The Value of an Investment
Sometimes I buy shares in a company, or I buy an ETF, and the price of the shares goes down. The novice investor would say I “lost money.” That is similar to thinking that buying a house for $500,000 during a great real estate market, only to see the value of the property decline to $400,000 and immediately declare a loss of $100,000. There is no loss or gain until an asset is sold. The real estate market and the stock market are voting machines. These votes can be short-term opinions. They usually are not weighing machines that tell you the real long-term value.
Voting and Weighing is Not Original With Me
The phrase, “In the short-run, the market Is a voting machine, but in the long-run, the market Is a weighing machine” is widely attributed to Warren Buffett. The idea for this statement probably originated with a work called “Security Analysis” by Benjamin Graham and David Dodd.
There is another nuance investors miss. The price of an investment goes down when a dividend is paid. For example, if a stock is trading for $10 per share on Monday, and they have a dividend of $0.50 per share, then the shares will drop in value to $9.50 on Tuesday, if Tuesday is the ex-dividend date. You don’t lose money when this happens. This is normal and sensible. Rather, you gain spendable cash. In fact, you gain cash that cannot disappear in the same way that the stock market voting machine might reduce your shares to $9 per share.
When you own shares of a company that does not pay a dividend, the current market price is the price of the business in the eyes of the investor community. It won’t drop simply because a dividend is paid, because there is no dividend. But you also don’t have anything to use for purchases until you sell the investment.
The Payback on Your Investment
Friday, I converted 400 shares of ARCC (Ares Capital) from my traditional IRA to my ROTH IRA. This is a taxable event. It is similar to withdrawing cash from the IRA. Because ARCC closed Friday at $18.20, I will owe federal and state income taxes on $7,280. However, any income from the sale of these shares in the future, and all future dividends, will be income without a tax obligation.
Based on the current annual payout of $1.92 per share, $768 will come into my ROTH IRA from this investment in the next twelve months. In ten years, it is probable that I will see $7,680 in dividends from these 400 shares, assuming the dividend remains constant. I, however, expect a growing dividend with very little change in the price per share.
There is another reason that I completed the conversion now. My IRA is set up to sell or move shares using the LIFO method. That means the last shares into the account are the first ones out. 100 of the 400 shares had a cost basis of $18.55 per share, and the next 300 had a cost basis of $19.21 per share. Therefore, I am paying taxes on the $18.20 value of the shares, not the higher cost basis of the purchase price of the shares. Think like an owner. It is best to buy back your shares at a lower price, and that is, in essence, what I am doing.
The Weight of ARCC
I believe the stock market is voting incorrectly on the value of ARCC as an investment. There are risks with every investment, but I view this investment as a good long-term investment that has the potential to beef up our income without an additional tax burden. I like the potential weight.
Furthermore, this also reduces my potential RMD for 2024. The Required Minimum Distribution is based on the total value of the traditional IRA on December 31 of each year. The 400 shares of ARCC will no longer be a factor in the 2024 RMD, or the RMD for future years as well.
Recommendation
If you have a traditional IRA, and you expect to have a similar or a higher income tax in retirement, then you should understand the RMD you will be required to take in the year you turn 73. Beginning in 2033, the SECURE 2.0 Act increases the RMD age to 75. There are two reasons for this exercise.
The first is that you should plan to have your IRA generating sufficient income from dividends that your RMD is covered by the dividends. That way you don’t have to sell any of your investments in a down market. The RMD amount is an age-based calculation. For example, at age 73 I am required to take a minimum of a specific amount from my traditional IRA. The “Distribution Period in Years” for age 73 is 26.5. Therefore, if I have $265,000 in my traditional IRA on December 31 of 2023, I must withdraw $10,000 from my IRA and pay income taxes on that amount in 2024.
Be careful. Each year it is very likely your retirement account balance can grow. Each year the percentage you must take for the RMD also increases. Therefore, if in year two my account grows to $280,000 even after my $10,000 withdrawal, I have to divide the $280,000 by the age 74 “Distribution Period” value of 25.5. This means my RMD for 2025 would be $10,980.
For many retirees this does not present a problem. However, if you were a prudent saver and investor, the RMD on $1,000,000 might surprise you. Remember, you have to add your RMD to your Social Security and other sources of income to calculate your potential income taxes. Of course, there are also standard deductions or itemized deductions like charitable giving that can help ease the pain. Furthermore, every dollar converted from my IRA to my ROTH no longer enters the equation.
Full Disclosure
Cindie and I own a combined total of 5,400 shares of ARCC in our IRA and ROTH accounts. I still have 1,700 shares in my traditional IRA, but I now hold 2,100 shares in my ROTH. If ARCC drops in value during the year, I may move more shares to the ROTH.
Know Your Flocks & Herds 