Recharaterize your Roth Conversion?

2010 may be remembered as the year of Roth conversions.  Remember that after-tax dollars are invested in a Roth IRA while pre-tax dollars go into a traditional IRA.  The advantage of a Roth IRA is the withdrawals from the account are tax free.  The Internal Revenue Code (IRC) permits Roth conversions, the transfer for funds from a traditional IRA to a Roth IRA.  However, it also requires that taxes be paid on the funds converted.  Usually the converted funds are taxed in the year of the conversion.  For example if you did a Roth conversion in 2009 then the funds transferred from the traditional IRA to the Roth IRA would have been taxed on your 2009 tax return.

Things were different in 2010.  The IRC, for 2010 only, allowed the taxes on the converted funds to be taxed over two years (2011 and 2012).  While this didn't reduce the total tax bite, it did spread the taxes out over two years making the taxes a little easier to pay.

Many taxpayers experienced “sticker shock” when they saw their 2010 tax returns on April 18^th this year and have started to have second thoughts about the conversion. 

All is not lost.  If you are in that boat then you have until October 17, 2011 to recharacterize (undo) your Roth conversion.  Before you make that decision there are a couple of important considerations.

First, the two year tax deal is lost forever if the Roth conversion in recharacterized.  The two-year payment option was only available for 2010 conversions.  We’re not in Kansas anymore (unless you happen to live there) and 2010 ended about six months ago.

Second, only the funds that with converted from a traditional IRA to a Roth IRA can be recharacterized.  That seems obvious, no?  But some people held out funds during the conversion to pay the taxes on the conversion.  Assume that a client withdrew $200,000 from a traditional IRA and converted $170,000 into a Roth IRA, withholding $30,000 for the tax bill on the conversion.  In a recharacterization only $170,000 can be converted back into the traditional IRA, taxes will have to be paid on the $30,000 that didn’t find it’s way into the Roth IRA.

Third, gains or losses on funds in the Roth IRA must be considered in any recharacterization.  Let’s look at gains first.  Assume $200,000 were converted into a Roth IRA and now the taxpayer only has sufficient funds to pay taxes on 70% of the conversion.  That means that 30%, or $60,000, of the original conversion needs to be recharacterized.  Assume also that the converted funds, due to some good investment decisions, now have a $300,000 balance.  The Roth fund has earned $100,000 of tax-free investment income.  However, the writers of the tax code took this into account.  Sorry.  If 30% of the converted funds are transferred back to a traditional IRA then 30% of the gain on the Roth IRA must also be converted back as well.  That means that rather than recharacterizing $60,000 the taxpayer will have to recharacterize $90,000 ($60,000 from the original Roth conversion plus $30,000 from the investment gain).

Now, what if the Roth IRA had a loss?  Assume the same set of facts as above, except that the Roth IRA had losses and the account balance has declined to $140,000.  Unless funds are recharacterized the taxpayer will still have to pay taxes on the full conversion amount of $200,000.  To recharacterize 30 percent as above the taxpayer will recharacterize $60,000 (30% of $200,000) but only transfer $42,000 (30% of $140,000) back to the traditional IRA.  If the taxpayer recharacterized and transferred back $42,000 then taxes would be due on $158,000 ($200,000 - $42,000). 

Don’t you just love taxes!

Email me with tax or investment questions and I'll consider them for future blogs.

Up the Creek

Don't ever want to be up the creek without a paddle.  Not literally nor figuratively.  Here I am in my new Father's Day present on the James River; thanks to my dear wife.  Pretty cool and lots of fun. 

In these troubled financial times it is always good to keep your head clear and above water.

Evaluating Credit Card Offers

Have you ever received an invitation to transfer your high-balance, high-interest rate credit card to a new card with zero percent interest for a year?  Is it a good deal or not?  Like many things in life, it depends. 

I was just asked that by a client who had a $10,000 balance on his credit card, was paying 14% interest and making monthly payments of $250.  The offer that he received in the mail was for 0% on transferred balances for a year, followed by 18% interest after that.

You can go to http://www.creditcards.com/calculators/ and run some simulations on your own.  However, let’s take a look at what we did.  First, we computed the payoff for his current card using the “payoff calculator”.  If he continues to make $250 per month payments and cuts the card up or at least doesn’t use it until it is paid off then he will pay the balance of in 55 months, that’s about four and one-half years, and will pay $3,549 in interest.

Next we looked how much he would have to pay per month at 0% interest.  Remember to take advantage of the low, zero percent, interest; he would have to pay the entire balance off in 12 months of less.  $10,000 divided by 12 months is about $833 per month.  He couldn’t do that.  In fact, paying $250 per month was his maximum payment.

If he converted to the new credit card and paid $250 per month for a year with zero interest  then he would reduce his balance by $3,000.  All of every payment for a year would reduce his account balance.  That way, after a year, when the higher interest rate kicked in his unpaid balance would be $7,000.  Back to the payoff calculator for another look.  Again assuming that he doesn’t use the card, makes the $250 per month payment, and accepts the new 18 percent interest rate he will pay the card off in 37 more months and will pay $2,147 in interest.

The following table summarizes his options.

	Keep the 14% Card	Pay off in 1 Year	Transfer Balance
Interest Rate	14%	0%	18%
Monthly Payment	$250	$833	$250
Months to Pay Off	55 months	12 months	12 at 0% 37 at 18% 49 months
Interest Paid	$3,549	$0	$2,147
Total Paid	$13,549	$10,000	$12,147

The second option, although the least expensive, was a no brainer.  He couldn’t make the payments.  He will be out of debt 6 months sooner and $1,402 richer if he transfers his balance to the 0 percent credit card.  However, this only works if he doesn’t start using the credit card again, makes $250 payments every month, and is able to keep the interest rate at 18% after the initial zero-interest period.  Being late or missing a payment could cause the interest rate to skyrocket.

Finally, is it always best to transfer credit card balances to zero-interest cards?  Nope.  Every case is unique.  Run the numbers before you make a decision.  Again, http://www.creditcards.com/calculators/ is an easy-to-use tool to help you analyze a credit card offer.

Where Did My Dollar Go?

Or The Stable Monetary Unit Assumption and Other Accounting Fallacies

Accountants make many assumptions as the record financial transactions and prepare financial statements.  One of the most critical is the “stable monetary unit assumption”.  This assumption presupposes that the purchasing power of the dollar is constant over time; that $1 today will purchase as much as did $1 thirty years ago.  This assumption makes it possible to prepare historical-cost based balance sheets. 

An historical-cost based balance sheet is one where the values of assets purchased at different times are added together using their historical acquisition costs (what the company paid for the assets at the time of their purchase) to compute the company’s financial position.

After all, a balance sheet has been defined as a picture of a company’s financial position at a point in time.  That means that an asset purchased in 1970 for $30,000 has a historical cost that is the same as an asset purchased today for $30,000.   Accountants, better than most, know that the purchasing power of the dollar has eroded over time.  Nevertheless, we ignore that fact when we prepare financial statements.

Changes in the purchasing power of the dollar are ignored by accountants in the United States we probably shouldn’t.  The following table shows the annual consumer price index since 2000 and the decline in the value of the dollar.

		Today’s $	$1 in 2000
		Would	Would
Year	CPI	Buy in 2000	Buy Today
2000	172.2	$                   1.00	$                  1.00
2001	177.1	$                   0.97	$                  1.03
2002	179.9	$                   0.96	$                  1.04
2003	184.0	$                   0.94	$                  1.07
2004	188.9	$                   0.91	$                  1.10
2005	195.3	$                   0.88	$                  1.13
2006	201.6	$                   0.85	$                  1.17
2007	207.3	$                   0.83	$                  1.20
2008	215.3	$                   0.80	$                  1.25
2009	214.5	$                   0.80	$                  1.25
2010	218.1	$                   0.79	$                  1.27

One dollar in 2010 would have purchased what you could have purchased in 2000 for 79 cents.  Alternatively, it took $1.27 in 2010 to have the same purchasing power as you had with $1.00 in 2000.  So what do you think, has your paycheck kept pace with the decline in the purchasing power of the dollar?

Everyone knows Walmart and probably knows that Walmart has shown tremendous sales growth.  Take a look:

The top line of the graph shows Walmart's sales as reported on their financial statements.  Walmart sales have grown from $156.2 billion in 2000 to $405 billion in 2010.  But wait, there’s more.  A dollar in 2000 would buy a lot more than $1 in 2010.  You saw that above.   In fact, the purchasing power of the dollar decreased by about 26 percent over that 10 year period.

The blue and red lines on the graph show Walmart's sales deflated to 2000 dollars and for the increase in the price of gold. 

When Walmart’s sales are deflated to year 2000 dollars you can see that sales did increase, but not as much as sales in nominal dollars.  If you were to price Walmart’s sales in gold then sales have actually decreased.  Which bring me to the key point in this blog.

The financial press talks about the increase in the price of gold when what is really happening is a decrease in the value of the dollar.  If you assume that the intrinsic value of an ounce of gold is constant over time then the worth of the dollar has been declining rapidly.  Remember, an increase in the price of gold (or any other commodity) reflects two things, a price change resulting from a change in demand for the commodity, and a price change resulting from the change in the value of the dollar.  Both have happened with the price of gold.

Finally, remember when you look at a company’s financial statements the amounts are expressed in nominal dollars, the value of the dollar when the financial statements were issued and not in constant dollars (dollars adjusted for changes in the purchasing power of the dollar).

Inflation on the Rise . . . But Where?

Some of us remember the high levels of inflation reached during the Carter Administration in the 1970s.  Those who don't learn from experience repeat the mistaked of the past.  The inflation rate in the United States is starting to tick upwards and may once again reach the extremely high inflation levels of the 1970s.

The official U.S. price inflation rate based on the Bureau of Labor Statistics (BLS)’s consumer price index (CPI) in the month of May on a year-over-year basis was 3.57%.  This was well above the Fed’s informal inflation target of 1.5% to 2%.

The year-over-year increase in the Consumer Price Index has been moving upwards for several month as the following chart shows:

                                       Year-over-Year
                                         CPI Increase

May 2011                              3.57%
April 2011                              3.16%
March 2011                           2.68%
February 2011                       2.11%
January 2011                         1.63%
December 2010                     1.50%
November 2010                     1.10%

Note that the official rate of price inflation has more than tripled over the past 6 months.
The National Inflation Association estimates the real rate of U.S. price inflation to currently be approximately 7.5% on a year-over-year basis.  This is consistent with the Shadow Statistics inflation chart below.

                              Source:  http://www.shadowstats.com/alternate_data/inflation-charts

Remember that the Fed’s core CPI, ignores food and energy prices.  If you have been to the grocery store or the gas pump then you know that those prices have been increasing as well.

After yesterday's stock market dive I expect a dead cat bounce today.  The unemployment news toady was "good" with only 414,000 new unemployment claims issued.  That's down 16,000 from the week before.  However the 4-week moving average has been constant at about 424,750.

Watch the money supply.  During the inflation of the 1970’s, surges in money supply growth predicted surges in CPI inflation, with now what appears simplistically to be a 3-4 year lag. The long period of disinflation that began in the early 1980s was also correlated with changes in the money supply.   Rising money supply may not be directly correlated with the CPI any more and so increases in the money supply don't tell where the inflation will show up.  However, money supply increases can serve as an early warning system for when you need to start looking. For example, money will be chasing something, and it might not be the goods and services in the CPI basket.  It might be financial assets . . . .

Unemployment and the Economy

The White House and MSM taking heads continue to claim that the unemployment rates is under 10 percent.  It's not.  Shadow Stats (available at http://www.shadowstats.com/) is showing the real unemployment rate at about 22.5 percent.  Here is their latest chart (6/15/2011):

Is it any wonder that retail sales are down? "The U.S. Census Bureau announced yesterday that advance estimates of U.S. retail and food services sales for May, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $387.1 billion, a decrease of 0.2 percent (±0.5%)* from the previous month, but 7.7 percent (±0.7%) above May 2010. Total sales for the March through May 2011 period were up 7.5 percent (±0.5%) from the same period a year ago. The March to April 2011 percent change was revised from +0.5 percent (±0.5%)* to +0.3 percent (±0.3%)*.

Retail trade sales were down 0.3 percent (±0.5%)* from April 2011, but 8.0 percent (±0.7%) above last year. Gasoline stations sales were up 22.3 percent (±1.7%) from May 2010 and nonstore retailers sales were up 15.9 percent (±3.1%) from last year.