Conversions and Correlations

A couple of quick follow ups from the last few days. 

Our first follow up is on the search for uncorrelated return streams. RCM Alternatives included the following table in a blog post to help sort out different types of alternative strategies.

The table gives an indication of what to expect from these strategies being more or less suited to crisis periods for example. I don't know how they are differentiating pure trend versus managed futures but my experience with what I have thought of as managed futures through two different calamites, the Financial Crisis and then 2022, is that managed futures does offer crisis alpha but you should draw your own conclusion. 

The table made me curious about the correlations of the four strategies. I just search for mutual funds that and hopefully Google had it right. The following correlation matrix is still useful regardless of the quality of the search results. 

The first three after VOO and VBAIX are funds we frequently talk about for blogging purposes, QGMIX is a client and personal holding and the last four are funds I don't know about, I just found them while searching. You can see the first four differentiate from plain vanilla VOO and VBAIX but they also differentiate from each other for the most part, not so much between EBSIX and AQMIX but the others, decently so. The correlation of DNAVX seems very close to VOO and VBAIX while the others are not as close, I believe they are too close to be considered truly differentiated. 

Not all of them have to have a correlation of -0.50 to be useful, that's not what I'm saying but it is worth knowing the extent to which an alternative strategy does diversify against more plain vanilla exposures. You don't want to find out after a large decline that a fund with the word macro in the name that you bought as a diversifier had a 0.90 correlation to your portfolio and offered no diversification benefit when you needed it. DNAVX was down 14% in 2022. That was a decent relative result but not a differentiated return stream.

Yesterday's retirement roundup, talking about inheritances and the rest, got me thinking a little about Roth conversions. Generally, I haven't seen too many situations where converting made sense in terms of expecting a future tax rate to be more than the tax rate while still working. Yes, some people expect that tax rates will be adjusted higher, but I'm talking about people making so much more in retirement that it pushes them into a higher bracket. Tax rates themselves could get raised one way or another whether that is sunsetting the temporary cuts enacted a few years ago or something else. 

Certainly, crunch your own numbers but for now, the 22% bracket married filing jointly ranges from $94,301-$201,050 and the 24% bracket married filing jointly ranges from $201,051-$383,900. Of course the effective tax rates will be less. The effective tax rate for married filing jointly for a $200,000 income is 14.26%. Yes there is state tax and FICA but you wouldn't be paying FICA after you retire. 

How likely are you to be making so much more money after you retire that it nudges you up into another bracket? For what it's worth, there is no reasonable scenario where I'd be making more money. While I would consider myself fortunate to still be doing this when I'm 75, that would be my preference, my practice is likely to be much smaller at that point and so my income would be much lower. 

In previous posts, we've talked about conversions in years where earned income is zero or very low. Ages 50's and 60's seem like a plausible time if someone retires but holds off on starting Social Security or has their hand forced out of work for some period of time. With no earned income, this paves the way to converting small portions of a traditional IRA for little to no tax. 

An income/conversion of $25,000 is below the standard deduction and has an effective federal tax rate of zero. A $50,000 income/conversion an effective federal tax rate of 4.47%. Such a low, effective federal tax rate is probably compelling for many people. The scenario I am describing of no income for a time, the federal tax rate is could very well go up once Social Security starts.

That's all ground we've covered before. The new wrinkle could be from an inherited IRA that isn't needed for a financial plan to work. A few years ago the law changed on inherited IRA withdrawals. The account has to be emptied out no later than ten years after it was inherited. Repeating for emphasis, you have to take it out. 

So the scenario is a 60 year old who is on track with their own retirement plan inherits a portion of a parent's IRA of $70,000. The $70,000, which has to be taken out over the next ten years, could go a long way to covering the tax owed on a series of small conversions. Yes, numbers would need to be crunched with respect to effective tax and so on, work with your accountant on that, but with a $600,000 IRA account, the $70,000 inherited IRA could pay the tax for converting half of the $600,000 over the course of several years.

There is also a bit of mental accounting with this idea but if someone has enough in their own plan that the inheritance is unneeded, this creates a use for it which, relating the story about my father from yesterday, would have made him very happy. Pulling this off would be threading a needle of sorts so consulting an accountant is very important. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.