Investing Insights: IRA Conversions, Cisco, and a Muni Pick

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Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Finding a good international stock fund is easier said than done. Ideally, you want a fund that provides exposure to foreign large-caps with both growth and value characteristics and some smaller companies and emerging-markets stocks thrown in for good measure. However, many of the best funds that do all of those things--including Oakmark International, Artisan International Value, and Dodge & Cox International Stock--are closed to new investors. Yet there are other funds that can fit the bill. Here are some of Morningstar's favorite funds in the foreign large-blend category that are accepting money from new investors.

Gregg Wolper: American Funds International Growth and Income is an unusual fund in the American Funds family for two reasons. One is its size. At $14 billion it's actually a pretty big fund. But in the American Funds context, that's much smaller than most siblings. It also has an income focus which is unusual not only in American Funds but in foreign funds in general. That income focus helps make it less volatile than most funds. On the foreign side, you don't get an income focus very much. That restricts their stock-picking to less volatile stocks, makes the fund easier to own over the long term. Like most American Funds, it also has a multi-manager structure. The departure of any one manager is not as critical as it would be at a sole manager fund. Finally, it has very low fees. Of course, that helps year-after-year. All in all, it's a very appealing package.

Dan Sotiroff: One of our favorite foreign stock funds is Vanguard Total International Stock Fund. This fund provides comprehensive access to the entire investment opportunity set overseas including both developed and emerging markets. It also provides investors with access to small-cap stocks listed overseas. Small-cap stocks have a unique characteristic in that their revenues and operations tend to be more closely tied to the local markets. They can offer a big diversification benefit that large-cap funds do not have. Another major attractive feature of this fund is its low expense ratio. Vanguard charges only 11 basis points for VTIAX, and it's one of the big reasons we have this fund rated Gold.

Alec Lucas: FMI International is a compelling option to add to a portfolio for exposure to international stocks. It's run by Fiduciary Management Incorporated of Milwaukee, a firm with a good track record of investing in undervalued stocks and doing so in a pretty concentrated way. What's unique about this fund is that it hedges its exposure to non-U.S. currency. It gives the portfolio a bit of a boost when the U.S. dollar surges relative to non-U.S. currencies as it has in 2018 and it can be a headwind when the U.S. dollar retreats as it was in 2017. Over a full market cycle, this is a very attractive option to add to a portfolio.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Can you be too old to convert a traditional IRA to a Roth? Joining me to discuss that topic is Ed Slott. He is an IRA expert, and he is also author of the newly revised Retirement Decisions Guide. Ed, thank you so much for being here. Ed Slott: Great to be back here at Morningstar, live in Chicago. Benz: Exactly. Thank you so much, Ed. I sometimes get the comment from investors, am I too old to convert this traditional IRA to Roth IRA? I want to tackle that question. But before we get into that, let's talk about why one would even consider such a conversion. What are the benefits?

Slott: All right. First, the idea of a Roth conversion is, you are moving money from a taxable IRA or even a 401(k) to a tax-free Roth, and there's a cost to that. You pay tax on the taxable amount converted. It adds to your income. But the benefit is, once it's in a Roth IRA, in retirement, once you have five years and 59 1/2 years old, that money grows tax-free forever. It's withdrawn tax-free anytime you want.

The biggest slip or benefit that most people don't even focus on is with Roth IRAs there are no required minimum distributions at 70 1/2 like you have for IRAs. Now, lots of people with IRAs don't like being forced to take distributions at 70 1/2, We talked about this before. They are forced to take money they don't need, add it to their income, raise their tax bill. With Roth, there are no lifetime required minimum distributions. That money can just grow. Remember, tax-free money always grows the fastest because it's not eroded by current or future taxes.When it come out, it's tax-free. In retirement, if you need it in retirement, it won't increase your tax bill.

Benz: There's this bit of received wisdom that people have heard that you can be too old to convert a traditional IRA to Roth. Do you think there's a kernel of truth there? Where is this coming from?

Slott: Well, there is something to that. You have to understand why you are converting. As a straight conversion, if you are, say, 70 1/2 or older--I just use 70 1/2 because that's the date for IRAs--but let's say you are around 70 or older, you are not doing it for yourself, because the cost--remember, there is a tax cost to converting. Given your life expectancy as you get older, say, after 70 1/2, the benefit you'll reap in your life expectancy won't be worth the upfront cost, probably. Unless you really have the other money sitting around and you just want to--I've had people say, look, I just can't stay in these RMDs. I'll pay the piper, pay the money. I'll never have to worry about it again. It's just off the table. Now, my money grows tax-free, and I've got plenty of money.

But the real benefit if you are doing it as an older person is for the next generation, for you children or grandchildren, because the power of the Roth IRA can grow over their life expectancy. Where a 70-year-old might only have a 13-, 14-year life expectancy or even longer maybe, but a grandchild maybe able to go out 60 years and the power of the Roth IRA is in the compounding tax-free. The big benefit is not so much for yourself other than those other issues--you just want to get rid of that IRA and not have any required distributions--but for your children or grandchildren who will also enjoy tax-free withdrawals. Now, with children and grandchildren, there are required minimum distributions when they inherit, but it's still tax-free.

Benz: You say that this is mainly something that one should consider if they are considering the next generation and wanting to pass on some tax-free assets to that generation. But can I infer from that that if I am someone who has looked at my IRA balance, my traditional IRA balance, and I think probably over my lifetime I'm going to consume everything in that IRA and perhaps I'm already retired, probably doesn't make sense for me to consider a conversion?

Slott: Right. Yeah, you hit it right on the head. It's more like an estate planning, legacy vehicle at that age. If you need the money or you'll consume it, chances are that you may even be in a lower tax bracket. Even with the new tax brackets now, you might be in a lower tax bracket, so it might pay to keep it.

Remember, the idea is to always pay taxes at the lowest rates. Maybe it doesn't pay to take a big hit in income if you are going to need that money right away. The benefit of the Roth is to keep it growing, compounding, tax-free over time. If you are going to pay a tax cost upfront just to take the money right out if you need it, that's not worth it.

Benz: I've sometimes heard that the years after one has retired but before those required minimum distributions have started, that that's a really opportune time to look at doing some conversions. Why would that be so?

Slott: I call that the sweet spot in your 60s. Why? Because many people, as I said, don't like the idea of looming required minimum distributions at 70 1/2. Some people in their 60s, maybe they just left the job, maybe they are retired, they are in a lower bracket, they can get that money in a Roth at a lower bracket. Now, everybody has to look at their own situation and see what the projected tax cost of a Roth conversion is. But you can lower the cost by doing a series of maybe smaller annual conversions. Remember, under the new tax law, all conversions now are permanent. You can't undo them.

Benz: The recharacterization is gone.

Slott: Right. That's gone. You could do a series of conversions, say, in your 60s with the ultimate goal of knocking down your IRA to nothing and building up your Roth IRA, so at 70 1/2 you don't have any required minimum distributions. It's all in a tax-free Roth.

Benz: How about after required minimum distributions have started? So, someone has passed age 70 1/2, are the conversions ever advisable at that life stage?

Slott: Well, again, you have to look at your own situation. Maybe you have big deductions or even big medical expenses, something that could really cut the cost. You are still in business, let's say, at 74 years old and you had a big loss, so you have to look at the tax situation. If you ever have a situation where income may be low because of high deductions, that may be the time to strike, to get that money in Roth at a very low tax cost. Or even if the stock market tanks--we've had these days where they go down 1,000 points--that may be the day to pounce when it's at a low value, you can get it into a Roth at a very low value.

While generally in your lifetime being older, say 70 years old, it may not be worth it, if you can reduce, significantly reduce the tax cost through deductions or other factors like I mentioned, it might pay to get that money. What if you are in a real low tax bracket, it really doesn't cost you anything to convert, then you should probably do that.

Benz: Important topic. Lots of considerations. Thank you so much for being here, Ed.

Slott: Great to be here. Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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Beth Foos: MFS Municipal Income Fund is a strong choice for investors looking for tax-free income over the long term.

This fund is managed by a seasoned team that delivers solid returns at a very competitive price. Veteran manager Geoff Schechter has been running this portfolio since 2000. In July 2015, Jason Kosty moved over from the research team to become his comanager here, bringing with him roughly 20 years of industry experience. These two managers work closely with a team of dedicated muni analysts and traders to build this portfolio from the bottom up.

They focus on finding mispriced pockets of the muni market and strong security selection to add value for investors. That can result in the fund holding slightly larger weights in lower quality bonds than their typical rival, however, but they only add to these positions when they think the price is right.

More recently, the team has held notable positions in insured Puerto Rico bonds, which have added yield but can also add volatility. The team sees value in these bonds particularly because of their discounted prices and the security provided by bond insurance. Over time, bets like these have boosted returns and have served investors well.

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Mark Cash: Within the networking technology sector, we believe that narrow-moat Cisco warrants investor attention. This stable moat trend company is attractive because of its shareholder return policy, free cash flow generation, and we expect Cisco to be successful in its transformation into a software- and services-focused firm.

Cisco remains the dominant supplier of switches, routers, and other networking gear for IT professionals. The market trend of networking professionals moving workloads to clouds is a threat to networking hardware providers like Cisco. However, the company is focused on high-growth areas of software-defined networking, analytics, wireless, and security solutions.

We believe a key advantage Cisco has is its ability to sell an entire networking solution, whereas competitors can only fulfill certain pieces of the network. A notable example of recent market success can be seen through Cisco experiencing its most successful switching product launch in history with its Catalyst 9000. The product is only sold as a subscription-based model and contains software-defined networking, analytics, and security features. We are encouraged that Cisco is rolling the recurring revenue sales model to more product lines, and that the majority of customers are signing up for the most expensive subscription tier that includes advanced analytics and security.

Lastly, regarding its capital return policy, Cisco remains committed to returning at least 50% of its free cash flow to shareholders in the form of dividends and share repurchases. Our expectation is that Cisco will return between 120% to 140% of its free cash flow to shareholders through fiscal 2020. The forecast is based upon $25.1 billion worth of shares being repurchased over the next 14 to 18 months, and we are forecasting an annual dividend increase.

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Zachary Patzik: The Morningstar convertible securities category is a small group of funds that focuses on unique and hybrid issues. MainStay MacKay Convertible and Columbia Convertible Securities both earn Morningstar Analyst Ratings of Bronze. Each of these offerings are led by experienced portfolio managers that have large and capable analyst teams at their disposal. However, each of these funds have been successful through different approaches.

The MainStay MacKay Convertible team quantitatively screens the convertible universe to exclude companies with small market capitalizations and those with low issuance, as well as busted securities with bondlike characteristics and deep-in-the-money convertibles, which are equity-sensitive and trade in tandem with company stock. Ultimately the team looks for catalysts, such as share repurchase programs or restructurings that they believe will support stock price appreciation in a six- to 18-month period. The resulting portfolio is generally more concentrated than its peers.

Meanwhile, Columbia Convertible Securities targets a wider array of companies in both market capitalization and credit rating in an effort to construct a portfolio that is representative of the convertible securities market. This also means that the fund incorporates the busted and more equitylike securities that MainStay MacKay Convertible excludes from the get go. Overall, the team prefers to make individual bets on companies over industries, yet modest active positions at the industry level are observed in the portfolio. This contributes to the fund's delta, a measure of equity sensitivity, being near that of its benchmark.

Despite these different investment frameworks, both funds have generated strong returns and rewarded investors over the long term.