The “Fifth Season” for Investors

Introductions

As an analyst, I was always intrigued with the term that retailers used to describe the time that was spent marking-down their inventory after their financial year closed. For financial statement purposes, (read: borrowing requirements), they needed to adjust ending inventories to provable levels. This period was called the “fifth season.” As an analyst looking at electronics companies’ years ago and financial service companies more recently, I separate the inventory adjustments from the operating results of the fourth quarter. For publicly traded companies, we can make some guesses but we do not know the adjustments to compensation and after-the-close price adjustments, among other items. Only when I work on private companies and non-profit institutions do I regularly see the post-period adjustments. I am still waiting to see a fifth season financial statement.

Investors also have a fifth season that can aid in their own portfolio management. As with most things of value, these facts are hidden in plain sight. The facts hide in the Internal Revenue Services’ required calendar year-end statements. Most of these arrive in the first six weeks of the year. Those who are invested in various forms of partnerships must wait until they receive their K-1 forms. As these documents come in, there is a natural tendency to gather them up for tax preparation work by an accountant or other tax preparer. When reviewing these documents, the focus is almost exclusively on the identification of taxable income. While this is important, it is a lost opportunity to construct the investment section of a personal balance sheet. Those who have read my book MONEY WISE, will know that I believe a properly drawn personal balance sheet with all assets and liabilities, contingent and intellectual, is the key to sound investing. For those who do not want to deal with judgments required to build such a statement, one can still use the formats used in reported financial statements to guide one’s investments. Looking forward on the investment horizon, are your investments where you want them to be? Are your investments in the optimum tax and estate set-up? These are the questions that one should be asking in the “fifth season.”

With the New Year, 2010 offers tax differences that you may not have dealt with before. The most publicized and uncertain of these changes is the absence of the federal estate tax. As this is a moving target, I am not going discuss the longer-term implications of actions today on your personal financial balance sheet and those of your individual and charitable heirs. I am calling to your attention the removal of the income limit on converting a regular investment retirement account (IRA) to a Roth IRA.

Restructuring your Retirement and Estate Plans

Allow me to set the stage for a person who can get optimum benefit from converting their regular IRA to a Roth IRA from a portfolio management viewpoint. Prior to January 1st , 2010, those with income of $100,000 or over were barred from making this conversion, so I am addressing a relative small slice of the population, but numbering in the millions. Most sizeable IRAs are the result of converting a corporate-sponsored retirement program, either from a defined-contribution or defined-benefit plan. For some individuals, we are talking about accounts valued into eight figures. At the same time, many of these people have sizeable after-tax funded investment accounts from earned or inherited wealth. In the early years of IRA accounts there were no restrictions on individuals setting up accounts, even though they were covered by other retirement plans. Many who have shifted employers have multiple IRA accounts.

For example purposes, I am assuming we are dealing with an individual who has a personal after-tax account and a couple of IRAs. Prior to 2010, assume that the size of the personal account was reasonably close to the size of his or her largest IRA. From a tax and estate management point of view, the personal account should have been loaded with equities, where the gains would have been taxed at the more favorable capital gains level while the account holder was alive, and passed to heirs on a date of death basis. The IRA should have been loaded with high income-producing investments, typically bonds and big dividend paying stocks. The income derived would accrue tax-deferred until it was paid out to its owner or his or her heirs. From an overall portfolio management standpoint, the IRA was the reserve element that provided something of a safety net under the more risky, hopefully higher return, equity-oriented account. Note that there is nothing in this two part portfolio set-up to prevent the use of market judgment impacting some reserves in the equity account, and concerns for interest rates and inflation in the IRA.

How does the Roth conversion opportunity change the investments in these portfolios? First, nothing has to change. Second, a decision needs to be made on where the funds will come from to pay the income tax on the conversion. The money can come from either the personal account or the IRA. This decision allows the taxpayer the chance to rebalance the two accounts. Third, if there are more than one existing IRA account, there is no need to convert them all to a single Roth IRA. One might choose to delay moving some to reduce the amount of taxes due in one year, or if there is a belief that one would be in a much lower tax bracket in the near future.

Where to Invest in 2010 for the Future?

The investment results for 2009 were a sizeable after-shock to the earthquake that hit the investment world in 2008. Some investors may feel that these results are normal, cyclical behavior and we can go back to investing as before. Others may feel that we have gone through a seminal period which should lead us to re-examine our thinking and modify our policies.

Space constraints do not permit me to suggest how each of the eleven different investment personalities described in MONEY WISE should view last year’s results and develop plans for the future. Stay tuned for next week’s blog, but the impatient can contact me before next weekend by using the “Comment” button on the blog or by replying to the email version. I will gladly send you the excerpt.

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