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Issue XIV

January 1998

Sharp Investing

The Tail that
Wags the Dog

In this issue of Sharp Investing we examine some of the investment implications of the Taxpayer Relief Act of 1997. IF YOU DON'T READ ANYTHING ELSE, BE SURE TO READ THE ROTH ARTICLE, STARTING ON PAGE THREE!

For the first time in quite a while, Congress
has provided investors with a number of attractive incentives to save and invest, as well as removing some of the more ridiculous penalties for doing too good of a job at saving and investing. While most professionals will tell you not to let playing the tax game dictate your investment strategy (known as letting the tail wag the dog), shrewd tax planning can greatly affect your long-term after-tax results and should be factored into the investment decision.

1. Repeal of Success Penalties

  • Those of you fortunate enough to have a seven figure Qualified Plan (IRA, 401k, etc) can breath a big sigh of relief. Previous tax law imposed a stiff 15% penalty on annual withdrawals exceeding an inflation-adjusted $150,000 from many types of Qualified Plans. With the new tax law, a normal distribution from your plan is taxed "only" at the regular tax rate, regardless of amount.

  • Homeowners can now exclude capital gains from a primary home (up to $500,000 if married). There are many qualifying details, so consult your CPA before counting on this new provision. For most of us, this provision allows people the flexibility to move to another home of lesser value without paying a large capital gain tax. This exclusion cannot be used more than once every two years.
  • Each U.S. citizen eventually will be able to shelter up to $1,000,000 instead of the previous $600,000 from federal estate and gift taxation. In addition, there is some further relief for owners of "family-owned" businesses. Once again, there are many details and qualifiers, so check with a good estate planner or attorney for details.

While most people did not let the previous "success penalties" affect their desire to create wealth, it definitely was a slap in the face to be penalized for extra success after a lifetime of paying taxes. Now that some of these penalties have been repealed, investors are able to do a better job of preserving wealth after a lifetime of creating that wealth.

2. Capital Gains Tax Rates

The incentive to hold securities "long-term" has been missing from the tax code since 1986. The Act of 1997 reintroduces this popular tax cut. There are three time periods to watch with regard to the long-term capital tax rates.

  • Stocks sold after July 28, 1997 but before January 1, 2001 and held for 18 months are subject to a maximum tax rate of 20% and a minimum tax rate of 10%, depending on income tax bracket.
  • Stocks sold after May 6, 1997 but before July 29th, 1997 and held for 12 months face the same 20/10% tax rates (this is a band-aid period added as an afterthought when Congress botched the code the first time around).
  • Stocks sold after December 31, 2001 and held for 5 years are subject to a maximum tax rate of 18% and a minimum of 8%, again dependent on income tax bracket.

These new long-term tax rates support Sharp Investment's buy and hold investing, and conflict with the modus operandi of most mutual funds. The average turnover in funds is 100%, which means the average holding period is 12 months, which means most mutual fund capital gains distributions will be taxed at short-term rates. At the 28% income bracket a long-term gain of 20% represents an after-tax gain of 16% whereas a short-term gain of 20% represents an after-tax gain of 14.4%. Compounding at these rates for 20 years, an initial $10,000 yields $147,407 from the short-term 20% return and $197,407 from the long-term 20% return. The same investment return yields a $50,000 difference from paying attention to the tax code.


If you are self-employed or own your own business, a SIMPLE IRA (Savings Incentive Match Plan for Employees of Small Businesses) is a new retirement plan that may fit your needs much better than existing plans. The key feature of the SIMPLE is the ability of an employee to fully fund a SIMPLE without regard to their level of compensation, assuming they earn at least $6,000 in the year of the contribution. An employee can defer a maximum of $6000 into a SIMPLE as a salary deduction, and an employer can match this contribution subject to a 1-3% cap (chosen by the employer) based on the employee's annual compensation.

For example, Ed the Entrepreneur pays himself a salary of $30,000 per year. He can contribute $6000 of this salary into his SIMPLE and can match another $900 from his company ($30,000 x 3%) for a total SIMPLE contribution of $6,900. Conversely, if Ed had a SEP (the best plan for small businesses prior to the SIMPLE), his maximum contribution would be $4500 ($30,000 x 15%).

"A business owner who makes a $6000 SIMPLE contribution for 20 years would have a retirement portfolio valued at $472,000, given a 12% investment return."

A SIMPLE is a great way for small business employees to make a large contribution to their retirement plan if they are not highly compensated, or choose to keep their salaries low. A SEP is still better if an employee is highly compensated and wishes to shelter a large amount (maximum contribution is around $22,500 indexed to inflation).

Key elements to a SIMPLE

  • Not subject to ERISA regulation (as is a 401k)

  • No other employer-sponsored retirement plan allowed is (no, you can't have a SEP for a highly compensated employee and a SIMPLE for a lower compensated employee for the same company)
  • Businesses must have less than 100 employees
  • Annual maximum contribution of $6000-$12,000 (if employee salary is at least $6000 - $200,000)
  • Regular IRA proceeds cannot be rolled to a SIMPLE, and SIMPLE contributions cannot be rolled to a regular IRA for two years after the contribution is made
  • Plan documents must be dated prior to October 1 of the year the plan is implemented
  • Employer contributions can be deposited up to the day taxes are due but employee contributions are due by the end of the calendar year

Congress has allowed the SIMPLE to be set-up for 1997 as long as the SIMPLE documents are dated prior to October 1, 1997 (You may submit the plan documents to a custodian at any point prior to your tax due date, they just have to be dated prior to Oct 1). There are also SIMPLE 401k's that have some different employer-matching details than the SIMPLE IRA. SIMPLE IRA's have their own qualifiers and details for employer-matching contributions, so as a business owner, if you have employees other than yourself, consult your CPA for details. A business owner who makes a $6000 SIMPLE contribution for 20 years would have a retirement portfolio valued at $472,000, given a 12% investment return.

4. Roth IRA's

By now, most of you have probably heard of the new form of IRA available as of January 1, 1998, known as the Roth IRA. The key element to the Roth is that the withdrawals eventually become completely tax-free as opposed to the tax-deferred status of a regular IRA. Those of us who have spent time daydreaming about living out our retirement years free of income tax in some tax-free Caribbean nation can now do it legally without having to become an expatriate.

The provisions surrounding the Roth are extremely complicated and there are currently differing interpretations on some of the finer points, which may not become clear until the IRS provides final interpretations sometime in 1998. It would be unwise to count on provisions without consulting a tax attorney or CPA.

As of January 1, 1998, most individuals can contribute up to $2000 annually to a Roth, the proceeds of which will be completely tax-free upon taking a qualified distribution. This is good, but not great. Two thousand dollars added each year for 20 years would yield a tax-free amount of $160,000 (assuming a 12% investment return).

However, there is a provision in the Roth that allows the proceeds from an existing regular IRA to be rolled to the Roth (Some experts also believe a 401k and a 403b retirement plan may be eligible to roll to a Roth also, but this point is still under debate). This is the great part! Rather than starting with a $2000 base, you can grow your tax-free portfolio from the existing size of your IRA's or 401k, which is most cases is much larger than the $2000. Alas, there is a big, bloody gotcha. You have to pay taxes on the rollover amount (but no penalty) and it is taxed as ordinary income, not as capital gains. But for 1998 only Congress has approved a special one-time provision in which the taxes due from the rollover can be paid over four years. This extra "income" can raise your current tax bracket and has to be factored into the cost benefit analysis.

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For example, a rollover from a regular IRA to a Roth IRA of $40,000, done between January 1, 1998 and December 31, 1998 would incur an extra $10,000 of declared income for the owner of the IRA for four years. Assuming a 28% tax bracket, the taxpayer would cough up an extra $2800 per year for four years for the privilege of creating a tax-free account.

Cost/benefit analysis. Assuming a 20-year time horizon, a 12% investment return, and the same tax rate (28%) on either end of the investing period yields the following results:

1. No roll: After-tax portfolio total from regular IRA: $278,000
2. Roll: After-tax portfolio total from a Roth: $386,000

Of course, the investor has paid $11,200 in extra taxes in years 1-4. If that money were invested, also at 12% (8.64% after taxes), the investor would have an additional $64,000 to add to the regular IRA. Of course, we all know that most people would not invest the extra money, but even this conservative assumption yields a Roth conversion worth an extra $44,000 in after-tax money.

There are several qualifiers and details for both establishing a Roth and converting an existing qualified plan to a Roth. These are all subject to change and interpretation in 1998:

  • Roth contributions are not tax deductible, as are some regular IRA contributions, but the proceeds are tax-free, unlike the regular IRA
  • Your Adjusted Gross Income (AGI) must be below $95,000 (or $150,000 jointly) in order to fully contribute to a Roth (up to $110,000/$160,000 for a partial contribution)
  • Your AGI must be less than $100,000 (both single and joint filers), not including the rollover amount, for the tax year in which you roll an existing qualified plan into a Roth (if above $100,000 you would pay an additional 10% penalty). The ability to shift income out of the roll year may allow you to qualify
  • Regardless of age, Roth distributions cannot occur without penalty before the Roth is five years old
  • After five years, Roth investors can take penalty-free distributions if age 59.5, for a first home, for higher education expenses, for medical expenses, and for death and disability
  • In addition, since you have already paid taxes on all Roth contributions, after five years the original contributions can be withdrawn penalty and tax free, even before reaching age 59.5. However, any new rollovers or contributions start the five year clock ticking again (i.e. any commingling invalidates the five year rule)
  • Investors can continue to contribute to a Roth past age 70.5 and don't ever have to take a distribution, providing a powerful estate planning strategy for passing money on to beneficiaries
  • There is a 10% penalty from using the IRA proceeds themselves to pay the taxes due on a rollover to a Roth IRA
  • Remember that funds cannot be rolled from one qualified plan to another more than one time within a 12-month period.

"There is a provision in the Roth that allows the proceeds from an existing regular IRA to be rolled to the Roth IRA. This is a great opportunity!"

Starting a Roth is a no-brainer, but determining if a rollover makes sense for you is a complicated matter. Your age, life expectancy, expected investment return, expected AGI for the rollover year, ability to pay the extra taxes, and assumption of future tax bracket all play an important part in the cost/benefit analysis. As 1998 unfolds, more clarity on the rollover rules will appear allowing investors to determine whether a rollover makes sense in their particular case.
The following Roth conversion example provides the opportunity for you to fill in the blanks and obtain a rough idea if a Roth rollover is right for you. Please call me at 503-520-5000 if you want help putting your situation through this analysis.

Roth Cost/Benefit Analysis Example

Ed is 35 years old, has 25 years until he can receive retirement benefits from his retirement plans, and will have a life expectancy of 18 years once he reaches age 60. He currently has $100,000 in a self-directed IRA. Since Ed has 70% of his IRA in Sharp Investments Aggressive Value stocks (45-year rate of return of 21.5%) and 30% in Low Risk Value stocks (45-year return of 16%), his expected rate of return is 20%. His expected federal tax bracket is 28% and Oregon state tax bracket is 9%. Although tax rates have generally increased over time, we are going to make a conservative assumption that his tax bracket will remain the same as today when he is eligible to start taking distributions. Last, Ed has no problem qualifying to start and roll funds to a Roth ($150,000/$100,000 AGI limits).

Federal Tax Tables*
SINGLE brackets Tax
Not over $24,650 15% of taxable income
$24,651 - $59,749 $3697.50 + 28% over $24.650
$59,750 - $124,649 $13,525.50 + 31% over $59,750
$124,650 - $271,049 $33,644.50 + 36% over $124,650
Over $271,050 $86,348.50+39.6% over $271,050
Married filing jointly Tax
Not over $41,200 15% of taxable income
$41,201 - $99,599 $6180+28% over $41,200
$99,600 - $151,749 $22,532 + 31% over $99,599
$151,750 - $271,049 $38,968.50 + 36% over $151,750
Over $271,050 $81,646.50+39.6% over $271,050
*courtesy of RoxAnn Snyder Strong, CPA, Napier & Co.


Taxable income _____________ (70,000)

Age______________ (35)

Life expectancy at age 60 (18 for males, 21 for females)_______________(18)

Current tax bracket ______________(28/9%)

Retirement tax bracket___________(28/9%)

Expected investment return__________(20%)

Rollover amount _______________($100,000)


Spreading the rollover tax across four years implies extra ordinary income annually of $25,000 ($100,000/4) ____________ which means an extra federal and state tax bill of $9250 ($25,000 x .37)_____________ for each of the next four years.

Ed's taxable income of $70,000_________ is less than the $100,000 AGI limit for a rollover, and his total 1998 income of $95,000 ($70,000 + $25,000)__________ does not put him in a higher tax bracket per the Federal Tax Tables.

Without a rollover, assuming a 20% return for 25 years, the IRA should be worth $9,540,000 (1.2025 x $100,000) ______________. However, this represents an after-tax amount of $6 million ($9,540,000 x [1-.37])_______________

Assuming Ed had invested the four years of Roth tax money ($9250) for the same 25 years, he would have a non-IRA portfolio of about $600,000 (the math gets a little complicated for this calculation so factor accordingly). _______________. This gives him a total after-tax portfolio of $6.6 Million____________

Now, with a Roth rollover, Ed's after-tax amount is the original $9,540,000 calculated above ______________.

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So, at the start of retirement, even assuming he invests the tax liability, Ed is 2.9 million dollars ahead with the Roth ($9.5M - $6.6M), and he still have another 18 years to live. Assuming he converts to more conservative investments at retirement, with either type of IRA, (100% LRV stocks yield 16%) shows further differences. With a regular IRA Ed must start taking large distributions at age 70.5 based on his remaining life expectancy. With a Roth, he am under no obligation to do so. This has big implications for estate planning and the ability to pass on wealth to his beneficiaries. With a regular IRA, his beneficiaries have to pay ordinary income tax and estate taxes, effectively wiping out most of the IRA. A Roth is only subject to estate taxes with no mandatory withdrawals required.

With the Roth IRA, Ed could live on an income stream of $1.52 million per year ($9,500,000 x .16) for the remainder of his life expectancy and still have almost $10 million to pass on to heirs. With a regular IRA and the invested tax money, the income stream would be $1.06 million ($6.6M x .16). Additionally, there are mandatory distribution requirements starting at age 70.5 for a regular IRA that quickly reduce the tax sheltered amount. The Roth provides 50% more income and a much larger estate to leave to heirs when compared to the regular IRA.

The bottom line: Investing four years of taxes (present value of $33,500) in converting Ed's IRA to a Roth IRA yields $2.9 million extra dollars in 25 years, a compounded after-tax rate of return of 19.5% and allows him to leave more money to heirs. If he saved and invested the $33,500 earmarked for taxes, he would have to earn a 31% rate of return to beat the Roth.

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13160 SW Butner Road
Beaverton, OR 97005

The clock starts ticking on the one-year window for spreading Roth conversion tax payments across four years Jan 1, 1998. Don't wait until the last minute to determine if this is for you, it may be the most important decision you ever make with regards to your retirement income.

A Roth conversion can be an extremely powerful wealth-building tool for those willing to pay the taxes today in order to live tax-free tomorrow. It can also be a great estate- planning tool for older investors that are looking to pass the proceeds of their IRA to beneficiaries with a minimum of taxation. For more information on Roth IRA's and other provisions of the 1997 Tax Relief Act, visit the websites: or

If you expect to make significant investment gains in 1998, as do clients of Sharp Investments, converting to a Roth early in the year can minimize the tax bite. On the other hand, waiting until late in 1998 allows for better interpretation of Roth laws, and gives you a better idea of your taxable income, which can be a critical issue for the self-employed. In any event, the decision to roll, how much, and when, is very specific to the individual situation and should be examined by a competent CPA. I am not a tax expert, I am an investment expert, and both sides need to be examined thoroughly before making such a big decision.

If the fit is right, conversion to a Roth IRA can provide a tax-free income for you and your heirs.
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