Tax planning in turbulent times part 1: the tools of the tax-planning trade

Whether you’re saving, investing, spending, bequeathing, or receiving wealth, there’s scarcely a move you can make without considering how taxes might influence the outcome. No wonder people get nervous when there’s lots of talk about higher taxes, but little certainty on what may come of it, and who it might affect.

How do we plan when we cannot know? The particulars may evolve, but it seems there are always an array of tax breaks to encourage us to save toward our major life goals—such as retirement, healthcare, education, emergency spending, charitable giving, and wealth transfer.

However, it remains up to us to make the best use of these “tools of the trade.” Today, let’s take a look at some of most familiar tax breaks available. In our next piece, we’ll cover how we help our clients incorporate them into and across their greater wealth goals.

Saving for retirement

The good and bad news about saving for retirement is how many tax-favored savings accounts exist for this purpose. There are a number of employer-sponsored plans, like the 401(k), 403(b) and SIMPLE IRA. There also are individual IRAs you establish outside of work. For both, there are traditional and Roth structures available.

In any of these types of retirement accounts, your dollars have the opportunity to grow tax-free while they remain in the account. This helps your retirement assets accumulate more quickly than if they were subject to the ongoing taxes that taxable accounts incur annually along the way (such as realized capital gains, dividends, or interest paid).

Tax treatments for different types of retirement accounts can differ dramatically from there. For some, you can make pre-tax contributions, but withdrawals are taxed at ordinary income rates in the year you take them. For others, you contribute after-tax dollars, but withdrawals are tax-free—again, with some caveats. Each account type has varying rules about when, how, and how much money you can contribute and withdraw without incurring burdensome penalties or unexpected taxes owed.

Saving for healthcare Costs (HSAs)

The Healthcare Savings Account (HSA) offers a rare, triple-tax-free treatment to help families save for current or future healthcare costs. You contribute to your HSA with pre-tax dollars; HSA investments then grow tax-free; and you can spend the money tax-free on qualified healthcare costs. That’s a good deal. Plus, you can invest unspent HSA dollars, and still spend them tax-free years later, as long as it’s on qualified healthcare costs. But again, there are some catches. Most notably, HSAs are only available as a complement to a high-deductible healthcare plan, to help cover higher expected out-of-pocket expenses.

Employers also can offer Flexible Spending Accounts (FSAs), into which you and they can add pre-tax dollars to spend on out-of-pocket healthcare costs. However, FSA funds must be spent relatively quickly, so investment and tax-saving opportunities are limited.

Saving for education (529 Plans)

529 plans are among the most familiar tools for catching a tax break on educational costs. You fund your 529 plan(s) with after-tax dollars. Those dollars can then grow tax-free, and the beneficiary (usually, your kids or grandkids) can spend them tax-free on qualified educational expenses.

Saving for giving (DAFs)

The Donor-Advised Fund (DAF) is among the simplest, but still relatively effective tools for pursuing tax breaks for your charitable giving. Instead of giving smaller amounts annually, you can establish a DAF, and fund it with a larger, lump-sum contribution in one year. You then recommend DAF distributions to your charities of choice over future years. Combined with other deductibles, you might be able to take a sizeable tax write-off the year you contribute to your DAF—beyond the currently higher standard deduction. There also are many other resources for higher-end planned giving. For these, you’d typically collaborate with a team of tax, legal, and financial professionals to pursue your tax-efficient philanthropic interests.

Saving for emergencies

There also are a variety of tax-friendly incentives to facilitate general “rainy day fund” saving, and to offset crisis spending, like the kind many of us have been experiencing during the pandemic. These include state, federal, and municipal savings vehicles; along with targeted tax credits and tax deductions.

Saving for heirs

Last but not least, a bounty of trusts, insurance policies, and other estate planning structures help families leverage existing tax breaks to tax-efficiently transfer their wealth to future generations.

With recent negotiations over the tax treatment on inherited assets, families may well need to revisit their estate planning in the years ahead. In fact, whether times are turbulent or tame, there’s always an array of best practices we can aim at reducing your lifetime tax bills by leveraging available tools to maximum effect. We’ll cover those next.

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The certain uncertainty of tax legislation

Tax planning is all about identifying opportunities that arise because of changes to a person’s tax situation from one year to the next. Many people think they do not need to consider tax planning because the information on their tax return does not change much year-to-year. Since the end of 2017, at least six new laws have been enacted with provisions affecting the tax code – meaning, the tax situation for many people has changed, if only due to an act of Congress.

The Tax Cuts and Jobs Act (TCJA), which was signed into law at the end of 2017 brought about sweeping changes for businesses and individuals. Since then, additional bills such as the SECURE Act, Disaster Act, CARES Act, FFCR Act and the American Rescue Plan have further changed the tax rules (and therefore the planning) for businesses and individuals.

Just in case you thought keeping up to date with the actual law on the books was difficult; there are currently several proposed bills that suggest even more, changes may be right around the corner. As recently as May, revenue raisers discussed as part of the American Jobs Plan and American Families Plan, could greatly impact the tax treatment of capital gains, gifts made to individuals and trusts, and various business tax provisions affecting small business owners, among others.

Additionally, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was enacted into law in 2019, maybe the most significant piece of retirement legislation since the Pension Protection Act of 2006. Under the SECURE Act, retirees can now wait until age 72 before they are required to take minimum distributions (RMDs) from their retirement accounts. The new law also changed the distribution options that beneficiaries have when they inherit a retirement account. But the fun doesn’t stop here – there is new legislation before the House of Representatives, dubbed SECURE Act 2.0, that would go even further in changing the rules around retirement accounts.

Staying current on all of these new and complex rules can seem daunting, especially since the changes that are most impactful to someone’s financial plan often do not make headlines. Even when a particular legislative change is well known, it may be unclear how or if it affects you.

An important part of our jobs as advisors is to stay informed on recent and proposed legislation that impacts the advice we give to our clients. We do not know what specific legislative changes we will get in the future – but we will be following the available guidance closely. So if you ever wonder how the “insert latest proposed bill here” affects your situation, all you need to do is ask!

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We all want income – but cash is what we really need?

Some of us still yearn for a simpler time, when we could expect to retire and live comfortably on interest and dividend income from our investments.  Protecting the principal of our nest egg would allow us to live many happy years without fear of running out of money.  Of course we may still want to take some stock market risk, in the hope that rising stock prices would increase our principal value enough to offset the impact of inflation.  Ideally, the growth in principal value would allow our income to grow enough to maintain its purchasing power.

If only it could be that simple.  In the 1950’s dividend yields exceeded 5% and in the 1970’s and 1980’s dividend yields averaged more than 4% on the S&P 500.  By March 2000 dividend yields had dropped below 2%, but the ten-year Treasury was yielding 6.2%, so a diversified portfolio could still generate income.  Times have changed.  Today, the dividend yield on the S&P 500 is 1.4%, and the yield on ten-year Treasury bonds is hovering around 1.5%, while inflation expectations are 2%, and maybe a good bit higher in the short term.  A diversified portfolio will not provide much income, and a bond portfolio will not maintain its purchasing power, even if all the interest is reinvested.

Is Spending Principal Bad?

Not necessarily, but it can be.  Take the example of municipal bonds, which are often issued with large coupons, so today you can purchase a ten-year tax exempt bond with a 4% coupon, or interest payment.  It sounds good, but there is a catch.  You have to pay $122 today for every $100 of face value, which will be the amount of principal returned to you ten years from now.  Over the ten year period you will receive 4% of face value, but that really represents interest income (yield if held to maturity) of 1.47% while the rest is an early return of your principal.   If you spend the 4%, you are spending part of your principal, and will have only $100 to reinvest (rather than $122) when the bond matures.

Total Return Can Provide Cash Flow And Protect Purchasing Power

The total return on stocks (dividends plus price appreciation) is more important than ever in a diversified portfolio that needs to provide current cash flow and protect purchasing power for the long term.

Stocks tend to appreciate in value, so selling a few shares of stock can be the best way to meet cash flow requirements.  Of course stock prices go up AND down, so selling stock can feel like you are spending down your principal, and no one wants to do that.  The fear of spending principal should be put in perspective.  The average annualized return on the S&P 500 from 1950 to 2020 was 11.2%, which includes 3.3% from dividends and 7.9% from price appreciation.  The 7.9% was not income, and could only be spent by selling shares.

Some Things Are Different And Some Things Are Not

With low interest rates, and low inflation expectations, we should expect a lower total return from stocks than what we observed on average from 1950 to 2020, and of course no one can predict stock movements in the short run.  However, we expect the total return on stocks to be meaningfully better than cash or bonds, so understanding how to use the total return to fund retirement spending will continue to be important for a comfortable retirement.

Managing portfolio risk, monitoring asset allocation, rebalancing, and managing cash flow are all part of what we do at Rockbridge.  Let us know if you would like to discuss how your investment portfolio will fund your future cash flow needs.

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Market commentary: Q2 2021

Stock Markets:

Stocks provided positive results over the most recent twelve-month period. While all markets have done well, especially stocks in domestic markets, the markets that lead and lag vary across the various periods.

While not shown in this chart, a globally diversified stock portfolio earned over 12% over the three-year period ending June 30th, which includes both the sharp fall-off due to the Pandemic and the recent snap back. These results once again demonstrate not only the futility of trying to predict markets, but also the importance of staying invested throughout market ups and downs.

Bond Markets:

The Yield Curve below shows the pattern of observed returns from holding bonds to term across several maturities. Today these yields go from essentially zero to about 2% across a twenty- year spectrum. Yields for bonds of longer maturities fell a bit over the last quarter, which had a positive impact on those bond returns. Over the past year, on the other hand, yields have increased bond returns negatively – an index of Treasury securities maturating between 7 and 10 years lost 4.7% over the trailing twelve months.

Today’s Investment Landscape: Is there a piper to be paid?

In response to the Pandemic, the Government has run massive deficits and the Fed has re-implemented“quantitative easing”, which has been largely successful. The domestic economy is coming back, and employment has rebounded. The stock market as measured by the S&P 500 is up just over 40% and interest rates continue at historic lows. While successful to date, it is unknown if we will eventually have to pay the piper with higher interest rates and sustainable inflation down the road.

Conventional macroeconomic models tell us that deficits can produce inflation. Additionally, increasing prices may reflect temporary dislocations in this unique period. The sharp ups and downs of lumber prices are an example of the temporary nature price changes. The Fed governors and many commentators argue that this price activity will be short- lived and are reasonably calm about the prospects for sustainable inflation.

The Fed has been a massive buyer of U.S. Treasury securities and helps to explain why Treasury yields are at historical lows. However, when (if) the Fed begins to sell these Treasuries to bring its balance sheet back to more normal levels, unless done carefully, could drive bond yields back up.

The Long-term:

Today’s investment landscape is cluttered with many unknowns. The long-term is best thought of as the time it takes for actual results to equal what is expected, i.e., “regress to the mean”, which can be a long time and requires patience. Below average results in any market will not necessarily continue and above average results will not persist either. After the recent sharp run-up in stock prices, many of the metrics used to gauge market results signal a fully valued market. Markets can snap back quickly and getting out prior to earning what is expected will only assure below average results.

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The fed giveth, and the fed taketh away

Around the globe, COVID-19 killed millions of people, caused nearly 100 million to lose their job, and decreased economic output by several trillion dollars. When times get this bad, we investors are prepared to see losses in our portfolios.

But in 2020 we saw the opposite. The S&P 500 was up 18%, almost double its 90- year average, and this year it’s up another 13%. What gives? There are several factors, but the biggest is probably the Federal Reserve (The government’s $6.8 trillion of stimulus is a close second).

What’s been done: Of the many actions taken by the Federal Reserve, the two most impactful have been the lowering of the Federal Funds Rate and the expansion of its balance sheet (quantitative easing or QE).

At the onset of the Coronavirus, the Federal Reserve lowered the Federal Funds Rate from 1.5% to 0%. Nearly all short-term and intermediate-term interest rates are affected by the Federal Funds Rate. Lowering this rate reduced the cost of borrowing on mortgage and home equity loans, auto loans, and other borrowing which spurs economic activity.

The Federal Reserve has always had a balance sheet, but it hasn’t been until recently that it was used to prop up asset prices in times of economic turmoil. The Fed’s balance sheet was about $900 billion prior to the 2008 Financial Crisis. It quickly increased to $2.2 trillion at the end of 2008 and then gradually expanded to $4.5 trillion in 2014. The pandemic roughly doubled the Fed’s balance sheet from $4 trillion to $8 trillion, where it stands today. The explicit purpose of the Fed’s bond purchases is to keep long-term interest rates low to spur long-term lending. A consequence is that it raises all asset prices from bonds to stocks to homes. The cheaper things can be financed, or the lower the discount rate of future cash flows, the higher the price is today.

Where things stand now: The Federal Funds Rate is close to 0% and isn’t expected to increase until 2023. The Federal Reserve is continuing with its quantitative easing program, buying $80 billion of treasury bonds and $40 billion of mortgage-backed bonds each month. Annualized, these $120 billions of monthly purchases work out to nearly $1.5 trillion per year. The Federal Open Market Committee has yet to make an official statement on the future of this program, but Chairman Powell has said a change in asset purchases will come before a change in the Fed Funds Rate, leading some to speculate it could happen by the end of 2021.

Many believe the Fed must trim back their accommodative policy or we’ll see significant inflation in the coming years.

What the future may hold: If recent history is repeated, the Federal Reserve’s unwinding of their accommodative policy will not be good for markets in the short term.

In 2013, the Federal Reserve was buying $85 billion a month in Treasury bonds and mortgage-backed securities. On June 19th, 2013, Ben Bernanke announced the Fed would stop (or “taper”) their asset purchases by the following summer. Both the stock and bond market had a “taper-tantrum,” with global stocks dropping 6% in the ensuing week and the aggregate bond market dropping 2%.

In 2018, the Federal Reserve began selling off its assets, reducing its balance sheet from $4.4 billion to $4 billion and increasing the Federal Funds Rate from 1.25% to 2.25%. This substantial reversal of accommodative policy corresponded with poor performance from the stock and bond market. Global equities declined 10% in 2018 and the aggregate bond market finished the year flat after briefly being down 3% at times during the year.

What investors should do: Understand that the incredible stock and bond returns over the last decade are unlikely to continue.

What investors should not do: Sell in and out of the market in anticipation of the Federal Reserve’s policy changes. Final thoughts: Federal Reserve tightening seems to have been harmful to markets in the past, but before being too clever for your own good remember:

1. No one knows for sure when the changes will happen.
2. Just because markets went down in the past doesn’t mean they will in the future. With all the factors affecting stocks and bonds, no one thing ever acts in isolation.
3. Expected returns from stocks and bonds are still positive, cash remains a poor investment.
4. Rising interest rates are harmful to short-term asset prices but mean greater expected returns in the future.

Over the short term, there will always be reasons to fret capital markets. However, if people keep working, business gets done, and wealth keeps being created, investors will reap rewards over the next 100 years just like they have over the last 100.

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