A Freshman Lesson on Tax Efficient Compounding

A Freshman Lesson on Tax Efficient Compounding

August 18, 2023

Last week we saw a handful of friends drop off their firstborns just like our respective parents did roughly, ahem, thirty years ago.  Drop-offs, move-ins, and all the other logistics of sending your kids to college for the first time can be an emotional experience. It's a huge milestone that marks a new chapter in their lives and yours. Excitement competes with anxiety as you help them settle into their dorm room, ensuring they have all of the essentials like bedding, towels, toiletries, shower shoes, and…

…a secure retirement? 

Yes!  Recent legislative changes allow distributions from 529 accounts to also provide a retirement boost to the beneficiary (i.e. the student.)  Starting next year, up to $35,000 from a 529 account can be converted to a Roth IRA owned by the 529 beneficiary for at least 15 years, without incurring any taxes or penalties.

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. Earnings and withdrawals are generally exempt from federal income tax. The money saved in a 529 plan can be used towards college tuition, fees, and the like.  But the savvy parent may want to reserve the last $35,000 and convert to a Roth IRA for their child.[i]

What’s that worth? 

A lot.  Albert Einstein once quipped that man’s greatest invention was compound interest.  And five decades between college graduation and retirement is a lot of time for compounding.  If we assume a 5% real (after inflation) rate of return, the $35,000 grows to a little over $400,000 in today’s dollars.  As a reference, the S & P 500 Index of large company US stocks has grown by 7% real (after inflation) since 1926.[ii] 

But the other thing about compound interest is that little differences can lead to very meaningful ending values.  The operative words here are “little” and “value”.  Gene Fama of the University of Chicago won a Nobel Prize for his work on the cross section of stock market returns, where he and coauthor Kenneth French discovered that small company and value stocks provided higher long-term returns.[iii]  They concluded this was the result of increased risk.  Small company stocks are more likely to fail than large companies.  Value stocks, those that have cheaper valuations like Price-to-Earnings, may be more prone to distress. 

How much more return?  Fama and French’s work extended through June 2023 showed small value stocks beat the S & P 500 by 3.9% per annum, over nearly the past 100 years.[iv]  Dimensional Fund Advisors launched a small company value mutual fund in 1993 to capitalize on this discovery.  With thirty years of live data, the DFA Small Company Value Fund beat the SPY by 1.3% per annum after fees.[v]

After taxes, this delta would shrink by about half.  A small company value strategy, even one linked to an index, requires more trading and rebalancing than an S & P 500 Index.  That “maintenance” leads to more capital gains taxes that interrupt compounding. 

But guess what?  The Roth IRA never pays taxes!

Let’s put it together.  If we add a 1.3% per annum small company value premium to our 5% expected return for the S & P 500, what happens to the magic of compounding over fifty years?   Remarkably, we see our balance nearly double to $753,000!  In other words, an initial Roth IRA balance grows to over 21 times its initial value…in today’s dollars.

The information contained above is for illustrative purposes only.  The above targets are estimates based on certain assumptions and analysis made by the advisor. There is no guarantee that the estimates will be achieved.

Of course, this is hypothetical.  Past returns, even those with conservative estimates, won’t necessarily repeat.  Further, it's always best to consult with a tax professional regarding your specific circumstances.  But, it does show the power of compounding.  And we believe it’s a a neat new tool to set up the next generation for a fulfilled life.  And isn’t that what college is all about?    

[i] The “last $35,000” can be applied equally to graduate school.  Regardless, coming up with the extra $35,000 to pay in cash creates lots of opportunities across the family.  Students can seek aid, gain residence (if they are out-of-state), work or seek scholarships.  Or grandparents can pay the last $35,000 in cash, preserving the remainder for the Roth conversion. 

[ii] Source Dimensional Fund Advisors.  Annualized results from 7/1926 to 6/2023.  We’re intentionally being conservative by not using the past as prologue.  Some of the very long-term returns of stocks has been driven by rising valuations that are, for planning purposes, not advisable to project into the future. 

[iii] Eugene F. Fama, Kenneth R. French, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics, Volume 33, Issue 1, 1993, Pages 3-56.  The theoretical big idea, the Efficient Markets Hypothesis, behind the research was the driving force behind the Nobel Prize. 

[iv] Source: Dimensional Fund Advisors.  Annualized results from 7/1926 to 6/2023.  Indexes used are the S & P 500 and the Fama-French US Small Value Research Index. 

[v] Source: YCharts.  Annualized results from 3/31/1993 through 07/31/2023 comparing the DFA Small Cap Value Fund to the SPDR S & P 500 ETF Trust.  Flatrock may or may not maintain a position in these securities.  Flatrock only recommends securities after fully understanding a client household’s complete financial picture and ability to bear risk. 

Disclosures

Investments in small-sized companies may involve greater risks than in those of larger, established companies. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of Flatrock strategies are disclosed in the publicly available Form ADV Part 2A.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‚Äźlooking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.