Roth 401k, you are taxed on the income that you defer to your 401k, but it grows tax free and is not taxed at all (under current laws) at withdrawal in retirement. If your tax rate is the same at the time of deferral as it is in retirement, then both types of 401ks produce the same amount of after-tax money in retirement. For most people who are into their mid-earning years, the premise that they’ll earn less in retirement and have more ability to control what portion of their retirement savings is subject to tax each year means they’ll probably be in a lower tax rate in retirement. This means they’d favor the pre-tax “Traditional” 401k. While the generalization is true, in general, like much of financial planning, the details of choosing between a Traditional 401k and a Roth 401k are complicated and really need to be evaluated on a case-by-case basis. Regardless of whether you contribute to a Traditional 401k, a Roth 401k, or a combination of the two, the IRS limits contributions at $17,500 per year (indexed to inflation and likely to increase to $18,000 for 2015) + $5,500 more if you’re over age 50. If your employer makes contributions to your 401k via matching, profit sharing, or direct contributions, a second limit applies. That is that your contributions plus your employer’s contributions cannot exceed $52,000 for 2014 (again indexed to inflation).

In addition to the Traditional and Roth 401ks, there is less well-known and less-popular type of 401k called the After-Tax 401k. Many plans do not allow an After-Tax 401k due to the difficulty in accounting for so many types of contributions. For those that do allow it, in this type of 401k, contributions are taxed in the year you earn them (they don’t go into the account pre-tax like a Traditional 401k), but at withdrawal in retirement, you only pay tax on the growth since you’ve already paid tax on the amounts you contributed. This is much less powerful from a tax perspective than pre-tax in (Traditional 401k) or tax-free out (Roth 401k), but is still advantageous in some cases because it means the growth (interest, dividends, and gains) is not taxed each year as it is earned and so that growth can continue to compound tax-deferred until withdrawal. The After-Tax 401k is not subject to the $17,500 employee contribution limit, but is subject to the $52,000 total contribution limit. This means that if you’re maxing out your Traditional/Roth 401k, and your employer isn’t contributing $34,500, and your plan allows an After-Tax 401k, there is room for you to contribute to your After-Tax 401k. Unfortunately, the tax on the growth of an After-Tax 401k is assessed at ordinary income tax rates rather than at lower, capital gain rates as an ordinary taxable brokerage account would be taxed. So, in general, an efficiently managed taxable brokerage can be a better option than an After-Tax 401k, especially when considering the liquidity advantage that comes with being able to access your money at any point for any purpose. This has been the root cause of the limited popularity and use of an After-Tax 401k.

Once you leave your employer, you can withdraw from your 401k and rollover the money to an IRA. Traditional 401ks go to Traditional IRAs and Roth 401ks go to Roth IRAs, all preserving their tax status. With After-Tax 401ks, it’s more complicated. If After-Tax 401k money is rolled over to a Traditional IRA, a portion of the Traditional IRA becomes “basis”, which is not taxed again at withdrawal and every withdrawal will be part growth (taxed) and part return of basis (not-taxed). If it’s rolled over to a Roth IRA though, the tax treatment used to be unclear. Many tax practitioners and plan administrators thought that the IRS would consider Traditional 401k money and After-Tax 401k money together in one rollover, assessing a prorated amount of tax if one were to try to roll pre-tax money to a Traditional IRA and after-tax to a Roth. This treatment would be consistent with the way the IRS taxes conversions from Traditional IRAs to Roth IRAs. If there are both pre-tax and after-tax (basis) dollars in a Traditional IRA, and you attempt to convert a portion of that Traditional IRA to a Roth IRA, you’d be taxed pro-rata on the amount. Others came up with complicated multi-step schemes to try to isolate the After-Tax portion of a 401k in its own account, such that it could be converted to a Roth tax-free. IRS guidance on Sep 18 clarified that effective immediately, After-Tax 401k dollars can be rolled over directly to a Roth IRA without any tax being due as long as it’s done at the same time as Traditional 401k money is rolled over to a Traditional IRA.

I find it hard to believe that this treatment will be around forever, but at least for now, this has opened the door for massive amounts of money to be tucked away in an After-Tax 401k and then rolled directly to a Roth IRA at the time service with that employer is terminated. Here’s an example of how it could work for someone earning $200k per year, maxing out her Traditional 401k with an 8.75% ($17,500) contribution, receiving a 3% ($6,000) employer contribution, and working for three years before moving on to another opportunity at a different employer:

 

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The person above would be able to stash away $85,500 in a Roth IRA after only 3 years while otherwise earning too much per year to be able to directly contribute to a Roth IRA. It’s clearly not for everyone since you need to have a lot of free cash flow in order to take advantage of the large contributions and your plan needs to include After-Tax 401k contributions as an option. If it can work for you, and you’re looking to tuck away large amounts of tax-advantaged money, this is a really big deal.

So here’s what to do: If you’re maxing out your $17,500 401k contribution each year and looking to put more than that away for retirement, send your 401k plan administrator a note (or call) and ask, “Does my 401k plan allow after-tax (non-Roth) contributions after I’ve hit my $17,500 maximum pre-tax contribution each year?” If the answer is “yes”, you can start to take advantage of this immediately.

One final note to keep in mind… tax rules are always changing. There’s nothing to say the IRS won’t change its mind or that Congress won’t pass a law to stop this treatment of After-Tax 401ks. That’s true of any tax law or IRS interpretation of that law. It’s prudent to monitor the tax landscape and adjust decisions accordingly. Contact your financial advisor before and while attempting something like this or if you have questions about it.

Misleading Markets

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While the Dow and S&P 500 have done fairly well this year and have held up decently so far this quarter, other asset classes that aren’t in the headlines, but are part of a well-diversified portfolio, have fared far worse. Some classes, like Commodities and Microcap Stocks have even fallen enough to be considered in a “correction” by its classical definition (10% down from highs). The table below shows (through 9/22) year-to-date and quarter-to-date returns for a select group of ETFs that represent major asset classes, along with their decline from their high over the last 52 weeks.

There’s no way to know whether this divergence in returns is predictive of poor returns to come, or if a reversion to the mean is more likely which would have underperforming asset classes begin to outperform. I just wanted to quickly point out that while the perception is that the market is at all-time-highs, this is really only true if you’re looking at US Large Cap Stocks in isolation.

PE Ratios, Earnings Yield, Interest Rates, & Valuation

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Many of you understand one of the most basic concepts in investments, the P/E ratio. For those who don’t, I’ll give you a brief explanation because you’ll hear “P/E” in almost any discussion on market or company valuation. “P/E” stand for Price-to-Earnings. It’s a ratio of what it costs to own a share of stock in a company, versus the annual earnings of the company that are attributable to that one share. In other words, PE = stock price ÷ annual profit per share. Annual profit is usually referred to as “Earnings Per Share” or “EPS”, so we can simplify a bit and say that PE = stock price ÷ EPS. It’s a measure of how expensive a stock is, relative to the earnings that one share of the company represents. For example, let’s take a look at Apple. The stock is trading at $92 per share. In the year ending Sep 2014, Apple is forecast to earn $6.88 per share (that’s about $41 Billion in profits divided by about 6 Billion shares outstanding). Thus, the PE for Apple is 92/6.88 = 13.37. Is that high or low? How do you determine a fair PE for a company?

To answer that, I like to take the mystery and complication of the stock market out of play and think about a small business, something that you can probably relate to a lot easier. Let’s say you and four friends start a business that earns a steady $50k per year in net profits. When you started the company, you decided you’d each own an equal 20% of the company. In case one of you wanted to sell a part of your share to someone else, you decided you’d each own 200 shares of a 1000 share total (still 20% of the company). If the company earns $50k per year, and there are 1000 shares outstanding, how much does each share of company earn? $50. That is, the EPS for your company is $50. Now, how much is your company worth (how much would someone being willing to pay for one share of your company)? Surely it’s more than $50k ($50 per share) right, because it’s earning $50k per year consistently, so someone who paid only $50 per share for it would get their money back in just a year. You would be highly unlikely to sell a share for such a low price… you’d just keep the share and earn the $50 over the next 12 months from profits instead. On the other hand, the company can’t be worth a billion dollars ($1 million per share), because even though someone paying $1M per share will eventually get their money back by earning $50 per year, 1) it would take several lifetimes, 2) there’s more risk that something happens to the business to reduce its earnings when you need to go farther out in the future to make back your investment, and 3) (most importantly) that $1M can be invested in something else that pays well north of $50 per year so no one would ever pay a million dollars for $50 per year even if it was guaranteed forever. Somewhere in between $50 and $1M per share there is a fair price though. Perhaps the best way to estimate is by using the third rationale above… how much money do I need to invest to earn $50 per year on something with a similar amount of risk? I can put $7700 in a 1-year CD and earn $50 at 0.65% interest. Clearly though, buying future profits of a business is higher risk than a CD so a buyer would want to earn more than the going rate for a CD. There’s also the chance that a buyer may not be able to re-sell the business in a year, so we should look at something that locks up money for a longer time period to compare. How about a 10-year investment-grade (BBB) rated corporate bond? That pays about 5% and has some real risk in it (the company could go bankrupt within 10 years and you wouldn’t get your money back). It would take a $1000 investment in that bond to earn $50 per year. There’s probably still more risk in the small business though because the only way you wouldn’t get your money back in a bond is if the company literally has no money and is forced to liquidate or file bankruptcy. In the small business, even if it just starts to breakeven for a while, there are no profits for the owners, so you may never get your money back. A buyer could argue that she would want a 5% higher return on an investment in your company than he/she could get from the corporate bond. The buyer would be willing to pay $500 per share then, since a 10% annual return on $500 is the $50 per share that your company is generating. $500 per share then might be a fair price for the business. A $500 price for a company earning $50 per year means a PE of 10.

What if your company was growing rapidly and your earnings were expected to increase considerably over the next few years? If $500 (PE of 10) was a fair price for a stable company, surely a buyer would be willing to pay more than $500 (higher than a PE of 10) for a rapidly growing company right? Of course, because he’s not only going to get just $50 per year, he’s going to get $50 this year and more than $50 next year and much more than $50 the year after that. That has to be worth more than the stable company that’s not growing. So now we know that PE’s should be higher for higher growth companies. This should seem pretty intuitive.

There’s another factor that can have a dramatic impact in a fair PE. What happens if interest rates fall and investment grade bonds start to pay 3.33% instead of the original 5%? If investors in a small business like yours still demand a 5% premium to what corporate bonds are paying, they’ll want an 8.33% return from an investment in your company. Since the company is still generating its consistent $50 per share per year, the only way to make that seem like a lower return is to push the value of the company higher. At $600 per share, the $50 in annual profits would be an 8.33% return. The reduction in interest rates pushed the PE (600/50 = 12) higher. So, we can generalize that lower interest rates lead to higher PEs. This may be less intuitive, so I’ll give another way of thinking about it. Instead of looking at the PE ratio, let’s look at its reciprocal. That’s the EPS / stock price. We can call this the “earnings yield”. For our small business above, the earnings yield would be 10% if the stock price was $500 (50/500), it would be 8.33% if the stock price was $600 (50/600) and it would be 5% if the stock price was $1000 (50/1000). If you could get 5% in a savings account or CD, would you ever purchase a company with a 5% earnings yield (remember, steady payments, not expected to grow)? I hope your answer is no, because there’s a lot more risk in the company than there would be in a savings account. So, if bank interest rates were 5%, there’s no way the small business could be worth $1000 per share (5% earnings yield, PE = 20). The price must be < $1000 per share. What if bank interest rates were only 1%? Now you might be willing to take 5% earnings yield in a riskier investment because you’re getting an extra 4% return over what you’d get in the bank. It should seem clearer that lower interest rates in general would make lower earnings yields seem more attractive. If lower rates lead to lower earnings yields, the lower rates must lead to higher PEs, because PE is just the reciprocal of earnings yield.

To summarize, remember that the P/E ratio is the price of a share divided by earnings per share. The reciprocal of the P/E ratio is earnings per share divided by share price and that’s called the “earnings yield”. The stronger the expected growth in earnings, the higher the P/E. The lower the level of overall interest rates, the lower the earnings yield, and the higher the P/E.