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Topic: Investment Management

Using Tracking Difference to Analyze Performance

By Scott Roark, MBA, PhD | August 30, 2019

Benchmarking vs. Tracking Difference

In a recent podcast episode (Edu #1925), we talked about benchmarking investment performance.  It is important for investors to know how well they (or their managers) are doing with the investment decisions they make.  One of the reasons that managers may not like to benchmark is that historically, relatively few managers consistently beat their benchmark.  There are a variety of reasons it is difficult to beat a benchmark.  Benchmarks are typically tied to an index which means it is a passive investment choice.  The problem with an index is that you can’t technically invest in one – when you buy an S&P 500 ETF, you are buying something that is very close to the index, but not the same as the index.  An index doesn’t have trading costs, taxes, manager fees, rebalancing costs and a variety of other possible drags on performance.  But you can generally feel pretty good when you buy your ETFs because the correlation between it and the index you are trying to mimic is usually higher than 99%+.

A similar way of stating the performance of an ETF and an index are very close is to look at their tracking difference (the difference between the index performance and the fund/ETF performance).  A good ETF or index mutual fund will have a very low tracking difference – measured in 1/100ths of a percent.  So for example, say the Russell 2000 index had a return of 7.59% and your Russell 2000 ETF had a return of 7.52%.  The tracking difference, in this case, would be 0.07%.  If you are trying to mimic the performance of an index by purchasing ETFs or mutual funds, the tracking difference is an important piece of information.

Using Tracking Difference

There are dozens of funds and ETFs (from dozens of fund companies) that track the S&P 500 for instance.  An investor might reasonably expect that when they purchase an S&P 500 fund, they will be getting a performance that very closely resembles the results of the S&P 500 index.  With many funds, that is what you are getting – something that very closely resembles the S&P 500 and has a tracking difference of 0.10% or less.

However, there are funds – typically ones with high expense ratios – that have relatively high tracking differences and really aren’t giving investors what they should be expecting.  One notorious example of an S&P 500 index fund has an expense ratio above 2.3%.  Compare this to many funds and ETFs that track the S&P with expense ratios of less than 0.1% and you can start to see why the fund’s returns will be well below the benchmark and there will be a large tracking difference.

What Else to Consider

In closing, I’ll mention one last factor that is related to investment performance – particularly for mutual funds.  That is the tax-efficiency of the fund.  This is related to the buying and selling of the fund and how that affects the taxable distributions from the fund each year.  If you are holding your investments in a tax-advantaged or qualified account (an IRA/401k/Roth), you may not care that much about this.  But in a taxable brokerage account, taxes represent a very real decline in investment performance.  The fund I mentioned above that had expense ratios (for an index!) over 2.3% also had an annual turnover of 157% (versus 4% for more well-run index funds) – there was a lot of buying and selling.  All this trading means that come tax time, there will likely be insult added to injury and the after-tax performance will be VERY far away from what the index return was.

Portfolio Diversification and Asset Correlation

By Scott Roark, MBA, PhD | July 5, 2019

What is Correlation?

Correlation between asset returns is an important consideration when you are managing portfolio diversification.  Correlation is a statistical measure of the relationship between items. An easy example to understand is the correlation between height and weight.  Usually, when height increases, weight also increases and you have what is called a “positive correlation” – these two things tend to move together.  An example of a “negative correlation” would be between the speed you drive and your gas mileage.  Typically, the faster you go, the lower your gas mileage.

How Does Asset Correlation Relate to Portfolio Diversification?

For your portfolio, the goal is to have a well-diversified collection of assets.  To be well-diversified means that you need assets that are “negatively” or not highly correlated with each other.  When one asset “zigs”, hopefully you have another asset that “zags” and when you put the two together, you have a less volatile (less risky) portfolio.

There is one important implication of this idea in terms of your investment holdings – it is not usually a good idea to have a large portion of your portfolio in your company’s stock.  This is because two of your largest assets – the large position you have in the stock AND the “human capital” you have tied up in the company through your employment can be highly correlated.  The danger, of course, is that the company goes through hard times and you lose both your job and a substantial portion of your wealth.   Employees of once high-flying companies like Enron, Lehman Brothers, Blackberry, GE and many more can testify to the risks involved with owning too much company stock.

Managing Risk

At the end of the day, correlation and diversification are all about risk.  Early in one’s career as you are building wealth and have a long horizon, there is less concern about risk because there is less to lose and more time to recover.  As one approaches and enters retirement, however, managing risk becomes very important because there is usually more to lose and less time to recover.  This means it is critical to have a well-diversified portfolio whose assets aren’t highly correlated.

If you’re concerned about portfolio diversification, please call our office to find out how we can help.

Excess IRA Contributions, Part 1: Basic Qualifications

By Jim Saulnier, CFP | May 24, 2019

Excess IRA Contributions: Basic Qualifications

We hear a lot about how important it is to contribute to an IRA. So, ‘how to contribute correctly’ becomes an important topic. Not that it is difficult, but there are some important rules regarding IRA contribution qualifications that you have to follow.

And since you put money into an IRA to allow it to grow in a tax-advantaged environment, you don’t want to break one of the rules and have it cost you money. One of the main ways that could happen is if you make excess contributions.

In this three-part guide on excess IRA contributions, we are going to review (1) the basic qualifications for making valid contributions, (2) some of the more complex situations you will have to navigate and (3) how you can fix accidental excess contributions and avoid costly penalties.

Why would you want to contribute to an IRA?

In a traditional IRA, your contribution may be fully or partially deductible from the amount of income on which you will be taxed this year. Your contribution will be made with ‘pre-tax dollars.’ Because you won’t pay taxes on those funds now, the portion you would have paid in taxes is also allowed to grow until it is withdrawn, or ‘distributed.’ You will pay the tax upon withdrawal, both on original funds and any gains.

When can you take money back out of an IRA?

You can withdraw money from an IRA whenever you want. However, if you are below age 59½ when you do so, you will pay 10% additional tax on the funds, above your applicable tax rate for that year. From age 59½ forward, you will pay just that year’s applicable tax rate. Then, at age 70½, you will start having to take out Required Minimum Distributions, or RMDs, based on an IRS formula. Not doing so may lead to hefty penalties.

How much can you contribute to an IRA?

For 2019, each person can contribute a total of $6,000 (or $7,000 if you are age 50 or older), as long as you have at least that much in ‘qualified income.’ Anything you contribute above your qualified income will be considered an excess contribution. You have to be particularly careful if you contribute to IRAs being held by multiple custodians (such as authorized banks and brokers), as it is your responsibility to monitor the total, and not the custodians’.

How do you define ‘qualified income’ for contributions?

In general, the IRS defines qualified income as wages, salaries, tips, professional fees, and bonuses. It also includes commissions, self-employment income, alimony, and separate maintenance, as well as nontaxable combat pay. However, you cannot consider Social Security, rental income, investment income, dividends, interest or royalties (among others) in your calculations. Using the wrong kind of income to justify contributing to a traditional IRA puts you at risk of making an excess contribution.

How does spousal income figure into IRA contributions?

You may not have any (or enough) qualified income to justify contributing fully to an IRA. However, if your spouse does and if you file a joint tax return, you can use your spouse’s income to qualify. Each spouse will hold a separate IRA, but the total of your combined contributions cannot be larger than the taxable income reported on the return. If it is, you will be facing penalties for excess contributions.

How long can you contribute to an IRA?  

You can only contribute to a traditional IRA until the year in which you turn 70½. Say you turn 70½ in December of 2019. You cannot contribute at all to a traditional IRA in 2019, even if you were still 69 in early 2019. When in the year you contribute is irrelevant. Any contribution you do make will be considered an excess IRA contribution.

What about Roth IRAs, how do they differ from traditional IRAs?

To start, contributions to a Roth IRA are not tax-deductible, so they are made with ‘after-tax dollars.’ As long as you meet the distribution qualifications, funds will not be taxed when withdrawn. (Remember, you already paid tax on the funds). However, because of the tax advantages Roth IRAs offer on gains, the IRS places caps on the income of those allowed to contribute. If your income is higher, you will have made an excess contribution.

Other differences? You can contribute to a Roth IRA regardless of age, that is, even after you reach 70½. You also do not have to start taking distributions at 70½ but can leave funds there for life.

What next?

Now you have the basic guidelines for contributing to an IRA without being penalized for excess contributions. More complex issues will be reviewed next. However, if you would like to make IRA contributions part of a strategic retirement plan, please reach out to our office so we can help.



It’s All Relative (Performance)

By Scott Roark, MBA, PhD | April 20, 2019

There are plenty of circumstances in life where you really don’t want to compare yourself with others.  Doing that is a fairly reliable way to make yourself feel bad – there will always be someone better looking, more athletic, more successful or richer than you.  But in the world of investing, it is critical to compare the performance of your portfolio to a suitable benchmark.  It gives you a sense of how well you are (or your investment advisor is) doing.

Comparing Yourself With Others

The trick in comparing investment performance is to ignore the headline number – absolute performance and instead focus on relative performance.  Absolute performance is simply the return you had – maybe up 7% for the year, or down 4% for the quarter.  Relative performance, on the other hand, compares your investment returns to a suitable benchmark.  The key word there is “suitable” – something else that reflects the characteristics (risk, asset allocation, etc.) of your investment.  So, you wouldn’t want to compare your bond portfolio or your High-Tech mutual fund to the S&P 500 – in both cases, the benchmark doesn’t reflect the nature of your investment.

There are some strange things that can happen when you start looking at relative performance.  First, you can be upset when you have a “decent” absolute return.  Perhaps your balanced mutual fund earned 5% for the quarter.  But if the benchmark for balanced funds is 9%, it is perfectly reasonable to be upset with your “decent” return – you did worse than you should have given the characteristics of your investments.

Stranger still is the situation where you should be happy with a negative return.  This would happen when your portfolio lost (for instance) 8% in value, but comparable investments lost 16%.  If that situation occurs, you are fortunate indeed – even though your value went down.

Let’s Be Reasonable

At the end of the day, you want a return that is reasonable given the investments you have made – what is frequently termed the “risk-adjusted return”.  If you are getting returns close (say within 1%) of an appropriate benchmark, you are doing pretty well.  Unfortunately, many investors – after paying advisor fees, mutual fund fees, and other transaction costs are well below where they “should” be.  And worse still, many of these investors don’t realize that fact.  Next time you are reviewing the performance of your investments, make sure you compare those results to the results of comparable benchmarks.

NUA – When You Have Employer Stock Held In Your Retirement Plan

By Justin Fundalinski, MBA | February 20, 2018

NUAAdmittedly, this overview of Net Unrealized Appreciation (NUA) is designed to be quick and concise.  There are far too many tangents that can be covered in a simple newsletter such as this, and the point of this article is not to educate you on every detail, but to get you thinking whether taking advantage of NUA makes sense financially.

What is NUA?

NUA is the Net Unrealized Appreciation of employer stock held in an employer retirement plan which under IRS rules allows you to be taxed outside of the retirement plan at preferential long-term capital gains rates rather than at ordinary income rates. What’s all that jargon mean?  If you have a qualified retirement plan at your employer that holds stock of that company, you just might be able to save yourself on some taxes.

What is the tax treatment of NUA?

Taxation of NUA distributions is made up of three parts.

  • First, any cost basis is taxed immediately as ordinary income upon the initial distribution. In this case cost basis is the value of the shares when initially purchased in the employer plan. Note: this portion could be subject to a 10% early withdrawal penalty.
  • Second, the NUA gain is taxable at long-term capital gain rates when the shares are sold. NUA gain is the difference between the cost basis (as defined above) and the actual value of the shares when they are distributed from the employer plan. Long term capital gains rates are 0%, 15%, and 20%.
  • Third, the post distribution gains are taxed at long or short-term capital gains depending on your holding period. That is, they could be taxed at capital gains rates or as ordinary income.

Notably, there are some other rules in the tax treatment of the NUA Gain portion.

  • NUA gains can be deferred but will eventually be taxed. These gains are not eligible for a step-up in basis at death.
  • NUA gains are not subject to the 3.8% Medicare surtax on net investment income.

How do you qualify for NUA tax treatment?

There are a few rules that you must abide by to qualify for NUA tax treatment.

  • You must distribute your employer stock from the employer plan “in-kind.” That is, you cannot sell the stock within the plan and transfer cash outside of the plan. You must move the actual shares. If you cannot move the shares you cannot use NUA.
  • You must distribute the entire account balance at your employer during a single tax year. That is the employer plan must have a zero-balance come December 31st. Where those dollars end up is up to you.  You can, for instance, move all or some of the employer stock to a non-qualified account to take advantage of NUA tax treatment, and move all other holdings to an IRA. There is flexibly here which opens the doors to various planning options.
  • The lump-sum distribution (a full distribution of the account in one tax year) must be made after a “triggering event.” Triggering events are death, disability (self-employed only), separation from service (non-self-employed only), or reaching 59½.  These are all independent triggering events so if you missed your opportunity for one, all is not lost.  For example, if you retire at 55 and take only a partial distribution to fund a vacation the year after retirement you just lost the opportunity to use NUA under the separation from service triggering event. However, you could take the full distribution once you reach 59½, or your children could take it after your death and use the NUA tax treatment.

What are the pros and cons?

The Pros:

  • Usually it is very appealing in the near term from a tax perspective as you may be able to realize income/assets out of a retirement plan at much lower tax rate.
  • It is not an all or nothing deal. You can pick and choose specific shares of employer stock to benefit yourself the most. This allows for substantial flexibility in planning.

The Cons:

  • It may not be as appealing in the long term from a tax perspective as you lose tax deferral and you force immediate taxation on the cost basis portion of the asset (as well as ongoing taxation of dividends and capital gains).
  • Often, benefits are highly driven by only two variables.
    • Cost basis in the account.
      • Low cost basis shares are far more beneficial than high cost basis shares. Just because you have NUA does not mean it is of value.
    • Unknown time horizon.
      • Will immediate tax benefits outweigh the benefits of tax deferral? Depends on how long you live.

It is important that you don’t engage in NUA transactions with out an immense amount of forethought and planning.  If you have any questions or if you are interested in our opinion on your NUA scenario please contact us directly.


Caution: New IRA Rules (Part 2)

By Justin Fundalinski, MBA | April 15, 2015

IRA distributions

Last month I focused our monthly article on helping you understand that it is not an IRA custodian’s responsibility to give advice on how to take IRA distributions.  It was discussed how they dismiss themselves from any responsibility if a distribution is taken incorrectly and you are forced to suffer undue tax consequences. I also defined some common IRA withdrawal types that can cause confusion when taking a distribution as well as outlined the newly implemented One Rollover Per Year Rule that will throw IRA account holders for a loop in 2015.  This month’s article is a continuation on this subject and is focused on helping IRA owners proceed with caution so that the new rules do not come back to bite them at tax time.

Quick Review of the One Rollover Per Year Rule:

In 2014 a major Tax Court decision impacted indirect transfers (60-day rollovers) beginning in January 2015. The new rule states that an IRA owner can only make one indirect rollover per any 12-month period, regardless of the number of IRA’s that they own. Prior to 2015, an IRA owner could move any IRA account that they had once per 12-month period.  If you act outside of this rule you will have to include any distributed amounts as income on your tax return and if you are under age 59½ you may be subject to an additional 10% early withdrawal penalty.

Who Is Most Likely to Be Affected?

My first inclination of who is most likely to break the new rule is anyone who maintains IRA bank savings accounts or CDs. I am not intending to knock bank custodians or bank IRAs, the fact of the matter is that we are all used to doing banking business a certain way – in person.  Think about it, if you decided to move your checking accounts to a new bank, would you start by going to the new bank and telling them to transfer your funds over from the old bank? No! You would go to your old bank, close the account, get a check, walk across the street and open up a new account before the ink on the check dried.  So what happens when you do this with two or more IRA CDs?  Whoops, you just made too many indirect transfers and you are subject to the consequences of the One Rollover Per Year Rule. If you have any accounts that are IRAs make sure you simply avoid this problem by moving funds with direct transfers.

Bank CD Owners Beware!

Another reason why bank CD owners could fall victim to the new rule is because banks have their own lingo for CDs that unfortunately uses one of the same terms as an IRA distribution type – “rollover.”  When you rollover a CD (in banker terms) it means that you reached the end of your original CD term and you want to continue in a CD for the same term but at the new prevailing interest rates.  So now we have one word with two definitions that can be used to describe two completely different things that you can do with same IRA CD.  It can be the banker term as defined above or it can be the IRA distribution term as defined in the previous article.   Are my lexicographers confused yet? To make this problem simple just remember this – DO NOT ASK YOUR BANKER TO “ROLLOVER” YOUR CDs TO ANOTHER BANK. You want to ask your new bank/custodian to move your funds by means of a direct transfer.

Errors of Others

Unfortunately, mistakes with of the One Rollover Per Year Rule will be caused by the errors of others. As mentioned in last month’s article, we recently worked with someone whose IRA was at a local bank custodian. This person was simply trying to renew their existing bank IRA CD for a shorter term. Rather than keeping the existing IRA open and just buying a new shorter term CD in it, the bank’s employee completed paperwork that closed the IRA and took a full distribution! The employee then directed this distribution into a CD in a new IRA (in effect this mistake is viewed as an indirect rollover in the eyes of the IRS). To add insult to injury three months later the same bank employee made the exact same mistake again! Each “distribution” generated an erroneous 1099 from the bank which was then reported as taxable income to the IRS of nearly $400,000 on an IRA that was valued at $200,000!

The bank’s representative completed distribution paperwork for this IRA owner (common practice even though custodians technically do not give advice on how to take the distribution) and she marked the distribution type incorrectly. Of course, the IRA owner signed off on the paperwork not knowing it was completed incorrectly and technically the problem lies on the IRA owner’s shoulders. Fortunately, as of the writing of this article the bank was attempting to “fix” the problem.  We have no doubt in time they will, but it will also most likely result IRA owner receiving a “letter audit” from the IRS in a few years asking her to explain why she didn’t declare $400,000 of IRA distributions on her taxes!

In summary, whether you are moving funds from a bank custodian or from any other type of IRA custodian it just isn’t as simple as it sounds.  If you have any questions or need help with this please remember that we are here to give you guidance.  Jim is a member of the Ed Slott Master Elite IRA advisor group and will be able to help with any and all of your IRA questions.


Caution: New IRA Rules (Part 1)

By Justin Fundalinski, MBA | March 15, 2015

IRA rules

In the world of IRAs, IRA Custodians (financial intuitions that are approved by the IRS to hold such retirement accounts) have lots of responsibilities that they must uphold. However, it is not their responsibility to assure you know the differences among all the confusing terminology that revolves around IRA withdrawals/transfers and the tax consequences behind them (for example: direct transfers, indirect transfers, and distributions are all ways to take money out of an IRA and all have different tax rules).  It is up to the account holder to sign off on the reason IRA funds are leaving an account, and if you are not educated on the IRA rules that just changed in 2015, unintended tax consequences may occur.

To illustrate this point, recently at the office we saw IRA withdrawal paperwork from a bank custodian that clearly stated above the signature line, “… no tax advice has been given to me by the Custodian” and, “I assume the responsibility for any adverse consequences which may arise from this withdrawal and that the Custodian is not responsible”.  The sad thing is that a bank employee filled out the paperwork, checked the incorrect distribution type, never went over this with their client, and the client signed off unknowingly.  With all the confusing terminology as well as changing tax laws this article is intended to inspire a bit of caution to those who move IRA funds – especially those who have multiple IRAs or move their accounts frequently (i.e. IRA CD/Interest rate shoppers).

Common Withdrawal Types:

Before we get into the depths of the topic at hand, a quick overview of three common withdrawal types is necessary.

A distribution is the easiest to explain of the various withdrawal types and is when an IRA owner takes money out of their IRA.  The reason someone may want to do this varies, but typically they either have to remove funds because of Required Minimum Distributions (the IRS wants their cut) or they want to remove funds because they need the money.  Any money that is withdrawn is subject to taxes as ordinary income (just as one’s wages or interest income is) and may be subject to a 10% penalty if they are under age 59½ when they take the withdrawal.

A direct transfer is a withdrawal from one Custodian directly to another Custodian.  This is a very common way of moving an IRA to another financial institution.  Most times a direct transfer is completed electronically, however if a check is issued, it is made payable to the new Custodian for the benefit of the IRA owner and not to the IRA owner themselves. For instance, if I were transferring my IRA to ABC Custodian the check would be made payable as: ABC Custodian IRA FBO Justin Fundalinski. Under current rules there are no limits on how many direct transfers an IRA owner can complete in a year.

An indirect transfer (aka 60-day rollover) is actually a distribution (as described above) from an IRA where the check is made payable to the IRA owner so that they can then turn around and redeposit the funds into a different IRA.  With indirect transfers, the IRA owner becomes the “middleman” between the retirement account custodians; hence, it is “indirect” and they become responsible for ensuring the check makes it to next custodian.  The indirect transfer is a tax and penalty free distribution of assets as long as one adheres to the 60-day rollover rules set forth by the IRS (in short – recontribute the funds to an IRA within 60-days of receiving the original distribution).  Unfortunately the 60-day rollover rule was refined in 2015 and became much more restrictive with the one rollover per year rule.

One Rollover Per Year Rule:

In 2014 a major Tax Court decision impacted indirect transfers (60-day rollovers) beginning in January 2015. The new rule states that an IRA owner can only make one indirect rollover per any 12-month period, regardless of the number of IRA’s that they own. Prior to 2015, an IRA owner could move any IRA account that they had once per 12-month period.

So what are the consequences? If you act outside of this rule you will have to include any distributed amounts as income on your tax return and if you are under age 59½ you may be subject to an additional 10% early withdrawal penalty. This rule change will undoubtedly have negative consequences on many people, but knowing how the rule works and the distribution types discussed above it will be business as usual.

Proceed with Caution:

Since there are so many possible scenarios that this new IRA rule change could wreak havoc on, getting into such detail is beyond the constraints of this month’s article. However, because it is something that IRA owners should understand, consider this a “to be continued,” and the following paragraph a spoiler of what you can expect next month.

Coming from many years of working at a national bank and understanding more banking and IRA jargon than I like to admit to, I can assure you that the majority of IRA owners that will be affected by the new one rollover per year rule will be IRA CD/bank savings owners.  So, if you need to move around IRA funds at your local bank before you can read next month’s article please make sure you understand the rules and terminology discussed above and don’t hesitate to contact us if you have any questions.


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