What Causes Bonds To Lose Value In Certain Market Environments?

Bonds are often revered as a safe investment compared to stocks but make no mistake, bonds like other investments are not risk-free, and there are certain market environments where they can lose value. As I write this article in May 2022, the Aggregate Bond Index is currently down 8% year to date. While this is definitely a more extreme year for the bond market, there are other years in the past where bonds have lost value.

How do bonds work?

Bonds in their most basic form are essentially loans paid with interest. Companies, government entities, and countries issue bonds to raise money to fund their operations. When you buy a bond you are essentially lending money to these organizations in return for interest payments and potentially appreciation on the value of the bond. Similar to traditional loans, bonds can default, interest can be fixed or variable, and bonds are issued for varying durations.  But unlike loans, the value of your original investment can fluctuate over the life of the bond.

Bond example

Before we get into all of the variables associated with bonds, let’s first look at a basic example. The US government is issuing a 10-year treasury bond with a 3% interest rate. You buy $10,000 worth of bonds so essentially you are lending the US government $10,000 for a duration of 10 years and during that 10 years, the US government will pay you 3% interest every single year, then after 10 years, the bond matures, the US government hands you back your $10,000.

Credit worthiness

Similar to someone asking to borrow money from you, all bond issuers are not created equal. You have to assess the credit worthiness of the company or organization that is issuing the bonds to make sure that they are going to be able to make their interest payments and return your principal at the maturity date. “Maturity date” is just bond lingo for when the bond issuer has to repay you the amount that you lent to them. When the US government issues bonds, they are considered by the market to be some of the safest bonds in the world because they are backed by the credit worthiness of the United States government. It would be a historic event if the US government were to default on its debt because the government can always print more money or raise taxes to make the debt payments. Compare this to a risky company, that is trying to emerge from bankruptcy, and is issuing bonds to raise capital to turn the company around. This could be viewed as a much riskier investment because if you lend that company $10,000, you may never see it again if the company is unable to emerge from bankruptcy successfully. For this reason, you have to be selective as to who is issuing you the bond.  

Bond rating agencies

Thankfully there are bond rating agencies that help investors assess the credit worthiness of the bond issuer. The two main credit rating agencies are Standard & Poors and Moody’s. Both have grades that they assign to each bond issuer that can range from AAA for the highest quality issuers all the way down to D. It’s important to look at both rating agencies because they may assign different credit scores or in the bond world called “quality ratings” to a bond issuer. But as we learned during the 2008 and 2009 recession, even the bond rating agencies sometimes make the wrong call, so you should complete your own due diligence in assessing the credit worthiness of a particular bond issuer.

Bond defaults

When a company or government agency defaults on its debt it’s ugly. All of the creditors of the company including the bondholders line up to split up whatever’s left, if there is anything left. There could be a number of creditors that have priority over bondholders of a company even though bondholders have priority over stockholders in a company. If you bought a $10,000 bond from a company that goes bankrupt, you have to wait for the bankruptcy process to play out to find out how much, if any, of your original $10,000 investment will be returned to you.

Bond coupon rate

A bond coupon is the interest rate that is paid to the bondholder each year. If a bond has a 5% coupon that means it pays the bondholder 5% in interest each year over the life of that bond. While there are many factors that determine the interest rate of a bond, two of the primary factors are the credit worthiness of the organization issuing the bonds and the bond’s duration.

 The credit worthiness of the bond issuer probably has the greatest weight. If a high-risk company is issuing bonds, investors will most likely demand a high coupon rate compared to a more financial stable company to compensate them for the increased level of risk.  If a 10 year US government bond is being issued for a 3% coupon rate, a high-risk corporate bond may be issued at a coupon rate of 7% or more. Higher risk bonds are sometimes referred to as high yield bonds or junk bonds. On the flipside, organizations with higher credit ratings, normally have the luxury of issuing their bonds at lower interest rates because the market views them as safer.

 The coupon payments, or interest payments, can be made to the bondholder in different durations during the year depending on the terms of the bond. Some bonds issue interest payments quarterly, semi-annually, once a year, and some bonds don’t issue any interest payments until the bonds matures.

 It’s because of this fixed interest-rate structure that high quality bonds are often viewed as a safer investment than stocks because the value of a stock varies every day based on what the value of the company is perceived to be. Whereas bonds just make fixed interest payments and then re-pay you the face value of the bond at a future date. “Face value” is bond lingo for the dollar amount the bond was issued for and the amount that is returned to the bondholder at maturity.

Fixed interest versus variable interest

While most bonds are issued with a fixed interest rate, some bonds have a variable interest rate. If it’s a fixed interest rate, the bond pays the holder a set interest payment over the life of the bond. If it’s a variable interest rate, the interest rate paid to the bond holder can vary throughout the life of the bond. Some of the more common types of bonds that have variable interest rates are floating rate bonds. The interest rate that these bonds pay is typically tied to the variable rate associated with a short term bond benchmark like the LIBOR or the fed funds rate. As the interest of those benchmarks moves up and down, so do the corresponding interest rate paid by the bond.

Duration of a bond

The next big factor that influences the interest rate on a bond is the duration of the bond. “Duration” is bond lingo for the length from time between when the bond is first issued and when the bond matures. Typically, the longer the duration of the bond, the higher the interest rate which makes sense. If a company wants to borrow $10,000 from you for 1 year versus 10 years, as the person lending them the money, you will most likely want a higher interest rate for a 10 year loan versus a 1 year loan because they are holding onto your money for a longer period of time which represents a greater risk to you as the bondholder.   

Interest rate risk

Bonds also have something called interest rate risk. Typically, when interest rates rise, the value of a bond falls, and vice versa if interest rates fall, the value of a bond rises. Up until this point, we have really just talked about coupon payments or interest payments made to a bondholder but the bond itself can change in value over the life of the bond. Let’s say a company is issuing bonds at $1,000 face value each, you buy a bond for $1,000 and at maturity you would expect to receive $1,000 back, but from the time that bond is issued and when it matures, you can normally trade that bond in the open market, and the value of that bond could sell for more or less than your original $1,000 investment.  

 If you buy a bond from a company that is a 10 year bond with a 5% interest rate but then interest rates across the economy begin to fall, and a year from now investors have difficulty finding bonds that are being issued with a 5% interest rate, another investor may pay you more than $1,000 to buy your bond and collect the 5% interest payment for the rest of that bonds life. So instead of just receiving $1,000 for the bond you may receive $1,500. The value paid over and above the bonds face value is considered appreciation which adds to your total return so the total return on a bond investment includes both dividends received and any appreciation if you sell it prior to maturity.

 But that is a two way street, using that same example above, let’s say a company issues you a bond for $1,000 paying a 5% coupon, but now interest rates have moved higher over the next year, and that same company is now issuing bonds at a 7% interest rate, no one wants your 5% bond because they can get a higher interest-rate by buying the new bonds today. If you were to try and sell your bond in the open market you may only receive $900 from another investor because again, they can just pay $1,000 by purchasing the new bonds with the higher interest rate.  

Holding to maturity

If you hold bonds to their maturity,  which means you don’t trade them while you’re waiting for the bond to mature, it eliminates a lot of this interest-rate risk because then it’s just a pure loan. You lent a company $1,000,  they pay you interest over the life of the loan, and then they hand you back your $1,000 at maturity. Interest rates do not impact the face value of a bond in most cases.

 However, when we talk about bond mutual funds, those bond funds can hold hundreds or thousands of bonds, and those mutual funds are priced by “marking to market” each day, meaning they total up all of the value of the bonds in that portfolio as if they were all being sold at 4pm each day.  It’s similar with bond ETFs but they trade intraday. Thus, if you own bonds via mutual funds or ETFs, interest-rate fluctuations will have a greater influence on the total return of your bond investment because there’s no option to just hold it to maturity. Depending on the interest rate environment this could either work for you or against you. The reason why many high-quality bond funds have lost value in 2022 is because interest rates have risen rapidly this year which has caused the value of those bonds to fall.

Duration Matters

There is a correlation between the time to maturity and the impact of interest rates on the price of a bond.   The longer the duration of the bond, the more that can happen to interest rates between the time a bond is issued and the time the bond matures.   For this reason, when interest rates move, it typically has a greater price impact on longer term bonds versus short-term bond.  

Simple example, your own a bond paying 4% that is maturing in 1 year and another bond paying 4% that matures in 20 years, interest rates are moving higher, and the equivalent bonds are now being issued at a 5% coupon rate. Both of your bonds would most likely drop in value but the bond that is maturing in one year will most likely drop by less because they will return your investment sooner, and you can reinvest that money at the new higher rate compared to the 20 year bond that is locked in at the lower interest rate for the next 20 years.

Why would you own a bond mutual fund?

After reading this, I’ll have investors ask, “why would you own a bond mutual fund versus individual bonds if you have this interest rate risk?” For most investors, the answer is diversification. If you have $100,000 to allocate to bonds, purchasing a few different bond funds may be a more efficient and cost-effective way to obtain a diversified bond portfolio compared to purchasing individual bonds. As mentioned earlier, these bond mutual funds may have thousands of bonds within this single investment which have been selected by a professional bond manager that understands all of the intricacies of the fixed income markets. Compare this to an individual investor that now has to go out and select each bond, do their own analysis on a variety of different bond issuer‘s to create diversification of credit, duration, and coupon payments to create their own diversified portfolio.  Also, since we’ve been in historically low interest rate environments, many fixing income investors have been reluctant to lock into a bond ladder which is a popular strategy for individual bond investors.

 Creating a diversified bond portfolio

Similar to stocks, when investing in bonds, it’s important to create a diversified portfolio to help safeguard bondholders against risk. Within a diversified bond portfolio, you may have bonds with varying credit ratings to help achieve a higher level of interest overall with the safer bond issuer‘s offsetting some of the more risky ones that are paying a higher interest rate. You may have bonds that are varying in duration from short-term, intermediate term, all the way to long-term bonds which may also allow a bond investor to achieve higher rates of return over the long term but maintain the necessary amount of liquidity because the short-term bonds are always maturing and are less sensitive to interest rate risks.  

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Additional Disclosure: All bonds are subject to interest rate risk and you may lose money. Before investing in, you should carefully consider and understand the risks associated with investing. U.S. Treasury bonds and municipal bonds maybe susceptible to some of the following risks: Lower yields, interest rate risk, call risk, inflation risk and credit or default risk. Investors need to be aware that bonds may have the risk of default.

Is Inflation Peaking? That’s The Wrong Question…….

As I write this article on May 11, 2022, the inflation number was just released for April indicating an 8.3% increase in the Consumer Price Index (CPI) which is the primary measure of the inflation rate.  The news and market analysts seem to be consumed with the question “has inflation peaked?”  Since the April CPI reading was below the March CPI of 8.5%, the answer may very well be “yes”, but I think there is a more important question that analysts and investors should be paying attention to and I would argue that the answer to this question will be more meaningful to the markets. Here it is, looking at all of the drivers of inflation right now, how does the inflation rate get back down to a level that will help the U.S. economy to avoid a recession?

 Claiming victory that inflation has peaked could be a very short celebration if the level of inflation REMAINS at an elevated level for longer than the market and the Fed expects.

The Inflation Problem Has Become More Complex

 At the end of 2021, it seemed to be the consensus that the primary driver of higher inflation was due to supply chain constraints in a post COVID world.  The solution to that problem seemed fairly simple, as the global supply chain heals, there will be more goods to buy, and prices will gradually come down throughout 2022; but that has changed now.  It’s not just supply chain issues that are driving inflation any longer, we now have:

• Global supply chain issues

• Russian / Ukraine conflict

• Oil still over $100 per barrel

• Tight labor markets

• Wage growth

• Strong corporate earnings but weaker forecasts

• Fed policy

I would also argue that some of the inflation catalysts listed above will have a more significant impact on the rate of inflation than just the COVID supply constraints.  In this article I’m going to walk you through the trends that we are seeing in each of these inflation catalysts and how they could impact inflation going forward.  We do not believe that the market is doomed to enter a recession at this point but with so many more forces driving inflation higher, monitoring what really matters to the longer term inflation trend should be foremost in the mind of investors as the war against inflation enters the second half of the 2022.

Russia / Ukraine Conflict

 Russia’s continued assault on Ukraine has caused a number of supply chain disruptions in itself but none more impactful to the U.S. than the price of oil.  The price of oil has been over $100 per barrel for months which is huge driver of inflation since goods need to be transported on planes, ships, trucks, and trains.  Oil companies are not in a rush to produce more because they are enjoying lofty profits and they realize that the price of oil could come down quickly if the violence ends in Ukraine. This is why they are hesitant to spend a lot of money to bring more production online because the price of oil could drop down to $80 or below within the next few months.   Could oil go higher from here? It could. The Chinese economy has recently been hampered by COVID outbreaks so demand for oil has eased within the last month, but if this changes you could see the price of oil hit new highs on increased demand from China and we are about to enter the summer travel season in the U.S.  If oil prices stay above $100 per barrel throughout the summer, it may keep inflation at elevated levels for longer than anticipated.

The Price of Oil

 We just went through what’s driving the price of oil higher but if the price of oil drops within the next few months it’s not an automatic victory.  If the price of oil is dropping because there is more supply coming online or because there is peace in Ukraine that is excellent, that should reduce inflationary pressures. However, if the price of oil is decreasing because demand is beginning to soften because the consumer is beginning to buy less, that’s not a positive indicator.  

More Jobs Than Workers

 Currently there are 5.9 million unemployed people in the U.S., and as of March there are 11.5M job openings which puts us at 2 job openings for every 1 person looking for work.  If you look at the chart below of the total job openings, it’s easy to see that we are in uncharted territory here:

So, when you have more jobs than people looking for work, what do you think is going to happen to wages? They are going to go up.  When you look back in history, one of the largest drivers of big inflationary periods is wage growth.  Think about it this way, if the government hands you a stimulus check, you will be able to buy more stuff or pay higher prices for goods and services than you normally would, but this is temporary. Once you have spent that government stimulus money, you can no longer afford to pay higher prices.

If you change jobs, and you receive a $30,000 raise, now you can pay higher prices, not just this year but next year, and the year after that.  Wage growth creates “sticky inflation”.  It doesn’t just go away when the supply chain recovers or when oil prices retreat.  As of April, wage growth has risen 6.4% over the past year, and the last time we saw wage growth over 6% was the 1970’s which not so coincidentally was a period of prolonged hyperinflation.

The only way I can foresee wage growth decreasing is a slow down in the economy which raises the risk of a recession.  It’s simple supply and demand.  If you have more jobs than people to fill them, companies will have to pay hire wages to attract and keep employees, the companies will most likely pass those higher costs onto the consumer in the form of higher prices, eventually the consumer can no longer afford those higher prices, the economy slows down, and then those excess jobs are eliminated.  Not a fun storyline.

Subtle Warning Signs In Corporate Earnings

 The tone from the Fed at the beginning of 2022 was that they will be raising rates to slow down inflation, but the economy is strong enough to withstand the rate hikes and we should be able to avoid a recession.  The U.S. economy is driven primarily by consumer spending, and the consumer definitely showed up to spend in the first quarter of 2022.   However, while many of the companies in the S&P 500 Index exceeded earning expectations, a number of them softened their outlook for the remainder of 2022 due to rising input costs and the impact of higher prices on consumer spending.  Knowing that the stock market and bond market are forward looking animals, even though inflation has not taken a huge toll on corporate earnings yet, clouds are beginning to form which investors should pay close attention to.

Tech Stocks Getting Hit

 As of May 9th, the S&P 500 Index is down 16% but the Nasdaq is down 26%.  When inflation shows up, valuations begin to matter over a company’s growth story because cash becomes king.  Here is how I explain it, if inflation is going up at 8% per year, if I ask you if you want me to give you $1 today or $1 a year from now, you would choose $1 today because a year from now, that dollar would have less purchasing power, because inflation is causing the price of everything to go up.  It works the same way with stock prices. 

The market uses P/E Ratios to determine how expensive stock is which is simply a company’s stock price divided by its earnings per share. If a company’s stock price is $100 and they are expected to earn $100 in profit for each share of stock, the P/E ratio would be 1.  But it’s common for stocks to trade at 10, 15, or even 30 times one year of forward earnings. The higher the PE ratio, the more assumed future growth is built into the price of that stock.  Some growth companies have very little in terms of net profit because they are spending a lot of money to make their big growth dreams come to life. These growth stocks can sometimes trade at a PE of 50, 100, or higher!!

When inflation hits and investors realize a dollar today is more valuable than a dollar tomorrow, they have to begin to discount those future returns that are built into stock prices.  A stock that is trading at 50 times their one year earnings will typically have to drop in price a lot more than a stock that is only trading at 10 times it’s future one year earnings because you have to discount 50 years of earnings instead of 10.   

Fed Policy

 The last variable in the inflation equation is Fed policy. The Fed has a really tough job right now, reduce inflation without pushing the economy into a recession.  When it was just supply chain issues, I think the market had it right by describing it as “the Fed is trying to engineer a soft landing”.  With new inflationary forces now entering the equation, I would describe the Feds task as “threading a needle while the needle is moving”.  

At the May meeting, the Fed announced, as expected, a 0.50% increase to the Fed funds rate, but during that meeting they also dismissed that a future 0.75% rate hike was on the table.  The markets cheered and rose significantly that day hearing that a 0.75% hike was unlikely but then the next day the market lost all of those gains, and continues to add to the losses - worried that the Fed was not raising rates fast enough to keep higher inflation at bay.   

It's All About Inflation

 While a lot of attention is being given to the Fed and what the Fed might do next, the focus has to come back to not just stopping inflation from going higher but how do they get inflation to decrease fast enough before it derails the consumer.   I highlight all of these inflation variables because you could get good news on supply chain improvements and corporate earnings but if oil remains above $100 per barrel and wage growth is still 6%+, it difficult to picture how the year over year change in the inflation rate gets below 4% or 5% before the end of the year.

The consumer is everything.  If the consumer has higher wages and the cash reserves to withstand the higher prices while the Fed is working to bring inflation down, it is possible that we could see a rally in the second half of the year. But the long inflation persists, the less likely that relief rally scenario becomes.

This Time It’s Different

I urge all investors to be careful here.  In the investment world you will sometimes hear the phase “this time it’s different” or “we have never been here before” which can add additional stress and anxiety to a market environment that is already scary.  I urge caution here because in 2022 there has been a trend that is very different.  In most market downturns, when stocks go down, bonds will typically be up, which is one of the benefits of a properly diversified portfolio.  When you compare historical returns of the S&P 500 Index versus the Aggregate Bond Index, you will see this pattern:

Unfortunately, as of May 9, 2022, stocks and bonds are both down a significant amount year-to -date:

It feels like we are getting close to a fork in the road.  Either we will begin to see meaningful improvement in the inflation rate over the next few months setting both the stock and bond market on a path to recovery in the second half of 2022, or despite the Fed’s best efforts, regardless of whether or not we have seen a peak in inflation, if inflation does not come down a meaningful amount by the fall, the U.S. economy may slip into a mild recession in 2023.  Until we know, investors will have to pay very close attention to these monthly indicators that are driving the inflation rate.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Can You Contribute To An IRA & 401(k) In The Same Year?

The answer to this question depends on the following items:

• Do you want to contribute to a Roth IRA or Traditional IRA?

• What is your income level?

• Will the contribution qualify for a tax deduction?

• Are you currently eligible to participate in a 401(k) plan?

• Is your spouse covered by a 401(k) plan?

• If you have the choice, should you contribute to the 401(k) or IRA?

• Advanced tax strategy: Maxing out both and spousal IRA contributions

 Traditional IRA

Traditional IRA’s are known for their pre-tax benefits. For those that qualify, when you make contributions to the account you receive a tax deduction, the balance accumulates tax deferred, and then you pay tax on the withdrawals in retirement.   The IRA contribution limits for 2022 are:

Under Age 50:  $6,000

Age 50+:            $7,000

However, if you or your spouse are covered by an employer sponsored plan, depending on your level of income, you may or may not be able to take a deduction for the contributions to the Traditional IRA.  Here are the phaseout thresholds for 2022:

Note:  If both you and your spouse are covered by a 401(k) plan, then use the “You Are Covered” thresholds above.

BELOW THE BOTTOM THRESHOLD: If you are below the thresholds listed above, you will be eligible to fully deduct your Traditional IRA contribution

WITHIN THE PHASEOUT RANGE:  If you are within the phaseout range, only a portion of your Traditional IRA contribution will be deductible

ABOVE THE TOP THRESHOLD:  If your MAGI (modified adjusted gross income) is above the top of the phaseout threshold, you would not be eligible to take a deduction for your contribution to the Traditional IRA

 After-Tax Traditional IRA

If you find that your income prevents you from taking a deduction for all or a portion of your Traditional IRA contribution, you can still make the contribution, but it will be considered an “after-tax” contribution.  There are two reasons why we see investors make after-tax contributions to traditional IRA’s. The first is to complete a “Backdoor Roth IRA Contribution”.   The second is to leverage the tax deferral accumulation component of a traditional IRA even though a deduction cannot be taken.  By holding the investments in an IRA versus in a taxable brokerage account, any dividends or capital gains produced by the activity are sheltered from taxes.  The downside is when you withdraw the money from the traditional IRA, all of the gains will be subject to ordinary income tax rates which may be less favorable than long term capital gains rates. 

 Roth IRA

If you are covered by a 401(K) plan and you want to make a contribution to a Roth IRA, the rules are more straight forward.  For Roth IRAs, you make contributions with after-tax dollars but all the accumulation is received tax free as long as the IRA has been in existence for 5 years, and you are over the age of 59½.    Unlike the Traditional IRA rules, where there are different income thresholds based on whether you are covered or your spouse is covered by a 401(k), Roth IRA contributions have universal income thresholds.

 The contribution limits are the same as Traditional IRA’s but you have to aggregate your IRA contributions meaning you can’t make a $6,000 contribution to a Traditional IRA and then make a $6,000 contribution to a Roth IRA for the same tax year.  The IRA annual limits apply to all IRA contributions made in a given tax year.

 Should You Contribute To A 401(k) or an IRA?

 If you have the option to either contribute to a 401(k) plan or an IRA, which one should you choose?  Here are some of the deciding factors:

Employer Match:  If the company that you work for offers an employer matching contribution, at a minimum, you should contribute the amount required to receive the full matching contribution, otherwise you are leaving free money on the table.

Roth Contributions:  Does your 401(k) plan allow Roth contributions? Depending on your age and tax bracket, it may be advantageous for you to make Roth contributions over pre-tax contributions. If your plan does not allow a Roth option, then it may make sense to contribute pre-tax up the max employer match, and then contribute the rest to a Roth IRA.

Fees:  Is there a big difference in fees when comparing your 401(k) account versus an IRA?  With 401(k) plans, typically the fees are assessed based on the total assets in the plan.  If you have a $20,000 balance in a 401(K) plan that has $10M in plan assets, you may have access to lower cost mutual fund share classes, or lower all-in fees, that may not be available within a IRA. 

Investment Options:  Most 401(k) plans have a set menu of mutual funds to choose from.  If your plan does not provide you with access to a self-directed brokerage window within the 401(k) plan, going the IRA route may offer you more investment flexibility.

Easier Is Better:  If after weighing all of these options, it’s a close decision, I usually advise clients that “easier is better”.  If you are going to be contributing to your employer’s 401(k) plan, it may be easier to just keep everything in one spot versus trying to successfully manage both a 401(k) and IRA separately.

 Maxing Out A 401(k) and IRA

As long as you are eligible from an income standpoint, you are allowed to max out both your employee deferrals in a 401(k) plan and the contributions to your IRA in the same tax year.  If you are age 51, married, and your modified AGI is $180,000, you would be able to max your 401(k) employee deferrals at $27,000, you are over the income limit for deducting a contribution to a Traditional IRA, but you would have the option to contribute $7,000 to a Roth IRA.

Advanced Tax Strategy: In the example above, you are above the income threshold to deduct a Traditional IRA but your spouse may not be. If your spouse is not covered by a 401(k) plan, you can make a spousal contribution to a Traditional IRA because the $180,000 is below the income threshold for the spouse that is NOT COVERED by the employer sponsored retirement plan.  

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Kiddie Tax & Other Pitfalls When Gifting Assets To Your Kids

There are a number of reasons why parents gift assets to their kids which include:

•  Reduce tax liability

• Protecting assets from the nursing home

• Estate planning: Avoiding probate

But the pitfalls are many and most people do not find out about the pitfalls until it’s too late.  These pitfalls include:

•  Kiddie tax rules

• Children with self-directed investment accounts

• Treatment of long-term capital gains

• Gifting cost basis rules

• College financial aid impact

• Control of the assets

• 5 Year look-back rule

• Divorce

• Lawsuits

• Distributions from Inherited IRA’s

 Kiddie Tax

The strategy of shifting assets from a parent to a child on the surface seems like a clever tax strategy in an effort to shift investment income or capitals gains from the parent that may be in a high tax bracket to their child that is in a low tax backet.  Unfortunately, the IRS is aware of this strategy, and they have been aware of it since 1986, which is the year the “Kiddie Tax” was signed into law. 

Here is how the Kiddie tax works; if your child’s income is over a certain amount, then the income is taxed NOT at the child’s tax rate, but at the PARENT’S tax rate.  Kiddie tax rules do NOT apply to earned income which includes wages, salary, tips, or income from self-employment.   Kiddie tax ONLY applies to UNEARNED INCOME which includes:

•  Taxable interest

• Dividends

• Capital gains

• Taxable Scholarships

• Income produced by gifts from grandparents

• Income produced by UTMA or UGMA accounts

• IRA distributions  

 There are some exceptions to the rule but in general, your child would be subject to the Kiddie tax if they are:

•  Under the age of 19; or

• Between the ages of 19 and 23, and a full-time student

 The only exceptions that apply are if your child:

•  Has earned income totaling more than half the cost of their support; or

• Your child files their tax return as married filing joint

 Kiddie Tax Calculation

Here is how the Kiddie tax calculation works.  For 2022, the first $1,150 of a child’s unearned income is tax-free, the next $1,150 is taxed at the child’s rate, and any unearned income above $2,300 is taxed at the parent’s marginal income tax rate.

Here is an example, the parents bought Apple stock a long time ago and the stock now has a $30,000 unrealized long term capital gain.   Assuming the parents make $200,000 per year in income, if they sell the stock, they will have to pay the Federal 15% long term capital gains tax on the $30,000 gain.  But they have a child that is age 16 with no income, so they gift the stock to them, have them sell it, with the hopes of the child capturing the 0% long term cap gains rate since they have no income.  Kiddie tax is triggered!!   The first $2,300 would be tax free but the rest would be taxed at the parent’s federal 15% long term cap gain rate; oh and if that family was expecting to receive college financial aid two years from now, they might have just made a grave mistake because now that teenager is showing income.  A topic for later.

That was an example using long term capital gains rates but if we used a source of unearned income subject to ordinary income tax rates, the jump could go from an assumed 0% to the parents 37% tax rate if they are in the highest fed bracket.

Putting Your Kids on Payroll

While we are on the subject of Kiddie Tax, our clients that own small businesses will sometimes ask “Do I have to worry about the Kiddie tax if I put my kids on payroll through my company?”  Fortunately the answer is “No”.  Paying your child W2 wages through your company is considered “earned income” and earned income is not subject to the kiddie tax rules.

Children with Self-Directed Investment Accounts

It’s becoming more common for high school and college students to have their own brokerage accounts where they are trading stocks, ETFs, options, cryptocurrency, and mutual funds.  But the kiddie rules can come into play when they are buying and selling investments in their accounts. If the parents claim the child as a dependent on their tax return and they buy and then sell an investment within a 12 month period, that would create a short term gain subject to ordinary income tax rates. If that gain is above $2,300, then the kiddie tax is triggered, and the gain would be taxed at the parent’s tax rate not the child’s tax rate.  This can lead to tax surprises when the child receives the tax forms from the brokerage platform and then realizes there are big taxes due, and the child may or may not have the money to pay it. 

For the child to file their own tax return to avoid this Kiddie tax situation, the child must be earning enough income to provide at least half of their financial support.

Kiddie Tax Form 8615

How do you report the Kiddie tax on your tax return?  I spoke with a few CPA’s about this and they normally advise their clients that once the child has unearned income over $2,300, the child, even though they may be a dependent on your tax return, files their own tax return, and with their tax return they file Form 8615 which calculates the Kiddie Tax liability based on their parent’s tax rate.

 

Impact on College Financial Aid

Before gifting any assets to your child, income producing or not, if you are expecting to receive any form of need based financial aid for your child for college in the future, be very very careful.  The FAFSA calculation weighs assets and income differently depending on whether it belongs to the parent or the child.

For assets, if the parent owns it, the balance counts 5.64% against the aid awarded. If the child owns it, the balance counts 20% against the aid awarded.  You move a stock into your child’s name that is worth $30,000, if you would have qualified for financial aid, you just cost yourself $4,300 PER YEAR in financial aid.

Income is worse. If you gift your child an asset that produces income or capital gains, income of the parents counts 22% - 47% against college financial aid depending on the size of the household.  If the income belongs to the child, it counts 50% against the FAFSA award.  Another note, the FAFSA process looks back 2 years for purposes of determining the financial aid award, so even though they may only be a sophomore or junior in high school, you don’t find out about that mistake until 2 years later when they are applying for FAFSA as a freshman in college.

Long Term Capital Gains Treatment

The example that I used earlier with the Apple stock highlights another useful tax lesson.  If you are selling a stock, mutual fund, or investment property that you have owned for more than a year, it’s taxed at the preferential long term capital gain rate of 15% as long as your taxable income does not exceed $459,750 for single filers or $517,200 for married filing joint in 2022, it’s a flat 15% tax rate whether it’s a $20,000 gain or a $200,000 gain because the rate does not increase like it does for “earned income”.   I make this point because long term capital gain rates are already taxed at a relatively low rate, and if realized by your child, are subject to Kiddie tax so before you jump through all the hoops of making the gift, make sure the tax strategy is going to work.

Gift Cost Basis Rules

When you make a gift, it’s important to understand how the cost basis rules work.  When you make a gift, there typically is not an immediate tax event, but the recipient inherits your cost basis in that asset. Gifting an asset does not provide the person making the gift with a tax deduction or erase the unrealized gains, unless of course you are gifting it to a charity or not-for-profit.  Let’s keep running with that Apple stock example, you gift the Apple stock to your child with a $30,000 unrealized gain, there is no tax event when the gift is made, but if the child sells the stock the next day, they will have to pay tax on the $30,000 realized gain, and if the kiddie tax applies, it will be taxed at the parent’s tax rate.  

Estate Tax Planning: Avoid Probate

Sometimes people will gift assets to their kids in an effort to remove those assets from their estate to avoid probate, a big tax issue surfaces with this strategy.  Normally when someone passes away and their kids inherit a house or investments, they receive a “step-up in basis”.  A step-up in basis means no matter what the gain was in the house or investment prior to a person passing away, the cost basis to the person that inherits the assets is now the fair market value of that asset as of decedent’s date of death.

Example: You bought your house 20 years ago for $200,000 and it’s now worth $400,000.  If you were to pass away tomorrow and your kids inherit your house, they receive a step-up in basis to $400,000 so if they sell the house the next day, they have no tax liability. A huge tax benefit.

But if you gift the house to your kids while you are still alive in an effort to avoid the probate process, your kids now lose the step-up in cost basis because the house never passes through your estate.  If you kids sell your house the next day, they will realize a $200,000 gain and have to pay tax on it which at the Federal level of 15%, could cost them $30,000 in taxes which could have been avoided.

There are other ways to avoid probate besides gifting that asset to your kids which allows the asset to avoid the probate process and receive a step up in basis. You could setup a trust to own the asset or change the registration on the account to a “transfer on death” account.

Distributions From An IRA Owned By The Child

If your child inherits an IRA, they may be required to take RMD’s (required minimum distributions) each year from the IRA.  Distribution are not only subject to ordinary income tax but they are also subject to Kiddie tax since IRA distributions are considered unearned income.  If you child inherits a pre-tax IRA or 401(k) be very careful when taking distribution from the account, especially taking into consideration the new distribution rules for non-spouse beneficiaries.

Control of the Asset

As financial planners, we have seen a lot of crazy things happen.  While some teenagers are very responsible, others are not.  When you gift an asset directly to child, they may not use that gift as intended. Even with UTMA and UGMA account, the parents only have control until the child reaches age of majority, and then account belongs to them.  If there is any concern about how the gifted asset will be managed or distributed, you may want to consider a trust or another type of account that provides the you with more control of the asset.

Lawsuits

From a liability standpoint, if you gift assets to your child, and those assets have a meaningful amount of value, those assets could be exposed to a lawsuit if your child were to ever be sued.

Divorce

If you gift assets to your child and they are already married or get married in the future, depending on what state they live in or how those assets are titled, they could be considered marital property. If a divorce happens at some point in the future, their soon to be ex-spouse could now be entitled to a portion of those gifted assets.

5 Year Lookback Rule

Some parents will gift assets to their children to avoid the spend down process should a long term care event happen at some point in the future and they need to go into a nursing home.  Different states have different Medicaid rules but in New York, the gift has to take place 5 years prior to the Medicaid application otherwise the assets are subject to spend down.

The other pitfall of gifting assets to your children is that while you may be able to successfully protect those assets from a Medicaid lookback period, the cost basis issue that we discussed earlier still exists. If you gift the house to your kids, they inherit your cost basis, so when they go to sell the house after you pass, they have to pay tax on the full gain amount, versus if you established a grantor irrevocable trust to own your house, it could satisfy the gift for the 5 year look back period in NY, but then your kids receive a step up in basis when you pass away since the house passes through your estate, and they can sell the house with no tax liability. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Selecting The Best Pension Payout Option

When you retire and turn on your pension, you typically have to make a decision as to how you would like to receive your benefits which includes making a decision about the survivor benefits.  Do you select….

• Lump sum

• Single Life Benefit

• 100% Survivor Benefit

• 50% Survivor Benefit

• Survivor Benefit Plus Pop-up Election

The right option varies person by person but some of the primary considerations are:

• Marital status

• Your age

• Your spouse’s age

• Income needed in retirement

• Retirement assets that you have outside of the pension

• Health considerations

• Life expectancy

• Financial stability of the company sponsoring the plan

• Tax Strategy

• Risk Tolerance

There are a lot of factors because the decision is not an easy one.  In this article, I’m going to walk you through how we evaluate these options for our clients so you can make an educated decision when selecting your pension payout option. 

Understanding The Options

 To give you a better understanding of the various payout options, I’m going to walk you through how each type of benefit works.  Not all pension plans are the same, some plans may only offer some of these options, others after all of these options, and some plans have additional payout options available.

Lump Sum:  Some pension plans will give you the option of receiving a lump sum dollar amount instead of receiving monthly payment for the rest of your life. Retirees will typically rollover these lump sum amounts into their IRA’s, which is a non-taxable event, and then take distributions as needed from their IRA.

Single Life Benefit: This is also referred to as the “straight life benefit”.  This option usually offers the highest monthly pension payments because there are no survivor benefits attached to it.  You receive a monthly payment for the rest of your life but when you pass away, all pension payments stop.

Survivor Benefits:   There are usually multiple survivor benefit payout options. They are typically listed as:

                100% Survivor Benefit

                75% Survivor Benefit

                50% Survivor Benefit

                25% Survivor Benefit

The percentages represent the amount of the benefit that will continue to your spouse should you pass away first.  The higher the survivor benefit, typically the lower your monthly pension payment will be because the pension plans realize they may have to make payments for longer because it’s based on two lives instead of one. 

Example: If the Single Life pension payment is $3,000, if instead you elect a 50% survivor benefit, your pension payment may only be $2,800, but if you elect the 100% survivor benefit it may only be $2,700.   The monthly pension payments go down as the survivor benefits go up.

Here is an example of the survivor benefit, let’s say you elect the $2,800 pension payment with a 50% survivor benefit. Your pension will pay you $2,800 per month when you retire but if you were to pass away, the pension plan will continue to pay your spouse $1,400 per month (50% of the benefit) for the rest of their life.

Pop-Up Elections:  Some pension plans, like the New York State Pension Plan, provide retirees with a “Pop-Up Election”.   With the pop-up, if you select a survivor benefit which provides you with a lower monthly pension payment amount but your spouse passes away first, thus eliminating the need for a survivor benefit, your monthly pension payment “pops-up” to the amount that you would have received if you elected the Single Life Benefit.

Example:  You are married, getting ready to retire, and you have the following pension payout options:

Single Life:  $3,000 per month

50% Survivor Benefit: $2,800 per month

50% Survivor Benefit with Pop-Up: $2,700 per month

If you elect the Single Life option, you would receive $3,000 per month, but when you pass away the pension payments stop.

If you elect the 50% Survivor Benefit, you would receive $2,800 per month, but if you pass away before your spouse, they will continue to receive $1,400 for the rest of their life.

If you elect the 50% Survivor Benefit WITH the Pop-Up, you would receive $2,700 per month, if you were to pass away before your spouse, your spouse would continue to receive $1,350 per month. But if your spouse passes away before you, your pension payment pops-up to the $3,000 Single Life amount for the rest of your life.

Why do people select the pop-up?  It’s more related to what happens to the social security benefits when a spouse passes away. If your spouse were to pass away, one of the social security benefits is going to stop, and you receive the higher of the two but some of that lost social security income could be made up by the higher pop-up pension amount.

Marital Status

 The easiest variable to address is marital status. If you are not married or there are no domestic partners that depend on your pension payments to meet their expenses, then typically it makes sense to elect either the Lump Sum or Straight Life payment option.  Whether or not the lump sum or straight life benefit makes sense will depend on your age, tax strategy, income need, if you want to preserve assets for your children, and other factors.   

Income Need

 If you are married or have someone that depends on your pension income, by far, the number one factors becomes your income need in retirement when making your pension election.  If the primary source of your retirement income is your pension and you were to pass away, your spouse would need to continue to receive all or a portion of those pension payments to meet their expenses, you have to weigh very heavily the survivor benefit options.  We have seen people make the mistake of electing the Single Life Option because it was the highest monthly payout and then the spouse with the pension unexpectedly passes away at an earlier age.  It’s a devastating financial event for the surviving spouse because the pension payments just stop. If someone were to pass away 5 years after leaving their company, they worked all of those year to receive 5 years worth of pension payments, and then they just stopped.   

We usually have to run projections for clients to answer this question, if the spouse with the pension passes away will their surviving spouse need 50%, 75%, or 100% of the pension payments to meet their income needs?  In most cases it’s worth accepting a slightly lower monthly pension payment to reduce this survivor risk.   

Retirement Assets Outside Of The Pension

 If you have substantial retirement savings outside of your pension like 401(k) accounts, investment accounts, 457, IRA’s, 403(b) plans, this may give you more flexibility with your pension options.  Having those outside assets almost creates a survivor benefit for your spouse that if the pension payments were to stop or be reduced, there are other retirement assets to draw from to meet their income needs. 

Example: You have a retired couple, both have pensions, and they have also accumulated $1M in retirement accounts outside the pension, if one spouse were to pass away, even though the pension payments may stop or be reduced, there may be enough assets to draw from the outside retirement accounts to make up for that lost pension income. This may allow a couple to elect a 50% survivor benefit and receive a higher monthly pension payment compared to electing the 100% survivor benefit with the lower monthly pension payment.

Risk Management

 This last example usually leads us into another discussion about long-term risk.  Even though you may have the outside assets to accept a higher monthly pension payment with a lower survivor benefit, should you?  When we create retirement plans for clients we have to make a lot of assumptions about assumed rates of return, life expectancy, expenses, etc.  But what if your investment accounts take a big hit during the next recession or a spouse passes away much sooner than expected, accepting a lower survivor benefit may increase the impact of those risks on your plan.  If you and your spouse are both able to elect the 100% survivor benefit on your pensions, you then know, that no matter what happens in the future, that pension income will always be there, so it’s one less variable in your long-term financial plan.

While this could be looked at as a less risky path, there is also the flip side to that.  If you lock up the 100% survivor benefit on the pension, that may allow you to take more risk in your outside retirement accounts, because you are not as dependent on those accounts to supplement a survivor benefit depending on which spouse passes away first.

Age

 The age of you and your spouse can also be a factor. If the spouse with the pension is quite a bit older than the spouse without pension, it may make sense for normal life expectancy reasons, to elect a larger survivor benefit. Visa versa, if the spouse with then pension is much younger, it may warrant a lower survivor benefit elect. But in the end, it all goes full circle back to the income need if the pension payments were to stop, are there enough other assets to supplement income for the surviving spouse?

 Health Considerations / Life Expectancy

 When conducting a pension analysis, we will typically use age 90 as a life expectancy for most clients.  But there are factors that can alter the use of age 90 such as special health considerations and longevity.  If the spouse that has the pension is forced to retire for health reasons, it gives greater weight to electing a pension benefit with a higher survivor benefit.  When a client tells us that their father, mother, and grandmother, all lived past age 93, that can impact the pension decision.  Since people are living longer, it increases the risk of spending through their traditional retirement savings, whereas the pension payments will be there for as long as they live.

Financial Stability Of The Company / Organization

 You are seeing more and more stories about workers that were promised a pension but then their company, union, or not-for-profit goes bankrupt.  This is a real risk that should factor into your pension decision.  While there are government agencies like the PBGC that are there to help backstop these failed pension plans, there have been so many bankrupt pensions over the past two decades that the PBGC fund itself is at risk of running out of assets.   If a retiree is worried about the financial solvency of their employer, it may give greater weight to electing the “Lump Sum Option”, taking your money out of the plan, getting it over to your IRA, and then taking monthly payments from the IRA.   Since this is becoming a greater risk to employees, we created a video dedicated to this topic:  What Happens To Your Pension If The Company Goes Bankrupt?

Tax Strategy

 Tax strategy also comes into play when electing your pension benefit. If we have retirees that have both a pension and retirement accounts outside the pension plan, we have to map out the distribution / tax strategy for the next 10 to 20 years.  Depending on who you worked for and what state you live in, the monthly pension payments may be taxed at the federal level, state level, or both.  Also, many retirees don’t realize that social security will also be considered taxable income in retirement.  Then, if you have pre-tax retirement accounts, at age 72, you have to begin taking Required Minimum Distributions which are taxable. 

There are situations where we will have a retiree forego the monthly pension payment from the pension plan and elect the Lump Sum Benefit option, so they can rollover the full balance to an IRA, and then we have more flexibility as to what their taxable income will be each year to execute a long term tax strategy that can save them thousands and thousands of dollars in taxes over their lifetime.  We may have them process Roth conversions, or realize long term capital gains at a 0% tax rate, neither of which may be available if the pension income is pushing them up into the higher tax brackets.

There are so many other tax strategies, long term care strategies, and wealth accumulation strategies that come into the mix when deciding whether to take the monthly pension payments or the lump sum payment of your pension benefit.

Pension Option Analysis

 These pension decisions are very important because you only get one shot at them.  Once the decision is made you are not allowed to go back and change your mind to a different option.   We run this pension analysis for clients all of the time, so before you make the decision, feel free to reach out to us and we can help you to determine which pension benefit is the right one for you.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Russia & Ukraine: Where Does The Stock Market Go From Here?

Russia’s invasion of Ukraine continues to add uncertainty to global markets. It’s left investors asking the following questions:

• What is the most likely outcome of the invasion?

• How will this impact the U.S. stock market and global economy?

• How high will oil prices go?

• Should the U.S. be worried about a Russia cyberattack?

• What is China’s role in this conflict?

• Will the stock and bond market crash in Russia create a global liquidity event?

• Does this change the Fed’s timeline for interest rate hikes?

• Do we expect a relief rally or the market selloff to continue?

We will provide you with our answers to these questions in this market update.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Buying A Second House In Retirement

More and more retirees are making the decision to keep their primary residence in retirement but also own a second residence, whether that be a lake house, ski lodge, or a condo down south.  Maintaining two houses in retirement requires a lot of additional planning because you need to be able to answer the following questions:

• Do you have enough retirement savings to maintain two houses in retirement?

• Should you purchase the house before you officially retire or after?

• Are you planning on paying for the house in cash or taking a mortgage?

• If you are taking mortgage, where will the down payment come from?

• Will you have the option to claim domicile in another state for tax purposes?

• Should you setup a trust to own your real estate in retirement?

Adequate Retirement Savings   

 The most important question is do you have enough retirement income and assets to support the carrying cost of two houses in retirement?   This requires you to run detailed retirement projection to determine what your total expense will be in retirement including the expenses associates with the second house, and the spending down of your assets over your life expectancy to make sure you do not run out of money.  Here are some of the most common mistakes that we see retirees make:

1. They underestimated the impact of inflation.  The ongoing costs associated with maintaining a house such as property taxes, utilities, association dues, maintenance, homeowners insurance, water bills, etc, tend to go up each year.  While it may look like you can afford both houses now, if those expenses go up by 3% per year, will you have enough income and assets to pay those higher cost in the future?

2.  They forget about taxes.  If you will have to take larger distributions out of your pre-tax retirement accounts to maintain the second house, those larger distributions could push you into a higher tax bracket, cause your Medicare premiums to increase, lose property tax credits, or change the amount of your social security benefits that are taxable income.

3.  A house is an illiquid asset.  When you look at your total net worth, you have to be careful how much of your net worth is tied up in real estate.  Remember, you are retired, you are no longer receiving a paycheck, if the economy hits a big recession, and your retirement accounts take a big hit, you may be forced to sell that second house when everyone else is also trying to sell their house.  It could put you a in a difficult situation if you do not have adequate retirement assets outside of your real estate holdings.

Should You Purchase A Second House Before You Retire?

 Many retirees wrestle with the decision as to whether to purchase their second house before they retire or after they have retired.   There are two primary advantages to purchasing the second house prior to retirement:

1. If you plan on taking a mortgage to buy the second house, it is usually easier to get a mortgage while you are still working.  Banks typically care more about your income than they do about your level of assets. We have seen clients retire, have over $2M in retirement assets, and have difficulties getting a mortgage, due to a lack of income.   

2. There can be large expenses associated with acquiring a new piece of real estate. You move into your second house and you learn that it needs new appliances, a new roof, or you have to buy furniture to fill the house.  We typically encourage our clients to get these big expenses out of the way before their paychecks stop in case they incur larger expenses than anticipated.

Mortgage or No Mortgage?

 The decision of whether or not to take a mortgage on the second house is an important one.  Sometimes it makes sense to take a mortgage and sometimes is doesn’t. Many retirees are hesitant to take a mortgage because they realize having a mortgage in retirement means higher annual expenses. While we generally encourage our client to reduce their debt by as much as possible leading up to retirement, there are situations where taking out a mortgage to buy that second house makes sense.

 But it’s not for the reason that you may think.  It’s not because you may be able to get a mortgage rate of 3% and keep your retirement assets invested with hopes of achieving a return of over 3%.   While many retirees are willing to take on that risk, we remind our clients that you will be retired, therefore there is no more money going into your retirement accounts.  If you are wrong and the value of your retirement accounts drop, now you have less in assets, no more contributions going in, and you have a new mortgage payment. 

In certain situations, it makes sense to take a mortgage for tax purposes.  If most of your retirement saving are in pre-tax sources like Traditional IRA’s or 401(k)’s, you withdrawal a large amount from those accounts in a single year to buy your second house, you may avoid having to take a mortgage, but it may also trigger a huge tax bill.  For example, if you want to purchase a second house in Florida and the purchase price is $300,000.  You take a distribution out of your traditional IRA to purchase the house in full, you will have federal and state income tax on the full $300,000, meaning if you are married filer you may have to withdrawal over $400,000 to get to the $300,000 that you need after tax to purchase the house.  

If you are pre-tax heavy, it may be better to take out a mortgage, withdrawal just the down payment out of your IRA or preferably from an after tax source, and then you can make the mortgage payments with monthly withdrawals out of your IRA account. This spreads the tax liability of the house purchase over multiple years potentially keeping you out of those higher tax brackets.

But outside of optimizing a tax strategy, if you have adequate after-tax resources to purchase the second house in full, more times than not, we will encourage retirees to go that route because we are big fans of lowering your fixed expenses by as much as possible in retirement.

Planning For The Down Payment

 If we meet with someone who plans to purchase a second house in retirement and we know they are going to have to take a mortgage, we have to start planning for the down payment on that house.  Depending on what their retirement picture looks like we may:

• Determine what amount of their cash reserves they could safely commit to the down payment

• Reduce contributions to retirement accounts to accumulate more cash

• If their tax situation allows, take distributions from certain types of accounts prior to retirement

• Weigh the pros and cons of using equity in their primary residence for the down payment

• If they have permanent life insurance policies, discuss pros and cons of taking a loan against the policy

Becoming A Resident of Another State

 If you maintain two separate houses in different states, you may have the opportunity to have your retirement income taxed in the more tax favorable state.  This topic could be an article all in itself, but it’s a tax strategy that should not be overlook because it can have a sizable impact on your retirement projections.  If your primary residence is in New York, which is a very tax heavy state, and you buy a condo in Florida and you are splitting your time between the two houses in retirement, knowing what it requires to claim domicile in Florida could save you a lot of money in state taxes.  To learn more about this I would recommend watching the following two videos that we created specifically on this topic:

 Video 1:  Will Moving From New York to Florida In Retirement Save You Taxes?

Video 2:  How Do I Change My State Residency For Tax Purposes?

 Should A Trust Own Your Second House

 The final topic that we are going to cover are the pros and cons of a trust owning your house in retirement.  For any house that you plan to own during the retirement years, it often makes sense to have the house owned by either a Revocable Trust or Irrevocable Trust.   Trust are not just for the ultra wealthy.  Trust have practical uses for everyday families just as protecting the house from the spend down process triggered by a long term care event or to avoid the house having to go through probate when you or your spouse pass away.  Again, this is a relate topic but one that requires its own video to understand the difference between Revocable Trust and Irrevocable Trusts:

 Video:  Should You Put Your House In A Trust?

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Should You Pay Down Debt or Invest Idle Cash?

When you have a large cash reserve, should you take that opportunity to pay down debt or should you invest it?  The answer is “it depends”.  It depends on: 

• What is the interest rate on your debt?

• What is the funding level of your emergency fund?

• Do you have any big one-time expenses planned within the next 12 months?

• What is the status of your financial goals? (college savings, retirement, house purchase)

• How close are you to retirement?

• What type of economic environment are you in?

• Understanding the debt secret of the super wealthy

All too often, we see people make the mistake of investing money that they should be using to pay down debt, and this statement is coming from an investment advisor.  In this article, I am going to walk you through the conversation that we have with our clients when trying to determine the best use of their idle cash.

What Is The Interest Rate On Your Debt?

 Our first question is typically, what is the current interest rate on your debt?  As you would expect, the higher the interest rate, the higher the payoff priority.  As financial planners, we look at the interest rate on debt as a risk-free rate of return, similar to a return that you might receive on a bank CD or a money market account.  If you have a credit card with a balance of $10,000 and the interest rate is 15%, you are paying that credit card company $1,500 in interest each year.  If you use your $10,000 in idle cash to payoff you credit card balance, you get to keep that $1,500.  We considered it a “risk-free” rate of return because you don’t have to take any risk to obtain it.  By paying off the balance, you are guaranteed to not have to pay the credit card company that $1,500 in interest.

If instead you decided to invest that money, you would have to invest in something that earns over a 15% annual rate of return to be ahead of the game.  To obtain a 15% rate of return is most likely going to involve taking a high level of risk, meaning you could lose some or all of your $10,000 investment so it’s not an apple to apple comparison because the risk level is different.  I will bluntly ask clients: “can you get a bank CD right now that pays you 15%?”  When they say “no way”, then I repeat the guidance to pay down the debt because every dollar that you pay toward the debt is receiving a 15% rate of return which you are not paying to the credit card company.

A Tough Decision

 A 15% interest rate on debt makes the decision pretty easy but what happens when we are talking about a mortgage that carries a 3% interest rate. Clearly a more difficult decision.  Someone who is 40 years old, that has 25 years until retirement might ask, “why would I use my cash to pay down the mortgage with a 3% interest rate when I could be earning 8% per year plus in the stock market over the next 25 years?”  The answer can be found in the rest of the variables below.

Emergency Fund

 When unexpected events happen in life, it is common for those unexpected events to cost money, which is why we encourage our clients to maintain an emergency fund.  Maintaining an adequate cash reserve prevents these unexpected financial events from disrupting your plans for retirement, paying  for college, from having to liquidate investments at an inopportune time in the market, or worse to go into debt to pay those expenses.  While it is painful to see cash sitting there in a savings account earning minimal interest, it serves the purpose of insulting your overall financial plan from setbacks cause by unplanned events which in turn increases your probability of achieving your financial goals over the long term.

What is the right level of cash to fund an emergency fund?  In most cases, we recommend 4 to 5 months of your living expenses.  There is a balance between having adequate cash reserves and holding too much cash.  There is an opportunity cost associated with holding too much cash.  By holding cash earning less than 1% in interest, you may be giving up the opportunity to earn a higher return on that cash, whether that involves investing it or paying down debt with it. 

Here is a common scenario, let’s say someone has $50,000 in cash in their savings account, and 4 months of living expenses is $30,000, that means there is $20,000 in excess cash that could be potentially earning a higher return than it sitting in their bank account.  If they are willing to accept some risk, they may be willing to invest that $20,000 in an attempt to generate a higher return on that idle cash, or the cash may be used to fund a college savings account or retirement account which could carry tax benefits as well as advancing one or more of their personal financial goals. 

But what if you don’t want to take any risk with that additional $20,000?  If you have a mortgage with a 3% interest rate, by applying that $20,000 toward the mortgage, it is technically earning 3% because you are not paying that 3% interest to the bank.   Since the interest rate on the mortgage is probably higher than the interest rate you are receiving in your savings account, that cash is working harder for you, and you have the added benefit of paying off your mortgage sooner.

Big One-Time Expenses

 Once we have determined the appropriate funding level of a client’s emergency fund and there is excess cash over and above that amount, our next question is “do you have any larger one-time expenses that you foresee over the next 12 months?”  For example, you may be planning a kitchen renovation, purchase of a house, or tuition payments for a child.  If you will need that excess cash to meet expenses within the next 12 months, you may want to just hold onto the cash.  If you use the cash to pay down debt, you won’t have the cash to meet those anticipated expenses in the future, or if you invest the cash, and the value of the investment drops, you may not have time to wait for the investment to recover the lost value before you need to liquidate the investment.  

Typically, when we talk about investing, whether it’s in stocks, bonds, mutual funds, or some other type of security, it involves taking more risk than just sitting in cash.  The shorter the timeline on the one-time expense, the more risk you take on by investing the cash.  Historically, riskier asset classes like stocks behave in more consistent patterns over 10+ year time periods, but it’s impossible to predict how a specific stock or even a bond mutual fund will perform over a specific 3 month period.

Now, if interest rates ever get higher again, and you can find a 6 month or 1 year CD, or money market that pays a decent interest rate, then you may consider allocating some of that short term excess to work in a guaranteed security.  Be careful of products liked fixed annuities, even through they may carry an attractive guaranteed interest rate, many annuities have surrender fees if you cash in the annuity prior to a specified number of years.

Status Of Your Various Financial Goals

 Our next series of question revolves around assessing the status of a client’s various financial goals:

• When do you plan to retire? Are your retirement savings adequate?

• Do you have children that will be attending college? Have you started college savings accounts?

• You just bought a house. Do you have an adequate amount of term life insurance?

• Do you expect to be in a higher tax bracket this year? We may need to find ways to reduce your taxes.

• Do you have estate documents in place like wills, health proxies, and a power of attorney?

• What are your various financial goals over the next 10 years?

If we find that there is a shortfall in one of these areas, we may advise clients to use their excess cash to shore up a weakness in their overall financial picture. For example, if we meet with a client that has 3 children, ages 8, 5, and 3, and we ask them if they plan to help their children to pay for college, and they say “yes” but they have not yet determined how much financial aid they may receive, how much college is going to cost, and the best type of account to save money in to meet that goal, we will probably run projections for them, discuss how 529 accounts work, and potentially allocate some of their excess cash to fund those accounts.

How Close Are You To Retirement?

 One factor that normally weighs heavily on our guidance as to whether someone should use excess cash to pay down debt or invest it is how close they are to retirement.   Regardless of the market environment that we are in, we typically encourage our clients to reduce their fixed expenses as much as possible leading up to retirement.  But when the stock market is going up by 10%+ and someone has $50,000 left on a mortgage with a 3% interest rate, they will ask me, why would I use my excess cash to pay down debt with a 3% interest rate when I’m earning a lot more keeping it invested in the market?

My response.  I have been doing retirement projections for a very long time and when we do these projections, we are making assumptions about:

• Annual rates of return on your investments

• Inflation rates

• Tax rates in the future

• The fate of a broken social security system

• How long you are going to live?

• Probability of a long-term care event

These assumptions are estimated guesses based on historical data but who’s to say they are going to be right.  In retirement you don’t have control over the stock market, inflation, or unexpected health events.  The only thing you have full control over in retirement is how much you spend.  The lower your annual expenses are, the more flexibility you will have within your plan, should one or more of the assumptions in your plan fall short of expectations.  There will always be recessions but recessions are a lot more scary when you are retired and drawing money out of your retirement account, while at the same time your accounts may be losing value due to a drop in the stock or bond market.  If you have lower expenses, it may allow you to reduce the distributions from your retirement accounts while you are waiting for the market to recover, which could greatly reduce the risk of running out of assets in retirement.  

Type of Market Environment

 While no one has a crystal ball, there are definitely market environments that we as investment advisors view as more risky than others.  When economic data is providing us with mixed signals, there are geopolitical events unfolding that we have no way of predicting the outcome, or we are navigating through a challenging economic environment, it increases the risk level of investing excess cash in an effort to generate a return greater than the interest rate that someone may be paying on an outstanding debt.   We definitely take that into account when advising clients whether to invest their cash or to use it to pay down debt.

 The Debt Secret of The Super Wealthy

 I have recognized a trend as it pertains to high net worth individual and how they invest, which is a concept that can be applied at any level of wealth.   Having less debt, can provide individuals with the opportunity to take greater risk, which in turn can lead to a faster and greater accumulation of wealth.

If someone has no debt and they have $90,000 in cash to invest, because they have no debt, they may not need any of that cash to meet their future expense.  Assuming they have a high tolerance for risk, they may choose to invest in 3 start-up companies, $30,000 each.   Since investing in start-ups is known to be very risky, all three companies could go bankrupt.  If 2 companies go bust, but the third company gets acquired by a public company that results in a 10x return on the investment, that $30,000 initial investment grows to $300,000, which subsidizes the losses from the other 2 companies, and still generates a giant return for the investor.   

Someone with debt and corresponding higher fixed expenses to service the debt, may find it difficult and even unwise to enter into a similar investment strategy, because if they lose all or a portion of their $90,000 initial investment, it could upend their entire financial picture.

Just an additional note, investors that are successful with these higher risk strategies do not blindly throw money around at high risk investments.  They do their homework but having no debt provides them with the opportunity to adopt investment strategies that may be out of reach of the average investor. 

In summary, there are situation where it will make sense to invest idle cash in lieu if paying down debt but there are also situations that may not be as obvious, where it makes to pay down debt instead of investing the idle cash.  Before just playing the interest rate game, it’s important to weigh all of these factors before making the decision as to the best use of your idle cash.  

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How To Pay 0% Tax On Capital Gains Income

When you sell a stock, mutual fund, investment property, or a business, if you have made money on that investment, the IRS is kindly waiting for a piece of that gain in the form of capital gains tax.  Capital gains are taxed differently than the ordinary income that you received via your paycheck or pass-through income from your business.   Unlike ordinary income, which has a series of tax brackets that range from 10% to 37% in 2022, capital gains income is taxed at a flat rate at the federal level.   Most taxpayers are aware of the 15% long term capital gains tax rate but very few know about the 0% capital gains tax rate and how to properly time the sale of your invest to escape having to pay tax on the gain. 

Short-term vs Long-Term Gains

Before I get into this tax strategy, you first have to understand the difference between “short-term” and “long-term” capital gains.  Short-term capital gains apply to any investment that you bought and sold in less than a 12 month period.  Example, if I buy a stock today for $1,000 and I sell it three months later for $3,000, I would have a $2,000 short-term capital gain.  Short-term capital gains are taxed as ordinary income like your paycheck. There is no special tax treatment for short-term capital gains and the 0% tax strategy does not apply.

Long-term capital gains on the other hand are for investments that you bought and then sold more than 12 months later.  When I say “investments” I’m using that in broad terms. It could be a business, investment property, stock, etc.   When you sell these investments at a gain and you have satisfied the 1 year holding period, you receive the benefit of paying tax on the gain at the preferential “long-term capital gains rate”.

What Are The Long Term Capital Gains Rates?

For federal tax purposes, there are 3 long term capital gains rates:  0%, 15%, and 20%.  What rate you pay is determined by your filing status and your level of taxable income in the year that you sold the investment subject to the long term capital gains tax. For 2022, below are the capital gains brackets for single filers and joint filers.

As you will see on the chart, if you are a single filer and your taxable income is below $41,675 or a joint filer with taxable income below $83,350, all or a portion of your long term capital gains income may qualify for the federal 0% capital gains rate.

An important note about state taxes on capital gains income is that each state has a different way of handling capital gains income. New York state is a “no mercy state” meaning they do not offer a special tax rate for long term capital gains. For NYS income tax purposes, your long term capital gains are taxed as ordinary income.  But let’s continue our story with the fed tax rules which are typically the lion share of the tax liability.

In a straight forward example, assume you live in New York, you are married, and your total taxable income for the year is $50,000.  If you realize $25,000 in long term capital gains, you will not pay any federal tax on the $25,000 in capital gain income but you will have to pay NYS income tax on the $25,000.

Don’t Stop Reading This Article If Your Taxable Income Is Above The Thresholds

For many taxpayers, their income is well above these income thresholds.  But I have good news, with some maneuvering, there are legit strategies that may allow you to take advantage of the 0% long term capital gains tax rate even if your taxable income is above the $41,675 single filer and $83,350 joint filer thresholds.  I will include multiple examples below as to how our high net worth clients are able to access the 0% long term capital gains rate but I first have to build the foundation as to how it all works. 

Using 401(k) Contributions To Lower Your Taxable Income

In years that you will have long term capital gains, there are strategies that you can use to reduce your taxable income to get under the 0% thresholds.  Here is an example, I had a client sell a rental property this year and the sale triggered a long term capital gain for $40,000.  They were married and had a combined income of $110,000.  If they did nothing, at the federal level they would just have to pay the 15% long term capital gains tax which results in a $6,000 tax liability.  Instead, we implemented the following strategy to move the $40,000 of capital gains into the 0% tax rate.

Once they received the sale proceeds from the house, we had them deposit that money to their checking account, and then go to their employer and instruct them to max out their 401(k) pre-tax contributions for the remainder of the year.  Since they were both over 50, they were each able to defer $27,000 (total of $54,000). They used the proceeds from the house sale to supplement the income that they were losing in their paychecks due to the higher pre-tax 401(k) deferrals.  Not only did they reduce their taxable income for the year by $54,000, saving a bunch in taxes, but they also were able to move the full $40,000 in long term capital gain income into the 0% tax bracket.  Here’s how the numbers work:

Adjusted Gross Income (AGI):      $110,000

Pre-tax 401(k) Contributions:         ($54,000)

Less Standard Deduction:              ($25,900)

Total Taxable Income:                     $30,100

In their case, they would be able to realize $53,250 in long term capital gains before they would have to start paying the 15% fed tax on that income ($83,350 – $30,100 = $53,250). Since they were below that threshold, they paid no federal income tax on the $40,000 saving them $6,000 in fed taxes.

“Filling The Bracket”

The strategy that I just described is called “filling the bracket”.  We find ways to reduce an individuals taxable income in the year that long term capital gains are realized to “fill up” as much of that 0% long-term capital gains tax rate that we can before it spills over into the 15% long-term capital gains rate.

More good news, it’s not an “all or none” calculation.  If you are married, have $60,000 in taxable income, and $100,000 in long term capital gains, a portion of your $100,000 in capital gains will be taxed at the 0% rate with the majority taxed at the 15% tax rate.  As you might have guessed the IRS is not going to let you get away with paying 0% on a $100,000 in long term capital gains because you maneuvered your taxable income into the 0% cap gain range. But in this case, $23,350 would be taxed at the 0% long term cap gain rate, and the reminder would be taxed at the 15% long term cap gain rate.

Do Capital Gains Bump Your Ordinary Income Into A Higher Bracket?

When explaining this “filling up the bracket” strategy to clients, the most common question I get is: “If long term capital gains count as taxable income, does that push my ordinary income into a higher tax bracket?”   The answer is “no”.  In the eyes of the IRS, capital gains income is determined to be earned “after” all of your other income sources.

In an extreme example, let’s say you have $70,000 in ordinary income and $200,000 in capital gains. If your total ordinary income was $70,000 and you file a joint tax return, your top fed tax bracket in 2022 would be 12%.  However, if the IRS decided to look at the $200,000 in capital gain income first and then put your ordinary income on top of that, your top federal tax bracket would now be 24%.  That would hurt tax wise. Luckily, it does not work that way.  Even if you realized $1M in long term capital gains, the $70,000 in ordinary income would be taxed at the same lower tax brackets since it was earned first in the eyes of the IRS.

Work With Your Accountant

Before I get into the more advanced strategies for how this filling up the brackets strategy is used, I cannot stress enough the importance of working with your tax advisor when executing these more complex tax strategies.  The tax system is complex and making a shift in one area could hurt you in another area.

Even though these strategies may lower the federal tax rate on your long-term capital gain income, capital gains will increase your AGI (adjusted gross income) for the year which could phase you out of certain deductions, tax credits, increase your Medicare premiums, reduce college financial aid, etc. Your accountant should be able to run tax projections for you in their software to play with the numbers to determine the ideal amount of long-term capital gains that can be realized in a given year without hurting the other aspects of your financial picture.

Strategy #1:  I’m Retiring

When people retire, in many cases, their taxable income drops because they no longer have their paycheck and they are typically supplementing their income with social security and distributions from their investment accounts.  This creates a tax planning opportunity because these taxpayers sometimes find themselves in the lowest tax bracket that they have been in over the past 30+ years.  Here are some of the common examples.

Example 1: The First Year Of Retirement

If you retire at the beginning of the calendar year, you may only have had a few months of paychecks, so your income may be lower in that year.  If you have built up cash in your savings account or if you have an after tax investment account that you can use to supplement your income for the remainder of the year to meet your expenses, this may create the opportunity to “fill up the bracket” and realize some long-term capital gains at a 0% federal tax rate in that year.

Example 2:  Lower Expenses In Retirement

We have had clients that were making $150,000 per year and then when they retire they only need $40,000 per year to live off of.  When you retire, the kids are typically through college, the mortgage is paid off, and your expenses drop so you need less income to supplement those expenses.   A portion of your social security will most likely be counted as taxable income but if you do not have a pension, you may have some wiggle room to realize a portion of your long-term capital gains as a 0% rate each year.

Assume this is a single filer. Here is how the numbers would work:

Social Security & IRA Taxable Income:     $40,000

Less Standard Deduction:                          ($12,000)

Total Taxable Income:                                $28,000

This individual would be able to realize $13,675 in long term capital gains each year at the 0% fed tax tax because the threshold is $41,675 and they are only showing $28,000 in taxable income.  Saving $2,051 in fed taxes.

Strategy #2:  Business Owner Experiences A Low Income Year

If you have been running a business for 5+ years, you have probably been through those one or two tough years where either revenue drops dramatically or the business incurs a lot of expenses in a single year, lowering your net profits.  Do not let these low taxable income years go to waste.  If you typically make $250,000+ per year and you have one of these low income years, start planning as soon as possible because once you cross that December 31st threshold, you have wasted a tax planning opportunity.  If you are showing no income for that year, you may want to talk to your accountant about realizing some long term capital gains in your brokerage account to realize those gains at a 0% tax rate.  Or you may want to consider processing a Roth conversion in that low tax year. There are a number of tax strategies that will allow you to make the most of that “bad year” income wise. 

Strategy #3: Leverage Cash Reserves and Brokerage Accounts

If you have been building up cash reserves or you have a brokerage account that you could sell some holdings without incurring big taxable gains, you may be able to use that as your income source for the year which could result in little to no taxable income showing for that tax year.  We have seen both retirees and business owners use this strategy.

Business owners have control over when expenses will be realized which influences how much taxable income is being passed through to the business owner.  If you can overload expenses into a single tax year instead of splitting it evenly between two separate tax years, that could create some tax planning opportunities.

Strategy #4: Moving To Another State

It’s common for individuals to move to more tax friendly states in retirement. If you live in a state now, like New York, that makes you pay tax on long term capital gain income, and you plan to move to Florida next year and change your state of domicile, you may want to wait to realize your capital gains until you are resident of Florida to avoid having to pay state tax on that income. This has nothing to do with the 0% Fed tax strategy but it might reduce your state income tax bill on those capital gains.

Bottom Line

There are few strategies that allow you to pay 0% in federal taxes on any type of gain.  If you are a high income earner, this strategy may not work for you every year but there may be opportunities to use them at some point if income drops or when you enter the retirement years.  Again, don’t let those lower income years go to waste. Work with your accountant and determine if “filling the bracket” is the right move for you. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Will The January Market Selloff Continue?

The markets have experienced an intense selloff in the first three weeks of 2022. As of January 21st, the S&P 500 Index is down over 7% for the month.  There are only a few times in the past 10 years that the index has dropped by more the 5% in a single month.  That begs the questions, “After those big monthly declines, historically, what happens next?” Continued decline? Market recovery?  We are going to answer that question in this article

 The recent selloff has also been widespread.  The selloff in January has negatively impacted stocks, bonds, crypto, while inflation continues to erode the value of cash.   It has essentially created a nowhere to hide market environment.  As of January 21, 2022, the YTD returns of the major indices are:

 S&P 500 Index: -7.7%

Nasdaq:                -12.0%

Small Cap 600:   -8.5%

Agg (Bonds):      -1.7%

Bitcoin:                 -24.1% 

In this article I’m going to cover:

• What has caused the selloff?

• Do we expect the selloff to continue?

This Has Happened Before

How many times has the S&P 500 index dropped by more than 5% in a month over the past 10 years?

 Answer:  4 times

 February 2020: -18.92%

November 2018:  -5.56%

December 2015:  -6.42%

July 2011: -10.40%

Next question: How many times did the S&P 500 Index post a positive return 3 months following the month with the 5%+ loss?

 Answer: ALL OF THEM

 Mar 2020 – May 2020:     16.7%

Dec 2018 – Feb 2019:    9.5%

Jan 2016 – Mar 2016:          8.6%

Aug 2011 – Oct 2011:         4.0%

Don’t Make The Jump In / Jump Out Mistake

There is no doubt that the big, swift downturns in the markets bring fear, uncertainty, and stress for investors but all too often investors let their emotions get the better of them and the lose sight of the biggest economic trends that are at work.  The most common phrase that I hear from investors during these steep declines is:

“Maybe we should just go to cash to stop the losses and then we can buy back into the stock market once the risks have passed.”

The issue becomes: when do you get back in?  Following these big temporary sells offs in the market, it is common that the lion share of the gains happened before things feel good again.  Investors get back in after the market has already rallied back, meaning they solidified their losses and they are now allocating money back into stocks when they have returned to higher levels.   

We accurately forecasted higher levels of volatility in the market in 2022 when we release our 2022 Market Outlook video.   It is also our expectation that with inflation rising and the Fed moving interest rates higher, the selloff that we have experienced in January, will not be the only steep selloff that we are faced with this year.  Before we get into the longer- term picture, let’s first look at what prompted the January selloff in the markets.

What Caused The Market Selloff in January?

There are a number of factors that we believe has caused this severe selloff in January:

 COVID Omicron cases have surged

• The Fed’s more hawkish tone

• Rising interest rates

• Tech sector selloff

• COVID investment plays unwinding

• Loss of enhanced child tax credit monthly payments

While that looks like a long list, at the risking sounding like a broken record, if you go back to the Market Outlook video that we released in December, all of these were expected.  It’s only when unexpected events occur that we then have to shift our strategy for the entire year.  Let’s look at each of these items one by one:

COVID Cases Have Peaked

One thing that caught the market by surprise over the past few months is how contagious the Omicron variant was and how many cases there would be. This caused the recovery story to stall as safety measures were put back into place to control the spread of the most recent variant.  The good news is it looks like the cases have peaked and are now on the decline. See the chart below:

It's a little tough to see in the chart but the blue line represents the number of confirmed COVID cases. If you look all the way on the righthand side, as of January 20th, they have dropped dramatically. The 7-day moving average has dropped by about 100,000 cases.   This trend supports our forecast that the economy will begin opening up again starting in February.  We expect the reopening trade story to be part of the market rally coming off of this tough January for the markets.

The Fed’s Hawkish Tone

It's the Fed’s job to keep inflation under control so the economy does not overheat.  Inflation has been running at rate of over 6% for the past several months and going into 2022, the Fed telegraphed making 3 rate hikes in 2022.  After the Fed’s January meeting, an even more hawkish tone was found in those meeting minutes, suggesting that more than 3 rate hikes could be on the table this year.  This caused interest rates to rise rapidly which hurt both stocks and bonds in January. 

 But let’s take a look at history. The last time the Fed started raising rates was in 2016.  Between 2016 and 2018, they hiked the Fed Funds Rate 8 times. During that two-year period, the S&P 500 was up 15.8%.  The lesson here is just because the Fed is beginning to raise rates does not necessarily mark the end of the bull market rally. 

Rising Interest Rates

Interest rates rose sharply in January which put downward pressure on both stocks and bonds.  Investor often have bonds in their portfolio to offer protection when the there are selloffs in the stock market but when interest rates are moving high and the stock market is selling off at the same time, both stocks and bonds tend to move lower together.  The yield on the 10 Year Treasury jumped from 1.51% on December 31, 2021 to 1.86% on January 18, 2022. That does not sound like a big increase but in terms of interest rates that is a huge move in 18 days. (In percentage terms, over 23%) 

 We do expect interest to continue to rise in 2022 but not at the concentrated monthly pace that we saw in January. 

Tech Stock Drop

Tech stock took a big hit in January. The Nasdaq is down 12% in the first three weeks of 2022.  In the 2022 Market Outlook we talked about tech stock coming under pressure this year in the face of rising interest rate and a lesson from the 1970’s about the “Nifty Fifty”.    These tech stocks tend to trade at higher valuations. Interest rates and valuation levels tend to have an inverse relationship meaning if a stock is trading at a higher valuation level (P/E), they tend to be more adversely affected compared to the rest of the market when interest rates move higher.

COVID Investment Plays Unwind              

In January, stocks that were considered “stay at home” COVID plays, like streaming, home exercise equipment, and electronic document providers experience large corrections.  Here are some of the names that fall into that space and their performance YTD as of January 21, 2022:

Netlfix:                 -33%

Peloton:               -23%

DocuSign:            -23%

Now that the United States has reached a level of vaccinations and positive COVID cases that would suggest that we are at or close to herd immunity, there seems to be a higher likelihood that future COVID variants may not cause extreme economic shutdowns that supported the higher valuation level of these “stay at home” investment strategies.

Loss of Child Tax Credit Payments

Since the Build Back Better bill did not pass in December 2021, the $300+ per month that many parents were receiving for the Enhanced Child Tax Credits stopped in January.  While those monthly payments to families were only meant to be temporary, it was highly anticipated that they were going to be extended into 2022 with the passing of the Build Back Better bill.   Not having that extra money every month could slow down consumer spending in the first quarter of 2022.

Do We Expect The Selloff To Continue?

No one has a crystal ball but I would be very surprised if we do not see a recovery rally in the markets over the next few months.  I think people underestimate the amount of money that has been injected into the U.S. economy over the past 18 months.  If you total up all of the COVID stimulus packages over the past 18 months, they total $6.9 Trillion dollars. Compare that to the TARP Stimulus package that saved the banks and housing market in the 2008/2009 recession which only totaled $700 Billion.  A lot of that stimulus money has yet to be spent due to supply change and labor constraints over the past year.

 It's our expectations that the supply chain, which is already showing improvement, will continue to heal as we move further into 2022, which will give rise to higher levels of consumer spending and in turn, higher corporate earnings.  

 Inflation will be the greatest risk to the economy in 2022, but if the recovery of the supply chain causes prices to stabilize and consumers have the cash and wages to pay these temporarily higher prices, the bull rally could continue in 2022.  But again, it will be choppy.  The market could experience numerous corrections similar to what we are experiencing in January that investors may have to hold through, especially as the Fed begins to announce interest rate hikes later this year.  We expect patience to be rewarded in 2022.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.