Two Free Lookback Options for U.S. Taxpayers    

When I was a derivatives trader in the 1980s and 1990s, a popular type of exotic option was invented, called the “lookback” option.   Traditional options allow the buyer to capture an asymmetric return based on an underlying index or asset price…. a way to speculate or invest in a very specific range of outcomes through a financially engineered product. A lookback option offered something even more highly engineered: the ability to set the option strike price and determine the payoff at the end of the option period, by “looking back” over the price history since the option purchase date. As you might imagine, these options were often very expensive, especially if the underlying asset or index were volatile.


So it may come as a pleasant surprise to learn that each year, the Internal Revenue Service offers its own flavors of lookback options, at no cost to the taxpayers who take advantage of them.


The “just in time” IRA / SEP / Solo 401k contribution


You are permitted to make IRA contributions, including SEP contributions, up until your federal filing deadline, which includes any approved extensions (so typically April 15 or October 15 of the following year). This option also extends to taxpayers with individual or solo 401k programs. Why is this so valuable?


Many taxpayers, especially small business owners and other self-employed individuals, do not have a good handle on their tax liability until their return is ready for filing. With the modern tax code, estimating tax is all but impossible without expert advice, and even then it can be a complex and expensive undertaking. But once the tax liability is known, IRS rules give the taxpayer an opportunity for a partial do-over ~ to increase their retirement contribution to reduce their tax liability.   This option is particularly useful for self-employed individuals with high income variability. Such individuals may not be able to plan for regular retirement contributions, because they may not have a good idea about their taxable income in any given year.  But they can make a retirement contribution for the previous tax year as late as October 15th of the next year.


Using this last minute planning approach, a taxpayer can save thousands of dollars in tax by making additional retirement contributions prior to filing, simply by taking an extra step before finalizing their return.


Undoing ROTH Conversion


ROTH conversion, which became allowable for all taxpayers in 2011, has been a huge boon to retirement savers in two ways. First, by allowing savers to ‘gross up’ the value of their pre-tax retirement accounts by paying current period income tax on the conversion amount, the rule has dramatically increased taxpayers’ effective retirement savings. Second, because ROTH conversion was first permitted during the early stages of what has become a significant bull market, investors have accumulated significant tax-free wealth through equity appreciation in their ROTH accounts. Because of the bull market in equities, one of the other valuable “lookback” options offered by the IRS has not been widely utilized, as there’s been no need for it.   This option allows a taxpayer to “undo” a ROTH conversion by “recharacterizing” the conversion by the due date of the prior year return, generally April 15 or October 15 if extended.   When would this option be valuable to a taxpayer, and how would one quantify the value?


Consider a scenario where a taxpayer, Mr. Jones, plans to convert his $100,000 IRA in January of Year 1.   His marginal tax rate is 40%, so Jones will incur a marginal tax liability in Year one of $40,000. He plans to pay this tax from regular savings.   To the extent that the account appreciates, Jones will be better off with the ROTH account, because the appreciation will be tax-free rather than tax deferred. If the account were to increase in value by 50%, Jones’ effective tax savings would be 40% * 50% * $100,000, or about $20,000. But what if the market tanks right after conversion?


In a market meltdown scenario, Jones still owes a tax liability of $40,000 in the year of conversion. But now assume the market has fallen by 50%.   The after tax value of the ROTH is $50,000. The value of a traditional IRA also would be $50,000, but the future tax liability is only $20,000.   The ROTH conversion, followed by a precipitous market decline, has cost Jones $20,000 in tax. This is where the lookback option comes in. The IRS allows Jones, up until his filing deadline (April or October of year 2), to recharacterize the ROTH conversion and effectively “undo” the conversion, reversing the tax liability. After a brief waiting period, Jones can proceed to convert the account to a ROTH once again, now at the lower market value, paying less tax and allowing for more potential tax-free growth of the account.


We have not attempted to quantify the value of this lookback option — perhaps this will be a project for this summer’s interns — but a cursory review of market volatility over the past few years, and a qualitative understanding of the lookback feature in the IRS rules, suggests that there is significant value for a taxpayer contemplating ROTH conversion.


Can You Retire Today with less than $1 million?

There is a misconception that in order to retire comfortably, it is critical to have at least $1 million in savings.  However, this is a false narrative for the vast majority of retirees.   According to CNN Money, spending for a typical household headed by a retirement-age person is less than $47,000 per year. Consider that work-related expenses, such as commuting, business attire, and income taxes will generally fall precipitously in retirement.  Being retired also provides retirees the free time to work on household chores and projects that previously might have been farmed out to others, resulting in time and money saved.  Since most individuals are able to cover a portion of their retirement expenses with social security or pension income, a million dollar investment account is not a prerequisite for financial security.


If you want to evaluate how much you’ll need in retirement, contact us.  We have sophisticated modeling tools that will help determine how much money you need and how long your money will last.


The Startup Idea Matrix for Businesses


The startup idea matrix is a clever table — a Google Workbook actually — that classifies consumer startups by market tactics and solution sets, suggesting strategies that businesses can apply in the B to B space.  This type of analysis is particularly interesting to us at North Capital, given the pace of innovation and creative destruction in the financial technology (FinTech) and regulatory technology (RegTech) industry segments, where we compete.   If one were to add a third dimension — industry vertical — the matrix would look different still, as certain areas are particularly well-developed and others are just beginning to be explored.

Why We Use Mutual Funds

For years prospective clients have asked us why we generally prefer to utilize mutual funds over ETFs in the construction of client portfolios, given the extremely low expense ratios and broad asset class coverage of ETFs.  For advisors who proselytize about diversification and the general efficiency of markets, as we do, ETFs would seem like the logical way to implement an asset allocation strategy.  Antti Petajisto has been studying ETF markets for over a decade, and his research quantifies the hidden cost of trading on open exchanges, as ETFs do, rather than once a day at net asset value, as mutual funds do, in what he describes as “the first comprehensive study of the pricing efficiency of all US-listed ETFs after the dramatic surge in new products.”


While the research monograph is a rather technical analysis of market dynamics, Petajisto’s conclusion highlights the hidden drag that we have been explaining to our clients for years:  the drag of transaction costs.  He writes:  “It is easy for an investor to fall into the trap of focusing so much on the expense ratios of funds that the transaction price for ETF shares is overlooked. Given that US ETF assets were about $2 trillion and growing in 2014, any nontrivial mispricing in ETFs has the potential to represent a considerable wealth transfer from less sophisticated individual investors to more sophisticated institutional investors.”  We agree.