### Roth Blueprint

I spent quite a bit of time developing a Roth conversion plan.  Conversion to effectively modify the bottom line has several moving parts to be optimized.  Each aspect in turn has it’s own set of optimizations.

Considerations:

When to conv#ert

How much to convert

Tax consequence (single and married)

SORR

Long term payback (break even)

Medicare cliffs

Difference between assets left in a TIRA (bonds v stocks)

Eventual use of Roth in a portfolio + SS (spending model)

Compounding

Self Insurance

Tax treatment diversity

Sequential portfolio diversity (non-Roth v Roth) clean out risk first.

Planning money to live on while Roth converting

Tax loss harvesting

post tax 8606 IRA money

1 When to convert

The problem of when to convert is related to the W2 income.  When you are earning any conversion will be added to your ordinary income.  If you make for example an AGI of  \$189K (top of 22%, married filing jointly, under age 65, standard deduction of \$24K) it  will cost \$28,179 in taxes.   If you Roth convert 100K the AGI will increase to \$289K (well into 24%) and your taxes will be another \$24,000 or \$52,179.  Every additional dollar above \$189K gets 24 cents whacked out of it.  In the end you spend \$24K to get \$100K into the Roth.  If OTOH you are living off of cash there is no income tax from a W2 source.  So you can convert \$289K and your tax whack is still \$52,179, BUT when it’s done you have \$289K sitting in the Roth.  You can convert 2.89 times as much money for the same tax dollar.  Tax law certainly is “progressive”.  Let’s say you want to convert \$1M.  If you do 4 conversions while W2-ing it you will have made a W-2 of \$756K (189×4) over 4 years,  400K net converted and a \$208,176 tax bill of which 96K was due to your Roth conversion.  Not so efficient.  Convert while living on cash and in the same 4 years you will have 1,156,000 net in the Roth and the same \$208,176 tax bill.  If you converted \$250K x 4 years to get your 1M your tax bill would be \$386,513 well into 35%.  Clearly if you want to minimize taxes, live off cash while doing it.

My analysis of when, is when you are retired and able to live off cash with no other income and you need to be able to live off cash for 4 years plus have the tax money available during conversion, which means pre-plan how to fund the conversion.  For the above 4 year example I would go to cash at age 66, 4 years before RMD and commence to converting, to end your conversion at 70.  Once you RMD the RMD money is ordinary income and just like a W2 can dramatically raise the cost of conversion but it’s even worse since you won’t have a W2 income to compensate so your portfolio is rapidly deflating.  Where you get “living on cash money” will be covered further on down the line.

2 How much to convert

Every dollar you efficiently convert is a dollar that will never be taxed again.   If you leave money in a TIRA especially money in equities it will continue to grow and that money once RMD’d will generate a tax bill.  If you have 500K in an equity rich TIRA with an 8% return you start at 18K distribution at age 70 and by age 80 you’re distributing 38K.  Your SS is 42K + 38K for 80K taxable and a tax bill of 6K well within the 12% bracket limit.

What if you have a 2M TIRA?

Once again you start out slow at about 73K and by age 80 it’s \$153K.  You left the 12% tax bracket long ago and you are approaching 24% bracket only 10 years into RMD!   If SS is say \$50K/yr your taxable SS is \$42.5K (SS is taxed at .85%) so your net is \$195,500, into the 24% bracket.  Tax on \$195K is  \$29K.  And the tax picture only gets worse from there.  So cleaning out the TIRA is a tax saving maneuver.  #1 the tax is less so the strain on the portfolio is less and #2 you have to get tax money from some where to pay.  The W2 is no longer buffering the assault.  If the market is down, you get to sell your shares low to pay the tax man.  Bad for SORR.  If you had the same situation with a 500K account SS of \$42.5K + \$38K is an income of 80.5K and a tax bill of \$6087  Much easier to come up with!

Let’s say you die at 80 leaving the estate to your spouse.  She will loose you’re SS and keep her own, or she will claim survivor benefits.  I estimate survivor will pay her maybe 36K/yr or 30K taxable.  At 81 the RMD will remain the same or be recalculated depending on the inheritor’s life expectancy, so let’s say it stays on the same schedule.  The next payout would be \$164K, add 30K SS for 194K   The (age 81) tax bill will jump to  \$39K from 29K from jsut into the 24% bracket to the 32% bracket.  Your ol lady is getting hosed!  She makes less on SS and pays a lot more in taxes because you died.  Cleaning out the TIRA into a Roth does the following:  The age 81 RMD is 41K plus the same 30K from SS for 71K  for a tax bill of \$8.5K just into 22%.  So your death in this scenario keeps her 2 tax brackets below the other scenario.  Uncle Sam already has his money so he leaves her relatively alone.  It only gets worse with a bigger TIRA.  By cleaning out the TIRA as much as possible and as efficiently as possible this scenario is avoided.

The other problem with not converting enough is growth in the TIRA post RMD.  Let’s say you have 2M and pull out 500K into a Roth leaving 1.5M

At age 80 your RMD is 115K and SS is 42.5K for \$157K and a tax bill of about \$21K intermediate between a 6K bill from a 500K TIRA RMD and a 29K bill from a 2M TIRA.  Cleaning out 500K helps but because the tax is progressive the power of conversion is eroded.

How about the whole shooting match!  You convert all 2M at the tip top of the 24% bracket!  The tip top is 340K when you include standard deductions, so 2M would be almost 6 years of conversion.  The taxes on 340K is 64K for a 6 year conversion cost of 375K.  With no RMD your tax bill on 42K SS is about \$1700

so to recap

 Roth 0 0.5M 1M 1.5M 2M – TIRA @ RMD 2M 1.5M 1M 0.5M 0M SS taxable age 80 RMD 153 115 77 38 0 42 tax in K going forward 29 21 13 6 1.7 – conversion/yr 0 100 200 300 340 – yrs conversion 0 5 5 5 6 – total tax paid at conversion 0 34 152 273 384 – living on cash 4 to 6 yr – – – – – – conversion to keep – – – – – – bracket below 24% – – – – – – – – – – – – – Spouse tax hit 36 26 15 10 1.7 30

The race is between dying and higher tax brackets.  The less you convert the higher the future tax bill, BUT the more you convert the higher the conversion tax bill so it’s pay me now or pay me later.  You owe the money and it will be taxed at an ever accelerating rate and once you die your spouse is hosed unless you planned for that.  Once RMD hits you’re locked in so what you gonna do?  Call Gasem!  One thing I did not cover are medicare cliffs.

Cliff 1 at 250K (married) a 3.8% surcharge is placed on your income so converting at 340K is even more expensive making a 250K ceiling more attractive

Cliff 2 If you make more they charge you more for medicare

This does not include a supplemental (typically about 150/mo) and it is per person  so when you convert 340K and you’re both 65  you pay about 11K per year

What you want is to stay in the 12% bracket for as long as possible and then in the 22% as long as possible.  The code is progressive so being middle class is your friend.  Soak the rich is alive and well!   I was noodling with the RMD calc and if you put only low yielding assets (bonds) in the TIRA the RMD goes down The age 80 RMD @ 3% return on a 2M TIRA is 95K v 153K in a 8%  TIRA, and the RMD accelerates more slowly.  For 0.5M the RMD at 80 is only 23K  Here is a table:

 TIRA @ RMD 2M 1.5M 1M 0.5M 0M age 80 RMD 3% 96 70 47 23 0 RMD + SS 138 112 89 65 42 top of 12% tax bracket 104 – – – – top of 22% tax bracket 189 – – – –

I estimate at a 1M IRA you will be well into the 90’s before you leave 22% and at 0.5M in bonds in the TIRA at RMD it will be a couple decades till you leave 12%  The outlook improves for your widow as well.

Tax savings if you don’t convert:

 tax savings between 100% to 0% 384 350 232 111 0 on RMD conversion – – – – –

If you don’t convert you save those taxes and they can keep compounding BUT the tax code is progressive so more and more will be taxed.  The rate of taxation goes up while the rate of return is pretty constant so the tax saving will erode quickly.

3 Account mix

I suggest 4 types Roth, TIRA, and post tax, and a Tax loss harvest account.  Your portfolio will develop over decades and there will be occasions to tax loss harvest.  Tax loss can be mixed with cap gain for a 0% tax bill.  Also as long as you stay in the 12% bracket the cap gain tax is zero and you only pay cap gain on the amount over the 12% limit.  If you have tax loss it can be applied to the over amount so a little dab of TLH can save you money if you bother to acquire it.   My FA has all of my tax lot info in his software so it makes harvesting effortless, and lucrative.

I used my post tax account mixed with TLH to pay for my Roth conversion.  I converted about 600K of post tax stock mixed with TLH for a zero dollar tax bill.  I saved about 100K in taxes.  The 600K pays for living expense and conversion taxes.  It offers another advantage in that it lowers my overall AA during conversion and in my early retirement which offers me some SORR protection.  This is recommended.    Most people are in accumulation mode but upon retirement you enter deflation mode and need to be ready to spend some money once the W2 disappears.   As the cash gets spent the AA will rise again but I’ll be farther into retirement so SORR becomes less important.  SS is deferred till age 70 so I have no income.  My chosen conversion is 250K per year x 4yrs which avoids most of the cliffs, and will convert net 1M and  a gross 1.4M @ 4% when compounded at conversion end.  My TIRA will be about 600K all in bonds and at 3%  will RMD 22k the first year and 28K at 80.  My net tax saving will be about 130K which will stay in the post tax account compounding.  I am moving the riskiest assets first, then down the line till only bonds remain.  My disbursement model at RMD is SS + RMD plus I will sell some post tax stock as needed.  Since I only get taxed on RMD and 85% of SS, my taxes will be low for a long time.  Between my TLH and <12% income I will have no cap gains as I disburse post tax money.  I won’t touch the Roth and let that grow as insurance in case of medical disaster or as a wealth transfer vehicle.  Everybody gonna die from something and some of those causes are very expensive so having money stashed beyond living expense money is a comfort, and not only you but your wife will incur expense.  By owning 4 account types I have excellent control over my tax picture going forward.   A  lot of my “conversion money” is from interest accrued in my post tax account over the decades

4 Account imbalances

You read a lot of boiler plate “fill up the pretax accounts” it may not be the best advice.  Those accounts are tax deferred not tax free and their size determines the tax consequences which are progressive and tilted toward soak the rich.  I’m sure there is controversy on this but I think equal tax deferred and post tax up to maybe 4M and then over in the post tax above that.  A 5M tax deferred is not a trivial liability in the grand scheme IMHO. YMMV but that’s my take.

5 8606 Money

My IRA and my wife’s IRA were funded post tax.  I kept all the 8606 sheets.  It turns out once taxed that money changes the tax basis for the life of the TIRA.  Every year a proportional smaller amount will be taxed than what the RMD requires so if you RMD 25K and you have a 80% basis adjustment you will pay tax on only 20K.  My adjusted basis allowed me and my wife to transfer 265K into the Roth with only 245K taxable.  I’ll top that up once I have a better picture of for the taxable portion of my ordinary income from my post tax account.    All of these little tid bits add up.  265K compounds faster than 250K.

5 Modeling

This was all modeled in Excel in modules so  could understand the implications of each on the other and get some idea of multivariate optimization.  My portfolio and conversion strategy was further modeled in some commercial software designed to advise optimized Roth conversion strategies.  My actual modules matched the commercial strategy very well in terms of prediction.  My final optimization was different than theirs because they suggested 100% Roth conversion.  Over a very long time I agree with their strategy but it takes a while for the conversion to turn cash flow positive, for the tax progressive savings to over come the initial cost of conversion.  The initial cost can be initially viewed as a negative SORR.  A slightly less aggressive conversion has less SORR character.  The cash flow positive point is about the same.  My wife is younger than me by 7 years and is genetically predisposed to live a long life, with no real history of cancer, typically age to 90+.  My side is dead by 80 from CAD and metabolic syndrome, so some attention to that is built in.  My modeling is more extensive than 10 years age 80, but models 5 year aliquots of time with and with out married filing jointly and takes into account progressive tax codes.  I also optimized SS but won’t go into that here.

6 Budgeting and cash flow management

I believe in budgeting as a means to judge progress but I’m not a slave to it.  I can afford my pre-retirement income, including a risk premium for health care etc aka the bennies I lost with the W2  I’ll call that Max budget.  I retired on 80% of my “max budget” as this was described as comfortable to most retirees.   After the dust settled I decided to experiment with belt tightening since you read about that as a solution to bad times and I wanted to understand what that actually felt like, not as just some bromide.  I could go down 80% of the 80% or 64% of what I can afford.  So I oscillate between 64% and 80%.  Some months are cheap months, some expensive.  If we want something like a trip to EU (been twice since pulling the trigger) I save up the differential between cheap and Max months and when I have the differential we fly.  My wife is good with that technique.  All in all I came in 11% under my 80% max budget last year.  This year looks about the same, a little more expensive but likely inflation related.  Inflation is something to consider as it will eat up the slop in the calculation, but I ain’t skaired.

This is pretty much what I did and am doing.  I’ve invested for several decades and investment vehicles exist now that did not then so you do what you do in the environment in which you find yourself, and the environment into which you are retiring.  If you got a ten year nest egg and a 50 year horizon, that life has a very different risk profile from mine.  That life is quite leveraged, my life is not.  I can survive quite comfortably at 0% interest for decades, but it gives some insight into my thought process. It is not advice just my experience.  It’s complicated and based on probabilities and probabilities are not certain.

Calculators I used

Tax plan calculator

Schwab RMD Calc

FV Calc

Excel

I’ve completed my first conversion this year and will convert my second early next year probably Jan and then be done till 2020.  I owe the IRS 42K by my estimate and 44K by the HR block Free filer which doesn’t take into account some writeoffs I will claim.  The official HR block software won’t be live till Dec so I will get a more precise estimate then, and will owe essentially the same tax again next year, so it’s working predictably and according to plan.  I came across a tax penalty rule that says for high earners (>150K) you need to prepay 110% of last years tax to avoid the penalty so I take that to mean if my tax is 42K this year I must pay 46.2K next year to avoid the penalty.  Of course I would then apply the extra 4.2K to next years taxes, talk about soak the rich!  They’re screwing you 2 years out on money you haven’t made yet!  All the more reason to get them out of your hair.  I also checked the credit card option to see if I could claim cash back points and with the “convenience fee” it worked out to be a wash between CC and a check.

I’m now officially sick of researching Roth conversion, but quite satisfied in the result.

### Playing with FIREcalc and FVcalc

FIREcalc is not my favorite.  It tells you what happened not what will happen, but it does give you some information.  There is a portfolio disbursement method called the Bernicke’s Reality Retirement Plan based on a scheme by Ty Bernicke built into FIREcalc.  The scheme is to start with a high payout and gradually reduce the payout by 2% or 3% per year to a constant payout in the future.

This is a payout scenario.  The retiree is 50.  The retirement amount is 3M and SS kicks in at 65.  He takes 160K for 5 years (55) then decreases the take so at 76 he is making about 75K per year till he dies.  Here is the scatter chart

It get’s pretty close to zero but never flames out for a 100% success looking in the rear view mirror.  BUT who wants a >50% paycut when they are 76?  You party like it’s 1999 and then ??? eat beans?  You get cancer at 77???  Your old lady starts alzin???

Here is 1M @ 6% over 20 years

It grows to 3.2M in a relatively safe 50/50 2 stock account if you don’t tap it.  Let’s tap it!  At 65 Bernicke is paying maybe 115K and living is getting kind of tight.  You;ve seen an income drop of 30%.   So 15 years into retirement we’ll tap the million for an extra 40K per year for another 15 years taking you out to age 80.

The million pays you 600K and you still have 1.4M in the bank at age 80.  Your take has tailed off from 160K/yr to 75K + 40K or 115K/yr and you’re now 30 years into retirement.  You had a blast when you were ER and later after cruising the world for a decade travel has lost it’s luster and you don’t drive much so your car replacement need is diminished etc etc.  If you get cancer the \$1.4m can pay you the average 92K per year excess medical needs for 30 years and still not run out of money or you and mama can split 30 years of care.  This is 1.4M @6% for 30 years at 92K/yr  disbursement.

While you’re living large off the Bernicke acct 1M is accumulating and basically gives you a second retirement income when Bernicke starts to pinch.

FIREcalc does not give absolutes on the future and this article does not look at tax consequence or SORR.  Instead it looks at a time shifted kind of diversity with different distribution schedules and different compounding and different SORR for each portfolio Bernicke and 1M.  For my example you need 4M total at age 50, fat fire for sure, but maybe only 20 years into a typical medical practice it might be doable without need for side gigs post retirement.  You can FIREcalc the 1M portfolio separately and get a different worse probably more likely result. but still surviving 85% of the time over 15 years.     Like  said this is play but intriguing.   It was too confusing to try and present those scenario’s

Here is a spread sheet of retirement spending.  At 57 spending starts to ramp down until age 66 where the Bernicke retirement has lost 20% (headed to 39% loss) at a \$127K payout.  At 67 portfolio 2 has grown to an estimated 1.5M (range .9M to 6M) and starts to throw off \$40K/yr constant.  The tail off starts again but this time winds it’s way down to \$138K  where it normalizes.  Over the 50 year course Port 1 pays out 5.9M and Port 2 pays out 1.3M on a \$4M investment.  This isn’t a detailed analysis accounting for taxes and SORR etc but a quick FV calculation says Port 2 will have several M at age 99 and FIREcalc says a 1M to 9M range in port 2 at age 99.   My numbers differ from FIREcalc’s numbers because FIREcalc does look at historical SORR.   These are my calculated numbers not from FIREcalc.

 age port1 port2 spending/yr 50 \$160,000 \$0 160,000 51 \$160,000 \$0 160,000 52 \$160,000 \$0 160,000 53 \$160,000 \$0 160,000 54 \$160,000 \$0 160,000 55 \$160,000 \$0 160,000 56 \$160,000 \$0 160,000 57 \$160,000 \$0 160,000 58 \$156,000 \$0 156,000 59 \$152,100 \$0 152,100 60 \$148,298 \$0 148,298 61 \$144,590 \$0 144,590 62 \$140,975 \$0 140,975 63 \$137,451 \$0 137,451 64 \$134,015 \$0 134,015 65 \$130,664 \$0 130,664 66 \$127,398 \$0 127,398 67 \$124,213 \$40,000 \$164,213 68 \$121,107 \$40,000 \$161,107 69 \$118,080 \$40,000 \$158,080 70 \$115,128 \$40,000 \$155,128 71 \$112,250 \$40,000 \$152,250 72 \$109,443 \$40,000 \$149,443 73 \$106,707 \$40,000 \$146,707 74 \$104,040 \$40,000 \$144,040 75 \$101,439 \$40,000 \$141,439 76 \$98,903 \$40,000 \$138,903 77 \$98,000 \$40,000 \$138,000 78 \$98,000 \$40,000 \$138,000 79 \$98,000 \$40,000 \$138,000 80 \$98,000 \$40,000 \$138,000 81 \$98,000 \$40,000 \$138,000 82 \$98,000 \$40,000 \$138,000 83 \$98,000 \$40,000 \$138,000 84 \$98,000 \$40,000 \$138,000 85 \$98,000 \$40,000 \$138,000 86 \$98,000 \$40,000 \$138,000 87 \$98,000 \$40,000 \$138,000 88 \$98,000 \$40,000 \$138,000 89 \$98,000 \$40,000 \$138,000 90 \$98,000 \$40,000 \$138,000 91 \$98,000 \$40,000 \$138,000 92 \$98,000 \$40,000 \$138,000 93 \$98,000 \$40,000 \$138,000 94 \$98,000 \$40,000 \$138,000 95 \$98,000 \$40,000 \$138,000 96 \$98,000 \$40,000 \$138,000 97 \$98,000 \$40,000 \$138,000 98 \$98,000 \$40,000 \$138,000 99 \$98,000 \$40,000 \$138,000 tot \$5,916,799 \$1,320,000 \$7,236,799 acct port 1 port 2 net

### Diversity

I woke up this morning thinking about diversity, as in non-correlated diversity.  There is correlated diversity and a vehicle like the S&P 500 is all about correlated diversity.  The stock mix reduces single stock risk down to market risk, but once market risk is achieved there is not much to be gained in Piling more and more issues higher and Deeper (PhD).  20 stocks across 10 sectors is 95% diverse.  Adding 980 more stocks only makes you 99% diverse.  A nod is as good as a wink to a dead horse.   I study the S&P 500 and all year long it’s been troubled.  20% of the stocks were in a bear market, 20% more were under water, meaning 200 of 500 stocks were doing bad the entire year despite the “RAH RAH best economy in history”.  Only 40 stocks were responsible for the majority of the gains and especially the FANG plus a couple, at any time.  The index has broken down and those 40 are no longer performing and some of the high FANG flyers are now in a bear.  How is this diversity when you are relying on 40 stocks to give you gain?  The problem is these stocks are highly but not perfectly correlated and so stocks have a general direction when going up and a very tight path when headed into the dirt, like a hand.  On the way up stocks look like an open hand each finger pointing in a different direction slightly diversified and slightly reducing risk.  On the way down the hand becomes a fist plowing into the ground.  The algorithms sell first and ask questions later.  Because of the high correlation the in the bad times algorithms erase the “illusion of diversity”.

Here is a picture of GLD (gold line) v S&P500 (blue line) since 2013.  The correlation between GLD and S&P 500 is 0.04, and the picture shows that gold is flat while S&P is exploding.  This is non-correlated diversity, the kind of diversity that saves you.

This is a longer term picture of S&P v GLD including the 2008 debacle.  Looking at GLD from 2005 when the S&P went in the toilet and dropped 50% GLD exploded in value, the typical flight to quality.  Again you see the benefit of non-correlation.  Stocks went down and then stayed flat for a long time while GLD went way up.

Stocks are property, GLD is property, just as Real Estate is property and Bonds are property.  These assets are not money, they however can be converted into money using a market mechanism.  The property is worth whatever someone is willing to give you for it at the instant you want or need to sell it.  The way you make money is buy the property  low sell the property high.  The way you loose money is buy property high sell the stuff low.  Suppose you retired in 2005 and are living off your assets.  What asset would you sell in 2008?  You bought GLD low sometime previous 2005 and you bought S&P high sometime previous to 2008.  Buy low Sell high, you would sell some GLD (sell high) and keep the stocks or even add to the stocks (buy low).  You sell some GLD and have money for  hamburgers!!  Selling the stocks low would blow up your compounding plan in the long run.  If all you own is stocks you’re hosed.

Let’s add some Bonds (BND the teal line)  In a 3 asset portfolio BND and S&P has a .05 correlation.  GLD and BND has a .44 correlation so BND pretty much does its own thing as the chart shows.  BND remains flat while S&P is crashing and  GLD is soaring.  In the case of a stock crash, BND might be a good source of hamburgers, or maybe a lil’ GLD AND a lil’ BND.  You see you now have 2 choices that won’t cream your retirement plan by being forced to sell stocks low.   Your GLD doesn’t have to last you forever only long enough to get through the bad time.  You can always buy some more from William Devane when the price comes down later.  It gives a ready source of value and gets you a year closer to death with your growth motor (stocks) intact.

You say yea but I’m a Real Estate guy!!! So let’s add some REIT

Purple (VNQ) doesn’t impress.  It doesn’t grow well but dives into the ground just fine, even more so than stocks and in the same time frame!  The correlation between stocks and VNQ is .72  You say I’m a Globalist!  I have Global to save my butt!  It’s diversity I tell ya!  Let’s add VHGEX which is .96 correlated with S&P.

Salmon (VHGEX) looks pretty much like dark blue to me from a diversity perspective.   If you gotta sell something you’ll be selling salmon low same as dark blue in a crash.  This is the story of non-correlated diversity.

I was thinking about dividends.  In a crash dividends at least for a while tend not to change even though the asset value plummets, so dividends may be a source of diversity but I’m not sure how to model that.  Many people brag about living on dividends as if that’s safe.  Not so sure it’s safe but the diversity may pay you.

Here is a calculator that looks at S&P 500 since Dec 1999.  I chose Dec 1999 since it would represent 18 years into a retirement spanning 2 downturns and is familiar since most of us lived it.  The average return on the S&P in this 18 yr period is 3.8%  (NOT 10%).  The reinvested growth is 5.8%  The dividend is 2%.  When you spend the dividend it is not really different than selling stocks, you just “sell” before you even “buy” (re-invest)  The fact the dividend might be considered diversified hurts and helps you.  You have a relatively stable stream at least for a while in a crash, but not re-investing means you don’t use that money to “buy low” in a crash.

Here is the inflation adjusted dope:

Inflation adjusted the S&P 500 sans dividends over the past 18 years has only grown 1.6% per year and only 3.5% with dividends reinvested.  Dividends therefore were 1.9% inflation adjusted.  To me this says dividends pay because of their non-correlation not because they are “safe”.   Next time some bogglehead putz tells you it’s stupid to own GLD tell em to go pound sand!

### Frogger

In the 80’s I was working in a pediatric ICU and we got a kid who was creamed.  There is an expressway in Chicago called the Eisenhower named after the 34th president.  It heads out of the city past the ghetto to the western and northwestern burbs.  It’s 10 lanes of 80+ mph Mario Andretti mayhem, testosterone, and precision driving, at once exhilarating and frightening, kind of like sky diving.  The kid had apparently been playing real life Frogger on the highway with his buddies.  Yea, let’s legalize dope!   We need more stupidity!  The tragedy is something that has stuck with me all of these decades.  Certain experiences change you.

Retirement is like playing Frogger.  You may make it to your  your little frog bungalow or…  In a recent podcast on Doc G’s site some folks with medical issues were talking about retirement in the face of chronic illness.  I have written on this,  but what to do? what to do?  How do you get to the frog hacienda intact?  My solution is to self insure.  My Roth is my self insurance.  It serves several purposes.  One is as a tax free, not tax deferred growth vehicle.  It does not annuitize like a TIRA.  If you have enough money to fund it properly you can risk the assets within it in a different way than you may risk the rest of your portfolio.  You may carry a 10% risk on the money you intend to live on in retirement.  You can calculate the risk by using the efficient frontier calculator or by setting up a personal capital account they will calculate it for you.  Let’s call this money SWR money.  You can set up separate money in a different account risked differently and to serve a different purpose than SWR.  You can set up a self insurance account.  My Roth is my self insurance account.  Once funded it will sit unmolested and compound.  I will not count it as part of my SWR v. net worth percentage.  I will own it but account for it as a different line item.  It will exist as insurance, to be used in case of disaster.  It can be risked for example at 6% (the risk of a 50/50 asset mix) with an expected 6% growth.  Such a low risk has a very high chance of being intact no matter when needed, and not so much subject to market whims.  Since I’m not pulling money from it, it’s basically immune to SORR.  The rate of return fluctuates but no withdrawals leaves things intact like a nice feather bed of security.

As time goes on the value will grow and protect more than catastrophic health issues.   At some point it becomes big enough to protect against portfolio failure as well, since you underestimated your need you will have a life boat, a ready source of hamburgers, just when you need it.  If not, your kids will have a nice nest egg.  This is about as small as I would go especially if married with kids.  You’re going to die from something and that’s going to cost dough, and your wife is going to die from something and that’s going to cost dough, or your kid may get sick, so you need a lot of compounding potential to get everyone to frog heaven.   The insurance stands side by side with SWR and gives you big time flexibility.

I see all the time people crowing about DIY finances.  Just buy low cost index funds they cry!  Financial advice?  What a rip off!,  Why I can buy VTSAX for 4  bp…  And that is true.  It is cheap, but is it wise?  Why studies have shown you can’t beat the market…  But those studies are generally compared against actively traded funds a worst case comparison.  What about passive factor based funds?  Why those AUM guys just want to pump and dump for 1% of your money…  It’s hard to find a 1% AUM Financial Adviser most are 0.5% and under.  The ones that use 1%, use 1% to weed out clients with small assets.  Crowdfunding, by gosh I believe in crowdfunding gonna make a mint… Plenty of articles out there decrying crowdfund risk.  Taxes ya I know all about taxes… Do you really?

I read article after article saying the “average retail investor” under performs the S&P by greater than 4%.   Another one I read says 3% performance for the DIY crowd over the last decade is average.  So if you can get a FA to help you get an additional 500bp return is it worth paying him 10% of that?

In ’92 I was listening to Alan Greenspan on CNBC in the surgical lounge and someone asked him “what would you invest in?” and he said I would invest in the whole market.  I never heard that before and it was entirely different than what I had been taught by the hype.  He obviously was a student of Harry Markowitz and understood diversity.   ’92 was the age of Compaq MSFT, Dell and Cisco.  One of the Internists bought Cisco and turned it into 10M in about 5 years.  He later got  Alzheimer’s and it didn’t do him much good.  The Greenspan comment started me on a journey to understand this different kind of “own everything” investing.   Own everything investing was Vanguards claim to fame and legitimacy, that and the .com bust.  After that people started looking for rationality.   People won Bigley in .com gambling, investing in smoke and lost even more Bigley.   I was day trading in those days but I also had a diversified investment account side by side with my speculative trading account.  I made money trading but it was a heck of a lot of work and a lot of stress.  After GE peaked at \$60 in 2000 and was \$20 in 2003, I understood my exuberance was irrational and I decided to give uncle Alan’s approach a try and plowed 1M into SPY in April of 2003.  I liquidated all of my losers and collected the LT cap loss and this 1M was my remaining cash.  It wasn’t all of my portfolio, but it was a chance to buy low.  It was the beginning of Gulf war 2 and the market was in the toilet and I asked myself should I vote for or against the US.  I was in the Navy during Gulf war 1 and decided FOR.  Right decision.

My Roth conversion provides exactly the portfolio safety I desire.  My portfolio is sub-divided into cash, LT cap loss, ST cap loss (small amount), Post tax brokerage, TIRA, Roth IRA and my Home.  My portfolio is quite a bit larger that my 30 year need so I can convert the Roth money into something of a self insurance account.  As I age and my wife ages eventually we will incur medical expense estimated at 300K per person from age 65 to death.  There are may things Medicare does not cover like assisted living or 24/7 memory care.  The Roth will be filled and then not touched as insurance against catastrophe.  1M in 10 years will be 1.8M, in 20 years will be 3.2M (my age 85) and 6.4M by my wife’s age 90 (she’s a lot younger), so plenty of money against catastrophe, or if we both drive into a bridge at a high rate of speed my kids will be ecstatic.  Either way the Roth has a job to do and it’s to protect our security, not to fund our cash flow.  I will get my daily hamburgers from other assets like SS some TIRA RMD, and post tax brokerage money mixed with TLH.   My situation is a bit complex and my wife has interest in the plan and can follow the arguments but does not eat and sleep it like me.  Phil acts as protection in the case of my demise.  The plan is the plan and will be executed and she can turn to Phil for guidance.  One kid is out of college and on her own and the other is 2 years away from fini so that whole Curly shuffle is winding down.

I pay nothing like 1% for this security, I won’t say how much except it’s way less.  It’s money well spent.  I’ve made far more in streamlined returns in the last 10 years than 20 years of professional financial advice will cost me.  You may think DIY is wise but if you loose in the end because of ignorance, arrogance, simple mindedness, bad risk analysis or abject stupidity based on internet boilerplate it will cost you far more.  Investing is not about a dopamine induced fog but clarity of purpose and risk management.   The other thing is implementing a plan like this takes time and it takes staging in the accumulation phase in what I call epochs.

Epochs occur over years to decades.  If you fund your retirement’s self insurance 40 years out, most of that will be in place as interest by the time you retire.  You could call that the retirement insurance epoch.  You already fund a 529 and rely on the interest to carry that through, you could call that the college expense epoch.  Just think of it like that.  Do not be mesmerized by the necessity of pre-tax money the restrictions are often more costly than the benefit.

Color me contrarian.

### More on Roth Granularity

So I physically started Roth conversion this week.  I have enough information to know the majority of my post tax distributions for the year, not exactly but close.  Should only be about 8K unqualified.  The unqualified is taxed as ordinary income and qualified as cap gain.  I will pay taxes on unqualified and write off my cap gains against my LT cap loss for zero tax on that aspect of my tax life.  So I have about 8K ordinary income to worry about off the top.

My first conversion is my wife’s IRA’s in entirety.  It’s about 140K.  She has 24K in post tax basis mixed in that money, so by working through the calculations in form 8606 her taxable income is reduced to about 115K, for a 140K conversion.  Therefore I’m up to about 123K (115 + 8) in taxable income for 2018.  The reason I closed her out first was because of the write off on her account.  It gets the maximum amount of money into her Roth to commence compounding.  My net tax saving for this move is 5K.  This will close out her remaining experience in Roth conversion as all of her money will be tax free in a Roth.

My next conversion will be my own and I will convert something like 125K and I may go a bit higher as my tax picture becomes clearer.   I chose \$250K as a max conversion instead of the top of the 24% because it avoids the 3.8% medicare surtax on amounts above \$250K and avoids higher medicare monthly premiums, and generates 22K less in taxes (88K over 4 years saved), while over 4 years I will converting about 2/3 of our TIRA.  The other 1/3 I will leave in bonds and go ahead and RMD that amount at 70 and use that money to buy hamburgers.  My conversion factor on 125K is 97.9% taxable because of my post tax money in there So on a 125K conversion only 122,375 will be part of my AGI.

My taxable AGI therefore will be 115K + 122K +8K or 245K with a 5 K safety factor since you can’t re-characterize Roth conversion anymore.  My net conversion will be 140K + 125K or 265K into the Roth and I will reinvest the 8K back into my taxable account.  My tax bill for that conversion will be \$41307 for a 265K conversion for an effective 15.6% tax rate.  I’ll send the IRS the 2018 money and we will be cool.  Had I converted 341K my effective tax rate would be over 19%.  My move in January 2019 will be to convert another 245K AGI.  With the conversion factor of 97.9%  I will be able to convert \$250K actual money from the Roth for a 2 year conversion of \$515K, over half of my estimated conversion amount.   My tax bill on that \$245K is also \$41,307 and I will send the IRS the money in January and we will be cool for FY 2019.  So by start 2020 @ 4% my 515K investment should be worth almost 536K.  I’ll do it again (250K, 245K taxable) in FY 2020 and be up to 814K in the Roth at 4%.  Finally in FY 2021 I’ll add the last (\$250K, 245K taxable) bringing our Roth’s to 1.1M with a tax bill of 165,228 or a 15% tax bite.  I’ll leave the rest of the TIRA to grow ever time as I withdraw and should have about 600K left in TIRA @3% return over 4 years.  \$600K will RMD \$22K the first year and will grow to \$28K the 10th year and \$32K by the 20th year.  The TIRA at my age 90 will still have \$340K available in funds just in case.   Every withdrawal from the TIRA going forward will use that 97.9% conversion in calculating the AGI, so \$22K RMD is only \$21.5K in AGI.  Every \$500 helps.  I will supplement my income by selling taxable stocks and using my LT cap loss.  As SS grows and RMD grows my “need” to access money from the post tax account to make budget diminishes, or I can slice off a little more from the post tax money roast and buy the ol’ lady a new car.   The Roth remains untouched.  It will transfer wealth to my kids or be available as insurance in case of medical disaster.  At 5% it’s estimated worth will be 3M at my age 90.

So by doing the conversion in this way, my future will cost me \$165K up front in taxes.  If I converted to 340K/yr (top of 24%) it would be about  256K in upfront taxes on the future.  I will leave the \$90K or so I save in taxes invested to grow @ say 5% and the interest off that easily pays for the unpaid taxes on the RMD.  Since the RMD is small the taxes are small.  This is an important point to understand.  I maximize my tax free growth by converting my wife’s IRA first.  I’ve been analyzing what assets of mine to convert and momentum is going first.  Next will be foreign and emerging.  Next US and finally alternatives commodities and REIT.  I will re-balance my AA across accounts.  Since I’m living off a wad of cash my AA presently is about 55/45%.  A desirable percent in early retirement adding some SORR protection.  As I spend that cash down and pay my taxes my AA will naturally rise to maybe 65%.  At that point SS kicks in and the TIRA RMD’s and I’ll be 5 years closer to death and my necessary SWR from taxable drops a lot, so I can afford a little more risk (actually a lot more risk but what’s the point of owning too much risk if you already won the game?)

### Aggregates

I woke up this morning thinking about activity.  Activity is the thermodynamic concept of non standard behavior in a chemical solution.  As solutions become concentrated the A + B =AB relationship become x*A + y*B = z*AB  where xyz are a kind of fudge factor which describes real behavior instead pristine theoretical behavior in chemical solutions.  The variability is due to how charge, solubility and entropy changes local environments for molecules instead of just viewing their behavior in a dilute solution.  The local matters in the real world.

Blood is an aggregate of hemoglobin contained in corpuscles and a kind of dirty proteinacious water called plasma.  The hemoglobin is highly soluble to O2.  You can stuff a whole lot of O2 into hemoglobin especially hemoglobin contained in corpuscles, but not so much in plasma or free hemoglobin in solution.  Your cells crave ATP and the ONLY way to efficiently make ATP is to deliver enough O2 to the cell mitochondria.  Not enough O2 = RIP.  So life itself depends on this method of hemoglobin aggregation.  Dis-aggregate the hemoglobin, and even though the amount remains the same the effective O2 delivery is so poor you will die.

I was reviewing the nature of VTI.  VTI is a total stock market tracking ETF.  People own VTI as a proxy for owning all the stocks in the US market.  It is commonly published there is some comfort that “all the stocks” are “more diversified” and therefore “safer”.  Actually the majority of diversity is achieved in as little as 20 stocks.  1000 stocks only provides 5% more diversity.   VTI as a tracking vehicle has as its portfolio 1560 stocks.  The total us market has a bit over 3800 stocks, so VTI is only 41% of “total stock market”.

Ya Ya blablabla so what?  Well the point of activity was to account for the non standard behavior of solution with high concentration.  Index funds make up 29% of the market.  That’s called an aggregate and I would call that a high concentration.  The behavior IMHO is not random but actually quite concentrated, and the measuring tool is just an estimate.  The “tracking fund” just estimates the actual total market.  In normal times it estimates beyond good enough.  But what about abnormal times?   The point of owning index funds is the so called safety of diversity.  If you sell VTI and Vanguard doesn’t have cash on hand it will have to sell 1560 stocks to raise the cash to pay you.  This causes a distortion in the tracking.  There is now downward momentum on those 1560 stocks in excess of normal market swing.  Remember you actually own VTI not the total market, so the value of your portfolio is the actual price of VTI not the price of the total market.  Now what if half of the 29% who owns the “index stocks” sell.  What happens to balance of the the index?  What happens to the value of your portfolio?  My impression is xyz kicks in and all of the “formula” which rely on say “8% long term market gain” goes out the window as momentum forces dynamic distortion onto the system, and the distortion will be worst in those 1560 stocks you own since those are the ones being most sold at fire sale prices.  The robots don’t care.  You give them a sell order, they sell sell sell, damn the torpedoes.

The point, the point?  Jack Bogel worries about this.  I’ve read it over and over in his writings but I don’t see it anywhere in the usual Bogglehead boilerplate.  Is your “diversity” really diverse or merely an illusion because your diversity is actually a part of an aggregate and therefore captured in that aggregate and not free to oscillate independently?  This is why some real bond mix like 60/40 IMHO saves you, because bonds are truly independent with a correlation of 0, and not captured as part of an aggregate.   Lemme see all ya gotta do is 4 x 25 in low cost index funds…

### The Other Motor

I wrote a post ‘on Creative Destruction  as the Motor that propels the American economy, and so it is.  There is another Motor that propels the individual’s financial reality and that’s work.   In my recent post on journaling your family financial history, you might also journal your own history.   If you’re honest with yourself, it will reveal your own relationship with money and work.  That analysis can be invaluable.

This “job” was gold as a learning experience regarding commerce.  I was making about 15 bucks a week (+- deadbeats) cash at my own hand.  60 bucks a month for an 11 year old in 1963 wasn’t chump change.  After that I always had a job except for 2 years of medical school.  I worked in a stone mill and quarry running a jack hammer, drove a wrecker, worked a gas station, drove a delivery truck in High School.  I couldn’t wait for ice storms so I could get in the wrecker and go give people jumps and pull them out of the ditch, like a true Lincoln Park Pirate

That’s my motor story.  None of it is about money.  It’s about taking advantage of the opportunity that presented.

### Journal Your Family’s Financial History.

My colleague Doc G has written about his financial pedigree.  He claims 3rd gen FI!  Your attitude toward money comes out of your family at a very basic level, like at a breathing air kind of basic.  There is probably a lot that is sorta known in the broader family about Finance, like Alcoholism or Robbery is sorta known.  It’s not something really dwelt upon and kind of ignored if it’s not in your face or kicking your patootie.

His bravery at posting got me to thinking about my own financial family history.  So I sat down and journeled me up a far reaching family financial history going back 4 generations as far as I knew, about back to great grand parents who lived in the late 1800’s.  There was a family farm back then for some aspect of the family,  and all the uncles and aunts would gather at the farm for reunion! and the women would bake pie and Blatz beer and Pabst Blue Ribbon drinkin men would get out the 10Ga shotgun and laugh as we pip squeak kids would set off a blast toward the sky and get kicked like hell in the shoulder.  That 10G was no joke!  Rite of passage.  The farm smelled of manure.  I’m not exactly sure where it was located, somewhere south of Gary IN.

My grandparents were born at the turn of the 20th century.   If you trace it, their jobs, their education, their success at raising a family in the face of things like WW1 and WW2, Korea, Viet Nam (reached into my generation) and the great depression, and various layoffs, unions. rotten offspring, successful cousins etc you have lain before you an understanding of the American economy for a century or more and how your personal family dealt with making it in America.  You understand the constraints of retirement.  Did Grandpa have a retirement?  If so what was he invested in? (a way to understand risk).  Did he advance at work?  Was he a Union man?  How did he survive the great depression?  What did his kids (your aunts and uncles) wind up doing?  What was their retirement like?  Did they save?  What about cousins?  What about cousins’ kids?  All of these people somehow survived with a real story, not just a blogosphere projection.  A real story that is the life you lived the financial air you breathed as a youngster.

From that you can also look at your relationship with money under that light and see what insight that provides.  It’s actually fascinating.   A quick example: My Dad was an engineer.  A professional engineer which means he was like board certified and could stamp jobs as sound design from an engineering perspective.  A valuable credential.  It means a project can get financed and insured. Prior to certification he was subject to getting laid off.  Engineers are in high demand in the good times but dead weight in the recession.  So that was my story, living in the house of an engineer with 4 kids who got laid off every so often and required a job change and possibly a move.  My Dad lived through 6 moves in his career.  The 7th was his retirement move to my town where he could be near me and watch his grand kids grow along with my Mom, who is still alive.  He knew  I would take care of Mom if anything happened, the ultimate in risk management, so I’m familiar with the finances and have seen how my Dad handled those.  He was a star.  My Dad handled my Nana’s finances once gramps died and he also handled my Aunt (gramps sis) who had no kids but was married to an entrepreneur back in the 40’s and semi retired to FL in the 50’s.  The guy was hell on wheels on the organ.  I was very familiar with those financial histories and their successes and relative failures.  (Word to the wise a CD ladder is a poor investment strategy in a 1973 stagflation, and 1980 raging inflation environment).

I discovered much more, likely too personal to relate, but the point is the point.  You are sitting on a treasure trove of personal insight and righteous systems analysis if you bother to look.  If you bother to look, Suze O won’t have anything on you.  You will have personal history of success and failure far beyond some 4 x25 blog snot.

### What’s the Motor?

Have you ever wondered where the advancement of your wealth comes from in an equity?  In a bond it comes from the coupon rate. In a \$1000 bond with a 5% coupon, your wealth advances \$50/yr.  This is actual interest and can be reinvested for compounding or used for spending.  A Bond therefore is a kind of legal contract offering you a money motor called cash flow.

A stock OTOH is a piece of property.  It’s ownership and it’s value is indeterminate.  For example more stock can be created or some can be bought back.   It’s only worth what someone will pay you for it.  If you own 1000 shares of BRK.B you own a percentage of BRK.B.  You can trade your BRK.B for money but until you do that you just own some property, same as a house or a farm or a car.  So what makes a stock valuable?  We glibly buy stocks and quack about the “magic of compounding”, but on it’s own property does not compound.  On any given day it can be worth more or worth less or even become worthless.  What’s the motor for a stock?

Henry Bessemer patented a process for making steel in 1856.  The process made steel purer stronger and easier.  The process existed in other parts of the world (cold blast) since the 11th century.  The story is an intriguing look into creativity and mythology and perhaps a dollop of theft, but none the less the blast furnace method of steel production ensued.  This new steel compared to cast iron lasted 10 times longer, was malleable and could be produced in vast quantities.  Bessemer’s process brought down the price and improved the quality.   Because of Bessemer’s process Minnesota’s Mesabi range of Iron Ore went from a 6% of need output to 51% and steel workers went to work making steel (imagine all those jobs and lives changed).  Cheaper steel allowed rail roads to prosper.  A rail was cheaper to make and lasted 10x longer.  At one point Chicago was the cross road for 14% of the nations railways.  My Grandfather  had a second grade education and worked the steel mills in south Chicago his whole life.  He raised 6 kids.  They were poor but Henry Bessemer’s innovation fed them.  My other Grandfather had an 8th grade education.  He became a meat buyer for A&P foods.  Eventually he worked his way to the C suite as VP.  I used to tag along to the Chicago stock yards where gramps would inspect and cull meat to send to the butchers, the meat my other grandfather would feed to his kids.  The meat got to Chicago as cattle on the trains, which road the rails so much improved by Bessemer’s process.  My uncle (grampa #1’s son) was a butcher who cut up the meat, and the abundance of meat brought down prices and grew strong people with good solid brains. God bless Henry Bessemer where ever you are!  The Chicago stock yards are what peaked my interest in commodities trading.  There’s gold in them there pens!

What this is, is a description of creative destruction.  Creative destruction is the motor that drives stock price.  It’s productivity and innovation and a relentless improvement in efficiency.  It destroys the inefficient and creates the efficient.  It’s a concept born of economist Joseph Schumpterer of the Austrian school which uses Marx’s dialectic as the motor.  In Marx’s theory production was static and money flowed from have not’s to haves causing what he thought would be social unrest to the extent the proletariat would rise up and smote their bourgeoisie overlords and usher in utopia.  Marx lived in the fossilized society of London and his  mistake was misunderstanding human ingenuity and creativity.  The sucker was stuck in the mud without the creativity to understand he was in the belly of a fossil not something alive and growing.  Unfortunately tens of millions died and lived in abject poverty over his stupidity.  Not creative destruction but pure destruction and quenching of the human spirit.

Production is not static so the pie can grow!  Not only can the pie grow but you can bake a bigger better pie or a dozen bigger pies!   What Schumpterer saw was the real dialectic is between creation and stagnation.  The creative dynamo would rise up and pulverize the fossil.   The creative dynamo would rise up, eat the fossils lunch and multiply the loaves and fishes (increasing value).  The real dialectic was Bessemer’s efficiency of the new steel v the inefficiency of cast iron.  The pie expanded and trillions were created out of thin air, and the opportunity flowed to my Grandfathers who each in their own way were able to feed their children, and their children had children.  Creative destruction of course predated Schumptlerer he just normalized an understanding.  It’s creative destruction,  improving efficiency and productivity that is the motor in stocks.  That’s were the excess value comes from.  Unlike a bond which is pretty much a fixed legal contract creative is a living thing where something is made from nothing.

There are tons of examples of this dynamo.   Cyrus McCormick developed a thrashing machine (also developed in Europe).  In pre-machine days 1 man could harvest 1 acre of wheat a day with a scythe.  Post machine 2 men could harvest 20 acres a day.   Henry Ford and his innovation, the recent fracking technology etc etc.  Examples enough to prove the path forward.   Anything that places a boot on creative destruction is deadly, and as investors you best know which side of your bread has the butter.  Creative destruction is the motor impelling us into the future, not the “magic of compounding”