What I’m Watching This Week – 6 October 2014

The Markets

For the second straight week, a Friday rally after encouraging employment numbers couldn’t outweigh equities’ losses earlier in the week. However, it did manage to rescue the Russell 2000 from a brief dip into correction territory (a correction is generally considered to be 10% down from the most recent high). Once again, the Dow industrials and the S&P 500 outpaced the small caps, while equities’ recent slump translated into gains for the price of the benchmark 20-year Treasury.

Market/Index 2013 Close Prior Week As of 10/3 Weekly Change YTD Change
DJIA 16576.66 17113.15 17009.69 -.60% 2.61%
Nasdaq 4176.59 4512.19 4475.62 -.81% 7.16%
S&P 500 1848.36 1982.85 1967.90 -.75% 6.47%
Russell 2000 1163.64 1119.33 1104.74 -1.30% -5.06%
Global Dow 2484.10 2551.32 2493.99 -2.25% .40%
Fed. Funds .25% .25% .25% 0% 0%
10-year Treasuries 3.04% 2.54% 2.45% -9 bps -59 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Last Week’s Headlines

  • The 248,000 new jobs created in September helped cut the U.S. unemployment rate from 6.1% to 5.9%; it’s the first time since July 2008 that joblessness has been below 6%. Also, the Bureau of Labor Statistics said hiring during the prior two months was stronger than previously thought. However, at least some of the decline in the unemployment rate resulted from 97,000 people dropping out of the labor force (for example, retiring baby boomers). That brought the percentage of people in the workforce to 62.7%–the lowest participation rate since 1978.
  • Though home prices measured by the S&P/Case-Shiller 20-City Composite Index continued to rise in July, the pace slowed significantly. Year-over-year gains were down in 19 of the 20 cities, and monthly increases were smaller in 17 cities. Nevertheless, the index was 6.7% ahead of a year earlier, and prices rose 0.6% during the month.
  • The European Central Bank declined to make any further cuts to interest rates until it sees the impact of bond purchases scheduled to begin this month, including sovereign bonds from Greece and Cyprus. However, President Mario Draghi reiterated that the ECB stands ready to adopt further stimulus measures if necessary.
  • Both personal income and consumption were up in August, according to the Bureau of Economic Analysis. The increase in private wages and salaries was almost double that of July, pushing personal income up 0.3%. Personal consumption–one of the Fed’s favorite measures of inflationary pressure–rose 0.5%. That increased consumption helped cut the savings rate from 5.6% to 5.4%.
  • The failure of China’s manufacturing sector to rebound in September from the previous month’s low level fanned concerns about global growth. HSBC Corp.’s Purchasing Managers’ Index remained at 50.2–barely above the level that would represent contraction.
  • The U.S. services sector continued to grow in September, but at a slightly slower pace. The Institute for Supply Management’s non-manufacturing purchasing managers’ index nudged downward one point from August’s record level to 58.6.

Eye on the Week Ahead

The Q3 earnings season will have its unofficial kickoff when Alcoa reports its results after Wednesday’s market close. Discussions of what should happen after the anticipated end of quantitative easing will be scrutinized when minutes of the most recent Federal Open Market Committee meeting are released on Wednesday.

Data sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Department of Commerce (GDP, corporate profits, retail sales, housing); S&P/Case-Shiller 20-City Composite Index (home prices); Institute for Supply Management (manufacturing/services). Performance: Based on data reported in WSJ Market Data Center (indexes); U.S. Treasury (Treasury yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.

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Rollover of After-Tax Dollars from 401(k) Plans

Background

Here’s the dilemma. You have a traditional 401(k) that contains both after-tax and pre-tax dollars. You’d like to receive a distribution from the plan, convert only the after-tax dollars to a Roth IRA, and roll the pre-tax dollars into a traditional IRA. (By rolling over/converting only the after-tax dollars to a Roth IRA, you avoid paying any income tax on the conversion.)

For example, let’s say your 401(k) plan account balance is $10,000, consisting of $8,000 of pre-tax dollars and $2,000 of after-tax dollars. Can you simply request a total distribution of $10,000, instructing the trustee to directly roll the $8,000 of pre-tax dollars to a traditional IRA and the remaining $2,000 of after-tax dollars to a Roth IRA?

In the past, many trustees allowed you to do just that. But in recent years the IRS had suggested that this result could be achieved only with indirect (60-day) rollovers, not direct rollovers. The legal basis for this IRS position was, however, not entirely clear. (The problem with indirect rollovers is that they are subject to 20% mandatory withholding and, if not executed correctly, could be fully taxable–and distributions prior to age 59½ might also be subject to a 10% federal income tax penalty.)

IRS Notice 2014-54

On September 18, in Notice 2014-54 (and related proposed regulations), the IRS backed away from its prior position. Based on the Notice, it is finally clear that employer-plan distributions can be split into more than one retirement vehicle with, for example, pre-tax money transferred directly to a traditional IRA (with no current tax liability) and after-tax money moved directly to a Roth IRA (with no conversion tax). Even though the new rules aren’t scheduled to go into effect until January 1, 2015, taxpayers can apply this guidance to distributions made on or after September 18, 2014. (The guidance also applies to 403(b) and 457(b) plans.)

The Notice provides the following technical rules:

•When calculating the taxable portion of a distribution from a 401(k) plan, all distributions you receive at the same time are treated as a single distribution, even if the proceeds are going to multiple destinations. This is important for allocating pre-tax and after-tax contributions to a distribution. For example, assume your 401(k) account is $100,000, consisting of $60,000 (6/10s) of pre-tax dollars and $40,000 (4/10s) of after-tax dollars. You request that $20,000 be rolled directly over to an IRA and $20,000 paid to you. This is treated as a single $40,000 distribution from the 401(k) plan. Of this $40,000, $24,000 (6/10s) is pre-tax dollars, and $16,000 (4/10s) is after-tax dollars.
•If you receive a distribution (as defined above), and roll all or part of the distribution over to one or more eligible retirement plans, your pre-tax dollars will be deemed allocated first to any direct rollovers you make, and then to any 60-day (indirect) rollovers you make. After all your pre-tax dollars have been so allocated, any remaining amounts rolled over will consist of after-tax dollars.
•If you are making direct rollovers to more than one eligible retirement plan (or indirect rollovers to more than one plan), you can direct the trustee how to allocate the pre-tax dollars among those retirement plans prior to the time the direct rollovers are made.

Examples

The Notice includes the following examples:

Julie participates in a 401(k) plan. Her $250,000 account balance consists of $200,000 of pre-tax dollars and $50,000 of after-tax dollars. Julie leaves her job, and requests a distribution of $100,000. The $100,000 distribution is deemed to include $80,000 of pre-tax dollars ($100,000 x $200,000/$250,000), and $20,000 of after-tax dollars ($100,000 x $50,000/$250,000). Julie requests that $70,000 be directly rolled over to the 401(k) plan maintained by her new employer and that $30,000 be paid to her in cash. Because the pre-tax amount of the distribution ($80,000) exceeds the amount directly rolled over ($70,000), the amount directly rolled over to the new plan consists entirely of pre-tax dollars. The remaining amount paid to Julie (prior to any withholding tax) consists of $10,000 in pre-tax dollars and $20,000 in after-tax dollars. Prior to the 60th day after the distribution, Julie chooses to roll over $12,000 to an IRA. Because the amount rolled over in the 60-day rollover ($12,000) exceeds the remaining pre-tax dollars ($10,000), the amount rolled over to the IRA consists of $10,000 of pre-tax dollars and $2,000 of after-tax dollars.

The facts are the same as in Example 1, except that Julie chooses to make $82,000 of direct rollovers — $50,000 to the new 401(k) plan and $32,000 to an IRA. The remaining $18,000 is paid to Julie. Because the amount rolled over ($82,000) exceeds the pre-tax amount of the distribution ($80,000), the direct rollovers consist of $80,000 in pretax amounts and $2,000 in after-tax amounts. Julie is allowed to allocate the pre-tax dollars between the new 401(k) plan and the IRA prior to the time the direct rollovers are made.

The facts are the same as in Example 1, except that Julie chooses to make a direct rollover of $80,000 to a traditional IRA and $20,000 to a Roth IRA. Julie is permitted to allocate the $80,000 that consists entirely of pre-tax dollars to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after-tax dollars.

Conclusion

Prior to Notice 2014-54, it was possible to achieve a tax-free Roth conversion of after-tax dollars in an employer plan, but it was a fairly complicated procedure using 60 day (indirect) rollovers, not direct rollovers, which involved several steps and required taxpayers to have sufficient funds outside the plan to make up the 20% mandatory withholding that applied to the taxable portion of the distribution. The ability to accomplish the same result in a more efficient manner using direct rollovers is welcome relief.

IRS Notice 2014-54 is titled Guidance on Allocation of After-Tax Amounts to Rollovers, and can be found at www.irs.gov/pub/irs-drop/n-14-54.pdf.

Designing a Benefit Package for Your Small Business

If you’re a small business owner, you face many challenges in growing your company. One of them is recruiting and retaining the best talent for your needs. When your primary goals are managing costs and increasing revenue, how do you sufficiently entice new recruits and reward current staff members for continually putting their best efforts forward? One way is ensuring that you provide a competitive, cost-effective benefit package comprised of both traditional and not-so-traditional benefits.

Traditional benefits

In order to remain competitive, nearly all employers should offer some form of health insurance and retirement savings plan. Yet according to the U.S. Department of Labor, only 57% of small employers (those with fewer than 100 employees) offer health coverage and just 49% offer a retirement plan. (Source: National Compensation Survey, March 2013)

Health insurance

Small businesses can typically choose among traditional plans or managed care/health maintenance organizations (HMOs). Traditional plans are typically more expensive but tend to provide more access to providers. HMOs generally carry lower costs but have fewer options for care providers. Some small employers opt for a high-deductible health plan (HDHP) along with a health savings account (HSA). In an HDHP, employees carry a higher burden for up-front costs, but the HSA allows them to set aside money on a tax-advantaged basis to help defray these costs.

Note that a provision in 2010’s Affordable Care Act requires employers with 50 or more full-time employees (as defined by the Act) to offer adequate health insurance that’s affordable or face a possible penalty. “Adequate” means that the company’s share of total plan costs must equal at least 60%. Coverage is “affordable” if an employee’s share of the premium is less than 9.5% of his/her household income. Originally, the provision was to take effect in 2014, but the Department of Health and Human Services recently delayed implementation until 2015. In addition, employers with fewer than 25 full-time employees will be eligible for a credit to help them pay for health insurance.

Retirement plans

In today’s economic and political environment, most adults view retirement planning as a high financial priority. That’s why it’s important to include a retirement savings option in your benefit package. There are several options available to small employers, including traditional 401(k) plans, SIMPLE savings plans, and SEP-IRAs. A financial professional can help you choose the plan that’s right for your company’s needs.

Other options

Other traditional benefits include the following group insurance policies:
• Life insurance: These policies generally provide employees’ survivors a death benefit in a set amount or an amount based on salary (e.g., two times salary).
• Disability insurance: These plans provide employees with an income stream should they become disabled. Benefit amounts are typically a percentage of salary.
• Vision and dental coverage: These plans tend to be highly valued by employees, as the costs associated with dental and vision treatments, which are generally not covered by health insurance, can be quite high.

Not-so-traditional perks

In addition to traditional benefits, there are several not-so-traditional perks you can offer to help set your organization apart in the competition for talent.

Wellness programs

Some employers offer workplace-based wellness programs. According to a 2013 RAND Health study sponsored by the U.S. Departments of Labor and Health and Human Services, about half of U.S. employers offer wellness promotion initiatives. The study found that such programs can help reduce risk factors such as smoking and increase healthy behaviors like exercise. In particular, incentive-based wellness programs help improve overall employee engagement and encourage individuals to take responsibility for their own well-being. Although the study did not reveal a significant reduction in health-care costs for the period analyzed, authors did note trends that might lead to lower costs over the longer term. (Source: Workplace Wellness Programs Study, RAND Corporation, 2013)

Flexible work arrangements

In today’s hectic world, time is nearly as valuable as money. A company that values the work-life balance of its employees is nearly as highly valued as one that offers the best insurance or retirement plan. For this reason, one of the most popular and appreciated employee benefits available today is a flexible work environment. Once the hallmark of only small and “hip” technology companies, flexible work arrangements are growing in popularity. In fact, flexible scheduling is now offered by many larger, more established organizations as well.

Some examples of flexible work programs include:
Flex schedules: work hours that are outside the norm, such as 7:00 a.m. to 4:00 p.m. instead of 8:00 a.m. to 5:00 p.m.
Condensed work weeks: for example, working four 10-hour days instead of five 8-hour days
Telecommuting: working from home or another remote location
Job-sharing: allowing two or more employees to “share” the same job, essentially doing the work of one full-time employee (e.g., Jan works Monday through Wednesday noon, while Sam works Wednesday afternoon through Friday)
Part-time or a combination: allowing employees to cut back to part-time during certain life stages, or use a combination of strategies to meet their needs

Allowing your employees to tailor their work schedules based on their individual needs demonstrates a great deal of respect and can generate an enormous amount of loyalty in return. Even if your business requires employees to be on-site during standard operating hours (such as a retail establishment), having a process in place that supports occasional paid time off to attend to outside obligations can have tremendously positive effects. These obligations might include doctors’ appointments, family commitments, and even unexpected emergencies, such as a sick relative. In some cases, these benefits have no costs associated with them, while in others, the costs may be minimal (e.g., the price of a smartphone or laptop to help employees remain productive while on the go).

Social activities

Sponsoring periodic activities can help workers relax and get to know one another. Such events don’t need to take much time out of the day, but can do wonders for building morale. Bring in lunch or schedule an office team trivia competition or group outing. If you work in a particular industry in which colleagues share a common passion, consider organizing events around that interest. For example, a sporting goods retailer could close up early on a slow-business afternoon and go for a hike or bike ride.

Concierge services, discounts

You may also be able to negotiate with other local companies for employee discounts and services. Laundry service, dry cleaning pickup/drop-off, and meal providers that can deliver hot, family-sized take-home dinners may help employees save both time and worry–and stay focused on the job.

Financial planning/education

For many people, money worries can be distracting and time consuming. Consider inviting a local financial professional into your office to provide counseling sessions for your employees. While you don’t necessarily have to pay for any services provided, simply offering the opportunity to get such help during work hours will be appreciated by your workforce.

Involve your employees

The best benefits are those that meet the needs of your employees. Before making any assumptions, solicit ideas from your employees and then conduct a survey to see what benefits they value the most. Consider putting together teams of associates to help with the idea generation and execution. By involving your employees in the decisions that matter most to them, you demonstrate that you value their time, efforts, opinions, and hard work.

QUARTERLY MARKET REVIEW: JULY-SEPTEMBER 2014

The Markets

Volatility returned to equities markets in Q3. A strong August was followed by losses in September, when any rallies began to focus around selected winners rather than benefitting stocks across the board. Investors exhibited a decided preference for large caps; the S&P 500 closed above 2,000 for the first time ever and the Dow industrials also set new all-time highs. The Nasdaq returned to a level it hadn’t seen since March 2000 and regained the lead for 2014. However, the Russell 2000, which has struggled for most of the year, fell deeper into negative territory year-to-date, while the Global Dow suffered from political conflicts abroad and concerns about global growth.

Bond investors continued to demonstrate surprising resilience. In early September, the yield on the benchmark 10-year Treasury fell to 2.35%–a level it hadn’t seen in more than a year–as prices rose. However, as the Federal Reserve continued to taper its economic support and ramped up discussion of how and when to increase rates, demand began to taper off (though geopolitical anxieties and a strengthening dollar kept the decline in check). Gold, which started the quarter at roughly $1,320, ended below $1,220. It was hurt in part by a stronger U.S. dollar, which by the end of the quarter had hit its highest level against the euro in almost two years. Dollar strength coupled with weaker global demand also meant lower oil prices; a barrel fell from $107 a barrel to roughly $93 during the quarter, a level it hasn’t seen since January.

Market/Index 2013 Close As of 9/30 Month Change Quarter Change YTD Change
DJIA 16576.66 17042.90 -.32% 1.29% 2.81%
NASDAQ 4176.59 4493.39 -1.90% 1.93% 7.59%
S&P 500 1848.36 1972.29 -1.55% .62% 6.70%
Russell 2000 1163.64 1101.68 -6.19% -7.65% -5.32%
Global Dow 2484.10 2534.47 -3.22% -2.73% 2.03%
Fed. Funds .25% .25% .25% 0 bps 0 bps
10-year Treasuries 3.04% 2.52% 17 bps -1 bps -52 bps

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.

Quarterly Economic Perspective

  • After contracting 2.1% in Q1, the U.S. economy grew at an annual rate of 4.6% during the second quarter. The Bureau of Economic Analysis said increases in consumer expenditures, exports, business spending on equipment, and spending by both state and local governments were major contributors to the growth. Meanwhile, after-tax corporate profits also rebounded from their Q1 slump, rising 8.6%.
  • The Federal Reserve’s monetary policy committee continued to unwind its economic support. Its September bond purchases were only $15 billion, and they are scheduled to end in October. The committee also reaffirmed that the key Fed funds interest rate won’t increase for a “considerable time” after that. However, a survey of members showed that most now expect steeper increases than previously estimated, with rates hitting 1.4% by the end of 2015 and 2.9% by December 2016.
  • Despite a slight improvement in August’s unemployment rate (6.1%), the number of new jobs added in August was a disappointing 142,000, according to the Bureau of Labor Statistics. The continued slack in the labor market is one reason cited by the Federal Reserve for its caution about raising interest rates.
  • The housing recovery showed signs of tapering off. New home sales fell in both July and August, and the National Association of Realtors® said a shortage of the cash buyers who had helped boost existing home resales in July cut resales the following month. Housing starts and building permits also slowed in August after a strong July, according to the Commerce Department, while the rate of home price increases in the S&P/Case-Shiller 20-City Composite Index began to taper off.
  • After a strong July, manufacturing gains began to taper off. The Commerce Department said durable goods orders rose and fell based on orders for commercial aircraft, which hit a record high in July and plummeted a month later; aside from transportation, durable goods orders rose 0.7% in August. Auto production also saw a strong July and weaker August, and after six straight months of gains, the Fed’s gauge of industrial production edged downward in August.
  • By quarter’s end, the Bureau of Labor Statistics said falling energy costs had helped cut consumer inflation by 0.2%. That left the annual inflation rate for the previous 12 months at 1.7%, down from Q1’s 2.1%. The 1.8% annual inflation rate for final-state wholesale prices also was lower than Q1’s 2%. The Bureau of Economic Analysis said both personal income and consumer spending saw gains throughout the quarter.
  • Conflicts over Ukraine continued to raise concerns about how Russian retaliation for Western sanctions might affect the fragile European economy. A eurozone GDP that essentially flatlined in Q2 and weakness in both Germany and Italy led the European Central Bank to promise more aggressive stimulus measures.
  • The Chinese economy continued to show signs of slowing in some key areas. By August, growth in industrial production was almost 7% instead of the previous month’s 9%, housing sales were down nearly 11% from the beginning of 2014, and HSBC Corp.’s Purchasing Managers’ Index remained at 50.2–barely above the level that would represent contraction.

Eye on the Month Ahead

With October’s Fed bond purchases expected to be the last, next month’s monetary policy committee announcement will be watched to see if a rate hike is still a “considerable time” away. Global investors will assess whether additional expected support from the European Central Bank is likely to help jumpstart the economy there.

Data sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Department of Commerce (GDP, corporate profits, retail sales, housing); S&P/Case-Shiller 20-City Composite Index (home prices); Institute for Supply Management (manufacturing/services). Performance: Based on data reported in WSJ Market Data Center (indexes); U.S. Treasury (Treasury yields); U.S. Energy Information Administration/Bloomberg.com Market Data (oil spot price, WTI Cushing, OK); http://www.goldprice.org (spot gold/silver); Oanda/FX Street (currency exchange rates). All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.

The Dow Jones Industrial Average (DJIA) is a price-weighted index composed of 30 widely traded blue-chip U.S. common stocks. The S&P 500 is a market-cap weighted index composed of the common stocks of 500 leading companies in leading industries of the U.S. economy. The NASDAQ Composite Index is a market-value weighted index of all common stocks listed on the NASDAQ stock exchange. The Russell 2000 is a market-cap weighted index composed of 2,000 U.S. small-cap common stocks. The Global Dow is an equally weighted index of 150 widely traded blue-chip common stocks worldwide. Market indices listed are unmanaged and are not available for direct investment.