April 2021 Newsletter

Table of Contents

• Investment Management – 1Q 2021 Investment Letter

• Retirement Planning – “A Backdoor Roth IRA Could Pad Your Retirement”

• Disclaimer

Investment Management

1Q 2021 Investment Letter

Glass Lake Clients and Prospects:

The past three months were characterized by bigger than expected changes. For instance, the third round of federal coronavirus relief signed by President Biden on March 11 came with a larger than expected $1.9 trillion price tag, equal to a massive 8% of GDP. Democratic wins in Georgia’s two senate seat runoff elections on January 5 gave the party the power to go big as they gained control of both the House and Senate.  

Covid-19 vaccination rates also ramped beyond most people’s expectations after a slow start in December and January. Impressively, nearly 30% of Americans received at least one shot by quarter’s end. Biden recently doubled his vaccination goal to 200 million in his first 100 days of office, which appears firmly on track. A sooner and more meaningful economic reopening caused Federal Reserve policy makers to raise their 2021 GDP forecast to 6.5% in March from 4.2% in December.

Figure 1: Covid-19 Vaccine Doses Administered and 7-Day Average

Source: New York Times citing Centers for Disease Control and Prevention
Note: Data not updated on some weekends and holidays. Includes the Johnson & Johnson vaccine as of March 5.

Interest rates took on the big change theme too. The 10-year U.S. treasury yield closed the quarter at 1.74%, up from 0.91% entering the year, as increased government borrowing and a larger post-pandemic surge in expected growth gave rise to the notion the Fed will eventually have to raise rates more meaningfully to tackle runaway inflation.

Figure 2: 10-Year Treasury Yields Have Rallied Hard Off Their Depths

Source: U.S. Department of Treasury

These reflationary conditions were ripe for economically sensitive value stocks to outperform growth. Indeed, the more economically sensitive small capitalization Russell 2000 index rose 12.4% in the first quarter, while the large capitalization S&P 500 index increased 5.8% and the tech-heavy Nasdaq Composite index edged 2.8% higher, according to Morningstar. Digging deeper, iShares’ US Energy ETF (IYE) and S&P’s Bank ETF (KBE) surged by 30% and 25%, respectively, while Cathie Wood’s ARK Innovation ETF (ARKK), which largely holds aggressive growth companies, declined 4% after being up as much as 26% in February.

Investing 101: Why are higher rates bad for growth stocks?
Since cash today is worth more than uncertain cash in the future, you need to apply a discount rate – typically the 10-year treasury yield, plus a premium for the risk you are taking on – to that expectation. Changes in the discount rate can have big effects on valuation of companies that have the bulk of their anticipated cash flows far into the future. By contrast, so-called value stocks have expected cash flows concentrated closer to the present, so higher rates have less of an impact on valuation. Further, improved economic growth assumptions boost near-term cash flow forecasts more so for value stocks than for growth stocks. 

The rise in rates helped to cool the most speculative areas of the market, such as lightly regulated special purpose acquisition companies (SPACs). Unlike traditional initial public offerings (IPOs), SPACs can make inherently speculative long-term forecasts that generate excessive hype. SPAC deals were hot in the quarter, with $95 billion raised in the first quarter versus $80 billion in a record 2020. Shares of new SPACs surged in January and February but fared much poorer in March, potentially making it more difficult for the roughly 430 SPACs seeking private companies to secure attractive deals.

My  Outlook

Upcoming legislation

President Biden unveiled his $2.3 trillion infrastructure plan on March 31. A second plan focused on childcare, healthcare and education is slated to be released later this month. The plan is to finance the $3 trillion or more of combined spending over 10 years with tax increases on corporations, upper-income households, and investors.

Congress was able to pass the Covid relief bill along party lines, but these legislative items should prove to be more difficult. The Senate filibuster effectively requires a 60-vote super-majority for most legislation. A special budget process called reconciliation could allow legislation to pass with a simple majority, but Senate Democrats will have to address procedural limits to do so. Even if that is accomplished, Democrats cannot afford to lose a single vote in the Senate and no more than three votes in the House because no Republican will support legislation with tax increases attached to it.

Although it is difficult to handicap at this early stage, I doubt further major legislation will be signed this year due to the procedural limits, likely Democrat in-fighting, concerns of overheating the economy and consternation over enacting tax increases during a pandemic.  

The Fed

The Federal Reserve is unlikely to raise its overnight federal-funds rate target from 0%-0.25% anytime soon despite prospects for a hot economy. In its March 17 meeting, only four Fed officials expected to raise rates in 2022, with three others eyeing 2023. That leaves 11 who do not expect to raise rates until at least 2024.

I agree with Fed Chairman Jerome Powell’s view that any inflation spike will prove to not be terribly persistent given well-anchored long-term inflation expectations and structural forces that suppress inflation such as an aging population and technological advances. Unexpected passage of another multi-trillion bill could change my view though.

10-year treasury yields

My baseline expectation is for the 10-year treasury yield to march towards 2.25-2.5% by year end as inflation temporarily spikes later this year. It is conceivable that yields reach as high as 3.0% this year as markets tend to overshoot in both directions, but yields could just as easily fluctuate around current levels.

Covid-19

Vaccine production and daily inoculations should continue to increase for a U.S. population that is increasingly more willing to receive the shots. Further, I anticipate vaccines will be approved for younger and younger age groups over the next few months, allowing for attainment of the requisite 70-85% of the population either vaccinated or previously inflected to achieve herd immunity by late summer. The nearly three million people per day inoculation rate will prevent the current Covid case uptick from becoming another super spike. However, other countries with much slower vaccination programs will struggle to contain more contagious virus variants.

Stock market

I expect the market to be choppy and uneven over the next six months but with a positive bias. An ongoing economic reopening and release of pent-up consumer demand should act as tailwinds to companies’ revenue but inflationary pressures in wages, materials, and freight, along with resumed corporate travel and company investments post-pandemic, could pressure margins and constrain earnings growth. The extent to which interest rates rise further will also have ramifications for valuations.

The most cyclical industries – such as oil & gas, banks, heavy equipment, travel & leisure  – probably continue to perform well if Covid-19 cases decline and economic reopening plans proceed as expected. These industries stand to benefit the most from a reopening, stimulus dollars spending, and a steeper yield curve. Still, some of these stocks appear to have fully priced in their better near-term prospects, so future share price gains could be less dramatic.

An ongoing value stock rally does not necessarily have to come at the expense of growth stocks. I expect the market to increasingly differentiate the growth companies that can power through challenging prior year comparisons. On the other hand, stocks of companies that experienced stay-at-home surges but do not do particularly well in an economic reopening setting will likely suffer. Meanwhile unprofitable aggressive growth companies are likely to continue being volatile with a downward bias, especially if treasury yields spike.

Client Positioning

I take a long-term view focused on compounding returns in a tax-efficient manner. You will not see me make dramatic asset allocation changes based on my views of Fed policy, legislation, or other factors. Further, I allocate the bulk of my clients’ equity positions in “quality growth” names that have strong and sustainable competitive advantages, above-average long-term growth prospects, high levels of profitability and free cash flows, and prudent levels of debt. I believe this investment philosophy affords my clients the best shot of generating maximum after-tax, risk-adjusted returns compounded over the long run. 

Indeed, I continue to invest over 80% of my clients’ equity allocations in companies I would characterize as quality growth. I have largely refrained from owning the more speculative, aggressive growth stocks that have had the greatest volatility. For example, you are highly unlikely to see me invest in electric vehicle, space exploration, marijuana, or Reddit-fueled meme stocks or SPACs any time soon because I believe fundamentals remain largely divorced from stock prices in those areas. Fundamentals always matter in the long run.

The remainder of clients’ portfolios continue to be invested in lower quality, highly cyclical companies that should more fully benefit from an ongoing economic reopening. Some of our “quality growth” companies have above-average cyclicality, so they stand to disproportionately benefit from a resurgent economy too. When including these, the cyclical mix rises to approximately half of clients’ equity portfolios.

Below are stock trades made in at least half of client accounts over the past three months with my rationale, subject to tax and other considerations. There were no major thematic changes.

Figure 3: Portfolio Changes in 1Q 2021

Clients should expect their equity portfolio to do best versus the market when economic optimism ebbs a bit and treasury yields halt their advance because the portfolios’ heavier mix of growth stocks do better when there is a scarcity of companies with earnings growth and when lower treasury yields prevail. My barbell approach of pairing foundational quality growth names with a few highly cyclical stocks should keep these factors from overwhelming portfolio performance. I will continue to monitor the market environment, but do not anticipate going much heavier on cyclical names at this point.

I hope you and your loved ones stay happy, healthy, and wealthy. We are almost through this pandemic!

Sincerely,

Jim Krapfel, CFA, CFP
Founder/President
Glass Lake Wealth Management, LLC
glasslakewealth.com
608-347-5558

Retirement Planning

A Backdoor Roth IRA Could Pad Your Retirement

Most understand Roth retirement accounts’ primary benefit is that money grows tax-free and can be withdrawn tax-free during retirement. Some also know that Roths avoid required minimum distributions. But few realize there is a method to move money into these tax-advantaged accounts above and beyond contributing to a Roth 401(k) for those whose income disqualifies them from directly contributing to a Roth IRA. In this article I explain the virtues of the backdoor Roth IRA, who is best suited for it, and how to execute the savvy maneuver.

401(k) Refresher

Saving for retirement traditionally starts with a 401(k) account through an employer. The employee can contribute up to $19,500 annually, or $26,000 if over 50 with a $6,500 catch-up contribution. Employers often offer a matching contribution to the employee’s 401(k), with the total employee + employer contribution subject to a $58,000 limit in 2021, or $64,500 with the catch-up contribution. It is well appreciated how advantageous it is to contribute an amount that will generate the full employer match.

A 401(k) participant can opt for pre-tax traditional, post-tax Roth (75% of employer plans offer a Roth option), and/or post-tax non-Roth contributions for amounts over the employee max (fewer employer plans allow this). Although pre-tax elections result in tax savings in the year of contribution, the associated retirement withdrawals are fully taxable and the account is subject to required minimum distributions (RMD) at age 72, unless one is still working for his or her employer. Conversely, a Roth contribution sacrifices immediate tax savings but gains tax-free treatment of retirement withdrawals and is not subject to RMD, so unabated tax-free growth is possible.

Carefully choosing whether to opt for traditional or Roth 401(k) contributions can optimize long-term  outcomes. As Exhibit 4 illustrates, a 25-year-old maxing out Roth contributions in his or her lower-earning years, then switching to traditional contributions as incomes ascend to higher marginal tax brackets, does better than sticking to either. If we forecast higher tax rates across all income levels, which is reasonable since tax rates are set to revert to higher levels in 2026 (if not sooner through new legislation), Roth contributions become more valuable than shown here. (Side note: this chart also reminds us of the power of compounding returns!)

Exhibit 4: Some Mix of Roth 401(k) Contributions Tends to Come Out Ahead in the Long Run

Assumptions: (1) max, static 401(k) contributions inclusive of catch-up contributions; (2) no employer match; (3) retirement age of 65; (4) 6% rate of return on 401(k) assets; (5) RMDs start at 72 for traditional 401(k); (6) 5% after-tax return on non-retirement assets; (7) marginal federal + state tax rates: 27% at age 25-29, 29% at 30-39, 37% at 40-64, 29% at 65+; (8) “Hybrid Approach” makes Roth 401(k) contributions through age 39 and Traditional 401(k) contributions thereafter

Source: Glass Lake Wealth Management analysis

The upside of 401(k) plans is that there are no income limits to neither (1) receive a tax deduction in the case of traditional contributions, nor (2) elect Roth contributions.

IRA Refresher

Once 401(k) contributions are maxed out, people with the ability and desire to find additional means to invest for retirement typically look to IRAs (and Health Savings Accounts if they have an eligible healthcare plan;  read my article to explore the virtues of HSA accounts). One can annually contribute up to $6,000 to an IRA, or $7,000 if over 50 with a $1,000 catch-up contribution, as long as there is earned income.

Like 401(k)s, contributions to IRAs can be classified as pre-tax traditional, post-tax Roth, or post-tax non-Roth (more on post-tax non-Roth in a bit). Traditional IRAs share traditional 401(k) traits such as penalty-free withdrawal allowance at age 59 ½, fully taxable distributions, and being subject to RMD at age 72. Unlike 401(k)s, the ability to make tax-deductible traditional IRA contributions and the ability to contribute at all to Roth IRAs are phased out at modified adjusted gross incomes (MAGI) specified below.

Exhibit 5: IRA Deduction and Contribution Phaseout Levels in 2021

Source: IRS.gov. “New income ranges for IRA eligibility in 2021.” Published 11/4/20

Due to these income limits, many who would like to contribute to an IRA either do not qualify for a tax deduction in the case of a traditional IRA, or do not qualify to contribute at all in the case of a Roth. However, those who earn too much to receive a deduction for a traditional IRA contribution may still contribute after-tax dollars. In this case, the account still grows tax-free, and withdrawals are taxed in proportion to the amount the traditional IRA has appreciated over time. For example, say $100,000 is invested with after-tax dollars into a traditional IRA that appreciated (tax-free) by $50,000 over time to $150,000. At time of withdrawal, one-third would be taxable because that represents the proportion of the account that had taxable gains.

The Backdoor Roth IRA

The good news is one can circumvent income limits of Roth IRAs by contributing after-tax dollars to a traditional IRA, then converting those assets to a Roth IRA. For example, a single 38-year-old with a MAGI of $180,000 could contribute $6,000 to a traditional IRA in 2021 using after-tax dollars (because he or she made too much to qualify for a pre-tax contribution), then convert those assets to a Roth IRA potentially tax-free, where it can grow and eventually be withdrawn tax-free.

Potentially is the operative word when it comes to taxability. That is because traditional IRA to Roth IRA conversions are subject to IRA aggregation and pro rata rules. For purposes of IRA conversions, the IRS pools together all traditional IRA accounts. Therefore, the portion of the Roth conversion that is considered taxable income in the year of conversion is proportionate to all traditional IRA assets containing pre-tax money. Assets in Roth IRAs and any 401(k)s are not factored in here.

This is not an easy concept, so let us look at a hypothetical scenario. Say Jack has $54,000 in a pre-tax, traditional IRA. Because he earns too much to qualify for a pre-tax contribution this year, he contributes the maximum $6,000 of after-tax money to a new IRA that he then converts to a Roth IRA. In determining the taxability of the conversion, the IRS looks at not only the $6,000 conversion, but also the $54,000 pre-existing IRA. Since $54,000 of the $60,000 invested in IRA accounts, or 90%, contains pre-tax money, 90% of the $6,000 conversion is considered taxable income. Put simply, Jack’s pre-existing traditional IRA makes most of the conversion taxable income, which could also push him to a higher income tax bracket.

As such, backdoor Roth IRAs are most suitable for high earners those who have no existing pre-tax IRAs. For those investors, post-tax contributions to a traditional IRA can be converted to a Roth IRA completely tax free. This scenario is most likely to present itself to someone in their 20s or 30s who has been with their employer for an extended duration and has either not had the option to or opted not to rollover his or her 401(k) to an IRA.

The tax savings of indirectly funding a Roth IRA versus an alternative of making contributions into a taxable account can be dramatic, as depicted in Exhibit 6. In this scenario of someone who withdraws 5% of their account value after retiring at age 65, the spread in account values dramatically widens out during retirement because a taxable account holder would pay long-term gains tax on positions presumed to have low cost bases from the many years of compounded growth. A Roth IRA owner need not worry about taxable gains.

Exhibit 6: Backdoor Roth IRAs can Significantly Boost One’s Retirement

Assumptions: (1) max, static backdoor Roth IRA contributions inclusive of catch-up contributions; (2) equal contribution put into a taxable account for comparison; (3) retirement age of 65; (4) 6% investment returns; (5) 25% annual portfolio turnover; (6) proportion of sale proceeds that is a taxable long-term gain is 20% in pre-retirement and 50% in post-retirement; (7) 20% long-term gain tax rate; (8) 5% of account value is withdrawn each year after retirement

Source: Glass Lake Wealth Management analysis

If one owns pre-tax IRAs, it does not necessarily mean a Roth conversion is nonsensical. Converting a portion of a pre-tax IRA could still be advantageous when an investor expects a higher marginal tax rate after turning 72. A higher tax rate could result from working through one’s 70s while also taking RMDs, a higher prevailing tax regime, or moving to a higher income tax state. One might also consider converting some pre-tax IRA assets to a Roth IRA is if he or she is planning to leave retirement assets to heirs in their peak earning years. Inherited Roth IRA assets generally do not incur income taxes upon sale, but inherited traditional IRAs generate taxable income because of their RMDs.

Bottom Line

A backdoor Roth IRA -- that is contributing after-tax money to a traditional IRA, then converting to a Roth IRA -- is a no-brainer for anyone who (1) makes too much to qualify for direct Roth contributions, AND (2) has no existing pre-tax IRA assets, AND (3) has the means to contribute more than the 401(k) contribution required to receive the full employer 401(k) match. When these conditions are satisfied, continually executing a backdoor Roth IRA can tremendously enhance one’s retirement portfolio.

Deciding whether to convert pre-tax assets to a Roth IRA is a less straight-forward exercise. If certain events cause a reduction in income, such as losing a job, starting a business, or retiring before age 72, and/or one’s marginal tax rates are expected to increase after age 72, then a Roth conversion may be advisable. An evaluation of a potential conversion should consider other factors not mentioned in this article and be discussed with a financial advisor, tax accountant, and/or estate planning attorney.

Disclaimer

Advisory services are offered by Glass Lake Wealth Management LLC, a Registered Investment Advisor in the State of Illinois. Glass Lake is an investments-oriented boutique that offers a full spectrum of wealth management advice.

The investment letter expresses the views of the author as of the date indicated and such views are subject to change without notice. Glass Lake has no duty or obligation to update the information contained herein. Further, Glass Lake makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, whenever there is the potential for profit there is also the possibility of loss.

The investment letter and financial planning article are being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory, legal, or accounting services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends or market statistics is based on or derived from information provided by independent third-party sources. Glass Lake Wealth Management believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions in which such information is based.